Friday, November 15, 2013 - Stuck in the Monetary Tar Pit

Stuck in the Monetary Tar Pit

by Sinclair Noe

DOW + 85 = 15,961

SPX + 7 = 1798

NAS + 13 = 3985

10 YR YLD + .01 = 2.70%
OIL - .04 = 93.72
GOLD + 3.10 = 1291.40
SILV + .04 = 20.88

Record highs for the Dow and the S&P 500; with the Dow closing in on 16,000, and the S&P closing in on 1800 or maybe 2000 if you blink. The Nasdaq is nowhere near record highs but it is close to 4,000 and that's a 13 year high.

It's rare that the Attorney General discusses an active investigation, but the New York Times reports Eric Holder is talking about the currency markets and how some of the biggest banks may have rigged trading in the largest and least regulated market in the financial world. Holder said: “The manipulation we’ve seen so far may just be the tip of the iceberg. We’ve recognized that this is potentially an extremely consequential investigation.”

The investigation still seems to be in the early stages; no one has been accused of wrongdoing, yet. The DOJ apparently has at least one trader who is providing evidence, and they have gathered a whole bunch of emails, instant messages, chat-room conversations, and other documents. Nine of the largest banks in currency trading have announced they are facing inquiries. The banks placed about a dozen traders on leave pending the outcome of the inquiry. And several banks are considering limiting the ability of their traders to chat electronically.

And this all comes on the heels of the Libor rate rigging scandal, the ISDAfix rigging scandal, and hell, it just seems like everything is rigged. The currency markets may be the biggest manipulation, at more than $5 trillion daily, and affecting almost all investments that must rely on a benchmark in a currency. The market for buying and selling foreign currencies has also become a major profit center for many global banks.

Meanwhile, Moody's the credit rating agency has cut 4 major US banks' credit rating by one notch. The banks that were cut are: Morgan Stanley, Goldman Sachs, JPMorgan, and Bank of New York Mellon. Moody’s said that there was less likelihood of a widespread bailout of banks by the United States government as there was during the financial crisis five years ago and that bank debt holders would be forced to shoulder more of the losses in the future. Moody's also said it expected banks would be required by regulators in the United States to hold a higher level of capital, which was likely to result in higher recoveries for creditors in any future bank default. Maybe too big to fail could become too big to bail.

In the ongoing debate over taper or not to taper, we had some interesting developments this past week. Fed Chair nominee Janet Yellen has indicated she will continue in the tradition of Bernanke, maybe even add a little monetary stimulus to the pot of QE, and although she would like to exit QE, she doesn't seem to be actively looking for the door.

Meanwhile, if we look at the targets proscribed for exiting QE, we're nowhere near an exit. Last week the unemployment rate inched up to 7.3%; of course, that data was a distorted by the government shutdown and we may need another month or two to smooth out the data. Meanwhile, a data point that hasn't received much attention is the PCE price index, which is at 0.9%, well short of the Fed's inflation target of 2%, and well short of the stated upper limit of 2.5% which might nudge the Fed to taper.

There just isn't much inflation. That doesn't mean there is no inflation, just that the threat of deflation is a greater concern than the threat of high or even hyperinflation. The core rate, excluding food and energy prices is 1.2%, which means that food and energy prices are low or dropping; good news for people who drive or eat food. And health care prices were only up at a 1.1% annual rate in the third quarter; I'm guessing that number could move higher in the fourth quarter. And the Fed has indicated that even if the unemployment rate falls down to 6.5 percent, they might be in no rush to tighten policy if inflation remains too low.

And inflation has been falling in Europe. In France inflation is at 0.6%; in Germany 1.2%, in Spain 1.3%, in Italy 0.8%, in Britain 2.2%, and for the entire Eurozone consumer prices rose just 0.7% in the year through July. The only place inflation isn't declining is Japan, where it is holding steady, and Japanese policymakers are thankful for that. Of course Japan has been involved in an experiment known as Abenomics, which is roughly triple the size and scope of QE on a per capita basis. Abenomics has been a big boom for Japanese stocks, and seems to be at least enough to put brakes on the descent into the deflationary death spiral of the past 20 years.

Let it serve as a reminder that deflation is perhaps more scary than inflation, and Abenomics serves as a playbook for how much ammo is required to fight deflation.

Central banks are finding it’s easier to push up stock and home prices than it is to prevent inflation from falling short of their targets.The greater danger comes when disinflation turns into deflation, which leads households to delay purchases in anticipation of even lower prices and companies to postpone investment and hiring as demand for their products dries up. The Fed and their central bank buddies around the globe are trying to avert the deflationary danger by pumping up their economies with lower interest rates and monetary stimulus. They have bet the run-up in stock and home prices they’ve engineered would boost consumer and corporate confidence and spur faster growth and higher inflation. Now they’re having to maintain or intensify their aid, running the risk those efforts do more harm than good by boosting equity and property prices to unsustainable levels. The danger is that someone actually looks at asset prices and says, “hmm, seems a bit steep.” Party over.

One of the overlooked aspects of inflation is the velocity of money. Right now, in the US, money is knee deep in a tar pit. The velocity of money is how fast a dollar changes hands and is circulated through the economy. Right now it stands at 1.58, the lowest rate of velocity in 60 years, below average, and down from 2.2 just 16 years ago.

All the central bank easy money lacks punch because the pipes that carry the cash to the rest of the economy are clogged. And that means the Fed's policies have not had the desired effect of creating a robust economy. So, the more important question is not whether the Fed will continue with QE, but what can they do to unclog the pipes; and if they can't do that, what tools do they have to bypass the process.

Bernanke has expressed his exasperation with the lack of fiscal policy, and Yellen made similar overtures this week. What we haven't heard is that there are some things the Fed could do to provide more direct stimulus (and it all goes back to increasing demand). And until such time as money starts to move again, there is little immediate risk of inflationary pressures.