Quote of the Day: Manipulation of Interest Rates Sow Seeds to Crisis

Because the interest rate is the price of money, manipulation of interest rates has the same effect in the market for loanable funds as price controls have in markets for goods and services. Since demand for funds has increased, but the supply is not being increased, the only way to match the shortfall is to continue to create new credit. But this process cannot continue indefinitely. At some point the capital projects funded by the new credit are completed. Houses must be sold, mines must begin to produce ore, factories must begin to operate and produce consumer goods.

But because consumption patterns have either remained unchanged or have become more present-oriented, by the time these new capital projects are finished and begin to produce, the producers find no market for their goods. Because the coordination between savings and consumption was severed through the artificial lowering of the interest rate, both savers and borrowers have been signaled into unsustainable patterns of economic activity. Resources that would have been used in productive endeavors under a regime of market-determined interest rates are instead shuttled into endeavors that only after the fact are determined to be unprofitable.  In order to return to a functioning economy, those resources which have been malinvested need to be liquidated and shifted into sectors in which they can be put to productive use. 

Another effect of the injections of credit into the system is that prices rise.  More money chasing the same amount of goods results in a rise in prices.  Wall Street and the banking system gain the use of the new credit before prices rise.  Main Street, however, sees the prices rise before they are able to take advantage of the newly-created credit. The purchasing power of the dollar is eroded and the standard of living of the American people drops.

We live today not in a free market economic system but in a "mixed economy", marked by an uneasy mixture of corporatism; vestiges of free market capitalism; and outright central planning in some sectors.  Each infusion of credit by the Fed distorts the structure of the economy, damages the important role that interest rates play in the market, and erodes the purchasing power of the dollar.  Fed policymakers view themselves as wise gurus managing the economy, yet every action they take results in economic distortion and devastation.

Unless Congress gets serious about reining in the Federal Reserve and putting an end to its manipulation, the economic distortions the Fed has caused will not be liquidated; they will become more entrenched, keeping true economic recovery out of our grasp and sowing the seeds for future crisis.

This is from US Congressman Ron Paul

Global Central Banks Ease the Most Since 2009

Here is what I wrote last night

Yet what sets the today’s markets apart from the 2008, Japan’s stagnation and or the Great Depression has been the central bank activism which as I have been reiterating has been navigating on uncharted treacherous waters.

Artificially manipulated interest rate together with money printing results to relative pricing of assets, which all comprises the inflation cycle.

For a little validation of my observations, here’s the latest Bloomberg article with the particulars, (bold emphasis mine)

Central banks across five continents are undertaking the broadest reduction in borrowing costs since 2009 to avert a global economic slump stemming from Europe’s sovereign-debt turmoil.

The U.S., the U.K. and nine other nations, along with the European Central Bank, have bolstered monetary stimulus in the past three months. Six more countries, including Mexico and Sweden, probably will cut benchmark interest rates by the end of March, JPMorgan Chase & Co. forecasts.

With national leaders unable to increase spending or cut taxes, policy makers including Australia’s Glenn Stevens and Israel’s Stanley Fischer are seeking to cushion their economies from Europe’s crisis and U.S. unemployment stuck near 9 percent. Brazil and India are among countries where easing or forgoing higher interest rates runs the risk of exacerbating inflation already higher than desired levels.

“We’ve seen central banks that were hawkish begin to turn dovish” against a “backdrop of austerity” in fiscal policy, said Eric Stein, who co-manages the $6.6 billion Eaton Vance Global Macro Absolute Return Fund in Boston. “You could debate how bad it will be for growth, but it can’t be good,” he said of the challenges facing the world economy.

Global Rate

Monetary easing will push the average worldwide central bank interest rate, weighted for gross domestic product, to 1.79 percent by next June from 2.16 percent in September, the largest drop in two years, according to data and projections from JPMorgan, which tracks 31 central banks. The number of those banks loosening credit is the most since the third quarter of 2009, when 15 institutions cut rates, the data show…

While central banks in Australia and Indonesia have reduced borrowing costs and the Bank of Japan increased asset purchases in October, other countries in Asia may be slower to ease policy.

The People’s Bank of China has raised its main interest rate three times this year to fight inflation. India’s central bank lifted rates on Oct. 25 by a quarter of a percentage point, while signaling it was nearing the end of its record cycle of increases as the economy cooled.

“Most central banks will wait and see how the situation develops in Europe,” said Joseph Tan, Singapore-based chief economist for Asia at Credit Suisse Group AG’s private-banking division. “If we do have a continuation of the political impasse in Europe and that leads to a recession in Europe, and the U.S. economy starts to slow again, then Asian central banks will cut interest rates.”…

Europe’s turmoil has led Australia, Brazil, Denmark, Romania, Serbia, Israel, Indonesia, Georgia and Pakistan to reduce interest rates since late August. Chile, Mexico, Norway, Peru, Poland and Sweden are also forecast by JPMorgan Chase to lower borrowing costs by the end of the first quarter, while Australia, Brazil, Indonesia, Israel and Romania may cut rates further.

In the U.S., Federal Reserve Chairman Ben S. Bernanke is considering further actions to lower borrowing costs in the world’s biggest economy. He vowed in August to keep the benchmark interest rate close to zero through at least mid-2013. The central bank in September decided to replace $400 billion of short-term securities it holds with longer-term debt to reduce rates on extended-maturity debt.

The article doesn't say it but global central bank asset purchases have been unprecedented, although in terms of interest rate rates--yes, they are 2009 lows.

Yet given the above, there will be NO deflation coming as central banks continue to aggressively ease. I even expect more coming from the ECB

On the other hand, prepare for a boom bust cycle in parts of the global economy and nasty inflation ahead.

Correlation isn’t Causation: Commodity Prices and Interest Rates

Correlations interpreted as causation.

This represents one of the most dangerous premises in making predictions.

An article in the Bloomberg suggests that the low interest rate environment may continue to fuel a rally in commodity prices.

From Bloomberg,

Commodities will resume a rally after their worst month in a year as the Federal Reserve keeps its benchmark interest rate at a record low following the end of a $600 billion asset-purchase program, said HSBC Holdings Plc.

The Standard & Poor’s GSCI Total Return Index of 24 commodities tumbled 6.9 percent last month, the first loss since August and the biggest drop in a year on concern growth may slow. The gauge rose 16 percent this year through April after rising 9 percent in 2010 and 13 percent in 2009 as output trailed demand.

Fed Chairman Ben S. Bernanke has indicated the bank won’t remove stimulus immediately after the second round of so-called quantitative easing concludes this month. The central bank will hold its policy rate in a range of zero to 0.25 percent until the year-end, a Bloomberg survey of 72 economists showed.

The CHART OF THE DAY tracks the S&P GSCI Total Return Index and the Federal Reserve’s target rates in the past three decades. Commodities typically move counter to borrowing costs and the GSCI index has advanced 33 percent since the end of December 2008, the month the Fed cut its benchmark rate amid recession.

Though I would agree that commodity prices could rally, partly coincidental to an artificially suppressed interest rates climate over the interim, I’d say that such correlation does not always hold.

Again reference point matters.

The framing of the Bloomberg chart begins in the 1980s and spans through 2010. This is the epoch of globalization.

However, prior to 80s, as the above chart from economagic.com shows, the correlation was much about rising commodity prices (CRB-Reuters-blue) along with rising interest rates (Fed Funds rate-red, 10 year Treasury yield-green), i.e. 1960s until 1980.

That’s because this era marked the ‘guns and butter’ policies of the US (Vietnam War and entitlement programs as Medicare and easy money policies of the US Federal Reserve).

In other words, this period characterized the economic environment known as stagflation (high inflation, high unemployment-which wasn’t incorporated in the traditional Keynesian model).

Bottom line: Correlations of variables highly depends on the underlying forces which drives them. Occasionally, some correlations reflect on the causal nexus, but for most instances they don't.

In my view, the current level of interest rates reflects on the du jour actions of monetary policies. And this seemingly benign trend may radically change, which subsequently, could upset the balance of the low interest rate-high commodity price correlation premise.

China’s Attempt To Quash Its Homegrown Bubble

``Indeed, there are two potential scenarios for EM stock prices: either a full-fledged mania will develop with multiples continuing to expand, or, a setback/period of indigestion will occur before a new upleg develops. Currently, the odds of a mania-type pattern developing in emerging markets are not significant. If a mania were to develop, Chinese stocks would be at the epicenter because China has the fastest growth rate”-BCA Research, Emerging Markets Appear To Be Fully Priced

China seems bowing to international pressure.

Since she has been accused of fostering or blowing bubbles, where even popular fund manager James Chanos has openly declared shorting China which became a recent controversy in his debate with Jim Rogers [see Jim Chanos Goes From Micro To Macro With Bet Against China], over the past 3 weeks, China has responded by engaging in a series of implied tightening measures, i.e. by allowing T-Bill rates to increase, by raising bank reserves, and last week by verbally arm twisting her banks to curtail credit expansion. It’s almost like one intervention per week.

And when government intervenes in the marketplace we expect the impact in the direction of the planned intervention to manifest itself over the short term. And that’s the reason why China’s markets have underperformed the G-7 and its emerging market peers.

However, in my view, the argument over bubbles seems grossly misunderstood. A Bubble is essentially a cyclical process, where government interventions in the economy, primarily via interest rate manipulations and compounded by other regulations, lead to massive distortions in the patterns of production and capital allocation, which eventually results to relative overinvestments [as discussed in What’s The Yield Curve Saying About Asia And The Bubble Cycle?].

In short, such process is exhibited through phases. And one of the symptoms is that suppressed interest rates with the accompanying credit expansion make long term investments appealing.

And we seem to be getting anecdotal evidences from these;

From Edmund Harriss of Guinness Atkinson, ``Economic growth of near 10% in the past year has been fuelled by domestic growth, almost all in­vestment, on the back of huge injections of liquidity and increased debt. Over $1 trillion of new credit has been extended and while we can see that the bulk is intended for medium- and long-term investment rather than short-term there is no doubt that money has found its way into the stock and real-estate markets. The appearance of state companies at land auctions (those who have had no prior interest in buying land) is significant. This has contributed to soaring land prices and helped a recent land sale in Guangzhou to achieve a record price of $852 per square meter ($78 per square foot), some 54% above the offer price.”

From Robert J. Horrocks, PhD and Andrew Foster of Matthews Asia, ``Nevertheless, it is prudent to be cautious about bank lending—not because we fear an unmanageable amount of nonperforming loans for the economy, but because Chinese banks generally made 3-year loans for projects with decade-long payoff periods (i.e., loans that were not appropriately matched to cash flows). Banks may have lent on the assumption of local government backing, which ultimately may not be provided.”

The other symptom is that increased money supply fosters rising prices in the economic system which leads to pressures to raise interest rates (see figure 4)

Figure 4: Danske Bank: China’s Rising Inflation

As you can see, while China has indeed been exhibiting symptoms of a formative bubble, as manifested above via investments in long term projects, aside from sporadic signs of frothy prices and emergent inflation, there seems to be less convincing evidences yet [see China And The Bubble Cycle In Pictures] that she has transitioned into the culmination stage or the manic phase -where bubbles have reached its maximum point of elasticity which is usually in response to the rollback of easy money policies by the government.

Besides, manic phases usually don’t draw in many and vocal skeptics. Instead the public will most likely be talking of a NEW PARADIGM. In other words, a manic phase would translate to a capitulation of pessimists, cynics and skeptics.

Hence, credit expansion is a necessary but not a sufficient condition for a bubble ripe for implosion. The other necessary ingredients to complete the recipe would be an asset price melt-up (intensive overvaluations) backed by euphoric public (hallucinatory bullish sentiment).

In addition, China seems reluctant to directly raise interest rates.

That’s because we think that policy arbitrage could work to induce the aggravation of China’s bubble cycle despite her rigid capital regulatory regime. And so far these have been manifested by the waves of capital flows into her system-indirectly or via unregulated channels. (see figure 5)

Figure 5: Danske Bank: China’s Staggering Hot Money Flows

China’s reserve accumulation has been a product of direct and indirect foreign money flows into the system (left window) which is likewise manifested through record accumulation of reserves (right window).

According to Danske’ Flemming J. Nielsen, ``We see no signs that China’s reserve accumulation is easing in today’s data and it appears that speculative hot money inflows has become a major policy challenge for China. Firstly, Peoples Bank of China (PBoC) will be struggling to neutralize the liquidity impact from its massive purchase of foreign exchange. This might be one reason for PBoC raising its reserve requirement for banks earlier in the week. Secondly it underlines that despite China’s capital controls, capital flows has become more important and it has become more difficult for China to maintain an independent monetary policy, while simultaneously maintaining a quasi peg to USD.” (all bold highlights mine)

And it is also one reason why the Chinese government has utilized unorthodox means of curbing the credit process through “verbal persuasion” over her banking sector.

So yes, over the interim perhaps we should expect the Chinese government to constantly apply further pressure on its system in an attempt to wring out hot money and reduce credit expansion to avert a full blown bubble from developing. And this could equally translate to possible weakness in China’s stock markets over the interim, as the market adjusts to the conditions of repeated interventions of the Chinese government.

But no, if her asset markets begin to recover even amidst these attempts or if markets start to disregard such policies then watch out, the asset melt up phase could commence.

And as we earlier described in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff, the more China tightens via the interest rate tool, the bigger the odds for a melt up as the spread of interest rates between China and G-7 economies widens. This would emanate from policy divergences- a tightening China, while the US, UK, Japan and EU remain loose-which becomes the fodder to the next bubble in motion.

Vietnam’s Inflation Control Measures And The Japanese Yen’s Record High

``If most of us remain ignorant of ourselves, it is because self-knowledge is painful and we prefer the pleasures of illusion.” Aldous Huxley

There are other issues that appear to have been eclipsed by the Dubai Debt Crisis.

Vietnam’s Inflation Control Measures

First, Vietnam announced a sharp hike in its interest rate to allegedly combat inflation. According to Finance Asia, ``The State Bank of Vietnam will increase its benchmark interest rate to 8% from 7% as of December 1”

In addition, Vietnam likewise devalued its currency the Dong by 5.2%. According anew to Finance Asia, [bold emphasis mine] ``The State Bank of Vietnam also reset the US dollar reference rate to 17,961 dong from its current level of 17,034 dong, in its third devaluation of the currency in two years. The central bank will also narrow the trading band of the dollar against the dong to 3% from 5%.

``This is an effort not only to bring confidence to the currency, but also to correct the difference versus where the dong is trading on the black market, which has been at about 19,700 per US dollar in recent weeks.”

Figure 6: Wall Street Journal: Vietnam’s Devaluation

In other words, currency controls have widened the spread between the black market rate of the Vietnam Dong relative to the US dollar and the official devaluation merely is an attempt to close the chasm. The Vietnamese economy has been suffering from a huge current account deficit to the tune of almost 8% of its GDP.

However, in spite of the fresh monetary actions (see figure 6) the black market rate for the Dong and the official rate remain far apart.

And because of the spike in interest rates, the Vietnam equity benchmark fell by 11.73% over the week.

However, a curious and notable observation is that Vietnam’s present policies seems like responding to a market symptom which can be characterized as our Mises Moment,

This from Thanhnien.com, ``Vietnamese lenders are facing a shortage of funds to meet rising demand for loans because gains in gold and the dollar are deterring people from putting money in the bank, according to a government statement. Commercial banks have had to raise deposit interest rates to as high as 9.99 percent over the past week and offered gifts and bonuses to depositors to lure them back, the statement on the government’s website said.” [bold emphasis original]

In other words, the Vietnamese people have been hoarding gold and foreign currency (US Dollar) and have shunned the banking system in response to Vietnam’s government repeated debasement of its currency. It’s seems like an early symptom of demonetization.

As we have previously quoted Professor Ludwig von Mises from his Stabilization of the Monetary Unit? From the Viewpoint of Theory,

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.” [bold emphasis mine]

Will Vietnam follow the path of the most recently concluded Zimbabwean monetary disease?

I was thinking of Venezuela as next likely candidate but here we have a next door neighbor exhibiting the same symptoms that ails every government that attempts to control or manipulate the marketplace.

The Japanese Yen On A 14 Year High

The second issue overshadowed by the Dubai Debt Crisis is that the Japanese Yen soared to its highest level against the US dollar in 14 years.

According to a Bloomberg report, ``The dollar dropped to the lowest level versus the yen since July 1995 and fell against the euro as the Federal Reserve’s signal it will tolerate a weaker greenback encouraged investors to buy higher-yielding assets outside the U.S.”

The strength of the Japanese yen had been broad based against other major currencies but gains were marginal.

The news blamed the Yen’s rise on the carry trade ``delay debt repayments spurred investors to sell higher-yielding assets funded with the currencies.”

Such oversimplification is not convincing or backed by evidence.

As noted earlier, the US dollar fell to new lows on the Dubai incident before rallying back Friday but eventually giving back most of its gains.

Besides, not all markets had been severely hit. In Latin America, Brazil, Columbia, Chile, Mexico and Venezuela all registered weekly gains. Emerging markets are expected to take it to the chin when carry trades unravel. This hasn’t been the general case.

In Europe, Germany, Italy, Norway, Sweden, Switzerland and Italy survived the week on positive grounds. So even if the Dubai debt crisis exposed Europe more than the others, the selling pressure wasn’t the same. UK home to RBS suffered marginal losses (.11%).

Again none of these accounts for as any solid or concrete signs of an unwinding of carry trade.

Figure 7: stockcharts/google: Nikkei-Yen and Japan exports

While the rising Japanese Yen has so far coincided with a lethargic Nikkei since August (see figure 7 left window), it’s not clear that such correlation has causation linkages.

Although the Japanese government thinks it has.

Again from the same Bloomberg article, ``Finance Minister Hirohisa Fujii said he will contact U.S. and European officials about exchange rates if needed, signaling his growing concern that the yen’s ascent will hurt the economy. The Bank of Japan checked rates at commercial banks in Tokyo, seen as a type of verbal intervention, Kyodo News Service reported.

``Japan hasn’t sold its currency since March 16, 2004, when it traded around 109 per dollar. The Bank of Japan sold 14.8 trillion yen ($172 billion) in the first three months of 2004, after record sales of 20.4 trillion yen in 2003. Japan last bought the currency in 1998, purchasing 3.05 trillion yen as the rate fell as low as 147.66.”

Well it came to my surprise that after all the political gibberish about Japan’s so-called export economy or export dependency, we realized that Japan’s economy is hardly about global trade.

According to ADB data, Japan’s trade in 2006 only accounted for 28.2% of the nation’s GDP, where export (right window) is only 16% of the GDP pie (yes this stunned me as I had the impression all along that Japan’s trade was at the levels of Hong Kong and Singapore and I had to check on official or government data).

The Philippines has even a higher share of trade (84.7%) and exports (36.9%)!

In addition, Japan’s industry, as a share of GDP pie registered for only 26.3%, according to the CIA factbook in 2008.

So a policy for a weaker yen is likely to benefit a small but strong lobbying segment of the society at the expense of the consumers (via cheaper products) or the society.

All these are strong evidences on why the world is facing a greater degree of risks from a hyperinflation episode.

The fallacious Mercantilist-Keynesian paradigm wants a race to devalue currency values, based on a simplistic one product, single price sensitivity, one labor, homogenous capital model which presumes global trade is a zero sum game. They hardly think of money in terms of purchasing power but from political interests based on “aggregate demand”.

Finally, Finance Minister Hirohisa Fujii isn’t likely to succeed in convincing his peers to collaborate to prevent the yen from strengthening. That’s because all of them share the same line of thinking or ideology. And Fed Chairman Bernanke has been on a helicopter mission that will likely to persist until imbalances unravel to haunt the global markets anew.

Will “Divergences” Be A Theme for 2009?

``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity."-President John F. Kennedy

Doug Noland of the Prudent Bear’s Credit Bubble Bulletin rightly describes today’s market activities as a “divergence”.

Where most global economies seem to be phasing into an excruciating and punishing downside adjustment, there seems to be some signs of ``unequivocal signs of life” in select debt markets as important credit spreads have somewhat materially eased.

Although the surface may yet conceal the ``acute stress out there not visible to the naked eye,” our ‘biased’ conjecture leads us to interpret that these could be possible incipient signs of our long awaited “divergent” responses to the “convergent” policy approaches because of the “divergent” structural frameworks of each of the national political economies. In short, our “spillage effect”.

True, while most of the major equity markets remain under significant pressure. These could have been prompted by the market’s ingestion of the onslaught of the negative news, yet even in this aspect we can also see some indications “divergences”.

Visible Acute Stress In US Banking System

Last week, the developments in the US banking sector unveiled the second chapter of the massive transformation of the US banking system. The erstwhile marquee banking behemoths in the name of Citibank and Bank of America, which have been enduring the US government’s surgical knife, will undergo another major operation.

Citibank [C], like a work of karma, which ‘danced’ to the tune of the “securitization” during the pop music days of the shadow banking system, will possibly end up being ‘securitized’ itself; sliced, diced and sold to investors or as this CNN Money report calls it: “divestiture”, e.g. Citibank’s brokerage unit the Smith Barney is reportedly in a deal to be merged with Morgan Stanley.

On the other hand, Bank of America [BoA] will need to enhance and facilitate its digestive juices to reluctantly swallow, under the behest of the US government, another former investment banking titan Merrill Lynch. This deal reportedly will be backstopped by a $20 billion capital infusion and a $118 billion guarantee on the outstanding liabilities from the US government (Bloomberg). And this comes already after previous injections of $15 billion to Bank of America and $10 billion to Merrill Lynch.

All these demonstrate how the government has been dealing with the conundrum of debt overhang as aptly described by this article from the New York Times, where ``any systemic solution has to deal with the bad assets, once and for all.”

And yet the problem of managing “bad assets” is fundamentally one of valuations and asset identification from which the US government won’t allow markets to determine. This signifies as the ultimate paradox; the US government has been earnestly trying to discover an acceptable substitute for market based pricing to no avail-without having to overpay for these ‘toxic’ financial instruments (these might not qualify for as an ‘asset’ since they can be priced at zero or have negative value) at the expense of their taxpayers and the perpetuation of the perils of the moral hazard.

Meanwhile, banks have been refusing to sell these instruments because of the consternation of recognizing added losses which would further impair their already ruptured balance sheets, and most importantly, in the hope that the US government will ultimately rescue them from their miseries.

Yet expectations and government responses have been “divergent”, decrying the BoA deal the Wall Street Journal editorial wrote, ``…the feds believe that the way to calm financial markets is to force the nation's largest, and a heretofore healthy, bank to swallow toxic assets it didn't want.”

At the end of day, the US government’s effort to subdue markets forces will mean a critical choice between saving the taxpayers or the banking system, where the endgame could be the outright nationalization of its banking system or yielding to debt deflation.

And the dominant view has been fittingly enunciated by the same New York Times article, ``That is why you would need to throw more capital into the banks as part of a systemic solution…In past financial crises, it has often been the bold and brilliant stroke that has restored confidence and revived the financial system. During the German hyperinflation of the 1920s, the government actually created a new currency. During the Latin American crisis of the late 1980s, the United States government created so-called Brady bonds, which cleverly allowed banks to get their Latin American debt off their balance sheets by turning it into tradable instruments. And here we are again, in need of bold action and strategic thinking and the restoration of confidence.” (bold highlight mine)

Therefore ‘bold and brilliant strategic thinking’ extrapolates to the creation of more of the same actions that brought us here in the first place. To paraphrase the famous US Senator Everett Dickson quote, ``A trillion here, a trillion there, and pretty soon you're talking about real money.” And the painful reality is that real money is being diluted with the wave of paper money issuance.

As we have repeatedly been saying political choices will ultimately shape the rapidly evolving markets, the economic environment and geopolitical landscape.

Divergences in Asia, Select Credit Markets?

In the context of the discussion about divergences, Asian debt offering last week has been tremendously received by the debt markets following the pace setting actions of the Philippines (see last week’s Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?).

According to Bloomberg (bold emphasis mine), ``Bond markets in the Asia-Pacific region are having their busiest January for at least a decade, with $32.3 billion in sales, as government guarantees and stimulus plans help boost investor appetite.

``New issues almost tripled compared with the first two weeks of last year, and more than doubled the $12.4 billion of January 2007, data compiled by Bloomberg show…

``All the bonds sold in Australia this year have sovereign backing, and all the bonds sold in Asia without government guarantees were denominated in local currencies, Bloomberg data show. Sales in Asian currencies including the Chinese yuan and Malaysian ringgit rose 41 percent this month to $4.6 billion compared to the same period a year earlier.”

Such overwhelming response to G3 denominated Asian debt issuance could possibly be construed as “knee jerk” reactions to the previous liquidity squeeze amidst the frenzied mayhem which effectively closed the global debt markets last October.

Perhaps issuers sensing a positive aura have jumped into the bandwagon to immediately work on securing foreign currency financing requirements as insurance against the risks of potential recurrent bouts of volatility seen last semester of 2008 or from a possible drought of capital considering the prospective tsunami of issuers from a world obsessed with government sponsored guarantees and stimulus.

In addition, the successes of the early movers appear to have triggered renewed appetite or unlocked anxious capital to possibly capitalize on the revitalized vigor in Asian credit markets.

Next, perhaps too, there could have been more demand for less credit risk prone Asian securities.

And lastly, possibly interest rate policies could be seen as starting to get some traction within the region.

Remember, Asia’s only link to the present crisis has been the trade and capital factor, and not balance sheets problems similar to its contemporaries in the Anglo Saxon economies. And as we have long argued, under the Austrian school of economics, interest rates tend to have different impact to economies based on the capital structure.

We quoted Arthur Middleton Hughes in our past article (see Global Market Crash: Accelerating The Mises Moment!) as saying, ``What this tells us is that the market rate of interest means different things to different segments of the structure of production.”

Figure 1: Danske Bank: Asia’s Bleak Exports and Industrial Production

It’s all gloom and doom out there. Such sentiment has been exacerbated by the preaching of the high priests of doomsday and by the negative economic data. For example, dramatic fall in China’s exports, which fell at the “fastest rate in a decade”-AFP (see figure 1 right window), have been compounded by the collapse of Industrial production seen in major Asian economies (left window). Nonetheless, all of these have eclipsed a scintilla of positive developments as evidenced by a surprising jump in China’s bank lending-WSJ (see figure 2) and an unexpected surge in China’s money supply-Forbes.

Figure 2: US Global Investors: Jump In China’s Bank Lending

According to US Global Investor’s: ``A significant rebound in money supply growth and bank lending in China during December suggests that the government’s stimulating policies may have achieved some success. However, challenges for the economy are likely to be sustained in the foreseeable future.”

We agree. And it is not just in the economic data but likewise seen from the relative strength of the equity benchmarks where from the start of the year, China’s Shanghai Index and the Philippine Phisix appears to have outperformed the region and the S&P 500 as shown in figure 3.

Figure 3: stockcharts.com: Divergences of Shanghai, Phisix vis-à-vis Asia and S & P

Since the advent of 2009, the Phisix (pane below center) is still up 4.13% alongside with the Shanghai’s Index up 7.3% (main window) while contemporary bellwethers of Asia and the US S&P 500 are all in the red.

Of course, two weeks of exemplary equity activities may not a trend make or it is simply too premature to tell. Or possibly too, China’s bank lending revival or resurgent money supply growth could merely be an anomaly. Yet these conflicting developments should make 2009 interesting as the unprecedented scale of government actions, which reflects on the grand struggle between government instituted policies and recessionary forces, will likely produce some unforeseen ‘black swan’ reactions.

And speaking of Black Swan, could the widely discredited “decoupling” a euphemism for “divergences” be the name of the game for 2009?

It has been our belief that Asia will probably recover earlier and outgrow the Western world over the coming years. This should possibly become evident once the global nexus of the forcible selling of the debt deflation process decelerates and as domestic economies adjust to the realisms of a “demand” slowdown in the West.

Many institutional analysts have been asserting that the world’s recovery will depend on the US, based on the Keynesian premise that the US comprises as the world’s only aggregate demand. We doubt so. In contrast, we believe that Anglo Saxon economies will be sternly hobbled by the gross inefficiencies brought by the stifling government interventions.

The onus of recompense on the burdensome costs of these interventions, the “crowding out” effect of government interventions on the private sector, and the reduced purchasing power from the torrent of stealth taxation policies combined could severely undermine the economic growth output potentials of the Anglo Saxon economies led by the US.

And unlike the mainstream view fixated with the aggregate demand dynamics, we believe that “supply” side adjustments (we are dissenters of the excess capacity argument) and “politically” motivated government policies will likewise militate on the highly fluid environment.

And as discussed in Phisix and Asia: Watch The Fires Burning Across The River?, we think that this crisis should serve as Asia’s window of opportunity to amass economic, financial and geopolitical clout amidst its staggering competitors. But this will probably come gradually and develop overtime and possibly be manifested initially in the activities of the marketplace.

And this spillage effect doesn’t seem contained to Asia alone, some emerging signs could be seen in the Euro zone, see Figure 4.

Figure 4: WSJ: ECB Rate Packs A Punch

The interest rate guided policies from the European Central Bank could have begun to influence bank lending rates to consumers.

According to the Wall Street Journal blog reports (bold highlight mine) ``But new data on the interest rates euro-zone banks charged households and firms in November suggest lower ECB rates did, in fact, make a difference. On Oct. 8, the ECB delivered its first rate cut of the crisis, taking its key rate to 3.75% from 4.25%. In November, they followed up with another half percentage-point cut to 3.25%. Today, the ECB noted in a statement that “almost all” average rates in November for the real-economy loans the central bank tracks “were lower than in the preceding month… Businesses also got some relief, with rates on new loans to non-bank firms falling to 5.53% in November from 5.86% in October. One month’s data, clearly, doesn’t confirm a trend.”

Again “divergences” could both signal a trend anomaly or an emerging inflection point, the path of which is unclear for the moment.

Thus from where we stand we have observed that despite the grim bleak outlook, some signs of “divergences” in Asia’s bond market, in select Asian equity markets and in some global credit risk barometers could transition to be important themes for 2009.

It is a suspicion that needs further confirmation by trend reinforcement.

We’ll keep vigil.

Welcome To The Mises Moment

``We have seen that each new control, sometimes seemingly innocuous, has begotten new and further controls. We have seen that for governments are inherently inflationary, since inflation is a tempting means of acquiring revenue for the State and its favored groups. The slow but certain seizure of the monetary reins has thus been used to (a) inflate the economy at a pace decided by government; and (b) bring about socialistic direction of the entire economy. Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocs. In short, we find that coercion, in money as in other matters, brings, not order, but conflict and chaos.”-Murray Rothbard, What has Government Done To Our Money

No investor today can rely on traditional metrics to ascertain investment themes since the financial markets have been living on government steroids.

Government has fundamentally usurped the role of gods as they determine the winners or the losers or which industries or businesses deserve to live or perish.

Such evolving shift towards the consolidation and expansion of government’s power in the marketplace or ‘state capitalism’ will mold a new risk environment from which will determine risk capital’s rate of return and how capital resources would be deployed overtime.

Yet most of the current policies applied are designed to impact immediate concerns and appear to be shrouded with unintended consequences. Hence, any serious investor would need to read into government actions and project their repercussions to the investing sphere.

Government actions today appear to be in unison with the goal to combat threats of “deflationary” recession. The collective belief is that the slack in ‘demand’ prompted by falling asset prices will induce the public to hold onto cash instead of generating consumption via the restoration of the credit cycle.

Thus government policies led by the US appear to be directed at patching up the lapses from an imploding bubble.

The Bernanke Doctrine

The direction of policy actions or what I would call as the ‘Bernanke doctrine’ has been telegraphed to the public since 2001 and has been his deflation fighting manual. I guess most central bankers have adopted his strategy so the seeming “collaborative” and “concerted” efforts.

The US Federal Reserve recently cut interest rates from a fixed target to range between 0 and ¼% which it expects to hold “for sometime”. And now that the US central bank has moved rates to near zero level (Zero Interest Rate Policy-ZIRP), which leaves them limited room to use interest rate as ammunition, they are left with the terminal option of balance sheet management. The Fed recently announced that they would:

1) purchase assets directly from the market- “will purchase large quantities of agency debt and mortgage-backed securities” and “evaluating the potential benefits of purchasing longer-term Treasury securities”,

2) provide credit directly- “will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses” and

3) expand the use of the printing press “consider ways of using its balance sheet to further support credit markets and economic activity”.

Notice that these endgame tactics involve the short circuiting the banking system which basically has not been different from Zimbabwe’s Dr. Gideon Gono’s strategy of using the printing presses aided by the an expansive government.

The aforementioned FED monetary policies, combined with the present fiscal package and the purported $850 billion inaugural program for the incoming President Barack Obama, which are allegedly aimed at jumpstarting the economy, seems headed for such direction.

And the buck doesn’t seem to stop here.

``The biggest fear is that people will do too little…like a start-up that fails because it didn't do enough”, the Wall Street Journal quotes an anonymous Democratic leadership aide on President Obama’s inaugural stimulus program.

This captures what we’ve been saying all along…political motives will shape policy decisions more than economic concerns. Officials will use the cover of popular demand to continually spend taxpayer money organically meant to keep afloat its US dollar standard fractional banking system even to the point where Ben Bernanke could resort to the nuclear option of the printing press based currency devaluation to inflate away the unsustainable debt levels.

The desire to print money to solve economic ailments can only lead to further financial or economic disorders.

Bernanke’s Asymmetric Playing Field

Yet the shift from interest rate to balance sheet or money supply management policy comes with many unknown effects.

One, the directives of US monetary policy seems to revolve heavily towards Ben Bernanke. This makes him, unknowingly to the public, the most powerful man in the world, an unelected official. Remember, the world operates around the US dollar standard system from which Bernanke’s clout has been strengthening.

As we pointed out in Is Ben Bernanke Turning The US Federal Reserve Into A Dictatorship?, the concentration of powers towards the center, by bypassing legal requirements or procedures and circumventing organizational hierarchy in the decision making process, could signify as consequence to the ongoing policy directional shift from ZIRP to the money supply.

According to Economist Bob Eisenbeis of Cumberland Advisors, ``The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC”, and since balance sheet management involves day to day decisions ``it is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.” Thus, the FOMC would probably be “mothballed” until ``the return of normalcy to policy formulation.” This explains the rational behind the apparent arrogation of power by Ben Bernanke.

Thus, the fate of the US and the world’s financial system (markets and banks) and even the economies now resides in the palms of Mr. Bernanke, see figure 1; ironically the same person who wrongly predicted the containment of the subprime crisis.

Figure 1: Cato.org: US Credit Triangle

Two, informational changes in the size and composition of the balance sheet or Bernanke’s present actions will be critical to market participants. The assets which the Fed buys today or in the future will give undue advantage over the assets it won’t be buying. Thus the fate of the markets depends on Mr. Bernanke’s biases, values or priorities (marginal utility). As we always say, inflationary policies always favor those with closest ties to the government.

Three, since the Fed relies on 17 primary dealers (including some foreign affiliates) to implement its purchasing activities, the said institutions will have “real informational advantage” (since they have access to Fed activities) or an information asymmetric edge over most market participants. Essentially, such developments makes markets today tilted towards an insider’s game.

In all, Ben Bernanke has altered the global financial market’s landscape into a casino like environment by playing with a loaded the dice, constantly changing of rules in the middle of the game to suit his predispositions and fostering an uneven playing field-where he assumes the role of the house. His newly assimilated omnipotent powers will likely shape world markets, economies or even implicitly political developments which could be laden with a minefield of unforeseen consequences. Hence, the risks are that policy mistakes made by omission or by commission will exacerbate further suffering to the world.

Global Central Banks Adopt The Bernanke Doctrine

The switch from interest rates to balance sheet policy management isn’t a development restricted to the US as Japan and Switzerland has also joined the trend of consolidating central bank power to wrench open the spigot of money supply with the goal to “stimulate” their respective economies.

The Bank of Japan (BoJ) cut rates from .3% to .1% last week and declared that it would increase purchases of government bonds, including inflation-linked bonds, floating rate bonds and 30-year bonds, aside from commercial paper. It will likewise consider buying corporate debt products (forextv.com).

The Swiss National Bank (SNB) also slashed rates by half a percentage point, last week, from 3-month Swiss franc LIBOR rate of 0.50-1.50 percent to 0.00-1.00 percent, its fourth cut in two months.

With policy rates at zero levels, the SNB is said to consider “quantitative easing” (running printing press) through unsterilized currency intervention by possibly buying ``Swiss franc bonds to lower borrowing costs or try to weaken the franc either by verbal or physical intervention.” (IHT.com).

According to Morgan Stanley’s Joachim Fels (highlight mine), ``the may choose to implement QE partly through unsterilised currency intervention, i.e., buying foreign currency without offsetting the impact on their balance sheet through open-market sales of other assets. The reasoning behind this is that for small open economies like Switzerland, the exchange rate is a more important driver of the economy than mortgage rates or other interest rates, and in the case of Japan, currency intervention might help to stem the recent sharp appreciation of the yen.”

Both the SNB and BoJ basically will be utilizing the same Bernanke’s textbook approach!

So as global central banks become more desperate they are likely to resort to their home printing presses aimed at devaluing their currency against everyone else. This raises the risk of a currency war or a tumultuous upheaval in the present monetary system, especially when Mr. Bernanke opts for the nuclear option.

Again this reminds as again of Ludwing von Mises who presciently wrote in Human Action, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

The currency markets will be the natural release valve for all these accrued government actions in 2009.

Welcome to the Mises Moment.

China Slashes Rates, Shanghai Composite At Critical Juncture

Faced with grim prospects of dramatically decelerating economic growth (World Bank Projections have cut growth forecast from 9.2% to 7.5% for 2009), an alarmed China has opted to aggressively use its monetary policy.

According to a report from Bloomberg (highlight mine), ``China lowered its key lending rate by the most in 11 years, extending efforts to prevent an economic slump less than three weeks after unveiling a 4 trillion yuan ($586 billion) stimulus plan.

``The key one-year lending rate will drop 108 basis points to 5.58 percent, the People's Bank of China said on its Web site today. The deposit rate will fall by the same amount to 2.52 percent. The changes are effective tomorrow…

``The bank lowered the reserve requirement for the biggest banks to 16 percent from 17 percent, effective Dec. 5. The requirement for smaller banks will fall to 14 percent from 16 percent. The central bank also reduced the interest rate that it pays on reserves deposited by commercial banks to encourage lending.

chart courtesy of Dankse Bank: Lending and deposit rate (left), reserve requirement (right)

Yet additional measures are being considered, from the same Bloomberg report,

``Two hours after the rate cut, China's cabinet said it was studying extra measures to help struggling companies in the steel, auto, petrochemical and textile industries; to increase key commodity reserves; and to expand insurance for the jobless.

``The government will also push ahead with fuel-price and tax reforms to help boost consumption, the cabinet said. A fuel-price cut would be the first in two almost years. The government regulates energy prices to contain inflation, which fell to a 17- month low in October.”

Fundamentally, the global contagion is expected to impact China via the export channel (and via portfolio flows), albeit exports still managed to grow robustly by 19.2% last October, but down from last September’s 21% with trade surplus swelling to a record $35.2 billion on declining import growth. A CLSA survey recently showed that export orders have dropped to its lowest since 2004, which possibly indicates that exports have yet to reflect on the substantial decline with a time lag.

But the continuing slump in the real estate industry seems likely a bigger concern considering that many loans from the informal sector could surface or find its way into the balance sheets of the formal banking sector, and increase incidences of Non Performing Loans. This should translate to a significant weakening domestic investment as we previously discussed in China’s Bailout Package; Shanghai Index At Possible Bottom?, which the Chinese government aims to offset with a massive stimulus package.

But, it is our hunch that perhaps China’s markets have already priced in or have discounted much of these somber expectations considering the harrowing bear market losses of 72% (from peak to trough).

Unless, the world will yield to a depression, the recent lows could possibly mark a cyclical transition from a declining phase to a “bottom” phase.

China’s Shanghai index appears to be testing the 50-day ma resistance.

A successful breakout from this resistance level could serve as one of our confirmation metrics. Otherwise a failed breakout means a test of the recent lows.