June 2012


With the market selling off currently there are all manner of opinions out there following the extension into QE4.

Technically, currently, the pattern remains bullish. A retest of the last lows is a standard technical pattern. You would buy long [if you didn’t already buy the low] the retest low, which might be a little higher, or lower, than the low of a couple of weeks ago. Technically then you have a pretty low risk [setting stops] entry, that should it fail, exits you from the market without too much damage.

Fundamentally, based on valuations [of any stripe] and macro-economic analysis, you would have to be cautious entering the market here. If you were to, a partial position. I still hold the 50% position entered last September/October, which was entered on a pullback test of the August lows. That position is still in profit. I have done nothing save generate income from selling covered calls/puts on the position. This will add about 10% to the existing dividend yield of circa 3.2%

The point is, if you are investing, the price action today, is pretty irrelevant, it is just noise. Trading noise is the preserve of day-traders and swing traders, don’t get sucked into the wrong time frame: conversely, if you are trading, don’t start trying to justify a position based on macro-economics or valuations, you’ll need something else, technicals, quant, something.

It is always fascinating to see interpretations of facts. Almost a Hume guillotine scenario. So let’s get into it.

Here is the hypothesis that the article will seek to prove.

The FOMC meeting began yesterday and will announce a decision today. As I and NDD have noted, the underlying data of the US economy for the last few months has been weakening. As such, it seems appropriate to think the Fed may act in some capacity, probably with some type of asset purchase program. Some will argue this is not warranted, or, more importantly, that this is going to lead to an inflationary spike. Nothing could be further from the truth, as I explain below.

One of the primary complaints about the Fed’s action of increasing their balance sheet is that the increase in money will lead to inflation. In essence, an increase in the supply of money inherently devalues it (increased supply = lower value).

So simple arithmetic should suffice. If you start with $1. That $1 dollar will purchase 100% of an available supply, adding a second $1 does what? It cannot purchase anything additional, $1 already purchases 100% of available production. You simply have $2. Money per se, is not wealth. Production is. We will gradually move to “valuation.”

However, this theory runs into two problems. First, the money has to get into circulation and then, second, be exchanged. Put another way, if the Fed prints the money and then the banks don’t lend it and consumers don’t spend it, the devaluation of the currency can’t occur. That lack of transmission of the Fed’s policy is exactly what is occurring right now.

But of course the money is getting into the circulation. Government expenditures are higher than their revenues, yet, the government continues to spend. How is that possible? Well the government can create more money, or borrow more money. The Federal Reserve currently monetizes the government debt. Therefore “new money” most certainly is entering the economy.

Of course further examination provides the reasons as to why this tremendous fiscal expansion has not yet resulted in an inflation that is far higher than the current inflation. So let’s look at the aggregate outcomes:

The results are starker within the PPI than CPI. The deflation + current level provide a measure of the distortion in prices created via the money & credit expansion. That is to say the rate of inflation is positive in that it exceeds the rate of asset [money & credit] destruction currently taking place, for example in the residential housing market: it is occurring however throughout the economy.

The three charts show the year over year percentage change in M1, MZM and M2, respectively. All three show that money is flooding the system: M1 is increasing at about a 15% YOY clip, MZM at 8.5% and M2 at about 9.3%; So — why has there been no commensurate increase in inflation?

There are two answers to that. First, the “money printing” is getting stopped at the banks. The Fed is purchasing assets from financial intermediaries and giving them money in return. But lending has been very weak during this expansion.

The charts are simply monetary aggregates. Our chappie simply considers monetary policy. He totally ignores fiscal policy. The banks, largely, are still capital restrained. They still hold impaired assets from previous loan cycles and lax credit standards.

Above is a chart of total loans and leases at commercial banks. Notice that the figure is right at pre-recession heights — and this is after almost two years of quantitative easing. And while we’ve seen an increase over the last few years, it is hardly a strong rise. Let’s look at the chart in logarithmic scale, which further highlights the situation:

Like a terrier, hanging onto the one explanation that explains his hypothesis and provides some empirical evidence. Unfortunately, simply incorrect.

The slope of the curve for the latest expansion (rise/run) is very low. It’s slightly above the level seen after the 1990 recession and the 2000 recession, but below that seen over the last 40 years. Put another way, loans just aren’t being made, meaning the “money printing” is not being transmitted through the financial intermediary system.

And the multi-decade low in velocity tells us that consumers aren’t spending what money is getting into the economy, but instead hoarding cash:

We now come to “Velocity” of money. I will reproduce this chart.

First, a definition of velocity: simply the number of times that money exchanges against goods and services. So as the chart depicts, individuals are in point of fact “holding” higher cash balances.

This “holding” is a valuation. The valuation on an ordinal, diminishing marginal utility scale, raises the value of holding cash, higher than the goods or services that could be exchanged for it. This higher valuation of money definitely offsets the loss of value that an inflation creates. Thus, the dilution of the money supply via inflation is offset to the current rate of inflation by the continued asset [value] destruction, and credit contraction, and the increased value of holding higher cash balances.

The velocity of M1 (top chart), MZM (middle chart) and M2 (bottom chart) all show that the speed at which money moves through the economy is at or near multi-decade lows.

True. See above.

Let’s put these two pieces of data together. First, while the Fed is technically flooding the system with money, this is not leading to inflation as there has been no respective increase in lending. As such, inflation cannot be transmitted into the system. And what money is getting into the system is being hoarded by consumers rather than being spent.

But there has:

Government debt has exploded higher. The debt is simply in a different sector.

So, the complaints that “money printing will lead to inflation and devaluation of the dollar (read: Ron Paul acolytes) are unfounded.

Well your argument does not come within a country mile of proving your hypothesis.

The Federal Reserve monetary policy announcement is out.

Rather than go on with full on QE3 (more bond buying), the Federal Reserve is extending what’s known as “Operation Twist” which means that the Fed will buy long dated Treasuries and finance that with sales of short-dated government bonds.

“You have enemies? Good. That means you’ve stood up for something, sometime in your life.” -Winston Churchill

People, though, soon realised that one of the key things which was driving the dollar rush in the first place was the number of foreign dollar-denominated liabilities outstanding. With the number of eurodollars (those dollars that circulate outside of the US) ultimately capped, pressure on the dollar exchange rate began to show as investors grappled to raise dollar funding to meet margin calls on depreciating dollar-denominated assets.

Currently US Treasury rates are at all-time lows. These rates are due to Federal Reserve interest rate suppression and money credit creation. Assuming that at some point Bernanke decides that his inflationary policy has run far enough, and the Federal Reserve ends the easy money credit creation, then, obviously, market interest rates will rise.

In the context of the initial quote, the holders of Treasury paper, amongst other US assets, like stocks, will see nominal values fall. Higher rates means lower nominal prices for Bonds, and rising rates, at some point, creates a demand for Treasury paper, and a selling of stocks to rotate into Treasury paper, particularly from Pension Funds and Insurance companies that look to match assets/liabilities.

Any shortage of US dollars, driven by these asset re-allocations, will, drive demand for the US Dollar higher, potentially igniting a dollar bull market, which might see a sell-off in Gold and Silver.

Rising rates, will be a trigger to sell, thus reinforcing the rise in rates from any leveraged traders, and as the following chart suggests, there are a few of them out there. The question is how high will rates need to go before the Pension Funds etc start to switch from equities or other assets into Treasury paper based on attractive yields. With a falling stockmarket, where will a bottom eventually be found, which will likely trigger the starting point of another secular bull market.

This puzzle was cracked by Bianco Research who pointed out last year that the Fed is simply misusing the term “household”. It turns out to be nothing more than a residual account – if it doesn’t fall into any other domestic category, it ends up under the household bucket. So if these are not the mom-and-pop accounts, which is what the “household” category sounds like, who is actually buying all these treasuries?

Bianco Research: – Our guess is the domestic buyer is a leveraged carry trader, a mutual fund, a brokerage subsidiary or other group that does not have its own category so it gets “dumped” into the default category of “households.”

That means that other than foreigners, the leveraged trader has been funding the US budget deficit. As much as politicians wish to believe in stable mom-and-pop treasury purchases called “households”, the reality is quite different. The reality is that the US government is relying on slowing Asia and domestic leveraged speculators for its rapidly growing funding needs. And such a scheme is clearly not sustainable in the long term.

If this continued for a few more years a break-up of the euro would become possible without a meltdown – the omelet could be unscrambled – but it would leave the central banks of the creditor countries with large claims against the central banks of the debtor countries which would be difficult to collect. This is due to an arcane problem in the euro clearing system called Target2.

Target2 is the crux of the matter in Europe. Debits/Credits are never settled with real goods/services or like the Federal Reserve system, once a year, with gold certificates. It might be questioned whether there is real gold backing the gold certificate, but that is another question.

Target2 never settles. Therefore the debits/credits can grow to enormous proportions with no check on the reality of settlement ever taking place. So large now are these cumulative totals that a default of a PIIGS, or the withdrawal of Germany, and the edifice collapses.

In contrast to the clearing system of the Federal Reserve, which is settled annually, Target2 accumulates the imbalances. This did not create a problem as long as the interbank system was functioning because the banks settled the imbalances themselves through the interbank market.

See above.

But the interbank market has not functioned properly since 2007 and the banks relied increasingly on the Target system. And since the summer of 2011 there has been increasing capital flight from the weaker countries. So the imbalances grew exponentially. By the end of March this year the Bundesbank had claims of some 660 billion euros against the central banks of the periphery countries.

Correct. The Target2 system both allows, and encourages capital flight. Capital flight does not prevent the losses however due to the intertwined nature of the ECB and National Banks through the debit/credit Target2 clearance through the ECB. The losses at the ECB, are losses in the credits held by the ECB to the relevant National Bank, German in this case. The Germans lose.

The Bundesbank has become aware of the potential danger. It is now engaged in a campaign against the indefinite expansion of the money supply and it has started taking measures to limit the losses it would sustain in case of a breakup. This is creating a self-fulfilling prophecy. Once the Bundesbank starts guarding against a breakup everybody will have to do the same.

It can’t really limit the already incurred losses, all it can really do is prevent taking on new losses, which due to the virtual non-existence of any real value in collateral, is almost guaranteed.

This is already happening. Financial institutions are increasingly reordering their European exposure along national lines just in case the region splits apart. Banks give preference to shedding assets outside their national borders and risk managers try to match assets and liabilities within national borders rather than within the eurozone as a whole.

If that is the case, more fool them. You need to off-load junk, and hold quality. Whether that quality is Greece [highly unlikely] or Germany. The problem is that the destruction of capital now is so great that even formerly quality German assets are now likely to suffer real impairment.

The indirect effect of this asset-liability matching is to reinforce the deleveraging process and to reduce the availability of credit, particularly to the small and medium enterprises which are the main source of employment.

True. The unemployment, worldwide, will I expect start to rise again. I don’t think we have seen the bottom in unemployment, and this is going to be really brutal and ugly.

The market is having a good day [week] so far.

This week’s COT analysis indicates a strong week. Last week the COT, on the bounce, was at 95% which was a +17% change. This week [last week’s data] the COT stands at 99.8% with a change of +29.8%. This indicates that there is substantial buying support from the commercials over the last two weeks.

When the sell-off started [end of April] the COT registered the following: April 28 Index 78% change -6%. May 4 Index 70% change -12%. May 11 Index 78.6% change -4.4%. The bottom, May 28, had a COT Index at 92% change +13%. From there, the COT has been bullish.

It will be interesting to see if this bullish positioning will continue through next week, or whether, there will be a lightening period again. We have the Federal Reserve and Bernanke jawboning, so that will undoubtedly have an impact, if there is a hint, or outright pledge to QE4, the markets will again experience that ‘melt-higher’ type of price action.

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