LEVERAGE LOANS - Now 55% "COV-LITE" versus 29% Prior to Financial Crisis

As we warned two months ago, the bubble in credit markets (which if you ask anyone at the Fed, except Jeremy Stein, does not exist) is nowhere more evident than in the explosive growth of so-called cov-lite loans. While total volumes of cov-lite loans are already at record, as the FT reports, we now have 55% of new leveraged loans come in “cov-lite” form, far eclipsing the 29% reached at the height of the leveraged buyout boom just before the financial crisis. LBO multiples have reached record highs and demand for secutizations of these levered loans (CLOs) has surged on the back of the Fed's repressive push of investors into more-levered firms and more-levered instruments.

Via The FT,

The amount of riskier loans offering fewer protections to lenders contained in packages of debt sold to investors have hit record levels, amid resurgent lending markets and a continued thirst for higher returns.

...

as “covenant-lite” loans, or loans that come with fewer protections for lenders, have this year become the norm in the US, CLO managers have been forced to relax the limits on the percentage of the loans that can go into their deals.

Already, 55 per cent of new leveraged loans come in “cov-lite” form, eclipsing the 29 per cent reached at the height of the leveraged buyout boom just before the financial crisis.

...

“CLO managers have clearly taken notice of this trend, and structures have come with more relaxed caps on cov-lites this year.”

While the majority of CLOs sold last year had a 40 per cent limit on the amount of cov-lite loans that could be bought by the vehicles, a 50 per cent cap has become the industry standard in 2013, according to data from S&P Capital IQ.

At least three deals have come to market this year with a 70 per cent limit.

So wondering where the leverage is building this time? Well, record high margin debt in stocks and record high exposure to the riskiest (and least protected) credit structures once again... but it's different this time (as Moodys told us).

QE - INEQUALITY

Where QE Cash Ends Up Tells Us Who Benefited 11-19-13 Zero Hedge

One can debate whether QE has benefitted Main Street or Wall Street until one is blue in the face, even though five years later, the answer is perfectly clear to all but the staunchest Keynesians and monetarists (and if it isn't, just pay attention to the 3:30 pm S&P ramp every day). One thing, however, that is undisputed is what the market itself says about where the QE money ends up when it is being spent by its recipients. And that story is so simple even a Keynesian would get it.

Stated briefly, luxury retailers such as Tiffany, Coach and LVMH are now up 500% since the Lehman lows, and about 30% above the prior cycle highs. On the other hand, regular retailers such as Macy's, Kohl's and JC Penney are barely up 100% from the crisis lows, and still more than 30% below the last bubble highs.

And that, in a nutshell, is precisely how the money from QE has been distributed.

Source: JPM

FAILURES - Market, Policy and Institutional

The Capital-Flow Conundrum 11-08-13 Eswar Prasad Brookings

When the Fed initially hinted at its intention to taper QE, policymakers in some emerging economies cried foul, but were dismissed by advanced-economy officials as chronic complainers. After all, they initially rejected the very policies that they are now fighting to preserve.

But emerging-market policymakers’ criticisms do not reflect an inconsistent stance; in both cases,

the crux of their complaint has been volatility.

They have already attempted to erect defenses against the potentially destabilizing effects of advanced-country monetary policy by

1. FX RESERVES: Accumulating foreign-exchange reserves and
2. CAPITAL CONTROLS: Establishing capital controls.
3. SHORT TERM RATES: Now they are calling on their central banks to ensure stability by, for example, raising short-term lending rates.

But this approach fails to address the underlying issue – and misdiagnosing the problem could have far-reaching consequences, not only leading to ineffective solutions, but also possibly causing severe distortions for specific economies and the global financial system as a whole. In order to design effective remedies, it is useful to distinguish among three types of failures that impede financial-market functioning.

The three types of failures that impede financial-market functioning.

MARKET FAILURES

First, there are market failures, which occur when, for example,

1. Investors display herd behavior,
2. Information asymmetries exist, or
3. The structure of incentives for investment managers encourages excessive risk-taking.

POLICY FAILURES

Second, there are policy failures, which occur when

1. Undisciplined macroeconomic policies and
2. Inconsistent or ineffective financial regulatory policies heighten the risks associated with volatile capital flows.

INSTITUTIONAL FAILURE

The third – and currently most problematic – failure is one of national or international institutions.

MONETARY DEPENDENCY

Using monetary policy to compensate for deficiencies in other policy areas constitutes an institutional breakdown: monetary policymakers are not necessarily getting it wrong, but they are constrained by the configuration of other policies.

Domestic monetary policy has become the first and last line of defense against growth slowdowns and financial panics, enabling policymakers to avoid pursuing other important, but far more difficult measures.

Using monetary policy to compensate for deficiencies in other policy areas constitutes an institutional breakdown: monetary policymakers are not necessarily getting it wrong, but they are constrained by the configuration of other policies.

GLOBAL GOVERANCE FRAMEWORK

The inadequacy of the current framework for global governance compounds the problem. The grim reality is that, with financial markets becoming increasingly interconnected, monetary-policy measures taken by any of the major economies have international spillover effects. An effective governance mechanism or reliable institution is needed to help emerging markets cope with these effects.

The lack of effective global economic governance has important implications for capital flows.

Emerging-market policymakers believe that they lack recourse to safety nets that would cushion the impact of volatile flows. Their efforts to “self-insure,” by, say, building up their foreign-exchange reserves, perpetuate global economic imbalances.

So how can policymakers address these failures? There has been some progress at the international level on regulatory reforms aimed at addressing market failures, though such efforts have been limited by strident resistance from financial institutions.

Solutions for policy failures are not difficult to discern.

• Flexible currencies,
• More transparent monetary frameworks, and
• Sound long-term fiscal policies can serve as buffers against capital-flow volatility.

Moreover, the functioning of emerging-economy financial markets should be improved, with policies aimed at

• Institutional development and
• Improved regulatory capacity.

While the right policies cannot eliminate risk, they can ameliorate the cost-benefit tradeoff from capital flows.

Fixing institutional failures is the most important – and the most difficult – step. Successful reform requires, first and foremost, finding the right mix of domestic policies. In the advanced economies, in particular,

• A sharper focus on long-term debt reduction, rather than short-term fiscal austerity, is needed, along with
• Structural reforms to labor, product, or financial markets, depending on the country.

In many of the troubled emerging economies, however, monetary policy has shouldered the burden of

• controlling inflation,
• managing the local currency’s value, and
• supporting growth.

This balancing act is difficult to maintain, leaving these economies vulnerable when the external environment turns unfavorable.

In India, for example, increasing productivity and long-term growth require fiscal discipline and a raft of financial- and labor-market reforms. But the central bank is being asked to do all the heavy lifting. In other emerging markets, too, the main challenge is to ensure that all macroeconomic and structural policies advance common goals.

At the same time, the governance structure of multilateral institutions like the International Monetary Fund must be reformed, in order to bolster their legitimacy in emerging markets. Otherwise, these institutions will remain ineffective in confronting collective problems related to macroeconomic-policy spillovers, and in providing insurance against crises.

Policymakers in advanced and emerging countries alike should

Focus on the underlying failures that destabilize their economies and impede growth, rather than trying to treat the symptoms by manipulating monetary policy or capital controls.

Unless they are supported by strong institutional structures at all levels, such measures will prove futile in managing capital flows.

LEADERSHIP - 'Value Transformer' Politicians are avoiding politics OR the voters are rejecting

The Three Types Of Politicians 11-13-13 OfTwoMinds Charles Hugh Smith

Solving profoundly structural problems by establishing a new foundation of values that most can embrace positively is the hallmark of leadership.

We can usefully classify politicians into three categories: caretakers, practical visionaries and values-transformers.

CARETAKERS maintain the status quo, a task that boils down to throwing a fiscal bone to every politically powerful constituency and doing so in a manner that does not create career-threatening blowback.

Caretaker politicians may or may not have what President George H.W. Bush famously called "the vision thing," but their actions are all of the caretaker variety, regardless of their soaring rhetoric.

Caretaker politicians take credit for things that would have happened even if they'd lost the election and some other caretaker politician had held the office: the new school would have built anyway, the strike settled one way or another, and the nation would have exited from the unpopular discretionary war.

The signature accomplishments of caretaker politicians always leave the status quo power structure and constituencies firmly in place; ObamaCare is an excellent example.

PRACTICAL VISIONARIES use their political capital to push through long-term, unsexy infrastructure projects that do not necessarily have powerful constituencies pushing for them and may have politically potent enemies. Examples include rebuilding or extending sewer systems, systemwide renovation of water works or power transmission lines, etc.

These long-term projects require major commitments of funds and competent long-term management, both of which must be cultivated by the practical visionary politician. They may also require overcoming significant political resistance from constituencies who are not benefiting (at least in their view) from the immense investment of public treasure.

Where the caretaker is happy to glad-hand his/her way through the short-term fray of competing demands, putting our fires and resolving minor battles, the practical visionary must have the vision and fortitude to keep investing effort and political capital in long-term projects that may not be sexy or popular.

The signature accomplishments of practical visionaries tend to be large-scale projects that were not slam-dunks: caretakers do not risk their political capital on long-term, unsexy projects, nor do they have the persistence, vision and character needed to work diligently for years to persuade or cajole doubters and then ensure the project is competently managed to completion.

Practical visionaries have "the vision thing" for concrete projects: revamp teacher education from the ground up, a new water treatment plant, an interstate highway system, etc. Their values are oriented toward improving the basics of civilization: water, waste, transport, education, etc. in fundamental, long-term ways.

Practical visionaries are often under-appreciated in their own time; they may only be appreciated long after they have retired or passed on.

Practical visionaries are also capable of wreaking great damage because they grind through even formidable opposition: those pushing "urban renewal" projects that bulldozed "slums" (i.e. affordable housing for marginalized populations) so freeways could tear the heart out of neighborhoods were convinced that making it easier for suburbanites to drive to their jobs in the city was worth far more than intact neighborhoods. Their confidence in that suburban mindset laid waste to many U.S. urban centers.

VALUES TRANSFORMERS: The third category of politician is very rare: those who can change the values of the populace and thereby transform the political landscape.

This type of politician is adept at transforming what appears to be unresolvable conflicts by establishing a values-based common ground that enables warring constituencies to bypass the old battle lines. This rare breed is not ideological, as ideologies are what create and solidify the conflicts and battle lines.

Values-transformers find a way to make every constituency feel as if they have participated in the solution, or even better, that the solution arose from their core values. Those constituencies that lose power as a result are treated with respect rather than denigration.

Solving profoundly structural problems by establishing a new foundation of values that most can embrace positively is the hallmark of leadership.

CONCLUSION

Either those with these leadership skills are avoiding politics or the voters are rejecting them in favor of caretakers who are incapable of challenging political powerful constituencies or finding common ground for desperately needed systemic reforms. 

POLITICAL FAILURE - The Consequences Of A Dysfunctional Political System

The Consequences Of A Dysfunctional Political System 11-18-13 Marc Faber via The Daily Reckoning blog,

As H.L. Mencken opined,

'The most dangerous man to any government is the man who is able to think things out for himself, without regard to the prevailing superstitions and taboos. Almost inevitably he comes to the conclusion that the government he lives under is dishonest, insane, and intolerable.'

It is no wonder that, according to a Gallup Poll conducted in early October, a record-low 14% of Americans thought that the country was headed in the right direction, down from 30% in September. That's the biggest single-month drop in the poll since the shutdown of 1990. Some 78% think the country is on the wrong track.

Some readers will, of course, ask what this expose about the political future has to do with investments. It has nothing to do with what the stock market will do tomorrow, the day after tomorrow, or in the next three months. But it has a lot to do with the future of the US (and other Western democracies where socio-political conditions are hardly any better).

I have written about the consequences of a dysfunctional political system elsewhere. In May 2011 I explained how expansionary monetary policies had favoured what Joseph Stiglitz called 'the elite' at the expense of ordinary people by increasing the wealth and income of the 'one percent' far more than that of the majority of the American people.

click to enlarge

I also quoted at the time Alexander Fraser Tytler (1747-1813), who opined as follows:

'A democracy cannot exist as a permanent form of government. It can only exist until voters discover that they can vote themselves largesse from the Public Treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the Public Treasury with the result that a democracy always collapses over loose fiscal policy, always followed by dictatorship'.

Later, Alexis de Tocqueville observed:

'The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money.'

To be fair to Mr. Obama, the government debt under his administration has expanded at a much slower pace in percentage terms than under the Reagan administration and the two Bush geniuses. In fact, as much as I hate to say this, Mr. Obama has been (or has been forced to be) a fiscal conservative.

click to enlarge

However, what 18th and 19th century economists and social observers failed to observe is that democracies can also collapse over loose monetary policies. And in this respect, under the Obama administration, the Fed's balance sheet has exploded. John Maynard Keynes got it 100% right when he wrote:

'By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some...

'Those to whom the system brings windfalls...become 'profiteers' who are the object of the hatred... The process of wealth getting degenerates into a gamble and a lottery... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.'

The Fed takes great pride in the fact that US household wealth has now exceeded the 2007 high. However, I was pleasantly surprised when I recently attended a presentation by Larry Lindsey, at my friend Gary Bahre's New Hampshire estate. He unmistakably showed, based on the Fed's own Survey of Consumer Finance and Flow of Funds, that the recovery in household wealth has been extremely uneven.

click to enlarge

Readers should focus on the last column of Table 1, which depicts the change in household wealth between 2007 and 2013 by wealth percentile. As can be seen, the bottom 50% of the population is still down more than 40% in terms of their 'wealth' from the 2007 high. (Lindsey is a rather level-headed former Member of the Board of the Governors of the Federal Reserve System, in which capacity he served between 1991 and 1997.)

Besides the uneven recovery of household wealth among different wealth groups, a closer look at consumer credit, which is now at a record level, is also revealing. Furthermore, consumer credit as a percentage of disposable personal income is almost at the pre-crisis high.

But what I found most interesting is how different income and wealth groups adjusted their outstanding total debt (including consumer credit, mortgage debt, etc.) following the crisis.

Larry Lindsey showed us a table - again based on the Fed's own Survey of Consumer Finance and Flow of Funds data - which depicts total debt increases and decreases (in US$ billions) among these different income and wealth groups.

I find it remarkable that the lower 40% of income recipients and the lower 50% of wealth owners actually increased their debts meaningfully post-2007. In other words, approximately 50% of Americans in the lower income and wealth groups who are both voters and consumers would seem to be more indebted than ever. A fair assumption is also that these people form the majority of the government's social benefits recipients.

Now, since these lower income and wealth groups increased their debts post-2007 and enjoyed higher social benefits, they were also to some extent supporting the economy and corporate profits. But what about the future?

Entitlements are unlikely to expand much further as a percentage of GDP, and these lower-income recipients' higher debts are likely to become a headwind for consumer spending. Simply put, in my opinion, it is most unlikely that US economic growth will surprise on the upside in the next few years.

It is more likely there will be negative surprises.

The Unintended Consequences of ZIRP 11-16-13 John Mauldin

Yellen's coronation was this week. Art Cashin mused that it was a wonder some Senator
did not bring her a corsage: it was that type of confirmation hearing. There were a few interesting
questions and answers, but by and large we heard what we already knew. And what we know is
that monetary policy is going to be aggressively biased to the easy side for years, or at least that is
the current plan. Far more revealing than the testimony we heard were the two very
important papers that were released last week by the two most senior and respected Federal
Reserve staff economists. As Jan Hatzius at Goldman Sachs reasoned, it is not credible to believe
that these papers and the thinking that went into them were not broadly approved by both Ben
Bernanke and Janet Yellen.

Essentially the papers make an intellectual and theoretical case for an extended period of
very low interest rates and, in combination with other papers from both inside and outside the Fed
from heavyweight economists, make a strong case for beginning to taper sooner rather than later
but for accompanying that tapering with a commitment to an even more protracted period of ZIRP
(zero interest rate policy). In this week's letter we are going analyze these papers, as they are
critical to understanding the future direction of Federal Reserve policy. Secondly, we'll look at
what I think may be some of the unintended consequences of long-term ZIRP.

We are going to start with an analysis by Gavyn Davies of the Financial Times. He writes
on macroeconomics and is one of the more of the astute observers I read. I commend his work to
you. Today, rather than summarize his analysis, I feel it is more appropriate to simply quote parts
of it. (I will intersperse comments, unindented.) The entire piece can be found here.

While the markets have become obsessively focused on the date at which the Fed will start to taper its asset purchases, the Fed itself, in the shape of its senior economics staff, has been thinking deeply about what the stance of monetary policy should be after tapering has ended. This is reflected in two papers to be presented to the annual IMF research conference this week by William English and David Wilcox, who have been described as two of the most important macro-economists working for the FOMC at present. At the very least, these papers warn us what the FOMC will be hearing from their staff economists in forthcoming meetings.

The English paper extends the conclusions of Janet Yellen's "optimal control speeches" in 2012, which argued for pre-committing to keep short rates "lower-for-longer" than standard monetary rules would imply. The Wilcox paper dives into the murky waters of
"endogenous supply", whereby the Fed needs to act aggressively to prevent temporary
damage to US supply potential from becoming permanent. The overall message implicitly seems to accept that tapering will happen broadly on schedule, but this is offset by superdovishness on the forward path for short rates.

The papers are long and complex, and deserve to be read in full by anyone seriously
interested in the Fed's thought processes. They are, of course, full of caveats and they
acknowledge that huge uncertainties are involved. But they seem to point to three main conclusions that are very important for investors.

1. They have moved on from the tapering decision
Both papers give a few nods in the direction of the tapering debate, but they are written with the unspoken assumption that the expansion of the balance sheet is no longer the main issue. I think we can conclude from this that they believe with a fairly high degree of certainty that the start and end dates for tapering will not be altered by more than a few months either way, and that the end point for the total size of the balance sheet is therefore also known fairly accurately. From now on, the key decision from their point of view is how long to delay the initial hike in short rates, and exactly how the central bank should pre-commit on this question. By omission, the details of tapering are revealed to be secondary.

Yellen said as much in her testimony. In response to a question about QE, she said, "I
would agree that this program [QE] cannot continue forever, that there are costs and risks
associated with the program."

The Fed have painted themselves into a corner of their own creation. They are clearly very
concerned about the stock market reaction even to the mere announcement of the onset of tapering.
But they also know they cannot continue buying $85 billion of assets every month. Their balance
sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I
can find no research that establishes a theoretical limit, I do believe the Fed does not want to find
that limit by running into a wall. Further, it now appears that they recognize that QE is of limited
effectiveness with market valuations where they are, and so for practical purposes they need to
begin to withdraw QE.

But rather than let the market deal with the prospect of an end to an easy monetary policy
(which everyone recognizes has to draw to an end at some point), they are now looking at ways to
maintain the illusion of the power of the Federal Reserve. And they are right to be concerned about
the market reaction, as was pointed out in a recent note from Ray Dalio and Bridgewater, as
analyzed by Zero Hedge:

"The Fed's real dilemma is that its policy is creating a financial market bubble that is
large relative to the pickup in the economy that it is producing," Bridgewater notes, as the relationship between US equity markets and the Fed's balance sheet (here and here for example) and "disconcerting disconnects" (here and here) indicate how the Fed is "trapped." However, as the incoming Yellen faces up to her "tough" decisions to taper or not, Ray Dalio's team is concerned about something else – "We're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't."

Dalio then outlines their dilemma neatly. "…The dilemma the Fed faces now is that the
tools currently at its disposal are pretty much used up, in that interest rates are at zero
and US asset prices have been driven up to levels that imply very low levels of returns
relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate
conditions."

The new ideas that Bridgewater and everyone else are looking for are in the papers we are
examining. Returning to Davies work (emphasis below is mine!):

2. They think that "optimal" monetary policy is very dovish indeed on the path for rates.

Both papers conduct optimal control exercises of the Yellen-type. These involve using
macro-economic models to derive the path for forward short rates that optimise the
behaviour of inflation and unemployment in coming years. The message is familiar: the Fed should pre-commit today to keep short rates at zero for a much longer period than exceed 2 per cent, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.

Compared to previously published simulations, the new ones in the English paper are even more dovish. They imply that the first hike in short rates should be in 2017, a year later than before. More interestingly, they experiment with various thresholds that could be used to persuade the markets that the Fed really, really will keep short rates at zero, even if the economy recovers and inflation exceeds target. They conclude that the best way of doing this may be to set an unemployment threshold at 5.5 per cent, which is 1 per cent lower the best mix of inflation and unemployment in the next few years. Such a low unemployment threshold has not been contemplated in the market up to now.

3. They think aggressively easy monetary policy is needed to prevent permanent
supply side deterioration.

This theme has been mentioned briefly in previous Bernanke speeches, but the Wilcox
paper elevates it to center stage. The paper concludes that the level of potential output has been reduced by about 7 per cent in recent years, largely because the rate of productivity growth has fallen sharply. In normal circumstances, this would carry a hawkish message spare capacity available in the economy in the near term.

However, the key is that Wilcox thinks that much of the loss in productive potential has
been caused by (or is "endogenous to") the weakness in demand. For example, the paper to recover more rapidly, as would part of the decline in the labour participation rate. In a reversal of Say's Law, and also a reversal of most US macro-economic thinking since Friedman, demand creates its own supply.

This concept is key to understanding current economic thinking.

The belief is:

• Demand is the issue and that lower rates will stimulate increased demand (consumption),
  presumably by making loans cheaper for businesses and consumers.
• More Leverage is needed!

The Misperception is:

• Current policy apparently fails to grasp that the problem is not the lack of consumption: it is the Lack of Income.
• Income is produced by productivity. When leverage increases productivity, that is
  good; but when it is used simply to purchase goods for current consumption, it merely brings
  future consumption forward.
• Debt incurred and spent today is future consumption denied.

Back to Davies:

This new belief in endogenous supply clearly reinforces the "lower for longer" case on
short rates, since aggressively easy monetary policy would be more likely to lead to
permanent gains in real output, with only temporary costs in higher inflation. Whether or not any of this analysis turns out to be justified in the long run, it is surely important
that it is now being argued so strongly in an important piece of Fed research.

Read that last sentence again. It makes no difference whether you and I might
disagree with their analysis. They are at the helm, and unless something truly unexpected
happens, we are going to get Fed assurances of low interest rates for a very long time. Davies
concludes:

The implication of these papers is that these Fed economists have largely accepted in their own minds that tapering will take place sometime fairly soon, but that they simultaneously believe that rates should be held at zero until (say) 2017. They will clearly have a problem in convincing markets of this. After the events of the summer, bond traders have drawn the conclusion that tapering is a robust signal that higher interest rates are on the way. The FOMC will need to work very hard indeed to convince the markets, through its new thresholds and public pronouncements, that tapering and forward short rates really do need to be divorced this time. It could be a long struggle.

On a side note, we are beginning to see calls from certain circles to think about also
reducing the rate the Fed pays on the reserves held at the Fed from the current 25 basis points as a
way to encourage banks to put that money to work, although where exactly they put it to work is
not part of the concern. Just do something with it. That is a development we will need to watch.

The Unintended Consequences of ZIRP

Off the top of my head I can come up with four ways that the proposed extension of ZIRP
can have consequences other than those outlined in the papers. We will look briefly at each of
them, although they each deserve their own letter.

1. The large losses from the continued FINANCIAL REPRESSION of interest rates on savers and pension funds

Simply put, ultra-low interest rates mean that those who have saved money in whatever
form will be getting less return on that money from safe, fixed-income investments. We're talking
about rather large sums of money, as we will see. Ironically, this translates into a loss of
consumption power when the Federal Reserve is supposedly concerned about consumption and
requires increased savings at a time when the Fed is trying to boost demand. This is robbing Peter
to favor an already well-off Paul.

A new report from the McKinsey Global Institute examines the distributional effects of
these ultra-low rates. It finds that there have been significant effects on different sectors in the
economy in terms of income interest and expense. From 2007 to 2012, governments in the
Eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion, both
through reduced debt-service costs and increased profits remitted by central banks (see the chart
below). Nonfinancial corporations – large borrowers such as governments – benefited by $710
billion as the interest rates on debt fell. Although ultra-low interest rates boosted corporate
profits in the United Kingdom and the United States by 5 percent in 2012, this has not
translated into higher investment, possibly as a result of uncertainty about the strength of the
economic recovery, as well as tighter lending standards. Meanwhile, households in these
countries together lost $630 billion in net interest income, although the impact varies across
groups. Younger households that are net borrowers have benefited, while older households with
significant interest-bearing assets have lost income.

McKinsey estimates that households in the US have lost a cumulative $360 billion.
Meanwhile, banks and businesses have done very well.

This loss of household income requires tightened spending by retirees and means that those
facing retirement have to spend less and save more in order to make sure they will have enough to
live on. It also requires the older generation to work longer, which is demonstrably keeping jobs
away from the younger generation, as I've documented clearly in past letters.

ZIRP means that the pension funds and insurance companies responsible for your annuities
are making significantly less on their portfolios than they had hoped. There are lots of ways to
express this loss, but I will offer three charts that will give us some indication of the magnitude of
the loss over a period of 30 years.

Most public pension funds work with some variation of the traditional 60-40 portfolio, that
is to say, 60% in equities and 40% in fixed income. They also target anywhere from 7 to 8.5%
returns from their portfolios over the next 30 years in order to be able to generate the money they
will need to pay retirees. The amount of assets they have today in their accounts is quite small in
comparison to future requirements, and thus they are depending upon the magic of compound
interest in order to be able to deliver the needed pension funds to their clients.

The next three graphs show what happens if interest rates are held near zero for three more
years, six more years, and ten more years. I assume that in the low-interest-rate environment
returns from investment portfolios will be less than 3.5% after expenses and then rise back to the
more typical (but optimistic) 7% level. What we see is that there are significant cumulative return
shortfalls after 30 years because of the initial period of low interest rates, with the shortfalls
ranging from 9% to 28% of the final needed assets, depending on how long ZIRP persists. Those
losses can be made up only by additional contributions from retirees and/or governments or by
some magical increase in expected returns.

Please note that there is nothing critical about the assumptions of 3.5% or 7% – you can
make whatever assumptions you like, but the simple fact is that there will be a cumulative shortfall
in later years as a result of a ZIRP environment in the initial years. Thus pensions will require
more funding by the pensioners at some point, which means that their future consumption will be
reduced. Once again we are borrowing from our future in order to finance ephemeral consumption
today.

2. The creation of a carry trade and MISALLOCATION OF CAPITAL

There is no question in my mind that many of my friends in the hedge fund and investment
world will see an extended zero interest rate policy as a gift horse. If you tell a rational investor
that he or she will be able to borrow money at very low rates for four or five years, then you are
inviting all manner of financial transactions to take advantage of low borrowing rates. If, as an
investor, you can borrow at 3% and get a 6% return, then a modest four times leverage gets you a
12% return on your capital. The financial engineering made possible by guaranteed low rates is
really rather staggering. Whole books could be (and probably are being) written about all the ways
to take advantage of such an environment. But also, the overall return from risk assets will be
reduced as investors look to create carry trades and leverage up.

So the very policy of encouraging investors to move out the risk curve in fact reduces the returns on the risks taken, especially for the average investor who can't take advantage of the financial engineering available to sophisticated investors. Wall Street makes a bundle, and Main Street gets stuck with higher risks and lower returns.

This is simply a trickle-down monetary policy by another name. The Federal Reserve
hopes to inflate wealth assets and thereby encourage the wealthy to spend more, which will
somehow trickle down to the average investor and worker on Main Street. This approach
exacerbates the rich/poor divide even further. This is not a design flaw or an unintended
consequence; it is the very essence of the policy. The fact that significant research shows that the
wealth effect is minimal seems to be lost in the policy debates. This is infuriating beyond my
ability to adequately express my frustration, but it is a clear result of the capture of the Federal
Reserve by academic economists and the implementation of the interesting theory that 12 people
can make better decisions than the market can about the value of money and the proper
environment for investments. This is the philosopher king writ large.

As Dylan Grice wrote so eloquently this week in the Outside the Box I sent you,

From these observations can be derived a straightforward corollary on economic policy
makers: trying to control a variable you can't measure (inflation) with a tool you don't fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren't supposed to happen.

3. What happens when the VELOCITY OF MONEY turns around?

We have no credible idea what drives movement in the velocity of money. As the chart shows below, it topped out in the '90s and has been dropping rather precipitously ever since. Charts that estimate the velocity of money back to the beginning of the 20th century show that we are close to all-time lows. One of the things we do know is that the velocity of money is mean reverting.

It will begin to go back up. The fact that it is been dropping has allowed the Federal Reserve to print money in a rather aggressive fashion without stimulating inflation. When the velocity of money starts back up, inflation could become a problem rather quickly. I have no idea when that might happen or why it would start to happen anytime soon. But one day it will happen. That's just the way of things. Central banks that might be comfortable with 2-3% or even 4% inflation will find themselves dealing with much higher inflation than they had anticipated. Janet Yellen told us she would be capable of raising rates to fight inflation if need be, just as Volcker did. Let's hope she doesn't have to prove it.

4. The misallocation coming from rates being held below the natural rate of interests

I have written on this in the past. When interest rates are held lower than the "natural rate
of interest," it becomes more efficient for companies and investors to use money for financial
transactions such as buying other companies rather than for productive purposes such as increasing
capacity and competing for customers and sales. Why take the risk of competition, which is
fraught with problems, when it is so much cheaper to simply borrow money and buy your
competition? There is a reason that so many industries have effectively ended up as duopolies
since the advent of low rates 12 years ago. While ZIRP makes money for those who have access to
capital and for those who can sell their assets, it does not create new productive capacity and thus
jobs, let alone help to create more efficient markets and pricing.

Psst, Buddy, Would You Like to Buy a Model?

As Jonathan Tepper and I write in Code Red, the Fed has elaborate models of the economy,
which they use to make projections about its performance. Sadly, the Fed's forecasting track record
is very poor. Now, they are giving us models in the papers we reviewed that suggest the proper
direction of monetary policy is toward an extended regime of ZIRP.

Think about that for a minute. We are about to base our monetary policy once again on
models built by a Fed that has repeatedly struck out in the forecasting game and whose models do
not inspire great confidence. Like previous policy approaches, this new one is almost sure to
produce unintended consequences and market disturbances.

The best and the brightest assure us they have the situation under control. How's that
working out with regard to Obamacare?

As investors and money managers, we have no choice but to play the cards we are dealt. Demanding new cards is not an option when you don't own the dealer or make the rules of the
game. There are ways to play even the poorest of hands, but it would be nice not to have to try to
manufacture returns from so little, with the rules of the game thwarting your efforts.

COMPLACENCY - VXV / VIX Ratio Sending A Clear Signal

BofAML Warns "Don't Get Complacent" 11-17-13 BoAML

In the near term, BofAML's Macneil Curry warns "we are growing a bit cautious/nervous, as US equity volatility is flashing a warning sign of market complacency that has often preceded a correction or a pause in trend." This 'red flag' is asterisk'd appropriately in the new normal with "to be clear, the balance of evidence is still very much US equity positive, but the near term downside risks have increased."

Via BofAML's MacNeil Curry,

We are bullish stocks, with the S&P500 targeting 1844 into year end [ZH: which sounds awfully close to an extraplotaed protjection of where the Fed's balance sheet implies year-end target].

However, in the near term, equity volatility warns of complacency and the potential for a correction lower.

Specifically, the VXV/VIX ratio (VXV is the BBG ticker for 3m SP500 Volatility) has reached levels that have often led to a market pause/correction.

While such a pullback would ultimately be corrective, Be Alert!

CURRENCIES - Near Term $ Weakness on Euro & Sterling Strength & Yen Cross Weakness

Dollar Remains Fragile 11-16-13 Marc To Market via ZH

US$ WEAKNESS

The US dollar looks vulnerable to additional losses.  Generally speaking, the technical outlook for the greenback has soured and, in fact, warn of some risk accelerated losses in the period ahead.  Nor can participants count on the economic calendar to stem the dollar's rout.  The US has a slate of economic reports next week as the government catches up with the delay from the shutdown, but nothing to put the tapering back into December.   

EURO STRENGTH

At the same time, while there is some expectation the ECB may do something more in a few weeks, following up on the recent repo rate cut, it is still far too early to expect the ECB to adopt what we have dubbed  as "nuclear options", such as

• A negative deposit rate or
• Quantitative easing.

Since it just

• Adjusted the price of money (theoretically),
• the next step will likely seek to influence the Quantity, perhaps a change in
  • collateral rules or
  • a reduction in reserve requirements.  

The euro's resilience in the face of the repo rate cut is demonstrated by its 1% rise on a trade-weighted basis, which is the key metric of its potential economic impact.  EONIA is essentially unchanged (about half of a basis point lower) since the rate cut (which is one should have expected, as EONIA trades closer to the zero deposit rate than the repo rate).  

The euro has recorded higher lows for six consecutive sessions  It tested the $1.35 in the second half of last week, but did not manage to close about it.  This corresponds to a retracement objective of the nearly 5.5 cent decline  beginning Oct 25. Assuming this level is convincingly breached, we see scope for the euro to rise 1% next week toward $1.3630.   A move below $1.34 would weaken the outlook, but it probably requires a close below the 100-day moving average, which held on this basis, despite some intra-day penetration recently.  It is near $1.3365 now.  

STERLING STRENGTH

Sterling made new highs for the month ahead of the weekend and now seems poised to re-challenge what appeared to have been a double top made in Oct near $1.6260.  Sterling had gone through the neckline (~$1.5890) early in the week, though not on a closing basis and the quickly rebounded, thanks to a favorable employment report and more optimistic BOE.  Its resilience was reflected in the speed at which the market shrugged off the weak retail sales report (-0.7% rather than flat as the consensus expected).  

USDJPY

The dollar did rise to two month highs against the yen and finished the last week with two consecutive closes (of the North American session) above the JPY100 for the first time in four months.  Contrary to the general assertion, it cannot be simply attributed to Fed tapering ideas.   The yen's 1.1% loss against the dollar occurred as the US premium over Japan (10-year interest rate differential) actually fell roughly 9 bp last week, slipping lower in three consecutive sessions before the weekend.  

The key test for the dollar is awaiting closer to the JPY100.60, the September high, which is just below the high from the second half of July set near JPY100.85.  A break of this would bring into view the early July high near JPY101.55, which is the high posted since the decline from the year's high set in May (~JPY03.75) to the early June low (just below JPY94).    Support has been established around JPY99 and it may require a break of that to signal a high is in place.  

YEN WEAKNESS

Yen weakness is more pronounced on the crosses than against the dollar.  Indeed, the yen's weakness appears to be, at least in part, not a dollar story.  It has fallen nearly 2% on a trade-weighted basis so far this month. Sterling is trading a multi-year highs against the yen and euro is testing the year's high.  The New Zealand dollar is testing the JPY84 level that held in both Sept and Oct.  The Canadian dollar is at two-month highs against the yen.   

With the third arrow of Abenomics still apparently a work in progress, any appearance of relying on currency depreciation may face criticism by the US and Europe.  Chinese official silence on the issue is noteworthy.   Perhaps, its refrains from criticizing so as not to encourage criticism of its exchange rate policy, though that doesn't stop the PBOC from time to time of being critical of the US (market determined) exchange rate stance.  

US$ INDEX

Turning to the dollar-bloc, from a technical perspective the US dollar is set to fall further.  The head and shoulders topping pattern we discussed last week proved for naught.  Even though the $0.8200 neckline was violated on Nov 12, there was no follow through selling and the Kiwi rebounded smartly (almost 2%) to vie with the euro as the strongest of the major currencies on the week.  It seems that the rule here, and in sterling, is play the range until convincingly violated.   If applied to the yen, it would seem to warn against playing the break out.  

AUSTRALIAN DOLLAR IN A RANGE BOUND BASING PROCESS

The Australian dollar was largely range bound for most of last week, but this is increasingly looking like a base, rather than a pause before the next leg lower.  The key may be the downtrend line drawn off the Oct 23 high near $0.9760 and Nov 6 high near $0.9545.  It comes in near $0.9400 on Monday, though falls toward $0.9325 by the end of the week.    Technically, a move above $0.9400 could spur another 1.0-1.5 cent advance.  

CANADIAN DOLLAR WEAKENESS

The move above CAD1.05 on Nov14 appeared to have exhausted the USD bulls.  A break now of CAD1.0430 (where a retracement objective and 20 day moving average lay) would confirm a near-term greenback high), and ideally CAD1.04, would suggest a move toward at least the lower end of the 5-month trading range (~CAD1.0250-CAD1.03).  

MEXICAN PESO

The Mexican peso's 1.75% rise last week edged out the South African rand as the strongest of the emerging market currencies.  The US dollar's decline brought it within a spitting distance of the uptrend line drawn off the Sept and mid- and late-Oct lows.  It comes in near MXN12.91 on Monday.  A break may signal another 1% decline in the dollar.  

Observations from the speculative positioning in the CME currency futures:  

1.  As was the case during the last reporting period, the two significant adjustments to speculative position were cut of gross long euro positions (by 17.2k contracts) and the jump in gross short yen positions (23.6k contracts).  Gross long euro positions were cut by 50k contracts over the past two week and as of Nov 12, were the lowest since mid-September (86.1k).   The gross short yen positions have increased by 37k contracts over the same period (to 116.1k).  

2.  The gross long Swiss franc positions have been cut by a third in the past two weeks (to 14.1k contracts).  At  43.9k contracts, the gross long sterling position was the smallest in two months.  The Australian dollar saw the largest jump in gross shorts (8.9k contracts) since May and at 56.3k contracts is the most in two months.  

3.  The net long euro position has been cut by 80% since late October (now stands at 16.8k contracts).  The net short yen position is the largest since May (to 95.1k contracts).