Category: central banks

Is Mario Draghi pulling away the punch bowl?

“Draghi hints ECB may start winding down QE,” read the MarketWatch headline this morning:

European Central Bank President Mario Draghi hinted on Tuesday that the ECB might start winding down its large monetary stimulus as the eurozone economy picks up speed, even as he warned against an abrupt end to years of easy money.

The comments, at the ECB’s annual economic-policy conference in Portugal, come as investors watch closely for a sign that the world’s second most powerful central bank is preparing to withdraw controversial policies such as its EUR60 billion ($67.52 billion) a month bond-buying program.

Mr. Draghi said the ECB’s stimulus policies are working and will be gradually withdrawn as the economy accelerates. However, he warned that “any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.”

With the Fed now talking about contracting its balance sheet and the BOJ and ECB doing the heavy lifting, this seems like a big deal, yet equity markets have barely noticed.  The Euro Stoxx index was -0.13% while S&P 500 futures are currently -0.07%.  3-month VIX futures (Oct contract) stand at just 14.25. The eurozone sovereign debt markets are a different matter:

Germany 10-year = -0.56% (0.32% yield-to-maturity)

France 10-year = -0.59% (0.69% ytm)

Italy 10-year = -0.80% (1.98% ytm)

“Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018,” said Marco Valli, an economist with UniCredit in Milan.

Mr. Valli said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion per month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts had been expecting.

Keep in mind, the ECB and Bank of Japan have been doing the heavy lifting as year-over-year growth in total assets shows:

Fed = 0%

ECB = +36.7%

BOJ = +20.0%

The bond markets are starting to pay attention (though still wildly delusional). Perhaps the equity markets should as well.

A central banker fesses up (almost)

William White, the Swiss-based chairman of the OECD’s review committee and former chief economist of the Bank for International Settlements (the central banker’s central bank), recently made some frank statements about future debt defaults from Davos, reported here by Ambrose Evans-Pritchard.  We parsed his comments and responded with a few of our own:

“The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up,” said William White.

Their ammo is used up.  That may be a good thing since all the central bankers can do with their interventions is cause mischief.  That won’t prevent them from trying.

“Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief,” he said.

“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something,” he told The Telegraph on the eve of the World Economic Forum in Davos.

All enabled by Central Bankers Gone Wild.  Since 2007 the Fed’s balance sheet quintupled.  The rest of the world’s central bankers followed suit.  The debt followed: cause and effect.

 “The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”

It will be disorderly and there is nothing the central bankers can do to stop it.  Year-to-date action in financial markets has been very orderly.  That will change.

The next task awaiting the global authorities is how to manage debt write-offs – and therefore a massive reordering of winners and losers in society – without setting off a political storm.

No!!!  The next task should be to shut down the entire central banking operation.  I guess we’re going to have to endure even more pain as the central banks compound their mistakes… once again.

Mr. White said Europe’s creditors are likely to face some of the biggest haircuts. European banks have already admitted to $1 trillion of non-performing loans: they are heavily exposed to emerging markets and are almost certainly rolling over further bad debts that have never been disclosed.

We agree.  Deutsche Bank is this cycle’s Lehman Brothers.  We are heavily short.

The European banking system may have to be recapitalized on a scale yet unimagined, and new “bail-in” rules mean that any deposit holder above the guarantee of €100,000 will have to help pay for it.

Get ready.  The euro zone is headed down the bailouts-for-banks path.

The warnings have special resonance since Mr. White was one of the very few voices in the central banking fraternity who stated loudly and clearly between 2005 and 2008 that Western finance was riding for a fall, and that the global economy was susceptible to a violent crisis.

What a telling quote!  Correct, these guys do not see around corners.  Nearly all of them failed to anticipate the 2008 meltdown.  Even when the subprime cracks appeared, nearly all thought the cancer was contained.  It wasn’t just 2008.  Interventionist economists missed the 1929 crash and 1970s inflation, failed to identify the 1989 Japan bubble and 2000 tech bubble, and thought the Soviet economy was exemplary before it collapsed in the late 1980s.

Mr. White said stimulus from quantitative easing and zero rates by the big central banks after the Lehman crisis leaked out across east Asia and emerging markets, stoking credit bubbles and a surge in dollar borrowing that was hard to control in a world of free capital flows.

The result is that these countries have now been drawn into the morass as well. Combined public and private debt has surged to all-time highs to 185pc of GDP in emerging markets and to 265pc of GDP in the OECD club, both up by 35 percentage points since the top of the last credit cycle in 2007.

“Emerging markets were part of the solution after the Lehman crisis. Now they are part of the problem too,” Mr. White said.

Spot on.  My jaw is on the floor.  I can’t believe any central banker would admit how much they screwed things up by trying to prop up the financial system in 2008.

Mr. White said QE and easy money policies by the US Federal Reserve and its peers have had the effect of bringing spending forward from the future in what is known as “inter-temporal smoothing”. It becomes a toxic addiction over time and ultimately loses traction. In the end, the future catches up with you. “By definition, this means you cannot spend the money tomorrow,” he said.

True statement.  There is a reason people defer spending: so they can invest today and have more in the future.  Central bank suppressing of interest rates breaks the regulator on this behavior, encouraging more spending today.  People are under the illusion that they can have their cake and eat it, too.  Unfortunately, there are no free lunches in economics.

A reflex of “asymmetry” began when the Fed injected too much stimulus to prevent a purge after the 1987 crash. The authorities have since allowed each boom to run its course – thinking they could safely clean up later – while responding to each shock with alacrity. The BIS critique is that this has led to a perpetual easing bias, with interest rates falling ever further below their “Wicksellian natural rate” with each credit cycle.

This is central-banker-speak for “moral hazard.”  Thank you very much Alan Greenspan for inventing the “Plunge Protection Team.”  Also, thanks to Robert Rubin, nicknamed “Mr. Bailout” (for good reason).

“Responding to each shock with alacrity?”  This is an understatement.  With each crisis the response has been exponentially greater.  The 2008 variant saw global central bank balance sheets probably go up 3-4 times and interest rates taken to zero for 8 years!

 The error was compounded in the 1990s when China and eastern Europe suddenly joined the global economy, flooding the world with cheap exports in a “positive supply shock”. Falling prices of manufactured goods masked the rampant asset inflation that was building up. “Policy makers were seduced into inaction by a set of comforting beliefs, all of which we now see were false. They believed that if inflation was under control, all was well,” he said.

This is a muddled statement, but revealing.  China joined the world economy in the 1990s, an unmitigated positive.  And yes, this extra supply masked underlying inflation.  But who caused that inflation?  Central bankers, of course.  Were they “seduced into inaction?”  Well, not exactly.  They were doing what they normally do: suppressing interests below the market level.  They should have gone to inaction: let interest rates rise to their natural level.  The revealing part of this statement is that central bankers are always fighting the bogeyman of deflation.  This is dangerous and what always give them an excuse to meddle.  Btw, if we’re going into debt defaults and asset declines, central bankers will have plenty of excuses to “fight deflation.”

Btw, a similar mistake was made in the mid to late 1920s when the Fed tried to “stabilize the price level.”  With electrification, new inventions and productivity gains, consumer prices should have gone down.  However, the Fed would not tolerate the dreaded “deflation” so they printed money.  Consumer prices were strangely (and unnaturally) flat during the second half of the 1920s.  In retrospect, most of the Fed’s inflation went into asset prices, blowing a great bubble.  This didn’t end well, if my recollection of history is correct.

 In retrospect, central banks should have let the benign deflation of this (temporary) phase of globalisation run its course. By stoking debt bubbles, they have instead incubated what may prove to be a more malign variant, a classic 1930s-style “Fisherite” debt-deflation.

Correct.  I doubt they’ve learned the lesson.

Mr. White said the Fed is now in a horrible quandary as it tries to extract itself from QE and right the ship again. “It is a debt trap. Things are so bad that there is no right answer. If they raise rates it’ll be nasty. If they don’t raise rates, it just makes matters worse,” he said.

Checkmate.  The best they can do is shut down the operation and do something productive, like work as greeters for Wal-Mart.

 There is no easy way out of this tangle. But Mr. White said it would be a good start for governments to stop depending on central banks to do their dirty work. They should return to fiscal primacy – call it Keynesian, if you wish – and launch an investment blitz on infrastructure that pays for itself through higher growth.

Bad idea!!!  More government “stimulus” can only make matters worse. If Mr. White is so concerned about high debt levels, why is he encouraging even more government debt?

 “It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit,” he said.

No, all they can do is wreak havoc.

Global asset deflation: nowhere to run, nowhere to hide

Over the past several months global stocks, bonds and currency markets have hit a wall.  Just 6-8 months earlier the central banks of Europe, Japan and the US were signaling endless monetary accommodation which initially emboldened global speculators and their reach-for-yield mantra.  Now we look around for evidence or confirmation that the four year stimulus experiment is DOA.

First, emerging market stocks, bonds and currencies have all dropped somewhere between 7% and 12% the last few months as the carry trade (borrowing in low cost currencies in order to buy higher returning risk assets, thus capturing the spread) comes off the boil.  Second, political commentary out of China confirms our earlier thoughts that a credit bubble for the ages has begun to burst.  Since the central banking talking heads opened their mouths last month, Shibor rates (Chinese overnight unsecured lending rate amongst 16 largest banks)  have spiked to levels not seen since 2004:

Shibor-overview

Here is the latest on the Chinese banking system from Bloomberg:

Policy makers could be taking advantage of tight funding to “punish” some small banks, which previously used low interbank rates to finance purchases of higher-yielding bonds, Bank of America Merrill economists led by Lu Ting wrote in a report. Tight interbank liquidity could last until early July, according to the report.

‘Warning Shot’

“The PBOC [People’s Bank of China] clearly has an agenda here,” said Patrick Perret-Green, a former head of Citigroup Inc.’s Asian rates and foreign exchange who works at Mint Partners in London. “To fire a massive warning shot across the banks’ bows and to see who is swimming naked. Moreover, it fits in well with the new disciplinarian approach” adopted by the government, he said.

Chinese regulators are forcing trust funds and wealth managers to shift assets into publicly traded securities as they seek to curb lending that doesn’t involve local banks, so-called shadow banking, according to Fitch Ratings.

The tightening is “emblematic of some of the shadow banking issues coming to the fore as well as some of the tight liquidity associated with wealth management product issuance, and the crackdown on some shadow channels,” Charlene Chu, Fitch’s head of China financial institutions, said in a June 18 interview. She earlier estimated China’s total credit, including off-balance-sheet loans, swelled to 198 percent of gross domestic product in 2012 from 125 percent four years earlier, exceeding increases in the ratio before banking crises in Japan and South Korea. In Japan, the measure surged 45 percentage points from 1985 to 1990, and in South Korea, it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. [Emphasis mine.  Japan and South Korea experienced bubble economies during these periods which both burst.]

Look at the massive growth in nonbank (shadow) lending in China post 2008 credit crisis while keeping in mind most of this was indirectly backed by the largest banks under the “wealth management” label:

Chinese shadow banking

Maybe this is why China made the news last week when a proposed 15.5 billion renminbi bond offering failed (for the first time in nearly 2 years), receiving only 9.5 billion renminbi.

Over in Russia and Korea we see even more instability permeating the credit landscape.

Romania’s Finance Ministry rejected all bids at a seven-year bond sale yesterday because of market volatility, while South Korea raised less than 10 percent of the amount planned in an auction of inflation-linked bonds. Russia scrapped a sale of 15-year ruble-denominated bonds June 19, the second time it canceled an auction this month, and Colombia pared an offering of 20-year peso debt by 40 percent. A cash shortage led to failures last week of China Ministry of Finance debt sales.

More than $6.9 billion left funds investing in developing-nation debt in the four weeks to June 19, the most since 2011, according to Morgan Stanley, citing EPFR Global data. The exodus is reversing the $3.9 trillion of cash that flowed into emerging markets the past four years as China’s annual economic growth averaged 9.2 percent and spurred demand for Brazilian iron ore, Russian oil and gas and Chilean copper.

Romania rejected all 688 million lei ($200 million) of bids at a bond sale yesterday because of “unacceptable price offers,” according to an e-mailed statement from the central bank. It was the first failure since August.

South Korea sold just 9 percent of the 600 billion won ($524 million) it targeted from 10-year inflation-linked bonds this week. Colombia’s government pared an auction on June 19 of 20-year inflation-linked peso bonds by 40 percent, to 150 billion pesos ($77 million).

Russia canceled planned sales of 10 billion rubles ($311 million) of notes this week, citing a lack of demand within an acceptable yield range of 7.70 percent to 7.75 percent. Yields on ruble bonds due in 2028 jumped 30 basis points, or 0.30 percentage point, yesterday to 8.1 percent, the highest level since the debt was sold in January.

After endless monetary interventions the prior 3-4 years governments around the world temporarily created the illusion that interest rates would stay below nominal GDP growth targets.  The sleight of hand only lasted this long because so many of the “professional money managers” never questioned the actions of central bankers (a.k.a. asset inflationistas) .  As currencies, bonds and stock markets decline in unison around the world, one might pose the question “Have central bankers lost control of their monetary experiment?”  Or better yet, why would so many “investors” believe that a group of central banks with combined reserves of $11.5 trillion could levitate with over $240 trillion in global assets?   Which then begs the question,  where does one hide?

Fred Hickey compares today’s central banks to 19th century patent medicine factories

Fred Hickey, editor of The High-Tech Strategist ($150/year, thehightechstrategist@yahoo.com), grew up in Lowell, Massachusetts, known as the “Birthplace of the American Industrial Revolution.”  In his latest HTS he discusses the genesis of the patent medicine industry in his hometown during the mid-1800s:

For a time, Lowell became America’s largest industrial center…  In addition to the textile factories, other industries grew up in the city around the same time, including patent medicine factories – Father John’s Medicine and J.C. Ayer & Co. among them.

Dr. J.C. Ayer founded J.C. Ayer & Co. in Lowell and his factory became one of the largest of its kind in the world.  Advertising was the key to success…, with the company distributing millions of copies of its free “almanac” (propaganda) annually around the world – in eight languages, including Chinese.  A sample from the almanac:

“The skillful pilot steers his ship through all dangers and guides her safely to port.  So the skillful physician pilots his patient through the perils of sickness to perfect health.  In cases of General Debility, so common at present day, he recommends the use of Ayer’s Sarsaparilla, because of its superior efficacy in aiding the formation of pure and vigorous blood, thereby restoring the normal condition to every fibre, organ, nerve, and muscle of the body.  It cures others and will cure you.  This standard remedy is compounded of the best tonics and alternatives known to science, and its superior qualities as blood-purifier and invigorator have stood the test of nearly half a century.”

Ayer became fabulously wealthy, amassing a fortune of some $20 million – quite a sum for the time.

Though Dr. Ayer never practiced medicine, the cover of each J.C. Ayer almanac was decorated with classical engravings such as one showing the Greek physician Hippocrates standing atop the earth declaring: “Heal the sick.”  What was not to believe with such evidence coming from a great doctor?

Hickey goes on the draw the parallel to central banking:

 Today, we look back and laugh – how could these people be so gullible?  Yet, the world is currently under the spell of its own modern-day quacks – known as central bankers.  Central bankers are touted as having the cure for all of our financial problems.  Their tonic, with the scientifically-sounding name of “quantitative easing,” or QE for short, is guaranteed to restore our financial health, to cleanse us from all our ills.  Whether the cause is spending beyond our means (perennial trillion dollar deficits and gigantic debts), making entitlement promises we cannot keep, building a gigantic welfare state of dependents, having a dysfunctional (and sometimes corrupt) government, constructing a byzantine tax system, tying up our businesses in a web of regulations, enabling “too-big-to-fail” banks to grow monstrously bigger – all can be cured with the magical elixir called QE.

Our skillful physician pilots (brandishing their doctorates from Princeton and M.I.T.) have discovered a miracle cure to be sure – at least that’s what one hears all day long from the talking heads on CNBC…  The media dissects Bernanke’s every utterance for clues as to whether he will supply more of the miracle or not.  The cameras are always on – even when he’s just laying out lame jokes at a Princeton commencement ceremony.

The QE medicine is seductive and addictive…

The best part yet – the QE medicine that he and other central bankers around the world are ladling out tastes so good… With QE, stocks will never fall on Tuesdays (20 straight up Tuesdays in a row), stock markets will never again have a 5% “correction,” (nearing 200 days without a 5% decline), investors can lever up with margin debt to record levels ($384 billion and counting – exceeding the 2007 pre-crash level)…  Investors have become so addicted to the QE wonder drug than even the merest hint of a lower dosage (tapering) sends up cries of anguish from the financial world.  Stock prices wobble; interest rates soar and CNBC anchors throw hissy-fits.

Other than the hallucinogenic effects, is the drug working?

Despite an additional $6 trillion of deficit spending, 0% interest rates and trillions of dollars of newly-created high-powered monetary reserves by the Federal Reserve (QE) that has driven asset inflation sharply higher (stocks, bonds, farmland, art and gold); over the past 4+ years we have experienced the slowest economic recovery in post-war history…  Last month investors celebrated a pathetic 165,000 jobs created, when 278,000 of those jobs were part-time.  In other words, we lost another 113,000 full-time jobs.  The U-6 unemployment rate (including part-time workers unable to find full-time work) ticked UP to 13.9%… With jobs hard to get and real inflation-adjusted incomes falling, the average American consumer is under pressure.  Witness the fairly miserable first quarter sales results from America’s largest retailers reported last month.  Same-store sales fell year-over-year at Wal-Mart, Target, Kohl’s and Sears…  Yesterday we received the Institute for Supply Management’s (ISM) report for May which, at a reading of 49.0, showed the biggest contraction in American manufacturing activity in four years – since the “Great Recession” of 2009…  I’ve been going through scores of first quarter earnings reports and conference calls from the largest technology companies.  The numbers and commentary were consistently gloomy – it was the worst batch of results I’ve seen since the end of the Great Recession.

At this stage of recovery something is terribly wrong.  Let me clue you in on a little secret – money printing doesn’t work.

The Japanese chugged plenty of this medicine…

Japan was the first to try “QE” to resolve its problems (though it was certainly not the first to try money printing).  They’ve been attempting to lift their economy out of a decades-long recession for many years.  The Bank of Japan (BOJ) tripled its balance sheet but did nothing to address the real underlying causes of the disease.  They did not address their lifetime employment system that hobbles business flexibility.  They did little to correct the ridiculous rules and regulations that suffocate the agricultural, medical and retail industries.  They raised taxes.  They massively increased government spending, wasting trillions of dollars and causing a debt pileup (235% of GDP and still rising) – the likes of which the world has never seen from a developed country.  As one would expect, the attempt failed spectacularly.

Yet the American snake oil salesmen claimed they didn’t drink enough!

Dr. Bernanke, and other high priests of central planning (including Paul Krugman) lectured the Japanese that their problem was they weren’t swilling enough of the QE tonic fast enough.  For a decade the BOJ resisted, always citing concerns over inflation.  Finally, Shinzo Abe was swept into power on the campaign promise of more licorice for everyone! After eliminating the key inflation-phobes (Masaaki Shirakawa) from the BOJ and replacing them with Bernanke-like clones (Haruhiko Kuroda), the new era of “Abenomics” was on…  The BOJ announced a plan to double its monetary base (high-powered money) within two years.  In other words, they opted to chug the whole bottle of medicine at once.

After discussing the post-WWI German experiment in money printing gone awry (Weimar hyperinflation), Hickey sees the American experiment ending badly:

Despite this horrific central banker record, U.S. investors still want to believe that Father Ben’s QE medicine will eventually work.  But just because the crowd believes this fantasy, doesn’t mean I have to.  As long as the Fed continues to print tens of billions of dollars a month, stocks can continue to climb higher, but the gap between the economic reality (poor) and the stock valuations (euphoric) widens to ever more dangerous levels.  Another crash is coming and I intend to avoid it – once again.

In conclusion, Fred Hickey offers an antidote to the QE drug:

Throughout history, the antidote to money debasement has always been gold.

Japanese government bonds take biggest 2-day hit in 5 years

As Tyler Durden of Zero Hedge reported, 10-year JGBs took their worst 2-day plunge since the financial meltdown of Q4, 2008:

The last 2 days have seen JGB prices plunge at the fastest rate since the post-Lehman debacles in Sept/Oct 2008 smashing back to 13 month highs.  5Y yields are surging even more – trading above 34bps now (up from 9.9bps on March 5th). These are simply astronomical moves in the context of JGB history and strongly suggest Abe & Kuroda are anything but in control of the quadrillion Yen domestic bond market as they jawbone inflation expectations into the psychology of the people.

Meanwhile, the Japanese yen has fallen off a cliff as the Bank of Japan (BoJ) opens the monetary floodgates:

Jeff Berwick, editor of The Dollar Vigilante Blog weighs in on the bond vigilantes calling the BoJ’s bluff:

Traders should take note of Japanese Government Bond prices.  On April 4th the Bank of Japan made the announcement that they intended to DOUBLE the money supply and buy government bonds roughly equaling $80B a month.  Does this number sound familiar?  It should since the US Federal Reserve’s own quantitative easing program is roughly $85 B a month.  An important data point to remember here is that the Japanese economy is only 1/3 the size of the US economy, but its own quantitative easing program equals that of the US.   To say Japan is “doubling down” on the same failed policy approach it has taken for the last 20 years would be a bit of a misnomer.  This is Japan’s “all in” move as I try to keep the gambling metaphor rolling.  A gamble is exactly what this is, a very big gamble with no precedent in economic history.

What are the consequences of rapidly increasing government spending, monetizing $80B a month in debt, and flooding the market with yen?  It is hard to miss the headlines as the Yen on the futures exchange is now trading at below 100 yen to the USD for the first time in four years.

Berwick offers an explanation as to why bondholders are beginning to act more rationally:

Why are bonds trading lower?  Think about this from a prudent lender’s point of view and you will have your answer.  If I give you yen, and you give me a security (bond) that says you will give me back my yen with interest in 10 years, then why would I sit with that security and let you pay me back with a devalued currency?  Well, in Japan bondholders appear to be speaking with their market participation.  Bond holders are doing exactly what they should be doing.  Bond holders should be liquidating bonds and converting money out of yen into non-yen denominated securities and investments (note all the M&A activity from Japanese companies in the last seven months as the smart money runs and not walks out of Japan and the yen).

How can the savers in Japan be sitting idly by and watching the purchasing power of their savings being destroyed?  We are on the first chapter of a very ugly time in Japan where policy makers decisions will strain the very social fabric of the country.  We will have a front row seat to the failings of the Keynesian economic philosophy.  It will not be pretty for Japan. And it could very well be the first major event in The End Of The Monetary System As We Know It.

Last Friday, in his Daily Rap, Bill Fleckenstein mentioned the possibility of a Japanese canary in the sovereign debt coal mine:

Japan was the epicenter of fireworks that spread around the world, as last night their equity market rallied 3% even as their debt market had a bit of a nasty spill. However, it must be kept in perspective that the change was rather small and rates have only backed up to where they were in February. So it is not exactly huge trouble, but it could be the start of a shift. At the moment, the bond and currency markets are declining in Japan. Should that continue and should the bond market worsen materially, it would be an early sign of what an eventual funding crisis would look like.

Of course, as long as Japan’s central bank is buying such huge amounts of paper it can thwart that for a time, but it could be the first sign of a bond market anywhere revolting against the printing press. As I say, it is very early days and I don’t want to make too much of it, but a trickle can eventually become a flood, and a trickle has to start somewhere.

Over three weeks ago, in our Q1 letter to investors, we mentioned the possibility of a “Wizard of Oz moment” as the BoJ accelerated its monetary experiment:

Two weeks ago, the Bank of Japan announced a doubling of its asset purchase program.  In Pavlovian response, speculators bid up Japanese government bonds strongly, with the 10-year yielding just under 0.40%.  The following day those gains completely evaporated.  Had the BoJ lost control and the market called its bluff?

For now Goldilocks prevails, but for how long?  Fleckenstein considers the glaring (and widening) disconnects:

So we continue to be in the most perverse sweet spot in the history of the money-printing era that began over 20 years ago. Between the BOJ and the Fed, we are printing about $1.8 trillion a year, along with massive deficit spending, and those policies are regarded as a panacea for equities and just fine for bonds, but horrible for assets that protect one against inflation. Of course, that makes no sense, but when you are in a warped environment (and this is the most warped ever), crazy things not only happen, they lead to even crazier outcomes until the madness finally stops, after which all hell breaks loose.

So much for the notion that central bankers are in control.  Did the global reach-for-yield bubble just go “pop”?

Can Cyprus create a contagion within the EU?

Over the last week Cyprus has made front page news as the country teeters on the brink of insolvency.  Knowing the powers at be have stricken the word from their playbook, or replaced it with “liquidity issue”, one must now consider the fate of the EU.   How can this be when Cyprus is a tiny .2% of eurozone GDP?   Consider this, according to the latest bank figures from the BIS, European banks had $38 billion of exposure to Cyprus!   In addition, last week the ECB threatened to withdraw emergency lending access (ELA) to the Central Bank of Cyprus unless they move forward with the proposed bank bail-in restructuring.

Cyprus has proposed the idea of a bail in as a way to recapitalize their insolvent banking system whereby depositors above and below 100,000 euros will be given haircuts of 9.9% and 6.75% respectively.

Of course, this completely violates traditional bank restructuring laws where depositors are the last party in line to incur any losses.  Which then begs the question, “why is the ECB trying to protect bondholders”?

Lets take a step back and review the moving parts in this game.  First, Cyprus is a low tax haven for Russian oligarchs while total deposits from Russia are somewhere near $26 billion or 130% of Cypriot GDP.  Total bank deposits are approximately $140 billion.

Over the last week the Central Bank of Cyprus has been posting sovereign debt at the ECB window, with undisclosed haircuts, in order to keep a lifeline open for the banks (which have been closed over this period of time).  During the Greek crisis haircuts ranged from initial 25% to 50% as the situation worsened due to strings attached by the ECB.

Final comments:  Why all of a sudden are the Cypriots being threatened by a complete removal of ELA by the ECB unless a bail-in is imposed on depositors?  Could one reason be the $9.7 billion in German bank exposure to Cypriot banks?  Or is there really no collateral, unlike Greece, so the ECB has no choice but to go after Russian oligarchs with a 10% money laundering fee?  Either way, the tiny country of Cyprus has already set off Spanish and Italian bank runs as the EU periphery prepares for possible bail-in aka ECB theft operations.  Now all we need to see is Mario Draghi making a statement, a la Ben Bernanke at the outset of the subprime bubble bursting, “Cyprus is only .2% of ECB and remains contained”.

Fed officials give their imprimatur to stock market bubble

greenspan-bubble

Last Friday former Fed chairman Alan Greenspan gave support that the 4-year bull market in stocks has room to run:

And right now, by historical calculation, we are significantly undervalued.  The reason why the stock market has not been significantly higher is there are other factors compressing it lower.  But irrational exuberance is the last term I would use to characterize what’s going on at the moment.

On March 4, Fed vice-chair Janet Yellen assured investors:

At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.

And on February 26, chairman Ben Bernanke gave stocks his stamp of approval:

I don’t see much evidence of an equity bubble.

Not to question these all-knowing masters of the universe, but there does seem to be a trifle of evidence to the contrary, that perhaps their zero interest rate policy (ZIRP) has stampeded savers into anything hinting at a yield.  Exhibit A: Over $1 trillion has poured into bond funds over the past 4 years (out of money market funds).  Exhibits B and C: Junk bond yields are at record lows and margin debt near record highs.  Exhibit D: Total credit market debt is a record $56.1 trillion (352% of GDP) compared to $49.8 trillion (also 352%) at the top of the credit bubble 5 1/2 years ago.

After the tech bubble burst, The Maestro admitted that when it came to detecting bubbles investors were on their own:

We at the Federal Reserve considered a number of issues related to asset bubbles–that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact–that is, when its bursting confirmed its existence.  (August 30, 2002)

Five years later those words proved prescient (one of the few times) as the Fed-heads missed the housing bubble and failed to recognize how it had metastasized into a full-blown credit bubble.  While still at the helm of the Fed, Greenspan weighed in on his 6-year experiment to contain the bursting tech bubble (which he failed to see coming):

Most of the negatives in housing are probably behind us.  (October 26, 2006)

Right before the subprime bubble burst, Janet Yellen was oblivious to any impending trouble:

I’m waking up less at night than I was [over the slowdown in housing].  So far, there’s been remarkably little effect on the rest of the economy.  (February 21, 2007)

After taking the reins at the Fed, Bernanke did his own Alfred E. Newman impersonation:

We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.  (May 17, 2007)

The Federal Reserve’s crystal ball does not do asset bubbles.  When its wizards begin to feel they possess such power (that is, denying the presence of a bubble), contrarians take notice.

The race to monetary hell

The Euro dropped to multi year lows as Hungary joined Greece in the global economic sovereign debt crisis. Like the Greeks, Hungary and other Eastern/Central European countries cope with economic contraction while debt servicing on both a private and public level remain insurmountable. Societe Generale (SocGen) rumors started overnight when several sources unveiled derivative impairment charges possibly linked to Hungary economic news which shouldn’t surprise anyone since SocGen has over $28 billion in Eastern/Central European debt exposure. To put things in perspective SocGens Eastern European exposure alone is roughly 60% of equity!

Other French banks remained quiet today as Trichet continues to monetize approximately $2-3 billion per day in Greek sovereign essentially bailing out his countryman’s finance houses while the Germans ask “where is our bailout”. According to latest ’09 filings some of the largest German banks are levered anywhere between 70-80X so a Greek bailout only partially removes some of the toxic waste from their respective balance sheets.

Institution A -TANGIBLE ASSETS(BILLIONS) B -TANGIBLE EQUITY A/B – LEVERAGE RATIO
DEUTSCHE BANK AG

€1,658

€27.4

60:1

COMMERZBANK AG

€842

€6.8

124:1

DEUTSCHE POSTBANK AG

€237

€3.0

77:1

LANDESBANK BERLIN AG

€143

€1.9

75:1

The Eurozone in general is challenged by rollover risk. Spain, for instance, has to roll over 40% of its external debt, which is about $700 billion to roll over, and because it is running a current-account deficit, it actually has to borrow more than that, which is almost another $80 billion. Just the government has to roll over about 20%, or about $125 billion. Spain will have to borrow more than it has ever borrowed before in the next year at the same time as people’s inclination to lend to Spain is reduced. The government debt of all the peripheral countries in the euro zone that has to be rolled over in the next three years is the equivalent of $1.9 trillion, and that doesn’t include the private-sector debt.

My Comments: The ECB has elected to enter the monetary race to hell so one should ask is Bernanke far behind? Answer: Dollar/Euro swap lines are wide open according to Bernanke thus an increase in the Fed balance sheet from current $2.4 trillion to $3 trillion seems likely.

Credit markets enter crisis mode

Last weekend’s bailout of Fannie and Freddie came as no surprise due to multiple years of excess mortgage credit creation hitting a wall in 2007. The downturn in home values in 2006 led to the demise of toxic lenders such as New Century and Countrywide Financial setting the stage for one last surge in GSE balance sheets in 2007-2008 as the remainder of mortgage freeways became jammed. No-homeowner-left-behind DC mantra continued to receive media support as marginal homeowners and McMansion dwellers pleaded for additional rate cuts or forbearance.

Initial intervention

Unprecedented credit facilities and other types of government intervention by central planners have proven to be inadequate for several reasons. As articulated numerous times (specifically here and here), we presented our case of a failed monetary system collapsing at epic speed. From the chronic denial by Hanky Pank and Bernanke last summer to the most recent assurance that Fannie and Freddie now have Paulson’s bazooka to fight the mortgage monster, has it become obvious that the central planners are in reactive/desperation mode and the inferno continues to rage as Paulson reaches for one more bucket of water?

Paradox of deleveraging

Eventually global central bankers providing ongoing credit lines to banks and brokers in return for suspect asset-backed collateral will come to the realization that this is a solvency issue. Additional collateral damage from rising unemployment, declining home prices and minimal wage growth all but guarantee the worst credit cycle since the Great Depression. Since this credit bubble evolved from the inception of credit default swaps it seems appropriate that we come back to square one. Players of all shapes and sizes wrote default insurance on a wide array of debt instruments which drove additional issuance as swaps hit multi year lows and debt issuance hit all time highs in 2006. Of course this changed last year when AAA-rated structured finance securities imploded and the confidence game ended. Shock waves went out to bond insurers, investment banks, banks, insurance companies, hedge funds and others who built faulty models based on asset inflation. Declining collateral coupled with unprecedented leverage of 40-1 has led to the inevitable unwind of planet leverage.

Tipping Point

Over the next 6 months roughly $500 billion in corporate borrowings come due with fewer and fewer possible creditors. Lehman Brothers is ready to join the equity holders of Bear Stearns and GSEs into the dustbin of history as credit default swaps soar and CEO Dick Fuld waves the white flag. AIG, though, remains the bigger tell in our opinion. Markets are screaming “game over” as credit default insurance on AIG surpasses 640 basis points, exceeding the March highs. How will this $1 trillion asset behemoth survive if the market refuses to finance $20 billion in additional debt later this month? Or do we turn to Merrill Lynch, who over the last 4 quarters destroyed 17 years of earnings? CEO John Thain has raised capital and sold assets yet his balance sheet has witnessed growth in Level 2 assets of some $280 billion the past 12 months while equity has declined from roughly $38 billion to less than $32 billion. Today we are inundated in bailout requests for both Ford and GM as automakers go to DC with a $50 billon hat in hand.

Central bankers’ end game

The heavy lifting has been completed by the Bernanke clan as 85% of the Fed balance sheet has now been lent out to casino dealers on Wall Street leaving Paulson with another challenge. Since his announcement in July of supporting Fannie and Freddie with additional taxpayer dollars, many asked the question of moral hazard. Will the Lehman Brothers demise force the government to remain on the sidelines when future financial institutions incur a bank run? Have we finally left the denial stage and accepted the fact that over $3 trillion in shadow banking system asset problems are dead ahead leaving central planners impotent? Or is Bernanke of the opinion that most of the shadow banking system was nothing more than speculation so it should fail along with housing speculators? At the end of the day we envision a credit contraction for the ages resulting in an L-shaped recession lasting several years.

Libor problems expose central bank incompetency

Rolling back the tape to August 2007 we’ve witnessed several failed attempts by global central banks when trying to alleviate the international credit crunch. Massive interest rate cuts by the US interventionists have resulted in climbing credit spreads across the entire debt market. Of late the powers at be instituted numerous credit facilities to both banks and brokers in a last ditch effort to keep the walking dead from following the Bear Stearns demise. Of course, when looking at Libor, one of the few remaining barometers in credit land, the rational investor should question the “knowledge and wisdom” of the Bernanke Fed.

Since the introduction of temporary and permanent lending facilities from the man behind the curtain the US Fed’s balance sheet has swapped out over $300 billion in treasuries for questionable mortgage backed securities. The unintended consequence has been a banking system reluctant to lend to one another since the Fed will take just about anything as collateral and lend at reasonably low rates. Based on the most recent auction results the Fed will have lent over 50% of their treasuries to the banking/brokerage community by the middle of June!

Commentary the other day by Federal Reserve Governor Richard Fisher should tell us everything about the impotency of our central bankers:

“This is a new development,” Federal Reserve Bank of Dallas President Richard Fisher said during an appearance in Chicago. “I need to learn more.”

Maybe Mr. Fisher, Mr. Bernanke and the other Fed members should take notes when Mr. Volcker speaks:

“A direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in times of crisis: lend freely at high rates against good collateral,” Volcker told the Economic Club of New York on April 8. “It tests it to the point of no return.”

My Comments: Ongoing intervention by global central bankers continues to distort the credit landscape. As banks and brokers drag their feet on mark to market issues related to Level 2 and 3 assets while failing to disclose off balance sheet exposure the lender of last resort has entered the arena. Unfortunately, the policies implemented have failed miserably leaving the obvious question to ponder: How much of the worthless collateral temporarily inherited by the Fed will ultimately end up being owned by the US taxpayer?

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