Abe-nomics, Bazookas and Cognitive Dissonance

In modern social psychology, cognitive dissonance is the feeling of discomfort when simultaneously holding two or more conflicting cognitions: ideas, beliefs, values or emotional reactions in your mind at the same time. The theory of cognitive dissonance proposes that people have a motivational drive to reduce dissonance by altering existing cognitions, adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements.

Source: Wikipedia

Following last week’s announcement by Bank of Japan Governor Kuroda that it will “do anything it can” to get Japanese inflation up to 2%, JPMorgan said in a communication that the Japanese, European and U.S. central banks are now in the same camp when it comes to monetary stimulus. The JPM economist who provided that assessment is undoubtedly well-remunerated, being in the regular habit of taking obscurantist developments and putting them in language that his less erudite bosses find comforting, easy to understand and easy to pass on as Gospel to the bank’s clients and investors.

In fact, based on actual statements made recently by these various central banking institutions, it seems that nothing could be further from the truth.

In January, Bloomberg blared the headline “Bernanke Dissatisfied With Growth Will Press on With QE Pace”. The Fed seems to be expecting growth and NOT inflation to be the result of its QE program.

Based in his recent comments ECB Governor Draghi is also focused on pushing a form of QE in the hopes that Euro-Zone Growth can recover to a more stable and higher growth path.

However, in contrast, the BOJ is hoping for inflation, and not growth. The specifics are simply that Governor Kuroda announced plans to double the BOJ’’s monthly bond purchases and achieve 2 per cent annual inflation within the next 2 years. This follows the smaller-sized, though entirely similar, expansionary policy that in the last two years has caused the Yen to fall almost 20 percent against the majors. Only the Venezuelan Bolivar and Malawian Kwacha have fallen by more over the same period.

The reality is that over the last 4 years one of the most enduring fictions promulgated by the authorities and their handmaidens on 19^th Street, is that central bank money printing and central government pump priming will act together to generate self sustaining growth in the economies hit by the Global Financial Crisis. This is an elaborate fantasy on which we have commented before.

There is in fact no amount of funny money and deficit finance that can steer things back onto a sustainable path unless the obstacles to growth and recovery are removed. All of the serious economic research and actual economic history that we have reviewed supports this central truth.

And now we have evidence that the world’s central bankers do not even agree on what it is possible to achieve through QE.

Is it inflation or is it growth??

This is like asking you if the objective of your exercise regimen is to gain more muscle or more fat and you actually believe that you can achieve either by following the same plan.

The real reason for the QE being pursued in the various economies of the G7 and the Euro-Zone is that Government finances in certain key countries are hemorrhaging and that this is interfering with the ability of certain Governments  to even keep up the pretence that financing requirements can be funded in the normal course.

As such the latest BOJ announcement is a sign of weakness and cause for concern rather than renewed hope. The markets which rallied on the news have got it wrong.

Source: The Japan Times

Beyond this, there are additional problems and concerns specific to the just announced Japanese policy update. For example

• Financial Policy. THis latest policy wheeze is nothing more than another salvo in an ongoing currency war. Therefore it is only likely that Japan’s trading partners will pressure the Government there to slacken their efforts to weaken the Yen in order to preserve their own growth prospects. This could lead to international tensions over economic policies;
• Monetary Policy Flexibility. The BOJ has been expanding its QE more aggressively than either the the FED and ECB, burdening its balance sheet with riskier assets and making even the possibility of an exit from this policy nothing more than a wistful fancy;
• Investor and Consumer Behavior. The QE policy distorts price signals; obscures the risk and risk/reward properties of investments; penalizes savers at the expense of borrowers (The Government being the biggest with the biggest interest tab. See above.) and encourages mal-investment;
• Starting Point Risk. This policy does not sufficiently take into account the very serious structural problems in the Japanese economy which have hampered growth and resulted in deflation. These include, most importantly the failure to properly remediate weakness in bank balance sheets, the effects of an aging population, including waning tax receipts; and the fact that Japan already has the largest (and effectively unsustainable) debt load on the face of the planet;
• Re-entry Risk. Monetary Policy implementation is a very uncertain process and the transmission mechanisms and relationships are not stable or predictable in even the medium term. There is no plan, no way to reverse what is being proposed, not in Japan, not in Europe and not in the US. If these policies do act on inflation and money demand drops as the policymakers wish, then it may trigger a self reinforcing bout of price  inflation that (a) will be hard to control; (b) will cause a variety of easily anticipated economic problems, and (c) very likely create new unanticipated problems, stresses and conflicts relating to the policies of competitive devaluation that are being pursued.

Of course we are sure that the policy wonks at the BOJ (and the FED and the ECB) are completely aware of the dangers and problems regarding their policies and of which we write. It is just that they cannot muster the intestinal fortitude, leadership and political will to opt for a solution that does not amount to a combination of bargain basement wallpaper, cheap glue and a snappy sales patter.

Therefore, at this juncture it is of only one thing we can be certain: if there is a limit to “safe money printing” (as if this term is not an oxymoron in and of itself), then the current set of central bank incumbents seem dead-set on finding it.

“…nobody is qualified to wield unlimited power.”

Friedrich von Hayek, The Constitution of Liberty, 1960

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La Ligne Maginot

The Maginot Line, named after the French Minister of War André Maginot, was a military defensive construct consisting of a deep line of concrete fortifications, tank obstacles, artillery casements, machine gun posts, and other defenses, which France constructed along its borders with Germany and Italy, during the interwar period between WWI and WWII.

Military experts extolled the Maginot Line as a work of genius, believing at that time that it rendered France impregnable against invasion from Germany. In the event, while the fortifications successfully acted to dissuade direct attack, they were completely ineffective from a strategic military standpoint. This obvious defect was laid bare at the beginning of WWII when the German Blitzkrieg easily outflanked the Maginot Line by moving through the Ardennes forest and Holland, completely sweeping past the heavily defended fortifications and conquering France in less than six weeks. Although constructed at huge public expense and using the best minds and materials available at the time, the Maginot Line has heretofore become emblematic of any plan or announced remedial strategy that people hope will prove effective but instead fails miserably.

When Lehman Brothers was sent to the knacker’s yard by its street rivals at Goldman Sachs and Morgan Stanley following closed door sessions with Government officials during the summer of 2008, the Best Minds on Wall Street and Constitution Avenue thought that they were protected from the fallout of a mega credit event by their risk management models and counterparty legal arrangements that included margin requirements, collateral postings and mark-to-market protocols. In fact with all major counterparty banks in place and able to continue functioning as market participants, the effect of the mega crash could have been contained, minimized and worked out. Before Dick Fuld and his management team was sent to the proverbial gibbet, the preponderance of derivatives contracts and exotic securities positions could have been settled out in a reasonably orderly fashion over time. However, with Lehman out of the way, the “netting” of derivatives and other exposures between institutions could no longer take place and someone had to step in to buy up the toxic waste that resulted from the abrupt halt to the “pass the hot potato game”. With Lehman out of the loop, the toxic waste had to end up on “someone’s” book.

The consequential effects of the secondary detonations in the securities and derivatives markets in the US following the demise of Lehman unleashed a wave of re-rating of sovereign risk which fell primarily onto the Europeans, who more than a decade ago had abandoned their treaty-bound commitments to fiscal probity and restraint in order to consummate a flawed monetary union riddled with institutional shortcomings and massive governance problems. “Someone” had to prop up Government Finance in the Euro-zone in order to give the pretence that things were still manageable or all of the banks there would have gone down the gurgler.

The “someone with the hot potato” in the US is the Fed which since the event has been mainly concerned with somehow papering over the losses, minimizing them, and possibly inflating them away. In Europe, the “someone” is the ECB which has under the prodding of its client institutions been stretching out the remediation process in order to dragoon the taxpayers of the various Euro-zone countries to shoulder the load of bailing out greedy banks and their profligate government clients.

The story of the Global Financial Crash is far from over. Nothing has been solved; and as we have repeatedly stated in our interactions with the public through speaking engagements, or on TV, or in the press, the policies that have been implemented so far have simply narrowed the degrees of freedom for future policy steps while at the same time increasing the likelihood of negative unexpected consequences being visited on markets (potentially with a heretofore unseen ferocity).

There are therefore still a few more chapters to play out in this unfolding narrative.

The present chapter opened around three weeks ago when, after a sleepy summer where nothing much happened, ECB President Draghi announced that he was going to do “whatever it takes” to save the Euro-zone and support the bond markets of all the deadbeat Euro-countries through central bank purchases of bonds (something that only a year ago had been definitively ruled out). At the time, most pundits fell into line and proclaimed that this “brilliant” move had effectively ended the crisis and all risk assets rallied sharply.

Since then, reality has set in. In fact, Draghi can no more proclaim to have unlimited resources to solve Euro-Crisis that he can claim to be able to solve world hunger. As we have said repeatedly in the past the democratic fact is that voters in the affluent Euro-core are not going to go for what these solutions imply. Moreover as the ECB expands its balance sheet “without limit” the credit quality declines and the risk profile of the ECB shareholders correspondingly increases. The expansion at Europe’s Central Bank is off-set with a deterioration of the national credit quality of the nations so that the entire construct sets itself up for the possibility of being further downgraded. We pointed this obvious flaw in this strategy out on the air around a year ago.

To complicate matters further, most securities analysts have been paring back earnings forecasts and published data has turned rather negative. In fact over 80% of the world’s manufacturing capacity is now in contraction.

On this side of the pond we were treated to Dr Bernanke going “All-in” with his open-ended commitment to print money through QE3 (an event that we have been predicting since QE1 was announced ). Without belaboring all of the issues, we have with Mr Bernanke’s implied claims that he knows better that the markets what interest rates should be and how capital and lending flows need to be directed at a particular point in time; let us just examine a small example of his fatal conceit that we have drawn from the speech he gave yesterday in Indianapolis.

“The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. ……. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending.(Page 7)”

While Dr Bernanke so glibly proclaims that “the securities held by the Fed will mature or will be sold back into the market” as if this operation was some kind of benign voodoo magic with no real-world consequence, we would ask the good Doctor what will happen to the issuing institutions whose securities are “maturing” on the Fed’s books? Won’t these notes have to be re-financed to support asset positions or ongoing activities at the borrowing institution? Who will conveniently show up to buy this re-issued paper in the amounts that the Fed has so done in the past, and, more importantly, at what price?

This is debt management 101.

In deference to the esteemed Fed Chairman, we will only ask one more question that flows from this fantastical description of his policy: If this is the magic bullet, and printing money actually reduces debt painlessly as you so describe, then why have we ever bothered with trying to do things any other way?

Now, after having read his speech yesterday and having managed to regain cognitive equilibrium, we offer on sober reflection that the ECB and Fed policy announcements boil down to acts of desperation that are now, so shortly after being introduced, becoming obvious to the markets. Market participants know that all they have to do is wait for the cracks to appear before pouncing and bleeding the central bank players for significant trading profits.

The bottom line thus is that all Draghi and Bernanke did with their “Big Bazooka” announcements is buy some time, much in the same way that the French Military planners bought some time in constructing the Maginot Line before the German Military planners found a way to beat it. The only question is, “How much time have they bought?” Our expectation is that within a few short months, the ECB and Fed policies will again fail to prove equal to the task. Unfortunately the two biggest central bank players in the world have gone “All-in” on a policy which amounts to an ill-advised high stakes game of poker with the markets. There can be no retreat now.

This is the worst position a gambler can be in because it exposes their strategy to significant event risks and unanticipated outcomes.

The next card that is dealt could in fact blow the hand that they are jointly holding completely out of the water.

Postscript: A little known fact is that the Maginot Line and the Federal Reserve Building in Washington DC were both completed in the same year: 1937, during a period in history when failed financial policies and regional hostilities were driving the world towards catastrophe. In the just two short years following, there ensued an outbreak of general hostilities that led to WWII which brought with it global privation, outbreaks of disease, the directed mass extermination of ethnic groups, the mentally challenged and LGB populations; the first detonation of nuclear devices over heavily populated areas, the forced resettlement of hundreds of millions of people and the death of tens of millions.

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Cognitive Dissonance*

There was a fantastic universal sense that whatever we were doing was right, that we were winning. . . .So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark—that place where the wave finally broke and rolled back.” Hunter S. Thompson, Fear and Loathing in Las Vegas

The Great Bull Market is winding down much in the same fashion as when the World moved past Hunter Thompson’s Go-Go Sixties and slipped into the stagflationary dystopia of the 1970’s. No better bellwether of this phenomenon is given today than the transformation of Facebook (Nasdaq: FB) from IPO darling to abused foster child in the few short days since the shares made their debut. Today with the Nasdaq ending flattish, Facebook moved lower for the second day and its shares are now changing hands at more than 17% below IPO levels despite frantic efforts by the dealer group to hold the line on price.

With the shares trading north of 75 on a P/E basis and earnings proving hard to grow rapidly, the Facebook IPO was probably a major disconnect with financial reality much in the same way that other disconnects are playing out across the globe.

In fact this “Facebook Flop” could be the sign of a major top.

More evidence of a “disconnect” comes from Greece. For example 75% of the population want to keep the Euro; while 75% of the population want to abandon austerity – the condition precedent the previous government bound the country to precisely in order to stay in the Euro. In a similar vein, polls in the Hellenes are still showing that more than half of the population expect a civil war there in the near future.

So, it looks like we will likely be in for some “shooting and looting” before this is over.

In what has now been framed as a debate between the supporters of the Hair Shirt of Austerity , most  notably Frau Merkel and her German countryfolk; against the Growth crowd, championed by Krugman, Obama, and many Euro countries, it is increasingly hard to maintain any confidence in the longevity of the EU in its current form; or for that matter the ability of politicians to chart a stable path to renewed prosperity.

In fact, the probable contagion impact of events that are flowing out of this policy impasse should be feared  because Europe and the US will not achieve a way out of this quagmire through either growth OR austerity, unless and until a key pre-condition for restarting those regional economic engines is met.

This is quite simply that we must have a reckoning and write-down of bad debts. Until now this has been resisted at all costs by banking and investor interests, aided and abetted by the world’s largest central banks and the IMF. Surely, the experience of Japan’s two “Lost Decades”, as an object lesson of what happens when you avoid the reckoning and write-down, should be reason enough to swallow the bitter pill and get on with the task at hand. Nonetheless Europe’s policymakers dither while patching over problems in place of applying durable solutions. What in fact was the Greek Bailout other than a mechanism to buy some time for the creditors? What was the failed effort to get Iceland to swallow its IMF-led bailout, other than a thinly-veiled attempt to hang the costs of bad bond positions on Icelandic taxpayers instead of the offshore banks that had gotten themselves burned? Why is the US Government not addressing the bank solvency problem that it has been obscuring from public view, or its structural deficit problem? Are any of these policies in any way socially sustainable beyond the very short run?

The answer is “No”.

Not surprisingly therefore, it looks like no one has confidence any longer that that the current set of plans will stick. Some are now suggesting a Greek exit (“Grexit”) as a way out coupled with a “firewall” for the rest of Europe to contain the contagion. This is fantastical thinking. In the first instance, the time window for that type of a move has long since closed – as we had repeatedly advised early on in the crisis, the best strategy would have been for the Greeks to have defaulted and negotiated a “soft exit” from the Euro some two years ago. This did not happen in time and now the terms of the Greek Bailout and the much larger size of the Greek liability make a default a very risky prospect for the Greeks, and for Europe. In the second instance the concept of a “firewall” is simply not credible in the current context. The only true “firewall”, to the extent it is possible to implement such a thing is: adherence to sound risk management, non-invasive but effective regulation, and a neutral “Hands-off” government policy posture that sets the stage for stable economic growth, development and trade.

At present, more, not less, European sovereigns are looking shaky, the EFSF/ESM bailout mechanism in Europe is unfunded and unworkable and the ECB is stretched. The recapitalization of Europe’s banks which last summer was being trumpeted to be completed by October 2011 has not progressed at all. In the US the situation is hardly different with many more insolvent banks being allowed to continue in business on the pretence that they are OK; the US economy is in “Nowheresville”, vast swathes of the personal sector suffering under some form of financial duress and the Fed is increasingly looking at a significant diminution in its menu of available policy options.

No one will be sheltered and no economy will properly recover until the rot and ruin of past excesses are carved away such that new shoots of durable economic activity can take root. This will not happen as long as there are zombie borrowers and zombie banks feeding off of the productive parts of the global economy at everyone else’s expense.

* Cognitive dissonance is a discomfort caused by holding conflicting cognitions(e.g., ideas, beliefs, values,, emotional reactions) simultaneously. In a state of dissonance, people may feel surprise, dread, guilt, anger, or embarrassment. The theory of cognitive dissonance in social  psychology proposes that people have a motivational drive to reduce dissonance by altering existing cognitions, adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements.

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The Canary in the Coal Mine – Part I

“Now if I tell you that you suffer from delusions; You pay your analyst to reach the same conclusions; You live your life like a canary in a coalmine; You get so dizzy even walking in a straight line”

Sting and The Police

Monday’s news of the failure of the debt ceiling negotiations in the US ahould not have come as a surprise to anyone who has followed this issue. Disheartening, sad, and ultimately dangerous to our economic well-being and Global Stability, yes, but unexpected, no. Recovery Partners was interviewed on that very topic yesterday and the full interview is avialable here in part 1 and part 2 or you can watch an abridged version on our site.

On Monday  Zerohedge posted a note on Austria, entitled “35 Seconds Of TV Air Time Explaining Why Austria’s AAA Rating Is Doomed“. Most of the discussion focused on the massive Central and Eastern European credit exposure. According to them, massive bank credit losses and a sovereign downgrade is a sure bet as well as the fact that contagion has spread to several Central and Eastern European economies.

Elsewhere on the Continent, the Sovereign obligations of Eurozone countries were getting smoked as spreads against German bonds blew out across the board.  Looking ahead at the heavy borrowing calendars for many of these countries the picture does not look good.

In related news, European stock markets dropped Tuesday after an expensive bond auction for Spain and as data showed that the U.S. economy grew at a slower pace in the third quarter than initially estimated.

Also today, IMF Managing Director Christine Lagarde said in an e-mailed statement to accompany a press release annoucing the creation of a new IMF fast-track liquidity facility. “This is another step toward creating an effective global financial safety net to deal with increased global interconnectedness.”  It is no surprise as these announcements came as Europe’s crisis threatens to spread to Spain and France. The real “non-announcement” here is that this is happening because the Euro-people have yet to implement the Bailout plans agreed to weeks ago in part because the EFSF has become non-functional and incapable of producing needed funding for cash-starved Euro-governments. This despite the recent publicly announced intentions to ramp up the EFSF to between EUR 1 and 2 Trn. How ironic it is that just over a year ago on the establishment of the EFSF, that Olli Rehn, EU commissioner, boasted that the EFSF would “never need to be used”. Now it is obvious that, apart from some half-completed bailouts, it has proven to be of extremely limited effectiveness and can no longer function.

And earlier this morning it was reported by the FT that the Chinese Banking Regulator (the CBRC) announced that the Chinese Property slump exceeded the test limits of the Chinese bank stress tests. In April, the CBRC told banks to test their loan books against a 50 per cent fall in prices, and also a 30 per cent fall in transaction volumes. In October, however, property transactions fell 39 per cent year on year in China’s 15 biggest cities, according to government data. The weaknesses in the Chinese scenarios echo earlier problems with stress testing in the EU, where regulators underestimated the potential impact of a sovereign debt crisis.

Joining the party, the Fed announced new stress tests for the top 19 US banks to take place between now and January and having the results announced by March 2012. There are six large banks that are going to attract particular focus according to the Fed press release and accompanying statements.

Watch this space.

Early Warning Systems and all That

During my time in New Zealand I remember seeing lorry loads and trainloads of sheep, cattle and pigs being packed off  to the slaughter houses and knacker’s yards. Over the time I was in that beautiful country, I observed the behaviours of these animals as the transport vehicles rumbled past and this left me with the indelible impression that these creatures somehow knew that something ominous was afoot….even though they could not read, write or understand a sentence of English, much less the road map.

 This brings to mind the OWS movement which appears to have swept the globe as a phenomemenon that defies definition. The OWS movement seems a jumble of contradictions: it professes respect for the enviroment but its activities have destroyed parkland and befouled inner cities with garbage and human waste; it professes respect and fellowship for citizens of the countries in which it staging its protests, yet it’s activities have significantly interfered with the commercial interests of small businesses and their employees, threatened passersby with violence and has otherwise commanded the attention of our law enforcement authorities to the deriment of others who might actually have benefited more from their attention at a particular time; and yet all along it professes to be able to “see the future” and is therfore justified in attempting to change that “fate” for everyone’s benefit. Moreover, in conversation, not one of the OWS protesters has been able to articulate a coherent vision, objective or group mission that all OWS protesters can agree with.

 The ultimate irony of the OWS “movement” however lies not in the paucity of substance, it lies in the fact that what little substance its demands and prescriptions contain, all seem to feature demands for exactly the wrong thing. This is quite simply that  the common thread among OWS protesters is that they are screaming for : more Government, more state control, more handouts, and generally speaking, for the Government or some other central authority to “solve” their problems. This is precisely the wrong prescription delivered at a time when the reality is that the cause of many of our challenges today is that the modern Welfare State has run out of rope, our political structures have not responded well to recent challenges and, combined with the demographic picture, that there is simply is no more “wealth” to be “spread around”. The choices Western society confronts today all revolve having to make do with less. That is the Bottom Line that the OWS is ignorant of at a fundamental level.

This “movement” in its present state will therefore likely fade away shortly and none too soon. Although the OWS folks sense that “something is wrong” in the world, they, like the animals on the way to the slaughterhouse, cannot articulate what it is they sense and fear, and, because of that and other inherent limitations, they are in no way equipped to devise strategies or action plans to avoid whatever fate awaits them, nor by the same token, to be able profess that they can render such advice to anyone else.

Given the present unsettled state of the world the real issue for clear-thinking people is: “What comes next after these “occupiers” fade into the sunset?”

For more on that, please dial in to Part II of our Canaries Blog series in 24 hours.

Posted in Bond Market, Canada, Crisis, Crminal Activity, EU, Fed Policy, IMF, OWS, Sovereign Debt, USA | No Comments »

The Brazil Trade

Quis custodiet ipsos custodes? (Who guards the guardians?)

Juvenal

It all seems to be coming down to the wire: Slowdwn in the US and Europe, downgrade of economic propects in Canada; Greece on the brink of default and financial contagion feared as a consequence. Since the onset of the Global Financial Crisis (GFC) the markets have repeatedly received asurances from the authorities that the situation was containable and under control and that the policy path set by them was appropriate. Now it seems that these assurances were misplaced. Where did it all go so horribly wrong?

The “Brazil Trade” was a joke scenario that was bandied about on many of the trading desks that I have worked on in years past. Basically the story goes as follows: you pick your trades ahead of a set of economic releases, do them in huge size and with leverage, and then buy a one-way ticket to Rio de Janeiro and go to the airport. Leave one of the traders on the trading desk to watch the screens and the blotter. After the numbers release, you phone your desk from the airport to find out what happened (yes, this storyline involves communications technology that pre-dates the Blackberry, I-Pads, and proliferation of digital news screens). If your positions go onside big time, then you leave the airport go back to the desk in anticipation of a big bonus payout, and life continues as usual. If, alternatively, you blow up, you get on the plane and live off of your previously accumulated pelf in moderate confort on the beach in Rio. (The Nick Leeson / Barings debacle in 1994 was a criminal variant of the Brazil Trade that involved a luxury yacht.)

The bottom line of the Brazil Trade is thus simple: if you win the low probability bet; you win really big and life goes on as before and is even better; if you lose, life as you know it is over because you are now a fugitive living in purgatory.

Any prudent banker or trader knows that you need to blow the bad deals and bad trades out of your portfolio before the next cycle of profit making starts. However, the entire approach to crisis management in North America and Europe over the last three years has been to attempt a short circuit of this process and to foist the impression on the markets and the public that no reckoning or adjustment was or is needed in order for life to go on as before.

And, in implementing this vision of the way out of the crisis, vast amounts of taxpayer dollars have been put at risk.

Now the strategy is starting to fray in earnest. In Europe political support for the bailout strategy is faltering, Germany appears to be positioning for Greek default, while the other peripheral countries slip closer to the edge and major banks’ share prices plummet – short selling ban or no. The resignation in the last few months of two senior ECB officials – Juergen Stark and Axel Weber (note: Weber was the heir-apparent to Trichet over Draghi) – signals deep policy divisions at the Central Bank. For the policy hawks unfortunately, these two resignations represent a victory of the bailout-supportive policy doves and, most likely, a continuation of present ECB policies.

In the US the latest wheeze in the form of the Obama Jobs Plan signals just how far removed from the reality of the markets the policymakers and politicians there are. What of the recent bust up over the debt ceiling and the stated need of the Debt Reduction Super Committee to find $4 Trillion in cuts before the end of 2011? Apparently this does not matter any more – $450 billion will be spent on extending unemployment benefits and other transfers before consideration of the funding mechanism is settled. More fundamentally, in our opinion the whole package boils down to a “potluck” policy grab bag that can only incentivize the unemployed in the US to stay unemployed. If passed by Congress, it will not achieve anything meaningful outside of an increase in the US Federal debt.

Canada is not immune. Not only are our debt levels very high by international standards, the can has been kicked down the road by the authorities here while our economy remains vulnerable to accelerating slowdowns in the US, Europe and China. There should be no question, but that the de-risking of the economy here from exposure to another major credit event must be a policy priority. For the avoidance of doubt we are not advocating more stimulus (in fact the very opposite) but more active risk management of the Zombie situation and more predictable control over government finances at all levels of public administration.

We are in this unfortunate situation because the authorities in North America and Europe never encouraged the markets to make the needed adjustments three years ago. Had they let the markets find a solution and refrained from meddling:

 The eventual price tag would have been lower and much more predictable,
 Inflation risks would be less,
 Unemployment would be lower,
 The number of sovereign, corporate and banking zombies would be MUCH LOWER,
 Sovereign debt burdens would be MUCH LOWER,
 The risks of an uncontrolled debt deflation and credit market collapse would be MUCH LOWER,
 The economies of America and Europe would be recovering.

The rapidly escalating crisis has swept the outcome of last weekend’s G-7 in Marseilles into the dustbin along with the sports pages and classified ads. This week we have more policy and political meetings in Europe; and next week we have the Federal Reserve Open Market Committee in a two day meeting down on L Street. The markets are now saying a Greek default is inevitable, other countries and buisnesses are edging closer to the precipice and yet the policymakers continue to bang the same drums.

Is anyone packed for a long trip?

Posted in Bank Loans, Bankruptcy, Banks, Canada, Crisis, Crminal Activity, EU, Fed Policy, Loan Losses, Sovereign Debt, USA | No Comments »

The Summer of Discontent

 ”The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”

 F A von Hayek, “The Fatal Conceit”

 If Ronald Reagan, Milton Friedman, or even Boris Yeltsin were alive today they would be shell-shocked to witness the transformation of Western countries’ public debate and public policy in the last twenty odd years from a celebration of victory by Free Markets over Communism into an embrace of the Power of the State.

In Europe and the US, governments now own or control banks, car companies, mortgage lenders, property companies and other former private sector enterprises. On both sides of the Atlantic public policy is increasingly reflecting an interventionist, heavy handed meddling by Governments who appear mistrustful of free markets. The folks currently at the center of policy-making in Brussels and Washington also seem to believe that it is possible to legislate results, pass laws to coerce behavior and generally thwart market outcomes as it suits them.

You might think that we are living in the old Soviet Union.

Don’t like the fact that the markets are starting to question the stability of European banks? Contrive a “Stress Test to allay market fears. When that doesn’t work and bank shares continue to get hammered, outlaw short selling and talk tough like you mean it. Simple. Listen to Jean Pierre Jouvet, the head of AMF, the French Financial Markets Regulator,“They wanted to test French resistance. This is our response, as always very determined, and it will be so for all those who want to put us to the test.” We’ll see.

 

Don’t like the fact that a variety of Euro area bonds are selling off in response to justifiable market fears regarding the deterioration in sovereign creditworthiness and hence increased likelihood of sovereign default? Well, then instruct the ECB and EFSF to start buying up these credits with money that is magicked up on a keyboard. Never mind that in doing this, you (the ECB and EFSF), are asking government ciphers to match wits with the likes of Michael Sherwood and his crew at Goldman’s, Bill Gross at PIMCO and Louis Bacon at Moore Capital; and that therefore this doesn’t really stack up as a fight that the apparatchiks can ever hope to win. Never mind that in all of recorded history government schemes to manipulate traded markets have always failed. And that in their wake massive credit and trading losses have accrued to the public purse accompanid by economic upheaval.

In the United States certain politicians (Nancy Pelosi among them),  are telling voters that Unemployment Insurance actually stimulates the economy because people spend their dole checks on goods and services; and that the Food Stamp programs (Over 45,000,000 recipients being served and counting)  are similarly stimulative. In the US it is now impossible for businesses to offer free coffee and donuts to clients; Grandmas can’t make home-baked pies for church socials, and kids can’t operate a lemonade stand without risking a $500 fine, all because of new US Federal regulations and armies of regulatory brownshirts freshly hired to enforce them (employed at salaries that are roughly double what they might earn in the private sector we might add). The new rules, regulations and directives burdening US business number in the thousands. 

The budget management and deficit reduction talks among the twelve member Super Committee will be getting underway shortly South of the Border. The fireworks that we saw connected to the debt ceiling negotiations are just a foretaste of what is to come in this set of “talks”. The real negotiation is over control of the 2012 Presidential and Congressional Elections. Democrats will be looking to recover ground lost by Obama in his botched handling of the debt ceiling debate while Republicans will be looking to drive the knife home and kill off Obama’s re-election chances for good. The stage is thus set for even more of the “political dysfunction” that S&P alluded to in its recent decision to downgrade the US. And the drama will play out agonizingly slowly, but loudly, over the next several months. Not a pretty backdrop either for financial markets or for Main Street.

Through all of this the markets are starting to crumble. Most commentators have raised their forecasts of the probability of a renewed slowdown  to 1 in 3 or 1 in 2. Some, like David Rosenberg of Gluskin Sheff, are saying that slipping into negative growth is a certainty. It is undeniable that economic growth in both Europe and North America is slowing. European economies are all growing at 1% annualized or less. Japan just printed a negative quarterly growth number. The US is limping along with a raft of indicators pointing to a sharp slowdown. In only one dimension this puts at risk the entire EU/ECB strategy of kicking the can down the road and hoping that the PIIGS and other debt-laden Euro-zone countries can grow out of their problems.

It is in this environment that this weekend’s annual meetings of Central Bankers at Jackson Hole Wyoming is taking place. Last year in a decidedly more upbeat environment (recall that the mantra then was that the recovery had arrived) Bernanke hinted at the unveiling of QEII and the markets promptly took off.

With the ECB and Brussels going “All-In” to stem contagion in the Euro-zone, what can Bernanke pull out of his bag of tricks to help boost confidence and get the US economy growing again? The answer is: “Not Much”. There is no more stomach for debt-financed stimulus in the US given the need to at least pay lip service to the objectives of the Super Committee. At the same time the Administration and Congress will continue to clamor for “action” to create jobs and re-start the economy.  This means that there is huge pressure on the Fed to “do something”. And, whatever the Fed “does”, the central banks of the world must fall in line or get steamrollered.

Our view is that the Fed has already recently tipped its hand by announcing the continuation of ZIRP for the next two years. Should the data continue soft as we expect it will, we foresee that Bernanke will at some point in the next few months, also implement another round of QE. Bernanke will likely strongly hint at this in any speeches and announcements coming out of Jackson Hole. No matter that the inflation indicators already exceed policy rates in both the Euro-zone and the US, Bernanke and the Fed are pre-disposed to action, can only take action in one direction, and will do so with a determination that reflects an unshakeable belief in their ability to control the economy. In our opinion they are sadly misguided in this and further, that any possible benefit can come out of the course they have already set.

So, for the period following the meeting of super-bankers,  our  short term prognosis is as follows: Government and Central Bank balance sheets will bloat further, unemployment will stay stubbornly high, economic growth will continue to crawl along at or below stall speed, the EU will continue to try and bail out failing Euro-sovereigns, the ECB and EFSF will continue to gorge on Euro-area debt that nobody wants to own; the Super Committee will serve up a dog’s breakfast; and the Fed will goose things further.

Similar to the fading days of the old Soviet Empire, the pressures for a financial collapse are building. Expect the outcome of the Jackson Hole meetings this weekend to add to, and not to subtract from, those pressures.

Posted in Bond Market, EU, Economy, Fed Policy, USA | No Comments »

Money for Nothing and Checks for Free

“Those whom the gods wish to destroy they first make mad.”   Anonymous Ancient Greek Proverb

Wow, what a crazy week. About everything that could happen did happen, except for the delivery and signing into law of a credible deficit reduction and debt control plan by the American Legislative and Executive Branches.

In the wake of that failure, investors in the US Dow Jones index rewarded President Obama on the marking of his first half century of walking on this planet by shaving 500 points or almost 5 % off of that stock market gauge. By the end of the week global bourses had shed around $2.5 Trillion of value.

The debt ceiling debacle wasn’t the only motivator behind the gloomy sentiment weighing on markets:  renewed fears that the global economy might be entering a double dip were fanned by weak purchasing reports from Germany, flattish consumption-related and employment numbers in North America, and growing doubts about the fiscal sustainability of the debt-laden laggards in Europe, now to include, most notably, Italy.

On Friday the markets looked set for another big dump following weak employment readings announced early in the  day by the US Labor Department. It is unmistakable that some foreknowledge of the reduction in the S&P US long term debt rating that was announced following the market close was given to the US Government. Therefore it is our surmise that the Plunge Protection Team swung into action to prevent another swingeing setback following on the heels of the 500 point plunge the day previous. Thus,  after a wild intraday ride, the Dow closed on a dead cat bounce, up 61.

These events prompted G-7 and G-20 country governments to convene a set of emergency consultations over the course of the weekend to discuss measures to combat the malaise sweeping global markets and to contain any contagion effect from exacerbating conditions further. The price action on several markets so far today does not engender optimism for a placid trading week ahead.

With the apparent exception of the United States and a few people here in Canada (see below) a growing realization that fiscal stresses in Western economies mean that Government spending needs to be cut back, entitlements need to be cut back, and Government generally needs to right size and reconsider its role. The bottom line is that the social safety net has become too expensive and people need to be made more reliant on their own efforts rather than rely on handouts from Governments.

It is in this context that we read an article last week in the Financial Post entitled “Only More immigrants can save Canada’s Economy” . In this piece, the author, who is associated with the New Frontier Institute, contends that in order to “save” Canada’s pension system that we need to allow immigration to reach a million people per year as an urgent  matter of policy.

What claptrap.

 Nowhere in this article is it mentioned that Canada does not have the capacity to admit that many immigrants into the country. In the last five years the amount of annual jobs growth has been well below 200,000 per annum. Where and how are we going to employ these immigrants? What of the strain on our already overstressed medical, educational and public security infrastructures? No mention. Yet the author makes reference to a recent speech by the Minister of Immigration, Jason Kenney that does clearly spell out all of the constraints and considerations involved in setting immigration policy.

Arctic Circle Cartoons 

What of recent studies that demonstrate that Canada’s immigration policies admitting as they do a few hundred thousand folks per year actually cost the public purse significant money? This is given short shrift. Ivory Tower schemes are suggested to hand over immigration policy to the provinces, magically reduce the cost of admitting immigrants and to assume away the host of logistical and social challenges implicit in this proposal, all in the name of ensuring that Canada can “fund the Baby Boom generation’s retirement obligations.”

And what of the political and social implications of such a policy? Namely that, if implemented, within one generation we effectively would be handing over electoral control of our entire country to a demographic that has no long term  relationship to this place. In exchange for what? A pension bailout that benefits a narrow slice of the population, much of which is quite well off without Government help.

The reality is that the pension deficits are real. Most pension funds are insolvent in Canada, and therefore this is a problem that requires urgent attention. The reasons for these deficits are many. Some reasons include faulty design, poor management, venal politicians agreeing to over-rich settlements with public sector unions, bad luck or bad markets, theft, fraud, perverse incentives, or the fact that some plans ail from all or a subset of the foregoing impairments. None of this however means that they should be bailed out. This makes no sense, particularly in the context of what we already know to be the case of the retirees at Nortel, Enron and numerous other companies that failed to provide safeguards for the pension obligations they had to  their retiring employees. The reality is that in any conceivable context, the prudent, economic, legally and morally correct course of action is to write down benefits in order to meet the resources extant within each of these funds and share them out to the retirees. There can and should not be a bailout unless we intend to become the next Argentina or Venezuela.

 No doubt pension reform is a large problem and one fraught with political and economic risks. However throwing away Canada’s entire future to try and paper over mistakes made by the same ”Baby Boomers” that this writing suggests need help is pure madness.

 The New Frontier website lists a number of prominent people as being part of their Advisory Board, among them Ruth Richardson, former Minister of Finance in New Zealand;  and Sir Roger Douglas, the architect of the economic reforms in New Zealand that served as a blueprint for leading the country out of the abyss of subsidies, government interventions and meddling that caused the catastrophic meltdown there in 1984. At the same time, the website is extremely coy about where it receives its funding from, leading us to surmise that it may be acting as a shill for a set of vested interests that want to bias public policy in favor of themselves rather than proposing policies that make long-term sense for Canada as a whole.

I worked under Ruth when I was managing New Zealand’s Sovereign Asset and Liability portfolios in the mid 1990’s and I have met Sir Roger a number of times. The prospect that Ruth or Sir Roger would endorse the policy recommendations as spelled out in the New Frontier article, and in the context of the commentary we provide above and as reflected in Minister Kenney’s recent remarks, is in my opinion a very low probability outcome unless there has been a massive sea change in how they view the role of Government and the constituents of effective policy. If the New Frontier Institute believes that this is not the case, we invite rebuttal, accompanied of course by the math that supports the “million immigrant a year” proposal.

 Who knows what the future might bring? Flush with a majority Government and a five year term in office ahead of him, shamefaced clarion calls for bailouts of their entitlement programs by special interests may be setting up Stephen Harper for his very own “Scargill Moment”.

Posted in Bankruptcy, Canada, Crisis, EU, Fed Policy, Restructuring, Sovereign Debt, Stock Market, USA | No Comments »

Fun With Numbers

“I am concerned about the fact that the recovery that we’re on is not producing jobs as quickly as I want it to happen,”  POTUS Barack Obama

President Obama has recently been chastising Americans for being too pessimistic about the future while at the same time continuing to push his high-spending agenda down the nation’s throat. Continued reliance on PR spin and blaming George W Bush for the country’s ills is no substitute for substantive steps to stem the red ink and deterioration of financial risk profile that his and his various predecessors’  policies have produced. Unfortunately, it is not only Obama, but perhaps the entire US leadership of the two mainline parties that have been ignoring the grim reality of the situation unfolding around them.

It is therefore of no surprise to us that Austan Goolsbee resigned several days ago as Obama’s Chief Economic Advisor in the wake of a slew of troubling economic numbers  (To which we might add, “Mr. President: What “recovery” are you referring to?”)

In this blog we examine some interesting statistics that we came across recently that these folks might do well to reflect on. For example, the unofficial number (based on the 1980’s calculation methodology) for the Misery Index at 25.3%, is now higher than it was under Jimmy Carter (21.8%) . Other statistics show that the US Government is now spending almost all tax revenues on entitlement programs while (ominously) financing the balance of its budgetary obligations by printing money. Paranthetically, no mention is being made by this Administration, or anyone else inside the Beltway, of the lack of Congressional spending authority for the warfighting operations in the Libyan quagmire and the newly disclosed “secret” operations in Yemen.

Here we go:

So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark—that place where the wave finally broke and rolled back.” — Hunter S. Thompson (Fear and Loathing in Las Vegas)

 

Posted in Bankruptcy, EU, Economy, Fed Policy, Hockey, IMF, USA | No Comments »

Disappointment is Sinking In

Last week we were interviewed on the European debt situation a number of times. You can view the interviews on our webpages in the Newsroom section here and here.

As serious as the situation in Europe is, it is merely a distraction from the much bigger debt crisis now unfolding in the United States. Ominously, the latest jobs numbers and other statistics show that the US economy might be rolling over again. Without the boost provided by the 206,000 jobs magicked up by the birth/death hand-adjustment, the May jobs figures would have beeen minus 153,000 workers. Not only are the jobs numbers weak, real wages are shrinking as well, providing scant reason for any optimism that the consumer can support the economy going forward. In fact, retail sales are arguably showing negative growth (as is the real economy) if we were to adjust the nominal numbers using inflation statistics from the MIT Billion Prices Project (running at 7% annulaized in the last 3 months) rather than the deflators normally applied by the Commerce Department.

Moreover, in the last few weeks we have seen data that show hoouse prices falling to new lows, weakness in bank lending and a drop off in consumer sentiment. This and other soft economic numbers is probably why Ben Bernanke in a speech today suggested that monetary policy was likely to remain ultra-loose for some time.

Unsurprisingly, a number of establishment economists such as Paul Krugman are now calling for yet more fiscal and monetary stimulus in order to “create” more growth. What these folks and their many acolytes do not seem to undestand is that there is no shred of data that supports the idea that fiscal stimulus can produce any type of predictable growth response in the economy at all (this is most eloquently argued by our friend Steve Hanke in a recent piece in the FP). Moreover, mainstream economic thinking also ignores the corrosive balance sheet effects of large deficits and monetary experiments that involve neophyte bond traders – Ben Bernanke -  laying down fixed income risk positions that amount to a non-trivial share of US GDP in terms of nominal size. The bottom line is that this situation will contribute to a continuing impasse in the US as regards needed fiscal reform and consequent inertia in reining in an out-of-control deficit picture. Finally, the probability of a QE3 to follow a short time after the conclusion of the current highly experimental QE2 monetary stimulus program has now become almost a certainty – as we have been predicting for some time now.

 Buckle up. The ride is going to get bumpy again

Posted in Bankruptcy, Crisis, EU, Economy, Fed Policy, USA | No Comments »

The Large Print Taketh Away and the Fine Print Giveth

“AAA/A-1+’ Rating On United States of America Affirmed; Outlook Revised To Negative

We have affirmed our ‘AAA/A-1+’ sovereign credit ratings on the United States of America.

The economy of the U.S. is flexible and highly diversified, the country’s effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the U.S. dollar over all other currencies gives the country unique external liquidity.

Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

Nikola G Swann, Standard and Poor’s 18^th April 2011

The “bombshell release” yesterday by Credit Ratings Agency Standard and Poor’s was greeted by most media as a “Wake Up Call”, that a “Government Bubble was targeted” and that the Ratings Agencies “now mean business when dealing with the US Government and its spendthrift ways”.

In reality the announcement yesterday seems to us more of a giant PR wheeze that doesn’t necessarily mean that anything much will change at all. In fact, in our opinion, the intent of the entire exercise is to allow the can to be kicked a little further down the road rather than to initiate substantive action.

For starters, there was nothing in the report that is new information as far as the US fiscal situation is concerned. Nor does the report set out what would constitute grounds for a return to stable ratings status other than some vague language about “deficit cuts greater than $4 Trillion”. This is an obvious soft target for politicians on both sides of the House and Senate to aim for and hit at some pint in the next three years.

Secondly a variety of academic studies have shown that credit ratings have and announcements of ratings changes tend to have almost zero predictive power. Typically these announcements are made after the event and tend to confirm what the market is already reflecting in terms of relative risk. What is surprising here is that the markets have held up as well as they have to this point.

Thirdly, the US Government has been on negative ratings watch before. Fitch put U.S. debt on a “negative ratings watch” in November 1995 until spring 1996, and Moody’s put some U.S. government bonds on review for a possible downgrade in January 1996.

Fourthly, The Chinese for their part laid down the gauntlet in November 2010 when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. We already know that the Chiness have cut back on their Treasury holdings. What this tells us is tha the largest offshore holder of Treasuries thinks that they have already turned into a bad deal, not that they someday might.

Fifthly, having been myself involved in Sovereign Ratings negotiations as a Sovereign Debt Manager I can assure our readers that much of what was announced yesterday and the reaction to it by Treasury and Fed officials was long planned and stage-managed in advance through a cooperative effort between the US Government and the Ratings Agency in question. Typically nothing is left to chance – in this case including the opportunity for Treasury and Fed spokespeople to flood the airwaves AHEAD of the S&P annoncement with their views on US creditworthiness. 

What we also find hugely risible (if were not so deadly serious) is the references the S&P makes to “effective monetary policy” and “unique external liquidity” in the US. The reality is that QE is an untested experiment that has been shown to feature a variety of unanticipated second order effects, some of which are contributing to various asset bubbles and civilian unrest; and that by itself, QE poses a huge re-entry problem for the Fed and US Financial markets (if not a treadmill to financial oblivion). Moreover, US “liquidity” is simply the ability of the Fed to print money at will. What S&P is really doing here is lending its credibility (or what is left of it) to supporting the massive money printing that the Fed has engineered. This policy is attracting huge and unprecedented criticism, even from within the Fed, but we are supposed to beleive that this is “AAA” finacial leadership for the world?

The practical effect of the announcement was thus designed in many ways is to provide positive support (through the imprimatur of the S&P analysts for a continuing AAA rating) for the current financial posture of the US rather than to apply a rational, transparent analytical framework to US finances and come up with a coldly objective assessment of creditworthiness. If the S&P had done the latter, they would undoubtedly have come to the same conclusion as the IMF did almost one year ago when the economists on 19th Street concluded that the US needed a fiscal adjustment on the scale of Ireland or Greece to stabilize matters, rather than some nebulous level of deficit cuts “above $4 Trillion”. Ireland is rated BBB+ (also a wheeze – they are bankrupt) and Greece is rated BB- The latter just auctioned 2 year bonds at yields in excess of 20%.  Note that the US fiscal position has measurably eroded from one year ago as has the economic outlook.

In view of the foregoing one must ask whether the country still rates an “AAA” rating by any conceivable rational and objective yardstick.

Some two weeks ago at a Euromoney Conference here in Toronto, our friend Barry Allan, Founder and President of Marrett Asset Management, summed up his views of Credit Ratings Agencies thusly:

“I don’t understand the reason for the existence of these organisations. In the first place they operate from a privileged position because any borrower who wants a rating needs to pay them to obtain one. This opens up the whole process to significant risk of professional conflict. And then, if the ratings provided are shown to be too sanguine by subsequent developments (and they frequently have been), there is no financial or other sanction assessed against the Ratings Agencies for the misdiagnosis and consequent losses to investors. This does not conform to any other rational business model that I know of.”

Posted in Banks, Bond Market, Crisis, Economy, Fed Policy, IMF, Sovereign Debt, USA | No Comments »