The Business Cycle Continues

The last 12 months have seen unprecedented political, financial, and legal change in America and the world. Anyone who thinks they can make a 5-year expensive financial commitment today and go golfing is fooling themselves. Everything needs to be hedged and watched closely with a highly critical eye, with a strategy to get out and reverse course quickly.

The deleveraging angle so often touted as the required outcome from our recent past excesses is moot. There are two ways it can happen and the Fed has predictably chosen the unnatural path. The first way (the natural way) is credit contraction. Not just your favorite metric, but the entire scope across the globe. One thing the recent generation gets out of the new free-trade global economy is spreading of the costs of managed economies. No longer can one central bank destroy a nation through lousy policy as happened in the 90s. Now the consequences of lousy policies are dispersed globally.

The second way, the artificial way, is the course all industrial and developing nations are doing today: debasing the currency. This method works by keeping current-dollar credit values constant from artificial central-bank stimulated demand (see monetarism), but reducing the purchasing power of those dollars by dilution of the currency.

That's precisely why the U.S. economy is stabilizing, and that in turn stabilizes bonds across the spectrum. Oh yea, we will pay for it, but the piper isn't going to come calling in the next 12 months. He's lining up his resources to come charging in sometime in the next 3 or 4 years. The details of the intervention are different this time, but the pattern of replacing wealth destruction with new money (whether by fractional reserve credit expansion from absurdly low rates or direct injections of new reserves when rate intervention is insufficient) has been used over and over with the same outcome every time: economic boom followed by economic bust.

The boom is just starting. The really horrible bust that everyone is ranting about today won't hit us until about 3 or 4 years. You can see that pattern in any of your favorite long-term macro-economic charts.

Corporate Bond Rally May Stall Now

Today high-rated corporate bonds are trading just barely above government guaranteed bonds.

Yesterday we got a glimpse through Seeking Alpha just how far we've come in the last year.

At least at the top end of the rating scale, there's hardly room for any more contraction in spreads. The long term prospects for high-rated corporate bonds doesn't look good unless in fact Bernanke can actually overcome the forces of monetarism and keep real inflation at historical lows.

The best bet in bonds is the lower grade issues at this point. If high-grade rates remain low on a recovering economy from central bank purchase demands, those lower rated investment grade bonds will see continued contraction in spreads as default risk subsides. If high-grade rates rise while the economy recovers, lower rated investment grade bonds may not see declining yields, but contraction in spreads can still produce stable prices and above-inflation yields.

There are two primary risks, one of which is almost ignorable. The first is demise of the global economy, which is most unlikely but theoretically possible. For that scenario you better have backup food supplies, loads of currency (legal and barter) tucked under your mattress, and a plan for wilderness survival. The second is inflation rates rising to the point where low grade bonds fall in value with or without contracting yield spreads. This is much more likely than the former, and highly probably if Governments around the world don't back off their stimulus programs in rapid fashion.

The good news on the inflation story is monetarism reveals this kind of inflation takes 12 to 24 months to find it's way into consumer prices. At that point one will have to switch to inflation investing.

Until then, high yields, contracting spreads, and green shoots are the fundamentals one should be keeping their eyes on, and high yield investment grade bonds provide a tempting opportunity not often available with fundamental support like we have today.

How Ben Bernanke Saved the World

Subtitle: "How I Learned to Land a Helicopter", by Ben Bernanke

The title is past-tense for posterity's sake. This link needs to be remembered in the future when reality testifies on Ben's behalf. Fortunately for Ben we can never know what might have been -- we only know what he claims would have been if not for his policy, and must believe reality is better no matter how bad it is in fact, when the facts are in.

This, though, is his expose on how he plans to keep the world from hyperinflation after the biggest creation of fresh dollars the world has ever seen. Download a copy for posterity before the Wall Street Journal archivists cut off the link.

This isn't very reassuring: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

It's reassuring if all one cares about is ensuring that interest rates rise. We'd really like to know how the next upward move in fed funds isn't going to create a financial shock like all the others in this present generation. Granted, inflation is under control as measured by CPI and a few other choice tools, but 9+% unemployment is approaching historic levels, so this last fed funds move failed on the employment objectives. And apparently wiping out American investors' wealth is an acceptable outcome (as happened in the dot-com bust and now the real-estate bust) since it isn't a policy mandate to target preservation of American 401(k) accounts.

Furthermore, it doesn't address the bank's fiduciary duty to shareholders. How are banks going to justify tiny ROI when fed-funds level of yields are earned on an ever growing pile of reserves? This is going to pressure banks to use reserves for higher-yielding assets. To keep bank stockholders from rebelling, the rate on reserves is going to have to be higher than fed funds. This program will create a ceiling for fed funds, not a floor. Small banks without large in-house investment departments like Goldman and Morgan (recently converted to banks) are going to demand yields that match ROI garnered from their securities market operations. Equity investors will not stand for ROI in single digits. If banks can't make loans to business, they will seek out returns in other markets like securities.

As taxpayers, we're not very reassured. It is certain this board of governors won’t make the same mistakes as their predecessors, but equally certain the mistakes they do make will be costly. One can always offer the blind assurance that it would be worse with any other option. But of course you can’t prove what might have been. You can only have faith. When it comes to faith in the central bank policies, our only faith is that they will create a boom-bust cycle just like they have for generations. As for us, we’ll prepare for the inevitable disaster in what ever form it comes in the next business cycle bust, including the potential of having to pay 80% tax rates on inflation-induced capital gains for the "rich" (where rich is defined as anyone not a ward of government social programs) to pay for the next Keynesian stimulus devised for the consequential bust of present-day quantitative easing.

TALF Fails Its Objectives

That title might be misleading. It fails the stated objectives, but some might wonder if the real objective is to ensure a steady stream of large transactional revenue for primary dealers.

According to the federal reserve:

The Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF), to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities...
Source: NY Fed

Notice on the July 16th facility, a full $0.6 billion in loans were requested. However, they weren't new loans. These were legacy securities. That means someone is putting up some old commercial real estate loans as collateral for cash, so they can do something better with them. It also reveals while they want to "support the issuance" of new securities, those working face to face with them aren't interested. There's too much junk in bonds they need to get rid of first.

One might argue, the proceeds from this loan might be used to fund new loans. While that's possible, its also possible they might be using the proceeds to fund payroll, pay bills, or who knows what.

But you see why the larger banks are in the money these days?

...Eligible borrowers must use a primary dealer...

The fee for the Fed alone is 20 basis points, or $1.3 million for this one operation on one day. No telling what kind of haircut the borrowers of the securities have to take with the primary dealers.

That also means one or more of the 17 dealers get piece of this action, even if they don't lend consumers a penny. One way to keep the banks solvent is to simply lend money back and forth between them; and you wonder if GDP is going to take off?

Maybe, maybe not. But one thing is for sure: those Goldman employees are going to be buying some pretty nice cars, clothes, jewelry, and other luxuries with their $386,395 annual salaries. Goldman is one of the primary dealers, and is no doubt making a boatload of money churning these legacy assets through all the facilities, not to mention the new bonds being issued by corporations, and the Federal Reserves direct purchase of securities.

As a matter of fact, Goldman is doing so well they confidently plan to issue around a billion dollars in unsecured bonds so they can leverage this new world of global liquidity. We don't yet what asset class is going to get that billion dollar stimulus injection, but something bubble somewhere is being pumped up.

Velocity of Money

We're going to have to do some serious research on the Velocity of Money. This topic keeps coming up, but there doesn't appear to be a good discussion of the fact that Velocity can't be measured; it can only be calculated.

Furthermore, the fact that it exists (though some think it doesn't) doesn't mean it is the cause of inflation. Most posts appear to interpret it that we.

We at SBC believe velocity is a consequence of the psychology driven by theories expounded on by monetarism and Austrian economics. Until we get the in-depth analysis, we'll have to suffice for a few comments on the web.

See today's note on Seeking Alpha.
And another on Across the Curve.
And what appears to be one of the first arguments discussing Velocity and Monetarism. Mauldin has good analysis, but we don't think it discredits the view of V as a symptom rather than cause. Rather, it simply explains why there is a 12 to 18 month delay between monetary expansion and price expansion.

If you have more background and commentary, please put them into the comments so we can consider them in our analysis.

Gold analysis at Seeking Alpha

Jake Towne has done an excellent job analyzing gold prices in Unlocking the Money Matrix: Gold Price Suppression. This deserves a careful review, especially by gold owners.

A first pass over this essay impressed us as the author uses many references to government and official documents. If we understand this correctly, the gold price is "managed" by central banks today, Paul Volker made a big mistake not to do likewise, and they won't make the same mistake this time until such time as their holdings preclude them from success. This premise is strengthened by a reference to a central bank research paper advocating just such a policy decades ago.

Someone pointed out months ago we don't have to worry about gold confiscation in the 21st century since it isn't the basis for money any more. This article suggests that even though that's true, the price of gold is the basis for psychology and fear in the populace, and that is something "they" certainly do need to control -- all nations, not just the U.S.

So it's interesting to consider how long they can succeed at controlling the price of gold, and what will they do when they no longer can?

There was also an interesting reference to replacing the many foreign currencies with just a few. This reminds us of the speech at the Council on Foreign Relations we pointed out last month advocating for fewer international currencies.

We don't believe in conspiracy theories (i.e. specific global planned and orchestrated events), but we do believe in a finite and very small universe of ideas. With billions of people and hundreds of thousands of leaders in government and business, it's not surprising for ideologies (like those at the CFR speeches) to hold sway over many powerful people who either intentionally or coincidentally align their actions to support the premises behind the conspiracies. Much like blogs and analysis hold sway over investor actions and move stocks, bonds, and currency prices in particular directions.

Mr. Towne has done an excellent job of research. What we now need is equally excellent peer review of the hard data. Please post your analysis as it comes in.

Oil Speculation

This topic is rich today! Other titles come to mind:

1973 all over again
Political Stupidity Trumps Hard Facts
What to Oil and Onions Have in Common

At least a year ago, while oil prices were still threatening global economic development, the Commodity Futures Trading Commission (CFTC) was embarking on another round at attempting market manipulation through government regulation to ensure price stability of this precious and vital commodity. Congress even started at least nine bills, presumably in case the CFTC didn’t do their bidding. Luckily for consumers, rationality and reason prevailed that time. Hopefully the history of onions helped the first debate.

Rinse and repeat
Not to be dissuaded by circumstances, they’re at it again. Like every bad idea bureaucrats sink their teeth into, giving up and letting go is not an option. The Financial Times summarizes the present reality of another move to "fix" the "volatility" in oil prices yet again.

The fact that the so called "mess" they are complaining about happens to be perfectly in line with what any clear-headed thinker should have expected is beside the point (to them). As Craig Pirrong at Seeking Alpha put it:

...the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar. In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities. Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard. That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s. Look at every measure of uncertainty, notably such things as the VIX volatility index. These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007). What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.

He goes on to provide yet another round of reason and fact-finding to refute the notions spewing from the halls of Congress.

Mr Pirrong also provides us with a nice graphical representation of trading data. Notice that plunge in oil prices from 2008 to 2009, and speculative long futures contracts during that time, directly contradict precisely the claims of the fools in Congress and the CFTC. Not that you should expect bureaucrats to see the light when you shine it in their face. In spite of the clear evidence to refute the idea, we can at least hope the CFTC pursues this because of congressional pressures to please the lemmings in the general population who don't know any better but to demand someone look into it.

Last time the world financial system nearly collapsed, OPEC used it as the impetus to band together in a more concerted effort to ensure their revenues were not ruined by American policy.

Independently, the OPEC members agreed to use their leverage over the world price-setting mechanism for oil to stabilize their real incomes by raising world oil prices. This action followed several years of steep income declines after the end of Bretton Woods, as well as the recent failure of negotiations with the "Seven Sisters" earlier in the month.
(Source wikipedia)

It’s unlikely the price controls on oil in the U.S. helped matters. Some say the world won't experience inflation like we did in the 70s, but the global quantitative easing is ruining the value basis for currencies everywhere like massive new stock issues dilute the values of equities. Between the potential for CFTC regulation of futures markets, and the potential for ruinous monetary and fiscal U.S. dollar policies, America once again appears to be setting up for another round of high oil and gas prices.

At least you now know you can confidently brush off whatever nonsense someone tries to feed you when they use open interest in oil futures to tell you where the price is going next. Like any investment, you actually have to know something about the fundamentals of the market to make a rational informed decision.

While the last few weeks have seen some profit taking and softness in crude spot and futures prices, we’re still bullish on the intermediate and long term price potential of oil. If Congress and the CFTC does nothing, human nature and normal supply and demand will provide price support. If regulation ensues, we might learn something from the onion (depending on what actions are taken) and have more opportunity to profit from this essential commodity.

Security Analysis

Are all equity investments created equal? Is a common stock, CEF, and ETF all fundamentally the same because they are bought and sold on the stock market exchanges? How about securities in the same class? Is it reasonable and necessary to presume all types should match their peers' fundamental metrics?

Today PHK went ex-dividend for the month and in typical fashion took a beating in price. This time it was compounded with a recent set of negative reviews at Seeking Alpha.

PIMCO High Income Fund: Substantially Overvalued?
CEF Funds Review: Worst to First

In the first, we've commented on the analyst's perspective asking some of these questions. If you have some insights to add, we hope you'll speak up and add your analysis to the mix, either here at SBC or at Seeking Alpha.

Round 2: Smart Securitization

Here we go again, boys and girls. Let the music begin. Last one without a chair is out!

Thanks to the wonders of modern finance, we can now spread out the risks of debt defaults by repackaing instruments into ladders of risk. Sound familiar? Well, you're wrong. No sir, this is the new era of smart securitization. Unlike the last time this system collapsed, this time the wizards of finance are going to do it right. So says Geoff Smailes, managing director of global credit solutions at BarCap.

These new mechanisms are in some respects similar to discredited structured products such as collateralised loan obligations, which were widely blamed for fuelling the financial crisis. But the schemes' backers argue there are two significant differences. First, they involve the securitisation of banks' existing assets, rather than of new lending. Second, bankers argue that the new products do not disguise the transfer of risk.

"This is the world of smart securitisation… not securitisation for leverage and arbitrage"
(Source: Financial Times)

Darn, we sure wish we had contacts with their buyers. We've got a great idea to lease the Brooklyn Bridge. No, we're not talking about selling the Brooklyn Bridge. That's obviously an old con job. No sir, we just plan to lease it. That makes all the difference in the world.

The New World Order in Stable Global Currency

Across the Curve recently pointed out some interesting developments in China's response to the financial crisis and their bloated dollar reserves. It should be a forgone conclusion Manhattan R/E prices will fall. No news there. But China now allows settlement in Yuan. Now that’s interesting.

However, this argument for the value of stable exchange rates was the basis for Bretton Woods, which didn’t turn out so well.

The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. (source: Wikipedia)

Go ahead, blame the collapse on the U.S., but the core fact is fixed exchange rates are really price controls on foreign exchange, with some enforcement mechanism to dictate what sovereign nations can and can’t do with fiscal and monetary policy. Notice a key phrase above, which is as true today as ever in the U.S. and every other nation: "…an era of more activist economic policy…” (read that as “managed economy”).

History is clear, price controls inevitably lead to misallocation of scares resources and poor financial decisions, then to gray and black-markets, which in the case of forex and national policy translates into cheaters who’s self-interests trump the desires of their partners. In the case of Bretton Woods, the strain of national interests working against the rules of fixed exchange finally blew up in ’72. But notice one of the preceding problems (emphasis added):

…The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing… (source: Wikipedia).

So how would a new forced stable exchange rate (i.e. if China somehow convinced the world their managed currency exchange rate to ensure vibrant exports was a better reserve system than floating U.S. dollar exchange rates) fare better in the 21st century than it did in the 20th, especially in light of the balance of trade surplus problem in the 20th century and China’s balance of trade surplus today?

Don’t get us wrong, we're not bashing China for their response to present problems. It's natural, normal, and expected for every nation to try and keep it's citizens productive, useful, and well fed. But swapping one fiat currency for another new one doesn’t seem like it will do our children any good.

Side Note: Turns out you can celebrate Bretton Woods 65th Anniversary this month, in case you don’t already have vacation plans. We hear New England is pretty in the summer, but the guest speakers look like the type to extol the virtues of Bretton Woods without much serious criticism of its failures or alternatives. Too bad Ron Paul, Mark Skousen, or just about anyone from the University of Chicago won’t be there to speak as an alternative voice.

Follow up on Fed Funds

Late in June we pointed out the Fed Funds market rates were rising, and had actually hit the upper limit of the target range. It appears to have been a normal month end, if not quarter-end, phenomena. Since then, fed funds have fallen back to the teens.

We can see from the Term Securities Lending Facility Options Program (TOP) that collateral pressures are expected at quarter-end dates (emphasis added).

The program is intended to enhance the effectiveness of TSLF (Term Securities Lending Facility) by offering added liquidity over periods of heightened collateral market pressures, such as quarter-end dates.

However, we can see also from the historical data that the TOPS program started out heavily over-subscribed, but has in the last two offerings been under subscribed. This is consistent with our June 16th observation that credit conditions have significantly improved.

We don't mean to imply the world economy is robust and healthy, but as Hussman often points out, we will take the facts as they come and adjust our opinions accordingly.

Collapse of the Dollar? I Don't Think So

There's a very good chance that dollar will decline in value relative to many currencies in the next few years. But to call it a collapse is hyperbole. Even if it collapses like the stock market did the previous two years, it would still be less than a 50% correction other than a very short-term steep trough at the zenith. As we pointed out in June, Robert Prechter is the only reputable analyst declaring equity investments dead.

Nevertheless, the hottest topic these days seems to be the collapse of the dollar because of America's horrendous debt load, the Fed's quantitative easing, loss of world reserve status, and who knows what else. We here at SBC would be inclined to bet you could find someone blame the dollar's demise on global warming, even.

Well, lets see if we can compare the British pound history to the same argument about reserve status. In the 18th century, the pound was the most equivalent asset to today's reserve currency, if you leave gold out of the discussion. At that time, it traded in the 20-cent range (relative to the U.S. dollar). The question of value is one of the most clearly subjective questions one can think of. Lucky for us someone has created a web site, Measuring Worth, that tries to provide "price" data for very long periods of time.

We can now compare the old reserve currency to the modern reserve currency and see what one should expect of the dollar exchange rate if in fact someone (like the IMF?) comes up with a replacement currency. We can see the dollar to pound exchange rate for more than 200 years was mostly stable in the low 20s during it's reserve period. Shortly after the first Bretton Woods agreement it started falling, and was again relatively stable for around 17 years (1950 - 1967). From that point on it enjoyed the roller-coaster thrill of the new world order of completely free exchange rates, apparently initiated by what Wikipedia called the "Floating" Bretton Woods. But in spite of that, the 2007 price was hardly different than 1967.

In the end, after 200 years of currency history, the British pound lost it's reserve status and sits about about 1/2 it's value from the reserve days. The only clear currency-based investment choice we can see from the advantage of hindsight from 1949 to the present is converting pounds to gold rather than converting pounds into the new global currency reserve emerging in that day (the dollar). Our friends at Kitco have some nice gold charting tools where one can compare the performance of gold relative to the dollar, and with a little work, convert that price chart to gold in British pounds.

We leave it as an exercise for the reader to analyze the choice between reserve currencies and stocks and bonds. But to argue that losing it's reserve status will ensure the "collapse" of the dollar is an exaggeration in light of reserve currency history. The real movers are more than just reserve status. When the data catches up with us, we'll look at foreign net purchase of U.S. debt in the early summer of 2009 and see how that theory is holding up.

Quote: C.S. Lewis

It is a common saying, one who does not learn from history is prone to repeat it. The ever-analytical C. S. Lewis explains why in his essay titled "Learning in War-Time" from the book The Weight of Glory:

... the scholar has lived in many times and is therefor(sic) in some degree immune from the great cataract of nonsense that pours from the press and the microphone of his own age.