Wednesday, March 9, 2011

Q.E. Money Printing Negative Feed Back Loop to Hyper-Inflation Oblivion

USFed Chairman Bernanke and the Quantitative Easing programs are caught in a negative feedback loop, the instruments at risk being the USDollar and the USTreasury Bond. The former suffers from lost integrity and direct inflation effect. The latter suffers from direct intervention and market ruin. The next QE round is guaranteed by the failure of the previous program in an endless cycle to be recognized later this year. Leaders are confused why the recovery does not take root. It is because the entire system is insolvent, and the 0% rate assures total capital destruction, not to mention the big US banks are sacred, never to be liquidated, a primary condition for recovery. Liquidation is tantamount to abdication of power of the Purse and control of the Printing Pre$$, never to happen. The greatest hidden damage is psychological, where the USDollar and its erstwhile trusted USTreasury Bond are no longer viewed as the safe haven.

Capital destruction is the main byproduct of monetary inflation, a concept totally foreign to the inflation engineers at the USFed and its satellite central banks. They are agents of magnificent systemic devastation. In the wake of each QE round are discouraged creditors who turn away in disgust. The damage and inflation feeds upon itself in stages of intense wreckage. The motive, need, and desperation for QE3 is being formed here and now, to be announced by late summer probably. Prepare for QE to infinity, endless hyper-inflation, a process that cannot be stopped, as the urgent needs grows. Any attempt to halt the process results in almost immediate total annihilation. So continuation of QE rounds serves to manage the deterioration process and guide the financial structures gradually and orderly into oblivion.


Simply stated, each QE round guarantees the next round, since damage is done, nothing is remedied, and the funding needs intensify. The list of damage factors is actually growing. The main factor is capital destruction from monetary inflation, as the price of capital is declared zero, and it flees from the USEconomy. Witness the industry long gone, hardly a critical mass remaining to support the system with legitimate income. 
Government regulation and taxes assure the flight continues in exodus. Almost half of the US Gross Domestic Product is derived from financial paper shuffling, whose negative value has been clearly displayed in the form of mortgage bond wreckage, profound bond fraud, home foreclosure processing, absent home equity withdrawals, bankruptcy processing, and piles of debt that burden households. US economists fail to comprehend the entire concept of capital, this from the supposed leading capitalist nation. The banking and political leaders struggle to produce jobs without a clue of what capital is, instead seeking to put cash in consumer hands. They should pursue business formation, with capital investment, encourage risk taking, provide broad tax incentives, and lead the consumer spending process with job creation and income production. But no. They prefer QE, the accelerator that pushes the nation over the cliff.

The bond market has been disrupted and corrupted, as the debt monetization has driven off foreign creditors, leaving the USFed isolated as buyer. The 0% rate slows the USEconomy tremendously by removing a proper return on honest savings. Return on capital is greatly disrupted all through the USEconomy. The heavily increased monetary supply maintains the emphasis on asset bubbles, as desperation sets in to find the next asset to produce a new bubble. The answer is USTreasury Bonds. A mildly violent reaction has come to the long-term USTBonds, while the short-term USTBills stay near 0% but with the aid of intense leverage power of Interest Rate Swaps. The long end reacts negatively to QE, while the short end is under QE control from the big bulging bid. The entire financial structure is crumbling under the surface. The USEconomy will continue to falter at minus 3% to minus 5% growth in a powerful ongoing recession, covered up by the fraudulent quarter to quarter calculations that permit deep deceptions from adjustments. Businesses cannot justify any expansion, given the household dependence upon home equity has vanished. Businesses have been put on notice, a certain shock, that the national health care plan will place greater burden on the business models. So the USGovt deficits will perpetuate in high volume, making the supply overwhelming in USTreasury securities and making the creditors retreat in a cringe of fear, shock, and disgust. The more the USFed buys its own paper feces with USTBond labels, the more the securities lose their security, the more the foreign creditors refuse to participate in the next auction, the more the integrity of the US$ and USTBond is shredded and lost. The United States has become a Weimar nation with gradual global recognition. Instead of a recovery, it slides into the Third World. Thus the need for the USFed to cover the next USTreasury auction in full, or almost in full. It is deeply committed to monetizing the entire USGovt debt. Call it Weimar, Third World, Banana Republic, whatever!!

An encouragement has come from the QE movement to the entire world to revolt against the USDollar, to seek an alternative, to establish bilateral trade mechanisms, and to bypass the current system that enables privilege, fraud, market meddling, which permits an unwarranted standard of living to the US and its people. The bilateral accords between Russia and China, between China and Brazil, between Germany and Russia, and between India and Iran are all telltale signs of revolt. They wish not to participate in the US$-based system. The consequence is a new trend to diversify out of the USTreasurys with existing reserves, and to avoid accumulation in the future within banking systems for satisfaction of trade settlement in global commerce. The foundation on a global level is crumbling for the USDollar. As the bilateral links build, eventually enough fabric will be woven to support a new global currency, or a new global system. Often mentioned in certain circles is a sophisticated barter system, built upon high level credits in exchange, with a vast trickle down flow of funds, within a balanced system. Nations addicted to deficits will be left out in the cold. The most deficit ridden is the United States, dragged down by endless war costs. Their location has another name, the Third World.

Furthermore, the inflation effect has crossed from the monetary side to the price systems, hitting the entire cost structure in a profound way. The moron bankers strive to cut off the process from handing higher wages to the workers, so that they can afford a higher cost of living. The leaders thus strive to bankrupt the Middle Class, hardly a pursuit in commitment of economic recovery. The cost squeeze is deeply felt by both businesses and households, businesses that cannot hold their workers as profits erode badly, and households that cannot maintain their spending patterns as incomes are devoted increasingly to food, fuel, clothing, insurance, and everything else. Tax revenues from wages and corporate profits and capital gains are descending into the gutter, not available to cover the USGovt deficits. Witness the death of the USEconomy in hyper-drive, pushed by the USFed Quantitative Easing. The impact on the worsening recession at the macro level, and the shrinking of both businesses and households, translates to larger deficits. Notice that in early 2009 when QE1 was first announced, and later when QE-Lite was announced, the USGovt minions forecasted reduced budget deficits for 2010 and 2011. The USGovt posted its largest monthly deficit in history in February, a $223 billion shortfall. Most decisions center on budget cuts, for education, welfare, projects, and more, while war spending is largely intact, priorities revealed. They have no clue how to build tax revenues. The Jackass forecast was for greater deficits due to the ravages of capital destruction and cost inflation, which both arrived with billboard attachments. The dependence therefore upon the USFed for its Printing Pre$$ buyer of USTreasury Bonds will increase with each QE round, assuring the next round.

The harsh savage negative reaction to QE2 kicked into high gear the movement of funds out of the USTreasury complex and into commodities generally. The shift to financial commodities in Gold & Silver has been even greater than for crude oil, the traditional hedge. Despite not being the leading non-financial commodity in price increase, the crude oil impact is enormous, in food production, in transportation costs, and especially in industrial feedstock costs. The result is an energy tax, compounded by a systemic cost that acts like a gigantic tax. The USFed QE program thus imposed a significant tax increase on the entire USEconomy. The entire population is aware, except for the USFed, the Wall Street master, and banking elite. Actually, they are aware, but they cannot speak about the scourge they unleashed since they would invite criticism and turn the blame onto themselves for destroying the United States financially, economically, and systemically. The moral fiber is long gone among leaders, as the US nation is being recognized as a fraud king playpen. The end result is that in the cycle, movement from USTreasurys to the USEconomy is not happening during this death spiral, as it normally does. Instead, the next bubble is in the entire commodity arena. Beware that such a trend is highly destructive, since it erodes the profit margins and disposable income, thus causing deep recession if not systemic collapse. The energy and material tax renders huge harm, pushing the system into a deeper recession. It never ended.

Money is fleeing bonded paper, as all bond markets are in a severe situation. Even the stock market is supported heavily by the Working Group for Financial Markets and Flash Trading, a form of self-dealing, whereby both prop up stock share prices. Hence, the USFed is left more isolated to purchase its own inbred cousin toxic paper securities. The USFed must continue with QE3, the only remaining details are the securities that join the USTreasurys. My bet is state and municipal bonds, along with a bigger swath of mortgage bonds that would otherwise be put back to the Big US Banks, the dead pillars taking up space casting long shadows. Numerous are the bond candidates for official rescue, since all of them are in deep trouble. Buyers are simply vanishing. The bond markets is in ruins, propped by QE.


The tragedy is that the USTreasury Bond is the location of the biggest and most important asset bubble in the last 100 years. It is propped by the QE debt purchase, enforced by the USFed, made urgently necessary by the USGovt deficits, and blessed by the USDept Treasury. The USTBond bubble is the last bubble with any semblance of positive benefit. The next bubble in commodities will be negative, harsh, and highly destruction, as they will lift costs without a corresponding rise in wages. That event has already been triggered. The key characteristic of asset bubbles is that in the late stages, they require an accelerated source of funds just to maintain their inflated condition. The QE programs will be endless because the USTBond bubble demands it, even infinite funds. Thus the mantra in criticism of QE TO INFINITY. With the heightened source and blossoming channels to fund it, the integrity of the USTreasury Bond complex will be ruined even as the reputation and prestige of the USDollar will be shattered. This is an end chapter, marked by central bank frachise model failure.


The US$ DX index is a bad joke, but its performance is highly revealing. As preface, the DX major component is the Euro, even though the biggest trade partner of the United States is Canada, with Mexico and China close behind. The argument is old and tired. Rare is the 30-year chart offered by the Jackass, since its reliance as a tool is often evidence of shallow analysis and little insight to offer for the current year and its main events. But the historical USDollar chart shows the great danger, since the world banking system rests on its unit of exchange. The DX index lows from 1991, 1992, 1995, and 2005 have all been breached, a major warning signal. Jesse at Cafe Americain points out the pennant flag pattern formed in the last three years. It must resolve up or down. My contention is that the pennant has already been broken on the lower barrier, a bear signal. The next QE3 announcement should send the DX index heading fast toward the 2008 critical low with a 71-72 handle. It is written; it will be done.

Many technical analysts are pre-occupied with monitoring the critical support levels. Those levels are 72, 75, and 76.5, seen in the weekly chart. Instead, focus on the lower barrier of the crucial pennant. The pennant trendline has been broken on the downside, an important development. Traders in the currencies, a multi-$trillion market, will take the minor technical breakdown and push the already weak USDollar lower. Many argue the Euro is in deep trouble, with a union in the midst of dismantlement. That might be true, but in the Reverse Beauty Pageant, the USDollar is by far the ugliest of the coined damsels. Its deficits are on par with the PIGS of Southern Europe in percentage terms. Besides, the US is the site of QE, the greatest monetary inflation scourge in modern history. Notice that the bounce in recovery off the October and November low of 76.5 could not manage a rise about the 20-week or the 50-week moving average. Those MA series serve as current overhead resistance. The DX chart is caught in powerful downward momentum. My forecast is for a breach of 76 in the next few weeks, and a battle of paramount importance at 74, the next critical support.
The intraday US$ DX chart shows more trouble in the very short term. The recovery off the 76 floor could not be maintained. In fact, the sudden swoon displayed its weakness if not artificial props. Be sure that the USDept Treasury with its fascist business model trusty tagteam of JPMorgan and Goldman Sachs are trying to do the herculean feat of preventing the USDollar from a powerful decline. The ugly truth is that JPM & GS are probably trying to manage the decline in the USDollar down to the 50-60 range in the US$ DX index, all as part of the USGovt agenda. The plan is to weaken the USDollar sufficiently enough to make the USEconomy competitive again with respect to export trade. The backfire in their faces is the price inflation curse and anathema. The price structures will rise first from the QE exercise in Weimar desperation, and will rise second from the US$ decline most assuredly worse than its major currency competitors. The report card will be seen in a much worse recession in the USEconomy, grander USGovt fiscal deficits, even larger USTBond issuance, and more grotesque QE debt monetization more characterisitic of a Third World Banana Republic.

Within the Jackass archives, an item was found from work done in 2005. What began as a graphic display of the grand liquidity trap emanating from the failed housing & mortgage bubble has turned out to be highly relevant in the aggressive metastasizing process from monetary inflation cancer combined with basic economic deterioration from capital destruction. Many are the ills of the USEconomy and its fractured financial foundation. Take the time to note all the different powerful factors at work that slow the entire system down. Forces are shown from external shocks and internal shocks. The money supply velocity is falling, ordered slower by the short-term interest rate stuck at 0%, the Zero Interest Rate Policy described as an important chamber label of failure. Recall the empty calls for an Exit Strategy throughout 2009 and into early 2010, as vacant as the Green Shoots and Jobless Recovery basis of propaganda that unmasks the fraudulent bank leadership. The Fed Funds Rate stuck at 0% cannot rise by USFed dictate, because the housing market would implode more quickly, because the USEconomy would sink more quickly, because the US stock market would dive like a dead mallard, because the USGovt borrowing costs would bring more deficit from debt service than other major items. The USFed has been backed in a corner for two years, no longer relying upon a temporary 0% rate to stimulate. It is stuck with 0% as a badge of dishonor, as a two ton cement block around its neck, as a Weimar membership card. The complex chart should remind the reader of a toilet, sewer drain, or even a rectum.

Some advice. As the movement swirls, as the next QE program details are revealed, as the central bank model is shattered in discredit, as the global monetary system crumbles before your eyes, as sovereign debt worldwide loses its exalted safe haven security, as your personal budget finances erode beyond your worst nightmare, invest what is left of your life savings in Gold and especially Silver. In time, they will be the primary portions of your portfolio with surviving value. Each will rise, but Silver will do a moon shot!!

Debt, Inflation and Global Economy Systemic Risks, The ZIRP Trap

I get a lot of client letters from various managers and funds, as you might imagine. I read more than I should. But one that shows up every quarter or so makes me stop what I am doing and sit down and read. It is the quarterly letter from Hayman Advisors, based here in Dallas. They are macro guys (which I guess is part of the magnetic attraction for me), and they really put some thought into their craft and have some of the best sources anywhere. So today we take a look at their latest letter, where they cover a wide variety of topics, with cutting-edge analysis and sharp insight. I really like these guys, and suggest you take the time to read the entire letter.#

Today (Tuesday) is the day I want you to start buying Endgame. The early reviews on Amazon are quite gratifying – writing a book is damn hard work, so when people say nice things it just feels good. Have a great week! Now let’s jump into the Hayman client letter.
John Mauldin, Editor
Outside the Box
The Cognitive Dissonance of It All
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." – Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
Dear Investors:

We continue to be very concerned about systemic risk in the global economy. Thus far, the systemic risk that was prevalent in the global credit markets in 2007 and 2008 has not subsided; rather, it has simply been transferred from the private sector to the public sector. We are currently in the midst of a cyclical upswing driven by the most aggressively procyclical fiscal and monetary policies the world has ever seen. Investors around the world are engaging in an acute and severe cognitive dissonance. They acknowledge that excessive leverage created an asset bubble of generational proportions, but they do everything possible to prevent rational deleveraging. Interestingly, equities continue to march higher in the face of European sovereign spreads remaining near their widest levels since the crisis began. It is eerily similar to July 2007, when equities continued higher as credit markets began to collapse. This letter outlines the major systemic fault lines which we believe all investors should consider. Specifically, we address the following:

• Who Is Mixing the Kool-Aid? (Know Your Central Bankers)

• The Zero-Interest-Rate-Policy Trap

• The Keynesian Endpoint – Where Deficit Spending and Fiscal Stimulus Break Down

• Japan – What Other Macro Players Have Missed and the Coming of “X-Day”

• Will Germany Go All-In, or Is the Price Too High?

• An Update on Iceland and Greece

• Does Debt Matter?

While good investment opportunities still exist, investors need to exercise caution and particular care with respect to investment decisions. We expect that 2011 will be yet another very interesting year.

In 2010, our core portfolio of investments in US mortgages, bank debt, high-yield debt, corporate debt, and equities generated our positive returns while our “tail” positions in Europe contributed nominally in the positive direction and our Japanese investments were nominally negative. We believe this rebound in equities and commodities is mostly a product of “goosing” by the Fed’s printing press and are not enthusiastic about investing too far out on the risk spectrum. We continue to have a portfolio of short duration credit along with moderate equity exposure and large notional tail positions in the event of sovereign defaults.

Who Is Mixing the Kool-Aid?

Unfortunately, “academic” has become a synonym for “central banker.” These days it takes a particular personality type to emerge as the highest financial controller in a modern economy, and too few have real financial market or commercial experience. Roget’s Thesaurus has not yet adopted this use, but the practical reality is sad and true. We have attached a brief personal work history of the US Fed governors to further illustrate this point. So few central bankers around the world have ever run a business – yet so much financial trust is vested with them. In discussing the sovereign debt problems many countries currently face, the academic elite tend to arrive quickly at the proverbial fork in the road (inflation versus default) and choose inflation because they perceive it to be less painful and less noticeable while pushing the harder decision further down the road. Greenspan dropped rates to 1% and traded the dot com bust for the housing boom. He knew that the road over the next 10 years was going to be fraught with so much danger that he handed the reins over to Bernanke and quit. Central bankers tend to believe that inflation and default are mutually exclusive outcomes and that they have been anointed with the power to choose one path that is separate and exclusive of the other. Unfortunately, when countries are as indebted as they are today, these choices become synonymous with one another – one actually causes the other.

ZIRP (Zero Interest Rate Policy) Is a TRAP

As developed Western economies bounce along the zero lower bound (ZLB), few participants realize or acknowledge that ZIRP is an inescapable trap. When a heavily indebted nation pursues the ZLB to avoid painful restructuring within its debt markets (household, corporate, and/or government debt), the ZLB facilitates a pursuit of aggressive Keynesianism that only perpetuates the reliance on ZIRP. The only meaningful reduction of debt throughout this crisis has been the forced deleveraging of the household sector in the US through foreclosure. Total credit market debt has increased throughout the crisis by the transfer of private debt to the public balance sheet while running double-digit fiscal deficits. In fact, this is an explicit part of a central banker’s playbook that presupposes that net credit expansion is a necessary precondition for growth. However, the problem of over indebtedness that is ameliorated by ZIRP is only made worse the longer a sovereign stays at the ZLB – with ever greater consequences when short rates eventually (and inevitably) return to a normalized level. 

Consider the United States’ balance sheet. The United States is rapidly approaching the Congressionally mandated debt ceiling, which was most recently raised in February 2010 to $14.2 trillion dollars (including $4.6 trillion held by Social Security and other government trust funds). Every one percentage point move in the weighted-average cost of capital will end up costing $142 billion annually in interest alone. Assuming anything but an inverted curve, a move back to 5% short rates will increase annual US interest expense by almost $700 billion annually against current US government revenues of $2.228 trillion (CBO FY 2011 forecast). Even if US government revenues were to reach their prior peak of $2.568 trillion (FY 2007), the impact of a rise in interest rates is still staggering. It is plain and simple; the US cannot afford to leave the ZLB – certainly not once it accumulates a further $9 trillion in debt over the next 10 years (which will increase the annual interest bill by an additional $90 billion per 1%). If US rates do start moving, it will most likely be for the wrong (and most dire) reasons. Academic “research” on this subject is best defined as alchemy masquerading as hard science. The only historical observation of a debt-driven ZIRP has been Japan, and the true consequences have yet to be felt. Never before have so many developed western economies been in the same ZLB boat at the same time. Bernanke, our current “Wizard of Oz”, offered this little tidbit of conjecture in a piece he co-authored in 2004 which was appropriately titled “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment”. He clearly did not want to call this paper a “Hypothetical Assessment” (as it really was).

Despite our relatively encouraging findings concerning the potential efficacy of non‐standard policies at the zero bound, caution remains appropriate in making policy prescriptions. Although it appears that nonstandard policy measures may affect asset prices and yields and, consequently, aggregate demand, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the zero bound. The conservative approach — maintaining a sufficient inflation buffer and applying preemptive easing as necessary to minimize the risk of hitting the zero bound — still seems to us to be sensible. However, such policies cannot ensure that the zero bound will never be met, so that additional refining of our understanding of the potential usefulness of nonstandard policies for escaping the zero bound should remain a high priority for macroeconomists.

–Bernanke, Reinhart, and Sack, 2004. (Emphasis Added) It is telling that he uses the verb “escaping” in that final sentence – instinctively he knows the ZLB is dangerous.

The Keynesian Endpoint – Things Become Nonlinear

As Professor Ken Rogoff (Harvard School of Public Policy Research) describes in his new book, This Time is Different: Eight Centuries of Financial Folly, sovereign defaults tend to follow banking crises by a few short years. His work shows that historically, the average breaking point for countries that finance themselves externally occurs at approximately 4.2x debt/revenue. Of course, this is not a hard and fast rule and each country is different, but it does provide a useful frame of reference. We believe that the two critical ratios for understanding and explaining sovereign situations are: (1) sovereign debt to central government revenue and (2) interest expense as a percentage of central government revenue. We believe that these ratios are better incremental barometers of financial health than the often referenced debt/GDP – GDP calculations can be very misleading. We believe that central government revenue is a more precise measure of a government’s substantive ability to pay creditors. Economists use GDP as a homogenizing denominator to illustrate broad points without particular attention to the idiosyncrasies of each nation. Using our preferred debt yardsticks, we find that when debt grows to such levels that it eclipses revenue multiple times over, (every country is unique and the maximum sustainable level of debt for any given country is governed by a multitude of factors), there is a nonlinear relationship between revenues and expenses in that total expenditures increase faster than revenues due to the rise in interest expense from a higher debt load coupled with a higher weighted-average cost of capital and the natural inflation of discretionary expenditure increases. The means by which sovereigns fall into this inescapable debt trap is the critical point which must be understood. In some cases, on-balance-sheet government debts (excluding pension shortfalls and unfunded holes in social welfare programs) exceed 3x revenue, and current fiscal policies point to a continuing upward trend.

The Bank of International Settlements released a paper in March 2010 that is particularly sobering. The paper, entitled “The Future of Public Debt: Prospects and Implications” (Cecchetti, Mohanty and Zampolli), paints a shocking picture of the trajectory of sovereign indebtedness. While the authors focus on GDP-based ratios as opposed to our preferred metrics, the forecast is nevertheless alarming. The study focuses on twelve major developed economies and finds that “debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States”. Additionally, the authors find that government interest expense as a percent of GDP will rise “from around 5% [on average] today to over 10% in all cases, and as high as 27% in the United Kingdom”. The authors point out that “without a clear change in policy, the path is unstable”. ( [p. 9])

When central bankers engage in “nonstandard” policies in an attempt to grow revenues, the resulting increase in interest expense may be many multiples of the change in central government revenue. For instance, Japan currently maintains central government debt approaching one quadrillion (one thousand trillion) Yen and central government revenues are roughly ¥48 trillion. Their ratio of central government debt to revenue is a fatal 20x. As we discuss later, Japan sailed through their solvency zone many years ago. Minute increases in the weighted‐average cost of capital for these governments will force them into what we have termed “the Keynesian endpoint” – where debt service alone exceeds revenue.

In Japan, some thoughtful members of the Diet (Japan’s parliament) decided that they must target a more aggressive hard inflation target of 2-3%. For the past 10+ years, the institutional investor base in Japan has agreed to buy 10-year bonds and receive less than 1.5% in nominal yield, as persistent deflation between 1-3% per year provides the buyer with a “real yield” somewhere between 2.5%-4.5% (nominal yield plus deflation). (We believe that Japanese institutional investors may base some of their investment decisions on real yields whereas external JGB investors do not.) If the Bank of Japan (BOJ) were to target inflation of just 1% to 2%, what rate would investors have to charge in order to have a positive real yield? In order to achieve even a 2.5% real yield, the nominal (or stated) yields on the bonds would have to be in excess of 3.5%. Herein lies the real problem. If the BOJ chooses an inflation target, the Japanese central government’s cost of capital will increase by more than 200 basis points (over time) and increase their interest expense by more than ¥20 trillion (every 100 basis point change in the weighted-average cost of capital is roughly equal to 25% of the central government’s tax revenue). For context, if Japan had to borrow at France’s rates (a AAA-rated member of the U.N. Security Council), the interest burden alone would bankrupt the government. Their debt service alone could easily exceed their entire central government revenue – checkmate. The ZIRP trap snaps shut. The bond markets tend to anticipate events long before they happen, and we believe a Japanese bond crisis is lurking right around the corner in the next few years.

Below, pleasBelow, please find a piece of our work detailing some important countries and these key relationships: 

What Other Macro Participants Have Missed and the Coming of “X-Day” pan has been a key focus of our firm for the last few years. We could spend another 10 pages doing a deep dive into our entire thesis, but for now we are going to stick with the catalysts for the upcoming Japanese bond crisis.

Investing with the expectations of rising rates in Japan has been dubbed “the widow maker” by some of the world’s most talented macro investors over the past 15-20 years. It is our belief that these investors missed a crucial piece to the puzzle that might have saved them untold millions (and maybe billions). They operated under the assumption that Japanese investors would simply grow tired of financing the government – directly or indirectly – with such a low return on capital. However, we believe that the absence of attractive domestic investment alternatives and the preponderance of new domestic savings generated each year enabled the Japanese government to “self-finance” by selling government bonds (JGBs) to its households and corporations. This is done despite their preference for cash and time deposits via financial institutions (such as the Government Pension Investment Fund, other pension funds, life insurance companies, and banks like Japan Post) that have little appetite for more volatile alternatives and little opportunity to invest in new private sector fixed-income assets. Essentially, they take in the savings as deposits and recycle them into government debt. Thus, it is necessary to understand how large the pool of capital for the sale of new government bonds.

We focus on incremental sales or “flow” versus the “stock” of aggregated debt. To simplify, the available pools of capital are comprised of two accounts – household and corporate sector. The former is the incremental personal savings of the Japanese population, and the latter is the after-tax corporate profits of Japanese corporations. These two pieces of the puzzle are the incremental pools of capital to which the government can sell bonds. As reflected in the chart below, as long as the sum of these two numbers exceeds the running government fiscal deficit, the Japanese government (in theory) has the ability to self-finance or sell additional government bonds into the domestic pool of capital. As long as the blue line stays above the red line, the Japanese government can continue to self-finance. This is the key relationship the macro investors have missed for the last decade – it is not a question of willingness, but one of capacity. As the Japanese government’s structural deficit grows wider (driven by the increasing cost of an ageing population, higher debt service, and secularly declining revenues) the divergence between savings and the deficit will increase. Interestingly enough, Alan Stanford and Bernie Madoff have recently shown us what tends to happen when this self-financing relationship inverts. When the available incremental pool of capital becomes smaller than the incremental financing needs of the government or a Ponzi scheme, the rubber finally meets the road. The severe decline in the population in addition to Japanese resistance to large scale immigration combine to form a volatile catalyst for a toxic bond crisis that could very likely be the largest the world has ever witnessed. Below is chart depicting this relationship:

Personal savings in Japan, while historically higher than almost any other nation, is now approaching zero and will fall below zero in the coming years (as recently pointed out by the Bank of Tokyo Mitsubishi) as more people leave the workforce than enter. For at least the next 20 years, we believe that Japan will have one of the largest natural population declines in a developed country. 

One last point about Japan that is more psychological than quantitative: there is an interesting psychological parallel between JGBs and US housing. In the last 20 years, Japanese stocks have dropped 75%, Japanese real estate has declined 70% (with high-end real estate dropping 50% in the last two years), and nominal GDP is exactly where it was 20 years ago. What one asset has never hurt the buyer? What one asset has earned a 20-year procyclical, ‘Pavlovian’ response associated with safety and even more safety? The buyers and owners of JGBs have never lost money in the purchase of these instruments as their interest rates have done nothing but fall for the better part of the last 2 decades. It is fascinating to see an instrument/asset be viewed as one of the safest in the world (10-yr JGB cash rates are currently 1.21%) at a period of time in which the credit fundamentals have never been riskier. Without revealing the Master Fund’s positioning here, we certainly intend to exploit the inefficiencies of option pricing models over the next few years. The primary flaw in pricing the risk of rising JGB yields is the reliance on historical volatility which, to this point in time, has remained very low. We believe that volatility will rise significantly and that current models undervalue the potential magnitude of future moves in JGB yields.

With all of the evidence literally stacking up against Japan, a few members of some of the major political parties are beginning to discuss and plan for the ominously named “X-Day”. According to The Wall Street Journal and BusinessWeek, X-Day is the day the market will no longer willingly purchase JGBs. Planning is in the very early stages, but centers around having a set of serious fiscal changes that could be announced immediately with the intention of giving the Bank of Japan the cover they will need to purchase massive amounts of JGBs with money printed out of thin air. If the BOJ were to engage in this type of behavior, we believe the Yen would plummet against the basket of key world currencies which would in turn drive Japanese interest rates higher and further aggravate their bond crisis. Neither the Fed, the Bank of England nor the European Central Bank have been able to consistently suppress bond yields through purchases with printed money – the bigger the purchase, the greater the risk of a collapse in confidence in the currency and capital flight. No matter how they attempt to quell the crisis, no matter where they turn, they will realize that they are in checkmate.

Will Germany Go “All-In” or Is the Price Too High?

We believe that an appreciation of the extent and limits of German commitment to full fiscal and debt integration with the rest of the Eurozone is crucial to understanding the path forward for European sovereign credit issues.

Despite consistent attempts by the European Commission and other members of the Eurozone bureaucratic vanguard to publicly promote as “done deals” various proposals to extend debt maturities, engage in debt buybacks and dramatically extend both the scope and size of the EFSF – the outcome has remained in doubt. In the end, the national governments of the member states will determine these policies regardless of what unnamed “European officials” leak to the newswires.

We believe that Angela Merkel has heeded the discord in the German domestic political sphere (where consistent polling shows a decline in support for the Euro and an increase in belief that Germany would have been better off not joining) and, as a result, set a series of substantial criteria for any German approval of further reform and extension of the EFSF structure. The areas canvassed – balanced budget amendments, corporate tax rate equalization, elimination of wage indexation and pension age harmonization – read like a wish list for remaking the entire Eurozone into a responsible and conservative fiscal actor in the mold of modern‐day Berlin. However, we believe (absent a dramatic change in the political mood) that several member states will never allow these requests to become binding prerequisites for further fiscal integration – the Irish and Slovaks on tax, the French on pension age, the Belgians and Portuguese on indexation, and almost everybody on the balanced budget amendment.

So the Eurozone seems to be at an impasse – the Germans are reluctant to step further into the quagmire of peripheral sovereign debt without assurances that all nations will be compelled to bring their houses in order, and the rest of the Eurozone rejects the burden of a German fiscal straightjacket. We continue to believe that, in the end, the German people will not go “all-in” to backstop the profligacy and expediency of the rest of the Eurozone without a credible plan to restructure existing debts and ensure that they can never reach such dangerous levels again.

A variety of solutions have been proposed to allow the de facto restructuring of Greek debt without engaging in formal default. The ECB and EC continue to be obsessed with preventing what they have deemed to be “speculators” from benefiting via the triggering of CDS on Greek sovereign debt. Not only is this pointlessly statist in its opposition to market participants, but it is also counterproductive to their other stated aims of maintaining financial stability and bank solvency, as much of the notional CDS outstanding against Greek sovereign debt is held as a bona fide hedge. Data from the Depository Trust and Clearing Corporation (“DTCC”) clearly invalidates the assertion that a rogue army of speculators is instigating a Greek bond crisis for a profit. According to the DTCC, there is only $5.7 billion net notional CDS outstanding on sovereign obligations of the Hellenic Republic, versus approximately $489 billion of total sovereign debt outstanding (as of September 30, 2010). Net CDS on Greek sovereign debt is equal to 1.2% of debt outstanding. (

Any revaluation of debt that reduces the real or nominal value of Greece’s debt outstanding – either through maturity extensions or through discounted debt buybacks necessarily creates a loss for existing holders. The European stress tests showed that up to 90% of sovereign debt is held to maturity by institutional players, and thus is still at risk of future write downs. There is no incentive to voluntarily submit to an extension or a buy back that reduces the nominal or real value of these bonds, and coercion will simply force the losses.

In the end the mathematics of the debt situation in Greece are inescapable – there is more than €350bn of Greek sovereign debt and at least €200 billion of it needs to be forgiven to allow the debt to be serviceable given current yields and the growth prospects of the Greek government’s revenues. This loss has to be borne by someone – either bondholders or non-Greek taxpayers. The current policy prescription that has Greece borrowing its way out of debt is pure folly. That is the reality of a solvency crisis as opposed to the liquidity crisis that the Eurozone has assumed to be the problem since late 2008.

Until a workable plan is created that shares the burden of these losses and then formalizes a recapitalization plan, it will continue to fester and spread discord in the rest of the Eurozone. In fact, it is clear from the price and volume action in peripheral bonds that there is an effective institutional buyer strike, and it is only the money printing by the ECB that is keeping these yields from entering stratospheric levels – yet still they grind higher. Some of this move in peripheral European bond yields has been driven by broader moves higher in rates, but putting these spreads aside, it is the absolute yield levels that govern serviceability for these states and both Spain and Portugal are current financing at unsustainably high levels.

Absent a serious restructuring plan, the Eurozone will continue to reel from one mini crisis to the next hoping to put out spot fires until the banking edifice finally comes crashing down under its own weight. In our view, it will severely affect a few states considered to be in the “core” of Europe as well.

Of Iceland and Greece

We recently traveled to Greece and Iceland in order to better understand the situations in each of these financial wastelands. We met with current and former government officials as well as large banks and other systemically important companies and wealthy families. This trip confirmed our quantitative analysis and ultimately was a lesson in psychology. We met many interesting people in both places but virtually all of them lived in some state of denial with regard to each country’s finances. As Mark Twain once said, “Denial ain’t just a river in Egypt.”

In Greece, they currently spend 14% of government revenues on interest alone and are frantically attempting to get to a primary surplus. This is analogous to a heavily indebted company trying to get to positive EBITDA while still being cash flow negative due to interest expense. The Greek government’s revenue is a monstrous 40% of GDP (only 15% in the US) and Greece has raised their VAT tax to 23% from just 17% this past summer. We don’t think they can possibly burden their tax-paying population much more even though the prevalent thought in Greece is that they need to tax the populace more to make up for those who pay no tax. Greece’s key problems today are all of the small and medium enterprise (“SME”) loans that are beginning to default. As the government begins to increase taxes on the Greeks, businesses are moving out of Greece to places like Cyprus, Romania, and Bulgaria (analogous to Californians, Illinoisans, and New Yorkers moving to Texas) where tax rates are much lower. Given the fiscal situation in Greece, a restructuring of their debts (i.e. default) seems the most probable outcome. At nearly 140% sovereign debt to GDP and 3.4x debt to government revenues, Greece put itself into checkmate long ago.

In one of the more comical meetings we have ever attended, one chief economist at one of the largest banks in Greece surmised that if the sovereign could transfer €100 billion of government debt to the personal balance sheets of the population that it would be a potential “magical” fix for the state’s finances (and subsequently pointed out that Greece would not be such an “outlier” as a result). When asked how the Greek state could accomplish such a feat, he said he did not know and that maybe Harry Potter could find a way. It is hard to believe, but he was completely serious. For him, it wasn’t important how or if it could happen – as long as the potential outcome made the situation look better for prospective bond investors. Greek banks have between 3-3.5x their entire equity invested in Greek government bonds. Consider that if these bonds took a 70% haircut (Hayman’s estimate of the necessary write-down), Greek banks would lose more than twice their equity.

Shortly after this meeting, my host informed me of an audit recently done on one of the largest hospitals in Athens. This hospital was hemorrhaging Euros, and the Greek government is required to make up the deficit with capital injections. Officials began an inquiry into these losses and found 45 gardeners on staff at the hospital. The most interesting fact about the hospital was that it did not have a garden. The corruption is endemic in the society, and it is no wonder that Greece has been a serial defaulter throughout history (91 aggregate years in the last 182 – or approximately half the time). It is unfortunate that it is about to happen once again. Although – as we have previously stated, restructuring is actually the gateway to renewed growth and prosperity over time – we have identified at least two assets that we would like to own in Greece in a post-restructuring environment.

Iceland, on the other hand, has a similar balance sheet and different culture. Iceland’s abrupt decline into financial obscurity was the driving force at Hayman that prompted us to look at the world through a different lens. I first encountered Iceland’s history and culture in a book I had read several years ago titled Collapse: How Societies Choose to Fail or Succeed, written by Pulitzer Prize winner Jared Diamond. Diamond is a professor of geography at UCLA and a determined environmentalist. His analysis is based on environmental damage that societies inflict on themselves and that there are other “contributing factors” to a collapse. One comment made early in this book caught my eye many years ago:

Some societies that I shall discuss, such as the Icelanders and the Tikopians, succeeded in solving extremely difficult environmental problems, have thereby been able to persist for a long time, and are still going strong today. –Jared Diamond, Collapse: How Societies Choose to Fail or Succeed

What caught my attention was the fact that Diamond uses Iceland as a country that has been able to “get it right” as a society for a very long time. What brought them to their knees in the last few years was a complete disregard for the risks inherent in allowing their banking system to grow unchecked (due to the overwhelmingly positive contribution to GDP and job growth). In a nation of 318,000 people and approximately $20 billion USD of GDP (2008), Iceland had over $200 billion USD in assets in just three banks. More importantly, Iceland had over 34x its central government revenue in banking assets. To put this into context, a 3% loss ratio in the banking system would completely wipe out the banks and the country’s ability to deal with the problem. Of course, this is precisely what happened and Iceland finds itself today in a state of suspended animation. The government immediately imposed capital controls (money was allowed in, but no money was allowed out) and began a process of determining which debts they could pay and from which multilateral lending institutions they would have to beg. Conventional wisdom suggests that Iceland has turned the corner and dealt with its demons and will emerge stronger and smarter going forward. Unfortunately, we don’t believe that to be the case yet.

Iceland currently spends an estimated 118 billion Icelandic kroner on interest expense (including gross interest on Icesave liabilities) alone against approximately 600 billion kroner of revenues at a weighted-average cost of capital of roughly 4.7% (even with heavily subsidized loans from the IMF and other Nordic countries). With gross debts as a percent of GDP (including Icesave) that exceed Greece (whose 10-yr bonds yield over 11%), we couldn’t find a real public market for Iceland’s debt. Today, their “stated” exchange rate of kroner to the USD hovers around 117 and the “black market” or “offshore” rate for the kroner is 176 (a 33.5% devaluation from the “onshore rate”). Pre-crisis, the official exchange rate was 60 kroner to the dollar – even the onshore official rates have devalued by nearly 50% to today. Government revenue declined in nominal terms throughout the crisis even while the currency depreciated by 50%! Imagine suffering a 50% devaluation in purchasing power and a concomitant increase in export competitiveness, yet the government cannot maintain nominal revenue, which is a key part of the recovery plan to avoid eventual restructuring. While Iceland is hardly an oasis of fiscal reform, we expect over time that it will recognize that restructuring will afford the best opportunity to share financial pain evenly and restart along the path of growth. Like Greece, we have identified attractive assets and investment opportunities in Iceland once the restructuring occurs and capital controls are lifted, allowing the currency to depreciate further towards a real “market” rate.

Iceland is a microcosm of what went wrong with the world, but after the IMF and Nordic loans, attention was diverted away from the problem. Iceland and Ireland share similar roots when it comes to their acute problems. With the development of the European Union and the creation of a European “free-trade zone”, inefficiencies were exploited between countries who had differing tax and deposit structures. Small countries like Ireland and Iceland could actually compete with much larger counterparts by offering slightly higher deposit rates with programs like Icesave accounts. The key problem was that no provincial regulator paid any attention to the size and leverage in each country’s banking systems or even cross border capital flows. In meetings with key politicians, academics, and regulators in early 2009, it became clear that absolutely nobody was paying attention to the gross size of each country’s banking systems or the ability to deal with the problems emanating from the crisis.

Both Iceland and Greece will have to restructure their debts before they are to attract sustained foreign direct investment again. We believe losses on their government and government guaranteed bonds will exceed 50% and new chapters in financial history will be written. Until then, we ask all of our readers to remember a quote from C. Northcote Parkinson: “Delay is the deadliest form of denial”.

Inflation – An Immediate Concern

We will keep our thoughts on this subject brief and straightforward. While the inflation/deflation debate is vigorously defended on both sides, and we certainly recognize the ongoing need for deleveraging which should apply deflationary pressures, it is difficult to ignore simple data which points to the contrary. In fact, we find very few assets around the world outside of US housing that are actually deflating in value. Hard and soft commodities across virtually all classifications continue to climb in value (in nominal terms) and many are at or near all-time highs. 

A very interesting chart from a recent Goldman Sachs research publication caught our attention. The authors highlighted the severe risks to headline inflation stemming primarily from global food prices. More specifically, they assess the risk to headline inflation on a country-by-country basis in a scenario where local food prices catch up to international food prices in local currency (as was the pattern in the 2007-2008 food inflation spike).

The results are alarming: 

We believe that that commodity price inflation has primarily been driven by demand coupled with (in some cases) supply-side shocks in 2010. Interestingly, United States “core” inflation will not move materially until the US housing market turns, which we believe could be up to 3 years away. The reason for this phenomenon is that housing (excluding the energy component) comprises roughly 37% of the headline CPI calculation and 49% of the core CPI calculation. ( The rest is just) The rest is just details, especially when food and energy are removed. Unfortunately, if you eat or drive every day, you are already feeling the impact of inflation.

Just remember: nflations are always caused by public budget deficits which are largely financed by money creation. If inflation accelerates these budget deficits tend to increase (Tanzi’s Law).

–Peter Bernholz, Monetary Regimes and Inflation (Emphasis Added)

With “Helicopter Ben” printing $3.3 billion per day ($2.3 million every minute), the consequences of this financial experiment could be staggering.

Does Debt Matter?

We spend a lot of time thinking about and discussing systemic risk. This is not because we are natural pessimists; rather, we believe that many investors cannot see the forest for the trees as they get caught up in the short-lived euphoria of the markets.

We ask ourselves, and urge you to ask yourself one simple question: Does debt matter? It was excess leverage and credit growth that brought the global economy to its knees. Since 2002, global credit has grown at an annualized rate of approximately 11%, while real GDP has grown approximately 4% over the same timeframe – credit growth has outstripped real GDP growth by an astounding 275%. We believe that debt will matter like it has every time since the dawn of financial history. Without a resolution of this global debt burden, systemic risk will fester and grow.

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The Crude Oil Economic Booby Trap

Rising oil prices threaten to derail the recovery. Oil at $106 per barrel (Monday's price) is not a problem, but oil at $160 is. With fighting increasing in Libya and social unrest spreading across the Middle East, no one knows where prices will settle. That leaves Fed chairman Ben Bernanke with a tough decision. Should he call off QE2 prematurely and let the stock market drift sideways or go-til-June and hope for the best? If the Fed tightens too early, deflationary pressures will reemerge further straining bank balance sheets and consumer spending. Housing prices will fall sharply and foreclosures will mushroom. But if Bernanke holds-firm with his zero rates and bond buying program--especially when the ECB is raising rates--he could trigger a bond market rout and send the dollar into freefall.

Bernanke has shrugged off the inflationistas saying that core inflation is still hovering at a safe 1 percent. But if oil keeps climbing, consumers will have to cut back on spending just when Obama's fiscal stimulus is winding down and just as the states are trimming their budgets. That will be a drag on economic activity and slow growth. Business investment will shrink, hiring will sputter, stocks will retreat, and the economy will head back into negative territory. It all depends on the price of oil. Here's Gluskin Sheff's David Rosenberg providing a little context to the fact that oil has "doubled" in just two years:

“There have been only five times in the past 70 years when this has happened within a two-year time frame: January 1974, November 1979, September 1990, June 2000, and August 2005. And now, December 2010. . . .

Of the five instances cited above, all but one involved a recession for the U.S. economy and that was in 2005 during the height of the credit and housing boom, which acted as a huge offset. But oil prices did keep rising and managed to outlast the euphoria in credit and residential real estate, so the recession may have been delayed at the peak of the ‘growth rate’ in the oil price, but it was not derailed as history shows.” (The Big Picture)

So spiking oil prices and recessions go hand-in-hand. Accordingly, bond yields have been trending lower anticipating deflation while the shriveling dollar has been steadily slipping for more than a month. All of this is adding to investor anxiety. Wall Street is on tenterhooks waiting to see whether Obama will tap the National Oil Reserve to stop the bleeding or just cross his fingers and hope that the violence subsides before the economy nosedives. And then there's Bernanke. What will Bernanke do?

Most likely, the Fed chair will stay-the-course as long as possible convinced that deflation is still enemy Number One. But he's bound to take a lot of heat from critics who point to the tumbling dollar and higher prices at the pump. If the troubles in Libya spread to Saudi Arabia, as now seems likely, all bets are off. Bernanke will have to pull out all the stops to keep the economy from tanking.

Bernanke does have alternatives, although none that assure that the smooth transfer of wealth from worker to banker. (like QE2) He could, for example, appeal to congress for a second round of fiscal stimulus to increase employment, reduce the output gap, and show trading partners that the US is eager to generate more demand for global exports. That would increase goodwill among US allies while building a stronger foundation for growth. To hell with the deficits. When the economy is firing on all 8 pistons and revenues are poring in, the deficits will vanish by themselves.

And there are other options, too, even if Bernanke chooses to stick with monetary policy alone. Here's a clip form a recent report by Richard Wood titled "Deflation, Debt and Economic Stimulus":

"The US, Japan, and Ireland are suffering from deficient private demand, rising debt, and a tendency to deflation.....The alternative approach (to quantitative easing) involves the central bank printing new money to directly finance fiscal stimulus. This neglected policy option – apparently largely overlooked by officials during the global economic crisis – is likely to be appropriate for countries where prices are falling (or inflation drops toward zero), private demand is deficient, interest rates are already too low and where public debt is excessive.

If monetary policy is considered on its own then there could be a case for terminating current quantitative easing programmes. This would steer Japan and the US away from the shoals of triple jeopardy (Leijonhufvud 2011).

Quantitative easing could be replaced with a policy of printing new money with an explicit objective to assist in the financing of future budget deficits (see suggested money-financed tax cut: Bernanke 2002 and analysis by Corden 2010). The deployment of new money creation in this manner would take some pressure off the need for severe fiscal austerity measures (at a time when continued stimulus is still required); minimize further increases in public debt; provide clear signals of policy intent (in relation to interest rate objectives, the method of financing deficits and the approach to delivering economic stimulus); and be more effective, have fewer adverse side-effects, and deliver stronger economic stimulus than further quantitative easing." ("Deflation, Debt and Economic Stimulus", Richard Wood, VOX)

Ahh, the dreaded monetization of the debt. It's a bad choice compared to fiscal stimulus, but vastly superior to QE2.

Ask yourself this question: Who benefits from QE2? Bernanke even admitted in an op-ed in the Washington Post that the program was aimed at boosting stock market prices. And former Fed chairman Alan Greenspan was even more explicit in an article that will be published in an upcoming issue of International Finance. Here's what Maestro has to say:

"I still embrace the view I held a couple of years ago, that ‘[w]e tend to think of fluctuations in stock prices in terms of “paper” profits and losses somehow not connected to the real world. But, the evaporation of the value of those “paper claims” can have a profoundly deflationary impact on global economic activity. … [such] that much of the recent decline in global economic activity can be associated directly and indirectly with declining equity values....

‘When we look back on this period, I very much suspect that the force that will be seen to have been most instrumental to global economic recovery will be a partial reversal of the $35 trillion global loss in corporate equity values that has so devastated financial intermediation. A recovery of the equity market driven largely by a receding of fear may well be a seminal turning point of the current crisis.’...

Equity values, in my experience, have been an underappreciated force driving market economies. Only in recent years has their impact been recognized in terms of ‘wealth effects’. This is one form of stimulus that does not require increased debt to fund it....

Despite the surge in corporate cash flow over the last two years and expectations of security analysts of continued gains in profitability, equity premiums remain near a half-century high. This indicates an exceptionally large and presumably unsustainably high discount rate applied to expected future earnings. If the latter holds up, and activism recedes, stock values, of course, would move higher and carry with them a significant wealth effect that should enhance economic activity.

Short of a full-blown Middle East crisis affecting oil prices, a euro crisis and/or a bond market (budget) crisis reminiscent of 1979, the ‘wealth effect’ could effectively substitute private ‘stimulus’ for public." ("The costs of government activism", Alan Greenspan, EurekAlert)

There you have it; Fed policy in a nutshell. If you want to reverse deflation and ignite a "global economic recovery"; pump up stock prices. In other words, if we just make the rich even richer, our problems will be solved. What could be simpler?

How is this any different from "trickle down" economics? It's the same thing, which is to say that QE2 is the same thing. The goal is to increase the "wealth effect" for the investor class to such an extent that the spillover lifts the rest of the economy back to prosperity and growth. It's baloney. QE2 has done nothing to increase demand or help consumers patch their battered balance sheets. The economy is more vulnerable than ever and skyrocketing oil prices could be the shock that sends the economy skittering back into recession.

Bernanke has other options. It's just a matter of whose interests he chooses to serve. 

China should buy more gold - government advisor

by Reuters

China should use some of its $2.85 trillion foreign exchange reserves to buy more gold XAU=, a government adviser was quoted as saying by local media reports on Wednesday.

Li Yining, a senior economist at Peking University and member of the Chinese People's Political Consultative Committee, an advisory body to the national parliament, said that China should use the precious metal to hedge against risks of foreign currency devaluations.

"China should increase its gold reserves appropriately, and China must take every chance to buy, especially when gold prices fall," Li was quoted by the official Xinhua news agency as saying.

His view that Beijing should diversify its foreign exchange reserves, the world's largest, into commodities is nothing new. Many other academics have publicly called on Beijing to do so.

But Li's views may carry more weight than most. Many of his former students are now high-ranking officials, including Chinese Vice Premier Li Keqiang, who is seen as Premier Wen Jiabao's likely successor in 2013.

However, Yi Gang, head of the State Administration of Foreign Exchange, which is responsible for managing most of the country's foreign currency holdings, said recently that it was not possible for China to make big purchases in the spot gold market.

"If China gets into these markets and pushes up prices to extremely high levels, the Chinese people will bear the cost at the end of the day as China is often the key buyer in these markets," Yi said.

He added that Chinese firms and households had purchased more than 300 tonnes of gold last year, and that it would have been hard for the government to buy any more with foreign reserve funds.

"The gold price shot up last year, and surging gold prices have forced Chinese people to pay more as there is strong demand for gold for those getting married and other events," he said. [ID:nTOE71P00H]

According to the central bank, China's state gold reserves have been held at 33.89 million ounces since April 2009.

Gold prices have risen about 10 percent in the last six weeks, as clashes in Libya and turbulence across the Arab world have encouraged investors to seek a safe haven, while oil has gained about 17 percent in the same period, increasing gold's inflation hedge appeal. (Reporting by Zhou Xin and Simon Rabinovitch; Editing by Jacqueline Wong)

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The Role of Biofuels in the Current Food Price Spike

With the UN food price index at decadal highs, the time for recriminations is upon us. In the firing line are speculators, national governments, the Fed, trade policies and the topic of today's discussion, biofuels.

To get some stats, I turned to the OECD-FAO Agricultural Outlook 2010-2019. The vast majority of ethanol is produced from coarse grains (i.e. maize/corn) and sugar cane, and the vast majority of biodiesel is made from vegetable oil.

For 2010, the UN Food and Agicultural Organization has estimated/predicted global production of 92.5 billion liters of ethanol and 21 billion liters of biodiesel, which is up from the average of 74.2 billion liters ethanol and 15 billion liters biodiesel from 2007-2009. Under current developed world policies, this is projected to rise to 159 billion liters ethanol and 41 billion liters biodiesel by 2020, almost all of which will be from first generation feedstocks.
Ethanol has an energy content of 24 MJ/liter and biodiesel 33 MJ/l, so the energy content for 2010 of the combined total is approximately 800 TWh. If a person requires 2,500 Calories per day (2.9 kWh), then this would feed, in theory, 750m people for a year. Whether using this for cars is ethical or not I'll leave up to you. (Hint: It isn't.)

The rising proportion of the various feedstocks diverted for biofuel use is shown below:
[Click to enlarge]

While disentangling the factors behind the recent price increases is very difficult, diverting up to 10% of global food calories to fuel cars is unlikely to have helped. It greatly reduces the margin for error in years with poor yields. It turns out food price volatility is a national security issue, too, as in MENA, so perhaps this will focus minds in Berlin and Washington to rescind the RFS2 and RED directives, in which case the proportion of grains used for biofuels would promptly plummet.
Happily, the GAO agrees that ethanol subsidies are a mess:
The U.S. General Accounting Office last week, disappointing the ethanol industry, issued a report saying that the excise tax credit and the RFS requirement "can be duplicative ... and can result in a substantial loss of revenue." The GAO put the cost of the tax credit at $5.7 billion. Meanwhile, a group of 90 different organizations called on Congress to end ethanol subsidies. The ethanol industry is going to have a hard time maintaining the tax support measures when they expire at the end of this year.
U.S. ethanol production is shown below, reaching the towering heights of 50 billion liters last year.

The proximate impacts of the removal of ethanol subsidies are likely to be January 2012 corn prices in freefall and oil prices sharply higher. December 2010 ethanol production was 918,000 barrels per day. Converted to oil equivalent, that's 0.6 mb/d. With OPEC spare capacity at most 2 mb/d, the loss of this oil supply would be, shall we say, problematic.
One way to play would be to go long the 2012 corn crush, although perversely if the corn crush blew out too much, ethanol might become competitive without subsidies. The corn crush is currently at historically low levels:
[Click to enlarge]

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More Corn, Fewer Beans | An exclusive survey of Corn & Soybean Digest online readers finds farmers plan to switch to more corn this year

Plant more corn, more beans, what? “At $6/bu., corn is going to attract greater interest than $13 beans. Corn will just look more alluring this year,” says Ed Usset, grain marketing specialist at the University of Minnesota and columnist for this magazine. “Farmers seem to be confident about producing a good corn crop and a little more hit and miss with soybeans and wheat.

To help get a pulse on just how you’re contemplating your acre mix this year, Corn & Soybean Digest conducted an exclusive online survey of readers.

Our planting intentions survey showed that 24% of our online readers plan to decrease their soybean acres this year. More than 41% of those said they’d reduce those acres by 11-20%.

This magazine’s research analyst Scott Grau estimates from the survey that soybean acres should decrease by about 7% this year.

On corn, 31% of our online readers said they expect to increase their acreage this year; 48% said they’d keep it the same and 15% said they’d reduce their acres. “Larger farms with more than 2,000 cropland acres are more apt to increase their corn acres than smaller operations,” Grau reports. “Larger farms are decreasing wheat acres to increase corn acres.”

So why would readers increase their corn acreage? Half said they need to stick to their crop rotation, 47% are betting on increased profits and 21% expect higher yields.

Bob Worth and his son Jon are bucking the expected more-corn trend. They intend to plant fewer corn and more soybean acres this year on their Lake Benton, MN, farm. When they finally put the planter in the shed, they should have 980 acres of corn and 1,300 acres of beans in the ground.

Their reasoning for more beans? “We need to stick to our rotation plus the cost of fertilizer is skyrocketing,” Worth says. “With $13 beans we can make a good profit. Maybe not as good as corn, but we don’t have the input and harvest expense we have with corn. In 2009 we spent a tremendous amount on drying our corn.”
In addition, he says last year the yield with corn-on-corn acres “just wasn’t there. I heard losses in southwest Minnesota were as high as 30 bu./acre.”

Other crops, like cotton and wheat, are asking for more acres this year, too, Usset explains. “The market remains volatile and in flux. The price of new-crop corn could be $1 more or less by April.”

China 2011-12 soybean imports seen at 58 million tons

by Commodity Online

World’s largest soybean consumer China’s import of the commodity is projected to grow by nearly 6 percent during 2011-12, according to USDA.

China will buy in 58.0m tones of the oilseed in 2011-12, some 5.5% more than in the current season, reports Agrimoney quoting Beijing office of US Department of Agriculture said in a report.

Falling domestic crop and growing needs for animal feed will keep up China’s import of the commodity continued to spur up demand, the report said.

While representing a slowdown on the pace of growth in 2010-11, the figure would set a record, and keep the pressure on supplies from America, the top soybean exporter.

China's soybean imports from America would reach 27.0m tones (992m bushels) next season, a rise of 2.0m tones (73.5m bushels) – more than the US is currently expecting its production to rise by.

As an extra sign of the pressure facing US stocks, it is estimated that China would import 25.0m tones of American soybeans in 2010-11, a figure 1.0m tones higher than the official USDA estimate.

The upbeat estimates to the strong demand for both soybean products – soy oil, for which consumption is being directly boosted by Chinese consumers' growing wealth, and soybean meal, which is feeling the demand indirectly, through a growing appetite for meat.

The growing demand for meat is spurring the consolidation of livestock producers into industrial enterprises keener to buy soy meal than small-time farmers.

However, domestic farmers were to put less ground to soybeans this season, preferring grains, which attract greater levels of government support, and higher value horticultural crops.

In eastern Chinese provinces, such as Hebei and Shandong, "soybean planting areas is expected to lose ground to cotton and corn", and to fall 10% in neighboring Henan.

The report added that soybean growers' "competitiveness continues to be undercut by low yields and poor efficiency", with a lack of crop rotation believed to be keeping yields at a little over half US levels of 3 tons per hectare.

The report also proposed that China would not imminently lower tariffs on soybeans and soyoil from 9% to 3% - speculation over which lifted Chicago prices of both commodities last week – despite the help such a reduction might be in the battle against food price inflation.

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Why commodity prices are surging on Libyan crisis

By Jon Nadler

Global powers did not come any closer to creating a Libyan no-fly zone and Col. Gaddafi’s loyalists appeared to gain the upper hand against rebels in at least one coastal city of the country on Wednesday. The situation prompted traders to keep bids on WTI oil prices just above $105 per barrel, and US dollar selling came back into the picture as well. NYMEX oil has now risen 20% over the past month, and Brent crude was trading at just above $114 in London this morning.

Yet, the US’ EIA inventory reports are believed to be showing a gain of 600,000 barrels for the week ending on March 4th, when they will be released later today. When the API released its report on Tuesday, the figures revealed that roughly 40 million barrels of dino juice are being stored in Cushing, Okla. –the delivery point for NYMEX crude. Let’s call that a near-glut in oil while the speculators dance away in New York and forecasters continue to chant about $200 oil as being just around the corner…

According to the top economics official at the US State Department in Washington, the current spike in crude oil prices does not reflect the fundamentals present in that market. Most market watchers concur that the disruption in Libyan oil flows is not a material threat to the overall oil supply picture and that intense speculative activity is what is really driving black gold to headline-generating levels at the present time. File that one under “what a surprise!”

Mr. Robert Hormats, the Undersecretary of State for Economic, Business and Agricultural Affairs remarked that he believes that: “the increase in prices is considerably greater than the decline in supply would ordinarily suggest." If there is any positive to the rise in oil values, well, it would have to be the fact that the oil production tax revenues of several states (Texas, Alaska, and Louisiana come to mind) have been getting a hefty boost and are helping to mitigate their budget deficits as well as lift the local economies.

The aforementioned combination of market impact factors (oil) drove precious metals higher following the apparent indecision in price patterns that was on display on Tuesday when it appeared more likely that something in the way of a positive development was going to come out of Tripoli. Efforts to stop the bloodshed in Libya appear to be stalled as politicians try to seek consensus on how to proceed with an intervention and are thought to be looking to the UN for some sign of approval for such strategies.

Spot metals dealings started the midweek session with decent gains across the board. Gold was bid at $1,435.70 per ounce (up $6.80) in New York, while silver advanced 27 cents to open at $36.32 on the bid side. Platinum and palladium gained $8 and $7 respectively, with the former opening at $1,813.00 and the latter showing a bid at $797.00 per troy ounce. Prices are thought to continue to receive support from the yet-to-be-resolved Libyan situation, but there are also more and more caution flags being raised about gold and silver’s future price prospects, interim gains to new possible records notwithstanding.

For example, while allowing for the possibility that there is [still] some potential upside in gold over the next 12 months, Steven Cunningham, Director of Research and Education at the American Institute for Economic Research, believes that “we've [already] witnessed the biggest part of the run-up in gold.” Mr. Cunningham opines that gold, at present, "is overpriced and overbought," and he advises taking profits and also reducing one's overall exposure to gold to 10%, and then maintaining that fixed percentage. Ten percent is precisely what this writer has been recommending as an untouchable, core, insurance holding in the yellow metals since…oh, about 1976. Stick with it. You cannot go wrong.

Another, similarly less-than-uber-bullish opinion comes from Ms. Pauline Shum, an associate Professor of Finance at the Schulich School of Business at York University. Ms. Shum cautions that "it is unrealistic to expect gold to repeat its performance [of the last decade] in the next 10 years." Meanwhile, another academician is a tad more…blunt when it comes to dispelling the prognostications and assertions being made about gold nowadays all over the blogosphere. According to Economics Professor Michael Dooley at UC Santa Cruz, and a partner at Cabezon Capital Markets LLC, those who suggest that gold and silver are the new currency, “They are nuts. Gold and silver will never again be used as currency or to back currencies.” Now there is one Marketwatch piece that will very likely generate several hundred comments (and flames) before the day is over. Emotions are running high enough that it has already elicited 85 impassioned posts since when it appeared at midnight last night. (complete with allegations that it is nothing but a “hit piece on gold”).

Of course, at a time when “news” that is really not news (heard it dozens of times, ever since India bought 200 tonnes of gold), but a lot of bullish noise is still being made about it, such as the latest Chinese academic advising his central bank to sell dollars and buy gold, one can clearly see that the bull/bear camps are as divided as ever, and that the ‘twain shall never meet on neutral ground. That neutral ground –quite possibly- could be that same 10% set-and-forget allocation strategy that ignores annual gold price movements and focuses on the core presence of gold in a portfolio, instead.

In the market’s background today, the US dollar was down 0.15 on the trade-weighted index and was quoted at 76.64, while crude oil remained resilient and was indicated at $105.14 following a small, 12-cent rise. The pivotal 76.20 mark in the US dollar on the charts has not yet materialized, but traders are keeping a close eye on it potentially being touched and sparking further weakness (towards the 74 area) if in fact a close at or beneath that key figure does become reality.

Something that will very likely soon become a reality, are higher interest rates. Over the past month, more and more central bankers have started to sound more and more hawkish, despite the perceived threat that Col. Gaddfi’s descent into madness is thought to possibly pose to the world’s recovering economies. Spiking oil prices have prompted NYU Prof. Nouriel Roubini to prognosticate another dip and another round of QE to come from the Fed.

However, on Tuesday, European Central Bank Governing Council member Axel Weber said he doesn’t want to defuse market expectations for as many as three separate [!] quarter-point hikes in the ECB’s benchmark interest rate, and that they are likely to take place this year. Mr. Weber told Bloomberg News that he “wouldn’t do anything here to try to correct market expectations at this point. It was the intention of the ECB to bring forward market expectations and I see no reason at this stage to signal any dissent with how markets priced future policies,” he said.

Over in the US, the latest report in a relatively light-on-statistics week shows that mortgage applications gained 16% in the week ending on March the 4th, and that was the largest such rise since June of 2010. Purchases and refinancing on the rise may be signaling that the US housing market is finally stabilizing. Housing conditions and the jobs situation are the two pivotal “to-watch” items on the Fed’s and the Obama administration’s current agenda.
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