Market’s Response To The Fed’s 25 Basis Points: Sell The News

``For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy.”-John Hussman, Hussman Funds

We expected the US Federal Reserve to cut rates by 50 basis points. Instead they delivered 25. Thus, global equity markets responded with a dramatic selloff. Since, as we earlier mentioned, the markets have been founded on the expectations of the provision of “steroids” from government intervention, the lack of element of positive surprise resulted to a traditional “sell on news”.

Our initial impression was that the Chairman Bernanke of the US Federal Reserve could have underweighted the risks brought about by today’s credit logjam. But this doesn’t tally with the FOMC’s accompanying statement (highlight ours), ``Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

So, while the Fed recognizes the underlying dilemma, they opted to act moderately for unspecified reasons.

Some analysts suggested that the Fed’s ambivalence could have been due to external pressures particularly from Central Banks, such as China. From Reuters (highlight ours), ``What I'm worrying about now is the weakening dollar and its potential impact on global growth. The dollar is the major currency for trade and its continuous depreciation will push up prices of global strategic goods such as oil and gold and reduce the wealth of dollar-holding nations," Vice-Commerce Minister Chen Deming said.

``So I want to see a strong dollar," Chen told reporters during a break in a two-day "strategic economic dialogue" near Beijing with senior U.S. officials led by Treasury Secretary Henry Paulson.

Since the motion of continuously reducing interest rates have been detrimental to the US dollar holdings of global central banks, then such decrials seem understandable.

On the other hand, others suggest that the Fed’s actions appear to be reflective of the reduced policy traction as LIBOR rates continue to rise as shown in Figure 1.

Figure 1: Northern Trust: LIBOR Less Target Fed Rates

LIBOR or London Inter-Bank Offer Rate as defined by investorwords.com is the ``interest rate that the banks charge each other for loans (usually in Eurodollars). This rate is applicable to the short-term international interbank market, and applies to very large loans borrowed for anywhere from one day to five years.”

So aside from interbank borrowing, LIBOR is a widely used benchmark for ascertaining most adjustable mortgage rates to rates of corporate loans to even government borrowing. Yet LIBOR is not determined by the Federal Reserve.

In other words, to quote Martin Weiss from Money and Markets, ``LIBOR is easily the single most important interest rate in the world…Even if the Fed lowered its target for fed funds to zero ... if the LIBOR rate fails to decline in tandem, or worse, actually goes up, the Fed's power to avert an economic decline in the U.S. will be shot to pieces.”

Hence the Fed’s tentativeness could possibly be construed as a deflection of its policies growing impotence over the ongoing debt and capital destruction or “deflationary process” in the financial markets.

Bernanke’s “Rabbit Out Of The Hat” Trick; the TAF (Term Auction Facility)

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

Our notion of the US Federal Reserve’s seeming insouciance was nevertheless reversed…a day after it tepidly raised its interest rates. In an apparent orchestrated effort led by the US Federal Reserve to combat the global credit gridlock, major central banks which included the European Central Bank, Swiss National Bank and Bank of Canada agreed to auction credit at favorable rates and to implement swap arrangements. In short, the Fed pulled proverbial “rabbit out of the hat”.

From the Australianews, ``It is understood the joint effort will make available more than $US100 billion ($A114 billion) this month. The US Federal Reserve is injecting $US40 billion; the Bank of England $US46.4 billion, the European Central Bank (ECB) $US20 billion, the Swiss National Bank $US4 billion and the Bank of Canada is providing $US3 billion.”

The joint effort is called as the temporary Term Auction Facility (TAF). According to the Federal Reserve (underscore ours),

``Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress…

``The minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate corresponding to the maturity of the credit being auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over the relevant term…

``The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will provide dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions. The FOMC approved these swap lines for a period of up to six months.”

These measures starkly reveals of the priorities of the US FEDERAL Reserve. It purportedly addresses the unraveling credit crunch or of the burgeoning illiquidity in the marketplace, whose aggravation could lead to a meaningful curtailment of the economic activities. So despite the meager amounts of the contingent liquidity provided for, relative to the total financial markets, such telegraphed actions have succeeded to temporarily narrow the spreads of the LIBOR rate from that of the target FED RATE as shown in Figure 1, courtesy of Northern Trust.

Second, the program deals with the stigma of banks borrowing from the discount window. Banks have been reluctant to borrow from the discount window because of the association of being “troubled” or “distressed”. So, under the new auction system, banks will be lent directly and quietly away from the prying eyes of the public.

Third, the measure aims to accept a much larger scope of collateral, which brings the question of the moral hazard of bailouts.

John Carney of dealbreaker.com says that the FED has announced that it will pay 85 cents on the dollar for CDO’s with no market price available. So effectively, the Fed under such circumstances will be providing cover or subsidies to distressed institutions holding “toxic wastes”.

Thus, Paul Kasriel of Northern Trust (emphasis ours), brings to light the ramifications of TAF, ``A question arises as to whether the Fed will be taking a large enough “haircut” on some of the collateral being presented to it by successful TAF bidders. If the markets cannot price some of these securities, how does the Fed know what they are worth? If a TAF borrower were to become insolvent, the Fed might not be able to recover the full amount it had loaned the bank. In effect, the TAF program, as well as the regular discount window facility, transfers credit risk to the Fed, which means ultimately, to the taxpayer. Depending on how the Fed prices the collateral presented to it, the TAF program could be construed as a taxpayer subsidy to banks presenting “questionable” collateral. Remember, there is no such thing as a free bailout.”

Here, central banks are seen clearly fighting the onset of deflation with inflation and the consequent socialization of financial markets. The odd part is that markets always get the blame for a bust which has been created and fostered by preceding inflationary policies.

Lastly the swap arrangement deals with the proviso of extending standby US dollar supplies to the ex-US financial marketplace in the face of a liquidity crunch.

Prof. Willem Buiter calls such policies as meaningless or “a substitution of motion for action” since it does not deal with the underlying problem of general liquidity, from Financial Times (highlight ours),

``So talk of a US dollar scarcity in the euro area is hilariously silly. In 1947 there was a US dollar shortage in Europe. There was limited current account convertibility of the European currencies and effectively no capital account convertibility. This, however, is 2007. If commercial banks or other market participants want more US dollars, they can buy them in the foreign exchange market or borrow them. In the Eurozone, they would need liquid euro assets to buy US dollars, or they would have to borrow US dollars, secured or unsecured. Indeed they could borrow euros (secured or unsecured) and use these to buy US dollars. All these courses of action are problematic today because there is a shortage of liquidity in the Euro area, that is, a shortage of euro liquidity, US dollar liquidity, Swiss franc liquidity or indeed any kind of liquidity. If there were adequate euro liquidity, commercial banks or anyone else could use that euro liquidity to buy eminently convertible US dollars in the extremely liquid foreign exchange market. The ECB could choose to sterilise its loss of US dollar reserves or not; it could chose to restore its US dollar reserves, or not. End of story. Dollar shortage - my foot.”

Nonetheless, such concerted actions by the key central banks highlight on the severity of the stress envisaged by the global financial markets. In fact, the overcast of gloom and doom scenarios appear to be today’s du jour outlook.

Asian Banks Refrain From TAF, Another Evidence of Decoupling?

``The crisis signals a necessary re-rating of risk. It turns out that it also represents a move towards holding more transparent and liquid assets, as one would expect. This correction is altogether desirable. It has, moreover, been selective. It is a striking feature of what has happened that emerging markets have emerged as a safe haven as investors run away from US households. For those in emerging economies, this must be sweet revenge. They should not cheer too soon. Today's favourites may be brutally discarded tomorrow.”-Martin Wolf, Financial Times, columnist

Yet, despite the contingent actions by key western central banks, Asian Central banks refused to join their counterparts, from the Financial Times (highlight ours),

``Asian central banks on Thursday refrained from joining their North American and European counterparts in taking emergency action to boost market liquidity, underlining what economists dubbed a much healthier funding environment in the region.

``The contrast in responses “absolutely confirms how different the situation is in Asia,” said Glenn Maguire, Asia chief economist at Societe Generale. “There are some funding strains in Australia, Korea and China but nothing significant enough to warrant any change [in the stance of central banks].”

`` “If anything, [Asian] liquidity conditions are excessively high,” said Paul Schulte, chief regional equity strategist at Lehman Brothers. “While the West was trafficking these credit products over the past five years, Asia was, thankfully, in rehab.”

``The Bank of Japan took the lead among Asian central banks in expressing support for the US-led emergency steps to ease liquidity concerns, but said it had no plans at this time to take additional measures of its own. The BoJ has been supplying funds against pooled collateral since last year, allowing borrowers to access funds using a variety of collateral.”

Why is this important? Because it shows of the disparity of the immediate effects of the recent credit triggered turmoil to the region’s economy and financial marketplace. In the decoupling debate, these serve as empirical evidences in support of the pro-decoupling stance.

While we agree that most current account deficit countries (e.g. US Spain Italy Greece et. al) which have supplied the demand side of the equation are likely to suffer from a growth slowdown, if not a recession, and risk a spillover effect throughout the world, where we part is on the probable degree of its impact to Asia and to emerging economies.

Our point is that the structural construct of Asia’s financial market are less reliant on debt or leverage as shown in Figure 2, which makes the region less vulnerable relative to western economies or markets.

Figure 2: IMF: Wide Variety in Terms of Capital Market

In a recent speech by Takatoshi Kato, Deputy Managing Director of the International Monetary Fund (IMF), Mr. Kato notes,

``There is no doubt that the Asia-Pacific region contains countries that vary widely in terms of the level of depth, liquidity, and sophistication of their capital markets. Australia, Singapore, Hong Kong, and Japan already have advanced markets. But what is impressive is capital markets in Korea, Malaysia, China, Indonesia, the Philippines, and Thailand are also developing very rapidly as these countries reap the benefits of institutional capacity building and other structural reforms and international portfolio diversification.” (emphasis ours)

Following Asia’s financial crisis in 1997, the region has learned how to insure itself with a stockpile of forex reserves as well as the attendant reforms in its financial markets.

As we have earlier said, we don’t deny the initial impact of a US led slowdown to the Philippine or Asia’s financial markets as discussed in November 19 to 25 [see A US Recession Will Initially Drag Global Equities Lower], but what we see as potentially divergent is the impact of global monetary policies [see November 19 to 25 Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?] to individual or importantly to regional financial markets.

The same article from Financial Times underscores the risk that matters most for us (highlight ours)…

`` Despite limited spillover into emerging East Asia from the US subprime turmoil, there are several signs of financial vulnerability related to sharp gains in equity and real estate prices [within the region],” the ADB said.

``Part of that slowdown is likely to stem from China, where “a series of tightening measures has been introduced to curb rapid investment growth and asset-price inflation since mid-2006, but the full effect has yet to be seen,” the ADB said.

``The ADB forecast that Chinese economic growth would slow next year to 10.5 per cent from 11.4 per cent this year. In September, the ADB had forecast that China’s economy would expand 10.8 per cent next year.

`` “The liquidity issue is not really concerning this region,” said Lee Jong-Wha, author of the ADB report. “Inflationary pressure is clearly the main concern, so central banks will become more cautious about that. The issue is monetary instability rather than financial problems.”

Simply put, in contrast to the Armageddon scenario proposed by some, the risks for Asia lies squarely in the hands of China’s reaction to a US-led global slowdown instead of the credit crisis.

Philippine Stocks and Peso Hinges On Asia’s Direction

``If demand in the US drops further, Chinese exporters will be devastated by a rapid and continuous fall in orders.”-China's commerce ministry

For us, the seeming resiliency of the Philippine equity market has been backstopped by a firming Peso and a steepened yield curve.

Since the August “credit turbulence” set in, domestic investors for the first time in the present cycle (since 2003) have lent massive support to keep index above its previous resistance level and now support at 3,400.

The Philippine Stock Exchange registered a net selling of Php 20.318 billion since the week ending August 2 or representing 75% or 15 out of 20 weeks. In short, in contrast to the past four years where foreign investors have propelled the local market, today, local investors have been weightlifting the Phisix amidst the credit crisis.

Figure 3: ADB Bond Monitor: Philippine Benchmark yields

Moreover, the yield curve of Philippine bonds has steepened as shown in Figure 3. According to the ADB’s December Bond Monitor, ``Yield curves in most economies also steepened this year, mirroring the trend in world markets. In Indonesia, Philippines, and Thailand, curves steepened as loose monetary policy pushed down yields on shorter maturities, while rising inflation pushed the yields higher on bonds with longer maturities.” (emphasis ours)

As the ADB mentioned, the steepening of our yield curve implies loose financial conditions which could have prompted for local investors to sustain the PSE at present levels, aside from the firming Peso. This comes in the face of a spurt of foreign selling following the advent of the credit crisis.

This brings us to the next level of risks…a China slowdown.

Asia’s firming currencies have been mostly symptomatic of its balance of payments or capital and/or current accounts surpluses due to the de facto “Bretton Woods 2”, or an informal “US dollar standard” arrangement where Asian currencies have been purposely kept low, as a subsidy to its producers to increase its export market share (at the expense of domestic consumption). As a corollary of trade, the surpluses of US dollars generated are either hoarded or mostly recycled into US assets e.g. treasuries, agencies, real estate or equities.

On the obverse side or viewed from the context of US or current account deficit countries, this phenomenon can contrastingly be extrapolated as a subsidy to its consumers at the expense of their domestic producers.

Where in relation to China’s currency regime as the world’s final assembly line, to quote Professor Michael Pettis, `` Rising industrial production is central to the monetary trap in which China is stuck. As production surges ahead of consumption, the trade surplus must also grow (since the excess must be exported), and as it does it forces the PBoC to expand domestic money supply in a way that then reinforces fixed asset investment and future growth in industrial production. A reduction in the rate of growth would imply a future reduction in the growth rate of the country’s trade surplus.”

In other words, should a US-Eurozone downturn meaningfully impact China’s trading activities, we could possibly see a diminishing rate of growth of its industrial production (see Figure 4), which could translate to lower trade surplus, reduced money growth or subdued rate of appreciation of the remimbi relative to the US dollar…unless increased domestic consumption fully substitutes for such weaknesses…which is quite unlikely.

Nevertheless a disorderly adjustment in China could result to the unexpected, massive outflows of speculative money which could reverse the trend of its currency’s appreciation.

Figure 4: Danske Bank: Slowing Industrial Growth

China’s Industrial production recently slowed to 17.3% (Chinaview.com), where according to Flemming J. Nielsen of Danske Bank (highlight ours), ``The most likely explanation for the recent weakness is the government’s intensified crackdown on inefficient steel producers for environmental reasons. China has recently reduced tax rebates on exports of high-energy and resource-intensive industries including steel and export of steel has plummeted by about 40% since April 2007.” Simply said, the recent slowdown can be seen in the light of domestic policies aimed at tempering industrial production growth, rather than emanating from external activities. Our fears have not yet been evident.

So if China’s currency regime as signified by its “borrowed” monetary policies from the US will be affected by the impairment in the financial flow linkages then its “expected” rate of currency appreciation could diminish or even possibly reverse. Obviously this will sap into the Philippine Peso’s recent strength, which should also risk being echoed in the activities of the Phisix.

Such is the reason why we should remain cautious until a clear trend becomes manifest.

2008: A Challenging Year of Inflation versus Deflation

``You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of '02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive…My view, instead, is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right. The problem is that real risk and perceived risk are two different things. And that's where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That's the psychological problem that most people have.”-Bill Miller manager of Legg Mason Value Trust

At the start of this year we projected that the Phisix would range by (+/– 5%) in the light of a US economic downshift and based on the mean reverting tendencies of markets. Apparently while indeed the US has seen some semblance of a slowdown, the strong run-up until the third quarter by global equity markets has proved our projections as inaccurate (Phisix is presently up 18% year-to-date and most likely will end up during at the yearend-with a few sessions to go― unless another August like shock erupts; like all of our earlier projections we tend to be too early).

Nevertheless, such outlook should be carried over for next year, specifically the Phisix and the Peso could correct (the Phisix could retest the 2,800-3,000 before recovering at the close of the year as well as the USD-Peso could bounce to the 45 level before a resuming its strength), as the strains of credit turmoil remains unresolved coupled with heightened risks of a US recession spilling over to a downdraft in global economic growth. Remember, if remittances have underpinned the virility of the Peso, as mainstream experts suggests, then a US recession-global growth slowdown should affect employment and migration trends enough to ease or even reverse the tempo of the Peso’s rise.

By our own measure, capital flow trends into Asia should determine the fate of the Peso in 2008. A moderate slowdown could exacerbate capital flow trends into Asia while in contrast any shock (similar to August) could result to massive unwinding of leverage positions.

The ensuing uncertainty described above will likely be accompanied by a concerted easing by global central banks in spite of today’s backdrop of magnified inflation. The TAF and the recent easing by the Bank of England and the Bank of Canada alongside with the US Federal Reserve is a prologue to the next year’s activities.

Besides, given the mean reverting proclivities of the markets where no trend goes in a straight line, this means secular or long term cycles will always be interrupted by countercycles.

Yes, speaking of inflation in spite of the deflationary developments rapidly unfolding in the frontiers of the financials, the world appears to be experiencing an onslaught of rising inflation (as measured in producer/consumer prices), mostly seen in energy and agricultural or food prices. Doug Noland writes in his Credit Bubble Bulletin,

``U.S. Consumer Prices were up 4.3% y-o-y in November. Our Producer Price index registered a 7.2% y-o-y surge. November Import Prices were up 11.4% from a year earlier. Euro-zone inflation jumped to 3.1% y-o-y, the strongest rate since May, 2001. German consumer inflation rose to an 11-year high (3.3%). Chinese inflation was at an 11-year high of 6.9% in November. Score of countries and regions – including Australia, Russia, Eastern Europe, and the Middle East - now confront heightened inflationary pressures, in what has developed into a powerful global phenomenon.”

Mr. Noland is right when he says the inflation is ``in the process of significantly limiting the Fed’s flexibility and capacity to orchestrate another Wall Street bailout.” But as we have always argued, for as long as the menace of deflation deepens, the likely thrust by global central banks is to err on the side of inflation and work to defer on the day of reckoning. No central banker would like to have a recession in their résumé, hence the inflationary boom-bust cycles.

Yet while we remain bullish on the Phisix and the Peso over the long term, 2008 poses to be a year of significant challenge where we think the performances of Gold and Oil as best guide in the ongoing battle between the forces of deflation and inflation.

The recent strength of the US dollar could be indicative of emergent deflationary forces as shown in Figure 5.

Figure 5: Stockcharts.com: US Dollar Rallies Signals Deflation?

So with global indices including the Phisix (above), Dow Jones World (pane below main window) and the US S & P 500 (lowest pane) on a clear downtrend, marked by lower highs at the onset of a rallying US dollar (main window-circle) amidst modest actions by major Central Banks, we are looking at potentially more downside volatility as financial market losses make themselves more apparent. The blue vertical line shows how global equity markets have become “synchronized” anew.

We have seen how central banks have employed “creative” (FHLB, M-LEC, TAF) options to defuse the unraveling crisis. We should expect intensified activities from them for as long as markets persist to exhibit an enduring loss of confidence. Or as the losses percolate or worsen, their accompanying actions are most likely to culminate into more aggressive rescue packages or face the risk of a full-blown crisis.

2008 will likely hallmark a tug-of-war between inflation and deflation.

Philippine Peso And Remittances: The Unsecured Knot

``One of the greatest tragedies of life is the murder of a beautiful theory by a gang of brutal facts."-Benjamin Franklin

The US dollar-Philippine Peso recently broke into the 41 level, the highest level in more than 7 years. Nonetheless, the Philippine Peso has been the top performing currency in Asia with a year to date gain of about 17%.

Figure 1 Left: World Bank: Remittances Year-on-year Growth on 3 month moving averages,
Right: Philippine Peso-USD Price Rate of Change (Inverted Scale)

Anyway, we read that the Peso has been “driven” by overseas money again. While the fundamental ratiocination appears to have given such correlation a strong link, as we demonstrated in our November 5 to November 9 edition see What Media Didn’t Tell About the Peso, these have not been airtight. In fact, based on price actions, the correlations have been more of a recent phenomenon.

The timely release of World Bank’s Remittance Trends 2007 as shown in Figure 1 (left window) exhibits the year-to-year growth of the remittances. This means that while nominal remittances have been growing, the rate of change on an annual basis have been on a decline since the last quarter of 2006 and bottomed out in July of 2007, only recently has this reversed to the upside.

In comparison with the Philippine Peso-USD (inverse scale: black line-right window) over a similar timeframe, we can identify some observable similarities and notable differences.

The peak of the October remittances coincided with the summit of the Peso last 2006, whereas the trough in the remittance this July was accompanied by a bottom in the Peso’s ROC last August.

Prior to these, the peaks and troughs have been rather distinct. As an aside, the degree of changes has been in stark contrast; for instance, the intensity of the latest ascent had been precipitate, even if we exclude the November performance, the ROCs would have been at the resistance levels relative to the benign reversal seen in the WB’s remittance chart.

Of course, one should be notified that due to the lack of breadth of our data on the Peso, the “apples-to-apples” or the equivalent year to year change has not been utilized. However, the overall trends should depict on these dynamics.

Our point is; relative price action, the Peso-remittance causality or correlation has been more of a recent phenomenon confirming our earlier views, but whose relationship cannot be reckoned as straightforward or infallible.

We are heartened by the news that new instruments (e.g. multi-currency Retail Treasury Bonds) have been designed by the Philippine Central Bank, the Bangko Sentral ng Pilipinas (BSP), aimed at our migrant workers, to hedge against the rising Peso.

But what seems to be amiss is a market based approach on these aspects. By introducing or adopting a franchise on alternative market platform/s, such as a domestic futures market (a genuine futures market-not the defunct MIFE model), which could allow more financial (non-banking) and nonfinancial institutions to even retailers to participate or access a wider range of hedging tools could spur the creation of varied hedging vehicles or instruments, such as indices like ETFs or Exchange Traded Funds, which could compete to offer better yields to OFWs or to the populace.

Remember, deeper and more sophisticated financial markets should reduce transaction costs thereby boosting efficiency and competitiveness in our domestic enterprises, as well as augment our economy’s capital formation channels. At the same time, by diminishing risks through hedging enhances returns potentials thereby attracting more participation from the populace.

This is one concrete way to yank out our inordinate dependence from politicians.

Open Market Economies or Che Guevarra’s Chimeras

``Ideologies are now served à la carte. Chávez makes common cause with the Cuban Revolution. But he parades under banners of Jesus Christ and calls Christ the “first revolutionary.” So much for Communism’s dismissal of the opium of the people. The Venezuelan leader talks a lot about women’s rights, but abortion remains illegal. Just as Chinese Communism can be capitalist, and Russian democracy look Leninist, Chávez’s Cuban-inspired socialism can be Catholic: what counts is power preservation.”-Roger Cohen, columnist International Herald Tribune

The public, impelled by mainstream media, has been made to believe that the success in a country’s political economy should be driven by “personality based” (rent seeking) politics or the “honesty-charity” model of “socialism”, or the belief that central planning should solve each and every of our daily problems.

This socialistic inclination appears to have diffused into the hoi polloi…do you see the proliferation of Che Guevarra T-shirts on the streets? (Gadzooks! Have mass murders or “democide” now become a paragon for economic salvation?!)

The irony is that while we opt for a political democratic form of government where we “elect” our leaders, we chose to subordinate our economic path to the whims of these leaders who eventually “fail” us by the “unwarranted” imposition of perceived popular themes of “injustice” and “corruption”.

When economic opportunities are determined by politicians then we subject ourselves to centrally planned governance-socialism. Bloated bureaucracy, surging government spending and soaring taxes are symptomatic of such dynamics. And so is the price of getting elected (see our November 18 discussion).

Yes, according to the recent World Bank’s Paying Taxes 2008 Report, the Philippines ranked 135^th of the 178 countries in terms of taxing businesses. This pales in comparison to our neighboring Malaysia, Indonesia, and Thailand which landed in 54^th, 63^rd, and 66^th spots, respectively (Businessworld). High tax rates equal to high costs of doing business. Should it be any wonder why we lack the required investments which contributes to the present economic plight?

Yet, the paradox is that we ask for more government. Why? Because many of our economic elites hide under the skirt of regulations to escape competition and even lobby for more laws to keep the statusquo or retain their competitive advantage.

On the other hand, most serving political officials, the wannabes (opposition) and their affiliates or associates-some in the media, some in the legal profession, and many in the church et. al. -advocate for bleeding heart or “doleout” economics or for more dependence on the government for a variety of purposes-anywhere from wielding the burgeoning public coffers for their self interests to the arrant lack of understanding of the implications thereof.

So in spite of all of the successive changes of leadership over the years, we continue to remonstrate on the actions of the incumbent leadership for exactly the same sins as the past administrations. And since we can’t comprehend on the true picture of what keeps us they way we are, we ask for the wrong cure-more government. As an old adage goes, ``Fool me once shame on you! Fool me twice, shame on me!”

Like a curse, hardly has it been known to us that our socialistic tendencies will continue to benight on us for as long as we chose to do so.

The fundamental problem with the ideals of socialism/communism is that its application has been incompatible with the universal laws of economics such as the law of scarcity, the individual’s sense of marginal utility and most especially economic calculation. Why do you think the USSR collapsed (lack of charity or honesty, perhaps-hahaha!)? Or communist China or statist India has now shifted their economic structures towards market-oriented economies?

Yet faced with every problem is the desire to use of the legitimate structural coercive machinery-government-as political mechanism for dispensation of fairness or justice. Do you ever think that government can ever be just, fair or honest? Our answer: No. Simply because “justice, fairness and or honesty” depends on how an incumbent defines these. Like market prices, which are subjectively valued, so as with the definition of one’s sense of fairness justice or honesty. Che Guevarra’s brand of justice was of public trial and mass execution…of the political opposition…should such be considered as one’s political model?

Anyway, since we are speaking of developmental issues, here is a recent pertinent narrative about Ireland’s transformation according to Dr. Steve Forbes of the eponymous Forbes magazine and his suggestions for Israel (emphasis ours),

``The dispute there between Protestants and Catholics has been bloody and has lasted for more than three centuries. Yet there now seems to be real progress toward peace. Why? Not because diplomats suddenly became more able but because of the profound changes to the south, in the Republic of Ireland, which for centuries had been one of the poorest economies in western Europe.

``Things started to change dramatically in the 1970s. Dublin aggressively courted foreign investment, using tax cuts and tax holidays as bait. Other tax and regulatory changes were made. Result: Ireland today is the most vigorous economy in western Europe. Its per capita income is now larger than that of Britain, France or Germany. The great boom in Ireland did not go unnoticed in the North, and in fact that region has benefited greatly from the Republic's prosperity. A vigorous, new middle class is rising in all of Ireland. As people become more prosperous they tend to focus on bettering their lives more than on blowing up their neighbors…

``Israel has made significant changes--especially under Benjamin Netanyahu, who was finance minister (2003--05)--but it could do a lot more, including instituting a low-rate flat tax. Until recent years, in fact, Israel's economy was grossly overregulated, overtaxed--hardly an inspiring free-enterprise model. The faster it can move to a Hong Kong/Estonia/Switzerland model, the better for its own well-being and security. A free-enterprise boom would be noticed by neighbors--and quietly emulated.”

The lessons are clear enough, the odds of successes for open market driven economies have conspicuously been lopsided than of any statist or socialist models, especially when in comparison to Che Guevarra’s revolutionary paradigm-Cuba. (Wasn’t he booted out by Fidel Castro for either incompetence or for conflict of ideals? And wasn’t all his revolutionary attempts in different countries-Panama, Dominican Republic, Bolivia, Congo-been a failure?).

The Socialization of Global Financial Markets

``Where in capitalism is the idea that you can spend more than you earn? Where in the vision of Adam Smith is the idea that foreigners will subsidize your standard of living – indefinitely? Where in laissez-faire is the notion that central bankers will prevent corrections by controlling the price of money? What had happened to the old sturm and drang? Where was Schumpeter’s ‘creative destructive?’ The new capitalists offered creation without destruction... resurrection without crucifixion! They offered not only to hold harmless investors in the face of their own bad judgment...but to revive booms before they ever expired and to cut short corrections before anything has been corrected.” –Bill Bonner

Global equity markets cheered anew the “socialization” of the financial markets, as shown in Figure 2, as major central banks such as the Bank of England and the Bank of Canada trimmed interest rates in response to the worsening global credit crisis and over concerns that such dislocations would spillover to the global economy.

Meanwhile the Reserve bank of Australia and the European Central Bank kept rates unchanged regardless of the signs of incremental increases of inflation (by their definition-higher consumer prices).

Figure 2: stockcharts.com: Equity Markets Applauds Central Bank Bailout Packages

The buoyant markets have been apparent in the Philippine Phisix (main window) alongside the US S & P 500 (above pane), the Dow Jones Asia ex-Japan (pane below window) and Emerging Markets (lowest pane) which have simultaneously recoiled following the other week’s tests at near critical support levels.

This came about as dovish statements from key central bank officials as Chairman Bernanke and Vice Chairman Kohn indicated of concerns of heightened downside risks which possibly telegraphed messages of a forthcoming rate cut this December 11^th.

As we have noted, the global equity markets since August have been living off from government crutches, i.e. buying the hope that the attendant remedial policy measures will be effective enough to thwart the ongoing rapid adjustments in the highly leveraged financial sector.

Despite several initial stopgap measures to contain the recent stress, equity markets continued to show signs of strain as selling pressures reappeared last November.

Recently even as equity markets appear to have been pacified the credit markets continue to manifest signs of significant dislocations as shown in Figure 3.

Figure 3: Financial Armaggedon.com: Biggest Spread since 1986

The chart depicts of the spread between US Libor rates or lending rates on unsecured funds charged by banks to each other relative US Treasury bills of the same maturity, from which today’s ``conditions are more akin to the chaos that developed around the time of the 1987 stock market crash, (highlight ours)” observes Michael Panzer of the Financial Armaggedon.com.

Mr. Panzer adds, ``More ominous, perhaps, is the fact that banks have much less in the way of cheap and relatively immobile customer deposits backing their outstanding loans than in the past. That means they are more dependant than ever on other banks and the financial markets to meet their funding needs”

This just shows how leveraged the global financial system is, deposit reserves which used to serve as sound collateral for lending has essentially dissipated. These have been replaced by collaterals of questionable value. In good times nobody challenged the viability of such premises. Now that the going gets though, the massive spike on yield spreads reflect on their reluctance to lend to each other which could signal a potential disorderly unwind.

Of course, again the equity market is hoping that the plans to mitigate losses from the mortgage market will gain traction as Treasury Secretary Mr. Henry Paulson alongside with industry lenders set up guidelines to freeze interest rates by affected parties.

But the problem is that these plans would only help a marginal number; from New York Times, ``The Greenlining Institute, a housing advocacy group in California that began raising alarms about subprime loans nearly four years ago, estimated that only 12 percent of all subprime borrowers and only 5 percent of minority homeowners would benefit from the rate freeze. The Center for Responsible Lending, a nonprofit group that supports homeownership, said the freeze would help only about 145,000 people.” (emphasis mine)

Second, is the concern over the breach of private contracts, from the Economist (emphasis mine), ``Whatever else it may be, the Bush administration’s agreement is an extraordinary intrusion by the government into private mortgage contracts…Whatever the economic arguments for the Bush administration’s plan, it amounts to poor public policy. America’s unfettered brand of capitalism is one of its strengths; investors may be less likely to trust a government that manipulates private contracts when conditions deteriorate. At a time when the economy is already weak and the dollar is suffering from a crisis of confidence, Mr Paulson’s awkward intrusion into the mortgage market looks more like desperation than a hedge against further trouble.”

Third is the ambiguous procedural process, again from the Economist (highlight ours), ``But how the process will work is not clear. A national blueprint may make it easier to identify those who are eligible for relief, but the process of renegotiating the loan, or applying a rate freeze, must be done individually. Lenders will need to check borrowers’ incomes, debt levels and the current value of homes before they can agree to a change in the terms of the loan. Mr Paulson, in fact, acknowledges his plan’s limitations by saying that other relief measures are under discussion.”

Another is about the incentives and potential consequences, from Minyanville’s Mr. Practical, ``The biggest ramification is this. Those investors will have to decide whether or not to accept the new terms. If they accept lower interest payments because it is better than default, the value (price) of the CDO will go down to reflect the new present value of the payments. This is a big fact that I think everyone is missing: the price of CDOs will be marked down from current levels. Banks' desire to lend will go down as a result of this. As an illustration, the spread between libor and ECB funding rate (equivalent fed funds) rose again last night and is at a record 89 basis points.

``A nuance of the above is that senior trauches of CDO now have a higher certainty of pay-outs while the junior trauches now may be worthless. These junior trauches will sue like crazy as this thing unfolds.”

``What will happen is that banks/other investors who own these will then take another write-down but then declare this is the end. This will not be true. A huge percent of all re-negotiated mortgages eventually still default. It just buys a little time for a few more interest payments. The bottom line is these folks bought houses they couldn’t afford when paying market interest rates. This is really a plan to help banks take one more write-down and declare all is well and then hope for some magic turnaround. But there won’t be a turnaround.”

Finally on the proposed government bailout, again Mr. Practical, ``So far Mr. Paulson is trying to make this look like a “voluntary” plan by lenders. We all know there is lots and lots of pressure being exerted by government to get them to volunteer. But I have a feeling Mr. Paulson’s plan does not end here. There is also talk of getting Congress to pass legislation to let states and municipalities issue tax-exempt debt to refinance loans for those who cannot keep their homes. This would be nothing more than a government led bailout of banks and large investors at the expense of taxpayers. ”

As we have long argued, the US government will protect the US dollar standard system with an attendant bailiout of its major conduits, even at the expense of the purchasing power of its currency. Yes, there could be some sacrificial lambs but the overall action appears to be pointing towards such direction.

Second like any governments, they tend to be reactionary in their approach to problem solving--responding mostly to short-term popular demands but whose actions are likely to benefit vested interest groups.

Third, it is the nature of governments, given the backdrop of today’s paper money system, to utilize manipulative (inflationary) policies to steer an economy towards a short-term boom then blame the markets for the ensuing bust from which they would find the necessary excuse, backed by socialist experts and grandstanding politicians, to justify for the next policy (inflationary) maneuvers.

Lastly, such rescue plan has yet to be implemented and we are already seeing some signs of a backlash, which means like most interventionist policies they tend to end up with long term unintended consequences.

Stock Markets: Monetary Policies Have Larger Impacts 2

``“Movie-plot threats”: the tendency of all of us to fixate on an elaborate and specific threat rather than the broad spectrum of possible threats. We see this all the time in our response to terrorism: terrorists with scuba gear, terrorists with crop dusters, terrorists with exploding baby carriages. It’s silly, really, but it’s human nature.’- Bruce Schneier, American Cryptographer and computer security expert, interview at Freakonomics

So where are we headed for?

Figure 4: Ratings and Investment Info: China’s Currency Reserves and the Shanghai Composite

First, we believe that monetary policies have very compelling influence on the directions of asset classes more than what the conventional wisdom leans on--predicated mostly on corporate earnings or on plain vanilla economic linkages as discussed last week.

Figure 4 from Ratings and Investments shows how China’s soaring foreign currency reserves have coincided with the spiraling Shanghai Composite Index. To fittingly quote Professor Michael Pettis of Peking University’s Guanghua School of Management, ``the root of China’s problem is the growth in the nation’s money supply caused by the currency regime.”

Second, the unfolding credit crisis which has been emblematic of the declining collateral values held by major financial institutions is about to test global central banks risk tolerance based on the prospects of deflation or of contracting liquidity.

As evidence, the rescue project by Secretary Paulson code named, “Hope Now Alliance” signifies the intent to slowdown the deterioration of the present financial conditions to the point of undeservingly manipulating contracts. In short, desperate times calls for desperate measures.

By our understanding of the ideological framework of Mr. Bernanke, based on his previous speeches Financial Accelerator and the Helicopter strategy, it is likely that the pursuit to preempt a deflationary outcome would be its principal policy activities. Hence, given such premise, it is our belief that the US Federal Reserve would cut no less than 25 basis points during the next FOMC meeting next week.

Nonetheless, there are other sources of potential risks, which we believe the authorities are well aware of, such as US commercial real estate, other asset backed assets as Auto Loans or Credit Cards, Credit Default Swaps, High Yield Bonds and Derivative Counterparty risks.

Third, with signs of decelerating economic growth becoming more apparent--OECD expects world growth in 2008 at 2.3% compared to 2.7% in 2007 (Canadian Press), global banks appear to be calibrating their policies with that of the US.

Hence, a prolonged turmoil in the credit markets, further downside volatility in asset prices and palpable signs of spillover to the real economy are likely to prompt for more liquidity spillage policies. The BoE and Bank of Canada’s actions are likely the first of a series of moves.

It takes only four central banks to make material impact on global liquidity at present; namely the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. Remember, as we mentioned in the past, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

While we expect the BoJ to remain on hold during this turbulent period, the rest including the hawkish ECB’s Jean Claude-Trichet, are likely to join the bandwagon once such dislocations become evident.

Figure 5: AMEINFO.com Arab General Index

Lastly, as we have been saying all along, we don’t claim to know or pretend to comprehend everything, because the world is too profound or complex to do a simple 1+1=2. There are simply too numerous variables to consider.

However, what we understand is that despite claims that the world financial markets in unison would suffer miserably due to a US hard landing, our perspective is that they could be subject to functional randomness based on the possibility of diverse responses to collective policy activities by global central banks. This could be due to the different state of developments of domestic financial markets, the divergent currency regimes or policies involved or exposure to leverage, as well as the distinctive constructs of the domestic economies, financial globalization notwithstanding.

Figure 5 from the Ameinfo.com tells us that the Arab General Index has climbed this year, unfazed by the recent tumult last August and September similar to China. This goes to show that not every equity bourse have their destiny tied with the fate of US markets…yet. Yes, we understand that most of the bourses indicated have not been significantly open to foreign investors, but our point is with prospects of more inflationary actions, money would have to flow somewhere.

Gary Danelishen writing for Mises.org gives a good account of inflation process (underscore mine), ``New money that enters the economy does not affect all economic actors equally nor does new money influence all economic actors at the same time. Newly created money must enter into the economy at a specific point. Generally this monetary injection comes via credit expansion through the banking sector. Those who receive this new money first benefit at the expense of those who receive the money only after it has snaked through the economy and prices have had a chance to adjust.”

As a saying goes, Discretion is a better part of valor.

Some Memorable Quotes from Friday’s Manila Peninsula Debacle

``The main issue in present-day political struggles is whether society should be organized on the basis of private ownership of the means of production (capitalism, the market system) or on the basis of public control of the means of production (socialism, communism, planned economy). Capitalism means free enterprise, sovereignty of the consumers in economic matters, and sovereignty of the voters in political matters. Socialism means full government control of every sphere of the individual's life and the unrestricted supremacy of the government in its capacity as central board of production management. There is no compromise possible between these two systems. Contrary to a popular fallacy there is no middle way, no third system possible as a pattern of a permanent social order.”-Ludwig Von Mises

Quote:

From the Philippine Daily Inquirer, ``What we did was not only our duty but our moral obligation,” said Trillanes said in justifying his latest act of defiance, adding,“It is our duty as religious individuals to do what is right.”….“Dumaan tayo sa tamang pamamaraan [We passed through the right processes]. Elected pero wala ring nangyari [We were elected but nothing happens]. They voted for me so that I can speak up for their rights and our advocacies,” said Trillanes, referring to his election as senator last May. (highlight ours)

Possible Translation:

I got 11 million votes during the last elections; therefore I deserve my pork barrel!! Where the heck is my pork???!!!

Our comment:

Friday’s failed power grab simply highlighted mainstream media’s favorite theme of “Personality based rent seeking” politics or the misguided belief that our country’s success or failure depends on the proverbial “magic wand” by one great leader that has yet to emerge or that the present country’s ills will simply vanish by the ouster of the incumbent via another revolution.

After TWO (successful) EDSAs and several aborted coups since 1986, we never seem to grasp that the leadership game of musical chairs will not subject us to deliverance; not as long as we sustain the vicious cycle of the patronage system which is rooted on our unwarranted dependence on government or our platonic love affair with the “socialist paradigm”.

Statements like this simply reflect on the abject predicament of our deeply flawed political-economic structure. Yet, when parsed, they appear to be very revealing. As a prominent saying goes, the more things change, the more they remain the same.

Quote:

From Bloomberg, ``Like soldiers, we're going to face this, whatever they want to do with me,'' Trillanes said inside the hotel after the raid and before being arrested. ``This is not our loss. If there's a loser here it's the Filipino nation.'' (highlight ours)

Possible Translation:

Where are you, my 11 million @#$% voters when I needed you??!!

Our comment:

Obviously, there is a clear distinction between the mandated function of an elected official to fulfill one’s designated tasks and a naked power grab. Put into a math equation: 11 million votes ≠ a license to grab the political leadership.

But politics like the financial markets occasionally strips out one’s computational logic or rationality especially when overwhelmed by vanity, in this case prompted by an apparent miscalculation from the ramifications of popularity based political actions.

Again instructive political statements like this seem to give credence to English author Samuel Johnson’s ever noteworthy and applicable quote, ``Patriotism is the last refuge of a scoundrel”.