My Cynical View. Please take with Grain of Salt

I Just read an article that reminded me of an issue I had let go by the wayside recently: the issue of quantitative easing and more specifically, the 3^rd round of it, or QE3.  To fully grasp the concept, one needs to understand that the intricacies of the treasury market.  Since the inception of QE2, the FED has thrown outrageous amounts of money at the treasury market to keep prices from falling.  Despite their best efforts, prices have fallen, sending interest rates higher.  I have been asked before, that if the FED is fighting a losing battle, i.e. rate are going higher despite their efforts, why do they even try?  My best guess is that without the FED QE2 intervention, interest rates would be quite a bit higher than they already are.

Here is the problem: If interest rates start to run higher, it will be even harder to create a sustainable recovery in the economy as homeowner will face higher mortgage rates leading to fewer buyers.  Corporate businesses would also have a harder time funding day to day activities which could induce further layoffs. 

Now we have been starting to hear talk of not needing QE3.  And that makes sense.  If we are to believe what the FED tells us, then the economy is improving.  In which case, why would we even need the drastic intervention going on at the FED?  It is my opinion that we desperately need this intervention.  The fact is that bond prices have fallen hard in since the start of QE2 despite hundreds of billions of dollars having been thrown at the problem. 

So in order for the FED to get the go ahead from congress to run a 3^rd round of QE, the public needs to believe that the economy is in dire straits.  Since the public really only watches the stock market for it gauge of economic health, we may need to see a stock selloff for enough people to think that continued FED intervention is needed.  Tomorrow is an ideal day for an event like this to occur.

Think about it.  The market looks complacent today.  We have had a gradual and consistent uptrend, with very little volume and volatility.  Basically, buying but with little to no conviction.  Not only that but I would bet that many people have been chopped out of the market in the past few days given all the swings and inconsistent movement.  So the weak hands on both sides have been shaken out for the most part. 

The NFP numbers are one of, if not the biggest trading event of the month.  I am thinking we may be in for a wild ride tomorrow.  The market has been pricing in a good number.  Today’s weekly jobs number was strong and yesterday’s ADP number was good also.  The best part is that you don’t even need a bad number for a big sell off to occur.  In fact, it may even be better is the number is bullish.  My guess is that weak buyers have been forced out by the recent trading action.  On a bullish number, these guys would be stepping back in to buy.  If the big players want this market to go down, they will have a fresh round of buyers to sell in to.

I’m not saying this will happen, but it seems like something that could happen, and I just wanted to pen it out for prosperity.  This market just seems a bit too complacent for my liking.

A Major Divergence

I was talking with a friend, showing him a chart when an interesting thought came to me.  What is gold telling me about inflation/deflation and what do short term interest rates have to say?  I present for you, two charts, plotted on the same time frame, for both gold and a December 2011-2012 Eurodollars spread.  Both are weekly charts plotting prices.  I show the charts then explain my interpretation.

Gold Weekly

Eurodollar December 2011- December 2012

So here we have two charts which go to the heart of investors' expectation on future inflation and deflation.  Yet both show a divergence in the charts.  It has been said that interest rate traders are the smartest out there, and one could easily argue that there are so many gold bugs out there that only know to buy gold.  If both of these facts are true, then we should expect a precipitous fall in the price of gold in with the next few weeks.  But I am not so sure about that as these charts do not represent anything too contradictory.  But it may shed some light into why we are heading down the road we are.

Before I go any further, let me explain what the second chart really symbolizes.  (For those that are familiar with Eurodollar markets you can skip this and the next paragraph.)  Eurodollars not a currency!  Eurodollars are US dollars held in and lent from foreign banks.  It is an extremely short term interest rate market based off the LIBOR.  An outright Eurodollar contract is prices as 100-LIBOR, so just as in the US treasury futures, when rates go down, prices go higher.  Since these are US dollars, this market is subject to swings based off of short term lending rate by the FOMC and everything else that effects the interest rate markets.(USD strength, economic data, etc.)

The LIBOR is the London Inter-Bank Offer Rate, or in English, what banks charge each other for short term loans. The futures markets shown above are based off the 30 day LIBOR.  In the futures markets, this is about as short term as you can get.  Anyway, what the second chart shows is the difference between expected short term rate at the end of 2011 and the end of 2012.  

What this chart shows is that starting around April 2010, this market started pricing in fewer rate hikes out in to the futures.  As the chart falls, so do expectations for tightening interest rate policy by the FED.  After reaching a high of 1.20% the spread has fallen back down to .6% currently.

From the beginning of 2009, the ED spread shows that expectations of a higher amount of rate increase for the year of 2012 were increasing.  In a sense, traders believed that in an environment when interest rates are going higher, on could expect the rate schedule to increase aggressively.  Well now it seems as is that perception has changed drastically, and in a few short weeks expectations for rate changes have fallen by half.  This signifies the belief that when the FED is forced into action, it will be a slow and gradual process, not the aggressive paradigm shifting rate hike schedule like had been previously indicated in the charts.  From the looks of things these days, I would anticipate this spread to continue to narrow down to around 30 but should it go back and hit the 2008 lows at 0, then one should head for the hills.

A spread value of zero would mean that traders do not anticipate any rate hikes by the FED for 2012.  It would signify a continuation of loose monetary policy for much longer than previously anticipated.  Let me be blunt here: This is a strong possibility right now, and could be the catalyst for a blow up in the price of Gold.

Should interest rates remain at the current, near zero levels through 2012 it would imply a few major issues.  The FED is so afraid of hiking rates, that it will keep interest rates at the currently depressed levels for quite some time.  This keeps the cost of credit very low, which is what we need to generate a recovery in the mortgage and housing markets.  But that is assuming that somehow, the US economy will right itself.  The only reason to keep interest rates that low for that long is the fear that hiking rates would kill the economy.  

Traditionally, when inflation is running higher, gold prices do the same.  In order to check that, the FED would raise interest rates, and gold would be contained.  The US dollar would also gain strength as part of the inter-market relationship.  Gold is saying that inflation is here and will be here to stay, while the interest rate spread is saying that low interest rates are gonna be here for a while to come.  It an sense the charts are confirming each other.

These charts could be at odds with each other in that lower rates mean the FED's primary concern is one of fighting deflation.  But from a long term perspective, they can both be right.  If the FED has got it wrong, it could be that their fight against deflation will actually lead to rampant inflation.

My theory is that we are now in a unique phase where we will witness both deflation and inflation.  True, I would be more concerned for a deflationary break in the near term, than an inflationary one.  But it is possible to have both.  

A distinction needs to be made here.  Inflation is a monetary issue, hyperinflation is a political issue.  A hyperinflation blowup could result from keeping interest rates too low for too long.  Combine that with the FED now monetizing debt through numerous buy back programs and you get a falling US dollar.  We will not get to that hyperinflationary scenario until the world starts fleeing from the dollar.  

Right now gold is hinting that that is exactly what is going on right now.  And the FED, which would normally raise rates to fight coming inflation is too focused on keeping rates low so it can try to stimulate the economy.  I fear that when all is said and done, there will be little that the FED can do to stem the incoming tide.  

POMO, the new four letter word

POMO, or Permanent Open Market Operations, see this, is one of the newest acronyms to hit the streets.  The caption below is taken from the FOMC website:

The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).

We ask our readers to focus on the bold text above.  It appears as if the FED is using POMOs as a means to keep interest rates low in keeping with their target Fed Funds rate.  But what is actually going on? It sure seems like market manipulation, but I guess no one really cares as long as the end result is higher stocks and a well bid treasury market.

The problem here is not simply in the POMO activities, but the combination of POMO along side of other stimuli present in today’s markets.  What we present here is a simplified explanation though we are confident in having highlighted the major principles of the strategy.  Primary Dealers (PDs) are the large banks that buy up US Treasuries and then sell them off to individual investors.  What the PDs are able to do is borrow funds at super low rates through the FED’s discount window.  What appears to be happening is that these PDs are borrowing FED money, and using it to buy US treasuries ahead of POMO days.  Since these POMOs have become an almost daily occurrence, this has become a large part of the stealth monetization taking place right in front of our eyes.

On the POMO days, the FED is buying back previously issued treasuries to the tune of a couple billion/day.  The PDs have been able to benefit from these actions as buying a US treasury ahead of the POMO almost guarantees them the ability to sell it back to the FED a few weeks later at a higher price.  No one is better than this than PIMCO’s Bill Gross, who hinted in a recent interview that he may have access to information weeks ahead of the rest of us.  See this. 

Anyway, the PD’s buy USTs with borrowed money from the FED, then turn around and sell them to the FED for a profit.  What does the FED get out of this aside from an increasing balance sheet?  It gets to keep interest rates low, though a strong bid for Treasuries, and the resulting profits given to the PD’s through the POMO days often rotate right into the stock market.  This is truly an ingenious idea on the FED’s part if it were not for the seemingly limitless amount of debt incurred though said transactions.  The bottom line for most is that interest rates remain low while the stock market stays elevated.  This is precisely what the FED wants.  They also want you to be ignorant of the fact that these debts will eventually have to be paid.

The only way to effectively pay this debt off is by devaluing the dollar, which of course is happening right now.  The end result is that the price of gold and commodities continue to rise.  I am sure that we will hear at some point soon that inflation in the price of goods is a healthy sign of growth to come, but this sure seems like the beginning of the end to me.  All that is really going on is that the FED is sacrificing our future to make things look better for the time being.  Volume has been absolutely abysmal in the recent stock rally, indicating that no real buying is occurring.  Tie in the POMO days with the positive feedback algorithms know as the HFTs, and you get a stock market that continues to run higher on light volume.  Any analyst will tell you that bull markets are not formed with weak buying.  Should the switch be turned off on the POMOs, what will happen to the stocks and treasuries?  The FED has backed themselves into a corner on this one, and the only outcome I see is an eventual collapse of epic proportions.  Of course, the FED could keep on printing money to run these POMOs, giving the banks even more underserved profits but it will eventually lead to a global shunning of the US dollar.  The only saving grace at the moment is that everyone else in the world is in the same shitstorm as the US.  Hopefully this will be enough to keep the relative weakness of the US dollar from turning into an outright collapse but I fear it will not.

These are complicated times, filled with corruption and shell games going on right in front of us.  It is worth noting one key point here.  Market manipulation was blamed when Crude Oil prices rose above $140/barrel in the summer of 2008.  This led to higher prices at the pump and the world was screaming for a stop to all the market manipulation and speculation running rampant.  Yet today we are witnessing an event of substantially larger proportions but no one seems to care.  I guess if the end result is a higher stock market and low interest rates it doesn’t bother anyone.  Forget the long term results, like a weaker dollar and continued anemic growth, today’s positive close in the stock market is all that matters.

Here is what I think a best case scenario will be through such intervention.  The dollar will continue to weaken, but given that whole world faces a similar problem, the next few years will be consumed with wild swings in the FX markets as each central bank tries to kill its own currency for the sake of paying off future debts.  A global devaluation of currency will keep the US dollar from falling all by itself, but it will have further ramifications.  The price of hard goods like food, energy, and metals will begin to skyrocket.  Something has to maintain value as investors seek a store of value, money will flood into the commodities markets.  This is happening right now, as grains and metals continue their parabolic move higher.

So the price of goods will increase, but without the coinciding increase in wages.  In fact, the increasing debt load and low rate schedule will only make it harder for the banks to remain competitive and profitable.  This in a sense will take away their desire to lend to individuals or small businesses.  In fact why lend to anyone when the POMO scam is such a great way to make short term, guaranteed profits?  This will precede a period of stagnant wage growth combined with an increase in the cost of goods.  Sadly it will probably not mean an increase in home values as debt based investments will take the heap of deflation that everyone is talking about while inflation runs rampant in the hard goods sector.

What we need now is for the FED to stop all intervention in the markets.  True, it would probably lead to a collapse in the stock market and soaring interest rates.  But shouldn’t the “free markets” be allowed to find their own bottom.  Only then will true buyers re-emerge and start to right our swinging ship back towards the correct course.  It will mean more pain in the short term but less in the long run.  The actions taken by the Central Banks today will likely only prolong the duration of the current depression we face.  In the end the markets will make their way to a bottom at some point, but how much debt will we as tax payers be on the hook for when all is said and done?  The only way the US can pay these debts without taxpayer money is to print money which only dilutes the value of the US dollar.  The only way to not dilute the value of the dollar is to charge higher taxes from those that actually need stimulus, the individuals.  Markets don’t go up forever, nor should they be forced to do so.  At some point they will fall and no amount of printed money will stop it. 

If you have read this and thought well I’ll just keep my money in stocks because the FED keeps rolling money into the stock market, think of this fun fact.  Even though the DOW is now back to where it once was in the early part of this decade, the value invested is down about 30% due to a severely weakened dollar.  The only real store of value though this time frame has been gold. 

For a great interview check out this one from the European side of CNBC which still maintains a modicum of credibility.  

The Race to the Bottom is in Full Force

Basic game theory will tell you that the first to defect will often see the greatest reward.  This is, of course, a very glib interpretation of the science but in the case of currency debasement it will likely hold water.

The race to the bottom has begun!  Brazil and Peru are outright buying dollars now in an attempt devalue their currencies and keep exports competitive.  See this and this.  Japan has now tried to do the same for the second time in a week and failed.  That's okay, intervention only costs a few trillion yen each time.  See this.  The Swiss franc has hit all time highs vs the dollar this morning as well!  See this.  The currency game is getting downright horrifying.  It is no wonder that gold has breached the illustrious 1300 level in the early morning trade.

The world is waking up to the fact that US dollar is becoming more and more worthless by the day.  No wonder the FED is monetizing debt (printing money to buy US treasuries).  No one in their right mind is going to hold US dollars with actions like these taking place every day.  I said it before and I will say it again.  No one can debase the good old US of A.  And think about it, how else will we pay of the mountain of debt accumulated every day without a severely depressed dollar down the road.

Weak dollar leads  to lack of demand for US treasuries which leads to higher interest rates to attract more buyers which makes it harder to get a loan which leads to another downswing in housing which will lead to more loss of capital which will lead to further debt accumulated to support a defunct financial system which leads to a weaker dollar.  And so the circle-jerk continues...

Wanna see another cool chart?

The following is a monthly chart of the S&P priced in Gold.  You can't see prices, but you can see the path our illustrious stock market has taken.  When people ask me what I would recommend doing with their money the old line keeps coming back, "Buy gold."  I am not a gold bug and I have learned some hard lessons on the buy side of the precious metals in my day.  But really, does it get much clearer than this?  Buying gold, be it though physical purchases, ETFs, or futures is your way of saying screw you to the US government, I am not going to sit back and wait while you trash the value of my hard earned money.  Incidentally, if you are going to buy gold futures, don't do it without a professional helping you out.  The risks are too high for someone not watching every minute of the day.

Stealth Monetization

The following is a regurgitated post found on Zero Hedge.  Therein lays a step by step process of how the Federal Reserve is indirectly buying US Treasuries.  This ongoing process is what has led interest rates to remain at such low levels. It is also why small business is not getting a piece of the pie.  The banks are swallowing all the public bailout money we all work so hard to earn.  If you are not outraged by this you just aren't paying enough attention.

Let me say it again in case you skimmed the previous paragraph.  The bailout money that has come from our tax dollars has gone directly to the Too Big to Fail Banks.  The banks have taken that money, and now are borrowing from the FED at super low interest rates.  What do they do with this super cheap money?  They buy US treasuries.  This is the new normal for monetization.  Why come out publicly when a thinly veiled shell game will suffice?  Throw in a few wars in the middle east, ramp up some protectionist hatred against China (see this) and voila. The smoke mirror machines are working at full force.  Don't hesitate to weed through the BS.  It's no easy task when there is so much of it out there!

Let me put it one more way.  This monetization is essentially like taking money out of your right pocket and putting in your left pocket and thinking you just made a cool 20 spot.  Except your left pocket now owes your right pocket $21.  See where this is going?  Read on for details.

Stealth Monetization

The Cusp of a New World Order

I want to begin by going back to claim I made that we would see hyperinflation in the coming decade.  In all honesty, this is a highly unlikely outcome.  What led the Weimar republic to hyperinflation was set of unique circumstances that will not be duplicated this time around.  The age of information allows for instantaneous dissemination of data and were that the case in post WWI Germany, I doubt the same outcome would have come to pass. 

Yet at the time of the great depression Keynesianism was in its infancy.  One could argue that Keynesian policies led the US out of the great depression but is those same misguided principles that have put us in our currently dire economic situation.  John Maynard Keynes’ theory is based on the idea that governments can control the economy my through tightening a loosening of monetary policy.  This means raising or lowering short term lending rates and adding or removing money supply.  Tight policy implies higher rates and less money while loose policy means more money and lower interest rates.  The idea is that in times of duress, the government can lower rates and add money into the financial system.  The goal is to stimulate lending and by extension further growth.

Right now, the FED has lowered rates to virtually zero and in theory we should be witnessing increased lending and a return to higher growth.  The last time we witnessed such a shift in policy was right after the tech bubble burst.  At the time, FED chairman Alan Greenspan began lowering rates and even came out and recommended individuals refinance loans into Adjustable Rate Mortgages.  This led to the last part of the housing boom.  Interest rates were low, and home values could only go up.  It only made sense to do exactly as he suggested.  This boom in housing led the mortgage industry to begin selling and reselling these loans in packages called Mortgage Backed Securities (MBS).  In effect a bank could lend money to an individual then repackage the loan with a bunch of others and sell the group as interest bearing security.  Of course the success of an MBS is based off everyone’s ability to pay off those loans.  As long as the loans performed, the money kept flooding in.  Yet when the teaser rates on the ARM loans reset higher, many homeowners were left unable to meet their monthly payments.  Since the MBS’ had been repackaged and resold so many times over, it was difficult for even industry professional to know how to handle these new securities, many of which ended up in pension and retirement funds.  A lot of them ended up in money market accounts.  You know the accounts that give you higher return on your savings?  Well the money markets collapsed when Lehman Brothers was allowed to fail.  It seems the money market accounts had been buying the MBS’ that we now know to be toxic.  What happened was that money market accounts started posting negative returns.  The means that a guaranteed return on deposits was not actually guaranteed.  What was once seen as the safest type of investment was now giving you 80 cents on the dollar.  Not the outcome most were looking for. 

The Day the World Almost Fell Apart

What happened next was possibly the scariest thing ever to happen to the financial system.  On September 18^th, 2008, the world almost fell apart!  See this.  Investors, institutions, mom and pop, began withdrawing funds from the money markets.  Around $550 billion over the course of an hour or two.  The link above is for a commentary on the topic that was never covered in the mainstream media.  In fact it wasn’t until almost three months later that even the most astute blog sites were able to report on the event.  This was run on the banks ala 2010.  Don’t be surprised if you never heard of this.  In fact, I would be surprised if you did.  This is not the kind of thing that gets talked about.  Ever.  If this kind of event were to have been made public the entire system would have collapsed.  In the end, the FED stepped in, threw about $105 billion dollars at the problem and halted redemptions in the money markets.  They put a guarantee on $250k per account and that seemed to stem the tide.  But the FED was not done, and was essentially forced to become the de facto short term lender as banks were now too scared to lend to each other.  And with good reason.  Who would be the next to fail and who would they take down with them?  Well we have not seen another major bank fail since.  Nor will we.  The systemic risks to the entire financial system are too high for another Lehman Brothers type episode.  This means the FED has now eaten mountains of bad debt.  The powers that be have also let the banks pretend that any of these toxic securities they may still hold are worth more than they are.  Bank balance sheets have now become a total sham and are being used to perpetuate the biggest Ponzi scheme in history.  Thus was the end of the housing boom.  But the cycle of deleveraging is not over.

Recovery Reshmovery

The recovery that our government hopes you believe in lays in the faith of investors the world across.  Our own government has taken in so much debt to bail out the banks, states, and everything else that there is no way it will be able to pay off those loans.  Except by issuing new debt.  As interest accrues, even at today’s low rates, the government will be forced to borrow more and more just to pay off current liabilities.  The only way out this mess is through a substantially lowered US dollar.  This means hard assets like gold, silver, and agricultural products will be some of the only sectors to retain value.  Today we watch in awe and horror as Gold sets another record high.  Silver is at a 30 year highs as well.  You know what isn’t at new highs?  The US Treasury market.  If this isn’t the clearest sign that the world is now starting to shun US dollars I don’t know what is. 

The next decade will bring about a radical shift in the way the world sees the US.  No longer will we be the bastion of health and prosperity we once were.  The US dollar will lose its reserve currency status and foreign central banks will no longer hold US Dollars in their coffers.  As we continue down this dark road I urge you to take a look at your investments and life goals.  If you were planning on starting a new career in a few years, maybe do it now.  If your money is in a stock fund, don’t just let it be, start to put some of it into the hard assets that may actually hold value over time.  Whatever you do, don’t lock up your money in long term treasuries.  I fear inflation could get to such an extreme that even a high yield on your money may not provide enough return to offset a loss in purchasing power.  Sadly, this probably won’t mean that the price of your home will go up.  In times like these it is the demand of necessary goods and inflation tracking investments that will appreciate.  Food, metals and energies.  People don’t need to own a home, but everyone needs to eat.  

Bust to Bust

To tie everything together we go back to the boom and bust cycles which are at the core of Keynesian theory.  After the tech bubble burst the housing boom ensued.  So where does the next boom come from?  Some argue that bond bubble is the next one to burst and I will not argue that fact.  If the FED can pull off another boom cycle into the bond market in this current environment I will very shocked.  This would mean that the US will need to show signs of stabilization for the world to feel safe in US dollars again.  The opposite is happening right now and I very concerned for our future.  We may be on the cusp of a new world order.  The underlying problems in the financial sector have been swept under the rug in the hopes that the storm will pass.  My fear is that we are now sitting in the eye of the storm and the worst is yet to come.