David Stockman: The US Federal Reserve is Destroying the Capital Markets

David Stockman, former Republican U.S. Congressman and director of the Office of Management and Budget, founding partner of Heartland Industrial Partners and the author of The Triumph of Politics: Why Reagan's Revolution Failed and the soon-to-be released The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy in an interview at the Gold Report has this biting message. [bold emphasis mine]

The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. The yield curve signals nothing anymore because it is totally manipulated by the Fed. The very idea of "Operation Twist" is an abomination.

Capital markets are at the heart of capitalism and they are not working. Savers are being crushed when we desperately need savings. The federal government is borrowing when it is broke. Wall Street is arbitraging the Fed's monetary policy by borrowing overnight money at 10 basis points and investing it in 10-year treasuries at a yield of 200 basis points, capturing the profit and laughing all the way to the bank. The Fed has become a captive of the traders and robots on Wall Street…

I think the likely catalyst is a breakdown of the U.S. government bond market. It is the heart of the fixed income market and, therefore, the world's financial market.

Because of Fed management and interest-rate pegging, the market is artificially medicated. All of the rates and spreads are unreal. The yield curve is not market driven. Supply and demand for savings and investment, future inflation risk discounts by investors – none of these free market forces matter. The price of money is dictated by the Fed, and Wall Street merely attempts to front-run its next move.

As long as the hedge fund traders and fast-money boys believe the Fed can keep everything pegged, we may limp along. The minute they lose confidence, they will unwind their trades.

On the margin, nobody owns the Treasury bond; you rent it. Trillions of treasury paper is funded on repo: You buy $100 million (M) in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out.

If that happens, the massive repo structures – that is, debt owned by still more debt – will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked.

Read the rest here.

Many people believe that the numerous incidences of irregularities seen in financial markets emanate from unscrupulous behavior by some market agents, little has been understood that central bank policies, together policies that cater to crony capitalism, have been incentivizing or fostering such behavioral anomalies.

And importantly, the nature of capital markets have been intensely distorted to the point where conventional wisdom of its mechanics has nearly been rendered obsolete.

Either we face up to such evolving realities or suffer from our recalcitrance to adjust when the day of reckoning arrives.

Global Stock Markets: Will the Recent Rise in Interest Rates Pop the Bubble?

The natural tendency of government, once in charge of money, is to inflate and to destroy the value of the currency. To understand this truth, we must examine the nature of government and of the creation of money. Throughout history, governments have been chronically short of revenue. The reason should be clear: unlike you and me, governments do not produce useful goods and services that they can sell on the market; governments, rather than producing and selling services, live parasitically off the market and off society. Unlike every other person and institution in society, government obtains its revenue from coercion, from taxation. In older and saner times, indeed, the king was able to obtain sufficient revenue from the products of his own private lands and forests, as well as through highway tolls. For the State to achieve regularized, peacetime taxation was a struggle of centuries. And even after taxation was established, the kings realized that they could not easily impose new taxes or higher rates on old levies; if they did so, revolution was very apt to break out.-Murray N. Rothbard

The rampaging bullmarket here and abroad has raised concerns that recent increases in nominal interest rates could put a kibosh to the current run.

As I pointed out before, the actions in the interest rates markets will be shaped by different circumstances[1] which means it is not helpful to apply one size fits all analysis to potentially variable scenarios that may arise.

Interest rates may reflect on changes in consumer price inflation, they may also reflect on the perception of credit quality and they may reflect also on the state of demand for credit relative to the scarcity or availability of savings or capital[2].

Since the current interest rate environment has been mostly manipulated by political actions, where the political goal has supposedly been to whet aggregate demand by bringing interest rates towards zero, then we are dealing with a policy based negative real rates economic environment.

So the crucial issue is, has the recent selloff in treasury bonds neutralized the negative real rates regime? The answer is no.

First of all, current environment has not been reflecting concerns over deterioration of credit quality as measured through credit spreads[3], which seem to have eased.

Also, milestone highs reached by global stock markets, led by the US, have encouraged complacency through a reduction of volatility[4].

Second, the yield curve of US treasuries despite having flattened (perhaps due to policy manipulations) still manifests opportunities for maturity transformation trade or lending activities.

Thus, we are seeing signs of recovery in business and commercial lending in the US.

Some of the banking system’s excess reserves held at the US Federal Reserve seem to be finding its way into the economy.

Lastly, many are still in denial that inflation poses a risk, despite rising Treasury Inflation Protected Securities (TIPS).

TIPs are government issued treasury securities indexed to the consumer price index (CPI) with maturity ranging from 5 to 30 years which are usually considered as inflation hedges. (That’s if you believe on the accuracy of the CPI index. I don’t)

TIPs seem to have converged with the S&P 500.

Financial markets could be pricing in a risk ON environment and real economic activities, calibrated by the current negative real rates regime, combined with signs of escalating consumer price inflation.

The reality is that mainstream and the political establishment will continue to deny that inflation exists, when the US Federal Reserve has already been rampantly inflating.

Monetary inflation is inflation. However the public is being misled by semantics of inflation by pointing to consumer price inflation.

As Professor Ludwig von Mises wrote[5],

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase

They put the responsibility for the rising cost of living on business, This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the Office of Stabilization and Price Control is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury goes on with inflation.

That’s because any acknowledgement of inflation would put to a stop or would prompt for a reversal of the Fed’s accommodative policies. And considering that the banking system has been laden with bad loans, and that welfare based governments have unsustainable Ponzi financing liabilities, then tightening money conditions, expressed through higher interest rates, means the collapse of the system.

Underneath the seeming placid signs of today’s marketplace have been central banking steroids at work as the balance sheets of major economies have soared to uncharted territories[6].

The US Fed and the ECB, as well as other central banks, including the local BSP, will work to sustain negative interest rates environment, no matter any publicized rhetoric to the contrary. There may be some internal objections by a few policy makers, but all these have signified as noises more than actual actions. The politics of the establishment has drowned out any resistance as shown by central banks balance sheets.

One must remember that the US Federal Reserve was created out of politics[7], exists or survives through political money and will die through politics. And so with the rest of central banks.

Thus there is NO way that central bankers will not be influenced[8] by political leaders, their networks and by the regulated. Political power always has corrupting influences.

A good example can be gleaned from Independent Institute research fellow Vern McKinley’s comments[9] on U.S. Treasury secretary Mr. Timothy Geithner’s recent Op Ed[10]

He recounts how the CEO of Bear, with his firm on the brink of bankruptcy, came to him looking for a shoulder to cry on. From his then leadership perch as president of the New York Fed, the bank ultimately extended nearly $30 billion for a bailout, the first in a series of such interventions.

Central bankers are human beings. Only people deprived of reason fail to see the realities of government’s role.

And since the FED has unleashed what used to be a nuclear option, other central banks have learned to assimilate the FED’s policy. This essentially transforms what used to be a contingency measure into conventional policymaking.

As been said before, inflationism has produced an unprecedented state of dependency

And that such state of dependency can be seen through the dramatically expanding role of non-market forces or the government.

As Harvard’s Carmen Reinhart observed in her Bloomberg column[11],

In the U.S. Treasury market, the increasing role of official players (or conversely the shrinking role of “outside market players”) is made plain in Figure 3, which shows the evolution from 1945 through 2010 of the share of “outside” marketable U.S. Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.

The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) has left the share of outside marketable Treasury securities at almost 50 percent, and when GSEs are included, below 65 percent.

These are the lowest shares since the expansive monetary policy stance of the U.S. regularly associated with the breakdown of Bretton Woods in the early 1970s. That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.

This is not an issue involving economics alone. This is an issue involving the survival of the current state of the political institutions.

Bottom line: Rising interest rates will pop the bubble one day. But we have not reached this point yet.

Again, the raft of credit easing measures announced last month will likely push equity market higher perhaps until the first semester or somewhere at near the end of these programs. Of course there will be sporadic shallow short term corrections amidst the current surge.

However, the next downside volatility will only serve as pretext for more injections until the market will upend such policies most likely through intensified price inflation.

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[1] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2011

[2] See I Told You Moment: Philippine Phisix At Historic Highs! January 15, 2012

[3] Danske Bank, The US bond market finally surrendered, Weekly Focus March 16, 2012

[4] See Graphics: The Risk On Environment March 14, 2012

[5] Mises, Ludwig von 19 Inflation Economic Freedom and Interventionism Mises.org

[6] Zero Hedge, Is This The Chart Of A Broken Inflation Transmission Mechanism? March 13, 2012

[7] See The US Federal Reserve: The Creature From Jekyll Island, July 3, 2009

[8] See Paul Volcker Warns Ben Bernanke: A Little Extra Inflation Would Backfire, March 16, 2012

[9] McKinley Vern Timothy Geithner's Bailout Legacy Not One To Be Proud Of, Investor’s Business Daily March 15, 2012

[10] Geithner Timothy Op-Ed: ‘Financial Crisis Amnesia’ Treasury.gov March 1, 2012

[11] Reinhart Carmen Financial Repression Has Come Back to Stay, Bloomberg.com March 12, 2012

The Remarkable Phisix-ASEAN Resiliency Amidst the Global Financial Storm

“Keynesians tend to assume that government spending has a big positive effect on economic growth. Others disagree. But if the impact of increasing government spending is large, then the impact of removing it is also. So policy makers better be sure that the boom is around the corner. And all these are just short-run considerations. Here's the real dirty secret of Keynesian policies: They are sure to have a negative effect in the fullness of time.” Kevin Hassett

So how has the global markets affected ASEAN benchmarks and Philippine Phisix during last week’s furor?

ASEAN’s Gradual Discounting of Global Equity Market Meltdown

Except for Monday and Tuesday, where the bears launched a ‘blitzkrieg’ that has resulted to two day cumulative loss of 6.3%, broken down to 2.3% and 4% respectively, the diminishing marginal (time) value of information has stunningly prompted for an exceptional performance by the Phisix and the ASEAN region.

Astonishingly, the Phisix has managed to shrug off or IGNORE the 6% loss by the US last Thursday and went on to even close marginally higher[1]!

The recovery during the last three sessions of the week accrued to a net loss of 2.61% by the Phisix, still significant but the figures hardly reveal everything.

The actions of the Phisix basically have been identical with most of our neighbors.

Except for Indonesia (JCI) which saw a measly .79% decline for the week and while the Phisix (-2.61%) and the Thailand’s SET (-2.86%) fell by more than the US, the latter two still posted positive returns on a year to date basis, respectively 2.87% and 2.84%. Only Malaysia which fell by 2.67% over the week, has been down by 2.3% on a year to date.

Yet there are some noteworthy developments here and in the region:

1. Again Indonesia, Thailand, and the Philippines remain on the positive territory, despite the global meltdown. Only Malaysia among the ASEAN tag team has been on the negative.

2. Regional volatility appears to be decreasing even as global markets continue to roil.

If such trend should persist then convergence in the performance of ASEAN bourses could deepen or could reflect on higher correlations of emerging Asian equities.

The statistical correlations may seem ambiguous, but from the above charts courtesy of the ADB[2] we can see how least correlated we are with US equities in relative terms.

Among ASEAN bourses only Malaysia has had above half a percent of correlations (left window). Indonesia (.38) has the least correlation followed tightly by the Thailand (.39) and the Philippines (.4).

So well into 2011 the correlations have tightened among ASEAN bourses which have also been reflected on the right window (emerging Asia-emerging Asia correlations, green line). Whereas correlations of emerging Asia with the US has clearly departed or has significantly diminished, where previous correlations .62 in 2009 has recently been only .46.

The implication is that global or US investors who seek to diversify away from high correlations performance with US assets may likely consider Emerging Asia or the ASEAN region as an alternative.

This is why the recent US downgrade is unlikely a net negative for Phisix or the ASEAN region as global diversification play could be a looming reality.

And this could also be why regional policymakers appear to be “bracing” for a possible onslaught of foreign capital flows[3].

3. Domestic participants appear to be learning how to discount events abroad.

In the Phisix, the seeming resiliency from the recent global market rout has primarily been an affair dominated by domestic participants.

Net daily Foreign trade (averaged on a weekly basis) exhibits net outflows last week (left window). Nonetheless, total outflows have yet to reach the May levels, in spite of this week’s dramatic volatility. This has likewise been reflected on the Philippine Peso which was nudged lower (.14%) to close at 42.64 to a US dollar this week.

The share of foreign investors to total trade has spectacularly declined as domestic investors has taken over or dominated (right window) trading activities. Local investors accounted for about 65% of this week’s trade.

I think the current trend of local bullishness can be buttressed by recent empirical evidence. Philippine bank lending in June has reportedly been strongly expanding[4]. Although official statistics say that most of the loan growth has been directed to ‘production activities’ led by power (62.3%) and financial intermediation (31.9%), I would surmise that many of these loans may have been redirected to the Phisix.

The Bangladesh stock market crash should be a noteworthy example to keep in mind where were substantial amount of bank loans had been rechanneled to the stock market. And when the government imposed tightening measures (both monetary and administrative), the Dhaka Stock Index collapsed[5]by about 40% in January of this year. Since, the Dhaka has hardly made a significant headway in recovering.

Nevertheless the Philippines maintains the steepest yield curve in Asia, which should even boost the appetite of banks to lend. This should serve as an impetus for the boom phase of the domestic business cycle which the Phisix seems to be part of the transition.

Importantly, policy rates remain very accommodative with only two marginal increases in the BSP’s policy rates as of June 2011. Meanwhile Indonesia’s rates are at record low (no wonder the outperformance).

Phisix and Market Internal Divergence

3. Market internals despite this week’s drastic swings has not been entirely negative.

Daily traded issues averaged on a weekly basis (left window) seem to validate the remarkable actions by local investors as this sentiment indicator continues to climb.

The advance decline spread computed on a weekly basis reveals of the same developments; lopsided lead by declining issues during the early selloff has partly been offset by the asymmetric difference by the advancing issues during days where the Phisix rebounded.

Proof of this week’s astounding resilience is that the early devastation from global market carnage hasn’t reached the intensity of the 1^st quarter storm marked by the Arab Spring-Japan triple whammy calamity selloffs.

In essence, the losses of the Phisix may have overestimated the actual actions in the general market or the Philippine Stock Exchange.

Said differently, the Phisix reflected on foreign outflows (selling of Phisix heavyweights) in contrast to the general market which manifested a much buoyant of local investors, an apparent divergence!

I argued of a potential ASEAN Alpha play at the end of July[6], here is what I wrote,

So it is unclear whether ASEAN and the Phisix would function as an alternative haven, which if such trend continues or deepens, could lead to a ‘decoupling’ dynamic, or will eventually converge with the rest. The latter means that either global equity markets could recover soon—from the aftermath of the Greece (or PIIGS) bailout and the imminent ratification of the raising the US debt ceiling—or that if the declines become sustained or magnified, the ASEAN region eventually tumbles along with them. My bet is on the former.

Therefore, I would caution any interpretation of the current skewness of global equity market actions to imply ‘decoupling’. As I have been saying, the decoupling thesis can only be validated during a crisis.

In the meantime, we can read such divergent signals (between ASEAN and the World) as motions in response to diversified impact from geopolitical turbulence.

For this week, the function of the Phisix (or ASEAN) as alternative haven has been demonstrably true for the domestic participants but unsubstantiated by foreigners fund flows.

My divergence theory seems as gradually being validated by the marketplace!

Again let me remind you, that divergence only thrives in a global scenario that doesn’t signify a real crisis or a recession, most likely from a global liquidity drain. For if the imminence of an overseas recession should emerge, we have yet to see how the local and regional markets would react.

Remember this is no 2008! This time the activist approach by the conventional ‘modern’ central bankers has been paving way for different outcomes on different markets.

Gold as Refuge, Also Played Being Out via Domestic Mining Issues

4. As Gold, the Japanese yen, and the Swiss franc has functioned as the du jour flight to safety assets during the current market distress, we seem to be witnessing the same phenomenon taking hold even in the local equity markets where gold mining issues have taken the center stage!

Whether from year to date (below window) or from last week’s amplified volatility, the market psychology of domestic investors on mining issues have ostensibly turned from the fringe to the mainstream.

One would note that in the sectoral charts above, Tuesday’s carnage only dented the mining sector (violent) which again found footing or used this decline as leverage to recoil higher. All the rest of Phisix (green) sectors, namely bank (blue), Commercial Industrial (grey), Holding (red), Services (light green) and Property (black candle), went in the direction of the mining sector but has been hobbled by the steep losses.

All I can say is that since the Philippines have NO physical markets for gold in terms of spot or futures or even Exchange Traded Funds (ETF), mining issues could have likely served as a proxy or representative asset.

That’s why in the face of the current market inconstancy or turbulence, despite the hefty gains, I would recommend a partial shift of asset exposures to gold mines as hedge. This is not a momentum play but rather a possible flight to safety move as we seem to be seeing here and abroad.

Conclusion

Mimicking the US Federal Reserve, my closing will be a reprise of my statement from last week[7] but with some alterations, enclose by brackets [ ]

The Phisix and the ASEAN-4 bourses have not been unscathed by the brutal global equity market meltdown.

However, excluding Friday’s [Monday and Tuesday’s] emotionally charged fallout and despite the weak performances of developed economy bourses during the week, the Phisix and ASEAN bourses has managed to keep afloat and has even demonstrated significant signs of relative strength, signs that could attract more divergent market activities in a non recessionary setting.

As global policymakers continue to engage in a whack-a-mole approach to the acute problems facing the developed economies’ banking-welfare based government system, the path dependent solution, as demonstrated during this tumultuous week, has been the age old ways of printing money and selective price controls.

The same foreseeable actions can be expected over the coming days, more patchwork with unintended consequences overtime.

And the outcome to the marketplace should be variable as the current conditions reveal.

Lastly, downgrades for Asia and possibly for Europe which may have a short term effect on Asian assets should actually be a plus for the region over the long run. This is not only from the possible diversification move but also from real capital flows.

That is if we adapt relatively sounder money approach and embrace economic freedom.

However if we continue to act in concert with global policy trends then we could expect these downgrades to eventually export boom bust cycles anew to Asia.

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[1] See Philippine Phisix: What An Incredible Turnaround! (Global Equity Markets Update), August 11, 2011

[2] Asian Development Bank Asia Capital Markets Monitor August 2011

[3] Bloomberg.com Asia braces for capital flows as currencies rise, gulfnews.com August 9, 2011

[4] BSP.gov.ph Bank Lending Continues to Accelerate in June, August 10, 2011

[5] See Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets, January 11, 2011

[6] See The Phisix-ASEAN Alpha Play, July 31, 2011

[7] See Phisix-ASEAN Outperformance Despite Global Meltdown, August 7, 2011

Global Market Crash Points to QE 3.0

I can already smell QE3. Now we'll see if Mr. Bernanke is a true money printer or an amateur money printer. If he is a true money printer, he's going to start printing soon, markets will rally but not to new highs-Dr. Marc Faber

Important: The US has been downgraded by the major credit rating agency S&P after the market closed last Friday[1], so there could be an extended volatility on the global marketplace at the start of the week. This largely depends if such actions has already been discounted. The first thing on Monday is to watch Japan’s response.

Nevertheless given the actions of the US markets last Friday, where rumors of the downgrade had already circulated[2], there hardly has been any noteworthy action which presages more trouble ahead.

At the start of the week, the mainstream attributed the weakness in the US markets as a function of the risk of a debt default. This, according to them, should arise if a debt ceiling deal would not be reached.

I argued that this hasn’t been so[3], for the simple reason that market signals has been saying otherwise.

A credit rating downgrade means higher costs of financing or securing loans and a possible rebalancing of the balance sheets of the banking system to comply with capital adequacy regulations.

The chart above shows that short term yields initially spiked (1 year note light blue and 3 month bill-light green) during the 11^th hour of the negotiations. But once the debt ceiling deal was reached and the bill was passed, interest rates across the yield curve converged as they fell along with prices of Credit Default Swap.

Instead I pointed to the deteriorating events in Europe as a possible aggravating factor on US markets.

Impact of Downgrades

There are two basic ways to measure credit risks. One is the interest rate, the other is through credit default swaps (CDS) which fundamentally acts as a form of insurance against a default.

It is misleading to think that downgrades drive the marketplace as some popular personalities as my former icon Warren Buffett recently asserted[4]

Financial markets create their own dynamics, but I don’t think we’re facing a double dip recession…Clearly what stock markets do have is an effect on confidence, and this selloff can create a lack of confidence.

Mr. Buffett has gotten the causality in reverse. Downgrades happen when market forces—popularly known as the bond vigilantes[5] or bond market investors protest current fiscal or monetary policies respond by selling bonds—has already been articulating them.

US CDS prices have steadily been creeping upwards[6], this has been indicative of marketplace’s perception of the festering credit conditions by the US. The problem isn’t that “selloff can create a lack of confidence”, but rather too much debt, which is the reason for the downgrade, has been fostering an atmosphere of heightened uncertainty.

Downgrades signify as a time lagged acknowledgement by social institutions of an extant underlying ailment being vented on the markets.

The fact is that 3 credit rating agencies have already downgraded the US[7].

Also downgrades as said above affect financial institutions more, not only because of higher costs of funds but also because of the compliance to capital adequacy regulations.

A fundamental picture of an ongoing market based downside rerating is the unraveling crisis in the Eurozone.

The escalating PIIGS crisis has been causing a panic on Spain and Italian bonds, whose interest yields have been spiking[8] and where European investors can be seen stampeding into Germany’s debt or the Swiss franc.

So how has Europe responded? In mechanical fashion, by inflationism.

Supposedly wrangling politicians/bureaucrats found a common cause or conciliatory ground to work on. The European Central Bank (ECB) commenced with its version of Quantitative Easing (asset purchases) initially buying Irish and Portuguese bonds[9], which the equity markets apparently ignored and continued to tumble.

The ECB now has promised to extend buying Italian and Spanish bonds, this coming week, in order to calm the markets[10].

The Swiss National Bank[11] has gotten into the act ahead of the ECB, by surprising the currency markets with an intervention allegedly meant to control a surging franc. I think that they were flooding liquidity for the benefit banks, with the currency as an excuse for such action.

The Swiss intervention, which has been estimated at CHF 30 billion ($39 billion) to CHF 80 billion[12], by expanding the monetary base, appears as having fallen short of achieving its declared currency goal (see right window). The franc trades at the levels where the SNB initiated the intervention. The result seems as $39 billion down the sink hole.

Japan has likewise followed the Central Bank money printing shindig by engaging in her own currency intervention, allegedly aimed at curbing the rise of the Yen. The Bank of Japan (BoJ) reportedly intervened with a record high amount in the range of $56.6 to $59.26 billion[13]

Total cumulative size of Japan’s QE has now reached 46 trillion yen[14] (US $627 billion)

Hence, the European debt crisis partly explains the recent global market crash.

And importantly the above dynamic demonstrates how central banks respond to a market distress or a mark down in credit standings.

As an aside, one would further note that since central banks of Japan, Eurozone and the Switzerland has now been funneling enormous liquidity into the system, all these funds will have to flow somewhere.

The same dynamics should be expected with the US, where a credit rerating would not only impair US government debt risk profile and the attendant higher costs of financing, but also debt of government sponsored agencies, municipal liabilities and corporate bonds who thrive on subsidies, guarantees, bailouts or other form of parasitical relationship to the US government.

Since many of these securities comprise asset holdings major financial institutions, a US downgrade also means downgrades for US banks, insurance companies and credit unions.

Martin Weiss of Weiss Ratings estimates that a staggering $6.3 trillion of securities constituting of government agency securities $2.2 trillion, $725 billion in municipal bonds and $2.9 trillion in corporate and foreign bonds are subject to immediate or future downgrades in the wake of a U.S. government debt downgrade[15]. This represents one-third of all the financial assets of all US financial institutions

So given the operating manual or basic procedure of central banks in treating downgrades, the S&P action essentially paves way for the next US Federal Reserve’s asset purchasing moves.

Thus, a downgrade on the US is essentially a downgrade on the US dollar.

[Funny how local investors continue to believe in the US dollar as safehaven, when the fundamental problem has been the US dollar!]

Current Environment Seems Ripe for QE 3.0

It’s been a long time theme for me in saying that part of the process to set up interventions has been through what central bankers call as the signaling channel[16].

The fundamental aim is to manipulate the public’s expectations in order to justify prospective policies, usually meant for inflation expectations management.

Over the May-June window, there had been extensive interventions in the commodity markets (raised credit restrictions sharply on various commodity markets, IEA’s release of strategic oil reserves[17] and the ban on OTC trades[18]) and in the debt and equity markets (via restrictions of short selling[19] and proscriptions on US asset sales by US residents through overseas markets[20]) which appears to have been designed as price controls.

This came amidst a spike in academic and research papers which tried to dissociate the Fed’s previous QEs with surges in commodity prices.

The process of interventions as I previously wrote[21],

First is to apply the necessary interventions on the market to create a scenario that would justify further interventions.

Second is to produce papers to help convince the public of the necessity of interventions.

Then lastly, when the 'dire' scenario happens, apply the next intervention tools.

As one can see, signaling channel has also been used to in the political context.

Similar to last week’s haggling for the US debt ceiling deal by two supposedly ‘opposing’ political parties, negotiations appears to have been leveraged or anchored on an Armageddon scenario from a debt default, if a deal had not been reached at the nick of time.

Channeling Mencken’s hobgoblins, fear had essentially been used as lever to reach an 11^th hour deal which means ramming down the throats of the Americans. The debt ceiling bill was predicated on what I called as legal skulduggery or prestidigitation[22] as government spending cuts were all based on promises (baseline projections rather than actual cuts)

Now that the debt ceiling bill has been passed, such jawboning appears to have morphed into a self-fulfilling prophesy. Markets went into a spasm.

This brings us to the core of what I think has been the epicenter of last week’s crisis.

The US equity market, represented by the S&P has been mostly buttressed by the money printing by the US Federal Reserve as shown from the chart from Casey Research[23].

One would note that in the above chart, an almost comparable decline occurred during the five month window since the Fed completed its QE 1.0 on March 2010.

The timeline for QE 1.0 is officially from March 2009 to March 2010, and QE 2.0 from November 2010 to June 2011.[24]

The difference between the actions of the US equities in post-QE 1.0 and post-QE 2.0 has been one of scale and speed.

Global equities functioned in the same manner too.

The closure of QE 1.0 (blue horizontal lines) saw an across the board decline and consolidation phase by global equity markets represented by world (FTSE All World FAW), Europe (STOX50), Asia (P1DOW) and Emerging Markets (EEM)—all marked by red ellipses. These had been reversed once the QE 2.0 was announced and implemented.

Importantly, during that post-QE 1.0 lull window (QE 1.0 blue horizontal lines; QE 2.0 green horizontal line) marked again by the red ellipses, the US dollar surged (USD), gold consolidated, US treasury yields (TNX) had been on a decline while commodities (CCI) likewise had been rangebound.

Today, post-QE 2.0, we see some important difference and similarities. Similar to the post-QE 1.0 environment, global-US equity markets have been under selling pressure as US treasury yields have been on a decline along with the commodity markets.

The difference is that the US dollar remains WEAK and has NOT generally functioned as the previous shock absorber during market stresses or during the post-QE 1.0.

Importantly gold continues to surge!

My point is: this episode of market turbulence seems like a contraption to the next asset purchasing measures by the US Federal Reserve or QE 3.0 (or in whatever name the Fed wishes to call it).

In other words, like the debt ceiling deal of last week, a crisis scenario has been put in place meant to justify the next round of interventions. And this reminds me of the shocking and revolting comment by Emmanuel Rahm, US President Obama’s former chief of staff which seem to resonate strongly today[25],

You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before.

With the US debt ceiling bill in place, the unraveling debt crisis in the Eurozone, an “alleged” risk of a sharp world economic growth slowdown or recession (I say alleged because I am not a believer), global equity market in turmoil, plus coordinated interventions by the central banks of Swiss, Japan and the ECB, pieces of the puzzles have been falling into place, as I have previously argued[26], which seem to pave way for Ben Bernanke and the US Federal Reserve to reengage in the next asset purchasing program.

And coincidentally the US Federal Reserve’s FOMC (Federal Open Market Committee) has been slated to meet on August 9^th Tuesday (Wednesday Philippine Time)[27]. And given the current turn of events, we should expect announcements that should reinforce a stronger policy response.

Public Choice and Possible Incentives Guiding Team Ben Bernanke

It’s fundamentally nonsensical to say that team Bernanke won’t engage in QE simply because of the futility or of the inefficacies of the previous QEs programs.

People who say this either fictionalize the role of individuals working for the governments or naively think that political operators operate on the basis of collective interests.

Public choice theory tells us that bureaucrats, like Ben Berrnanke, are equally self interested individuals. This means that since they are not driven by the incentives of profit and losses, the guiding principles of their actions are usually based on the need to preserve or expand their political careers (tenureship) by serving their political masters or by making populists decisions.

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

Moreover, political operators are also most likely to desire acquiring prestige and social clout by virtue of having expanded political control over the economy under the guise of social weal. That’s why more and more regulations are being imposed on the belief that a command and control economy would be more effective than one of free markets. Never mind the experience of Mao’s China and the USSR. Socialist champion billionaire and philanthropist George Soros got a taste of his own medicine when the Dodd Frank law compelled him to close his 40-year hedge fund[28].

Public choice also tells us that the political operators have beholden to vested interest groups such as the banking sector. The US Federal Reserve has thrown tens of trillions of dollars to save both US[29] and foreign[30] based banks. This accounts for as demonstrated preference or deciphering priorities from action over words.

Moreover, since their careers have been erected on the incumbent institutions, why should they enforce radical reforms that would only jeopardize their career or the institution’s existence, whom their allegiance have been impliedly sworn to?

To add, some policymakers operate on the ideological principles such as the theory of wealth effect, where increases in spending that accompanies an increase in perceived wealth[31]. From such pedagogical belief emanates the trend of ‘demand management’ based policy actions.

Take for instance, Ben Bernanke’s chief dogma “Crash course for central bankers” which he wrote as a Princeton Professor[32].

There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

Today, most of the central bankers seem to adhere to such principles.

So even if previous QEs didn’t work as planned, what will stop Mr. Bernanke from pursuing the same policies and expecting different results? All he has to do is to assume the academic stance of saying the past policies didn’t work because they have not been enough.

So while I don’t know what’s going on in Team Bernanke’s mind, personal incentives, path dependency and dogmatism all point to QE 3.0 pretty soon.

Political Actions over Economic Data and Technical Picture

Lastly the US economic picture can be seen positively or negatively depending on one’s bias, but in my view, I hardly see the imminence of recession.

In the US, ISM Manufacturing index[33] has fallen steeply but this has not yet gone beyond the 50 threshold which could be an indicator of a recession. Offsetting this view is that recession probability from the yield curve has been very low[34].

Of course looking at economic figures are based on the past (ex post) activities. Since today’s markets have been driven by political actions such as QEs, then past data wouldn’t weigh so much compared to the anticipatory (ex ante) policy directives by central bankers.

Yet the problem with today’s conventional mindset has been that of the chronic addiction to rising prices of anything, be it economic data or asset prices. Anything that falls translates to the necessity or call to action for government intervention.

So false signals can be used as basis to demand political actions.

Nevertheless I also think that technical factors did play a secondary role in last week’s US market crash.

The S&P has been on a bearish head and shoulder pattern.

Given the current market milieu, technically based market participants jumped into the bearish momentum from which this pattern became another self-fulfilled reality.

The pattern basically aggravated the current environment rather than having caused it.

Bottom line:

If the US Federal announces a major policy stimulus anytime soon, then this should be seen as a strong signal to buy both commodities or on ASEAN equity markets and the Phisix.

Otherwise, we should expect more downside market volatility and probably take some money off the table.

Again, profit from political folly.

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[1] See NO Such Thing as Risk Free: S&P Downgrades US August 6, 2011

[2] Telegraph.co.uk Debt crisis: as it happened, August 5, 2011

[3] See Today’s Market Slump Has NOT Been About US Downgrades, August 3, 2011

[4] Bloomberg.com S&P Erred in Cutting U.S. Rating: Buffett, August 7, 2011

[5] Wikipedia.org Bond Vigilante

[6] See Graphic: US Default Risk—Short and Long Term, August 2, 2011

[7] See How the US Debt Ceiling Crisis Affects Global Financial Markets, July 31, 2011

[8] Danske Bank Mr. Trichet will ECB buy Italy? ECB Preview August 4, 2011

[9] See ECB Intervenes in Bond Markets, More to Follow, August 5, 2011

[10] See ECB Expands QE: Will Buy Italian and Spanish Bonds, August 6, 2011

[11] See Hot: Swiss National Bank Intervenes to Halt a Surging Franc August 3, 2011

[12] Marketwatch.com Swiss central bank battles to halt franc’s rise August 3, 2011

[13] CNBC.com Japan Sells Record $58 Billion in FX Intervention, August 5, 2011

[14] Danske Bank Japan: BoJ tries to draw a line in the sand, August 4, 2011

[15] Weiss Martin, Day of Reckoning! TOMORROW!, August 1, 2011, Moneyandmarkets.com

[16] See War on Precious Metals: The Rationalization Process For QE 3.0, May 7, 2011

[17] See War on Commodities: IEA Intervenes by Releasing Oil Reserves, June 24, 2011

[18] See War on Gold and Commodities: Ban of OTC Trades and ‘Conflict Gold’, June 18, 2011

[19] See War on Speculators: Restricting Short Sales on Sovereign Debt and Equities, May 18, 2011

[20] See US Government’s War on US Expats and American Investments Overseas, June 21, 2011

[21] See War on Precious Metals Continues: Silver Margins Raised 5 times in 2 weeks!, May 5, 2011

[22] See Debt Ceiling Bill: Where are the Spending Cuts?, August 2, 2011

[23] Casey Research Too Much of a Good Thing

[24] Ricketts Lowell R. Quantitative Easing Explained Liber 8 Federal Reserve Bank of St. Louis, April 2011

[25] Wall Street Journal In Crisis, Opportunity for Obama, November 21, 2008

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

[27] Mam.Econoday.com FOMC Meeting Announcement 2011 Economic Calendar

[28] See George Soros on Closing Hedge Fund: Do As I Say, Not What I Do, July 27, 2011

[29] See US Taxpayers Could Be On The Hook For $23.7 Trillion!, July 21, 2009

[30] See Fed Audit Reveals US Federal Reserves’ $16 Trillion Bailouts of Foreign Banks, July 26, 2011

[31] Wikipedia.org Wealth effect

[32] See The US Stock Markets As Target of US Federal Reserve Policies, May 11, 2011

[33] Harding Jeff, Destruction of Capital Resulting in Global Manufacturing Slowdown, Minyanville.com August 2, 2011

[34] Moneyshow.com A Red Flag for Emerging Markets... and the US, Minyanville.com August 4, 2011