Luck Is The Residue of Good Design: Reserve Bank Transfers to the Treasury For 2013

"The Federal Reserve Board on Friday announced preliminary unaudited results indicating that the Reserve Banks provided for payments of approximately $77.7 billion of their estimated 2013 net income to the U.S. Treasury."
Src: Fed Press Release, January 10, 2014

One has to wonder how much of the national debt the federal reserve should buy up. Since operating costs are fixed, essentially if The Fed bought 100% of Treasury debt it would essentially be an interest free loan since the "surplus" of all that debt payment would just go back to the Treasury.

If that statement isn't intuitive, here's the math:

• Pretend "total cost of servicing the U.S. Treasury debt" was $453.3 billion.
• Pretend 100% of that debt servicing payments went to The Fed.
• Pretend The Fed needs "$20 billion for operations" (see the press release difference between what they recently earned and what they just returned)

If they owned all the debt, the cost of servicing the national debt would be 20 billion, not 453.3.

• 453.3 - 20 = 433.3
• "total cost of servicing the U.S. Treasury debt" minus "$20 billion for operations" = "surplus to return to the treasury"
• 453.3 - 433.3 = 20
• "total cost of servicing the U.S. Treasury debt" minus "surplus returned to the treasury" = "the net cost of servicing the national debt paid out from tax revenues"

Here's a common everyday scenario of how that works.

Son: Dad, this car must be worth a million bucks! It's a classic!
Dad: No son, no one will believe you unless you could get someone to pay you that much.
Son to his rich Uncle: Will you buy this for me for $1 million if I pay you a kickback? I need to recover my 10 grand I put into it.
Uncle: Sure, here's $1 million.
Son to Uncle: Thanks here's your receipt for $1 million.
Son to Dad: Look dad, I sold it for $1 million!
Dad: Wow, that's awesome. Sorry I doubted you.
Son to Uncle: Here's $999,990,000 back. I really only needed $10,000.

Test question: What was the 'true' cost of the car the uncle bought?

So the argument against fear that China will dump all our Treasuries is silly. In a crisis, The Fed simply agrees to buy it and store it for safekeeping until such time as a market buyer can be found to pay a reasonable price. That's exactly what they did in the bank run. When the world was about to come to an end (circa 2008) everyone (virtually, not literally) sucked up Treasury debt in a panic as the asset of last resort on earth. Naturally, most of those people calm down and eventually decide to go buy something better like stocks, bonds at rates above 2%, houses, etc., etc. Meanwhile, the Federal government started dumping new Treasuries on the market to cover the cost of all the unemployed.

Net Result: Massive flood of Treasuries coming to a market near you!

Reaction: The Fed simply agrees to buy it and store it for safekeeping until such time as a market buyer can be found to pay a reasonable price. We now know, also, that this safekeeping time frame is about 5-6 years. Like a storm water retention pool, they open the door and "collect" the "flood waters" in a safe storage facility until such time as they can trickle it out into the streams without washing away all the neighborhood homes and cars (pun intended).

One might argue, with a flood of new money to China (i.e. printing press operations to buy it all up) the value of the dollar would collapse.

Fantastic! Two great things to come out of that:

1. All the friggin' money Microsoft, Apple, Intel, and whomever that is locked up offshore because they don't want to pay tax on it would be going down the toilet unless they cash it in and bring it back home. The risk management dealers in their internal Treasuries would quickly do the math and realize paying tax is cheaper than loosing purchasing power. Not only that, making products offshore would price them out of the domestic market bringing those products back to America's friggin' huge economy. Bringing back the money instead would allow them to build factories to build domestically for less money.
2. The prices of American goods and services (and labor) would become "dirt cheap" just like China. So all the companies in all the nations on the planet would suddenly be looking for ways to hire Americans to produce their goods and services. And American businesses who are paying dirt-cheap labor in China and India would be paying through the nose because of their more expensive currencies. Those televisions, iPods, phones, clothes, etc., etc., would be cheaper to make here than there. American cars would be a fraction of the cost of foreign cars, and the auto industry is a HUGE part of our economy.

China knows this. China knows they can barely care for their billions of humans even in a weak global economy with America on the edge. China knows their political systems would collapse if their unemployment rates started climbing like America's from Americans shutting down manufacturing in China. China knows a population addicted to government stability would never support their totalitarian regime if they were starving. China doesn't have America over a barrel, America has them over a barrel. Or maybe the better analogy is the good-guy bad-guy movie scene where each is pointing a Glock 37 at the other's face. It's left as an exercise for the reader to assign good and bad labels on the player's in this scenario.

While we prefer sound money over fiat money, we have to say, the QE policy by the fed not only was a shrewd solution to a global run on the bank, it was a shrewd political statement to China (whether intentional or by unintended consequence) that the U.S. will do anything it takes to secure the value of U.S. Treasury debt.

Just another fantastic real-world example of the Navy SEAL's training motto:

“Luck is the residue of good design."

Dollar Liquidity Swaps Become Permanant

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank announced on Thursday that their existing temporary bilateral liquidity swap arrangements are being converted to standing arrangements, that is, arrangements that will remain in place until further notice.
src: FRB Press Release

One might think they've been doing this for a while and finally made it official. Not so, at least not between the U.S. and Switzerland. According to the SNB, they stopped making this available back in February 2010 for a time, and then started up again on May 11, 2010. The Bank of England had a similar note about May 11, 2010. We're not sure what was specially about that day, but it's now permanently special.

Maybe they are making lots of money on this deal, or maybe they simply need it so much they finally admit they can never stop swapping currencies. One wonders if all the QE money is sloshing around so much the big brokers keep the Central Banks scrambling to keep the currency availability high for some HFT regimen in international bonds.

The Central Bank of Japan provided and interesting set of amendments revealing (at least for Yen/Dollar swaps) the Federal Reserve will set the interest rates without qualifications (they struck the methodology for rates and now just hand it over the the New York Fed.

Here are the links for further reading.
SNB Guidelines
CBJ Amendments
BOE Guidelines

Let the Trade Wars Begin

Global anger swells at Fed actions

One can only wonder how this can end up good for the peons on every continent subject to the dictates of the global power mongers. If someone has some evidence to show how democracy benefits the commoner better than monarchies and dictatorships, we'd love to read it. Until then, we'll have to settle for finding ways to protect our ass-ets from the consequences of wars over national sovereignty.

PIIGS - Propped Up By Hope

Maybe Governor Daniel K. Tarullo's testimony to Congress helped the stock market sell off yesterday. There's nothing better than a federal official making an official proclamation that "Europe is still in trouble, and it can mess up the U.S.,too. We don't expect another U.S. bank crisis, but ya never know!" That, of course, was a paraphrase. Actually, the direct quote was

...holding out hope that further financial disruptions can be averted

There ya go, Europe is propped up by hope!

Too bad the fed can't just get involved in more swap markets. Their excess profits are returned back to the US Treasury, and the last crisis not only earned $5.8 billion in interest on forex swaps alone, but cut the cost of federal funding from the flight to dollars.

It's good business being a central bank.

Over the life of the previous temporary swap program (from December 2007 to February 2010), all swaps were repaid in full, and the Federal Reserve earned $5.8 billion in interest. Finally, the Federal Reserve bears no market pricing risk in these drawings.

How Can Stock Market Asset Prices Fall?

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.

Profit Taking Rules the Day

It appears the last two days saw big moves upward in all of the following:

10 and 30 year U.S. Treasurys
GLD
DBB
FXE
SPY
DIA
QQQQ

Stocks, bonds, commodities, everything on a roll at the same time. This can't be a sentiment shift (since Treasurys typically move the inverse of equities.) Our guess is derivative profit taking is pushing up underlying securities.

Contagion: Been There, Done That

If you haven't seen Commanding Heights, we highly recommend it. It goes best with a strong thinking cap so you can read between the lines and find the subtle nuances of cause and effect in global finance.

I part three in particular, they covered the Asian Financial Crisis that started from a small little economy, that through currency controls created the exact same financial situation we had last year (don't miss the entire city built from the ground up on debt financing to which no one ever moved in to populate!), and as the piper came calling and financiers decided they were no longer going to sing that tune, it spread to all the healthy nations in the region as electronic funds transfers sucked all the money out of the region, one nation after another.

The funny thing is, that time the money needed a place to park, so it fled to another emerging nation -- Russia. They didn't go into details on the underlying reasons for Russia's default on debt, but ultimately it lead to Long Term Capital's implosion.

And then Brazil was hard on its heals with another collapse in this game of financial dominoes, but was averted by a quick influx of bail out money as the signs of stress were about to crack.

In every case: bail out after bail out after bail out.

The difference in 2008 was apparently "they" (those with all the money under control) learned how not to make the same mistake. When credit stopped in 2008, the money this time went straight to U.S. Dollars. No messing around this time with some new emerging entity that offered hope and promise of the perfect utopia. Instead, get out, park the money in the one nation and one security most likely to not have a political revolution over the hub-bub, and wait it out.

So in spite of all the uproar over Federal Reserve emergency lending and government bail out of banks in 2008, it really was not unprecedented. It was exactly what was done the last time. The only difference being this time it was an internal massive bailout instead of foreign nation massive bailouts. We contend the labels on the entities in question are irrelevant. It's the same thing every time (remember the third-world financial bail outs in the 80s?) Apparently it's a necessary evil every decade.

There is nothing new under the sun. Watch it, learn to read the signs, and get ready for a repeat since the fundamental foundations, the global monetary systems, haven't changed one bit. The hard part is learning how to discount and ignore the incessant monthly claims that "it's going to happen again!! Sell now and protect yourself!!!"

Meanwhile, like last time, it appears the contagion has stopped spreading. See our other post today, The Financial Crisis of 2008 is Officially Over.

We left out one interesting link on those references though. Just as Brazil's contagion was contained by preemptive quick response, The Fed has preempted the Commercial Real Estate issues that are falling on the heals of this most recent global financial crisis. Like Brazil's non-issue of the 90s, we predict the present CRE "crisis" will also become a little known financial issue of 2010.

In a nutshell, banks can restructure the loans and won't be "criticized" for what otherwise would have been bad lending practices. It's now OK to carry bad debt on the books.

Just like Japan? Well, not exactly. Turns out we can learn another important fact from Commanding Heights. In the 90s, when Japan's banks were stuck with all those bad loans, one bold man stood up and suggested if they want to get out of the crisis they need to loosen up the over-bearing burdensome regulatory structure that was constraining the banks. He was quickly fired from his cabinet post, they refused to "fix" the systemic problem, and the lost decade ensued.

If Benny and Timmy had nationalized the banks in the U.S. to "solve" our crisis and put massive layers of regulation on them (as if you can implement "Soviet Union Economics" and create vital capital formation) then we would have been destined for a lost decade in the U.S. as well. Instead, we have a much better chance of getting back to normal, which is setting ourselves up for another crisis in the teens of the 21st century just like the previous three decades.

Who cares about Latvia, anyway?

Apparently the financial markets consider it a minnow in an ocean of liquidity. Stocks and bonds are all doing just fine today, thank you, while Latvia is having serious currency problems that threaten Sweden's banks, while the other Euro nations are strained themselves.

"Latvia's latest crisis unfolded as new data confirmed economic fragility across Europe, where nine countries -- including Germany and Italy -- drew warnings Wednesday from the European Commission for widening budget deficits."
(source: WSJ)

An analyst from Brown Brothers provides more detail of some of the austerity programs -- limiting liability of homeowners. Apparently no big deal to the West, since credit default swaps are down today.

It might very well be a perfect setup, as Jansen at Across the curve points out:

"Maybe all this means that we are setting up for a giant duration grab which will leave the curve far flatter than anyone though possible. Investors will delude themselves into thinking that there is no risk in a 10 year Treasury or a 30 year bond.

When everyone is in the pool someone will saunter by and throw a plugged in toaster into the deep end. It will surely end very ugly."
(Source: Across the curve)

To which someone created a fanciful depiction of the toaster in response. One can only wonder if the founders of Thinkorswim had this type of metaphor in mind when they got started. It certainly seems appropriate.

We believe the thinkers can use today's experience to gain a better understanding why it's prudent to discount the U.S. economy bashers, as it is clear that economic troubles in the U.S. are matched by the Eurozone troubles. There just isn't all that many places to flee to if you want to stay out of financial trouble.

So it's no wonder that even in the face of massive deficits in the U.S. all the way out to the visible horizon US Treasury prices hold their own. Even if it's true that the U.S. is a sinking boat, all the other boats have big holes in the hull, too. The U.S., being the biggest boat in the pool, will most likely be one of the last to soak it's passengers.

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.

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!

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.

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.

Take aways from Barrons, August 22nd, 2009

Stocks: Where's the demand-driven commerce? So far everything has been driven by government spending.

Look before you Leap

Gummy Bears

Banking and Finance: Commercial and Residential mortgages are worsening in some respects, in spite of all the green shoots. Some numbers and quotes from the Federal Reserve, and announcement that TALF will be extened.
Weekly Review

Technology: So where is the so-called PC Refresh cycle going to come from? Intel painted a rosy picture of the future, but three other tech companies have now joined the crowd of those who simply don't see any particular good news in the making.
View From the Top: No Rebound in Sight

Dividend Investing: Another piece on why reinvestment of dividends makes a good long term strategy. Read it if you haven't heard about that angle before. Skim for tickers if you have and like the idea. We think it makes sense to have some long term holdings in this phase of the business cycle in large cap companies with strong dividend histories. We'll leave it to the reader to judge whether Greek history provides any value to the theory.
Marathon Investing

Bonds: The best may be over for the bond market unless we get a sell off in corporates and munies and a rally in Treasuries for another buying opportunity. You can look for bond yields at your favorite quote provider, but there's also a good story on the municiple market. Suffice to say spreads between Treasury and corporates have narrowed in the last few months making it harder to find corporate bonds with a good chance of covering potential drop in purchasing power from quantitative easing. We might as well stick with the safety of Treasurys.
Seeking Yields on Munis That Aren't Puny

Speculative Plays:
Long MELA: "Taking Aim at Skin Cancer"
Short SHLD: "Washed Out"

Strategic Thinking:
Stocks are overpriced unless utopia breaks out real soon now. Commodity prices are priced right as long as China keeps buying what it doesn't presently need and India keeps it's capitalism in tact. Western economies are most likely going to see muted growth while Asia continues it's expansion of the middle-class demand for goods and services. The mindset "follow the money" suggests being invested directly in Asia and Brazil if not indirectly through domestic companies that get a high volume of revenues from them.

The off-the-cuff allocation at this point is long blue-chip dividend paying companies, short US indexes, and long commodity based companies or funds that pay dividends (or short their puts for dividends and purchases on pull-backs).

Caveat: While we are bullish on commodities in the one year time frame, we don't want to hide the fact that this week Barron's has a story that this might be a dangerous outlook. See "Base Metals on Borrowed Time"

Best of the Week
BRIC - forget Russia -- go where the commerce is. The interview with Christopher Wood contains some good insight into the macro-economics of the global economy, and why Brazil, India, and China have some specific characteristics about each of them that makes a focused investment in the right places a good idea. We highly recommend paying particular attention to his analysis of decoupling (in economics as well as the stock market) and what signs to look for that indicate decoupling of Asia equities.

What's our take on his expose?
Look for falling interest rates in Brazil. If FOREX fundamentals are right, Brazil bonds might be choice instruments there for income and long-term capital gains. One might also use the yields to buy something that is a domestic currency hedge in case your FOREX eats away at the gains.

India has the best of the equity markets of the three. See the interview for why that is. Our take then would be to look for small cap companies that supply goods and services to businesses.

In China, the strength is in state-owned companies, as they get the best of command economic privelidges. Thier financial services are especially inviting as corruption and greed that ruined Western finance is dealt with in China via execution. You may not share our opinion on the death penatly, but we think it provides a strong incentive for bank managers in China to be careful of thier actions.

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.

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.

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.

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.

The End of National Currency

If the Council on Foreign Relations wasn't so full of influential powerful traditional men and women from around the world, I'd write this off as ranting from some deluded conspiracy theorist. But it's no joke -- these people really think like this and carry weight with people that matter.

In "THE RISE OF MONETARY NATIONALISM", Benn Steil, Director of International Economics, argues that national currencies create nothing but trouble for the global economy. The premise is that the troubles we've seen are created by the inability to manage economic activity because of a lack of an organized over-arching system of "good" currencies so those dumb little "emerging" nations don't mess people up with their uninformed and inexperienced economic planning.

I like the implications of the first part -- if we just had a lot fewer currencies, maybe one global one in fact, then we could regulate and manage a perfect economic world. Those darn national currency speculators are just nothing but trouble for everyone, wrecking all our lives. What we need are professionals to plan the global economy. He even goes so far as to say, "The economics profession has failed to offer anything resembling a coherent and compelling response to currency crises." Poor Benn, he appears to have been isolationg himself.

George Reisman offers a much better answer to the many global crisis in his essay, "Our Financial House of Cards". Lo and behold, he's part of the economic profession, too! The reason you won't find this in prestigious [cough] institutions like the Council of Foreign Relations is it doesn't provide men and women with the power they want over other people's lives.

It never ceases to amaze me how those who are afraid of the Moral Majority and "Right Wing Radical Religious Zealots" have no problem putting some other group in control over their private free-will behaviors. Oh no, we don't want religious slavery, but economic slavery, that's fine. How 'bout we just liberate ourselves from slavery, period?

If you plan to be an investor for 30 years you might want to read these two points of view and consider how you'll protect yourselves when "they" sell the idea of one global currency. It shouldn't be too hard. Imagine how your little lone nation has messed up your finances, then imagine what it would be like if they do it on a global scale and remove your ability to allocate your assets in some safe harbor. I suspect it won't be a very obscure idea in the next 5 years when all the global money printing press operators have had their fill and we start reaping the consequences of our new love for Quantitative Easing.

And all this time I thought it was the unregulated credit futures and derivative speculators that got us into trouble this time. Ha, so glad I now know better who the real villains are. Do you?