Scientists And Mathematicians On Banknotes

Here is an interesting collection of global banknotes.

They aren't printed on with political leaders but with famous scientists and mathematicians.

Below are some of the samples...


You can see the rest of the collection on the website of Physicist Jacob Lewis Bourjaily.

Paul Kedrosky has this observation, ``Interestingly, despite the U.S. arguably being the foremost country in the world in advancing modern science, no 20th century U.S. scientist is represented on these notes. With the exceptions of Franklin and Jefferson, who were polymaths and politicians too, the U.S. is entirely absent from this collection of scientists on banknotes. There is no Crick, Watson, Fleming, Goddard, Salk, Turing, etc."

A China Bubble?

Has China's incredible defiance of the financial crisis been a bubble?

For some analysts the answer is yes.

Here is Bloomberg's Chart of the day, ``Rallies in commodity prices and mining-company shares stem from a “bubble of belief” in China’s economy that is likely to burst, according to Albert Edwards, a strategist at Societe Generale.

``“I believe we will look back on the Chinese economic miracle as the sickest joke yet played on investors,” Edwards wrote yesterday in a report. To support his argument, he cited falling earnings at the country’s industrial companies.

``The CHART OF THE DAY shows year-over-year percentage changes in profits, as compiled by China’s National Bureau of Statistics. The chart combines monthly data from 2005 and 2006 with a quarterly index, started in 2007, that tracks companies in 22 provinces. This quarter’s report is set for June 26.

``Commodity prices climbed 21 percent this year through yesterday, according to the UBS Bloomberg Constant Maturity Commodity Index. Mining stocks paced a 23 percent gain in the MSCI World Materials Index, the year’s top performer among 10 industry groups in the MSCI World Index.

``While the Chinese economy expanded 6.1 percent in the first quarter from a year earlier, Edwards wrote that he was skeptical about its ability to sustain that level of growth during a global recession."

“The bullish group-think on China is just as vulnerable to massive disappointment as any other extreme example of bubble- nonsense I have seen over the last two decades,” his report said. “The fall to earth will be equally as shocking.”

The Shanghai index has been up about 66% from the 2008 troughs.

Chart from World Bank

Our view is that while China's booming economy may have evinced some signs of bubble blowing, as shown by the exploding loan growth, mostly in response to government fiscal and monetary actions, it seems unclear that this bubble will implode anytime soon.

So far China's boom has clearly been engineered by government stimulus as shown by the massive growth in government Fixed Asset investments (FAI)...

And the apparent impact has been a resilience in consumer income and spending as shown above.

The idea of a "China bubble" shouldn't be confined only to China, because China has the capacity to absorb more debt considering its high savings and low systemic leverage.

Instead "bubble dynamics" should be seen applied to generally most OECD and key emerging nations as governments collectively had been printing money to get around this crisis.

Chart from Danske

Moreover, the recent commodity boom isn't largely tied to an "economic boom" but rather China's tacit desire to diversify away its US dollar holdings from US government's attempt to inflate away its overindebtedness problem.

Bubbles, which actually represent business cycles shaped by government policies, can last longer than what mainstream experts project.

Besides, governments around the world, considering their adopted economic ideology, will probably continue to pump money to sustain price levels.

We see the next bubble to be a government debt bubble which would probably be vented mainly on the currency markets.

Remember, it seems more than just traditional "demand and supply" at work. It appears that "inflation dynamics" have been growing a far larger influence in today's world.

Graphic: 7 (+1) Ingredients That Led To Today's Financial Crisis

Interesting graphic on the anatomy of today's crisis [hat tip: Barry Ritholtz/wallstats.com]

I'd like to add an 8th variable; policies and regulations that has skewed the public's incentives towards the bubble.

As Tyler Cowen wrote in the New York Times, ``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong."

To add, this from Arnold Kling of Econlib, ``Our high corporate tax rate, along with the deductibility of interest for corporations, encourages corporations to look for ways to minimize equity financing. For individuals, government-subsidized mortgages and the tax deductibility of mortgage interest help to encourage over-leveraging."

INO's Adam Hewison On The S&P 500: Market Tenor Has Changed, Emphasis On The Negative

INO.com's Adam Hewison conducts a lucid technical analysis presentation of the US benchmark the S&P 500.

Click on the chart below to direct you to INO's webpage.

I hope technicians out there will enjoy this.

The Best Global Retail Opportunities Are To Be Found In Emerging Markets

A.T. Kearney in a recent report says that retail opportunities are to be found in Emerging Markets. There are three aspects why this would be so; namely, lower rents, the growth expansion towards tier 2 cities and lastly acquisition.

The first is lower rents.

Here we quote the Wall Street Journal,

``According to the consulting group, there’s room for growth in places such as Dubai, where the housing bust has left many a glass tower empty and is helping to ease rental prices. Builders are starting to lower the price of retail space in Eastern Europe as well.

``Cheaper rents in the emerging markets are good news because that’s where the economy is expected to rebound this year. While GDP continues to sink in the U.S. and Europe, it is forecast to rise in many developing countries on the back of expected 5.2% average growth in nations like Brazil, Russia, India and China — the so-called BRIC economies. And with the economy back in positive territory, the developing world’s growing middle class should soon be ready to open its wallet again."

The second aspect could be found in the tier 2 cities or cities which could benefit from the expanding logistical networks arising from the congestion or saturation of tier 1 or major cities.

The retail cycle as illustrated by AT Kearney

Again the same Wall Street Journal article urges western companies to take advantage of this time restrained opportunities, ``Western retailers should be quick to pop their heads in the emerging part of the world, A.T. Kearney warns. The window of opportunity to seize share in an emerging market usually lasts around seven to 10 years, “when real estate is still inexpensive, logistics networks are beginning to improve, consumers are beginning to spend their disposable income on branded products and there aren’t a lot of competitors around.”

The last would be acquisition opportunities. The recent crisis has exposed some emerging market retailers to deep financing problems, yet these companies carry valuations that are attractively low.
So acquisitions could come by with inherent advantages of "key distributions, consumer insights and premium real estate footprints."

Unfortunately, the Philippines ranks 25th, nearly at the bottom of the 30 emerging markets incorporated in the study.

Has World Trade Been Picking Up?

Yes, according to Businessweek.

Chart from Panjiva

This from Businessweek's Joe Weber,

``In yet another sign that some key players are acting as if recession is on the run, more offshore manufacturers are shipping goods into the consumer-driven U.S. market, global-trade tracker Panjiva reports. The May trade data mark the third consecutive monthly rise in the number of shippers moving such goods, the first such Trifecta since the firm began following this metric in July 2007.

``“Increasingly, it feels that the worst is behind us,” says Josh Green, chief executive officer of the trade-tracking firm. Waxing cautious, however, he adds “Still, we have a long way to get back to the pre-crisis level of global trade.”

``Nonetheless, the data, released June 16, suggest that global trade has hit bottom and is taking the first steps toward recovery. Some 131,688 suppliers were active in May, up 2% from the number in April. The rises in shipper tallies give the Panjiva analysts heart, since such totals have been sliding since at least July 2007, when they counted 161,905 shippers moving goods into the U.S.

``The analysts point to other barometers of improvement, too. The percentage of significant manufacturers on a watch list – those in danger of going out of business – dropped a percentage point to 30% in May, for instance. This marked the first such decline since Panjiva started tracking this metric last September."

Read the rest here. (Hat tip: Mark Perry)

The recent rise in the Baltic Dry Index, commodities (CRB) and oil could be partly be due to this.

Nevertheless, our take has been that the collapse in global trade was mainly a consequence of the seizure "shock" in the US banking system which virtually shackled global trade flows by constricting access to financing.

Although the paradigm which underpinned the past boom won't be revived, present signs of recovery could have been due to the replenishment of inventory destocking.

As for how sustainable this would be remains to be seen.

Iran's Ongoing Election Drama in Pictures, George Friedman's Take and Social Networks

Boston.com has a fantastic deck of pictures covering the ongoing bitterly disputed post-presidential elections drama.

See first part here Iran's Presidential Election

second part here Iran's Disputed Elections

And third part here Iran's Continued Election Turmoil

Meanwhile, here is Stratfor's George Friedman take on the elections...


Finally, we learned how instrumental or pivotal social networks have been contributing to this unfolding spectacle.

This from the Reuters,

``The U.S. State Department said on Tuesday it had contacted the social networking service Twitter to urge it to delay a planned upgrade that would have cut daytime service to Iranians who are disputing their election.

``Confirmation that the U.S. government had contacted Twitter came as the Obama administration sought to avoid suggestions it was meddling in Iran's internal affairs as the Islamic Republic battled to control deadly street protests over the election result.

``Twitter and Facebook have been used as a tool by many young people to coordinate protests over the election's outcome." (bold highlight mine)

Jessica Hagy's Indexed: Teachers Can Save The Economy"

A simple but striking message from Jessica Hagy on how "Teachers Can Save The Economy"

Monetary Forces Gaining The Upper Hand Equals The "Bailout Bubble"?

It's been our repeated assertion that monetary forces have been dominating the financial markets and this has been generating some spillover effects to the real economy from which the mainstream labels as "greenshoots".

An article from the Wall Street Journal seems to recognize this phenomenon, which they brand as the "BAILOUT Bubble".

chart from the WSJ

Quoting the WSJ, (bold emphasis mine)

``But governments around the world are pumping money into the economy at a frenetic pace. Because businesses can't put trillions of new dollars to work in such a short time, the money is finding its way into financial markets. Some investors have begun speaking of a "bailout bubble" being created in certain markets, and about a "melt-up" in demand fueled by the growing supply of money."

``"All that money that was printed had to go somewhere," says Joachim Fels, co-head of global economics at Morgan Stanley. "It has been pushing up commodity prices and stock prices, starting in emerging markets and then pushing over into developed markets."

``The U.S. government alone has allocated $11.4 trillion to direct and indirect stimulus in the past two years, of which about $2.4 trillion has been spent, according to an estimate by Daniel Clifton, head of policy research at New York's Strategas Research Partners. Most of the money has been pushed out in the past year.

``The money is gushing from direct grants, central-bank lending, tax breaks, guarantees and other items. China has announced plans for $600 billion in direct stimulus spending; Russia, $290 billion; Britain, $147 billion; and Japan, $155 billion, according to Strategas. Those countries and others are spending trillions more indirectly.

``"It is quite easily the biggest combined fiscal stimulus the world has ever seen in modern times," says Jim O'Neill, chief economist at Goldman Sachs. "That liquidity will impact anything that is sensitive to it, ranging from short-term fixed-income securities through stock prices through property prices and into people's personal wealth."

We might add that government direct spending (e.g. infrastructure and etc.), federally insured mortgages, and Federal Reserve purchases of US treasuries and mortgage bonds from overseas investors and central banks as possible alternative channels from which bailout money has been reallocating of risk.

Dr. John Hussman recently wrote taking a different approach, he says, ``the proper way to think of all of these bailouts and stock issues is not that new purchasing power is being created, but that ownership of existing assets and liabilities has changed in a way that reallocates risk from the private sector to the government. There is not a bunch of money "looking for a home." The overall effect of the bailouts has been to put Treasury securities and temporary bank reserves in the hands of the financial companies, in return for preferred stock and temporary repos of commercial mortgage backed securities. Let those corporate securities fail however, and that's when we have a real money creation problem, because the government will have created liabilities that it cannot buy back in using the assets it took in when it created them. That's a huge risk here."

Nevertheless, the WSJ article goes on to say that this isn't likely going to end well.

``The growing liquidity also is creating serious policy challenges. Senior economists, including Federal Reserve Chairman Ben Bernanke in congressional testimony on June 3, have begun warning that the government can't keep piling up debt at current rates without creating severe financial problems.

``In coming years, officials will need to raise taxes, cut spending, or both to mop up the ocean of liquidity they have created. That process could weigh on growth and stifle the market boom...

``If the government fails to mop up the money, the consequence could be even worse: inflation and a collapsing dollar."

``Past liquidity-driven booms haven't ended well. In 1998, the Federal Reserve injected cash into the economy to rescue teetering bond markets. The unintended outcome: Technology stocks soared and then cratered. After the government turned on the spigot in 2001 to stave off deflation, residential real estate surged and then collapsed."

So whether this is about money flows or reallocation of risks or stages of inflationary cycle (the latter view is where I lean on), the end game isn't going to be anywhere tranquil.

Policymakers are only deceiving themselves to believe that surges in stocks and commodities signify as "recovery" or "signs of stabilization". They perhaps know deep down inside that a "policy of bailouts will only increase their number", which means persistent expanded inflation to keep prices at present levels. And their supporters, nonetheless, advocate this.

Yet all these are unsustainable.

Nicolas Kristof: Why The War On Drugs Is A Failure

The war on drugs seems to have turned out like the US prohibition of alcohol or the "Volstead Act" in the 1920s.

The consequence of which was not only a failure of regulation to achieve its goal, but that it had created more problems than what it was meant to achieve, particularly black market for bootleg liquors, gangsters, mass violence, mass murder and etc.

Obviously the end result was that the Act was lifted in 1933.

Now, New York Times' high profile columnist Nicolas Kristof makes a pitch on why the same legal efforts to purge drug use seems to achieve parallel unintended consequences akin to the defunct Volstead Act.

This excerpt from his excellent article "Drugs Won The War" (all bold emphasis mine)

``This year marks the 40th anniversary of President Richard Nixon’s start of the war on drugs, and it now appears that drugs have won.

``“We’ve spent a trillion dollars prosecuting the war on drugs,” Norm Stamper, a former police chief of Seattle, told me. “What do we have to show for it? Drugs are more readily available, at lower prices and higher levels of potency. It’s a dismal failure.”

``For that reason, he favors legalization of drugs, perhaps by the equivalent of state liquor stores or registered pharmacists. Other experts favor keeping drug production and sales illegal but decriminalizing possession, as some foreign countries have done.

``Here in the United States, four decades of drug war have had three consequences:

``First, we have vastly increased the proportion of our population in prisons. The United States now incarcerates people at a rate nearly five times the world average. In part, that’s because the number of people in prison for drug offenses rose roughly from 41,000 in 1980 to 500,000 today. Until the war on drugs, our incarceration rate was roughly the same as that of other countries.

Second, we have empowered criminals at home and terrorists abroad. One reason many prominent economists have favored easing drug laws is that interdiction raises prices, which increases profit margins for everyone, from the Latin drug cartels to the Taliban. Former presidents of Mexico, Brazil and Colombia this year jointly implored the United States to adopt a new approach to narcotics, based on the public health campaign against tobacco. [see below-BTe]

``Third, we have squandered resources. Jeffrey Miron, a Harvard economist, found that federal, state and local governments spend $44.1 billion annually enforcing drug prohibitions. We spend seven times as much on drug interdiction, policing and imprisonment as on treatment. (Of people with drug problems in state prisons, only 14 percent get treatment.)...

``It’s now broadly acknowledged that the drug war approach has failed. President Obama’s new drug czar, Gil Kerlikowske, told the Wall Street Journal that he wants to banish the war on drugs phraseology, while shifting more toward treatment over imprisonment.

``The stakes are huge, the uncertainties great, and there’s a genuine risk that liberalizing drug laws might lead to an increase in use and in addiction. But the evidence suggests that such a risk is small. After all, cocaine was used at only one-fifth of current levels when it was legal in the United States before 1914. And those states that have decriminalized marijuana possession have not seen surging consumption."

Read the rest here

The 3 former presidents of Latin American Nations mentioned above by Mr. Kristoff are Mr. Fernando Cardoso the former president of Brazil, Mr. Cesar Gaviria former president of Colombia and Mr. Ernesto Zedillo former president of Mexico, whom also made the same argument early this year at the Wall Street Journal.

``The war on drugs has failed. And it's high time to replace an ineffective strategy with more humane and efficient drug policies. This is the central message of the report by the Latin American Commission on Drugs and Democracy we presented to the public recently in Rio de Janeiro.

``Prohibitionist policies based on eradication, interdiction and criminalization of consumption simply haven't worked. Violence and the organized crime associated with the narcotics trade remain critical problems in our countries. Latin America remains the world's largest exporter of cocaine and cannabis, and is fast becoming a major supplier of opium and heroin. Today, we are further than ever from the goal of eradicating drugs.

Read the rest here

Be reminded that laws or regulations no matter how noble its goal, can have unintended or long term "unseen" consequences.

And at the end of the day, regulations fall into the taxonomy of economics. The success of which would be determined by the tradeoffs between long term costs and benefits.

Mark Mobius: The Most Important Lesson Is To Be Patient

From Franklin Templeton's monthly Emerging Markets Review

Feature of the Month: Q&A on Emerging Markets with Mark Mobius, Executive Chairman, Templeton Asset Management Ltd. (red highlight mine)

Emerging markets have been outperforming thus far in 2009, do you think this trend will continue for the rest of the year?

Although we are optimistic about the opportunities for upside potential, it is important to realize the volatility is still with us and will be with us for some time. This means that there will be periods when the markets go down as well as periods when they go up. We should therefore take advantage of dips in the markets to buy stocks cheaply, paying attention to valuations and long-term earnings growth prospects in order to avoid buying or holding expensive stocks. We continue to find good value in markets like China, Thailand, Brazil, Mexico, Turkey and South Africa.

What sectors are you looking at now?

Commodity stocks look attractive because many of them have declined below their intrinsic value and we expect the global demand for commodities to continue its long-term growth. Consumer stocks also look attractive. With rising per capita income and strong demand for consumer and other goods, the earnings growth outlook for these stocks is positive.

Will the global equity market retest the low point in March?

There is always the possibility of this happening and it could be triggered by something totally unexpected, such as war breaking out on the Korean peninsula or a massive global flu pandemic. As I have said, markets will continue to be volatile as global economies remain fragile and we should see rises and falls in the months ahead.

Which country do you expect to be the best performer from the BRIC markets?

That would be impossible to say at this time but we think China has a good chance of achieving that goal. Of course, I'm talking about measuring that move from the beginning of this year. Russia also looks very undervalued.

In view of China’s strong market performance, would you say that it’s in a bull market?

You can see that it is a bull market since the increase has been so dramatic but it would be difficult to call it a sustainable bull market in view of its very sharp rise. I still feel that we will face volatility and there will be corrections along the say. We, do however, expect China to continue to take lead the global market recovery.

Will the Chinese government propose another stimulus package in 2009? Why?

That all depends on the success of the measures already in place. They clearly have the resources to do this again. We should expect them to act if current measures and programs do not give the desired results.

You mentioned in October that Russia's cheap stocks were an once-in-a-lifetime opportunity. Since then, the RTS Index in Russia fell a bit more to 498, then subsequently doubled this year. After that great performance, are stocks still a good value, or is it time to take a breather?

Russian stocks still look cheap. Yes, they have risen dramatically from their low point but they are still a long way from their previous high. Of course, the P/E has risen this year but Russian stocks, as represented by the MSCI Russia index, are still trading at a single-digit P/E of 6.8x as of end-May, 2009, an increase from an even lower 3.4x as of end-December 2008.

Do the economic problems within Russia--unemployment rising to 10 percent, inflation at 13 percent, and possible GDP contraction of 6 percent--undermine the investment case for the country right now?

These factors will have a short-term impact on the market, but we always evaluate companies on a long-term basis – taking a five-year view. Thus, we are in fact able to benefit from buying stocks at cheaper prices now.

Do you see any parallels between the market crash in Russia of 1998 and the one over the last year? Is there fear focused on this market that leads to sharper crashes than elsewhere? Did you learn anything in 1998 about Russia that helped you navigate this crisis?

No, because Russia and most other markets are in a much stronger position, financially and economically, than they were in 1998. Russia built up strong foreign exchange reserves and trade surplus which has enabled it to withstand external shocks to its economy.

The Russian market was also affected by the correction in commodity prices due to its high exports of oil and other commodities, as opposed to any extraordinary fear focused on this market. However, we maintain the view that commodity prices will continue to increase in the long-term due to greater demand from emerging markets and a relatively inelastic supply. This shall, thus, benefit Russia in the future.

The most important lesson we’ve learnt from 1998 or any other crisis is that markets always recover - it’s just a matter of time. Thus, one should always maintain a long-term and patient view to investing.

Lastly, you have been investing in the emerging markets for the last 4 decades. Being an expert in investing in emerging markets, do you have any advice to share with investors during the recent market situation?

It is very important for investors to remember some key principles: (1) diversify - it is important to diversify in order to minimize risk - this is why investing in a diversified mutual fund is best for investors, (2) look globally - no country has a monopoly on good opportunities so you must search globally - this is why we have global emerging market funds, (3) be patient - don't expect to obtain quick gains - the long term investors do best, (4) don't invest unless you understand the investment your are making - understanding will strengthen your confidence and enable you to make long term investments.

Graphic on Iran's Basic Political Structure

Iran recently held its presidential elections which turned out to be a tumultuous bitterly contested exercise.

Anyway, below is a flowchart of Iran's political system.

(hat tip: Paul Kedrosky)

Steepening Global Yield Curve Reflects Thriving Bubble Cycle

``The way out of a deflationary trap is to first induce inflation and then to reduce it. That is an intricate operation and success is far from assured. As soon as economic activity in the United States revives, interest rates on government bonds are liable to shoot up; indeed, the yield curve is likely to steepen in anticipation. Either way, a rise in long-term interest rates is liable to choke off the recovery. The prospect of the greatly increased money supply turning into inflation is likely to lead to a period of stagflation. That, however, would be a high-class, desirable outcome because it would avoid prolonged depression.” George Soros, My Outlook for 2009

The overwhelming performance of today’s stock markets and commodity markets has sent a few bears “capitulating”. The stunning surges in the markets has had powerful psychological leash that has been proselytizing much of the “consensus” to interpret for a “strong” economic recovery.

This clearly has been a manifestation of the operational aspects of the reflexivity theory feedback loop-where people interpret price signals as signifying real events, and where real events reinforce the price signals.

For mainstream analysts, the “animal spirits” have been roaring back to life!

For us, the present phenomenon have been reflecting the escalating symptoms of the influences of monetary forces over the markets and the real economy, which is another way of saying-we are witnessing anew serial bubble blowing dynamics at work which is being fueled by policy induced inflationary forces.

Upward Sloping Global Yield Curve Drives Maturity Mismatches

Notably steeping yield dynamics has been part of the bubble blowing framework, see figure 1.

Figure 1: BCA Research: Global Yield Curve Strategy

The independent Canadian Research outfit BCA Research believes that it would take central banks at least the 2^nd half of 2010 for the policymakers to begin raising rates thereby flattening the yield curve or the ``relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.” (wikipedia.org)

According to the BCA, ``During the last recession, the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004, a few months before the Fed began its tightening campaign in June of that year. Last week, Atlanta Federal Reserve Bank President Dennis Lockhart outlined the unusual scenario that if faced with inflation, the Fed could potentially increase the target funds rate even as it continued to pursue quantitative easing. Although technically possible, thanks to the recent policy of paying interest on bank reserves, this outcome is highly unlikely. Rate hikes will be politically impossible in the near term. It would be far easier to gradually and quietly unwind monetary stimulus in the reverse order that it was implemented, i.e. by selling long-term securities. Bottom line: Government yield curves are at cyclical extremes but a material flattening phase may still take until late 2009 or early 2010.” (bold highlight mine)

This would be an example of looking at similar data sets but with divergent interpretations.

Notice that during the dotcom bust at the advent of the new millennium, produced a steepening of the global yield curve which coincided with the incipient boom in the US real estate industry (green circle).

Further notice of BCA’s observation that “the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004”- eventually paved way for the real estate bust which emerged in 2006 albeit more than a year later, whereas the bearmarket in stocks finally surfaced in 2007 about a year after the cracks in the US real estate industry became unstoppable force.

Why is this?

Because, according to Professor Philipp Bagus and David Howden, ``maturity mismatching can turn out to be a very profitable business, involving a basic interest arbitrage. Normally, long-term interest rates are higher than their corresponding short-term rates. A bank may then profit the difference — the spread between short- and long-term rates — through these transactions. Yet, while maturity mismatching can turn out to be profitable, it is very risky as the short-term debts require continual reinvestment (i.e., a continual "rollover" must occur).” (bold highlights mine)

In other words, the widening yields spread greatly benefits banks which aside from profiting from maturity mismatch arbitrage also provide funding that fuels the speculative “animal spirits” in the marketplace through the “borrow short and lend/invest long” or the basic framework for what is popularly known as the “carry trade”.

And the ensuing risks emanates from the burgeoning mismatches of assets and liabilities, the liquidity and rollover risks. Why? Because according to Professor Jeffrey Herbener, ``The swollen liabilities of checkable deposits are payable on demand to customers while the matching assets of loans are not recoverable on demand by banks. Profits earned by entrepreneurs no longer correspondent completely to the satisfaction of consumer preferences, but are systematically distorted by the artificial spending stream fed by the central bank. Entrepreneurs are misled by the credit expansion into shifting the use of factors into activities considered less-valuable by consumers.” (bold highlights mine)

Borrowing short and investing long needs constant liquidity infusion because long term investments like real estate can’t be monetized soon enough in the same manner as placements in money market funds. And where a sustained episode of liquidity shortage surfaces, trades founded on this platform ultimately collapses. This had been one of the major hallmarks of the financial crisis of 2007.

But we seem to be presently seeing the resurrection of a similar edifice.

I would like to further add that present policies which induce speculative bubbles don’t generate ‘productivity gains’ that’s because the “artificial spending stream” have been causing entrepreneurs to misallocate or engage in malinvestments.

Moreover, speculating in the marketplace don’t generate net jobs as jobs added are those from the financing side (e.g. brokers, investment houses etc.) at the expense of “unseen” investment and jobs lost serving consumers.

And importantly, once the yield curve flattens or reverses to negative, capital instead of accumulating would be lost, as the unsustainable bubble structure would be eviscerated! In 2008, ADB estimates financial assets losses at $50 trillion (Bloomberg)!

Philippine Yield Curve Reflects Global Direction

Figure 2: Asian Bonds Online: Philippine Benchmark Yield Curve

The elevated slope of the yield curve also applies to the Philippine setting see figure 2.

Remember, the Philippine private sector is largely little leveraged on both absolute and relative levels (compared to Asia).

Hence, when our Central Bank officials as BSP deputy governor Diwa Guinigundo say ``Having the scope for higher savings does not mean of course that we should discourage consumption expenditure in the economy…Consumption sustains higher level of economic activity,” we should expect a boom in credit take up to occur as policies shapes the public’s incentives.

So you can expect domestic bankers and financers to knock on your door and, to paraphrase Mark Twain, lend you their umbrella (offer you generous loans or credit) when the sun is shining (as markets appear to be booming), but eventually would want it back the minute it begins to rain (crisis).

Rest assured present policies will foster persistent expansion of “circulation credit” that should benefit the Philippine Stock Exchange (PSE) and the Phisix over the interim and the present cycle.

Yield Curve Could Steepen Further, “Benign” Inflation

We agree with the BCA when they suggested that ``Rate hikes will be politically impossible in the near term.” That’s because the economic ideology espoused by Central Bankers and mainstream analysts essentially ensures the continuation of asset supportive policies.

More than that, as Emerging Market (EM) economies begins to experience a cyclical “boom” EM central banks will likely continue to add on US dollar reserves, which most likely will be recycled into US treasuries. The BRICs or the major emerging markets of Brazil, Russia, India and China reported the fastest pace of US dollar buying worth-$60 billion of US dollar reserves in May (Bloomberg).

US dollar purchases by Asia and Emerging markets will likely be sustained for political goals, but the composition of purchases has been substantially changing. This most likely reflects on EM central bankers concerns over US policies, as EM officials have been openly saying so.

Meanwhile the concentration of official purchases has markedly weaned away from agencies with diminishing exposure on long term securities (T- bonds) and has apparently been shifting into short term bills.

Yet if the present direction of US treasury acquisitions persists, then the short end of the yield curve will likely remain supported and probably won’t rise as fast as the longer term maturity.

Figure 3: Northern Trust: Rising Treasury Yields versus Falling Private Security Yields

On the other hand, yields of US treasury bonds have been rising perhaps mostly due to “expectations” on economic recovery as private sector credit spreads has meaningfully declined, see figure 3.

Northern Trust chief economist Paul Kasriel explains, ``If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield. But again, yields on privately-issued debt are falling. In sum, investor risk appetite is returning, which is a good thing for the prospects of an economic recovery, not a bad thing.”

And last week’s 30 year bond auctions successfully drew up a good number of buyers. Despite higher yields (since August of 2007) the bid to cover and number of indirect buyers (possibly foreign central banks) saw significant improvements (Bloomberg).

So maybe, for now, markets appear pricing in a US economic recovery as the credit markets, stock markets and commodity markets, the Volatility or Fear Index and Credit Default Swaps on sovereigns debts have all been in confluence to reveal signs of dramatic improvements over the marketplace.

As my favorite foreign client recently observed, this is could be the benign phase of inflation.

Nevertheless in congruence with the observation of the BCA Research, it seems that the yield curve for US sovereign securities could remain in an upward sloping direction even if it has already been drifting at the cyclical extremes. The massive funding requirements by the US government (estimated at $2 trillion for 2009 out of the $3 trillion estimated for the world) for its deficit spending programs ensure higher yields for the longer maturity sovereigns. This combined with US official policy rates at zero interest levels and emerging market central banks purchases on the shorter end.

And we could expect the slope of the global yield curve to track the direction of the US but perhaps at a much subdued scale as debt issuance compete with limited global capital.

So as long as the yield spreads continues to widen, we should expect the fury of monetary “speculative” forces nurtured by the global central banks to be vented on the global stock markets and commodity markets.

US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!

``For speculative and especially for Ponzi finance units a rise in interest rates can transform a positive net worth into a negative net worth. If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” Hyman Minsky, Inflation Recession and Economic Policy

Price signals have a powerful psychological impact. The recent upsurge in global stock markets has been heralded by many as an end to the crisis.

We beg to differ.

In contrast, we think that this is a lull before the storm for the US.

Further, we think that this appears to be seminal phase to an even more severe crisis in the future; one that will deal with a possibility of combined bubbles of private and public sector debt in the face of outsized inflation!

Figure 4: IMF: Global Financial Stability Report (2007)

As you can see in Figure 4, for most of 2009 the reset schedule for subprime mortgages have indeed been at a diminishing pace. Hence, the seeming moratorium in the market turmoil as these subprime resets ease.

However, renewed pressures on foreclosures will likely be felt or experienced later this year as Option adjustable rate and Alt-A mortgage resets mount and is expected to accelerate and culminate by 2011!

Burning Platform’s James Quinn gives us the details (bold highlights mine), ``There are over 4 million homes for sale in the U.S. today. This is about one year’s worth of inventory at current sales levels. You can be sure that another one million people would love to sell their homes, but haven’t put their homes on the market. The shills touting their investments on CNBC every day fail to mention the approaching tsunami of Alt-A mortgage resets that will get under way in 2010 and not peak until 2013. These Alt-A mortgages are already defaulting at a 20% rate today. There are $2.4 trillion Alt-A loans outstanding. Alt-A mortgages are characterized by borrowers with less than full documentation, lower credit scores, higher loan-to-values, and more investment properties.

``There are more than 2 million Alt-A loans in the U.S. 28 percent of these loans are held by investors who don’t live in the properties they own. That includes interest-only home loans and pay-option adjustable rate mortgages. Option ARMs allow borrowers to pay less than they owe, with the rest added to the principal of the loan. When the debt exceeds a pre-set amount, or after a pre- determined time period has passed, the loan requires a bigger monthly payment.”

And yes, the US economic system will be envisaged with more bouts of deflation….

McKinsey Quarterly estimates that some $2 trillion worth of losses has yet to be recognized.

About half of these losses will be accounted for the US financial system, see Figure 5.

Figure 5: McKinsey Quarterly: $3.12 trillion of losses from 2007-2010

Let me quote the McKinsey Quarterly in What’s Next For US Banks (bold emphasis mine),

``While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. For example, credit card losses are highly correlated with unemployment. By projecting unemployment rising to a certain level, stress testing can then project the attendant credit losses.

``McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession (Exhibit 2). Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion of the remaining $1.5 trillion to $2 trillion of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. These numbers are in the same range as those of the US government, which calculated a $600 billion high-end estimate of credit losses for the 19 largest institutions.”

So despite the declaration by Mr. Ben Bernanke in the US Congress last week that, ``The Federal Reserve will not monetise the debt” and even warned of the burgeoining deficits (Financial Times), we believe that Mr. Bernanke isn’t being forthright.

He wasn’t even trying to be funny.

The fact that the US Federal Reserve earmarked $1.25 trillion to acquire $750 billion of agency mortgage backed securities and $300 billion in longer term treasury securities belies Mr. Bernanke’s statement.

Moreover, the Wall Street Journal reports that the ``Fed has purchased $156.5 billion of government bonds” and ``has bought $555.9 billion of mortgage securities.” (see figure 6)

In short, the Mr. Bernanke hasn’t only been talking, he has been nearly exhausting its allocation for Quantitative Easing (QE) or effectively monetizing debt!

Figure 6: WSJ: Fed to Keep Lid on Bond Buys

So we can’t easily buy into cacophonous signals shown by the Fed that they are having second thoughts on buying more of the above government securities. As the WSJ reports, ``Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation.”

Just wait until the pressures from Alt-A and Option adjustable resets, combined with strains from the commercial mortgages, credit cards and auto and leveraged loans escalates, then all these appearances of jawboning against inflation will be moot.

This means that more episodes of systemic deflation should translate to even more inflation from the US government via Ben Bernanke’s Federal Reserve and Tim Geithner’s US Treasury!

Global Inflation Transmission From Quantitative Easing

I might like to also add that perhaps the US dollar reserves recently harvested by the BRICs, as earlier noted, could have been proceeds from US Federal Reserves purchases of Long term Treasuries and Agency backed mortgages than from export revenues or portfolio inflows, both of which while exhibiting some signs of improvements are less likely to have contributed to such material reserve accumulation.

Foreigners own a substantial segment of US treasuries as much as it owns mortgage debt backed by the Agencies. As of 2007, according to Yale Global’s Ashok Bardhan and Dwight Jaffee, ``Foreign ownership of US Agency securities, bonds and mortgage-backed securities (MBS) issued or backed by agencies such as Ginnie Mae, Fannie Mae and Freddie Mac totaled just under $1.5 trillion. While the absolute amounts may be large, it’s the share held by foreign investors of total US securities outstanding that conveys the significance of these global financial flows.”

So even while foreigners have been selling agency debt prior to the Fed QE program, the recent activities could have opened the window for more accelerated liquidations on the part of Emerging Market central banks on their portfolio holdings of US mortgage securities backed by Federal Agencies.

And part of these proceeds could have been recycled into short term US T-bills.

AND as the Federal Reserve prints money to buy US securities held by foreigners, this could, effectively, serve as transmission channels for many of the global monetary inflation taking place, aside from, of course, the collective national fiscal spending being undertaken worldwide.

So it matters less that the current account balances have been improving due to reduced consumption and rising savings, since the inflationary mechanism appears to be retransmitted via the financial claims channel into the world.

And perhaps part of the outperformance by emerging markets could have been driven by such inflationary leakages.

And more of this could be in play see figure 7.

Figure 7: Casey Room: Rapidly Expanding Government Debt

And perhaps too, Mssrs. Bernanke and Geithner could be tacitly rooting for Emerging markets and Asia to miraculously pull the US out of the doldrums which implies even more QE!

Conclusion

The main issue is if US government liability issuances to fund the US deficit spending programs would eclipse the ability by the world or by US savers to finance these. Then the US will either be faced with massively inflating or defaulting.

Don’t forget that aside from rescue packages and the prospective entitlement (Social Security, and Medicare) strains, President Obama has ambitious health, environment, infrastructure, education and energy programs that could equally pose as additional pressures to US taxpayers.

Hence the recent overtures by BRICs to fund the IMF (WSJ) instead of recycling spare reserves into the US could be another proverbial “writing on the wall”.

Lastly, it isn’t total borrowing that should be THE concern, as some observers opine as necessary.

The last boom saw household and financial sector borrowing explode, which brought the world economy to the brink of a collapse through its unraveling.

This was in spite of US Federal debt not being in play.

The crux of the issue is if the present debt load incurred by either the private sector or by government or both can be paid for by the economy operating under a new environment characterized by higher tax rates, vastly increased regulations, lesser degree of a free markets and a hefty politicization of the economy.

As Hyman Minsky wrote in Finance and Profits: The Changing Nature of American Business Cycles, 1980 ``Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.” (bold highlight mine)

Hence if the deficit spending programs equates to another form of “Ponzi financing” then financial instability is to be expected in the fullness of time.

So it ain’t over until the fat lady sings!