Official inflation is over 4 percent in the UK, so how printing more money is going to help meet a 2 percent inflation target is a bit difficult to grasp, but let us not quibble over such details. What counts is that the Bank of England is the undisputed champ of QE. After the next round of money printing, the BoE will have created new money to the tune of 20 percent of GDP, and will fund more than a quarter of all outstanding government debt via the printing press.

£275 billion of QE so far have not solved the crisis — the economy last year grew by less than 1 percent — but have lifted inflation and thus squeezed real incomes. At the same time, this policy has kept the government’s borrowing costs low and the banks from shrinking and in certain cases from collapsing. As with any policy of monetary debasement, the direct beneficiaries are the state and the banks.

This has tradition behind it. The Bank of England was founded in 1694 for the specific purpose of financing the Crown, which at the time was in low standing with its creditors. From its inception the Bank of England enjoyed numerous legal privileges that cemented its dominant position in the nascent but growing British banking system. Among them was the privilege to issue money against obligations of the Crown — a form of early ‘debt monetization’. Of course, the gold standard was a hindrance to unlimited money creation, so whenever the state needed more funds, usually at times of war, the Bank of England was conveniently absolved of any of its contractual agreements to redeem in specie, and kindly asked to fund the state through the creation of new money.

Gentlemen, start your printing presses!

But only after the gold standard was abandoned and the dollar’s gold window finally shut in 1971, the party could really begin. From 1965 to 2007, the year the present crisis started and UK banks began to collapse, the pound has lost more than 90 percent of its purchasing power! Two generations of British savers have been locked in a desperate struggle to sustain the real value of their savings. But hey, why save? Just borrow!

Such persistent monetary debasement has created a freak economy, in which every high street is littered with the cheap-looking branches of retail banks and in which property speculation is a national pastime. The English seem to live in the smallest and oldest houses of all of Europe but thanks to money-induced housing booms consider themselves to be wealthy, on paper at least, as long as they managed to get onto the housing ladder early enough. Why bother with engineering, once the hallmark of British industrial superiority, when you can flip a few semi-derelict terraced houses with borrowed money?

On a GDP-per-capita basis, 19 countries in the world now generate more income than the UK, but the UK is still world leader when it comes to leverage. According to a study by McKinsey, private and public debt combined stand at 5 times GDP, only Japan comes close.

But when the bubbles finally burst, the overstretched banks teeter on the brink of collapse, and the credit edifice wobbles, the central bankers counter with the only tool at hand: more money printing at an ever increasing rate. The central bankers are the arsonists of this crisis who now pose as fire fighters quickly labelling further monetary debasement ‘stimulus’. (In June 2011, Mervin King, the governor of the Bank of England, was knighted for his efforts during the financial crisis.)

This is the BoE’s strategy: to fight a hangover by opening another bottle of booze. “There is not a credit boom that a few trillion pounds cannot extend for a few more years.” That seems to be the modus operandi.

Or, will the public debt situation be better? Will the economy have deleveraged and rid itself of an unsustainable debt load? And will the economy then grow without the burden of the accumulated debris from previous cheap-money booms? –No, and no again! Deleveraging is verboten! Credit contraction is verboten! Bringing the economy back to anything that resembles a stable and sustainable structure is verboten! QE is designed specifically to stop the cleansing of the economy’s imbalances.

“Quantitative easing” has one objective: to generate headline growth through more money debasement, more credit creation, more balance sheet extension, and more debt! More money, more credit, more debt! If that sounds familiar, it is because that was the growth model of the past twenty years, the growth model that has set us up for the crisis.

The central bankers and their supporters among financial market economists have no other model. More money, more credit, more debt — that is the motto of the fiat money economy, and ever since the last link between state money and gold was severed, all central banks have constantly expanded their balance sheets, constantly bought government debt and created new bank reserves, constantly encouraged bank credit creation and borrowing.

In a fiat money economy, central banks are designed to be “quantitative easers”. That is what they do. The only thing that has changed recently is that the disastrous consequences of such a policy are now palpable and that the private sector is reluctant to participate any longer. The drastic acceleration in money printing that is now called “quantitative easing” simply marks the desperate attempt to outrun the system’s desire to shrink.

No, I am sorry, dear experts, but the idea that any of this will stop at £400 billion, £600 billion, or £1,600 billion is silly. You obviously failed to grasp the very essence of a paper money economy. We removed the golden shackles so that there will NEVER be an end to credit expansion and monetary debasement.

Well, actually there will be an end. But that will come not through a calm measured decision by the MPC, the monetary policy committee that is digging itself an ever deeper hole. It will come when the public begins to lose faith in this charade. But whether that point is reached at £600 billion or at £325 billion, nobody can say.

Regards,

Detlev Schlichter

Paper Money Collapse

Parting Shot:

(From Mac Slavo of SHTFPlan…)

“Proponents of Gold Standard May Be Violent Extremists; Report ALL Suspicious Activity To the FBI”

If you support returning the United States monetary system to sound money backed by the gold standard and believe that our country is bankrupt as a consequence of out-of-control spending and fiat money printing, then you may soon receive a visit from your local DHS/FBI office.

This morning your family, friends and neighbors were alerted by representatives of the Federal Bureau of Investigation that you and those who share similar ideas as you are potentially dangerous extremists that could threaten the national security of the United States:

“Anti-government extremists opposed to taxes and regulations pose a growing threat to local law enforcement officers in the United States, the FBI warned on Monday.

These extremists, sometimes known as “sovereign citizens,” believe they can live outside any type of government authority, FBI agents said at a news conference.

“The extremists may refuse to pay taxes, defy government environmental regulations and believe the United States went bankrupt by going off the gold standard.

Source: Reuters

Whether you like it or not, if you promote the ownership of gold, reject the notion that forced taxation is your patriotic duty and prefer to live in a country with limited government interference, you have now been stereotyped and grouped in with the handful of criminals who have recently turned violent against law enforcement officials. And, chances are that those close to you, who may not necessarily share your views, have now been alerted to your volatile nature and potential for violence against local law enforcement officials and the free people of the United States.

“Routine encounters with police can turn violent “at the drop of a hat,” said Stuart McArthur, deputy assistant director in the FBI’s counterterrorism division.

“‘We thought it was important to increase the visibility of the threat with state and local law enforcement,’ he said.

“In May 2010, two West Memphis, Arkansas, police officers were shot and killed in an argument that developed after they pulled over a “sovereign citizen” in traffic.

Last year, an extremist in Texas opened fire on a police officer during a traffic stop. The officer was not hit.”

The narrative is clear: If you share the same ideas as someone who has made a personal choice to turn to violence in the past, then you too must be an equal threat. Furthermore, the FBI is actively instructing businesses in your local area to be on the look-out for suspicious activity which may be precursors to anti-government activities. In a related story from Infowars, Paul Watson reports that FBI advisory aimed at Internet Cafe owners instructs businesses to report people who regularly use cash to pay for their coffee as potential terrorists.

“The flyer, issued under the FBI’s Communities Against Terrorism (CAT) program, lists examples of “suspicious activity” and then encourages businesses to gather information about individuals and report them to the authorities.

…

“Indeed, the flyer aimed at Internet Cafe owners characterizes customers who “always pay cash” as potential terrorists.

“Of course, the vast majority of people who visit Internet Cafes use cash to pay their bill. Who uses a credit card to buy a $2 dollar cup of coffee? A lot of smaller establishments don’t even accept credit cards for amounts less than $10 dollars.

“Other examples of suspicious behavior include using a “residential based Internet provider” such as AOL or Comcast, the use of “anonymizers, portals, or other means to shield IP address” (these are routinely used by mobile web users to bypass public Internet filters), “Suspicious communications using VOIP,” and “Preoccupation with press coverage of terrorist attack” (this would apply to the vast majority of people who work in the news or political blogging industry).”

Source: Info Wars

Also See: FBI CAT – Potential Indicators of Terrorist Activities Related to Internet Café [pdf]

In a coincidental stroke of good luck and timing for the national security apparatus of the United States, the recently passed National Defense Authorization Act (NDAA) allows for the rounding up and detainment of of these potential extremists without charge or trial, because the last thing we need is for courts, juries, and evidence to be involved in ensuring the security of American citizens.

Be warned fellow Americans. No one will be immune to the violative laws, policies and regulations of the police state which is quickly and forcefully embedding itself into all aspects of American life and culture.

In the new America, every man, woman and child is a suspect, person-of-interest and potential terrorist.

–Mac Slavo,

SHTFPlan.com

There Will Be No End to Quantitative Easing was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Like snow at high altitudes, the central banks’ new money is piling up. As reported last week, all the world’s major central banks have turned on their snow machines. The U.S. Federal Reserve has been authorized to “print” $1.75 trillion worth of new money in order to buy Treasury bonds. The Bank of England has its own program — worth 75 billion pounds, so far. Even Switzerland has been printing money — so much that its money supply, as measured by M2, is growing at 30% per year. And two weeks ago, the European Central Bank announced that it too would begin creating money in order to buy corporate bonds.

“Quantitative easing” it is called. As a refresher for readers with real lives and better things to do, QE is how central banks describe what is essentially an act of counterfeiting. They buy bonds with money created — electronically — specifically for that purpose. Abracadabra — “money” comes into being.

The feds aim to provide liquidity for the cities and farms. But so far, only a trickle is coming down. Instead, chilly weather in the upper reaches of the financial sector holds it frozen in place. Hundreds of billions come down from central banks, but there it stays…waiting for spring.

Today, here on the back page, we ask ourselves a simple question: What will happen to it?

The feds’ counterfeit money does such a good imitation of the real thing, you can’t tell them apart. But the problem with all money is that it is as fickle and unreliable as a bad girlfriend. One minute she goes along with the flow. The next minute she turns silly and bubbly. And then, she gives you the cold shoulder.

According to theory, an increase in the supply of something leads directly to a decrease in the price of it… That is, if other things remain constant. Despite the credit crunch, the banking freeze-up, and the economic recession, the money supply in the U.S. as measured by M1 is actually rising at 14% per year. Yet consumer prices are not keeping pace. The latest report shows them actually going down slightly over the last 60 days.

Turns out, causing inflation is not as easy as it looked; controlling it probably will be even harder. It’s not enough to manage the quantity of money; you also need to be able to control its behavior. Money can be a solid, a liquid, or a gas depending upon the temperature of the economy. At normal temperatures, money runs freely, watering the economy. And when things really get hot, it vaporizes, creating gaseous bubbles such as those of the late Bubble Period. But when the temperature falls, money shivers in wallets and bank accounts — reluctant to go out into the cold.

Economists refer to the “velocity of money” to describe the magnifying effects of motion. When the same dollar bill appears in three different places in the same day, it is as if the money supply has been multiplied threefold. In a freeze, on the other hand, it comes to a dead stop.

When the thaw will come we don’t know. But the authorities are ready for it. When consumer prices begin to rise, they’ll stop adding to the money supply. Then, they’ll withdraw liquidity, as need be, to keep it under control.

They know that runaway inflation would cause problems — the collapse of the dollar…and the U.S. Treasury bond market, for example. So at the first signs of inflation, they will move quickly to remove excess liquidity from the system. How? Their emergency plan is simple enough. Now they are buying bonds. When their inflation targets are met, they will begin selling them.

We thought the Bubble Epoch was the peak in claptrap and illusions. But we were only in the foothills. The feds now pretend to bail out the economy by giving money to companies that pretend to be concerned, run by people who pretend to know what they are doing. And when they run short of money, they create more of it, pretend it is real…and pretend they can tell it what to do.

What is likely is that money will have a mind of its own. First, the markets will react…and the authorities will not. They will remember their own critiques of Japanese and Roosevelt-era monetary policy. In both cases, they believe central banks removed the punch bowl too early — before the party really got rolling. In both cases, the recovery was cut off.

Then, while they are hesitating, money will turn on them. Inflation rates will rise further. The velocity of money will pick up. And investors — including foreign governments — will become eager sellers of government debt. Suddenly, it will be too late. In order to remove the monetary inflation they previously added, central banks will have to sell bonds, instead of buying them, trying to reabsorb money from the economy. The extra cash will then disappear back into the central banks. But in order to bring inflation under control, the biggest bond buyers in the world must turn into the world’s biggest sellers. Bond prices, already falling as investors fear the worst, will collapse immediately. An avalanche of dollars will fall upon the world markets — as dollar holders all over the world become desperate to get rid of them.

We don’t know what day it will happen. But we have a good idea as to what time of day central bankers will realize that they are doomed. About 4 AM is our guess. That is the moment when Ben Bernanke and other central bankers begin to feel like members of the Donner Party. That is, like imbeciles.

Regards,
Bill Bonner

May 29, 2009

Treasury Bond Avalanche was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is a government’s last resort when it can no longer ease monetary policy by lowering interest rates. And with an official rate of 0%-.25%, there is really no room for the Fed to go lower. In fact, the Fed seems to have an inherent dislike of saying our official rate IS actually 0%. So they keep this charade of a rate “range” in place for a little window dressing… and quickly turn to quantitative easing.

By pouring money directly into the economy, effective rates are supposedly made lower, money is made cheaper and everybody has more of it. That, of course, makes people feel wealthier (whether they are or not), so they spend more money. This creates more sales. More sales create more jobs. More jobs create bigger companies. Bigger companies create bigger profits. Bigger profits make companies less nervous about taking out corporate loans. Corporate loans helps companies expand.

Expansion makes Wall Street think the company will have bigger future profits.  Wall Street’s hopes drive up the company’s stock price, and their bond rating. This helps the company borrow more money at an even better rate, and the expansion cycle continues.

But all of this is contingent on the cheap price of money.

You may have heard the term “cheap money” before. And it’s not easy to wrap your head around the concept. After all, isn’t a dollar always a dollar? Not exactly…

Whether money is “cheap” or “expensive” depends on what it costs to borrow money. When interest rates are high, the cost to borrow is high — and money is said to be expensive. When rates are low, the cost to borrow is low — so money is said to be cheap.

Common monetary theory says that cheap money jumpstarts an economy. People feel like they have more money, so the cycle gets going, just in the way I described earlier.

However, there is a hidden cost to cheap money — and it’s called inflation. When a government pumps too much money into the economy, it will overheat. More money chasing the same amount of products raises prices.

Now, to the first recipients of this new money, it doesn’t matter. When the money first enters the system, prices have not adjusted upward yet. So people have new purchasing power without price increases.

The last people who receive the money (after it trickles down) are the worst off. They have seen prices rise already, but by the time the new money gets to them, it has less purchasing power. So you have some pretty angry folks.

Then a day eventually comes when the government has to turn off the money faucet. Prices continue to rise, but everybody has less cash to buy things with. The masses begin complaining and wanting the government to “do something.”

So the government starts raising rates, and everybody complains some more. But by that time, the pinch is on, and the yeast has started working its way through the bread. It is much easier started than stopped, and everybody hurts until it does. There are no winners in inflationary periods. There are only people who lose less than others because they were better prepared.

The Fed’s quantitative easing will try to lower the cost of money by pushing it through the economy. The question is, how much is too much? At what point do people stop feeling wealthy and only feel the squeeze of higher prices?

The whole circus is beginning to happen now. When the Fed announced its plans, traders, investors, institutions and governments around the world began selling off the dollar. Hard. It fell 6.3% in 24 hours against the euro. Every major currency appreciated against the U.S. dollar. Simply put, traders were saying that the Fed’s actions made the dollar worth less.

But two big concerns remain. First, why did the Fed decide to take this action? As I said, this is usually a tactic of last resort… so what piece of news or indicator mandated this huge policy change?

Perhaps more importantly, how much longer will the Fed take this course? The monetizing (inflating) of trillions of dollars in debt calls into question the safe-haven status of the U.S. currency. Devaluing makes it seem less like a stable reserve currency and a lot more vulnerable.

On a broader view, the European Central Bank may attempt to do the same. They have publicly stated they are nearly at the end of their rate adjustments, although their rate is currently more than a full point higher than the United States. Honestly, it is questionable whether the European Union can perform a Quantitative Easing operation across all 16 member countries. It would be technically difficult to pull off… and next to impossible politically.

But if they do attempt quantitative easing, it will mute the Fed’s actions, blowing through trillions of dollars more with little or nothing to show for it.

So to sum up, if the ECB does not inflate, the dollar looks very bad going forward. If they do, the prospects for an inflationary “recovery” for the United States are slim to none. And slim just left town…
And now we have to add in another piece of the puzzle…the People’s Republic of China.

Red Storm Rising

China has been attempting to flex its newfound economic muscle. Chinese Premier Wen Jiabao’s veiled warning that the United States had better watch its step and keep its promises.

Last Monday, the nation fired another warning shot across the bow. Zhou Xiaochuan, president of China’s central bank, issued a very well-written and forceful essay to the World Bank. Without naming names, he expressed concern about the world’s dependence on just a few reserve currencies. www.pbc.gov.cn/english/detail.asp?col=6500&id=178

He called for the introduction of a world reserve currency, based not on a sovereign country’s currency, but rather on an IMF-based note. He suggested basing it on the IMF’s SDRs, or Special Drawing Rights, a unit of account that the IMF has been using since the 1960s. The proposed currency could also be grounded upon a basket of commodities for the backing of its value, and member countries would make “contributions” to this universal monolith.

Of course, other nations would have to be open to such an arrangement, and even if they were, developing this idea would likely take a long time. But that’s not really the point. The point is, China is expressing its displeasure at what it perceives to be a real inequity between itself and the rest of world. While China is doing its best to weather the downturn, the collapsing demand for its exports has closed many factories and put 20 million people out of work.

What China wants is for its investments to be spared. And for it to be considered above our own national agenda. Because right now our agenda of inflation and their agenda of a stable or appreciating dollar are at odds.

And this provides some of the background for our Australian play. Take a look…

Looking for Thunder from Down Under

I have said before that the likely winners in this worldwide economic crisis will be countries like Canada and Australia. They have an edge because of their commodity-related economies and currencies. Oftentimes you’ll hear them called the CommDolls (commodity dollars) for short.

Of the two, I like Australia better. Canada is inextricably tied to its neighbor to the south (namely, us), and that’s more than just a little problematic. Australia, on the other hand, is not tied to the United States and has many other real positives going for it.

Keep in mind, the U.S. dollar devaluation is under way. And the words of warning from China’s top officials suggest the country is already considering moving its investments to whatever other possibilities exist. Indeed, is has already begun doing so — mainly, into its own economy.

It has produced a stimulus that has been roughly estimated at somewhere just above $550 million, or 14% of the country’s GDP. Its infrastructure expansion is already up 30% from last year, hoping to boost domestic demand. Bank lending is up 24% due to its own monetary easing. Yes, exports are off substantially, and I think will likely continue to drop, but even so, the personal savings rates there are much higher, and China does have the reserves to continue moving things along with little to no borrowing. Plus, they have promised to do more stimulus if it appears to be necessary.

As China attempts to lift itself up by its own bootstraps, Australia comes into the picture. It has been widely understood that Australia is a little China. Not in culture, custom or language, but in economics. A significant part of Australia’s commodities flow into China, and the more the Chinese move ahead, the better it is for Australia.

Also, let’s consider that Australia’s central bank is still holding its interest rates at 3.25%. In a fairly stable country, with a fairly stable currency, that is one heck of an attractive rate. Why, it is downright appealing! It is true that they have followed other developed countries in lowering their national rates. But I think it is the propensity of all central banks to err in their “corrections” of the market. That is, they often lower rates too quickly and too far — as I think is the case here — then they raise them far too slowly to stave off the coming of inflation.

Indeed, Australia may now become the benefiting member of the next carry trade.  After all, if can you borrow money at .25% and invest it at 3.25%, you stand to make a decent haul. And as risk appetite re-enters the market, you can bet your bottom dollar that Australia will likely be a real beneficiary.

More importantly, the continent’s economy has not been too rattled by the worldwide crisis. Wages are up 5.7% by official statistics. That’s great, especially when you consider that full-time employment is up. Now some people may question the importance of Australian employment given that the recent figures showed only a marginal improvement in job numbers. But inside the figure, we have a strong drop in temporary employment, but a surge in full-time filled positions. Going forward, this is good!

Business investment is up 6% over the last quarter — also a sign of good health. As business expands, so does the work force, followed by wages… and next thing you know, interest rates are headed north as well.
Retail sales are up 0.8% this quarter. Even their housing market has only suffered a 3% decline. On top of all that, it has recently run a trade surplus, another sign of a healthy economy.

Now this does not mean it is just smooth sailing ahead, or that there aren’t downside risks. Its central bank could continue to overreact. That would be detrimental. Or commodity prices could take another hit. After all, many producer contracts were locked up last June, and many producers are still protected by them. This June could be an entirely different story. Producers may have to take a big hit compared to last year. That would be detrimental. And the China factor may not pan out as quickly or as well as it appears.

But all things considered, a long position in the Australian dollar doesn’t seem like too bad of a bet.

Regards,
Bill Jenkins

March 30, 2009

Devaluation and a Chinese Warning Shot was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

For those unfamiliar with the term “carry trade,” I will use the definition found on Freebuck.com.

“Carry trade — The speculation strategy that borrows an asset at one interest rate, sells the asset, then invests those funds into a different asset that generates a higher interest rate yield. Profit is acquired by the difference between the cost of the borrowed asset and the yield on the purchased asset.”

Nightmare Scenario

I view the nightmare scenario something like the following:

1. End of quantitative easing (QE) in Japan
2. End of ZIRP in Japan (Rising interest rates)
3. Rising interest rates in Europe
4. Falling interest rates in the U.S.
5. Tightening credit in the U.S.
6. A rising yen vs. the U.S. dollar

Quantitative Easing

Quantitative easing has already ended in Japan. Quantitative easing simply means excessive printing of money by the Bank of Japan in order to defeat the deflation that has been raging for about 18 years.

I believe that ZIRP (zero interest rate policy) and QE (quantitative easing) prolonged Japan’s deflation, but for now, that is irrelevant. The key point is that both are about to come to an end. Proof of the end of QE can be found in the following chart, courtesy of Contrary Investor:

As you can see, money supply in Japan nearly doubled between 2001-2006. Hedge funds could borrow yen at zero percent and invest in the U.S. stock market; or gold; or silver; or, after all of these rate hikes, U.S. Treasuries and get 5%. The only real worry was the yen rising in value more than the return on other investments. With Japan unwilling to let the yen rise, players piled high on the carry trade.

From a U.S. dollar perspective, when interest rates were slashed to 1%, another possible carry trade was to borrow funds in U.S. dollars and invest in gold, silver, or equities. With the S&P dividend ratio under 2% and interest rates close to 5%, the U.S. carry trade slowly died with each rate hike.

Rising interest rates in Europe and Japan and falling rates in the U.S. (a global equalization of interest rates) will end more of these carry trades.

Contrary Investor points this out:

“Historical periods of meaningful rate of change decline in the Japanese monetary base have preceded each meaningful U.S. recession of the last three decades. Just eyeing them out, these large percentage drops occurred in ’73/’74, ’79/’80, 1990, and 2000. If, indeed, history has the chance of repeating itself ahead, what should we now be expecting for the macro U.S. economy as we look directly at current Japanese monetary base contraction?”

Speculation in various markets is extreme, as noted by trillions of dollars worth of derivatives floating around. The unwinding of those derivatives and any related carry trades is not likely to be a smooth event. In “Financial War Games,” I talked about the European Central Bank running “stress tests” to see if it could handle a derivative meltdown. We might just be put to the test. Clearly, we are at a serious crossroads of the greatest liquidity experiment the world has ever seen, with multiple players, in multiple countries, doing mind-boggling things with tremendous leverage.

Right now, we see the “Fed in a Quandary” about what to do. In spite of that, Bernanke thinks the Fed can magically control the global economy with a looming U.S. recession on top of a housing bubble bust. It is the height of hubris.

ZIRP

QE is toast. Let’s consider the end of ZIRP (Zero Interest Rate Policy). Bloomberg is reporting, “Yosano Says Japan Must Eventually Say Deflation Over”:

“Japan’s government will eventually need to declare an end to deflation, Economic and Fiscal Policy Minister Kaoru Yosano said.

“‘At some point citizens will need to be told by academics or politicians that sustained price declines have ended,’ said Yosano, who was speaking to lawmakers in Tokyo today. ‘Hardly any consumers are under the impression that prices are falling.’

“Japan’s core consumer prices have risen for the past six months, signaling the economy’s tussle with more than seven years of deflation is ending. Rising prices and an expanding economy may prompt the Bank of Japan to raise borrowing costs for the first time in almost six years as soon as July, economists say.

“Chief Cabinet Secretary Shinzo Abe reiterated separately that the central bank should keep borrowing costs near zero to support the economy. He said the bank and the government need to work together to end deflation and ensure prices don’t resume falling. Abe was speaking to reporters at a regular news conference in Tokyo today.”

For now, Japan seems unwilling to let interest rates rise, as evidenced by the Financial Times article “BOJ Injects $13 Billion Into Market to Cut Rates”:

“The Bank of Japan on Monday injected a massive Y1,500 billion ($13.3 billion) into the money market as it desperately sought to keep overnight interest rates under control.

“The injection came as overnight rates once again tested the 0.1% ceiling, calling into question the central bank’s ability to keep rates at ‘effectively zero,’ in line with its stated policy.”

The market is attempting to force Japan to hike. Japan is resisting. With a national debt of 150% of GDP, how much longer can Japan resist? A rising yen would be bad for those borrowing in yen and investing in U.S. Treasuries. A rising dollar is bad for those borrowing U.S. dollar and buying gold, silver, or falling U.S. dollar-denominated assets. The crosscurrents on some of these trades are significant, even though the yen and the dollar cannot both fall relative to each other. What can happen, however, is falling asset prices (stocks, gold, silver, copper, equities) at a rate greater than any interest rate differential. That is likely in a monetary tightening situation as we are seeing in both Japan and the U.S.

E.U. Money Supply

Writing for the Financial Sense Market Wrap Up on May 31, Paul Nolte had this interesting commentary:

“Many fingers are pointing to money supply (or lack of M3 being reported) as a key to the ‘blown-up’ U.S. economy. However, the reality points to places outside the U.S. The various Ms are running at relatively low year-over-year rates — MZM 3.9%, M2 4.5%, and M1 a measly 1.8%. This contrasts with the big inflation years during the ’70s and ’80s, when these aggregates were well over 10% (and sometimes north of 15%). Even the monetary base is growing at a 4% rate, less than one-third of the pace of the early ’90s. So where is the liquidity coming from? One place is Europe, where the European central banks are boosting money supply by a torrid 8% annual rate. While ‘Helicopter Ben’ may have a tough name to overcome in the months ahead, investors need to look elsewhere when complaining about excessive monetary growth.”

Bingo. Once again, “dollar bears” only point out what the U.S. is doing, forgetting about gross distortions in Japan, Europe, and the U.K. Long term, this is, of course, good for gold, but short term, the unwinding of various carry trades can wreck havoc on those that are overleveraged.

With that excessive expansion of credit in Europe, interest rates in the E.U. are poised to rise. Please be prepared to click off No. 3 on the list above if and when it happens.

Fed Cause

No. 4 is a given. The Fed at some point will pause. The unwinding of the housing bubble in the U.S. assures it. The question is when. The problem if it does not pause is that the blowup of the housing bubble will accelerate, and the problem if it does is a potential bond market revolt. Jobs here are the key. Falling jobs in conjunction with a housing bubble bust will let the Fed get away with a pause and subsequent cuts. This, of course, is where it gets complicated. Will Japan react to slowing U.S. demand by attempting to weaken the yen yet again? If internal demand in China and Japan picks up, Japan can perhaps happily keep hiking. If not, can Japan can abruptly end QE and go back to ZIRP to fight one more round of deflation? I think not.

Everyone talks about hyperinflation in the U.S. What happens to the Japanese if they stay on its current QE/ZIRP path forever? At some point, a national debt at 150% of GDP matters even if “they owe it to themselves.” It might seem funny to be talking about massive inflation in Japan, but under the right circumstances, I could foresee a loss of faith in the yen. Typically, emergence from K-Winter is a slow event with slowly rising inflation, but with central bankers everywhere taking all sorts of untried experiments with liquidity, some sort of major currency problem with the yen is possible. If the BOJ changes its mind about QE (something I do not expect), then a loss of faith in the yen is certainly possible. It is a scenario that is on virtually no one’s radar, yet it is not really that far-fetched (even if at this point it is unlikely). Yet everyone assumes the U.S. dollar will blow up. The contrarian in me suggests that if a huge currency problem of some sort emerges, it just may be elsewhere. Perhaps this scenario unfolds sometime down the road in a panic move by Japan to reinstate QE.

Credit Tightening

Let’s move on to No. 5. Is credit tightening in the U.S. so unlikely? I think not. All it takes to kick it off is accelerating housing declines. The ultimate nightmare scenario for U.S. housing would be a situation in which long-term mortgage rates decouple from the 10-year Treasury note and stubbornly refuse to drop in the face of easing actions by the Fed. I view that as a possibility that I have not heard discussed elsewhere. Rising default risk could potentially change mortgage lending standards in situations in which large downpayments are not made. Regardless of whether that specific scenario unfolds, consumer credit is showing signs of stress and money supply growth is far greater in the E.U. and China than it is in the U.S. In fact, money supply in China is up a staggering 22%, as noted in “9th-Inning Liquidity.” Falling home prices, falling jobs, and a correction of the negative savings rate in the U.S. is all that it will take for huge credit problems in the U.S. to surface. At this point, all three of those seem extremely likely.

A Rising Yen

Some have argued that with interest rates in Japan at zero, a modest rise in interest rates to 1% will not stop the yen carry trade. Borrowing at 1% in Japan get 4-5% in the U.S. — what could be simpler? I disagree. A rise in the yen greater than the interest rates’ differential would cause a loss for yen carry trade players. Assume for a second that rates fall to 4% in the U.S. and rise to 1% in Japan. At that point, the U.S. Treasury yield will still be over double the dividend yield on the S&P (a situation not that great for U.S. dollar carry trade players). And from the perspective of the yen carry trader, all it would take to wipe out profits would be a mere 3% rise in the yen. Notice that it would not take a collapse of the U.S. dollar to cause huge problems. A mere 6% move versus the yen would cause a tremendous amount of damage. I suppose one could try to hedge that currency risk, but ask yourself how well Fannie Mae has done hedging its interest rate risk. It may not be the easiest thing to do.

An additional problem for Japan is that a rising yen would hurt Japanese exports. That might not bode well for the Japanese stock markets. As long as Japan could slow the rise of the yen via ZIRP and QE policies, yen carry trade players had the green light to pour it on. That green light is now a brightly flashing yellow (possibly even red) given that every increase in Japanese interest rates will help fuel a rise in the yen.

There you have it: the nightmare carry trade scenario. All in all, it looks closer than anyone might have thought. Perhaps that is the message of a 100-point plunge in gold; copper going down lock limit several times; silver ramping to the moon; just to fall off a cliff; various emerging markets indexes plunging; and global equity markets taking a collective nose dive.

Should a nightmare unwinding of various carry trades unfold as I expect it to, “dry powder,” as in cold hard cash, just may be a good thing to have.

Regards,
Mike Shedlock ~ “Mish”
June 5, 2006

Nightmare Carry Trade Scenario was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.