Sunday, April 24, 2011

Storm Clouds from The East

In the last twenty five years, the Gov't of China has been stashing US Dollars as a reserve.. and as their economy has grown, these reserves have become massive.. a little over three trillion, some of which are US Gov't Bonds as well as cash. This demand for US Dollars has held up the value of the USD for years now, especially of late since Bernanke has been printing USD like mad. It's been a cozy arrangement for both nations; it has allowed China to sell their goods to us and have the currency in which they sell it hold some value. China has, especially since the 2008 Lehman meltdown, warned us to stop printing money like madmen as it devalues the value of the trillions of USD they hold. Over the last year, and especially the last six months, China had experienced serious inflation.. especially for food and gasoline, which last week led to a huge protest by truck drivers at Shanghai's largest port. They have of late tried to raise the reserve requirements of their banks {which has the effect of curbing lending by Chinese banks} but this has had little effect so far. Much of the money in China is arriving via investments from abroad.. much of it in newly printed US Dollars thanks to The Fed's policies. Many have loudly accused Bernanke of "exporting inflation", and China seems to be one of the main recipients of this policy. For China this is a serious matter-- food and fuel expenses are a large part of a common Chinese family's budget, and if these continue to rise precipitously it might {as China's leaders have openly expressed} lead to unrest, as witnessed by the dock protests this week. This last week, the Head of the People's Bank of China {PBoC}, one Zhou Xiaochuan, had this to say: "Foreign exchange reserves have exceeded the reasonable levels we actually need. The rapid increase in reserves has led to excessive liquidity and has exerted significant sterilization pressure. If the government does'nt strike the right balance with it's policies, the buildup could cause big risks". This was his way of saying that China needs to reduce it's three trillion in excess reserves. Today came an even bigger warning from one Xia Bin, a member of the Monetary Policy Committee of the PBoC: "One trillion dollars would be sufficient. China needs to invest it's cash reserves more strategically by using them to acquire resources and technology needed for the real economy"  This could mean that China "diversifies" the other two trillion US Dollars. If this were to become China's policy.. and it looks increasingly like it will instead of simply revaluing their currency, it would mean essentially that China is going to unleash a flood of US Dollars to begin purchases of natural resources and technology. In short, it seems that China wants to spend them now before they become worth even less. To me, if they indeed take action, this would be a strong vote of no confidence by the PBoC. This would mean that the USD would lose value even faster than it already is. If you thought gas and food prices are high now, just wait until they begin this process in earnest. Over the last few days, the price of nearly all commodities.. silver especially.. has gone up sharply, and I'm thinking this action from China is a large part of the reason why. $5.00 gas anyone ? China has a habit of making loud warnings but doing very little when push comes to shove. But they have to do something to curb inflation in their own nation, and as yet seem quite reluctant to revalue the Yuan.

Meanwhile in Japan, it seems that their demographics are catching up with them in the wake of Fukushima. You see, Japan is the world's oldest nation.. and the number of citizens who are elderly is rocketing upwards.. and the cost of their social security and medical needs are also skyrocketing. The Japanese Government will have to borrow yet more money to keep up. Then came Fukushima, and the need to borrow hundreds of billions of Yen to rebuild the area. So far, the Japanese government has been extremely lucky in that their government can borrow from it's own citizens, who are willing to loan their government money at extremely low interest rates. When the people don't step up to loan the Gov't money, the buyer of last resort has been the Japanese Government Pension Investment Fund.. indeed about 2/3rds of the GPIF's money is in government bonds.

But this week, the GPIF.. thanks to an increasing number of pensioners and the ridiculously low interest rates they get back from their Japanese Gov't Bonds {JGB's}, announced that they had a shortfall in revenue of about $78 billion. From Reuters: "Japan's GPIF is planning to withdraw 6.4 trillion yen {$78 billion USD) from it's assets in the current fiscal year to cover a shortfall in pension payouts. The GPIF is likely to raise cash by selling JGB's and other assets in it's portfolio as pension contributions and tax income continue to fall short of payouts, which are growing because of Japan's rapidly aging population" 

Think about it.. at a time when Japan's government needs to borrow more and more money.. it's biggest cash cow is not only not loaning them more money, they're actually selling bonds.. and the JGB's that the GPIF throws onto the market will compete with the JGB's that the Japanese government will need to fund itself. In short, it means that Japan will likely have to raise the interest rates it offers on JGB's to keep itself solvent. The problem here is that Japan's government has the world's highest Debt-GDP ratio in the world. It owes so much money that even a small hike in interest rates {which would mean that Japan's government has to pay more of it's revenues to interest payments on its debts, and thus less to other things like Social Security and Medicare} might have big consequences. In short, Japan is a nation that is getting very old very fast and is enormously in debt. On the good side.. Japan has a lot of assets abroad.. including about a trillion dollars in US Bonds. One thing the GPIF could do is to dump the US Bonds instead of the JGB's onto the market, thus raising the interest rates our own government has to pay on it's own debt. While this $78 billion is not a huge amount in the grand scheme of things, it marks a serious turning point for Japan.. in the wrong direction.

Monday, April 18, 2011

Greece, US Money Supply and the S&P Downgrade

 I'd like to cover a few things here today, with the first being Greece. The originial EU rescue of Greece envisioned a three or four year aid package, after which time the situation was supposed to stabilize and Greece was to return to the bond markets. It was a terribly flawed plan to begin with, and the markets saw it as such. Today the Greek 2 year bond hit an unbelieveable 20% interest rate (see chart above). In short, the bond markets have even less faith in the Greeks to repay, and rightly so. The amount of money the Greek government owes is staggering, and it still needs to borrow every month to make ends meet. Simply put, even if Greece were to outrightly default on it's debt, they would still need to borrow money each month. To it's credit, the government of Greece is making budget cuts and increasing taxes, but it's not nearly enough to meet the commitments it's made to it's people. Good ole fashioned corruption is a large problem to boot. For the last year.. even last week.. EU bureaucrats have constantly maintained it's faith that Greece would pay it's debts and come out of this. But last week, there were reports circulating that Germany was drawing up plans to deal with a Greek default, despite denials from German Finance Minister Wolfgang Schaeubel. These rumors set off the latest deterioration in Greek bonds-- not that it mattered much as nobody was going to loan Greece money anytime soon anyways. Greece has consistently missed budget goals set out by the bailout terms, and their accounting methods are questionable at best.

This has happened before in recent history.. Latin America in the 1980's to be precise. At that time, US Treasury Secretary Nicholas Brady came up with what were known as "Brady Bonds". These were bond options given to the creditors of these Latin nations-- most often, these involved the creditor taking a straight up haircut on the debt while the other option involved extending the debt in order to lower the yearly payments. These Brady Bonds were guaranteed by a special issue of US 30 Year Zero Coupon Bonds. For the most part, this was a success.. most of the nations who took these did indeed pay them off, with the exception of Ecuador, who defaulted on their Bradys in 1999. The other Latin nations.. Mexico, Brazil, Colombia and Venezuela among them.. went on to get their fiscal houses in order.. Brazil especially. It can be done.

My guess is that by the Ides of May, we're going to see what the End Game is in Greece, and I'd wager that it will be some form of Brady Bond deal guaranteed by either the ECB, the EFSF, the IMF or a combination of these. But will this eventually succeed with Greece this time ? My concern here is fourfold: first is that in today's world, there are credit default swaps written on Greek debt.. and as soon as this plan is announced,  there will be a deluge of these hitting the books of the banks that wrote them. Also, much of Greece's debt is to itself in the form of pension funds and Greek banks (which also have credit default swaps written on them), and these will also take a nasty hit.. thus crippling the Greek economy further. Third, the Greek government will be forced to finally live within it's means as it will have no real access to credit for some time-- and this will mean deep cuts in Greek government spending on social and medical programs, another kneecap to Greece's economy. Fourth-- and most seriously-- if Greece were to get such treatment, you should expect Ireland and Portugal to line up pretty quickly shortly thereafter. The problem here is that Euro banks are unbelievably overleveraged and have written credit default swaps on Irish and Portuguese debt as well as Greek-- many banks {especially Irish, Portuguese and Greek banks) will not be able to survive these dual torpedoes, especially given that these economies will begin to seriously contract, forcing yet more businesses and mortgages to go belly up. In the case of Portugal's debt, much of it is owed to an already crippled Spanish banking system. As for Greece, they have a restless population prone to riots and a military establishment prone to throwing out incompetent civilian governments. Is there a chance it winds up as rosy as what happened in Latin America ? For the bankers, the answer is probably no. As for these nations ? Time will tell. One thing is certain-- for the people of these nations, lean times are a'comin.

Onto the next topic du'jour-- the United States's economic problems. Today the rating agency S&P downgraded the US to a negative outlook, though the US did keep it's AAA rating. It was a bold step-- and one which the Obama Administration was forewarned about last Friday. This weekend, Treasury Secretary Tim Geithner went on a media publicity blitz, reassuring anyone who would listen that things are just fine. When somebody important stands up and tells you that "all is well !!" you know it's time to panic. Panic time has not yet arrived.. but day by day the Day of Reckoning draws ever nearer. My last post details the dual deadlines facing the US this summer-- raising the debt ceiling and the end of QE2. My guess-- a deal gets done to raise the debt ceiling, but QE2 does indeed end-- for a while anyways.

The downgrade was not too shocking or upsetting to me.. it was long overdue as a matter of fact. But an article I read today on ZeroHedge did rattle me.. more accurately, a chart. Here is a chart of the US Money Supply published last week: {above}

This is the total supply of money in the US. This year, it has rocketed upwards.. action not seen since shortly after the Lehman disaster. Indeed in 2010, the overall money supply had more or less stabilized. In my last article, I posted an opinion from Lee Adler, who wondered aloud what exactly is spooking the banks into hoarding this much cash into their vaults. While the obvious answer is thatQE2 is whats causing this, we must remember that this chart does not include the QE2 money, which has put another $400 billion into the system.. in other words, the US has printed about $900 billion so far this year. Most commonly banks hoard money like this in order to be able to absorb some big losses they see coming down the pike.. this is what happened in the 2008 spike, and Adler believes it might be the case again. But I'd like to offer another opinion-- they're hoarding it so as to be able to purchase US Bonds when the Fed halts QE2 in June. Whatever the answer is, it appears the banks are aware something big is about to change.

Sunday, April 10, 2011

Bill Gross and The Road to Athens (Ruin)

Bill Gross is the co-CEO (along with Dr. Mohamed El-Arian) of Pacific Investment Management Co (or PIMCO for short). PIMCO oversees over $1.1 trillion in people's money. It runs the world's largest Mutual Fund, called the Total Return Fund. On Wall Street, when Bill speaks, people listen-- even more so when he acts decisively.. which he has just done over the last few months. Here's a chart of what the PIMCO has done with their investments over the last 3 years:

What's happening here is that Herr Gross is abandoning US Treasuries and going into cash-- in a very big way, more than he's done in years. Why ? In selling off his treasuries (and mortgage paper) he seems to be telling us that he believes the interest rates on US Treasuries will be going up and that the USD will be strengthening. Why would these two things happen at the same time, especially given that inflation seems to be raging at a dandy clip of late-- including tonite, with gold hitting (another) all time high with Crude, Silver and Corn all taking off to the moon ? He's telling us that there will be no more QE after June when QE2 ends. Given the extent of his positions in both cash and treasuries, it's apparent that Gross believes there will be a significant hike in the interest rates the US Gov't needs to pay to borrow money and that come June, the US Dollar will snap back, perhaps quite strongly. So what does this mean for the average working serf in America ? A strengthening dollar will mean that prices of goods such as gas and bread will come back down to earth-- good news for most of us working serfs. But here's the bad news: credit will be much harder to come by, helping to choke off any recovery. The US Gov't will begin to pay a higher and higher interest rate to borrow money. I look for the US Ten Year to approach 4.5% this summer. When this happens, the US Gov't has to pay more and more interest-- and thus will have to borrow even more to cover it's expenses as well as the added interest. More bad news: this will likely signal a pull back in the US stock markets-- but not a crash. In ending QE2 (and the repurchase of US bonds) Ben Bernanke is essentially saying to Obama "We've printed a couple trillion dollars to help you guys get over the hump. But now it's time for you to stop borrowing so much and get your house in order".  With all due respect, the US Gov't will never willingly do this. If Gross is right (and he almost always is) the US Gov't is about to be cut off from printing endless amounts of dollars to fund itself and we will be forced to make very serious cuts in spending, raise taxes (or a combination thereof) or our government will begin down the Road to Athens as interest rates on UST's go up and up. Here's the opinion of Lee Adler, a veteral Wall Street analyst who runs a rather expensive advisory letter to investors: “The evidence shows that banks are again out of the Treasury buying game. It also shows that they lost money in the first quarter, which is insane considering that their cost of funds is zero. It’s an indication of just how dire the circumstances are. Banks continue to accumulate cash at a frantic rate in their accounts at the Fed. The last time reserves rose this fast was in the midst of the crisis in 2008.
“Although the banks did buy some Treasuries in mid March, they have again stopped buying and reduced their holdings, opting to hold cash at the Fed instead. The banks are pulling cash out of the system and depositing it in their reserve accounts even faster than the Fed is printing it, lately 60% faster. We have to wonder what has them so spooked.
“At the same time, FCBs [foreign central banks] purchases of Treasuries are also backsliding, and are well below the threshold where they need to be to keep the markets stable. These elements essentially neutralize the Fed’s pumping. It may not be enough to send the
markets lower, and in the absence of new Treasury supply, Fed buying should be enough to keep the field tilted in favor of higher prices. April’s bias should be to the upside, but the background drag will be there. Things will get tougher in May when Treasury supply increases, and really tough this summer when the Fed presumably will stop pumping.” 

Sunday, April 3, 2011

Monetization Nation

First off, sorry for the delay in postings-- I'm having electric problems in the house.. specifically the room where I have my wireless router. A week and an expensive (and long) extension cord later and-- I'm back !!

For the most part, thanks to Bens printing press and the US Government spending three dollars for every two it takes in taxes, the economy has begun to see signs of life. The U6 unemployment rate has dropped below 16% for the first time in a long time. While there will undoubtedly be a revision in the numbers, the trend is down-- at least in the short term. But even now there are ominous signs-- real wages for Americans continue to decline, as do home prices. If QE2 ends in June as I expect, job creation will come to a halt shortly thereafter as the Fed's rocket fuel is withdrawn. 

Speaking of these things.. Ben's printing presses and US Government deficits.. lets get down to some figures here. Since the start of QE2 last November, the US Government has issued $890 billion in bonds. Of these, $291 billion was for debt maturity paydowns of bonds that matured. This leaves us a net of $589 billion in new issuance since November. Since it's illegal for the Fed to outrightly go to the auction and purchase debt itself, what it does is it goes into the secondary markets behind the auctions and does it's purchasing. Since November, the Fed has used these secondary markets to purchase bonds using a tool that's commonly called POMO (permanent open market operations). Since November, the Fed has used POMO to purchase $491 billion in bonds, with much of these bonds being the ones recently auctioned off. In short, the Fed is (re)purchasing approximately 83% of all bonds issued by the US Government. What this says is that the usual purchasers of US Debt-- domestic investment funds and foreign investment funds, have come up with approximately 17% of the needs to fund the US Gov't, with Ben's printing presses doing the rest. Simply put, we're printing "funny money" to fund the US Government's operations. 

QE2 is due to end in June, and I believe it will end-- but only for a time. For the US Government to legitimately fund the 83% of debt needs that the Fed is currently doing, the interest rates offered will absolutely have to go up if they have even the faintest hope of remaining solvent. I look for the 30 year US Bond to go north of 5% and the 10 year to reach 4%. Still pretty good in actuality. But this money will have to come from somewhere, and there is a chance that some of it will come from the stock markets (I look for the NYSE to go back towards 10K). If there is a crisis abroad, foreigners will also pile into US Bonds. Inflation has begun to roar over the last six months-- food prices were one of the primary reasons (along with despotism, hopelessness and disenfranchisement) that started the current crisis in the Middle East. Prices will continue to rise here in the US as well; take a look at the price of a loaf of bread these days as well as the price of gas, which I think will near $4.00/gal this year. Diesel is already there. If we continued down this same path, gas would reach $5.00/gal sometime next year. For a sitting President hoping to be reelected, this is not an option. 

But lets ask ourselves this-- how long can any government spend three dollars for every two it takes in and then print the difference ? The US is caught in a numbers vice grip-- print and suffer inflation, or somehow (between a combination of spending cuts and higher interest rates to attract legitimate buyers) fund ourselves legitimately. My guess-- when the US Ten Year Bond approaches 4.5%, Bernanke will crank up the presses again. If there is a crisis abroad, it might actually be some time before this comes to pass. But if the markets and world economy continue to expand and recover, we'll see it before 2011 passes us by. 

A large part of the problem resides in Congress-- Republicans absolutely refuse to go along with any tax hikes, and Democrats absolutely refuse to allow any cuts to social programs. The path of least resistance you ask ? Borrow like there's no tomorrow. Some of this lies with us, the voter as well-- if given the choice between a candidate who says "Listen folks-- we're flat broke and we're going to have to pull the troops out of Afghanistan, cut Medicare and raise taxes" or Candidate B who says "This is a tough time, but none of these drastic measures are needed-- there are better options" the electorate will vote overwhelmingly for Candidate B every time. We as a people refuse to willingly face the Day of Reckoning. But make no mistake-- it's coming. Ireland was a very low tax, high growth nation throughout most of the 2000's-- and today they've been scuttled out back to the IMF's outhouse and have an unemployment rate north of 15% thanks in large part of their banks loaning too much to too many (sound familiar ?). The only difference between the US and Ireland is time.