How Did Argentina Lose Its Place Among the World's Top Economies?

It is generally well known that at the turn of the 20th century, Argentina was a prosperous country with one of the world's largest economies  (in the top 10), however, what exactly caused its demise into today's class warfare and poverty?


Question:  How did this occur?  Do we see similar themes occurring today in the U.S.?  Is this commentary accurate?


Argentina “was” one of the richest countries in the world until…(from randysright, link below)

In the early 20th century, Argentina was one of the richest countries in the world. While Great Britain’s maritime power and its far-flung empire had propelled it to a dominant position among the world’s industrialized nations, only the United States challenged Argentina for the position of the world’s second-most powerful economy.  


It was blessed with abundant agriculture, vast swaths of rich farmland laced with navigable rivers and an accessible port system. Its level of industrialization was higher than many European countries: railroads, automobiles and telephones were commonplace.  


In 1916, a new president was elected. Hipólito Irigoyen had formed a party called The Radicals under the banner of “fundamental change” with an appeal to the middle class.  


Among Irigoyen’s changes: mandatory pension insurance, mandatory health insurance, and support for low-income housing construction to stimulate the economy. Put simply, the state assumed economic control of a vast swath of the country’s operations and began assessing new payroll taxes to fund its efforts.

For the rest please see....
http://randysright.wordpress.com/2010/03/25/argentina-was-one-of-the-richest-countries-in-the-world-until/



To find out for sure I am going to read this:
http://www.amazon.com/Argentina-Economic-Chronicle-richest-countries/dp/0979557607

Fed Asks for Help and Bank of Japan Moves Next Meeting

Does this send a message of confidence? Or does it simply illustrate that the Fed is "making it up as it goes along" as ex-vice chairman Blinder said last week. (Story below)

Fed Asks Dealers to Estimate Size of Debt Purchases:

What sort of message does this send the markets? 

Japanese central bank moved its next meeting:

Interesting to note that the Japanese central bank moved its next meeting to after the Fed meets presumably so as not to be blindsided by any unexpected Fed money printing....(http://www.marketwatch.com/story/bank-of-japan-holds-steady-moves-up-meeting-2010-10-28)

Fed Asks Dealers to Estimate Size of Debt Purchases

     Oct. 28 (Bloomberg) -- The Federal Reserve asked bond dealers and investors for projections of central bank asset purchases over the next six months, along with the likely effect on yields, as it seeks to gauge the possible impact of new efforts to spur growth.

     The New York Fed survey, obtained by Bloomberg News, asks about expectations for the initial size of any new program of debt purchases and the time over which it would be completed. It also asks firms how often they anticipate the Fed will re- evaluate the program, and to estimate its ultimate size.

     With their benchmark interest rate near zero, policy makers meet Nov. 2-3 to consider steps to boost an economy that’s growing too slowly to reduce unemployment near a 26-year high.

Financial-market participants are focusing on the size, timing and maturities of likely purchases aimed at lowering long-term rates, with estimates reaching $1 trillion or more.

     “If they buy too much, I think there’s a real chance that rates are going to rise because people are worried about inflation,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “If they don’t buy much, they’re not going to have a market impact.”

     William Dudley, president of the New York Fed and vice chairman of the Federal Open Market Committee, set expectations of about $500 billion for a new round of so-called quantitative easing, a figure he used in an Oct. 1 speech.

                        Investor Concern

     “What the market wants to hear is that the Fed is going to buy $1 trillion” of Treasuries, said Joseph Lavorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York.

“Concerns that it might be less is causing investors to worry about how deep and broad this program is going to be.”

     Treasuries rose for the first time in seven days today, pushing the yield on the benchmark 10-year note down two basis points, or 0.02 percentage point, to 2.698 percent as of 10:38 a.m. in London. The yield climbed to the highest in more than a month yesterday on speculation that the Fed will buy less debt than some traders had been expecting.

     Europe’s Stoxx 600 Index increased 0.7 percent today and Standard & Poor’s 500 Index futures rose 0.3 percent.

     The New York Fed’s survey coincides with a Treasury Department questionnaire asking dealers about the outlook for bond-market liquidity. Treasury officials say any additional program of asset purchases by the Fed won’t affect borrowing plans.

                      Avoiding Disruption

     Treasury officials say they want to avoid any disruption to the $8.5 trillion market in U.S. government debt, the world’s most liquid, as the Fed weighs restarting large-scale asset purchases. The Treasury also doesn’t want to give any impression to investors, particularly those based overseas, that it might be coordinating with the Fed to finance the national debt.

     “Treasury debt-management decisions are designed to deliver the lowest cost of borrowing over time and are entirely independent from monetary-policy decisions made by the Federal Reserve,” Mary Miller, assistant secretary for financial markets, said in an e-mail to Bloomberg News yesterday. Before joining the Treasury last year, Miller was head of global fixed- income portfolio management at T. Rowe Price Group Inc. in Baltimore.

     The Treasury is scheduled to hold its quarterly meetings with bond dealers tomorrow, ahead of the department’s Nov. 3 refunding announcement.

                        Treasury Yields

     The New York Fed surveyed primary dealers required to bid in U.S. debt auctions. It asked dealers to estimate changes in nominal and real 10-year Treasury yields “if the purchases were announced and completed over a six-month period.” The amounts dealers can choose from are zero, $250 billion, $500 billion and

$1 trillion.

     Deborah Kilroe, a spokeswoman for the New York Fed, declined to comment.

     “Yields would have to back up” if the market is overestimating the size of Fed purchases, said Joseph Abate, money-market strategist at Barclays Capital Inc. in New York.

“The dealer community is running much less leverage than they did before. The amounts of inventory they are financing is smaller. Their capacity to absorb extra supply is lower.”

     The Treasury is watching for signs the Fed’s buying program might affect market operations. Fed purchases would take place as the Treasury reduces debt issuance, raising questions of whether the government would have to sell additional securities to avoid market disruptions.

                        ‘Nuclear Option’

     “That’s certainly kind of a nuclear option for Treasury,”

Stanley said. “They would always and everywhere like to avoid that.”

     Extra debt sales have happened just twice in the past decade, with so-called snap reopenings of existing securities in the aftermath of the Sept. 11, 2001, terrorist attacks and at the height of the financial crisis, in October 2008. The Treasury acted to shore up market liquidity and prevent a trading freeze caused by shortages of highly sought securities.

     The Treasury has put a premium on selling its debt in a regular and predictable fashion. Those efforts may be tested by the Fed’s purchase campaign, which would take place in the secondary market rather than at Treasury auctions.

     The Fed’s purchases might run as high as $100 billion a month, some analysts say -- almost equaling the entire amount the government is likely to sell.

                      ‘Tugging’ the Wheel

     “If the Fed commits itself to buying back the bulk of the Treasury’s net new issuance through open-market purchases, it will have more than one hand tugging on the wheel of federal debt management policy,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

     Crandall said the frequency of note auctions, combined with low interest rates, “sharply increases the likelihood of accidental reopenings in the next phase of the rate cycle.”

     The Fed is unlikely to buy up the entire supply of new securities, although it may adjust its internal guidelines of how much it can hold of any given issue. The Fed limits itself to owning no more than 35 percent of any specific security it holds in its System Open Market Account, or SOMA.

     “Our Treasury strategists point out it could also cause pricing distortions along the curve, if, for example, the Fed continues to target a 40 percent purchase concentration in the 6-10 year maturity bucket, as it has in its recent purchases,”

analysts at JPMorgan Chase & Co., including Alex Roever, wrote in an Oct. 22 research report. The report predicts the Fed will buy about $250 billion a quarter during the easing campaign.

     The central bank makes the securities in its portfolio available to dealers through its daily securities lending operation, making it unlikely that Fed purchases alone would lead to an acute shortage of a given issue.

     For now, the Treasury is doing everything it can to show borrowing independence. The department is extending the average maturity of its debt and ramping up sales of 10-year and 30-year securities while cutting issuance of the medium-term securities the Fed is more likely to buy.

Sons of the Rich, Sons of the Saint, Where is the Child Without Complaint? (Jacques Brel)

Pimco has done remarkably well throughout the crisis by positioning itself in mortgage bonds bailed out at 100 cents on the dollar and then Treasuries which surged upwards throughout the Euro crisis and U.S. summer slowdownon and talk of debt monetization….

Now, with the looming instutionalization of the debt monetization approaching just after the November elections, an interesting comment from Pimco deploring it. 

Investors take note, Pimco is the 200 pound gorilla in the Treasury room sitting next to China and Japan and seems to be stirring…..the question is, if Pimco is not bullish on Fed policy and Treasuries, then what are they bullish on – emerging market debt?

From the Huffington Post:

Bill Gross: Fed Policy Is A ‘Brazen’ ‘Ponzi Scheme’

The Fed should stop meddling with the economy now, before it does more damage, say two top asset managers.

The Fed Reserve Bank’s quantitative easing program, expected to begin next week, in which the central bank will go on a spending spree to inject more money into the economy, will deal untold damage to the system it attempts to support, say Pimco managing director Bill Gross and GMO chief investment strategist Jeremy Grantham. These purchasing strategies, in which the Fed will likely buy government bonds, intending to lower interest rates and stimulate demand, don’t work, Gross and Grantham say in letters to investors: They actually make things worse.

“I ask you: Has there ever been a Ponzi scheme so brazen?” Gross says. “There has not.”

(click on the link above to continue reading the article)

“Death: to stop sinning suddenly.” (Elbert Hubbard)

Nestor Kirchner has passed on and so Argentine asset markets rise….a fitting tribute reminiscient of the spontaneous cheer which arose from the floor of the New York Stock Exchange upon the news of the resignation of then-Govenor Elliot Spitzer….

The question now:  Sell Cresud (CRESY)? 

Argentine Debt, Stocks Gain as Kirchner Death May Undo Policies

By Ye Xie and Eduardo Thomson

     Oct. 27 (Bloomberg) — Argentine bonds and stocks gained as the death of ex-president Nestor Kirchner bolstered speculation that opposition lawmakers will win next year’s election and reverse the country’s debt management policies.

     Yields on dollar bonds due in 2033 dropped 27 basis points, or 0.27 percentage point, to 9.19 percent as the price jumped 2.35 cents to 91.5 cents on the dollar, according to JPMorgan Chase & Co. Argentine stocks trading in New York surged the most since 2008. Local markets are closed for a holiday.

     Kirchner, who carried out the harshest debt restructuring since World War II before handing power to his wife, Cristina Fernandez de Kirchner, in 2007, died of a heart attack, according to the presidential website. His move to replace key personnel at the statistics institute in 2007 fueled criticism from economists and politicians including Vice President Julio Cobos that the government is underreporting inflation.

     “I don’t want to sound heartless, but it does enhance the chance of an opposition candidate winning” next year’s presidential election, said Edwin Gutierrez, who manages about $6 billion of emerging-market debt, including Argentine peso- and dollar-denominated securities, at Aberdeen Asset Management Plc in London. “He is seen as a big stumbling block to some indicative normalization.”

     Argentine dollar debt yields 533 basis points more than U.S. Treasuries, the most among emerging-market countries after Venezuela and Ecuador in JPMorgan’s benchmark EMBI+ index. The yield gap over Treasuries declined 49 basis points today, the most in a year, to the lowest since June 2008.

 ‘Wide Open’

      Kirchner, 60, had said in July that either he or Fernandez would run for president in next year’s election.  “He was seen as a potential candidate for the October elections to succeed his wife, so now the political map is going to be wide open,” Alberto Ramos, an economist at Goldman Sachs Group Inc. in New York, said in a phone interview.

     Goldman Sachs estimates Argentine annual inflation is about 25 percent, or more than double the 11.1 percent rate the government reports. Both Fernandez, 57, and Kirchner have said the government’s data is accurate.

     In 2005, Kirchner offered creditors bonds worth 30 cents on the dollar in exchange for $95 billion of defaulted debt, the harshest restructuring terms since World War II, according to Arturo Porzecanski, an international finance professor at American University in Washington.

 Yield Gap Declines

      In June, Fernandez settled with holders of $12.2 billion of bonds who had rejected the 2005 offering. Argentina’s yield gap over Treasuries has declined from 807 basis points at the end of May as Fernandez’s restructuring with holdout creditors signaled the country is looking to regain access to the international bond market.

     Creditors including billionaire investor Kenneth Dart and New York-based hedge fund Elliott Management Corp. are still suing the government in international courts for repayment of the debt.

     Argentina lost its position in the benchmark emerging- market stock index in June last year and joined MSCI Inc.’s so- called frontier measure. MSCI cited restrictions on capital flows that require international investors to deposit 30 percent of investments with the central bank for a year.

     “This potentially opens the door for somebody who can help us reduce capital controls and start opening the market a little bit more,” said Paul Herber, who helps manage $5 billion at Forward Management LLC in Seattle, including Argentine stocks in the Accessor Frontier Markets Fund.

 MSCI Argentina

      The MSCI Argentina index of six locally-based companies gained 6.4 percent to 3,342.65 at 12:07 p.m. New York time. It rallied as much as 13 percent, the steepest intraday advance since Nov. 24, 2008. Grupo Financiero Galicia SA, the South American country’s biggest consumer lender, surged as much as 26 percent. Argentina’s benchmark Merval index climbed to a record in each of the past five days.

     Investors are buying Argentine American depositary receipts on prospects that “the Kirchner era” of high inflation and low corporate investment may end, said Greg Lesko, who helps manage $750 million at Deltec Asset Management in New York.

     “There is no guarantee that the next person will be any better, but change is what the market has been wanting,” Lesko said by telephone.

 –With assistance from Ben Bain in New York. Editors: James Attwood, Lester Pimentel

The U.S. is a Banana Republic (Part 2)

Unlike ordinary investors, Warren Buffet does not have to use mark to market accounting….. 

I know Berkshire is an insurance company, so you can argue that it does not have to mark to market its investments (in the past this would mean its fixed income investments), but to say that the ‘prospects’ of a particular food company and a particular bank two years out are such that they do not require being market to market IMHO is a bit rich….who amongst us human beings can predict anything two years out, anyway?

Buffett Says U.S. Bancorp’s Prospects Negate Need for Writedown (By Hugh Son)

Oct. 25 (Bloomberg) — Warren Buffett’s Berkshire Hathaway Inc. opted against writing down its holdings in U.S. Bancorp and Kraft Foods Inc. because of the prospects their shares will recover, the billionaire’s company told regulators.

     “The underlying businesses of Kraft Foods and U.S. Bancorp were each financially sound and continued to possess significant future earnings potential,” Berkshire said in a May 7 letter to the U.S. Securities and Exchange Commission that was released today. “It is reasonably possible that the market prices of Kraft Foods and U.S. Bancorp will recover to our cost within the next one to two years.”

     Berkshire was asked by the SEC in April why it didn’t write down about $1.9 billion in market declines in the company’s equity portfolio. Unrealized losses as of Dec. 31 included $789 million on Kraft, the maker of Oreo cookies and Ritz crackers, and $646 million on U.S. Bancorp, Berkshire told the SEC.

     The stake in Northfield, Illinois-based Kraft was down 18 percent from Berkshire’s cost, and the holding of Minneapolis- based U.S. Bancorp had dropped by 27 percent as of the end of 2009. Kraft advanced 17 percent this year through Oct. 22 and U.S. Bancorp climbed about 4.8 percent. Berkshire is the largest investor in Kraft stock and the No. 3 holder of U.S. Bancorp, according to data compiled by Bloomberg.

     The SEC said Sept. 8 that it reviewed Berkshire’s response on questions related to filings including the 2009 annual report and had no further comments. Such correspondence is typically made public about 45 days after the completion of a review.

     Steve Dale, a spokesman for U.S. Bancorp, declined to comment as did Kraft’s Michael Mitchell and John Nester of the SEC. An assistant to Buffett didn’t immediately return a message seeking comment.

Need some digestion on the SPX ?

G20 Update – Not Positive for the U.S. dollar…..

G20 Update – Not Positive for the U.S. dollar…..

Per JP Morgan Research:

 *         Bottom Line on the G20 – the final communiqué touched on three key points: 1) FX; 2) trade; 3) IMF reform.  On the subject of global currencies, the final language was inline w/the draft leaks made to the press in the days leading up to the event.  No single currency was singled out and a commitment was made to adopt “more market determined exchange rates” and to “refrain from competitive devaluations”.  On trade, the US-proposed 4% limit for trade surpluses/deficits was rejected (as was expected) in favor of more general language (there was a commitment made to reducing “excessive imbalances”).  One of the most significant developments at the weekend summit was the reform of the IMF, granting emerging market economies are larger voice at the institution.  The key focus point for investors was on FX and there the outcome of the weekend was inline w/expectations (some may take the weekend as a neg. for the dollar given there was no explicit language aimed at strengthening the greenback; however, Geithner did reiterate a “strong dollar” policy on the sidelines of the event while the prospect of a smaller QE2 on Nov 3 and greater GOP control of the Congress, which could come w/it spending constraints, may keep a bid under the buck in the coming week).

 *         The language around currencies from the official G20 statement is pretty much right inline w/press reports leading up to the event and are relatively vague – “move towards more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies. Advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in exchange rates. These actions will help mitigate the risk of excessive volatility in capital flows facing some emerging countries. Together, we will reinvigorate our efforts to promote a stable and well-functioning international monetary system and call on the IMF to deepen its work in these areas. We welcome the IMF’s work to conduct spillover assessments of the wider impact of systemic economies’ policies”

 *         Geithner’s statement was a bit more specific on currencies – “we have agreed to cooperate more closely on exchange rate policy.  Countries with significantly undervalued exchange rates committed to move towards more market-determined exchange-rate systems that reflect economic fundamentals, as China is now doing.  The countries responsible for the dollar, euro and yen recognized the importance of preserving stability among the major currencies and avoiding excess volatility and disorderly exchange rate movements. We all committed to refrain from competitive devaluation, or undervaluation”

 *         Speaking to reporters after the G20, Geithner says the US has a special responsibility to support the dollar; Geithner said, “It is the policy of the US to support a strong dollar…and we recognize the special responsibilities we have to help contribute to global financial stability” as a country with a key reserve currency. (Bloomberg/DJ)

 *         There was no 4% deficit/surplus target although a paragraph did emphasize a commitment to stabilize unsustainable trade imbalances – “strengthen multilateral cooperation to promote external sustainability and pursue the full range of policies conducive to reducing excessive imbalances and maintaining current account imbalances at sustainable levels. Persistently large imbalances, assessed against indicative guidelines to be agreed, would warrant an assessment of their nature and the root causes of impediments to adjustment”

 *         The G20 Fin ministers reached an agreement to enhance the voting powers at the IMF of emerging economy countries – The ministers agreed that two of the nine European seats on the 24-seat IMF board will be shifted to emerging economic powers. As well, 6% of the voting and financing quota of the IMF will be shifted from advanced countries to emerging ones.  WSJ

*         Germany accuses the US of indirectly manipulating the dollar via the Fed’s super-easy monetary policy.  http://www.cnbc.com//id/39808247http://www.cnbc.com/id/39808247

*         Geithner tells Bloomberg in an interview after the G20 meeting that China is engaged on the issue of currency and understands that it’s in Beijing’s interest to see the yuan higher as they don’t want to be dependent on US monetary policy.  Reuters

*         Geithner in China – following the completion of the G20 Finance Ministers talks, Geithner traveled to China for talks w/Vice Premier Wang Qishan; the two discussed US/China eco relations and made preparations for the upcoming G20 Leaders Summit – Bloomberg

 *         Official Communique: http://bit.ly/9D0nQW

 *         Geithner’s statement: http://bit.ly/bAPFDJ

The U.S. Banana Republic (Part 1)

The last comment is the most telling…..

*BLINDER SAYS FED UNLIKELY TO ADOPT `SHOCK AND AWE’ STRATEGY

*BLINDER SAYS $500 BILLION IN FED ASSET PURCHASES `TOO SMALL’

*FORMER FED VICE CHAIRMAN BLINDER SPEAKS ON BLOOMBERG TELEVISION

*BLINDER SAYS FED POLICY MAKERS `MAKING IT UP AS THEY GO ALONG’

There is no distance on this earth as far away as yesterday (Robert Nathan)….

What is the latest Big Mac Index telling us?  Buy Malayasia, Thailand, Russia, Singapore? 

It would seem that all of these surplus countries will have higher surpluses once the Fed’s QEII is rolling, and all (other than Singapore) will have higher priced commodity outputs……will we be looking back in a year at how cheap a burger was in these countries….?

Economist Big Mac Index

Big Brother Wants to Know if you Wire More than $1k

The U.S. already has the basic infrastructure for capital controls (reporting, tracking, etc), however this is not generally known outside of the accounting and legal professions who have to ensure that clients comply with the recent rules.
 
Also, the willingness of the U.S. government to look favorably upon capital controls in other countries (Brazil, others), makes it more likely that capital controls may be used at some point here in the U.S. – a concept which previously would be unthinkable….however – considering what the Fed is signaling, things previously thought “unthinkable” are becoming reality….

On September 30, 2010, the Financial Crimes Enforcement Network (“FinCEN”) issued a notice of proposed rulemaking (“Proposed Rule”) that, if implemented, would mandate certain depository institutions and money service businesses (“MSBs”) to affirmatively provide records and report information to FinCEN relating to certain cross-border electronic transmittals of funds (“CBETF”). Federal regulations (and certain state money transmitter laws) already require that these financial institutions maintain and make available essentially the same information, but do not require the affirmative reporting of this information, if it does not rise to the level of a suspicious transaction.

 http://www.srz.com/102010_fincen_issues_proposed_rule_on_electronic_transmittals_of_funds/

U.S. Debt Monetization Theme Continues…..

Trade idea: participate in foreign currency appreciation and loose U.S. monetary policy through a broad basket of Asian ETFs (plus Brazil): EWH, EWS, EWM, EWT, THD, EWY, EEM, EWZ…these funds are up significantly since the August lows, so scale in.

from Ken Landon, J.P.Morgan Strategy, NY (Oct 21, 2010)

 * NEWS – The big theme is intact: an expected increase in money printing and debt monetization by the Fed is keeping the dollar under pressure against most currencies. US Treasury officials seem pleased with the recent movements in the FX market, although they would like China to increase the pace of CNY appreciation. In any case, in lieu of a more analytical Lowdown, today I will make a few comments on some news stories that caught my eye. I will use the summary given by JPM’s “Market Intelligence” group when introducing the articles:

 1) Geithner tells the WSJ that the US doesn’t intend on devaluing the dollar as a way to achieve prosperity.  Geithner said he would use the G20 meeting as a forum to advance efforts to “rebalance” the world economy so it is less reliant on US consumers, to move towards establishing “norms” on FX.  WSJ   http://tinyurl.com/267ahmp

 John Normand already commented on the Geithner interview and concluded that there is no change in US dollar policy. Mr. Geithner parsed the world into three groupings by currencies: currecies of countries, such as China, that are grossly “undervalued,” those that are “fairly” valued (i.e., G3), and those currencies of countries that are taking appropritate actions through intervention and capital controls to prevent “overvaluation” or inflationary pressures.

 According to the WSJ, “Treasury Secretary Timothy Geithner said he would use weekend meetings of G-20 finance ministers to advance efforts to “rebalance” the world economy.”

 Central planning on a national scale is daunting enough, but now the meaning of “globalization” — formerly associated with opening up markets and trade — is co-ordination between governments to “rebalance” global economic activity. Such an effort likely will end in extraordinary dislocations and slower economic growth. The underlying framework that drives the world-view of “global imbalances” is at its core opposed to the free movement of capital and labor across national borders. Because the core philosophy opposes free movement of key economic factors such as capital and labor, it ultimately leads to trade protectionism with all its negative consequences.

 In my opinion, the interview with Geithner is just another reason to sell USDs despite the Treasury Secretary’s claim that “the U.S. doesn’t aim to devalue its way to prosperity.”  When the world’s largest importer of capital openly endorses capital controls such as taxation of inflows, as Geithner did in the WSJ, then the logical conclusion is that the US is amenable in principle to doing so itself. I do not think such controls are likely in the near-term, but I do think that such statements reveal the core philosophy that is guiding the policy actions of Washington.

 As for trades that are implied by the Washington world-view, short USD and long a basket of Asian currencies makes sense. Historically, Asian currencies and Asian equity markets are highly and positively correlated. A trend appreciation in regional FX likely will attract a huge portfolio inflow into Asian stock markets (i.e., stronger currencies is not a reason to turn bearish toward Asian equities).

 2) Fed Article in the FT – says Fed officials are considering a more “flexible” approach to further QE.  “Fed officials are weighing an approach that allows more discretionary meeting-by-meeting decisions than the unconditional “shock and awe” stimulus it launched during the depths of the crisis in 2008 and 2009”  See: http://tinyurl.com/35calpd

 I found nothing new in this FT article. In my opinion, the view that the Fed will announce an incremental approach to QE is already accepted by most people in the market. It also is not surprising that the Fed would want a “discretionary” approach that is contingent upon incoming economic data. In fact, that is the message that Fed officials have been transmitting to the market over the past several weeks. To my knowledge, no one is advocating a large “shock and awe” announcement. In my framework, which is not within the mainstream, the Fed’s primary objective of additional debt monetization is to provide a continuous source of funding for the central government. An open-ended discretionary approach fits in perfectly with that objective because it does not limit the amount in dollars or the amount of time over which “QE” will be implemented.

 3) Foreclosure crisis tops White House agenda – Tim Geithner, Treasury secretary, Shaun Donovan, housing secretary, and Tom Perrelli, associate attorney-general, held a closed meeting on Wednesday to co-ordinate the administration’s response to the problem. (FT) http://tinyurl.com/22wm4rw

 Investors have beaten down the stocks of large banks in recent weeks because of the foreclosure “crisis.” However, of more significance for markets is the following story:

 Foreclosures – the White House on Wed says it has found no sign of “systemic” home foreclosure problems that threaten US financial stability or structural problems that could undermine investments linked to mortgages.

http://www.cnbc.com//id/39767501 

 Housing and Urban Development Secretary Shaun Donovan said “We have not found any evidence at this point of systemic issues in the underlying legal or other documents that have been reviewed.”  The Obama Administration has so-far refused to support a systemic moratorium of foreclosures. The comments by Secretary Donovan makes it increasingly unlikely that such a moratorium will be imposed by the executive branch, which provides some clarity in a situation that has remained murky for the pass few weeks.

Parsing This Morning’s Speech

from Ken Landon, J.P.Morgan Strategy, NY (Oct 15, 2010)

 * BERNANKE – There is plenty to digest and many points that can be discussed about the Chairman’s speech, which carries the title “Monetary Policy Objectives and Tools in a Low-Inflation Environment.”  Instead of commenting on everything, I will focus just on things that interest me and that I have not written about before.

 1) First, the opening passage is an ode to higher inflation. According to the Chairman, central banks won the war against inflation in the 1980s through the 2000s (i.e., they won the war against a phenomenon that they themselves created), but now policymakers must focus on preventing the opposite bogeyman (i.e., too low inflation or even deflation).

 2) Bernanke: “a single-minded focus by the central bank on price stability, with no attention at all to other factors, could lead to more frequent and deeper slumps in economic activity and employment with little benefit in terms of long-run inflation performance.”

 My comment: When I read that sentence, the word “could” jumped out at me. In other words, the Chairman could not quite bring himself to using a definitive “will” because, in my opinion, the statement is not proveable.  Yes, such a single-minded policy “could” lead to more frequent “slumps,” but it “could” also lead to more stable growth. Bernanke obviously chose to focus on one tail risk and ignore the other when making that statement.

 As an aside, there was an era when the management of money was not in the hands of politicians. Those were the days when bank managers had a “single-minded” focus on the stability of the value of the currency issued. In those days of competition between issuers of currencies, it was fatal not to have such a “single-minded” focus. There were no legal tender laws forcing anyone to accept the currency of one bank or another. During the 100 years prior to the establishment of the Fed, the US experienced both high average growth and ZERO average inflation.  Yes, there were times when prices moved higher (inflation) and times when prices moved lower (deflation), but the average was zero. It was during that period that the country experienced the Industrial Revolution and high growth.  There is plenty of historic precedent of periods in which inflation was non-existent and growth was high.

 3) Bernanke: “Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate. The longer-run sustainable rate of unemployment is the rate of unemployment that the economy can maintain without generating upward or downward pressure on inflation.”

 My comment: the above is illustrative of the demand-side view of the Fed. They really do believe that inflation is *caused* by things such as higher wages or rising prices of healthcare, etc. From their own words, it is not apparent that they understand that inflation is a decline in the purchasing power of money and changes in overall wages and other prices are *effects* and not *causes*.

 4) Bernanke: “Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.”

 My comment:  “Suggests”? This indicates uncertainty about the validity of the policy. The effect of the policy on bringing down longer-term interest rates is not something that I would question here. I think Fed action did in fact lower those rates. However, what is questionable is the conclusion that such action supported the economic recovery.  Lower long-term rates and flatter yield curves are usually associated with slower future growth and not higher. Changes in short-term interest rates have a much higher explanatory power for future growth than do changes in long-term rates. The Fed can indeed pull down long-term rates with aggressive debt monetization, but it does not have the power to positively affect the economy by doing so. The Japanese tried this exact same policy over the past decade or so and they failed miserably in boosting growth.

 I’m done with commenting on the speech. I intentionally left out a lot of material because much of it was a rehash of previous statements of either Bernanke or the FOMC. The message that Bernanke conveyed today was the same as what the market has been pricing, which is an imminent increase in debt monetization. That is, Bernanke did not break new ground. He merely confirmed the market’s expectations.

 full speech:  http://tinyurl.com/28fkwtv

USD Very Oversold Short Term

The USD is very oversold short term…beware of a sharp pullback in risk-on trades over the next few days…

Short term index options like SPY are very cheap right now (VIX at 19)….

Art Cashin On Hyperinflation

(Today we will revisit one of the most devastating economic events in recorded history.It all began with the efforts of a few, well-intentioned government officials.)

Originally, on this day (-2) in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to “jump start” a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental “more is better” theory they simply created more and more money.

But economic stagnation continued and so did the money growth. They kept making money more available. No reaction. Then, suddenly prices began to explode unbelievably (but, perversely, not business activity).

So, on this day government officials decided to bring figures in line with market realities. They devalued the mark. The new value would be 2 billion marks to a dollar. At the start of World War I the exchange rate had been a mere 4.2 marks to the dollar. In simple terms you needed 4.2 marks in order to get one dollar. Now it was 2 billion marks to get one dollar. And thirteen months from this date (late November 1923) you would need 4.2 trillion marks to get one dollar. In ten years the amount of money had increased a trillion fold.

Numbers like billions and trillions tend to numb the mind. They are too large to grasp in any “real” sense. Thirty years ago an older member of the NYSE (there were some then) gave me a graphic and memorable (at least for me) example. “Young man,” he said, “would you like a million dollars?” “I sure would, sir!”, I replied anxiously. “Then just put aside $500 every week for the next 40 years.” I have never forgotten that a million dollars is enough to pay you $500 per week for 40 years (and that’s without benefit of interest). To get a billion dollars you would have to set aside $500,000 dollars per week for 40 years. And a…..trillion that would require $500 million every week for 40 years. Even with these examples, the enormity is difficult to grasp.

Let’s take a different tack. To understand the incomprehensible scope of the German inflation maybe it’s best to start with something basic….like a loaf of bread. (To keep things simple we’ll substitute dollars and cents in place of marks and pfennigs. You’ll get the picture.) In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents. Two years later it was 19 cents. Two years more and it sold for 22 cents. By 1919 it was 26 cents. Now the fun begins.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (wide spread rioting broke out). The next month it hit $3 billion. By mid month it was $100 billion. Then it all collapsed.

Let’s go back to “marks”. In 1913, the total currency of Germany was a grand total of 6 billion marks. In November of 1923 that loaf of bread we just talked about cost 428 billion marks. A kilo of fresh butter cost 6000 billion marks (as you will note that kilo of butter cost 1000 times more than the entire money supply of the nations just 10 years earlier).

How Could This All Happen? – In 1913 Germany had a solid, prosperous, advanced culture and population. Like much of Europe it was a monarchy (under the Kaiser). Then, following the assassination of the Archduke Franz Ferdinand in Sarajevo in 1914, the world moved toward war. Each side was convinced the other would not dare go to war. So, in a global game of chicken they stumbled into the Great War.

The German General Staff thought the war would be short and sweet and that they could finance the costs with the post war reparations that they, as victors, would exact. The war was long. The flower of their manhood was killed or injured. They lost and, thus, it was they who had to pay reparations rather than receive them.

Things did not go badly instantly. Yes, the deficit soared but much of it was borne by foreign and domestic bond buyers. As had been noted by scholars…..“The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits.” In layman’s English that means foreign bond buyers said – “Hey this is a great nation and this is probably just a speed bump in the economy.” (Can you imagine such a thing happening again?)

When things began to disintegrate, no one dared to take away the punchbowl. They feared shutting off the monetary heroin would lead to riots, civil war, and, worst of all communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.

Currencies, Culture And Chaos – If it is difficult to grasp the enormity of the numbers in this tale of hyper-inflation, it is far more difficult to grasp how it destroyed a culture, a nation and, almost, the world.

People’s savings were suddenly worthless. Pensions were meaningless. If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months. People demanded to be paid daily so they would not have their wages devalued by a few days passing. Ultimately, they demanded their pay twice daily just to cover changes in trolley fare. People heated their homes by burning money instead of coal. (It was more plentiful and cheaper to get.)

The middle class was destroyed. It was an age of renters, not of home ownership, so thousands became homeless.

But the cultural collapse may have had other more pernicious effects.

Some sociologists note that it was still an era of arranged marriages. Families scrimped and saved for years to build a dowry so that their daughter might marry well. Suddenly, the dowry was worthless – wiped out. And with it was gone all hope of marriage. Girls who had stayed prim and proper awaiting some future Prince Charming now had no hope at all. Social morality began to collapse. The roar of the roaring twenties began to rumble.

All hope and belief in systems, governmental or otherwise, collapsed. With its culture and its economy disintegrating, Germany saw a guy named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting. And then came World War II.

We think it’s best to close this review with a statement from a man whom many consider (probably incorrectly) the father of modern inflation with his endorsement of deficit spending. Here’s what John Maynard Keynes said on the topic:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.
Lenin was certainly right. There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.

To celebrate have a jagermeister or two at the Pre Fuhrer Lounge and try to explain that for over half a century America’s trauma has been depression-era unemployment and deflation while Germany’s trauma has been runaway inflation. But drink fast, prices change radically after happy hour. And, tell Fed Chairman Bernanke that it was the “German Experience” that caused many folks to raise an eyebrow when he alluded to the power of the “printing press” a few years ago. But, rest assured that no one would let it happen again.

Who do you believe?

Krugman, Niall Ferguson Renew Debate Over U.S. Fiscal Stimulus

2010-10-13 06:41:01.277 GMT By Bomi Lim and Michael Heath
   
Oct. 13 (Bloomberg) — Nobel Prize-winning economist Paul
Krugman and Niall Ferguson, author of “The Ascent of Money: A
Financial History of the World,” clashed anew today over how to
revive the U.S. economy.
    Krugman, 57, a Princeton University professor, is urging
the Obama administration to undertake a second round of fiscal
stimulus, while Harvard University historian Ferguson, 46, warns
such a course may trigger a “debt spiral” in the world’s
biggest economy.
    “The risk is that at some point your fiscal policy loses
credibility in the eyes of investors,” Ferguson said at the
World Knowledge Forum in Seoul. “Then, very quickly, you will
find yourself in a debt spiral of rising rates, widening
deficits, crumbling credibility and yet more rising rates.”
    The debate comes as minutes of the Federal Reserve policy
makers’ meeting on Sept. 21 show they were prepared to ease
monetary policy “before long” as growth slows and the jobless
rate remains near a 26-year high.
    “We actually never did significant fiscal expansion,”
Krugman said at today’s forum, appearing beside Ferguson. “What
does a trillion dollars of borrowing do to the U.S. long-run
fiscal position? The stimulus right now makes almost no
difference.”
    The administration’s two-year $814 billion stimulus program
ends Dec. 31, and Krugman said two months ago another $800
billion is necessary. While the National Bureau of Economic
Research said in September that the worst U.S. recession since
the Great Depression ended in June 2009, the unemployment rate
held at 9.6 percent last month.

                     Investor Confidence
    Ferguson said the U.S. risks losing investors’ confidence
as more spending exacerbates its weak fiscal position, adding
the U.S. debt situation is worse than that of Greece. Krugman
dismissed the comments, saying there is no evidence in the
markets that bondholders will flee.
    “The markets are fine until they are not fine,” Ferguson
countered.
    “For more than a year since our debate began, it’s the
Chinese who’ve been consistently agreeing with me, saying that
they regard the course of U.S. fiscal and monetary policy as
dangerous,” the Harvard professor said. “So it’s not just me
you are arguing with Paul, actually, it’s the Chinese
government.”
    China in July held almost $847 billion in U.S. Treasuries,
more than double the amount it held four years earlier.
    U.S. economic growth slowed to an annual rate of 1.7
percent in the second quarter from 3.7 percent in the first
period. The growth figures are adjusted for changes in prices;
nominal gross domestic product doesn’t adjust for inflation.
    The economy probably expanded at a 1.9 percent pace in the
quarter ended Sept. 30, according to the median estimate of 62
economists surveyed by Bloomberg News.
    Krugman, a New York Times columnist, wrote last year during
a previous clash that Ferguson “hasn’t bothered to understand
the basics” of economics. Ferguson has said Krugman’s economic
assumptions are based on a “flawed” reading of John Maynard
Keynes’ model.

James Grant Interview

James Grant Interview

The “Money Illusion”

Once again, commentary that the Fed is monetizing the debt and that the market is aware of it……

from Ken Landon, J.P.Morgan Strategy, NY (Oct 12, 2010)

 * MONEY ILLUSION – As attached chart 10Y_TIPS.gif shows, the yield of the 10Y TIPS, which is a rough proxy of the riskless real rate of return on capital in the US, has fallen to an historic low below 0.4%. Equities have rebounded smartly over the past six weeks, but the overall financial market is sending ominous signals about expected growth over the coming decade.

 It has long been a theme of the Lowdown that a deteriorating Policy Mix in Washington will weigh on growth for years to come. This “hollowing out” of American prosperity is occuring because policymakers are showing no understanding that the engine of growth is driven by people who invest capital and those that utilize that capital to create something that did not exist before. That is, investors and business decision-makers are the actual engines of growth. Policies that create incentives and remove obstacles of increased investment and production are positive. Policies that remove incentives and place obstacles in the way of productive individuals are negative.

 In this respect, Fed Vice-Chairman Yellen’s recent comments are instructive. On Monday, Yellen said, “It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.” Although the statement is true, nowhere was there to be found any mention of the Fed’s policies on investors and on capital flows. Lower interest rates may cause borrowers to boost leverage. However, low interest rates also my cause lenders to avoid risk-taking altogether. A slide in real rates in the US will, over time, cause capital to seek out higher returns in faster-growing regions of the worlds (e.g., EM). Notice that new capital restrictions in many EM countries have accompanied the recent slide in US real rates.

 On balance, the Policy Mix started to turn negative in June 1999 and became progressively worse since then. It was from that time that the “supply side” revolution of the 1980s started to be eclipsed by the notion among policymakers that markets are inherently prone to “failure” and that central planners must intervene to control freedom of exchange in markets (despite his “free market” reputation, Greenspan led that charge).

 Attached chart SPX_GOLD.gif shows the nominal S&P 500 stock index against the same index priced in terms of gold. Many observers speak of “bubbles” and “asset inflation” when referring to the 72% rebound in the S&P 500 since March 2009. However, in terms of gold, the S&P is up just 18% since then, which is a pitiful performance during the early stage of an economic recovery.

 * MONEY ILLUSION – Economists refer to people’s focus on the nominal, as opposed to the real, price of things as “money illusion.” In other words, people do not focus on the actual purchasing power of money, but its nominal value. In fact, it is this money illusion that much of Keynesian economic theory is based on. To “stimulate” employment, for example, the standard economic model says that a boost in inflation will lower real wages, which in turn will lead to a pick up in employment (i.e., businesses will hire because of the lower real cost of labor relative to the prices received for finished goods and services).

 Similarly, a significant portion of the 11% rebound in the S&P 500 since late-August is nothing more than a money illusion. In terms of gold, the S&P is up only 2.8% over the same period. (I use gold as the yardstick because it has a proven track record of maintaining relatively stable purchasing power over many decades and even centuries. If you want a more detailed discussion of this, then please ask and I’ll send you my report from March 2007.)

 Of course, the other side of the coin of the “money illusion” is inflation. Attached chart 10Y_INFL.gif shows that the 10Y Inflation Breakeven priced in the US Treasury market has surged nearly 50 bps since late-August. The market is taking the Fed at its word. Investors are not taken in by the “money illusion,” which is also reflected in the recent surge in gold to all-time highs.

 * Speaking of the Fed, the FOMC will release minutes from its meeting of September 21st.  It was the FOMC’s statement from that day that caused the market to expect additional debt monetization. As a result, the market will carefully assess every word and comma in today’s minutes that refers to debt monetization (i.e., colloquially known as “quantitative easing).

 In my opinion, the mold is already set.  The US government is chosing to inflate away the trillions of dollars of debt that it has issued over the past few years. The Fed will be used to fund the spending of the Federal Government. The result will be a debauchment of the currency and higher inflation. I therefore remain bearish toward the USD and view the occassional rebounds as opportunities to sell once again. The same goes for gold. Sell-offs will provide better entry points for those who seek to preserve their capital.

 ”Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” — John Maynard Keynes in The Economic Consequences of the Peace, Chapter VI, pg.235-6

 Kenneth Landon, Oct 12, 2010  kenneth.landon@jpmorgan.com

During WWII the Fed Successfully Targeted 10yr Rates at 2.5%

There is no reason to think that they will not be able to do so again…..

from Ken Landon, J.P.Morgan Strategy, NY (Oct 7, 2010)

 * FED – The press is now filled with breathless accounts of another “option” that the Fed may use to stoke inflation. This time, the supposed monetary magic lies with the literal targeting of yields along the US Treasury curve. Here is how today’s Washington Post describes it:

 ”Instead of just announcing that it will create, say, $500 billion out of thin air and buy bonds with the money, the Fed could instead announce it will target a certain interest rate and then buy Treasury bonds so that rates in the marketplace reach that level.”

 (see: http://tinyurl.com/29t6qbu for full article)

 The article briefly mentions Chairman Bernanke’s previous advocacy of such a policy, which he highlighted in his notorious “Helicopter Ben” speech in November 2002.  Here is the key passage from that speech:

 ”So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities….A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years…Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).”

 (full speech can be viewed at: http://tinyurl.com/2wja)

 * It is obvious from Chairman Bernanke’s own words that he is amenable to a policy that targets US Treasury rates along the entire yield curve. He has already aggressively used the Fed’s “authority to operate in the markets for agency debt.” It is not a difficult stretch of the imagination that he would also use the Fed’s authority to target long-term US Treasury rates.

 In a somewhat bizarre reference in the article from the Washington Post, the journalist wrote:

 ”While the Fed and other central banks have experience announcing planned bond purchases and setting targets for overnight lending rates, targeting longer-term interest rates is an untested strategy that could have hard-to-predict consequences.

 ”‘We’re in the experimental drug phase of monetary policy,’ said John Makin, a resident scholar at the American Enterprise Institute. ‘These are all very nice ideas, but there’s no real experience to tell you what works best.’”

 I say that reference is “bizarre” because there is a prominent example of the Fed literally targetting the 10Y UST rate. Between April 1942 and March 1951, the Federal Reserve explicitly set a ceiling of 2.5% on the 10Y UST. The central bank committed to buying unlimited amounts of USTs in order to control rates. The explicit rate-targetting of USTs ended with the famous Fed-Treasury Accord of 1951 that granted the central bank more leeway in implementing monetary policy.

 The purpose of the 2.5% ceiling on the 10Y UST was clear. The Fed was turned into a source of financing of the government’s war spending. Here is how the San Francisco Fed described that period of time:

 ”During the decade before the 1951 Accord, Federal Reserve actions were dominated by considerations arising from the government’s World War II financing needs. The Treasury, faced with the need to raise funds far in excess of tax receipts in order to finance the war effort, wanted to keep interest rates on government securities at low levels. The Treasury view was supported by the Federal Reserve, and the Fed adopted an explicit policy of supporting the government bond market. Particularly during 1942 to 1945 when the government was engaging in massive borrowing, this was clearly an important consideration. As expressed by G.L. Bach, “In this period, Federal Reserve and Treasury officials agreed, with perhaps more patriotic fervor than foresight, that there must be no shortage of money to buy the weapons of war .. .”

 (see: http://www.frbsf.org/publications/economics/letter/1993/el93-21.pdf )

 Fast forward approximately 70 years and it is not hard to imagine the same agenda motivating a similar UST rate-targetting regime in 2010. Whether under direct political pressure or not, the Fed is part of the apparatus used by Washington to finance its massive spending (in 2009, government spending as a percentage of GDP surged to 25% from 19.4% in 2007 and an average of 19.3% during the previous 60 years). To paraphrase the San Francisco Fed, “the Treasury, faced with the need to raise funds far in excess of tax receipts in order to finance” the rapid expansion of the Federal government “wanted to keep interest rates on government securities at low levels.” The Fed is obviously doing its part to lubricate the Treasury’s current financing needs.

 * Attached chart 10Y_4251.jpg shows the 10Y UST rate and the CPI rate between 1940 and 1960. Notice that between Apr 1942 and Mar 1951, the Fed successfully held the yield of the 10Y UST below 2.5%. In fact, the average yield of that period was 2.4%. The central bank was able to do so despite the fact that average CPI was 5.7%. Not only was inflation high, but it was also extremely volatile between 1942 and 1951, which is not surprising given the Fed’s commitment of aggressively monetizing debt. At one point in 1947, CPI hit 20% yoy and then, in 1949, it turned negative and fell as low as -2.9%.

 * The purpose of this history lesson is to illustrate that the Fed has in fact controlled rates along the entire US Treasury curve even during a period of high and volatile inflation. Contrary to the assertion of the Washington Post and the commonly-held belief that “targeting longer-term interest rates is an untested strategy,” there is a glaring nine-year period in the mid-20th Century that shows the power of the Fed to hold long-term UST rates below a certain level *if* it makes a commitment of monetizing unlimited amounts of debt. Bernanke has talked highly of such a policy in the past.

 The result of such a policy would be higher and more volatile inflation, which makes the recent plunge in TIPS yields and surge in commodities prices perfectly understandable. The Fed will soon implement aggressive policies with the stated purpose of boosting inflation. The market is in fact taking the central bank at its word and acting accordingly.

 We are literally at the dawn of a new era of rising inflation. This is the context of the recent decline in the USD and erupting global tensions (i.e., the “currency wars”).  The Fed was able to maintain its UST rate-targetting policy for nine full years the last time they entered this territory. There is no reason to believe that the current episode will be a quick one, which means that the USD is likely to weaken and trend to successive historic lows.

 * To reiterate one of my recent themes, the “real” is preferable to the “abstract” when central banks are actively printing money and monetizing debt. Hard assets are preferable to fiat paper currencies and financial assets that are harmed by inflation. In FX, the obvious winners are the commodities currencies. Elsewhere, formerly popular assets from the 1970s will make a comeback. Farmland and precious stones, among others, may once again become popular with investors who seek to protect the value of their capital. Deeply depressed assets such as real estate should also perform well.

 Kenneth Landon, Oct 7, 2010  kenneth.landon@jpmorgan.com

“Fed is banking on phony wealth effect” (from Reuters)

Surprising comments from Reuters (usually they are a staunch supporter of this government’s policies)

http://blogs.reuters.com/great-debate/2010/10/07/fed-is-banking-on-phony-wealth-effect/

The Federal Reserve is committed to enticing Americans into doing once again what worked out so badly in the last decade: spending the phony paper gains engineered by overly loose monetary policy.

That, at least, is the very strong impression given by a speech by Brian Sack, the markets chief of the New York Federal Reserve, a man whose job it will be to implement the second round of large-scale quantitative easing coming after the elections in November.

A round of speeches from key Fed officials has given the clear view that, faced with deteriorating conditions and trapped by the lower bound of zero in its monetary policy, the Fed is preparing to once again buy up large amounts of Treasuries, perhaps even more than the government is issuing on an ongoing basis, in an attempt to drive down market interest rates and stimulate the economy.

Will that do any good, given that people generally do not want to borrow and the banking system is impaired?

“Balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be,” Sack said in a speech in Newport Beach, California on Monday.

“It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions.”

So, there you have it: pump up asset prices and hope that people spend some of the ephemeral gains. The idea that people will spend more if their houses and other assets rise in value is called the wealth effect, but this policy creates only pretend wealth.

In fact, many people in the U.S. now face diminished retirements and generally straitened circumstances precisely because they mistook the rising prices of their house and Internet stocks for wealth and spent or borrowed against it. Is the U.S. actually so desperate for economic activity that this is the best it can do? Apparently so.

“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?” Dave Rosenberg, chief economist and strategist at Gluskin, Sheff wrote in a note to clients.

CALLING DR RICARDO

So, now that the strategy is clear the question is will it work? So far, the promise of QE seems to be affecting the term premium in debt markets, reducing longer-term funding costs, and stock market traders also seem to think it will be good for equities.

The reality of QE when it arrives may be a bit different: debt markets are less dislocated than last time and so the value of the balm will be less, while stocks are far more richly priced.

A more interesting question is how households and businesses react to the paper wealth if the Fed is successful in creating it. Businesses may use their newly rich equity prices to go and buy other businesses, especially ones with actual resources attached, such as mining companies. They will be less interested in investing in new production unless they see strong signs from households that they are interested in buying more again.

For households, you have to wonder if there is a sort of Ricardian equivalence that applies to manufactured asset price inflation caused by QE or otherwise loose monetary policy. Ricardian equivalence is the controversial idea that consumers realise the fiscal constraints of their governments and will, for example, not spend a tax rebate if they know it means a tax rise down the road. Would they similarly not spend asset gains they see as false?

Clearly this idea did not apply to the interplay of policy, asset prices and consumption in the last decade. People spent some of the paper wealth that was created by loose policy under Alan Greenspan. That, however, was before they were burned by the housing crash, and Greenspan had the good sense to effectively conceal his experiment from his subjects. Now that the Federal Reserve has come out and said it is trying to ramp up asset markets, the feel-good factor from a rising stock market may be lacking.

If QE will work it will work as the big gun in the currency war, driving down the value of the dollar. In doing that,  though, the Federal Reserve takes considerable risks; that investors lose confidence in the dollar and in the U.S.’s commitment to its lasting value, and that they react by pulling back from dollar investments. This cannot be good for U.S. consumption, other than it might cause people to buy things now rather than later in diminished dollars.

Perhaps the real beneficiaries of QE will be commodities, or, whisper it not, gold.

Savers told to stop moaning and start spending

There is something terribly wrong here:  I once believed that you would only here this type of commentary from central bank officials in Zimbabwe…. 

Savers should stop complaining about poor returns and start spending to help the economy, a senior Bank of England official warned today.

http://www.telegraph.co.uk/finance/personalfinance/savings/8028884/Savers-told-to-stop-moaning-and-start-spending.html

When the Well is Dry, We Learn the Worth of Water (Ben Franklin)

I was shocked to read this, as it neatly encapsulates what I was thinking about Fed Policy…..key exerpt from below:

“In my opinion, we are literally witnessing a financing operation of the profligate US government. The seeming scientific language about growth and inflation merely fits the bill for pursuing the primary objective.”

What happens when ordinary people discover this, and prices skyrocket?

from Ken Landon, J.P.Morgan Strategy, NY (Sep 22, 2010)

* FED – What did the Fed accomplish with its easing bias and focus on low inflation? UST yields have fallen across the curve, with the 2Y now at new lows near 0.4%. The 10Y UST has plunged 16 bps to the current level near 2.54%. The conventional view is that lower rates along the curve and the Fed’s intention to keep Fed funds close to zero is a bullish factor for the economy and “risk” assets. I do not agree. In fact, I find it amazing that the Fed is literally recreating the policy errors of the BoJ, which has undermined growth and rates of return on capital in Japan over the past decade.

What makes me so unenthusiastic about the Fed promise of so-called “stimulus”? The first thing to point out is that although the yield of the 10Y UST is down 16 bps since the close on Monday, the yield of the 10Y TIPS is down by 26 bps to just 0.66%, which is an historic low (see attached chart). As a result, the 10Y inflation breakeven is up by nearly 10 bps. The Fed’s actions are literally lowering investors (i.e., savers) expectations about the real rate of return on capital in the United States. With lower expected returns, there is much less incentive to invest. Keeping capital idle or liquid in very short-term investments is increasingly likely. Just ask the Japanese. They have plenty of experience with this sort of thing.

Second, the state of the economy improved on the margin since the August FOMC meeting, regardless of the Fed’s expressed concerns. Equity and credit markets have been improving and the European sovereign credit crisis is gradually fading as a global macro factor. Since the FOMC meeting in Aug, the USD has weakened against major currencies and gold has surged in price. And yet, the Fed is expressing concern about low inflation, which may be based on the fact that backward-looking measures of inflation (e.g., CPI, PCE) have been been subdued (but not much new info has been gleaned since the Aug FOMC).

Furthermore, I do not accept the somewhat widespread belief that the Fed “knows something that we don’t know.” Their history of missing major turns in the economy and failure to foresee even near-term changes suggests that they do not have a monopoly on knowledge. In fact, market indicators have proven to be better indicators of future growth and inflation.

All of this leads me to believe that the Fed is merely fulfilling its *primary* objective — the reason why it was created by an act of law in 1913 — which is to be a source of funding for the central government. By locking short-term rates near zero *and* promising additional debt monetization (i.e., “QE”), the Fed, like the BoJ, can push yields lower across the Treasury curve. The main beneficiary of these lower UST yields is the issuer, which is none other than the US Treasury. In my opinion, we are literally witnessing a financing operation of the profligate US government. The seeming scientific language about growth and inflation merely fits the bill for pursuing the primary objective.
Yes, I do expect many readers to write back in outrage. Many people believe the Fed is acting because it has no other option (is that an argument for taking action that is widely expected to have little positive impact, if at all?). How could I question the motives of the Fed? I question it because I want to understand the true driver of monetary policy in this country. Hopefully, an understanding and different perspective can shed light on the seeming “conundrum” of quickly falling UST yields and skyrocketing gold and commodities prices. As I see it through my framework, it now makes sense that a sensitive indicator of inflation like gold can in fact move higher even when UST yields are falling. Real yields are being decimated in the US. This is an ominous sign for future growth. The inflation breakeven is starting to trend higher again (major low was hit in late-Aug).

To conclude, the Fed is creating incentives for investors to avoid risk-taking and to take the sure bet:  buy USTs and you are guaranteed that the Fed will not disrupt things by hiking rates. The BoJ did this exact same thing. And like Japan over the last 20 years, the US government keeps coming up with new fiscal spending packages, which have to be funded in some way. The BoJ played its part and so, it seems, will the Fed. The net result will be capital being syphoned from the private sector — from productive use — to fund consumptive activities of the central government. Is it any wonder, then, that real yields are plunging and the USD is sliding lower against all major currencies?

I have been bearish toward the USD even before the FOMC meeting, which merely intensified my conviction. Gold is surging and inflation breakevens have been trending higher since late-Aug. This is the perfect environment for the commodity currencies that benefit from decent global growth and higher rates of inflating by the Fed.

Conslusion? Sell U.S. dollars because the Fed exists solely to assist the treasury lowering the interest rates on its paper!