This is certainly a possibility. For example, if Bill (the borrower) forgets his lunch money on Monday, he might ask his coworker Sally (the saver), “Can you lend me $10 and I’ll pay you back $11 tomorrow?”  If Sally agrees, then it is clear that her $1 in interest on the personal loan was paid out of Bill’s reduced income for that month. In other words, if Bill’s take-home pay that month were $5,000, then he would actually only have $4,999 to work with, because of his $1 expenditure in “buying a loan” from Sally. At the same time, if Sally’s normal paycheck were also $5,000, then this particular month she would actually have $5,001 to work with, after earning $1 in providing “lending services” to Bill.

In the scenario above, what basically happened is that Bill financed his consumption with an “advance” made by Sally. On the Monday morning is question, when Bill left his wallet at home, Sally had to have in her pocket enough spare cash to lend $10 to Bill. Perhaps this made her rearrange her planned spending that day, or perhaps it simply meant that Sally carried less cash in her own purse than she originally had desired. In any event, Sally provided a definite service to Bill. Given his mistake, both parties benefited. In a sense Bill’s total monthly consumption was lower, but he preferred having $1 less in order to obtain his usual $10 lunch on the particular Monday. There is nothing irrational or “uneconomical” about Bill’s decision to pay $1 for Sally’s loan.

Making loans so that borrowers can finance their present consumption (at the expense of future consumption) is certainly part of what happens in a market economy on a grand scheme; it constitutes a large portion of the credit card industry. However, you should not conclude that all savings and investments are of this nature. When we consider the lifetime savings plan (outlined in a previous section), there doesn’t need to be one or more borrowers who grow deeper in debt as the decades roll on. In fact, it is possible that every single person in a market economy provides for a comfortable retirement through saving and investment during his or her working career.

[This is a point worth pondering more. It is essential and its misunderstanding is the root cause of much of a lot of misery. To read more explanations about basic economics, make sure to read Robert Murphy’s book Lessons for the Young Economist — Ed.]

How is this possible? For every Sally who saves and earns ever-growing streams of interest income, doesn’t there have to be a Bill somewhere who borrows and pays ever-growing streams of income? Yes and no. The key is that the loans or investments can be made in productive enterprise, rather than simply being lent to an individual who increases his consumption in the present. Is the savings are channeled into expanding production (rather than merely financing consumption), then “total output” grows over time, in principle allowing every member of society to enjoy larger incomes.

In Lesson 12 we will go over the mechanics of credit card and debt more carefully, but for now we just need to understand that the big picture of what would happen if everyone in society suddenly decided to save a large fraction of his or her income. In order to save more, each person would cut back on consumption. That means people would spend less on fancy restaurant, sports cars, electronic gadgets, and designer clothes. At the same time, people would increase the amount of money they lent and invested in businesses, either directly (through buying corporate stock or bonds) or indirectly (by depositing the money with banks which then advanced loans to businesses).

These large swings in how people spent their incomes — diverting it away from consumption and toward investments — would ultimately steer workers and other resources out of the industries catering to immediate consumption, and toward industries catering to long-range production. For, example, high-end retail and jewelry stores would see their sales plummet, and they would lay off workers and cut back on their inventory. Fancy restaurant too would lay off workers and close down some of their locations.

The laid-off workers would look for jobs in other industries, and this extra compensation would push down wage rates in those sectors. At the lower wage rates, businesses in these other industries would be willing to hire displaced workers. Other resources besides laid-off workers would be redirected to new uses, as well. For example, the owners of now-vacant buildings (which used to house clothing stores and other retailers) would lower their asking price for rents, making it easier for other businesses to expand their operations by filling the buildings.

If we ignore the real-world disruptions that would occur during the transition, even a large and sudden increase in the savings rate wouldn’t affect “total spending.” It’s true that consumption spending would (initially) be much lower, but investment spending by businesses would be correspondingly higher. The total number of jobs (eventually) would also be the same, because the laid-off waiters and mall employees would now be working in factories producing drill presses and backhoe loaders.

The essential insight is that a sudden increase in savings allows the economy’s output to shift away from consumption goods and into capital goods. Just as Robinson Crusoe was able to enhance the power of his bare hand through the wise use of saving and investment — even though he had nobody to “lend to” on the island — so too can the whole population enhance each other’s labor productivity by channeling more resources into the production of machinery and tools. There is no “cheating” going on here; everyone’s income can grow larger over the years when everyone is more physically productive because of the growing stockpile of capital goods.

Regards,
Robert P. Murphy
Whiskey & Gunpowder

February 14, 2011

How Savings and Investment Increase an Economy’s Output was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

SLASHING the Bank of England’s base interest rate to an historic low of 0.5% was supposed to “rebalance” the economy…tipping it away from galloping consumption towards an export-led recovery.

But all that the Pound’s slump since rates began sinking in March 2008 has done so far, however, is gift a 50% gain to UK gold owners.

“While we were hit with a great recession, we now know that the world has indeed avoided a great depression,” said UK prime minister Gordon Brown at a Reuters press conference in London this morning.

Just as with the war in Iraq, however – another “shock and awe” campaign planned with little thought for the collateral damage – we’ll never know how things would have panned out if brave men like Brown hadn’t done “whatever it takes”. And just like in Iraq, victory has been declared way too early.

New data today showed industrial production in the UK sinking to 1991 levels. The employment rate has sunk back to 1996 levels, meaning a net loss of private-sector work when you allow for Brown’s intervening civil-service jobs jamboree. And despite the collapse in Sterling, the UK’s trade deficit has been widening for more than a year, verging at last count on the record 3% of GDP hit at the very top of the credit bubble, 2005-2008.

“Let us be clear,” says Brown, “the economy is growing, but remains fragile.”

And the cost of this success…?

• The interest paid on the average cash ISA account now lags retail-price inflation by 3.3 percentage points per year – the worst real returns to cash in over three decades (source: Bank of England and ONS data);
• Annuity rates have fallen by 6p in the pound, offering barely £6,000 per year on pension savings of £100,000 (source: WilliamBurrows.com);
• Real wage growth – on average, and after inflation – has gone negative for the first time since 1974, falling well over 1.5% since March 2008 (source: ONS data).

Not quite depleted uranium. But just as insidious.

“In the medium to long term, inflation has to come through,” says Nouriel Roubini’s latest fixed-income hire at RGE Monitor, former Citi managing director and wealth-management strategist, Arun Motianey.

“Just allow it…just admit it. It doesn’t matter where the inflation comes from. It doesn’t have to be through monetization of public-sector deficits, although at a pinch we may need to do that. What I am saying is that if we do get cyclical [demand-driven] inflation, then let that inflation stay…allow it help to write down the real value of debt.”

Naturally, Motianey was talking to CNBC this week because he’s got a book to promote. (We’re all shills in the end, remember.) And naturally, so as to make a few a sales, his policy prescriptions conclude with handy tips for investors on “How do you preserve purchasing power, how do you preserve savings?” amid the inflation which Motianey says we should (and shall) get.

We can have it both ways, in short. Debt can be inflated away, while creditors are somehow protected. I can’t say whether gold bullion is part of his saver’s solution. But when fixed-income economists beg for inflation…and pretend that savers won’t get screwed in the process…you’ve got to wonder where else you can hide.

Regards,
Adrian Ash
BullionVault
Whiskey & Gunpowder

March 11, 2010

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

Collateral Damage in the War on Depression was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

There are two types of bids in these auctions: competitive and non-competitive. The non-competitive bidders agree to buy the bonds at whatever rate the Fed offers. The competitive bidders will buy the bonds only if they are paying some minimum interest rate. When the bonds are auctioned the non-competitive bids are accepted first at the lowest interest rate offered by the competitive bidders. Any bonds left after the non-competitive bids are sold to the competitive bidders in the order of increasing interest.

Last Tuesday, the lowest bid was 0.0% – no interest. The highest bid accepted was at 0.055%–almost nothing. Nearly 99% of the bids were competitive ones. This makes sense – who in their right mind would buy a bond that pays no interest? (And who DID buy a little over 1%’ worth?!) But almost 30% of the bonds went at the HIGHEST yield. This is quite unusual. How many bidders are going to guess the exact percentage down to the thousandth of a percent? This could signal the market is starting to demand higher interest rates to buy U.S. debt and we will likely have to pay more interest in the very near future, a nice traditional attitude, or at a rough cynical guess, at the very least somebody knew something ahead of time about just how high competitors were willing to go and how much money they were willing to spend. Let’s worry this one around a bit. Forget the interest, which is inconsequential. The first two questions that cross my Medieval mind are “Who was confident enough of prospective buyers’ interest in T-bills to hold off and demand ‘top’ dollar?” and “WHY did they want ten billion in short term bonds–four weeks being very short term–in the first place?” The interest isn’t even penny ante; there is almost certainly more money to be made in lightning trades.

The only answer that sprang to my mind immediately was that someone knew or had strong reason to suspect that it will be safer or more advantageous to hold one sort of government paper rather than the same government’s fiat currency very soon. On the surface, one would suppose the things are interchangeable, which only makes me wonder more what is lurking down in the murky depths. If I know that my competition is willing to buy two-thirds of what is available…and that all the bonds must be sold lest the foundation rock even more under the monetary world (and by the rules of the game)…why do I put in my top bid at 0.055%? Why not try for more, toss in .075%, perhaps, and see who blinks?

What do I really want, the interest, to keep up the sham of an auction, or to hold the T-bills for what they represent/may be worth at a later date?

Let’s let that percolate through the assorted facts and theories in our minds while we look at WHO was buying the bonds.

There are 3 types of bidders in the competitive bid world:

1. Primary Dealers – The banks that are “part” of the Fed (J.P Morgan, Citi, e.g.).
2. Direct Bidders – Groups that bid directly through the Treasury department. Direct bidders are usually other countries such as China and Japan. China, of course, just sold off about that much US paper, leaving Japan holding the biggest and ugliest of the Old Maids out there.
3. Indirect Bidders – These have to bid for the T-bills through a Primary Dealer…but neither the Primary Dealer nor the Fed is required to report who they are. Hmmm. Now, why would anyone want to keep a thing like that secret, other than embezzlers or Congressmen who had kept the cash in their freezers, or possibly someone who wouldn’t want to be known for picking up such a position…Sometimes accounting for how one came by money can be quite embarrassing…

Historically, these are individuals or banks that are not members of the Federal Reserve System. In the last year the Fed has also bid on the T-bills it was issuing through the indirect bidder channels. This is one of the ploys that makes honest folks like us whimper, because it seems like money laundering or Dr. Seuss’ Star-Bellied Sneetches. After the money has been run through the machine several times it can be quite difficult to keep up with what is “real” and what is imaginary, even for fiat currency.

Swapping trading cards is one of the ways they have accumulated their $5.1 trillion balance sheet. Note: Indirect bidders are reported through the primary dealers. Whimper again. If the Primary Dealer doesn’t have to report that he bought, how does he explain reporting who he sold the T-bills to? “Oh, look, the cute wee elves drank the little bowls of milk we put out for them and left us certificates to sell!?”

It is…disturbing…that only 19% of the paper was bought by Direct Bidders, i.e., by foreign governments.

“Primary Dealers are required to buy whatever debt does not sell at auction. Thus it is possible, although unlikely, that the Fed just could not sell the full $37B and the Primary Dealers were forced to eat it. The reason I say this is unlikely is because $37B is a LOT of money even to organizations as big as the Primary Dealers. The Fed is NOT going to put their buddies (the Primary Dealers) in a cash flow bind if there is any way they can help it. But, if the primary dealers did get stuck with that big a chunk, it would mean that our debt is not even AA rated (as Moody’s has been reporting lately.)” comments my friend, Mike. Well…maybe. We were batting around the idea after a recent auction that there weren’t enough direct bids to cover most of the T-bills offered and speculating on the ramifications of that. It should be noted that the rules/definitions of what constitutes an “indirect bidder” have been loosened and fuzzied recently which hardens my suspicions that because our paper is being seen as less and less desirable new ways of disguising who is buying (or “buying”) are being sought. There have been rumors, let’s call them, of funds being transferred to other nations who use them to purchase/”purchase” our bonds. It could be that Citi has laid the groundwork to spring the “no withdrawals for 7 days” scheme to cover forced buys anticipated in an auction in March.

To digress only slightly into the banking situation, Citi is in bad odor this time for warning customers that effective 1 April it will “reserve” the right to deny withdrawals for seven days, almost certainly “banking days.” (See “New Meaning to Special Drawing Rights?”) Wells is in deep kimchee, WAMU and over a hundred other banks are pushing up daisies…banking in general is a pretty dicey business for anyone without a platinum parachute and/or the ability to pull strings…something like 700 banks are in the coronary ward…and FDIC is down another big hunk ($21 Bn) and gasping on the way to reaching into their $500 Bn from the Fed.

Last Tuesday, nearly 70% of the debt issued went through the Primary Dealers and will either be resold to indirect bidders or kept by the Primary Dealers. (In normal times the goal is for the Primary Dealers to be stuck with the debt to leave indirect buyers free to invest their money in the stock market and corporate bonds.) But, then again, in normal times the Treasury is not issuing debt at these levels. Or with this frequency.

The last time this much of the debt issued went through the Primary Dealers was in mid-January of this year. That did not alarm many at the time because the stock market was generally going down and it was easy to suppose Fed paper was picked up by folks selling their stocks and parking their money in T-bills for a month or two until the market returned. This time seems different-–or maybe we’re just being cautious or even paranoid.

Nearly a third of the bonds purchased by the Primary Dealers went at the highest rate (30% of $37B–the amount sold at the highest rate–about the same as 43% of $25.9B, a previous result that I discussed in an article the name of which escapes me. I write a lot of the things, you know!)

It appears that a gaudy chunk of the Primary Dealer purchase went to one person/organization. My friend, Mike, commented “That certainly could be a ‘whale’ like a George Soros or Warren Buffet sensing–or setting up–an imminent drop in the stock market and trying to protect his money – even though the stock market has been going up more or less again for the last month, but it could also be the Fed again buying through the Primary Dealer channel to hide just how bad the quality of our debt is.” It gets harder and harder to hold on to that triple-A rating. Moody’s is of the opinion that AA is pushing it. Spontaneous laughter…maybe Timmy needs to get one of those firms that run banners across the bottom of the screen offering to straighten out bad credit ratings.

Hmmm…Once may be an oddity or somebody’s accountant dropping a decimal, but we’re starting to develop a pattern that I would be inclined to label a trend if we get one more dot that belongs on the same plane. Three dots may show us who’s playin’ with the money. Recall that the Fed announced that it wouldn’t buy any more after 31 March, 2010, so in the next month Uncle Sam needs to come up with a new player in the game of “you buy mine and I’ll buy yours.”

Are you, too, starting to feel that all of this is meshing in ways investors aren’t going to like? The knowledgeable gentleman who brought these facts to my attention commented “at least a 60% chance that Direct Bidders (China, Japan, etc.) no longer want U.S. debt and we are going to start seeing bad inflation in the next few months and the ‘bad’ inflation will turn into ‘way bad’ inflation within a year because the Fed is just monetizing the debt through the Primary Dealer channel.” Optimists forecast hyperinflation no later than 2012, but only the green shoots crowd doesn’t expect it by then. That was my tentative conclusion in January, when we had an auction that looked like this. The banker boys are playing ring-around-the-rosy with electronic digits, or, to put it bluntly again, laundering fiat money.

Knowledge comes from tearing words and figures apart hunting for contradictions, nuances, and straws in the wind. We’re past the occasional straw and looking at what (honest!) is known as a “flake” of hay, a hunk ripped off for an individual animal. That’s useful terminology on more than one level: the well-positioned flakes are ripping us off, as usual, but it is also possible that some of them will be eaten in the process. If all the banks on the watch list fail the estimated bite for FDIC is something like $409 Bn, which, when added to how much it is in the red now, would wipe out c. 86% of the imaginary “special fund,” and another half a trillion dollars.

Analysts work with what we’ve got and keep dumping data in the hopper. Our..inner minds?…extrapolate from the handful of puzzle pieces we have and test hypotheses and conjectures, worrying bits of data that don’t appear to fit anywhere, and leaping blithely over several missing steps when necessary to form working hypotheses. If the picture appearing weren’t so unpleasant I would be enjoying myself because quite a few bits are slotting into my mental grid very neatly. A reader asked recently that I write an article on how I think and analyze, and the one- sentence answer is “Accumulate a lot of information and impose order on it.” In time we learn to deduce what the probable structure is and keep that hypothesis in mind until something disproves it. Not closing our minds in the process! We’re trying to discover the truth, not pushing global warming.

Facts that indicate we’re in for–at best–the Greater Depression with strong possibilities of civil unrest or even dictatorship have been accumulating for several years, now. All that has varied are the time table and speculation on which pillar will collapse first placing further stress upon the remaining supports. Every additional strain makes the aging system that much more rickety, and here in the Whiskey Bar we’ve been expecting the collapse of the commercial real estate bubble–and the collapse of the bond market. One odd recommendation I haven’t found a logical home for in the emerging picture is taking physical possession of stock certificates. Helpless gesture; I didn’t think anyone who dealt in round lots ever wanted to hold those things. Don’t we just leave them “in street name?” Ideas, anyone? A simple answer is a pitying, “You were a trader, so you never planned on holding anything you bought for more than a few months to a year or so. People who are in it for “growth” or “investment” should keep up with such papers in case the computers all go out.”

I expect the bond market to go first, and soon. As Abraham Lincoln asked, “How then will I fill my coffers?” If the Washington gang can’t sell paper to cover creating “money” out of thin air, where will they go for funds? My call is the GRA, a grab for the fifteen trillion held in private retirement accounts of one sort and another. I’m no Miss Cleo, but the sheer relief of “solving” the projected debt now and through perhaps 2020 will almost certainly set off an even bigger bender of government spending. Hurrah, hurrah, they don’t have to decide between shutting down a lot of useless, detrimental government programs and throwing Grandma out when she needs an MRI…can put off whether to make trial lawyers or union/government pensions take the next hit…can put off cutting welfare programs while inflating their way out…They think. Some day soon we’ll discuss Juan and Eva ruling Argentina.

Sorry, Charlie, as the old tuna commercial went. The only way from here is down, down, down.

The above was my first draft, which I sent to Pete (the Middle East expert), Mike (who sent me the basic figures, darling man that he is) and our own Tex Norton, before leaving the matter to bubble through my brains. Today is when things really started to pop. Tex wrote back thanking me for the “brilliant” thought that there may come a time when an instrument denominated in dollars may be worth more than the face value–and my mind bonged “Ka-ching! Like silver ‘dollars’ being worth more than FRN.” I thanked Tex prettily but started writing that I’m not fully responsible for what the gremlins in the gray matter do. Just as I prepared to write that I didn’t know why that such a disparity in relative value might be, my brain smacked me firmly. Of course I can account for how it might be that a short-term T-bill could suddenly be worth more than face value.

Two things were obvious instantly and my brain added, smugly, “And don’t forget Hugo Chavez.” Right. He devalued lately, but there is a tiered system; what your money is worth depends on where you are spending it. Brain also said, “GM, yoyo.” Right; what your stock was worth after the government takeover depended upon whether you were union, management, or Joe Nobody who owned 22 shares. The “obvious” reasons were what we know about legislation with short sections that exempt “certain corporations located in New Jersey” or American Samoa, and SPQ-USA, where Senators rail loftily over bonuses they had already approved in previous legislation. Ayn Rand, of course, and the “frozen” railway bonds which could be melted by those with pull and cash. Piece of cake.

The fix is in, and in time to come–perhaps very shortly–some bonds may be more valuable than other pigs. My advice is that we NOT buy T-bills because that’s bound to be a mug’s game; the rules will be written carefully to benefit only connected players, and not for the man in the street or even the Whiskey Bar.

Regards,
Linda Brady Traynham

March 1, 2010

Gaming Imaginary Money was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

First, let’s check out the chart below from the 2008 annual budget audit by the U.S. Government Accountability Office. It shows that the U.S. government must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches).

What’s the big deal? $3.4 trillion is a small number by today’s standards, isn’t it? Not exactly.

The chart shows how incredibly interest-rate sensitive U.S. government borrowing now is. Not only is it a big ask to ask the world’s creditors to continue funding such large deficits (there are only so many savings available to borrow, after all), but the interest expense on that debt is likely to go up as the fiscal position of America deteriorates.

And if America can’t find anyone willing to finance its deficits, what then? Well, the luxury of issuing debts in the currency you also print is that you can print money to pay for them. Technically, you can never become insolvent when you enjoy this privilege. The Fed, for example, can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

But this monetisation of the debt is another way of saying that international creditors are no longer willing to pick up America’s spending tab. They will be betting against the American economy, not on it. Even if the Fed takes the unusual step of moving out further along on the yield curve to set interest rates (and keep the bond vigilantes from sending yields to the moon) this is a clear signal to owners of dollar-denominated assets and holders of dollar currency reserves to get out.

Another scenario to watch for is when creditors begin asking the U.S. to issue debts in currencies other than its own (Yuan, Euros). That would be something. In the meantime, they will look to lessen their dollar reserves.

That may not be such an orderly process. And the urgency to get out of the greenback and into something better will only pick up pace as it becomes clear the politicians in America (along with the Fed) are not likely to suddenly rediscover fiscal prudence.

You never know. The Fed may assert its independence and baulk at more quantitative easing. But we wouldn’t count on it. And we reckon tangible assets and possibly emerging market equities would be the biggest beneficiaries of capital flows out of the dollar…and into anything else.

The next chart is for you, Paul Krugman. Krugman, among others, continues to insist that larger public sector deficits are necessary if the Western world is to avoid a Japanese-style deflationary “Lost Decade.” He claims the government must increase spending as households and businesses deleverage and reduce debts.

Advocates of this idea claim that public sector deficits, as a percentage of GDP, have no real limits. And the example they cite is Japan. As you can see from the chart below, Japan’s debt to GDP ratio is nearing 200%. America’s isn’t even half of that yet (it’s about 98%, or $13 trillion). If Japan can finance a deficit at 200% of GDP, then why are we worried that U.S. deficits half that size would threaten interest rates or the dollar?

First off, it’s worth pointing out that high public sector-debt-to GDP ratios haven’t worked in Japan, if by work you mean pave the way to a stable recovery. Advocates might say-as advocates of the stimulus here in Australia often say-that the public spending made things less worse. But the opposite is true. It’s made things more bad!

Or just worse, if you prefer. We mean that the public spending has done two things, neither of which is productive, and both of which, in fact, waste capital and resources. First, public sector spending to prop up financial firms with dodgy assets prevents the needed reckoning in asset prices that would produce market clearing prices for commercial and residential real estate. You get zombie banks and a zombie economy and zombie house prices.

Secondly, there’s no indication that all the infrastructure spending in Japan has produced any kind of lasting growth for the economy. It may have built some great roads and bridges. But we wonder if it solved any of the underlying problems? What’s more, the capital and resources that went into those projects was directed by political considerations and not available for the private sector, which could have put them to some use at least designed to produce a return on the capital.

The underlying problem which deficit spending does not solve is compounded by demographics. Japan’s government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation’s resources, if the older population clams up with its money. And like in the U.S., you’ll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That’s bordering on Ponzidom.

Japan has been able to run a higher-than-average public debt-to-GDP ratio because it has had such a high personal savings rates. This kept borrowing costs low for the government. But we’d expect that to change soon. A debt-to-GDP ratio of 200% will be very difficult to finance in the world as it is-much less in a world where those rates begin to rise and when Japanese savers begin to consume their savings.

Finally, what about Europe? Our argument here is simple: Europe’s monetary union is going to come unstuck. Why? Europe has one interest rate for twelve different economies. That does not leave national governments with the flexibility to print money and inflate away political problems. This will be intolerable, the monetary union will break up.

The sign to watch for is a spike in the yields on euro-denominated debt. As the chart below (from Stratfor) shows, earlier this year bond yields did in fact begin to widen. Germany Bunds have the most stable rates, as Germany has traditionally the most stable fiscal and monetary policies in Europe (they did not go hog wild for stimulus).

But for Spain, Ireland, Greece, Portugal, Italy and Austria (whose banks lent large for real estate in Eastern Europe), another round of falling asset values really would show that the GFC has become a sovereign debt crisis. And will Germany bail out these nations? Can it afford to?

We don’t know the answer to those questions. But it is worth pointing out that by assuming or guaranteeing the liabilities of the financial sector, national governments have also assumed the risk. And the bond markets will be left to decide how to price this risk.

How it ends is anyone’s guess. But our take is that the Super Cycle in fiat money is at its peak. And as it unwinds, it’s going to take national governments and their financing model with it. They will be forced to adopt a new model and take a new form to survive.

This means a great deal of political and economic upheaval. It’s no coincidence that the last time the world faced such monetary upheaval was when it went off the gold standard and straight into essentially thirty-two years of military and economic conflict (1913-1945). If the world is about to become that disordered again, you’ll need a plan to deal with it.

Regards,
Dan Denning
Daily Reckoning Australia

November 5, 2009

Debt to GDP Ratios Indicate Governments Going Bankrupt was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Say like Coca Cola re-launches New Coke, but people actually like it. Would that mean the laws of physics had been repealed? Or would you need to change what you think…?

“Gold and bonds do not usually go up or down together. But try telling that to the markets over the last two months,” writes Mark Hulbert at MarketWatch.

“Since early August, in fact, gold bullion has risen by around 10% and the Treasury’s 10-year yield, which moves inversely with Treasury prices, has fallen by nearly 15%.

“These moves are substantial, in other words, and more than just day-to-day noise in the data. What’s going on?”

Put another way, “If the gold price is so high, why are 10-year Treasury yields so low?” asks a columnist at EuroWeek, the capital markets newspaper.

To repeat: Rising gold says people fear inflation. Or so both Hulbert and EuroWeek reckon, along with pretty much the rest of the planet. But inflation fears would mean rising interest rates and falling Treasury bonds…and that’s the very opposite of what’s actually happening to government debt.

“Either way you look at it then, recent trends are unsustainable,” says Hulbert. “Something’s got to give” apparently. And it won’t be his assumption that gold and bonds shouldn’t rise together.

“If central banks take the punch bowl away at the wrong time,” says EuroWeek, “those who have bought Treasuries will have been on the right track and we will face deflation. Whereas if they let the party go on for too long the gold hoarders will have been right…and we’ll be wheeling our cash for bread around in wheelbarrows.”

The key assumption that makes these two things impossible, of course, is that gold only goes higher on strong inflation…a demonstrably idiot claim given a quick glance at the 1930s. Or this decade’s four-fold gains. Or the 50% surge of fall/winter 2008.

Back to gold in a moment, however. Because while bonds say deflation, “Equities say reflation” as the Pragmatic Capitalist notes, together with David Rosenberg at Gluskin Sheff and pretty much everyone else. “The stock market is telling a very different story from the bond market,” TPC explains, and “unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors.”

Yet again, these two things “don’t typically rise alongside” each other. Yet stocks have risen more than 11% since mid-June, while the 10-year Treasury yield (which moves inversely to bond prices, remember) has dropped nearly 0.7%.

“There have been 4 famous cases of such bond and stock divergences in the last 20 years. The most famous is the summer of 1987. We all know what occurred then.  The other three cases were fall ’94, summer ’98 and winter 2000. All three preceded declines in the market. Of all 4 instances, three of them preceded 15% declines in the S&P 500.”

Now throw in rising gold prices, and we’ve got rising stocks…rising bonds…AND rising gold. Hell, since Wednesday this week they’ve even pulled back together, too!

Is the moon made of cheese or what?

The curve-ball in all this – or so we guess here at BullionVault tonight – is not gold, nor stocks, nor even bonds. It’s the underlying guess-work, intuition, assumptions.

That gold only rises when the cost of living soars…or bonds only rise when stocks go down…or that a flood of money, created at zero per cent rates, can’t drive all things higher together, even the promise of cash redeemed in the future…lapped up by a pensions and finance industry faced with $11 trillion in Treasury-debt supplied, but a central bank vowing to step in if buying fails and cap any rise in rates.

Because right alongside, hedge funds are buying futures and options with virtually free finance. What’s not to love in this über-Reflation Rally redux…?

Regards,
Adrian Ash
BullionVault

October 21, 2009

Inflation, Deflation and Reflation at Once was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Both the Aussie and New Zealand dollars were up against the greenback. These two are probably not rising because they are commodity currencies. The strength of commodities versus the U.S. dollar is only relative at the moment. But the interest rate differential might be a factor.

The Federal Reserve Open Market Committee met in America last Tuesday. Economists surveyed by Bloomberg expected the U.S. central bank to cut short-term rates to just twenty-five basis points, and it did. That puts them at just 0.25%. Though pathetic, the move is largely symbolic.

The Fed is prepared to go “into the wild” if Ben Bernanke is to be believed. Consider the facts. U.S. government debt is already at $10.5 trillion. The Fed’s balance sheet assets are at over $2 trillion and growing. America’s deficit spending is set to explode in 2009. The Fed HAS to go unconventional and pursue some kind of fourth generation monetary warfare against deflation.

Here’s what you can expect. The Fed’s next move will be adding other assets to its balance sheet. It will pay for these assets with new money borrowed by the Treasury or brand new money altogether. Sometime in 2009 this will lead to an exodus out of the U.S. dollar. Fortress Treasury Bonds will crumble. The popping of the bond bubble will drive up oil and gold. Both were on the move yesterday.

But what to your wondering eyes will appear as the Fed charts its new course into the monetary wild? Well, the first..ahem…assets the Fed may pursue are securities backed by U.S. mortgages. Remember, the Fed is trying to drive down short and long-term rates in the U.S. to bring mortgage rates down.

If mortgage rates come down and bank balance sheets are sufficiently repaired, then the Fed hopes the entire manoeuvre will engineer a bottom in the U.S. housing market. The collapse in residential real estate is at the epicentre of the whole wealth-destroying phenomenon to begin with. The Fed strategy is both direct and indirect strategy. Let us compare it to military strategy for just a moment.

In his book Strategy, British historian B.H. Liddell Hart suggests that the key to unlocking the stalemate on the Western Front in World War One was an indirect attack through Turkey and the Balkans. Attempts at decisive, game-changing confrontations (like the battle at Verdun) only resulted in massive casualties. The only way the British and the French could really threaten Germany was by opening up a new front in the East, which meant going ’round the long way. This puts Gallipoli in an interesting strategic light.

Hart was a big advocate of the indirect strategy, attacking your enemy where he least expects it and achieving the element of surprise. Other military strategists and historians like Clausewitz and Victor Davis Hanson believe that direct, decisive major battles have played a more important role in history than the indirect approach. So what does this have to do with the Fed and gold?

The Fed has already tried the indirect approach to reliquefying capital markets and arresting the fall in U.S. home values. It’s tried interest rates and a whole array of lending programs. The indirect approach has failed. So the direct approach is what remains, although by Fed standards, it is not a tactic the Central Bank often resorts to. It is crude. It relies on brute force and money printing.

The direct method is to support security and asset prices by buying them. If you can’t make a market work, make the market. Be the market maker. The Fed will start buying mortgage-backed bonds. And it probably won’t stop there.

Though it is bound by the number zero when it comes to interest rates, the boundaries of quantitative easing are theoretically limitless. As long as the appetite for U.S. bonds grows, the Treasury can keep selling them and feeding the proceeds to the Fed. With this money, in theory, the Fed could buy anything it wanted to and put it on the balance sheet…baseball cards, pin ball machines, expensive paintings, or even discount mulchers from Wal-Mart (to turn all that new green paper into something truly useful).

While the bounds of Fed borrowing are theoretically limitless, investors will eventually not support the U.S. government’s monetary and fiscal policies. Interest rates in the U.S. will go up and the dollar will go down.

With the U.S. dollar retreating against other currencies, it will also retreat against commodities. In fact, the dollar’s move this week doesn’t look so much like a retreat as it does a gradual losing of the ground it claimed in the last few months. Perhaps the strategic tides are turning.

If they are, it means the market’s bias is shifting away from recession fears in 2009 toward inflationary fears now. Equities have priced in recession. No commodities will price in inflation.

That should lead to higher commodity prices. And for those commodities that are also money (gold, and to a lesser degree, silver) it should be good news. A stronger Aussie dollar might hurt Aussie investors in this respect—unless the U.S. dollar price of gold rises faster than the AUD/USD.

That is the trouble with the world of paper money. Everything is relative. Nothing is completely rational (although nothing ever is). The Fed may give the appearance of acting with due measure. But it probably has no idea what it’s doing. It’s using exact methods and theories for an inexact world.

Or, as G.K. Chesterton put it, “The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

Regards,
Dan Denning

December 24, 2008

U.S. Dollar Retreating Against Commodities was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

According to Mark Hulbert at CBS Marketwatch, 1958 was the last time the yield on the S&P 500 exceeded the yield on the 30-year bond. 1958? Are you kidding? Elvis joined the U.S. Army in 1958. Eisenhower was in the White House, Khrushchev in the Kremlin, and Menzies was elected for the fifth time in Australia.

The world may have lived on the edge of nuclear holocaust in 1958, but at least some things were more certain. You were better dead than Red. What was good for GM was good for America. And everyone liked Ike.

The world is much more confusing today. The yield on S&P stocks was 2% this time last year, a 74% increase in the last twelve months. We reckon stocks will start to look even more appealing when the yield reaches 5% or 6%, which would also mean lower stock prices first.

But there’s a bigger story going on, too. It’s what we call the Fed’s war on cash. You see, the Fed is driving down yields on government bonds and notes of all maturities quite deliberately. More on what it’s up to below. But it’s not just the Fed that’s pulling out all the monetary stops to float the world on a sea of credit.

It’s a now a race to the bottom for central bank interest rates. New Zealand’s central bank cut its main interest rates by a whopping 1.5% overnight. But the Kiwis have some work to do. Short-term rates across the Tasman are still at 5%, 450 basis points above Ben Bernanke’s Fed.

You don’t normally see such aggressive rate cutting in an economy until unemployment levels are much higher. It’s the classic Keynesian trade-off between inflation and unemployment. You can keep prices stable by keeping the rate growth low and savings high.

But slow, steady, prudent growth doesn’t create jobs fast enough for politicians. So rates are lowered! This leads to lower unemployment rates, but higher inflation. The big change in the last thirty years is that higher inflation was tolerable for most workers in the Western world because it seemed to come with some juicy benefits.

The first was asset price inflation. Houses and stocks went up too! Real wage growth was flat (or even fell). But the value of things you bought went up! On paper, everyone got wealthier.

Then, when China came along and started churning out geegaws and widgets faster than you could slap down a credit card, the apparent virtues of a little bit of inflation seemed limitless. Stocks and house prices went up, but consumer goods, durables, and electronics got cheaper.

This so-called “Great Moderation” suckered people into a dangerous financial strategy: asset-based saving and debt accumulation. And why not?

In a way, it’s perfectly rational. If credit is cheap and asset prices are rising, why not borrow to buy stocks and houses? The debt service is low, employment was pretty easy to find, and capital appreciation in your assets would smooth out any rough edges to the strategy.

Well, now that strategy is coming unhinged. In fact, the larger implication is so scary that only people like Robert Shiller dare to mention it: asset price appreciation is not a retirement strategy. It was a good run, from 1982 to 2000. But the idea that the stock market is society’s way of managing the risk of old age is now showing its own age. Investors are skittish.

“Fortress Investment Group LLC fell 25 percent to a record low,” reports Bloomberg, “after the private-equity and hedge-fund manager halted redemptions from its Drawbridge Global Macro fund, which had lost value this year.” Investors are seeking redemptions of over $3.5 billion from Fortress.

The run on the hedge funds is only restrained by the lock-up periods most investors agree to when turning their money over to a fund manager. But time takes care of that. Investors will continue asking for their cash back if they believe the market is either too risky or too mediocre.

This move to cash must distress the Fed and other central banks. It wants banks to lend, businesses to spend, and consumers to borrow. But the exact opposite is happening. So now we see the Fed doing its best to punish those in cash and force them to spend, or at least get out of government bonds and buy stocks.

Banks are content for now to build up a war chest of excess reserves. In fact, there’s been a surge in excess reserves held at the Fed by banks, and not just since the crisis began last October (the same is true of cash held at the RBA by authorised deposit taking institutions, see column K).

In other words, banks are happy to borrow from the Fed, but sad to lend to anyone. So what do they do? They deposit their new borrowings right back with the Fed, where they earn 1.5% interest (in excess of the target Fed Funds rate).

According to Fed data, U.S. financial institutions had just $60 billion in excess reserves held at the Fed at the end of September. On October 5th, the TARPenstein was passed. By the end of October, excess reserves held at the Fed had grown to $267 billion. By the end of November, it was $610 billion. Don’t fight the Fed! Flee to it!

Even a Congressman should be able to figure out what’s going on here. Correlation is not causation. But it sure looks like a lot of TARP money has gone straight to banks and financials, who’ve then put the money hard at work…on the Fed balance sheet, where it’s safe, secure, and earning 1.5%.

Maybe that was the whole point of TARP anyway. To beef up bank capital positions and not increase lending and spending. But the Fed is busy elsewhere in the bond market trying to get investors out of cash into something (anything!) else.

In a march that would have made General Sherman glow with joy, the Fed is systematically decimating the yield on U.S. government bonds and notes. It is blitzkrieging its way through the U.S. yield curve, buying, or threatening to buy U.S. bonds and notes in order to lower rates.

Don’t believe it? Bloomberg reports that the yield on 90-day Treasuries is .01%, while Ten-year U.S. notes yield 2.66%. Both yields, as you can see on the chart below from the Dallas Fed, are down.

By buying up securities with different maturities the Fed lowers interest rates. Investors crowd in looking for safety and, of course, rising prices. But what is the Fed really up to? Is it really trying to reduce American savers and those on fixed incomes to a state of pauper hood, where a lifetime of savings is consumed in a firestorm of inflation?

That is no way to treat your grandparents. So let’s give the Fed the benefit of the doubt and say that the ultimate objective of the policy is to drive interest rates on government bonds so low that savers and more importantly, banks, begin to loan out some of their excess reserves, or better yet, use them to buy distressed assets from each other.

If you want to use a military metaphor, the Fed is dropping big rocks on safe houses from its EZ Money helicopter battleship. One basis point at a time, it is methodically destroying any rational reason for investment advisors to put their clients in Treasuries.

And so if you’re not going to be in ultra-safe Treasuries because they are really no better than cash, then what will you do with your money? You have to do something with it. You will spend it. Or invest it.

Either way, you will get rid of it. There is no value in holding it, at least rationally. Emotionally, it feels safe, which is why ten-year yields are back at Eisenhower levels.

The risk here is that once everyone is crowded into the Treasury market, everyone gets too scared to leave. Safety in numbers, etc. On the one hand, it puts a lot of concentrated capital at risk in a great inflation. On the other, it sets up U.S. interest rates up for a massive spike if investors fear an inflationary spike and flee U.S. bonds to stocks or commodities. Talk about an interest rate shock.

Any way you look at it, the plunge in ten-year yields is impressive by historic standards. What you’re seeing is major dysfunction in capital markets. Capital is fleeing entrepreneurial risk for government bonds. Pressure is building. Something is going to give.

Regards,
Dan Denning
www.dailyreckoning.com.au

The Fed’s War on Cash was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

After all, gold offers a refuge against bad times ahead. Like all good insurance, it’s best bought before trouble arrives — not during or after.

And just how much worse can the news get from here?

1. The Dow’s on track to close out its worst June since the Great Depression, down almost 10 percent for the month.
2. GM’s stock is trading at a 54-year low, taking it right back to when CEO Charles Wilson declared “what was good for the country was good for General Motors and vice versa.”
3. U.S. Dollars — the bedrock of world forex reserves — now buy one-third less against the rest of the world’s money compared with 2002.
4. The price of crude oil has risen more than five times over since U.S. and U.K. troops liberated the oil fields of Iraq in 2003.

5. Libya is threatening to cut its oil production in protest at U.S. anti-terrorism laws; Tehran just pulled $75bn worth of investments from Europe to avoid sanctions against Iran’s nuclear program.
6. Global inflation has risen from three percent last June to more than 5.2 percent per year today; analysts at Barclays Capital believe U.S. inflation will hit 5.5 percent by August.
7. Real estate prices have turned sharply lower in the U.S. (down 15 percent year-on-year), Ireland (down 13 percent) and the U.K. (down 3.6 percent) as well as in Spain, Australia, South Africa and the emerging economies of east-central Europe. Price in Riga, Latvia dumped 38 percent in the year to May.
8. Western consumer confidence has sunk to multi-year lows; emerging-market consumers face the worst rates of inflation in more than two decades, rising 25 percent year-on-year in Vietnam and more than 13 percent in India; surging fuel and food prices have sparked protests and riots in Asia and now unionized strikes across Europe.
9. Investment and lending banks are being forced to take back “securitized” debt onto their balance sheets, destroying their capital adequacy ratios and halting new lending as pension & insurance funds try to flee risk. In the U.K. alone, new lending fell 95 percent in May after allowing for such “de-securitization.”

Watch out below! It’s every man for himself — women and children included! Or so the financial pundits now claim.

Makes you wonder where they’ve been during the bull market in gold starting in 2001. But with inflation surging and new credit shrinking, “we’re in a nasty environment,” said Tim Bond, head equity strategist at Barclays bank in London, this week.

Above all, “there is an inflation shock underway,” he said in Barclays’ latest Global Outlook. “This is going to be very negative for financial assets. [So] we are going into tortoise mood and are retreating into our shell.

“Investors will do well if they can preserve their wealth.” And investors who choose to buy gold are usually looking to achieve just that.

Indestructible, un-inflatable, and instantly priced in the world’s only true globalized market, gold bullion stands apart from all of those boom-time investments. Stocks, bonds, securitized debt, real estate…you can keep ‘em when the end of the world strikes.

These happy assets promise to pay you income. They also rise in value as the economy grows. Whereas gold, in sharp contrast, just sits there — neither smiling nor frowning, and never paying an income. Its value comes from, well, from its gold-ness alone.

And as the spike above $1,000 an ounce showed in mid-March — just as Bear Stearns collapsed — you need the end of the world to make buying gold worthwhile.

Right?

Well, perhaps not.

Because the value put upon gold should also be expected to benefit from sub-zero real rates of interest. War and terror be damned! The only sure push that gold prices need is low interest rates colliding with rising inflation.

And right now the world’s got that in spades.

“Figure 8,” notes Michael Lewis of Deutsche Bank in a recent paper for the London Bullion Market Association (LBMA), “illustrates the strong performance in gold returns as US real interest rates decline. We find that when real interest rates in the U.S. move below -3 percent, gold returns have tended to be significant.”

Listen up at the back! Because the Federal Reserve’s key interest rates stands at just 2.0 percent, scarcely half the rate of U.S. consumer-price inflation. And with a real return paid to cash of minus 200-basis points, you really should doubt the Fed’s true intent toward the value of money from here.

Even with the Euro trading above $1.57 on the foreign exchange markets, however — and even with the European Central Bank (ECB) promising to raise interest rates to defeat inflation next week — the Eurozone’s 320 million consumers are also suffering a 12-year record rate of wealth destruction. Here in the United Kingdom, after inflation and tax since the middle of 2003, the real returns paid to cash savings have stuck right on zero since mid-2003.

The fast-growing economy of India, meanwhile, offers negative real interest rates of 3 percent and worse. Taiwan’s real interest rates sit slap bang on zero after a rate-hike this week. And Chinese cash savers are way under water with inflation running at seven percent.

Any wonder “the number of credit cards in circulation jumped 93 percent in the year ending March 31 to 104.7 million,” as the Asia Times quotes the People’s Bank of China this week? Central banks everywhere want you to spend money, not save it, forcing the issue by destroying the value of money itself.

So any wonder that the world bid for gold — a tangible asset that can’t be inflated and can’t be destroyed — just keeps rising higher? “The purpose of money is to be a store of value,” said Dr. Marc Faber — the infamous fund manager behind the Gloom, Boom & Doom letter — to CNBC today.

(He kept laughing for some reason. No doubt he’s long gold…)

“When interest rates are negative, it destroys the wealth of honest depositors who have their money in the bank and don’t want to speculate,” Faber went on. “Now what people should do, basically, is to invest in gold. Because when it comes to action, the Fed shows no concern about inflation…

“The policies pursued by Mr. Bernanke have damaged the American public enormously by pushing commodity prices — specifically food and oil prices — much higher. And so real incomes are going down and discretionary spending is being hurt very badly.”

Gold represents wealth, in a word. Just remember that it won’t actually grow wealth, because it’s not a productive asset. Whatever else you might want from a metal, wealth preservation is the gold buyer’s best hope.

And that might prove all investors can ask if the news on inflation and rates, stocks, bonds and jobs, doesn’t start getting better.

Regards,
Adrian Ash
BullionVault
June 30, 2008

Gold Price Dip was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But Hofmann’s hallucinations seem little worse than most acid-induced visions. Or so people tell us…

“Beginning dizziness,” he wrote in his lab journal for 19 April 1943. Looking to find a stimulant for the circulatory and respiratory systems, he’d just concocted — and taken — a big dose of lysergic acid diethylamide-25.

“Feeling of anxiety,” he noted, before adding in due course “Difficulty in concentration. Visual disturbances. Desire to laugh.”

Finally, Hofmann scrawled the words “most severe crisis” and fled the lab on his bicycle. It seemed to stay stationary even as it wheeled him back home, where his neighbor — who brought him a nice glass of milk to calm him down — appeared as a witch in a colored mask.

He felt possessed by demons. The furniture in his bedroom began to menace him. All pretty run of the mill stuff if you dabble with psychotropics, in short.

But such “fantastic images” don’t always ease into the sensations of “good fortune and gratitude” Hofmann got to enjoy later that day. Hallucinations can still cause the “most severe crisis” — even without some fool laying Witches Hat by the Incredible String Band on the turntable.

“Inflation will return to the two percent target,” claimed Mervyn King, head of the Bank of England, and one half of the financial furry freak brothers running Anglo-American monetary policy.

“Growth will eventually recover to a sustainable rate.”

Just a central banker’s wide-eyed hallucination? Maybe not. Like Albert Hofmann’s wobbly bike-ride six decades ago, the credit cycle will get us home in good time, ready to turn once again from boom to bubble to bust. But like any powerful psychedelic, the trip gobbled down by Western investors could last much longer than anyone dares hope right now.

And just what was the Governor smoking when he claimed, “In these [current] circumstances, the household saving rate is likely to rise…”?

The Bank of England has been cutting U.K. interest rates since December. Its latest Inflation Report says it will continue to cut interest rates “in line with [bond] market expectations,” too.

And U.K. households have grown their savings only once when interest rates fell in the last four-and-half decades. That brief period lasted for two years at the start of the 1990s.

Both before and since — and most markedly during the previous post-war recessions (of 1974 and 1981) — people have tweaked their savings almost precisely in line with changes to the rate of interest, as set by the Bank of England itself.

King’s starry-eyed vision, however, “is part of a rebalancing of the U.K. economy, away from spending and importing, toward saving and exporting,” he told reporters last week.

The sky’s turned all purple in Washington too if U.S. policy-makers think the credit crunch will somehow boost household savings there.

Put another way, “who had heard of collateralized debt obligations just 10 years ago?” as Niall Ferguson, history professor at Harvard, asked in a speech opening New York’s new Museum of Finance back in January this year.

“Collateralized loan obligations? Credit derivatives? These forms of financial instrument are of very recent origin. So are the hedge funds; so are the private equity partnerships; so are the sovereign wealth funds; and so are those wonderfully named entities, the conduits…”

Ferguson then flashed up a series of charts “to illustrate the speed with which these phenomena have proliferated.” First, mortgage-backed securities. Starting in 1980 – “when scarcely any such thing existed” — they total $3.5 trillion-worth today. Then he cited “the whole range” of other newly born asset-backed instruments — automobile loans, equipment loans, student loans, credit card-backed debt derivatives…

“Over the counter derivatives outstanding?” the professor asked. “Well, if you’d asked someone to name that figure in 1987 it would have been a very small number indeed.”

Ferguson’s theme bears repeating; he likens the huge growth in complex financial products to an evolutionary spurt, “an explosion of life forms [amid an] unusually benign climate.”

Whereas I see it more as a chemistry experiment gone horribly wrong. The hare-brained PhDs mixing up the medicine are too spaced out to even guess at what’s now sitting in the Petri dish. And the financial monsters it has spawned aren’t merely in the scientists’ minds.

Take hedge funds, for example; Ferguson notes that in 1990, those financial life forms known as “hedge funds” numbered around 600 (also including funds of funds). Now they’ve reproduced and multiplied up toward 10,000.

“As a form, the hedge fund dates back to the 1940s. But this population explosion is of very recent origin.”

The raw numbers also hide a “regular, annual dying out”; there’s chronic survivorship bias in the data. In 2006, for example, 717 hedge funds were culled; the 2007 figure should be even larger. And here, believes Ferguson, we see survival of the fittest in action. If he’s wrong, perhaps it’s just the contingency of life itself, allowing the standard proportion of idiots to thrive and market their “top decile” performance to a new generation of unwitting investors.

“A lot of reporters ask me these days whether we’re in the midst of a commodity bubble,” said Dr. Benn Steil, senior fellow at the Council on Foreign Relations, at the Hard Assets Conference in New York in mid-May.

“In fact, I’m going to Washington to give a Senate testimony. [Because] my perspective is that the more interesting, and indeed more important, question to ask is whether we’re at the end of what I would call a ‘fiat currency bubble’.”

Like Professor Ferguson, Dr. Steil looks back “to the early 1980s” to find the origins of whatever it is we’re now watching mutate, if not die out.

Under Paul Volker at the Federal Reserve, “inflation, and at least equally importantly inflation expectations, were driven out of the system through a pretty ruthless policy of very tight money, high interest rates. Very tight money.”

What followed was “the golden age of the fiat Dollar” says Steil, reminding us that credit expansion was unshackled from gold in 1971, when Richard Nixon stopped redeeming the U.S. currency for bullion altogether. It took tight money — “very tight money” — to bring the resulting inflation of the 1970s under control.

The fiat money experiment then broke out of the lab with the “explosion” of financial life-forms witnessed from 1980 right up to last summer. Indeed, it all ran just fine until around 2002, when the cost of key raw materials — notably wheat and oil, as in Steil’s charts above — began to shoot higher in terms of Dollars and other government-backed currencies.

Measured against gold prices, however, they’ve barely budged. “That shouldn’t surprise people,” says Steil, “because as we go back to the era of the gold standard from about 1880 until the outbreak of the First World War in 1914, prices around the world in countries that were on the gold standard were also remarkably flat.

“The figure looked just like this. So gold is behaving as it has historically.”

In the hot, fetid climate of low interest rates and surging credit supplies, central bankers like Ben Bernanke and Mervyn King are hallucinating if they think they can control the monsters spawned by the fiat money experiment.

And tripped out on delusions of “minor god” status, these furry freaks really do believe they can talk Wall Street and the City back down from their current wave of “worst crisis ever.”

Regards,
Adrian Ash
BullionVault
May 27, 2008

Central Bank Mistakes was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.