Eight Drivers

There are many events and economic reports that can roil the market in the days ahead.  Yet, just as importantly, there are already forces at play that will shape market developments.  Here are 8 thoughts about what to expect.  

1.  The US employment data failed to have much impact on expectations the timing of the Fed's tapering.  A recent news wire poll found a median expectation for it to begin in Oct and by about $20 bln.  The key issue is whether the appreciation of this is sufficient to stabilize long-term US interest rates.  It does not appear to be, which means, barring a significant surprise, US yields do not appear to have peaked yet.  The 10-year yield can rise into the 2.25%-2.40% area.  This need not be supportive of the dollar against the other major currencies, if it is part of a larger unwind of positioning.  

2.  The interest rate on a 30-year fixed rate mortgage has risen from 3.6% to 4.1% in recent weeks.  It is first time its is above 4% in a year.  Yet, the impact on the housing market may be mild.  Rates are still not high, by nearly any metric.  Activity has been lifted by participants, like institutional investors, that are less sensitive to marginal interest rate changes.  Moreover, the real hindrance has not been the cost of credit, but the access.  If lenders have greater confidence of a self-sustaining recovery, then perhaps they would increase their willingness to lend.


3.  After testing 1600 last Thursday, the S&P 500 gapped higher on Friday.  It extends from Friday's opening and low print of the session (1625.27) to Thursday's high (1622.56).  Although there are several different types of gaps, this one appears to be one of  two kinds. The first kind would be filled over the next day or two and that would suggest a near-term set back.  The second kind will not be filled in the near-term and it is a type of break-away gap.  After retreating by 5% over two-weeks, the gap signals the end of that move, which means new advance is at hand.  We are inclined toward the latter and anticipate it will lead to new highs for the index.  

4.  The S&P 500 peaked on May 22, the day before the Nikkei.  The Nikkei has slumped 21%, which brought it within spitting distance of a 50% retracement of its gains since the election was called in mid-Nov '12.  The pre-weekend rally in the S&P 500 and the recovery of the dollar against the yen following the US employment report, points to a likely recovery of Japanese shares.

5.   The key political event of the week is the German Constitutional Court ruling that is expected Tuesday or Wednesday.  As has been done with other measures that are forging greater European integration, there is a legal challenge to the ECB's Outright Market Transaction program.  It could side step the issue and refer the ECB powers to European courts, claiming perhaps that it does not have the authority to rule.  It could agree with the complainants and find that the ECB has encroached on a right that belongs to the German people through the parliament.   It could find that the OMT is not an infringement on Germany sovereignty and use the case as another opportunity to draw conditions or lines that need to be respected, which is what we expect.

6.  The Bank of Japan and the Reserve Bank of New Zealand meet in the week ahead.  The BOJ concludes on Tuesday.  There may be some minor operational tweeks and it could announce a new longer-term repo facility (2-years) as a possible way to help stabilize the JGB market.  The RBNZ meets on Thursday and we see it in no hurry to raise interest rates, though that is the direction of the next move in rates.   The New Zealand dollar has dropped nearly 10% against the US dollar since early April, though has gained 1.5% against the also falling Australian dollar.   The central bank, which has begun intervening in the foreign exchange market, no doubt welcomes the weaker currency.  

7.  There are several economic reports that offer headline risk in the days ahead.  At the start of the week, in Japan, a small upward revision in Q1 GDP is not great shake, but April's current account will be scrutinized.  The increase in bank lending is expected to continue, bolstered by reconstruction efforts and foreign investment.  Machinery orders are likely to have been set back at the outsized March jump.  A rise in corporate goods prices reflects higher cost imports, including energy, and this has been aggravated by the weakness of the yen.  Weekly MOF portfolio flows have taken on greater interest of late.  It is a light week for European reports, but the focus will be on industrial production reports (including the UK and Sweden).   The UK also reported on the latest labor market conditions.  The euro area reports CPI figures at the end of the week.   The two economic highlights for the US will be the retail sales report on Tuesday and industrial production on Thursday.  The consensus looks for a 0.4% and 0.2% rise respectively in the headline figures, while the retail sales measure used for GDP calculations is expected to rise 0.3% while manufacturing is expected to have risen by 0.2%.  Risk seems asymmetrically distributed to the downside of both reports.  

8.  There are several central banks in the emerging markets that meet, including India, Korea, Philippines, Chile and Russia.  None are expected to cut key lending rates, though there is some expectation for the Philippine Central Bank to cut its special deposit rate by 25 bp (to 1.75%), which it has done three times this year to try to curb the short-term capital inflows.  Brazil's markets will also be closely watched after last week's lowering (technically not abolishing) the tax on foreign purchases of Brazilian bonds to zero and S&P put the country's ratings outlook on negative watch.  South Korea may also be interesting after 3 nuclear reactors last week were suspended indefinitely for using forging safety certificates.  At the end of last year 2 other pans were closed for similar reasons.  With seven other reactors out of service due to routine maintenance, the country has lost about a third of its electricity capacity.  The government warned of "unprecedented shortages".  This may be another headwind for the South Korean economy that could last the better part of the summer.  

Richard Koo: „Honeymoon For Abenomics Is Over“

As we noted just two weeks ago - before the hope-and-change-driven exuberance in Japanese equities came crashing down - "those who believe in Abenomics are suffering from amnesia," and Nomura's Richard Koo clarifies just who is responsible for the exuberance and why things are about to shift dramatically. Reasons cited for the equity selloff include Fed Chairman Ben Bernanke’s remarks about ending QE and a weaker than expected (preliminary) Chinese PMI reading, but, simply put, Koo notes, more fundamental factor was also involved: stocks had risen far above the level justified by improvements in the real economy. It was overseas investors (particularly US hedge funds) that responded to Abe's comments late last year by closing out their positions in the euro (having been unable to profit from the Euro's collapse) and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher. Koo suspects that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible...

Had they understood this, they would not have behaved in the way they did.

Many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies - should be effective. In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher.


Via Nomura's Richard Koo,

Divergence in investor behavior fueled virtuous cycle of lower yen and higher stocks

More specifically, the sharp rise in equities that lasted from late in 2012 until a few weeks ago and the several virtuous cycles that fueled this trend were themselves made possible by a special set of circumstances.

Whereas overseas investors responded to Abenomics by selling the yen and buying Japanese stocks, Japanese institutional investors initially refused to join in, choosing instead to stay in the bond market.

Because of that decision, long-term interest rates did not rise. That reassured investors inside and outside Japan who were selling the yen and buying Japanese equities, giving added impetus to the trend.

Japanese institutional investors understand private demand for funds is negligible

The next question is why domestic and overseas investors responded so differently to Abenomics. One answer is that many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies—should be effective.

Short-term rates in Japan have been at or near zero since around 1995, some 18 years ago. The BOJ engaged in an aggressive quantitative easing initiative from 2001 to 2006, under which it supplied more than ¥30trn in excess reserves at a time when statutory reserves amounted to just ¥5trn. Yet neither the economy nor asset prices reacted meaningfully.

In the last few years, Japanese corporate balance sheets have grown much healthier and interest rates have remained at historic lows. Yet private demand for funds did not recover because 1) firms were still in the grip of a debt trauma and 2) there was a shortage of domestic investment opportunities.

Japan’s institutional investors were painfully aware of this reality, which had left them facing a lack of domestic investment opportunities for more than a decade. From their perspective, there was no reason to expect another foray into quantitative easing by the BOJ under pressure from the Abe administration to lift the economy, and therefore no reason to change their behavior.

But overseas investors bet on bold monetary easing

Meanwhile, overseas—and particularly US—hedge funds that had been betting on a worsening of the euro crisis until last autumn were ultimately unable to profit from those positions because the euro did not collapse.

Then in late last year, the Abe government announced that aggressive monetary accommodation would be one of the pillars of its three-pronged economic policy. Overseas investors responded by closing out their positions in the euro and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher. I suspect that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible. Had they understood this, they would not have behaved in the way they did.

Bond and equity markets took very different views of Japan’s economy

The yen weakness and stock market appreciation brought about by this money began to buoy sentiment within Japan, paving the way for further gains in equities. They also prompted retail investors to enter the market, providing more fuel for the virtuous cycle. Japanese equities were up 80% from their lows at one point. However, this virtuous cycle was based on the key assumption that interest rates—and long-term interest rates in particular—would not rise.

This condition was satisfied as long as domestic institutional investors remained in the JGB market, but consequently the views of the Japanese economy held by equity and bond market participants diverged substantially.

Moreover, even though the moves in the equity and forex markets were led by overseas investors with little knowledge of Japan, the resulting improvement in sentiment and the extensive media coverage of inflation prospects forced domestic institutional investors to begin selling their bonds as a hedge.

Honeymoon for Abenomics finally ends

The result was a correction in the JGB market from mid-April onwards, with the ensuing turmoil prompting a correction in equities as well.

In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher. This means further gains in equities will require stronger corporate earnings and a recovery in the economy.

Yen weakness likely to persist on trade deficits

The share price increases driven by the prospect of improved corporate earnings due to the weaker yen will probably persist going forward. Now that Japan is running trade deficits, the yen is unlikely to see the kind of appreciation observed in the past. Naturally, exchange rates are relative things, and the yen might well rise back into the 90–100 range against the US dollar depending on conditions in the US economy. But I do not expect USD/JPY to return to the area below the mid-80s.

The yen’s decline to around 100 against USD has definitely been a positive for the Japanese economy. But authorities will need to tread carefully when dealing with additional yen weakness, including the question of what might stop the yen from falling further. Excessive drops in the currency could spark a “sell Japan” movement like that seen in 1997, when investors simultaneously sold off the yen, Japanese stocks, and Japanese bonds.

In addition, the cheap imports represented by the proliferation of so-called ¥100 shops have played an important role in maintaining the living standards of ordinary Japanese consumers at a time of sluggish or falling incomes. Further declines in the yen might benefit a handful of exporters but could also lower living standards for the majority of people.

Virtuous cycle for Abenomics has reached turning point

Now that USD/JPY has fallen to what I see as a comfortable level and the Japanese bond market has broken its silence, I think the virtuous cycle for Abenomics in evidence since late last year is at a critical juncture.

That is not to say that current exchange rates or long-term bond yields are cause for concern. Compared to where they were before, current levels are both reasonable and comfortable.

But from this point on, the environment will be very different in the sense that there will be greater emphasis on 1) consistency between the bond and stock markets and 2) the negative implications of a weaker currency.

“Bad” rise in rates continues, fueled by inflation concerns

The Bank of Japan began buying longer-term JGBs on 4 April with the goal of pushing yields down across the curve. The outcome of those purchases, however, has been exactly the opposite of what Governor Haruhiko Kuroda intended, with long-term bond yields moving higher in response.

Domestic mortgage rates have increased for two consecutive months as a result. This is clearly an unfavorable rise in rates driven by concerns of inflation, as opposed to a favorable rise prompted by a recovery in the real economy and progress in achieving full employment.

The more the market senses the BOJ’s determination to generate inflation at any cost, the more interest rates—and particularly longer-term rates—will rise, adversely impacting not only Japan’s economy but also the financial positions of banks and the government.

Recovery can offset many negatives of rising rates

As I also noted in my last report, a recovery-driven rise in rates occurs when the economy rebounds and approaches full employment, fueling concerns about inflation and pushing interest rates higher.

Because the economy is in recovery, banks are lending more to the private sector and government tax revenues are expanding. Even if higher interest rates cause losses on banks’ bond portfolios or increase the cost of borrowing for the government, there is sufficient offsetting income. In other words, the government and banks are both capable of absorbing significant increases in interest rates as long as the economy is in recovery.

But higher rates before recovery weigh on economy

However, today’s BOJ is recklessly easing monetary policy to generate inflation expectations in the hope that those expectations will spark a recovery in the real economy. In this case, inflation expectations precede the recovery, creating the risk that rates will rise before the economy picks up.

Since there is no increase in bank earnings from additional lending activity and no increase in tax revenues from a recovering economy, the financial positions of banks and the government deteriorate in direct proportion to the rise in long-term interest rates. The resulting shrinkage of equity capital constrains banks’ ability to lend, while the government is forced to cut spending or increase taxes. Both of these outcomes will naturally weigh on the economy.

Of special concern is the risk that a rise in rates prior to a pick-up in private loan demand will force the government to engage in fiscal consolidation. The economy could quickly sink if the government stops borrowing and spending at a time when there are no private-sector borrowers.

Fiscal consolidation counterproductive if it precedes pick-up in private demand for funds

In this regard, it was shocking to note that BOJ Governor Kuroda, senior IMF official David Lipton, and even a handful of private-sector economists in Japan have over the last two weeks urged the government to engage in fiscal retrenchment to prevent a further rise in interest rates.

I would have no objection if they were making the argument because they had proof that private demand for funds was about to increase substantially. But without such evidence, they risk sending Japan’s economy back into the abyss.

If private demand for funds were actually on the rebound, the private sector would be able to borrow and spend the unborrowed private savings that have weighed on Japan’s economy for the last 20 years without any need for fiscal stimulus. That, in turn, would free up the government to put its finances in order and in fact would mean it was time for it to do so. But fiscal consolidation in any other circumstances could lead to a repetition of the Hashimoto government’s failed experiment in 1997.

Unfortunately, the lack of data for the period since Mr. Kuroda’s policies began makes it difficult to draw any certain conclusions at this time.

Real estate purchases have no impact on unborrowed savings…

It should be noted that the sharp rise in share prices has refocused attention on the real estate market, prompting some investors and individuals to buy property now before inflation sends prices higher. Although the resulting demand for loans does increase the demand for funds, transactions like these that merely involve a transfer of ownership do little to resolve the problem of unborrowed savings that is at the heart of Japan’s economic malaise. A transfer of ownership only shifts savings around within the financial system—the buyer’s deposits decrease and the seller’s deposits increase, but the savings remain within the financial system. The money must be used for consumption or investment in order for the problem of unborrowed savings to be resolved.

But increased investment does

In addition to new demand for loans, the deployment of businesses’ retained earnings for new investments can also reduce unborrowed savings, since any reduction in retained earnings represents a decline in unborrowed savings languishing somewhere at financial institutions.

Increased investment demand therefore reduces the need for the government to borrow and spend, enabling it to pursue fiscal consolidation without adversely affecting the economy. In this regard, the claim in the 3 June issue of the Nikkei that large Japanese enterprises plan to invest 12.3% more in FY13 than they did in FY12 is a welcome development. This probably includes export-related firms and companies competing with imports that have decided to ramp up domestic production for the first time in many years in response to the weak yen.

“Bad” rise in rates renders two of three pillars of Abenomics powerless

We cannot be too complacent, however, because the size of the surplus private savings problem in Japan is huge. At the moment we only have data through 2012 Q4, and they show that private sector savings amounted to a seasonally adjusted 7.11% of GDP in spite of zero interest rates. This means the public sector must be borrowing and spending a comparable amount in order to keep the economy going.

If the level of savings is largely unchanged today, Japan’s economy could easily stall if the government were to stop borrowing and spending the private sector savings surplus. The second pillar of Abenomics—fiscal stimulus—was put in precisely to address this risk. If an unfavorable rise in interest rates not only prevented the government from borrowing and spending but actually forced it to raise taxes and cut back on expenditures, that would be putting the cart before the horse.

It would effectively mean that an excessive reliance on the first pillar—monetary accommodation—had prompted an unfavorable rise in rates, forcing the government to abandon the second pillar, which is essential when the private sector is saving so much at zero interest rates.

“Bad” rise in rates should be addressed with adjustments to monetary policy

In this regard, we need to watch out for the possibility of an increase in long-term rates driven by mounting inflation concerns without a recovery in private demand for funds. If, for example, people see inflation picking up before long—even if there is no inflation today—they will no longer be willing to hold 10-year government bonds yielding less than 1%. If they decide to convert their JGBs to cash and buy them back once prices have fallen, long-term rates will rise sharply. This kind of selling is already being observed in some quarters.

When facing this kind of unfavorable rise in rates fueled only by inflation concerns and not by a recovery in private demand for funds, the government should respond not with fiscal consolidation but rather with adjustments to the BOJ’s overly accommodative monetary policy.

If the BOJ refused to modify its policy and forced the government to engage in fiscal retrenchment, the Japanese economy will suffer badly given the weakness of private demand for funds.

On the other hand, when interest rates are rising because of a recovery in private demand for funds, the proper response for the government is to raise taxes and cut spending in order to keep upward pressure on interest rates in check. If the Japanese economy were actually in such a phase, the economy could probably continue making progress even after the consumption tax is hiked next April.

Unfavorable rise in rates must be dealt with carefully

Then-BOJ Governor Toshihiko Fukui, who understood all of this, said in 2005 that there was no problem with fiscal consolidation as long as its scale was consistent with the recovery in private demand for funds (see my report dated 8 March 2005 for details). But the officials now making a case for fiscal consolidation—Mr. Kuroda, Mr. Lipton, and private economists—give no sense of having confirmed that private demand for funds is actually picking up.

The implication is that they may respond to an unfavorable rise in rates by scaling back fiscal expenditures instead of making adjustments to monetary policy. We need to watch out for this risk very closely.

Only 22% of people surveyed by the Nikkei felt Japan’s economy is actually recovering (27 May 2013), suggesting relatively few have benefited from Abenomics’ honeymoon thus far.

Moreover, an increase in long-term rates at a time when 78% of the population is not personally experiencing a recovery is most likely a “bad” rise in rates, and the authorities need to address it very carefully, keeping a close eye on private demand for funds.

Slamming The Money Market “Gates” – Capital Controls Coming To $2.6 Trillion Industry

The first time we wrote about the Volcker-led Group of 30 recommendation to crush Money Markets in January 2010 by effectively imposing capital controls and fund "gates", whose purpose was simply to scare investors out of the $2.6 trillion liquidity pool and force said capital to reallocate into a much more "reflation friendly" asset classes such as stocks, many were concerned but few took it seriously. After all, such a coercive push into a "free" market at the time seemed incomprehensible (if, in reality, turned out to be just a few years ahead of its time).

Fast forward two years to July 2012 when the same proposal of "risk-mitigation" by allocating a portion of the balance to a "loss-absorption fund", which would "create a disincentive to redeem if the fund is likely to have losses" was not only re-espoused by Tim Geithner, and the NY Fed but the SEC put it to a vote and the proposal would have almost passed had it no been for a nay vote by Commissioner Luis Aguilar opposing Mary Schapiro in the last minute. Still, once more many largely unconcerned about the implications behind this urgent push to intervene and establish pseudo-capital controls in this major source of potential stock buying "dry powder."

A few months later, following the coercive bail-in of Cypriot deposits, and the new "blueprint" for Europe bank rescues, whereby the authorities have strongly hinted that no more than the insured limit should be kept as as a deposit at a bank and it is preferred that the balance is invested in stocks or some other ponzi-enabling instrument, many have finally started to wonder if indeed there isn't some overarching strategy to "tax" financial assets in a world slowly but surely going insolvent and where the much desired debt inflation is so slow to materialize (just as we predicted would happen in September of 2011 in The "Muddle Through" Has Failed: BCG Says "There May Be Only Painful Ways Out Of The Crisis").

Today, with a brand new leader, Mary Jo White, now that the clueless and co-opted Mary Schapiro is long gone, the $2.6 trillion Money Market Fund industry is one step closer to finally being gated. But don't it call it that - the SEC prefers the term "protecting investors"

From Reuters:

A portion of the $2.6 trillion money market fund industry would be required to fundamentally change how it prices its shares in an effort to reduce the risk of abrupt withdrawals, under a proposal released by U.S. regulators on Wednesday.


Funds could also charge withdrawal fees and delay return of funds to customers in times of financial distress, under the Securities and Exchange Commission's proposal.


The SEC plan comes after a long debate over whether changes made in 2010 were enough to avoid a repeat of a run on money market funds seen at the height of the financial crisis.

Naturally, those who see the writing on the wall - the MMF industry - is not happy:

The fund industry has warned that further major reforms could kill investor interest in money market funds.

Well, of course. After all this is the whole point. Recall what we said in July of 2012:

In a nutshell, money market funds (much more on this below), have always been one of the most hated liquidity intermediaries by the central planners: they don't go into stocks, they don't go into bonds, they just sit there, collecting no interest, but more importantly, are inert, and can not be incorporated into the rehypothecation architecture of shadow banking.


And perhaps that is precisely why the Fed is pulling the scab off an old sore. Recall that for the past year, our primary contention has been that the core reason for all developed world problems is the gradual disappearance of good collateral and money good assets.


Even if the MMF cash were to shift, preemptively, into bonds, or any other "safe" investments, the assets backing the cash can them enter the traditional-shadow liquidity system and buy time: the only real goal at this point. In the process, the cash itself would be "securitized" and provide at least a year or so in additional breathing room for a system that has essentially run out of good liquidity, and in Europe, out of any collateral.


Expect more and more efforts to disgorge the $2.7 trillion in money market funds as the world gets closer and closer to D-Day. And what happens with MMF, will then progress to all other real asset classes as the government truly spreads out its capital controls wings.

Funny: we said this 9 months before a capital control "disgorgement" struck in Cyprus. Fear not: it is coming to every other "taxable" financial asset. But whereas we thought the money market forced capital expropriation would be first, some places like Europe were so desperate they couldn't afford to wait that long.

So what proposals is the SEC planning on applying in order to enforce the capital reallocation pardon avoid investor losses? There are two, both perfect strawmen, and have been well-known since the first time we approached this topic three and a half years ago.

In a compromise move, the SEC's plan mostly focuses on prime funds for institutional investors, which are seen as more prone to runs because those investors are more sophisticated and more likely to pull large blocks of money first if there is a panic.


The SEC estimated that institutional funds represent 37 percent of the market with $1 trillion in assets.


The SEC's plan calls for two alternative proposals that it said could be adopted alone or in combination.


The first piece would require prime funds used by institutional investors to transition from a stable, $1 per share, to a floating net asset value (NAV) - a move designed to reduce the risk of runs like those during the financial crisis.


The SEC said that retail and government funds, which are not considered to be at the same risk for runs, would not have to move to a floating NAV. Retail funds are defined as those that limit shareholder redemptions to $1 million per day.


The industry has long fought against moving away from a stable share price, which it says is appealing to investors looking for a safe product.


The second proposal, meanwhile, would give fund boards for institutional and retail funds the authority to impose so-called "liquidity fees and redemption gates" during times of stress.


That would give funds the power to stop an outflow of investor money, an idea that the SEC's two Republican commissioners last year said they might be able to support.

We are not sure what is more amusing: that the SEC is so naive it thinks someone will actually believe it can prevent a capital run in a financial panic, or that its transparent attempt to spook money market investors away from their holdings now that the threat of imminent lock ups and gates looms over their heads is not what this is all about. We anticipate that the SEC will drop numerous analogies to Cyprus as a reminder that if something can be gated, it will be gated.

What is more important, is that unlike Schapiro's plan the current SEC proposal should have no difficulty in passing.

The initial industry reaction on Wednesday indicated the SEC's plan may not generate the same degree of opposition that the SEC faced last summer when then-SEC Chair Mary Schapiro called for what some consider stricter reforms.


Schapiro, who stepped down as SEC head last December, had advocated for a series of possible reforms, including capital buffers and redemption holdbacks, or a broader switch to a floating NAV - two ideas vehemently opposed by the industry.


She was unable to muster the votes needed to issue a proposal for comment after three of her fellow commissioners said they could not support her plan without additional study.


Schapiro's proposal was starkly different from what the SEC unveiled on Wednesday. This time, the SEC's plan contains some proposals that a few fund sponsors have previously said they could live with.


"It has been a journey to get to this point," said SEC Chair Mary Jo White, who took over the agency earlier this spring.

And if the industry is onboard, all the token SEC votes needed to enforce the plan will be in place.

At that point money markets will merely be the latest experiment in behavioral control: how to spook those with money in the multi-trillion industry enough to where they pull their cash and either spend it on trinkets, boosting inflation - a very welcome outcome for the Chairman - or merely investing it in the "stock market." Perhaps instead of a lock up, at times of crisis MMF investors will be given the opion of allocating funds to the Solyndra du jour (a la the Cyprus bank bailout) or lose all the money.

We are confident the central planners will find a way,

Five Questions Facing the Market

What is the outlook for Fed policy?

Can Japanese officials stabilize the bond market?

Is the ECB going to adopt a negative deposit rate?

What are the latest inflation readings? 

Is the soft landing still intact for China?

What is the outlook for Fed policy?  


The dramatic market reaction notwithstanding, we think Bernanke and the FOMC minutes were clear.  To calls from some members to consider scaling back on the long-term asset purchases at next month's meeting, Bernanke essential said no, that it is too early, and he and the majority of the FOMC needed several more months of data to make that determination. 

And when that determination in made, we are talking about the pace of QE, not terminating it.   In addition, the Fed and some economists argue that the accommodation of QE lies in the stock of long-term assets that the central bank keeps off the market not so much with the flow of purchases.

It is true that QE will come to an end, which is partly why we thought references to QE-infinity were misplaced,(purposely?) confusing indeterminate with permanent.    Ceasing QE operations is a delicate process in which the Fed has been engaged in twice before.  The Fed's guidance suggests it will only adjust monetary on the basis of economic performance.  A slowing of QE and its eventual likely means the economy is stronger.  In addition, the faster than expected decline in the US budget deficit means that new net supply will also fall.

We continue to look for underlying US dollar strength.  Yet, to the extent that some of the dollar's recent gains are a reflection of a more hawkish reading of the Fed's stance than we think is really the case, we worry that the dollar is vulnerable to the disappointment.  Such a dollar pullback would provide medium term investors with a new opportunity to take on exposure.

Can Japanese Officials Stabilize the Bond Market?  There are high political and economic stakes at risk by both the volatility and direction of Japanese bond yields.   The BOJ continues to struggle to stabilize the market.  In addition to domestic source of volatility, officials have had to cope with a rising long-term global yields.  Over the past month, Japan's 10-year yield has risen 31 bp, the US 37 bp and Germany 25 bp and UK gilts 24 bp.

The Abe government wants its cake and eat it too.  It wants to take credit for the economic recovery (and the fastest growing economy in the G7), demonstrate its commitment to ending deflation, and keep bond yields stable and low.  With earnings bolstered by the translation of foreign sales and income from foreign investment back into the weaker yen, corporations appear to be benefiting from Abenomics.  Yet they are not facilitating its agenda by raising wages and investment.

BOJ officials will again meet with Japanese bond dealers in yet another attempt to prevent its operations, in which it is buying 70% of the new issuance, from destabilizing the market.  After the last meeting, the BOJ made more frequent and smaller purchases.

The rise of Japanese interest rates changes the cost-benefit comparisons for institutional investors in buying foreign bonds.  The rise in JGB yields has spurred on insurance company to indicate it was going to increase its allocation domestically.   Japanese investors have sold about $95 bln worth of foreign stocks and bonds this year, while foreign investors have bought about $80 bln of Japanese shares.

Is the ECB going to Adopt a Negative Deposit Rate?   ECB President Draghi himself raised the possibility at the meeting earlier this month.    If the goal is to help revive lending, especially to small and medium sized business and improve the transmission mechanism of monetary policy, then we expect a serious analysis to highlight the risks and downplay the likely benefits.

That said, as ECB President Draghi has surprised many observers with his boldness--unwinding both to Trichet's rate hikes in his first two meetings--and ability to innovate--two LTROs and the OMT.   At the same time, OMT has worked by brandishing it not actually deploying it.   The dramatic success that moral suasion was not lost on Draghi.  We suggest the negative deposit rate is more like the OMT than the LTRO.   Because of the potential disruptive effects such a policy could have, we think the bar to it is high.  Unless there is a further material deterioration in conditions in the euro area, we do not expect the ECB to adopt a negative deposit rate.

There is asymmetrical risk around the euro.  It is more likely to sell-off sharply on a move to negative deposit rate than rally when the ECB, as we expect fails to signal a cut in the deposit rate next week.  Moreover, a refi rate cut is not the done deal many observers suggest.  As the new staff forecasts next week will likely show, most of the weakness see thus far was largely anticipated. 

What are the latest inflation readings?  Disinflationary forces have emerged in the first part of the year, while there continues to be pockets of deflation.  Earlier today Japan reported its corporate service price index for April, which fell for the first time in three months.  The headline rate fell 0.3%, for a -0.4% year-over-year reading; twice as large of a fall as the consensus expected.  The core rate fell 0.4%, also the first decline in three months.  The 0.7% year-over-year decline is the 11th consecutive decline.  

Japan will report CPI figures at the end of the week.    Sweden is also experiencing deflation as year-over-year CPI is negative.  Today it reported record low PPI of -5.3% year-over-year.  The 1.1% month-over-month decline compared with a consensus of -0.2%.   

Disinflation forces are strengthening in Germany.  It reported a 1.4% decline in April import prices.  This was more than 3 times larger than the market expected.  This warns of some downside risks to the CPI figures (the states begin reporting tomorrow). 

The euro area CPI estimate will be reported at the end of the week.  There are downside risks to the consensus 1.4% forecast (1.2% in March).  The US reports the Fed's favorite (but not only) inflation measure at the end of the week as well.  The core PCE deflator was up 1.1% on a year-over-year basis in March.  The small decline the consensus expects would put it into record low territory.

Is the soft landing still intact for China?  The issue in China has morphed from what kind of landing to how soft of a landing.  Premier Li Keqiang acknowledged the serious challenges of achieving 7% growth over the next decade after a 10% pace over the previous decade.   It is not that the new government is more tolerant of weaker growth, but it actually wants a more sustainable pace, especially if it reflects a restructuring, especially in terms of moving away from industries with excess capacity.  An important speech over the weekend suggests the new government sees using more market pricing signals as a means to foster restructuring.

China has become an increasing inefficient user of capital.  Every incremental unit of investment is generating less GDP growth.  That investment is increasingly debt financed.  Capital from offshore, some foreign, others from Chinese sources (see recent discussions of concealed capital flows in exports).   This explains the acceleration of reforms in the financial sector and the appreciating yuan.

David Einhorn’s Q1 Investor Letter: „Under The Circumstances, It Is Curious That Gold Isn’t Doing Better.“

Sadly, not much in terms of macro observations this quarter or discussions of jelly donuts, but a whole lot on the fund's biggest Q1 underperformer, Apple and the hedge fund's ongoing fight for shareholder friendly capital reallocation as well as proving Modigliani-Miller wrong. And then this cryptic ellipsis: "Under the circumstances, it is curious that gold isn’t doing better." Say no more, David. We get it.

In other positional news, Greenlight closed out longs in XRX and ESV and shorts in AVB and MBI. Greenlight also initiated a long position in Germany EVK (ahead of public listing). It appears Greenlight is still long Green Mountain.

From Greenlight Capital, as of May 8

Dear Partner:

The Greenlight Capital funds (the “Partnerships”) returned 5.8%1, net of fees and expenses, in the first quarter of 2013.

It was a quarter of reversal: Marvell Technology Group (MRVL), our biggest loser in 2012, was our biggest winner this quarter. Yen puts, our biggest losing position in both 2010 and 2011, were our next biggest winner. On the other hand, Apple (AAPL), a top three winner in 2011 and 2012, was our biggest loser.

Overall, it was a decent start to the year with a good risk-adjusted return. It’s unlikely for us to keep up with the sort of one-way market that we saw in the first quarter, where the S&P 500 never suffered more than a trivial weekly decline. Our long portfolio roughly matched the S&P 500, we had a modest loss in our short portfolio, and macro was positive. We are four years into an economic recovery. Corporate earnings, which grew steadily during the initial stages of the recovery, are now growing anemically. The market advance can be better explained by investors convincing themselves that extraordinarily accommodative monetary policy is bullish for stocks. Unconventional monetary policy is now a global phenomenon.

The Japanese government replaced its conservative central banker with a more aggressive one. This regime change has led Japan into the global battle to see who can debase their currency the fastest and this drove our gains in Yen puts, as the Yen weakened from ¥86.74 to ¥94.19 against the dollar.

Now every major central bank is fully engaged in aggressive, unconventional policy. It seems that as each bank implements a new experiment without immediate consequence, the new policy is deemed safe, if not effective. Other central bankers notice and, acting in the philosophy of ‘Anything you can do, I can do better,’ take turns in one-upmanship. This serially correlated behavior smacks of bubble mentality. But investors are currently complacent about the unintended consequences of central bank money printing, and like most investment cycles and fads, this will persist until it doesn’t. Under the circumstances, it is curious that gold isn’t doing better.

AAPL shares fell from $532 to $443 during the quarter. The biggest problems with our AAPL investment are disappointing earnings and a diminished forecast. When AAPL announced its year-end result, it made clear that it would earn less in the March quarter than it did a year ago. Forward estimates have been falling for a while. Last July, consensus estimates for fiscal 2014 were $64 per share; estimates now stand at $44. When we thought the company would earn $64 per share, the shares seemed cheap even as they reached $700 in September. Of course, that required AAPL to meet that forecast.

Our thesis is that AAPL has a terrific operating platform, engendering a loyal, sticky and growing customer base that will make repeated purchases of an expanding AAPL product offering. Unfortunately, there have been a series of disappointments including slower sales growth, lower margins, and increased competition. There have also been delays in new carrier wins, next generation product introductions, and new product category launches. While all of these have had an understandably negative impact on AAPL’s share price, we take a longer view and believe our thesis is intact.

As shareholders, we watched AAPL accumulate a cash stockpile greater than the market capitalization of all but 17 companies in the S&P 500, and recognized that its high cost of capital and shareholder-unfriendly capital allocation were depressing the stock price. AAPL’s management and Board, either unconcerned or unaware of the detrimental effects of AAPL’s all common equity capital structure, seemed uninterested in finding a solution.

As shareholders who believe in AAPL’s core business, we wanted to help AAPL resolve its cash problem in a way that satisfied AAPL, the market, and its shareholders. Based on years of observation and many discussions, we believed that AAPL would not issue debt under any circumstances, and especially not to return cash to shareholders. With this in mind, coupled with our awareness that AAPL was loath to repatriate (and thereby pay taxes on) its overseas cash, last year we suggested iPrefs to Peter Oppenheimer, AAPL's CFO. We had no better luck than any of the many other investors and analysts who for years have pressed Apple to return excess capital to shareholders. Our concerns fell on deaf ears.

In February, CalPERS came out in loud support of a proposal aimed at improving AAPL’s corporate governance that inexplicably bundled several measures into a single voting measure. The proposal, which included an unwarranted provision prohibiting AAPL from issuing preferred stock, was in direct violation of SEC rules, and we filed a lawsuit insisting that AAPL allow the shareholders to vote on each measure separately. We believed this would generate a public dialogue around AAPL’s capital allocation strategy.

When Tim Cook later called the lawsuit a sideshow, it was understandable. Whereas we chose to focus on the very real issue of Apple’s capital structure, others seemed more intent on turning things into a circus. A lawyer known mostly for preserving the autonomy of Boards to act in any manner they wish wrote a piece titled Bite the Apple; Poison the Apple; Paralyze the Company; Wreck the Economy. Given the hysteria implied in the title, one would think we had suggested that AAPL hire Steve Ballmer to run new product development. A retired Fortune 500 CEO said “I’d give Einhorn the back of my hand,” prompting us to wonder why he wouldn’t give us the front of his hand. Perhaps most startling was the reaction from CalPERS, who vigorously defended the proposal.

The essence of corporate governance is form over substance. The belief is that properly-made decisions will lead to better decisions, so it was odd to watch self-identified corporate governance advocates support a proxy proposal that violated SEC rules. Incongruously, CalPERS believes good corporate governance is unnecessary when approving policies that purport to improve corporate governance.

Others ignored the circus and focused on the balance sheet. We received feedback from many AAPL shareholders, including some of AAPL’s largest institutional investors, thanking us for initiating the public discussion. Even some who disagreed with our idea helped further the public debate. Respected NYU finance professor Aswath Damodaran wrote a critical piece that pushed us to refine our presentation of the iPrefs idea. These thoughtful responses reinforce the value of speaking publicly, despite the more obvious drawbacks.

In the end, the judge sided with us, and AAPL withdrew the proposal from consideration. Once the shareholder meeting passed, there was nothing left for a court to do, so the case became moot and was dropped. Not long after, we met with AAPL management and its investment bankers to further discuss AAPL’s options. We believe that our thoughts were given a fair hearing.

Ultimately, the Board and AAPL decided to abandon their “no debt” philosophy and gave birth to iBonds. As rejections go, AAPL’s bond issuance ($17 billion in bonds were issued at about a 2% average interest cost) was as good as anything shareholders could have hoped for and the market seems to agree. AAPL announced that it will return $100 billion to shareholders by the end of 2015 and will evaluate returning additional capital annually. This vastly more shareholder-friendly capital allocation policy is a dramatic shift from where AAPL stood just a few months ago. We have added to our AAPL position. We now await the release of Apple’s next blockbuster product.

The other significant loser in the quarter was Green Mountain Coffee Roasters (GMCR). We would love to be the “Credentialed Bear” that gets invited to ask tough questions at its annual shareholder meeting, but we aren’t waiting by our iPhones. Shares of GMCR increased from $41.34 to $56.76 in the quarter.

In addition to MRVL and the Yen, Vodafone (UK: VOD) was another material winner during the quarter. It is now clear that Verizon does in fact want to buy VOD’s 45% interest in Verizon Wireless. We can hear them now. We believe that a premium sale followed by a successful return and/or redeployment of the proceeds could unlock substantial value latent in VOD stock. VOD without Verizon Wireless might also become a good acquisition target for AT&T. During the quarter VOD shares advanced from £1.54 to £1.87.

MRVL reversed its 2012 decline as investors began to pay attention to MRVL’s prospects for share gains in controllers for hard disk drives and flash memory drives, as well as its new processor for cell phones and tablets. The company should see significant fixed operating leverage in 2013, as it has been carrying the cost of the investments in these products without any corresponding revenue until now. The company has also continued to buy back stock aggressively, adding to the potential earnings leverage.

We initiated a long position in Evonik (Germany: EVK), a global chemical business, through a private placement at an effective price of €29.13 per share, ahead of a public listing in April. EVK has a high quality portfolio of chemical assets in the U.S., Europe and Asia, including market leadership in methionine, a high margin, high structural growth business that tracks the demand for animal feed. EVK’s business is less cyclical than that of its European peers as demonstrated by its positive EBITDA growth each year even during the recession. EVK is currently in the middle of a capital investment cycle that we believe will enable it to grow its earnings power from €2.50 in 2012 to €4.00 per share in 2015/2016. We think that its combination of secular growth, superior asset quality, and low cyclicality makes EVK the premier European chemical company, which deserves a rerating to a premium multiple.

We initiated a long position in Oil States International (OIS), a solutions provider for the oil and gas industry, at an average price of $77.16 per share. OIS has four business segments: Well Site Services, Tubular Services, Offshore Products, and Accommodations.

We believe that the company trades at a significant discount to the sum of its parts. Though the shares trade at slightly less than 7x 2013 EBITDA (a multiple typically associated with its lower multiple businesses), the majority of its profits come from Accommodations, which is a high growth, high return-on-capital segment that deserves a much higher valuation. At 8.6x 2013 EBITDA, an appropriate multiple given a sum of the parts analysis of OIS’s business mix and where comparable companies trade, OIS would be worth close to $120 per share. We believe that OIS could unlock significant shareholder value by converting the Accommodations unit into a REIT and separating it from the rest of the company; if completed, it would suggest a valuation of $155 per share.

We closed several positions during the quarter including longs in Ensco (ESV) and Xerox (XRX), and shorts in Avalon Bay (AVB) and MBIA (MBI).

We bought ESV, an offshore contract oil driller, after the Macondo oil spill. At the time, we believed that the shares were depressed over fears of curtailed offshore drilling. Subsequently, the fears were resolved and the drilling business recovered. We earned a 34% compounded return over our 4+ year holding period. The return was helped by favorable trading around the position. We sold in order to redeploy the capital into OIS.

XRX did not perform as well as we had hoped. We bought the shares based on expectations that synergies from its acquisition of Affiliated Computer Services would lead to revenue growth and margin improvement. Unfortunately, the company did not deliver.

Despite this, we sold the shares for a modest gain.

We finally gave up on our short of AVB. Our initial short in early 2007 worked nicely during the credit crisis, but we overstayed our welcome. It is a mediocre business with cyclical risk and an extreme valuation due to its REIT nature. Nonetheless, the company recently acquired Archstone  properties and issued a lot of stock. The shares declined from their recent highs and we took the opportunity to admit defeat and exit with a loss.

During the quarter, we finally declared victory on our MBI short, which we have held in some capacity since 2002. It was rough sledding for the first five years until the stock collapsed from $76 to $2 between 2007 and 2009. This was another case of a misunderstood business and a management team engaged in assorted accounting and business chicanery. While it is possible that sleepy regulators will ultimately put this company and its management out of their misery, the opposite seems equally possible. We’ve decided to enjoy the healthy profit we made and step aside for the time being. Cumulatively, this was the third most profitable short position in our history.

* * *

The Web’s Most Comprehensive Apple Analysis & A Roadmap To Apple’s Resurgence That Management Is Ignoring!!!

This short post has more pertinent Apple analysis than a year's worth of Goldman's research. Don't believe me? Get some of the best Goldman research from the year and compare it, or better yet send it to me and I'll post it so we can all compare! In the meantime...  

In February I opined on Apple's attempt to appease institutional investors in the post "Regarding A Potential Stock Split & Cash Dividend For Apple". I am vehemently against Apple paying dividends or splitting its stock. Apple has witnessed a significant operating obstacle in front of it, and instead of attempting to navigate deftly around that obstacle, it is allowing itself to be distracted by non-operators (large investors, primarily hedge funds, who are eyeing its cash horde). Worry less about fancy cash repatriation schemes via debt issuance, cash dividends and stock splits and worry more on how to stem the tide of market share, technological capability and innovation loss relative to the extremely aggressive and capable Android powered competition. More importantly, focus on how to defeat the progenitor of Android, Google. 

As excerpted from the afore-linked article:

Only short term thinking traders really want Apple to return cash, reference Apple, Big Hedge Fund Stars & The Sell Side/Vaudeville Act To Burn Your Hard Earned Money As A Punchline That's Just Not Funny. Apple needs to put that cash horde to work aggressively, and quite quickly to build up its expertise and assets in the cloud, where it's sorely behind and in danger of never catching up. Apple also needs to significantly beef up its hardware and software in the portable device field. All three of these aspirations will hit margins, and Apple is seriously behind in all three aspects as well. For more on this, reference In Case The Mainstream Media Didn't Get The Memo, I Crush The Apple Reality Distortion Field On CNBC.

Giving cash to shareholders when you should be investing it yourself is an awful idea for the long term prominence of this company, whose days already appear to be quite numbered as a leading tech titan.

Now, to be honest, all tech titan's days are numbered, at least as a tech titan. Apple is currently and sorely outclassed in the tech features and capability race at the same time it has lost its iconic leader and competition has more than quintupled.

I rehash these points because as I fine tune our most recent Apple valuation model, incorporating the most recent quarterly results along with the bond offering details, I see some alarming developments that further my belief that Apple is no longer a growth company in spirit, in practice, and soon in growth rate, but has matured and is taking on the characteristics of a company who market has matured. The major problem with this is that Apple's market has NOT matured, and as a matter of fact, is still in the high growth stage. It is Apple management which has dropped the ball here, foregoing longer term opportunity to appease financial investors' shorter term desires. A very bad idea, and a devaluing event for longer term equity investors of Apple stock.

Apple cash reinvestmentApple cash reinvestment

It is no surprise that Apple's margins are dropping uncontrollably for they can no longer differentiate their product enough to justify a premium. Notice hos the drop in margins track the drop of R&D/marketing, albeit with the requisite time lag.

Apples margin free fall by Reggie Middleton on CNBCApples margin free fall by Reggie Middleton on CNBC

This 15 minute video features all of the ins and outs of how Apple fell, why it fell, and how it can rise again.

Apple's management is in desperate need of a cloud infrastructure build-up and build-out. They also need a significant hardware and OS refresh. Without such, they will become RIMM'd, or shall I say Blackberry'd.

As you can in the app below, Apple's mobile product margins are all trending down, at the same time their market share and ASPs are downward trending as well. This sample is one page out of our ten section Apple valuation model, a model which I will make available to all professional and institutional subscribers next week, one updated with the latest quarterly results and the recent bond offering. You can subscribe here to access this model, as well as Google's and Facebook's next week. 

I've embedded the sample app that was used to create the charts above. It is apparently too complex to post here, but can be access about midway down the page on BoomBustBlog here.


Related articles:

What Sell Side Wall Street Doesn't Understand About Apple - It's Not The Leader Of The Post PC World!!!

Following up on Deconstructing The Most Accurate Apple Analysis Ever, I am offering subscribers an updated valuation of Apple now that it has fallen to EXACTLY where I warned subscribers in October (the week of its all-time high of about $707 it would fall) to. After playing with the iPhone 5 for about a week, I told subscribers to expect the stock to bounce up against the pessimistic band of our valuation analysis. Apple last traded at $420, this is how I put it 5 months ago...

image124 image124image124image124

This report is still available for download to paying subscribers:

Currency Positioning and Technical Outlook: Heavy Dollar Looks Likely


There are several incremental additions to our information set from developments over the past week.  The US manufacturing sector is stalling, with the ISM at new four month lows, and the sector failed to add jobs in April, for the first time since last September.  The euro area economy remains weak and the German engine also appears to be flat lining.  

Industrial output in Japan is stabilizing, albeit at weak levels, while domestic consumption remains restrained and wage growth is poor.  This suggests that only the weak yen component of Abenomics seems to be working.  Ironically, it is the UK's economy that provided the upside surprises in recent days and sterling was rewarded by being bid to new 11 week highs and finally reaching our $1.56 objective first cited here in late March.

In terms of policy, there were no surprises by the FOMC, but by including into the statement what Bernanke and others have already said about its flexibility, to quicken or slow the pace of its purchases in response to economic developments, drives home the point about the symmetry of its stance.  Although the recent FOMC minutes showed there was a discussion about tapering off purchases, it is still possible that the Fed may have to accelerate its purchases, especially if growth slows sharper than anticipated and if disinflation continues.    

The ECB delivered a 25 bp cut, but effectively kept the door open to more action, which could include another 25 bp rate cut in the refi rate and possibly measures to support the ABS market for non-financials.  Although Draghi seemed to suggest greater willingness to consider a negative deposit rate, our sense was that this was not a signal of intent or even desire.  We suspect that a negative deposit rate would be disruptive and another headwind for the financial sector and savers.  Draghi's rhetoric may have been aimed at demonstrating that the ECB had not exhausted its options. 

The US dollar fell against the major currencies, except the yen, last week and appears poised, from a technical perspective, to continue to trade heavily in the days ahead, though the week will begin slowly with both Tokyo and London markets closed on Monday.  

The Dollar-Index did rally in the second half of last week, but ran into a wall of offers near 82.50 a key retracement objective of the previous week's drop.  Provided this area holds, we are more inclined to see it fall toward 81.20 and maybe 80.70. 

The decline in the euro in the second half of last week largely held a trend line drawn off the April 4 and April 24 lows.  The trend line comes in near $1.3070 on Monday and  $1.3125 by the end of next week.  Initial resistance is see near $1.3160 and then $1.3240.  The euro has not managed to finish the North American session above $1.32 since Feb 20.  Good demand for euros around $1.30 has spurred talk of central bank interest.

After the conclusion of the Golden Week holidays, Japanese institutional investors are thought likely to begin implementing the investment plans for the new fiscal year.  We remain skeptical of the magnitude of the outflows.  Many core European bonds, like France, Belgium and Austria offer record low yields.  Yield in the large peripherals, like Spain and Italy are at multi-year lows.  Meanwhile, anecdotal reports suggest the foreign appetite for Japanese shares,  which in the year through mid-April, has been nearly $65 bln (more than twice the pace of the year ago period) may be slowing. 

Short-term speculative sentiment remains wholly yen negative and technically the market looks poised to try again at the JPY100 level.  A break of it could see a quick move toward JPY101.40.  Now only a break of JPY97 would dampen the constructive technical tone.  

It has taken a bit longer than we anticipated, but sterling has reached our $1.56 objective, but it does not look as if the move is over.   The next target is near $1.58, while a break of $1.54 would suggest a top is in place. 

The dollar-bloc finished last week on firm footing.  Although poor data have increased the risk that the Reserve Bank of Australia cuts interest rate as early as next week, the Australian dollar finished the week at three day highs.  A move now above $1.0325 would target $1.04.   Some Aussie bulls may also take heart from the recover in copper prices, which finished the week at its best level since mid-April.   Gold prices traded broadly sideways last week, but also managed to record a marginal new high since the dramatic sell-off in mid-April. 

The Canadian dollar recovered from the knee-jerk sell-off on news that the new central bank governor sounded a bearish note when talking about the need to boost exports to reinvigorate the economy.    The US dollar slipped as we anticipated last week into the CAD1.0070-CAD1.0100 area.   Our next target is near CAD1.0020. 

We turn more cautious the Mexican peso as the dollar approaches the MXN12.00 area.  The dollar bounced smartly off this area in mid-April.  Technical indicators suggest that with a running start the greenback can be pushed through there now.  However, our cautious stance is based on two considerations.  The government seems to be turning less receptive to further peso gains and the trade is very crowded.  The Mexican peso has been the strongest currency we monitor here, up about 6.5% year-to-date and strongest in the emerging markets as well. 

Observations on the speculative positioning in CME currency futures:

1. The net short position of the euro, yen, sterling and Canadian dollars were reduced, while the net long Australian dollar and Mexican peso were pared.

2.  The net Swiss franc position swung from long back to short.  The net long position was a function of reduction of gross longs and shorts, while the shift back to a net short position was function of the establishment of new shorts and paring of longs.

3.  The net short yen position was reduced for the second consecutive week, but participation was reduced as gross longs and shorts fell.

4.  There was no gross position adjustment of more than 10k contracts.  In fact, all but three positions (gross long euros, gross short yen and Canadian dollar positions) changed by no more than 6k contracts.

5.  There was almost a doubling of gross short peso positions to 7.4k contracts.  The increase snapped a five week streak in which the gross shorts were reduced.  However, peso gains after the end of the reporting period may have forced out these late shorts.



Buy PHYSICAL Gold. NOW: The Discount of a Lifetime: Or Why You Must Abandon the Fake Paper Gold Market


For previous articles by the author go to: Gordon Gekko's Blog - http://www.gekkosblog.com


They just showed their hands. The paper Ponzi pyramid is wobbling. It’s time to go in for the kill.


Let me explain. But first let’s get a handle on what’s happening:


“We’ve traded gold for nearly four decades and we’ve never … ever… EVER… seen anything like what we’ve witnessed in the past two trading sessions,”


Dennis Gartman, via The New York Times


“This is an orchestration (the smash in gold).  It’s been going on now from the beginning of April.  Brokerage houses told their individual clients the word was out that hedge funds and institutional investors were going to be dumping gold and that they should get out in advance…it is the Fed’s concern with the dollar because the dollar is being printed in huge quantities at the same time that other countries are abandoning the use of the dollar as international payment.


The exchange value of the dollar is (being) threatened, and if that collapses the Fed loses control over interest rates.  Then the bond market blows up, the stock market blows up, and the banks that are too big to fail, fail.  So it’s an act of desperation because they’ve got to establish in people’s minds that the dollar is the only safe place, it is the only safe haven, not gold, not silver, and not other currencies.


And to help protect this policy they have convinced or pressured the Japanese to inflate their own currency.  The Japanese are now going to print money like the Fed.  They are lobbying the ECB to print more.  So I see this as a dollar protection policy...I know where the gold is coming from in the market, it’s just paper.  It’s naked shorts, there is no gold there.  If somebody wanted to take delivery on those contracts nobody would be able to provide it.  I don’t know what the source of the (physical) gold is...


..I think the power of the West has already been lost.  When you have off-shored your manufacturing and professional service jobs, you’ve hollowed out your economy.  So gold or no gold, the United States economy has been severely damaged and I don’t think it can recover...


This gold business (smash in price) is something to do with the dollar….They are trying to destroy gold as a (safe) haven from the dollar in order to carry on the Fed’s policy of negative real interest rates.  That is what is driving the illegal policy of selling naked shorts in order to manipulate a market.  If you and I were to do something like this without the government’s instruction or protection, we would be arrested.  So the fact that it’s illegal, being done by the authorities, tells me that they are seriously worried about the dollar.


(All emphasis mine.)


Paul Craig Roberts, Former Assistant Secretary of the Treasury (via King World News)


If there is one thing this latest shock-and-awe “theater” in the Gold market tells us, it’s that the government and banksters (i.e. the oligarchy) must be REALLY pissing their pants. It doesn’t show their strength – it lays bare their weakness. They just made it abundantly clear (again) how important Gold is in their scheme of things. A rapidly rising Gold price would reveal the utter fraud of their paper money Ponzi scheme and reveal them as simple hucksters, charlatans and scamsters counterfeiting money and hiding behind all the elegant regalia. The emperor would be naked. Can’t let that happen. The franchise of the paper dollar – arguably the most profitable franchise in history enabling theft on a global scale - must be protected at all costs. Something is or must be about to go seriously wrong with their empire of fake paper money (perhaps the recent gyrations in the JGB market is a tell).


With this recent paper Gold market “drama” they have only shown their desperation and weakness. The level of their desperation this time is so great that they had their bought-and-paid-for shills in the media mouthpieces attack and mock Gold and its buyers even before the sell-off (which further goes to proves that it was orchestrated; I’ll provide more evidence below). Consider this in an article “Lust for Gold” which appeared in the New York Times on the 11th April by none other than the lead bankster shill and cheerleader Paul Krugman:


After all, historically, gold has been anything but a safe investment…John Maynard Keynes famously dismissed the Gold standard as a “barbarous relic”, noting the absurdity of yoking the fortunes of a modern industrial society to the supply of a decorative metal…for a while, rising gold prices helped create some credibility for the goldbugs even as their predictions about everything else proved wrong, but now gold as an investment has turned sour, too. So will we see prominent goldbugs change their views, or at least lose a lot of their followers.


Its funny how the paperbugs liken Gold buyers to a cult, while not realizing they themselves sound like one, with their irrational faith in and defense of paper money (well, not completely irrational - they know where their next paycheck is coming fromJ). While I may provide a full rebuttal to Mr. Krugman in a later article (it barely deserves one, childish and inane as it is), I will point out this: If Gold is so inconsequential and such a “barbarous relic”, why is the government lapdog media busy trying to discredit it and all those who buy it? I mean just look at the sheer gloating:


From the Business Insider:


The WSJ also joined in the fun:



I’ll tell you why - because underneath all the bullshit they are spewing they know that buyers of Gold are not actually buying anything but voting against their paymaster government and bankster oligarchy. There is nothing spectacular about Gold except for its ability to reveal the truth about the scam being run by our ruling feudal masters, and this is the one and only reason why Gold and all those who buy it are so vilely derided by the establishment.


The global economy is still in shambles and the oligarchy have shown that they can’t do ANYTHING of ANY real consequence except manipulating the public opinion – either via “market” shenanigans or media mouthpieces. Just think about it – a global empire, a powerful and apparently invincible oligarchy threatened by just an inanimate piece of metal. But they know that because all their power is based on lies and deception, a simple truth - the rising price of Gold indicating the massive dilution of currency - can completely destroy it. Having become thoroughly corrupt, impotent and incompetent, unable to fix anything (they couldn’t run a lemonade stand if their lives depended on it) and fast becoming desperate with Gold having risen more than seven-fold from about $250 in 1999 to $1900 in 2011 exemplifying the worthlessness of their paper money and reality catching up to them, they did the only thing they knew: attack the messenger - Gold. It’s a short term fix which perpetuates their paper money franchise and thus their power, but longer term it’s meaningless. It doesn’t fix the massive misallocations which have occurred and are occurring due to central control of money via the paper money system and it doesn’t change one bit of the truth of the present dilapidated state of our economy and society which is a direct result of it. In fact it’s making the situation worse as by not allowing the misallocations to correct and reallocation of capital to productive hands to occur, huge amount of scarce resources – both human and material – continue to be wasted on unproductive enterprises.


Unless and until the following factors are no longer true, there is and will remain a case for buying Gold. These factors did not vanish overnight because of a single orchestrated plunge:

1.      Exponentially increasing Government and private debt

2.      Exponentially increasing money supply

3.      Consistent rise in the price of items of daily need (yes I know there is no “inflation” but anybody who goes to the supermarket knows what a crock of bullshit the government CPI numbers are)

4.      Rising unemployment and falling incomes

5.      Corrupt government and politicians


The banksters are acting like a child throwing a tantrum because daddy (Gold) is going to take their toy (paper money) away from them, so they simply wail and try to hit back at daddy, as if that would accomplish anything. People who know the truth should simply sit back and laugh at the banksters and their shenanigans while using the opportunity to buy even more.


The Discount of a Lifetime


The way this price fall occurred makes it clear that there were NO fundamentals behind the move and, paradoxically, strengthens the case for Gold even further. Let’s take a look at exactly how this latest plunge in Gold price happened (via Ross Norman):


The gold futures markets opened in New York on Friday 12th April to a monumental 3.4 million ounces (100 tonnes) of gold selling of the June futures contract in what proved to be only an opening shot. The selling took gold to the technically very important level of $1540 which was not only the low of 2012, it was also seen by many as the level which confirmed the ongoing bull run which dates back to 2000. In many traders minds it stood as a formidable support level... the line in the sand.


Two hours later the initial selling, rumored to have been routed through Merrill Lynch's floor team, by a rather more significant blast when the floor was hit by a further 10 million ounces of selling (300 tonnes) over the following 30 minutes of trading. This was clearly not a case of disappointed longs leaving the market - it had the hallmarks of a concerted 'short sale', which by driving prices sharply lower in a display of 'shock & awe' - would seek to gain further momentum by prompting others to also sell as their positions as they hit their maximum acceptable losses or so-called 'stopped-out' in market parlance - probably hidden the unimpeachable (?) $1540 level.


The selling was timed for optimal impact with New York at its most liquid, while key overseas gold markets including London were open and able feel the impact. The estimated 400 tonne of gold futures selling in total equates to 15% of annual gold mine production - too much for the market to readily absorb, especially with sentiment weak following gold's non performance in the wake of Japanese QE, a nuclear threat from North Korea and weakening US economic data. The assault to the short side was essentially saying "you are long... and wrong".


The CME's 10% reduction in the required gold margins in November 2012 from $9133/contract to just $7425/contract made the market more accessible to those wishing both to go long or as it transpired, to go short. Soon after we saw the first serious assault to the downside in Dec 2012, followed by further bouts in January 2013 - modest in size compared to the recent shorting but effective - it laid the ground for what was to follow. One fund in particular, based in Stamford Connecticut, was identified as the previous shorter of gold and has a history of being caught on the wrong side of the law on a few occasions. As baddies go - they fit the bill nicely.


The value of the 400 tonnes of gold sold is approximately $20 billion but because it is margined, this short bet would require them to stump up just $1b…. By forcing the market lower the Fund sought to prompt a cascade or avalanche of additional selling, proving the lie ; predictably some newswires were premature in announcing the death of the gold bull run doing, in effect, the dirty work of the shorters in driving the market lower still1.


(All emphasis mine.)


If someone is selling anything, the rational thing to do would be to get the best price possible, right? Would you get the best price if you sell your lot in one go flooding the market? Would you want to overwhelm all the bids and crush the price? Yes, but only if exactly that was your objective – to crush the price. Nobody sells 400 tons (!) of gold in one go if they are trying to get the best possible price. So this wasn’t a case of varied market participants selling their gold holdings having considered the fundamentals for Gold and arrived at the conclusion their long position didn’t make sense anymore. This was a case of concerted selling by one single entity whose sole intention was to drive down the price. Not only that, nobody sells $20 BILLION worth of Gold in ONE GO without some sort of state/CB backing. You think some piddly hedge fund manager would have the balls to do this while risking prosecution and jail time? So not only was this market manipulation, but state-sponsored market manipulation completely unrelated to the reality and the fundamental basis for buying Gold, which remains as strong as ever.


But it gets better. While this is the probably the most spectacular takedown of the Gold price ever, but by no means is it the first or the only one. Anyone who has actually traded the Gold futures market for any length of time knows that this happens on a regular basis. So basically the government/Central Banks use the paper gold futures market as a price control mechanism for Gold (of course, they can’t impose price controls on Gold overtly as it would reveal the lie - if Gold is a barbarous, meaningless relic why would you need to impose price controls on it?). But what happens when price controls are imposed on something? Shortages start to occur resulting in an even greater moonshot in price than would have otherwise occurred. A “black” market (which is actually the free market at play and depicts the true price of the commodity) eventually emerges where it sells at a premium to the official price. There are two reasons for this:

1.      Buyers - aware that the commodity/good is available at a discounted price - beat a path to the door of whoever is foolish enough to sell it at the government mandated price. Availability at that price soon runs out.

2.      The good becomes even scarcer as the costs of producing and selling it are no longer covered by the government mandated price. Aware of this, sellers withdraw from the market and demand ever higher prices for the good.


And remember: for marketable goods, the “out” is money, but the only “out” for money is a superior form of money. When the paper currencies become unstable, the only “out” is Gold so you can be sure there will be no lack of buyers, only sellers – and there is no upper limit to high it can go. Theoretically, the price will be infinity when no seller is willing to sell Gold in exchange for paper. You want to be “out” of paper before we reach that event horizon.


If the rigging in the futures market keeps continuing, the futures price at some point will decouple from the physical and become meaningless. This is exactly why you should use this opportunity to buy as much physical as possible at discounted prices while there are foolish sellers still willing to sell at the stated official (futures) price. I’m sure many of you remember Gold’s spectacular fall from about $1000 to $680 circa 2008. How many of you have regretted not buying at those levels while you have been watching Gold’s inexorable rise since? You’ve been waiting for a price drop, haven’t you? So what are you waiting for? We saw the same scary headlines in the MSM that we are seeing now with the same bullshit reasons – while the reality hasn’t changed ONE BIT. Some media mouthpieces are proclaiming a bear market in Gold has begun while others are hoping that their paymasters’ moronic ideas are finally working but remember this is the same media that sold you real estate before the bust, the same media that sold you DOW 36000, the same media that sold you Obama’s “hope and change” and has pilloried gold and gold buyers whenever its price crashes but has been largely silent throughout the past 13 years of the gold bull run. There’ve been many of you saying Gold is too expensive and waiting for an opportunity to buy in. Well, the banksters in using the futures market as a propaganda vehicle against Gold have unwittingly provided you with one. Overcome your fears for fortune favors the brave. It’s time to go in for the kill.


Don’t Pick Pennies In Front of The Steamroller – Get Out Of The Paper Markets


First, you must be clear why you are buying Gold. Sure, paper gains are nice to have but are only a side effect. The real reason is this (from one of my previous articles):


Any type of financial asset that has a counterparty – which is pretty much all the paper assets in the world – bonds, futures, any and all derivatives and yes, even the paper currency – will crash. What will they crash against? Yes, that’s right - Gold. All the world’s capital – trillions, perhaps quadrillions of it - will come rushing into the very tiny physical (NOT paper) Gold market. Remember, the world’s real physical capital – real assets such as land, oil-refineries, mines, infrastructure, etc. will not vanish, only it will be re-priced in terms of Gold and its ownership transferred to those who hold it. Since everything stays on this planet, it is a zero-sum game and the winner will be Gold. In other words, an ounce of physical Gold will command a lot more in real purchasing power than it does today. Just like a national currency is a claim on goods and assets within that country, Gold will be a claim on global goods and assets worldwide.


In other words, wealth preservation in the face of a currency collapse and an insurance policy against the idiocy and depredations of our monetary masters.


For those of you who have read my work, this current smash shouldn’t come as a surprise. In fact – not to beat my own drum – but if you understood and followed my advice, you would have been out of the paper markets and not affected one bit by these shenanigans. If you wish to trade the paper market for short term paper gains, by all means do it (at your own risk though - and you just saw what that “risk” looks and feels like), but in the end always – ALWAYS – convert those paper gains to real profit by buying the physical metal because Gold will never ever attain its true price in the futures markets. They can always issue an unlimited supply of naked paper contracts. The following extract from one of my previous articles explains the reality of the futures market:


The futures market is nothing but a tool for the dollar managers (US Government/Fed/Bullion banks) to manage/control the price of Gold. Any rational observer with an iota of brain who has watched the gold market for any reasonable length of time can tell that the price is intentionally driven down during the Comex trading hours. If you don’t believe this, either you’re in denial or worse – collusion - and IT WILL end up costing you big time. Given the massive, concentrated and long-term (the entire past decade - they haven't been net-long - not once - during that time period) nature of their short positions, it really isn’t that hard to deduce that the banks do not nearly have enough metal to cover their shorts and that the sole intention of the massive short position is to control the price. Whenever the price rises (or threatens to rise) the big bullion banks ala JP Morgan create massive naked shorts introducing fake supply of Gold in the market, thus driving the price down. “But the price has been rising for the past decade, hasn’t it? So how can you say they are driving it down?”, many people ask. Well, the constraint on the bullion banks has been the availability of the physical metal. If the metal is not available, the fraud of the paper market is exposed and they lose their price managing ability. So they allow the price rise to a level at which there are some weak hands willing to sell and then they hold it there till all the sellers have been exhausted (I am assuming the Fed has already sold all the US Gold during the past decade). So strong are Gold’s fundamentals that despite the massive rigging, all they have been able to do is slow its rise. The weak hands who sell the physical metal at every price rise have helped them in this endeavor. But soon, as the bond market implodes, they will run out of sellers. Treat the availability of real metal at today's paper price a gift and buy as much as you can.


To those who think that the Comex shorts will be crushed one day and the price of paper Gold will do a moonshot, to them I will say that you are dreaming. The Comex shorts will be crushed, but not in their own casino! If and when a majority of paper Gold longs demand delivery a force majure (who do you think the US Government will side with?) will be declared with cash settlements and/or offers of equally worthless GLD shares (don’t tell me you didn’t know about this). By some accounts, this is already happening. What will happen to the paper price then? That’s right – it will utterly collapse even as the physical’s price is rocketing. Paper gold holders will dump it all to buy the physical – which, unfortunately – will most likely not be available at all…in light of the sum total of the recent developments mentioned in this update I think it is too risky to be trading right now and one should just sit 100% in physical Gold and some currency for day-to-day needs…Trading paper markets for paper gains is like picking up pennies in front of the steamroller. It’s time to stop trading and just buy the physical metal….


They don’t have nearly enough Gold to cover all the contracts they’ve sold in the market. If you’ve bought one, stand for delivery. I’m sure many will be offered cash premiums in place of Gold. Refuse. Demand the metal. This is the right time to tighten the screws on them while they are vulnerable having sold 400 tons of non-existent Gold in the market. Getting out of the fake paper market and collapsing it will have a threefold benefit:

1.      Buying physical with cash preserves your anonymity and safeguards your wealth in your hands away from the prying eyes of the looters posing as “the government”.

2.      Counterparty risk is eliminated as there is none. You’re home free.

3.      The fake paper market will collapse due to non-availability of the physical and non-participation of the majority. The sooner it happens, the sooner Gold will attain its true value and the emperor will be naked for all to see. This fake money system needs to collapse so the work of reallocation and rebuilding can begin. The cancerous tumor of banksters needs to be eliminated from the economy.


Make no mistake, this is a war. A war for your freedom, liberty and life. They have won the battle but they are not going to win the war. It is upto you to make sure they don’t take you down with them. Those buying gold are not in it for the short term pleasure of paper profits but because they understand that it is the only way to safeguard your wealth and a claim to a chair when the music of the paper pyramid Ponzi finally stops.


To me, the only question is: Who Would I Trust With My Wealth?




Or This:



The best time to buy is when there is blood in the streets. That time is NOW.


So don’t panic. Just buy the physical, sit back, relax and enjoy the show!




1. Some people may find this description of events to be too “conspiratorial”, but rest assured, if anyone does the diligence, I’m sure they won’t find things differently. This is how things are “done” in the “markets” today.





Zombie Dance Party: Same Girls, New Music


"As long as the music is playing, you've got to get up and dance. We're still dancing.”

Chuck Prince

CEO, Citigroup

Bloomberg News reports that Bank of America Corp. (BAC), the best performer in the Dow Jones Industrial Average for 2012, has more than doubled since the start of the year “as the company rebuilds capital and investor confidence.”

My friend Meredith Whitney just upgraded BAC to a “Buy,” a call that is a little late given the stock’s performance to date.  But at just 0.5x book value, to be fair to Meredith, you could argue that the bank is still undervalued.  And many people do in fact believe this.  If we accept the basic bull market thesis for BAC being touted by Whitney and others, what is a reasonable valuation for BAC?  

Let’s set some assumptions.  

First, if you believe the bull market thesis for BAC, you must assume that the bank is going to prevail in the massive litigation it faces with respect to legacy mortgage securities.  This is a considerable assumption, but Whitney and the rest of the Sell Side analyst community seem to already have taken this leap of faith.  For the sake of their clients, let’s hope they are right.  

BTW, watch some of the more critical bank analysts ask BAC and other TBTF banks about the adequacy of reserves for civil litigation and put back claims by Uncle Sam in the Q4 earnings calls this January.  

Second and more important even than the litigation is the question of business model. Earlier this week, BAC CEO Brian Moynihan said that he was satisfied with a high single digit market share in the US mortgage sector.   Wells Fargo (WFC) is close to 40%.  BAC at < 10% market share nationally is perhaps a more profound assumption than the question of the BAC mortgage litigation.  BAC was once the dominant player in mortgage lending, both directly and through third part originations (TPO).  To have this bank’s huge balance sheet at such a low level of deployment is bad for the real estate market and for future earnings.  

Thanks to Senator Elizabeth Warren (D-MA) and the ill-considered Dodd Frank legislation, the TPO market has virtually disappeared.  The lending capacity once represented by Countrywide, WaMu and Lehman Brothers is gone.  BAC is still purchasing some production from outside providers, but the volumes are miniscule compared with the pre-2007 period. Thus the question comes: When Street analysts are showing a positive revenue growth rate for BAC and its peers, from where precisely is this revenue going to come?

Because of Dodd-Frank, Basel III and the Robo-signing settlement, the largest US banks are being forced out of the mortgage market.  Earlier this week, I talked about this dynamic on CNBC’s “Fast Money.” Suffice to say that analysts who assume that BAC will double in 2013 may not understand the new drivers – or lack thereof -- of revenue and earnings in all of the TBTF banks.

That said, I think it may be reasonable for BAC and even much maligned Citigroup (C) to double in the next twelve months, but not because of revenue or earnings growth.  If BAC hits street estimates for revenue in 2013 (+3-4%), is this a sufficient driver to justify a double in the stock?  No, but a doubling of the dividend is a good enough reason for cash starved investors.  In a very real sense, the biggest driver for stocks like BAC or C is not internal revenue growth but the zero rate policy of the FOMC.

During 2012, the preferred stocks of names like BAC and C have appreciated more than 15 points in price.  Yields for preferred issuers like the TBTF banks and General Electric (GE) have fallen by almost two points.  Is this because the revenue growth or earnings of these names have been growing?  No, these metrics are flat to down.  The appreciation of these securities has been driven by the FOMC and the Fed’s ridiculous zero rate policy.  ZIRP does not create jobs nor is it helping bank revenue.  

"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions’ earnings to $37.6 billion in third quarter 2012," notes the FDIC in the most recent Quarterly Banking Profile.  "Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs."  The fact that the TBTF banks are relying on fee income and line items like investment banking to hit revenue and earnings targets is very telling.  

So when you see Sell Side analysts like Meredith Whitney being so constructive on the TBTF banks, even with the poor operating performance, investors need to ask themselves a question.  Is the prospective appreciation of BAC and C the result of strong business fundamentals?  Or is the prospective appreciation of these stocks more a case of traumatized investors fleeing to the fantail of the Titanic to avoid the icy cold financial repression of zero interest rates?  Keep in mind that most of the improvement in earnings which seems to impress Whitney and other analysts has come as a result of expense reductions, mostly credit costs.  Efficiency ratios for the large banks are over 60%, of note. 

Even if you believe that BAC is going to escape the most horrific outcome in the mortgage litigation, the valuation target that is reasonable for this bank, C and the other TBTF institutions such as JPMorgan Chase (JPM) and WFC, is probably between 1 and 1.25x book value.  So yes, given that valuation framework, you can justify a doubling of BAC from current levels to say $20-25 per share.  But keep in mind that this stock was trading at $40 back in 2008 and over $50 in 2006 prior to the acquisition of Countrywide.   Are we likely to see BAC go to over 2x book value again?  Well, maybe, but not because of strong earnings or revenue growth rates.  

Should names like BAC or C manage to get above 1.25x book, it will be because of the Fed and ZIRP.  And as and when Fed interest rate policy changes, look out below.  As I noted on CNBC, without the benefit of a strong mortgage origination and securitization business, the TBTF banks are going to become far less volatile and far more boring.  Even the marginally higher capital levels of today, pre-Basel III, will imply lower asset and equity returns.  And this is not a bad thing.   

Yet investors are really not prepared mentally or emotionally for a market where the large banks are not delivering double digit revenue and earnings growth, whether organically or via M&A.  Most institutional investors, keep in mind, have no idea how the TBTF banks actually make money.  So when well-meaning Sell Side analysts predict wondrous stock price appreciation for the Zombie Dance Queens, the proverbial sheep on the Buy Side sing with joy -- and rush into the interest rate trap so lovingly constructed by Chairman Bernanke and the Fed.  Keep in mind that the corollary of ZIRP is massive interest rate and market risk on the books of all banks.  Think trillions of dollars in option adjusted duration risk.

Without the benefit of gain on sale from mortgage origination and securitization, it is difficult to construct a long term bull scenario for any US bank, large or small.  As and when the Fed normalizes interest rates, the business models of the TBTF banks are going to be far less exciting.  Mark-to-market losses on securities will wipe out stated earnings.  New and innovative ways of presenting “pro forma” earnings will appear on the scene.  The TBTF bank CEOs will rightly blame Washington.  

In this future banking market, names like C which currently trade on a 2 beta will have higher dividends, but relatively flat earnings and revenues.  Cost cutting, not growth, will fund these payouts to investors. Occasionally you will see big numbers from these names when the investment bankers have an especially good quarter.  But overall the TBTF banks are evolving into low growth utilities with nice dividends.  This is precisely the way banks used to be before President Bill Clinton’s “Great Leap Forward” in terms of housing and home ownership.   And, again, this is not a bad thing.  

But investors in the TBTF banks need to understand that the business model for this industry has changed.  The business model for banks is going to continue to evolve away from the high-beta, high volatility model of the 2000s to something that looks more like banking in the 1950s.  The action in terms of significant volume growth is in the non-bank sector.  Get used to it.  




We Are On The Road To Serfdom

Authored by Detlev Schlichter; originally posted at DetlevSchlichter.com,

We are now five years into the Great Fiat Money Endgame and our freedom is increasingly under attack from the state, liberty’s eternal enemy. It is true that by any realistic measure most states today are heading for bankruptcy. But it would be wrong to assume that ‘austerity’ policies must now lead to a diminishing of government influence and a shrinking of state power. The opposite is true: the state asserts itself more forcefully in the economy, and the political class feels licensed by the crisis to abandon whatever restraint it may have adhered to in the past. Ever more prices in financial markets are manipulated by the central banks, either directly or indirectly; and through legislation, regulation, and taxation the state takes more control of the employment of scarce means. An anti-wealth rhetoric is seeping back into political discourse everywhere and is setting the stage for more confiscation of wealth and income in the future.

War is the health of the state, and so is financial crisis, ironically even a crisis in government finances. As the democratic masses sense that their living standards are threatened, they authorize their governments to do “whatever it takes” to arrest the collapse, prop up asset prices, and to enforce some form of stability. The state is a gigantic hammer, and at times of uncertainty the public wants nothing more than seeing everything nailed to the floor. Saving the status quo and spreading the pain are the dominant political postulates today, and they will shape policy for years to come.

Unlimited fiat money is a political tool

A free society requires hard and apolitical money. But the reality today is that money is merely a political tool. Central banks around the world are getting ever bolder in using it to rig markets and manipulate asset prices. The results are evident: equities are trading not far from historic highs, the bonds of reckless and clueless governments are trading at record low interest rates, and corporate debt is priced for perfection. While in the real economy the risks remain palpable and the financial sector on life support from the central banks, my friends in money management tell me that the biggest risk they have faced of late was the risk of not being bullish enough and missing the rallies. Welcome to Planet QE.

I wish my friends luck but I am concerned about the consequences. With free and unlimited fiat money at the core of the financial industry, mis-allocations of capital will not diminish but increase. The damage done to the economy will be spectacular in the final assessment. There is no natural end to QE. Once it has propped up markets it has to be continued ad infinitum to keep ‘prices’ where the authorities want them. None of this is a one-off or temporary. It is a new form of finance socialism. It will not end through the political process but via complete currency collapse.

Not the buying and selling by the public on free and uninhibited markets, but monetary authorities – central bank bureaucrats – now determine where asset prices should be, which banks survive, how fast they grow and who they lend to, and what the shape of the yield curve should be. We are witnessing the destruction of financial markets and indeed of capitalism itself.

While in the monetary sphere the role of the state is increasing rapidly it is certainly not diminishing in the sphere of fiscal policy. Under the misleading banner of ‘austerity’ states are not rolling back government but simply changing the sources of state funding. Seeing what has happened in Ireland and Portugal, and what is now happening in Spain and in particular Greece, many governments want to reduce their dependence on the bond market. They realize that once the bond market loses confidence in the solvency of any state the game is up and insolvency quickly becomes a reality. But the states that attempt to reduce deficits do not usually reduce spending but raise revenues through higher taxes.

Sources of state funding

When states fund high degrees of spending by borrowing they tap into the pool of society’s savings, crowd out private competitors, and thus deprive the private sector of resources. In the private sector, savings would have to be employed as productive capital to be able repay the savers who provided these resources in the first place at some point in the future. By contrast, governments mainly consume the resources they obtain through borrowing in the present period. They do not invest them in productive activities that generate new income streams for society. Via deficit-spending, governments channel savings mainly back into consumption. Government bonds are not backed by productive capital but simply by the state’s future expropriation of wealth-holders and income-earners. Government deficits and government debt are always highly destructive for a society. They are truly anti-social. Those who invest in government debt are not funding future-oriented investment but present-day state consumption. They expect to get repaid from future taxes on productive enterprise without ever having invested in productive enterprise themselves. They do not support capitalist production but simply acquire shares in the state’s privilege of taxation.

Reducing deficits is thus to be encouraged at all times, and the Keynesian nonsense that deficit-spending enhances society’s productiveness is to be rejected entirely. However, most states are not aiming to reduce deficits by cutting back on spending, and those that do, do so only marginally. They mainly replace borrowing with taxes. This means the state no longer takes the detour via the bond market but confiscates directly and instantly what it needs to sustain its outsized spending. In any case, the states’ heavy control over a large chunk of society’s scarce means is not reduced. It is evident that this strategy too obstructs the efficient and productive use of resources. It is a disincentive for investment and the build-up of a productive capital stock. It is a killer of growth and prosperity.

47 percent, then 52 percent, then 90 percent…

Why do states not cut spending? – I would suggest three answers: first, it is not in the interest of politicians and bureaucrats to reduce spending as spending is the prime source of their power and prestige. Second, there is still a pathetic belief in the Keynesian myth that government spending ‘reboots’ the economy. But the third is maybe the most important one: in all advanced welfare democracies large sections of the public have come to rely on the state, and in our mass democracies it now means political suicide to try and roll back the state.

Mitt Romney’s comment that 47% of Americans would not appreciate his message of cutting taxes and vote for him because they do not pay taxes and instead rely on government handouts, may not have been politically astute and tactically clever but there was a lot of truth in it.

In Britain, more than 50 percent of households are now net receivers of state transfers, up 10 percent from a decade ago. In Scotland it is allegedly a staggering 90 percent of households. Large sections of British society have become wards of the state.

Against this backdrop state spending is more likely to grow than shrink. This will mean higher taxes, more central bank intervention (debt monetization, ‘quantitative easing’), more regulatory intervention to force institutional investors into the government bond market, and ultimately capital controls.

Eat the Rich!

In order to legitimize the further confiscation of private income and private wealth to fund ongoing state expenditure, the need for a new political narrative arose. This narrative claims that the problem with government finances is not out-of-control spending but the lack of solidarity by the rich, wealthy and most productive, who do not contribute ‘their fair share’.

An Eat-the-Rich rhetoric is discernible everywhere, and it is getting louder. In Britain, Deputy Prime Minister Nick Clegg wants to introduce a special ‘mansion tax’ on high-end private property. This is being rejected by the Tories but, according to opinion polls, supported by a majority of Brits. (I wager a guess that it is popular in Scotland.) In Germany, Angela Merkel’s challenger for the chancellorship, Peer Steinbrueck, wants to raise capital gains taxes if elected. In Switzerland of all places, a conservative (!) politician recently proposed that extra taxes should be levied on wealthy pensioners so that they make their ‘fair’ contribution to the public weal.

France on an economic suicide mission

The above trends are all nicely epitomized by developments in France. In 2012, President Hollande has not reduced state spending at all but raised taxes. For 2013 he proposed an ‘austerity’ budget that would cut the deficit by €30 billion, of which €10 billion would come from spending cuts and €20 billion would be generated in extra income through higher taxes on corporations and on high income earners. The top tax rate will rise from 41% to 45%, and those that earn more than €1 million a year will be subject to a new 75% marginal tax rate. With all these market-crippling measures France will still run a budget deficit and will have to borrow more from the bond market to fund its outsized state spending programs, which still account for 56% of registered GDP.

If you ask me, the market is not bearish enough on France. This version of socialism will not work, just as no other version of socialism has ever worked. But when it fails, it will be blamed on ‘austerity’ and the euro, not on socialism.

As usual, the international commentariat does not ‘get it’. Political analysts are profoundly uninterested in the difference between reducing spending and increasing taxes, it is all just ‘austerity’ to them, and, to make it worse, allegedly enforced by the Germans. The Daily Telegraph’s Ambrose Evans-Pritchard labels ‘austerity’ ‘1930s policies imposed by Germany’, which is of dubious historical and economic accuracy but suitable, I guess, to make a political point.

Most commentators are all too happy to cite the alleged negative effect of ‘austerity’ on GDP, ignoring that in a heavily state-run economy like France’s, official GDP says as little about the public’s material wellbeing as does a rallying equity market in an economy fuelled by unlimited QE. If the government spent money on hiring people to sweep the streets with toothbrushes this, too, would boost GDP and could thus be labelled economic progress.

At this point it may be worth adding that despite all the talk of ‘austerity’ many governments are still spending and borrowing like never before, first and foremost, the United States, which is running the largest civil government mankind has ever seen. For 5 consecutive years annual deficits have been way in excess of $1,000 billion, which means the US government borrows an additional $4 billion on every day the markets are open. The US is running budget deficits to the tune of 8-10% per annum to allegedly boost growth by a meagre 2% at best.

Regulation and more regulation

Fiscal and monetary actions by states will increasingly be flanked by aggressive regulatory and legislative intervention in markets. Governments are controlling the big pools of savings via their regulatory powers over banks, insurance companies and pension funds. Existing regulations already force all these entities into heavy allocations of government bonds. This will continue going forward and intensify. The states must ensure that they continue to have access to cheap funding.

Not only do I expect regulation that ties institutional investors to the government bond market to continue, I think it will be made ever more difficult for the individual to ‘opt out’ of these schemes, i.e. to arrange his financial affairs outside the heavily state-regulated banking, insurance, and pension fund industry. The astutely spread myth that the financial crisis resulted from ‘unregulated markets’ rather than constant expansion of state fiat money and artificially cheap credit from state central banks, has opened the door for more aggressive regulatory interference in markets.

The War on Offshore

Part and parcel of this trend is the War on Offshore, epitomized by new and tough double-taxation treaties between the UK and Switzerland and Germany and Switzerland. You are naïve if you think that attacks on Swiss banking and on other ‘offshore’ banking destinations are only aimed at tax-dodgers.  An important side effect of these campaigns is this: it gets ever more cumbersome for citizens from these countries to conduct their private banking business in Switzerland and other countries, and ever more expensive and risky for Swiss and other banks to service these clients. For those of us who are tax-honest but prefer to have our assets diversified politically, and who are attracted to certain banking and legal traditions and a deeper commitment to private property rights in places such as Switzerland, banking away from our home country gets more difficult. This is intentional I believe.

The United States of America have taken this strategy to its logical extreme. The concept of global taxation for all Americans, regardless where they live, coupled with aggressive litigation and threat of reprisal against foreign financial institutions that may – deliberately or inadvertently – assist Americans in lowering their tax burden, have made it very expensive and even risky for many banks to deal with American citizens, or even with holders of US green cards or holders of US social security numbers. Americans will find it difficult to open bank accounts in certain countries. This is certainly the case for Switzerland but a friend of mine even struggled obtaining full banking services in Singapore. I know of private banks in the UK that have terminated banking relationships with US citizens, even when they were longstanding clients. All of this is going to get worse next year when FATCA becomes effective – the Foreign Account Tax Compliance Act, by which the entire global financial system will become the extended arm of the US Internal Revenue System. US citizens are subject to de facto capital controls. I believe this is only a precursor to real capital controls being implemented in the not too distant future.

When Johann Wolfgang von Goethe wrote that “none are more hopelessly enslaved than those who falsely believe they are free” he anticipated the modern USA.

And to round it all off, there is the War on Cash. In many European countries there are now legal limits for cash transactions, and Italy is considering restrictions for daily cash withdrawals. Again, the official explanation is to fight tax evasion but surely these restrictions will come in handy when the state-sponsored and highly geared banking sector in Europe wobbles again, and depositors try to pull out their money.

“I’ve seen the future, and it will be…”

So here is the future as I see it: central banks are now committed to printing unlimited amounts of fiat money to artificially prop up various asset prices forever and maintain illusions of stability. Governments will use their legislative and regulatory power to make sure that your bank, your insurance company and your pension fund keep funding the state, and will make it difficult for you to disengage from these institutions. Taxes will rise on trend, and it will be more and more difficult to keep your savings in cash or move them abroad.

Now you may not consider yourself to be rich. You may not own or live in a house that Nick Clegg would consider a ‘mansion’. You may not want to ever bank in Switzerland or hold assets abroad. You may only have a small pension fund and not care much how many government bonds it holds. You may even be one those people who regularly stand in front of me in the line at Starbucks and pay for their semi-skinned, decaf latte with their credit or debit card, so you may not care about restrictions on using cash. But if you care about living in a free society you should be concerned. And I sure believe you should care about living in a functioning market economy.

This will end badly.

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