East Asia And The ASEAN Yield Curve

This is a sequel to our earlier post What’s The Yield Curve Saying About Asia And The Bubble Cycle?, but this time in graphs.

The idea is that steep yield curves emanating from central bank policies incentivize the market to engage in various interest rates arbitrages like carry trades, stock market speculations and other borrow-short-invest-long transactions which essentially fuels bubble cycles.

A reminder is that interest rate policies and the shape of the yield curves impact the asset markets with a time lag. Said differently, asset markets respond to rate curves belatedly.

As earlier shown, in the US yield curve has been extraordinarily steep which most likely implies strong support to her asset markets. Importantly, because the US government has reflating its banking system, the arbitrages are likely to support global markets more as investors seek to optimize returns at the long end.

This means that the US dollar carry trade is likely to inflate further. And carry trades aren't likely to be confined to the US dollar but diffused to major currencies which have all engaged in competitive devaluation via a combination of suppressed interest rates, fiscal spending and most importantly, quantitative easing programs.

In addition, because asset market reflect a time lag on the curve, credit systems hobbled by deleveraging (such as in the US, UK and parts of Europe) could probably see belated marginal positive responses or improvements but would not likely reach the level it had during the last boom.

It is in Asia and emerging markets where a credit fueled bubble cycle is likely to take place.

In Asia where low interest rates have generated more policy traction than in crisis affected Western developed economies, the yield spreads also remain elevated.

And as earlier pointed out, combined with the other policies all these have been manifested in asset outperformance.

Again the steepness of the yield curve in the region should lend support to the asset markets for the meantime. As local investors and speculators and the domestic financial institutions will be incentivized to take advantage of the wide chasm in interest rates.

The following charts are all from Asian Development Bank's Asianbondsonline.com.

China

Japan

South Korea

Singapore

IndonesiaMalaysia

Philippines

Thailand

Finally, it would be foolish for anyone to think that stock markets move in a straight line, because in reality they don't.

Nevertheless, any attendant weaknesses should be construed as countercyclical or temporary events because aside from many other factors, steep yield curves are likely to support credit activities that should work favorably for asset markets.

Emerging Market guru and Franklin Templeton's chief honcho Mark Mobius nails it when he recently wrote, ``what I said was that in a bull market as we are now experiencing, there will be corrections as the market continues to march upwards, and such corrections could be anywhere from 15 to 20%, or even 30%. We have to be ready for such short-term volatility. The markets in China, Asia, and Dubai have seen corrections of 20% or more during the recent crisis, so these kinds of corrections should not be surprising.I want to emphasize that I am not predicting any specific correction but I am just saying that we have to prepare for such corrections and that we not be alarmed by them given current market conditions. Overall, I believe we will continue to see markets rise in the long run." (bold emphasis mine)

In short, market operates in cycles.

What’s The Yield Curve Saying About Asia And The Bubble Cycle?

``What is being ignored is the more fundamental question of whether the Fed should be attempting to set or influence interest rates in the market. The presumption is that it is both legitimate and desirable for central banks to manipulate a market price, in this case the price of borrowing and lending. The only disagreements among the analysts and commentators are over whether the central banks should keep interest rates low or nudge them up and if so by how much.” Richard M. Ebeling, Market Interest Rates Need to Tell the Truth, or Why Federal Reserve Policy Tells Lies

What’s The Yield Curve Saying About Asia And The Bubble Cycle?

-The Ultimate Black Swan-Armageddon

-The Cyclical Nature Of Bubble Cycles

-Measuring Boom Bust Cycles Via The Yield Curve

-What’s The Yield Curve Saying?

-Bubble Cycles Do NOT Discriminate

The Ultimate Black Swan-Armageddon

WATCHING National Geographic’s ‘Apocalypse How’ made me realize how the world is so vulnerable to the exogenous forces of nature and how man could be completely helpless in the face of such overwhelming power.

Yes, you may forget the farcical anthropogenic climate change, because the forces of nature would be exponentially be way far far far far more powerful and potent than the outcome from any of our collective destructive actions.

Besides, as remarked by the scientists interviewed in the TV documentary program, like any part of nature, our world operates on its own cycle. This means that the “ice age” could be just around the corner in some thousands of years to come, while the sun will expire on its own, by running out of fuel to burn, in about 5 billion years, and that today’s “aging” earth, even without the sun’s demise, will likely meet its end on its own.

And the sad part is that there is nothing mortal man can do to stop it. Every species or anything else that is part of nature will cyclically become extinct.

While we have been made aware by media of these apocalyptic scenarios through a variety of science fiction movies that could or may occur; such as huge asteroid/s crashing on earth, super volcano eruptions, alien invasion, robot uprising and many more, there are other factors such as the black hole, gamma rays from an imploding star or the unleashing of a mighty wave of solar flares from our sun, that could send our world into oblivion, unpredictably and instantaneously.

This would be the ultimate black swan for us- a low probability high impact event- our Armageddon.

Even in nature we see the variances of applied risks:

-cyclical risks (demise of sun or earth)-which if we are lucky enough would allow the Homo sapiens species commodious time to prepare for such eventuality through technological innovations and applications that could enable our descendants to scour other parts of universe for relocation

- and the Black Swan risks, which I guess leaves us to get insured with the Almighty.

The good news is that cycles extrapolate that for every death means a new birth somewhere. It’s just that we won’t be appreciating it, since we can’t know everything even when we’re alive, and perhaps because it is least of our concerns- since it ain’t about us.

However, in the understanding of nature’s dynamics, as consolation, a new life is taking place…somewhere.

The Cyclical Nature Of Bubble Cycles

This brings us back to the markets.

The difference between dealing with the complex forces of nature and that with actions of human beings is that the cyclical risks factors appear much magnified in the latter than the randomness elicited from the former.

But in contrast to the presumptive fallacious assumptions of the self-righteous aggregatists, the less complexity of social science doesn’t translate to technocratic omniscience since social sciences remain fluid, dynamic and adaptive to the constantly changing environments. Importantly they aren’t mechanistic.

The reason is that human actions are based on incentives: People are guided by what they perceive as satisfying some ends by engaging in specific means as distinguished by the scale of values (marginal utility) and time preferences, which comes in two parts-a low and high preference. In the Austrian School, low time preference means long term while high time preference means short term.

Interest rates function as major incentives in ascertaining the allocative (savings, investment and speculation) decisions of economic agents. To quote Professor Ludwig von Mises on interest rates and its money relation, ``The final state of the market rate of interest is the same for all loans of the same character. Differences in the rate of interest are caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract. Differences in interest rates which are not brought about by these differences in conditions tend to disappear. The applicants for credits approach the lenders who ask a lower rate of interest. The lenders are eager to cater to people who are ready to pay higher interest rates. Things on the money market are the same as on all other markets.”

In other words, in a laissez faire environment, creditors and debtors have essentially the same incentives as with buyers and sellers- both parties compete with their own class to serve the other parties or to satisfy the market, whereby both seek the price levels which satisfy their interests. Therefore, the rates of interest are determined by the demand and supply of credit through time preferences.

Unfortunately we aren’t in laissez faire environments where central banking has usurped the function of free markets in an attempt to perpetuate boom cycles via interest rate manipulation.

In Making Economic Sense, Murray N. Rothbard describes the boom bust cycle from monetary expansion primarily from interest rate controls (bold highlights mine), ``Inflationary bank credit is artificial, created out of thin air; it does not reflect the underlying saving or consumption preferences of the public. Some earlier economists referred to this phenomenon as "forced" savings; more importantly, they are only temporary. As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level. Only a repeated injection of inflationary bank credit by the Fed will keep interest rates artificially low, and thereby keep the artificial and unsound economic boom going; and this is precisely the hallmark of the boom phase of the boom-bust business cycle.

``But something else happens, too. As prices rise, and as people begin to anticipate further price increases, an inflation premium is placed on interest rates. Creditors tack an inflation premium onto rates because they don't propose to continue being wiped out by a fall in the value of the dollar; and debtors will be willing to pay the premium because they too realize that they have been enjoying a windfall.”

So in contrast to the myopic mainstream, which sees the market as operating in some ‘randomesque animal spirits’, interest rates mold the public’s mindset (not just capitalists or speculators but also workers, housewives and everyone else) as to how money gets allocated.

In short, boom bust episodes don’t come by haphazard chance; they function like nature, they are cyclical. Importantly, inflationism also reflects on the conditions of money.

Measuring Boom Bust Cycles Via The Yield Curve

Figure 1: Steve Hanke, stockcharts.com: Austrian Trade Cycle And The 2003-2008 Bubble Cycle

Where interest rates have been distorted to create a false impression of the abundance of savings via central bank injected money from thin air, the allure to invest in long term projects becomes relatively more compelling (see figure 1, left window).

That’s the reason why Americans and many bubble economies of the world had been seduced into the real estate bubble trap in various degrees.

Cato’s Steve Hanke describes how the process evolved (all bold underscore mine), ``An artificially low interest rate alters the evaluation of projects – with longer-term, more capital-intensive projects becoming more attractive relative to shorter-term, less capital-intensive ones.

``Austrian theory played out to perfection during the most recent boom-bust cycle. By July 2003, the Federal Reserve had pushed the federal funds interest rate down to what was then a record low of 1%, where it stayed for a full year.

``During that period, the natural (or neutral) rate of interest was in the 3-4% range. With the fed funds rate well below the natural rate, a credit boom was off and running. And as night follows day, a bust was just around the corner.”

As you can see in the right window of figure 1, during the dot.com bust, the US Federal Reserve hastily pared interest rates that pushed up or sharply steepened the yield curve (spread between 10- year and 2- year spreads-blue trend line).

Since interest rates always impact the markets with a time lag, the S & P responded and began to rise in 2003, or about 2-3 years after.

Then the US Federal Reserve began to lift policy rates in June 2004, thereby reversing the monetary easing as shown by the flattening trend of the yield curve.

The flattening of the yield curve subsequently led to the peak of the US real estate industry in 2005 (more than a year after), again with a time lag, as shown in our charts in China And The Bubble Cycle In Pictures, and eventually crashed in 2006 (see here for Case Shiller update).

The aftermath similarly had the US and global stockmarkets belatedly react by gradually unraveling in 2007. The culmination of which was manifested by a spectacular collapse that had been heralded by the infamous Lehman spectacle of September 2008. The crash proved to be the capitulation or the turning point for the markets.

What’s The Yield Curve Saying?

So where’s the yield curve now?

Figure 2: stockcharts.com: Skyrocketing Yield Curve

This noteworthy observation from moneyandmarkets.com’s Mike Larson, ``We just saw the spread between 2-year Treasury Note yields and 30-year Treasury Bond yields widen to 379 points. That’s the highest in almost three decades of record-keeping. And the 10-year TIPS spread I’ve highlighted on multiple occasions blew out to yet another 18-month high of 246 basis points earlier this week.” (emphasis his)

This means that the incentives to profit from the yield curve arbitrage have never been as compelling as before. Investors will likely be tempted to borrow short and invest long.

Meanwhile, for financial intermediaries they will be incented to enhance their maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).

So both the demand and supply variables will likely be responding positively to the incentives provided by the gaping interest rate spreads as a result of policy distortions.

As you can see in the chart above, like in the past, world markets ($DJW) have belatedly responded to the steepening of the yield curve, albeit faster than in the previous cycle- the recent reaction had 1½ years lag compared to previous 2-3 years lag.

The faster response appears to have been abetted by the Quantitative Easing (QE) program, aside from other guarantees and other Federal Reserve as the “last resort functionaries” seen in diversified alphabet soup to the tune of TRILLIONS of dollars.

Moreover, gold ($gold) appears to be resonating the current undulations of the yield curve.

As caveat, correlation isn’t causation. This isn’t to suggest that gold has been driven by the yield curve arbitrage. What can be casually observed is gold’s apparent rhythmic symmetry with the curve during the past 3 years.

It must be remembered that Gold has risen in spite of the current and previous easing-tightening policy cycles, which experienced two boom-bust episodes during the last decade. Gold has been up for 9 straight years with an average of 17.1% returns denominated in US dollars (James Turk)!

Bubble Cycles Do NOT Discriminate

SUBSIDIZED interest rates are likely to generate borrowing traction for institutions or industries or countries which had been LEAST blemished by the recent bubble.

This had been elaborated by both Professor von Mises- where credit take up is ``caused either by differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”- and by Professor Rothbard’s description of the impact of such policies- ``As the increased money supply works its way through the system, prices and all values in money terms rise, and interest rates will then bounce back to something like their original level”-as duly noted above.

China’s recent response to increase bank reserves, aside from last week’s higher T-bill sales, is on path to this as discussed in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff.

Figure 3: McKinsey Global Institute: Leverage of Financial Institutions

It is also the major and fundamental reason why major emerging markets and Asia have fundamentally outclassed and significantly outsprinted developed economies in 2009 and why it would likely do a similar rendition in 2010.

Again, specifically because low systemic debt, high savings rate, least affected banking system (see figure 3) and importantly the increasing adoption of economic freedom among other variables have allowed policy impelled circulation credit to percolate more within the national borders and within the region in a relative scale compared with other parts of the globe.

And this is why many have been aback by the sudden surge or the rampant improvement in Asian and major emerging markets financial markets, which have prompted some skeptics to call a “top”.

Figure 4: Bloomberg Chart of the Day: Asian Outperformance

For instance, the combined European sovereign Credit Default Swaps (CDS) or a gauge of default risks of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) have spiked more than those of their emerging Asian counterparts (see figure 4-upper window) for the first time in history as measured by the CDS. This implies that Asian debts have been inferred as less risky than its European peers.

By using non sequiturs or the implication of political risks such as “nuclear armed neighbour”, “number of political coups”, “unstable neighbour” or “imposed currency controls”, an analyst calls for a “top” for emerging markets based on what he thinks as unrealistic valuations and euphoric sentiment that replicates 1994.

The analyst appears to have forgotten about the ``differences in the soundness and trustworthiness of the debtor or by differences in the terms of the contract”, which serves as the essence of what default risks is about.

Where the PIIGS have taken on debt more than they can afford to pay for, they were ultimately found swimming naked when the tide receded, to paraphrase Warren Buffett.

The markets have, in essence, justifiably priced such debt laden PIIGS as relatively more likely to default than the Asian peers, because the latter have learned, endured and painfully adjusted from the excesses of the Asian crisis (twelve years past) and have engaged in a more circumspect borrowing and lending activities and eluded emulating the West’s risky behavior during the last bubble cycle. [Although eventually persistent bubble policies will likely force us to embrace extravagance]

In the same context, we see a parallel in the default risks dynamics manifested on corporate debt ratings via VIX indices (figure 4-lower window). Americans have been perceived as having the most relative risks, the UK second and lastly China (go back to figure 3 to answer any whys).

Besides it would signify as spurious analysis to anchor on past performance. Who would have ever thought that Iceland, once belonging to the world’s elite, has fumbled? [see Iceland's Devaluation Toll: McDonald's and Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?]

In short, bubble cycles have effectively sanctioned credit extravagance with no palpable discriminations; because it is a market imposed discipline.

Once it had been the Asians and now it is the turn of the Europeans and the Americans. That’s how the cycle, under the laws of scarcity, operates.

So the general rule is whoever inflates eventually suffers from the consequences of such political actions (yes inflation is fundamentally a political decision), irrespective of the identity (nationality) or present and past financial or economic standings or political or culture framework.

For now, markets appear to have been rewarding the prudent.

And like the forces nature, there are cyclical risks that one can insure against and there are black swan risks.

Poker Bluffing Booby Traps: PIMCO And The PIIGS

``…the state consists not only of politicians, but also those who make use of the politicians for their own ends; that would include those we call pressure groups, lobbyists and all who wrangle special privileges out of the politicians. All the injustices that plague "advanced" societies, are traceable to the workings of the state organizations that attach themselves to these societies.”-Frank Chodorov, Gentle Nock at Our Door

The mainstream is loaded with booby traps.

Without critical thinking it would be easy for anyone to get entranced or fall victim to the metaphorical enchanting ‘songs of the Sirens’, as in one of Odysseus’ tests in his voyage home to Ithaca.

PIMCO’s Bill Gross: Do What I Say, Not What I Do

Basically a major objection to an upside market is that policy reversals from central banks are likely to lead to a withdrawal of liquidity, thereby adversely affecting market outcomes.

Here are some examples:

Pimco’s Bill Gross: ``if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.”

From John Maudlin: ``The Fed is going to stop the music in March. There will be a scramble for the chairs. This is a huge experiment with no precedent.”

The World Economic Forum chimes in, ``The risks of a sovereign-debt crisis, asset-price-bubble collapse and a hard landing for the Chinese economy will be high on the agenda of global leaders convening in Davos, Switzerland, for the World Economic Forum this month…

``The report found a collapse in asset prices to be the most severe and likely risk, amid concerns that the weak dollar and low global interest rates could fuel a liquidity-driven, rather than debt-driven, bubble.”

Note: Either the journalist here misquotes the authority interviewed or the authority doesn’t understand that liquidity is driven by debt.

In contrast, Morgan Stanley analyst Manoj Pradhan argues that liquidity won’t get affected by the reversal of policies, (bold highlights mine, italics his)

``Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB [Global Central Bank] is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

David Kotok of Cumberland Advisors has what I think the better perspective,

``In our opinion, we think the Fed is now trapped.

``By becoming the buyer of last resort, the Fed has now impacted the markets in such a way that the very idea that it may withdraw has caused mortgage interest rates to rise. Markets aren't dumb, and they realize that rates will rise, for two reasons. First, if the supply of funds to Freddie and Fannie stops with the Fed's purchases, then home-mortgage interest rates will have to rise. Moreover, they will rise even further if the Fed starts selling its existing securities into the market. What this also means is that the interest-rate risk associated with any future increases in interest rates will be shifted from the private sector to the Fed and ultimately the taxpayer – and this risk will grow as the Fed begins to unwind its current low-interest-rate policy.” (bold emphasis mine)

In other words, like us, Mr. Kotok believes that markets have essentially been propped up by the Fed and “exiting” the market could prompt for unwarranted uncertainty and result to increased volatility. Hence, Mr. Kotok prescribes a more transparent and credible strategy to alleviate the ‘exit risks’, as well as, raising reserve deposits to mitigate any incidental upsurge of the risks of inflation.

It’s true that markets aren’t dumb, but they haven’t been negatively reacting to the alleged ‘exit risks’ either, which is due on March. Maybe it’s because the Fed still covertly supports the stock market [as argued in Politics Ruled The Market In 2009].And importantly, markets aren't representative of their actual state, instead they represent distorted markets from massive interventions.

Moreover, it would also be quite naïve to think that Fed Chair Ben Bernanke or the US Federal Reserve backed by its huge platoon of economists and the sundry of employed experts, aside from their extensive network of allies in Wall Street or in the academia, are nitwits.

What we are suggesting is that these concerns are apparently NOT out of bounds for the Fed officials or authorities including Mr. Bernanke.

They know it.

On the contrary, asset prices seem to exhibit the top concern in the scale of priorities for authorities. And this has been flagrantly echoed by the official from the World Economic Forum, `` a collapse in asset prices to be the most severe and likely risk”.

They see it.

In short, global officials appear to prioritize the asset market dimensions as we have been arguing for the longest time.

They’d most probably act on it.

Hence, the other way to read the insights from Wall Street mainstays as Bill Gross is that they’re engaged in a psy-war, or particularly reverse psychology.

Being a political entrepreneur, who have constantly benefited from policy maneuvers by their central bank, one can’t ignore that the current missive by Mr. Gross signifies as tacit appeal to Ben Bernanke for maintaining or even expanding current policies.

Mr. Gross seems to be an avid adherent of the recent Nobel Prize winner and Keynesian high priest Paul Krugman, who proposed last December that the Federal Reserve should buy $2 trillion MORE of assets to jumpstart credit!

In other words, many of the talking heads seem to operate like masquerading propagandists, whose overall agenda have been cosmetically dressed up or disguised as ‘analysis’.

In putting money where his mouth is, Mr. Gross’ PIMCO has actively been expanding its global equity exposure by incorporating emerging market specialists (‘pirated’ from the top notch Franklin Templeton firm) to its team.

According to citywire.co.uk, ``The group is also going on the offensive in the equity space, last month hiring leading global equity fund managers Anne Gudefin, Charles Lahr and Neel Kashkari from franklin Templeton to improve its level of expertise in the area.”

Moreover, PIMCO pared its holdings of US and UK debt and appears to have switched into Southeast Asia’s sovereign debts!

So if Bill Gross sees an ominous reckoning for 2010, ``If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy”, then why has he been aggressively expanding on his global equity-bond markets to even add Southeast Asian debts on his portfolio mix?

Apparently actions don’t match with rhetoric.

This category of bluffing appears to reinforce our thesis discussed last week. [see Poker Bluff: The Exit Strategy Theme For 2010].

The PIIGS Bogeyman

Another objection recently brought up has been the possible risks of contagion from Europe’s crisis affected PIIGS-most notably Greece, (as Ireland has reportedly been coping positively with present austerity policies).

I would place such “concern” in the same category of the Dubai Debt Crisis, as it would seem more of a political than of an economic/financial problem [see Why Dubai’s Debt Crisis Isn’t Likely THE Next Lehman].

Yet again this would seem to uphold my contention that today’s trend will be more on political bluffing aimed at perpetuating inflationary policies.

This fabulous excerpt from Danske Bank’s Fixed Income Research team (all bold highlights mine),

``Moody’s sent out a report on the European Sovereign outlook on Wednesday, in which they argue that countries such as Portugal and Greece could be facing a “slow death” as higher debt costs will cause the economies to “bleed” economic potential. Hence, a large part of the future public revenues would have to be spent paying off the debt rather than on welfare etc. Moody’s thinks that the risk of a “sudden death” is negligible, but warned that the countries have to act and do NOT have an open window indefinitely in order to restore public finances. Moody’s highlighted Greece, saying that it would have significantly less time than Portugal. Hence, if the forthcoming fiscal austerity plan from Greece is not considered to be sufficient, then Moody’s is very likely to downgrade Greece, and this will bring Greece closer to ECB’s temporary threshold of BBB-, as the other rating agencies will also act. Portugal tried to distance itself from Greece…

``Furthermore, the current rating threshold is only temporary and is valid until the end of 2010, and we do not think that Greece will have been able to stabilise its finances such that its rating will be at or above A-. The risk of Greece not being able to use its government bonds as eligible collateral was highlighted at yesterday’s ECB meeting. Here, Trichet said that ECB “would not change its collateral rule for the sake of any particular country”, although on the question as to whether Greece or any other country could leave the Euro area, Trichet replied that "I do not comment on absurd hypotheses".

What’s the article been saying?

For Greece, it means ‘Heads I win, Tails you lose’, a bailout is in order. Just look at Trichet’s statement, the dice is loaded for a Greece rescue.

Why?

Because the European Central Bank (ECB) is likely to suffer more from the ripples of a withdrawal (unlikely expulsion) which appear likely to risk materially undermining the political and monetary significance of the European Union.

More proof?

The ECB has recently issued a report on the prospects of a withdrawal or expulsion from ECB based on the LEGAL aspects,

Here is the Wall Street Journal Blog (all bold emphasis mine), ``Written by the ECB’s legal counsel, it notes that “recent developments have, perhaps, increased the risk of secession (however modestly), as well as the urgency of addressing it as a possible scenario.”

``It concludes that unilaterally withdrawing from the European Union “would not, as a matter of public international law, be inconceivable, although there can be serious principled objections to it; and that withdrawal from EMU without a parallel withdrawal from the EU would be legally impossible.”

``As for expulsion, “the conclusion is that while this may be possible in practical terms — even if only indirectly, in the absence of an explicit Treaty mechanism — expulsion from either the EU or EMU would be so challenging, conceptually, legally and practically, that its likelihood is close to zero.”

“Absurd hypotheses, legally impossible and close to zero” reverberates as strong political phrases which seem to reinforce our view that the obvious course of political action will be a bailout of Greece.

Yet even assuming the worst scenario that if Greece were to withdraw, considering its present financial and economic state, the most likely actions that she would undertake would be similar to the others-inflate by devaluing its resurrected currency, the drachma.

So it would be just a matter of WHO does the inflating, the ECB or Greece.

Of course the ECB bailout would come with the attendant ‘disciplining chastisement’ policies which mostly likely would signify melodious political leadership face saving soundbytes.

Besides, PIIGS sovereign debts account for only 38% of the Euro denominated Government Debt securities as of November 2009 as per the ECB. The biggest exposure would be Italy (20.16%) and Spain (12%) the balance spread between Ireland (1.506%), Portugal (1.91%) and Greece (2.43%).

Finally, if one were to argue that the hubbub over Greece should translate to a contagion, we should be seeing rising default risks in the credit standings of broader Europe (see figure 5)

Figure 5 Danske Bank: Smooth Credit Ratings Still Intact, Peak In Default Risks

Apparently this has not been the case, as seen in the iTraxx Europe CDS (left window) which consists of 125 investment grade companies, the iTraxx Crossover CDS (middle window) which comprises of 50 sub-investment grade credits and the default rates of Europe and the US (right windows) which appears to have peaked as measured by Moody’s and Danske Bank.

Like in last week’s article, I wouldn’t be calling on their bluff. Neither should you.

Desperately Looking For Normal-In Pictures

Here is another demonstration of how massively disconnected the stock markets are with conventional fundamentalism (e.g. economy or earnings)-which is the reason why many "experts" have been utterly perplexed.

Russia's RTSI had been one of the top world performers for 2009 and produced 129% in local currency gains!


The conventional thought have been that stocks function as forward looking indicators for the economy with about a window of 4 to 6 months ahead.

Yet the Russian economy has wobbled ALL throughout last year as shown below from US Global Investors.


According to US Global Investors, ``Russian GDP contraction is estimated to decelerate to -5.3 percent in the fourth quarter compared to -9.8 percent in the third quarter. The beginning of economic recovery as well as the base effect means a substantial upside to 3-4 percent growth estimate in 2010."

The RTSI spiked by another astounding 8% this week!

More.

In our recent post, Venezuela's Path To Hyperinflation we noted that despite the recent crisis-massive devaluation and electricity rationing-Venezuela's stock market benchmark, the IBVC, soared by a whopping 10.85% this week!

Chart From Bloomberg

No, it isn't that Venezuela is immune or crisis proof.

Instead it is likely that we are witnessing accelerated signs of the demonetization process or the trajectory towards hyperinflation.

Bottom line: the common denominator appears to be massive inflationism and how these has mangled economic calculation and has thus resulted to unexpected volatility.

Global Political Freedom Backslides, Asia Improves

Speaking of freedom. It has generally been a bad news for global political freedom.

The Economist recently observed that recent trends reveal of a general deterioration of political freedom even prior to the crisis. This means that many countries have turned inwards.


From the Economist (all bold highlights mine)

``Political rights and civil liberties around the world suffered for the fourth year on the trot in 2009, according to the latest report published by Freedom House, an American think-tank. This represents the longest continuous period of deterioration in the history of the report. The number of electoral democracies dropped from 119 to 116, the lowest figure since 1995. Six countries were downgraded: Lesotho to partly free and Bahrain, Gabon, Jordan, Kyrgyzstan and Yemen dropped into the “not free” category. Around a third of the world’s population live in countries deemed not free, although over half of these live in China. In the Middle East and North Africa 70% of countries are not free. Still, freedom was on the march in 16 countries, notably in the Balkans, where Montenegro is now considered free, and Kosovo is partly free."

The chart below shows of the distribution pie of the world's political freedom according to Freedomhouse.org

And here is the 20 year trend of the global political freedom.

Notice that the surge of nations that assimilated political freedom was during the 90s. This coincides with, if not signifies as the aftermath of the fall of the Berlin Wall and India's liberalization.

And global political freedom appears to have climaxed during 2004-2005.

Nevertheless, as mentioned above, the marked declines had been accounted for by marginal emerging market states, so the loss in political freedom may not be as significant relative to economic contribution.

According again to Freedomhouse.org

(all bold highlights mine)

``In this year’s findings, five countries moved into Not Free status, and the number of electoral democracies declined to the lowest level since 1995. Sixteen countries made notable gains, with two countries improving their overall freedom status. The most significant improvements in 2009 occurred in Asia.

``The Middle East remained the most repressive region in the world, and some countries that had previously moved forward slipped back from Partly Free into the Not Free category. Africa suffered the most significant declines, and four countries experienced coups.

``This year’s findings reflect the growing pressures on journalists and new media, restrictions on freedom of association, and repression aimed at civic activists engaged in promoting political reform and respect for human rights.

“In 2009, we saw a disturbing erosion of some of the most fundamental freedoms—freedom of expression and association—and an increase in attacks on frontline activists in these areas,” said Jennifer Windsor, Executive Director of Freedom House. “From the brutal repression on the streets of Iran, to the sweeping detention of Charter 08 members in China and murders of journalists and human rights activists in Russia, we have seen a worldwide crackdown against individuals asserting their universally accepted rights over the last five years.”

In other words, despite the bad news there have been some noteworthy improvements.

And consistent with recent accounts that exhibits a trend towards adapting more economic freedom [see Asia Goes For Free Trade], Asia seem to defy withering concerns of political freedom.

Here is how political freedom in East Asia is classified (green -free, yellow partly free and blue-not free). Again from Freedomhouse.org

This implies that for political freedom (civil liberties and political rights) to flourish via representative governments requires economic freedom to similarly blossom.

Why?

The preeminent economist Milton and wife Rose Friedman provides the answer:

``Economic freedom is an essential requisite for political freedom. By enabling people to cooperate with one another without coercion or central direction, it reduces the area over which political power is exercised. In addition, by dispersing power, the free market provides an offset to whatever concentration of political power may arise. The combination of economic and political power in the same hands is a sure recipe for tyranny.

``The combination of economic and political freedom produced a golden age in both Great Britain and the United States in the nineteenth century. The United States prospered even more than Britain. It started with a clean slate: fewer vestiges of class and status; fewer government restraints; a more fertile field for energy, drive, and innovation; and an empty continent to conquer. . . .

``Ironically, the very success of economic and political freedom reduced its appeal to later thinkers. The narrowly limited government of the late nineteenth century possessed little concentrated power that endangered the ordinary man. The other side of that coin was that it possessed little power that would enable good people to do good."

In short, economic freedom and political freedom are two obverse sides of the same coin.

Economic Freedom And Natural Disasters: Haiti's Tragic Earthquake

Professor Don Boudreaux nails it.

While media have been fixated with the devastation of the recent earthquake in Haiti, which up to this writing has now tallied some 50,000 deaths, many have attributed the destructive loss of lives to many other peripheral causes, including the absurd ("pact with the devil").

What has hardly been mentioned is WHY Haiti's impoverishment had made her disproportionately vulnerable to human life losses in such natural calamities.

From Professor Boudreaux of Cafe Hayek says it best: [all bold emphasis mine]

``The ultimate tragedy in Haiti isn’t the earthquake; it’s that country’s lack of economic freedom.

``Registering 7.0 on the Richter scale, the Haitian earthquake killed tens of thousands of people. But the quake that hit California’s Bay Area in 1989 was also of magnitude 7.0. It killed only 63 people.

``This difference is due chiefly to Americans’ greater wealth. With one of the freest economies in the world, Americans build stronger homes and buildings, and have better health-care and better search and rescue equipment. In contrast, burdened by one of the world’s least-free economies, Haitians cannot afford to build sturdy structures. Nor can they afford the health-care and emergency equipment that we take for granted here in the U.S.

``These stark facts should be a lesson for those who insist that human habitats are made more dangerous, and human lives put in greater peril, by freedom of commerce and industry."

Let me add that the Philippines should be a more worthwhile in comparison.

We suffered from an even more destructive quake in July 16, 1990 which according to wikipedia.org registered 7.8 and resulted to an estimated 1,621 deaths

The Philippines has a per capita of $920.19 (ranked 106th according to nationmaster.com) almost double that of Haiti $480.52 (ranked 126th).

And by economic freedom, the Philippines is way up the list at 104th according to Heritage Foundation, compared to Haiti's 147th spot.

In short, capital or wealth generated from economic freedom has indeed been a key factor in reducing the risks of higher casualty toll from natural calamities.

As Ludwig von Mises wrote, ``It is fashionable nowadays to pass over in silence the fact that all economic betterment depends on saving and the accumulation of capital. None of the marvelous achievements of science and technology could have been practically utilized if the capital required had not previously been made available. What prevents the economically backward nations from taking full advantage of all the Western methods of production and thereby keeps their masses poor, is not unfamiliarity with the teachings of technology but the insufficiency of their capital."