As the world's Reserve Currency the US has enjoyed what is referred to as "Exorbitant Privilege". The US has been able to 'print' money but not suffer the consequences of the associated inflation and currency debasement that comes with such irresponsibility. This is because the 'exorbitant privilege' effectively allows the US to export its inflation. This inflation returns initially as higher import costs, but eventually as hyperinflation, as the world slowly abandons the US dollar and its reserve currency status. This 'exorbitant privilege' continues to work until something which was well understood prior to the US going off the gold standard no longer works. That is a concept referred to as the "Triffin Paradox".
The US Council on Foreign Relations aptly describes why Triffin's dilemma becomes unsustainable: "To supply the world's risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened."
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THE P/E COMPRESSION GAME: An Old Game with a Different Twist to Misprice Risk
We are manipulating markets metrics in such a fashion as to intentionally Misprice, Misrepresent & Hide RISK. Prior PE reference boundary conditions which reflected risk have decoupled. Never has the game of forward operating earnings (versus historically trailing earnings) been more inappropriate than presently. Forward PE's can only be of value in rapid revenue and profit growth eras. This is not what we have presently. It is the wrong tool for the wrong job! Unless you are a sell side analyst, then it is exactly the right too for the difficult selling job you have. We have an era of Peak earnings growth RATES, slowing profit growth RATES and Peak PEs which are reflective of rapidly contracting PE's. We have a secular bear market in REAL terms but PE's are not contracting at a sufficient enough rate to reflect this. Though PEs in nominal terms net out inflation, they don't reflect the underlying downward trend in real terms. MORE>>
We have witnessed QEfinity "Unlimited", OMT "Uncapped', and the US Election results. Now we begin to watch the Fiscal Cliff political poker game unfold. So far it has been a Buy on the Rumor, Sell on the News scenario with markets down significantly since each event, but appearing to find support at the 200 DMA. With US government facing another downgrades to its "Risk Free" status, earnings plummeting and a clear global slowdown in progress, what should we expect before year end and more importantly in the New Year? The short answer is 'volatility' as we complete the "Right Shoulder" of a classic Head and Shoulders pattern of a major Long Term Technical structure. Once complete we then head lower.
A Santa Claus Rally is highly likely despite a rarely confirmed Hindenberg Omen and technical chart patterns that mirror the pre-1987 market crash - way too closely for this analyst. The markets are at levels of extreme risk which is not priced in. Most investors are best advised to stand aside and error on being too conservative. It is too risky at this moment to be either net long or short. Soon however there will be a lower risk entry to be net short the market for the 2013 market clearing event, which the macro charts are consistently signaling.
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BOND SHORTAGE - Potential Panic Buying
As Ayn Rand stated:
You can avoid reality, but you cannot avoid the consequences of avoiding reality.
The avoidance of reality has overtaken our society. The consequences of doing so have been building for decades and will soon overwhelm us. On our current path, much of what we knew and cared about will be destroyed.
A great friend of mine and one of the best bond traders on Wall Street said this recently: “Get ready for The Great Bond Shortage in North America. If it has a cusip and it is rated, it is going higher/tighter.” I am down with his observation. The compression in bond spreads since the Fed started all of their “made-up/newly printed money for free” antics is the root of all of this and I do not expect a change anytime soon. There are various estimations for the 2013 net new issue supply in all sectors of Fixed Income but I peg it around $400 billion. Around $800 billion will be paid to bond holders during the year in coupon payments and, if reinvested, will cause a supply deficit of about $400 billion for the year. Exacerbating all of this is the Fed, who will buy around $500 billion in MBS this year and perhaps the same amount in Treasuries which could take $1 trillion out of the market all by itself. Consequently we face a lack of bonds denominated somewhere between $900 billion and $1.4 trillion, depending upon the Fed, which will increase the rolling train of compression, lower interest rates further in all likelihood and cause great angst for investors who will find very little of value left in the Fixed Income markets. Safety; yes but yield; no.
While this is taking place we will find a different scenario in the equity markets. The Fed will not be investing money directly in equities and so the liquidity that has propped the stock markets during the Treasury buying phase and will help at the margin with the MBS purchases is not going to have such a dramatic influence in my opinion as the MBS cash is likely to flow back into other segments of the bond markets and not so much into equities. There is also the American Fiscal Cliff, the worsening recession in Europe, the slow-down in China and the possibility of some political event in Greece, Spain, Portugal or Ireland as the funding nations in Europe get strained and could break during 2013. There is a point I assure you and I think we are verging on it where the people of various nations, under their own strain of recession, just cannot afford the grand scheme of European Union and revolt. The IMF is already getting testy with Greece and when Spain shows up hat in hand, their data is found to be inaccurate and the price tag far past the ridiculous estimations of the EU/ECB then “buddy can you spare me a dime” may fall on deaf ears. It should be noted that during the worst year of the Great Depression, 1933, that America had an unemployment rate of 25% which is exactly where we find both Spain and Greece today. A telling sign of things to come perhaps?
"We all know what to do, we just don't know how to get re-elected after we have done it."
-Jean-Claude Junker
12-03-12
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6
6- Bond Bubble
FISCAL CLIFF - We are Being Manipulated
6 Reasons the Fiscal Cliff is a Scam 11-22-12 James K Galbraith Alternet.org
Stripped to essentials, the fiscal cliff is a device constructed to force a rollback of Social Security, Medicare and Medicaid, as the price of avoiding tax increases and disruptive cuts in federal civilian programs and in the military. It was policy-making by hostage-taking, timed for the lame duck session, a contrived crisis, the plain idea now unfolding was to force a stampede.
In the nature of stampedes arguments become confused; panic flows from fear, when multiple forces – economic and political in this instance – all appear to push the same way. It is therefore useful to sort through those forces, breaking them down into separate questions, and to ask whether any of them justify the voices of doom.
First, is there a looming crisis of debt or deficits, such that sacrifices in general are necessary? No, there is not. Not in the short run – as almost everyone agrees. But also: not in the long run. What we have are computer projections, based on arbitrary – and in fact capricious – assumptions. But even the computer projections no longer show much of a crisis. CBO has adjusted its interest rate forecast, and even under its “alternative fiscal scenario” the debt/GDP ratio now stabilizes after a few years.
Second, is there a looming crisis of Social Security, Medicare and Medicaid, such that these programs must be reformed? No, there is not. Social insurance programs are not businesses. They are not required to make a profit; they need not be funded from any particular stream of tax revenues over any particular time horizon. Reasonable control of health care costs – public and private – is necessary and also sufficient to keep the costs of Medicare and Medicaid within bounds.
Third, would the military sequestration programmed to start in January be a disaster? No, it would not be. Military spending is set in any event to decline – and it should decline as we adjust our military programs to our national security needs. The sequester is at worst harmless; at best it's an invitation to speed the process of moving away from a Cold War force structure to one suited to the modern world.
Fourth, would the upper-end tax increases programmed to take effect in January be a disaster? No, they would not be. There is no evidence that the low tax rates on the wealthy encourage them to spend or invest, no evidence that higher tax rates would deter the spending and investment that they might otherwise do.
Fifth, would the middle-class tax increases, end of unemployment insurance and the abrupt end of the payroll tax holiday programmed for the end of January risk cutting into the main lines of consumer spending, business profits and economic growth? Yes, over time it would. But the effects in the first few weeks will be minimal, and Congress could act on these matters separately, with a clean bill either before the end of the year or early in the new one.
Sixth, what about all the other cuts in discretionary federal spending? Yes, some of these would be very damaging if allowed. Simple solution: don't allow them.
In short, Members of Congress: if you can, just pass the President's bill on middle-class taxes, and, if you can, eliminate the domestic sequester. Then, please go home. Enjoy the holidays. Come back in January prepared to extend unemployment insurance, to phase out the payroll tax holiday gradually, to restore stable funding to necessary programs and to start dealing with our real problems: jobs, foreclosures, infrastructure and climate change.
Thus far, the US has been the mainstay of Western recovery - the basis upon which investors' cautious optimism is espoused.
Via Sean Corrigan's Material Evidence, Diapason Commodities:
...a host of interrelated indicators are flashing red; especially when one notes that these are closely correlated with either non-financial corporate profits and/or the stock market level itself - and form the basis of an informed realist's skeptical pessimism at equity market exuberance.
Take the industrial production diffusion index, for example. This is back at its lowest reading since the slump itself and the pace of deterioration these past few months is both unmatched in a quarter of a century and barely beaten in the troubled decade and a half which preceded that stretch.
Manufacturing – supposedly the great white hope of the new America – has seen wage rates creeping up by less than 1% p.a. in nominal terms and reverting to where they were in 1998 in real terms – hardly a sign of rising productivity.
Hours worked tell a similar story: they have been flat to lower in 2012, having only recouped around a quarter of the losses suffered in the Crash. Here they rest fully a third below the stationary mean around which the first sixty years of post-WWII cycles gyrated. They are no higher now than before the Broken Window boost of Pearl Harbor and flounder not only 70% below 1953’s population-weighted high, but 45% lower than when the last pernicious wave of ‘hollowing out’ set in, in the wake of the Asian Contagion in 1998.
Core capital goods orders have suffered a summer and autumn every bit as bad as at the beginning of the Tech bust, if not suffering a decline any where near as precipitous as during the onset of GFC itself. Overlay a graph of these with the S&P500 and you will see that they have traced out a very similar pattern in the great bubble era from 1995 to date. In a like manner, durable goods shipments (which have enjoyed an r-squared of 0.7 vis-à-vis the S&P over the last 15 years) have dropped since July’s (double-top) peak at a pace only surpassed this last decade during the calamity of 2008-9 itself.
[Perhaps most incredibly - over the past 15 years, the 3-month change in Durable Goods Shipments has reached a 2-sigma drop just three times before the current plunge; the performance of the S&P 500 over the next two months was as follows:
June 1998 (from 1133 to 957) -15%
January 2001 (from 1366 to 1160) -15%
September 2008 (1282 to 968) -25%
But this time is different we are sure...?]
Turning to trade, the annual growth of container exports from Long Beach and LA is now incontrovertibly in the negative column after 2 ½ years of gains – once more, a condition associated with either regional (Pacific) or global contraction.
Finally – and a little more esoterically – the diffusion index version of the fairly reliable Chicago Fed indicator, after maintaining levels consistent with a somewhat anaemic recovery since the start of 2010, and having spent the last eight months edging ever lower, now hovers perilously close to a cut?off below which every official recession of the last half-century has been recognized to have held sway.
Some will say that the paralysis induced by the approach of the dreaded ‘fiscal cliff’ is at fault. That may well be, though bitter experience tells us that some sort of face-saving compromise will be hashed out, probably in the form of some token tax rises imposed on the friendless ‘Rich’, together with a catalog of largely illusory reductions to the currently scheduled rise in expenditures (no actual cuts are likely to be implemented in this world of Orient Express ‘Austerity’). No doubt, the latter while be concentrated conveniently out in the far years of the current projections. Both sides of the House will then claim a victory and both will make much ado about its laudable display of statesmanship and responsibility. Meanwhile, the debt will continue rising at something not that far removed from its present $1.2 trillion annual pace.
In any case, to the extent that the same arguments apply to fiscal laxity as they do to monetary – namely, that the system quickly develops a tolerance to any given level of artificial input, thereby necessitating a continual upping of the ante if the ‘stimulus’ is to remain effective – America has already jumped off a rather large cliff. We say this based on the fact that whereas the four quarters to Sep’08 saw a 7.5% percentage increase in government capital and current outlays over the earlier like-period which topped anything seen in the last 20 years (and which gave rise to a record?beating, nominal $525 billion increment in spending), the running total for the latest 12?months shows a near?zero increase in expenditures over the prior span for the first time since the end of the Korean War.
Air Force One – as a metaphor for the entire government component in the economic mix - may still be cruising at an unimaginable speed, therefore, but the afterburners are no longer propelling it to even greater prodigies of flight in the way they once were.
Ironically, equities are already trying to rally on the premise that a fudge will be achieved in the budget talks, yet unless every CEO in the land celebrates the striking of the deal by indulging in an unbridled orgy of ‘pent-up’ capex and hiring, the gathering weakness in the economy may only widen the disparity between a stock market artificially inflated by the Fed’s success at suppressing the correct pricing of capital and the underlying course of commerce and industry.
Oh, and just to make matters worse, the really disruptive ‘cliff’ we face over year-end may well be the regulatory one whereby the temporary Transaction Account Guarantee program – an FDIC scheme to extend a comprehensive safety net to deposits of more than the usual $250,000 ceiling - will finally expire and so potentially trigger a $1.4 trillion shift in the allocation of caution swollen, corporate cash balances.
Not the least of the side effects of this will be that it will render all attempts at monetary analysis moot for some appreciable period of time when clarity, not opacity, is what we so urgently need. Joy, indeed!
We all hear this is the next new, new thing and it will be different this time as the talking heads blather with wild abandon. Not wishing to join this group either in theory or style I am always quite reticent to walk into this space but the world since 2008 has been different than in past difficulties in one very poignant manner. The world’s three major central banks have all acted in concert and so we have been dealing with, really, just one set of responses that have been conducted on a global scale. Since we cannot invest off-planet or in some parallel universe the options that we have then are quite limited which is why, in my opinion, that the focus on Inflation or Deflation, historically always the epicenter of the discussion when major changes are made to monetary supply or fiscal policy, is not getting played out in the manner that most might suppose. I will go further, it is not Inflation or Deflation that are going to matter in the short run, though it will later; it will be the lack of bonds of any sort to purchase and a stock market that may be dangerously out of sync with the fundamentals opening the possibility of a crash and not a small one if it occurs. Institutional investors are edgy, that I can tell you with certainty, and it would not take much to see a flight from equities into bonds/commodities/gold regardless of the available yields and just because the money was relatively safe. Americans lost thirty-six percent of their wealth during 2008/2009 and while memories are short the pain of that experience has not yet been forgotten.
Inflation and Deflation, it should be noted, only work in operative systems. The question then becomes what takes place if the system breaks down and value, of any sort, is no longer present and that would be the scenario labeled “Crash.” Recently the senior spokesperson for bonds, the eminent Bill Gross, suggested buying Gold and I can well understand the rationale for his comment. If so much money is printed and so little regard is placed upon fundamental economic principles then the Real Estate crash of several years ago will look like child’s play by comparison. Then if you add in a Europe that could implode from the demands of the troubled nations, some sort of social revolution taking place in the same countries or the sounder nations refusing to fund or even being unable to fund then we have an economically impaired world that is squared and cubed by worthless currencies. Remember assets are not only relative, which is how we approach them in a functioning system, but they are absolute and indicative at the same time. All three operate in tandem and while the latter two are mostly ignored; they are there none-the-less. If gold becomes the reserve currency and is trading at $8,000 or $10,000 an ounce then the value of the Dollar, the Euro or the Yuan is close to worthless. The Inflation factor of food and other goods with costs that are prohibitive to buy basic essentials is another option but that would be even worse in my opinion. This is not the way of it yet but there is a tipping point where so much capital is created that a currency loses its value as a tool of purchase.
“Money for nothing and chicks for free” may play out for awhile in the glitter of Friday and Saturday night but Sunday through Thursday may write another story. Inflation and Deflation have another edge and that is Valuation which is why “Crash” may precede their better known cousins based upon Valuation which would be a systemic breakdown of the first order. Gold, silver and metals are really a currency option at some point if the value of paper money is found to be wanting. It won’t be the Dollar as evaluated against some other currency but the value of any and all of them that may come into question. The path would be out of equities and into bonds with yields not only falling to zero but perhaps through zero and then out of bonds and into cash and then out of cash and into gold and other metals. “Systemic Breakdown” would be the functioning words.
“As happens sometimes, a moment settled and hovered and remained for much more than a moment. And sound stopped and movement stopped for much, much more than a moment.”
-John Steinbeck, Of Mice and Men
Late Friday the Stabilization Funds of Europe lost their “AAA” rating mostly having to do with the economic deterioration in France. If Germany follows then it may be the first step in some sort of breakdown. At the same time America has been downgraded and our step over the Fiscal Cliff could have the same sort of affect here. I think that it be accurately said that easy credit, loose money and an overabundance of capital caused the events of 2008/2009 and since then the central banks have pumped even more liquidity into the system begging the very real question if we aren’t in for some sort of do-over of those events. No one is sure, I am not sure, but the possibility is no longer some other universe outlier or black swan that cannot be sniffed in the early morning breeze. If the mood changes and all currencies are viewed as lacking value then relative comparisons are hardly the point. Milton Friedman and Ben Bernanke have argued that the events of 1929 were caused by a contraction in money supply and hence our current policy but what is the other side of this coin if monetary expansion and capital supply is so great that the valuation of every currency declines as a result of their lack of worth; there is the appropriate question in my view.
Another interesting aspect of this consideration is what people do if there is no yield and the equity markets are in decline. If investors cannot generate enough income, one way or another, then what becomes of the seniors and others on a fixed income? Will it be the inability to pay mortgages, rents and then defaults and then bank failures? Some very unpleasant consequences to consider but if the expansion of money and credit are to continue unabated here and in Europe and if Draghi’s “Save the World” speech gets enacted then where does it all stop and what happens in America and Europe if there is no end in sight?
"No, you’re wrong there—quite wrong there. The bank is something else than men. It happens that every man in a bank hates what the bank does, and yet the bank does it. The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.”
-John Steinbeck, The Grapes of Wrath
12-03-12
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