#bernanke

Why discontinue?

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This is a chart of the change in the US Fed balance sheet, a series that has just been discontinued. Is this because the Fed is about to step up its activity and offering wider disclosure on tapering activity might spook markets? Given that 72% of the growth in S&P earnings has been driven by buybacks since 2012, it stands to reason the market is not exactly providing the type of confidence inducing organic lift the index reflects. Bank of America revealed that “net buying of Tech sector in the 1H was entirely buyback-driven.” 

Kind of reminds CM of the day Bernanke’s Fed announced it would no longer report M3 money supply a year before the financial markets headed into the GFC. CM estimated on p.4 of a report several years ago that M3 money supply by 2018 on constant long-term growth rates would turn into around $35 trillion from the $10 trillion at the time it was discontinued.

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Nothing to see here? Throw a deteriorating fixed income market with fewer buyers and corporates that have binged on cheap credit to fuel buybacks, it doesn’t look like the stuff dreams are made of. The chart below shows that quarterly pre-tax US profitability is struggling since 2011. Earnings (E) are not doing so well. It is by the grace of falling number of traded shares (S) that makes the EPS look flattering.

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We took the liberty of comparing corporate profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper (but now hide the results of) its balance sheet. So as an investor, would you prefer the relative safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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Discontinuation of series always carries a sense of deep cynicism for its true intention. It is not an onerous data set to cull. Sure we can fossick around and try to find it hidden in the archives of the Fed website but the idea is that they probably don’t want to publicise how much more they intend to flog.

Waking up to a horror of our own creation

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Some will say I am a pessimist. I’d prefer to be called an optimist with experience. At only age 16 (in 1987) I realized the destructive power financial markets had on the family home. Those memories were etched permanently. We weren’t homeless or singing for our supper but things sure weren’t like they use to be. It taught me much about risk and thinking all points of view rather than blindly following the crowd. That just because you were told something by authority it didn’t mean it was necessarily true. It was to critically assess everthing without question.

In 1999, as an industrials analyst in Europe during the raging tech bubble, we were as popular as a kick in the teeth. We were ignored for being old economy. That our stocks deserved to trade at deep discounts to the ‘new economy’ tech companies, no thanks to our relatively poor asset turnover and tepid growth rates. The truest sign of the impending collapse of the tech bubble actually came from sell-side tech analysts quitting their grossly overpaid investment bank salaries for optically eye-watering stock options at the very tech corporations they rated. So engrossed in the untold riches that awaited them they abandoned their judgement and ended up holding worthless scrip. Just like the people who bought a house at the peak of the bubble telling others at a dinner party how they got in ‘early’ and the boom was ahead of them, not behind.

It was so blindingly obvious that the tech bubble would collapse. Every five seconds a 21 year old with a computer had somehow found some internet miracle for a service we never knew we needed. The IPO gravy train was insane. One of my biggest clients said that he was seeing 5 new IPO opportunities every single day for months on end. Mobile phone retailers like Hikari Tsushin in Japan were trading at such ridiculous valuations that the CEO at the time lost himself in the euphoria and printed gold coin chocolates with ‘Target market cap: Y100 trillion.’ The train wreck was inevitable. Greed was a forgone conclusion.

So the tech bubble collapsed under the weight of reality which started the most reckless central bank policy prescriptions ever. Supposedly learning from the mistakes of the post bubble collapse in Japan, then Fed Chairman Alan Greenspan turned on the free money spigots. Instead of allowing the free market to adjust and cauterize the systemic imbalances, he threw caution to the wind and poured gasoline on a raging fire. Programs like ‘Keep America Rolling’ which tried to reboot the auto industry meant cheaper and longer lease loans kept sucking consumption forward. That has been the problem. We’ve been living at the expense of the future for nigh on two decades.

Back in 2001, many laughed me out of court for arguing Greenspan would go down in history as one of the most hated central bankers. At the time prevailing sentiment indeed made me look completely stupid. How could I, a stockbroker, know more than Alan Greenspan? It was not a matter of relative educations between me and the Fed Chairman, rather seeing clearly he was playing god with financial markets.  The Congressional Banking Committee hung off his every word like giddy teenagers with a crush on a pop idol. Ron Paul once set on Greenspan during one of the testimonies only to have the rest of the committee turn on him for embarrassing the newly knighted ‘Maestro.’ It was nauseating to watch. Times seemed too good so how dare Paul question a central bank chief who openly said, “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”

We all remember the horrors of the collapse of Lehman Brothers and the ensuing Global Financial Crisis (GFC) in September 2008. The nuclear implosions in credit markets had already begun well before this as mortgage defaults screamed. The 7 years of binge investment since the tech bubble collapse meant we never cleansed the wounds. We would undoubtedly be in far better shape had we taken the pain. Yet confusing products like CDOs and CDSs wound their way into the investment portfolios of local country towns in Australia. The punch bowl had duped even local hicks to think they were with the times as any other savvy investor. To turn that on its head, such was the snow job that people who had no business being involved in such investment products were dealing in it.

So Wall St was bailed out by Main St. Yet instead of learning the lessons of the tech bubble collapse and GFC our authorities doubled down on the madness that led to these problems in the first place. Central banks launched QE programs to buy toxic garbage and lower interest rates to get us dragging forward even more consumption. The printing presses were on full speed. Yet what have we bought?

Now we have exchange traded funds (ETFs). Super simple to understand products. While one needed a Field’s Medal in Mathematics to understand the calculations of a CDO or CDS, the ETF is child’s play. Sadly that will only create complacency. We have not really had a chance to see how robots trade in a proper downturn. ETFs follow markets, not lead them. So if the market sells off, the ETF is rapidly trying to keep up. Studies done on ETFs (especially leveraged products) in bear markets shows how they amplify market reactions not mitigate them. So expect to see robots add to the calamity.

Since GFC we’ve had the worst post recession recovery in history. We have asset bubbles in bonds, stocks and property. The Obama Administration doubled the debt pile of the previous 43 presidents in 8 years. Much of it was raised on a short term basis. This year alone, $1.5 trillion must be refinanced.  A total of $8.4 trillion must be refinanced inside the next 4 years. That excludes the funding required for current budget deficits which are growing despite a ‘growing economy’. That excludes the corporate refinancing schedule. Many companies went out of their way to laden the balance sheet in cheap debt. In the process the average corporate credit rating is at its worst levels in a decade. Which means in a market where credit markets are starting to price risk accordingly we also face a Fed openly saying it is tapering its balance sheet and the Chinese and Japanese looking to cut back on US Treasury purchases. Bond spreads like Libor-OIS are already reflecting that pain.

Then there is the tapped out consumer. Unemployment maybe at record lows, yet real wage growth does not appear to be keeping up. The number of people holding down more than one job continues to rebound. The quality of employment is terrible. Poverty continues to remain stubbornly high. There are still three times as many people on food stamps in the US than a decade ago – 41 million people. Public pension unfunded liabilities total $9 trillion. Credit card delinquencies at the sub prime end of town are  back at pre-crisis levels. We could go on and on. Things are terrible out there. Should we be in the least bit surprised that Trump won? Such is the plight of the silent majority, still delinquent after a decade. No wonder Roseanne appeals to so many.

A funny comment was sent by a dyed-in-the-wool Democrat, lambasting Trump on his trade policies. He criticized the fact that America had sold its soul for offshoring for decades. Indeed it had but queried that maybe he should be praising Trump for trying to reverse that tide, despite being so late to the party. Where were the other administrations trying to defend America all this time? Stunned silence.

Yet the trends are ominous. If we go back to the tech bubble IPO-a-thon example. We now have crowd funding and crypto currencies. To date we had 190 odd currencies to trade. Of that maybe a handful were liquid – $US, GBP, JPY, $A, Euro etc – yet we are presented with 1,000s of crypto currency choices. Apart from the numerous breaches, blow ups and cyber thefts to date, more and more of these ‘coins’ are awaiting the next fool to gamble away more in the hope of making a quick buck. Cryptos are backed by nothing other than greed. Yet it sort of proves that more believe that they are falling behind enough such they’re prepared to gamble on the biggest lottery in town. One crypto used Wikipedia as a source for its prospectus.

Yet the media remains engrossed on trying to prove whether the president had sex with a porn star a decade ago, genderless bathrooms, bashing the NRA, pushing for laws to curtail free speech, promoting climate change and covering up crime rather than look at reporting on what truly matters – the biggest financial collapse facing us in 90 years.

There is no ‘told you so’ in any of this. The same feelings in the bones of some 30 years ago are back as they were at the time of Greenspan and Lehman. This time can’t be avoided. We have borrowed too much, saved too little and all the while blissfully ignored the warning signs. The faith and confidence in authorities is evaporating. The failed experiment started by Greenspan is coming home to roost. This will be far worse than 1929. Take that to the bank, if it is still in operation because you won’t be concerned about the return on your money but the return of it!

蜘蛛の糸 The Spider’s Thread – when helicopters can’t save central banks from hell

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Almost 100 years ago a children’s tale known as “The Spider’s Thread” (Kumo no ito) described Buddha’s compassion for a criminal named Kandata. It sums up the problems facing the Bank of Japan and how it intends to climb out of fiscal hell.

Buddha is meandering around Paradise one morning, when he stops at a lotus-filled pond. Between the lilies, he can see, through the crystal-clear waters, the depths of Hell. He notices one sinner in particular – Kandata. Kandata was a cold-hearted criminal, but had one good deed to his name: while walking through the forest one day, he decided not to kill a spider he was about to crush with his foot. Moved by this single act of compassion, the Buddha takes the silvery thread of a spider in Paradise and lowers it down into Hell.

Down in Hell, the myriad sinners are struggling in the Pool of Blood. Kandata, looking up by chance at the sky above the pool, sees the spider’s thread descending towards him and grabs hold with all the might of a seasoned criminal. The climb from Hell to Paradise is not a short one, however, and Kandata quickly tires. Dangling from the middle of the rope, he glances downward, and sees how far he has come. Realizing that he may actually escape from Hell, he is overcome by joy and laughs giddily. His elation is short-lived, however, as he realizes that others have started climbing the thread behind him, stretching down into the murky depths below. Fearing that the thread will break from the weight of the others, he shouts that the spider’s thread is his and his alone. It is at this moment that the thread breaks, and he and all the other sinners are cast back down into the Pool of Blood. In the end, Kandata condemned himself by being concerned only with his own salvation and not that of others.

Bernanke was in Japan warning advisors to PM Abe that Japan risked slipping back into deflation (err it is already in deflation). He noted that helicopter money — in which the government  issues non-marketable perpetual bonds that are linked to O/N rates plus a premium with no maturity date and the Bank of Japan (BoJ) directly buys them — could work as the strongest tool to overcome deflation.  The government would hold the right to redeem the perpetual bonds at their face value. It would only logically choose to redeem if inflation came back in the mix.

In essence the BoJ has bought 40% of outstanding JGBs ($4 trillion) and the balance is held mostly by domestic financial institutions. If they end up swallowing all the $10 trillion of outstanding JGBs the idea is that they are packaged as a swap into perpetuals. The Diet would have to ratify this transaction and the complexity of it would likely bamboozle most Japanese politicians. I’m not quite sure if that makes it an easier or harder sell. The BoJ’s balance sheet is as big as the US Fed

None-the-less, if you park a majority of the $10 trillion dollars (Y1,000 trillion) or 2x GDP then it doesn’t overcome the need for the government to raise Y40-50 trillion (or raise a Switzerland) annually to cover the shortfall in the budget deficit given the dwindling tax base. This gap is ongoing.

While $10 trillion dollars can be put inside a velvet bag and packaged in a way that disguises the contents then it come down to how willing financial institutions will step up to buy new JGB issuance. The risk is that if the BoJ is the only willing buyer them the psychological impacts on the lack of confidence of buying JGBs any collapse in the currency will potentially create inflation that will be far harder to control. Japan imports 60% of its food and most of its raw materials and energy. To all of a sudden be faced with dollar denominated contracts to mitigate risk for suppliers Japan’s inflation could soar way beyond desirable levels. Would a yen fall to Y300 or Y400/$ from almost parity today? Then we are staring down the barrel of double digit rate inflation.

Let’s consider the collapse of the Argentinian Peso in early 2000s. It exploded from 1/US$ to 4/US$ and today trades closer to 14.5/$. At the time inflation surged to 25% and has remained between 5% and 20% since. 

As soon as markets have seen the MoF & BoJ in cahoots on monetising the debt, the risk is that they can always do it again. No-one ever suspected they would do it in the first place but once it is done it can be done again and Japan is 10x the size of Argentina so the knock on effects are far greater. 

Imagine even 10% rates of inflation in Japan. Banks that have loan books that are 30 years fixed at 3% and below with 90%+ of financing coming from deposits. If the currency was collapsing, Mrs Watanabe would be flocking to safe havens – gold, US$ etc. If there was a run on the banks, deposit rates would have to go high enough to offset the flight. At the same time, the net margins would be crucially negative causing the likelihood of nationalisation with yet more printed money…exacerbating the problem.

Which takes us back to Kandata. The financial gods may lower a spider’s thread but if central banks become too greedy in implementing helicopter strategies, it will snap as they climb from the infernal hell they’ve traded themselves into. Then it really will be a pool of blood.

I also think listening to Bernanke is not necessarily wise as he merely continued in the footsteps of Greenspan to lead us into the GFC. Should we credit those who got us into this mess with pretending they’ve got us out of it? To me, the failing experimentation in financial markets is disproving a lot of theories of monetary policy (especially NIRP) and the declining confidence in central banks expressed by rising poverty is being shown in the shake up of incumbent political classes. It feels that the big RESET button will have to be pushed.