Monday, February 25, 2013 - Playing With Fire

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Playing With Fire

by Sinclair Noe

DOW – 216 = 13,784
SPX – 27 = 1487
NAS – 45 = 3116
10 YR YLD - .07 = 1.90%
OIL - .86 = 92.27
GOLD + 12.30 = 1594.80
SILV + .26 = 29.12

Let's make sure you're prepared for the week.

Late Friday, Moody's cut Britain's sovereign credit rating by one notch to Aa1 from Triple-A, with a stable outlook. Moody's cited the prospect of a further slow-down in the British economy, which would in turn undermine the government's deficit reduction plans. The official word from the Bank of England is that the downgrade will not affect deficit reduction targets, but there are calls for stimulus spending, specifically infrastructure spending, where a one pound investment results in 3 pounds of economic growth. Alternatively, the risk is that too great a focus on deficit reduction could further squeeze the economy and domestic corporate revenues.

This was a vote of no confidence in Britain's austerity policies which have only served to worsen the economic outlook. The pound sterling dropped to $1.51 earlier in the morning, a two-and-a-half year low. UK sovereign debt actually strengthened in late trading. The Triple-A rating may be lost but it has not resulted in a surge in UK borrowing costs, at least not yet. It's difficult to figure exactly how a lower credit rating effects a soverign nation which prints its own currency. The Brits, though, are playing with fire.

The revival of sovereign debt fears have largely been buried under several rounds of QE around the world. As for precious metals, the impact may be mixed: A stronger dollar is bearish, while the revival of sovereign debt risk is bullish for precious metals. And with the EU crisis back in the headlines, we have a brief repreive in the US Treasury bond tumble, with rates dropping for the first time in a long time. On the other end of the continent, the Italians are likewise, playing with fire.

One of the reasons for sterling pound's recovery is the twists and turns in the Italian election. The European economic crisis and the austerity policies that came in its wake have had a destructive effect on democracy in almost every member state. Politicians, some out of conviction and some simply in pursuit of advantage, have identified a constituency of anger and discontent ripe for exploitation.

The Italians are voting for a new Prime Minister and the candidates include an old Prime Minister. Silvio Berlusconi is trying to tap into the populist anger by promising to repeal a tax on primary homes introduced last year. We'll wait to see, but Berlusconi might have drummed up enough support to stop the front running coalition of Bersani and Monti and create a deadlock in Parliament. Again, we'll wait and see but any surprises here could re-ignite sovereign debt issues in Europe; so,don't be surprised if we see Italian bonds shoot into the stratosphere again.

Meanwhile, Fed Chairman Ben Bernanke goes to Washington to deliver his two-day testimony before Congress. Wall Street traders will be looking for clarifications of the Fed minutes. Most notably, whether the Fed will seek an exit from QE before the economy reaches the target numbers of 6.5% unemployment or 2.5% inflation. The rate-sensitive sectors, most notably housing and autos, are kicking into a higher gear.

Lawmakers criticized Bernanke during past outings; they questioned the effectiveness of his strategy and fretted about inflation, all the while trying to deflect criticisms of fiscal policy, or the lack thereof. The most recent Fed minutes seem to point to Bernanke talking about an improving economy. "Most participants" at the central bank's Jan. 29-30 meeting said the asset purchases have helped "stimulate economic activity, and many pointed, in particular, to the support that low longer-term interest rates had provided to housing or consumer-durable purchases.”

Of course the Federal Reserves Quantitative Easing Stimulus Plan doesn't have a broad reach through the economy, and limits were on display with a fourth quarter cut in defense spending, leading to a 0.1 percent contraction in GDP. Government outlays dropped 6.6 percent from October through December, subtracting 1.3 percentage points from growth. The Fed has an extra job to do because it has to offset some of this austerity.

The central bank might not be able to offset further reductions, as well as the impact of taxes that rose in January. The automatic budget cuts known as sequestration would reduce 2013 gross domestic product growth by 0.6 percentage point and pare about 700,000 jobs by the end of 2014. And the sequester hits on Friday, unless Congress can work out a deal before then; don't hold your breath.

The Murdoch Street Journal reports Congress has already given up on Friday's deadline and is now looking forward to the next deadline, which is March 27^th, when Congress will need to pass a new federal budget or a continuing resolution or face the prospect of shutting down the government. Congressional leadership, if that's not too much of an oxymoron, has already started discussing a bill to fund government operations through September. The lack of action on the sequester is strange, to say the least. One line of thinking is that it won't be resolved until we see long lines at airports, or kids kicked out of Head Start, late arriving tax refunds, or some other ugly optic. The other line of thinking is that the bigger cuts will come to defense programs, so some of the economic impact will fall on overseas activities, which would blunt the domestic impact.

The effects of the sequester should not be underestimated, especially because it would hit at the same time as the Japanese and British and Euro-zone are looking at the negative effects of austerity programs and fiscal contraction. In the stock market, the S&P 500 has now gone 505 days without a 10% correction; that's only happened 6 times in the last 50 years. We're ripe for a bit of a pullback.

Still, it doesn't necessarily spell doom and gloom. The interest rate sensitive housing and auto sectors have improved; this could not occur without the zero interest rate policy of the Fed, and also because household finances are looking more solid than they have in years. Of course, one reason for the improving household financial situation is that many people defaulted on debt, which is the fastest course for most people to increase net worth. The point is that it works, and we're finally on the cusp of what almost looks like a normal recovery.

This hint of normalcy suggests the slow improvements in the labor market over the past few years can now provide a bigger boost to consumer spending, which will in turn create more jobs; the virtuous cycle. This is not to say the sequester doesn't matter; it does. It will slow growth, but the growth may now have enough momentum to where it won't be stopped in its tracks.

Even after the austerity shock recedes, nobody is expecting a boom. Credit is still hard to come by, especially for the millions of Americans who defaulted on their debts during the depression. Europe's debt crisis and higher gasoline prices also pose constant threats to recovery. Of course, we've heard the refrain before: recovery is just around the next corner, just a couple of quarters away. And that is where the recovery has remained; just out of reach; an ongoing promise of tomorrow; just out of reach.

Today also marked the first day of the BP trial, the federal civil trial against the operators of the doomed Deepwater Horizon oil rig. The trial is a high-dollar showdown pitting oil giant BP's cash wealth against the legacy of one of America's richest, yet most troubled wildlife habitats.

The April 20, 2010 spill that began with an explosion that killed 11 rig workers and ended three months later with over 200 million gallons of light crude spilled into the Gulf still resonates physically and psychologically in the five coastal states affected, even as BP has gone to massive lengths to clean up the mess while paying billions in damages to residents and communities along the sullied coastline. The trial which started today is about answering the still-critical question: Did BP exhibit "gross negligence" in its operation of the rig, causing the largest offshore oil spill in US history? If so, the company could be on the hook for up to $17 billion in damages, after having already paid out $24 billion.

The trial judge (there is no jury) will have to decide what percentage of responsibility each of the three major players - BP, the speculator; Transocean, the rig owner; and Halliburton, a key drilling consultant - will have to bear if found responsible. While BP has claimed responsibility, the ultimate legal liability is not cut-and-dried as the judge has made clear that the two other companies also may bear blame for what became a domino effect of missed signs and overlooked problems that finally led to the explosion. And that is really a big part of the case. Was the accident ultimately avoidable or did the companies carelessly and negligently cut corners as they hunted for profit. Gross negligence is a very high bar that BP believes cannot be met in this case. They will contend this was a tragic accident, resulting from multiple causes and involving multiple parties, but not gross negligence.

The trial could drag out for 3 months, or BP could seek a settlement. One reason for the states’ difficulty in shaping an offer has been their disagreement over how the money would be paid. Some states, like Florida, prefer to see the company pay more in economic damages because those would give the states greater flexibility in spending the payouts. Payments for pollution-related penalties typically must be used for environmental purposes.

There's a lot of talk about currency wars these days, but very little understanding about what that means for specific countries, economic growth, inflation, and your pocketbook. Let's fix that.

First of all, there has been no declaration of any currency war. And won't be. Currency wars lead to global crisis. Currency adjustments, however, are happening all the time. Here's an over-simplified explanation about how currency adjustments affect you.

If Japan exports cars to America and America exports grain to Japan, each has to pay the other. American grain exporters want to get paid in dollars, so they can spend those dollars in the US. The Japanese want to get paid in yen so they can pay their workers in yen, pay their taxes in yen, and spend their money in Japan.

American car importers can "buy" yen with their dollars to pay the Japanese for their cars, or the Japanese can accept dollars as payment and then use those dollars to buy yen themselves. Of course it works the other way around if you're a grain farmer selling to Japan.

But the value of yen to dollars, or dollars to yen, isn't constant. There is no set exchange rate. Exchange rates are set in open currency trading markets where currencies are bought and sold to the tune of several trillions of dollars a day, every day. One day a dollar might buy 100 yen and the next day it might buy only 98 yen, or it could buy 102 yen. Lots of factors determine exchange rates, but the biggest, by far, is interest rates.

Currency adjustments are all about the value of your "home" currency relative to other countries' currencies. Our home currency in America is the dollar, in Japan it's the yen, and so on.

Countries that export a lot of goods want their currency to be "cheap" relative to other countries, especially those countries who are buying the home countries' exported goods. If the value of American dollars to Japanese yen is strong, meaning a dollar can buy a lot of yen, when you buy a Japanese car, for example, it will take fewer dollars to pay for it.

Because Japan exports a lot of cars it wants its currency to be "cheaper" than other currencies so it doesn't take as many dollars, or euros, or pounds to buy a Japanese car, or any product exported from Japan.

Here's the problem. America is a huge exporter of goods and services, too. So is Germany, and of course so is China. All governments want to support their exporting industries. It's about manufacturing and jobs, and revenue and profits, and economic growth and standards of living. The easiest way to facilitate an export-driven economy is to keep the home currency "cheap" relative to other currencies.

If exporting countries, especially those that don't have big domestic demand bases, meaning less-developed and "emerging-markets" economies, are all trying to export their way to growth and they all want to have their currencies be "cheap" on a relative basis, that can't happen. Everyone's currency can't be cheap at the same time.

So, adjustments are made. Governments who want to stimulate growth through exports take measures to lower the value of their currencies. Japan's new Prime Minister, Shinzo Abe, in an unusual exception to the pacifist approach to currency skirmishes, recently fired a shot heard round the world. To lower the value of the yen, Abe is demanding domestic monetary easing, aggressive stimulus, and more dangerously, has openly been talking down the yen.

Sound familiar? That's because the US has been involved in its own stimulus program, which includes more American exports. Also, the Federal Reserve has kept interest rates low, as in very low. One of the ways the Fed has done this is by "printing" money. The Fed has the ability, beyond the reach of Congress or the President, to buy what it wants, which is most often US Treasury government bonds. It pays for what it buys by simply issuing "credits" as payment.

Those credits are turned into money as they are spent by the government whose bonds the Fed buys, or by banks who sell the Fed their underwater mortgage-backed securities. Thus, the banks supposedly have money to lend.

Because the Fed has kept interest rates so low in America, investors are parking their money in other countries where interest rates are higher. In order to put your money into a bank in another country that offers higher interest rates than banks offer in the US you have to first buy that country's currency. And that bids up that country's currency relative to the dollars that you are selling.

In addition to the dollar being weakened, by investors selling dollars to buy and invest in other countries currencies, the amount of money being printed by the Fed means that at some point in the future all that money in the system will cause prices to rise, and causing the dollar to fall further. And if the dollar is falling relative to the Japanese yen or the euro, other countries who want to grow their exports are going to eventually do what they have to in order to lower the value of their own currencies.

That's how we get into currency wars.

You'll know when it's starting to spread. Interest rates will start to rise; watch the yield on the U.S. 10-year treasury. There are no real safe havens in a currency war. Commodity prices will rise; you'll see it in your grocery bills. Eliminate your debt and accumulate cash, and when prices crash, be ready to buy.