Wall Street

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Rich people prefer productive companies while the poor prefer shiny lumps of metal.

Gallup’s poll on Americans’ favorite investments always makes fascinating reading.

Every year, Gallup asks Americans to choose the best investment from the following choices: Real estate, stocks and mutual funds, gold, savings accounts and certificates of deposit, or bonds.In the years since the 2008 financial crisis and housing bust — after which Americans as a group briefly ranked gold as their favorite investment — real estate has once again swung back into favor:

[Gallup]

But as Barry Ritholtz notes over at Bloomberg View, the most interesting thing is that there are some serious differences between the investment styles of the poor and the rich.

Read More At TheWeek.com

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Is China’s economy headed for a crash?

In his assessment of the global economy’s performance 2013, legendary financier George Soros warned of dangers in the Chinese economy:

The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam.

That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35 percent of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing.

There are some eerie resemblances with the financial conditions that prevailed in the U.S. in the years preceding the crash of 2008. [Project Syndicate]

That, as William Pesek notes, is a rather ominous conclusion. So is China due a crash?

Read More At TheWeek.com

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Why the Volcker Rule won’t solve the problem of Too Big To Fail

The Volcker Rule was originally proposed to end the problem of banks needing taxpayer bailouts. Paul Volcker, the former chairman of the Federal Reserve, proposed that commercial banks using customer deposits to trade — a practice known as proprietary trading — played a key role in the financial crisis that began in 2007.

Five former Secretaries of the Treasury — W. Michael Blumenthal, Nicholas Brady, Paul O’Neill, George Shultz, and John Snow — endorsed the Volcker Rule in an open letter to the Wall Street Journal, writing that banks “should not engage in essentially speculative activity unrelated to essential bank services.”

The Volcker Rule was signed into law as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July of 2010, but its implementation has been delayed until yesterday when it finally received approval from the five (!) regulatory agencies that will enforce it — the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

Read More At TheWeek.com

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Why the United States Cannot Default

keep-calm-and-read-the-constitution

In this post, I am not going to argue that the USA should not default because it will cause havoc in global financial markets. This — if the debt limit is not raised or abolished via a trillion dollar coin or other means by October the 17th — is a distinct possibility, but much has been said of this already. Nor am I going to argue that the United States Treasury will somehow manage to skirt defaulting via emergency austerity measures. This is possible too, though has also been discussed elsewhere.

I am going to argue that in the long run, whether the United States raises the debt ceiling or not, it is technically impossible for the United States to default. This simple fact is encoded in the Fourteenth Amendment to the Constitution:

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.

While bondholders may not get their money including interest immediately, the courts will rule in their favour when the matter comes to court. The Fourteenth Amendment is absolutely clear on that. Some credit default swaps may trigger (this depends, I think, on the wording of individual credit default swap contracts, which in itself may cause further confusion) but in the end bondholders will absolutely and assuredly get their money. This means that United States Treasuries remain low-risk assets. And that — even in the event of default — should keep interest rates on Treasury debt relatively low. There will be no crushing exit of the bond vigilantes — after all, why would they choose to crash a market they are already deeply invested in if they will sooner-or-later get paid? People, generally, who buy large quantities of US Treasuries are not sitting around and reading libertarian blogs pondering the issues of dollar debasement and the end of the dollar as the global reserve currency. The latter may be a real longer term issue, and I think in the next 50 years, perhaps even the next 20 years we will see more alternative reserve currencies emerge. But that is another story for another day.

In the medium term and the short term the thing that is keeping bond buyers buying bonds is the search for yield over cash. If you have billions of dollars in cash at your disposal as many investment managers and countries do, and your imperative is low-risk yield, government debt beats cash that yields nothing, it beats commodities speculation and stock market speculation, and it beats corporate bonds as corporations are not sovereigns. A guaranteed dollar-denominated yield, even a very low one is still very attractive to treasury buyers, even if some large treasury buyers like the Chinese government have made some bond-vigilante-like noises in the past few years. These have thus far proven to be hot air, even if I have in the past made the mistake of paying too much attention to such noises.

Personally, I wish to see the debt ceiling abolished entirely, either through the absurdity of trillion dollar coins (my original objection, that authorising a trillion dollar coin would look silly has been made entirely moot by the fact that the United States Congress already looks extremely silly due to the ongoing standoff) or otherwise. At the very least, the debt ceiling should be denominated in real economic activity, not an arbitrary number of dollars, and in setting such a ceiling it should be remembered that Great Britain successfully sustained and paid down a sovereign debt of over 250%. Higher sovereign debt levels for a rich, powerful country like the United States are not dangerous. It is — as we are seeing — destructive both to markets and to society that a sovereign can be reduced to gridlock and turmoil and confusion over such a simple thing as a spending or borrowing authorisation. The real dangers here are not overspending or running out money, but unnecessary forcible austerity imposed by lawmakers, sucking money and economic activity out of the economy, and creating chaos and confusion in markets. There are already many real problems in the US economy — millions of people unemployed, weak growth, lack of job creation, private debt overhang and slow, painful deleveraging. The last thing the US economy needs is an unnecessary crisis of uncertainty and confusion created by economic illiterates in Congress.

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Why Does Anyone Think the Fed Will Taper?

Simon Kennedy of Bloomberg claims:

The world economy should brace itself for a slowing of stimulus by the Federal Reserve if history is any guide.

Personally, I think this is nutty stuff. In enacting QE3, Bernanke made pretty explicit he was targeting the unemployment rate; the “full-employment” side of the Fed’s dual mandate. And how’s that doing?

fredgraph (21)

It looks like its coming down — although, we are still a very long way from full employment. And a lot of that decrease, as the civilian employment-population ratio insinuates, is due to discouraged workers dropping out of the labour force:

EMRATIO_Max_630_378 (1)

Moreover, of course, quantitative easing — substituting zero-yielding cash into the money supply for low-yielding assets — is about the Federal Reserve attempting to reinflate the shrunken money supply resulting from the collapse of shadow intermediation in 2008. And the broad money supply remains extremely shrunken, even after all the QE:

And the bigger story is that America is still stuck in a huge private deleveraging phase, burdened with a humungous debt load:

Japan, of course, tapered its stimuli multiple times at the faintest whiff of recovery. Bernanke and Yellen will be aware of this.

Much more likely than abandoning stimulus is the conclusion by the next Fed chair — probably Yellen — that the current transmission mechanisms are ineffective, and the adoption of more direct monetary policy, including helicopter money.

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A Visual Representation of the Zero Bound

I’ve been trying to understand the relationship between savings and interest rates in the economy. There are many theoretical models and constructs that purport to represent the relationship between savings and interest rates, but it is interesting to look at it from an empirical standpoint. This graph shows savings at depository institutions as a percentage of GDP against the Federal Funds Rate:

Mises

The actual cause of the desire to save rather than consume or invest is uncertain. Perhaps this is a demographic trend — with more people closing in on the retirement age, they seek to save more of their income for retirement. Perhaps it is a psychological trend — fear of investment in stock markets and bond markets, due to fear of corruption, or market crashes or a general distrust of corporations. Perhaps it is a shortage of “safe” assets — by engaging in quantitative easing, central banks are removing assets from markets and replacing them with base money, and deleveraging corporations are paying down rather than issuing new debt. Perhaps it is anticipation of deflation — people expecting that saved money will increase its purchasing power in future. Perhaps it is a combination of all these things and more. But whatever it is, we know that there is an extraordinary savings glut.

There have been a lot of assertions that interest rates at present are unnaturally or artificially low. Well, what can we expect in the context of such a glut of savings? Higher interest rates? Based on what?

There was a clear negative association between savings and interest rates up until interest rates fell to zero, while the savings rate continued to soar. Theoretically, lower interest rates ceteris paribus should inhibit the desire to save, by lowering the reward for doing so. But interest rates cannot fall below zero at least not within our current monetary system — there exist some theoretical proposals to break the zero bound using negative nominal interest rates, but these remain untested and controversial. Even tripling the monetary base — an act that Bernanke at least believes simulates an interest rate cut at the zero bound — has not discouraged the saving of greater and greater levels of the national income.

In the long run, the desire to save increasingly massive percentages of the national income will cool down. Sooner or later some externality will jolt the idle resources in the economy into action. But that is the long run. In the short run saving keeps soaring. Investors are not finding better investment opportunities for their savings and the structure of production does not appear to be adjusting very fast to open up new opportunities for all of that idle cash.

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On the Relationship Between the Size of the Monetary Base and the Price of Gold

The strong correlation between the gold price, and the size of the US monetary base that has existed during the era of quantitative easing appears to be in breakdown:

fredgraph

To emphasise that, look at the correlation over the last year:

inversecorrelation

Of course, in the past the two haven’t always been correlated. Here’s the relationship up to 2000:

2000

So there’s no hard and fast rule that the two should line up.

My belief is that the gold price has been driven by a lot of moderately interconnected factors related to distrust of government, central banks and the financial system — fear of inflation, fear of counterparty risk, fear of financial crashes and panics, fear of banker greed and regulatory incompetence, fear of fiat currency and central banking, belief that only gold (and silver) can be real money and that fiat currencies are destined to fail. The growth in the monetary base is intimately interconnected to some of these — the idea that the Fed is debasing the currency, and that high or hyperinflation or the failure of the global financial system are just around the corner. These are historically-founded fears — after all, financial systems and fiat currencies have failed in the past. Hyperinflation has been a real phenomenon in the past on multiple occasions.

But in this case, five years after 2008 these fears haven’t materialised. The high inflation that was expected hasn’t materialised (at least by the most accurate measure). And in my view this has sharpened the teeth of the anti-gold speculators, who have made increasingly large short sales, as well as the fears of some gold buyers who bought a hedge against something that hasn’t materialised. The global financial system still possesses a great deal of systemic corruption, banker greed and regulatory incompetence, and the potential for future financial crashes and blowups, so many gold bulls will remain undeterred. But with inflation low, and the trend arguably toward deflation (especially considering the shrinkage in M4 — all of that money the Fed printed is just a substitute for shrinkage in the money supply from the deflation of shadow finance!) gold is facing some strong headwinds.

And so a breakdown in the relationship between the monetary base has already occurred. Can it last? Well, that depends very much on individual and market psychology. If inflation stays low and inflation expectations stay low, then it is hard to see the market becoming significantly more bullish in the short or medium term, even in the context of high demand from China and India and BRIC central banks. The last time gold had a downturn like this, the market was depressed for twenty years. Of course, those years were marked by large-scale growth and great technological innovation. If new technologies — particularly in energy, for example if solar energy becomes cheaper than coal — enable a new period of spectacular growth like that which occurred during the last gold bear market, then gold is poised to fall dramatically relative to output.

But even if technology and innovation does not produce new organic growth, gold may not be poised for a return to gains. A new financial crisis would in the short term prove bearish for gold as funds and banks liquidate saleable assets like gold. Only high inflation and very negative real interest rates may prove capable of generating a significant upturn in gold. Some may say that individual, institutional and governmental debt loads are now so high that they can only be inflated away, but the possibility of restructuring also exists even in the absence of organic growth. A combination of strong organic growth and restructuring would likely prove deadly to gold.

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Even After All The QE, The Money Supply Is Still Shrunken

Here are the broadest measures of the US money supply, M3 and M4 as estimated by the Center for Fiscal Stability:

Charts6_amfm1

With the total money supply still at an absolute level lower than its 2008 peak, it is obvious that the Federal Reserve in tripling the monetary base — an expansion by what is in comparison to other components of M4 a relatively small amount — has been battling staggering deflationary forces. And with the money supply still lower than the 2008 peak and far-below its pre-2008 trend, the Fed is arguably struggling in this battle (even though by the most widely-recognised measure, the CPI-U the Fed has kept the US economy out of deflation). 

Those who have pointed to massively inflationary forces in the American economy based on a tripling of the monetary base, or even expansion of M2 clearly do not understand that the Fed does not control the money supply. It controls the monetary base, which influences the money supply but the big money in the US economy is created endogenously through credit-creation by traditional banks and shadow banks. The Fed can lead the horse to water by expanding the monetary base, but in such depressionary economic conditions it cannot make the horse drink.

What does this imply? Well, either the monetary transmission mechanism is broken, or monetary policy at the zero bound is ineffectual.

What it also implies is that hyperinflation (and even high inflation) remains the remotest of remote possibilities in the short and medium terms. The overwhelming trend remains deflationary following the bursting of the shadow intermediation bubble in 2008, and to offset this powerful deflationary trend the Fed is highly likely to have to continue to prime the monetary pump Abenomics-style into the foreseeable future.

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The Magazine Cover Top?

John Hussman makes an entirely unscientific but still very interesting point about market euphoria — as epitomised by a recent Barron’s professional survey leading a magazine cover triumphantly proclaiming “Dow 16000” — as a contrarian indicator:

wmc130422a

I have no idea whether or not the Dow Jones Industrial Average will hit 16,000 anytime soon. A P/E ratio of 15.84 seems relatively modest even in the context of some weakish macro data (weak employment numbers, weak business confidence, high energy input costs) and that priced in real GDP they look considerably more expensive, but it’s healthy to keep in mind the fact that euphoria and uber-bullishness very often gives way to profit-taking, stagnating prices, margin calls, shorting, panic and steep price falls. That same scenario has taken place in both gold and Bitcoin in the past couple of weeks. Leverage has been soaring the past couple of months, implying a certain fragility, a weakness to profit-taking and margin calls.

Psychologically, there seems to be a bubble in the notion that the Fed can levitate the DJIA to any level it likes. I grew up watching people flip houses in the mid-00s housing bubble, and there was a consensus among bubble-deniers like Ben Stein that if the housing market slumped, central banks would be able to levitate the market. Anyone who has seen the deep bottom in US housing best-exemplified by a proliferation of $500 foreclosed houses knows that even with massive new Fed liquidity, the housing market hasn’t been prevented from bottoming out. True, Bernanke has been explicit about using stock markets as a transmission mechanism for the wealth effect. But huge-scale Federal support could not stop the housing bubble bursting. In fact, a Minskian or Austrian analysis suggests that by making the reinflation of stock indexes a policy tool and implying that it will not let indexes fall, the Fed itself has intrinsically created a bubble in confidence. Euphoria is always unsustainable, and the rebirth of the Dow 36,000 meme is a pretty deranged kind of market euphoria.

Nonetheless, without some kind of wide and deep shock to inject some volatility — like war in the middle east or the Korean peninsula, or a heavy energy shock, a natural disaster, a large-scale Chinese crash, a subprime-scale financial blowup, or a Eurozone bank run  — there is a real possibility that markets will continue to levitate. 16,000, 18,000 and 20,000 are not out of the question. The gamble may pay off for those smart or lucky enough to sell at the very top. But the dimensions of uncertainty make it is a very, very risky gamble.

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Why the Gold Crash? The Failure of Inflation to Take Off

One of the key features of the post-2008 gold boom was the notion that inflation was soon about to take off due to Bernanke’s money printing.

But so far — by the most-complete inflation measure, MIT’s Billion Prices Project — it hasn’t:

AnnualInflation

To me, this signifies that the deflationary forces in the economy have so far far outweighed the inflationary ones (specifically, tripling the monetary base), to such an extent that the Fed is struggling to even meet its 2% inflation target, much less trigger the kind of Weimar or Zimbabwe-style hyperinflation that some gold enthusiasts have projected.

The failure of inflation to take off (and thus lower real interest rates) is probably the greatest reason why gold’s price stagnated from 2011 and why gold has gone into liquidation the last week. With inflation low, investors became more cautious about holding gold. With the price stagnant, the huge gains that characterised gold’s rise from 1999 dried up, leaving more and more long-term investors and particularly institutional investors leaving the gold game to hunt elsewhere for yield.

I myself am an inflation agnostic, with deflationista tendencies. While I tend to lean toward the notion of deeply-depressed Japan-style price levels during a deleveraging trap, price levels are also a nonlinear phenomenon and could both accelerate or decelerate based on irrational psychological factors as much as the level of the money supply, or the total debt level, or the level of deleveraging. And high inflation could certainly take off as a result of an exogenous shock like a war, or series of natural disasters. But certainly, betting the farm on a trade tied to very high inflation expectations when the underlying trend is largely deflationary was a very bad idea, and those who did like John Paulson are being punished pretty brutally.

The extent to which this may continue is uncertain. Gold today fell beneath its 200-week moving average for the first time since 2001. How investors, and particularly institutional investors react to this is uncertain, but I tend to expect the pendulum to swing very far toward liquidation. After all, in 2011 most Americans named gold the safest investment, and now that psychological bubble is bursting. That means that for every goldbug buying the dip, many more may panic and sell their gold. This could easily turn to a rout, and gold may fall as low as the cost of production ($900), or even lower (especially considering gold’s high stock-to-flow ratio). Gold is a speculation in that it produces no return other than price rises. The last time gold got stuck in a rut, it was stuck there for almost 20 years.

However, my case for physical gold as a small part of a diverse portfolio to act as a hedge against systemic and counterparty risks (default cascades, Corzine-style vaporisation, etc) still stands, and lower prices are only good news in that regard. The financial system retains very many of its pre-2008 fragilities as the deregulated megabanks acting on margin continue to speculate in ways that systematise risk through balance sheet interconnectivity. Another financial crisis may initially lower the price of gold on margin calls, but in the long run may result in renewed inflows into gold and a price trend reversal. Gold is very much a barometer of distrust in the financial, governmental and corporate establishment, and as middle class incomes continue to stagnate and income inequality continues to soar there remain grave questions over these establishments’ abilities to foster systemic prosperity.