Where Is The Next Bubble?

Look out for the next round of "emerging markets".

In the late 90's the easy money policy coincided with the advent and new-found stability and strength of the Internet, pumping huge amounts of speculative money into dot-com ventures. In the early 00's, the easy money policy coincided with the advent of the new-found stability and strength of credit derivatives. Readers might recall Enron set the stage for a new way to look at derivatives, after which the same geniuses of mind that invented them for energy and bandwidth extrapolated the concept into credit markets like never before. The question for us today is what financial model has the same characteristics that make for speculative exploitation?

First, it must be global in nature -- accessible and understandable to every language, culture, and nation. The last two bubbles occurred everywhere. In fact, there isn't a single nation big enough to absorb all the money in the world by itself. We need a band-wagon big enough for the entire human race.

Second, it has to be relatively new, as in "iteration 3". It has to be a bit of a novelty for the commoner and limitless. Bubbles don't grow where there are walls or boundaries. The Internet iteration 1 was limited to academia nerds, with commoners intrigued by the mystery of the new concept. Iteration 2 of the Internet found some bold adventurists dabbling in newly invented business models that only a very few understood well enough to make sense of. By iteration 3, the commoners began to understand this new business from having been exposed to it as consumers in iteration 2. The Internet had no bounds. So when the easy money politics of Alan Greenspan kicked in, it was a no brainier for high-finance to use that cheap easy money to take extraordinary risk on new ventures into this emerging new opportunity called "The Internet".

In the case of credit markets, collateralized debt began with mortgage backed securities, invented and implemented first in the federal lending agencies created in the 1930s and later. In the 70s, securitization of those mortgages was invented. (source: "Introduction to Commercial Mortgage Backed Securities (CMBS)"). For years they mostly sat their as a tool for the nerds of finance. With the advent and spread of computers, the agency bonds became a common investment playground of everyday finance. By the time Greenspan stepped in to rescue the markets from the dot-com bust with round two of ridiculously low interest rates, the collateralized debt instrument was so well established and proven it was now ready to exploit that cheap easy credit through the carry trade, in which even Japanese housewives were speculating.

Now that Ben Bernanke is fully entrenched with round three of subsidized and ridiculously low interest rates, where will that money go? It might very well be the Asian and South American emerging markets. In the '90s, a wave of free market economics swept the globe. The managed economy fell into disrepute. Small and large nations alike abandoned their commanding heights and implemented market reforms. In this iteration 1 of emerging markets, only the nerds of economics understood what was going on. No common investor in their right mind would gamble on such a large experiment in finance as to invest in a former dictatorship. By the time the collateralized debt machine was in place, these nations had established themselves as more than just a wild experiment. Their reforms actually appeared to be working. Business ventures in these nations seemed to be sticking. Policy official spoke the same language as industrial nations. Global trade and open markets were working. During the 2000's, the term "Emerging Market" and BRIC became reputable areas of interest for normal investment firms. Average investors were leery, but interested, and willing to dabble with 10% exposure to this "industry" as the bulk of their portfolio focused on Real Estate and domestic equities. Most importantly, they were learning the lingo of international investments and cursory knowledge of foreign economics.

Enter iteration 3 of emerging markets. The fuel for such an explosion could very well be the U.S. carry trade. If Bernanke can keep interest rates unnaturally low "for an extended period" like he has said, it just might fuel a new round of exploitation in those growing non-US markets, which would lock up huge amounts of US Dollar assets in foreign debt at absurdly low rates, and drive the price inflation we should have seen in the US into those other markets instead. The confirmation of this new bubble will be normal asset allocations in the high double digits in emerging markets by Western investors. The peak will come when taxi drivers and hair dressers share tips about the nations they are exploiting.

If Carry Trade Wave 2 is funded with dollars, we would not see significant price inflation in the US. Instead, price inflation will be "exported" to emerging markets as an ample supply of funds flows to them. Just as "credit risk" became a thing of the past in the last bubble, "foreign investment risk" would be a thing of the past in this bubble, as their GDPs explode in what would be sold as the new age of international trade. That would be the ultimate confirmation, when broker pitches include the assurance that foreign investment is nothing to fear as emerging nations support each other without the 'need' for the U.S. economy to sustain them.

Don't Ask, Don't Tell

Putting a new twist the common vernacular ...

Subtitle: "Why we need to keep our operations hush-hush secret", by Scott G. Alvarez, General Counsel, United States Federal Reserve Bank, in testimony before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C, September 25, 2009.

If you don't believe me, you can read the full text of the prepared speech for yourself as we've linked to it above. Or you can just believe me when I say the basic message is, "Trust me, we do all this for your own good. These aren't the drones you're looking for. You can go about your business."

Don't ask why we're on a Star Wars kick this week. It just seems to be working out that way. May the force be with you.

Embrace Your Feelings

That’s the wisdom from “Old Ben” of Star Wars fame as he tried to take down the Evil Empire's death star. Looks like the nation of France is embracing The Force after all these years as they try to take down the Evil Empire's death star “players”.

I'm sure it's just a coincidence the author of "France to count happiness in GDP" at the Financial Times is Ben Hall.

The Economic Policy Journal blog has a free summary of the news.

Money Supply Blog

The Financial Times has a blog on Money Supply around the world. We haven't yet formed an opinion about it yet, but the graphic (logo?) is slightly innacurate in our estimation. That scafolding and framing holding up the nations should be a house of cards, not steel. Steel is SO-O-O 19th century!

Bond Fundamental Shift on the Horizon

Not sure if this horizon is near or far, but it will be an interesting experience when we get there.

Sources say the Fed is in secretive talks with bond
dealers to restart "reverse repurchase agreements" in an effort to siphon
some of the $1T-or-so it's pumped into the economy. Unused since last December, reverse repos take cash out of circulation when the Fed sells securities to its 18 primary dealers for a set duration.
(source: SeekingAlpha).

So if the Fed is delivering inventory into the system, and the Federal Government is issuing new inventory into the system, how exactly are interest rates supposed to stay low for an extended period if this horizon is not equally far away?

Why Everyone Is So Bullish on Gold

Cliff Wachtel at Seeking Alpha asked the question today, why are "speculators" buying so much gold while "professionals" are shorting?

It appears to us he fails to realize (or he's obfuscating his real understandings for some journalistic reason) the broader fundamental nature of where prices and value come from. By that we mean the fundamental nature as described by Ludwig von Mises' in Human Action.

In the fall of 2008, the Federal Reserve made it abundantly clear that they would stop at nothing to ensure they could control all financial markets and keep dollars flowing. Finally, after the success at keeping security markets open, they found themselves with functional markets but little or no demand for debt. As money piled up in accounts of all kinds, they then had to worry about the collapse of money velocity.

There is absolutely only one way to make money moving -- punish anyone who doesn't trade it (spend it) in exchange for non-money. Since they have no legislative power, the only tool is debasement and negative interest rates (charging savers for storing money instead of rewarding them with interest payments).

Debasement was easy -- in Dec '08 and Jan '09 they announced unprecedented (in the U.S.) money creation schemes in the purchase of agency debt and U.S. Treasurys. Negative interest rates seemed to manifest themselves by the nature of the credit crisis.

So we now find ourselves in an environment where holding cash carries a risk that has to be weighed against the risks of buying bonds, stocks, commodities, or anything else. Furthermore, add to the equation the necessity of businesses of all kinds to produce a ROI above single digits, and the natural inclination is to buy something that has potential for price appreciation or income. It's no surprise to us in this light, that equities and bonds are showing price strength in spite of so many macro-economic weaknesses and the fragility of all those green shoots.

Enjoy for now the fact that institutions are doing the buying of equities, bonds, and commodities. When the higher costs of the latter start squeezing business profits, they will either have to raise producer and consumer prices or suffer systemic business losses.

In the former case, PPI and CPI go up, which means the risk of "holding cash" now hits consumers with inflation -- they will start spending their cash before it's purchasing power disappears, empowering producers to raise prices (the ultimate feedback loop). In the case of the latter, shrinking profit margins will be bad for equities, which religiously motivates another round of policy changes to "stimulate" the economy, further devaluing (diluting) cash (i.e. dollars).

Very few choices today will provide price support for purchases in either scenario of inflation or economic stimulation (i.e. more currency debasement). One of them is precious metals and their centuries-old reliability as a store of value. It's not a coincidence that some sovereign nations are thinking of gold again as they did before the prevalence of fiat currencies and floating exchange rates. The only major institutions who seem to be bucking that trend are the biggest institutions in traditional western industrial regions who pin all their hopes on fiat currencies. They are the bankers and commercial traders Cliff refers to in his post.

Update Sept 22:
ColdCore now reports at SeekingAlpha some details about those other sovereign nations and their interest in acquiring the "real money" that the west shuns.

Corporate Bonds Priced to Perfection

Just posting this to record the event for future reference. This example of today's bond market pricing is a set up that makes us uncomfortable about bond prices. They've rallied so much that spreads don't allow much in the way of price appreciation on Corporates unless Treasury rates across the curve all come down.

It would be an unusual situation indeed for the U.S. economy to recover and have Treasury yields drop from where they are now. Some examples of price movement lately:

Colgate deal which priced several weeks ago at T+ 67. The deal was a six year maturity. That issue is now traded 14 basis points rich to the 7 year Treasury.
Walmart 5 year paper issued in May at T+ 125 basis points. That paper trades 40 basis points over the 5 year Treasury.
MSFT 5 year paper is freely available at T+ 25

Source: Across the Curve

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Update 10/15/2009
J.D. Steinhilber, over at Seeking Alpha, provides some current bond information and more detail on the bond investor's dilemma.

Carry Trade, Funded by the U.S.

There's an interesting piece out of Across the Curve today from a USD/JPY analysis. If it's a fluke of nature and prices revert to the recent normal relationships, it will be easier to predict the outcome of US fiscal policy. If this is the start of a protracted trend, the global dynamics of money flow will be very different.

Namely, all this excess liquidity piling up from US and global quantitative easing would not produce the normal expected price inflation in the U.S. if dollars are borrowed by the Carry Trade crowd to fund their currency speculations outside of U. S. borders.

3mth USD LIBOR is now LOWER 3mth JPY LIBOR. This spread turned negative about three weeks ago, and in the same timeframe, Usd/Jpy has also fallen 2.9% (see chart attached).
Bottom line, the USD is soon becoming the new global funding currency...
(Source: Across the Curve)

We're not going to jump on a bandwagon touting that last sentence just yet, but if it comes to fruition it would sure change the dynamics of Bernanke's unwinding process. It might be the mechanism that gives the U.S. another stab at exporting the fiscal consequences of policies to the developing world. In other words, more of what has just happened in the last 10 years.