qe3

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The Latest Bubble?

Subsidies encourage the type of behaviour they are subsidising.

And the Federal Reserve’s QE Infinity is subsidising the market for mortgage backed securities by taking them out of the market at a price floor.

Unsurprisingly, the market for mortgage-backed securities is near all-time highs:

And Wall Street is doing some wild and wacky things.

UBS has just launched a 16-times-leveraged MBS ETN. The ETN, called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT, offers double the return of the Market Vectors Global Mortgage REITs Index – itself an investment vehicle 8x leveraged to mortgage-backed securities.

The idea appears to be that with the Fed acting as a buyer-of-last-resort that prices will take a smooth upward trajectory and that 16:1 leverage makes sense for retail investors as a bet on a sure thing.

Of course, back in the real world, there is no such thing as a sure thing. As Pedro Da Costa recently noted, banks are sitting on the proceeds of MBS purchases, rather than passing on the money to customers in the form of lower interest rates. As the New York Fed’s William Dudley recently noted:

The incomplete pass-through from agency MBS yields into primary mortgage rates is due to several factors—including a concentration of mortgage origination volumes at a few key financial institutions and mortgage rep and warranty requirements that discourage lending for home purchases and make financial institutions reluctant to refinance mortgages that have been originated elsewhere.

Those leveraging up on MBS might want to consider the implications if the Fed were to change its QE3 transmission mechanism — a transmission mechanism that William Dudley is willing to admit is broken — and buy other assets instead of MBS. Without a buyer of last resort with a printing press, prices would seem to be at current levels unsustainable. And those junk MBS products that the market is leveraging up on now in the hope that the Fed will buy them all will be left out in the cold. Such an event would bad news for anyone leveraged 16:1 on MBS.

But such an event would be an ingenious pump and dump, shifting the burden of junk MBS off Bulge Bracket balance sheets and onto the books of not only the Fed — which has already sucked up huge swathes of toxic junk — but also small-time speculators looking to book leveraged gains, but who end up taking the hit. 

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Krugman, Newton & Zombie Banks

Paul Krugman:

Mitt Romney – supposedly advised by Mankiw among others – is outraged:

[T]he American economy doesn’t need more artificial and ineffective measures. We should be creating wealth, not printing dollars.

That word “artificial” caught my eye, because it’s the same word liquidationists used to denounce any efforts to fight the Great Depression with monetary policy. Schumpeter declared that

Any revival which is merely due to artificial stimulus leaves part of the work of depressions undone

Hayek similarly decried any recovery led by the “creation of artificial demand”.

Milton Friedman – who thought he had liberated conservatism from this kind of nonsense –must be spinning in his grave.

The Romney/liquidationist view only makes sense if you believe that the problem with our economy lies on the supply side – that workers lack the incentive to work, or are stuck with the wrong skills, or something.

Perhaps Krugman ought to consider more seriously the reality that since both Japan and now America have gone down the path of continually bailing out a corrupt, dysfunctional and parasitic financial system that neither nation has truly recovered.

Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish. While some surely perished from misfortune, and some surely survived from luck, this basic antifragile mechanism ensured the survival of the fittest agriculturalists and the transmission of their methods, ideas and genes to further generations. In the financial sector today the Darwinian mechanism has been turned on its head; in both Japan and the West, financiers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure with injections of liquidity. Markets have become hypnotised and junkified, trading the possibility of the next injection of central banking liquidity instead of market fundamentals.

So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008. That crisis was caused by excessive financial debt. Many Wall Street banks in 2008 had forty or fifty times as much leverage as they had equity. The problem with leverage is that while successful bets can very quickly lead to massive profits, bad bets can very quickly lead to insolvency, liquidity panics and default cascades.

Following 2008, many on Wall Street promised they had learned their lesson, and that the days of excessive leverage and risk-taking with borrowed money were over. But, in October 2011, another Wall Street bank was taken down by bad bets financed by excessive leverage: MF Global. Their leverage ratio? 40:1.

So why was the banking system bailed out in the first place? Defenders of the bailouts have correctly pointed out that not bailing out certain banks would have caused the entire system to collapse. This is because the global financial system is an interconnected web. If a particularly interconnected bank disappears from the system, and cannot repay its creditors, the creditors themselves become threatened with insolvency. Without state intervention, a single massive bankruptcy can quickly snowball into systemic destruction. The system itself is fundamentally unsound, fundamentally fragile, and prone to collapse.

Government life-support has given Wall Street failures the resources to continue their dangerous and risky business practices which caused the last crisis. Effectively, Wall Street and the international financial system has become a government-funded zombie — unable to sustain itself in times of crisis through its own means, dependent on suckling the taxpayer’s teat, alive but yet failing to invest in small business and entrepreneurs.

My theory is this: our depression is not a problem of insufficient demand. It is systemic; most prominently and immediately financial fragility, financial zombification, moral hazard, and excessive private debt, alongside a huge number of other long-term systemic problems.

The new policy of unlimited quantitative easing is an experiment. If those theorists of insufficient aggregate demand are right, then the problem will soon be solved, and we will return to strong long-term organic growth, low unemployment and prosperity. I would be overjoyed at such a prospect, and would gladly admit that I was wrong in my claim that depressed aggregate demand has merely been a symptom and not a cause. On the other hand, if economies remain depressed, or quickly return to elevated unemployment and weak growth, or if the new policy has severe adverse side effects, it is a signal that those who proposed this experiment were wrong.

Certainty is something that economists in particular should be particularly guarded against, even as a public relations strategy. Isaac Newton famously noted in the aftermath of the South Sea bubble that “I can calculate the motion of heavenly bodies but not the madness of people.” In the sphere of human action, there are no clear and definitive mathematical principles as there are in astronomy or thermodynamics; there have always been oddities, exceptions and quirks. There has always been wildness, even if it is at times hidden.

So we shall see who is right. I lean toward the idea— as Schumpeter did — that the work of depressions and crises is clearing out unsustainable debt, unsustainable business models, unsustainable companies, unsustainable banks and — as much as anything else — unsustainable economic theories.

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The New European Serfdom

So let’s assume Greece is going to leave the Eurozone and suffer the consequences of default, exit, capital controls, a deposit freeze, the drachmatization of euro claims, and depreciation.

It’s going to be a painful time for the Greek people. But what about for Greece’s highly-leveraged creditors, who must now bite the bullet of a disorderly default? Surely the ramifications of a Greek exit will be worse for the international financial system?

J.P. Morgan — fresh from putting an LTCM alumnus in charge of a $70 trillion derivatives book (good luck with that) — is upping the fear about Europe and its impact on global finance:

The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn. This is a big amount but let’s assume that, as several people suggested this week, these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?

The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.

The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case. And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.

A multi-trillion € shock — far bigger than the fallout from Lehman — has the potential to trigger a default cascade wherein busted leveraged Greek creditors themselves end up in a fire sale to raise collateral as they struggle to maintain cash flow, and face the prospect of downgrades and margin calls and may themselves default on their obligations, setting off a cascade of illiquidity and default. Very simply, such an event has the potential to dwarf 2008 and 1929, and possibly even bring the entire global financial system to a juddering halt (just as Paulson fear-mongered in 2008).

Which is why I am certain that it will not be allowed to happen, and that J.P. Morgan’s histrionics are just a ponying up toward the next round of crony-“capitalist” bailouts. Here’s the status quo today:

Greece no longer wants to play along with the game?

Okay, fine — cut them out of the equation. In the interests of “long-term financial stability”, let’s stop pretending that we are bailing out Greece and just hand the cash over to the banks.

Schäuble and Merkel might have demanded tough fiscal action from European governments, but they have never questioned the precept that creditors must get their pound of flesh. Merkel has insisted that authorities show that Europe is a “safe place to invest” by avoiding haircuts.

Here’s my expected new normal in Europe:

After all — if the establishment is to be believed — it’s in the interests of “long-term financial stability” that creditors who stupidly bought unrepayable debt don’t get a big haircut like they would in a free market.  And it’s in the interests of “long-term financial stability” that bad companies who made bad decisions don’t go out of business like they would in a free market, but instead become suckling zombies attached to the taxpayer teat. And apparently it is also in the interests of “long-term financial stability” that a broken market and broken system doesn’t liquidate, so that people learn their lesson. Apparently our “long-term financial stability” depends on producing even greater moral hazard by handing more money out to the negligent.

The only real question (beyond whether or not the European public’s patience with shooting off money to banks will snap, as has happened in Greece) is whether or not it will just be the IMF and the EU institutions, or whether Bernanke at the Fed will get involved beyond the inevitable QE3 (please do it Bernanke! I have some crummy equities I want to offload to a greater fool!).

As I asked last month:

Have the 2008 bailouts cemented a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

And will the inevitable 2012-13 bailouts of European finance cement this aristocracy even deeper and wider?

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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).

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Steve Jobs, Jobs and Reincarnation

Readers will know that my feelings toward Apple are profoundly mixed.

As I wrote back in July:

The notion of well-oiled blue-shirted brigades of lanyard-wielding corporate minions dancing, speaking and thinking in line to the beck and call of Steve Jobs goes beyond running an efficient operation. It’s obsessive-compulsive, and downright creepy. In my view, the sooner a competitor arises that delivers minimalist, solid and sleek computers at a similar price and without all this peculiar control-freakery, without the backdoor surveillance, and without the cultlike undertones, the better. I will jump ship as soon as I possibly can. But right now? Apple has no real competitors.

But there is no doubt Apple has a vast array of good qualities beyond having great products. There are three crucial ones: value creation, job creation and innovation.

From Sovereign Man:

While people like Warren Buffet are pleading with the government to raise their taxes and give away their wealth to sycophantic bureaucrats, Jobs showed time and time again that the best way to improve people’s lives is to create value and be productive.

Steve Jobs was one of the most productive human beings to have ever lived; he started several successful companies which directly employed tens of thousands of people. Indirectly, his businesses improved the livelihoods of millions across the globe, from Chinese factory workers to iPhone app programmers to Apple shareholders.

In building an empire and unimaginable wealth for himself, Steve Jobs enriched the lives and livelihoods of others by creating value. Not by forced redistribution. Not by giving things away. By creating value.

Ironically, just as I write this I am watching President Obama on Bloomberg Television trying to explain how many jobs his new plan will create– 1.9 million in his estimate:

“We’re just going to keep on going at it and hammering away… until… something gets done. I would love to see nothing more than Congres act… so aggressively.”

Politicians would do themselves and their constituents a great service by comparing their own track record for enriching people’s lives against Steve Jobs’ performance, and then kindly stepping out of the way. The path to prosperity is not paved in votes, but rather in freedom: the freedom to create, produce, risk work hard… and be rewarded for your efforts.

Well, amen to that. Our markets sorely need new value, new innovation and new jobs, and the answer to that conundrum — as I painstakingly pointed out here — is creating new wealth, not new taxes as many currently seem to advocate.

In my view, Jobs greatest contribution to the philosophy of economics (and something I have hammered on in recent months) is the importance of failure:

If you can’t succeed or fail, it’s really hard to get better.

The story of Jobs’ life, and the story of free market capitalism is very much one of trying and trying and trying again, learning from experience, and gradually improving. Look at the difference between a Power Cube G4 and a Mac Mini. The difference between a first-generation iPod and the new iPhone. Lisa and Mac OSX.

Sadly, as American Presidents heap praise on Jobs and his innovations, they’re not exactly heeding his advice. As I point out on an almost-daily basis, the highly interconnected global financial system has experimentally shown itself to be fundamentally flawed, and systematically broken. The establishment response — at both a national and global scale — has not been to put failures to one side and try new systems (hopefully ones that allow for less interconnection, less leverage and less risk — and subsequently less fragility) but to pump money and bail out failures to make the same mistakes all over again on a bigger scale.

So as Steve Jobs’ body begins its journey back into nature, back into the oxygen, carbon, nitrogen and hydrogen cycles — to be reborn, as we will all be, as new organisms — perhaps it is time governments started listening to his advice? Perhaps it’s time for the global financial system to die and be reborn…?

Farewell.

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No iPhone 5 (Yet)

So the rumours were true and Apple’s iPhone 5 was beset by enough technical difficulties to be canned (for now) and replaced by a souped-up iPhone 4:

Except it is the iPhone 5. Its technical specifications are exactly in line with what was expected of the iPhone 5. The only missing pieces were the bodywork and the title.

I think this is instructive. In the highly superficial world of technology, if your latest product looks exactly like your last product, will anyone but specification-obsessed-geeks care?

How difficult would it have been to tweak the casing, call it the iPhone 5, and watch the hoards flock to it?

In spite of a late-day rally, Apple’s stock is down for the day:

How often is it (in recent history) that Apple stock falls on the day of a major product launch?

The entire episode smacks of mismanagement and reminds me of the market’s disappointed reaction to Operation Twist. Like Apple-junkies, the POMO-junkies wanted their version of the iPhone 5 — QE3.  Just like the iPhone 4s, Operation Twist is what the junkies wanted — a massive money-printing operation (over the yield curve) in all but name. Yet the junkies end up disappointed.

Steve Jobs might have been dictatorial and Machiavellian, but at least he knew how to manage expectations and give the market what it wanted. The fear for Apple is that now Apple has lost its envisioner-in-chief that those same obedient automata who so smoothly executed Jobs’ vision will now fuck-up that last great bastion of American innovation (no Ben — “innovative” monetary policy is not innovation).

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Bernanke Didn’t Pump, Equities Get Dumped

So what happens now QE3 hasn’t occurred? Let’s see what I wrote last month:

QE3 has already been priced in so there would be shock. Confidence would plummet, followed swiftly by asset prices, especially the blown-up pufferfish S&P, DJIA and Nasdaq. Two exceptions would be gold, which would shoot up — well above $2000 — and treasury bonds, whose yields would edge ever lower. And plummeting asset prices would mean debt-deflation, leading to more bank failures, and the debt-deflation spiral posited initially by Irving Fisher, and later by Friedman, Schwarz and Bernanke.

Continue reading →

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No QE3 (Yet)

So Bernanke announced a twist operation, shifting the weight of bonds toward the long-end of the maturity spectrum, and a program to roll maturing mortgage backed securities. This means that the Fed’s balance sheet will remain largely unchanged — in other words, very bloated.

But in the immediate term there will be no QE3, no drop on interest in excess reserves, no purchases of equities, commercial paper, foreign debt or any of the wackier theories about Bernanke surprising the economy into recovery. What does this mean for projections on the US economy? Very little — without an artificial updraft of stimulus, and with the ongoing global pressures, it seems inevitable that equities — Bernanke’s metric of choice — will sooner or later end up in the ditch by the wayside.

From the Guardian:

The Fed said the economy faced “significant downside risks”; one of those risks being the volatility in financial markets around the world. US stock markets reacted badly to the move. The Dow Jones Industrial Average closed down 283.82 points, or 2.49%, at 1124.84. The Dow has fallen two of the last three trading days following fears that Europe’s financial woes will spread to the US.

As I wrote last month:

Bernanke’s policy since 2007 as Governor of the Federal Reserve has been to pump money to reflate the rest of the economy to catch up with swollen debts acquired during the bubble — debts, especially in real estate, that would otherwise be defaulted upon as post-crash deflation took hold, leading to bank failures, credit retraction and a huge deflationary spiral to the bottom. That was his thesis in 1983 in regard to the 1930s, and he has been particularly lucky (or unlucky) to be able to test his thesis through policy. The real question is — what is supporting asset prices now? Is it real, new organic growth in America? No — growth is low, stagnant, and led by corporate profits, not small business or industrial output. Is it a booming real estate sector? No — confidence and prices are as low as 2009. Is it lower dependence on foreign oil, and a booming energy sector? No — America is more dependent on Arab oil than at any time in history, and the Arabs are wealthier than ever. Is it deeper, wider and burgeoning consumer demand? No — consumer demand for all but the rich is stagnant, burnt out by crippling food and fuel inflation, and rampant unemployment especially among the young.

He will print eventually — perhaps not this week or month, but he will — no matter how clear Wen Jiabao has been that QE3 should not happen.

Some interesting commentary comes from Peter Tchir of TF Market Advisors

Disappointment With The Fed

There are lots of things out there that once they have been done, can never be undone. Ben just disappointed the market for the first time. Whether he knew it or not he failed to beat expectations. He has been so good at managing expectations and using that as a policy tool he lost sight of how far ahead of itself the market had gotten. Everyone expected twist and seriously, what’s a 100 billion in size between friends in this crazy market.

He downgraded the economy but didn’t use that as an excuse to do more. There was no new, ingenious idea. If anything they tried to clarify the commitment to hold rates low til 2013 is dependent on economic conditions remaining weak.  Yet there were still 3 dissenters.

Ben has been a fan of making markets dance to his tune based on expectations. By disappointing some people I expect his ability to keep the market up by talking will be reduced as investors will need to see action rather than being told vaguely that there could be action. That will take time to play out and even I have to admit he gave us something today, just not enough.

The conclusion is very simple: intervention breeds expectation of more intervention, which breeds dependency.

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Can Bernanke Print Gold?

This week, I looked at America priced in gold — and noted that America is experiencing gold-denominated deflation. This means that when assets are priced in gold they have consistently fallen in price. Lets re-cap. Here’s the Dow Jones Industrial Average:

Continue reading →

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Goldman Sachs on Why QE3 is Still Definitely On

From Goldman Sachs:

BOTTOM LINE: Bernanke offers little guidance on near-term policy outlook, but extension of September meeting makes easing at this meeting a bit more likely than before.  We continue to think that further easing via manipulation of the Fed’s balance sheet —either through expansion or restructuring of the average duration of holdings—is likely by early 2012. 

Continue reading →