January, Wednesday 04, 2012

DOW +21 = 12418
SPX +0.24 = 1277
NAS –0.36 = 2648
10 YR YLD +.04 = 2.00%
OIL +.29 = 103.25
GOLD +8.90 = 1613.50
SILV -.55 = 29.26
PLAT –12.00 = 1427.00

Bill Gross manages PIMCO’s $244 billion Total Return Fund, the largest bond fund in the world. Every so often, Gross posts an investment letter on his website. His most recent letter is entitled “Welcome to 2012”.

In the letter, Gross said "paranormal" was a more fitting description for the current economic environment than the phrase "New Normal," coined several years ago by his chief co-investment officer Mohamed El-Erian to describe a world of low-growth and high unemployment. This year, Gross argues that process will get messier.

"We are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding - delevering - because there's too much paper and too little trust," he said.

Those factors may lead financial markets to experience "the fat-left-tailed possibility of unforeseen - delevering - or the fat-right-tailed possibility of central bank inflationary expansion."

So, this goes right in line with what I’ve been talking about for quite some time. The situation in Europe, the ongoing situation in the USSA all points to de-levering and the response to de-levering by the central bankers – especially the Federal Reserve – is to pump free money into the markets.

That’s really about all they can figure out to do, because they don’t know what else to do. They need the economy to improve in order to generate jobs, but the economy can only improve if people have jobs. They need the economy to recover in order to improve our deficit situation, but if the economy really recovers long term interest rates will increase, further depressing the housing market and increasing the interest expense burden for the US, therefore increasing the deficit. A recovering economy would result in more production and consumption, which would result in more oil consumption driving the price above $100 per barrel, therefore depressing the economy. Americans must save for their retirements as 10,000 Baby Boomers turn 65 every day, but if the savings rate goes back to 10%, the economy will collapse due to lack of consumption. Consumer expenditures account for 71% of GDP and need to revert back to 65% for the US to have a balanced sustainable economy, but a reduction in consumer spending will push the US back into recession, reducing tax revenues and increasing deficits. 

And don’t forget, the housing market is still declining. There are approximately 2.25 million foreclosures still in the pipeline. Nationally, housing prices are expected to continue to drop for another 2 years, at least.

And the de-levering continues on the Federal Reserve’s balance sheet. The Fed has scooped up at least $1.5 trillion in toxic mortgage backed securities, which are now worth only about $700 billion (and that’s just the MBS). How will they unload this toxic waste? The simple answer is that it is going to be extremely difficult. The treasuries they bought will drop in value if and when interest rates rise – and interest rates will rise with another round of quantitative easing. So quantitative easing can’t be unwound without destroying the Fed’s balance sheets, and the US economy. The Fed is in a hole and they can’t get out. The only hope is that they can drag this out and slowly, quietly slough off the toxic waste.

This is why the Fed yesterday announced they will communicate any changes in interest rate policy well in advance. They’re trying to drag it out as long as they can; they’re trying to soften the blow as much as possible. Grandma’s on the roof. Just want to let you know.

That takes us back to Bill Gross’ descriptive "fat-left-tailed possibility of unforeseen - delevering - or the fat-right-tailed possibility of central bank inflationary expansion." On the de-levering side you have a European implosion or a black swan event. On the inflationary side, you’ve got the Fed creating money out of thin air and passing it out to the bankers. How’s that been working out so far?

Over in Europe, the European Central Bank is using the Fed’s playbook. In the last week of December, the ECB loaned more than a half trillion euros to the Eurozone banks at the new lower rate of 1 percent. The banks then took the cash and parked it in the ECB’s overnight deposit account, where they earn a little more than 1 percent (about 1.26%)  and they don’t have any risk and they don’t have to worry about lending the money to other banks because who knows what toxic mess another bank may have on their books, and if their toxic mess is anything like our toxic mess, you sure as hell don’t want to do business with those losers. Italian banks are now issuing state guaranteed paper to obtain funds from the ECB and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near Ponzi by another.

So the ECB just created a half trillion euros, created the money out of thin air, this is a massive injection of liquidity – and Europe didn’t implode this week but it didn’t solve any problems either.  In fact, we may have a new problem developing. If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a broker. The bankers, the investors, and even the depositors can behave like a kid on the playground – they can take their bat and ball and go home and pout. This is the credit risk of a Zero Interest Rate Policy.

And faced with this prospect, the central bankers will inject even more liquidity into the financial system. That is the playbook; it’s what they do; it’s about the only tool left in the tool belt.

Then you start looking at the dominant theme – de-levering or inflation. We know it’s a combination, but what will be the dominant theme.. Inflation would be rough on bonds. De-levering would be rough on stocks. The dollar would likely get hit in a reflationary environment. Commodities could go either way but definitely higher if there is a black swan event. Precious metals may look a little pricey but they don’t carry counter-party risk and the central banks can’t print unlimited quantities.