1994 Redux? But Not In Bonds

In UBS' view, 1994 is critical for guiding investing today. The key point about 1994 was not that US bond yields rose during a global recovery. But that the leverage and positioning built up in previous years, on the assumption that yields would remain low, then got stressed. The central issue, they note, is that a long period of lacklustre growth, low rates and easy money induces individual investors, funds, non-financial corporates and banks to reach for yield. In many cases, they gear up to do it. And as Hyman Minsky warned; in this way, stability breeds leverage, and leverage breeds instability.



Via UBS: 1994 Redux?


Sebastian Mallaby has written an excellent account of the 1994 bond market blowout in ‘Hurricane Greenspan’, chapter eight of his book ‘More money than God’ (Bloomsbury press, 2010). In his depiction of the legendary hedge fund trader Michael Steinhardt – he describes how hedge funds, and a range of other financial institutions, chased convergence trades from 1990-1993.

They played term carry (borrowing short term to buy long dated bonds within the US). They ran cross regional carry trades (borrowing in Germany or the US to buy Italian & Spanish bonds as these countries prepared for EU membership).

And they rushed to buy assets that were priced off convergence trades; emerging market property, peripheral banks. They even bought defensive growth stocks (with the idea that the PE on a defensive growth stock should converge to the inverse of the 10 year yield).

We argue below that the set-up today is very similar to that in early 1994.

The danger in these trades is that a cyclical recovery, especially a global cyclical recovery, will cause yields to rise and compel policy makers to withraw accommodation. And that this can induce an outsized reaction in all the convergence trades ultimately priced off treasuries, as leverage is removed.

This is why the central lesson from 1994 is that, after a long period of easy money, when a cyclical recovery kicks in and policymakers are setting to remove accommodation, at all costs avoid convergence trades and avoid assets that are priced off convergence trades.

And the popular convergence trades of the past months have been;

  • Emerging market credit
  • Emerging market property
  • Southern European sovereign debt
  • Peripheral European sovereign debt
  • US mortgage backed securities
  • US and global high yield debt
  • Global defensive growth stocks.

So what brings us to think that we can use 1994 as a guide to investing for the rest of 2013?

In the section below we highlight several key developments from 1990-1995 and the comparison with the current situation;

1990-Feb 1994

The Fed ran a very easy monetary policy from 1990-early ’94 in an attempt to reflate the US economy in aftermath of the S&L crisis. We have seen lower rates & even easier monetary policy since 2009.

US growth remained lacklustre throughout 1990-1993, going through a series of moderate ‘mini-cycles’. We have seen even more lacklustre growth over the past four years.

US 10-year treasury yields fell from 9% to 5% from 1990-early 1994, as a recession and then disinflationary pressure pushed down inflation expectations. Treasury yields fell from 4.3% in 2007 to 1.4% in the summer of 2012.

US banks hoarded treasuries.

Lending remained lacklustre.

Corporates hoarded cash & paid back debt.

From 1990-1994 Capital flowed into emerging markets. Asia boomed. The former USSR saw large inflows also. Capital flowed heavily into emerging markets from 2009-11, although it then slowed in 2H11 & 2012 as the Fed ended QE2.

Credit spreads tightened from 90-94, and from 09-13.

Commodities remained in the doldrums from 1990-1994. This was unusual, given the strong capital flows into emerging markets. But the implosion of the military/industrial complex in Russia from 1989 saw domestic demand for commodities collapse. Russia then exported nickel, aluminium, palladium, platinum, copper and oil to get hold of hard currency. Commodity prices came under intense pressure. This contrast is with the 2009-13 period – where capital flows & restocking drove commodity prices higher from 2009-11, but where capital outflows, destocking and new supply drove prices lower in 2011/12.

Headline CPI trended down, persuading many that there was no cause for rate hikes. We have seen a similar trend from mid-2001.

The dollar trade weighted index range traded between 80 & 95 from 1990-1995. An interesting development was that the dollar weakened while the US economy recovered through 1994, and while the Fed raised rates 225bps. The DXY has been range trading in a similar manner, broadly between 75 and 90 since 2009.

The extended period of low rates and strong capital flows into emerging markets induced a huge build-up of leverage across financial & non-financial institutions on a global basis.

The strong flows of capital into emerging markets set off the procyclical growth dynamic we have described regularly.

Capital inflows induce central banks to print their own currency to buy the dollars coming in. Bank deposits rise, and banks lend to construction and engineering companies. Growth & inflation pick up. And with nominal rates sticky, real rates fall. That in turn incentivises procyclical gearing up to buy & build houses, inventory and general fixed capital formation.

The Asian tigers grew aggressively, and their stock markets boomed going into 1993. Emerging markets recovered in 2009/10, struggled into 2011/12 and then saw a patchy recovery until recently.

The problem with the reflationary process in emerging markets is that it sows the seeds for its own destruction. Because the low real rates in EM induce excessive gearing & fixed capital formation – compared to a more balanced allocation of capital, had real rates stayed steady above zero. This leaves misallocated capital, and the latent potential for bad loans to emerge when credit becomes scarce. It also causes a deterioration in the trade balance. Both make emerging markets increasingly dependent on capital flows to stay afloat.

In many cases, emerging market governments will react to rising inflation by attempting to restrict credit growth (rather than raising rates). The problem with this is that it incentivises US dollar borrowing.

Emerging market business finds it attractive to borrow in dollars when domestic inflation is rising, the domestic currency is appreciating, and domestic borrowing costs are higher than dollar funding. And it is even more attractive when the activity the loans are funding – from inventory building to FCF – sees price/cost rises.

But when the trends reverse – the domestic currency depreciates, the dollar funding becomes more dear, the inventory values fall – then emerging market corporates can find themselves squeezed. Very rapidly.

But it is not just EM. In the long history of financial crises, the ‘reach for yield’ during a slow growth and low yield environment has on multiple occasions set up the conditions for financial stress when yields eventually rose.

The book ‘More money than God’ by Sebastian Mallaby (Bloomsbury, 2010), gives an excellent description of the leverage and yield enhancing structures that built up in the 1990-1993 period, and the carnage inflicted upon that leverage in 1994. Some examples include:

  • Bank & hedge fund carry trades – borrowing at the short end to purchase long dated bonds.
  • Borrowing in USD and German marks to buy Italian and Greek long term debt
  • Borrowing to buy high yield corporate debt.
  • he use of interest rate swaps to generate yield enhancement.
  • Leverage purchases of buy-to-let properties

We have also seen a significant build up in leverage over the past four years. Buy-to-let investment has risen strongly in the US/UK/Switzerland/Scandinavia. Retail investors have become heavily exposed to credit through mutual funds and credit ETFs.

Investors became very overweight long duration defensive growth and dividend yielding equities, at the expense of cyclical exposure.

Investors have left themselves highly exposed to any kind of cyclical rally outside the US, as well as within it. Valuations (as we noted here) are extremely varied.


As macro activity in the US accelerated, corporates stopped hoarding cash and started to seek to borrow to expand their businesses.

US banks, which had been hoarding treasuries, sold them to make way for increased corporate loans. Treasuries started to sell off.

The Fed then responded to the steepening curve and the improving macro conditions by raising rates by 25bps in February 1994. This came as a surprise to the market, which was not aware of the Fed’s internal deliberations. The transcript of the February meeting indicates that Fed members were wary of a 1988/89 style spike in inflation if they did not start the process of tightening.

Greenspan believed that the curve would flatten, as markets anticipated tighter policy moderated inflation expectations in the future.

But that’s not what happened.

The rise in rates instead dented the derivative trades predicated on no rise in yields, and it squeezed carry traders. That induced a more aggressive unwinding of treasury holdings, as leveraged carry trades unwound. And the Banks accelerated the sell off as they sold treasuries to make space for increased corporate lending. So the yield curve steepened over the year, with 10-year yields rising 306bps vs the 225bp rise in Fed funds.

An array of casualties ensued, from Orange county, California, that went bankrupt due to its exposure to a series of exotic interest rate swaps. To a number of prominent hedge funds – which saw extreme losses in February 1994.

Then there was the international fallout. The sharp increase in domestic demand for credit, combined with the increase in real rates induced powerful capital flows back to the US. This sucked liquidity out of several emerging markets, whose central banks had to retire domestic currency to repay the dollars exiting their countries. Soon, countries that had seen the most aggressive investment booms, which had done the most aggressive US dollar borrowing, and which suffered the largest current account deficits, came under intense duress. The Mexican peso crisis erupted, and the seeds were sown for a sustained deterioration in Asia, before the full collapse of the Asian crisis in 1997.

One of the conundrums of 1994 was the US dollar. It would be logical to think that, with a sharp rise in US growth, in rates & yields that the US dollar would have rallied. But it didn’t. It fell.

An important reason was that the US recovery, while stronger than expected, was not a big surprise. But what was a surprise was the European recovery – after the sustained post-unification funk in Germany, and the Scandinavian banking crisis in 1992. In our view in commodity strategy – it was the relative surprises – which made Europe’s recovery much more unexpected, that triggered the currency move.

This is particularly interesting today – with the broad consensus that the US dollar is going to rally, due to the more robust recovery in the US and the potential for tapering.

But it is always worth keeping an eye on relative macro surprises.

We see the potential for a counter trend fall in the US dollar.

Now there are clearly some stark differences between today and 1994. Back then interest rates were much higher. So 300bps on treasuries increased rates by three fifths. The same rise from the July low would treble rates. And certainly, the authorities are first talking about an extended period of QE tapering. We are still a distance away from actual rate hikes.

The Fed is also much more transparent than it was under Greenspan in the early 1990s.

Where conditions are similar is that a very large structure of leverage has built up on the back of low rates, from leveraged property & credit buying, large retail exposure to yield enhancement products (high yield ETFs etc), earlier dollar leverage driven investment booms in emerging markets.

So where are we now. It looks to us very similar to February 1994.

The Fed’s continued insistence on talking tapering despite the recent rollover in US macro surprises has started to unsettle leveraged yield enhanced positioning.

The US high yield ETF has come under severe pressure. The US mortgage spread has blown out relative to the US 30-year treasury yield. South African and Indian currencies are under pressure. India has responded by raising taxes on gold imports.

In 1994, Mexico was the first to feel the brunt. Followed by South Korea in 1997. In 2013, South Africa is feeling the pressure. Although other emerging markets, notably China, continue to benefit.

The next big question is; can the US withstand a higher cost of capital, like it did from 1994-98.

In short, no!

In the mid-late ‘90s, the US coped with a higher cost of capital in several ways. It enhanced productivity through a rapid adoption of tech. Corporates geared up, which ensured strong liquidity growth and ‘efficient’ balance sheets. Corporates went through a second round of ‘just in time’ inventory management and outsourcing. Consumers benefited from the strong dollar and falling commodity prices – seeing their disposable incomes improve. And the disinflation in EM translated to a downtrend in yields from 1994, which allowed for an acceleration in the housing market and an expansion of household debt.

But we have a number of concerns that hint at vulnerability.

The first is that the potential for sustained disinflation over multiple years is less, because yields are already low. Consequently, there is less scope for a sustained recovery in housing – beyond the initial flurry of demand from rising household formation. The sharp rise in mortgage spreads is one hint that this transition may be more difficult. The spread on mortgages may be particularly important for the leveraged buy-to-let investors, who have been heavily involved in the recent surge in housing sales.

Because we understand that a large part of the buying is from investors then seeking to rent out the properties, we suspect that the follow-through consumer demand may not be as aggressive as previously imagined. If a household buys a house, taking on debt, it opens the floodgates to increasing debt fuelled buying of cars, household furnishings and white goods. A very different psychology comes from paying a month up-front on a rental. You are much more likely to cut back, to be more frugal.

Government debt levels are clearly extended, and the deficit needs to be cut to prevent further deterioration

A more subtle point is that the extended expansion of government spending as a share of GDP in response to the financial crisis is crowding out the private sector, and reducing the productive potential of the US economy. This stands in stark contrast with the tight control of government debt in the early 1990s under the Clinton administration.

These suggest that it is much less likely that we see the US enter a ‘high plateau’ of growth as we saw from 1995-98, where the US saw a powerful productivity & credit fuelled boom while the emerging markets deflated. And it makes it more likely that the US stays on a lower trajectory, interspersed with periodic recessionary slowdowns in the years ahead.

The point at which the market realises this would likely herald a significant risk-off event.

Where Do We Stand: Wall Street’s View

In almost every asset class, volatility has made a phoenix-like return in the last few days/weeks and while equity markets tumbled Friday into month-end, the bigger context is still up, up, and away (and down and down for bonds). From disinflationary signals to emerging market outflows and from fixed income market developments to margin, leverage, and valuations, here is the 'you are here' map for the month ahead.


Via Russ Certo of Brean Capital,

Treasury yields surged to their highest level in more than a year last week with the 10yr note yield touching 2.22 bps mid-week vs. 1.60 yield as recent as May Day.  The 30 year mortgage rate rose above 4%.  Paul Volcker said benefits of buying bonds are "limited and diminishing" and that central banks are often late in removing stimulus. 

The S&P 500 ended the week off 1.14% as volatility returned across financial landscape, led by Nikkei which fell 5.73% on the week and over 12% in two week period.  It was also revealed that Euro-zone unemployment rose in April, to a new high of 12.2%, or 19.3 million people.  In this demographic the young are nearly three times as likely as older people to be out of work. 

The S&P 500 snagged its best month since January and stretched its string of consecutive monthly gains to seven, the longest since 2009. The Dow has risen in 17 of the last 20 months and is up 14.3% in 2013, scoring its best five month start to a year since 1997. 

As the week started, price action reflected investor enthusiasm regarding housing recovery as Case/Shiller housing price index showed prices spiked 10.9% in March from year ago period and ALL 20 metro areas measured posted gains for the third month in a row.  Although as we know, the week didn't end with such enthusiasm as the Dow slid 208 points on Friday

As Barron's notes this weekend, the climb in housing prices over the past year has added more than $1 trillion to the market value of single family homes, causing a "wealth affect."  Consequently, consumer spending rose at the second fastest rate since Great Recession. Moreover, residential investment has grown over each of the past eight quarters. 

But the devil is in the details, government guarantees of home mortgages are at 91.6%.  VA and FHA have insured 46.4% of all mortgages, a huge increase from around 10% in 2007.  Most of the loans in this program have zero to 5% money down.  If mortgage rates were to rise to 6%, like 2006, from recent lows of 3.5%, monthly payments on a 30 year fixed mortgage would rise by a third, meaning the same -priced home would cost about one third more.  http://www.nytimes.com/2013/06/01/business/global/in-japan-a-hard-to-bud...

Regarding rates and in a relative sense, the bond selloff this month represented a 2% price drop in iShares Core Total U.S. Bond Market ETF (AGG).  In other words, a year's worth of income was lost in a month.  We have made the distinction recently that this bears watching for technical reasons. 

The evolution of financial market structure and product engineering lends itself to the notion that fixed income products designed in the fund and ETF arena possess equity like NAV characteristics and as retail investors measure performance, negative as noted above, actual loss of principal on mark to market basis may be less than understood and digestible in the retail investment arena.

With month, quarter, and year to date negative total rate of return performance for broad swath of fixed ETF and fund asset class, performance, liquidations, and redemptions may drive sales of physical securities and BWIC in the actual capital marketplace.  I noted anecdotally last week, bonds ultimately mature, hopeful at par but funds don't with an odd perpetual risk profile for investors.   

For example, the iShares Barclays 20+ year Treasury ETF (TLT) lost 7.7% in May and iShares FTSE NAREIT Mortgage Plus Index ETF, (REM) which tracks REITS cratered 11.8% in May.   Trading in the mortgage market was unruly last week marked with gaps in price action and vacuum of liquidity, resulting in the cheapest valuations on mortgage/Treasury basis in years. 

Sell in May and go away should have referred to bonds not stocks and this particular strategy was off to a rough monthly start prior to Friday.  S&P up 2.1% in May versus 6.3% decline in the month last year as most recently issued and auctioned in May refunding 30 year bond is down 9% in price similar to other fixed market declines above. 

Even worse or riskier from market profile is that leveraged bond funds that allow investors to amplify low yields and augment income now make up about 20% of all assets in intermediate and long term bond ETFs launched post crises.  Nearly 50 of these financially engineered funds have taken in $10 billion recently and now represent a formidable market of about $52 billion in the entire category. 

Quick responsible note: guessing large percentage of this genre is retail based and decidedly less of institutional representation which could also adversely impact understanding and stickiness of assets or commitment to the sector, flighty.  Even worse than that and magnifying the prospective imbalances in markets is the advent of a newer brand, low volatility ETFs, which have proliferated and grown even faster, by 1,000% this year.  http://online.barrons.com/article/SB500014240527487048953045785033621346...

In fact, in a surprisingly short period as many players lulled by months/years of low volatility were looking to Memorial Day summer kick off have  been met with some of the most interesting price action in years, just as the "lack of volatility" fund products and expressions have become one of the fastest growing asset classes.  The above shellacking wasn't just limited to risk free rate core sovereign markets, it was also manifested in other high yielding interest rate sensitive proxies like utilities, energy master limited partnerships, dividend payers in equity space, and even commodities, bit coins, and emerging market space.   Maybe, that's what Barron's was asking this weekend, "Is the Low-Beta Bubble Deflating"?  http://online.barrons.com/article/SB500014240527487048953045785034731891...

It's not clear whether investors should appreciate value of declining prices in fixed income, consider further declines or contemplate exposures or imbalances more in the equity space as margin debt in the U.S., money borrowed against securities in brokerage accounts, as measured this week, has risen to its HIGHEST level ever. The $384 billion surpassed the previous peak set in July 2007. 

Side-note:  relative to the size of the economy, 2.25% of GDP, margin debt is far from record but has climbed to these levels relative to economy only twice in half century.   In each previous case the increase came during bull markets (technology bubble and housing boom) that ended with rapid falls in share prices. 

In each case there were double digit increases in share prices during the year before margin debt got to that level.  In both instances, the stock market decline began WHILE margin debt was at a high level, and accelerated as debt levels fell, presumably because investors were liquidating securities that were losing money.  Kind of an anecdote and aside, the FAMED Hindenburg indicator gave off a positive signal last week, suggesting imminent decline in equity prices.

Rising margin debt generally viewed as an increase in speculative fervor used to be controlled by the Federal Reserve.  But the last time the Fed adjusted margin rules was in 1974, when it reduced the down payment required for stocks to 50% from 65%.  That came during a severe bear market.  It is reasonable to consider that the Fed utilizes a suite of other tools to manage perception of speculative excesses.  This is a debate that continues to be active in the critical community.  http://www.nytimes.com/2013/06/01/business/economy/shades-of-prerecessio...
Record margin and what it represents for markets should also be considered in the context of record cash and futures volumes in the U.S. Treasury market in the latest week.  Record futures volumes have been  noted to be reflected or partially distorted in large calendar rolls but by a variety of measures the animal spirits in these markets seem to have awoken from a long hibernation. 

These risk expressions are also coincident with the volatile performance of high beta asset classes around the world.  Generally the recipient of capital formation seeking growth opportunity, emerging markets were reflective of this global retreat of risk as investors pulled back meaningfully from the developing world.  In fact, generally benign optics of U.S. equity bourses has NOT reflected far more risk reduction around the rest of the emerging world. 

The Brazilian real hit four year lows against the USD this week. This is despite the fact that the Brazilian Central Bank on Friday FAILED to stop the weakening with a foreign exchange swap whereby the bank swapped $877 million reals.  In addition, the Turkish lira traded to a 17 month low to the USD on Friday even after the Central Bank governor, Basci, jawboned the bank may take additional steps to defend the lira.  Investors pulled 2.89 billion out of emerging-market equity funds on the week. 

Flows appear to be reversing in far stretching markets South Africa, Thailand, Indonesia and even Mexico.    Mexico, one of the U.S. largest trading partners and mutually beneficial symbiotic geographical relationship, cut its 2013 growth forecast earlier this month to 3.1% from 3.5%, contributing to a more than 6% fall in the peso in May.  

Bonds denominated in these rapidly depreciating currencies are vulnerable or reflect newfound value pending on your disposition.  For instance, yields on peso denominated 10 year government bonds rose to 5.36% on Friday, versus an all-time low of AT THE START OF THE MONTH of 4.5%. http://online.wsj.com/article/SB1000142412788732441260457851665379431557...

Are markets sensing a removal of accommodation by the Fed and other central banks, not so, in above markets?  Or global final demand decline?  As a prospective harbinger of demand for global products and services, LOW Chinese demand contributed to a decline of 7.2% in Cotton prices in May.  With its warehouses brimming with Cotton, due to excess capacity and slack demand, estimates are for imports to be 35% LOWER next season.  China possesses 63% of the world's cotton stocks and one should take note when there is slack.  The U.S. incidentally exports 75% of its cotton overseas.  This is a residual China slowdown story even though the Barron's piece this weekend speaks of micro-specifics. http://online.barrons.com/article/SB500014240527487048953045785034922569...

In fact, commodity softs loosely represent "stuff in the ground" and to some extent like all commodities reflect the nuances of final industrial and/or consumer demand.  Cotton is a soft and the softs at large have been getting OBLITERATED.  Look at coffee in the world of $4 lattes.  Sugar...  This particular group was and has been sending off warning signals BEFORE the varied and myriad widespread distinguished selloff expressions reared their ugly risk expression heads in global retreat.    Please ask for the chart that was compiled for me by our friends at Business Insider which called attention to this anomaly WHILE most global risk expressions like credit spreads and equity bourses were charging to new all-time high valuations.  This "soft" asset class is really making a statement, even last week with broad impressive further declines.

Of course, China is the manufacturer of last resort of all sorts of demand side products and commodity usage to the rest of the world and Euro-Zone jobless rate, as aforementioned, hit a record of 12.2% last week.  This is the highest rate for the Euro-zone since records began in 1995 and may reflect why Chines manufacturing warehouses are loaded with excess capacity, like cotton.  http://online.wsj.com/article/SB1000142412788732441260457851677098794816...

Asian buyers shun U.S. Wheat:  Demand, liquidity, monetary tidings, and trade.  http://online.wsj.com/article/SB1000142412788732468220457851698061154892....

Thomas Donlan in Barron's editorial frames that "a brief victory in a currency war is likely to produce a long defeat" as applied to Japan. 20 years of zero rates and rising national debt of 225% of GDP, 10 year $2.4 trillion infrastructure projects and with borrowing costs of less than 1% IS consuming a QUARTER of all NATIONAL tax revenues.  He crystallizes the obvious, a currency war for trade.  http://online.barrons.com/article/SB500014240527487045093045785153824443...

Japan:  Vending machines in Japan have become a stubborn barometer of the country's struggle against deflation.  Many vending machines in Japan sell soft drinks for prices lower than they were in the 1980s.  http://www.nytimes.com/2013/06/01/business/global/in-japan-a-hard-to-bud...

Ironically, Chinese yuan achieved a record level against the USD last week and was signified by $7.1 billion acquisition interest in Smithfield Foods, hogs to feed the people.  Bringing home the bacon: http://online.barrons.com/article/SB500014240527487048953045785034722419...

Marc Faber is not left out of the discussion as Barron's featured a weekend interview.  His perspective of the broad consequence of world finance characterized by years of money printing are well known.  He details that stocks, bonds, art, wine, jewelry, and luxury real estate are all the beneficiaries of monetary tidings.  Hampton's property prices rose 35%, condos in Manhattan selling for over $100 million, record art sales, and 60 gains in the Nikkei. But central bank policy not reaching the worker in Detroit.   He claims China's "huge credit bubble" as not going to end well.   Provocative article titled, "Bubble, Bubble, Money and Trouble."  http://online.barrons.com/article/SB500014240527487045093045785115611945...

Which brings us back full circle to the Fed and global central bank policy.  On Friday, a key gauge of inflation fell in April to the LOWEST LEVEL ON RECORD, a drop that could take pressure OFF the Fed to wind down its asset purchases.  Core prices in the deflator rose 1.1% from a year earlier.  For the 17 countries that share the Euro, consumer price inflation in May was 1.4%.  In Japan, core consumer prices fell .4% in April.  http://online.wsj.com/article/SB1000142412788732468220457851744394663002...

This Friday consensus estimates for May nonfarm payrolls is a gain of 175,000 with jobless rate constant at 7.5%.  Some suggest less is more and more is less from a central bank policy prerogative point of view.  Weaker number, more stimuli in form of reduced tapering of Fed purchases, steroid juice to ailing markets.  Strong number,  reduced asset purchases, removal of liquidity and animal spirits.

No Mo‘ POMO?

Authored by James Howard Kunstler via The Burning Platform blog,

Whenever the Federal Reserve wants to tweak the dials of the economy - or pretend that it can - it turns first to its sock puppet at The Wall Street Journal, John Hilsenrath, and “leaks” a rumor of policy change. They like to do this late on Fridays when financial markets are about to close, so that market players will have a whole weekend to ponder the Fed’s actions like medieval viziers reading goat entrails.
Last Friday’s puddle of steaming guts was a supposed preview of the Fed’s “exit strategy” from its reckless policy of “quantitative easing” or “money” creation (or “liquidity,” if you like). In other words, they supposedly intend to stop juicing the financial markets with fake wealth, i.e. capital not accumulated from real productive activity, but just fictively created on computer hard drives. For the past year they have been doing this to the tune of $85 billion a month, “buying” US Treasury bonds and bills and an assortment of miscellaneous securities (mostly trash that can’t be pawned off on anyone else) through their so-called “primary dealer” bank cohorts, the too-big-to-fail usual suspects, who “earn” hefty transaction fees in the process of conveying all these pixels from Point A to Point B. These interventions are called Permanent Open Market Operations, or PoMo.
The theory all along has been that this $85 a month would seep down to Main Street to provoke spending (increasing the “velocity of money) and therefore “jump start” the economy. The theory has proven itself to be complete horseshit, of course. All it has done is suppress interest rates on bonds, depriving old people of income off their savings by so doing. It also artificially jacked up reckless lending on loans for houses, cars, and college degrees, juiced the share price of stocks, and boosted food prices. Meanwhile, an increasingly former middle class languishes in a purgatory of foreclosure, penury, and desperation. The Fed can’t really do anything to help them. It can only burden them with more easy-credit debt, especially their college-age children. But ours is a financialized economy and finance is too abstruse for most ordinary people to understand, so they just muddle along in a fog of dashed hopes and repossession.
Lately, though, the financial markets at the heart of the financialized economy - that is, an economy based on buying and selling increasingly dubious “paper” assets rather than on capital formation through producing things of value - are sending distress signals. The aforesaid efforts at economic dial-tweaking have only produced distortions and perversions in the basic functioning of the markets they’re designed to tweak. They pervert the “price discovery” mechanism by dumping “free money” into equity markets. They distort “risk premiums” by steering money out of savings, where it earns less than nothing, into riskier investments subject to the vagaries of everything from weather (commodity markets) to control fraud (bank stocks) to geopolitics (Toyota stock). They debauch market expectations in general by implying permanent artificial life-support. They promote market gaming such as front-running equity prices via high frequency trading on computers, naked shorting (pretending to borrow shares that, in fact, do not exist) and the abuse of futures markets — lately illustrated in the ongoing smash of paper gold and silver contracts, with the side effect of driving yet more money into stock markets. Finally, they undermine the meaning and value of money itself, which is the most dangerous game of all because when people lose confidence in their national currency, nations dissolve in political chaos.
Despite the aura of control, Fed officials (and casual observers) may sense things spinning out of control. Of course, hyper-fragility is exactly the effect that all the Fed’s own actions would predictably lead to. When you divorce truth from reality, strange things are bound to happen. The Fed ventriloquists who speak through Hilsenrath at The Wall Street Journal suggest they would accomplish their exit from the current $85billion-a-month QE policy in a set of “halting steps” by irregularly dialing down QE issuance month-by-month to fine-tune the results on-the-fly, as markets may require. This is also complete horseshit because they could only accomplish controlled tweakings by somehow signaling their intentions beforehand through some lackey like Hilsenrath. Otherwise, they could not pretend to control the results of their actions. They might as well just throw spaghetti at the wall to see if it sticks. Unfortunately, the “halting steps” idea would only provide even more opportunities for selective, complex front-running, shorting, and gaming — which is to say setting up more dangerous behavior with more uncertain and possibly destructive outcomes.
Anyway, there’s no evidence at this moment that anyone believes what was leaked to Hilsenrath. It could easily be more smoke and mirrors aimed at concealing the fact that the Federal Reserve has no idea what it has been doing and fears the consequences. There is one thing that we know for sure in this strange period when bankers have tried to manage reality in the absence of truth: that advanced industrial-technological economies designed to run on $20-a-barrel oil can’t run on $100-a-barrel oil, and that is why the US economy was subject to financialization in the first place - to offset declining productive activity by an attempt to get something for nothing. Notice that this macro-trend coincided exactly with the rise of legalized gambling all over America. That is how the idea that you could get something for nothing got to be normal. The world is about to find out that you really can’t get something for nothing. It will be a harsh lesson.

Desperately Seeking $11.2 Trillion In Collateral, Or How „Modern Money“ Really Works

Over a year ago, we first explained what one of the key terminal problems affecting the modern financial system is: namely the increasing scarcity and disappearance of money-good assets ("safe" or otherwise) which due to the way "modern" finance is structured, where a set universe of assets forms what is known as "high-quality collateral" backstopping trillions of rehypothecated shadow liabilities all of which have negligible margin requirements (and thus provide virtually unlimited leverage) until times turn rough and there is a scramble for collateral, has become perhaps the most critical, and missing, lynchpin of financial stability.

Not surprisingly, recent attempts to replenish assets (read collateral) backing shadow money, most recently via attempted Basel III regulations, failed miserably as it became clear it would be impossible to procure the just $1-$2.5 trillion in collateral needed according to regulatory requirements.

The reason why this is a big problem is that as the Matt Zames-headed Treasury Borrowing Advisory Committee (TBAC) showed today as part of the appendix to the quarterly refunding presentation, total demand for "High Qualty Collateral" (HQC) would and could be as high as $11.2 trillion under stressed market conditions.

In short, there is a unprecedented "quality" collateral shortage (for more on what the definition of quality is, read on).

And since the topic of HQC scarcity only emerges when market conditions are stressed, one can ignore the TBAC's baseline case of normal conditions, which see a topline of collateral requirements of "only" $5.7 trillion. Needless to say that if not even the Basel III required asset/collateral creation of $1-$2 trillion was a failure, even the base case requirement would never be satisfied.

The bigger picture however is one of an ever-growing asset-liability mismatch, as happened during the Lehman collapse. Since there is a total excess of shadow money and other liabilities already created that may need up to $11.2 trillion in collateral at any one moment for full book netting (which incidentally is based on SFAS-140 accounting rules which are self-contradicting), the only hope for the financial system is to chug along for the next decade without major risks and tremors, and slowly create the much needed high quality collateral.Or such is the hope.

Furthermore, since the private sector still appears to be in a state of shock from the Great Financial Crisis, collateral creation is all but halted. In the purely physical sense this is further aggravated by the lack of private sector CapEx investment, whereby corporations refuse to spend in order to procure hard assets, which may then be transformed into HQE via assorted lending pathways ending up on bank balance sheets indirectly, and then be further absorbed by the financial system providing even more quality collateral.

Intuitively this should make sense: while private sector companies can create unlimited balance sheet liabilities courtesy of the ZIRP-enforced scramble for yield, which means any and all debt can be issued without limits, it is the use of funds that is critical, and it is here that companies have been failing desperately because as also explained previously, instead of investing the newly created cash in CapEx and PP&E due to the Fed's disastrous policies, management teams use the company as a toll, with the cash promptly dividended out or used for buybacks and other short-term shareholder benefiting transactions, not growing corporate assets in any way, and certainly not creating any secured liabilities, only unsecured. Sadly the liabilities thus created are of such low quality that they can not result in HQC replacement, and instead are merely a levered equity extraction out of the private sector which implies an even greater explicit private sector risk without offsetting asset creation (the matching accounting entry is a reduction in shareholder equity which does nothing for system collateral).

As a result of this unwillingness or inability of the private sector to create quality collateral, which could then become someone else's quality asset and so on up the fractional reserve repo chain, it is all up to the Fed.

The TBAC acknowledges as much when it says that all QE is, is a "transformation of non-cash HQC to cash HQC." Stated otherwise, in addition to all its other practical QE roles, such as monetizing the US debt, and enforcing the wealth effect as Primary Dealers repo out QE reserves and use the barely haircut cash to purchase risk assets (instead of engaging in loan creation), what QE is also doing, via reserve transformation through the monetization of Treasury debt and MBS a topic we have also explained previously, is to inject into the financial system, billion after billion and trillion after trillion, the "safe assets" that banks will need to fall back on if and when the risk flaring episode comes, and there is a scramble for quality assets.

An immediate implication is that should the private sector continue to hold back on collateral creation via such "Old Normal" conduits that feed the shadow money system, such as securitizations and repo expansion, it will be up to the Fed to inject up to the $11 trillion in additional HQC before the financial system is proclaimed safe. This means QE will continue for a loooooooong time.

Another implication is that finally, after years of confusion, someone gets it. Gets what? This:

"Effective money = shadow money + M2"

This is precisely the point we have been making for the past three years in all those posts focusing on the relative moves in the US shadow banking system, i.e., shadow money, and which virtually none of the current monetarists (and by extension Keynesians) seem able to grasp since all textbooks on monetary theory appear to be from the 1980s when shadow liabilities, repo and custodian assets simply did not exist. They do now, and certainly did in 2008 when they reached a record of $21 trillion (give or take, depending on one's definition of shadow money), double what M2 was.

Of course, our definition is more granular and is simply the sum of all credit money liabilities held by the traditional banking system, to which we add the money held in the shadow banking system - money that is literally created in a limbo where "confidence" is really the only collateral, and is why the Fed is, more than anything, terrified about what the next market collapse will do to the shadow banking system which unlike 2008, will almost certainly experience a terminal run on the liabilities as there is no effective collateral!

What all of the above means, is that when considering quality collateral, one has to consider the amount of all liabilities in existence - both conventional and shadow! And it is this shadow delta of $15 trillion that is always ignored and/or forgotten by everyone except those who know quite well that any reminder of the massive delta can lead to an instant deep freeze of confidence in the system.

Because what it means is that as the Treasury's own advisor has said, there is a $11.2 trillion undercapitalization gap in the consolidated financial system, a gap which can only be filled by the Fed over a period of years.... an assumption which means that the market has to not only be priced to perfection for years, but that the Fed will not lose control over not only the US market but that the MIT-BIS diaspora will keep the entire G-7 capital markets in check for the duration of this experiment. Of course, it won't be the first time the Fed and the capital markets have made the fatal assumption that a handful of academics with zero real world experience can contain several hundred trillion in unforeseen consequences.

So just what does the TBAC define by "high quality collateral"? Hint: there is no mention of the word gold anywhere so don't go getting any ideas. Of course, for the Treasury and its advisors, even the mere concept that a barbarous relic may have more "quality" than paper-created "assets" is preposterous. We can only imagine the intellectual bloodbath that would result if any of them were ever exposed to the Exter pyramid...

Anyway: here are is how the "very serious people" in the establishment see "HQC"...


Money-like assets, with little credit, duration and liquidity risk.

Anything Bernanke says is a high quality asset (until it isn't of course):


This one is really funny: "an asset not expected to depreciate" - like housing:


Anything that has low haircuts... Just because banks look at where other banks mark them, and a result in 2007 give a 5% haircut on a BBB+ rated CDO tranche just before it blows up with zero recovery.


To summarize:


Now we get to the important part: what is the total demand for high quality collateral? Based on back of a napkin calculations, somewhere between $2.6 and $11.2 trillion!


Demand comes from regulatory requirements such as Basel III (since mothballed, as it became quite clear not even the $1.0 trillion in minimum collateral needed could not be sequestered).


Another demand driver: standardized clearing of derivatives which will require a far higher Initial Margin as well as, knock on wood, the end of collateral rehypothecation. Incidentally the latter is precisely why central clearing as designed will never fly, as rehypothecating what passes for safe assets now is the primary source of incremental collateral 'creation':


Another demand source: bilateral margin requirements for non-central clearing transactions. The reason why up to $4.1 trillion in additional collateral is needed here is precisely why gross is never net, until it is, and one the weakest link in the bilateral chain of counterparties breaks, forcing immediate gross netting without offsets. A fact so simple, that only the smartest people in the room always tend to forget it.

Finally, the most intangible demand source of all: economic uncertainty, and "flight to quality" - or in other words, the fudge factor for the unpredictable. The $1 trillion estimate provided here is very arbitrary, and the real number may be less, but likely will be orders of magnitude greater as the real life example of the Exter pyramid collapse takes place in shadow space:


That takes care of the demand. Now, the far more thorny question: supply. And here is where the Fed comes into play.

Because the safest of safe collaterals in a fractional reserve banking system, in which money creation always falls back to the monetary authority, we have sovereign collateral creation. Yet where would sovereigns be without QE. As the TBAC itself says, in bold, black letters, "QE is a transformation of non-cash HQC to cash HQC" - said otherwise, without the Fed, which is indirectly facilitating the ramping of risk assets as we explained to Steve Liesman before, the Primary Dealers would be unable to buy stocks without the repo transformation of reserves which results in Dealers ending up with risky stocks instead. This is the closest to an admission of the above we have ever seen.


What happens next is the magic of rehypothecation. As the TBAC says, once issued, this sovereign "collateral", aka debt, or assets for the buyer, "35% of this amount is reused 2.5 times." This means that depending on the terms of the rehypo agreement: the haircut, the reuse velocity and other metrics, this could be the sole source of collateral if needed, especially when one adds the Fed in the equation.


One key aspect of central clearing houses and bilateral margin requirements would mean the end of the kind of rehypothecation that send MF Global into a liquidity tailspin. This means that up to $7.6 trillion in supply would be removed. Alternatively, and this is perhaps that biggest punchline: rehypothecation, which is nothing but the paper shuffling of a security from point A to point B to point C and back to point A again, provides up to $7.6 trillion in Schrodinger collateral: or securities which are there but aren't, and certainly not there if and when everybody demands delivery at the same time!

Remember rehypothecation does not mean the collateral is there. It is merely representing a counterparty can have access to said collateral.... eventually... maybe... possibly... in an ideal world in which no other counterparty has claims to the same collateral.


Putting it all together, it means that should the system finally wise up and remove the black box gimmick of rehypothecation which is literally "accounting magic" (and also financial fraud), the Fed and its peer central banks would need to fill a hole as large as $10 trillion!

Still think QE is ending ever?


So now that we understand the fine nuances of the impending collateral scarcity? Well, from a policy standpoint it means that as long as asset prices are rising, there is no fear of a collateral crunch. It is, after all, "procyclical"


Ever heard of the trivial saying "money is whatever people agree it is" - well, that's great. But problems emerge when one assumes houses are money. As the chart below shows, households chose to hold less cash during the last bubble as the "moneyness of houses rose. Sure enough, "when the moneyness fell, cash holdings rose abruptly." Still confused why the Fed is desperate reflate the housing bubble at any cost? Simple: it is the only lever left for the Fed to force households to not only spend, but to ramp up on credit.


So while we are on the topic of money, and in order to tie it all together, let's close the loop and introduce the final variable - Shadow Money. In this context, the TBAC has their own definition of shadow money: the value of outstanding bonds*(1-average repo haircut). In other words, if the repo haircut is zero, the outstanding shadow money stock is effectively double what the Treasury has issued. Confused why bonds sometimes appear like Giffen goods? This is why.


A visual example based on the TBAC's definition: there is now some $30 trillion in total public and private shadow money! Still think M2 is the full story?


And finally, vindication: proof that all those other 'experts' on money creation really have absolutely zero understanding of what money creation truly is. Putting it all together: Effective money = shadow money + M2.  To wit:


The unprecedented amount of shadow money chasing "safe assets" explains one thing: why bond yields are where they are, and why the more bonds central banks issue, the lower yields will go. That is, of course, until the entire shadow world described above comes crashing down.

The one missing link in the above has been the absence of the private sector from collateral creation. The problem is that for the private sector to step up, confidence level has to be so high so as to no longer demand public sector QE-transformed collateral. But therein lies the rub: since the Fed's QE is pushing collateral into the market, not having it pulled, there is little demand for exogenous private sector collateral. And thus we have the close loop where more QE creates demand for more QE, even as the private sector is increasingly more closed out of the marketplace. Of course, for true capital formation, it is the private sector that would be responsible for all collateral. That however would imply risk of failure, and the elimination of a Risk Put, such as the global Bernanke Doctrine. In other words, welcome to the biggest Catch 22 possible (and conceived) in the centrally-planned universe the Fed has created for itself...


The next chart should be familiar to regular readers. It shows that when private sector collateral generation broke following the Lehman collapse, the Fed had to step in:

Yup: those who said Zero Hedge noted precisely this in "The Fed Has Another $3.9 Trillion In QE To Go (At Least)" back in September 2012, are absolutely correct.


And there you have it. All you have about money creation in textbooks, all fancy three letter theories that purport to explain the creation and reality of "Modern Money" are 100% wrong, because while they attempt to explain a theoretical world of money creation, what they all happen to forget and ignore is one simple thing: practical reality.

And practical reality is precisely what the TBAC had in mind when it wrote the above presentation of stark caution, because no matter what one says, there is a $11+ trillion collateral shortfall at any given second. A shortfall that can and will be triggered the second the central banks lose control of the financial system which every single day rests on a thread of stability.

Because the thought experiment we presented earlier can be extended one further: assume tomorrow the real black swan appears and all the liabilities: traditional and shadow, promptly demand collateral delivery. Well, the $11 trillion shortage would mean that risk values of, for example the S&P, would be haircut by a factor of, say, 75%. Or back to the proverbial 400 on the S&P500.

Still think owning real high quality collateral, not of the paper but of the hard asset variety such as gold, is a naive proposition, best reserved for fringe lunatic, tin foil hatters and gold bugs?

Go ahead then: sell yours.

The Fed Engaging In Quantitative Easing Until Unemployment Falls Is Like a Medieval Doctor Bleeding a Patient with Leeches …

The Federal Reserve announced that it will keep on engaging in quantitative easing in the amount of $85 billion dollars per month (or more) until unemployment improves.

That is like a medieval doctor bleeding a patient with leeches until his iron deficiency goes away.

Ken Griffin - head of Citadel Capital - noted this week:

As we've all learned over the years, if you reduce the cost of capital you increase your use of fixed assets and you take out jobs. Corporate America, seeing an ever increasing cost for its employee base and extraordinarily low interest rates, is taking every step it can possibly take to reduce employment, to build factories abroad and domestically to substitute technology and automated processes for people.

By way of background, Dallas Federal Reserve Bank president Richard Fisher said in 2011:

I firmly believe that the Federal Reserve has already pressed the limits of monetary policy. So-called QE2, to my way of thinking, was of doubtful efficacy, which is why I did not support it to begin with. But even if you believe the costs of QE2 were worth its purported benefits, you would be hard pressed to now say that still more liquidity, or more fuel, is called for given the more than $1.5 trillion in excess bank reserves and the substantial liquid holdings above the normal working capital needs of corporate businesses.

Similarly, former Secretary of Labor Robert Reich pointed out in 2010:

Cheaper money won’t work. Individuals aren’t borrowing because they’re still under a huge debt load. And as their homes drop in value and their jobs and wages continue to disappear, they’re not in a position to borrow. Small businesses aren’t borrowing because they have no reason to expand. Retail business is down, construction is down, even manufacturing suppliers are losing ground.


That leaves large corporations. They’ll be happy to borrow more at even lower rates than now — even though they’re already sitting on mountains of money.


But this big-business borrowing won’t create new jobs. To the contrary, large corporations have been investing their cash to pare back their payrolls. They’ve been buying new factories and facilities abroad (China, Brazil, India), and new labor-replacing software at home.


If Bernanke and company make it even cheaper to borrow, they’ll be unleashing a third corporate strategy for creating more profits but fewer jobs — mergers and acquisitions.

William F. Ford – former president of the Federal Reserve Bank of Atlanta – wrote in 2011:

Table 2 below shows our estimates of the possible losses in spending power, output, and employment generated by the Fed’s artificially low interest rates. Even by our most conservative estimate, which only looks at the $9.9 trillion in assets most directly affected by depressed yields on Treasurys, the losses are impressive. The average yield on Treasurys in June 2010 was 2.14 percent compared to an average of 7.07 percent in the previous nine recoveries, a difference of 4.93 percentage points. The projected annual impact of this loss of interest income on just $9.9 trillion of rate-sensitive assets translates into $256 billion of lost consumption, a 1.75 percent loss of GDP, and about 2.4 million fewer jobs.(Our calculations assume that the recipients of interest income face a 25 percent average income tax rate and consume 70 percent of their after-tax income.)




Had these jobs not been lost, the unemployment rate would be 7.5 percent, instead of the current 9.1 percent, and this is the minimal effect we estimate.




As the estimate of the total of affected interest-sensitive assets gets bigger, the negative effects of depressed yields becomes even more striking. Using our mid-point estimate of $14.35 trillion of interest-sensitive assets, a 4.93 percentage point reduction in interest rates annually cost the economy $371 billion in spending, 3.5 million jobs, and 2.53 percent of GDP. This is a sizable effect, given that during this time GDP grew by only 2.33 percent and the economy added only 870,000 jobs.


With the additional jobs that might have been created by higher interest income levels, the unemployment rate could fall to 6.8 percent. And output could grow more than twice as fast as it has. The resulting GDP growth rate of 4.86 percent would then be closer to the average second-year growth rate of the past nine recoveries, and the U.S. economy would be well on its way to a vigorous recovery, rather than struggling as it is now.


This midpoint appraisal is our best estimate of the likely effect of the Fed’s policy. It may still be on the low side.


The numbers do not account for any so-called multiplier effects. Additional spending by recipients of interest income creates revenues for businesses, which in turn increases the income of their owners and employees, who themselves spend more. This, in turn, could boost overall spending and employment by more than the gain in interest income alone would suggest.




The housing market has not even begun to recover since the QE initiatives were created. U.S. auto sales and the stock market also remain well below pre-recession levels. And the sharp decline of the U.S. dollar has not created an export boom. But it has put upward pressure on the cost of our food and energy imports.


And tens of millions of U.S. savers, largely the elderly, still are facing strained circumstances created by Fed-driven abnormally low interest rates across the entire Treasury yield curve.


The negative impacts on output and employment caused by quantitative easing through the interest income effects shown here are large. In fact, they may outweigh the expected, but hard-to-document, positive effects of the QE program.

John Doukas - founding and managing editor of European Financial Management, a leading journal in European finance, and  Chair in Finance and Eminent Scholar at Old Dominion University, Virginia - wrote this April:

The repeated Quantitative Easing (QE) policies of the US Federal Reserve in the aftermath of the global financial crisis, with similar actions by the Bank of England and the European Central Bank (ECB), have failed miserably to restore growth and reduce unemployment.




The practice of expansionary monetary policy leads to capital misallocation as it favours short-term spending at the expense of long-term spending (investing less in long-term projects). That is, it creates a savings-investment gap that reduces the capital formation required for the economy to grow, which renders a high fraction of its existing capital stock obsolete. This, low interest rate policy, an outcome of quantitative easing, in turn, has an adverse effect on productivity forcing capital to migrate in foreign/emerging markets in order to realise higher returns. In other words, excessive money supply fails to increase real economic activity because it raises the labour cost while it lowers the cost of capital. Depressing yields at home, as a result of quantitative easing, in an open economy setting, leads yield-seeking investors into higher-risk investments such as emerging markets.




While quantitative easing, like expansionary fiscal policy, may increase aggregate spending, this does not trickle down to the real economy because relative prices (labour vs. capital) work against it. This results in higher rates of unemployment with capital flying to foreign markets. A related effect is that foreign economies, especially those with lower labour costs than western economies, become more attractive places to invest because of these lower costs and promising higher returns to capital. That is, quantitative easing encourages outsourcing, as capital is excessively substituted for overseas labour causing jobs and product innovation to move offshore. Imported goods and services from these countries, then, become more attractive to western consumers because they are cheaper in comparison to the ones locally produced resulting in great outflow of capital, outsourcing and unemployment. This vicious circle exacerbates the disadvantaged position of western economies as they are forced to continue relying on overseas lenders to meet their spending needs, leading to mounting budget deficits and external debt.

Moreover, it is well-documented that quantitative easing increases inequality.  Quantitative easing doesn’t help Main Street or the average American. It only helps big banks, giant corporations, and big investors.  Too much inequality causes economic downturns and decreases aggregate consumer demand ... and companies fire workers when demand decreases.  So quantitative easing also indirectly - but in a very real fashion - destroys jobs by destroying consumer demand.

Putting His Mouth Where His Money Is: Meet Dylan Grice’s New Home

It is no secret that one of Zero Hedge's favorite mainstream strategists over the years was SocGen's Dylan Grice, which perhaps in itself was a logical warning sign that his career in the mainstream was doomed to a premature end. Sure enough, several months ago, Grice, whose guiding motto has been sound money uber alles as he dutifully exposed - as much as he could  - crack after crack in the facade of the status quo, announced he was leaving SocGen, and was headed for greener pastures, literally, in this case Zurich-based fund Edelweiss, run by Anthony Deden. And while lateral moves in the financial industry are nothing new, we were quite impressed to learn that unlike most other "capital preservation" managers, Dylan Grice's new home has a rather stunning allocation of AUM to precious metals. How stunning? Decide for yourselves.

That's right: 60% of Edelweiss' capital is allocated to PMs, as over the past 7 years, more and more cash was allocated to gold, silver and the like. This is orders of magnitude more invested in real assets than most other "wealth preservation" funds will allocate to the sector.

Naturally, the performance of the fund has tracked that of the precious metal sector, and has as expected, outperformed the vast majority of its competitors in the past decade.

Here is how Grice's new employer describes itself:

Founded in 2001, Edelweiss Holdings is an open-end investment company focusing on the preservation of wealth against the erosion of the purchasing power of money.


As stewards of capital, we seek to provide durable refuge in an uncertain world. We reject the hollow output of an unprincipled financial system, preferring instead the timeless substance of honest entrepreneurship.


As responsible owners, we value independence, scarcity and permanence both as to our thinking and also as to the aggregate nature of our investment collection.


Our practice is intellectually honest, conservative, disciplined, respectful of capital and entirely free from conflicts of interest. Edelweiss Holdings employs its own investment team reporting to a board of independent directors.

And the refreshing introduction letter from its founder:

Understanding what we do at Edelweiss Holdings requires an understanding of why we do it—and the ideas behind why we do it. Above all else, it requires an appreciation of what we call the sanctity of savings. This idea imparts a deep respect for honest capital and for the knowledge and wisdom embedded in that capital.


Saving involves sacrifice. Sacrifice requires fortitude. Fortitude should be rewarded over time by an accumulation of capital, granting the saver more options and freedom than he or she otherwise would have had. There is unlikely to be a second chance to re-accumulate a lifetime’s savings. When it’s gone, it’s gone. That capital is precious to the saver.


But that capital is precious to the wider community, too. In a free society, the most profitable activity is likely to be that which satisfies the greatest desire. Since savers provide the capital which makes that activity possible, they make the satisfaction of society’s desires possible too. And capital grows cumulatively, today’s capital stock laying the foundations upon which tomorrow’s prosperity is built. The better the allocation of scarce capital to its most productive use today, the more solid those foundations. Whether people realize it or not, the decisions we make with the capital and savings of today’s generation are our bequeathment to tomorrow’s. We are consequently motivated by a conviction that the wise stewardship of honest capital is a fundamentally noble endeavor and view the responsibility of managing savings as much a burden as it is a privilege.


Capital is scarce. It is valuable. And so it is vulnerable. It is vulnerable to confiscation explicit and implicit, to competitive erosion and to bad ideas. The protection of honest capital thus requires honest thought: about the world, its dangers and opportunities, about our investments, about the nature of risk. Above all it requires honest thinking about ourselves, our capabilities and our limitations.


Some might liken our approach to “value investing.” But we’re not sure what “value investing” is. The cheapest stocks are often some combination of bad businesses and poor management. Others might see us as “contrarian.” But we don’t know what “contrarian” means either. It is contrarian to cross the road with one’s eyes closed, yet we prefer to cross with our eyes open. So we are quite consensus sometimes. We currently own a relatively large holding of gold in our vaults. In the past we have had similarly large concentrations in government bonds, or in oil royalties and other types of assets. So, some might think we practice “macro investing.” But we don’t know what “macro investing” is either. Do macro investors try to predict the future and make their bets accordingly? We don’t. Our crystal ball is as foggy as the next man’s.


We are none of these things. We are independent. We see ourselves as honest entrepreneurs in search of honest entrepreneurs, patient in action and careful in thought. We are not traders. We are owners. And the ownership of productive resources run by honorable and able people is the best way we know of protecting the scarce savings of our shareholders.

It looks like Dylan has found a perfect place to call home. We look forward to presenting his periodic musings to an audience that certainly shares his employer's views regarding resource allocation and certainly capital formation.

CME Declares Force Majeure Due To “Operational Limitations” On NYC Gold Depository

From GoldCore Gold Bullion

CME Declares Force Majeure Due To “Operational Limitations” On NYC Gold Depository

Today’s AM fix was USD 1,747.25, EUR 1,349.54, and GBP 1,090.46 per ounce. 
Yesterday’s AM fix was USD 1,747.25, EUR 1,347.56, and GBP 1,090.87 per ounce.

Silver is trading at $34.08/oz, €26.41/oz and £21.34/oz. Platinum is trading at $1,620.50/oz, palladium at $666.40/oz and rhodium at $1,065/oz.


Cross Currency Table – (Bloomberg)

Gold edged up $1.30 or 0.07% in New York yesterday and closed at $1,748.40. Silver traded off and recovered climbing to a high of $34.16 and finished with a gain of 0.12%.

Gold moved slightly upward today after Greece’s creditors reached a new bailout deal, which will help fund emergency aid for Athens.

The 34.4 billion euro in aid plus reducing interest rates on the bailout loans expect to cut Greek debt to 124% of GDP.  The interest rates have been dropped to 50 basis points above the interbank rate so countries like Italy and Spain will be lending at a loss.

The Eurozone’s dangerous  but easy policy choice of “extend and pretend” continues which is bullish for gold in the coming months.

Mark Carney has been named as the new governor of the Bank of England by Chancellor George Osborne.

Mr Carney, the governor of the Canadian central bank, will serve for five years and will hold new regulatory powers over banks.

Carney would be considered something of a monetary dove.  The Goldman Sach’s alumni’s appointment means that ultra loose monetary policies will likely continue at the Bank of England leading to weakness in sterling – especially versus gold. 

The US Commodity Futures Trading Commission said that institutions and hedge funds slightly raised their bullish bets on silver and gold futures in the week ending November 20th.

The White House and Republicans are still in a stalemate over the fiscal cliff. The White House press secretary said that President Obama is still waiting for a realistic proposal to look at. 

“President Obama would be open to proposals that closed loopholes or capped deductions,” Carney said, “so long as raising the top tax rate remains on the table.”

Obama has asked for $1.6 trillion in higher revenues to pay down the debt. In the 2011 debt ceiling negotiations, Republicans were considering a plan that would involve only $800 billion in new revenue or half what is needed to avoid the cuts and pay down the deficit. 

“Extend and pretend” will also likely be seen in the U.S. – with obvious ramifications for the medium and long term outlook of the dollar. 

The Chinese Ministry of Industry and Information Technology said that China aims to produce between 420 and 450 tonnes of gold bullion in 2015, up about 25% from 2011, while consumption may reach 1,000 tonnes at that time. 

XAU/EUR Currency, 1 Year – (Bloomberg)

CME Group declared a force majeure at one of its New York precious metals depositories yesterday, run by bullion dealer and major coin dealer Manfra, Tordella and Brooks (MTB), due to “operational limitations” posed by Hurricane Sandy.

MTB has “operational limitations” following Hurricane Sandy and can’t load gold bullion, platinum bullion or palladium bullion, CME Group Inc., the parent of the Comex and New York Mercantile Exchange, said today in a statement.

MTB must provide holders with metal at Brinks Inc. in New York to meet current outstanding warrants in relevant delivery periods with compensation for costs, Chicago-based CME said.

The CME said that MTB will not be able to deliver metal as the lower Manhattan company deals with "operational limitations" almost a month after the arrival of Hurricane Sandy.

MTB is one of five depositories licensed to deliver gold against CME's benchmark 100-troy ounce gold contract, held 29,276 troy ounces of gold and 33,000 troy ounces of palladium as of Nov. 23, according to data from CME subsidiary Comex.

In a notice to customers on Monday, CME declared force majeure for the facility, a contract clause that frees parties from liability due to an event outside of their control.

CME said that individuals holding MTB warrants or certificates for a specific lot of metal stored in the depository, may receive gold delivered from Brinks Co. (BCO) in New York. MTB is responsible for any additional costs incurred by customers receiving metal from Brinks, CME said.

"This shouldn't have a material impact on the way market participants are doing business," a CME spokesman said. "They'll still contact MTB if they want to take delivery on contracts," and MTB will arrange for delivery through Brinks according to Dow Jones Newswires.

In a notice posted to its website dated Nov. 12, MTB said the firm "sustained substantial damages" following Hurricane Sandy's arrival in New York City on Oct. 29, and had curtailed its operations.

The force majeure will remain in effect until further notice from the exchange, the CME said. The delivery period for CME's December-delivery precious metals futures begins on Friday.

XAU/GBP, Daily – (Bloomberg)

(Bloomberg) -- Turkey Becomes Gold Reprocessing Center for Iran, Hurriyet Says 
Scrap gold and gold jewelry imported into Turkey from Greece, Portugal, Cyprus, countries in the Balkans and North Africa being converted to standard gold bars within 4 hours in Turkey, Hurriyet newspaper says, without saying where it got the information.

-- Iranians use Turkish lira payments for natural gas at Turkish banks to buy gold in Turkey.

-- Gold is then exported back to Iran, or to countries including India, U.A.E., Qatar and Kuwait, where it can be exchanged for currency and transferred back to Iran.

NOTE: U.S. to review Turkey’s exemption from Iran sanctions in December, after Turkish Deputy Prime Minister Ali Babacan said Iran is buying gold in Turkey with money received for natural gas.

(Bloomberg) -- ETF Securities Starts Gold, Silver, Platinum Funds on HKEx
The ETFs will track the London benchmark prices of the metals and begin trading tomorrow, according to a statement on the Hong Kong Exchanges website today.

The funds on silver and platinum are the first on the exchange for those commodities.

(Bloomberg) -- IShares Silver Trust Holdings Unchanged at 9,818 Metric Tons
Silver holdings in the IShares Silver Trust, the biggest exchange-traded fund backed by silver, were unchanged at 9,818.07 metric tons as of Nov. 26, according to figures on the company’s website.


                Nov. 26    Nov. 23    Nov. 21    Nov. 20    Nov. 19    Nov. 16

                   2012       2012       2012       2012       2012       2012


Million Ounces  315.658    315.658    315.658    317.643    318.127    319.579

 Daily change         0          0 -1,984,433   -484,013 -1,452,093 -1,452,117


Metric tons    9,818.07   9,818.07   9,818.07   9,879.80   9,894.85   9,940.01

 Daily change      0.00       0.00     -61.73     -15.05     -45.16     -45.17

NOTE: Ounces are troy ounces.

(Bloomberg) -- Silver Expected to Outperform Gold in 2013, CICC Says
China International Capital Corp. comments in e-mailed report today.

Silver seen at $35/oz in 3 mths; $38/oz 6 mths; $35 in 12 mths.

Silver forecast to average $36/oz in 2013; $32/oz in 2014.

NOTE: Silver for immediate delivery trades at $34.17/oz at 2:59 p.m. Singapore time.

For breaking news and commentary on financial markets and gold, follow us on Twitter.       


Gold Climbs as Greek Debt Agreement Lifts Euro; Silver Advances - Bloomberg

Gold futures edge higher after Greek deal – MarketWatch

India 2012 gold demand likely to rise 23% - MarketWatch

Gold ticks higher after Greek debt deal - Reuters

Euro zone, IMF agree on Greece debt deal - MarketWatch


Mark Carney: New age is dawning for the Bank as George Osborne bags his man – The Telegraph

Greece Kicks The Can For The Third Time - SocGen's Take: "More Will Be Needed" – Zero Hedge

China to Import More Gold on Suring Demand and Tepid Domestic Output – The China Perspective

Capital Formation and the Fiscal Cliff - GoldSeek

On Artificial Interest Rates And The Forfeiture Of Growth For Dividends

Diapason Commodities' Sean Corrigan provides an insightful introduction to the critical importance of a market-set rate of interest and central banks' manipulated effect on the factors of production.

"Fixated with using their illusory ‘wealth effect’ to avoid a full realization of the losses we have all suffered in a boom very much of those same central bankers’ creation - or else cynically trying to achieve the same denial of reality by driving the income-poor into accepting utterly inappropriate levels of financial risk - they are destroying both the integrity and the signalling ability of those same capital markets which are the sine qua non of a free society."

As Ron Paul also confirms in the clip below "with artificial interest rates, we get an artificial economy driven by mal-investment leading to the inevitable bubbles" and while central banks hope for this 'created credit/money' to flow into productive means (Capex), instead it has (in today's case where QE is no longer working) created an investor-class demand for yield - implicitly driving management to forfeit growth-and-investment for buybacks-and-dividends.


Ron Paul's interview with Laisses Faire outlines the impact an artificial interest rate has on the economy...

and Sean Corrigan of Diapason Commodities provides a more in-depth look at the process by which a manipulated interest rate impacts the factors-of-production (or the risks and rewards of the real business cycle)...

What is not to be overlooked is that the applicable rate of interest is not some abstract entity, utterly variable according to the whim of the banking system, but rather is one of the fundamental ratios prevailing in the vast, interconnected topology of exchange - in this case, between the value put on goods available at once and on those only accessible at some future date...


Take the act of deciding upon the launch of a new or expanded line of business. Obviously the entrepreneur will make his best guess as to the stream of revenues he may gather and will set these off against his estimates of what it will cost him to achieve them. Thus it is, of course, that a lowering of the rate of generally accepted rate of interest makes his challenge seem a less daunting one: our man will not only have less to pay out on any hired capital he requires, but the possibility of earning a greater return in some other fashion...Yet - whether he recognises this or no - his reckoning is intimately bound up with the information which the interest rate is conveying with regard to the likely relative abundance of his inputs and the relative demand for his outputs over the entire investment horizon of his project...


It should be all too apparent by now that if we are to enjoy conditions which are favourable to both the greatest degree of co-ordination between the market’s multitude of actors; if we are to remove all impediments to the early recognition of such lapses from that co-ordination as must inevitably occur in a shifting world of imperfect knowledge and changing tastes, then any interference with the spontaneous, holistic formation of prices is not to be countenanced, much less embraced as a tool of dirigisme.


Rather, it is vital that the myriad interactions between buyer and seller, producer and consumer, saver and spender, employer and employee should be allowed to make its due contribution to the universal field of prices thence to reveal how best to marshal our limited resources in order to deliver more of what appears to be the more urgently required and to expend fewer efforts on the less. This is not true only in the here and now, but also over time.

Clearly, we have no gold standard to impose discipline on either the ruling elite or the bankers who are their political symbionts... granted, we have a wider range of  non?bank and other credit instruments to confuse the issue; but none of them alter the fact that investment is best undertaken when both the money and the means corresponding to that money have been voluntarily set aside to finance it, or that, conversely, investment is worst entered upon when it is launched on a soon cresting wave of counterfeit capital, conjured up by the banks or the government printing press.

12-11-20 TA - As a Matter of Interest


which leads to the current remarkably non-traditional text-book situation that Citi describes - where equities are now the yield-providing asset as management is punished for spending capital on growth or investment and is praised for buybacks and dividends as the Fed's artificial premise in which we live has created a monster...

Policy-makers have adopted aggressive methods to push interest rates and bond yields down to unprecedented levels. It is hoped that these low rates will trigger a stronger recovery in corporate capex and jobs. Evidence of this remains sketchy...


We think that QE may be having the opposite impact to that intended. Instead of encouraging capex and job creation, ultra low interest rates are bringing yield-starved capital into the global equity market. These investors are more interested in dividends and share buybacks than corporate expansion. Those CEOs who give them what they want should be rewarded by share price outperformance. Those who do not may find themselves replaced.


Citi Equity Yield


If we are to salvage any residue of our liberty, restore any semblance of our prosperity, and again secure to ourselves the right to enjoy our property, this [manipulation] must be ended before it consumes our capital...

If all this means that we have fewer projects underway at any one time, so be it: we will waste far less of what we hold scarce and end up holding fewer things as scarce as we do now.

The Garden of Eden may well be denied us, but that does not mean the only remaining choices are the debtor’s gaol or the soft totalitarianism of de Tocqueville’s worst imaginings...

...it is saving that makes us rich, not spending, and it is only by saving – not through authoritarian fiat ? that a naturally lowered interest rate confers a lasting aid to capital formation.

If policymakers hope that listed companies can help drive down current high levels of unemployment then it could be a long wait. Corporate expansion plans are likely to remain constrained by uncertainties about the global economy and a shareholder base that is more interested in share buybacks and dividends than capex and job creation.

Source: Citi, Diapason Commodities

QE3, Deflation and the Money Illusion


The announcement last week by the Federal Open Market Committee that the central bank would initiate additional, open-ended purchases of residential mortgage backed securities was more than a little sad.   Let us count the ways. 

The first reason for sadness was the idea that people here in New York and elsewhere in the global financial community were actually surprised by the Fed’s move.  The FOMC is fighting deflation.  Credit continues to contract globally as much of the western world goes on a pure cash budget.  So while I would like to see the Fed raise short term rates, the fact is that the central bank has little choice but to support the markets.  But buying RMBS will neither help housing nor reverse the current deflationary spiral on which we all ride. 

The second reason to be circumspect is the fact that the Fed’s leaders continue to pretend that driving down yields in the RMBS markets will have any impact on the housing sector or the economy.  The two thirds of the mortgage market that cannot refinance their homes will be unaffected by QE3.  In fact, the latest Fed purchases are a gift to Fannie Mae and Freddie Mac and the hedge fund community.  A fund on the floor of our offices in New York actually started dancing around like little children shouting “QE3” after the Bernanke press conference.

“The entire move in MBS prices will go into profit margins,” one mortgage market veteran told the Berlin-New York-Los Angeles mortgage study group last week.  “FHFA has made sure that the mortgage market has oligopoly pricing and zero competition for the existing servicers.  QE3 is risk free profits for the unworthy.  And we wasted 40 years and Trillions of dollars fighting the USSR over the need for a free enterprise system?  Mussolini would be proud.”

Unfortunately, since two thirds of the mortgage market cannot be refinanced, the effect of the Fed’s largesse will indeed go straight to the GSEs and Wall Street zombie banks.  This is the key, historical error being committed by Bernanke and the rest of the FOMC.  Instead of looking for ways to stoke consumer demand by restoring income and consumer demand, the Fed is simply feeding subsidies to Wall Street.  Since the Fed does not think that savers like grandparents and corporations spend money, the error is magnified several orders of magnitude. 

The basic problem with the people on the FOMC today is that they are all Obama appointees who are by and large neo-Keynesian in outlook.  By spending all of their time trying to prevent the 50% drop in GDP which occurred in the 1930s, the Fed forgets or never knew that this catastrophe was the result of the disappearance of private sector capital – not a lack of government spending.  And why did this happen?  One word:  Fraud.  Bill Black has been talking about fraud for years,  So does Fred Feldkamp, the father of the good sale in RMBS.  And so have we at IRA and many others.  

The third sadness is that people still don’t understand that fraud is the core problem in the market economies.  Until you deal with fraud and start to restructure the trillions of dollars in bad assets now choking the US economy, no amount of Fed ease will reverse the contraction in credit.  This is not so much a monetary problem as much as a political issue.

Just as during the 1920s and 1930s it took years for our leaders to understand that fraud was the core issue menacing the US economy, today the same process of discovery and revelation grinds slowly forward.

Fear causes investors to withdraw from markets and save cash.  But because Chairman Bernanke and the Fed refuse to attack the source of the fraud – namely Bank of America and the other zombie banks – the US economy is destined for years of stagnation and eventual hyperinflation.   Economists at the Fed think that the rising propensity to save is a function of interest rates, but no amount of financial repression is going to convince investors to take first loss on a private label RMBS until they trust the representations of the issuer.  Trust me on this since I am in the bank channel right now marketing a non-conforming RMBS offering.  

Just as the grey market banking sector collapsed from the peak of $25 billion starting in 2007, the confidence of the great market economies is collapsing under the weight of socialist economic prescriptions and cowardly advice coming from the legions of economists who work for large banks.  Most economists have figured out that the old linkages between savings, consumption and debt have broken asunder.  Yet none of these captive seers dares to suggest that the banks themselves need to be restructured.

Jeff Zervos of Jeffries is one of the key Fed cheerleaders.  He writes in a research comment: “The bottom line is that the Fed is printing money, debasing the currency and devaluing debt. The policy is redistributive, regressive and reflationary. It’s a nasty business for sure, and the truth must be obfuscated from the public. But if we want to avoid a second great depression, it is the right thing to do. Good luck trading.”

Good luck indeed.  So long as the Fed refuses to become an advocate for restructuring and merely keeps interest rates low, there will be no progress on the economy or jobs because aggregate credit continues to contract.  The Fed’s actions are not really growing the money supply much less credit, it is merely trying to slow the decline.  Whether we talk about the run-off of the private label mortgage market or the wasting effect of low rates on savers, the US economy is being put into a no leverage, pure cash model by the happy Keynesians who run the Fed.  

The fourth sadness is that mainstream economists from Zervos to Bernanke to Richard Koo at Nomura refuse to even talk about rebuilding private sector wealth creation.  In a brilliant luncheon talk last week at the Bank Credit Analyst investment conference, Koo accurately described the breakdown in the relationships between major economic aggregates.  He also illustrated nicely the jump in savings in Japan and the other major industrial nations following market shocks.  

But Koo, like most of our former colleagues at the Fed, thinks that only increased debt and public sector spending are the answer to the deflation threat.  But the key lesson of the Great Depression was that government must avoid actions and policies that cause private sector investors to flee the markets.  This is precisely the result we now see from the Fed’s actions.  

Now you might argue that the Fed is merely following the advice of Irving Fisher, the great US economist, who wrote in 1933 that vigorous monetary policy is needed in the face of debt deflation.  One must wonder, though, if Fisher would not scold all of us today for failing to attack fraud and restructuring at the same time.  Like most Keynesians, Fisher believed that government could manipulate income and investment via monetary policy. 

Yet even Fisher was guilty of embracing the same fallacy that government can print money without affecting negatively consumer behavior.  As Ludwig Von Mises wrote in the new preface to his classic book, the Theory of Money and Credit:

“There is need to realize the fact that the present state of the world and especially the present state of monetary affairs are the necessary consequences of the application of the doctrines that have got hold of the minds of our contemporaries. The great inflations of our age are not acts of God. They are man-made or, to say it bluntly, government-made. They are the off-shoots of doctrines that ascribe to governments the magic power of creating wealth out of nothing and of making people happy by raising the 'national income'.”

Could it be that the monetary actions of the Fed and other monetary authorities around the world are scaring investors, eroding confidence in private markets and worsening deflation?  Most economists never consider that FDR’s anti-business rhetoric and policies helped to drive private capital formation to zero in the 1930s.  Likewise today, the Fed’s reckless and arguably illegal actions in terms of monetary policy are terrifying investors and members of the public around the world.  But all that Jeff Zervos, Richard Koo and their Keynesian pals that the Fed have to say is “good luck.” 

We need to take a new direction if the economic catastrophe predicted by luminaries like Paul Krugman does not come to pass.  The core principles are two: fight the fraud and restructure bad assets.  If we hold responsible those who have committed fraud against investors and at the same time move quickly to restructure and break up banks such as Bank America, we can restore public confidence in markets and reverse the deflation which is even now gaining momentum in the US economy.  Contrary to the assertions of Zervos and others, there is no need to hide government policy from the public view.

Restructuring is the necessary condition for credit expansion and job growth.  Without private sector credit growth there can be no jobs. Without justice for investors, pension funds and banks defrauded to the tune of hundreds of billions of dollars, there can be no investor confidence to support private finance.  And unless the Fed and other regulators in Washington break the cartel in the US housing sector led by Fannie Mae, Freddie Mac and the top four banks, there will be no meaningful economic recovery in the US for years. Instead we will face hyperinflation and social upheaval, both care of the well-intentioned economists on the FOMC.

Guest Post: Everything You Know About Markets Is Wrong?

Submitted by Eric L. Prentis,

The financial elite—using academe for intellectual cover—want you to believe that markets are efficient, as defined by the Efficient Market Theory (EMT). My research strikes down this hoary old EMT economic dogma, used by duplicitous bankers and hedge fund managers to con US politicians and 99% of Americans.

The Efficient Market Theory (EMT) is a significant foundation theory in economics. Prove the EMT wrong, and economics becomes largely an empty shell. Therefore, the EMT is the most important fundamental issue in economics and for America.

US politicians mistakenly use EMT based economic theories to pass laws favorable to Wall Street. First causing and now worsening the credit crisis. Examples of credit crisis enabling legislation include:

  • Gramm–Leach–Bliley Financial Services Modernization Act of 1999
  • Commodity Futures Modernization Act of 2000
  • Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
  • Jumpstart Our Business Startups (JOBS) Act of 2012

Three tenets define the EMT.

  • The first tenet—that markets are in equilibrium and if unexpected events cause disequilibrium, it is only temporary because markets are self-equilibrating—is disputed in the literature. A stock market always in equilibrium and efficient is impossible because traders have different endowments, beliefs and preferences. In addition, arbitrage costs throw markets out of equilibrium.
  • The second tenet—that stock prices “fully reflect” all information—has long been challenged in the literature, with many inconsistencies reported. Tenet number two goes on to say asset prices properly represent each asset’s intrinsic value, and as a result, prices are always accurate signals for capital allocation. Researchers in behavioral economics find fault with this EMT assumption, because it does not account for human nature and inherent herding behavioral instincts of market participants. EMT theorists—Eugene F. Fama and Burton G. Malkiel—claim assuming market equilibrium is close enough to reality, and that research into EMT tenet two contests only the semi-strong form of efficiency. That is, where earning higher returns than the stock market, with lower risk, is not achievable by knowing all publicly available information. EMT theorists continue to support the EMT and say, “If you want to do better than stock market returns, you have to take on more risk than the stock market.”
  • EMT tenet number three is most important—that is, stock prices move randomly or are uncorrelated with, if not independent of the prior period’s price change. Therefore, earning higher returns than the stock market, with lower risk, is impossible to achieve using only past prices (i.e., technical analysis stock trading rules or stock charts). Empirically prove EMT tenet number three wrong— because it tests the weak form of market efficiency—and the EMT is wrong, period!

EMT theorists specify two methods to test EMT tenet number three. The first method is statistical inference. Calculate serial correlation coefficients of stock price changes. If the serial correlation coefficients are zero or close to zero, this supports assuming serial independence in the price data. Therefore, one can infer that technical analysis stock trading rules cannot work. The second method requires using a technical analysis stock trading rule predictive model that forecasts the future, based solely on past prices—where expected profits are greater and risk lower than they would be under a naïve buy-and-hold policy.


Research that supports the EMT makes one-or-all of the following mistakes:

  • Using the wrong data—Systemic market risk and random unsystemic risk make up individual company stock price movements. As much as 50% of a company’s stock price actions are random unsystemic risk variations associated with the internal circumstances within that particular company. The remaining 50% of a company’s stock price movements represent the systemic risk of the overall market. The random unsystemic risk is the chaotic portion of the stock price data—that if removed leaves only the systemic market risk of the overall market, which may then be analyzed. Most EMT research studies day-to-day stock price movements of individual companies, which is mistaken. Granted, this unsystemic and systemic, day-to-day individual company data look random, but it is the wrong data to analyze to determine overall, long-term market trends.
  • Using the wrong method to analyze the data—Most researchers use statistical inference to test tenet number three. However, there is a serious problem with using statistical inference to test whether stock price data are independent. That is, it is difficult to distinguish between a rootless series and one where the systemic quality is faint. Research shows that five-thousand years of data are needed to identify independence in stock price data using statistical inference. However, these data do not exist. Consequently, statistical inference is not the correct method to use to test tenet number three.
  • Jumping to mistaken conclusions based on half-truths—Statistical inference tests using day-to-day individual company data report serial correlation coefficients that are close to zero. This supports assuming serial independence in the price data. Therefore, one can infer that tenet number three is valid. Unfortunately, this proves nothing of the sort. Analyzing the wrong data over an inadequate number of years simply gives a false positive.


What day-to-day stock price movements are for individual companies is the wrong research question. Instead, we want to know what the overall stock market is doing over the long term. The correct way to look at market data follows.


Using correct data—Individual company stock price behavior, which includes the randomness of unsystemic risk, is not evaluated. Instead, only systemic market risk is analyzed in my published journal research—please see here and here—by comparing only systemic market risk of two well-diversified S&P 500 Index portfolios. S&P 500 Index portfolio B is for active trading and S&P 500 Index portfolio A is the benchmark portfolio. Focusing only on systemic market risk in the data studied, removes much of the random or chance stock market price behavior of individual companies.

When investing over 1, 2, 3, 4, 5 years or more—day-to-day stock price movements are immaterial to trading success and may be thought of as just daily market chatter. Concentrating on daily price movements of individual company stock or the stock market as a whole is not the correct question. Day-to-day stock price action is volatile. To dampen out this daily chatter and give perspective to what is occurring long-term in the stock market, S&P 500 Index “monthly price data” are used to smooth out stock price volatility.

Monthly price data are important in dampening out day-to-day price movements. However, using last month’s price to predict next month’s price is also not conducive to long-term trend development. To further smooth price variations and focus on systemic stock market risk. Nine and two-month simple moving average (SMA) trend lines are fit to the S&P 500 Index monthly price data for actively managed portfolio B. Smoothing out data volatility, which gives an overall view of the long-term stock market trend. This is the third step in removing much of the random stock market price behavior from the research data.

Focusing only on systemic stock market risk in the monthly data and smoothing stock price volatility using nine and two-month SMA trend lines for the well-diversified S&P 500 Index portfolio B—to lessen random variations—is a major difference between my research and other EMT research in the literature, and a major reason the results are so significant.

My research covers 1871-through-2008, 138 years. All available Standard & Poor’s (S&P) 500 Index data are included in this research study, making it the longest duration and complete in the literature.


Using the correct method to analyze the data—Fama’s approved second method for testing the EMT, requires using technical analysis. Fama says to develop and test, over both good and bad economic conditions, a technical analysis stock trading rule predictive model that forecasts the future, based solely on past prices—where expected profits are greater and risk lower than they would be under a naïve buy-and-hold policy.

My empirical research method directly tests stock market price independence of EMT tenet number three, using a new technical analysis stock trading rule predictive model. To test whether expected profits are greater and risk lower than a benchmark naïve buy and hold policy, which Fama calls, “an equally valid scientific method versus statistical inference.”


Empirical results—In my US stock market research, the relative maxima and minima stock trading rule S&P 500 Index portfolio B—by $495,360 dollars (i.e., $580,423 - $85,063)—makes +582% more money than buy-and-hold S&P 500 Index portfolio A—and is only 64% as risky over 138 years—from January 1871 through December 31, 2008.


The new technical analysis relative maxima and minima stock trading rule predictive model makes substantially more money at significantly less risk than the naïve buy-and-hold policy. EMT theorists say this thorough beating of the US stock market should be impossible to achieve using only technical analysis. Thus, tenet number three and the weak form of the EMT are invalid, making the Efficient Market Theory wrong, period!



 Neoliberal economic philosophy, starting around 1980 and now mainstream in academe and American politics, promotes laissez-faire economic policies of reducing the size of government, deregulation and privatization of government services. Neoliberal economists base this philosophy on the belief that neoclassical economic theory is correct. That is, that “markets are efficient”—my research shows the EMT is dead wrong.

Gullible US politicians believe that markets are efficient and defer to them. Therefore, US politicians abdicate their responsibility to manage the overall economy, and happily for them, receive Wall Street money. Mistakenly, the primary focus during the 2008 credit crisis is on fixing the financial markets (Wall Street banks) and not the “real economy.” 

Wall Street touts markets as trustworthy and infallible, but that faith is misplaced. Big market players easily manipulate markets. For example, by changing accounting laws so banks no longer have to mark-to-market, High Frequency Trading (HFT) front running, and multinational companies buying back their common stock shares, along with favorable huckstering of stock positions on CNBC—owned by Comcast and General Electric. In addition, Chairman Bernanke, because of his Quantitative Easing II, takes credit for the Russell 2000 Index of small company stocks reaching an all-time high of 860.37.

The Federal Reserve (Fed) talks of added quantitative easing (QE), but this would mainly help the richest 1% of Americans and hurt the “real economy,” with higher gasoline and food price inflation. Unfortunately, QE only helps overinflate the stock and commodity markets by manipulating prices. Despite Fed programs QE I&II and Operation Twist, America is experiencing the worst economic recovery from a recession, ever! President Obama, if he wants to lose the 2012 election, will let Bernanke electronically print more QE money and make the “real economy” worse than it otherwise would be.

The continuing credit crisis is serious—with the world economy poised for a double-dip recession. The current US government policy of increasing the national debt by $5 trillion dollars over the past four years, keeping insolvent banks from going bankrupt, a Federal Reserve zero interest rate policy (ZIRP), causing malinvestment, and monetizing the national debt (which is what tin-pot dictators do just before they are forced to flee the country) with quantitative easing by the Fed, and austerity for the 99% to repay bad bank loans has not worked—and doing more of the same will not work—and defines insanity.


The financial elite are using this “cover-up and pray” policy—hoping that rekindled “animal spirits” will bring the economy back in time to save the status quo. This is impossible because the trust is gone. The same sociopaths control the economy. Instead, the financial elite are just protecting themselves with outlandish pay bonuses, based on cooked books; while the “real economy” flounders with high unemployment, unsustainable budget deficits, a struggling real estate market, and low capital formation, crumbling infrastructure and high gasoline and food price inflation.


Conclusion—this is what to do:

  1. Reenact the Glass-Steagall Act. Allowing investment banks to speculate with savers’ money is criminal.
  2. The daisy-chained, unregulated $707 trillion dollar OTC Derivatives market will bring down the world economy, when it goes bust. JP Morgan’s recent huge OTC Derivative trading losses are a prelude to this eventuality, with many more instances to come. Start unwinding the OTC Derivatives market now, before it is too late.
  3. Insolvent banks are a drain on the “real economy.” Force insolvent banks to go bankrupt. TBTF is an irrational policy. Allow capitalism to work for the 1%.
  4. Public and private debt to GDP is about 360%, and 30% of Americans are being hounded by bill collectors for unpaid debts. Americans can no longer service their massive debt loads. Allow debt forgiveness for the 99% and institute austerity for the 1%—they can afford it.
  5. ZIRP is destroying capital formation and savers. Allow interest rates to rise, which will increase consumer demand. The Fed’s manipulation of capital markets causes malinvestment—resulting in crippling long-term penalties for the “real economy.”
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