Tuesday, April 26, 2011

Welcome to Slaughterhouse-Finance

"There are no characters in this story and almost no dramatic confrontations, because most of the people in it are so sick and so much the listless playthings of enormous forces. One of the main effects of war, after all, is that people are discouraged from being characters.
–Kurt Vonnegut, Slaughterhouse-Five

Hardly a day goes by without an excellent analysis of hard facts and data being followed by a surprisingly disconnected conclusion. Over the weekend, it appeared to be Zero Hedge's analysis of a video report by Eric deCarbonnel of Market Skeptics, which concluded that the Federal Reserve, U.S. Treasury market, and U.S. dollar may all be on the verge of imminent implosion due to the Fed's AIG-esque policy of selling large amounts of protection against an increase in Treasury bond rates. A rebuttal to this view was provided the next day on The Automatic Earth, in a piece entitled, Bailing Out The Thimble With The Titanic.

In this piece, it was essentially argued that the U.S. dollar and Treasury market are symbolic of the Fed and the financial elite class, as partly confirmed by deCarbonnel's report, and these elite institutions have been engineering a successful bailout of those markets over the last few years, in tandem with natural financial dynamics and at the expense of everyone else. The bailout was “successful" in the sense that those markets will most likely remain stable in value for at least the next 2-3 years. Today (April 19), we are provided an excellent report by Chris Martenson, entitled The Breakdown Draws Near, but, as usual, all roads lead to financial chaos in Washington, D.C.

The "excellent" part of the report comes from the thorough data it provides regarding global liabilities that are maturing for banks and governments over the next few years. First, we are given a reference to the IMF's conclusions regarding global bank liabilities maturing in the near-term, with a stern eye locked on Europe [1]:

The world's banks face a $3.6 trillion "wall of maturing debt" in the next two years and must compete with debt-laden governments to secure financing Many European banks need bigger capital cushions to restore market confidence and assure they can borrow, and some weak players will need to be closed, the International Monetary Fund said in its Global Financial Stability Report.

The debt rollover requirements are most acute for Irish and German banks, with as much as half of their outstanding debt coming due over the next two years, the fund said.

The IMF basically tells us what has become painfully obvious by now - European banks and governments are both struggling to acquire the capital necessary to service their existing and/or refinance maturing debts, and there isn't nearly enough to satisfy them both. The latter fact is especially true when factoring in the maturing liabilities of banks and governments in other parts of the world, which is something that Martenson focuses on in the remainder of his analysis.

It is important, however, to note the added twist in the IMF's statement, in which it says that "some weak players will need to be closed". While it is specifically referring to European banks, the logic can be applied just as well to banks and governments all around the world, but we will return to that point later. In the rest of Martenson's report, we find out that Spain is actually pinning a significant portion of its private financing hopes on China, which, in turn, is facing its own imminent financial crisis due to an imploding real estate bubble.

But it is Spain that is first in the firing line and its 10-year bond premium in the secondary market widened 14 basis points to 194 bps. Madrid is hoping for support from China for its efforts to recapitalise a struggling banking sector... [2]
Prices of new homes in China's capital plunged 26.7% month-on-month in March, the Beijing News reported Tuesday, citing data from the city's Housing and Urban-Rural Development Commission. [3].

We can also expect that housing bubbles in countries such as Australia and Canada will start to implode in lockstep with China, as their economies are both highly dependent on Chinese import demand for natural resources. A renewed round of real estate busts, combined with the ongoing slump in Europe and the U.S. and less aggressive monetary policy (-temporary- winding down of QE), will also feed off of and into a collapse in global equity and commodity values. That collapse will wipe out large swaths of imaginary capital existing on the books of major institutions. All of that leads us to Martenson's seminal question, "Who Will Buy All of the Bonds?", specifically meaning the public bonds of Europe and the U.S.

Martenson refers to the Treasury International Capital (TIC) Report in his piece, which indicated that there was a "lower-than-trend" net inflow of foreign capital ($26.9B) into long-term securities for the month of February, which includes those going into long-term Treasury bonds. When including short-term securities, we see that there was a healthy net inflow of $97.7B into U.S. bond markets from foreign investors. [4]. What this data indicates is that, during the month of February, there was significant foreign investment in U.S. bonds, but 72% of that was into short-term securities (which do not include 10 or 30-year Treasury bonds).

He goes on to conclude that this inflow dynamic will get worse as Japanese purchases drop off in the next few months, and that the proposed "spending cuts" for a few federal programs will hardly do anything to reduce the supply of Treasury bonds over this same time period. I agree that there is a strong possibility of reduced purchases by the Japanese government in the short-term, as well as the governments of China and the UK. In addition, the minuscule spending cuts will indeed be irrelevant to the overall size of the 2011-12 federal budget deficits.

To go from there to the conclusion that the U.S. Treasury faces an imminent funding crisis, however, requires a few major and unlikely assumptions; the classic hallmark of those fretting over hyperinflation of the dollar in the short-term. As briefly discussed above, a slowdown in foreign government purchases of U.S. Treasury bonds could be significantly offset by an increase of inflows from private foreign investors fleeing the equity, commodity, government agency and mortgage-related investments of other regions, as well as domestic investors fleeing those same risky investments.

And that's where we return to the IMF's little "hint" in its report from last week. The financial elites do not need anyone to buy ALL of the bonds, only those that are most important to maintaining their wealth extraction operations. The weak players? Well, they can all fight over the scraps and devour themselves in the financial marketplace. The truly significant capital will be transported towards a few central locations by natural forces and by human design, like lambs to the inevitable slaughter. Of these locations, the most critical are surely the U.S. Treasury market, which can be used to support major U.S. banks, and the U.S. currency market.

What are the chances that the majority of people who find themselves invested in U.S. government bonds and the dollar will get anything close to a return on their investment over 10, 20 or 30 years? The answer to that is probably a massively negative percentage, because the psychological pain of holding on for that long will be even worse than the total wipe out itself. However, the herd typically doesn't figure out how close they were to the edge of the cliff until after they are tumbling down the other side.

Stoneleigh at The Automatic Earth has repeatedly pointed out that people in such fearful environments tend to discount the future by an increasing rate, which means they care less and less about what will happen several decades, years or even months from the present time. The discount situation of financial elites is similar because they know how precarious the dollar-based financial markets are, so their concern is over whether they can corral all of the lambs into one or two places over a relatively short time period. So far, most of the evidence says that not only is it possible, but the process is already well under way.

Another unlikely assumption contained in Martenson’s report is the following [emphasis mine]:
With the Fed potentially backing away from the quantitative easing (QE) programs in June, the US government will need someone to buy roughly $130 billion of new bonds each month for the next year. So the question is, "Who will buy them all?"

I say the above question is an unlikely assumption because it seems to imply that the Fed may stop QE for another whole year after the QE-lite and QE2 programs wind down. If recent history has taught us anything, it's that a fearful deflationary environment is the perfect justification for the Fed to resume QE, and perhaps at an even larger scale than it has "monetized" in the past. Will the American people be up in arms about monetization of the federal debt or an indirect link to sociopolitical unrest, when their own finances, homes and careers are once again being beaten down by the unrelenting force of debt deflation? I really doubt they will be.

In the next section of his article, Martenson himself refers to how significant QE has been when talking about proposed budget cuts [emphasis mine]:
For the record, these 'cuts' work out to ~$3 billion less in spending each month, or less than the amount the Fed has been pouring into the Treasury market each business day for the past five months.

In addition, as discussed in Bailing Out The Thimble With The Titanic, the Fed may also be using Treasury put options to help them exert more control over long-term rates that cannot be reached as easily by QE programs. With regards to the latter, the following table is the Fed's "liquidity injection" schedule for the next month, which is certainly winding down, but still towers over any notional amount that has been "negotiated" by the politicians on Capitol Hill in their budget talks [5]:

The other major assumption involved here is that interest rates will start to rise along the curve, and this will make sovereign default much more likely, since a significant portion of Treasury debt is in notes with relatively short-term maturities. This logic is circular at best, since it relies on the fact that sovereign default and/or inflation concerns will drive short-term interest rates up in order to posit the argument that increased short-term interest burdens will lead investors to be more concerned about sovereign default or inflation (from printing). There is certainly a positive feedback involved in such dynamics, but the feedback must be rooted in some initial economic or political trigger.

As mentioned earlier in this piece, and many other times on The Automatic Earth, the dominant and natural economic trend is debt deflation, while the dominant (and natural) political trend is aggressive fiscal and monetary policies that are crafted to funnel money into major banks, rather than the productive economy. There are very few reasons to think that either of these trends will reverse in the short-term, either by design of the financial elite class or by the inadvertent consequences of their actions. They have no doubt painted themselves into a corner, but their corner is significantly larger than the concentration camps built to imprison a large majority of the global population. The latter fact is clearly evidenced by the perpetual taxpayer subsidies given to financial institutions in the sullied names of "economic recovery" and "austerity".

The cities of Greece continue to erupt in violence as its citizens are forced to bail out European banks, and, meanwhile, Americans continue to mistake their own reflections in the global mirror. Earlier this year, Standard & Poor's rating agency downgraded the outlook for the triple-A rated status of Treasury bonds (from "stable" to "negative"), in what was nothing less than an act of aiding and abetting the politicians, bankers and major corporate executives who strive for the imposition of austerity on everyone but themselves. The only difference between Greece and the U.S. is that the latter is not a "weak player" in the eyes of elite institutions, such as the IMF. Which means that, while the Greek taxpayers may soon be put out of their misery, we will die a much slower death, choking on our own debt for years to come.

He kept silent until the lights went out at night, and then, when there had been a long silence containing nothing to echo, he said to Rumfoord, "I was in Dresden when it was bombed. I was a prisoner of war.
-Kurt Vonnegut in Slaughterhouse-Five

Thursday, April 21, 2011

Bailing Out the Thimble With the Titanic

Dr. Steve Keen, the ever-insightful Australian economist who runs the Debt Deflation website, wrote an excellent piece in March of 2009 entitled Bailing out the Titanic with a Thimble. It essentially argued that the U.S. government's fiscal stimulus and the Fed's liquidity injections would be wholly insufficient to restart growth in the private credit markets, and so far this analysis has been spot on.

Ilargi and Stoneleigh, who run The Automatic Earth, have also been preaching this same message for several years now, and have repeatedly stated that the U.S. dollar and treasury market would be the beneficiaries of the debt deflationary trend. It was most recently repeated in Ilargi's latest post, Our Prosperity is Owed Back Plus Interest.

Yet, since late 2010, it would appear on the surface that long-term treasury rates have been inching upwards and that commodity prices have been going through the roof. This superficial trend has led many commentators to "double down" on their predictions of a Treasury market collapse and imminent hyperinflation of the dollar.

Some people point to sustained oil price increases as evidence of their predictions, but, as mentioned before, that trend has been wholly discredited as a byproduct of actual monetary inflation. It is merely a result of the Fed exporting speculative debt to investors worldwide, who fully take advantage of the "speculative" part by betting on increases in the prices of equities and commodities.

Other people have been focusing more on the treasury market aspect, pointing to Pimco's net short position on U.S. Treasuries and the brief trend of rate increases as evidence of imminent chaos in the market. Of course, they can also point to the fact that the federal government is running record deficits to allegedly support the private economy, with no real end in sight.

As The Automatic Earth has cautioned, however, what matters most right now are the systemic dynamics of deterioration in private finances and social mood, rather than the fundamentally unsustainable nature of deficit spending. A major component of these dynamics is the monetary objectives and policies that will be undertaken by financial elites through their proxy, the Federal Reserve.

Last week I wrote two pieces regarding this component, Jumping the Treasury Shark and Bill Gross: Master of Monetary Psy-Ops), and, specifically, about why the elites desperately want to maintain stability in the Treasury market, and how Pimco's sharp reduction in Treasury exposure is most likely not a long-term bet against the market.

Today, we get a dose of healthy confirmation through a video report by Eric deCarbonnel at Market Skeptics, entitled:

FRAUD: Federal Reserve Is Selling Put Options On Treasury Bonds To Drive Down Yields:

It is featured in a Tyler Durden piece on Zero Hedge named Doubling Down To (DXY) Zero: Has The Fed, In Its Stealthy Synthetic Bet To Keep Long-Term Yields Low, Become The Next AIG?. In essence, it reveals some strong evidence to suggest that the Federal Reserve is already, or is actively considering selling large amounts of protection against treasury rate increases (Put Options) to various investors as a means of controlling the long end of the treasury curve (which, as per deCarbonnel, is illegal). Indeed, the Fed actually used this shell tactic back in 2000, as explained by Vince Reinhart, who was Fed secretary and economist at the time [1]:

The System has also been willing to put its balance sheet at risk to encourage appropriate expectations about interest rates or to calm fears about funds availability. As plotted at the top right, the Desk sold options on RPs for the weeks around the century date change that totaled nearly $0.5 trillion of notional value. Given that the Desk already operates in all segments of the Treasury market, we wouldn’t have to move up a learning curve if instructed to increase purchases of longer-dated issues.

We find out that there is, in fact, no need for the Fed to "move up the learning curve", step up its game and scale up the walls of the treasury curve with multiple trillions worth of gross sales of interest rate swaptions. That essentially means that there is no desire on the part of financial elites to let long-term rates rise significantly or to let the Treasury market destabilize, and, on top of that, they are in the process of leveraging themselves to the point of absolutely no return.

The question then arises, however, of whether they will actually be successful in "pinning" long-term rates for a few years, or whether "Operation Swaption" is a time bomb set to detonate within the next year, when rates significantly increase in response to sovereign default and/or inflation concerns.

The analysis from Zero Hedge would suggest that the latter is a very likely possibility, as implied in the article's title. Tyler Durden suggests that the Fed may be the next AIG, except without anyone big enough waiting in background to bail them out of their misery.

Alas, that [the Fed's printing press] will have no impact whatsoever, if indeed the Fed has been reduced to finding ever fewer counterparties to a synthetic bet to keep long-term rates low, as very soon, with inflation ticking up, all hell may break loose in an identical replay of what happened to AIG once the Fed's put is called against it. [2].

Durden is making the assumption that there will be ever-fewer incremental buyers of treasury bonds, and therefore fewer investors that would want to hedge their treasury exposure by buying protection from whichever primary dealer bank (most likely JP Morgan) is acting as a front for the Fed. He is also assuming that inflation will "tick up" very soon, causing rates to increase and forcing the Fed to make good on their massive bets, which they simply cannot do, because it would expose them as being the underlying counter-party to the trade. Indeed, that would most likely trigger a self-reinforcing dumping of treasury bonds and a set of events that ultimately result in a full-blown currency crisis.

There are two major flaws that I perceive in these assumptions, however, with the first being that price inflation, primarily for energy and food, will continue increasing as it has been over the last year or so. This argument has been addressed and largely discredited numerous times by The Automatic Earth, and even Zero Hedge itself has suggested, back in February, that the exact opposite may occur in the short-term. That article was the focal point of a piece I wrote shortly after, Exporting Speculative Debt, and it contained the following argument regarding a peak in total margin debt used by hedge funds, and the lowest level of free cash since 2007, when the latest credit bubble also peaked:

At ($45.9 billion) this number is just below the ($52.8) billion last seen just before the August 2007 quant wipe out which blew up Goldman's quant desk, and arguably was the catalyst for the beginning of the end. In other words, as we have shown, everyone is now purchasing on margin and the level of investor net worth is the lowest in over 3 years. Which means that should the market decline from this week persist and the Fed be unable to stop it, the margin calls will start coming in fast and furious, and unwinds in otherwise stable products like gold and silver are increasingly possible as hedge funds proceed to outright liquidations. [3].

That leads us to the second assumption that the Fed will not be able to "pin" down long bond rates because there will not be enough incremental buyers of treasuries seeking to also hedge their exposure. When global equity and commodity markets begin their downward cascade in response to the ongoing debt deflation and a temporary end to quantitative easing, margin calls will indeed be coming in fast enough to make your portfolio spin. The demand by institutional investors for a "safe haven" will emerge as quickly as the daylight descends into pitch black, and it will then become clear that the intent was never to bail out the Titanic with a thimble, but the other way around.

The bond markets of Japan and Europe simply can't make the grade, and, as referenced in Jumping the Treasury Shark, there really isn't enough gold to soak up all of that capital. Instead, the U.S. dollar and Treasury bond, because of their fundamental weakness, will be the refuge of choice and design, and this will also serve to aid the Fed's Mafioso protection scheme for controlling rates. The world has been flooded with dollar-denominated debt for decades, right up until now, and soon all of those liabilities will come pounding on the front door. And who will answer? Why, the Fed and the financial elites, of course.

They will invite the debt deflation in with open arms, because now they are holding vast sums of cash, and treasury bonds that simply cannot go bad. It will simultaneously be used as a justification for "gradual" austerity measures targeted at the middle and lower classes, as the public deficit will remain elevated to finance further bailouts of the financial elite class and brutal military operations for resources. The insidious shell game and unprecedented transfer of wealth will continue on, at least for some significant period of time, before the fires set by the elites burn out of control and finally engulf them.

Saturday, April 16, 2011

Bill Gross: Master of Monetary Psy-Ops

Every so often, and more often than not, a rumor emerges in the blogosphere about a significant development, seemingly adverse to the interests of the U.S. federal government, being manufactured by the government to further solidify their control over the masses. Sometimes these rumors are plainly absurd on their surface, and sometimes they are just too perfect to be true. The nature of these "psy-ops" is that they are nearly impossible to verify with any direct evidence until well after the fact, so we must rely on indirect logical analysis and a bit of intuition.

Personally, I always find it curious when a piece of news that pops up into the public domain just doesn't seem to fit in with the systemic realities that I otherwise perceive. It could be that I am simply taking these realities for granted and it is time to re-evaluate them, but it could be that they don't fit because they were never intended to. A report last month from Zero Hedge showed that Pimco had reduced the treasury exposure of its Total Return Fund from 18% to 0%, and a more recent report has shown that it actually has a net short position on treasuries. [1].

Pimco is the world's largest bond fund, and its manager Bill Gross has been quite vocal over the last two years about the U.S. treasury's massive and unsustainable deficits. He was so vocal about it that he decided to load up on treasuries and make a killing from February of 2009 until July of last year, with only a few brief respites in between. That's just the type of person Bill Gross is - he's a shark wading in the deep blue waters of Wall Street, and, like most other ones, he's an "insider trader".

He went on a treasury-buying binge in February 2009, just in time to fully ride the coat tails of the Fed's QE operations that commenced in March and monetized $300B in long-term treasury debt. [2]. No one in the public domain knew about the existence of this program in February, or the extent to which it would be carried out. It's not about economic fundamentals and it's certainly not about principles or "what's right", it's only about money and, specifically, lots and lots of money.

Now, the TRF is net short treasuries and many people are convinced that its short position is, in fact, nothing short of a prediction by Gross that the treasury market will soon collapse. Indeed, he seems to be at least betting that rates will increase significantly in the short-term. Perhaps that is true or perhaps he is making a bad bet, but perhaps we should also be wary of such plainly advertised convictions. After all, the insider "beltway" encompassing Wall Street and Washington has two lanes running in both directions.

If the Fed has a hidden agenda, then it would not hesitate to use Gross and his bond fund to pursue it, and if there's any institution with a hidden agenda, it's the Fed. At the beginning of 2009, the prospect of the Fed launching operations to monetize the federal debt was a radical one, unexpected by all but the most well-connected money managers.

By this time, QE has been going on for so long and with such force that it has become a standard routine. It has even gotten to the point where mainstream publications, such as the Wall Street Journal [3], are accusing the Fed of directly influencing the eruption of bloody revolutions in foreign countries. The Fed needs to maintain integrity in the U.S. treasury market above all else [4], but it is also needs to maintain a semblance of integrity in its own house.

It's in the process of walking a delicate tightrope, and the rope it struggles to walk has increasing amounts of slack. With additional QE to supplement the MBS prepayment re-investments and QE2 operations, both of which are currently winding down, the Fed risks stoking the fires of social and political chaos which constantly threaten to consume it. This dynamic is the result of primary dealer banks selling newly issued treasury coupons to the Fed at scheduled times and walking the profits down the beltway into equity and commodity markets. The Fed must now fear that further hot money speculation in commodities will make gas and certain foods unaffordable for not only the poor Tunisian people, but for the average American energy guzzler as well.

Without additional QE, however, the Fed loses all control of U.S. asset markets, and, by proxy, asset markets the world over. So what it really needs is a sort of timeout, in which it can engage in an immature display of wild-eyed frustration, erratically flailing its hands up in the air, shouting, "We're Done!". Then, it can sit back and watch fear set in the eyes of investors worldwide, as they realize that no more QE means no more over-valued equity and commodity markets. And no more of those means no more towers of leveraged capital producing unspeakable returns 24/7, day in and day out. Instead, all of that imaginary capital will be squashed down into a dime-sized pancake and will return nothing but the foul odor of putridly stale losses.

It is at that point when senior editors at the Wall Street Journal will abandon their offices and go running to the Fed with their guts in hand, furiously apologizing in one breath and then begging for more QE in the next.

"You see, Mr. Bernanke, our subscribers have been calling en masse to cancel over-priced yearly subscriptions as their investment capital continues to get wiped out in the stock, commodity and real estate markets. For Christ's sake, man, we need your help!" 

The systemic fear generated from crumbling markets worldwide will first serve to attract scared capital into the treasury market, as it still remains the only place to go for people with sums of money that won't fit under any mattress. Besides, the only real difference between the U.S. dollar and short-term treasury bills or notes is that the latter could potentially give you a fixed income over their duration. The fear will then serve to further justify treasury asset purchase operations by the Fed, the ongoing sociopolitical destruction in the Middle East be damned. So how does Pimco and Bill Gross fit into all of these deceptive monetary tactics? Well, the fact that TRF currently holds a record 38% of its assets in dollar-denominated cash is a telling one. [5].

Every investor knows that the best and quickest way to make money is to own something that virtually no one else does, right before it gets hot and takes off towards the moon and the stars. An unexpected end to QE operations will send the dollar soaring, and as mentioned before, all asset markets plunging except for the U.S. treasury market. Bill Gross may have dumped all of his treasury exposure for now, but has any other major financial institution or money manager followed his suit? Has the Fed announced any plans to sell its treasury holdings back into the primary or secondary markets?

Of course not. These institutions are not worried about rates surging outside of their control anytime soon, and will be glad to make a few extra bucks from higher interest payments (paid by taxpayers) before the "rush to safety" really gets underway. I suspect that, by that time, there would have been a significant reversal in the treasury holdings of TRF and the superficial justifications for the investment decisions of the omniscient Bill Gross. Perhaps he will continue to have minimal exposure to U.S. treasuries throughout the year, as a partial hedge to his fund's enormous cash holdings, but that certainly should not be taken as an absolute bet against the treasury market.

Gross is merely a beltway insider with a purpose, which happens to coincide with the purpose of every other insider and elite - to preserve the dollar-based financial system. He is the magician's assistant, distracting the audience in the front with a short-con while the magician sets up the long-con behind him. The bad cop who beats the suspect over the head and tells him he has one last minute to confess before the entire case is blown wide open, followed by the good cop who enters the room and promises they will go easy on the suspect and recommend leniency to the judge, as long as just tells them where all the money is hidden. Once again, it is not about enforcing the law or finding justice, it's only about using deception to drive all of that money out of its hole and into their hands.

Besides, did anyone really think that the world's biggest bond fund was about to unconditionally give up on the world's biggest bond market (which just so happens to support every other U.S. bond market, and foreign ones as well)? Personally, I think Bill Gross is going to continue doing what he does best - speaking in half-truths and pretending like he cares about day-to-day developments in the U.S. fiscal situation, while carting his millions in compensation to undisclosed personal bank accounts around the world. That is one financial shark who cannot survive outside of the deep waters, and his next feast of flesh will be no less filling than the last.

Monday, April 11, 2011

A Brief Message to Regular Readers of Simple Planet

I am posting this because I want anyone who regularly checks my site for new pieces to know that I greatly appreciate their interest, and I take it as a huge compliment.

Over the last few months, however, I have been posting most of my articles on The Automatic Earth (theautomaticearth.blogspot.com) before posting them here. Ilargi and Stoneleigh have been very generous with letting me publish my articles on their site, and I also feel that their "big picture" and systems perspective on economics, finance, energy issues and environmental issues is extremely similar to my own. Therefore, I plan to continue working with them and writing for their site as it continues to evolve.

Since any new pieces that I write will be first published on TAE, and will only appear here a few days later, I encourage any regular readers of this site to begin visiting TAE on a daily basis to find my latest work. TAE also has a great comment section filled with very knowledgeable and insightful commentators. While I will still respond to any comments I happen to see under my articles on Simple Planet, I will spend significantly more time reading and responding to comments/questions on the TAE page.

I apologize for any inconvenience this may cause anyone, but I'm sure that really isn't an issue for anyone here.

Once again, thank you very much for reading and I hope to see some new "faces" in the TAE comment section!


Sunday, April 10, 2011

Jumping the Treasury Shark

By now, it is is painfully obvious that the U.S. economy is not going to "recover" and that its fiscal situation will continue to deteriorate over the next few years, at least to those of us who value being truthful to ourselves. This will happen regardless of how much chatter is generated by the politicians about "fiscal responsibility" and the importance of reducing the deficit, or an imminent "government shutdown". That begs the question, however, of what will actually happen to the U.S. treasury market and the dollar as a "store of value" during this time.

Those two investments are ultimately driven by the forces of supply and demand, just like all other ones. Their supply will be plentiful, as the federal government generates new credit to fund the increasing gap between tax revenues and spending, so the question is whether there will be enough demand to meet the supply. The answer to that question is not as simple as determining whether rational investors will maintain their confidence in the U.S. treasury market and place their limited capital at its feet.

Your average financial investors (individuals, asset managers) are, A, not rational, and B, not the only source of support of support for the market. The latter is clear enough from the fact that the Federal Reserve, a privately-owned institution with no actual reserves, is now the largest creditor of the federal government, as its treasury holdings surpassed those of China earlier this year. The Fed (along with a few other central banks and the IMF) is merely a front for a cartel of major financial institutions that are primarily located in the U.S., Japan and Europe, as well as other multinational corporations that work with them to maintain their operations.

These institutions, unlike the average and irrational financial consumer, will not necessarily throw their support behind the treasury market out of panic or fear of a worsening global economy. If they choose to continue "investing" in U.S. treasuries, it will be a calculated decision that is based on what they believe is the best method of preserving their wealth and power. It is obvious to even the mainstream financial world that the public bond markets of the EU (and possibly the UK) and Japan are not going to last much longer, so those investments are not really options at all.

The choice they face can be analogized to the choice faced by a middle-class entrepreneur with a relatively profitable business operation in his home country. Although the businessman may be getting anxious about the market for his products and his ability to continue generating revenues and profits, he is also very experienced at operating the company in its current environment, with his current clients and his traditional methods of conducting business.

The market for his products may indeed by on the verge of collapse, but he cannot be sure that a similar market in another artificially-created jurisdiction would be any healthier for his business. On top of that, his family and friends all live in the jurisdiction where the business currently operates, and the businessman is very familiar with his local clients and his community.

There is no guarantee that a smaller market in another community would even be able to accommodate the scale at which he is used to operating his business, or that new clients there would be able or willing to entertain his services. Ultimately, the physical, financial and psychological costs of such a dramatic switch do not appear to be worth the trouble for the businessman. He decides to simply continue running his local business and hoping or praying for the best possible outcome.

Are the major financial players, who hold trillions of their net worth in dollar-denominated debt-assets, any different from the hypothetical businessman above? Perhaps they have a degree of more flexibility in their decision-making process and significantly more resources to help them decide, but they are also slaves to tradition and the human tendency of sticking to what they know.

The debt-dollar markets (equity markets, commodity markets, real estate markets, bond markets), already systematically entrenched around the world, combined with the "full faith and credit" of the federal government and the Fed's unrestricted license to generate credit with the push of a button, tilt the scales in favor of sticking it out with the U.S. treasury market and currency. There are certainly alternative courses of action at the disposal of the wealthiest institutions in the world, but they are all a far sight short of being attractive.

One alternative plan would be to begin dumping all of these debt-assets on some clueless investors and taxpayers (via government programs such as TARP) and use the freed up capital to invest in hard assets (land, gold, oil, grains, etc.) and/or perhaps in the "emerging markets" of India, Brazil, China, etc. Personally, if I somehow ended up in the wacky world of financial elites, where priority #1 is to protect ungodly amounts of wealth and political power during a global economic depression, then I would dismiss this alternative as soon as it was presented to me.

The plan would have numerous flaws, some of which are too complex to even predict, but my general line of thinking could be summed up by comparing a few statistics and conducting a simple analysis.

The global bond market was valued at $91T as of 2009, and the U.S. treasury market accounts for almost 8% of that value. [1].

The "over-the-counter" derivatives market was notionally valued at $615T as of 2009, with interest rate derivatives accounting for 70% of that value, and 32% of those being directly sensitive to the value of the U.S. dollar and rates on the U.S. treasury curve. [2].

The U.S. has the first and third-largest equity markets in the world, and they combine to have a market capitalization of about $15T, which also equals the total capitalization of the other eight markets in the largest ten. [3]
About 5.3 billion troy ounces of gold have been mined in human history as of 2009, and gold is currently selling at record prices, for about $1450/oz.

There are less than 10 billion acres of arable land on Earth, and some of the most expensive farmland in the U.S. averaged about $2K/acre in 2006.[4],[5].

Average consumers of financial products in the developed world simply do not have enough capital to buy up a significant portion of the dollar-denominated debt-assets that the elites would like to dump, especially when those assets are "officially" marked as being much more valuable than they really are. Foreign governments, of course, can barely afford to finance their own operations, let alone pour additional funds into U.S. treasuries. The same is true of institutional asset managers (pension funds, mutual funds, etc.) who may have rebounded a bit of business activity since 2007-08, but are still teetering on the edge of destruction from quarter to quarter, not knowing whether they will record a profit or a digital suicide note when the next one comes around.

These institutions may be willing to aid the elites in transferring worthless mortgage and equity instruments to average workers and taxpayers through government directives, pension plans and mutual funds, but they simply do not have the free capital to do the same for U.S. treasuries. That is truly the limiting factor, as the U.S. treasury market and its sprawling derivatives contract extensions make the stock market look like a penny-ante game of Bingo at Uncle Sam's Fiesta Rancho Casino.

Regular old investors or fund managers with modest stock portfolios and limited capitalization cannot absorb the behemoth treasury market at full value, or anything close to it. Even if they could, where would the elites take the dollars that they received in exchange? The exact same problems described above apply to farmers, miners, manufacturers, etc. who work, invest and deal in the markets for hard assets. Besides, there is no need to pay people for their gold, land or oil when you can just take it by brute military force.

And that's really the beauty of the debt-dollar system for the financial elites. It is globally established and it comes with the implicit understanding that, if you buck the system, there will be a fiery dose of hell to pay. These elites have all the time and resources they need to abandon the current system and down-size from the Yukon Denali to the Ford Focus, but the word "sacrifice" isn't a part of their vocabulary. Instead, they will fight hard to keep the system functioning in whatever form they can manage, as long as it remains at the same scale of operation.

They are not under the illusion that the U.S. treasury or currency markets are sparkly diamonds in the rough, or even shined shit in the land of fool's gold. Fundamentally, the dollar is no healthier than the euro and they know it. The choice, however, is whether to wholly abandon the treasury shell game between the federal government, the Fed and private banks or to keep a good thing going while it seems to be working. They are banking on the Fed's monetary operations, political illusions (the appearance of two parties working towards reducing the deficit), panicked "flights to safety"and a little bit of luck to preserve the debt-dollar system until global markets "reset" and economies begin to grow once again.

Perhaps they will keep other options open, as lifeboats to hop into in the last second before the Treasury Titanic is fully submerged. The problem for them is that such backup options never really end up working out as planned, especially when time is not on the same side as you are. It is also a distinct possibility that, despite what anyone wants or plans, the treasury market will blow its lid sky high next month or the month after. Possible, but not very likely, given the current situation in global bond markets and the "full court press" that is being launched by the elites. Personally, I give the treasury market and the dollar at least a few more years before their shine truly wears off, and the fan has its way with them.

Thursday, April 7, 2011

The Last Financial Samurai and Its Merciless Sword

A Japanese warrior may demonstrate hardened values of "honor" and "loyalty" to the members of his tribe, but he can never become a true Samurai without first learning to wield the sword with precise form and discipline. It takes years of study, practice and, most of all, an unflinching perseverance towards becoming the best warrior in your tribe.

Many claim that the last true Samurais died out with the industrialization of Japan in the mid-19th century, and perhaps with the unsuccessful Satsuma rebellion against the Japanese Imperial Government (although there are reports that those in the rebellion used modernized weaponry to fight). [1]. The Samurai tradition may have largely disappeared in its technical form, but it has continued on in a symbolic form to this day.

Our current global economic system is the last vestige of a dying art - the art of material exploitation and oppression. Every technological gain since the Industrial Revolution has come at the expense of people's lives, livelihoods and cultural values. Insightful thoughts from the likes of Henry Ford, Robert Oppenheimer or Bill Gates cannot miraculously manifest themselves into new inventions without the net energy and material resources required for the production process.

These resources are neither unlimited in quantity nor evenly spread throughout the various political entities on Earth, so one would not expect them to be voluntarily relinquished in large amounts by those who exist in their surroundings. Yet, they always seem to leave their place of origin with increasing velocity and end up in fewer and more distant locations around the world.

Indeed, where there's oil, gas and minerals, there are lakes and rivers of blood. The current global financial system is the Samurai class of the industrial warrior society; an appendage of the mechanistic state that has honed its skills of material exploitation to near perfection. If this process of exploitation is a dying art, then its practitioners are the last living members of an endangered species.

In Japan, the birthplace of the Samurai tradition, the government and central bank have been relegated to the class of bumbling warriors for some time now. The latest environmental and nuclear disasters there have merely exposed the extreme level of their incompetency at maintaining the illusion of economic stability.

There is perhaps only one seasoned practitioner of the art remaining, and its skills with the blade set it a league apart from all of the clumsy novices and decrepit old geezers - the Federal Reserve. This lethal organization is currently at war with the natural and creative forces of institutional destruction.

By all accounts from the surface of the battlefield, it is winning. The tradition of the "Samurai Fed" is best represented by the U.S. currency (debt-dollar) and the massive U.S. treasury market. Their value must be defended by the Fed at all costs, or else the wealth of global financiers evaporates and the crucial battle is lost, which, in turn, may cost it the entire war.

The Fed's sharpened steel is now nothing more than a credit-printing press and the executive authority to purchase debt assets from banks in the "open market". Private credit markets have been thoroughly neutralized by the ongoing siege of debt deflation, and national governments must therefore pump increasing amounts of liquidity into these markets to maintain global order. However, there is only so much liquidity to go around, and the funding requirements of national/local governments are only getting exponentially larger.

Many analysts point to Europe's sovereign debt crisis and the all-encompassing mess on Japan's plate as evidence that governments around the world are losing the crucial funding battle, and therefore the U.S. will soon follow in their footsteps and the Fed will lose control of the treasury market. It is important to remember, however, that all of these states involved do not necessarily belong to the same tribe of warriors.

For the right to control the flow of credit-based liquidity, perhaps still the most precious resource in our complex global economy, they are more than willing to wage battle with each other on the jagged edges of the abyss. The major weaknesses in the bond markets of Europe and Japan are strengths for the U.S. bond market, as investment capital will rapidly navigate away from perceived risk towards perceived short/medium-term safety.

While correlated stock and real estate markets around the world continue to implode, the world's largest bond market will still provide at least an iota of positive return and investment security. In addition, the Fed has already surpassed China to become the largest creditor of the U.S. government [2], and it can easily scoop up any treasury paper dumped off by countries in desperate need of cash.

None of the above is to suggest that the U.S. economy will suddenly become healthy, asset values will stabilize or that anyone will be particularly receptive to further sword play by the Fed. However, public opinion is the last thing that matters to such an institution now (or the politicians it controls), and it will most likely be willing to sacrifice both the U.S. stock and real estate market for the sake of the greater "cause".

This cause has always been to transfer productive wealth from the workers, savers, taxpayers, etc. to a select group of corporations and individuals, while protecting core structures that allow the exploitative system to continue functioning. The U.S. bond market and currency will be defended by the Fed simply because the financial elites have not yet divested themselves of their numerous debt-dollar assets, and prepared themselves for a wholesale bond market collapse.

But what price will the Fed be forced to pay for taking such a bold stand against the forces of systemic decay. The Samurai warrior lives most of his life by the merciless sword, and he is sure to die by it as well. The Bank of Japan and its government are beginning to face that inevitable fate now, as well are the various central banks of Europe. Those in "emerging market" countries such as Brazil, India and China were just starting to show off their swordsmanship, but now realize that they lack the high level of discipline and natural talent expected of the Samurai.

These warriors have struggled mightily with their systemic adversary of debt deflation, but they all have fallen to the force of its overpowering blows, or will fall soon enough. That leaves only the Fed left standing on the vast battlefield; surveying the terrain, readying its sword and preparing to make one final stand, after which it will finally lay claim to its destiny. The ensuing battle will certainly be short, but it will also be one for the ages.

Sunday, April 3, 2011

Greatly Mistmatched Expectations

A common criticism of the U.S. financial industry repeatedly dished out after 2008 was that the high-level executives preferred to pursue short-term gains, rather than the long-term stability and growth of their respective institutions. The claim is that their compensation packages incentivized them to take excessive risks with their loans and securitization practices. Yet, we only have to look to another bloated and unproductive American industry to see how this criticism completely misses the broader storyline. I am speaking of the entertainment industry, and, more specifically, the professional sports industry.

The National Football League (NFL) is currently in the process of attempting to solidify a "lockout" of the players for the 2011 season, which would also serve to lock out the numerous other workers associated with NFL teams and venues. After collective bargaining failed to make any progress, the NFL players' union decertified so that the players could launch a class action anti-trust lawsuit against the League and its owners. If this lawsuit fails, the lockout will continue and there will be no games scheduled for the 2011 season.

The team owners had reaffirmed a collective bargaining agreement ("CBA") in 2006, which gave the players 60% of NFL revenues and unrestricted free agency (no conditions on signing with another team after contract expiration). In 2008, they decided to "opt out" of that CBA and, since that time, have been attempting to completely renegotiate their existing contracts with employees (players), just as any exploitative cartel would during an economic depression. [1].

The NFL has seen its revenues plummet since 2008 as ticket, merchandise and concession sales have all dropped off. Now, the team owners and their corporate sponsors would like to keep a larger slice of the $9B revenue pie in the future. They are proposing to decrease the percentage share of revenue given to players, or perhaps even implement fixed salaries without revenue sharing, and extend the regular season by two games, among other things. [2].

The collective negotiations were obviously just a show, since the owners knew from the beginning that they had massive amounts of leverage over the players. Unlike their counterparts in professional basketball, many of these players do not have guaranteed contracts, are not paid exorbitant salaries (relative to their value for the team), are prone to significantly increased risk of injury as they get older and are also heavily in debt. While the owners believe they can afford to miss out on revenues for a season, the players, given their lifestyles and expectations, do not. One sports commentator described the owners' mentality as one that is willing to endure "short-term pain" for "long-term gain". That's why they are so confident in their ability to ultimately get what they want.

Major financial institutions and their executive decision-makers have, similarly, decided that they will pursue a strategy of short-term pain for long-term gain. They literally and figuratively hold unfathomable amounts of leverage over the global economy, and the lingering threat of debt deflation has, so far, only served to increase the strength of their stranglehold. The short-term pain comes in the form of a few financial institutions being sacrificed at the altar of greed, slightly reduced share values (relative to their peak) and a public relations nightmare for perhaps a year. That's really it. From the perspective of these financial executives, it will be smooth sailing from here on out, because global economic actors are still entirely dependent on their good will.

As the global financial situation remains unstable and continues to deteriorate, they expect to get concessions from the players (central/local governments and their taxpayers) all along the way. These concessions may come in the form of direct subsidies, backdoor monetary policy (quantitative easing), austerity and tax hikes (continued servicing of government debt) or cheap access to public assets (land, oil, etc.). It is not just the financial crisis which provides them with leverage, but every sociopolitical crisis that stems from it and even unrelated crises.

In fact, every single crisis in the last three years (see sub-prime housing meltdown, Haiti EQ, Pakistan floods, Russian drought, European sovereign debt crisis, MENA revolutions, Japanese EQ/flood/nuclear meltdown) has been used as justification for further taxpayer subsidies to the financial industry. Governments and private individuals simply do not have enough funds for relief efforts, so they must finance most of it.

People are dying and something must be done, but, given the current monetary paradigm, governments can only take action through the issuance of more debt and the payment of more interest to private banking cartels. It is no wonder, then, that certain Wall Street executives are earning millions in salaries and bonuses while the rest of the world quickly crumbles into little bits and pieces.

The "plan" was not to blindly chase risky investments until everything crashes and everyone goes broke, but to make large sums of money while also gutting the productive economy and deliberately plunging the entire world into a state of hopeless dependency. Those of us in the developed world have all ended up like the NFL players, watching the wealth pie shrink as we hold grossly mismatched expectations, but no chips at the table to bargain with.

At the same time, however, those NFL players do see a slight glimmer of symbolic hope in front of them. It is true that the ongoing anti-trust lawsuit against team owners is essentially meaningless, yet another procedural display of injustice at work, and the players will never be able to meet their material expectations. However, the court of public opinion may offer them the next best thing - a form of revenge on the greedy owners and corporate sponsors. Justice, in our current society, can only be measured by how equally the losses are shared.

American sports fans do not want to go an entire season without professional football, partly because of our selfish need for mindless entertainment, but also because many of the fans view the teams as an extension of their immediate family. They follow every single detail of the team's performance, anticipate every single game with child-like enthusiasm and celebrate every victory like it was a validation of their own existence. They also mourn the losses like they would if a close relative had just passed away. The team owners figure that this level of extreme attachment will always serve to bring the fans back, no matter how disappointed they are in the short-term, as they always have in the past.

We are not living in the past, however, and the average American person, whether a sports fan or not, has just about reached his or her breaking point. They can no longer afford to buy season tickets or even tickets to individual games, and now they are being told that that they can't even watch their favorite players on TV. We can no longer afford to buy homes, cars, boats, computers or even gas, and now we are being told that we must pay higher taxes and receive less public benefits.

If that is really a recipe for long-term gain, then I must take my hat off to the financial masters of our world. That would mean they have managed to subjugate billions of productive workers around the world and steal what little wealth these workers have left, without generating any real threats to their own wealth or power in the process. If they end up on the wrong side of a slim margin of error, however, then they have only managed to carry the weight of the world on their shoulders for a few short yards, right before the strain became too great and they collapsed in a heap on the field.