Phisix: Will the Risk ON Environment be Sustainable?

High Volatility Continues

The Philippines Phisix had an ENORMOUS ‘RISK ON’ week with a raucous shindig over the outcome of the Greece elections.

The Phisix jumped by an eye popping 3.84% for the week to take the top spot in the region. This week’s gain practically obliterated the previous two weeks of losses.

ASEAN markets somewhat shared the carousal.

Unknown to most the Phisix-ASEAN blast came amidst highly volatile global market actions.

While most of the world shared the early excitement brought about by the pro-Euro Greece victory, gains eventually succumb to heavy losses. It’s only in Japan and in the major ASEAN markets where gains were maintained until the week’s close.

Even in the US, market breadth has been decisively either ON or OFF or a phenomenon driven by a rising or sinking tide.

Bespoke Invest writes[1],

We consider all or nothing days in the market to be days where the net daily A/D reading in the S&P 500 exceeds plus or minus 400. After a slow start to the year, the pace of all-or-nothing days has really picked up as nine of the year's sixteen occurrences have all come since the beginning of May. At the current rate, the S&P 500 is on pace to see 34 all-or-nothing days this year.

This demonstrates of the continued high volatility that has dominated the financial markets.

Another “Political” Intervention to Bolster the Phisix?

I suspect that interventions from non-market forces may be responsible anew for the resiliency of the Phisix.

The Phisix was bizarrely unruffled by the rout of the US markets last Thursday and even closed slightly positive on Friday.

Friday’s session opened with the Phisix sharply down driven by the developments in the US. But in no time, aggressive buyers constantly bid up the heavy market cap stocks, particularly by PLDT [PSE: TEL] and Bank of the Philippine Islands [PSE: BPI] significantly higher, thus driving the major domestic composite higher.

The 75 point pendulum swing from the troughs to the highs translated to another amazing 1.5% intraday move (intraday chart from technistock.com).

Such peculiar aggressive buying behaviors occurred when the region’s bourses suffered from losses.

Friday’s closing scorecard for Asia from Bloomberg.

Why would any rational market agent aggressively buy up such index issues in the knowledge that they can take advantage of, and save a lot through bargain hunting or buying defensively, considering the prevailing dour market sentiment?

Are these forces really sooo exceedingly bullish such that they expect Philippine equities to immediately zoom even amidst all the surrounding risks? Are these forces price insensitive? Or are they assuming the role of market makers or of stock market operators?

Remember these entities are dealing with tens, if not hundreds of millions of pesos worth of equity positions. So they are unlikely to be gullible retail investors.

While it may be true that both issues posted heavy foreign buying on that day, statistics may not tell the true story. Foreign buying can come from offshore entities owned by local non-market entities or from foreign institutions allied to the local political class.

Besides, their actions appear to be inconsistent with actions of portfolio managers around the world as emerging market funds have registered net outflows.

From Reuters[2], (June 21^st)

Funds that focus on emerging markets also saw outflows last month, eVestment found. For the ninth consecutive month investor withdrawals outpaced allocations to those managers, with $1.1 billion in redemeptions in May.

Even if foreign investors have distinct treatment on various emerging markets, I find these seemingly deliberate market defying actions as very suspicious.

As a side note, the Phisix has posted two consecutive weeks of net foreign buying.

Also Friday’s action seems to parallel the dynamics executed over the same environment three weeks back[3]. Yet such an attempt had been shot down by a single day loss[4].

Three weeks into a recovery, these operators have hardly been significantly up today.

The point is ‘interventions’ will eventually be smoothed out or neutralized by the underlying forces which drives the financial markets.

Will the Current Phisix Divergence Last?

This week’s dramatic upside showing by the Phisix nonetheless highlights another anomalous divergence within the region; particularly the winners Philippines (PCOMP orange)—Malaysia (FBMKLCI red) and the laggards as Thailand (SET yellow)—Indonesia (JCI green).

In the past, ASEAN price trends have largely moved in consonance, inflection points have almost been synchronized (blue vertical lines)

So either divergence become a lasting (decoupling) feature, or that eventually a recoupling will happen—where the laggards catches up or the winners will fall in line with the laggards.

My bet is on the latter—recoupling. There have hardly been any durable signs of divergences. And a decoupling within the region must also mean a decoupling with the world. That would be unlikely.

As previously discussed[5] the Philippines IS sensitive to developments abroad particularly through the merchandise trade channel (which accounts for about 50% of GDP) and through the OFW-remittance channel (which is about nearly 12% of GDP)

I believe that the possibility of a decoupling may happen in the event of a currency crisis. However current setting which has been about unwieldy debt and boom bust cycles doesn’t seem conducive for such scenario. Of course I could be wrong.

Even in terms of conventional methodology, sustained divergences may seem implausible.

If economic growth should prove to be an indicator of future profits or earnings, then current manufacturing surveys of major economies does not seem to be supportive of further earnings or profit growth.

Europe’s largest economies Germany and France seem headed towards or if not have already been in a recession. The US manufacturing index has likewise slumped, while China’s manufacturing index has steadily been on a decline as shown by the charts from Danske Bank[6].

Of course this ultimately depends on the persistence of such trends.

The same applies to earnings growth.

The consensus view of earnings of global publicly listed companies according to the UBS appears to be rolling over[7].

So if stocks continue to rise even as economic growth begins to stagnate, which subsequently suggests of increasing risks of a downturn in profits, then deductive logic tells us that rising stocks won’t be sustainable.

Sustained rise in stocks means that valuations will eventually become ‘pricey’ and thus subject markets to the risks of the regression to the mean[8]—or outlier events that statistically reverts towards the mean.

In short, markets will decline either orderly or in disorderly fashion depending if markets will adjust today or sometime in the future to reflect on the evolving realities.

So there hardly have been fundamentals (even in the conventional perspective) in support of a sustained upswing EXCEPT for interventions by central banks that supports the financial markets.

And here lies the essence of today’s volatile markets.

Diminishing Returns and the Withdrawal Syndrome

As I pointed out last week, expectations of central bank rescues have functioned as the focal point of the market’s directions.

I wrote[9],

Global financial markets have relied heavily on the “buy the rumor” from central banking rescues.

These are likely to have two short to medium term outcomes.

One, if central bankers FAIL to deliver in accordance to market’s expectations, then we will likely see another huge bout of downside volatility in global equity markets…

On the other hand, if markets may be temporarily satisfied with REAL actions of central banks (e.g. $1 trillion bailout) then we should see a minor or a slight “sell on news”. But this should be seen as opportunities to RE-ENTER the markets incrementally.

Like the bailout of Spain, the Greece elections have had a short term effect on most of the world markets.

[As a side note, to call the Philippine (Phisix) and Malaysia’s (KLSE) one week deviation as sustainable trends would be based on HOPE.]

The attention of global financial markets eventually shifted to the US Federal Reserve to deliver the promise of stimulus.

The Ben Bernanke led Federal Open Market Committee (FOMC) DID deliver, but did so reluctantly.

The FOMC extended Operation Twist until the yearend by only about three-fifths ($267 billion) of the original size ($400 billion)[10]. But along with it comes more assurance of “additional asset purchases would be among the things that we would certainly consider”

Unknown to most is that the current bailouts have been subjected to the laws of diminishing returns.

For instance, the positive impact to the marketplace from bailouts in Eurozone has been shortening or experiencing diminishing returns as measured and documented by a recent study[11].

The same diminishing returns can be seen from US Federal Reserve actions (QE 1, QE 2, and Operation Twist or Maturity Extension Program MEP) as shown by the yields from different debt instruments[12].

The point is that central bankers will need to step up or INTENSIFY the scale of balance sheets expansions. Otherwise similar or lesser degree of actions would mean vastly reduced positive impact to the marketplace which alternatively accentuates the risks from downside volatilities.

So the Fed’s announcement belatedly incited a huge slump on the S&P 500, Thursday.

Again, the slump can be construed as ventilation of the frustrated expectations or as consequence to “sell on news” or as manifestations of diminishing returns or a combo of the three.

Yet it would be misguided to view the FED’s actions as simply providing what the market wanted as proposed by the populist analyst John Mauldin[13],

So why did the Fed continue Operation Twist? Because the market (that amorphous, omnivorous blob) expected something from the Fed. This summer's version of Twist and Whisper was about the least they could do.

The FED has been CONDITIONING the markets of the coming FED actions that has artificially propped up the markets[14].

So the market expectations simply adjusted to pledges made by officials. Besides market participants have been brainwashed like Pavlov’s dogs with the Bernanke “inflation” Put.

And that’s why bad news became good news—or markets rose amidst a spate of bad news—for the simple reason that major central bank authorities continually whetted on the appetite of the marketplace with guarantees of support.

The genuine reason for the extension of Operation Twist is that the FED continues to finance the US treasury or bails out the US government.

While Operation Twist has been designed to nudge market’s appetite to take on more risk “by taking long-term bonds off the market”, notes the Wall Street Journal[15], what has been happening, instead, is that the US Treasury has been taking advantage of low interest rates to ramp up on the issuance of long term securities.

This means that the Fed has actually been accommodating the shift in the debt maturity profile by the US Treasury, whose moves may have been possibly intended to reduce rollover risks[16] or the risk from refinancing debt that could be triggered by an upward move of interest rates.

A surge in interest rate would balloon interest payments and deficits and most likely trigger a debt crisis ala the Eurozone (see chart above[17]). A US debt crisis would likely elicit a currency crisis if the FED insists on resorting to the printing press to solve her problem of debt.

But of course, the Fed’s accommodation has also been about the growing debt of the US which now stands at $15.809 trillion according to USdebtclock.org

US politicians have become so addicted to debt based spending such that House Minority Leader Nancy Pelosi, D-Calif., writes the Washington Examiner[18], thinks that President Obama should unilaterally eliminate the debt ceiling. Politicians really believe that they are above the laws of economics.

And perhaps the Fed’s parsimonious actions may have been due to the reduced number of short term instruments available for the twist (US Treasury securities held by the FED for 1-5 years maturity has been collapsing).

Or perhaps, Mr. Bernanke would like to avoid a political backlash similar to that of the last quarter of 2011, which may have prompted him to jilt the markets expecting for QE 3.0[19].

Bottom line, the current uncertainty dynamic comes with the growing gap between actualized policies and market expectations mainly premised on the pledges of backstops from central bank authorities.

The failure to meet such expectations is likely to provoke turbulent episodes symptomatic of a withdrawal syndrome.

Uncertainty leads to volatility.

As the past 3 weeks has shown, the Phisix has not been immune to volatility in both directions.

China’s Languid Economic Conditions Aggravates Political Uncertainty

Developments in China has been adding to the landscape of uncertainty.

Reports of a worsening decline in the manufacturing index[20] have not only led to a technical breakdown of China’s Shanghai markets but also to a breakdown of commodity prices.

The SSEC will soon test the immediate support level (green horizontal line)

China’s economy seems to be in a slomo burn rate.

And the epicienter of China’s weakness (bursting bubble?) emanates from the property sector (see chart above[21]) which continues to reel from a slomo decline, and which has spread to the manufacturing sector.

An even grimmer news is that reports say that China has been artificially been propping up economic statistics for political reasons[22], particularly for the coming national elections, as local officials pad up statistical output in order to get promotions. The implication is that China’s economic performance has been weaker than what has been published

So far, the Chinese national government has repeatedly shown reluctance to aggressively intervene. Most of interventions has been marginal, done on a stealth State level[23], on the monetary aspects (lowering of interest rates)[24] and on the cosmetic inflation of economic statistics.

So the deterioration in China’s economy has been aggravated by political deadlock.

Low Oil Prices Jeopardizes the Oil Welfare State and Enhances Risks of War

The ongoing economic slowdown in multiple fronts (most especially in China) has hurt commodity prices and has led the US Oil (WTIC) benchmark to break below the $80 level.

And with oil prices slightly below the $80 threshold, this should begin to affect the fiscal balances of many welfare states of oil producing economies, whose critical welfare threshold is at the $80 level and above (see chart[25]).

As I previously wrote[26],

The welfare states of many of the major producers, particularly OPEC economies or even non-OPEC such as Russia greatly depends lofty oil prices, perhaps about $85 and above. Even President Obama’s green energy projects have been anchored on high oil prices.

This means that if oil prices breaks below their welfare threshold for a prolonged period, then this would incite popular uprising and the eventual collapse of the current political order.

And this is why oil producing governments have been limiting private sector’s access to oil reserves. Yet the capacity by these governments to bring oil to the surface has been constrained by government budget, which has been mostly spent on welfare (yes to buy off their political privileges from their constituents), and the lack of technology.

The implication of the above is that these governments will probably try to restrict production, seek the war option (e.g. urge the US to militarily take on Iran), inflate their economies to pay for their welfare system or influence major central banks and politicians of major economies to resort to more inflationism.

And it is why the brinkmanship politics in the Middle East has scaled up the drumbeats of war not just on Iran, but also on Syria.

Foreign policy interventions have been about promoting the interests of the welfare states allied to the West and the interests of the neoconservative political class who represents the interests of the military industrial complex.

As Ron Paul rightly points out[27],

And once again, we are about to engage in military action against Syria and at the same time irresponsibly reactivating the Cold War with Russia. We're now engaged in a game of "chicken" with Russia which presents a much greater threat to our security than does Syria…

Controlling Iranian oil, just as we have done in Saudi Arabia and are attempting to do in Iraq, is the real goal of the neo-conservatives who have been in charge of our foreign policy for the past couple of decades.

So politicians are looking for political scapegoats from which to divert people’s attentions, as well as, to create justifications for more inflationism.

Bottom line: Either from demand-supply perspective or from monetary inflation, falling commodity prices can hardly be seen as positive for stock markets for the moment.

Falling commodity prices are manifestations of an ongoing liquidation process from malinvestments and from the political uncertainty over ambiguous policies.

We would need to wait for declared actions from political authorities. Otherwise, should markets awaken to the reality of false promises, downside volatility will likely be amplified.

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[1] Bespoke Investment Group Another All or Nothing Day!, June 21, 2012

[2] Reuters.com Investors fled Europe-linked hedge funds in May-report, June 21, 2012

[3] See Phisix: Very Impressive Day or Month End Close for May 2012, May 31, 2012

[4] See Phisix: Last Week’s Big Surge Wiped Out in a Single Day! June 4, 2012

[5] See Will the Phisix Divergence Last? June 4, 2012

[6] Danske Research Time for another important EU summit, June 22, 2012

[7] Zero Hedge Three Charts Your Stockbroker Won't Want You To See, June 18, 2012

[8] Chegg.com Definition of Regression to the Mean Regression to the mean, or regression threat, refers to the statistical phenomenon of outlier data moving toward the mean in subsequent non-randomly selected tests. Statisticians need to take regression to the mean into account when designing experiments.

[9] See Dealing with Today’s Uncertainty: Patience is the Better Part of Valor June 17, 2012

[10] See US Federal Reserve Extends Operation Twist, Commodities Drop June 21, 2012

[11] See The Diminishing Returns from Euro Bailouts Becoming Evident June 20, 2012

[12] Zero Hedge The Diminishing Returns Of Central Planning, And Why More Printing Would Have No Impact June 15, 2012

[13] Mauldin John, Daddy's Home Goldseek.com June 24, 2012

[14] See Bad News Is Good News: Global Markets Rise on MORE Stimulus Expectations June 20, 2012

[15] Wall Street Journal Economics Blog Bernanke Acknowledges Treasury Strategy at Odds With Fed Policy, June 22, 2012

[16] Investopedia.com Rollover Risk

[17] Zero Hedge Presenting Dave Rosenberg's Complete Chartporn, June 1, 2012

[18] Washington Examiner Pelosi: Obama should unilaterally eliminate the debt ceiling, June 22, 2012

[19] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms, September 22, 2012

[20] See China’s Manufacturing Troubles Hasn’t Gone Away June 21, 2012

[21] Businessinsider.com SocGen: China's Housing Market Correction Is 'Sending Shock Waves Through Its Economy', June 18, 2012

[22] See China’s Economy has been Artificially Embellished for Politics June 24, 2012

[23] See China’s New Loans Unexpectedly Surged in May June 12, 2012

[24] See HOT: China Cuts Lending Rates and Deposit Rates June 7, 2012

[25] King Byron What’s the Deal With Oil Prices? June 13, 2012 Daily Reckoning.

[26] See Phisix: The Correction Phase Cometh, May 14, 2012

[27] Paul Ron When Will We Attack Syria?, June 20, 2012, lewrockwell.com

US Federal Reserve Extends Operation Twist, Commodities Drop

So Ben Bernanke and the US Federal Reserve finally gave the markets the steroids (Bernanke Put), which they have been desperately expecting.

From Bloomberg,

The Federal Reserve will expand its Operation Twist program to extend the maturities of assets on its balance sheet and said it stands ready to take further action to put unemployed Americans back to work.

The central bank will prolong the program through the end of the year, selling $267 billion of shorter-term securities and buying the same amount of longer-term debt in a bid to reduce borrowing costs and spur the economy.

“If we don’t see continued improvement in the labor market, we’ll be prepared to take additional steps if appropriate,” Fed Chairman Ben S. Bernanke said at a news conference in Washington following a two-day meeting of the Federal Open Market Committee. “Additional asset purchases would be among the things that we would certainly consider.”

Policy makers moved to shore up the world’s largest economy as faltering growth leaves it vulnerable to fallout from the European debt crisis and looming fiscal tightening in the U.S. Fed officials today lowered their outlook for growth and employment, foreseeing a jobless rate of at least 7.5 percent at the end of 2013.

But there has been a material difference. Operation Twist 2 represents a little more than three quarters of the original $400 billion programme.

Yes, US markets declined marginally in response.

But the significant drops in gold and importantly oil prices (nearly or at the brink of breaking down), whether seen from a consumption or from a monetary inflation perspective, have not been consistent with, or supportive of, the actions of the sprightly stock markets. Said differently, the FED has pulled their punches and the commodity markets noticed them.

Be very careful out there.

Chart of the Day: US Money Supply Hits Wall, Points to Trouble Ahead

I pointed out last Sunday that in response to the ongoing capital flight from crisis affected European nations, the US Federal Reserve have resorted to the contraction of its balance sheet which may further prompt for a decline in money supply. This may have been compounded by the culmination of Operation Twist.

Chart and the following quote from goldmoney.com

Simply put: the more sluggish money supply growth is, the more likely it is that we see a stock market and broader economic crash that would make 2008 look like child’s play.

Since US Federal Reserve is likely to respond forcefully to any material convulsions in the financial markets, a “crash” does not seem inevitable (yet). But this should NOT be discounted.

Like it or not, expect further turbulence and volatility ahead.

Be careful out there.

Central Bankers Whets Wall Street’s Fetish For Inflationism

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

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

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

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

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

Writes Dr. Yardeni[2]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reports the Dow Jones[16]

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

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

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

As the great Ludwig von Mises wrote[18],

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

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

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

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

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

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

[5] Wikipedia.org Sterilization Capital account

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

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

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

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

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

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

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

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

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

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

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

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

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

What To Expect in 2012

Everything we know “based on evidence” is actually based on evidence together with appropriate theory. Steven Landsburg

Prediction 2011: Largely on the Spot But Too Much Optimism

First, a recap on the analysis and the predictions I made during the end of December of 2010 in an article “What to Expect in 2011”[1]

I identified four predominant conditions that would function as drivers of global financial markets (including the Philippine Phisix) as follows:

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

2. More Inflationism: Bailouts and QEs To Continue

3. Effects of Divergent Monetary Policies

4. The Globalization Factor

How they fared.

1. Low Interest Rates Regime

I noted that the US Federal Reserve has the “penchant to artificially keep down interest rates until forced by hand by the markets”; this has apparently been validated last year even as most of the market’s focus has shifted to the Eurozone.

In fact, suppressing interest rates has not just been undertaken by the US Federal Reserve, whom has promised that current zero bound rates (ZIRP) would be extended to 2013[2] aside from manipulating the yield curve via ‘Operation Twist’, but by major developed and emerging central banks as shown above[3].

Apparently, the worsening debt crisis in Eurozone compounded by Japan’s triple whammy natural disaster and China’s slowing economy (or popping bubble?) has intuitively or mechanically prompted policymakers to respond concertedly, nearly in the same fashion as 2008. This has resulted to a decline of global interest rates levels to that of 2009[4].

2. Bailouts and QEs Did Escalate

Except the US Federal Reserve, major global central banks have already been actively adapting credit easing or money printing policies.

The balance sheets of top 3 central banks has now accounted for almost 25% of world’s GDP[5]. Yet this doesn’t include the Swiss National Bank[6] (SNB) and the Bank of England[7] (BoE) whom has likewise scaled up on their respective asset purchasing programs.

The world is experiencing an unprecedented order of monetary inflation under today’s fiat standard based modern central banking.

3. Divergent Impacts of Monetary Policies on Financial Markets

I previously stated that

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

While global equity markets have been down mostly on partial and sporadic signs of liquidity contraction arising from the unfolding Euro crisis and from indications of a global economic slowdown, monetary policy activism or strong responses by central banks did result to distinctive impacts on the marketplace.

Emerging markets with the least inflationary pressures exhibited resiliency. ASEAN 4 bourses, going into the close of the New Year, were among the ten world’s best performers[8] and served as noteworthy examples of the above.

The relative performances of global bourses have likewise been reflected on the commodity markets[9].

4. Globalization Remained Strong which Partly Offset Weak Spots

While there had been signs of partial stagnation of global trade in terms of volume during the last semester of the 2011, trade volumes remained at near record highs and have hardly reflected on signs of severe downturn or a recession[10] despite the Euro crisis.

Since deepening trends of globalization (in finance and trade) has also been expanding the correlations of the financial markets[11], which has been largely characterized as ‘Risk On’ and ‘Risk Off’ environments, the aggressive actions by central banks and the non-recessionary global environment in the face of the Euro crisis and patchy signs of economic slowdown has partly neutralized such tight relationship which allowed for selective variances in asset performances.

Overall, almost every condition that I defined in December of 2010 had been validated.

5. Mostly Right Yet Too Optimistic

On how I expected the markets to perform, I wrote,

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

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

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

2011 saw the Philippine Phisix and ASEAN bourses marginally up, which means that I have been too optimistic to suggest of a minimum 20% return that was way off the mark.

Nevertheless, it hasn’t been that bad since the long-time darling of mine, the Philippine mining index, overshot on my expectations.

And given that the mining sector’s extraordinary returns has alternated every year[12], it is unclear if mining index will remain to be the horse to beat. Yet, current global monetary dynamics may change all that.

Aside, another observation of mine has been validated.

Gold, allegedly a deflation hedge/refuge, has not turned out as many have said.

Except for the July-September frame, gold prices have largely moved along with the price direction of the S&P 500 (blue circles).

The July-September frame which marked a short-term deviation from the previously tight correlations seems to coincide with the end of the QE 3.0. This along with the unfolding Euro crisis put pressure on US equity markets first, which eventually culminated with FED chair Ben Bernanke’s jilting of the market’s expectations of QE 3.0.

The belated collapse of gold prices (red circle), in response to Mr. Bernanke’s frustrating of the market expectations for more asset purchasing measures, had been aggravated by other events such as the forced liquidations by MF Global[13] to resolve its bankruptcy and several trade ownership issues aside from other trade restrictions or market interventions[14] that has stymied on gold’s rally.

Nevertheless, the gold-S&P 500 linkage appears to have been revived, where both gold and the S&P has taken on an interim upside trend (green line).

The S&P 500 closed the year with microscopic losses while gold registered its 11^th year of consecutive gains, up 10% in 2011.

Expect Volatile Markets in 2012

When asked to comment on the prospects of the stock market, JP Morgan’s once famous resounding reply was that “It [Markets] will fluctuate”.

1. Markets will Fluctuate—Wildly

2012 will essentially continue with whatever 2011 has left off.

Since 2011 has been dominated by the whack-a-mole policies on what has been an extension of the global crisis of 2008, which in reality represents the refusal of political authorities for markets to clear or to make the necessary adjustments on the accrued massive malinvestments or misdirection of resource allocation in order to protect the political welfare based system anchored on the triumvirate of the politically endowed banking sectors, the central banks and governments, then we should expect the same conditions in 2011 to apply particularly

1. Monetary authorities will continue to keep interest rates at record or near record low levels.

2. Money printing via QE and bailouts will continue and could accelerate.

3. There will be divergent impact from different monetary policies and

4. Globalization will remain a critical factor that could partly counterbalance the nasty effects of the collective inflationist policies (unless the ugly head of protectionism emerges).

I would add that since presidential election season in the US is fast approaching, most candidates or aspirants including the incumbent have been audibly beating the war drums on Iran[15], where an outbreak may exacerbate political interventions in the US and in the global economy and importantly justify more monetary inflationism.

One must realize that continued politicization of the marketplace via boom bust and bailout policies compounded by various market interventions and the risk of another war has immensely been distorting price signals which should lead markets to fluctuate wildly.

2. China and Japan’s Hedge—Steer Clear of the US Dollar

And where reports say that China and Japan have commenced on promoting direct transactions[16] by using their national currencies hardly represents acts to buttress the current system.

The Bank of Japan has also been underwriting their own Quantitative Easing (QE) which means the Japanese government are engaged in ‘competitive devaluation’ which is no more than a ‘beggar thy neighbour’ policy.

Instead, what this implies is that Japan and China, being the largest holders of US debt, seem to be veering away from their extensive dependence on the US economy as they reckon with, not only interest rate and credit risks, but also of currency, inflation, political and market risks. Even China and Japan appear to be taking measures to insure themselves from wild fluctuations.

On the other hand, China’s bilateral currency agreement with Japan plays into her strategy to use her currency as the region’s foreign exchange reserve[17].

3. Heightened Inflation Risks from Monetary Policies

QE 3.0 has not been an official policy yet by the US Federal Reserve but their balance sheet seem to be ballooning anew (chart from the Cleveland Federal Reserve[18]).

Yet this, along with surging money supply and recovering consumer and business credit growth, will have an impact on the US asset markets which should also be transmitted to global financial markets, as well as, to the commodity markets.

Yet given the large refinancing requirements for many governments (more than $7.6 trillion[19]) and for major financial institutions this year amidst the unresolved crisis, I expect major central banks to step up their role of lender of last resort.

Again the sustainability of the easy money environment from low interest rates and money printing by central banks will depend on the interest rates levels which will be influenced by any of the following factors: 1) inflation expectations 2) state of demand for credit relative to supply 3) perception of credit quality and or 4) of the scarcity/availability of capital.

Today’s bailout policies have been enabled and facilitated by an environment of suppressed consumer price inflation rates, partly because of globalization, partly because of the temporal effects from price manipulations or market interventions and partly because of the ongoing liquidations in some segments of the global marketplace such as from MF Global, the crisis affected banking and finance sectors of the Eurozone and also perhaps in sectors impacted by the economic slowdown or the real estate exposed industries in China, which may be suffering from a contraction.

However I don’t believe that the current low inflation landscape will be sustainable in the face of sustained credit easing operations by the central banks of major economies. Price inflation will eventually surface that could lead to restrictive policy actions (which subsequently could lead to a bust) or sustained inflationism (which risks hyperinflation). Signs from one of which may become evident probably by the second semester of this year.

Yet I think we could be seeing innate signs this: Given the current monetary stance and increasing geopolitical risks, oil (WTI) has the potential to spike above the 2011 high of $114 which may lead to a test of a 2008 high of $147.

4. Phisix: Interim Fulfilment of Expectations and Working Target

In the meantime, I expect the Philippine Phisix and ASEAN markets to continue to benefit from the current easy money landscape helped by seasonal strength, improvements in the market internals, and in the reversals of bearish chart patterns as forecasted last December[20]

The bearish indicators of head and shoulders (green curves) and the ‘death cross’ have now been replaced by bullish signals as anticipated[21]. The Phisix chart has now transitioned to the golden cross while ‘reverse head and shoulders’ (blue curves and trend line) has successfully broken out of the formation. It doesn’t require relying on charts to see this happen. Even the Dow Jones Industrials has affirmed on my prognosis[22].

The S&P 500, oil (WTI) and the Phisix seem to manifest a newfound correlation or has reflects on a synchronized move,whether this relationship will hold or not remains to be seen.

I believe that the Phisix at the 5,000 level should represent a practical working yearend target; where anything above should be a bonus.

Again all these are conditional to the very fluid external political-financial environment, which includes risks from not only from the Eurozone, but from China and the importantly US—whose debt level is just $25 million shy from the debt ceiling[23] (probably the debt ceiling political risk will become more evident during the last semester).

Moreover, I believe that gold prices will continue to recover from the recent low.

Gains will crescendo as global policymakers will most likely ramp up on the printing presses. Gold will likely reclaim the 1,900 level sometime this year and could even go higher and will end the year on a positive note.

But then again all these are extremely dependent or highly sensitive to the situational responses of global policymakers.

Predicting social events or the markets in the way of natural sciences is a mistake.

As the great Ludwig von Mises explained [24],

Nothing could be more mistaken than the now fashionable attempt to apply the methods and concepts of the natural sciences to the solution of social problems. In the realm of nature we cannot know anything about final causes, by reference to which events can be explained. But in the field of human actions there is the finality of acting men. Men make choices. They aim at certain ends and they apply means in order to attain the ends sought.

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[1] See What To Expect In 2011, December 20, 2010

[2] See US Federal Reserve Goes For Subtle QE August 10, 2011

[3] Centralbanknews.info What Will 2012 Bring for Global Monetary Policy? December 27, 2011

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

[5] Zero Hedge Top Three Central Banks Account For Up To 25% Of Developed World GDP, January 5, 2012

[6] See Hot: Swiss National Bank to Embrace Zimbabwe’s Gideon Gono model September 6, 2011

[7] See Bank of England Activates QE 2.0 October 6, 2011

[8] See Global Equity Market Performance Update: Philippine Phisix Ranks 6th among the Best, December 17, 2011

[9] See How Global Financial Markets Performed in 2011 December 31, 2011

[10] Key Trends in Globalization, New world trade data indicates slowdown but not recession in the global economy, November 25, 2011 ablog.typad.com

[11] Allstarcharts.com BCA Research: High Equity Correlations Are Here To Stay, January 4, 2011

[12] See Graphic of the PSE’s Sectoral Performance: Mining Sector and the Rotational Process, July 10, 2011

[13] See MF Global Fallout Haunts the Metal Markets, December 12, 2011

[14] See War On Gold: China Applies Selective Ban December 28, 2011

[15] See Could the US be using the Euro crisis to extract support for a possible war against Iran? January 8, 2012

[16] Bloomberg.com China, Japan to Back Direct Trade of Currencies, December 26, 2011

[17] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency, April 20, 2011

[18] Cleveland Federal Reserve Credit Easing Policy Tools

[19] See World’s Biggest Economies Face $7.6 Trillion Bond Tab as Rally Seen Fading January 4, 2012

[20] See Phisix: Primed for an Upside Surprise December 11, 2011

[21] See How Reliable is the S&P’s ‘Death Cross’ Pattern?, August 14, 2011

[22] See US Equity Markets: From Death Cross to the Golden Cross, December 31, 2011

[23] Zerohedge.com Here We Go Again: US $25 Million Away From Debt Ceiling Breach, January 5, 2012

[24] von Mises Ludwig Misapprehended Darwinism, Refutation of Fallacies, Omnipotent Government p.120