QE 2.0: It’s All About The US Banking System

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” Ludwig von Mises

It’s time for a little gloating.

Last week we noted how global financial markets would likely respond to two major events that just took place in the US this week.

Globalization Versus Inflationism

We noted that while the outcome of the US elections would matter, it would be subordinate to the US Federal Reserve’s formal announcement of the second phase of the Quantitative Easing or QE 2.0.

Nevertheless we mentioned that in terms of the US Midterm Elections, still the odds greatly favoured a rebalancing of power from a lopsided stranglehold by left leaning Democrats towards the conservative-libertarian right that could result to what mainstream calls as “political gridlock”.

Such stalemate would thereby reduce the chances of government interventionism, which should have positive implications for both the markets and the US economy[1].

Figure 1: The Drubbing Of Keynesian Policies (USA Today[2])

Of course, what the surveys earlier conveyed had been merely translated into actual votes-Americans largely repudiated the highhanded Keynesian spend and tax policies adapted by the Obama administration. This also signifies as a decisive defeat for President Obama’s illusory “Change we can believe in”.

Except for the Senate which had only 37 seats, out of the 100, contested, Republicans swept the House (239-188) and the Governorship position (29-18). Yet, even in the Senate, the chasm in the balance of power held by the Democrats had been significantly narrowed (from 57-41 to 51-46).

To rub salt into the wound, even President Obama’s former seat at Illinois was won by a GOP candidate[3], Mark Kirk.

The burgeoning revolt against interventionist Keynesian policies has likewise been an ongoing development in Europe[4].

And as we have repeatedly been pointing out, two major forces have been in a collision course: technology buttressed globalization (represented by dispersion of knowledge and the deepening specialization expressed through free trade) and inflationism (concentration of political power).

The rising tide against Keynesianism, which translates to a backlash from these two grinding forces, can be equally construed as a manifestation of an evolving institutional crisis or strains from traditional socio-political structures adjusting to a new reality.

As Alvin and Heidi Toffler presciently wrote[5],

``Bureaucracy, clogged courts, legislative myopia, regulatory gridlock and pathological incrementalism cannot but take their toll. Something, it would appear will have to give...

``All across the board –at the level of families firms industries national economies and the global system itself—we are now making the most sweeping transformation ever in the links between wealth creation and the deep fundamental of time itself. (italics mine)

For now, the forces of globalization appear to be the more influential trend.

Validated Anew: QE 2.0 Is About Asset Price Support

However, as we also noted, Keynesianism hasn’t entirely been vanquished[6]. They remain deeply embedded in most of the political institutions represented as unelected officials in the bureaucratic world. Importantly, they are personified as stewards of our monetary system.

Here is what I wrote last week[7],

``The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

Straight from the horse’s mouth, in a recent Op-Ed column[8] Federal Reserve Chair Bernanke justifies the Fed’s QE 2.0,

``This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. (bold highlights mine)

Once again I have been validated.

The path dependency of Ben Bernanke’s policies has NOT been different[9] from his perspective as a professor at Princeton University in 2000 when he wrote along the same theme.

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

Figure 2: stockcharts.com: Global Equity Markets Explode!

The net effect of QE 2.0 has been almost surreal.

Global equity markets (DJW), as expected, skyrocketed to the upside from the higher than expected $600 billion or $75 billion a month (for 8 months) of US treasury long term security purchases that the Federal Reserve will be conducting with new digital dollars. Markets reportedly estimated the QE program at $500 billion[10].

And the Federal Reserve made sure in their announcement that $600 billion will not be a limiting condition. The FOMC said that they “will adjust the program as needed to best foster maximum employment and price stability”[11].

It’s simply amazing how the Fed’s QE 2.0 transmission mechanism has been worldwide. Whether in Asia (P1DOW-Dow Jones Asia), Europe (E1DOW-Dow Jones Europe) or Emerging markets (EEM-iShares MSCI Emerging Markets Index), the story has all been the same—markets breaking out to the upside.

I’d like to add that such bubble blowing policies has NOT been limited to the Federal Reserve.

Immediately after the Fed’s announcement, the Bank of Japan voted unanimously to support the domestic stock market by engaging on their own version of QE that would include “exchange-trade funds linked to the Topix index and Nikkei Stock Average, and Japanese real-estate investment trusts rated at least AA, the bank said. It said it would begin buying Japanese government bonds under its new program next week.[12]” (bold emphasis mine)

Add to these the inflation of global central banks international reserve position to the tune of $ 1.5 trillion over the past 12 months[13].

Hence the consequences of massive inflationism are likely to be fully felt yet in the markets.

The False Premise: Aggregate Demand Story

The substantiation of our analysis isn’t limited to Bernanke’s statements alone. Markets have likewise bidded up the major beneficiaries of the QE 2.0 program—the banks and the financial industry (see figure 3).

Figure 3: Financial Industry: From Laggards to Leaders (charts from US global Investors and stockcharts.com)

The mainstream wisdom goes this way: Money printing does not create inflation. With low inflation, printing money is, therefore, needed to generate demand that would spur inflation. This form of circular reasoning[14], which characterizes Keynesian economics, is what is sold to public as rationalization for the current policy. The mainstream sees it as an aggregate demand problem that can only be addressed by money printing.

The mainstream fails to see that there is NO such thing as a free lunch or that prosperity cannot be conjured or summoned by the magic wand of the printing presses.

All these so-called technocratic experts refuse to learn from history or deliberately distort its lessons, where debasing money has always been meant to accommodate for the political goals or interests of the ruling class.

Yet monetary inflation eventually crumbles to nature’s laws of scarcity for the simple reason that it is unsustainable. Printing of money does NOT equate anywhere to the same degree as producing goods and services. Printing of money can be limitless, while production of goods and services are limited to the available scarce resources.

Unknown to many, printing of money is subject to the law of diminishing returns (getting less for every extra output or a law affirming that to continue after a certain level of performance has been reached will result in a decline in effectiveness[15]) and law of diminishing marginal utility (general decrease in the utility of a product, as more units of it are consumed[16]).

And it is why repeated experiments with paper money throughout the ages of human affairs have repeatedly failed[17]. And I don’t see why the grand US dollar standard experiment today as likely to succeed either. The QE programs fundamentally reflect on the same symptoms of any degenerating or festering de facto money regime. We should expect more QE programs to happen.

Yet the aggregate demand story is basically premised on debt. To promote aggregate demand is to promote debt. Debts either incurred by the private sector or by governments in lieu of the private sector. While productive debt and consumption debt are hardly distinguished, consumption debt is promoted. Savings are disparaged as economically harmful. And the promotion of debt is the essential or critical element to fostering bubbles.

Figure 4: World Bank: Banking Crisis Since the 1970s

Hasn’t it been a wonder that since the closing of the Bretton Woods gold-dollar window in 1971, bubbles became a permanent fixture worldwide?

Yet, the public hardly can see through who the major beneficiaries from the debt based aggregate demand story. Obviously, it is the banking and the financial industry as they represent as the major funding intermediaries or financiers to both the private sector and importantly to the government.

And the banking system had been structurally incented to hold (or buy or finance) government debts into their balance sheets as they have been classified as less risky assets and thus requires less capital in accordance to the Basel Accord[18].

During the last crisis the unholy alliance of the central banking-banking industry cartel had been exposed as seen by the trillions worth of bailouts by the US Federal Reserve[19].

Yet the politicized nature of central banking (everywhere) obviously leads to cartel structured relationships, as survivability depends not on profitability based on market forces, but from the privileged conditions bestowed upon by the political strata.

And the QE 2.0, which I argued as having been unmoored from the prospects of the US or global economy, but rather aimed at safeguarding the balance sheets of the banking system has successfully boosted the prices of financial equity benchmarks, such as S&P Bank Index (BIX), the Dow Jones Mortgage Finance Index (DJUSMF), the S&P Insurance (IUX) and the Dow Jones US General Financial Index (DJUSGF), all along the lines of Bernanke’s design.

The industry that had miserably lagged[20] the recent stock market recovery in the US has in one week suddenly outclassed the rest.

Of course people who argue about the success or failure of policies frequently look at the effects depending on the time frame that support their bias.

For instance, policies that induce bubbles will benefit some participants, during its heydays. Hence, policy supporters will claim of its ‘success’ seen on a temporary basis as the bubble inflates. Yet overtime, an implosion of such bubbles would result to a net loss to the economy and to the markets. The overall picture is ignored.

And the same aspects would also apply to those arguing that the Fed’s rescue of the banking system has been worthwhile. They’re not. The benefits of a temporary reprieve from the recent crisis envisages greater risks of a monumental systemic blowup. If Fed policies had been successful, then why the need for QE 2.0?

So for biased people, the measure of success is seen from current activities than from the intertemporal tradeoffs between the short term and long term consequences of policies.

In other words, yes, the QE 2.0, which constitutes the continuing bailout of the US banking industry, seems to successfully inflate bubbles, mostly overseas. But at the end of the day, these bubbles will result to net capital consumption, if not the destruction of the concurrent monetary regime.

The next time a major bubble implodes there won’t likely be free lunch rescues as these will be limited by today’s massive debt overhang.

The Effects of QE 2.0: Promotes Poverty And A Shift To A New Monetary Order

Of course while the equity price performance of the US financial industry stole the limelight the next best performers have been the Energy and the Materials Index.

In other words, as I have long been predicting, the accelerating traction of the inflation transmission channels are presently being manifested in surging prices of commodities and commodity related equity assets aside from global equity markets.

While this should benefit equity owners and producers of commodity related enterprises, aside from the financial sector, those who claim that inflationism is justifiable and a moral policy response to the current conditions are just plain wrong. Such redistributive policies to the benefit of the banking sector come at the expense of the underprivileged.

What is hardly apparent or seen is that the current government structured inflation indices have been vastly underreporting inflation.

Yet surging agricultural and food prices would not only harm a significant percentage of financially underprivileged by reducing their money’s purchasing power but also promote poverty in the US and elsewhere.

Figure 5: Food Expenditures By Income Level

Tyler Durden of Zero Hedge quotes a JP Morgan study[21], (bold emphasis mine)

When the Fed considers the possible consequences of a falling dollar resulting from QE2, it should perhaps focus on food and energy prices as much as on traditionally computed core inflation. First, the food/energy exposures of the lower 2 income quintiles are quite high (see chart). Second, the core CPI has a massive weight to “owner’s equivalent rent”, which suggests that the imputed cost of home occupancy has gone down. Unfortunately, this is not true for families living in homes that are underwater, and cannot move to take advantage of it (unless they choose to default and bear the consequences of doing so). Due to the housing mess, there has perhaps never been a time when traditionally computed core inflation as a way of measuring changes in the cost of things means less than it does right now.

Figure 6: ADB[22] Asia’s Share of Food Expenditure to Total Expenditure

And as said above the effects are likely to hurt the underprivileged of the emerging markets more than the US.

So inflationism or QE 2.0 poses as a major risk to global poverty alleviation and prosperity, a blame that should be laid squarely on these policymakers and their supporters.

Of course as the ramifications of inflationary policies worsen, the subsequent scenario would be for political trends to shift towards holding the private sector responsible for elevated prices and for ‘greed’ in order to institute more government control and inflationism.

As the great Ludwig von Mises once wrote[23],

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

Here free trade will likely give way to protectionism; that is if public remains ignorant of true causes of inflation and if the world would stubbornly stick by the US dollar as preferred global medium of exchange.

Of course Asian nations were hardly receptive to the unilateral actions by the Federal Reserve. The conventional recourse in dealing with QE 2.0 has been via currency appreciation, tightening of domestic liquidity by raising bank reserves or increase policy rates or lastly ‘temporary’ capital controls. So far some countries as South Korea have threatened to impose some variation of capital controls.

Yet we should expect the world to shift out of the US dollar regime once inflationism becomes rampant enough to pose as a meaningful hurdle to national economic development and global trade. The Bloomberg quotes China’s Central Bank adviser Xia Bin[24],

``China should counter the U.S. through regional currency alliances, speeding international use of the yuan and seeking stability in exchange rates through the Group of 20, which holds a summit next week”

A currency from a political economy that engages in significantly less inflationism, has deep and developed sophisticated markets, has a convertible currency and hefty geopolitical exposure is likely to challenge the US dollar hegemony, whether this would be the yuan (which for the moment is unlikely) or the Euro, only time will tell.

Of course, we can’t discount gold’s role in possibly being integrated anew in the reform of the monetary architectural system.

Figure 7: Virtual Metals[25]: Central Bank Gold Holdings and Sales

Global Central banks appears to be rediscovering gold as possibly reclaiming its role as money in a new monetary order. A new monetary order is not question about an if, but a when.

Once as net sellers, central banks seem to be transitioning into potential net buyers.

So again, our peripheral insight seems being validated with the ongoing process of shifting expectations by authorities on the functions of gold.

As I pointed out last year[26], gold is presently seen by an ECB official as a form of economic security, risk diversification, a confidence factor and an insurance against tail risks. Once these factors become well entrenched, a store of value role would likely be the next step. And more QE’s would only serve to push gold towards such a path.

Those who obstinately relish the bias that gold is nothing but a barbaric relic will likewise suffer from taking on the wrong positions. But they eventually will succumb to the shifting expectations as with many monetary authorities today. The reflexive process of having prices influence fundamentals has clearly been taking shape.

With gold prices at $1,390 mainstream economists like celebrity Nouriel Roubini[27], who last year debated savvy investor Jim Rogers and declared “Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense”, must be squirming on his seat for the likelihood to be proven wrong once again.

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[1] See US Midterm Elections: Rebalancing Political Power And Possible Implications To The Financial Markets, October 31, 2010

[2] USA Today, 2010 Elections: Live Results

[3] Politico.com Roland Burris will serve in November, November 5, 2010

[4] See An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles, October 25, 2010

[5] Toffler, Alvin and Toffler, Heidi Revolutionary Wealth Random House p.40

[6] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[7] Ibid

[8] Bernanke, Ben What the Fed did and why: supporting the recovery and sustaining price stability, Washington Post, November 4, 2010

[9] Bernanke, Ben A Crash Course for Central Bankers, Foreign Policy.com or wikiquote Ben Bernanke

[10] Macau Daily Times Asian markets rise, dollar falls, November 5, 2011

[11] Board of Governors of the Federal Reserve System, November 3, 2010 Press Release

[12] Marketwatch.com Bank of Japan holds steady, details asset plans, November 4, 2010

[13] Noland, Doug QE2 Credit Bubble Bulletin, Prudent Bear.com

[14] See Thought Of The Day: The Keynesian Circular Thought Process, June 22, 2010

[15] Wordnetweb.princeton.edu law of diminishing returns

[16] Wiktionary.org law of diminishing marginal utility

[17] See Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System, November 1, 2010

[18] See The Myth Of Risk Free Government Bonds, June 9, 2010

[19] See $23.7 Trillion Worth Of Bailouts?, July 29 2010

[20] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[21] Durden Tyler, How Ben Bernanke Sentenced The Poorest 20% Of The Population To A Cold, Hungry Winter, Zerohedge.com November 5, 2010

[22] Asian Development Bank: Food Prices and Inflation in Developing Asia: Is Poverty Reduction Coming to an End? April 2008

[23] Mises, Ludwig von The Truth About Inflation

[24] Bloomberg.com Asians Gird for Bubble Threat, Criticize Fed Move November 4, 2010

[25] Virtualmetals.co.uk The Yellow Book September 2010

[26] See Is Gold In A Bubble? November 22, 2009

[27] See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009

Should We Chart Read Market Actions From QE 2.0?

``We can chart our future clearly and wisely only when we know the path which has led to the present." - Adlai E. Stevenson

Now we know that no trend moves in a linear fashion.

Yet we cannot be heavily reliant on chart actions to determine the “overbought or oversold” conditions from which to base our positions.

In any major trend (bear or bull cycles), overstretched markets or securities can last for an extended period.

Besides, chart actions greatly depend on patterns from past performances in the probabilistic assumption of a recurrence. The operating word is here probability.

But charting does NOT incorporate the prospective stimulus-response and action-reaction by the public to the ever fast evolving highly fluid environment nor does charting impute exactly similar conditionalities from which decisions had been shaped. This is despite some successful repetition of patterns.

For instance can charting say to what degree the markets will react to a sustained QE? The answer is NO.

And it is from such dimensions that I accurately debunked earlier claims by perma bears of the supposed repetition of the Great Depression, through the alleged similarities in the unfolding of chart patterns[1].

For most of the perma bears, whom have been influenced by some form of (political or economic or cultural) bias rather than sound analysis, they can characterized by the frequent use of post hoc fallacy and data mining to support their desired outcome.

This is why I also correctly disproved earlier notions of chart based bearish patterns which ALL failed to pan out.

I earlier wrote[2],

``They never seem to run out of materials to throw in, after the earlier “death cross” and the ERCI leading indicator, whose effects remain to be seen, now they point to the Hindenburg Omen as a reason to take flight.”

Now that the actions have been reversed and that all former bearish patterns have evaporated, chartists have been talking about the bullish “Golden cross”. Duh!

Yet even if one looks at the charts, the synchronous breakouts in global markets imply a tailwind effect or “momentum” in favour of continuity going forward. As charts have yet to signify distribution or exhaustion.

Also the assumption that charts impute all the necessary information is similar to the flawed premises of the Efficient Market Hypothesis (EMH) which ignores the role of the individual entrepreneurial activities that generate variable outcomes and the erroneous implication that all participants have the same homogenous ‘rational’ expectations[3].

And in learning from the recently departed Benoit Mandlebroit, the father of fractal geometry, on why not to trust charts, Mr. Mandlebroit wrote[4],

``And in the fun-house mirror of logic of markets, the chartists can at times be correct...But this is a confidence trick: Everybody knows that everyone else knows about the support points, so they place their bets accordingly. It beggars belief that vast sums can change hands on the basis of financial astrology. It may work at times, but it is not a foundation on which to build a global risk-management system.” (bold emphasis mine)

In other words, Mr. Mandlebroit shares the analysis disputing the homogeneity of rational expectations incorporated in charting, such that everyone employing the same pattern recognition techniques would render charting to be impractical and an undependable tool for investment or trade.

For me, chart patterns have higher probability of repetitions only when it treads on major trends.

Yet I find more value in identifying the stages of the trend or the cycle, where charts only serve as supplemental role or a guidepost for entry and exit points rather than for main reasons to anchor on a major investment or trading decision.

Hence, given the current market actions and fundamental based developments brought about by QE 2.0, I am unlikely to recommend any position that would fight the major trend.

Remember, QE 2.0 represents uncharted waters in modern central banking, unless we’d include Zimbabwe Gideon Gono’s approach as part of this.

So why use traditional or conventional tools to engage in something unprecedented?

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[1] See Seeing Patterns Where None Exist, February 17, 2010

[2] See The Importance of Peripheral Vision, August 23, 2010

[3] Shostak Frank, In Defense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis

[4] Mandlebroit, Benoit B and Hudson Richard, The (Mis) Behaviour of Markets, Profile Books p .8

Oil Markets: Inflation is Dead, Long Live Inflation

There seems to be an ongoing dissonance in the oil or energy markets.

Bespoke Invest shows us that crude oil inventories “are now at their highest levels of the year”, while distillates and gasoline “both saw larger than expected draws in their stockpiles”.

Yet crude oil prices are approaching the April highs.

And as mentioned above it isn’t just crude oil, such dissonance is likewise extended to the gasoline markets (Gaso).

The obvious answer is that the recent actions don’t just reflect on the consumption pricing model but from the reservation pricing model.

As we previously pointed out, commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.

Thus, we seem to seeing inflation dynamics incrementally playing out in the commodity markets.

Meanwhile, there has also been a small recent pop in the natural gas market (NATGAS).

I’d be convinced of the deepening risks of the inflation cycle, when Natural Gas chimes in. So far, this hasn’t been so.

Yet the odd part is that mainstream says inflation hardly exist. I wonder what kind of world they seem to be living in.

Global Equity Markets Update: Peripheral Markets On Fire, Philippines Grabs Lead In ASEAN

Here is a nice update on the performances of global equity markets from Bespoke Invest

Says Bespoke Invest,

At the moment, the average 2010 performance of the 81 countries listed is +12.19%. As shown, Sri Lanka leads the way with a gain of 97.16%. Bangladesh ranks 2nd at 74.88%, followed by Estonia (62.46%), Lithuania (49.56%), and the Philippines (43.54%). Of the G-7 countries, Germany has done the best with a gain of 11.30%. Canada ranks 2nd at 7.24%, and the US ranks third with a gain of 6.78%. Japan has been the worst performing G-7 country with a decline of 13.15%. Italy and France are both down still for the year as well.

Of the BRIC countries, India is leading the way with a gain of 17.18%. Russia ranks 2nd at 11.08%, followed by Brazil (+4.84%) and then China (-7.51%).

Additional observations:

Only 17 out of the 81 bourses are in the red. This includes the crisis affected PIIGS, China (whose bourse has been repeatedly under siege from her government aimed at curtailing her inner ‘bubble’ demons) and Vietnam (agonizing from high inflation)

Another way to see this is that global inflationism has led a rising tide lifting all boats phenomenon

It’s been a tight race among peripheral emerging markets led by South Asia, Eastern Europe and Southeast Asia.

The relative performances of BRIC and G-7 bourses have been mixed.

The Philippines has eked out a marginal lead from Indonesia (this is based on local currency. For the moment I don’t have access to dollar based returns)

Opinions As Opiate

I like this graphic depiction by Jessica Hagy on opinions because I find it poignantly relevant.

While Ms. Hagy calls it Opinions are like bellybuttons, I would call this ‘opinions as opiate’.

For me, the proportion of mainstream opinions are tilted towards what Ms. Hagy describes as based on low evaluations:

- parroting someone else ideas or regurgitating statements like an incantation or

-engaging in nice sounding political or economic talking points that in the end only signifies gossip.

Since gossips are hardwired on us for social/peer acceptance or for “feel good” or for attention generating or for self-esteem purposes, this may seem like an opiate. After all, gossips are hardly premised on sound evaluation but mostly on heuristics or mental short-cuts.

Global Equity Markets: Decoupling or Recoupling?

Many have come to believe that the outperformance of ASEAN markets represent signs of decoupling.

BCA Research argues otherwise and observes that the “average correlation between national equity markets has trended higher over the past decade”

They add, (bold emphasis mine)

Equity market correlation reached a peak during the 2008 financial crisis, and what eventually led to the largest global easing episode in history. But correlations still remain high and this suggests that the benefits of diversification are dwindling as investors shift between asset classes rather than between regions in response to market events. It is unlikely that the period of high correlation will end soon. The importance of macro events/drivers (government deficits, financial system health, emphasis on monetary stimulus) over the past decade has been rising and will be an ongoing feature on investors’ radar screens for years to come.

Worth noting:

1. Intensifying globalization has made financial markets more correlated and not less. Hence the above average activities seen in ASEAN or many emerging markets represent outperformance and can hardly be construed as strong indications of decoupling.

And the above dynamic seems also reflected in terms capital flows on direct investments (chart from Google Public Data).

In other words, cross border movements of capital has intensified similar to scale of improvements in world trade. I see this as financial globalization.

And as we have repeatedly been saying, the decoupling is dynamic that has yet to be proven. This will only be evident when global markets and the economies come under duress and not during inflation driven booms.

2. Since the world has been more integrated than in the past, macro dynamics will equally play a bigger role in determining trends in the financial markets or in economic developments. The relevant macro factors will perhaps depend on the proportion or the extent of a country’s exposure to world integration or globalization. And this is where the variability in national performances would emerge.

Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System

Tocqueville Asset Management LP’s John Hathaway poignantly writes:

The world’s monetary system is in the process of melting down. We have entered the endgame for the dollar as the dominant reserve currency, but most investors and policy makers are unaware of the implications.

The only questions are how long the denouement of the dollar reserve system will last, and how much more damage will be inflicted by new rounds of quantitative easing or more radical monetary measures to prop up the system.

Whether prolonged or sudden, the transition to a stable monetary system will become possible only when the shortcomings of the status quo become unbearable. Such a transition is, by definition, nonlinear. So central-bank soothsaying based on the extrapolation of historical data and the repetition of conventional wisdom offers no guidance on what lies ahead.

History has shown that paper money system don’t last long.

The only exception is that of the medieval Chinese experience which reportedly lasted 600 years. But the historical account of this isn’t certain: wikipedia says it was during the Song Dynasty, the Buttonwood’s Blog at the Economist says it was during Emperor Tsung while Dollardaze.org’s Mike Hewitt says this was during the Tang dynasty.

Meanwhile Murray Rothbard argued that the first paper money in the US was issued by the colonial government of Massachusetts in 1690.

Nevertheless Dollardaze’s Mike Hewitt examined 775 world currencies which includes the 176 in circulation (as of 2009) and 599 not in circulation, and found that

-the “median age for all existing currencies in circulation is only 39 years” and

-that the extinction of currencies had primarily been through acts of war and hyperinflation.

Incidentally and ironically, the US dollar standard since 1971 is 39 years old and seems to feel the same strain from old political habits.

Yet the attraction of the paper money system is that it allows government to pursue its political agenda via unsustainable free lunch policies.

As Murray Rothbard wrote in Mystery of Banking,

The inventions of paper and printing gave enterprising governments, always looking for new sources of revenue, an “Open Sesame” to previously unimagined sources of wealth. The kings had long since granted to themselves the monopoly of minting coins in their kingdoms, calling such a monopoly crucial to their “sovereignty,” and then charging high seigniorage prices for coining gold or silver bullion. But this was piddling, and occasional debasements were not fast enough for the kings’ insatiable need for revenue. But if the kings could obtain a monopoly right to print paper tickets, and call them the equivalent of gold coins, then there was an unlimited potential for acquiring wealth. In short, if the king could become a legalized monopoly counterfeiter, and simply issue “gold coins” by printing paper tickets with the same names on them, the king could inflate the money supply
indefinitely and pay for his unlimited needs.

Eventually, as always, monetary debasement gets abused and suffers from rampant inflation or at worst hyperinflation. And this will require either massive reform or a new currency system.

The current US dollar standard paper money system seems to be in a no different path from its forbears, as free lunch and mercantilist policies are being subtly pursued through global currency debasement.

Some call this the “currency wars”. I call this cycle the Mises moment.

And rampaging gold prices priced in every major currency (US dollar, Euro, Yen, Pounds, Canadian Loonie, Aussie Dollar, Indian Rupee, South African Rand and Gold in G5 index) seems to be saying this for quite sometime—the endgame could be near.

Charts from Gold.org (as of October 25, 2010)

For the “gold is barbaric metal” camp, paper money will reign forever even when unsupported by history and economic laws for the simple reason of dogmatic belief over free lunch politics.

But as Professor Ludwig von Mises once wrote,

The return to gold does not depend on the fulfillment of some material condition. It is an ideological problem. It presupposes only one thing: the abandonment of the illusion that increasing the quantity of money creates prosperity.

Unfortunately, anything unsustainable won’t last. And Voltaire would be validated anew, paper money eventually returns to its intrinsic value—zero.

Ireland’s Fiscal Austerity Seen From The Big Picture

One of the popular rejoinders or justifications made by mainstream economists has been to refer to Ireland as an example of the perils of having to impose fiscal austerity.

The general idea is the lack of aggregate private demand as measured by a decline in private spending should be substituted for by the government, in order to boost the economy. This is premised on the assumption that every variable in the economy are homogenous and subject to the same sensitivity from interventionist policies.

Yet we understand Ireland as having an ongoing crisis with her banking industry such that her government has undertaken massive recapitalizations of Allied Irish Bank and Anglo Irish Bank to the tune of “some €50 billion ($68 billion) this year and will push Dublin's budget deficit to an estimated 32% of GDP” according to Wall Street Journal.

Ireland’s banking woes continues to be reflected on her sovereign spreads as with the other crisis affected Euro nations classified as the PIIGS. (chart courtesy of Danske)

If the focus is plainly on unemployment, then the mainstream is right, high unemployment continues to plague the country. (chart courtesy of tradingeconomics.com)

However, unemployment will always be a lagging indicator. In a market economy as Ireland, profitability will be the primary gauge for investments, which eventually will be reflected on the job market.

First of all, despite the selective nature of evidence brought by the mainstream, Ireland isn’t in all that deep funk.

Ireland appears to be emerging from a deep recession and is expected to continue to grow through 2011 in spite of the fiscal tightening measures.

According to Finfacts

IBEC, the business group, said today the economy will return to growth in 2011 despite the greater than anticipated scale of the fiscal adjustments needed over the coming four years. GNP (gross national product) will grow 1.2% in 2011 and 3.4% in 2012 while GDP (gross domestic product with no adjustment for the profits of multinational operating in Ireland) will grow 2.2% and 3.1%. The forecasts for 2012 can be only guesswork and the outturn depends on the robustness of the international recovery in rich countries.

The business group says the final national accounts data for 2009 show that the nominal size of the economy was much lower than the Department of Finance had originally estimated while the global economic recovery has lost steam in recent months and Government’s growth forecasts for the 2011 to 2014 period now appear too optimistic.

The full accounting of the banking costs means that the debt-to-GDP ratio will reach 100% this year and will peak at about 115% in 2014. While this represents a rapid escalation from the pre-crisis debt ratio it is not exceptional in international terms - - IBEC says it is just above the debt level of the Eurozone and the US, about the same as that in Belgium and below that in Italy.

Second, deflation hasn’t been a persistent scourge as the mainstream paints it to be.

True, the unravelling of the global crisis has brought about a bout of deflation, but this appears to be on the mend.

Third, for the mainstream to argue that politics always favours government intervention, this report from the BBC, (bold emphasis mine)

Despite public sector cuts averaging more than 15%, and a further huge bank bail-out, making Ireland the EU's most indebted nation, the popular backlash against the government's fiscal tightening has never really materialised.

Bottom line: All these add up to demolish the myth that adapting fiscal discipline will be a bane to the economy.

US Midterm Elections: Rebalancing Political Power And Possible Implications To The Financial Markets

``The most enthusiastic supporters of such unlimited powers of the majority are often those very administrators who know best that, once such powers are assumed, it will be they and not the majority who will in fact exercise them." Friedrich von Hayek, The Constitution of Liberty

Trick or treat.

The way we celebrate Halloween will similarly be parlayed into the political sphere next week.

One of which would have an important bearing in the global financial markets.

While everyone will likely be focused on the US Midterm elections, what would seem crucial would be the US Federal Reserves’ formal announcement of its next phase of ‘credit easing’ policies: Quantitative Easing 2.0.

But we will deal with both.

US Midterm Elections: A Rebalancing Act

We shouldn’t expect much from the US Midterm elections. From our perspective, what is likely to change will only be the redistribution of the political power, from a lopsided stranglehold of Congress by the Democratic party into a more balanced exposure with that of the Republicans, that should serve as a control from an abuse of political power.

As political analyst Stratfor’s George Friedman rightly describes[1],

The Democrats will lose their ability to impose cloture in the Senate and thereby shut off debate. Whether they lose the House or not, the Democrats will lose the ability to pass legislation at the will of the House Democratic leadership. The large majority held by the Democrats will be gone, and party discipline will not be strong enough (it never is) to prevent some defections.

In other words, Democrats would likely lose their capability to highhandedly ram down the throats, or railroad unpopular ‘socialist’ policies to the American public, similar to the Obamacare, where polls say that a majority, or 53% of the public, has favoured its repeal[2]. And obviously such a backlash is likely to get translated into votes.

Figure 1: Every Action Has A Consequence; A Likely Political Comeuppance (chart from Danske Bank)

Apparently, the Democrats haughtily put into motion President Obama’s former Chief of Staff Rahm Emmanuel inglorious advise[3],

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

And since every action has consequences, the unintended ramifications from these unilateral political actions, perhaps construed as an abuse of power, could likely be a political comeuppance next week. Moreover, there are many signs where public sentiment appears to have shifted incrementally towards accepting more libertarianism[4].

And another very important setback for the incumbent party has been the failed effects of the cumulative stimulus programs in bolstering the US economy, which has been predicated on mainstream economics.

And one of the repercussions from this failure has been the spontaneous emergence of Tea Party Movement groups[5] in 2009, which amazingly has expanded swiftly and now accounts for anywhere 15-25% of the US population according to some estimates[6].

Tea Party groups basically protest on the burgeoning role of government interventionism in the US political economy.

Yet like anywhere else, under a democracy, people will likely be voting, not for idealism or ideology or platform, but against what they would perceive as either proponents of injustice or fear. In short, elections are mostly about symbolisms based on sentiment or voter emotions.

So whether it is the Philippines or in the US, journalist Franklin Pierce Adams (1881-1960) observations should resonate emphatically ``Elections are won by men and women chiefly because most people vote against somebody rather than for somebody.”

And one reason why I think there wouldn’t be much change even with a prospective rebalancing of political power, or political gridlock as many have labelled them, is that many who run for office only piggyback on so-called principles only when public sentiment supports them.

Eventually once elected into office, these principles usually get sloughed off when personal conveniences weigh in.

And recent history has shown this.

The passage of the Emergency Economic Stabilization Act of 2008[7] should serve as a good example. The bill was initially rebuffed at the first vote at the US House of Congress on September 29^th, but following the paroxysm in the financial markets possibly in response to this, the House reversed and ratified it, on October 3^rd, in a bipartisan support. Ironically, this law serves as one of the main anchors for today’s monumental swing in political sentiment.

Also, political competition represents mostly a zero sum game where one gains at the expense of another. As Henry Louis Mencken rightly pointed out ``Under democracy one party always devotes its chief energies to trying to prove that the other party is unfit to rule - and both commonly succeed, and are right.”

The implication is that a house divided could translate to more political horse trading and backroom dealing, where the administration may either lean towards more a centrist stance or risk a political impasse from maintaining the present hardcore path of left leaning policymaking.

And unlike the past, where both the Congress and the Executive branch had been controlled by a single party, which seem to have made the Democrats think that they had a blanket mandate to foist laws as they see fit, the reconfiguration of power will likely make prospective policies more public sentiment sensitive.

And I’d like add that those who think that political ‘pragmatism’ equates to politics as operating in a fixed state will likely be been proven wrong again, if current polls will be actualized into votes, this Tuesday.

People’s dependence on government isn’t a constant for the simple reason that economic laws ultimately shape politics.

And where redistributive policies or programs would have reached its limits or to paraphrase Milton Friedman, there is no such thing as a free lunch, politics will have to come home to roost to face the new reality.

The recent lifting of the legal retirement age in France, in spite of the crippling protests and riots[8], should serve as a vivid example of the unsoundness of the welfare state system. Eventually, unsustainable systems crumble under their own weight, regardless of what people think.

Pragmatism isn’t about the false belief of sustained public’s acceptability of free lunch policies, on the contrary, pragmatism is about understanding the limits of redistribution operating under the ambit of the natural laws of economics.

Political Gridlock And The Financial Markets

And how should a divided government fare for the financial markets?

Based on past performance, they would seem favourable.

According to Danske Bank research team writes[9], (bold emphasis mine)

Interestingly, periods with the White House controlled by a Democrat and Congress controlled by the Republicans – a situation that is likely to be in place from 20 January 2011 - have seen the best average equity market performance. One important caveat is, however, that this result is heavily influenced by the fact that the period 1995-99, during which President Clinton faced a Republican-controlled Congress, coincided with the technology equity market boom.

When looking solely at the party controlling Congress, equities have performed better during periods of Republican control than in periods of Democratic Congress majority. This could indicate that from the point of view of investors, a Republican-controlled Congress is generally seen as less likely to put through legislation that is hostile to business, both in terms of tax policies, but also in terms of regulation issues. In the current situation, with financial sector regulation issues likely to remain high on the agenda in 2011-12, a Republican-controlled Congress could be seen as less likely to enact further measures to tighten regulation.

We can only conclude that the financial market conditions and the economic environment will likely be dependent on the kind of relationship that would emerge and cultivated from political diversity.

Nevertheless our caveat remains, past performance are not reliable indicators of the future, and that many other factors may influence the hue of US politics.

But if the chances of reduced government intervention in the economy are increased from a political gridlock, then the new political arrangement would likely boost business confidence, and thus becomes a positive influence, rather than undermine it.

And only the politically blind and those addicted to unsustainable inflationary big government would see this as some fictitious horror tale.

And as before, they will always miss out being right.

---

[1] Friedman, George U.S. Midterm Elections, Obama and Iran Stratfor.com October 26, 2010

[2] Rasmussen Reports, Health Care Law, October 25, 2010;

thehill.com POLL: Dislike of healthcare law crosses party lines, 1 in 4 Dems want repeal, October 6, 2010

[3] Wall Street Journal OpEd, A 40-Year Wish List, January 28, 2009

[4] See US Politics: A Libertarian Renascence?, October 29, 2010

[5] Wikipedia.org Tea Party Movement

[6] Examiner.com Video: Tea Party struggling in its efforts to find leadership, April 12, 2010

[7] Wikipedia.org Emergency Economic Stabilization Act of 2008

[8] Wall Street Journal Editorial, Dissecting French Schizophrenia, October 29, 2010

[9] Danske Bank, Much ado in the week ahead, Weekly Focus October 29, 2010

Trick Or Treat: The Federal Reserve’s Expected QE Announcement

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion

What I think would be the most important driver for the global financial markets over the coming weeks would be the prospective announcement by the US Federal Reserve’s Quantitative Easing version 2.0 on Wednesday.

The Gist of QE 2.0

I do NOT share the view that QE has been FULLY factored IN on the financial markets for the simple reason that estimates of the scale and duration and or terms have been widely fragmented. And there hardly appears to be any consensus on this.

The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

And all talks about currency wars, global imbalances and others are most likely to be diversionary ‘squid’ tactics to avoid the public from scrutinizing on the Fed’s arbitrary actions.

I see the ongoing QE 2.0 as heavily correlated with the legal issues surrounding the ownership[1] of many mortgage securities that has plagued the industry over the past few weeks.

Of course, it is also possible that Federal Reserve Chairman Ben Bernanke and company maybe pre-empting the results of the midterm elections, which they might think, could upset the current policy directions directed at providing subsidies to the banking system. The possibility of Cong. Ron Paul taking over the banking committee in Congress, they might see as a potential risk that could disrupt the viability of the banking system.

More Evidence Of Inflation

Yet there is hardly any convincing evidence that the US will likely succumb to another recession even without QE 2.0.

Even the credit markets have been saying so as we earlier pointed out[2].

Figure 2: Improvement On US Credit Markets (charts from St. Louis Fed)

For an update (see figure 2): Bank Credit of All Commercial Loans seem to be picking up momentum anew (top window), even Individual loans at ALL commercial which have recently skyrocketed, seem to be in a short pause but still looking vibrant (bottom pane) while Commercial and Industrial Loans of ALL Commercial banks seem to be bottoming out (mid window).

Figure 3: US Monetary Aggregates Points To Inflation (St. Louis Fed)

And even US monetary aggregates[3] appear to be saying the same story: MZM (upper window) and M2 (mid window) have recently been exploding skywards, while the M1 multiplier, a former favourite tool of permabears which tries to measure velocity of money, appears to be emerging fast from a bottom. And this is even prior to the Fed’s supposed renewed engagement with QE.

What all these seem to be pointing out isn’t what the mainstream and the officialdom has been looking at: we seem to be seeing are convergent signs of emergent inflation!

You have seen the actions US credit markets and US monetary aggregates, now the actions of the financial markets.

Figure 3: EM Equities, US Bonds and Commodities In A Chorus

We have argued that the convergence between rallying US bonds and a bullmarket in gold and or commodity markets would seem incompatible, from which the incoherence the markets would eventually resolve.

We seem to be seeing clues of this happening now, of course, going into our direction.

And deflationistas, whom have adamantly argued that bonds will likely benefit from a so-called liquidity trap, and have used the deflation bogeyman as justification for more inflationism, appear to be on the wrong the trade anew.

As one would note in Figure 3, emerging market equities (MSEMF or the MSCI Emerging Market Free Index), the CRB or a major commodity benchmark, a bellwether of Treasury Inflation Protection Securities or TIPS (iShares Barclays TIPS Bond Fund) and 10 year US Treasury Yields appear to be in a chorus.

What all these (credit market, monetary aggregates, financial markets) seem to be indicating isn’t what the mainstream and the officialdom have been looking at. (They’ve been fixated with employment figures).

Instead, what we seem to be seeing is a convergence of surging inflation worldwide!

And this is even prior to the Fed’s coming actions.

Not only that.

Last week, the US government sold $10 billion of 5 year Treasury Inflated Securities (TIPS) at minus .55% or negative interest rates for the first time in US history[4]!

TIPS investors don’t just earn from coupon yields, they earn from the adjustment of the securities’ par value[5] along with that of the consumer price index (CPI) thus giving protection against inflation as measured by CPI (which I think is vastly underreported).

This only means that the aggressive bid up of TIPS, which has led to a milestone of negative interest rates, represents a monumental swing in investor sentiment towards a deepening recognition of our transition to an inflationary environment which over the recent past had only been a fringe idea!

And this, in essence, would validate our 2009 prediction that inflation will be a key theme for 2010[6]!

And this also means that the premises of deflationistas are being demolished or dismantled as inflation expectations emanating from central bank policies deepens.

What To Expect

So how does QE 2.0 translate to the actions in the Financial markets?

If the Fed announcement should fall substantially below market expectations (perhaps $ 1 trillion or less) then we are likely to see some downside volatility which should prove to be our much awaited correction.

Yet any substantial volatility in the financial markets would translate to the Fed likely upping the ante on the QE 2.0. Remember falling asset prices would pressure the balance sheets of the banking system, and thus, would prompt for the Fed to make additional injections.

However, given the penchant of the Fed to resort to shock and awe, I wouldn’t be surprised if the FED would equal or go over the previous $1.75 trillion[7] monetization of treasury and mortgage related securities in 2009.

Of course, the other important aspect would be how other central banks would react to the Fed’s actions. We cannot take the Fed’s action as isolated.

If Bank of Japan and Bank of England would augment the Fed’s QE 2.0 by increasing its exposure on its current programs, then we should expect money flows into emerging markets to expand significantly. And this should go along with commodity prices and commodity currencies.

From the current market actions, we seem to be witnessing the early stages of a crack-up boom.

I remain bullish on equity markets, which I see as protection or serving as insurance against the currency debasement programs being undertaken by central banks to promote covert political agendas.

For Emerging Markets and Philippine stocks, we should remain exposed to commodities, energy and property issues.

[1] See The Possible Implications Of The Next Phase Of US Monetary Easing October 17, 2010

[2] See The Road To Inflation, August 29, 2010

[3] M1: The sum of currency held outside the vaults of depository institutions, Federal Reserve Banks, and the U.S. Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions (except demand deposits due to the Treasury and depository institutions), minus cash items in process of collection and Federal Reserve float.

The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

MZM (money, zero maturity): M2 minus small-denomination time deposits, plus institutional money market mutual funds (that is, those included in M3 but excluded from M2). The label MZM was coined by William Poole (1991); the aggregate itself was proposed earlier by Motley (1988).

M2: M1 plus savings deposits (including money market deposit accounts) and small-denomination (under $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments under $50,000), net of retirement accounts.

St. Louis Federal Reserve, Notes on Monetary Trends

[4] Financial Times, US Treasury sells negative-rate bonds, October 26, 2010

[5] Investopedia.com Treasury Inflation Protected Securities - TIPS

[6] See Following The Money Trail: Inflation A Key Theme For 2010, November 15, 2009

[7] The Economist, A roadmap for more Fed easing, December 4, 2009

Example of Government Wastage

This is a good example how government fritter away taxpayer money.

From the Wall Street Journal Blog, (bold highlights mine)

The U.S. Internal Revenue Service had difficulty implementing new tax benefits in 2010, paying $111 million in erroneous benefits related to the stimulus law, a Treasury Dept. report said.

The IRS didn’t have controls in place to stop people who weren’t eligible from claiming the $8,000 first-time homebuyer tax credit, and tax credits for plug-in vehicles, among others. The findings were released Thursday by the Treasury Inspector General for Tax Administration.

To put the errors in perspective, IRS processed more than $81 billion in claims for stimulus-related tax benefits in 2010, involving upwards of 90 million returns.

About 126,000 of those returns were flagged by TIGTA as including erroneous claims that weren’t caught by the IRS before they were processed. In some cases, the IRS put compliance controls in place during the tax-filing season to catch the errors.

The underlying message is that the stimulus programs has led to undue wastage.

And the sad part is that no one seems accountable for such errors. And I don’t think that this is limited to the “stimulus programs”.

To consider, the stimulus is just one aspect of the variable bureaucratic operations, which means there would be many more leakages elsewhere.

And applied to the Philippines where social institutions are weaker than the US, the losses would be magnified.

US Politics: A Libertarian Renascence?

In the Cato Blog, David Boaz posits that in the US, current political trends seem to evolve towards the re-emergence of libertarianism.

Mr. Boaz writes,

This chart, prepared for me by Garrett Reim, shows recent trends in public opinion polls on several issues — support for smaller government, marriage equality, and marijuana legalization along with opposition to President Obama’s health care plan and to the job the president is doing. The latter two have moved more sharply, but all five lines move at least marginally in a libertarian direction:

Read the rest here.

What was popular then may not be popular now.

As we have long been saying—the world doesn’t not operate in a stasis. And this applies to politics too, where public sentiment continuously changes depending on the prevailing conditions.