Sunday, November 27, 2011
Sometimes they do ring a bell! The S&P 500 fell 4.7% closing at 1158.67 the lowest level since October 7th. It seems to me that the failure of the German 10yr Bund auction marks a point where investors now believe that there is a greater chance that the ECB will be forced to monetize the rollover of sovereign debt maturities and money demand to shift downwards with a capital flight out of Europe.
What was it that caused US banks to demand a record amount of effectively under the table cash from the Fed?
There are four indicators today which show as clearly as anything can be shown the state of our global debt-based monetary and financial system. Any one of them alone should be all the evidence one needs that the system is unsustainable. Put them together and much more than the canary is singing.
First, the most popular (measured by its nominal “value”) investment vehicle today is a combination of a bet that sovereign debt will go bankrupt and an “insurance policy” that if/when it does, the holders of the debt paper will be made whole. These are called “credit default swaps” or CDSs, conceived in the early 1990s and unleashed on the investment world shortly thereafter. The total of CDSs outstanding doubled every year from 2003 to 2007. This growth paused in 2008 – early 2009 and then exploded again with the onset of “quantitative easing”.
The second indicator is the mere fact that it is now universally accepted in the investment world that the only “safe” government debt is one issued by a government whose central bank has demonstrated its willingness to print money.
The third indicator is the fact that the “sovereign debt crisis” hype is focused exclusively onEuropein a desperate attempt to prevent the discovery that everybody is in the same boat.
And the fourth and last is Gold. On the paper markets, the price of Gold can and is being manipulated. Beyond Gold’s price appreciation is the ever increasing global demand for physical Gold and the fact that central banks throughout Europe andAsiaare adding to their supply.
Here is a chart of what Austrians call True Money Supply (TMS) that was prepared by Michael Pollaro of The Contrarian Take.
This chart is a bit difficult to read but from late 2008 to June, 2011 the Fed pumped almost $2.1 trillion into the system in response to the initial crash (QE1). As the economy started to fade again in 2010 it put in its second round, QE2. QE2.5 (Operation Twist) is the Fed’s attempt to keep long Treasury rates down and shifted its purchases of Treasuries from short-term to longer-term paper. The chart on the right, the red line, shows the history of the monetary infusions.
The left chart reveals that after QE1, MS (I use TMS2) grew until it peaked in December, 2009 (marked by the vertical red arrow). GDP responded and by Q2-2009 GDP starting rising until it peaked in Q2-2010. MS started shrinking again after December, 2009 as credit demand declined and loans were called or paid down, and banks parked money in excess reserves at the Fed. By the end of Q2-2010 GDP started to decline again after 12 months of growth. That prompted QE2 in November, 2010 and MS increased until August, 2011 where it may have peaked (see the second red arrow). GDP also followed, and as of Q3-2011 was increasing.
To summarize, every time the Fed injected money directly into the system via quantitative easing (“helicoptering”), GDP rose after a lag, and when MS started to decline after the injection of steroids ran its course, GDP declined after a lag. Very little real economic growth or capital formation occurred as a result of these Fed actions, otherwise they wouldn’t have needed QE2, and that is why the economy will decline again. The numbers the Fed looks at will be declining (economic output, employment, price levels) and that will motivate them to do QE3 which they believe will have positive effects on the economy. It is also something that many investors follow and are hoping for. The hope that money “printing” will solve anything is misplaced; it will only cause further harm to the economy.
The expansion of the Fed’s balance sheet through the purchase of treasury and mortgage securities has been largely financed by an increase in the banking system’s excess reserves.
This is totally different than if, say, the Fed had to step into the Treasury market because investors had lost confidence in the federal government’s ability or willingness to pay its debt obligations. First, the mechanics of such a Fed intervention would be unclear. Second, and more relevant forEurope, is what would happen to the demand for the dollars if the Fed was seen as printing money to pay off bad debt the Treasury couldn’t roll over?
If the ECB were to begin monetizing “bad” sovereign debt, we suspect that money demand in Germany and the stronger core countries could shift dramatically as the perception of the Euro as a hard currency would be begin to fade. Unlike many analysts who have no skin in the game, the German people understand the difference between the Federal Reserve’s quantitative easing and the money printing of, say, the Banco Central de la Republica of Argentina in the 1980’s. Such a loss of confidence in the ECB could cause the Euro collapse and set off a major currency crisis.
This is not to say the ECB doesn’t have room to engage in quantitative easing alá the Fed. As banks shrink their balance sheets,Europewill experience an acute credit crunch and monetary contraction. This could create “room” for the ECB to expand the monetary base a bit faster.
But let’s keep clear the difference between debt monetization and the quantitative easing that is taking place in theU.S.,U.K., andJapan. The major stakeholders in the Euro currency certainly will.
Market Behavioral Analysis:
Economic theory states that it is the fickle nature of confidence, including its dependence on the public’s expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained. The above mentioned German Bund auction failure is signaling that the future events include monetization.
As the situation in Europe deteriorates and money fleeingEuropeaccelerates and European economies lock up we expect the US Dollar to strengthen and equity markets world wide to approach 2009 lows.
Free To Choose:
“The more corrupt the state, the more numerous the laws.” – Tacitus, The Annals of Imperial Rome
We have an established short position @1223. VIX is still below the 40+ reading we expect will be necessary to mark a tradeable bottom. We anticipate many rumors and plans emanating from Europe that will cause large % swings. However, we feel that the realization that you can’t cure a debt crisis with more debt is settling in and S&P is on its way to 1086 Pivot Bottom1 where we would take profits. Ultimately we expect a move to 850.
We are short US Bonds from 141’16. A dramatic German 10yr auction failure where a full 35% was un-bid has left UST as the last “safe haven” for now. We feel that the rally since the Bund auction failure was muted and that the world may have already gotten their full of the endless supply of UST. Target for this trade is Pivot Bottom 1 at 138.
We are short EC @ 1.4040. Euro has resumed its slide. First target is 1.3000. The “good news” rally was short lived as the realization that the austerity needed and the printing necessary to save the Euro will drive the price to our first target of 13000.
We got the expected pullback to $95 and established a long Jan Crude position. Pick any of the following reasons: Fiat Printing, Resolution of Debt Crisis, Mid-East Conflict, and the laugher better unemployment numbers.
Our long has been established at 3.2220. Copper has broken the breakout of the W bottom. This throws the chart into some discord. We will remain long looking for a move to the Pivot of 3.8600.
Performance based on a $200,000 futures account.