Wednesday, November 14, 2012 - How I Learned to Stop Worrying and Love the Bomb

How I Learned to Stop Worrying and Love the Bomb

by Sinclair Noe

DOW – 185 = 12,570
SPX – 19 = 1355
NAS – 37 = 2846
10 YR YLD un = 1.59%
OIL + 1.10 = 86.48
GOLD + 2.70 = 1728.60
SILV + .24 = 32.84

President Obama held his first post-election news conference today. I was a little surprised when he announced the presidential pardon for Big Bird.

Then he moved on to the more serious issues, like the sex life of generals.

In addition to addressing the Petraeus scandal, Mr. Obama used the opportunity to broach a far more expected crisis; the looming "fiscal cliff." He stressed that unless Congress acts to avert the "fiscal cliff" all Americans could see their taxes could go up and the economy could fall back into a recession, and he insisted that the top 2% of income earners see a tax increase.

So, that's where it stands. Both sides digging in their heels.

Everyone is afraid of falling off the fiscal cliff, but there's another dangerous countdown clock about hit to zero and no one is talking about it, even though it will spell even more financial problems for us all.

At midnight on December 31, 2012, we'll get tagged; the Transaction Account Guarantee (TAG) program will expire. The TAG program was initiated at the height of the crisis when depositors were fleeing banks for fear they would go under. So, the FDIC upped regular deposit insurance from $100,000 to $250,000 and under the TAG banner initiated unlimited insurance for all non-interest bearing transaction accounts.

If or when the unlimited insurance expires, corporations, businesses and depositors will be looking for a safe place to park their cash, and there is quite a bit of parking; those soon-to-be-uninsured deposits total some $1.4 trillion. Where will the money go? Likely to the biggest banks, money market funds and the safety of short-term U.S. Treasuries. This will create serious negative repercussions.

First, the too-big-to-fail (TBTF) banks that created the credit crisis and spawned the Great Recession are much bigger now than they were in 2008, and are about to get even bigger.

Because the failure of any one of America's big five banks would implode the global financial system, they will never be allowed to fail. That makes them a fortress for depositors, regardless of expiring guarantees. The same isn't true for the smaller banks that will start disappearing.

The problem for the economy is that TBTF banks are going to have to make bigger and bigger loans and orchestrate far-reaching lending schemes that encompass wide swaths of the population (as they did with mortgages) to accommodate the greater economies of scale their huge size demands. That's going to lead to massive concentrations of risk, which the TBTF banks have proven has been, and will be, their downfall. The counterparties on these deals are the other TBTF banks. And for the average consumer that means less competition, higher fees and transaction costs, and less access to credit at the local level, or at least a big risk premium for stooping down to deal with a small local business.

Next, when businesses and corporations can't justify the risk of parking money in cash, they'll start chasing yield. Money market funds will be the preferred parking place for a lot of that cash. Even though money market funds don't pay much, they allow quick withdrawals and are considered a good substitute for non-interest bearing checking accounts at banks, but there's a problem with money market funds. They aren't guaranteed. They were back when the Federal government was guarantying all financial parking lots at the time of the crisis, but no more. 

What's potentially problematic is that if billions of dollars of cash goes seeking some yield in money market funds, fund managers are going to have to put those new monies to work. And where do a lot of money market funds go to buy short-term interest bearing instruments so they can offer the best yields to potential billion-dollar customers? Too often they turn to European banks issuing short-term paper.

And then a lot of the cash coming out of bank checking accounts is going to go into short-term Treasury bills and notes. Right now the Treasury issues about $30 billion of one-month T-Bills every week. If the majority of the $1.4 trillion sitting in banks in soon to be uninsured accounts heads into these most liquid instruments it would take a year of issuance to satisfy that demand. Now, don't forget, the Federal Reserve is buying some $45 billion a month of Treasuries and agency paper. And, what about money market funds? If they get flooded with cash, they too will be buying the short- term issues spit out by the Treasury. What happens if there is actually some deal on the fiscal cliff that results in smaller deficits? The Treasury wouldn't have to issue as much new debt as it does now. The demand for short-term Treasuries could very conceivably turn their yields negative.

What happens then? As if corporations, pension funds, and people aren't yield starved enough. Will the further implosion of yields and the continuing destruction of fixed income cause everyone to reach further and further out on the risk curve? It's already happening. Junk bond funds are seeing record inflows as investors are clamoring for yield.

And the TAG is just a very small part of the fiscal cliff.

Meanwhile, we saw the minutes of the Federal Reserve's October 23 & 24 FOMC meeting. The Fed has been selling $45 billion a month in short-term Treasurys and using the proceeds to buy an equal amount of longer-term securities. When Operation Twist ends after December, the Fed will run out of short-term investments to sell. The minutes show support among “a number of” Fed policymakers to replace Twist with another program of long-term bond purchases. The Fed heads also confirmed they plan to keep interest rates near zero for a few more years, and there was some talk of establishing numerical targets for the economy. Nothing earth-shattering here, but I'm willing to wager there were some off the record discussions about the fiscal cliff.

The economy has been hooked up to the anesthetic drip of low interest rates and cheap money. Cheap money that caused the crisis has been replaced by even cheaper money to prevent a worse one. The chances of a rapid recovery are a good deal less than anyone wants, and a fair chunk of that is due to the global economic situation. Today, the Bank of England issued its most pessimistic outlook since the financial crisis. The economy will not recover its pre-recession peak for another three years as Britain faces a “period of persistently low growth” and sticky inflation.

In Euro-land, a popular backlash is building against cuts to public services and the “internal devaluation” policies that have targeted wages and Europe’s high levels of social protection with the aim of restoring competitiveness to the EU’s highly indebted economies. This year unemployment is expected to reach record levels of more than 11% in the eurozone and 10.5% in the EU. Taking a step away from the statistics, it means that more than 25m Europeans will be unemployed this Christmas. It is going to get worse. EU forecasts predict that joblessness rates will climb even further.

In Spain, once an EU pin-up for growth and a country that was not in debt before the banking crisis, youth unemployment has hit 55% and the recession is still deepening. There have been general strikes across Europe; hundreds of thousands participated. Tens of thousands took to the streets in Madrid. Protesters burned things; police fired rubber bullets.

Tens of millions of Europeans blame austerity for suppressing demand and acting as a dampener on growth at a time of economic recession triggered by the financial crisis. The deadly combination of slowdown plus austerity, compounded by economic imbalances built into the EU’s single currency, has pushed countries, especially the southern European economies at the heart of the eurozone debt storm, into what looks like a deep and protracted slump; and it is bad enough to drag down even the most powerful Euro-economies, and don't think it won't affect the US economy.

Europe has had much more austerity in aggregate than we have and it isn't working for them. And for all the people who are so scared about the fiscal cliff, what they're are really arguing is that slashing spending and raising taxes on ordinary workers is destructive in a depressed economy, and that we should actually be doing the opposite.