I had a chance to interview former Federal Reserve Vice Chairman Alan Blinder, on Capital Account last week. I started off this interview with some questions about the Greenspan administration, which you don’t actually see in this episode. Rather, this interview starts with a video that I play for the former Vice Chairman of himself speaking at the Woodrow Wilson Institute on the origins of the 2008 financial crisis. I used the clip to inquire about interest rate fixing, and the role of the Fed in setting the price of money. I was surprised that Alan Blinder admitted that the Fed actually doesn’t know what the right interest rate should be, although he did not seem to think that the market could set the interest rate better than a board of economists.
I won’t pretend that I don’t love Jim Grant. I have been reading his Interest Rate Observer for years, and his humor, though highly particularly, is HIGHLY hilarious (though you don’t see it in this video).
Lauren interviewed Mr. Grant on Capital Account for a full segment that can be seen on the show’s youtube channel, but the part that was picked up was a question that I had the opportunity to ask Jim myself regarding interest rates.
Go to the 7:23 mark if you want to see just our show.
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.
So the Fed came out with its long-awaited FOMC announcement today. We got operation twist, as excepted, along with an announcement by the Fed that it will reinvest money that it gets from its agency debt and MBS holdings back into MBS. The Fed Funds Rate will remain at 0-.25 percent, and banks will continue to get paid on reserves they park at the Fed.
…the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative..
…the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction…
…the Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
I said last night that stocks were sure to tank today after the FOMC announcement no matter what the Fed came out with, because no matter what the Fed says or does, markets know deep down that the fundamentals of this economy will not be helped by any new Fed action. Indeed, stocks tanked, including bank stocks, some of which were downgraded earlier in the day.
Although reinvesting interest payments from existing agency debt and agency MBS back into agency MBS, as well as rolling over maturing Treasuries and keeping rates at near zero is pretty straight forward (they are all ways of maintaining or increasing liquidity levels and thus keeping borrowing costs low), what exactly is the logic of “operation twist?” I wish this were a rhetorical question, but it isn’t. I have been struggling to understand what the point of this move is since it was first announced as a possibility earlier this summer.
Just to clarify, operation twist means that the Fed will, instead of expanding the size of its balance sheeting by engaging in more quantitative easing and money printing, simply sell 400 billion dollars worth of fixed income securities (in the form of treasuries that are maturing in 3 years or less) and simultaneously buy 400 billion dollars worth of fixed income securities (in the form of treasuries maturing between 6 and 30 years from now). By expanding the supply of treasuries in the short end of the market, while simultaneously increasing demand for treasuries on the long end, the fed will be twisting or flattening the yield curve, driving down borrowing costs for those looking to lock up their money for the long-term, while driving up borrowing costs for those looking to lend for the short-term. Just more manipulation of interest rates, but this time with an extra dimension of ambition.
So, what exactly is the point here? Banks traditionally make their money by borrowing at a low, short-term rate and lending long at a higher rate. The difference between the rate at which banks borrow money and that at which they lend it out is called “the spread,” and it is where they book a profit. By flattening or inverting the yield curve, the Fed is eliminating this spread, so how exactly are the banks supposed to continue to make money, and how does this incentivize them to lend?
Also, as I have stated previously in my Does the Fed really want Banks to Lend article from August 30th, it is my contention that the Federal Reserve is scared at the prospect of bank lending picking back up. With all the excess reserves that the Fed has allowed to build as a result of its various loan programs and monetization efforts (the Fed has managed to more than triple the base money supply since 2008), the prospect of unfettered bank lending is potentially inflationary. It would also assume that banks don’t need those excess reserves in order to pad their balance sheet ahead of further write downs on under- or non-performing assets. After all, if the Fed were not worried about this, why would it have kept its IOER (interest on excess reserves) policy in place, paying the banks not to lend. That’s a perverse incentive is it not?
Considering where we are at right now, with the economy looking more and more like it won’t be able to keep muddling along without dipping back into official recession, is this all the Fed can muster after 2 days of FOMC meetings? The short answer is yes, which is why you should be positioned for a bear market in equities and further stock market declines.
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.
Came across this post on FT Alphaville, and since we have been on the subject of QE3 and all for oh, a few months now, I thought I would share it with you. I hope you don’t get that sick feeling in your stomach like I do whenever someone utters the phrase “quantitative easing.”:
Tuesday’s FOMC statement drew attention for its commitment to 0 – 0.25 per cent rates until at least mid-2013. This led to the less than sudden realisation that holding (some) stocks was more attractive than nursing the corpse of a 2-year bill. More operation shout than operation twist; the front-end of the yield curve is all but locked down for the forseeable future.
But the other key point in the statement noted by FT Alphaville on Tuesday has also been picked up by Street research houses. It included a new paragraph hinting at some of the Fed’s remaining policy tools:
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.
This has got some analysts, including the Goldman Sachs Global Economics group, hearing echoes of a “promise” made in the final paragraph of the September 2010 FOMC statement, which foreshadowed the introduction of QE2:
The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.
The difference this time around, of course, is the absence of any reference to the Fed being “prepared to provide additional accommodation if needed”. That hasn’t stopped some Street economists from thinking that QE3 is now the central scenario, especially given the Fed also revised down its growth and inflation forecasts. Others are waiting for Ben Bernanke’s speech at Jackon Hole later this month but most anticipate some form of further intervention.
I had said in a previous post today that if the Fed came out and actually offered another round of quantitative easing that the markets would tank because the news would just reaffirm how ineffective they have been thus far, and therefore, how ineffective they will be in the future.
Well, the Fed came out and made a statement alright, but it wasn’t QE3. Instead of presenting a new program with specific open market objectives (basically, with specifics on what the Fed was going to buy and how much they were going to buy – which would have been a sure failure in my view), Ben Bernanke did something far more disconcerting. He offered what, to my knowledge at least, is the first open-ended promise for the continuation of ZIRP (zero interest rate policy) in the Federal Reserve’s history, with the policy promised to last at least through 2013. On top of that, Bernanke said that the Fed is standing ready in preparation to assist the economy and financial markets further, with the appropriate tools, if and when things deteriorate further. Here is an excerpt from an article on the FT covering the story:
“The committee currently anticipates that economic conditions – including low rates of resource utilisation and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” The Fed added that it would “continue to assess the economic outlook” and was prepared to employ its policy tools “as appropriate.”
The market’s initial reaction to this news was for the markets to tank. The Dow erased all of its roughly 250 point gain made throughout the course of the day (243 at its top) and actually went another 206 points in the red: a 450 point swing. The Dow then proceeded to snap back upwards, erasing all the loses and ending the day 606 points off its lows and 430 points above where it closed yesterday. Wow.
I don’t say wow because markets aren’t volatile, and that we haven’t seen things like this before. I say wow rather, because this market was basically told today by the Fed, “if you thought you had a hard time reading the tea leaves before, we are going to make it open-endedly impossible for you to do so in the future.” Basically, the Fed, with its now official, open-ended pledge to do whatever is necessary to keep this market from ever adjusting to the realities of the underlying economy and for prices to adjust to reflect fair values, is extracting what little relationship the markets had left to the underlying fundamentals of the global economy and flushing it down the toilet. Financial expert may be the official nomenclature for those investing or speculating, but the real title should be “policy expert,” because anyone who wants to trade in this market anymore has to be just as much of an expert on the efficacy of monetary and fiscal policy, political turnover, and beltway gossip than he or she has to be on economics or finance.
What was announced today, in my views, is potentially even more damaging to the economy than a new round of bond buying, because it signals an open-ended support that the Fed expects to provide for at least another two years (and probably far more), coupled with the implementation of all sorts of new and creative liquidity programs and open-market operations. Basically, the Fed seems to be saying with this statement that it never plans on allowing the economy to find its own way again, and this is not an exaggerated interpretation. Saying to the market that you plan to keep the cost of capital to zero and plan to intervene further with new easing measures at any further sign of significant weakness says to me that you have no intention on letting markets function, and therefore, you want to move the global economy further into this pyramid scheme of collectivism, and banking and corporate consolidation.
So, although the markets rallied today, perhaps off the belief that the Fed was being somewhat hawkish in not advocating for a third round of quantitative easing (which is how this is being reported on CNBC anyway), as I had imagined it would, they will soon find that nothing has in fact been solved, and that the problem is just being made worse.
I have said it before, and I will say it again, the Fed is out of bullets, and no amount of ZIRP is going to get banks lending again in the face of what is clearly a balance sheet recession with low growth prospects for the future. Without a liquidation of the debt, we are just replacing old debts with new ones, and propping up a failed financial system that rests like a giant parasite on the backs of the people.
It’s never possible to draw a line and say “this is when it all started,” but one can certainly look at the 1960′s in America – the guns and butter deficits that ultimately ended in the breakdown of gold convertibility in 1971 – as a point of departure for sound money and healthy economic growth for the global economy.
Since 1971, the US – the engine of growth for global exports – began running chronically sickening current account deficits. In other words, it began consuming more than it could produce. However, with the aid of the Federal Reserve and other central banks around the world, this alarming imbalance was able to remain in place for what is running now on 40 years.
The current fiat monetary system is designed to self-destruct. It is architected in such a way so as the only outcome is unmitigated disaster caused by disoriented capital flows responding to false market signals. This is why, since going off of the last iteration of the gold standard in 1971, we have had stagflation followed by one debt crisis after another. We had the Latin American debt crisis, the savings and loan, the 1987 stock market crash, the Mexican debacle, the Asian Financial crisis, LTCM, the NASDAQ, the housing refinancing credit bubble, and now, the bubble in sovereign debt, as nations around the world have stepped in for what should hopefully be the last bailout that this system is ever meant to carry out.
And throughout all this time, we were told that we were actually living through “The Great Moderation,” where central banks around the world had come fully in control of the business cycle, smoothing out recessions and making the boom all the more powerful. We had put the fate of humanity in the hands of technocrats, statisticians, economists, policymakers and politicians. Homage was paid to the market but the banking oligopoly called the shots. Now we have finally arrived at a point where, after years of “save me” cries being lobbied out to politicians and central bankers, our patrons have run out of bullets. The credit mechanism is irreparably broken.
Just as QE2 proved less effective than QE1 in papering over the crisis that broke last in 2008, I expect the next round of easing to be even less effective. More importantly, I expect its announcement – whether that announcement is tomorrow, next week, next month or next year – to result in markets actually tanking. Why? Because at this point, any reminder of quantitative easing is bound to recall images of impotence, helplessness and confusion. Markets know that all this money printing has done is add further smoke to a battlefield already littered with mines. Investors have no idea where to put their money anymore, because prices have been so grossly manipulated. This is why gold has broken out above 1,750 an ounce (despite my deepest hopes that we would have seen a buying opportunity correction at 1,300) and this is why any further plans at monetary easing and money printing by the Fed will result in nothing but despair.
In Europe, the situation is a bit different. The Eurozone debt crisis is such that markets could actually rally if leaders there announced some “Grand Bargain” that involved the issuance of a new Eurobond, a European Treasury and a “Marshal Plan” for Europe. That’s not going to happen for political reasons – at least not at the present moment – but its something that could actually instill confidence in the European economy, which still has plenty of industry and productive capacity. This is not to say that I agree with such a solution, because I don’t, but I think that it is novel enough that it could keep things together on the continent for a while longer.
So, given my opinion that any new round of easing by the Fed will be useless, and given my view that the Eurozone debt crisis will have to get much worse before the political will emerges for a “Grand Bargain” (that is still destined to fail, in the end, because it doesn’t address the underlying, structural imbalances of the global economy), my answer to the question posed in the title of this post should be already obviously. Central banks have fire their last bullets at this latest credit bubble collapse, and in my view, no longer have control over the real deflation overtaking the globe.
As Ludwig von Mises has so famously said, and as I have so often been quoting him as saying: “There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”
We are headed towards the later.
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.
Another great analysis from ZeroHedge on the recent drain in treasuries held at custodial accounts at the Federal Reserve:
Treasury securities held in custodial accounts at the Fed, considered by some the best real-time representation of foreign holdings of US Treasurys considering that the TIC update is not only wildly inaccurate in its monthly update, but is also 3 months delayed, dropped by the largest amount in 4 years. From a total of $2.704 trillion, USTs held in custodial accounts declined by $18.7 billion to $2.685 billion. This is the second largest decline in history, only topped by the $22.1 billion in the week of August 15, 2007 which is the week that followed the great quant crash of 2007 that wiped out, among others, Goldman Alpha. This observation is in stark contrast to the recent record strength of bond issuance, after both the 5 and 7 Years auctions posted record Bid to Cover investor interest.
One explanation is that while foreign investors are aggressively buying up the belly of the curve, they are even more aggressively selling the other parts of the curve, namely both the short (sub 2 Year) and the Long (10-30 Year). Another explanation is that the weekly change in Custodial data is largely noise and has no bearing on total foreign holdings of debt, which however we would largely discount. Another question is whether the large outflow from bonds is a consequences to recent market volatility, or is the basis for one: i.e., will the money be used to purchase stocks, or, if as China is posturing, is this merely capital leaving the US and entering Europe. Lastly, the nearly $20 billion in USDs likely will have to be converted to another FX denomination: should any notably USD weakness be observed in the next several days, this could well be a reason.
A chart of total Custodial Treasury holdings:
And old faithful: the neverending weekly “record” Fed balance sheet chart: