Business Conditions, Sentiment, the USD and Gold

File under confirmation bias:

The Philly Fed’s Business Conditions Index is still hanging tough after its most recent update, though it’s still slightly negative relative to historical data.

A point of interest we came across on the Philly Fed’s site is its regional July Business Outlook survey (pdf). The apparent downturn in sentiment in early 2010 appears to coincide with our “strong dollar” call in January 2010, which was based heavily on increasing verbal hawkishness (pdf) from the Obama administration on fiscal matters:

The timing could very well be coincidental, but we think sentiment and fiscal expectations are related at some level, which may be supported by some other interesting features in that graph, from a “sectoral balances” point of view.*  

One is that business sentiment was most buoyant at the time of President Bush and the GOP’s major fiscal easings in 2001 and 2003 (blue circle); the other is the steady downward trend in  sentiment as the Clinton administration’s and Dole-Gingrich GOP’s widely revered budget surpluses were materializing (green line):

Again, this is purely circumstantial evidence, and would require much more analysis to see if anything academic can be made of it. But it does fit nicely with the theoretical frameworks we’re relying on to guide clients through these “interesting times”.

It might also be reassuring that the USD has taken a slight break from its strengthening trend (the red line below is the inverted trade weighted USD index inverted, and the blue line is foreign commercial paper, a measure of foreign credit and business activity in the private sector).

While it’s not at a level that augurs an imminent return to the headiness of 2007 and early 2008, some stability at current levels would be a welcome sign for the world’s credit, goods, and services markets:

There’s also an interesting new bit of evidence that supports our Nov-Jan warnings of a strengthening USD and weakening gold prices. From the FT:

…more than 10 [banks] based in Europe…swapped gold with the Bank for International Settlements in a series of unusual deals that caused confusion in the gold market and left traders scratching their heads…

The Financial Times has learnt that the swaps, which were initiated by the BIS, came as the so-called “central banks’ bank” sought to obtain a return on its huge US dollar-denominated holdings. The BIS asked the commercial banks to pledge a gold swap as guarantee for the dollar deposits they were taking from the Basel-based institution…

Some analysts speculated that the swap deals were a surreptitious bail-out of the European banking system ahead of last week’s publication of stress tests…

…two central bank officials said some of the commercial banks…needed the US dollar funding and were keen to act as a counterparty with the BIS. The gold swaps began in December and surged in January, when the Greek debt crisis erupted and European commercial banks were facing funding problems…

In other words, large banks on the continent were more than willing to swap gold for USDs with the BIS when facing credit strains and stress tests. This is something to keep in mind among all the gold bug chatter — unbacked paper or “fiat” money can become dear, even relative to precious metals. Witness gold’s long term decline against the Yen as Japan’s balance sheet recession and negative turn in age structure unfolded:

 The wrench, as we always try to point out, is the USD’s global reserve status. More dovish monetary policy in the U.S. (which can only be accomplished via renewed “quantitative easing” and its distorting impacts) could very well stoke renewed inflationary pressures abroad, with feedback effects on certain components of U.S. price levels. In fact, the deep decline in Yen per gold ounce might have been driven in part by the absence of Yen carry trade mechanisms. Once those mechanisms were in place and more widely available (circa late 1990s or early 200s?), Yen-gold was freed to the upside.

The fact that the USD is the traditional carry trade currency is a reminder that USD-gold could still have plenty of room to run, and that uncertainty is why we are not placing any bets on gold prices, either to the upside or the downside. But to the extent that any rally is driven by Ponzi-style leverage — which is still quite possible due to the anemic and slow moving nature of some of the reform measures in Dodd-Frank – gold will, like residential real estate before it, eventually come crashing back down to more normal levels.

It may even be near “normal” levels now. The caveat we’re trying to put forth is that if fiscal, trade, or monetary policymakers err on the hawkish side in the next five to ten years, then USDs will be in scarcer supply, and all else equal, that would mean lower prices generally — even for gold.

One last note — preliminary second quarter GDP came in light at 2.4%. This is a steep fall from recent quarters, and it too lends some support to our argument (and others’) that federal stimulus played a significant role in driving and/or supporting private sector activity in 2H09 and early 2010.  That’s why we think that any concerted move towards fiscal tightening in the quarters ahead — whether through tax cut expirations (we’re talking to you, Democrats) or spending cuts (ahem-ahem-ahem, GOP) — will substantially raise the probability of a second recession.

* We note that the New School’s History of Economic Thought (HET) website has yet to publish anything on the recently deceased Wynne Godley, who helped to articulate the intersectoral balances approach. As with age structure, underappreciation implies to us that Godley’s balances framework can be put to an investor’s advantage. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. You should consult with your personal financial advisor before engaging in any investment activity. Any mention of investable companies and/or securities is incidental and for illustrative purposes only.

“Money we don’t have”

Good NYT article on deficit hysteria, with an especially illustrative quote from Rep. Cooper (D, TN):

“We have to stop spending money we don’t have,” said Representative Jim Cooper, a Tennessee Democrat who voted against the bill. “I hope deficit reduction fever is catching.”

The U.S. is in the midst of a balance sheet recession, with demographic ratios shifting an an unfavorable economic direction for several more years.  Under those conditions, deficit reduction fever will lead directly to the dreaded Japanese Disease —  another decade of stagnation, underemployment, and opportunity costs, all of which will impose greater burdens on future generations than expanded federal deficits would.

And policymakers — not to mention most members of the electorate, including analysts and the media — continue to commit two fundamental errors regarding fiscal policy:

1. They believe that all deficit spending must be financed with interest bearing debt, thus competing with the private sector for scarce financial resources.  However, judging by current Treasury rates, there’s still plenty of room for expanded federal borrowing.  And there’s a symbiosis between federal deficits and repair of balance sheets in the financial sector, as evidenced by the perfect quarters turned in by several major investment banks recently.  Politically, that relationship is almost nauseating, as it’s doing very little to relieve distressed households — but it nevertheless makes apparent the  dynamic between public sector fiscal deficits and private sector balance sheet relief.
2. They also believe implicitly that the U.S. is on a gold or similar standard, where fiscal and monetary policies are constrained by the supply of some exogenous factor, and governments can thus literally “run out of money.”  Governments can’t run out of money, as it is ’created’ by nothing more than digital ledger entries.  In other words, government (today, via operations of the quasi-private Fed) is the sole creator and supplier of high powered money.  Thus, the only constraint on money creation is inflation and a loss of confidence in the currency, and at the moment, those forces are emphatically not in play.  This too is symptomatic of Japanese Disease.

The fears of incumbent politicians like Cooper are certainly understandable.  But they’re borne of either ignorance about how these things work, or self-preservation.  Either way, it smacks of lousy political leadership. 

And given that Republicans are likely to benefit in November, we’d expect the trend towards fiscal conservatism to intensify.  Even President Obama, in a speech yesterday, promised the following:

• A three year freeze on all non-discretionary federal spending beginning in 2011
• Expiration of tax cuts via sunset provisions
• Elimination of 120 federal programs
• Reinstatement of PAYGO
• Higher fees on banks that are expected to lower federal deficits by $90B over ten years

He promised all of this as a way to force the public sector to budget in the same way that families and businesses do.  Again, this is wrong, and is borne of either ignorance or pandering.  And as with Congress, it smacks of crummy political leadership either way. 

The administration’s jawboning is also reminiscent of budget austerity measures touted by the Carter administration in the 1970s in reaction to the “tax revolt” — austerity measures that contributed to its eventual demise, even though they may have been more appropriate to the conditions prevailing at the time (e.g., baby boomers entering adulthood, global trade and financial integration, etc).   Today, austerity is far less appropriate, but even more vigorously pursued.  That almost certainly spells trouble for Obama in 2012 – assuming the GOP can field a worthy candidate and avoid blowing all of its political capital in the intervening years. 

You also have to wonder, were he to experience a change of heart, whether there’s any credible way for him to backtrack from his neo-liberal rhetoric.  The DLC, Brookings, Peterson, and all the other usual suspects have painted the guy into one hell of a corner.

In the meantime, assuming that reality will align with rhetoric, the political climate continues to be favorable to the USD and Treasuries, and rather risky to gold.  A contrarian call? You bet.  But it’s based on what we think is a well-grounded and – just as importantly – non-ideological assessment of the facts. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. SCM is an Amazon.com associate, and earns a commission on sales generated through links from our website. Some clients of the firm are long GLL and/or long TLT.  At the time of writing, neither the firm nor its principals owned any securities mentioned. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.nytimes.com/2010/05/29/us/politics/29deficit.html

http://www.japanreview.net/review_bsr.htm

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=2

http://www.investmentnews.com/article/20100602/FREE/100609973

http://seekingalpha.com/article/208174-how-deficit-hawks-will-keep-cutting-spending-until-we-re-all-on-food-stamps

“Follow through” meaning…?

Remarks by US Treasury Secretary Timothy Geithner yesterday that Europe must “follow through” on its support of sovereign debt markets:

Treasury Secretary Timothy Geithner said on Wednesday that he wanted to see Europe “follow through” with its rescue package aimed at stemming the spread of the Greek debt crisis.Geithner, speaking to CNBC Television in an interview, said: “Absolutely Europe has the capacity to manage through this. We just want to see them follow through.”

Could this relate to the ECB’s complete sterilization operations yesterday?

As decided by the Governing Council on 10 May 2010, the ECB will conduct specific operations in order to re-absorb the liquidity injected through the Securities Markets Programme. In this regard, the ECB will carry out a quick tender on 18 May at 11.30 in order to collect one-week fixed-term deposits with settlement day on 19 May. A variable rate tender with a maximum bid rate of 1.00% will be applied and the ECB intends to absorb an amount of EUR 16.5 billion. The latter corresponds to the size of the Securities Market Programme, taking into account transactions with settlement at or before Friday 14 May. The benchmark allotment amount in MROs takes into account the liquidity effect of non standard measures, assuming an unchanged size of the Securities Markets Programme and full sterilisation of this amount via the above mentioned liquidity-absorbing operation. Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem´s credit operations. The ECB intends to carry out another liquidity-absorbing operation next week.

And if so — how in the world did global markets, which had rallied going into the operation, miss that it was coming – given how clearly it had been telegraphed?!?

We suspect that Geithner is speaking code for the obvious — that distressed sovereign debt needs to be monetized, i.e., replaced with new, non-interest bearing debt, commonly referred to as euros. To the extent that it stems a deflationary debt spiral, it will not cause inflation if done effectively and without panic — it will simply stem rapidly unfolding deflationary pressures.

But given the ECB’s stubborn belief that monetization is always and everywhere inflationary and its resulting refusal to do what’s needed in a timely fashion, the risk of a full blown currency crisis continues to rise.  That risk seems to be at work in gold prices.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

URLs:

http://finance.yahoo.com/news/Geithner-urges-Europe-follow-rb-4018525460.html?x=0&sec=topStories&pos=5&asset=&ccode=

http://www.ecb.int/mopo/implement/omo/html/index.en.html

http://www.ecb.int/press/pr/date/2010/html/pr100510.en.html

Astounding assertion from Hassett

Kevin Hassett must have been asleep for the past two decades.

First, in a column yesterday on sovereign debt, he argued (correctly we think) that the current rescue package for Greece is doomed:

The fatal flaw in the plan is that the European nations bailing out Greece — even Germany, where government debt has risen to about 80 percent of gross domestic product — have similar budget problems and even less political will to take similar medicine. Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.

But he starts heading for the deep end (emphasis added):

In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower.

During the financial crisis, faith was restored in large financial institutions because toxic assets were essentially exchanged for government bonds. If government bonds become toxic, there will be no effective treatment options remaining. The collapse will have no bottom.

There are three problems here.

First, to call European governments “hopelessly bankrupt” is to simply recognize that the EMU was designed in such a way as to prevent the ECB from monetizing the debts of member nations. Some relatively simple changes to the EMU framework would prevent EMU member governments (or a supranational fiscal body) from ever becoming ”hopelessly bankrupt.” Such changes might not be high probability, but they are clearly on the minds of European leaders and policymakers.

Second, to say that there are “no effective options remaining” if all of Europe were to face default is bizarre. In a sovereign debt deflation spiral, some level of monetization, either via direct open market purchases of government debt, or unsterilized fiscal expansion, or both, is the patently obvious answer. And his convenient use of ”essentially” in describing the prior chapter in the global financial crisis allows him to leave out a critical step – money creation. And no, Cassandra, in a debt deflation spiral, monetization and fiscal expansion are unlikely to prove inflationary.

Third, to claim that a “collapse will have no bottom” is rhetorical fear mongering, devoid of any conception of natural cycles, including human ones. Every collapse has an end, by definition. In the worst case, the world’s monetary and financial systems collapse, and we end up bartering with our neighbors, friends, and families; in other words, a two century step backwards. Not pretty, but not exactly “bottomless” either. And to believe that the world’s institutions would stand by and let such a thing happen is ridiculously far fetched, better suited to a backyard-bunker novel than a business column.

He then goes off the deep end completely (emphasis added, black only):

While the U.S. has been above the fray so far, an International Monetary Fund working paper published in 2003 suggests it is hardly in safe territory…

The paper, written by economists Paolo Manasse of the University of Bologna along with Nouriel Roubini of New York University and the IMF’s Axel Schimmelpfennig, studied historical sovereign-debt crises, exactly the situations that Western nations are hoping to avoid. They found that external debt levels — money owed to foreigners — exceeding 50 percent was a key indicator that debt default may occur.

Here is the chilling fact: the average external debt as a percent of GDP among countries in their sample the year before a sovereign debt crisis was 54.7 percent, and 71.4 percent in the crisis year. The U.S. external debt on Dec. 31, 2009, was $13.77 trillion, or almost 100 percent of GDP. For much of Europe, the story is worse.

A key force driving external debt higher has been the increase in government borrowing. In its first year, the Obama administration managed to add more than $8 trillion to the expected 2019 debt, now projected to reach $17.5 trillion.

Even the optimistic scenario only delays the inevitable. Along this path, lenders continue to happily purchase government debt in the near term. But even then, the relatively healthy U.S. will look like Greece within a decade.

Our advice? Read the paper before letting Kevin get too far under your skin. The Manasse-Roubini study’s sample was composed of 54 “market access countries”, which means emerging economies with significant access to international capital markets.  Examples include Algeria, Argentina, Bolivia, Brazil, Chile, Costa Rica, Egypt, Indonesia, Jamaica, Jordan, Korea, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, South Africa, Thailand, Turkey, Uruguay, and Venezuela. It was not a study of mature economies with deep and fully developed capital markets and an internationally recognized currency, e.g., the U.S., the U.K., Japan, and western Europe. Chilling??? Come on, Kev…

For Hassett to extend the study’s findings to the U.S. and other developed economies without serious qualification betrays a certain degree of historical ignorance (including Japan, whose recent history he must have slept through), or financial ignorance, which seems unlikely given his credentials, or just good old intellectual dishonesty in the service of political ends. Whichever one is at work, it reflects poorly on him.

He continues:

The only path forward is one in which the major developed nations collectively make long-run budget adjustments designed to soothe market fears before a crisis ensues. Given that the only nation serious about deficit reduction right now is Greece, it seems almost impossible for this story to reach a happy end.

Which markets is he watching, exactly? Credit spreads have been coming under increasing strain as countries have been rolling out their austerity plans. And if being “serious about deficit reduction” is a magic pill, why is Greece’s sovereign debt still the most loathed in the EMU? 

And which nations is he listening to? Spain, Portugal, and Ireland are clearly serious about deficit reduction, and Italy is signalling that it might be; and yet their credit obligations are also relatively unloved by the market. Hassett is clearly missing some part of this dynamic.

And recent flights to safety notwithstanding, the USD and Treasuries have been strengthening as deficit reduction moves towards center stage in U.S. politics. This is eerily similar to how Japanese Government Bonds and the Yen behaved from 1989 — incessantly grinding higher despite repeated warnings like the one Hassett is now making to ”the major developed nations.”

What’s happening in Europe, and to the debt of Greece and the other ‘PIIG’ nations in particular, is being driven by the combination of an undeveloped fiscal structure for the EMU and strict constraints on the ECB’s open market activities. Yes, Greece’s prior government screwed up royally (apparently with some help from our sacred financial sector) and needs to make adjustments and amends to its fellow EMU members. But certain aspects of the crisis are also related to national policies and the EMU’s institutional framework that are depressing total output in much of the EU — in other words, there are amends aplenty to go around. And most importantly, hairshirt economics are not likely to improve the situation.

Hassett concludes:

Our choice is panic now, or panic later.

Clearly, Hassett is choosing panic now. And the last people you want by your side in a crisis — much less making decisions — are the panicky types.

URLs:

http://preview.bloomberg.com/news/2010-05-17/greece-s-bailout-heroes-arrive-in-leaky-boats-commentary-by-kevin-hassett.html

http://www.businessweek.com/news/2010-05-17/eu-faces-trichet-s-quantum-leap-call-as-euro-falls-update2-.html

http://www1.voanews.com/english/news/europe/Greek-PM-Considers-Legal-Action-Against-US-Banks-93885419.html

http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece

He likes it! Hey Nicky!

At the moment, Mr. Market looks pretty satisfied with the EMU’s surprisingly large rescue plan – European stock bourses are up over 5%, France’s CAC40 over 8%, while U.S. equity futures are up over 4%.  Vienna’s ATX and the Madrid General, with their home countries also heavily exposed to troubled sovereign debt (Spain doubly so), are up over 9% and 12% respectively:

Of course, following a week when indices were down 7 to 11%, these kinds of gains still leave markets roughly 3% shy of last week’s highs.

It’s not clear how much of this consists of short covering, and how much reflects renewed belief in fundamentals.  European officials still sound as if they are strongly committed to austerity — perhaps the sizeable rescue package reflects nothing more than a desire to spread the pain to bearish traders as well?

And globally, a handful of analysts have noted that many cyclical asset prices have optimistically decoupled from leading indicators such as Chinese property markets (see this rather cautious piece by former uber bull Ajay Kapur, for example: http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1350&group_id=1&pageNo=1).

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

“An absolute general mobilization” in Euroland

Wow…the EU may, may, have finally put together a mammoth, TARP sized plan to prevent or at least mitigate a 2008-style meltdown on the continent. As described in an article by Ambrose Evans-Pritchard of The Telegraph (UK):

“It is an absolute general mobilization: we have decided to give the eurozone a veritable economic government,” said French president Nicolas Sarkozy, once again basking as Europe’s action man. “Today we have an attack on the whole of the eurozone. This is a systemic crisis: the response must be systemic. When the markets open on Monday morning we will be ready to defend the euro.”

Great caution is in order. German Chancellor Angela Merkel has so far said little. The descriptions of the deal agreed by EU leaders in the early hours of Saturday are coming from the French bloc and EU bureaucrats. How many times during the Greek saga of the last four months have we heard claims from Brussels that turned out to be a distortion of what Germany had actually agreed, causing each relief rally to falter within days? They had better get it right this time.

Perhaps it shouldn’t be surprising that the French bloc is pushing such a description, given their relative exposure to Greece and their immense exposure to Italy:

Image by Bill Marsh/The New York Times

Evans-Pritchard continues, noting what a seminal event this is for the EMU and the euro:

…if the early reports are near true, the accord profoundly alters the character of the European Union…The creation of an EU rescue mechanism with powers to issue bonds with Europe’s AAA rating to help eurozone states in trouble — apparently €60bn, with a separate facility that may be able to lever up to €600bn — is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.No EMU country will be allowed to default, whatever the moral hazard. Mrs Merkel seems to have bowed to extreme pressure as contagion spread to Portugal, Ireland, and — the two clinchers — Spain and Italy. “We have a serious situation, not just in one country but in several,” she said.

The euro’s founding fathers have for now won their strategic bet that monetary union would one day force EU states to create the machinery needed to make it work, or put another way that Germany would go along rather than squander its half-century investment in Europe’s power-war [sic] order.

According to Evans-Pritchard, a key problem with the present accord, beyond German inflation phobia, is that its key components still include severe austerity measures:

The answer to this — if the objective is to save EMU — is for Germany to boost its growth and tolerate higher `relative’ inflation. This would allow the South to close the gap without tipping into a 1930s Fisherite death spiral. Yet Europe will have none of it. The weekend deal demands yet more belt-tightening from the South. Portugal is to shelve its public works projects. Spain has pledged further cuts. As for Germany, it is preparing fiscal tightening to comply with the new balanced budget amendment in its Grundgesetz.

In other words, while Germany may have surrendered significant ground on the matter of closer fiscal integration, it has apparently not given up on its demands for severe austerity measures in other EMU nations. Note that even Sarkozy’s quote closes with the somewhat cryptic statement that “on Monday morning we will be ready to defend the euro.” Does that mean that a stronger euro will be pursued by policymakers, or that stabilization measures will be taken that, in the long run, should ensure the euro’s continued existence? The former would only exacerbate the sense of crisis and panic, so it’s tempting to assume that Sarkozy and other European leaders are committed to the second. However, Evans-Pritchard closes with two disconcerting historical references that should give pause:

While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.

We should see a good deal of dislocation (relocation?) and continuing volatility in markets tomorrow, with credit markets being key ones to watch. If European leaders can manage to soften the austerity demands, quell their inflation paranoia, and execute on a meaningful stabilization program, then things should settle down in reasonably short order.  If they can’t, then keep your seat belts fastened.

Another critical issue is whether the backstop provided by a new facility is large enough relative to the debt levels at the center of the crisis. According to data in a recent Spiegel article, it might be, all told. In 2012, there’s E370B of debt maturing in the PIIGS nations, E328B in 2011, and 276B in 2012. And something that has been completely overlooked in this crisis is that, according to Ajay Kapur’s research, most of the PIIGS countries are on the cusp of favorable turns in demographic composition, at least as it relates to financial sector performance. That certainly adds an interesting wrinkle to the story.

TOH to Zero Hedge for links to the Telegraph and Spiegel articles.

UPDATE 5/9/2010 — The ECB has announced that its bond market operations will be sterilized, which means it intends to offset the creation of new euros resulting from its planned bond market purchases. The net effect is to undo any actual debt monetization. This indicates to us that current plans to ‘protect the euro’ are indeed likely to have a deflationary bias. It will be interesting to see how forex markets react — do they think it can be done (stronger euro), or will they bet on inevitable ECB easing (weaker euro)?  This does nothing to undermine Stephen Lewis’ warning above about “deflationary totemism”.  

URLs:

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/7702335/Europe-prepares-nuclear-response-to-save-monetary-union.html

http://learning.blogs.nytimes.com/2010/05/04/its-all-greek-to-me-understanding-the-debt-crisis-in-europe/

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1

http://www.businessweek.com/news/2010-05-09/ecb-intervenes-in-bond-market-as-part-of-eu-debt-crisis-plan.html 

A brief “Now what?!?”

Equity markets and indices are down over 2% today on worries about what most pundits refer to as the “Greek bailout,” which took its (supposedly) final shape over the weekend, with details to follow from the IMF and other parties. The terms, as currently laid out, are brutal, a fact reflected by the intense street protests in Greece and the government’s loss of union support. The theories and practices underlying them are highly questionable and pitifully anachronistic as well, which make it all the more frustrating.   

There’s no doubt that Greece has made some mistakes, that the lack of accurate fiscal disclosures by its previous government was extremely unethical, and that labor market reforms may be in order. But there are humane ways to approach and work through the entire imbroglio. Unfortunately, neither the IMF nor major eurozone countries seem to be giving that much thought. And as Marshall Auerback has pointed out, Germany’s longstanding inflation paranoia has it behaving as if it’s 1921 all over again; when to us, reality appears to be much closer to the deflationary late 1920s and 1930s.   

We referred to the Greek plan as pitifully anachronistic because it embodies what we might call gold standard era thinking, when the supply of new money was a function of mining output and demand for gold ownership in the private sector. At the turn of the 20th century, economist Knut Wicksell pointed out the need for a “rational monetary system“, while highlighting intellectual obstacles to it:   

It is no exaggeration to say that even to-day many of the most distinguished economists lack any real, logically worked out theory of money, a circumstance which has not, of course, been particularly conducive to the success of modern discussions in this field.   

Wicksell’s sentiments are still relevant today, and (in our view) have been powerfully echoed and expanded upon by proponents of neo-chartalism, also known as Modern Monetary Theory. Bill Mitchell, an occasionally acerbic but ever prolific member of the MMT club, recently posted the following diagram on his website:   

The essential point of the diagram is to illuminate that, under a fiat currency system, the government (whether through its treasury or via a quasi-public central bank) is the sole provider of money. And one of the resulting takeaways of this fact is that under certain conditions, fiscal austerity in the public sector will impose significant costs on the private sector. In turn, that will tend to raise the value of money, all else equal, which is the essence of deflation. And as Wicksell pointed out over a hundred years ago, deflation, like inflation, comes at a cost (emphasis added):   

…when a rise or fall occurs in the money prices of all, or of most, commodities…[a]djustment can no longer proceed through changes in demand or through a movement of factors of production from one branch of production to another. Its progress is much slower, being accomplished under continual difficulties, and it is never complete; so that a residue, either temporary or permanent, of social maladjustment is always left over.   

By linking the inflation boogeyman to public sector debt levels, prevailing economic theory sometimes leads to poor policy prescriptions and outcomes, as we are now seeing in Greece. It also fails utterly to explain the experience of Japan over the last two decades, and it looks set to fail in both the Eurozone and the U.S. in the coming decade.  So far, our contrarian calls for a strengthening USD and a dovish view of long term U.S. Treasury yields has lent support to this thesis.   

As with our recent “What Happened?!?” piece, we also think it’s important to tie the Greek “rescue” package to the current U.S. policy outlook. Today, speaking to the Business Council, President Obama once again invoked our “unsustainable fiscal deficit” and argued for immediate reimplementation of PAYGO. Looked at in terms of Mitchell’s diagram above, that implies that at best, the federal government is unlikely to add to the supply of vertical money.  It’s also important to realize that a concept like PAYGO essentially restricts the vertical money supply function to the central bank. And yet, according to recent testimony from Fed Chairman Bernanke, the Fed is targeting roughly a 50% contraction in its balance sheet, which also implies a contraction in narrow or vertical money supply (though rising velocity could give the Fed some room to work with).  Similarly, it was over tightening in both the fiscal and monetary spheres that led to the 1937 recession after several years of economic recovery.

The upshot of all this is that leaders in the public sectors of both the U.S. and the Eurozone are clearly signalling their intentions to “crowd out” private sector saving and, potentially, income. And unfortunately, electoratal majorities in key countries seem to support this direction. Normally, we expect electoral outcomes to approach optimal, but in this particular case, we suspect that the historic lack of economic and financial education might steer us wrong. Then again, voters with incomes might be making some rational inferences about deficits, austerity, and taxes. If so, the burden of adjustment could rest even more heavily on the on the un- and under- employed (believe it or not, that’s something that a handful of policy pundits have advocated, and that at least one senator briefly pursued).   

Either way, deflation will be the inescapable result of excessive restriction or contraction in vertical money.  We’re currently getting slight whiffs of it from credit markets and price indices (although the latter are still positive); cooling measures in China are also likely to help it along. As noted in our “What Happened?!?” piece, we don’t expect it to manifest in an economic downturn until 2012 or 2013, but it could show up in market prices before that. We’ll be watching commodity markets closely, as a broad decline in those prices would provide an especially powerful confirming signal.  Stay tuned…   

URLs:   

http://www.newdeal20.org/2010/03/30/greece-and-the-eurozone-angie-aint-it-time-to-say-goodbye-9235/   

http://www.newdeal20.org/2010/04/12/the-piigs-problem-maginot-line-economics-9697/   

http://en.wikipedia.org/wiki/Inflation_in_the_Weimar_Republic   

http://en.wikipedia.org/wiki/File:GDP_depression.svg   

http://mises.org/books/interestprices.pdf   

http://bilbo.economicoutlook.net/blog/?p=7864  

http://www.econlib.org/library/Essays/wcksInt1.html   

http://symmetrycapital.net/index.php/blog/2010/04/a-brief-what-happened/ 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

A brief “What happened?!”

It was a tough day in major equity indices yesterday, with the S&P 500 down over 2%.

We don’t think it had much to do with the Senate’s lengthy grilling of Goldman Sachs executives. Rather, it was mostly about the continuing sovereign crisis in Europe, especially Greece and Portgual. We think it might also have been helped along by President Obama’s remarks on deficit reduction earlier in the day, though that’s a much more controversial assertion. 

On top of Germany’s continuing hard line on support for Greece, S & P substantially lowered its ratings yesterday on the sovereign debt of Greece and Portgugal. Such actions lower the price that buyers are willing to pay for their debt in the market place. The resulting price adjustments are often exacerbated by rules governing institutional portfolio holdings and bank capital, as multiple large sellers head for the exits simultaneously. Momentum driven speculators might play a role as well. 

In turn, lower bond prices mean higher bond yields. For example, if a bond with a $100 face value pays an annual coupon of $5, its stated yield is 5%. But if the best price the bond can fetch is $50, then the yield rises to 10%, or $5 divided by $50. The yield to maturity on such a bond is even higher, since the holder eventually receives the $100 face value at maturity. 

This is trouble for Greece because a large slug of its sovereign debt matures this year, meaning that it will have to pay an exorbitantly high price (in terms of interest rates) on its new debt. If those rates are high enough that default or insolvency become inescapable, then current bond holders may not be able to recover the full face value of the bonds they own. There’s been a good deal of talk about debt restructuring, which is basically a process aimed at helping a debtor avoid a worst case outcome while containing the total damage done to creditors.

Importantly, the price adjustments did not just hit Greek and Portuguese debt, but also that of Ireland, Italy, and Spain. It’s more than a little ironic that dithering by the same governments that want banks and nations to shore up their balance sheets is having the exact opposite effect. And if that dithering continues long enough for full blown contagion effects to take hold, then the threat of the euro payments system locking up will become too large to ignore. That’s the very thing that the USD payments system faced in the wake of Lehman’s collapse and AIG’s near collapse in 2008, and which U.S. policymakers took such drastic measures to avert. Could Greece prove to be the eurozone’s Lehman, or at least its Bear Stearns? [Update 4/28/10 - We just noticed that Marshall Auerback asked a similar question on April 12th]

Ironically, Germany’s Angela Merkel has claimed that the primary motive for her country’s intransigence is to preserve the eurozone. And yet the current EMU is essentially what they’ve anted up in the high stakes game they are playing with Greece and other eurozone governments.

While we’re not huge fans of the credit rating agencies, especially given their track records during the mortgage crisis and during the twenty year bull market in Japanese government bonds, yesterday’s announcement might actually have some value when all is said and done, as long as the markets’ severe reactions act as a wake up call to European leaders. The news flow today seems to support that thesis, though only time will tell.

Meanwhile, President Obama’s remarks reminded us that the threat of premature fiscal tightening in the U.S. is still in play. We think that his call to cast a critical eye upon all federal expenditures and carefully address longer term structural deficits is absolutely appropriate (just as we think it’s fair for the German electorate to raise similar questions about Greece). However, we’re concerned that he might be a victim of the same budget surplus fetishism that has gripped many Democrats since the 1990s.

For example, he repeated, as erroneously as ever, that the federal government’s budget is like that of any family. But in fact, the federal government’s budget is more properly thought of as a complement to family and private sector budgets in the U.S. For example, if the private sector desires to increase it savings, the public sector should run larger deficits, all else equal. And if the public sector does not fully accomodate this desire, one likely result is higher private sector leverage (debt). We’re careful to point out that this dynamic is complicated by global effects — but it should still sound familiar to anyone who was awake during the past decade or two.

Amazingly, the same budget fetishists who continue to decry ”crowding out” effects in borrowing ignore those same effects when it comes to saving. 

Until the President and policymakers demonstrate a better grasp of this, our call for long term USD strengthening remains on the table. And if stringent fiscal reforms are accompanied by a Fed tightening cycle, watch out. This isn’t likely to unfold until 2012-2013 (late 2011 at the earliest). However, it’s important to point out that underlying demographic cycles have the potential to make things all the worse, perhaps along the lines of a 1937 redux.  

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, some of the firm’s clients own shares of Alpha Bank (ALBKY), National Bank of Greece (NBG), and Currencyshares Euro Trust (FXE). One of the firm’s principals owns shares of Goldman Sachs (GS). The firm, its clients, and its principals do not hold any positions in Lehman Brothers, AIG, or the debt of any sovereign issuers mentioned.

URLs:

http://preview.bloomberg.com/news/2010-04-27/greece-s-junk-contagion-pressures-eu-to-broaden-bailout-after-market-rout.html

http://www.newdeal20.org/2010/04/12/the-piigs-problem-maginot-line-economics-9697/

http://seekingalpha.com/article/200708-greece-will-have-the-last-laugh

http://www.newdeal20.org/2010/03/30/greece-and-the-eurozone-angie-aint-it-time-to-say-goodbye-9235/

http://www.cnbc.com/id/15840232?video=1478940638&play=1

http://www.whitehouse.gov/omb/blog/10/04/27/Laying-the-Path-to-Fiscal-Responsibility/

Banking regulation: Volcker vs. Basel

There’s additional chatter about financial regulatory reform today due to a luncheon speech that Paul Volcker’s giving on the subject. The debate continues to center around whether more stringent restrictions under the so-called Volcker Rule make sense, or whether capital requirements are a better way to go. The latter approach has some eloquent defenders, and seems to be favored by Asian and European regulators, but they should take heed of this new IMF study:

Using data for over 3,000 banks in 86 countries, we find that neither the overall index of BCP [Basel Core Principles on capital requirements] compliance nor its individual components are robustly associated with bank risk measured by Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z score.

And the band plays on…with each passing day it becomes more doubtful that something constructive will be done before the next financial crisis unfolds.

URLs:

http://www.imf.org/external/pubs/ft/wp/2010/wp1081.pdf

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

Poor auctions signifying…what exactly?

A good deal is being made of subpar Treasury auctions this past week and whether they signify a turning point in the market’s appetite for U.S. government debt. It’s certainly possible, but we suspect that there’s a more nuanced and global explanation.

First off, a 10 year Treasury yielding almost 4% annually does not look like a bad deal given the intermediate growth outlook in the U.S., despite what so many other pundits are saying (unless you believe that we’re on the verge of persistent domestic inflation, i.e., a widespread USD surplus…anyone?).

Second, if Treasury auction participants came to market with only cash and held no other assets, then the prevailing theory would be harder to refute. However, the most important participants in treasury auctions are the New York Fed’s primary dealer banks, which are divisions of BNP, Bank of America, Barclays, Cantor, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies, JP Morgan, Mizuho, Morgan Stanley, Nomura, RBC, RBS, and UBS. These bank divisions and their parents already own large amounts of financial assets. Thus, they also need to manage risk when making purchase commitments. And one of the biggest risks of the past week was whether the Eurozone could agree on an assistance plan for Greece.

The following members of the Fed’s primary dealer banks are also primary dealers for Greek debt: Barclay’s, BNP, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merill Lynch (assumedly this is Bank of America), Morgan Stanley, Nomura, RBS, and UBS. This provides just a glimpse of the overall mosaic, as dealers also act as agents or conduits for public, and not just principals. However, it’s an important one, and it’s reported (and reasonable to assume) that several of them do own large slugs of Greek government debt.

Thus, given the uncertainty surrounding management of Greece’s funding crisis, and how it spiked again this past week as Germany dug in its heels, it’s quite possible that some of the usual buyers of U.S. Treasury debt are simply distracted and/or increasingly risk averse (even using low central bank interest rates to finance the purchase of protective credit default swaps, which probably offered more comfort in the immediate environment than new Treasuries).

 Consider, for example, that French and German banks are believed to be exposed to $119B of Greek debt. Assuming sane leverage ratios of 10x (a dangerous assumption to make), the potential financial loss is equivalent to a significant percentage of the two countries’ annual GDP of $6T (e.g., a 15% decline in the value of Greek bond holdings, if unhedged, would equal roughly 3% of combined French and German GDP).

As tempting as the U.S.-Treasury-on-the-brink hypothesis is for the public debt Cassandras, we think ours does a better job of incorporating the sharp strengthening of the USD over the past week, and market behavior since yet another agreement began to take shape.

Combined with the fact that speculative credit markets are looking awfully frothy, some other strange market signs, and the likelihood of federal fiscal consolidation in 2011, we think you have a recipe for an eventual rally in Treasuries. It reminds us a little bit of the post 9/11 Treasury market selloff. Caveat venditor?

IMPORTANT DISCLOSURES: The author does not own shares of any companies mentioned. Clients of the firm own shares of ALBKY, SHY, TLT, MFG, and NBG. A principal of the firm owns shares of C, GS, and MS. Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

URLs:

http://www.newyorkfed.org/markets/pridealers_current.html

http://www.bankofgreece.gr/Pages/en/Markets/HDAT/DispItem.aspx?Item_ID=3220&List_ID=1af869f3-57fb-4de6-b9ae-bdfd83c66c95

http://www.businessinsider.com/germany-will-have-to-become-greeces-abu-dhabi-since-way-too-many-foreigners-hold-greek-debt-2010-1

http://dealbook.blogs.nytimes.com/2010/02/25/banks-bet-greece-defaults-on-debt-they-helped-hide/

http://online.wsj.com/article/SB10001424052748703798904575069712153415820.html

http://www.bloomberg.com/apps/cbuilder?ticker1=DXY%3AIND

http://www.businessweek.com/news/2010-03-27/bunds-fall-greek-bonds-rise-after-eu-leaders-agree-aid-plan.html

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJZgGddV4mIY

http://ftalphaville.ft.com/blog/2010/03/24/185091/new-negative-territory/