The Fed Shrugs

Since talk of the taper started, interest rates have been gradually rising. When Bernanke talked about the possibility of tapering QE in mid 2014 so long as growth and unemployment remain on track, rates leapt to their highest level since 2011:

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A simple supply-demand analysis of Treasuries says that if the Fed buys less, ceteris paribus the price will fall and rates will rise. The Fed is implying it will buy less, and lo and behold markets are selling off on expectations that future demand will be lower. The analysis of those who say that quantitative easing is raising interest rates seems increasingly dubious to me.

The alternative analysis is that rates are rising on sentiment that the economy is improving. I wouldn’t rule that out, but the trouble is that the economy is still deeply depressed. GDP is still far below its pre-crisis trend. Broad monetary aggregates are still massively deflated. Lots and lots of working-age people who were working before 2008 still haven’t returned to the labour force:

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So while equities have returned to their pre-crisis heights — unsurprisingly, after all the financial sector is the Fed’s monetary transmission mechanism — the real economy, broadly speaking, hasn’t.

So it’s surprising to me that there is any talk of tapering. Headline unemployment is still 7.5%, and core inflation is just 1%, 1% below the Federal Reserve’s self-imposed target. Bernanke referred to disinflationary and deflationary forces in the economy as “transitory”, but any such diagnosis would seem to be the height of naïveté. The deflation of the shadow money supply and broad monetary aggregates is an ongoing structural transformation in the post-shadow-banking-bubble world. There is nothing “transitory” about it. If inflation was 3% or 4% and unemployment was below 6%, then talk of a taper would be expectable. Right now it just makes it seem like the Fed doesn’t have a clear framework. If QE3 was supposed to target unemployment, why is the Fed considering tapering when unemployment is still so high? Yes, the Fed’s internal DSGE models are saying that unemployment will continue to fall. Of course they do — these models have assumptions of clearing labour markets built into them! But right now inflation is below-mandate and unemployment is above mandate. Assuming away current conditions with the term “transitory” is basically saying that when the storm is long past the ocean is flat again.

Of course, at the zero-bound I think the Fed’s transmission mechanisms are relatively powerless in terms of any ability to stimulate employment or growth. It has taken the horse to water, but the horse hasn’t drunk. What the Fed can control with balance sheet monetary policy is interest rates on assets it buys. By shrugging, the Fed is signalling for a rise in government borrowing costs. That may be extremely premature.

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Is China Really Liquidating Treasuries?

The news that China has become the first sovereign to establish a direct sales relationship with the U.S. Treasury (therefore cutting out the middleman and bypassing Wall Street ) raises a few interesting questions.

From Reuters:

China can now bypass Wall Street when buying U.S. government debt and go straight to the U.S. Treasury, in what is the Treasury’s first-ever direct relationship with a foreign government, according to documents viewed by Reuters.

The relationship means the People’s Bank of China buys U.S. debt using a different method than any other central bank in the world.

The other central banks, including the Bank of Japan, which has a large appetite for Treasuries, place orders for U.S. debt with major Wall Street banks designated by the government as primary dealers. Those dealers then bid on their behalf at Treasury auctions.

China, which holds $1.17 trillion in U.S. Treasuries, still buys some Treasuries through primary dealers, but since June 2011, that route hasn’t been necessary.

The documents viewed by Reuters show the U.S. Treasury Department has given the People’s Bank of China a direct computer link to its auction system, which the Chinese first used to buy two-year notes in late June 2011.

The biggest Chinese outflows in U.S. Treasuries occurred in the months following the establishment of this relationship:

Which begs the question for some analysts — was China really selling? Or was China stealthily buying direct from the U.S. Treasury (unrecorded) and selling back into Wall Street (recorded)?

Well, according to the Treasury, the Treasury International Capital data seeks to record foreign holdings of U.S. securities, not just the flows, and given that the Treasury was the seller in these direct transactions (and so obviously was aware of them) there’s no reason to believe that they wouldn’t include any such direct outflows in the data. That suggests very strongly that yes, China really was selling.

And maybe the real reason that the Treasury offered China direct access (thus cutting out the middleman and offering China cheaper access than ever) was precisely because China was selling, and because the Treasury was concerned about the effect on rates, and wanted to give China some incentive to keep buying. As Jon Huntsman noted in a 2010 cable leaked by Wikileaks, the PBOC has felt pressured to keep buying, and as various PBOC officials have hinted in recent months, China is actively seeking to convert out of treasuries and into gold. And that makes sense — treasuries are yielding ever deeper negative real rates. People holding treasuries are losing their purchasing power. No wonder the treasury is willing to cut Wall Street out of the deal.

And it isn’t like the Treasury would have taken this move lightly — cutting Wall Street out of the equation is a slap in the face to Wall Street.

This raises a much more interesting question — now that the PBOC has effectively been upgraded to primary dealer status, would the Fed start buying treasuries directly from the PBOC in order to manage rates downward and prevent a spike in Treasury borrowing costs should China choose to quicken the pace of a future liquidation, potentially bursting the treasury bubble?

Bernanke vs Greenspan?

Submitted by Andrew Fruth of AcceptanceTake

Bernanke and Greenspan appear to have differing opinions on whether the Fed will monetize the debt.

Bernanke, on behalf of the Federal Reserve, said in 2009 at a House Financial Services Committee that “we’re not going to monetize the debt.

Greenspan, meanwhile, on Meet the Press in 2011 that “there is zero probability of default” because the U.S. can always print more money.

But they can’t both be true…

There is only 0% probability of formal default if the Fed monetizes the debt. If they refuse, and creditors refuse to buy bonds when current bonds rollover, then the U.S. would default. But Ben said the Fed will never monetize the debt back on June 3, 2009. That’s curious, because in November 2010 in what has been termed “QE2″ the Fed announced it would buy $600 billion in long-term Treasuries and buy an additional $250-$300 of Treasuries in which the $250-$300 billion was from previous investments.

Is that monetization? I would say yes, but it’s sort of tricky to define. For example, when the Fed conducts its open market operations it buys Treasuries to influence interest rates which has been going on for a long time — way before the current U.S. debt crisis.

So then what determines whether the Fed has conducted this egregious form of Treasury buying we call “monetization of the debt?”

The only two factors that can possibly differentiate monetization from open market operations is 1) the size of the purchase and 2) the intent behind the purchase.

This is how the size of Treasury purchases have changed since 2009:

Since new data has come out, the whole year of 2011 monetary authority purchases is $642 billion – not quite as high as in the graph, but still very high.

Clearly you can see the difference in the size of the purchases even though determining what size is considered monetization is rather arbitrary.

Then there’s the intent behind the purchase. That’s what I think Bernanke is talking about when he says he will not monetize the debt. In Bernanke’s mind the intent (at least the public lip service intent) is to avoid deflation and to boost the economy – not to bail the United States out of its debt crisis by printing money. Bernanke still contends that he has an exit policy and that he will wind down the monetary base when the time is appropriate.

So In Bernanke’s mind, he may not consider buying Treasuries — even at QE2 levels — “monetizing the debt.”

The most likely stealth monetization tactics Bernanke can use — while still keeping a straight face — while saying he will not monetize the debt, will be an extreme difference between the Fed Funds Rate and the theoretical rate it would be without money printing, and loosening loan requirements/adopting policies that will get the banks to multiply out their massive amounts of excess reserves.

If, for example, the natural Fed Funds rate — the rate without Fed intervention — is 19% and the Fed is keeping the rate at 0%, then the amount of Treasuries the Fed would have to buy to keep that rate down would be huge — yet Bernanke could say he’s just conducting normal open market operations.

On the other hand, if the banks create money out of nothing via the fractional reserve lending system and a certain percentage of that new money goes into Treasuries, Bernanke can just say there is strong private demand for Treasuries even if his policies were the reason behind excessive credit growth that allowed for the increased purchase of Treasuries.

Maybe Bernanke means he will not monetize a particular part of the debt that was being referred to in the video. Again, though, he could simply hide it under an open market operations 0% policy or encourage the banking system to expand the money supply.

Whatever the case, if you ever hear Bernanke say “the Federal Reserve will not monetize the debt” again, feel free to ignore him. When he says that, it doesn’t necessarily mean he won’t buy a large quantity of Treasuries with new money created out of nothing.

Remember, Greenspan says there’s “zero probability of default” because the U.S. can always print more money. Does Greenspan know something here? There’s only zero probability if the Fed commits to monetizing the debt as needed. If Greenspan knows something there will be monetization of the debt, even if Bernanke wants to call it something else.

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.

Is it Always a Good Time to Own Gold?

Is it always a good time to own gold?

Absolutely not. A portfolio in the S&P 500 or Treasuries in 1973 has returned a much higher rate than gold bought that year — even if gold raced ahead up ’til 1980, and is racing ahead again now. We know that throughout history gold has sustained its purchasing power, and fiat currency has lost its purchasing power. But we also know that stocks have grown their purchasing power.

But gold continues to rise — so what makes gold different right now? Well, from a technical perspective, America and the West are in a secular bear market:

But a technical perspective doesn’t really give enough political and economic background to explain why we are where we are.

Continue reading

Huntsman Cable: China & US Trade War Heating Up

I have talked at length before about the dangers of a U.S.-China trade war.

Now, former U.S. Ambassador to China and Presidential candidate John Huntsman weighs in.

From Wikileaks:

a. “Sino-U.S. ‘trade war’ is heating up again”

The Shanghai-based Shanghai Media Group (SMG) publication, China Business News: “The United States provoked a trade war again by imposing high anti-dumping duties on Chinese-made gift boxes and packaging ribbon.  This once again shows that 2010 is off to a difficult start for Sino-U.S. relations.  It also reflects that, because of the mid-term elections, Obama is eager to prove to the American voters that the U.S. Administration’s China policy is tough so as to restore his declining support rate. Yao Jian, the Ministry of Commerce spokesperson, issued a statement on February 1, saying that following the financial crisis American trade protectionism has risen.  China has become the biggest victim of the U.S.’s abusive implementation of trade remedy measures.

b. “The United States no longer sits still; it frequently uses evil tricks to force China to buy U.S. bonds”

The Shanghai-based Shanghai Media Group (SMG) publication, China Business News: “This time the quick change of the U.S. policy (toward China) has surprised quite a few people.  The U.S. has almost used all deterring means, besides military means, against China.  China must be clear on discovering what the U.S. goals are behind its tough stances against China.  In fact, a fierce competition between the currencies of big countries has just started.  A crucial move for the U.S. is to shift its crisis to other countries – by coercing China to buy U.S. treasury bonds with foreign exchange reserves and doing everything possible to prevent China’s foreign reserve from buying gold.

If we [China] use all of our foreign exchange reserves to buy U.S. Treasury bonds, then when someday the U.S. Federal Reserve suddenly announces that the original ten old U.S. dollars are now worth only one new U.S. dollar, and the new U.S. dollar is pegged to the gold – we will be dumbfounded.

Today when the United States is determined to beggar thy neighbor, shifting its crisis to China, the Chinese must be very clear what the key to victory is.  It is by no means to use new foreign exchange reserves to buy U.S. Treasury bonds.  The issues of Taiwan, Tibet, Xinjiang, trade and so on are all false tricks, while forcing China to buy U.S. bonds is the U.S.’s real intention.”

And considering that using military means to force China to continue to reinvest in treasuries is completely pointless it seems like America’s free lunch will soon be coming to an end. Most interestingly of all:

The nature of such behavior is a rogue lawyer’s behavior of ‘ripping off both sides': taking advantage of cross-strait divergences, blackmailing the Taiwan people’s wealth by selling arms to Taiwan, and meanwhile coercing China to buy U.S. treasury bonds with foreign exchange reserves and extorting wealth from the mainland’s people.

No doubt, America’s divide-and-conquer tactics have been highly successful, and highly advantageous to America. The real question, of course, is how long will it be ’til both the Chinese and Taiwanese governments tire of sending their productive capital to America (either for treasuries, or weapons) so that Americans can have a free lunch? A dollar devaluation? War on the Korean peninsula? QE3? QE4? QE Gold?