Thursday, January 31, 2013

Thursday, January 31, 2013 - Friedman, Von Mises, Adam Smith, and Inflation

Friedman, Von Mises, Adam Smith, and Inflation
by Sinclair Noe

DOW – 49 = 13,860
SPX – 3 = 1498
NAS – 0.18 = 3142
10 YR YLD - .02 = 1.99%
OIL - .49 = 97.45
GOLD – 12.90 = 1664.50
SILV - .56 = 31.56

Let's cover some of the economic news and then I'll try to tackle one of the most pressing questions of our time.

The Commerce Department reports personal incomes rose a seasonally adjusted 2.6% in December, the fastest pace in eight year. Sounds good, but the numbers are a bit of a fluke. Personal dividend income jumped 34.3% in December, pushed forward by concerns about the fiscal cliff. That is income that won't be paid out on a regular schedule, so the big increase will be matched by a later decrease in dividend income. Excluding the dividends and other distortions, personal income rose 0.4% in December. Wages and salaries rose 0.6% in December after a 0.8% gain in November and were up 5.4% year-on-year.

Consumer spending rose 0.2% in December, in line with expectations. With incomes running faster than spending, the personal savings rate rose to 6.5% of disposable income from 4.1% in November. It was the highest savings rate since May 2009.

Initial jobless claims jumped 38,000 to a seasonally adjusted 368,000 in the week ended Jan. 26. A separate survey this week produced by the payroll processor ADP said the U.S. gained 192,000 private-sector jobs in January, the highest in nearly a year. The ADP report is not an accurate indicator for the official government jobs report which will be released tomorrow morning, but it was enough to inch estimates up to 170,000 jobs added in January, with the unemployment rate possibly dipping to 7.7%. We'll wait and see.

We end the month of January with a go-go stock market. The Dow Industrials gained 5.8% for the month, the best January performance since 1994. The S&P 500 index posted a monthly gain of 5.1%. There is an old saying: as January goes, so goes the year. And when we see 5%+ January gains in the market, it usually does relate to a strong year, in the neighborhood of 20%. Dial back the exuberance just a smidgen. We're right up against old record highs and that will probably prove strong resistance. Don't forget fourth quarter GDP was negative, etc., etc.

Anyway, that brings us to today's question: Where is the inflation? Not exactly, the most pressing question of out time, but a good question nonetheless, a question that seems to leave many baffled. The central bankers are printing money at an unprecedented pace, and not just the Fed; it's a global race, and despite targets, there really is no exit plan in sight. All that money floating around should result in inflation, maybe skyrocketing inflation, maybe hyper-inflation. Toss in massive government deficits and we'll need wheelbarrows of cash to buy a loaf of bread. But it hasn't happened. Where's the inflation?

About 2%.

The relationship between money and prices is usually explained by the quantity theory of money, which tries to explain the relation between price inflation and money supply growth. So, when a country like Zimbabwe started printing more and more money, the result was hyperinflation. The basic equation is M*V = P*Y; this is the central equation in Milton Friedman's monetary policy; there are many variations on the equation.

Here's how it works: M is the money supply, times the velocity of money, and that should equal the price level, P, times output – or the GDP. So, you have a pile of money that is circulated at a fast or slow rate and that equals the price level times the output – what gets made with all that money.

The money supply has been increasing by almost 7.5% per year for the past 5 years, and more recently it has increased somewhere between 8.2% and 13.1% depending upon your preferred measure. Compare that to the other side of the equation, GDP, which has been growing around 2%, and went negative in the fourth quarter. The two sides of the equation don't match. In fact we would need to see inflation around 6% to 12% for the formula to work.

Where's the inflation?

Well, Friedman apologists would say that prices are sticky; it takes time to move prices. Well, it's been five years of the Fed printing money with reckless abandon. The other excuse is that the velocity of money has slowed down. Which it did for a while, but it has picked up again. Velocity just means that the same dollar gets spent many times in a period of time, usually over the course of a year. Of course, now we spend more digital money than paper cash, so that debit card transaction is moving around at light speed. The check is no longer “in the mail”, it's already made the trip on fiber optics.

But then there is a big chunk of money, around $1.6 trillion that the big banks are holding in reserve with the Federal Reserve. That money is parked. It doesn't move at all. The central bankers have effectively killed Friedman's monetary theory. And the inflationistas say that if, or when the banks start lending the trillion dollars in reserves the inflation will hit the fan, big time. Of course, this assumes the $1 trillion just comes gushing out, like floodwaters over a broken levee. I think it would be a bit more nuanced.

Another theory comes from the Austrian school of economists, like Ludwig von Mises, and they will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of "malinvestment" - investment that should not economically have been made, and which has less value than its cost. I'll explain the flaw in just a moment, but let's carry the malinvestment idea out to its logical conclusion first.

Eventually, like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.
This didn't happen in Japan. The banks went on lending to bad companies, the Japanese economy stagnated and has been stuck for 20 years. In Japan, the politicians have decided to print more money and do still more deficit spending. Japan has debt of 230% of GDP and so it might become difficult to sell more debt. And if the Japanese can't sell their bonds, that would cause the Japanese government to default and will more or less shut down the Japanese economy - the penultimate worst possible outcome. Liquidation wouldn't be confined to Japan, it could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy US Treasuries.
Now, here's the flaw with the malinvestment idea; ultra-low rates do not create an orgy of speculation in which markets create a huge volume of malinvestment. Just the opposite; high interest rates lead to malinvestment. Adam Smith, the father of modern economics, wrote in the Wealth of Nations: that if the legal rate of interest was “fixed so high as eight or ten percent, the greater part of the money which was lent would be lent to prodigals and projectors ( the promoters of fraudulent schemes), who alone would be willing to give this high interest... A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. When the legal rate of interest, on the contrary is fixed but a very little above the lowest market rate, sober people are universally preferred as borrowers, to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people than in those of the other. A great part of the capital of the country is thus thrown in the hands in which it is most likely to be employed with advantage.”
And we are seeing the wisdom of Adam Smith today. The higher interest rate environment of 8 years ago led to an orgy of speculation; today, rates are lower but it is tougher to get a loan. And when loans are made today, it should result in greater output, thus counter-balancing prices. It almost looks like Bernanke has created a new monetary ground where he can rapidly increase the money supply without getting inflation. Almost, but not quite.
There is still malinvestment. Closer reading reveals that Adam Smith might have been talking about the derivatives market. Today, the orgy of speculation exists in the OTC derivatives market, largely unregulated and ten times bigger than the global GDP, and it is out of control. Until Bernanke and the other central bankers can rein in the derivatives markets, it will remain the heart of malinvestment; sucking capital out of productive hands; and if the derivatives market collapses, it has the potential to drag down the credit and debt markets in a flash.
At that point, you're likely to get more inflation than you want.

Wednesday, January 30, 2013

Wednesday, January 30, 2013 - GDP Shrinks, Fed Stands Pat

GDP Shrinks, Fed Stands Pat
by Sinclair Noe

DOW – 44 = 13,910
SPX – 5 = 1501
NAS – 11 = 3142
10 YR YLD + .02 = 2.01
OIL + .46 = 98.03
GOLD + 12.50 = 1677.40
SILV + .64 = 32.12

GDP shrank in the fourth quarter, and we had that report on the same day as the Fed wraps up an FOMC meeting. So, I've been reading a bunch o' blogs and articles about how the Fed has been printing money, expanding its balance sheet to more than $3 trillion, failing to generate economic growth, failing to generate jobs, diluting the dollar, and generally condemning the American economy to the inevitable tortures of hyper-inflation. The internets are offering up the full spectrum of opinions: from the idea that the GDP Shows Federal Reserve Just Screwing the Average American to the apologetic Five Reasons the GDP Report is Misleading (hint: the economy will bounce back in a heartbeat, by golly gosh) to Fed Stays the Course: Is Its Monetary Policy Wrong?

Let's start with the GDP report. The economy shrank from October through December for the first time since the recession officially ended, hurt by the biggest cut in defense spending in 40 years, fewer exports and sluggish growth in company stockpiles. The Commerce Department said the economy contracted at an annual rate of 0.1 percent in the fourth quarter. That’s a sharp slowdown from the 3.1 percent growth rate in the July-September quarter, and well below expectations of 1% growth.

The weakness may be because of one-time factors. Government spending cuts and slower inventory growth subtracted a total of 2.6 percentage points from growth; and don't forget Hurricane Sandy, which cut into GDP. The slower growth in stockpiles comes after a big jump in the third quarter. Companies frequently cut back on inventories if they anticipate a slowdown in sales. Slower inventory growth means factories likely produced less. Those categories offset faster growth in consumer spending, business investment and housing; the economy’s core drivers of growth.

Let's look at some numbers. Residential investment jumped 15.3 percent, a sign that the housing sector continues to recover, for one. Similarly, investment in equipment and software by businesses rose 12.4 percent, an indicator that companies are still spending.  The 22.2 percent drop in military spending, the sharpest quarterly drop in more than four decades, along with the drop in inventories and exports overwhelmed more positive indicators in the private sector.

Subpar growth has held back hiring. The economy has created about 150,000 jobs a month, on average, for the past two years. That’s barely enough to reduce the unemployment rate, which has been 7.8 percent for the past two months. We'll see the January jobs report on Friday.

The economy may stay weak at the start of the year because an increase in Social Security taxes is cutting into take-home pay. Tax hikes combined with cuts in government spending is an easy formula for negative growth. Another positive aspect of the report: For all of 2012, the economy expanded 2.2 percent, better than 2011′s growth of 1.8 percent.

Bottom line is that the GDP report was lousy. Which leads to the inevitable question, what went wrong? If the Federal Reserve policy of printing money to get us back into growth was working, trillions should have bought us the biggest expansion in history. Instead it bought us negative growth and 8% unemployment. At what point does the Federal Reserve admit they are wrong? Which probably isn't the right question, but let's look at it anyway.

The Fed wrapped up their FOMC meeting, and they did not admit the error of their ways. The Fed attributed the pause in growth to the impact of Hurricane Sandy and other “transitory factors,” and it said that there were some signs of increased strength in areas including consumer spending and housing.

The Fed affirmed the stimulus program it announced in December, saying that it would hold short-term interest rates near zero at least until the unemployment rate fell below 6.5 percent and expand its holdings of Treasury securities and mortgage-backed securities by $85 billion each month. Keep in mind, QE 4 – To Infinity and Beyond – is a fairly fresh program. The Fed says: “The committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline.”

Still, you have to admit that $85 billion a month starts to add up; 40 billion here; 45 billion there; after a while you're talking about real money. And still no signs of the demon inflation nor economic growth. What does this really tell us? More than likely, the problems with the economy and with the financial sector were and are far worse than the attempted cures. The cesspool of toxic assets still being purged from banks' balance sheets was much bigger than anyone has been willing to admit. The banks have been unwinding their derivatives positions but not eliminating them, and those derivatives were massive; probably somewhere north of $700 trillion dollars, which is a really big number.

To put it into perspective, we should note that the gross domestic product of the entire world stands at around just 60 trillion dollars.  The US residential real estate market is worth 23 trillion dollars.  The total value of all the US stock markets is a mere 16 trillion dollars.  The value of the entire world’s stock markets is about 50 trillion dollars. 

A derivative is essentially a bet.  They were used responsibly in business for centuries as insurance against loss.  For example, in a simple derivative contract a farmer might bet against the success of his own crop to insure that if his crop fails he will not be at a total loss.  If the crop is productive that year, he loses the bet but reaps a profit from sale of his product.  If the crop fails, on the other hand, he can collect on the bet and make up for his loss of profit.  Derivatives provide a way to produce even returns in markets that are subject to uneven productivity.

One of the problems with today’s derivatives market is that it has expanded from its initial purpose of hedging and simple speculation to allow for betting on just about anything financial.  During the housing bubble we saw banks like Goldman Sachs betting on the failure of the very products they were selling as “AAA” rated safe investments.  They made a ton of money on the failure of their own financial products in this way, which represents just a little bit of a conflict of interest. While the housing-related derivatives have taken up less of the overall market, the overall market continues to grow. Today’s synthetic derivatives market even allows for betting on other people’s bets. This has created a multi-level ponzi scheme of derivatives that are based on the success of other derivatives, using huge degrees of leverage at every layer. In addition to remaining vastly unregulated and opaque, the market for the creation and exchange of derivative contracts operates much like the roulette wheel at a Las Vegas casino.

Basically, there is no other game in town to realize the kind of profits banks and their clients demand these days, so the roulette table is the place to be. Part of the attraction for the banks is that derivatives are traded over the counter, not through regulated exchanges, and the notional value of derivatives is recorded OFF the balance sheet of an institution, although the market value of derivatives is recorded ON the balance sheet. Attempts at regulation have been effectively blocked. So, we don't really know how much of the Federal Reserve's stimulus has gone into the Black Hole which represents the big banks gambling addiction in derivatives.

Where else has all the Fed stimulus money been going? The Fed is exchanging about $4 billion in newly created money every business day for various types of bonds. All else being equal, the Fed's bond buying puts more money in investors' hands to buy other assets, including stocks.

So let us follow that newly created money. The major dealers who sell the bonds to the Fed can take that money and buy other bonds in the open market. The new seller then gets paid with that newly created money, which in the bank clearing system, acts just the same as money you and I work for.
To make this really simple, the Fed creates $4 billion a day and eventually some of that money goes into equities. And that, of course, helps keep stock prices elevated. So it doesn't matter that we are having major problems with the underlying economy and markets that normally would depress stock prices. This is why you don't fight the Fed.

So, a large, not-quite-sure-how-much, but large amount of the Fed's stimulus efforts went to making sure the derivatives Black Hole did not swallow the entire universe; and that hasn't happened yet, so good job. Another large chuck of change goes to propping up bonds and equities and the Wall Street traders that trade them; and the major market indices are close to record highs, so good job. But the broader economy sucks; so in this regard the Federal Reserve gets very low marks indeed.

America cannot succeed when a shrinking few do very well and a growing many barely make it. Yet that continues to be the direction we’re heading in. The top 1 percent of earners’ real wages grew 8.2 percent from 2009 to 2011, yet the real annual wages of Americans in the bottom 90 percent have continued to decline in the recovery, dropping 1.2 percent between 2009 and 2011. In other words, we’re back to the widening inequality we had before the debt bubble burst in 2008 and the economy crashed. Not even the very wealthy can continue to succeed without a broader-based prosperity. That's a big reason why the recovery has been so weak; why the economy shrank in the fourth quarter.

Of course, fiscal policy has been ugly. As I said earlier, tax hikes combined with government spending cuts is a quick formula for negative growth. And the Federal Reserve standing pat won't get the job done either.

Tuesday, January 29, 2013

Tuesday, January 29, 2013 - Stimulus Truths and Tweaks

Stimulus Truths and Tweaks
by Sinclair Noe

DOW + 72 = 13,954
SPX + 7 = 1507
NAS – 0.6 = 3153
10 YR YLD +.03 = 2.00%
OIL + .88 = 97.32
GOLD + 9.40 = 1664.90
SILV + .54 = 31.48

We have a gaggle of economic reports this week and we'll try to keep up.

The Conference Board reported that its gauge of consumer confidence dropped to 58.6 in January, the lowest level since November 2011. Consumers are more pessimistic about the economic outlook and, in particular, their financial situation. The hike in the payroll tax is taking the brunt of the blame for the less-than-rosy outlook. Disposable income is actually declining. It's hard to be happy when your purse shrinks.

The sales price on existing homes dropped in November according to the S&P/Case-Shiller home-price index, down a non-seasonally adjusted 0.1% decrease in November following a 0.2% decline in October. After seasonal adjustments, the 20-city home-price index rose 0.6% in November. Despite the recent decline, prices were 5.5% higher than during the same period in the prior year, for the strongest year-over-year growth since August 2006.

Tomorrow, we'll get a glimpse of 4th Quarter GDP. The economy likely grew at a 1% pace, which is very weak.

Also tomorrow, The Federal Reserve wraps up its first FOMC meeting for the new year. They will likely continue with a fairly aggressive approach to stimulate the economy. In December, the Fed committed to adding $45 billion of monthly Treasury purchases to the existing QE3 program to buy $40 billion in mortgage debt a month. The purchase program has no end date. Last week the Bank of Japan announced a stimulus plan that includes US Treasury purchases. The Fed also adopted a new policy that targeted short-term interest rates to the outlook for unemployment, saying rates would stay low until the jobless rate falls below 6.5% as long as inflation stays tame.

The official unemployment rate is 7.8%, down from the 10% rate recorded in late 2009. Employment in the private sector has risen by more than 5 million over the past three years but it represents a sluggish recovery. Just over 12 million people are classified as unemployed (meaning they are actively looking for work), with an additional 6.5 million who aren’t looking but say they want a job; many of those people are long-term unemployed. Long-term unemployment imposes additional costs in the form of higher social spending and reduced economic output.

The unemployment rate in Europe is 10.7%, with 26 million out of work. Last week, the International Labor Organization reported nearly 200 million people worldwide are unemployed. Compared to the rest of the world, the US looks pretty good.

The British economy is flirting with a triple dip recession. The UK's gross domestic product fell 0.3 percent in the fourth quarter. One of the major problems has been a strong austerity program which cut investment spending. To be clear and fair, spending in the UK has changed composition rather than shrunk. Spending on social maintenance has gone up but investment spending has tanked. And of course I mean government investment spending, not private. This would indicate that removing government investment spending hurts the economy, not because it displaces private investment, but because it supplements and enhances private investment.

It’s not as if observers hadn’t warned about the effect of contractionary fiscal policy. In the summer of 2012, the IMF issued recommendations, saying deeper budget-neutral reallocations could support recovery. Such reallocations within the current overall fiscal stance could include greater investment spending funded by property tax reform or spending cuts on items with low multipliers. Automatic stabilizers should continue to operate freely. It will also be important to shield the poorest from the impact of consolidation.

The IMF said, scaling back fiscal tightening plans should be the main policy lever if growth does not build momentum by early-2013 even after further monetary stimulus and strong credit easing measures. Temporary easing measures in such a scenario should focus on infrastructure spending and targeted tax cuts, as they may be more credibly temporary.
It's not as if we haven't seen contractionary policies fail in the past. Andrew Mellon, as Secretary of the Treasury, advised Herbert Hoover: "Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”

So, the evidence continues to accumulate to overwhelming levels in favor of a front-loaded fiscal and monetary expansion, and the evidence supports the view that growth cannot be induced by contractionary policies in the current economic environment. And while tax increases could slow growth, there is no indication tax cuts in this environment are enough to encourage hiring.

One idea is to push US banks to lend more. The banks now have about $1.6 trillion in reserves parked at the Federal Reserve, not doing anything except making the banks feel safer. The Fed could put a cap on bank reserves, forcing the banks to do something with about $1 trillion in excess reserves, like lending it out to small businesses that are now being strangled by tight credit. It might help move money, but who will take a loan without a need. We have a demand problem, not a supply-side problem.

Any spending now, which would increase the deficit, must decrease the debt burden in the longer-term. In other words, we need investments, not just throwing money around. Infrastructure spending puts people to work n projects that promote economic growth. Those newly employed people spend their paychecks, circulating money, increasing the velocity of money in an otherwise stagnant environment. Economic growth is the optimal way to reduce the long-term debt burden. The money spent on infrastructure improves productivity and improves efficiency and saves us money over time.

We have neglected routine maintenance of our infrastructure for too long. We all know that it is cheaper to change the oil in our car's engine than it is to replace the engine. It is cheaper to fix a leak in the roof of the house than to interior of the house get soaked in a downpour. Pay now or pay more later.

But what about the cost versus benefit for new infrastructure? On the cost side, money is cheaper now than ever. Interest rates are near zero. High unemployment has reduced wage costs. On the benefits side, we have sufficient technological improvements to warrant upgrades in roads, bridges, water works, the electric grid, energy, transportation, and shipping in order to remain competitive globally.

Of course, there is an alternative lesson to be learned from the British triple dip. Some believe the UK government is desperate to keep interest rates as low as possible in order to avoid a housing market collapse where most mortgages go unpaid, which would result in the collapse of all UK banking – you know, something like a repeat of 2008. Also, if interest rates rise, interest payments on private and public debt would balloon. Further, if interest rates rise, the pound would strengthen, causing exports to slow even further.

According to this train of thought, in order to keep nominal interest rates low the UK government has chosen many years of recession as their strategy, because recession keeps down imports of oil and allows nominal interest rates to be low without triggering higher inflation, which is already running fairly high because of the higher cost of imports.

If nominal interest rates go up, and the housing market debubbles causing the collapse of the UK financial systems, the UK will be in an situation similar to Ireland or Lithuania, with a very sharp, long depression, instead of a milder, longer recession.

There is yet another possible motivation for the lack of investment in the US economy. The Fed is effectively printing profits to the largest Fed member institutions in exchange for MBS the banks have accumulated with cash from earlier sales to the Fed in lieu of lending because banks' net margin is negative in real terms after charge-offs and delinquencies as a share of loans.

All of the stimulus by the Fed is designed to disguise the fact that the banks still have hundreds of billions of dollars, if not trillions, in charge-offs to clear, which is preventing banksters from growing their loan books. "Stimulus" is really "bank liquidation".

In the meantime, the US government is borrowing and spending $1 trillion a year to prevent nominal GDP from contracting and thus forestall further contraction in bank assets and corporate profits, which are now at a record to GDP, as is non-financial corporate debt to GDP. Of course, that's just a theory and it does nothing to improve the unemployment picture, but it does provide a convenient target for the Federal Reserve to aim at, and keep just out of reach; this provides a reason for the Fed to continue QE because there is no viable exit strategy.

I'm sure there are plenty of other considerations or theories which might apply, but tweaking monetary and fiscal policies at the margins is largely irrelevant, and in an environment of tweaking, it leads to speculation. What this tells us is that there is a small window of opportunity to try to grow the economy. If we don't grow it now, it will be increasingly more difficult to grow it in the future.

Monday, January 28, 2013

Monday, January 28, 2013 - What's Going On

What's Going On
by Sinclair Noe

DOW – 14 = 13,881
SPX – 2 = 1500
NAS + 4 = 3154
10 YR YLD + .03 = 1.97%
OIL + .69 = 96.57
GOLD – 4.80 = 1655.50
SILV - .34 = 30.94

This will be a big week of economic reports, including: the Federal Reserve concludes its first policy meeting of 2013 on Wednesday; the monthly jobs report on Friday (look for a gain of 165,000 jobs and the unemployment rate to hold steady at 7.8%); earnings reporting season continues according to expectations; tomorrow brings an update on fourth quarter GDP; later in the week we'll see reports on incomes, spending, and sentiment.

Today we learned orders for durable goods, the big-ticket items made in the US, increased 4.6% in December, fanned by a big batch of bookings for military and commercial aircraft. Demand also improved for most other makers of long-lasting goods, suggesting that US manufacturers could be poised for a modest rebound in 2013. Then Caterpillar issued a less than bright outlook for 2013, which put a damper on the sector.

Toyota Motors retook the title of world's largest auto maker, posting a 23% gain in global sales to a record 9.75 million vehicles in 2012. General Motors moved to second place in global sales at 9.29 million; Volkswagen was in third place with 9.07 million sales.

The National Association of Realtors reports pending home sales fell 4.3% in December, with low inventory cutting results. The trade group's pending-home-sales index declined to 101.7 in December from 106.3 in November.

No policy changes are expected from the Fed this week, but investors will be on the lookout for further clues to policy makers’ assessment of the economic recovery. Last year, the Fed said it was committed to holding interest rates near zero as long as unemployment remained above 6.5% and inflation remained below 2.5%.

It‘s less clear, however, what it would take to get the Fed to end its open-ended third round of quantitative easing, because the analysts still don't quite believe the Fed targets for inflation and employment. Minutes of previous Fed meetings have highlighted a wide divergence of opinion over the potential time frame for the program. Beyond the targets and the time frame, nobody is quite sure how the Fed can possibly back away from juicing the economy. And an equally intriguing thought is what the Fed might do if all their stimulus continues to disappoint. Don't expect big surprises from this week's Fed meeting. The Fed will continue to pass out money for their buds on Wall Street; they will continue their $85 billion per month bond-buying program and keep short-term interest rates near historic lows. Esther George, president of the Kansas City Federal Reserve, has said that the Fed’s willingness to give away easy money could undermine the stability of the financial system in the future.
Not surprising then to hear a new elite consensus on the US budget deficit. One of the functions of the World Economic Forum in Davos – decide for yourself whether this is a virtue or a vice – is to give the plutocrats a venue for figuring out their party line. For a long time, the conventional wisdom among this crew has been that the deficit and the debt were the United States’ chief economic problems. Not only was the deficit the United States’ most important economic woe, it was the most important economic issue in the entire world. But, then the rich guys figured out that if austerity is actually imposed, it might deter the Fed from loading bags of money into their helicopters and dumping it on their buds on Wall Street. So the new idea out of Davos is that deficits don't really matter.

The fact that deficit cutting was the right prescription in the 1990s doesn’t necessarily make it the priority today. So, the rich guys in Davos are abandoning the deficit fighting dogma in favor of economic policy that is more like medical treatment than religion. It isn’t a dogma that should be cleaved to under every circumstance. Instead, it is a doctor’s black bag, whose particular instrument depends on the specific patient.
Viewed in that way, there is no contradiction between supporting a hawkish approach to U.S. government spending in the 1990s and a more expansionary bias today. The world has changed, so the right policy needs to be different, too .Today, the long-term interest rate is negligible, the constraint on investment is lack of demand, productivity has vastly outstripped wage growth, and the oft-repeated mantra that reduced deficits spur investments and you’ll get more middle-class wages doesn’t work in the same way,
In other words, deficit reduction does not constitute the basis for satisfactory growth strategy. Instead, to get growth, particularly for the beleaguered middle class, you need “investment,” a category a budget hawk might simply term “spending.” Let's all remain flexible.

Of course, there is still the Machiavellian intrigue of DC politics, but today, a surprise as a bipartisan group of senators. Four Republicans and Four Democratic senators agreed on an immigration reform plan they hope to move quickly with legislation giving 11 million illegal immigrants a chance to eventually become American citizens. The senators released the outline of a comprehensive immigration reform effort - one with plenty of details missing - that still must be turned into legislation.

A funny thing happened on the way to the bank. Bloomberg reports: More than $114 billion exited the biggest U.S. banks this month, and nobody’s quite sure why.
The Federal Reserve releases data on the assets and liabilities of commercial banks every Friday. The most current figures, covering the first full week of 2013, show the largest one-week withdrawals since the Sept. 11, 2001, attacks. Even when seasonally adjusted, the level drops to $52.8 billion—still the third-highest amount on record, and one for which bank experts and analysts were reluctant to give a definitive explanation.

The most obvious culprit is the expiration of the Transaction Account Guarantee program, the extraordinary federal effort to shore up the country’s non-gigantic banks during the 2008 financial crisis. Big banks were considered “too big to fail,” while smaller ones were vulnerable to runs. The TAG program backstopped their deposit bases by temporarily offering unlimited insurance on money kept in non-interest-bearing accounts. That guarantee ended on Dec. 31, so a decrease in deposits would be expected first thing in January.

But hold on: The Fed data show $114 billion leaving the 25 biggest banks—about 2 percent of their deposit base. Only $26.9 billion left all the others, equivalent to 0.9 percent of their deposit base. Experts had predicted that the end of TAG would hurt the nation’s small banks because the big ones are still considered too big to fail.

So if the missing $114 billion is not the result of the TAG program expiration—or at least not all related to TAG—what’s going on? The first quarter is always a wacky quarter. And January 2013 has seen an incredible amount of change. First, the fiscal cliff drama had companies shifting dividends and had bank clients guessing what their tax liabilities would be, which might explain the $60.4 billion pumped into the largest banks during the week ending Dec. 26. (Seasonally adjusted, it was the sixth-highest level on record.) Second, the payroll tax just went up, sticking most wage earners with paychecks that are 2 percent smaller.
Third, ordinary investors may be ready to move out of federally guaranteed accounts and into investments. Stocks did very well in 2012. Equity mutual funds saw their second-highest inflows on recordin the first week of the year. Market exuberance is high, with one measure of risk aversion at a three-decade low.

If deposits are really trending down—and at the end of the month, we’ll be smarter than we are now—if that’s the case, it can tell us a few things. It could tell us is that the law of elasticity is finally catching up with deposits. In other words, contrary to what economic theory predicts, deposits have been piling up at banks ever since the crisis, even though they offer pitiful yields. That may finally be ending, but it is a little too early to tell. One week does not make a trend. Still, $114 billion is a big figure, and it’s one to keep an eye on.
Activists from the hacker collective known as Anonymous assumed control over the homepage of a federal judicial agency Sunday morning. In a manifesto left on the defaced page, the group demanded reform to the American justice system and what the activists said are threats to the free flow of information.

The lengthy essay largely mirrors previous demands from Anonymous, but this time the group also cited the recent suicide of Reddit co-founder and activist Aaron Swartz as has having "crossed a line" for their organization. Swartz was facing up to 35 years in prison on computer fraud charges. Prosecutors said he had stolen thousands of digital scientific and academic journal articles from the Massachusetts Institute of Technology with the goal of disseminating them for free.

Anonymous says Swartz was "killed because he was forced into playing a game he could not win - a twisted and distorted perversion of justice - a game where the only winning move was not to play."

"There must be a return to proportionality of punishment with respect to actual harm caused," it reads, also mentioning recent arrests of Anonymous associates by the FBI. In their statement, the hackers say they targeted the homepage of the Federal Sentencing Commission for "symbolic" reasons.
The group claimed that if their demands were not met they would release a trove of embarrassing internal Justice Department documents to media outlets. Anonymous named the files after Supreme Court justices and provided hyperlinks to them from the defaced page. I've heard about efforts to follow the links, which don't seem to link to anything, but this could get interesting.

Friday, January 25, 2013

Friday, January 25, 2013 - Closing In On the Days of Milk and Cookies

Closing In On the Days of Milk and Cookies
by Sinclair Noe

DOW + 70 = 13,895
SPX + 8 = 1502
NAS + 19 = 3149
10 YR YLD + .10 = 1.95%
OIL + .06 = 96.01
GOLD – 8.10 = 1660.30
SILV - .44 = 31.28

Once upon a time, about five years ago to be more precise, we lived in a land of milk and cookies. Some of you are old enough to remember those happy days when the Dow Industrials hit the dizzying heights of 14,164 in October 9, 2007. The all-time high on the S&P 500 index was 1565, made on October 9, 2007.

Of course, the heady, happy days full of hubris were followed by cataclysmic, economic catastrophe as the global financial meltdown followed in short dis-order. Some of us saw it coming, even if we weren't quite sure how it would hit us. Still, it's an old and oft repeated story. "Pride goeth before destruction, and an haughty spirit before a fall”; but with humility comes wisdom.

If only.

What can we expect if we hit new highs? Likely a crash. That's the pattern. Build it up to watch it fall. Part of the reason for the pattern is that the main driver for market gains has been the Federal Reserve's near constant injections of stimulus into the markets; and if we hit highs, the thinking is that the Fed could back off the juice, and when that happens, the financial markets get a nasty case of the Cold Turkey shakes.

There is little debate over whether the Fed has played an integral role in pumping up the markets. A July, 2012 study from the New York Fed stated flatly that the market owed most of its post-1994 gains - that's more than 1,000 points ago on the Standard & Poor's 500 - to the 24-hour period before the Fed's Open Markets Committee meetings. Central bank liquidity has been by far and away the most important driver of asset prices since that haughty October of 2007.

The Fed began purchasing $85 billion per month earlier in January as part of its expanded third round of quantitative easing. Initially, the Fed had planned to purchase $45 billion per month in mortgage backed securities. However, with the expiration of the second Operation Twist in December, the Fed rolled the purchases of treasury bonds into QE3 and began purchasing a total of $85 billion per month in securities this month.

This week marked a historic event for the Fed; their balance sheet grew to $3 trillion for the first time ever -- the largest in the Fed's nearly 100 year history. As of Jan. 23, the Fed's balance sheet climbed by $48 billion to $3.01 trillion. The announcement coincided with the S&P 500 closing at its highest level since December 2007 as the index nears the psychological 1500 level. Three trillion is a lot of money. The shame is that the Fed couldn't by more with that much.

You could point to the broader economy to make a case that the stimulus has been somewhat effective. The big theme of 2013, according to Wall Street investment shops, will be the "Great Rotation," a massive move out of bonds and into stocks. Economic growth is expected to accelerate, facilitating the shift. The past seven years have seen a Great Divergence in terms of fund flows. Investors have poured $800bn into bond funds and redeemed $600bn from long- only equity funds. But recent data show the first genuine signs of equity-belief in years. The past 13 days have seen $35 billion come back into equity funds; $19 billion of which is via long-only.

Again, the Fed's hand is seen guiding the markets. The structural long position in fixed income is simply threatened by low expected returns thanks to low rates and the mathematical reality that a small rise in rates can cause total return losses in portfolios. Retail inflows into equity markets have started to pick up; more inflows are expected to be reported in the weekly numbers; still, individual investors are lightly positioned in equities relative to history.

Quarterly earnings for the S&P 500 reached a crisis nadir of minus-9 cents a share for the fourth quarter of 2008, when QE began, to an expected profit of $25.18 a share for the fourth quarter of 2012; unfortunately the stimulus for corporate America hasn't effectively filtered down to Main Street.

And all that earnings growth has a dark side. Wall Street is so addicted to Fed stimulus that good economic news is seen as bearish because of the reliance on the central bank backstop and the fears that an upturn will deter the Fed from further stimulus. Bullish economic news is bearish. Bearish economic news is bullish. Wall Streets thrives on pretzel logic. Maybe there is nothing the Fed can do to truly help the economy. Sure, the Fed can pump money into Wall Street; which is great if you're a Wall Street banker; not so great for the rest of the country.

Today, Tim Geithner wraps up his tenure as Treasury Secretary, and the Washington Post has a report that supposedly shows that Geithner was tough on banks. The crux of the story is that Geithner is quoted as saying “F--- the banks,” during some unspecified meeting. Strong words but nothing to indicate the banks have had anything but cowering compliance and sweetheart deals during Geithner's tenure.

For now, the markets are going higher and the economy is improving. So far, we've managed to avoid a downturn. We narrowly avoided a tumble over the fiscal cliff with a down-to-the-wire deal on New Year's Day.  The three-month suspension of the US debt ceiling renders DC uneventful in the short term. The passage of the House Republican bill to suspend the debt ceiling for three months, allowing the government to keep paying its bills and giving lawmakers additional time to hammer out a long-term deal. We'll hear the case for cutting spending. When combined with the tax increases that did occur as part of the fiscal cliff deal, the impact from those looming spending cuts could result in trimming the country's economic growth of some 1.25% this year.

The CBO cautioned in November that "if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product will drop by 0.5% in 2013, reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year." In other words, the CBO predicted a recession in the first two quarters of the year. It looks like we've dodged that bullet, but only for a few months.
And the Fed has promised it will keep the Fed Funds rate unchanged into 2014, maybe longer. Maybe. Of course, there is a strong possibility that the Fed is just making it up as they go. This week, we saw the transcripts from the Fed in the pre-crisis, haughty, hubris-filled, record high days of 2007. The transcripts revealed the Fed had no clue what they were doing. With humility comes wisdom, and the transcripts were surely humbling, but only time will tell if there is wisdom in the pain. Can the market really stand on its own? What happens when the Fed dials back Quantitative Easing? The Fed thinks they can gradually turn the dial from”unlimited” to “just enough”. More likely, as soon as they touch the dial, the party is over.

Meanwhile, we've been trying to provide some insights into the economic bash that is an annual event in the Swiss resort town of Davos. Today, Mario Draghi, the European Central Bank President took the stage at the World Economic Forum and he took his bows. Draghi says the  central bank measures last year had prevented a banking crisis. And he also praised government leaders for steps they took to strengthen the currency union, for example agreeing to put the central bank in charge of supervising banks — a change that will be phased in over the next year.
Draghi said the euro zone economy has stabilized at a very low level and should begin to recover in the second half of 2013. Data released today supported the thesis of a gradual recovery. The Ifo business climate index, a closely watched indicator of business confidence in Germany, rose more than expected. The survey suggested that the euro zone’s largest economy is growing again after a contraction at the end of 2012.

What’s more, the central bank says more euro zone banks than expected had chosen to make early repayment of three-year central bank loans they took out a year ago. The volume of early repayment is seen as a sign that at least some banks are healthier than they were, and able to raise money on their own. The central bank said 278 banks would pay back 137 billion euros, of a total of 489 billion euros they borrowed a year ago at exceedingly low interest rates.

Draghi did express concerns that the calm in the financial markets had not yet led to economic growth and better lives for European citizens. Once upon a time, I told you the Europeans were taking a page from the Federal Reserve's playbook. Case in point.

Thursday, January 24, 2013

Thursday, January 24, 2013 - Financial Talk Radio Content Enhancement Bill of 2013

Financial Talk Radio Content Enhancement Bill of 2013
by Sinclair Noe

DOW + 46 = 13,285
SPX +0.01 = 1494
NAS – 23 = 3130
10 YR YLD +.01 = 1.84%
OIL + .84 = 96.07
GOLD – 17.10 = 1668.70
SILV - .59 = 31.74

Archived audio at (financial review)

First, let's deal with Apple and then we'll move on. Interesting side note, on this day in 1984, then-Apple Chairman Steve Jobs introduced the Macintosh, one of the first and most successful personal computers to use a mouse and a graphical user interface Late yesterday, the company announced mediocre earnings. That’s when everyone started freaking out. Analysts dissected every second of the conference call, trying to predict the specs of the next iPhone or what the company might do with its mountain of cash. CNBC’s coverage was especially hilarious. The talking heads asked their expert guests over and over again to tell the people when they should buy this stock; which is like telling people when to catch a falling knife.

The price action has been horrible. The chart’s broken. There’s really no reason to try and catch shares as they continue to flame out. Apple’s fall from grace isn’t the big story here. Just six months ago, Apple stock was trading near $700. The stock made up a whopping 20% of the NASDAQ-100. So every single tick moved the market. If Apple had a bad day, there was a good chance it would drag the rest of the Nasdaq down with it.

What’s important now is how the market will fare with shares of a rather large and formerly-leading stock steadily trending lower. The Nasdaq took a hit today. No surprise. Still, it looks like the Nasdaq has created some separation from Apple. Over the past six months, the Nasdaq is up nearly 7%, while Apple stock has dropped double digits. Rotation has already started. Many speculators have moved out of Apple and on to other opportunities. After all, there are plenty of interesting momentum stocks out there that could become the next rising star.

Apple’s drop won’t be the demise of this market. The company will be fine; they are still making money; it's not like they're broke. They have a ton of cash, and eventually they'll become a boring, dividend paying tech company.

It's not like Apple is Morgan Stanley for goodness sake. Five years ago, Morgan Stanley put together and sold $500 million of collateralized debt obligation to a Chinese bank and a Taiwanese bank. They loaded the CDO with bad debt and then they bet against it. This is all coming to light because the banks are suing Morgan Stanley, treading where the SEC and the Department of Justice fear to tread. And we are seeing some documents revealed through the discovery process; and it basically shows Morgan Stanley to be disgusting slime. The paper trail includes some emails describing the CDO as Nuclear Holocaust, S-Bag, Hitman, and other colorful names.

And the internal documents outline Morgan Stanley's business model: “Ability to short up to $325 million of credits into the CDO.” In other words, Morgan Stanley could — and did — sell assets to the Stack CDO intending to profit if the securities backed by those assets declined. The bank put on a $170 million bet against Stack, even as it was selling it. In the end, of the $500 million of assets backing the deal, $415 million ended up worthless.

Why might Morgan Stanley have bet against the deal? They were getting information from fellow employees conducting and receiving private assessments of the quality of the mortgages that the bank would purchase to back securities. These reports weren’t available to the public. 

In the fall of 2005, bank employees shared nonpublic assessments of how the subprime market was full of toxic assets, ready to implode. In February 2006, the bank began creating at least one bundle of CDOs worth $500 million, in part so that it could bet against it. In April 2006, the bank created its own internal hedge fund to short the subprime market; employees of that internal hedge fund had access to private due diligence reports. Finally, by early 2007, the bank appeared to realize that the subprime market was faring even worse than it expected. So Morgan Stanley bankers looked to peddle as a safe and sound investment what its own employees were internally deriding, with very colorful names.

How does someone sell something they know is a toxic asset? “Hey, just calling to let you know we got a nice little CDO here at the shop, we call it Nuclear Holocaust, but don't let the name fool you. This baby's a beauty.”

Mary Jo White has been selected as the next SEC chairwoman to replace the outgoing Mary Schapiro. As a former United States attorney in Manhattan, Ms. White has a strong law enforcement background. White also spent more than 10 years as a leading white-collar defense lawyer. That means she has also been privy to how firms and individuals respond to government investigations.

Also, Lanny Breuer is leaving his post as the head of the criminal division of the Department of Justice. A couple of nights ago, PBS ran a Frontline show call the Untouchables, dealing with the financial crisis, and specifically the lack of prosecutions; the show included an interview with Breuer. Breuer has been criticized for his lack of interest in prosecuting banks and more important, bank executives for their conduct during the crisis, and the basic justification was that such cases are difficult to make. Kind of like having a Pope who doesn't believe in religion.

While it may be difficult to prosecute for some crimes like fraud, history teaches us that there are many ways to skin a cat. Remember the Prohibition-Era gangster Al Capone was not convicted of bootlegging, he was convicted of tax evasion.

Top bank executives could be prosecuted for making false certifications under Sarbanes Oxley, which requires at a minimum that the bank certify the adequacy of internal controls, which for a large trading firm, includes risk management. Another approach might be collusion and lack of arm’s length pricing in the CDO market, which would lend themselves to antitrust charges. Price fixing is criminal under the Sherman Act.

This is a Department of Justice that has been willing to pursue creative and sometimes strained legal theories to go after John Edwards, and used a weak case to destroy Aaron Swartz, but becomes remarkably unimaginative as far as big bank misdeeds are concerned.

The false premise in the “protect the banks at all cost” has always been that it would cause too much collateral damage, but this left the American people to bear the cost of Wall Street’s scams. Even any half cocked comparison of the relate “cost” being shoveled onto the American public compared to an FDIC resolution of even one of the Too Big To Fail banks shows this excuse not to prosecute is non-sense.
It will be interesting to see where Mr. Breuer lands in the private sector. His legacy at the Department of Justice is that crime does pay, extremely well.

On that subject, sort of, Christine Lagarde, the managing director of the IMF, the International Monetary Fund, speaking at the World Economic Forum in Davos warned that corrosive inequality is hurting the world's economic recovery. In a combative speech to an audience of some of the world's wealthiest financiers, Lagarde said that bankers' pay should be cut to close the gap between the rich and poor: "Excessive inequality is corrosive to growth; it is corrosive to society. I believe that the economics profession and the policy community have downplayed inequality for too long.”

Ms Lagarde also warned that necessary reforms of the multinational banking sector were being watered down by industry lobbying. She said: "We can already see too many signs of waning commitment – dilution of reforms, delays in implementation, inconsistency of approaches. And we can see the risks – a further weakening in capital and liquidity standards; and not enough progress on key areas like cross-border resolution, shadow banking, and derivatives.” Lagarde told delegates that bankers' pay is too high: "Ultimately, this is all about accountability: we need a financial sector that is accountable to the real economy– one that adds value, not destroys it."

Lagarde was speaking after Jamie Dimon, chief executive of US bank JP Morgan, launched an attack on banking regulators, who he accused of botching attempts to protect taxpayers from future bailout costs. Dimon may have been a bit unhinged when he claimed banks were “ports in the storm” during the crisis. Side note here: The AFL-CIO's Reserve Fund, a union fund that owns JPMorgan shares, wants the bank's board to form a committee that would explore breaking up the bank. In response, JPMorgan is seeking permission from the SEC to prevent the measure form coming up for a vote at the next shareholders meeting in the Spring.

Today, British Prime Minister David Cameron, speaking in Davos, called for a global effort to clamp down on tax avoidance by businesses and more urgent efforts to stimulate global trade. The UK has had a running battle with several multi-national corporations not paying taxes, including Google and Starbucks. Cameron took a swipe at the coffee seller: "Any businesses who think that they can carry on dodging that fair share, or that they can keep on selling to the UK and setting up ever-more complex tax arrangements abroad to squeeze their tax bill right down -- well, they need to wake up and smell the coffee, because the public who buy from them have had enough.” Last month, Starbucks caved to public pressure and agreed to pay more UK taxes.

And back in Washington, the House has officially passed a bill to temporarily suspend the debt ceiling until May, kicking the can down the road to financial Armageddon. We still get another fight in March, when spending cuts kick in automatically and the government budget actually expires, and we have the possibility of a government shutdown. The bill is officially titled the “Financial Talk Radio Content Enhancement Bill of 2013”.