The Bear Caught in the Liquidity Trap – “Why it’s a bear Market of Course!”

September 23, 2011 By Leave a Comment

"Why it's a bear Market of Course!" - Reminiscences of a Stock Operator

Nobody should be puzzled as to whether a market is a bull or a bear market after it fairly starts. The trend is evident to a man who has an open mind and reasonably clear sight, for it is never wise for a speculator to fit his facts to his theories. Such a man will, or ought to, know whether it is a bull or a bear market, and if he knows that he knows whether to buy or to sell. It is therefore at the very inception of the movement that a man needs to know whether to buy or to sell. – Jesse Livermore

I did a couple of interviews for RT today, and during the second one, I had a chance to get into an issue that I don’t feel can be addressed enough. The issue that I raised relates to the ineffectiveness of central bank easing during a balance sheet depression, which we are currently in.

A balance sheet depression or recession is different from normal economic downturns, in that it is marked by particularly high levels of debt. The private sector debt burden is so onerous in such cases, that even at zero percent interest rates, banks are so concerned with paying down their debts and minimizing their liabilities that they stop lending, using all fresh money to pad their balance sheets. Basically, an economy facing a balance sheet depression has a giant black hole in the center of its financial system that sucks what appears, during the capitulation stage of the downturn, to be endless amounts of money and credit into the heart of the singularity.

This is why near zero interest rates, quantitative easing (flat out monetization of debt or money printing) and the creation of special loan facilities have done nothing to bring the economy back to healthy growth. The only thing that these policies have managed to do is prevent any significant write downs and bankruptcies of insolvent banks – the same banks, incidentally, that house the black holes that are destroying any prospects for future growth.

The chart above shows the growth in total credit market debt as a function of GDP since 1922. By early 2009, during the midsts of the financial crisis, total credit market debt in the US was 50% more (at 380% of GDP) than it was at its peak during the Great Depression. This means that although we may not have seen a contraction in GDP analogous to what we saw during the great depression, the potential for that contraction is there given the size of the overall debt burden in the economy. The only question is, how much of this debt needs to be liquidated, because it is the extent of the malinvestment racked up during decades of easy credit that will ultimately determine how bad this depression gets. Likewise, the Fed’s role as sugar daddy for the banking system will determine how many decades we must endure of what the US is now calling “the new normal” of high unemployment and low economic opportunity, as bad debt is slowly written off through central bank money printing.

So, to bring this conversation back to today, I think understanding where we are in this credit cycle is important because it can help explain why we are on the verge of another bank crisis that could accelerate our move into a new recession (if we are not already in one, technically speaking of course). Although the spark this time around seems more and more like it is going to be the banking system in Europe, led by French banks, the root of the problem is the same: massive amounts of debt piled up over many years can no longer be paid back. This debt allowed for a gross misallocation of capital by funding projects above and beyond the scope of profitability, and sustained a global economy full of structural imbalances that have now reached a breaking point imposed by the laws of financial gravity.

It has been my view for some time that the US economy would head back into a deflationary period marked by a renewed destruction of money and credit, and this is why the end of QE2 has not led to a collapsing US bond market as some, including PIMCO, had feared. Instead, 10-year government bond yields have now dropped to well below 2%, a further indication that investors have more faith that an over-indebted US government will protect the value of their money better than an over-leveraged private sector.

During a period of private sector deleveraging, one should expect bull market assets to sell off, and this presents investors with great buying opportunities. Gold represents just such an asset, and although it had one of its larger sell-offs in recent memory today, I still expect the price of gold to decline further during this new round of deleveraging, as investors liquidate assets ahead of further write downs and collateral calls. I have been early on my gold call, having first made it in March of 2011 (though I own gold, not having bought any additional gold during that period means that I missed a 400 point move to the upside), but I still believe that the correction I am waiting for in this market is yet to arrive. As much as I love precious metals and hate paper currency, I understand that transactions are still settled in cash, and you can’t close a contract with bars of gold.

So, I guess what I am saying is, expect more “market turbulence” ahead and keep your eyes open for buying opportunities in bull-market assets as liquidations continue. Anyone who positioned himself/herself in cash prior to this summer can still sit pretty and wait for better deals.

Filed Under: Credit, Debt, Deflation, Federal Reserve, Homepage Gallery, US Treasuries

Paul Krugman on why Gold may not be a Bubble

September 7, 2011 By 7 Comments

Paul Krugman published a funny post on his blog last night called “Treasuries, TIPS, and Gold.” If I had to sum it up in one sentence, I would say that it is a floundering attempt to justify, in an academic and “intellectual” sense, the current bull market in gold. It is replete with nonsense.

First of all, let me just say that people like Paul Krugman, who are obsessed with intellectualizing everything, will never understand gold. The human brain is not the be-all and end-all of human perception, and people who identify themselves with their mental body, and not their spiritual body, will never understand this. I don’t want to get into a philosophical or spiritual conversation here, but the real reason that many academics and other “intellectual-types” get so many things wrong in their lives – including the bull market in precious metals – is that they think that the human brain is adequately equipped to understand reality and explain the forces that drive it. This is why they are great at “explaining” why something has already occurred, but suck at understanding why something is occurring. It is also why they suck at forecasting market trends, because markets are a social science. Social science is art, and if you don’t have a romantic bone in your body, you are never going to understand that.

Having said this, Paul Krugman doesn’t even make a strong intellectual argument in his post, which is the most frustrating part of all. He makes the claim that gold is not rising in price based on inflation expectations, but rather “because expected returns on other investments have fallen.” I happen to agree with him on this point, and it is an argument that I have made many times before, that gold is reacting to concerns over credit risk and property rights in a period of financial system insolvency, bankrupt sovereigns, and a trend towards more authoritarianism in the western world (if you don’t think the post-911 world has not thrown guarantees on individual freedom and property rights into question you are obviously living in another universe). If gold were a hedge against price inflation, then it would have been rising all through the 80′s and 90′s, but it wasn’t. Instead, it made a 20-year low in 1999 after having fallen 70% from its 1980 peak of $850 per ounce. This is a huge loss of purchasing power for anyone having bought gold during this period, and it is one that cannot be ignored.

However, Paul Krugman rejects the inflation story, while embracing the deflation story, using fake statistics and absurd logic. To start with, he claims that real returns on investments are near zero by using inflation-adjusted interest rates on 20-year US treasuries (TIPS) as the prime measuring stick. This is ridiculous. You can’t argue against rising inflation expectations as a rational for holding gold, while at the same time eliminating inflation entirely from the picture by using numbers that exclude inflation. After all, the main argument of prominent inflationists like Peter Schiff, John Williams, and Ron Paul (just to name a few) is that government CPI numbers are bogus, and that the interest rates reflected in things like TIPS (which are adjusted for inflation based on what the government says is inflation) are not a hedge against real inflation, and therefore, offer a negative real return on investment. If inflationists believed that fixed-income securities like TIPS were actually providing positive returns adjusted for real inflation, or that a bankrupt government could be trusted with actually reporting what real price inflation actually is, then they wouldn’t need gold. It’s just a ridicule piece of evidence to use, because it completely ignores the core foundation of the opposition’s argument, and the fact that Paul Krugman is using it here is highly disingenuous to say the least.

Paul Krugman then proceeds to make the argument that, because real returns on investment are near zero, it makes sense for people to hoard gold (since putting their money somewhere else would be pointless) now, during a period of deflation, with the logical expectation that demand for it will rise in the future and therefore push the price upwards. He writes:

Here’s how it works. Imagine that there’s a fixed stock of gold available right now, and that over time this stock gradually disappears into real-world uses like dentistry. (Yes, gold gets mined, and there’s a more or less perpetual demand for gold that just sits there; never mind for now). The rate at which gold disappears into teeth — the flow demand for gold, in tons per year — depends on its real price…people are willing to hold onto an exhaustible resources because they are rewarded with a rising price.

And he then goes on to say:

The logic, if you think about it, is pretty intuitive: with lower interest rates, it makes more sense to hoard gold now and push its actual use further into the future, which means higher prices in the short run and the near future.

So, what Paul Krugman is saying is that, since gold is an exhaustible resource for which demand will always exist (hence, perpetual demand), buying gold now, during a period of deflation, is a rational thing to do, since one would expect the demand for it to rise once the economy picks up again. At that time, according to Paul Krugman’s logic, the rising “actual” or flow demand for gold will not result in rising (or substantially rising) gold prices since prices would have already been bid up to a steady level as a result of hoarding during the deflationary period that we are currently in.

This explanation is worthless. It isn’t wrong and it isn’t right. It isn’t anything. It completely misses the target entirely, because it attempts to explain the rising gold price strictly in terms of supply and demand of gold as an industrial commodity. It neither addresses the arguments of inflationists (who view gold as a hedge against ongoing currency debasement through money printing and higher consumer prices), nor pro-gold deflationists like myself (who view gold as a hedge against credit risk and fear over deterioration of property rights within the context of a large debt overhang that eats up all the newly printed money). It’s a complete red herring of an argument.

There are a few other aspects to this argument that are even more ridiculous, but I’m afraid that if I try and articulate them that I will just end up confusing myself, so I’d rather not attempt it. The major take-away from Krugman’s latest post is that, despite the fact that he has no clue what is going on in the gold market, his evolving position supports a rising gold price. He is warming himself up to the idea of investing in gold, but by the time he and his lemming followers actually start piling in, gold will already be in bubble territory. At that point, mainstream news pundits and economists alike will be parrotting equally ridiculous rationals for why gold is a good investment (or as Paul Krugman states, that there will “always be demand for gold”). When that happens, you will know the top is in, and it will be time to sell your gold to all the suckers who spent the first decade of this soon-to-be multi-decade bull market telling you about how $400, $800, or $1,200 gold is a bubble.

 

Filed Under: Deflation, Economics, Gold, Homepage Gallery

Does the Fed really want banks to lend?

August 30, 2011 By 9 Comments

With the Fed yet to announce a new round of quantitative easing, some economists are starting to offer their own opinion about what else the central bank can do to introduce more money into the American economy and spur growth. One of the proposals I have heard is for the Fed to eliminate its policy, instituted in October of 2008, of paying interest on reserves and excess reserves kept by banks at the Fed.

I believe that anyone advocating for this proposal either does not understand why the Fed is paying interest on reserves to begin with, or believes that there is somehow enough loan demand for profitable investments that the enormous mountain of reserves now sitting with the Fed won’t result in hyperinflation if it were actually drawn down.

Let’s start first with the reason why the Fed is paying interest on reserves, because this is something entirely new and was only instituted in 2008 as a result of the crisis in the credit markets. You will recall at the time that interbank lending had frozen up, as banks were afraid that they may not have enough cash on hand to meet their short-term obligations. There was not only uncertainty about the health of a given bank’s own balance sheet (the value of its own assets and quality of its own loans), but there was also massive uncertainty about the health of other banks’ balance sheets, which is why we heard so much at the time about “counterparty risk.” The demand for money was high relative to the supply (drop in bank lending = drop in supply of money and credit), and so interest rates began to spike, as was seen most prominently in the interbank lending market (the interest rate set by this market is known as LIBOR). This is the core component of what we think of as the money markets, and it was freezing up. A freeze in money markets means that everyone from Fortune 500 companies to small businesses can’t get the money they need to meet their short-term obligations, since so much of today’s business is conducted on credit. And since a failure to meet one’s financial obligations is the definition of insolvency, the chain of events taking place at the time would have resulted in the bankruptcy of an untold number of banks, corporations, and small businesses, and could very well have collapsed the American economy into a state far worse than what we saw after 1929.

So, in response to this freeze in credit markets, central banks around the world (the Federal Reserve playing leader of the pack) needed to find a way to prevent, first and foremost, a collapse of the banking system. During the great depression, approximately 1/3 of all banks went belly-up, and many economists, Ben Bernanke included, contributed this collapse of the banking sector as the prime cause of the depression. It was his intention, therefore, to make sure that the financial system would be propped up at all costs, even if it meant risking hyperinflation at some unforeseen date in the future. I say hyperinflation, because the only way for the Fed to keep the banking system from failing as a result of all the bad loans and onerous debt that it had created over the years was to expand the money supply. It did this using all those “loan-facilities” we have heard so much about, and which were exposed by the most recent Fed audit by the GAO. Since banks would not lend to each other, the Fed decided that it had to pick up the slack, and it did just that, pumping in trillions and trillions of dollars worth of credit into the financial markets in order to keep the system from falling apart.

Most of this money came in the form of loans meant to meet short-term liabilities, but clearly a great deal of the money the Fed has created has simply been used to monetize outstanding debt (Treasuries, GSE paper and certain financial derivatives like the credit default swaps issued by AIG). The monetization is evidenced by the extraordinary rise in the adjusted monetary base since 2008, which is widely regarded as “money.” (in a fiat money world, money is not easily definable, so there are various definitions for money including the widely cited M1). In turn, because banks were afraid to lend money out during the crisis, and because the Federal Reserve incentivized banks to keep an excess amount of money on reserve by paying interest on overnight balances at the Fed, much of this newly created money began to accumulate as excess reserves on the balance sheets of the nation’s largest banks as can be seen here. And of course, with interest from the Fed being the equivalent of risk-free money, excess reserves held at the Fed can only grow the money supply over time, creating inflationary pressures that will eventually have to be released (the mechanism by which such a release could theoretically occur is something that we can speak about another time, but I have my doubts about how effective it will be).

[*Note: I find it interesting and noteworthy that, for the first time to my knowledge at least, the nominal supply of base money in the economy is greater than M1, which actually includes demand deposits. This may very well be the result of the perverse incentives now operating in the marketplace that reward banks for not lending money out, thus preventing base money from turning, through the multiplier effect of fractional reserve lending, into demand deposits. Hence the term "Zombie Banks"]

So, taking into account the fact that we may be headed back into recession (by official standards at least), banks may still be unwilling to lend out the reserves they have on hand, and the Fed unwilling to promote such action, for fear that further write downs on overvalued assets and non-performing loans will force banks to draw down their reserves anyway. The larger-than-required reserves being held by the banking system, therefore, may be all too justified given the continued uncertainty about the health of global balance sheets. However, even if banks were willing to lend the money out, there is good reason that the Fed should be extremely skeptical about allowing for such a prospect, and the reason why is because it could cause run-away inflation or even hyperinflation.

I have talked before, both on this blog, as well as in interviews, about how the money multiplier is broken in the banking system. The money multiplier is just another name for the fractional reverse lending process by which base money is converted into demand deposits. It is the process by which a bank takes X amount of money, and pyramids on top of it fresh loans that show up as deposits in other banks within the system. Here, the bank is functioning with the expectation that, at no given moment in time will the demand for bank capital (basically, depositors withdrawing their money from the bank) outstrip the amount of money that the bank has on reserve. In this sense, any bank engaged in fractional reserve banking is inherently and theoretically bankrupt, but in practice it usually does not have to acknowledge this fact since the amount of money it keeps on reserve is enough to cover its expected short-term obligations. In the even that depositors’ demand for their money exceeds the amount of capital that a bank has on hand, the bank goes from being theoretically bankrupt, to functionally bankrupt. When this occurs, it is usually referred to as a “run on the bank,” but unlike banks in the 1930′s which instructed tellers to slowly count the cash leaving depositors hands from the front as money was being rushed in through the back, today’s banks have been able to rely on a much more powerful, and institutionally rested Federal Reserve System to keep them from sinking into the bankruptcy abyss.

Once you understand how money is pyramided in a fractional reserve system, then you can understand how even a modest increase in base money (or actual money lets say) can quickly expand by at least 10 times that amount through the multiplier effect. Therefore, not only would Bernanke and the Fed have to worry about the inflationary effects of adding an extra 2 trillion or so dollars into circulation by emptying out excess bank reserves (prior to the onset of the financial crisis, excess reserves were roughly $1.5 billion, whereas now they are right around $1.7 trillion!) they would also need to be concerned about the multiplier effect that this money would have on demand deposits in the economy. In essence, the alarming amount of money now sitting in reserve at the nation’s largest banks has the potential, if lent out, to create runaway or hyperinflation. If this were to occur, arresting the process would prove extraordinarily difficult for the Fed, as it would have to raise interest rates dramatically by selling assets from its portfolio in exchange for trillions of dollars in federal reserve notes that it created in the past 3 years. Such an action would collapse the US economy, and this is why I said earlier that I do not believe the Fed will be able to stop inflation if it gets started this time around in the way that the Volker Fed did during the 1980′s. In any case, the rate of interest on deposits would have to go much higher than the 20% reached by Paul Volcker during his inflation fighting, because the potential for the problem today is much greater, so it’s really a practical impossibility. Let’s not even pretend like the Fed could stop the inflation, because it can’t. Sorry.

So, if the Fed can’t afford to allow banks to lend the money that they have accumulated on reserve, then how exactly is “credit supposed to start flowing again?” It isn’t, and that’s the point. The banks, having recklessly inflated the largest credit bubble in history, have now decided that the option that best benefits them is to allow the economy to slowly roast under decades of zero or negative growth as the economy dips in and out of recession and deflation as far as the eye can see. As long as the banks can remain afloat, they will continue to generate risk-free revenue through Fed subsidies of various sorts (the interest paid on reserves is just one form that these subsidies take) as the economy is allowed to collapse all around them. So long as social unrest does not become unmanageable, the cumulative effect of such a policy over time is to grossly accumulate a disproportionate amount of the world’s wealth on the balance sheet of financial institutions with a lifeline to the central banks. Bank executives become the new global landlords, and we rapidly move from what was once a relatively free-market capitalist economy into a neofeudal state where banks and multi-national corporations own the bulk of the world’s assets and charge onerous rents, payment for which is made by issuance of more loans by the largest banks, for the most basic type of accommodations. It will be subsistence farming on a global, technocratic scale, and this is again, why you hear me say that I will alway choose a system reset over what we have today, because the only thing that the current system is leading us towards is global serfdom.

Filed Under: Banks, Ben Bernanke, Credit, Currency, Debt, Deflation, Dollar, Dollar Collapse, Federal Reserve, Homepage Gallery, Hyperinflation, Inflation, Uncategorized

It’s all about the Banks

August 19, 2011 By Leave a Comment

The Banks Family from 'The Fresh Prince of Bel Air'

Many people want to say that 2011 is starting to feel a lot like 2008. I disagree. I think its worse.

2008 came as a shock to many people. No one believed that credit markets could freeze the way they did, and that major financial institutions like AIG and Lehman could fail the way that they did. No one believed that AAA debt could turn illiquid, and that the entire derivatives universe could come crashing down. 2008 was all about disbelief.

After 3 years of living in denial, financial markets are beginning to come to terms with the fact that markets have ceased permanently to function. The only reason we made it around the corner into 2011 is because we have been hooked up to government sponsored lifesupport. Now people are starting to question the lifespan of the respirator…

Think about this for a moment please. After 3 years of close to 10% official unemployment, 0% interest rates, and exploding government deficits, we find ourselves, once again, on the precipice of a renewed contraction in global GDP. How is this possible? I thought central banks could prevent depressions?

If central banks could prevent depressions and save the banking system, then why is the index of five-year bank CDS’s now trading wider than during 2008? Why are three-month interbank lending rates for euros are at their highest levels since 2009? Why have yields on 10-year US treasury bonds dropped below 2% if official inflation is over 3%? Why is gold trading at near 1,900 dollars per ounce? Why is Bank of America laying off 3,500 workers? So many questions…

I believe that the banking system is largely bankrupt. How do I know? Well, let’s take the metaphor of a black hole. You can’t actually ever see a black hole because it doesn’t emit any light, but that doesn’t stop you from being able to detect its presence. The same way that you can detect a black hole in space – by observing its gravitational effects on nearby objects – so too can you detect a black hole in the banking system, by observing its effect on money and credit in the economy. When banks are bankrupt, their desire to lend is reduced and their desire to hoard cash is accelerated. The closer you venture towards the event horizon, the stronger the effect.

Permanent zero (the Fed’s determination to keep interest rates at 0% for at least the next 2 years) is just one of many signs that the banking sector is insolvent. Banks actually borrow money at a lower rate than what they can make by keeping that money at the Fed on deposit. That’s free money. And what about the fact that investors are willing to loan their money to the US government at 2% every year for the next 10 years when official price inflation comes in well above that at 3.6%. And lastly, let’s not forget that the FDIC continues to insure all non-interest bearing deposits, regardless of the balance of the account and the ownership capacity of the funds for at least another 16 months. That’s unlimited coverage. Why, oh why?

Again, the answer to all of these questions is that the banks are bankrupt, and the only thing keeping them, the financial markets, and the rest of the economy alive is government sponsored life support, primarily through special loan facilities, central bank interventions, and fiscal spending up the ying-yang. The markets know this, but they have been willing to play along for the past three years because they figured the government could keep things from falling apart. Well, now it seems that the markets are starting to question the intelligence and resolve of their “public servants,” who are appearing themselves, more bankrupt by the minute. The only difference here is that politicians don’t go broke from lack of financial capital. They go broke from lack of political capital, and as people around the western world begin to catch onto this ponzi scheme of collusion between governments and banks, the ease with which these cleptocrats have been able to perpetuate their fraud is coming under sever constraints.

The only question that remains for me is, what is going to be the spark that is going to start the next bank panic, and what will governments do then?

Filed Under: Bailout, Banks, Deflation, Homepage Gallery

So where are we now?

August 7, 2011 By Leave a Comment

For a while, I concerned myself on this blog with whether or not we would see another round of quantitative easing by the Federal Reserve (in other words, would the Fed continue buying US treasuries in the secondary market to cover the large fiscal deficit). I have found myself diverging from those with whom I usually agree on this matter, and have stated often that the US would only engage in another round of major money printing operations if, and when, it became painfully obvious that we were in a renewed debt deflation similar to what we saw in 2008-2009.

It’s impossible to know how much monetary aggregates (money supply and credit and thus prices) would have to contract in order to convince the Fed that more money printing could be conducted without risk of of runaway inflation, but I tend to believe that the Federal Reserve is going to be playing it much more safe in the coming months than it has been thus far. With nominal interest rates as low as they can go, and concern about the deficit causing political gridlock in Washington, I find it largly inconceivable that the Fed could launch another full round of easing at the present time.

Instead, what I find much more plausible, is that the fall in commodity and equity prices that we saw over the past week will continue (with the necessary countertrend rallies of course) for a bit longer, until the political will returns for the Fed to step “back into the breach” as it were. Only with a renewed downturn in equity markets and a public frightened at the prospects of financial Armageddon will the government have the political cover to print more money. This, and continued weakness in Europe coupled with analogous money printing by the BOJ would suffice to help the Fed hide the effects of more QE on the price of ordinary goods and services, and thus what most people think of as inflation.

So far, I have been proven right, though mistakes have been made along the way. It is true that my own move into cash in March proved timely, as yields have been dropping on T-bils and Treasury notes, but my additional expectations for further dollar strengthening and a more sizable correction in the price of gold and silver have proven either incorrect, or slightly early. Though I expect to see continued weakness in equity and commodity markets (with equities bearing the brunt of the action), my hopes for significant dollar strength (a break of the DXY above 80) coupled with a BTFD move in gold to $1,300 per ounce seem less likely. Instead of the dollar benefiting significantly from the problems in Europe, and the open market operations by the Bank of Japan, it has been gold and the Swiss Franc that seem to have picked up the slack.

The strength of the Franc has been most concerning, because it signifies further willingness by investors to exchange convenience and liquidity for safety and security . The same is true of gold, as those buying gold are clearly more concerned about bank solvency, public sector deficits and property rights violations than they are in remaining liquid ahead of any possible downturn. Though I am a longterm dollar bear and precious metals bull, my expectations for short-term reversals in the trajectory of these two markets have proven overdone. In fact, the close relationship that we saw between falling equity and commodity prices, and the value of the US dollar seems to be increasingly fractured, if not broken entirely. Where the USD once benefited vis-a-vis other currencies during periods of liquidation, it seems that gold and the Swiss Franc have picked up the slack.

The only saving grace for the dollar at this point could be further deterioration in the Eurozone, as the type of political intransigence that we have seen in the US hits the stronger economies of Germany and the Netherlands, as they come to grips with the prospects of an insolvent Italy being priced out of credit markets and having to access a newly expanded EFSF (we are talking trillions of euros in credit backstops). Here too, I have chosen to go against the consensus, expecting that the costs of bailing out ever more European Sovereigns will prove politically infesible for the German government. At the very least, I expect the EU to kick out some of the weaker peripheral economies in order to convince the citizens of the stronger core that there is indeed some level of structure in Europe.

So, where does this leave us? Well, I continue to believe that the driving concern going forward remains a contraction in money supply and credit, and so worries about inflation are bound to take a back seat. However, the strength of the Franc and the resilience of gold make me believe that the USD will benefit less from this contraction than I previously believed. The 800 pound gorilla in the room remains banking sector solvency, and so long as the private sector is burdened by such huge levels of debt, the economy cannot hope to recover. Governments will continue to take on the liabilities of a bankrupt banking system for as long as they can (Federal Reserve loan facilities in the US and SPEs like the EFSF, EFSM, etc. in Europe) as political tensions build up, with violence escalating as a result, especially in the European periphery, making it more and more difficult for politicians and policymakers alike to implement the type of changes that professional economists and media pundits wrongly believe will bring us out of this crisis (more deficit spending in the US and a fiscal consolidation of the Eurozone into a United States of Europe).

Alas, nothing has changed. The debt clogging up the arteries of the global economy has not been allowed to clear, and instead, governments have take up the liabilities of the private sector and the banks by guaranteeing the losses through the public purse. The only solutions to the problem of resource misallocation caused by mounting debt and asymmetrical economic growth proposed so far have been to expand the debt burden, thus further misallocating resources and tipping the economy back into depression. Until policymakers and citizens alike recognize that the only way to return the economy to some sort of sustainable economic growth will involve write downs, liquidations of debt, and bank bankruptcies, we are bound to continue muddling our way through to another lost decade in the West.

Filed Under: Ben Bernanke, Deflation, Federal Reserve, Inflation

Bill Gross taking some heat from Tom Keene

May 26, 2011 By Leave a Comment
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Here is Bill Gross on Bloomberg. He has been taking a lot of heat lately for his short position in treasuries. Meanwhile, the fund manager still expects an end to quantitative easing this summer, and as such, a natural rise in interest rates going forward. Let’s hope he is right.

Filed Under: Deflation, Inflation, US Treasuries

Jim Grant and the Opportunity for Holding Cash

May 23, 2011 By 1 Comment

James Grant of "Grant's Interest Rate Observer"

Jim Grant gave an interview to the Associated Press recently, where he was asked a number of questions about the US economy, the Federal Reserve and of course, inflation.

Because Jim Grant is a smart guy and understands that the Federal Reserve’s policy is to inflate prices, devalue the currency and destroy credibility in the dollar, many misguided people just assume that he expects inflation every day, all the time. This is not true.

Jim Grant knows that prices do not move in only one direction, and like many intelligent students of austrian economics, he recognizes that there are moments, even in a corrupt monetary system that holding cash is preferable to everything else. When holding cash is preferable to spending it, the result is inevitably deflationary.

Deflation can last a day or a week or a month or a year or 10 years. I don’t know how long this next wave of deflation will last, and neither does Mr. Grant, but I can assure you from the multiple interviews that he has given over the past couple of months that he expects a liquidation in asset prices to come at some point in the near future.

That being said, don’t expect the deflation to last too long. I doubt we are even looking at a year. A scenario of sharp price declines over a short time horizon seems quite reasonable.

I will leave you with the relevant excerpt from the AP interview that makes this point:

Q: Where should people put their money now?

A: The trouble with the present is that nothing is actually cheap. My big thought is that our crises are becoming ever closer in time. The recovery time from the Great Depression was 25 years. The stock market peaked in 1929. It got back there in 1954. We had a peak in 2000, crash, levitation, then the biggest debt crisis in anybody’s memory. The cycles are becoming compressed. The temptation to become invested at peaks of these shorter cycles is ever greater.

Perhaps one way to proceed is to hold cash at the opportunity cost of not much in Treasury bills. You make nothing, but you want to have this money when things are absolutely, not just relatively, cheap. This time of full or overvaluation shall pass. On recent form, it’ll pass in a thunderclap and there will be a panic and it’ll seem as if the world’s ending. And that’s when somebody who is nimble can get fully invested in a comfortable way.

It won’t feel comfortable, it will feel awful, but I think that’s the way to do it. I mean everything (you could invest in) is either uninteresting or rich, it seems to me.

Filed Under: Deflation, Inflation

More Evidence of Selling Pressure

May 14, 2011 By Leave a Comment

The Chicago Mercantile Exchange

Will the selling pressure in commodities continue, and when will this spread into equities? Equities are the weakest link in the chain, so you better believe that if commodities are taking a hit, equities are going to tank like the Exon Valdez.

The only reason prices have gotten this high is because of investors’ faith in the central bank liquidity backstop. When this faith comes into question again, as it did in 2008, you will see renewed liquidations.

No amount of money printing can prevent a price collapse caused by panic selling.

From Reuters:

Big hedge funds and speculators cut their bullish bets on commodity markets by $17 billion in the week through Tuesday, the biggest bear turn since at least 2009, regulatory data showed on Friday.

The so-called “managed money” funds cut their overall net long holdings in 22 U.S. futures markets by over 222,000 contracts or 13 percent in the five days ended May 10, according to Reuters calculations based on the Commodity Futures Trading Commission’s weekly Commitment of Traders.

The data, based on both futures and options positions, confirm that some big hedge funds, commodity trading advisors (CTAs) and other major speculators dramatically pared back long positions during a week in which prices abruptly collapsed before staging a modest rebound.

But it also shows that in some markets, such as oil, the story was more complicated.

The one-week cut in holdings was the largest since 2010, when available data begins. Total fund length still stood at its highest since mid-March at 1.5 million contracts.

“I would view this as a bearish situation. We have a confirmed flow of selling with substantial remaining net long positions that can fuel an ongoing flow of that selling,” said Tim Evans, energy analyst at Citi Futures Perspective.

The value of total fund holdings fell to $116.8 billion, less than a third of the total amount of investor capital estimated to be allocated to commodity markets worldwide. Some of that money is in over-the-counter contracts or invested via banks, which are part of a different CFTC group.

Although it is an imperfect gauge, the CFTC data offers the best clues yet as to how traders positioned during the most volatile week in two years.

Crude oil collapsed by $10 on May 5 in a rout that traders are still struggling to explain, taking commodities with them, but then rebounded Monday and Tuesday.

Oil Longs Slash $6.5 Billion  

The biggest decline in the value of net long positions occurred in the crude oil market, where prices dropped by about 6.5 percent. The New York Mercantile Exchange’s U.S. crude oil futures and the IntercontinentalExchange’s look-alike contract saw speculators’ net long position drop by $6.5 billion.

The notional figure is calculated by Reuters based on the change in the net position from a week ago, multiplied by the contract’s value at the end of the period. Because most investors trade commodities on margin, the drop in the value of positions is not directly equivalent to total divestment.

Bullish bets on oil fell to the lowest since late February, when traders were beginning to factor in more geopolitical risk from Middle East instability and war in Libya.

But the drop occurred even as the total open interest — the number of outstanding futures contracts that haven’t been settled — rose to a record, indicating that more traders were opening positions than were closing them during the week.

While bullish speculators sold long positions actively during the week, bearish speculators also added new short  positions, increasing the short interest to the highest since late February.

The “swap dealers” category, generally big  banks, covered some of their large net short position.

Gold, Silver Liquidation

Precious metals also saw heavy selling during the week, although this was more the result of pure long liquidation than traders taking up new short positions.

Long holdings in COMEX gold fell by nearly 20,000 contracts or 10 percent on the week, a reduction equivalent to roughly $3 billion, the biggest drop since last November. Gold futures fell by about 1.5 percent that week.

Net length in COMEX silver, whose deep sell-off from a record high began the previous week, fell by nearly a quarter with funds cutting their bullish holdings by $1.1 billion.

Big hedge funds had actually begun paring positions weeks before prices reached an all-time high of nearly $50 an ounce.

At about 19,000 contracts, speculative net length is at its second-lowest since early 2010.

The Chicago corn saw similar positioning dominated by fund managers taking profits.

Bullish funds cut their length by some $950 million to take positions to their lowest in six weeks, and near the lowest since the middle of last year.

Prices fell by a more modest 1.8 percent.

“They still have a sizable amount and if things don’t go their way, there could be more liquidation to come,” said grains analyst Mark Schultz at Northstar Commodity Investments Co. in Minneapolis.

Filed Under: Commodities, Deflation

PIMCO Adds to its Cash Position – again, what is the outlook for inflation?

May 10, 2011 By 11 Comments

I have devoted a great deal of space on this blog covering PIMCO’s balance sheet. I have only done so because I think that voting with one’s pocketbook, as PIMCO does every day, serves as a far better measuring stick for one’s convictions than just publishing op-eds in the NY Times.

This being said, no one actually knows for sure (except the guys at PIMCO) why Bill Gross and the gang managing the firm’s Total Return Fund (TRF) have liquidated more of their fixed income security positions and added to their treasury put.

According to data released by the firm for the month of April, PIMCO’s flagship TRF added to it’s treasury short position, bringing its exposure to -23% on a Duration Weighted Exposure basis, up from -18% the month before (the position now represents roughly 4% of PIMCO’s assets under management).

But that is just a $3bln increase from last month (total short position is roughly $10bln), and although the fund would need to have a certain amount of cash on hand in order to hedge itself against losses on its short position, the $89.2bln that it has accumulated in cash (or 37% of the total) is too dominant a position to be thought of purely as a bulwark against rising bond prices.

It is conventional wisdom that bond prices move inversely with respect to inflation. When money and credit expands in an economy, all things being equal, the price of bonds will drop as investors demand a higher yield to compensate for a destruction in purchasing power, and supposedly, more economic opportunity in growth sectors like equities and commodities. The opposite is thought to occur during deflation, or otherwise thought of as a contraction in money supply and credit. In this case, economic activity is expected to contract and the value of money is expected to rise, leading investors to shun higher risk assets like equities and commodities and increase their demand for bonds, which would also benefit nominally from the rising purchasing power of their denominated monetary unit.

Well, this may be conventional, but I would hardly call it wisdom, and it leaves no room for nuance. If this thought process were at all indicative of reality, we would have seen sharp price declines in US treasuries and yields on new issues would have completely choked off credit to the economy by now. After all, hasn’t the Fed been printing money like crazy? Haven’t wee seen a 300% increase in the adjusted monetary base since 2008? Are prices not rising across the economy?

Yes, money supply is increasing and inflation is rising, but bond prices and treasury yields do not reflect this. Why? Well, its simple, because the Federal Reserve is spending that money buying up US debt. It’s not like the Fed is printing money and then using all that money to buy corn futures and the shares of General Motors. It is specifically using all this new money to buy Treasuries, so naturally, the price of Treasuries is being kept artificially high by the very inflation that bond holders are supposed to hate. 

I point this out because so many inflationists out there are starring to PIMCO’s $10bln short position in Treasuries and saying “Look! Bill Gross thinks bond prices are going to crash. He must be expecting inflation!”

Wrong. Bill Gross most certainly is expecting bond prices to crash, but this does not mean that he is expecting inflation. In point of fact, if the Fed were to stop buying bonds, as Bill Gross seems to be expecting (thus an end to QE2 and no immediate roll-over into QE3), then treasury yields would have to rise, since they are being kept artificially low by the very bond buying being conducted by the Fed. However, to suggest that this alone means that we are going to get inflation shows a fundamental misunderstanding of what is going on right now in the bond market.

If the Fed were to continue printing money, but simply chose to monetize some other facet of the economy – say it decided to buy equities with QE3 – then bonds would undoubtedly crash and inflation would skyrocket. But the Fed is not going to do this. If the Fed does not engage in another round of quantitative easing, it not only means that it won’t be buying anymore US government debt, but also that it won’t be buying much of anything. This is deflationary.

Therefore, just as we have had inflation during a period of remarkably low bond yields, so too can we have deflation during a period of higher yields and lower bond prices.

Of course, there is also the possibility that an exit by the Fed from the bond market will only temporarily crash the market long enough for the economy to take a giant nose dive and send investors careening into short-term paper, once again giving a boost to Uncle Sam’s adjustable rate mortgage payments. The Chinese may sell into this move however, minimizing any dollar strength.

So, implications of an end to quantitative easing for the broader economy aside, it is simply not true that a rising yield curve translates into inflation. Circumstances must be taken into account, and in this environment, given the realities of Fed money printing and its role in supporting artificially high bond prices, you can expect a contraction in money and credit in the face of rising interest rates.

If you think this sounds nonsensical, then you must explain to me why having falling or stagnant rates in the face of an expansion in money and credit makes more sense.

Filed Under: Deflation, Dollar, Inflation, US Treasuries

Liquidation in Commodities Resumes

May 5, 2011 By 10 Comments

Source: ZeroHedge

Please note the following from ZeroHedge:

The liquidation wave has arrived, as the entire commodities complex, with an emphasis on silver and crude, continues to feel the wrath of a bipolar market which from inflation has suddenly realized that the underlying deflation needs to exhibit itself before the US Central Bank has a justification for more monetization. Elsewhere, the by bar biggest bubble in the world: the dollar short, is blowing up, with the EURUSD on route to post a 300 pip move in a few hours. Basically, the tit for tat repeat of 2010 in this Anno Domini 2011 continues.

I couldn’t have said this better myself…except I already have MANY times. I’m glad the guys at ZeroHedge are reporting it as well.

Just because Bernanke has his hands on the printing press doesn’t mean that we can’t get a liquidation, and although this liquidation will be used as an excuse for QE3 and more money printing, it’s not going to stop the ball from rolling downhill right away.

A rush for liquidity, in conjunction with margin and collateral calls is going to drive prices down across the board before the inflation resumes, and we are going to get buying opportunities in those assets that are in a long-term bull market (see here, here, and here)

This is why PIMCO is 31% in cash, and this is why I have been ringing the deflation alarm bell for months. It is also why I had Peter Schiff and Mike “Mish” Shedlock on my Sound Money radio show recently.

Filed Under: Commodities, Deflation
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