Bernanke’s Put: Putting The Punch Back Into The Punchbowl!

``The great problem is, of course, how to provide such emergency relief without allowing it to degenerate into permanent relief; how to relieve the extreme distress of those who are poor through little or no fault of their own, without supporting in idleness those who are poor mainly or entirely through fault of their own. To state the problem in another way (as I have earlier done): How can we mitigate the penalties of failure and misfortune without undermining the incentives to effort and success?-Henry Hazlitt (1894–1993) founding board member of the Mises Institute, libertarian philosopher, economist, and journalist for The Wall Street Journal, The New York Times, Newsweek, and The American Mercury.

A surprising 50 basis point cut by the US Federal Reserve sent US equities to a bacchanalian revelry, which spontaneously reverberated across the globe.

Equity bulls were quick to broach on the receding risks of recession and the gridlock in the global credit system as a consequence to the magical stroke of liquidity injection which should keep the shindig going. Analyst Doug Noland quotes a comment of former U.S. Treasury secretary Paul O'Neill ``Fed put the punch back into the punchbowl."

Here is accompanying statement of the US Federal Reserve last Tuesday (highlight mine):

``Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

``Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

``Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

As we have repeatedly pointed out, the performances of the financial markets has been proven to have the most bearing among the considerations of the US policymakers.

Since our monetary system operates on the standard of revolving leverages, where borrowed money bought even more borrowed money, such requires conditions that would propagate even more dosages of leverage or gearing to sustain the system, hence the Hyman Minsky’s Ponzi financing system or euphemistically the Fractional Banking System.

To subject the system to liquidity deceleration or to a contraction of leverage brings to fore systemic risks; the risks that the Paper Money Standard could unravel. In the words of financial derivatives expert and author of “Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives” Satyajit Das (highlight mine), ``Risk itself has changed significantly. Financial crises are less and less the result of economic downturns, geopolitical events or natural disasters. They are more and more the result of the structure and activity in financial markets. Financial crises now do not necessarily mirror the underlying real economy. Economic cycles have become less pronounced.”

Therefore, an economy greatly dependent on the kinesics of financial assets would inherently engender policy responses directed at its unceasing benedictions.

For those who propound the latest actuations by the FED as signifying pre-emptive or “proactive” actions eludes the rudiments of such dynamics.

For us, the FED’s unanticipated action could OBVERSELY be construed as a sign of PANIC.

An unchanged rate, regardless of the financial markets reaction could have represented “principled” banking at its finest. On the other hand, a 25 basis points cut could have ACKNOWLEDGED the problem, but seen in the light of CONTAINMENT. However, the 50 basis points cut PLUS a similar cut in the discount rates ACCENTUATED the FED’s apprehensions over the immeasurable and profound ramifications of the credit market seizure contagion! This comes amidst risks of “some inflation”, according to the FOMC statement, which is almost tantamount to throwing gasoline to quench the fire (see Figure 1)…

Figure 1: Barry Ritholtz: Fear of a Dollar Collapse, part II

From analyst Barry Ritholtz (highlight mine), ``Speaking of surges: As you can clearly see above (bottom left chart), the amount of MZM (repos) versus M2 during 2007 is enormous.

``This means that the Fed is "inflating" at a rate faster today than it did right after 9/11, or during the deflationary scare of 2003.”

The inebriate has been given his bottle of whiskey.

For us, the US FED and even the Bank of England’s “nationalization of deposits” of Northern Rock corroborates Nassim Nicolas Taleb’s Ethical Problem; the deep-seated nature of authorities for TREATMENT-based POLITICALLY MOTIVATED policies rather than preventive measures.

As evidence, the US dollar trade weighted index, which fell 1.33% this week (see figure 2), has been sacrificed in the altar of today’s monetary system in exchange for the survivorship of its natural constituents.

Figure 2: fxstreet.com: US Dollar Index Plunges to Multi-year lows!

Daily Reckoning’s Bill Bonner excerpted economists Lewis & Clark poignant remarks whom we quote (emphasis mine), ``It seems intended to bail out the speculators on Wall Street...and the imprudent borrowers in the housing market...but it merely redistributes the losses onto the people who don’t deserve them – the general population of dollar holders, dollar earners, and dollar savers all over the world.”

Where mainstream experts mostly argue on the superficial aspects, particularly the symptoms of social or wealth inequality, a few of them fixate on the root causes…as the great Milton Friedman once said, ``Inflation is a form of taxation that can be imposed with legislation.”

Comparing Past Outcomes From FED Actions Is A Gambler’s Fallacy

``There are no facts, only interpretations”-Friedrich Nietzche

The euphoria in the global markets following the FED’s actions places a positive spin in an otherwise risk fraught landscape. Should this be instead reckoned as the proverbial “Wall of Worry” to climb?

Equity bulls revert to rate cutting antecedents such as in September 1998 (+25% in 6 months), July 1995 (+11%), June 1989 (+9%) and September 1984 (+5%) as prospective models, where policy actions benefited the equity markets, from which today’s markets could replicate. We hope they are right, but alas, hope is not a strategy.

However, the bulls equally dismiss on the subsequent 2001 tech bust as an “outlier” event for having the infamous 9/11 to “unjustifiably” weigh on the circumstances. Such argument we believe is selective perception or ``how we view our world to create or justify our own reality (Sherif & Cantril, 1945)”.

In essence, the bulls argue that in the realm of probability distributions, given the high success ratio of monetary policy actions as reflected by the market gains in the aftermath, the probability is thus weighted to favor market gains under the present circumstances.

How valid is such claim?

Figure 3: Economagic: Reprise of 2001 “Outlier”?

The US markets went on a wild ovation in response to the US Federal Reserve’s unexpected rate cuts. On Tuesday, the Dow Jones Industrials rocketed 2.51% (335 points), the broadbased S & P 500 soared 2.92% (43.13 points) and Nasdaq flew 2.71% (70 points).

Effectively, based on the dimensions of technical readings alone, the US markets are now in bull territory, which equally delivers most global markets including the Phisix into bullish grounds.

But given such developments, should we then join bandwagon? Not so fast, I believe.

The tech bust in 2001 appears to have manifested a parallel repertoire when the FED initiated its policy changes then.

In January 3, 2001 the FED “surprised” the market as it lowered its FED FUND rates by 50 basis points to begin its “preemptive” campaign to fight deflationary forces.

The US equity markets went into fabulous hyperdrive: the Dow sprung by 300 points or 2.8%, the S & P 500 zoomed by 5% (!!) or 64.9 points and even astonishingly the Nasdaq whizzed skywards by 14.17% (!!!) or 324.83 points. Again, notice of scale of gains by the US markets then, compared to last Tuesday.

Unfortunately such burst of adrenalin wavered as the one-day gains were wiped out in the coming sessions see figure 3.

In addition, the same chart tells us that the 9/11 outlier event argument occurred when the US economy was already suffering from the throes of RECESSION (see steep fall amidst the red shadow). Hence the tragic event aggravated the already deteriorating sentiments. In other words, even WITHOUT a 9/11 the markets then was into a CYCLICAL DECLINE.

Thus, since the 9/11’s relationship was COINCIDENTAL rather than CAUSAL, writing off the 2001 equation from the probability list was unwarranted.

Nonetheless, the basic difference between 2001 and today is that the US markets sputtered immediately while today’s markets have managed to hold its gains (yet?).

Figure 4: Economagic: long term view FED Funds and S&P 500

Another basic nuance cited by the bulls lending to the supposed “increased odds” for a positive outcome entails historical precedents that have come ABSENT recessions.

In figure 4, ALL policy changes (inflection points shown by the red line) SUBSEQUENT to or DURING recessions, marked by the red shadows, saw the US markets FALL.

In other words, the defining contrast of the probability distribution, following the FED rate cuts, SHOULD BE IF A US RECESSION OCCURS OR NOT.

One should be reminded that each of the said periods had distinct or dissimilar dynamics which influenced the financial markets then. And should NOT be lumped and generalized as similar with that of today.

Whether the markets will do a rhythmical reprise of 1998 as discussed in our August 13 to 17 edition (see US Markets: Unlikely A Reprise of 1998) or that of a 2001 appears to be a 50-50 odds given the above facts.

Assigning greater odds to a positive outcome is similar to a gambler’s fallacy (wikipedia.org), ``where the random event is the throw of a die or the spin of a roulette wheel, gamblers will risk money on their belief in "a run of luck" or a mistaken understanding of "the law of averages". It often arises because a similarity between random processes is mistakenly interpreted as a predictive relationship between them.”

A gambler’s fallacy can be exemplified by coin tosses. If a coin has been flipped five times and comes up with a series of “heads”, then the usual bet for the next toss would that of a “tail” since people would be inclined to think that the “law of averages” could deliver a “tail” outcome. But this ignores the fact that coin flipping is a 50-50 odds where each “flip” is INDEPENDENT of the results of the previous tosses, hence the fallacy.

So in the present environment where the recession prospects is a RISK concern, it would appear that as the chart shows, if the US falls into a recession the market goes down while if it escapes recession it could go up. In short, a 50-50 odds.

Now when bullish commentaries tells us that the previous streaks of rate cuts ended with a positive return, we understand these as prognosis shaded with a confirmation bias. And when they introduce probabilities using the same data in support of such claims, we also understand these as forecasting based on a gambler’s fallacy.

The bullish or bearish outcome will depend on a myriad of interacting factors such as the resolution of the bottlenecks in the global credit system, the reappearance of risk taking appetite, a return of confidence to the global financial markets, the strength of the global economy, the resiliency of the heavily levered US economy, the fate of the US dollar, political risks as growing protectionist sentiment and many, many more…

As The Us Dollar Falls, Stagflation Becomes A Reality

``Much has been written about panics and mania…. But one thing is certain; that at particular times a great deal of stupid people have a great deal of stupid money. At intervals… the money of these people — the blind capital, as we call it, of the country — is particularly large and craving: it seeks for someone to devour it and there is a 'plethora'; it finds someone and there is a 'speculation'; it is devoured and there is a panic." – Walter Bagehot, "Essay on Edward Gibbon"

In our previous outlooks we mentioned that given the mixed signals delivered by the markets, some of these would be resolved after the Fed’s action.

Well as Bernanke and Company waved the magic wand, indications became clearer, Bond Yields over the long end climbed, Gold surpassed its previous highs, the Baltic Freight index soared to record levels alongside ALL TIME HIGH Crude Oil prices, a crumbling US dollar index—all of which points towards the resurgence of inflationary pressures.

Figure 5: stockcharts.com: US Treasuries yield bolt higher

Figure 5 shows how the 30 year and 10 year treasury yields have surged following the FED’s actions while 3 month yields remains soft. The Yield spread of the 2 year and 10 year treasuries is at the highest level since May 2005.

A further steepening of the yield curve implies more inflation pressures. This should be confirmed by a motile rise in commodities as well as a drop in the US dollar, hence places the Bernanke in a box. Question is, could this lead the FED to a ONE and DONE move?

Since we are predisposed towards the view that the US monetary policies have been anchored to the developments in the financial markets particularly the equities market, its direction going forward would likely determine the FED’s next moves.

For instance, a continued surge in the equity market, or a Dow Jones breakout from the 14,000 levels could effectively put a tether on the future rate hikes, which is unexpected by the markets. On the other hand, a slippage of the Dow Jones Industrials back to the 10% loss levels could likely impel the FED to continue with its present phase of liquidity expansion.

While we see the more likelihood of a second scenario, we simply cannot discount the first. As we earlier said, markets can go either way from this point. Mr. Bernanke can further revise or rewrite lending rules, as they recently had--to accommodate more eligible collateral and they could print money and bonds to buy all those affected or “freezed-up” assets which could send US markets higher at the expense of the US dollar.

Moreover, a rising market may not imply diminished risks; not when GOVERNMENTS INSTEAD OF MARKET PARTICIPANTS THEMSELVES DRIVE THE MARKETS. Remember, markets today are heavily stacked towards the expectations of a “socialization” of the financial economy, where government interventions are greatly expected to deliver the elixir to the recent crisis. The argument for rate cuts has been synonymous to the arguments for political subsidies.

To consider, the threshold levels and record levels of gold, oil and the US dollar index is in itself a source of concern (figure 6). As we previously said, while mainstream analysis heavily discounts a US dollar crisis, we don’t see this as unlikely. The fact that the US dollar trades a few PIPS (price interest points) away from its LIFE time lows could trigger a massive and violent reaction either way. And violent reactions suggests of amplified volatility.

For instance, the US dollar fell heavily on rumors that the Saudi government would junk the US dollar peg and diversify AWAY from US dollar assets. This was apparently triggered by the Saudi Arabia’s government’s refusal to adjust rates alongside the recent US monetary actions, where since 1986 Saudi’s currency has been pegged to the US dollar at 3.75 riyals for every dollar, hence are required follow the interest rate policies of the US.

Quoting Ambrose Evans Pritchard of the Telegraph (highlight mine), ``This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

``Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

``The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.”

With surging inflation as consequence to a US dollar peg, the oil rich Kingdom could finally break from its linkage as Kuwait last May.

Notwithstanding, in July according to the US Treasury International Capital System, net foreign purchases of long-term securities dramatically slowed to $19.2 billion from June’s $120.9 billon. This reflected the net foreign purchases by foreign official which declined to $4.4 billion in July from $53.8 billion in June.

In short, these could represent troubling evidences of the US dollar losing support as the de facto world’s foreign currency reserve. The denouement of which could reveal itself when prime commodities like oil get to be traded in ex-US dollar currencies.

For now, it is likely that as the US dollar swoons, the risks grows where pressure is felt by foreign holders of US dollar assets to slacken from adding more positions or to even become net sellers.

This is why as we have said last week we find gold and commodities and their proxies in the Philippine markets in the form of equities as possible HEDGES against risks from any financial crisis that could transpire.

Figure 6: stockcharts.com: Inflationary Landscape?

Yet, we remain UNCERTAIN of how a potential selloff in the US markets (assuming a recession comes to play) could affect Asian or Emerging Market or Philippine assets, although a soft US dollar has in the past provided important support to them.

We believe that Philippine mines should continue to outperform as the inflationary setting accelerates.

One should not forget that while governments’ control the money tap, the leakage from such actions will percolate unevenly, hence inflation may appear in any asset class from anywhere across the globe where such transmission permits. So while global economies downshifts, such inflationary scenario translates to a stagflationary outlook, an almost similar landscape that took place during the 1970s to the 1980s.

We also believe that Asia will be the strongest link if a negative correlation or a prospective decoupling occurs. Until evidences suggest of such dynamics becomes apparent, we will position only in small amounts to reflect on the risks we can afford to take as conditions warrant.

US Commercial Paper Markets: A Run on The Shadow Banking System?

``Federal Reserve independence is not set in stone…The dysfunctional state of American politics does not give me great confidence in the short run…and there may be ``a return of populist, anti-Fed rhetoric,'' Alan Greenspan ``The Age of Turbulence: Adventures in a New World” quoted from Bloomberg

In the financial sphere, it has been one heck of an interesting week where some ironic developments persist to unfold…

One, global central banks debate on how to resolve the present juncture…

Two, global equity markets continue to crawl higher despite the barrage of negative developments (are these salutary signs of “climbing the wall of worry?”) amidst conflicting messages seen across different markets and…

Lastly the Phisix survived the week with some bruises from an onslaught of foreign selling worst than during the August lows (!).

The Bank of England seemed to have assumed the “principled” path of central banking by adamantly refusing to go along the way of its peers in rescuing the money markets. It even rebuked the US FEDERAL RESERVE and the EUROPEAN CENTRAL BANK for “moral hazard” or by acting to bail out some banks last Thursday, from which we quote UK Central Bank governor Mervyn King (highlight ours), ``The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior, that encourages excessive risk-taking and sows the seeds of a future crisis.” Mr. King’s view was supported by Canada’s Central Bank Governor David Dodge.

Well, such rhetoric was good until Northern Rock, UK’s fifth largest mortgage lender, came knocking on its doors for liquidity support. Of course, there always has to be some justification; here is Bank of England’s statement, ``the FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

Incidentally, the problems at Northern Rock has NOT been due to US subprime papers but rather from banks reluctant to lend to each other, this from the Economist (highlight mine),

``Yet Northern Rock appears to be less of a protagonist in the current credit crisis than a bad case of collateral damage. Its problems were caused not because it risked its shareholders’ money on poorly judged investments linked to American subprime mortgages, as many far bigger and more international banks have. Instead, it has been hit by a failure to borrow from other banks to fund its mortgage lending practices. The interbank market where such borrowing usually takes place has partially seized up in recent weeks because big banks are hoarding as much capital as they can to pay for the cost of their own bad investments.”

As you can see, the ongoing liquidity drought in the credit markets has begun to affect the peripherals, as banks load up on their reserves to prepare for portfolio adjustments (losses).

Yet, much of today’s liquidity seizure has been seen via the US $2 trillion commercial paper markets.

Commercial paper markets are short-term (unsecured) debt instruments or promissory notes issued by financial and non financial companies with maturities ranging up to 270 days and an average 30 days (capital-flow-analysis.com). Such instruments are usually used by companies to fund their day-to-day operations such as inventory purchases or manage working capital.

These papers are usually bought by money market funds or by mutual funds that invests in short term papers.

The problem lies with the asset-backed commercial paper market or short term vehicle issued by financial institutions backed by physical assets such as receivables (mortgages, bonds, credit cards, car loans or other trade receivables), some of which had been collateralized by subprime mortgages.

Where many of the pooled investment vehicles as the Structured Investment Vehicles (SIVs) used by banks and sold to the public had been borrowed in the form of asset-backed commercial papers, the losses in the US subprime sector has resulted to a freeze in financing due to the questionable valuations of these vehicles.

In effect, the liquidity freeze in the commercial paper space has crimped on the access to financing by corporations to manage their day-to-day operations. This has likewise raised the cost of borrowing, and increased the risks of corporations raising cash by selling other assets in order to raise cash.

PIMCO’s managing director Mr. Paul McCulley labels such developments equivalent to a bank run but in the form of “The Shadow Banking System”, where in his outlook, Mr. McCulley wrote (highlight mine),

``Technically, that’s called systemic risk. And in the current circumstance, it’s called a run on what I’ve dubbed the "shadow banking system" – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.

``Unlike regulated real banks, who fund themselves with insured deposits, backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with un-insured commercial paper, which may or may not be backstopped by liquidity lines from real banks. Thus, the shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks and/or to liquidate assets at fire sale prices.”

In Friday’s commentary, the cautiously bullish BCA Research (see figure 1), seeing the continued pressures in the credit markets, now joins the ranks of those calling for rate cuts…

Figure 1: BCA Research: Monitoring the Credit Crunch

Quoting BCA Research, ``The price of credit remains elevated in many areas. The asset-backed commercial paper market remains locked up, with investors seemingly unwilling to buy at any price. Term financing is difficult to get and this, along with nascent banking sector concerns, has contributed to the ongoing elevation in LIBOR rates and the fed funds-LIBOR basis swap. The 2-year swap spread also continues to widen towards the previous peak. Similarly, both corporate bond and CDS spreads are grinding higher. Perhaps most worrisome, the price of debt for some consumers has also surged, as indicated by the recent blowout in the 30-year fixed jumbo mortgage rate. It is when creditworthy customers cannot access credit that the Fed must step in and deliver relief.”

So how are rate cuts supposed to help?

The lowering of rates aims to reduce the impact of higher borrowing spreads and potential loan losses. Remember, in a highly levered financial system, marginal moves reverberate! Yet, rate cuts cannot be taken with certitude that confidence will be restored, especially if the damage has been widespread.

All told, despite the gradual progress seen in the equity markets, the credit markets tell us that ALL IS NOT NORMAL and that the present liquidity drought has been seen affecting a broader part of the global economy. This suggests to us that the downside risks are far greater than what the consensus expects.

On Bailouts: Left Hand Doesn't Know What The Right Hand Is Doing; Asymmetric Market Signals

``Monetary policy, at bottom, is not independent of fiscal policy. While reckless fiscal policy invariably ends in attempts to “monetize” the government's debt by printing money instead of issuing bonds, inflation is ultimately always and everywhere a fiscal phenomenon. Money and bonds are essentially portfolio substitutes, and interest rates fluctuate in order to ensure that the existing quantities of both assets are held in equilibrium.”-John Hussman Ph.D., Hussman Funds

Anent the Bank of England’s bailout of Northrock: As we always insist, Bailouts or government interventions have always been a manifestation of the ETHICAL PROBLEM—political authorities’ preference for a “treatment based solution” instead of a preventive cure, aside from its INFLATIONARY CONSEQUENCES in light of the quest to preserve the health of the prime conduits of today’s functioning FIAT MONEY Standard.

The risks of inflation and the MORAL Hazard problem has always been used as the perpetual POLITICAL SLOGAN of which these institutions proclaim as their nemesis, but behind the scenes surreptitiously work to uphold…or a case of a “left hand doesn't know what the right hand is doing.”

Allow me to quote PIMCO’s Paul McCulley anew (highlight mine), ``Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation. The question is not whether the Fed Put exists, but where is its strike price?”

For instance, some would readily believe the propaganda that the FED’s utilization of its REPO tool constitutes only of a substitution of liquidity or does not translate to monetary inflationary. While on the surface, such arguments look plausible, on a deeper context, particularly viewed within the TIME VALUE of Money frame, REPO activities are evidently inflationary.

Minyanville.com Professor Succo or Mr. Practical has a trenchant explanation (highlight mine),

``But the main point is that it is not the Fed that creates liquidity in an economy; it is the commercial banking system. What the Fed (mostly) provides is the temporary liquidity for these banks to do so.

``Large money center banks lever their assets. They take deposits and CDs and REPOs as liabilities and lend money and buy securities as assets with it. Every time they take in money via a liability they earn a spread (taking risk). So first, the writer is not understanding the time value of money: those REPOs, even though they have to be paid back, earns spreads over their life. This is liquidity for banks. And that spread, once earned, gets levered – voila – 10 to 1 or more.”

``Here is the problem. All those risky securities the banks have been carrying and earning spreads on have fallen slightly in value. Because of the immense leverage, just this small mark down of assets had seized up the banks from lending more money as they have to keep more cash to finance the lower mark on the assets. The temporary REPOs by the Fed act to finance those mark downs. The banks are “hoping” that their value goes up during the duration of the REPO. If they do not, the Fed will have to roll them and that liquidity becomes more permanent. Few people realize just how little the value of those assets held at banks have to fall before all the world's banks' capital is wiped out.”

In today’s world of the fractional banking system, whose degree of leverage has been equally reflected outside the banking sphere, a marginal fall in asset prices owned by banks or other financial institutions could pose as sufficient risk enough to destabilize the entire financial system. Hence, monetary authorities being aware of these conditions have been quick to respond to any incidences of heightened volatility.

So to suggest an answer to Mr. McCulley, the strike price could be the 10% threshold in the US equity market which has recently been touched and correspondingly has sparked an outcry for political subsidies.

And as we have pointed out repeatedly in the past, the markets have already priced in a FED “bailout” or a rate cut even prior to the FED’s action which is slated this September 18^th, as shown in Figure 2. The argument today is the depth or degree of the whole process.

Figure 2: ChartoftheDay.com: Effective FED FUNDs RATE

So whatever gains we have recently seen has been CONCRETIZED on the foundations of such expectations.

Of course, there is always the “BLACK SWAN” risk that the FED might do otherwise. But such actions could unleash violent reactions in the financial markets with unseen magnitude and repercussions, which we think the Mr. Bernanke and Company would be unwilling to gamble with.

Besides, given the inherent predilections of the authorities, even exhibited by those across the Atlantic, this paints Mr. Bernanke to the corner.

Anyway, evidences have been escalating where signs of the credit crisis, once confined to the jurisdictions of Wall Street, have now started to take its toll at MAIN Street, see Figure 3. This should help justify Mr. Bernanke’s prospective action.

Figure 3: New York Times: Double Warning On Recession

When mainstream media broaches of a trend, it usually signifies either an accelerating momentum or it could also mark a peak of a deeply entrenched trend.

In this case we believe that it is the former, since the Recession chatter has hardly hit the mainstream airwaves, until last week.

Mr. Floyd Norris in an article entitled “Double Warning That a Recession May Be on the Way”, opens with (emphasis mine), ``THE employment statistics and the bond market are combining to send out a warning that has been heard only rarely in the past two decades: A recession is coming in the United States.”

Mr. Norris points to the bond market’s negative yield curve as a precursor, punctuated by the recent job numbers as potential harbinger of a US recession. Of course, the August retail figures likewise points to a meaningful softening of the US economy.

In addition, even inveterate bull as Larry Kudlow has raised his recession probability forecasts to 50%!

What we are trying to point out is that there is a SNOWBALLING trend from the fringes to the mainstream forecasting of a hard landing for the US.

While we do not adhere to sentiments of the consensus (none I think correctly predicted the US payroll losses last September 7^th) especially during MAJOR inflection points, we think that a good number of these forecasters are riding on the RECESSION bandwagon to use the occasion to apply PRESSURE on the authorities to do SOMETHING to save the markets.

Yes, US equity markets have impressively climbed above its downtrend line as depicted in Figure 4.

Figure 4: Stockcharts.com: VIX Still on an Uptrend

US benchmarks registered substantial gains this week, the Dow Jones Industrials up 2.5% (upper window) while the S&P 500 was higher 2.11% while the Nasdaq rose 1.42%.

Meanwhile, the volatility indicator as shown by the VIX index at the main window, still hovers above the 20 levels and most importantly reveals of an uptrend which implies that there could be further bouts of selling in the offing.

Technically while the US benchmarks have popped beyond some critical thresholds such as resistance levels, moving day averages and downtrend lines, they were accompanied by LOW and DECLINING volume, which makes as us skeptical of the recent recovery.

Further, most of the recent gains came at the near end of each of the sessions, which has fueled speculations of U.S. government’s handprints.

One must remember that bond markets and credit conditions are not within the ken of the public since these are usually transacted within the confines of the specialized institutions, whereas stocks have more a permeating psychological bearing to the public. So based on incentives alone, it wouldn’t a far fetched notion for US authorities to meddle with the futures market to fillip these benchmark indices.

So what we have here is an asymmetry of market signals; bond markets still suggesting for a marked slowdown, credit conditions remain extremely tight (hence the wide spreads), US dollar broke below the 80 level coupled with and rising commodities as RECORD WHEAT, RECORD OIL, and a BREAKOUT in gold indicative future inflation, while stock markets have been climbing on expected bailouts.

Such incongruence will be sorted sooner rather than later and will prove some of these markets wrong.

As for Asia, we are seeing a conspicuous recovery in the GMF SPDR S&P/Citigroup Emerging Asia Pacific index exhibited by the lower pane. Since the index contains publicly listed companies from the Asia Pacific Region as China, India, Indonesia, Malaysia, Pakistan, the Philippines Taiwan and Thailand. Our observation is that perhaps the outperformance had been due to dazzling gains of China and the remarkable recovery in Indian stocks, while all the rest remain sluggish as that of the Phisix (pane below main window).

Next week has some potentials for added volatility in US stocks as the earnings period sets in with several important brokers submitting disclosures, such as Lehman Brothers, Morgan Stanley, Bear Sterns and Goldman Sachs aside from the much awaited Fed’s September 18^th FOMC meeting.

It would be interesting to see how…

1. the market responds to the FED cuts (we are inclined to expect a “sell-on-news” if the FED drops by 25 basis points) and…

2. the credit crisis has affected the balance sheets and bottom lines of such financial institutions; and if their recent declines have been already discounted by the markets or if the markets will be rocked by surprises.

Phisix: MINING and SERVICES Outperform; Buy Mines When Gold Crosses $726!

``The most important thing about money is to maintain its stability; You have to choose (as a voter) between trusting to the natural stability of gold and the natural stability and intelligence of the members of the Government. And, with due respect to these gentlemen, I advise you, as long as the Capitalistic system lasts, to vote for gold.”-George Bernard Shaw

As we have propounded last week, it is our belief that while a decoupling may not manifest itself strongly yet, we may be entering into stagflationary period like the 70s to 80s where inflationary momentum would accelerate as authorities try to stave off a wave of debt destruction. Such politically calibrated policies should set precious metals and other commodities on FIRE.

We do not agree with those downplaying the decoupling scenario since their arguments have all been tied with the “economic” dimensions omitting the potentials of monetary leakages. In a complex world driven by multifaceted variables, tunneling or vetting on single dimension could lead to severely flawed analysis.

We also are inclined to view that as the US FEDERAL Reserves acts to rescue on its principal constituents in order to “safeguard” today’s paper money standard system, Asian markets being the “strong” link could benefit immensely from the opening of the money spigot, which would be initiated by the US Federal Reserves.

However, given that the present system is structured heavily from leverage, the risks of a US hard landing spreading globally and debt deflation overwhelming the inflationary activities by Central Banks could pose as a TEMPORARY SHOCK.

A further potential shock could be a DISORDERLY DECLINE of the US dollar (measured by its trade weighted index) which has been bluntly dismissed by the mainstream or perhaps a bust or collapse in the China’s skyrocketing stock and property markets.

Hence, given the shock potentials with undefined ramifications (Knightian uncertainty or Mandelbrotian Gray Swan), we will try to limit our exposures to the markets until signs are lucid enough to determine the strength of the seminal trend.

We’d like to remind our readers that if the 2000 tech bust would be the precedent then, despite the Fed’s gamut of rate cuts from 6% to 1% then, global equity markets could likely to suffer from a similar decline as discussed in our August 6 to 10 edition [see A “Normal” Correction in the FACE of Massive Government Interventions? No Can Do!]. Today’s juxtapositions to the 1998 or 1987 scenario presumes that the US eludes a recession; such is likely to be an apples-to-oranges comparison.

Since the Phisix is part of the Asian equity asset rubric then the likelihood is that movements in open markets in Asia are likewise to REFLECT on the Philippine benchmark.

As an example we’d like to point out how ASEAN have been sold last week, in spite of the recent rebound in US equities. The Philippines and Malaysia took the brunt down 1.18% and 1.15%, respectively but we saw similar but moderate declines in Indonesia (-.64%) and South Korea (-.79%).

The peculiar part is that the intensity of the selloff (Php 2.48 billion) by foreign money topped the height of the August panic (Php 1.42 billion) in the Philippine Stock Exchange last week!

Of course, anyone can easily blame these blights on politics. But since the local investors had been net buyers relative to their foreign contemporaries then it is UNLIKELY that politics had been the driver to last week’s activities.

Where the local populace has treated the recent saga of the ex-President as a TELE-Drama series, it is evident that the locals are the parties obsessed with banal political controversies centered on “Personality based politics”. Given such predisposition, locals are likely to be swayed by political developments.

On the other hand, foreign money has been stoic to Philippine politics if the records from 2003 are to be examined closely. Of course, past performance may not be indicative of future activities.

Since the Phisix has rebounded from its August lows, it appears that the recent activities have shown some departure from broad market moves to sector specific actions.

Notably as shown in Figure 5, the mining index and the Services segment of the Phisix has continued to show relative strength compared with the rest of the field.

Figure 5: PSE Sectoral Issues: Divergences at Work

The Bank sector (Red), the Phi-All (Violet), Phisix (Green), Commercial Industrial (Light Orange), Holding (Blue) and Property (Blue Gray), appears to have hit a wall and has been losing steam.

In contrast the Mining and oil index (black candle) and the Services (Lime Green) Index seems to have generated sustained momentum. The services sector comprises of the Telecommunication, Information technology, Transportation Services, Hotel and Leisure, Education and Diversified Services. In our view, the buoyant performance of the Telecom heavyweights could have been responsible for the levitated Services index.

Meanwhile, it can also be construed that since gold has performed strongly in the face of a sagging US dollar index and on the account of heightened inflation expectations, aside from parallel movements in the global mining sector (best performance has been the Australasia, shown in figure 6, and African Gold stocks), local mines could have responded in the same measure relative to its foreign peers.

Figure 6 Bigcharts.com: FTSE Gold Australasia

We received several feedbacks imputing the rise of specific mines or oil stocks to certain activities as the reopening of new mines, outstanding earnings, speculations on drilling activities or prospective deals, all these tend to focus on company SPECIFIC attributes. Yet, such view reveals of the inherent cognitive biases by the average investor and glosses over the scrutiny that mining and oil stocks have been RISING IN GENERAL.

While the outperformance of the mines is a recent wonder to behold, it has yet to be proven that the local mines could withstand any potential shocks seen in the global markets. Foreign money support on local mines have been sporadic and on select issues. Hence, we should still proceed with utmost cautiousness, regardless of our bullish outlook.

As we have previously explained, a monumental development found in the domestic stock market today is the signs of significantly increased participation by local investors. Since the August lows, local investors have spearheaded the recovery over the broadmarket. Last week’s foreign selling also demonstrated how local investors managed to absorb big amounts of foreign selling with limited damage. We have no data whether local retail investors or institutions have been responsible for this.

We discussed this phenomenon as early as 2004 see July 05 to July 09 2004 [To Expand Philippine Capital Markets, Demand Is Key]; whereby we expect the secular [long term cycle] transformation to draw back local investors into the markets. Aside from the deepening trends of global financial integration and technology-enabled connectivity and access to data, we believe that the overall weakness in the US dollar will likewise influence local investors to repatriate overseas investments as the Phisix goes higher. So much for our long term outlook.

For the moment, we believe that the risk prospect is greater for the overall markets, but we see some selective opportunities with respect to the commodity sector, particularly gold and oil. And we gladly observe, local investors have now been partially receptive to such outlook.

Our treatment of gold is as alternative money and not your run-of-the-mill commodity. Should gold continue to be responsive to the activities of global monetary authorities, then we will be increasing our exposure to the mines gradually, in the condition that the latter shows the same sensitivity (here and abroad).

As a barometer, a gold breakout of $726 of levels requires meaningful exposure to the mining sector, as proxy to owning the metal itself, considering the lack of gold market here.

Slowly but surely our projections are becoming a reality.

Will the Driver of the World Financial Markets Please Stand?

``Since the 1970s, the US has experienced five outright recessions and two mid-cycle slowdowns (in 1986 and 1995). Most of the US recessions that led to sharp slowdowns in the RoW were caused by common shocks such as oil shocks and the bursting of the IT bubble in 2000. The 1991 recession, for example, did not have much of an impact on Europe; emerging markets actually accelerated. At the same time, the two mid-cycle slowdowns were associated with a very modest growth slowdown elsewhere. Countries’ business cycles are primarily driven by global shocks or idiosyncratic factors that affect the region or the countries in question, and tend not to originate from a single country.”-Stephen Jen, Morgan Stanley, Assessing the Collateral Damage from the Crisis

The gist of today’s debate on the financial markets can be narrowed into three fundamental variables: an economic growth slowdown, a US recession and a global depression.

On the surface, none of them looks positive for global equities, yet it is odd how many have turned some scenarios into a positive spin in support of their biases.

For most of the bulls, the core of their arguments amidst the slowdown scenario centers on the sustained strength of the global economies that may cushion the US economy from a hard landing or a “decoupling” (the premise of which we will not question but rather observe on how they would react under the unfolding events).

And most importantly, the expectations that global central banks led by the US Federal Reserves would effectively steer away the present crisis from a disaster with the much needed elixir.

For instance, a favorite bullish analyst of ours, while acknowledging the rising risks of a US recession, which he places at 30% (double from the past!), says the reason to be bullish is that ``it isn’t a good idea to fight the FED”, where the FED is expected to institute a “monetary bailout” and cut interest rates aggressively, which should prompt for an orderly turnaround.

As you can see, such bullish premise focuses entirely on the success of the authorities to execute bailout measures on market participants, one of the principal beneficiaries of the inflationary process (money and credit expansion) in today’s Paper Money Standard.

In short, FAITH if not HOPE determines his winning formula! This is dangerous stuff. Looking for justification to confirm one’s bias is known as CONFIRMATION Bias or (wikipedia.org) ``the tendency to search for or interpret information in a way that confirms one's preconceptions.”

As an aside, this clamor for rescue reminds me of the “socialization of the rich” to quote James Grant, an op-ed writer for the Forbes magazine.

If one were to argue about the yawning income gaps, then the Fed’s future action should bring into light how inflationary activities boost “special interest groups” or inequality.

Oh please, bailouts are bailouts in whatever form…

…since “money is created via thin air” in spite of some “sterilization” efforts

…still “who pays for the losses via wider collateral acceptance by Central Banks?”

…and “how does Central Banks know how to value illiquid assets held by institutions in trouble?”-ain’t these outright subsidies?

Eventually these will be paid by the citizenry via higher taxes or reduced value of the currency or through diminished purchasing power which translates to a lower standard of living.

Well, the financial markets priced in such scenario which led to the breakdown of the US dollar trade weighted index BELOW 80, a multiyear low! More below…

Nor can we argue with technicians who say that the US markets are playing out the same patterns seen during the past bottoms. One thing technicians tend to overlook is that the operative conditions before and conditions today are patently dissimilar.

US Fed Chair Bernanke’s Hands Are Tied!

``Mr. Bernanke is the epitome of US economic thinking. He is like a navigator in the 16th century who did not believe the earth to be round. There is no such a thing as an “inflation target” except the increase in the annual supply of money, which the Fed does control. The increase in the quantity of money is inflation and not the consumer price index, which in the case of the US is doctored anyway. So, how would the good Dr. Bernanke wish to target inflation? Are rising oil and commodity prices, which are conveniently excluded from the core CPI, not inflation??? Mr. Bernanke “targeting of inflation” centers in my opinion around a flawed theory and is one of economic theory’s greatest sophism.”- Dr. Marc Faber, Good Luck Mr. Bernanke, November 8, 2005

Yes, understandably the FED is in a tight bind.

As we have noted in the previous outlook, US market’s present level appears to be sustained by the MASSIVE expectations for a bailout. One can just look at Fed rate futures and bond markets to see how the financial markets have been SCREAMING for these! And failure to deliver is likely to result to a total rout!

For Mr. Bernanke and their ilk, delivering the therapeutic dosages seems difficult knowing that inflation (relative to consumer/producer goods) still abounds elsewhere as shown in Figure 1.

Figure 1: Economagic.com: CRB Grains Subindex Surges to RECORD HIGH!

Because when global central banks open the monetary taps, they cannot control where the money flows.

As we have previously predicted, a confluence of events…a spike in demand, climate change, demographic trends, water shortages, desertification, environmental hazards, lesser arable lands, market distorting policies (e.g. Biofuel subsidies) and lower dollar value…today conspired to bring CRB Grains Sub-index to a Record high, led by record Wheat prices followed by surging prices of soybean, oat, rice, corn and canola! Yes Anton, Beer prices are likely to go up!

In addition, we see oil prices in another attempt to break its previous high!

Nonetheless, following the bloodbath in the US markets last Friday, as US payroll data dropped to its lowest level in four years, the politicization of the markets appears to have gained momentum. This report from the New York Times (emphasis mine),

``For the first time in four years, economic concerns are rivaling the war in Iraq as a top issue on the political agenda.

``Sensing new political momentum, Democrats in Congress and on the presidential campaign trail are stepping up their criticism of President Bush’s handling of the economy and offering their own proposals.

``And now that the malaise in housing and credit markets appears to be infecting the wider economy, the Federal Reserve could feel more pressure from Democrats and Republicans alike than it has since Alan Greenspan, then the Fed chairman, incurred the wrath of President George H. W. Bush for not cutting rates faster in the early 1990s.”

Some have alluded to Ex-Chair Paul Volcker’s tight money policies as a possible precedent for Mr. Bernanke, to which respond quoting Dr. Marc Faber in his June 23, 2003 GBD report titled, Financial Implications of a Reflation (emphasis mine),

``I would therefore argue that even if Paul Volcker hadn’t pursued an active monetary policy that was designed to curb inflation by pushing up interest rates dramatically in 1980/81, the rate of inflation around the world would have slowed down very considerably in the course of the 1980s, as commodity markets became glutted and highly competitive imports from Asia and Mexico began to put pressure on consumer product prices in the US. So, with or without Paul Volcker’s tight monetary policies, disinflation in the 1980s would have followed the highly inflationary 1970s.

``In fact, one could argue that, without any tight monetary policies (just keeping money supply growth at a steady rate) in the early 1980s, disinflation would have been even more pronounced. Why? The energy investment boom and conservation efforts would probably have lasted somewhat longer and may have led to even more overcapacities and to further reduction in demand. This eventually would have driven energy prices even lower.”

As we have been saying ad nauseum…POLITICIANS and their factotums or affiliates mostly resolve to act on treatment based solutions based on political signification. It is short term issues which delivers the vote, that’s why!

In essence, the scenario of a FED supported economic “soft landing” appears largely premised on oversimplified explanations in support of bullish biases of the analysts.