Christopher Casey: GDP is Designed to Advance the Keynesian Interventionist Agenda

My third and last post on 'GDP week'.

At the Mises Institute, Christopher Casey writes that GDP (statistical G-R-O-W-T-H) has represented an economic tool (designed by Keynesians) to justify political interventionism (bold mine; footnote omitted)

GDP purports to measure economic activity while largely divorcing itself from the quality, profitability, depth, breadth, improvement, advancement, and rationalization of goods and services provided.

For example, even if a ship — built at great expense — cruised without passengers, fished without success, or ferried without cargo; it nevertheless contributed to GDP. Profitable for investors or stranded in the sand; it added to GDP. Plying the seas or rusting into an orange honeycomb shell; the nation’s GDP grew.

Stated alternatively, GDP fails to accurately assess the value of goods and services provided or estimate a society’s standard of living. It is a ruler with irregular hash marks and a clock with erratic ticks.

As proof, observe this absurdity: in 1990, Soviet GDP equaled half of US GDP, according to the 1991 CIA Factbook. No one visiting the Soviet Union in 1990 would believe their economy came close to 50 percent of the quality and quantity of the goods and services produced in America. GDP-defined production may have been strong, but laying roads to nowhere, smelting unusable steel, and baking barely edible breads stretches the definition of “production.” And this describes the goods which were actually produced. There is no accounting for the opportunity cost of forfeited essential goods and services.

How can this be? Why does GDP poorly reflect economic size and vitality? The blame largely resides with three fallacious concepts embedded within GDP “measurements”:

(1) intermediate goods (e.g., steel) must be eliminated to avoid “double counting”;

(2) government expenditures consist of viable economic activities; and

(3) imports should be netted against exports.

The Overstatement of Consumption

Which transactions should be included within GDP? Since most products consist of other products, GDP architects attempt to avoid “double counting” transactions by largely including only final goods and services produced. By their methods, the production of a car is counted (as an increase in inventory), but the metal, rubber, and plastic purchased in its creation is not. But the rules behind what makes a transaction “final” are arbitrary. The logic could just as easily justify including the sale of an automobile to a consumer and disregarding its previous production. In addition, any “final” transaction during a given time period does not necessarily include intermediate goods produced in that same time period: metal, rubber, and plastic purchased today will likely be for a different car produced or sold in a different (future) time period.

Regardless as to the arbitrary nature of determining final sales and notwithstanding the problem of temporally matching intermediate goods with their associated final sales, the exclusion of certain “intermediate” transactions simply excludes massive volumes of economic activity. Thus, GDP understates the economy as a whole while grossly overstating its consumption component relative to business investment. A better measure of overall production was created in 2014 when the US Commerce Department began publishing Gross Output which incorporates intermediate transactions. Using Gross Output, the commonly cited statistic of consumption accounting for 70 percent of all economic activity quickly falls to a mere 40 percent. 

The Treatment of Government Expenditures as Productive

If GDP purports to measure economic activity which benefits society, the inclusion of government expenditures is dubious. GDP “produced” in the Soviet Union is no different than GDP “produced” by any government — the difference is but one of scale. All government spending is to some degree malinvestment, for as Murray Rothbard noted:

Spending only measures value of output in the private economy because that spending is voluntary for services rendered. In government, the situation is entirely different ... its spending has no necessary relation to the services that it might be providing to the private sector. There is no way, in fact, to gauge these services.

The absence of voluntary action renders prices impotent, and without true price discovery, benefits cannot be ascertained. This does not mean all goods and services provided by government would cease to exist; rather, some production (e.g., hospitals, schools, roads, etc.) would revert to the private sector. To the extent government expenditures for goods and services would be produced by the free market, the true government contribution to GDP may be positive but overstated (it currently approximates 20 percent of US GDP). A more accurate depiction of economic activity would reduce if not eliminate the contribution of government expenditures. Or perhaps, as Rothbard argued, the higher of government receipts or expenditures should actually be deducted from GDP since “all government spending is a clear depredation upon, rather than an addition” to the economy.

The Problems of Subtracting Imports from Exports

As Robert Murphy has noted several times, the netting of imports against exports in determining GDP seriously understates the contribution of trade to overall economic activity. To wit, an economy which exports $1 and imports $1 will have the same GDP contribution (zero) as one which exports $100 billion and imports $100 billion. Obviously, the latter economy would be far worse off with the sudden cessation of trade.

A fixture of GDP is the mercantilist mentality of treating exports positively and imports negatively. Why are exports additive to GDP while imports are deductive? If the goal of GDP is to measure the goods and services provided to people within a geographic region, imports — not exports — are the benefit. Exports are but payment for imports. The problem and confusion arises because the GDP calculation unrealistically excludes other forms of payment: it should make a difference if imports are funded with increasing debt levels or if funds are accumulated from previous years of compensated exports. If China converted over $1 trillion in US debt instruments into imports of American goods and services, its people benefit today, but under GDP accounting, the negative impact of imports would offset greater consumption and/or government spending (the increase in GDP was previously realized in the years during which exports created a trade surplus).

GDP is Designed to Advance the Keynesian Agenda

Simon Kuznets (1901–1985) revolutionized econometrics and standardized measurements of GDP, with his research culminating in his 1941 book, National Income and Its Composition, 1919–1938. While not a Keynesian per se, the nature and timing of his research fueled the Keynesian revolution since central planning requires economic statistics. As Murray Rothbard noted:

Statistics are the eyes and ears of the bureaucrat, the politician, the socialistic reformer. Only by statistics can they know, or at least have any idea about, what is going on in the economy. Only by statistics can they find out ... who “needs” what throughout the economy, and how much federal money should be channeled in what directions.

GDP’s faulty theoretical underpinnings and politically motivated acceptance distort the performance and nature of an economy while failing to satisfactorily estimate a society’s standard of living. In fact, Kuznets partially understood this. In his very first report to the US Congress in 1934, Kuznets said “the welfare of a nation [can] scarcely be inferred from a measure of national income.” Yet the blind usage of GDP persists. That its permanence and persistence only serves the Keynesian policies of greater consumer spending, increased government expenditures, and larger exports through currency debasement should not be considered coincidental. Unfortunately, the resulting economic stagnation, debt accumulation, and price inflation are as inevitable as they are predictable.

I wrote about the GDP here.

Regardless of statistical mirages, eventually economic reality prevails. This means that for the Philippines, the obverse side of every politically induced credit inflated BOOM is a BUST.

On the headlong belief on the accuracy of the GDP, this quote largely attributed to Plato seems very relevant

The worst of all deceptions is self-deception 

Arnold Kling: The Economy is Not ONE Big GDP Factory

More on the GDP Week.

Blogger and Adjunct Scholar for the Cato Institute, Arnold Kling, writing at the Econolog (Library for Economics and for Liberty) distinguishes camping trip economics (macroeconomics) with woolen coat economics (complex patterns of specialization, production methods, trade, and innovation.) to arrive at the GDP myth. (bold mine)

In macroeconomics, the conventional misrepresentation treats the economy as one big GDP factory. Macroeconomists look at total output, as measured by GDP, and they think of it as produced by homogeneous labor and homogeneous capital. Again, this is camping-trip economics, with value assumed to be embedded in the endowment of labor and capital, rather than in the coordination required to create patterns of specialization, production methods, trade, and innovation.

Conventional economists use the term "potential GDP," and they will say that the economy is operating "below potential" during a recession. From a coordination point of view, the meaning of such concepts is in doubt.

A conventional economist would say that the U.S. economy was operating at its potential in early 2007, prior to the onset of recession. Subsequently, it was operating far below potential.

From the coordination perspective, one might ask what this "potential GDP" means. If the United States in 2009 had produced exactly the set of goods and services that it produced in 2007, would this have meant that it was operating at its potential? In particular, that would mean going back to building the same number of houses, creating the same number of mortgage securities backed by sub-prime loans, discarding any post-2007 innovations in health care or computer technology, and so on.

It certainly is true that there are fluctuations in the proportions of employed and unemployed workers. Thinking of the economy as a GDP factory leads to a very limited view of the causes of such fluctuations. If there is only one good produced, then the only meaningful choice that people can make is an intertemporal one. They can decide when to work more and consume more, and, conversely, when to work less and consume less. In fact, this stunted theory of economic fluctuations is what macroeconomics degenerated into in the 1980s, particularly at the "freshwater" schools of the University of Chicago and the University of Minnesota. Meanwhile, the "saltwater" schools of MIT and Berkeley retained the GDP factory with intertemporal choice issues while adding some relatively arbitrary rigidities in nominal wages or prices, to arrive at what was called New Keynesian economics.

Instead, thinking of the economy in terms of coordination, there are myriad reasons for employment to fluctuate. Consider all of the adjustments that would have to take place in order for the economy to shift some resources from woolen-coat production to the development of smart-phone apps. In fact, the U.S. government's data on JOLTS (job openings and labor turnover statistics) shows that millions of jobs are created and destroyed each month, compared to which the aggregate net gains and losses of 200,000 or so per month seem relatively minor.

Read the start here.
 
In my view, macroeconomics is heuristics (mental shortcuts) clothed by mathematical formalism.

Martin Feldstein: GDP Doesn’t Measure Quality

For the Philippines, this week marks 'GDP week'. The Philippine government will issue its estimate of statistical economic condition for the 1Q 2015. 

The consensus opinion sees the Philippine economy as undergoing something sort of a perpetual magical boom. They hardly realize that this has been an inflationary credit boom, which implies boom-bust cycles.

Yet, last quarter’s nitty gritty from supposedly 6.9% growth, plus recent data hold deep contradictions relative to popular wisdom. Even more, headline numbers contradict economic reasoning. For instance, according to government data, prices have been slumping broadly from both supply side and demand side. This comes even as credit continues to swell, despite having fallen from its peak at the 2H last year. Yet the consensus believes that the establishment will report a boom! A likely boom from statistical pumps!

Nonetheless, the following post (and series of posts for today) has been intended to show why the romanticization of statistical growth has been severely misplaced.

Harvard economist and the president emeritus of the National Bureau of Economic Research (NBER) and former chairman of the Council of Economic Advisers and as chief economic advisor to President Ronald Reagan Martin Feldstein, writing at the Wall Street Journal talks of the difference between quality and quantity. (bold mine)

Government statisticians are supposed to measure price inflation and real growth. Which means that, with millions of new and rapidly changing products and services, they are supposed to assess whether $1,000 spent on the goods and services available today provides more “value” or “satisfaction” to American consumers than $1,000 spent a year ago. Even more difficult, they are tasked with estimating exactly how much it costs now to buy the same quantity of “value” or “satisfaction” that $1,000 could buy a year ago.

These tasks are virtually impossible, and the problem begins at the beginning—when an army of shoppers go around the country at the government’s behest to sample the prices of different goods and services. Does a restaurant meal with a higher price tag than a year ago reflect a higher cost for buying the same food and service, or does the higher price reflect better food and better service? Or what combination of the two? Or consider the higher price of a day of hospital care. How much of that higher price reflects improved diagnosis and more effective treatment? And what about valuing all the improved electronic forms of communication and entertainment that fill the daily lives of most people?

In short, there is no way to know how much of each measured price increase reflects quality improvements and how much is a pure price increase. Yet the answers that come out of this process are reflected in the consumer-price index and in the government’s measures of real growth.

This is why we shouldn’t place much weight on the official measures of real GDP growth. It is relatively easy to add up the total dollars that are spent in the economy—the amount labeled nominal GDP. Calculating the growth of real GDP requires comparing the increase of nominal GDP to the increase in the price level. That is impossibly difficult.

Read the rest here.

Phisix 7,800: Bearish Signals Converge; Yield Curve Inversions Incite Interventions!

When we lose our individual independence in the corporateness of a mass movement, we find a new freedom—freedom to hate, bully, lie, torture, murder and betray without shame and remorse. Herein undoubtedly lies part of the attractiveness of mass movement. We find there the “right to dishonour” which according to Dostoyevsky has an irresistible fascination. –Eric Hoffer in the True Believer

In this issue:

Phisix 7,800: Bearish Signals Converge; Yield Curve Inversions Incite Interventions!

-Surging 1 Month Treasury Yield Foments Yield Curve Inversions!

-Flattening Yield Curve: The Widespread Downside Price Pressures in the Philippine Economy!

-Massive Friday Interventions To Steepen the Yield Curve!

-Market Manipulations: Lessons from International Events

-Deepening Bearish Convergence: Fast Eroding Market Internals

-Deepening Bearish Convergence: Shrinking Volume, Skewed Distribution of Trading Activities and Chart Formation

-Financial Market Alerts: IMF on Shrinking Liquidity, IIF on Emerging Market Outflows and Financial Group Calls for Bubble Curbs

Phisix 7,800: Bearish Signals Converge; Yield Curve Inversions Incite Interventions!

Treasury markets exhibit the health of a given system’s credit and economic conditions, as well as, play a lead role in determining the interest rates of the banking system. This is even more critical if monetary policies have become key drivers of economic activities.

Therefore, any signs of strains related to credit conditions will be manifested or vented through the treasury markets first.

Last week, I noted that Philippine treasuries experienced outsized volatility in that the yields of one month bills spiked to a 2012 high.

And it’s not just for the 1 month bill, but the yields of intermediate papers with maturities of 1, 2 and 3 years has likewise soared. The result of which has been to flatten the yield curve. The flattening of the yield curve has intensifying since December 2013 despite increasing incidences of interventions.

Also last week, the Philippine central bank, the Bangko Sentral ng Pilipinas, floated the idea or hinted of the assimilation the US Federal Reserve’s bailout tool called TAF as part of liquidity management tool.

I asked[1]

Yet hasn’t it been contradictory if not satirical to hear of discussions of the use of bailout tools (rationalized as macroprudential tools) in the midst of what has been popularly perceived an endless boom?

Will the TAF be followed by other Lending of Last Resort (LOLR) bailout tools that eventually end up with deposit haircuts?

Yes I do expect some heavy interventions in the coming the week.

But if the current volatility has manifested an outlet valve from balance sheet impairments, then the impact from day on day market interventions will be short-lived.

The next measures will be the cutting of rates and more macroprudential (bailout) instruments.

Surging 1 Month Treasury Yield Foments Yield Curve Inversions!

Two very important events this week that has hardly been seen by the public.

First, the yield of 1 month bills continued to climb through Thursday (based on investing.com data). However, Friday’s interventions managed to marginally clip or shave 10 basis points from last week’s high.

Importantly, the surge in 1 month yield caused collapsing spreads and yield curve inversions!

For two days last week, the yield of the 1 month bill slightly surpassed the yield of the 7 year bonds—a yield curve inversion (left)!

And in two weeks, the yield spread between 1 month and 7 year essentially collapsed!

And it’s not just the spread between 1 month and 7 years, but an inversion occurred last week with 5 year treasuries last week (right)!

Even more, over the week the yield spread between 1 month relative to of 5, 7, and 10 year maturities have collapsed (right)! Aside from the sporadic inversions with the 5 and 7 year, 1 month yields has inverted with yields of 1 to 4 year maturities!

Simply awesome! Everything A-OK eh?

Here is the Federal Reserve Bank of New York on the flattening and inversion of the yield curve[2] (bold mine)

Monetary policy can influence the slope of the yield curve. A tightening of monetary policy usually means a rise in short-term interest rates, typically intended to lead to a reduction in inflationary pressures. When those pressures subside, it is expected that a policy easing—lower rates—will follow. Whereas short-term interest rates are relatively high as a result of the tightening, longterm rates tend to reflect longer term expectations and rise by less than short-term rates. The monetary tightening both slows down the economy and flattens (or even inverts) the yield curve.

Changes in investor expectations can also change the slope of the yield curve. Consider that expectations of future shortterm interest rates are related to future real demand for credit and to future inflation. A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates. At the same time, slowing activity may result in lower expected inflation, increasing the likelihood of a future easing in monetary policy. The expected declines in short-term rates would tend to reduce current long-term rates and flatten the yield curve. Clearly, this scenario is consistent with the observed correlation between the yield curve and recessions.

In the perspective of the business cycle, balance sheet imbalances brought about by funding maturity mismatches likewise contributes to changes in the yield curve as previously shown here[3].

So these factors may interweave to forge yield curve cycles.

So the flattening of the yield curve comes with the “reduction in inflationary pressures”, and “future slowdown in demand for credit and real economic activity”. Except for statistical growth, have we not been seeing this today? 

Flattening Yield Curve: The Widespread Downside Price Pressures in the Philippine Economy!

A flattening (and the inversion) of the yield curve has indeed reduced price pressures in the Philippine statistical economy.

It’s really not just on the government’s consumer price inflation (CPI) data which continues to tumble. Government CPI fell by 2.2% this April. 

There has been a broad based decline in prices at the supply side too.

This month, the Philippine Statistics Authority (PSA) reported of the downtrend in the growth rate of general retail prices[4] which has been in place since from August 2014 (left window). Month on month March data even CONTRACTED by .1%! And most of the gains have largely been from food! This data is supposed to reflect on the supply side aspect of consumer activities!

Also the broad based decline of manufacturing input prices have led to SIX consecutive months where the growth rates of the PSA’s producer’s prices survey as of March 2015[5] have been CONTRACTING! (see right)

Last week I showed PSA’s growth rate of wholesale price index for select construction materials at the National Capital Region has been DOWN for FIVE consecutive months.

This week, the PSA’s retail prices for selected construction materials[6] for the National Capital Region for the month of April crashed to NEGATIVE (left window)! Year on Year, as well as, month on month retail construction prices fell by .1% apiece! Since January 2015, construction prices have been falling.

So in the construction sector, wholesale activities have now matched with retail activities!

And yet the popular wisdom has been that the Philippines have been enjoying a construction boom! Ironically, price deflation in both wholesale and retail sectors in the face of a credit financed construction boom???!!! How consistent has that logic been?

Yet whatever happened to prices? Have market prices outlived their primary function to coordinate the balance of demand and supply? Or has economics been driven to obsolescence from the establishment’s impetuous devotion to headline numbers?

Remember, the reported 4Q GDP 2014 has been skewed towards government construction activities, which based on their statistics offset weaknesses in many parts of the market economy. Now based on prices, activities in the construction sector seem to have waned, so where will G-R-O-W-T-H come from? 

Well, here is a guess: they will just pop out of statistics!

And how about the current conditions of general wholesale prices? Wholesale activities function as intermediaries for retail activities. These enterprises are likely to be traders for local manufacturers or for importers, or they may be importers themselves. Since wholesalers generally depend on retailers (with the exception of supply shocks), the health of the retail activities should resonate generally with wholesale activities.

So what do we get?

Here is the Philippine Statistical Authority on March 2015 general wholesale prices on a national scale[7]: An annual decrease was still posted in the country’s General Wholesale Price Index (GWPI) at 4.9 percent in March. In February, it was recorded at -5.1 percent and in March 2014, 4.6 percent. This was effected by the annual declines still observed in the indices of crude materials, inedible except fuels at -8.1 percent and mineral fuels, lubricants and related materials, -33.0 percent. In addition, slower annual growths were seen in the heavily-weighted food index at 7.4 percent; chemicals including animal and vegetable oils and fats index, 1.9 percent; machinery and transport equipment index, 2.4 percent; and miscellaneous manufactured articles index, 1.8 percent. However, higher annual rates were noted in the indices of beverages and tobacco and manufactured goods classified chiefly by materials at 8.0 percent and 2.2 percent, respectively

National wholesale prices have been contracting for 5 consecutive months (right) with NCR leading the region!

Curiously, have prices of global oil (WTIC and Brent) and petroleum products not been rebounding from the troughs of January? So why the continued plunge in the prices in fuel and fuel related industries, if these has been mostly about external linkages? And aside from oil and petroleum products, why has price growth rates been slowing for machinery and transport equipment and miscellaneous manufactured articles?

Have crashing wholesale prices been signs of a credit funded aggregate demand based boom? Or instead, has these been signs of a growing slack in demand in the statistical economy? Or could these have been signs of inventory overhang? Or perhaps could it be both? 

The NSCB’s 4Q GDP shows of a divergence between retail and wholesale trading activities (left) with wholesale activities sharply rising as retail activities slump!

Absent a material recovery from consumers, if the NSCB’s data has been anywhere accurate, then the inventory overhang could have most likely been a significant factor in driving price pressures to the downside!

And if it is true that that there has been an excessive buildup of inventories, then this should translate to negative impact on manufacturing and imports today. However, while manufacturing and import data previously affirmed signs of weakness, current numbers have suddenly recovered! Where government data defies economic logic, then this represents either a statistical quirk (anomaly) or another instance of statistical pump.

And even more, inventory buildup means higher financing costs for those enterprises that funded these with credit. This should mean lesser profits or even financial losses. So it is of no doubt to me that increased demand for immediate funding has likely pressured short term rates higher. Of course, funding pressures can originate from many other bubble sectors as property, financial intermediaries and hotel.

And as I have previously shown, the growth rate of banking loans by the trading sector, which constitutes wholesale and retail activities, have been in a seven month downtrend as of March (right window). The 7 month decline has reached November 2013 levels. Although credit growth to the sector have still been growing by over 10%, considering the downside pressures in both retail and wholesale prices, the critical question is—where has the money been flowing to?

If one notices, current price conditions for consumers, construction, retail, manufacturing, hardly reveals of a boom, but rather of a growing slack in the economy. Yet for the establishment it will remain a boom. That’s because for them, G-R-O-W-T-H comes from pulling rabbits out of the statistical hat.

A few examples.

Citing statistics, we have been told by the government that there has been profuse liquidity in the system. On the contrary, some markets and other related statistics point to the opposite direction. Philippine treasuries have been exhibiting a flattening of the yield curve with recent events underscoring an acceleration of this trend. Bank credit growth has been falling, money supply growth collapsing, falling prices have not been limited to consumer prices but to the overall supply side sector. Importantly, pressures on short term yields have become apparent…too apparent perhaps for the BSP to hint of adapting the US Federal Reserve’s Term Auction Facility (TAF)!

Citing statistics, we have been told that consumers have led the boom. Yet based on NSCB data Household Final Consumption Expenditures and retail activities have been plummeting. OFW remittances stagnated from November 2014 to February 2015 with a sudden sharp rebound only last March 2015. Retail and wholesale prices have been on a downtrend, if not in a deflation, for at least 5 months. Retail and wholesale credit growth has been falling since September 2014. Consumer prices have been falling. Consumer credit appears to have peaked (which only a few have access). Jobs grew by a measly 2.5% in 2014 with real wages suffering a loss particularly for NCR jobs which accounts for two fifths of the labor force! And those losses, to my estimates, have been severely understated!

How about Philippine stocks? Same story: booming headline (index) as consequence of market manipulation, but generally about half of the listed firms have been on bear markets!

It’s all showbiz.

Based on the NY Fed’s assessment of the yield curve’s influence, real economic growth for the Philippines, while still positive, must be dramatically distant from consensus expectations of 6-7%.

Expect another statistical government pump next week, Thursday where 1Q 2015 GDP will be announced.

Of course, as pointed above mainstream opinion have manifested signs of either logical fallacies—survivorship bias, recency bias and fallacy of composition, and or, just outright disinformation.

Massive Friday Interventions To Steepen the Yield Curve!

This brings me back to the yield curve inversion.

It may be true that one or two weeks may not a trend make. But the current flattening yield curve has been a long progression, with recent events only amplifying the process.

I have also written last week that interventions have only produced a whack-a-mole effect with interventions in one maturity have led to yield surges in other maturities. And because of the huge move by the 1 month treasuries I expected a massive intervention.

Well, my expectations just came true.

This Friday, interventionists mounted a comprehensive coordinated strike at the Philippine treasury market which has been tightly held by the government and banks.

They intensely pumped 1-4 year treasuries that collapsed yields. Forcefully sold down or increased yields of the 5 year maturity to undo its inversion with 1-4 year treasuries. Partly sold 7 year (which erased the inversion with 1 month bill) and marginally pumped up all the rest (1,3 and 6 months and 10,15, and 25 years). [see left] The result has been to sharply widen the spread (see left)

These interventions have palpably been conducted to reverse the flattening yield spread and douse suspicions of an emerging liquidity crunch. 

Well perhaps these faceless interventionists have been reading me (which flatters me). Perhaps too this may just be a coincidence.

Anyway, such yield spread manipulation aimed at superficially steepening the yield curve will do little if the real causes of the short maturity yield spikes have been from balance sheet problems.

If my suspicions are accurate then this only encourages rollerovers of unserviceable or unviable liabilities that magnify the problem, thus the temporary widening of the yield curve will just buy time and will worsen the credit conditions.

Yet let us see for how long the effects to forcefully steepen the yield curve lasts?

Market Manipulations: Lessons from International Events

Here is a Bloomberg report where US regulators unearthed emails that allegedly proved that British multinational banking, Barclays PLC, had been guilty of the rigging of the interest rate swap market in 2008[8].

It was a simple process, according to the CFTC: Barclays traders told their brokers to buy or sell as many interest-rate swaps as needed just before 11 a.m. New York time to push the benchmark in the desired direction…

“You did well at the 11 o’clock fix, man,” he said to a broker, according to the CFTC complaint. “Sounded like you were actually holding the spreads up with your hands; like, it felt like you were bench pressing them over your head.”

Here’s how a broker described the process to a trader in 2007, according to the CFTC: “If you want to affect it at 11, you tell me which way you want to affect it we’ll, we’ll attempt to affect it that way.”

Another time that year, a Barclays trader told his broker to buy as much as $400 million worth of swaps to move the benchmark, according to the complaint

The manipulation scheme involves a time schedule where market participants conspire to set or fix prices. Rings a bell?

The above interest rate fixing manipulation happened at the humongous derivatives market which comprises about $381 trillion market for interest-rate swaps and the $44 trillion market for options on swaps. The benchmark involved has been the ISDAfix, an interest rate swap benchmark, that helps “pension funds determine their future obligations and lenders decide how much to charge borrowers”.

Last week, six big banks Citicorp, JPMorgan Chase & Co., Barclays Plc and Royal Bank of Scotland Plc pleaded guilty of conspiring to manipulate the price of U.S. dollars and euros from which the said banks have been ordered to pay $5.8 billion in damages. Although the amount looks big via headlines, in reality, the fine represented a slap on the wrist. These banks have basically been beneficiaries of Financial Repression, a hidden subsidy which transfers the public’s resources to the government that are channeled through them. Additionally, these banks have either been bailed out or have accessed bailout money during the last crisis. They are likely to be bailed out again once crisis re-emerge.

It’s not this essay’s intention to talk about their predicament. However, what I wanted to demonstrate are lessons from the above:

One, market manipulation has been happening to almost every financial market.

Two, market size and incumbent regulatory regimes have not served as deterrent.

Three, the above manipulators, whom have been tagged as “the Cartel”, have frequently represented a collusion of the biggest financial firms

Four, market manipulation will continue to exist because of the moral hazard, and perhaps also due to regulatory capture. For instance, cosmetic penalties will hardly change the incentives of manipulators. And perhaps the reason for this is that all the fessing up has been all for show.

Yet how do the above international events apply to the local setting—where end of the day price fixing, which according to a domestic statute are illegitimate, has represented the norm? (wonderful charts courtesy of colfinancials)

This reminds me of why swindles and frauds occur during manias, panics and crashes.

According to historian Charles Kindleberger and Robert Z. Aliber[9] (bold mine)

Some entrepreneurs and managers may skate close to the edge of fraudulent behavior because of an apparent increase in the reward–risk ratio; the potential increase in their wealth from cutting the corners and bending the rules and deceiving the public may seem extremely large relative to the risk of being caught and fined or exposed to public embarrassment. Some may have calculated that they can make a big fortune and keep it if the rule-breaking is undetected; they may still get to keep half of it if they’re caught. The odds on going to jail are low, and the prisons for white-collar crime are like modest country clubs with drab clothing

Crash and panic, with their motto of sauve qui peut, induce many to cheat in the effort to forestall bankruptcy or some other financial disaster. A little cheating today may avert catastrophe tomorrow. When the boom ends and the losses become apparent, there is a tendency to make a big bet in the hope that a successful outcome will enable escape from what otherwise would be a disaster

How relevant they seem today.

Deepening Bearish Convergence: Fast Eroding Market Internals

Here is a follow-up and an update of last week’s essay where I pointed out of the difference between what the index say and what the general market has been saying.

If the current stock market benchmarks were to be reformulated as being an equal weighted index, rather than today’s market cap orientation then the performances of the various indices will vastly be different in the sense that ALL sectoral indices will likely be in bear markets while the Phisix will likely be range bound rather than record highs based on market cap.

Yet current market performances only entrenches the glaring divergences between headlines and market internals. However market  internals have indicated signs of deterioration.

Let us examine market internals.

Market internals are important because they reveal of the general conditions of the stock market. It is a measure of the general sentiment relative to key benchmarks. In other words, market internals may affirm or may diverge from headline developments. Affirmation highlights sustainability of a trend while divergence signals internal conflict.

For instance, when the Phisix hit the record high on April 10, the advance decline spread hardly participated in the landmark ramp. On a weekly basis, advancers led decliners by only 2 issues! 

Essentially, the week that the Phisix hit a historic high, the general market manifested only a neutral balance between the bulls and the bears. Said differently, the broader market hardly participated in the shaping of the monumental event. 

It’s not exactly what bullmarkets are made of.

Recent events reinforce the bearish internal dynamics.

The other week (week ending May 15) the Phisix jumped by a significant 1.53%, however advancers led decliners by a scanty 7 issues only! 

On the other hand, this week (May 22) when the Phisix skidded by .91% (net of marking the close pumps), decliners trumped advancers by a whopping 169 issues!

Over the past two weeks, the prevailing bias has been heavily tilted towards sellers!

Yet actions of the last two weeks have signified a legacy or a carryover from the start of the year!

From the inception of the year 2015 through this trading week, advancers led decliners only in 6 weeks of 20 weeks or just 30%! This is against the 16 of 20 weeks or 70% where declining issues led advancing issues! This means that in terms of sentiment, sellers ruled the broader market (70% to 30%) in 2015 despite the historical April highs!

That’s a sign of divergence—the paucity of participation by general markets.

And notice too that in the context of the 30% or positive market breadth for 2015, only ONCE did advancers lead by more than 100!

This is against 3 weeks where negative market breadth posted 150+ margin in favor of decliners and 1 week where margin for negative breadth was 100+ also in favor of decliners.

So in terms of sentiment depth, negative breadth outpaced positive breadth by a stunning chasm of 4 to 1!

So we have a bull market seen via the index or the headline, but evidently the bull market hasn’t been shared by the overall performance of the entire population of listed issues.

And to understand why bear markets have dominated the general markets it is best to recall of the past—or current actions have signified a legacy or a carryover from the original record of May 2013!

In 106 weeks through last week (May 15) 66 weeks or 62.3% have been ruled by the bears (decliners) as against 39 by the bulls (advancers) or 36.8%. There was a week (July 4, 2014) where bulls and bears where at a balance or zero.

The total number of bears (decliners) during weeks where they dominated totaled 6,804 as against the aggregate number of bulls’ (advancers) at 2,430. In ratio, this makes decliners thump advancers by 2.83 to 1!

Also over the past 106 weeks, bulls managed to generate a positive breadth of 100+, only 9 times! In contrast, the negative breadth by the grizzlies had been broad. For margins of 100s—24 weeks! For margins of 200s—6 weeks! For margin of 300—1 week (November 22, 2013)! In ratio, 3.44 bears for every 1 bull!

So despite all the headline worship of the bullmarket, the bears had been gnawing at the decaying core!

Is it any wonder why the desperate index pumps?

The above is a fantastic demonstration of how the establishment has pulled the proverbial wool over the public’s eyes.

As a side note, this week should be very interesting. 

The Philippine government’s NSCB will release the 1Q 2015 GDP data on Thursday.

Whatever the numbers that will appear, this will likely serve as fodder for actions at the Phisix.

When the 4Q 2014 GDP was announced in January 29th, the Phisix ended the week higher by .77%. However while the headlines index partied on the data, market breadth posted a fantastic deviation. Over that week, decliners led advancers by a material 52. Again headline benchmarks went up as broader markets sold off!

Deepening Bearish Convergence: Shrinking Volume, Skewed Distribution of Trading Activities and Chart Formation

Interestingly too, record Phisix for 2015 has hardly been accompanied by peso volume. 

When the first record 7,400 was carved in May 15th 2013, the average daily peso volume for that week was then at a considerable Php 14 billion.

Yet peso volumes accompanying succeeding attempts to break the 2013 record of 7,400, and the successful breach this year until April’s 8,127 record, represents a far cry from the original highs established in May 2013

There had been two attempts to traverse past 7,400 in the 2H of 2014, the first and second botched attempts were in September 24th and December 3rd. The average daily peso volume for weeks of these events registered Php 9.6 billion and Php 9.3 billion respectively.

The successful breach of 7,400 in January 9th posted an average daily volume for that week at Php 10.3 billion or only 73.6% of May 2013’s equivalent record high volume. (Then advancers led decliners by a paltry 53)

When PSEi 8,127 had been etched on April 10, the average daily peso volume for that week was only Php 9.036 billion! This represents only 64.54% of May 2013 and 87.8% of January 2015’s breakout volume!

Additionally, peso volume for the week ending May 22, and last week’s May 15, represents the SECOND and THIRD lowest volume for the year at Php 7.6 and Php 8.4 billion correspondingly!

The dearth of volume simply exhibits the lack of participation in the general market which has been highlighted by the dominance of sellers than buyers as revealed in the market breadth.

How can there be volume when a lot of people (mostly retailers) have likely been caught by the bears? Most of them had been mesmerized by media and the industry that the boom has been a one way street. So they bought into the fantasy and got stuck holding losses which continues to bleed them. Now many of them have been reluctant to add more position.

So the present bull market in the stock market index has become dependent on new deposits coming mostly from advertisements, media hypes and or from office promotions.

This brings us to the deeply skewed distribution of activities and valuations of the Phisix basket.

The above represents the Price Earnings Ratio (PER) in blue and Year to date gains in red by each issue comprising the Phisix basket divided into the top 15 (left) and the next 15 (right)

It is quite obvious that both the high bars representing valuations (blue) and returns (red) have been HEAVILY tilted or CONCENTRATED towards the top 15 issues (left).

In perspective, the cumulative market weightings of the top 15 issues as of Friday’s close constitute a staggering 79.67% of the Phisix!

Considering that the Phisix closed this week with a year to date returns of 8.02%, only NINE issues of the 15 or 60% delivered above Phisix gains.

In the context of market weighting, these issues constituted 48% of the basket! And the same issues has an average PER of 29.76 and an average year to date returns of 15.56%!

This tells us that the foundations of Phisix 7,800 has been pillared from ONLY TEN issues wherein NINE issues emanate from the top 15 and only 1 issue (Globe) from the next 15.

Or said differently, record Phisix has signified a product of a rather select number of issues which has delivered outsized returns that has buoyed the index which everyone else glorifies.

Alternatively, the latter half has also evidently played little role in setting of the record headline numbers.

The above goes to show where index pumping operations have been directed to and how the headline numbers have been ‘shaped’ by index managers.

Yet not all has been well for even some of the top 15. There are now three issues in the red for the year. And if to include all negative ytd performances for all Phisix basket; 9 issues or 30% of the index have posted losses. 

This is almost equal to the number of outperformers.

In short, Phisix 7,800 depends on a narrowing number of issues to maintain current levels which looks unsustainable.

It would take a broader scope of participation from Phisix issues for the April highs to be reached again.

But on the other hand, if the baggage from the losers increases or continues to be a drag on the gainers then the correction phase should be expected to deepen.

Finally, the Phisix chart appears to chime and converge with all of the signals above.

The PSEi chart appears to be indicative of a head and shoulder reversal formation with a neckline at around 7,750. 

Should the pattern materialize where the neckline breaks down, then the Phisix will likely fall back below 7,400 and likely test the former resistance of 7,350 which should now become the support level.

But don't worry because index managers will attempt to reshape the chart!

Nonetheless for 2015, sellers have dominated the broader market, this comes in the face of a headline record highs that has comprised by only about TEN issues. 

The divergent forces reveals of a stark conflict between the headline and the general sentiment that will have to be resolved. A healthy trend (on either direction) will depend on its resolution. 

Financial Market Alerts: IMF on Shrinking Liquidity, IIF on Emerging Market Outflows and Financial Group Calls for Bubble Curbs

It’s another week of where both international private and multilateral institutions issued notes of caution on the growing risks of instability in the global financial markets.

At the IMF’s Blog, Mr. José Viñals, Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department warns that given the sharp rise in the correlations across all major asset classes over the past 5 years (see left window), such has increased the risks of financial contagion from “episodes of decreased market volatility”. 

The IMF cites recent events as the US treasury bonds flash crash last October 15 2014 and the dislocation in the currency markets following the Swiss central bank’s pulling the plug on its euro cap. Although the recent “liquidity crunch episodes have so far not exerted long-lasting adverse impact”, the risk is that “the evaporation of market liquidity today could result in more market stress with potentially adverse knock-on impact on the global economy and financial stability”[10]. The IMF particularly mentions corporate bonds of advanced economies and emerging market bonds as especially vulnerable to the risks of illiquidity.

Meanwhile, the global association or trade group of financial institutions, the Institute of International Finance also issued an alert from their latest early warning system on emerging markets[11]. The IIF observed that the latest bond tantrums have instigated “a sharp decline in portfolio inflows” which “began on May 1”, that have been “broad-based across Ems” and has affected EM Asian countries most” (see right window). The IIF’s early warning system has been designed to detect “turning points in capital flows to emerging markets”

Also, concerned that ultra-low interest rates have increased the risks of financial instability, a group of financial executives representing various financial institutions including Douglas Flint, HSBC chairman, Anshu Jain, Deutsche Bank co-chief executive, Michel Liès, head of Swiss Re, and Larry Fink, chairman and chief executive of BlackRock will issue a joint statement next week, which will be coordinated by the World Economic Forum, to urge authorities to boost their crisis-busting arsenals via macroprudential tools

The Financial Times reported[12] that the group warned that should rules be narrowly applied, then “this could push risks into the more thinly regulated realm of shadow banks.” So instead of “reducing the need for authorities to raise interest rates to rein in investor exuberance”, the group has pushed for regulatory curbs on overvalued property assets that “need to be deployed across the financial system” and “not just on companies such as commercial banks that fall within the traditional regulatory perimeter”.

The high profile group has apparently been alarmed by the heightened financial instability risks from ultra-low interest rates for them to lobby authorities to increase regulations on the financial system. Yet instead of treating the disease (ultra-low interest rates), they call for therapies directed at the symptoms (overvalued assets). And just how will authorities establish objectively which assets are overvalued and which are not? The lobbying group will do advising on authorities? So they get to frontrun the marketplace?

And has ultra-low interest rates not been a part of authorities’ crisis-busting arsenal which has been abused and now transformed into the principal source of their concerns? Can’t get off the addiction?

Moreover, to what extent will regulations prevent the transferring of risks to shadow banks or for institutions to just game the system, capture regulators and keep the bubble inflating?

Or perhaps have such an appeal signified as tacit positioning for politically based access to credit when the calamity arrives?

---

[1] See The Philippine Potemkin Stock Market: Record Highs Outside, Bear Markets Inside! May 17, 2015

[2] Arturo Estrella and Mary R. Trubin The Yield Curve as a Leading Indicator: Some Practical Issues Volume 12, Number 5 July/August 2006 FEDERAL RESERVE BANK OF NEW YORK www.newyorkfed.org/research/current_issues

[3] See Philippine Bonds Close the Year with a Rally; Flattening Yield Curve as Business Cycle Indicator December 29, 2014

[4] Philippine Statistics Authority General Retail Price Index in the National Capital Region (2000=100) : March 2015 May 4, 2015

[5] Philippine Statistics Authority Producer Price Survey: March 2015 May 4, 2015

[6] Philippine Statistics Authority Retail Price Index of Selected Construction Materials in the National Capital Region (2000=100) : April 2015 May 15, 2015

[7] Philippine Statistics Authority General Wholesale Price Index (1998=100) : March 2015 May 15, 2015

[8] Bloomberg.com The E-Mail That Helped Catch Barclays: ‘ISDAfix Is Manipulated’ May 21, 2015

[9] Charles Kindleberger and Robert Z. Aliber, chapter 9 Frauds, Swindles, and the Credit Cycle, Manias, Panics, and Crashes A History of Financial Crises Fifth Edition p. 168 Nowandfutures.com

[10] José Viñals, Flash Crashes and Swiss Francs: Market Liquidity Takes a Holiday, iMF Direct Blog May 20, 2015

[11] Institute of International Finance, IIF Flows Alert: Bond Tantrum Takes Toll on EM Flows May 19, 2015 IIF.com; Institute of International Finance Weekly Insight: Disruption Watch May 21, 2015 IIF.com

[12] Financial Times Finance chiefs urge action on bubble fear FT.com May 18, 2015