Why so many Americans are missing out on the stock market boom

The stock market has been on a major tear for the last four years, with both the Dow Jones Industrial Average and S&P 500 climbing to all-time highs:

But the gains aren’t trickling down to the majority of Americans.

Read More At TheWeek.com

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Securitisation and Risk

João Santos of the New York Fed notes what forward-thinking financial writers have been thinking for a long, long time:

There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.

Historically, banks kept on their books the loans they originated. However, over time they increasingly replaced this originate-to-hold model with the originate-to-distribute model, by syndicating the loans they originated or by selling them in the secondary loan market. The growth of securitization provided banks with yet another opportunity to expand the originate-to-distribute model of lending. The securitization of corporate loans grew spectacularly in the years leading up to the financial crisis. Prior to 2003, the annual volume of new collateralized loan obligations (CLOs) issued in the United States rarely surpassed $20 billion. Since then, this activity grew rapidly, eclipsing $180 billion in 2007. 

Corporate loan securitization appealed to banks because it gave them an opportunity to sell loans off their balance sheets—particularly riskier loans, which have been traditionally more difficult to syndicate. By securitizing loans, banks could lower the risk on their balance sheets and free up capital for other business while continuing to earn origination fees. As with the securitization of other securities, the securitization of corporate loans, however, may lead to looser underwriting standards. For example, if banks anticipate that they won’t retain in their balance sheets the loans they originate, their incentives to screen loan applicants at origination will be reduced. Further, once a bank securitizes a loan, its incentives to monitor the borrower during the life of the loan will also be reduced.

Santos’ study found that the dual phenomena of lax lending standards and securitisation existed as much for corporate debt as it did for housing debt:

To investigate whether securitization affected the riskiness of banks’ corporate lending, my paper with Bord compared the performance of corporate loans originated between 2004 and 2008 and securitized at the time of loan origination with other loans that banks originated but didn’t securitize. We found that the loans banks securitize are more than twice as likely to default or become nonaccrual in the three years after origination. While only 6 percent of the syndicated loans that banks don’t securitize default or become nonaccrual in those three years, 13 percent of the loans they do securitize wind up in default or nonaccrual. This difference in performance persists, even when we compared loans originated by the same bank and even when we compared loans that are “similar” and we controlled for loan- and borrower-specific variables that proxy for loan risk.

This is an important study, because it emphasises that this is a universal financial phenomenon, and not one merely confined to mortgage lenders that were encouraged by the Federal government into lending to risky mortgagees. The ability to securitise lending and so move the risk off your balance sheet leads to riskier lending, period.

This exemplifies the problem with shadow finance. Without the incentive of failure for lenders who lend to those who cannot repay, standards become laxer, and the system begins to accrue junk loans that are shipped off the lenders’ balance sheets and onto someone else’s. This seems like no problem to the originating lender, who can amass profits quickly by throwing liquidity at dubious debtors who may not be able to repay without having to worry about whether the loan will be repaid. The trouble is that as the junk debt amasses, the entire system becomes endangered, as more and more counterparties’ balance sheets become clogged up with toxic junk lent by lenders with lax standards and rubber-stamped as Triple-A by corrupt or incompetent ratings agencies. As more laxly-vetted debtors default on their obligations, financial firms — and the wider financial system, including those issuers who first issued the junk debt and sold it to other counterparties  — come under pressure. If enough debtors default, financial firms may become bankrupt, defaulting on their own obligations, and throwing the entire system into mass bankruptcy and meltdown. This “risk management” — that lowers lending standards, and spreads toxic debt throughout the system — actually concentrates and systematises risk. Daron Acemoglu produced a mathematical model consistent with this phenomenon.

In a bailout-free environment, these kinds of practices would become severely discouraged by the fact that firms that practiced them and firms that engaged with those firms as counterparties would be bankrupted. The practice of making lax loans, and shipping the risk onto someone else’s balance sheet would be ended, either by severely tightened lending standards, or by the fact that the market for securitisation would be killed off. However, the Federal Reserve has stepped into the shadow securities market, acting as a buyer-of-last-resort. While this has certainly stabilised a financial system that post-2008 was undergoing the severest liquidity panic the world has probably ever seen, it has also created a huge moral hazard, backstopping a fundamentally perverse and unsustainable practice.

Shadow finance is still deleveraging (although not as fast as it once was):

But so long as the Federal Reserve continues to act as a buyer-of-last-resort for toxic junk securities produced by lax lending, the fundamentally risk-magnifying practices of lax lending and securitisation won’t go away. Having the Federal Reserve absorb the losses created by moral hazard is no cure for moral hazard, because it creates more moral hazard. This issue soon enough will rise to the surface again with predictably awful consequences, whether in another jurisdiction (China?), or another market (securitised corporate debt? securitised student loan debt?).

The Eminent Domain Mortgage Heist?

Matt Taibbi:

Something very interesting is happening.

There’s been so much corruption on Wall Street in recent years, and the federal government has appeared to be so deeply complicit in many of the problems, that many people have experienced something very like despair over the question of what to do about it all.

But there’s something brewing that looks like it might be a blueprint to effectively take on the financial services industry: a plan to allow local governments to take on the problem of neighborhoods blighted by toxic home loans and foreclosures through the use of eminent domain. I can’t speak for how well the program will work, but it’s certaily been effective in scaring the hell out of Wall Street.

Under the proposal, towns would essentially be seizing and condemning the man-made mess resulting from the housing bubble.

I approach the issue and constitutionality of eminent domain — government seizing of property in exchange for whatever the government defines as just compensation — very suspiciously. While I am altogether hostile to the idea of government being able to declare that what is yours is not yours, it has recently become a device for government to transfer private property from one private owner to another.

In Kelo v. City of New London (2005), the use of eminent domain to transfer land from one private owner to another private owner to further economic development was deemed to be constitutional. In a 5–4 decision, the Court held that the general benefits a community enjoyed from economic growth qualified private redevelopment plans as a permissible public use under the Takings Clause of the Fifth Amendment.

While seizing land with compensation to build a highway for public use is one thing, seizing property for the private profit of others is quite another. Yet many like Taibbi are heralding the potential of seizing underwater mortgages. I will consider any initiative to reduce total debt and deleveraging costs, as I believe that excessive total debt is the largest cause of today’s depression. But given the history, I have every right to be cautious and even suspicious.

Taibbi:

The plan is being put forward by a company called Mortgage Resolution Partners, run by a venture capitalist named Steven Gluckstern.

Here’s how it works: Mortgage Resolution Partners helps raise the capital a town or a county would need to essentially “buy” seized home loans from the banks and the bondholders (remember, to use eminent domain to seize property, governments must give the owners “reasonable compensation,” often interpreted as fair current market value).

Once the town or county seizes the loan, it would then be owned by a legal entity set up by the local government – San Bernardino, for instance, has set up a JPA, or Joint Powers Authority, to manage the loans.

At that point, the JPA [i.e. the taxpayer!] is simply the new owner of the loan. It would then approach the homeowner with a choice. If, for some crazy reason, the homeowner likes the current situation, he can simply keep making his same inflated payments to the JPA. Not that this is likely, but the idea here is that nobody would force homeowners to do anything.

On the other hand, the town can also offer to help the homeowner find new financing. In conjunction with companies like MRP (and the copycat firms like it that would inevitably spring up), the counties and towns would arrange for private lenders to enter the picture, and help homeowners essentially buy back his own house, only at a current market price. Just like that, the homeowner is no longer underwater and threatened with foreclosure.

First — why municipalities? Why not states? The answer is that while all states other than Vermont have some form of balanced budget amendment, and cannot so easily take on debt, municipalities can freely take on debt. How much? Well, it’s almost certain to be open to legal challenges by current mortgage-holders, and courts may end up forcing municipalities to pay far more than municipalities initially stipulate. But at whatever values the mortgages are seized at, there is no doubt that the taxpayer will end up holding a lot of new debt.

The biggest problem though, is surely the danger of corruption. How many municipalities will end up using these opaque procedures to enrich well-connected insiders? How many will buy junk at inflated prices, or seize and sell to a well-connected insider at far below value? Who polices such transactions? Where is the transparency? How do we make sure that this is not just an excuse for bad lenders to offload junk to the taxpayer at inflated prices and cream a profit when they were set to reap a loss?

Matt Taibbi admits:

MRP absolutely has a profit motive in the plan, and much is likely to be made of that in the press as this story develops. But I doubt this ends up being entirely about money.

“What happened is, a bunch of us got together and asked ourselves what a fix of the housing/foreclosure problem would look like,” Gluckstern. “Then we asked, is there a way to fix it and make money, too. I mean, we’re businessmen. Obviously, if there wasn’t a financial motive for anybody, it wouldn’t happen.”

And you can restructure all you like, but many underwater homeowners with a serious income shortfall will still not be able to pay their mortgages. Who carries the can? If the mortgage has been  sold on then the loss will be on the new owner. In reality this is far more likely to be the taxpayer. Simply, the taxpayer may well end up carrying the can for a whole lot of bust mortgages.

What Taibbi — who usually has a very good sense of moral hazard — and MRP effectively seem to be considering is not only the continuation and expansion of Kelo, but also potentially the transfer of liability from bust irresponsible lenders to the taxpayer. While this is sure to enrich the bureaucracy and well-connected insiders — and admittedly, while it may help some underwater homeowners — it seems incredibly risky for the taxpayer.

While debt-forgiveness is one way out of the debt trap, we should be careful and recognise that many so-called debt-forgiveness schemes may instead be dressed-up scams and frauds that end up enriching special interests while putting the taxpayer deeper into a hole. 

H/T to @MoiraCathleen

Skyscraper Index Indicates Next Global Crash in 2013

Most of us are at least passingly familiar with the theory: the completion of a new tallest skyscraper presages a market crash. Over-exuberant construction reflects over-exuberant markets, and over-confidence often spills over as the hyper-bullish slowly (and then quickly) realise that the good times are over.

Here’s the story so far:

And here’s the next chapter — earmarked for completion in January 2013:

Where else but China? As if that country didn’t already have enough empty buildings, enough empty office space, enough empty homes, and enough grey uninspired architecture. And it’s not like Changsha — the relatively-sparsely populated city where the thing is to be built — is running out of countryside to expand into.

Sky City One is planned to be prefabricated and built onsite, to a timeframe of just ninety days (that will instil confidence that the building won’t spontaneously collapse, right?) and at a much lower cost than the current titleholder (which of course presaged the 2008 crash, and bankrupted its builders) the Burj Khalifa.

“A milestone of life-style transforming” sounds about right (they have enough money to build a 200 storey building, but not enough to pay for good English translation?). The world will be a very different place after the next crash.

Not so good news for property speculators who are sure to dump money into what will soon be little better than a tax liability. But good news for Jim Chanos, and every other investor determined to short everything Chinese.

Identifying a Treasury Crash

Readers have asked my opinion on whether or not China and Russia’s recent treasury offloading spree amounts to the first phase of a potential Great Treasury Crash.

Here’s a reminder:

There are two very strong pieces of evidence here for dollar and treasury weakness and instability: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when these perceptions will be shattered.

A large sovereign treasury dumper like China with its $1+ trillion of treasury holdings throwing a significant portion of these onto the open market would very quickly outpace the institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”.
  3. Both of the above.

Now the pace and scope of any coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

So here’s the relevant data:


Clearly, what we would expect to see in the nascent phases of a crash is that blue line to spike while the other lines all decline significantly.

Does this look like that to you? Well, frankly, no. China’s holdings have merely declined to 2010 levels — hardly a nosedive, but certainly signifying China’s lukewarmness toward the Obama-Bernanke administrations. Right now they are just testing the water.

Significantly, rates have risen in the past few days, signalling that even in spite of all the QE and Twisting, Bernanke’s task remains volatile.

So — while it is all very easy and attention-grabbing to spew fear-mongering projections of an imminent crash — I have to be realistic. 2013 or 2014 or even later seems a much likelier timeframe for this momentous and historic eventuality. And of course, black swans can derail any projection. Humans will always be fallible, no matter how much processing power we put behind our prognostications.

So there is really no timeframe to my prediction. Certainly, Bernanke has proven himself to be a proficient can-kicker. Too many economists have scuppered their reputations by making timed predictions which fail to play out.

And my prediction is not an economic prediction, so much as a geopolitical one, and political science is an oxymoron; politics (like any other market — yes, it’s a market to be bought and sold) can swerve and tilt in any direction in the time-being, even while its broader historical trends are clear and evident. (In this case, the rise of China, the end of American primacy, and the death of the dollar as a reserve currency).

Is Housing Bottoming Out?

On the surface, it looks like it:

Image

My main caveat here is that the United States is — for many reasons including geopolitics, demographics energy, monetary policy, etc — in a completely new historical period, so it is plausible that we are moving toward a new normal.

The persons-per-household numbers have remained low, even in spite of the house price slump, suggesting there is no latent surge in demand waiting to burst forth and pick up prices:

Image

Most worryingly, prices have kept falling even in spite of the fact that there is very little building:

Image

So while prices are falling to historic lows it is difficult to say where demand will come from. Certainly —and wrongheadedly, because America is relatively underpopulated — America does not appear willing to liberalise immigration laws. In nominal terms, house prices somewhat stabilised due to the post-2008 money printing operations. But in terms of purchasing power (i.e. in ounces of gold, barrels of oil, calories of food) there does not seem to be much reason to believe house prices will be rising any time soon.

2012

Many bloggers and commentators have been pumping out their visions for 2012. I would do the same, had I not done it in October:

Gold is up against a wall of incorrect perceptions: namely, that haven assets are limited to dollars, and to US treasury bonds. In the mainstream lexicon, gold is used to hedge tail risk and to make jewellery, and until that perception is shattered (specifically by an event that reveals Treasuries and dollars for the risky and debased assets that they really are) then I don’t think the funds will begin to significantly increase gold allocations (when they do, they will claim they are “hedging tail risk”).

There are two very strong pieces of evidence here for dollar and treasury weakness: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when (not if) these perceptions will be shattered.

What would a treasury crash look like? Most likely, it would be dictated by supply — the greater the supply of treasuries coming onto the market, the more there are for buyers to buy, the lower prices will be forced before new buyers come onto the market. Specifically, a treasury crash would most likely begin with a big seller dumping significant quantities of treasuries bonds onto the open market. I would expect such an event to be triggered bylower yields— most significant would be the 30-year, because it still has a high enough yield to retain purchasing power (i.e. a positive real rate). Operation Twist, of course, was designed to flatten the yield curve, which will probably push the 30-year closer to a negative real return.

A large sovereign treasury dumper (i.e. China with its $1+ trillion of treasury holdings) throwing a significant portion of these onto the open market would very quickly outpace the dogmatic institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike actually corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the (hugely dogmatic) market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”
  3. Both of the above.

If such an event was big enough to cause yields to spike 1% (very conservative estimate) it would jar the status quo enough to trigger a significant gold spike, as funds and banks move to cash positions (sensing both the post-crash buying opportunities, and margin hikes) and seek to “hedge tail risk”.

Now the pace and scope of China’s coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

The pace of events might also be significantly accelerated in the light of a Greek default.

Now 365 days is a strangely arbitrary period over which to make long term economic predictions. The business cycle is not tied to years, nor even decades. It wends and shifts in the winds of history, fluttering and flurrying. I have no idea if this scenario (or something similar) will play out in 2012, or 2013.

But I do know this: unless there is a real recovery in America — in employment and industrial output, as well as GDP — as well as a shift away from reliance on foreign oil and goods, and a successful deleveraging of the entire economy — especially government debt and shadow banking — it will play out sooner or later.

I took great pleasure last month to present a very similar scenario predicted by none other than Paul Krugman in 2003:

During the 1990s I spent much of my time focusing on economic crises around the world — in particular, on currency crises like those that struck Southeast Asia in 1997 and Argentina in 2001. The timing of such crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

I’m not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls “an early warning system to identify the likelihood of countries entering into financial crises.” Developing nations are looking pretty safe these days. But applying the same model to some advanced countries “would set Damocles’ alarm bells ringing.” Lehman’s press release adds, “Most conspicuous of these threats is the United States.”

Is America safe, despite its scary numbers?

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

Readers are, of course, encouraged to share their views on 2012 (and the future in general) in the comment section.

Meanwhile, here’s some prescience from Jefferson:

Happy New Year.

Post-Industrial Decline in England

Today, I want to give a short virtual tour of the city in which I grew up, Stoke-on-Trent. Stoke-on-Trent grew up around the pottery industry.

From Wikipedia:

Since the 17th century, the area has been almost exclusively known for its industrial-scale pottery manufacturing, with such world renowned names as Royal DoultonDudson Ltd, Spode (founded by Josiah Spode), Wedgwood (founded by Josiah Wedgwood) and Minton (founded by Thomas Minton) being born and based there. The presence locally of abundant supplies of coal and of suitable clay for earthenware production led to the early but at first limited development of the local pottery industry. The construction of the Trent and Mersey Canal enabled the import of china clay from Cornwall together with other materials and facilitated the production of creamware and bone china.

Stoke-on-Trent is a world centre for fine ceramics – a skilled design trade established in the area since at least the 12th century. But in the late-1980s & 1990s Stoke-on-Trent was hit hard by the general decline in the British manufacturing sector. Numerous factories, steelworkscollieries, and potteries were closed. This resulted in a sharp rise in unemployment.

Of course, Stoke is by no means typical, but it does typify some problems that are found in many cities across the Western world: the loss of manufacturing jobs, and a subsequent decline into mass unemployment, drug abuse, state dependency, and social and economic degeneration. This is a tough cycle to break — slashing welfare handouts is impossible, because there are no jobs for feckless welfare recipients to take. So — without a serious regeneration budget — the state has little choice but to leave much of the city welfare-dependent and festering.

What I really want to get across is the depth of the post-industrial decline and dereliction in such cities. When they lost their manufacturing sector to cheaper overseas competition, many of these cities lost their reason to exist. They just left an angry, workless and disaffected concentration of population tightly bundled together. Being deprived of capital and investment means that infrastructure, housing and social welfare grossly declined:

The City Centre

Boarded-Up Housing

Dereliction

Former Industrial Glory

Broken Wasteland

Panorama

The Problem is Fragility

Mainstream opinion on economic conditions at present is a steaming shitheap of errors.

Deluge of hopium from ABC (sponsored by Citigroup, no joke):

Stocks closed higher on Thursday after European leaders agreed on a plan to avert a Greek default and the Commerce Department announced third-quarter gross domestic product grew 2.5 percent, boosted by higher consumer spending, allaying fears that the economy is slipping into another recession.

The Dow Jones industrial average increased about 2.9 percent to 12,209 and the tech-heavy Nasdaq increased about 3.3 percent to 2,784 at the end of the day. The S&P 500 had its biggest monthly rally since 1974, according to Bloomberg, increasing 3.4 percent to 1,285.

The GDP rate was in line with what economists were expecting. The 2.5 percent growth rate is almost triple the 0.9 percent pace of economic growth in the first half of this year, which has been far too slow to generate any job growth. Unemployment has remained stubbornly high at over 9 percent.

The thing is, high unemployment and low GDP growth (now — ahem — magically cured) are (and always were) secondary problems. They’re the things that hurt, sure — but they’re not the cause of the illness — they’re just symptoms The main problem is systemic fragility, and the failure to understand the economy from a systemic perspective, and understand the systemic risks. If the financial system (both global and national) is not resilient to shocks and the unexpected, the system will unravel under the slightest pressure. As I have repeatedly explained, the Western economic paradigm is a highly fragile for two reasons: over-dependence on foreign goods and resources controlled by hostile nations, and the pattern of interconnected financial debt that leaves the system open to collapse if just one significant player collapses:

Not only did the bailouts disable creative destruction (the engine of innovation and social progress), they also created so much debt that they have already damaged the ability of future generations to save, invest and innovate.

Worse, they did nothing to address the fundamental fragility of the system. All of that interconnected debt means the system is still fragile to a default cascade, which means that if the system is to be “saved” again, it will require more bailouts and more debt-acquisition, further eroding the ability of taxpayers to save and invest, as governments tax and inflate the currency to pay down the debt.

I expect future generations to look back on this episode as a bizarre aberration. America — surely the greatest producer and innovator in the history of human civilisation — forgot how markets work and the notion of creative destruction, forgot that an empire dependent on hostile partners (i.e. China and the Arab world) is hugely fragile, and then forgot the fact that America emerged as a superpower as a director result of its status as a great creditor and manufacturer, and that the old European empires lost their superpower status through loss of productivity and massive debt acquisition.

The beautiful thing about artificial abstract systems is that they can be remade at will, unlike ecosystems or organisms. It would be so easy — in principle — to rip up the global financial system and start again, because it’s all abstract. But there are too many vested interests — creditors want their pound of flesh, consumers and businesses want stability and fear change, and so establishment economists and thinkers will hunt ceaselessly for any kind of confirmation for the idea that the system is stabilising, that things are getting better, that things can go back to normal, that prosperity will return.

Well, prosperity may return, at least for a few short years, before the mass of interconnected leverage crumbles back into the murk from which it came. And as credit contracts (as is inevitable in a fractional reserve system) employment will slump, GDP growth will stall, and anger will rise.

The danger is that next time, the gears and wheels of productivity that hold up the abstract falsehoods of finance and consumerism will fail. I am not really a fan of Ayn Rand, but the analogy of Atlas shrugging holds true — in this case, the workshops, mines, and factories of “poorer” exporters holding upon their shoulders the parasitic mass of the consumerist Western nations. It won’t be industrialists and capitalists shrugging — it will be shipyard workers, machine operators, truck drivers, coal miners and construction workers, squeezed and dispossessed. Why should wealthy Westerners live a lavish lifestyle subsidised by the blood sweat and productivity of poorer nations? Because America has nuclear weapons? Because it invades nations that threaten to trade oil in things other than dollars? That kind of belligerence is a house of cards — it works with Third World despots, but not with an angry, politically engaged and dispossessed mob. I see it in the Occupy protests — the police can beat and brutalise protestors, but belligerence doesn’t change anything — the protestors are a hydra, cut off a head and two grow back.

The economic elite of the 20th Century learned to appease their malcontents by continuously raising the standard of living, expanding property ownership, and bringing plenty of food to tables, and new consumer goods to homes around the globe. If the economic elite of the 21st Century cannot learn to do the same I fear the malcontents will unleash hell.

 

Gold in 2012 & the Coming Bond Crash?

Since that spurt up to $1917, and the slump down to $1528 gold has been on ice below $1700. The technical analysis suggests that there is little to get excited about until gold breaks out of the $1600 to $1700 range, and I tend to agree. This is a slow-motion degeneration: triggers for a breakout seem limited to a deeper Euro meltdown (coming — and ultimately leading to a default cascade, and a derivatives meltdown), more American money printing (coming), or (most importantly) a large scale and visible dumping of dollars or treasuries by foreign creditors. Black swans like another Fukushima, incidences of terrorism, or broader social unrest might be bullish for gold in the long term, but gold right now (at least in the West) is up against a wall of perceptions: namely, that haven assets are limited to dollars, and to US treasury bonds. In the mainstream lexicon, gold is used to hedge tail risk and to make jewellery, and until that perception is shattered then I don’t think the funds will begin to significantly increase gold allocations.

There are two very strong pieces of evidence here for dollar and treasury weakness and instability: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) claims to be committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So when these perceptions will be shattered? Here are bond yields since 2007:


The bond market is a market, and like any other it is determined by supply and demand (Zero Hedge readers — algorithmic trading is still a form of supply and demand, albeit a fucked-up one). Low yields mean high prices, which mean that demand is still high — pretty close to all-time highs — which means that in the market the belief that treasuries are a haven still mostly holds.

A large sovereign treasury dumper like China with its $1+ trillion of treasury holdings throwing a significant portion of these onto the open market could very quickly outpace the institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so rashly goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”.
  3. Both of the above.

Now the pace and scope of any coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely a Chinese liquidation.

The pace of events might also be significantly accelerated in the light of a full-blown Eurozone default.

So in conclusion — give or take the inevitable QE3 spike — I expect gold prices to be stable or lower — even in the context of low real interest rates — up ’til a significant treasury liquidation. I don’t know when or if this will occur, but if it does, I would expect gold prices to soar in the following months. If it doesn’t occur and markets return to stronger organic growth, the gold bull market will probably end.

It must also be noted that a stock market crash will probably send gold lower in the short term, as with 2008. Ironically, the subsequent flight into treasuries (driving rates lower still) might be a NASDAQ-esque “blow-out top” that signifies the end.