Monday, September 8, 2014

Facing Reality in the Eurozone

by Adair Turner

LONDON – European Central Bank President Mario Draghi’s recent speech at the annual gathering of central bankers in Jackson Hole, Wyoming, has excited great interest, but the implication of his remarks is even more startling than many initially recognized. If a eurozone breakup is to be avoided, escaping from continued recession will require increased fiscal deficits financed with ECB money. The only question is how openly that reality will be admitted.

The latest economic data have forced eurozone policymakers to face the severe deflationary risks that have been apparent for at least two years. Inflation is stuck far below the ECB’s 2% annual target, and GDP growth has ground to a halt. Without strong policy action, the eurozone, like Japan since the 1990s, faces a lost decade or two of painfully slow growth.

Until last month, growing concern provoked unconvincing policy proposals. Jens Weidmann provided the novel spectacle of a Bundesbank president calling for higher wages. But wage growth will not occur without policy stimulus.

Draghi sought to talk down the euro exchange rate to improve competitiveness. But Japan and China also want competitive exchange rates to spur export growth, and the eurozone already runs a current-account surplus. The German model of export-led growth cannot work for the eurozone as a whole. Structural reform is certainly needed in some countries to increase long-term growth potential; but the impact of structural reform on short-term growth is often negative.

The eurozone needs higher domestic demand to escape the debt overhang left behind by pre-crisis excess. In countries such as Spain and Ireland, private debts grew to unsustainable levels. In others, such as Greece and Italy, public debt also was too high. Household consumption, business investment, and public expenditure have all been cut in an attempt to pay down debt.

But simultaneous public and private deleveraging is bound to depress demand and growth. Faced with private deleveraging in the 1990s, Japan avoided an even deeper depression only by running large public deficits.

That is why eurozone fiscal austerity has become self-defeating. The more aggressively the Italian government, for example, cuts expenditure or increases taxation, the more its public-debt burden – already above 130% of GDP – will likely grow to unsustainable levels.

Until two weeks ago, eurozone policymakers denied this reality. On August 22, at Jackson Hole, Draghi admitted it. Without higher aggregate demand, he argued, structural reform could be ineffective; and higher demand requires fiscal stimulus alongside expansionary monetary policy.

The Italian economists Francesco Giavazzi and Guido Tabellini have spelled out what coordinated fiscal and monetary policy could mean. They propose tax cuts equal to 5% of GDP for 3-4 years in all eurozone countries, financed by very long-term public debt, all of which the ECB should buy. They argue that ECB quantitative easing alone, with no fiscal relaxation, would be ineffective.

Giavazzi and Tabellini’s proposals may entail too large a stimulus. But they also highlight a crucial question: How does quantitative easing stimulate an economy? The Bank of England has presented QE as a purely monetary policy tool that sustains economic growth in the face of necessary and desirable fiscal consolidation. It works, the BoE has argued, by reducing medium-term interest rates, increasing asset prices, and inducing shifts in investor preferences that indirectly stimulate investment and thus demand.

The US Federal Reserve’s position has been more ambiguous. Fed Vice-Chairman Stanley Fischer, like former Chairman Ben Bernanke, has stressed that premature fiscal consolidation can hold back post-crisis recovery. Thus, the Fed has implicitly viewed QE in part as a tool to ensure that rising bond yields do not offset the beneficial impact of large deficits.

The Fed’s position is more persuasive. Fiscal stimulus has a direct and powerful impact on demand. In Milton Friedman’s words, it enters directly into “the current income stream.” Monetary stimulus alone is less direct, takes longer, and risks causing adverse side effects. Continued low interest rates allow unsuccessful companies to struggle on, slowing productivity growth; asset-price rises exacerbate inequality; and monetary stimulus works only by reigniting the private credit growth that generated the debt overhang in the first place.

But if fiscal stimulus must be facilitated by central bank bond purchases to prevent yield increases and to assuage fears about debt sustainability, doesn’t that amount to monetary financing of fiscal deficits?

The answer depends on whether the purchases prove permanent. In Japan, where the central bank now owns government bonds worth 35% of GDP (a level that is rising fast), they undoubtedly will. There is no credible scenario in which Japan can generate fiscal surpluses large enough to repay its accumulated debt: a significant proportion will remain permanently on the Bank of Japan’s balance sheet. Likewise, if Giavazzi and Tabellini’s proposal were adopted, the result would almost certainly be some permanent increase in the ECB’s balance sheet.

Should we admit that possibility explicitly in advance? The argument in favor is that failure to do so would raise fears about how increased public debt would ever be repaid, or about how the ECB would “exit” from a swollen balance sheet, in turn undermining the stimulative impact of fiscal and monetary coordination. The argument against is moral hazard: If we admit that modest ECB-financed deficits are possible and appropriate now, what will prevent politicians and electorates from demanding large and inflationary ECB-financed deficits on other occasions?

The political risks are certainly great. Optimal policy may therefore require a non-transparent fudge; monetary and fiscal “coordination” might mean, after the fact, permanent monetary finance, but without ever openly admitting that possibility. But, fudge or not, Draghi has moved the debate forward dramatically. Without a greater role for fiscal policy, the eurozone will face either continued slow growth or an eventual breakup.

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6 big mistakes you can make benchmarking to the S&P 500

by J.J. Zhang's

“Compared with the S&P 500 market returns” is one of the most commonly used terms in the personal finance world. You see it everywhere comparing how this stock, this ETF, this hedge fund, or how your portfolio stacks up versus the S&P 500.

As an engineer, I have a deep appreciation for benchmarks and metrics and there’s no denying that it’s an important comparison to make. However, there are a number of flaws with the way many use this benchmark that unfortunately can skew their impression of returns. Here are six of the most common mistakes:

1. Ignoring friction

The exact S&P 500 index benchmark return is impossible to achieve. The S&P 500 index is a purely theoretical product. It’s a frictionless construct which ignores trading fees, bid-ask spreads, liquidity, and all sorts of other factors. The two leading S&P 500 ETFs, SPDR’s SPY, -0.12%   and Vanguard’s VOO, +0.48%  , have expense ratios of 0.09% and 0.05% which represent real costs investors have to pay to get S&P 500 performance.

Because of these expenses, they’ll always perform slightly worse than the S&P return. Instead of comparing your results versus the theoretical S&P 500 return, using VOO returns are a much more realistic benchmark.

2. Failing to account for dividends

Another common mistake (or purposely misleading figure) some companies or people use is due to dividend accounting for the S&P 500. With a current yearly yield of about 2% to 3%, dividends add significantly to the overall total return.

However, some benchmark comparisons use the pure S&P index change, which excludes dividends, lowering returns and coincidentally making their performance look better. For comparison, 10-year returns for the S&P 500 with dividends results in a 162% increase while the same period without dividends yielded only a 110% increase.

A more accurate method is to compare with the VOO plus its yearly dividend yield or a total return measure including dividend reinvestment.

3. Forgetting taxes

Tax is another complicating factor in comparing returns, especially for special tax affected accounts. While the S&P 500 may gain 10% in one year, capital gains tax can change that figure significantly. Some people may end up with only a 15% capital gains tax, others are taxed at greater than 30%, and some may not be taxed at all. In some cases such as dividends from foreign-based stocks, an automatic 15% withholding is applied while for non-U.S. resident foreigners holding U.S. stocks, an automatic 30% is applied.

The mistake some people make is comparing real after-tax returns with S&P benchmark pretax returns. Even if you own a passive ETF and don’t sell, you likely still have an implied tax rate which Uncle Sam will make you pay someday. For more accuracy, compare equally on a taxed or non-taxed basis. I personally use pretax simply for convenience and ease of calculation though one should recognize the big potential for taxes to alter your final real return.

4. Missing the smaller picture

Stepping back from talking about the S&P 500 returns brings up the question of why we use the S&P in the first place. The S&P 500 is a list of 500 U.S. domiciled companies chosen by S&P Dow Jones Indices. While it is a good selected list of the largest and most important companies in the U.S. and covers about 80% of the total U.S. equity market by capitalization, there’s no inherent essentialness to it.

If the point of a benchmark is to compare versus the market, a more complete equity comparison would instead be the Wilshire 5000 or the tradable equivalent , the Vanguard Total Stock Market ETF VTI, +0.46%   which “represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and microcap stocks regularly traded on the New York Stock Exchange and Nasdaq.” While it still excludes certain investments such as ADRs and MLPs and non-U.S. headquartered companies, it’s a much more complete measure.

5. Looking only at the U.S.

Similarly, VTI also brings up the question of why we focus on U.S. equity markets as the standard benchmark. All practical modern equity asset allocations include a mix of both U.S. and international stocks. While U.S. companies are still among the largest and most important companies in the world, the U.S. market only makes up approximately one-third of the total world market cap ($18 trillion vs. $53 trillion, as per the World Bank), and thus captures only a small portion of the real “market” performance.

For a pure passive market comparison, the world index is arguably a more realistic measure. Though considerably smaller than their U.S. equivalents, the iShares MSCI ACWI Index ETF ACWI, +0.43%   and Vanguard Total World Stock ETF VT, +0.22%   both are reasonable alternative benchmarks to use.

6. Failing to recognize portfolio diversity

Lastly, the biggest mistake people make is using equity market indices like the S&P 500 as a benchmark for their total portfolios. While the S&P 500 or similar indices are reasonable benchmarks for equity based assets such as stocks or stock mutual funds, the average investor should have a balanced mix of bonds, REITs, or other non-stock assets. Those assets have a different mix of expected returns and volatility and serve different purposes.

Just as you wouldn’t compare a bond fund return to the S&P 500, you shouldn’t compare your total diversified portfolio to the S&P 500. The best approach is to compare each asset type to its own benchmark or change to benchmarks that take these factors into account such as Sharpe ratios. However, for those who prefer something quicker and simpler, an alternative suggestion may be to compare vs. a simple 50:50 portfolio of the world market ETF and a bond market ETF AGG, -0.05%  .

Though benchmark comparisons are an important part of investing discipline and useful for identifying both successes and failures for possible portfolio changes, it is only true if they are apple-to-apple comparisons. I find this especially relevant when people contact me lamenting their portfolio underperformance vs. the S&P 500 — a properly diversified portfolio has different risk-reward profiles and thus should not be simply compared with the S&P 500.

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Scotland’s Independence Movement Gains Lead in Polls

by Pater Tenebrarum


Globalists everywhere must be horrified. It seems the Scots might after all go for becoming an independent nation. It should be remembered here that Scotland only joined the Union in the early 1700ds – and did so voluntarily, sort of. Actually, many Scottish nobles had been bankrupted in the “Darien Scheme” – an attempt to establish a trading colony named Caledonia in Panama, which went horribly wrong – which weakened their resistance to signing the Act of Union.

Numerous attempts to incorporate Scotland into a larger political entity by military force had failed since Roman times. The Romans probably realized that   the North wasn’t worth it when the Picts on one occasion almost completely destroyed the 9th Legion. Even though the Romans later won the battle of Mons Graupius, they never succeeded in actually subduing the area. The Romans then decided to erect Hadrian’s Wall, so as to simply keep the Picts and other tribes out, many of which had acquired a fearsome reputation.

A later rather famous conqueror of England, William of Normandy, proved very successful in his conquests and soon had England under control, ending the line of the Wessex kings. While he actually defeated Malcolm III of Scotland in battle in 1072, he didn’t get Scotland – instead, it is considered likely by historians that he only got Malcolm’s son Douglas as a hostage to ensure the former’s adherence to the peace treaty.

Anyway, until the Act of Union in 1707, Scotland has always been an independent country. Even after the union, it retained its own legal system (which is based, curiously enough, on Roman law). From the beginning of the 19th century onward,   political devolution was increasingly demanded, and granted bit by bit, until Scotland finally got a parliament of its own again in 1998 (incidentally also in the wake of a referendum).

In short, Scotland is actually uniquely well positioned for independence, as it has all the institutions in place that are widely held to be required for statehood. Obviously, it would be even better for it to become a capitalist anarchy, but one must take whatever one can get. In Dr. Walker’s article on Scottish Independence, many of the philosophical and economic questions surrounding the issue were already discussed in great detail (See “Scottish Independence” Part 1, Part 2 and Part 3).

Hitherto, the pro-unionists could safely dismiss the referendum on independence as a kind of late in the year April Fool’s joke, since the “No” vote has almost constantly been in the lead according to various polls. A lot of scaremongering propaganda has emanated from these quarters, painting pictures of doom if Scotland were to become independent, but the Scots tend to be a stubborn lot. Apparently, just 11 days before the referendum, they have changed their mind:

Scotland pollThe “yes” vote takes the lead – click to enlarge.

We’ll Say it Again: Small is Beautiful

One point we wish to stress once again is that it is actually as a rule much better for the citizenry to live in a smaller rather than a bigger country. This is not only shown by the data – the world’s most prosperous places are mostly small, even tiny nations – it should be obvious why this is the case. One only needs to consider the argument often employed by the EU’s centralizers who dream of instituting a European super-state: allegedly, it is of advantage if a political entity can “throw its weight around on the world stage”.

The individual citizen may well swell with pride upon hearing that the political area in which he lives is considered “powerful”, but should realize upon reflection that all this power projection tends to be rather costly, and that he is paying for it. The people who actually enjoy “throwing their weight around” are invariably only members of the political elite, many of whom must be suspected of being outright psychopaths. We are not exaggerating, as there exist studies that show that psychopathic traits are “many of the same that make effective leaders”. If you actually want leaders that is, who apparently need to be “mad enough to lead”. We rather hold with Hayek that in government, the worst tend to rise to the top, so we’d be perfectly fine without any “leaders”.

The larger the political entity, the less influence the average citizen actually has on its policies. Politicians who are closer to their constituency by virtue of the constituency being small, are far less likely to institute policies that end up doing more harm than good. We have previously mentioned the excellent custom of the Isle of Man, where those making new laws must read every single one of them out loud every year on Tynwald Day, come rain or sunshine, in open air – both in Manx and in English.

This is an excellent way to cut down on unnecessary legislation. The current allegedly “unproductive” US Congress would likely take far longer to read out all the laws it has made in a single year than it has taken to enact them (in fact, even an “unproductive” Congress produces such a mountain of legal red tape that it is impossible for its members to read the bills before voting on them). Clearly, Isle-of-Man style law-making is to be preferred.

What Scotland decides on the day of the referendum is not only important for Scotland. A longstanding trend toward increasing European concentration of power and centralization would be partially reversed, and an important example would be set for others to emulate. We imagine that many in Catalonia, Sardinia, the Veneto and other regions with strong independence movements are casting a hopeful eye in Scotland’s direction.

If Europe consisted of far more numerous, smaller polities, political competition would heat up, as it would be quite easy for citizens to vote with their feet. There is no reason to fear that trade barriers would be re-erected, since it would be to everybody’s disadvantage to institute such policies. Common currency areas could exist as well, but there would also be more room for experimentation in the monetary field.

If Scotland actually becomes independent, it would merely represent a small first step, but all new trends have to begin somewhere.


From our perspective, the latest poll results in Scotland are excellent news and a very hopeful sign.


Robert the Bruce addresses his troops before the Battle of Bannockburn. He was King of Scotland from 1306-1329, and a famous military leader during the first of the so-called “wars of independence” in the late 13th and early 14th century, when Scotland successfully fought off two English attempts to conquer it.

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What I Learned in China About the Fate of the US Dollar

by Bill Bonner

Surreal Art and Car Lotteries

A huge plastic bull with a mushroom cloud coming out of his fundament … and a guy with horns on his head, crushed against the wall.

It is art. Titled: Things Are Not What They Seem. It is also a puzzle. Because we can’t tell what it seems to be. In fact, it doesn’t seem to be anything at all… just an odd piece of surreal art.  It is exactly what it seems to be, in other words. Maybe that is the joke.
Another statue … in a kind of rough bronze … has a woman (at least, it appears to be a woman) with her legs splayed, and her arms over her head, lying on the floor.

The Parkview Green mall in downtown Beijing is easily the biggest, most modern and most stylish mall your editor has ever seen. It looks like something imagined from the future – made of steel, glass and concrete… with soaring interior spaces crisscrossed by elevated walkways and escalators… and a collection of oversize pieces of art that rivals the Tate Modern in London.

china-2Tianjin Goldin Finance 117

(Photo credit: unknown)

It also has chic shops … restaurants … and even a Tesla car dealership.

“But you have to get in line to buy one of these,” said the young man who showed us the car.  In Beijing, you can’t buy a car even if you have the cash. Traffic jams and air pollution are such serious problems that the government rations new car purchases.

“In China, you enter a lottery to get a new car,” says a friend. “You don’t win the car. You win the right to buy it.”

A Nation to Watch

“China is the nation to watch,” begins a Beijing colleague. “It is already the biggest trading nation in the world. And it will soon pass the US as the world’s biggest economy. But what is really important is that it will also overtake the US in two other important categories: military power and money.

“No nation ever became the world’s biggest economy without also dominating the world’s money and the world’s armed forces.

“If you think back to the succession of great nations – from Spain in the 16th century… to the Netherlands… to France… to Britain… and finally, in the 20th century, to the US – each one dominated the financial system at the time. And each dominated, militarily at least, the territories around it.

“Now, the US is making a show of supporting the nations around China… as though it could stop China by teaming up with the Philippines and Japan.

“This is like the early 19th century, when France tried to get all of Europe to unite against Britain, the rising power of that era. It didn’t work… especially when Napoleon attacked Russia to stop it from trading with the British. Now it’s the US that has made a new enemy of Russia. This has made Russia China’s friend.

“You can’t stop a nation whose time has come. And China’s time is coming. Everybody here believes it. And we know it has two components – money and firepower. We don’t talk much about the army. But we talk openly about money.

“Right now, world trade is done in US dollars. China’s currency, the renminbi, is used in less than 3% of settlements. That’s because the renminbi is not fully convertible. But the government knows it has to change this.

“It will make the renminbi a world currency, not just a Chinese one… and give other nations an alternative to the dollar. That is already happening, by the way.

“Contracts worked out between China and other nations call for settlement in renminbi, not in dollars. And we’re talking some very big contracts. And when the renminbi is fully convertible, you’ll see more and more of the world’s trade shift to renminbi.

“There is even talk of backing the renminbi with gold. Gold always flows to the rising power. China is the world’s biggest buyer of gold. What do you think will happen to the dollar when much of the world shifts to a gold-backed renminbi?”

USDCNY(Monthly)Recently, the US dollar has been strong – but not against the renminbi, which has strengthened again after a three month long correction earlier this year – via, click to enlarge.

The above article is from Diary of a Rogue Economist originally written for Bonner & Partners. Bill Bonner founded Agora, Inc in 1978. It has since grown into one of the largest independent newsletter publishing companies in the world. He has also written three New York Times bestselling books, Financial Reckoning Day, Empire of Debt and Mobs, Messiahs and Markets.

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Europe Takes the QE Baton

By John Mauldin

The Age of Deleveraging
How Bizarre Is It?
Time to Ramp Up the Currency War
Europe Takes the QE Baton
Introducing Tony Sagami
San Antonio, Washington DC, Chicago, and Boston

If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre. It increasingly feels like we’re living in the world dreamed up by the creators of DC Comics back in the 1960s, called Bizarro World. In popular culture "Bizarro World" has come to mean a situation or setting that is weirdly inverted or opposite from expectations.

As my Dad would say, “The whole situation seems about a half-bubble off dead center” (dating myself to a time when people used levels that actually had bubbles in them). But I suppose that now, were he with us, he might use the expression to refer to the little bubbles that are effervescing everywhere. In a Bizarro French version of very bubbly champagne (I can hardly believe I’m reporting this), the yield on French short-term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. I can almost understand German and Swiss yields being negative, but French?

And then Friday, as if to compound the hilarity, Irish short-term bond yields went negative. Specifically, roughly three years ago Irish two-year bonds yielded 23.5%. Today they yield -0.004%! In non-related un-news from Bizarro World, the Spanish sold 50-year bonds at 4% this week. Neither of these statistics yielded up by Bloomberg makes any sense at all. I mean, I understand how they can technically happen and why some institutions might even want 50-year Spanish bonds. But what rational person would pay for the privilege of owning an Irish bond? And does anyone really think that 4% covers the risk of holding Spanish debt for 50 years? What is the over-under bet spread on the euro’s even existing in Spain in 50 years? Or 10, for that matter?

We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies. The realist in me scratches my already well-scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05% from an already negligible 0.15%. Wow, that should make a lot of deals look better on paper.

We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the US Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away. (Note: this letter will print longer than usual as there are a significant number of graphs. Word count is actually down, for which some readers may be grateful.)

But first, I’m glad that I can finally announce that my longtime friend Tony Sagami has officially come to work for us at Mauldin Economics. Tony has been writing our Yield Shark advisory since the very beginning, but for contractual reasons we could not publicize his name. I will say more at the end of the letter, but for those of you interested in figuring out how to increase the yield of your investments, Tony could be a godsend.

The Age of Deleveraging

Extremely low and even negative interest rates, slow growth, unusual moves by monetary and fiscal authorities, and the generally unseemly nature of the economic world actually all have a rational context and a comprehensible explanation. My co-author Jonathan Tepper and I laid out in some detail in our book End Game what the ending of the debt supercycle would look like. We followed up in our book Code Red with a discussion of one of the main side effects, which is a continual currency war (though of course it will not be called a currency war in public). Both books stand up well to the events that have followed them. They are still great handbooks to understand the current environment.

Such deleveraging periods are inherently deflationary and precipitate low rates. Yes, central banks have taken rates to extremes, but the low-rate regime we are in is a natural manifestation of that deleveraging environment. I’ve been doing a little personal research on what I was writing some 15 years ago (just curious), and I came across a prediction from almost exactly 15 years ago in which I boldly and confidently (note sarcasm) projected that the 10-year bond would go below 4% within a few years. That was a little edgy back then, as Ed Yardeni was suggesting it might go below 5% by the end of the following year. That all seems rather quaint right now. The Great Recession would send the 10-year yield below 2%.

Sidebar: The yield curve was also negative at the time, and I was calling for recession the next year. With central banks holding short-term rates at the zero bound, we no longer have traditional yield-curve data to signal a recession. What’s a forecaster to do?

I was not the only one talking about deflation and deleveraging back then. Drs. Gary Shilling and Lacy Hunt (among others) had been writing about them for years. The debt supercycle was also a favorite topic of my friend Martin Barnes (and prior to him Tony Boeckh) at Bank Credit Analyst.

Ever-increasing leverage clearly spurs an economy and growth. That leverage can be sustained indefinitely if it is productive leverage capable of creating the cash flow to pay for itself. Even government leverage, if it is used for productive infrastructure investments, can be self-sustaining. But ever-increasing leverage for consumption has a limit. It’s called a debt supercycle because that limit takes a long time to come about. Typically it takes about 60 or 70 years. Then something has to be done with the debt and leverage. Generally there is a restructuring through a very painful deflationary bursting of the debt bubble – unless governments print money and create an inflationary bubble. Either way, the debt gets dealt with, and generally not in a pleasant manner.

We are living through an age of deleveraging, which began in 2008. Gary Shilling summarized it this week in his monthly letter:

We continue to believe that slow worldwide growth is the result of the global financial deleveraging that followed the massive expansion of debt in the 1980s and 1990s and the 2008 financial crisis that inevitably followed, as detailed in our 2010 book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. We forecast back then that the result in the U.S. would be persistent 2% real GDP growth until the normal decade of deleveraging is completed. Since the process is now six years old, history suggests another four years or so to go.

We’ve also persistently noted that this deleveraging is so powerful that it has largely offset massive fiscal stimuli in the form of tax cuts and rebates as well as huge increases in federal spending that resulted in earlier trillion-dollar deficits. It has also swamped the cuts in major central bank interest rates to essentially zero that were followed by gigantic central bank security purchases and loans that skyrocketed their balance sheets.  Without this deleveraging, all the financial and monetary stimuli would surely have pushed real GDP growth well above the robust 1982–2000 3.7% average instead of leaving it at a meager 2.2% since the recovery began in mid-2009.

The problems the developed world faces today are the result of decisions made to accumulate large amounts of debt over the past 60 years. These problems cannot be solved simply by the application of easy-money policies. The solution will require significant reforms, especially labor reforms in Europe and Japan, and a restructuring of government obligations.

Mohammed El-Erian called it the New Normal. But it is not something that happens for just a short period of time and then we go back to normal. Gary Shilling cites research which suggests that such periods typically last 10 years – but that’s if adjustments are allowed to happen. Central banks are fighting the usual adjustment process by providing easy money, which will prolong the period before the adjustments are made and we can indeed return to a “normal” market.

How Bizarre Is It?

We are going to quickly run through a number of charts, as telling the story visually will be better than spilling several times 1000 words (and easier on you). Note that many of these charts display processes unfolding over time. We try to go back prior to the Great Recession in many of these charts so that you can see the process. We are going to focus on Europe, since that is where the really significant anomalies have been occurring.

First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. This chart depicts inflation in the two main European economies, Germany and France.

Note too that inflation expectations for the entire euro area are well below 1% for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.

But as I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.

With inflation so low and a desperate scramble for yield going on in Europe, rates for 10-year sovereign debt have plummeted. It is not that Italy or Spain or Greece or Ireland or France is that much less risky than it was five years ago.

Note that banks can get deposits for essentially nothing. They can lever those deposits up (30 or 40 times), and the regulators make them reserve no capital against investments made in sovereign debt. Even after their experience with Greek debt, they essentially claim that there is no risk in sovereign debt. If your bank’s profits are being squeezed and it’s hard to find places to put money to work in the business sector, then the only game in town is to buy sovereign debt, which is what banks are doing. Which of course pushes down rates. Low interest rates in Europe are as much a result of regulatory policy as of monetary policy.

Next is a chart of 10-year bond yields. We’ve also included the US, Japan, and Switzerland. Note that Japan and Switzerland are in the 50-basis-point range. (Japan is at 0.52%, and Switzerland is at 0.45%). Italy and Spain now have 10-year bond yields below that of the US.

The following chart is a screenshot of a table from Bloomberg, listing 10-year bond yields around Europe. Note that Greece is at 5.48%. Hold that thought while you look at the table.

This next chart requires a minute or two of analysis, and looking at it in black and white probably won’t work. Essentially, this is the spread of the yields of 10-year bonds of various European countries over German bunds. Note that only two years ago Greek debt paid 25% per year more than German debt did. Anyone who bought Greek debt when that country was busy defaulting has scored big. (While I probably take far too much risk in my portfolio, I will readily admit to not having enough nerve to do something like that.) The other thing to note, and it is a little bit more difficult to see on this chart, is that for all intents and purposes the market is treating European-wide EFSF debt as German debt. There are only 10 basis points of difference.

Now let’s take a little stroll through history and view a chart of the yield curve of French debt. The top dotted line is where the yield curve was on January 1, 2007. We took our first look at this chart last Tuesday in preparation for this letter, noting that short-term French debt was at the zero bound. It went negative on Thursday, and negative all the way out to two years! Note that a 50-year French note (which I’m not sure actually trades) yields a hypothetical 2.5%, only modestly more than a 30-year would yield. You might have to have the patience of Job, and I’m not sure quite how you would go about executing the trade, but that has to be one of the most loudly screaming shorts I’ve ever seen!

Here is the equivalent chart for the German yield curve going back to January 2007. Note that German debt has a negative yield out to three years!!!

While it should surprise no one, German long-term bond yields are at historic lows. I recall reading that Spanish bond yields are lower now than they have been at any other time in their history. I actually applaud the Spanish government for issuing 50-year bonds at 4%. I can almost guarantee you the day will come when Spain looks back at those 4% bonds with fondness. (I assume that the buyers are pension funds or insurance companies engaged in a desperate search for yield. I guess the extra 2% over a ten-year bond looks attractive … at least in the short term.)

And finally, let’s really widen our time horizon on German yields:

Time to Ramp up the Currency War

The yen hit a six-year low this week (over 105 to the dollar), creating even more of a problem for Germany and other European exporters to Asia. The chart below shows that Germany’s exports to the BRIICS except China are down significantly over the past few years, partially due to competition from Japan as the yen has dropped against the euro.

The yen-versus-euro problem (at least from Germany’s standpoint) is exacerbated by the remarkable appetite of Japanese investors for French bonds. This has been going on for over a year. In May and June of this year alone, Japanese investors bought $29.3 billion worth of French notes maturing at one year or more (presumably, this was before rates went negative). Note that even with minimal yields, the Japanese investors are up because of the currency play. (Interestingly, Japanese investors are dumping German bonds, again a yield play.)

Japanese analysts say that Japanese investors are hesitant to take the risks on the higher-yielding Italian and Spanish bonds, but for some reason they see almost no risk in French bonds. (Obviously not many Thoughts from the Frontline readers in Japan.) This behavior, of course, helps to drive down the price of the yen relative to the euro. (Source, Bloomberg)

Interesting side note: the third-largest country holding of US treasuries behind Japan and China is now Belgium. When you first read that, you have to do a double-take. Digging a little deeper, you find out there’s been a 41% surge in Belgian ownership of US bonds in just the first five months of this year. As it turns out, Euroclear Bank SA, a provider of security settlements for foreign lenders, is based in Belgium and is where countries can go to buy bonds they are not holding in their own treasuries. This buying surge is helping hold down US yields even as the Federal Reserve is reducing its QE program. Further, there is serious speculation, or rather speculation from serious sources, that Russian oligarchs are piling into US dollars by the tens of billions, again through Belgium.

Europe Takes the Baton

It is probably only a coincidence that just as the Fed ends QE, Europe will begin its own QE program. Note that the ECB has reduced its balance sheet by over $1 trillion in the past few years (to the chagrin of much of European leadership). There is now “room” for the ECB to work through various asset-buying programs to increase its balance sheet by at least another trillion over the next year or so, taking the place of the Federal Reserve. Draghi intends to do so.

Risk-takers should take note. European earnings per share are significantly lower than those of any other developed economy. Indeed, while much of the rest of the world has seen earnings rise since the market bottom in 2009, the euro area has been roughly flat.

Both the US and Japanese stock markets took off when their respective central banks began QE programs. Will the same happen in Europe? QE in Europe will have a little bit different flavor than the straight-out bond buying of Japan or the US, but they will still be pushing money into the system. With yields at all-time lows, European investors may start looking at their own stock markets. Just saying.

Draghi also knows there is really no way to escape his current conundrum without reigniting European growth. One of the textbook ways to achieve easy growth is through currency devaluation; and as we wrote in Code Red, the ECB will step up and do what it can to cheapen the euro in competition with Japan.

Just as the world is getting fewer dollars (in a world where global trade is done in dollars), Draghi is going to flood the world with euros.

Bank of Japan Governor Kuroda has steered the BOJ to where it now owns 20% of all outstanding Japanese government debt and is buying 70% of all newly issued Japanese bonds. The BOJ hoped that by driving down long-term rates it could encourage Japanese banks to invest and lend more, but bond-hungry regional Japanese banks are still snapping up long-term Japanese bonds, even at 50 basis points of yield. Given the current environment, the Bank of Japan cannot stop its QE program without creating a spike in yields that the government of Japan could not afford. Hence I think it’s unlikely that Japanese QE will end anytime soon, thus putting further pressure on the yen.

The BOJ is going to continue to buy massive quantities of bonds and erode the value of the yen over time in an effort to get 2% inflation.

In a world where populations in developed countries are growing older and are thus more interested in fixed-income securities, yields are going to be challenged for some time. Those planning retirement are going to generally need about twice what would have been suggested only 10 or 15 years ago in order to be able to achieve the same income. Welcome to the world of financial repression, brought to you by your friendly local central bank.

Introducing Tony Sagami

When we first launched Mauldin Economics some two years ago, my partners and I thought there was a need for a good fixed-income letter with a little different style and focus. My very first phone call was to my longtime friend Tony Sagami, to ask if he would write it. I have known Tony for almost 25 years. We have worked together, he has worked for me, and we have been competitors, but we’ve always been good friends.

Even though he now lives in Bangkok most of the year, we still visit regularly by email and Skype, and try to make a point of catching up in some part of the world at least twice a year. In addition to his talents as a writer, Tony brings a seasoned perspective and huge experience as a trader and investor. (Seasoned is a technical term for getting older, having made lots of instructive mistakes in your early years.) He has a way of taking my macro ideas and efficiently and effectively putting them to work. I know Yield Shark subscribers must be happy, because our renewal rates are very high by industry standards.

As I mentioned early in the letter, for contractual reasons we haven’t been able to name Tony as the editor of Yield Shark. I’m really pleased that we can do so now. Tony was recently in Dallas, and we did a short video together so that I could introduce him. You can watch the video and learn more about Tony here. You will soon be receiving information from my partners about a new newsletter that Tony will also be writing, which we are tentatively calling The Rational Bear.

San Antonio, Washington DC, Chicago, and Boston

My respite from travel will be over in a few weeks as I head to the Casey Research Summit in San Antonio, September 17-21. It actually takes place at a resort in the Hill Country north of San Antonio, which is a fun place to spend a weekend with friends. Then the end of the month will see me traveling to Washington DC for a few days.

I’ll be back in Dallas in time for my 65th birthday on October 4, and then I get to spend another two weeks at home before the travel schedule picks back up. I will make a quick trip to Chicago, then swing back to Athens, Texas, before I head on to Cambridge, Massachusetts, for conferences. There are a few other trips shaping up as well.

My time at home has been well spent, as I’m catching up on all sorts of projects, spending more time in the gym, and just enjoying being home. Surprisingly, being at home has allowed me to see more friends than usual as they’ve come through town. Dennis Gartman was in yesterday, and we spent two pleasant hours catching up over lunch. He is one of the truly consummate gentlemen in our business and a bottomless reservoir of great stories. A perfect evening would be Dennis Gartman and Art Cashin holding court at the Friends of Fermentation after the market closes. You’d just sit there and scribble notes.

The other thing about being home is that it makes me want to get on a plane and go see even more friends! Yesterday I caught up with George and Meredith Friedman on the phone, and we realized it has been well over a year since we’ve seen each other, which is unusual for us. I really enjoy them, and they are their own source of endless stories. George and Meredith travel much more than I do, and all over the world at that, doing speeches and research and the like; but we agreed that sometime in October we will make a visit happen, whoever is doing the flying. I think one of the reasons that God made planes was so that friends could see each other more often.

A special hat tip goes to my associate Worth Wray for finding and creating most of the charts for this week. Plus helping me think through the letter. He has been a huge help this last year.

You have a great week and take a friend who tells great stories to lunch. It will do wonders for your outlook on life.

Your still can’t believe negative French interest rates analyst,

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Tepper Calls an Audible

by Marketanthropology

We've made the case before (see Here) that for all the pomp and circumstance, Fed policy over the last three decades has done very little to deviate yields from what became a genuinely symmetrical and balanced return from the profound 1981 highs. Where they have had effect - we would argue, is around the fringe in introducing volatility to the slope of the decline, with numerous interventions and surprises as they navigated various market conditions. The chart referenced below with the 1941 to 1981 mirrored trajectory captures that story, especially when contrasted with the relative smoothness of the previous long-term cycle in the first half of the 20th century, when the Fed was still in its infancy and developing the first edition textbook of accommodation and reduction, they have continued to build upon with each passing cycle.  
On both sides of the spectrum, whether through bailouts, interventions or rate tightenings - the Fed has looked to shake the tree from time to time when the markets are deemed too complacent, accommodative or risk adverse. Coincidentally - or not, these occasions over the last thirty years have been when yields have fallen back proximate to the mirror of the cycle. Has it been beneficial? We'll save that nuanced argument for the historians, but do believe it demonstrates quite clearly the nature versus nurture aspect of the Treasury market. The Fed may find efficacy with the cattle prod at times, but the herd of the largest security market in the world will still closely follow the inherent migration pattern - one that many analysis, pundits and traders have attempted to call an audible from over the years.  

Coming into this year, we had looked for the taper-tantrum squeeze in 10-year yields to reverse from the relative extreme punctuated at the end of last year. The irony being, the collective wisdom in the market in late December and early January was wresting with how different markets would cope with a rising rate environment. Gold and gold miners were left for dead. Emerging markets were viewed as a fashion craze of the previous cycle, but unwearable in a rising rate environment.  China? "You must be crazy", we were told. Utility stocks? They'll strongly underperform.

Loss on most was the fact that 10-year yields had surged over 80% higher in only a few short months, eclipsing the entirety of influence on long-term yields of the previous rate tightening cycle (~70%) and roughly doubling the effects of the surprise tightenings by the Fed from 1994 through February of 1995. Not surprisingly, it was a great time to buy long-term Treasuries, gold and precious metals miners, emerging market and Chinese equities and utilities.

With 10-year yields rising the most since the first week in June, bond bears started sticking their heads outside their caves last week, looking to feed and remind us once more that investing in Treasuries is akin to swimming in gasoline in a lightening storm. Emboldened by comments from Appaloosa Management's David Tepper, declaring, "It's the beginning of the end of the bond market bubble", the bond bears gain a credible ally and spokesman just as the Fed looks to shut down their country kitchen this fall - as the ECB notifies us of their own grand opening that same month. Exquisite - or desperate, timing we wonder? While Tepper's reputation and fortune have very much been built on the former, more than a tinge of the later comes to mind - with respect to the severe structural limitations of the European condition and the modest proposal the program will begin with. With that said, it is the thought that counts and we can't deny that Draghi is at the very least forging a reputation of delivering the goods - whatever they may be.

Although we don't believe that the bond market is in a bubble per se, over the last two years we would agree that the Treasury market has been going through a transition of the beginning of the end of the move that began over 30 years ago. The main difference, is we don't expect yields to sustain a pivot higher, but remain in a long-term range roughly between 1.5 and 3.0 percent over the next several years, as the markets wrestle with normalization of monetary policy from the extraordinary measures enacted over the past five years. To that end, we defer to history and the over 70 year patterned memory of the cycle, that points to Yellen's patient refrain of lower - longer.

In the obvious sense, the timing of the ECB announcement appears tailored to mitigate the swift collapse in yields that occurred at the end of the two previous QE salvos, as investors apprehensions without the Fed's training wheels and soup kitchen took over. While conventional market wisdom infers that QE helps a central bank put a cap on yields, as we mentioned earlier - the evidence in the market is very much to the contrary. QE by all accounts has successfully stimulated participants away from the safe-haven shores of Treasuries and into riskier assets.  

When the Fed started tightening first in the summer of 2004, US 10-year yields diverged higher away from Europe. As shown below in the chart between US and German yields, it wasn't until the financial crisis took hold in the back half of 2008 did the two markets once again converge. Maintaining its leadership role in dictating broader monetary policy direction, US yields fell below Europe in the fall of 2008 - as the Fed cut swiftly towards the lower bound of the fed funds rate. Reaching the bottom in December of that year, the ECB would take its time over the next five, meeting the Fed just last November.

Propelled by the cattle prod of QE3 and the threat of the taper last spring, US 10-year yields have diverged considerably from Germany - Europe's strongest economy, as the ECB has continued to cut below where the fed funds rate currently resides. As our last bunch of QE biscuits warm, and with the ECB finally pulling a page from our own quantitative cookbook, it seems reasonable to suspect that the spread between US and Germany will begin to come in soon. The question - we suppose, is where the next convergence might take place: higher or lower than where US yields currently reside? Will US yields enjoy support extended from the new European initiative, or will nature exert its influence over the cycle and cause them to meet lower at a later date? Longer term, our money is still on the latter and from a relative performance point of view, we continue to favor long-term Treasuries relative to equities today. From our perspective, Tepper's audible will meet the same fate as the many quarterbacks who have made the call over the years. Sacked - behind the line of scrimmage.

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The China Boom Story: Alibaba and the 40 Thieves

by Charles Hugh Smith

I suspect the Alibaba IPO may well prove to be the high water mark of the China Boom Story in more ways than one.

We all know the story of Ali Baba and the 40 Thieves. Poor woodcutter Ali Baba discovers the 40 Thieves' secret cave where they stashed all their ill-gotten wealth. Various adventures follow, with the loyal slave girl being the heroine who repeatedly saves Ali Baba from death at the hands of the Thieves and their resourceful, cunning leader.

My favorite filmic depiction of the story is the 1934 film Chu Chin Chow starring Chinese-American actress Anna Mae Wong as the heroic slave girl. (Another Arabian Nights' inspired fantasy also stars Wong as a loyal slave girl: the 1924 silent film The Thief of Bagdad with Douglas Fairbanks and Anna Mae Wong. Clearly, Hollywood's favored role for Miss Wong was loyal "exotic" slave.)

On the current stage, the drama being played out is that of Chinese Internet company Alibaba, which is set to go public on the U.S. stock market next week in a staggering $21 billion IPO (initial public offering). Many market pundits expect the current rally in stocks to continue through next week, if for no other reason than to insure the investment banks dump all the Alibaba shares on a credulous public at full pop. Alibaba To Raise $21 Billion In Historic IPO.

The IPO share price of between $60 and $66 would peg Alibaba's value around $160 billion.

Behind the rah-rah, Alibaba's fair market value is problematic: What's an accounting puzzle like Alibaba (really) worth?
As the world’s largest e-commerce company prepares to go public, its murky financials don’t make it any easier for investors to figure out the company’s value.

In the bigger picture, the same can be said of the entire China Boom Story, which has supported the global expansion of trade, commodities and stocks for the past two decades: is it for real, or is it fundamentally an elaborate facade of carefully designed props, borrowed money and opaque accounting?

Let's start by stipulating that the great wealth created by China has been generated by the hard work of its enormous workforce, many millions of whom have toiled back-breaking hours in mind-numbing factory jobs to better the prospects of their children, many of whom were left behind in the rural villages the parents left as migrant workers.

This story has been told in two documentaries: China Blue and Last Train Home.

The largely untold story of the China Boom is the vast thievery that has siphoned off much of the wealth into the hands of a crony-Communist Party-state few:

-- peasants' land stolen by local governments and their crony developers

-- wages stolen from workers by unscrupulous factory owners and their thoroughly corrupt government cronies

-- value stolen from consumers via the substitution of shoddy or even poisoned ingredients for the product being advertised (top Party officials get all their food from secret organic farms)

-- product design and intellectual property stolen by copycat manufacturers who pirate everything under the sun without paying a yuan of royalties

-- corrupt officials stealing from everyone via bribes, illicit partnerships, shares in land development deals, etc. etc. etc.

-- last but not least, the European, American, Japanese and Korean corporations that are complicit in all these layers of officially sanctioned theft to lower the wholesale cost of their $40 jeans (retail) to $4 from $5 to maximize their gargantuan profits at the expense of the officially exploited. (Interesting how that reduction didn't result in any corresponding reduction in the retail price.)

Few dare ask if the Alibaba IPO isn't just the latest in an unending string of officially sanctioned thievery of the credulous or powerless. Is Alibaba worth $160 billion as advertised? Based on what earnings? By what accounting standards? How much of these net earnings will actually flow to shareholders?

Or is the Alibaba IPO just another snatch-and-grab by U.S. investment banks anxious to skim their share of the China Boom Story before the whole flimsy backstage set implodes in the collapse of shadow banking and shoddy real estate development?

I suspect the Alibaba IPO may well prove to be the high water mark of the China Boom Story in more ways than one: the apex of Wall Street's greedy complicity in selling the fantasy, the apex of "China's real estate bubble is not a bubble, and no, it will never pop," and the apex of the wealth divide between the handful of thieves who are busy transferring their wealth out of China and the reach of those they ripped off, and the exploited mired in a polluted factory to the world that cannot possibly prosper without a permanently expanding real estate bubble and an equally permanent global expansion.

The Chinese thieves are busy stashing their ill-gotten wealth in the West. Perhaps it's just a matter of time before the modern-day equivalent of loyal slaves arise to take back what was stolen from them.

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Markets expect negative overnight rates in the Eurozone through mid 2016 as reserves become a "hot potato"

by Sober Look

Last week's unexpected decision by the ECB to set the rate on bank excess reserves to -0.2% is sending liquidity holders scrambling. The idea behind negative rates is to penalize cash position holders. The amount of reserves in the Eurosystem is constant at any one time, so the penalty-carrying reserves just bounce around from bank to bank like a "hot potato". The ones stuck with liquidity overnight will pay the 20bp penalty. The ECB hopes this will force the banking sector into more lending, with some lenders preferring extra credit risk over the pain of holding reserves.
Of course a great deal of this is wishful thinking, as undercapitalization and deleveraging (combined with tepid demand) will continue to plague credit creation. Quite soon the Eurozone banks will be forced to raise massive amounts of equity capital in order to improve leverage ratios (see story) and additional lending would require even more capital raising. The timing is not great.
So what are banks doing with their cash? The easiest option is to buy sovereign debt, particularly short term notes. Government paper has minimal to no impact on regulatory capital needs and does not cost banks the 20bp charged by the ECB. That's why banks (and others) are willing to (in effect) pay the German government to hold some of their excess liquidity. Below is the chart of German 6-month bill yield.

Banks are also trying to lend to each other as liquidity sloshes through the system. Taking bank credit risk does raise capital requirements, but if limited to the higher rated banks, the marginal capital needs for those loans are relatively small. Of course the better rated banks are taking advantage of this situation by funding themselves in the interbank market at zero to negative rates. The chart below is the EONIA (overnight) interbank rate (equivalent to the Fed Funds rate in the US).

Source: ECB

Moreover, the forward markets are now pricing EONIA rates to stay firmly planted in the negative territory through at least the mid-2016. The chart below shows the forward curve before and after the ECB action.

Source: Natixis

As the ECB expands its balance sheet via the TLTRO program, excess reserves in the banking system will grow. This liquidity will become increasingly expensive due to sheer size of cash balances that are costing banks 20bp. That's why the market expects even lower EONIA rates going forward, as banks pay more to avoid getting stuck with large overnight reserve balances.
Just as Japan is getting caught in what is becoming a perpetual quantitative easing program (see discussion), the Eurozone is looking at negative rates for some time to come. The unprecedented monetary experiments by global central banks will be with us far longer than originally expected.

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"We" Don't Want The Ukraine Ceasefire To Hold

by Raul Ilargi Meijer

It’s exceedingly safe to assume that the main reason the Kiev government agreed to a ceasefire on Friday was that the Ukraine army was losing on just about all fronts. Which they blame on Russian troops and weaponry being involved in increasing numbers, but there’s still to this day no proof for that.

The ‘rebels’ suspect that Kiev will use the ceasefire only to regroup, send in more men and guns, and fortify its positions. Moreover, the same ‘rebels’, who in the western press are increasingly awarded the “pro-Russian” label, even though they have no intention of joining Russia, have accused Kiev of having already violated the ceasefire within hours of it being announced.

Does anyone truly believe the US/EU/NATO coalition, which has spent billions on their Ukraine regime change project, are going to leave it at this? That they’re willing to admit defeat and will now retreat to their original positions, minus East Ukraine? If so, please have a look at the Brooklyn Bridge I have up for sale on Ebay. It has an absolutely lovely weathered look, literally tons of patina, and a history to die for.

I still haven’t seen one single western journalist take an in-depth look at the role of Victoria Nuland, Geoffrey Pyatt and their EU accomplices. Nobody seems interested in what these people have done over the past years that led up to Yanukovych’ ouster in February, and the subsequent civil war Kiev unleashed upon its own people. Not one single western journalist. And it’s not as if there’s no story there.

Meanwhile, the demonization of Vladimir Putin by those same journalists continues unabated. I saw something pass by just now about a Ukrainian priest claiming Putin is obsessed by Satan, no less. That’s the sort of thing that is duly reported in the west. Not Victoria Nuland.

And western politicians too play the same grossly over the top game like they were born for it. US officials have announced they will ‘degrade’ Islamist State (Obama) and chase them into Hell where they belong (Joe Biden). That’s the kind of language that ‘earns’ them applause.

As if there’s nothing wrong with using the images of an American being decapitated for hollow political gain. As if honor has nothing to do with it. In the exact same way that using 298 deaths on flight MH17 didn’t keep anyone from assigning blame, in graphical terms and without any evidence. I guess this is welcome to the age of communication. The more there is, the more is hidden. Perhaps there comes a point where communication equates to propaganda, where information can’t help turning into spin.

But so, yes, I don’t see the west giving up on Ukraine anytime soon. But I don’t see either the Donbass people, or those who support them, doing so either. And the more bases and attack and defense systems, and rapid deployment troops, NATO positions ever close to Russia’s borders, the more Moscow will feel obliged to counter-act.

It’s a stupid way to deal with things when you have two heavily militarized forces opposite each other. But it’s what we see develop as we’re watching. And it looks as if the media war in the west has been won by the west, to the extent that nothing that can be said from here on in will ever be able to wipe the completely invented anti-Putin allegations from our cumulative unconsciousness.

Even if Tuesday’s preliminary MH17 report by the Dutch Safety Board, for which reportedly so many detectives were engaged that no other crimes were solved at all the past two months or so, points not to Putin or Donbass rebels as the guilty party or parties, the allegations against them will still be left in everyone’s unconscience.

Not that I think there’s much chance of that; My guess is the preliminary report will leave so many questions open that there’ll be plenty room to keep the suspicions against Russia and the Donbass alive. The full report won’t be concluded until next summer, so the artificially induced bad taste can simmer and fester for another year.

But I’m still curious to see the report. As I am to see the Russian Union of Engineers’ report which we will present here at the Automatic Earth shortly.

To get back to why I started writing this, I don’t see a truce or ceasefire holding for long. The ‘rebels’ have a lot of reasons to keep fighting: first off, there were winning, and second, they were on their way to establish a land bridge to the Crimea, which would lift their isolation.

And as I said, I don’t see the west give up on their expansionist project. They can now make all of their people believe it was Putin who violated the 1997 NATO-Russia Founding Act (not that anyone has any idea what that is), that NATO is right to expand eastward, even if it’s obvious that Russia can only respond by countering that expansion with force.

The west will find a reason to blame the other side, rebels or imagined Russians, for violating the ceasefire, and use it to increase its military power. Americans and Europeans alike have so far taken all the ‘news’ they were served hook line and sinker, and why should that change? In other words, US/EU/NATO are free to do whatever they want, as long as they can spin a somewhat credible anti-Putin line in their media. And just about any line is credible by now.

But the ceasefire will truly stop when conditions are laid upon the table. Kiev will never ever again rule over the Donbass, the sole region to make Ukraine an economically viable entity. The gory and bloody attempts over the past 6 months to subdue the east Ukraine population have failed, and there won’t be a second chance.

What’s left of the Donbass after the shelling by its own official government will not agree to be governed by that same government. Ukraine as we draw it on the map today has ceased to exist. But that doesn’t mean the west won’t be willing to give it another try.

No matter how awry this goes, the likes of Obama and Barroso and Juncker still think they’ll win because they have bigger dicks a.k.a. guns. And the guys behind the curtains are laughing out loud. They have the ‘bigger’ view.

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JPMorgan Stunner: "The Current Episode Of Excess Liquidity Is The Most Extreme Ever"

by Tyler Durden

Curious why everything is being bought in the aftermath of last week's ECB's unprecedented announcement, and both bonds and stocks are either at or just shy of record highs ignoring completely the worst US nonfarm payroll print of 2014? JPM's Nikolaos Panigirtzoglou explains why.

From "The ECB's liquidity boost", here first is the background on where in the global central bank central-planning experiment we stand right now:

The ECB President stated in this week’s press conference that the ECB’s forthcoming programs, i.e. TLTROs coupled with ABS and covered bond purchases, could take the ECB’s balance sheet back to early 2012 levels, i.e. to €3tr from €2tr currently. These remarks, not only suggest that the ECB might have a target in mind regarding the size of its balance sheet, but raise questions about the boost to global liquidity from prospective ECB actions.

In aggregate, G4 central balance sheets started rising rapidly from the end of 2010 driven by the Fed’s QE2 followed by the BoE’s QE, ECB’s LTROs, Fed’s QE3 and BoJ’s QE. As a result of these central bank actions, G4 central bank balance sheets expanded by almost $4tr over 4 years i.e. by $1tr per year since the end of 2010 (Figure 1). With the ECB aiming at a €1tr expansion of its balance sheet, this $1tr per year pace in G4 central bank balance sheet expansion is likely to increase rather than decrease from here, despite the Fed’s tapering. The BoJ is already expanding its balance by close to $650bn per year, so adding a similar pace of increase for the ECB’s balance sheet (€500bn or $650bn per year) should result in an annual pace of G4 central bank balance sheet expansion of $1.3tr, even as the Fed ceases bonds purchases.

This ECB-driven quantitative expansion is hitting the global financial system at a time when liquidity is already very high. And this is true for both “narrow” or “banking sector liquidity” and “broad” or “non-bank sector” liquidity.

The G4 banking system is already flooded with excess reserves of around $4.5tr i.e. reserves commercial banks have with central banks in excess of what they need to meet usual liquidity needs. Given that the banking system cannot get rid of reserves in aggregate, these zero yielding reserves become the “hot potato” that banks try to pass to other each until the relative pricing is adjusted enough to remove the incentive for banks to get rid of these reserves. With the ECB aiming at increasing the amount of excess reserves even further via its TLTRO/bond purchase programs, G4 narrow or banking sector liquidity should exceed $5tr, exerting even more downward pressure on 2-5 year government bond yields of core countries, the preferred habitat of banks.

This is where global liquidity currently stands:

To assess excess money supply, we update the model we previously published in Flows & Liquidity, Apr 26th 2013. Beyond nominal GDP and financial wealth, i.e. the stock of tradable bonds and equities in the world, the model includes an uncertainty variable. Uncertainty is important as it makes agents hold more cash during periods of elevated risk perception, for precautionary reasons. We proxy uncertainty via the US monthly index constructed by Baker, Bloom and Davis. To measure policy-related economic uncertainty, they construct an index from three types of underlying components. One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty. This uncertainty proxy is shown in Figure 2 along with its smoothed version. This uncertainty proxy declined sharply over the past two years and has completely unwound the post Lehman increase.

To estimate the gap between money supply and a medium-term demand target, we regress real money balances, global M2 deflated by global CPI, against 1) real GDP (i.e. the level of nominal GDP deflated by global CPI), 2) real financial wealth (i.e. the total capitalization of global bonds and equities deflated by global CPI), and 3) the uncertainty proxy described above. To remove the impact of FX changes from our global money stock measure, we aggregate the M2 stocks of various countries at constant (today’s) exchange rates. The regression results are shown in Figure 3. All three variables are statistically significant with a positive sign as predicted by theory.

Excess (i.e. the residual in our model) money supply is currently in record high positive territory. The current residual suggests that global money supply which stood at $68tr at the end of August is $5tr above our estimated medium-tem money demand target. The residual of the regression turned positive in May 2012 and has risen steadily since then. This is both because of real money supply increasing and money demand decreasing due to lower uncertainty (Figure 2: Global M2 reached $68tr in August this year and is up by $15tr or 29% since the end of 2010 when G4 central bank balance sheets started rising rapidly. The capitalization of both bonds and equities in the world had risen by a similar 31% over the same period and the current pace of M2 growth suggests that global equities and bonds should continue to grow by at least 6% per annum.

Of this $15tr increase in global M2 since end 2010, $5tr was due to G4 and the rest $10tr was due to the rest of the world, mostly EM. Strong credit growth in EM economies has boosted our measure of excess liquidity in recent years and this force led by China continues unabated. It is often mentioned that this Chinese or EM liquidity is trapped within EM. We disagree. It is true that domestic economic agents in China and other EM economies face restrictions in deploying their capital abroad. But domestic liquidity in China and EM is channeled to the rest of the world via reserve accumulation, i.e. via the official sector, as capital restrictions put upward pressure on EM currencies.

The punchline:

Prospective ECB actions are likely to widen the above $5tr estimated gap between global money supply and demand. That is, the ECB's quantitative expansion is hitting the financial system at a time when broad liquidity is also very high. The rise in excess liquidity, i.e. the residual in the model of Figure 3, is supportive of all assets outside cash, i.e. bonds, equities and real estate. The current episode of excess liquidity, which began in May 2012, appears to have been the most extreme ever in terms of its magnitude and the ECB actions have the potential to make it even more extreme, in our view. Before then, there were three major episodes of excess liquidity (i.e. positive residual) in our model: 1993-1995, 2001-2006 and Oct 2008-Sep 2010. These were periods of strong asset price inflation suggesting that excess liquidity could have been a factor supporting markets at the time.

You don't say.

It is also important to note that liquidity is not constrained by borders. For example, foreign institutions could also sell ABS or covered bonds to the ECB, so the prospective injection of liquidity by the ECB could reach foreign as well as domestic institutions. Anecdotally, both the Fed and the BoE have bought significant amount of bonds from foreign institutions during their QE operations. In addition, in a global and interlinked financial system, via arbitrage, the ECB operations can end up suppressing yields of higher yielding bond universes outside the euro area by more than domestic bonds.

Finally, add JPM to the long list of entities, from billionaires Icahn, Zell, Soros, Druckenmiller, to the BIS, to and increasing number of Fed presidents themselves, warning that the fun days of bubble inflation are almost over.

These liquidity boosts are not without risks. We note that they risk creating asset bubbles which when they burst can destroy wealth leading to adverse economic outcomes. Asset yields are mean reverting over long periods of time and thus historically low levels of yields in bonds, equities and real estate are unlikely to be sustained forever.

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China’s Copper Imports Slow Due to Probe

By Chuin-Wei Yap

China’s commodity imports in August mostly softened, led by a 12% decline in the volume of copper shipments from a year earlier due to the fallout from a government probe into metal financing at Chinese ports.

Copper imports fell to 340,000 metric tons, according to customs data Monday.

Chinese authorities earlier this year launched investigations into alleged fraud involving aluminum and copper stocks used as collateral for loans in China. Commodity-backed financing has fueled imports of copper in recent years, but this appears to be ebbing due to the investigations.

“Banks became much more cautious” after the probe, said OCBC economist Xie Dongming. “They don’t want to give financing with that sort of collateral anymore.”

There were other factors at play. Local copper processing mills that had shut down for maintenance or due to breakdowns restarted operations in August, adding to local supply and reducing the demand for imports. These included Jinchuan Group’s 400,000-ton Gansu province smelter and Dongying Fangyuan Co.’s in Shandong province.

Still, copper import volumes were largely unchanged in August from the previous month. Demand will likely be underpinned in the second half of 2014 by China’s spending on its power grid, a top demand source for copper, according to Barclays Research.

In the longer run, tight supply globally could lend support for copper prices despite China’s anemic demand, analysts said. Barclays pointed to supply disruptions in Indonesia, which has put bans on the export of unprocessed copper.

By comparison, iron ore imports rose 9% on year in August. The relatively high levels of purchases were likely due to the lowest iron ore prices in five years. Ore prices last Friday reached $83.6 a ton, down 38% from the start of this year – a level not seen since August 2009, according to data provider The Steel Index.

Low global iron ore prices put the squeeze on China’s fragmented and small marginal producers, which is likely to sustain China’s demand for foreign ore, Gavekal Dragonomics said. Customs data Monday showed iron ore imports between January and August were up 17% on year.

Soybean imports last month fell from a record-high volume set in July, a widely expected adjustment amid relatively low global soy prices. Shipments totaled a relatively high 6.03 million tons.

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Will The 300 Year Old Uk Survive?

By: Andrew_McKillop

No Longer Certain “No” Will Win
Unsurprisingly to me, the Yes voters in Scotland are getting more affirmative and less secretive about their preference for an independent Scotland. Because its a classic “first past the post” voting system and process, a minority will decide what happens – but few complain about that time-worn electoral process in Britain, except for example the Lib Dems who want proportional voting because it would give them more seats in the Westminster parliament. 

In any case, there is no such thing as a “Maybe” or “Don't know” or “No preference” voting choice available for the Scottish referendum.

Yougov opinion polls now report a tiny majority in favour of a Yes vote. In the remaining days before the referendum wildcards will be more important than ever in deciding the result, but the simple fact that the Yes movement has recovered from a 20% lead of the No movement in previous months shows that we have a “tidal shift” under way. The momentum is there.

The emotional appeal for continued Union among the No vote camp is predictably getting strident. We are told by people who haven't lived for centuries that “The UK we have known for 300 years will be gone”. They certainly didn't know it for 300 years!

Dodgy claims by the No camp are that full independence for Scotland will be even more of an economic disaster for it, than for England, are now everywhere. The most interesting point is the No camp now allows itself to say England will also be worse off. Its previous line of patter was that only Scotland would suffer from its foolish vote for Independence.

Suddenly we hear that Arab potentates and Russian oligarchs will no longer be “parking their funds” in either England or Scotland if they separate. The GB pound will plummet but with a much cheaper English pound the potentates and oligarchs should be happy to buy their London penthouses at 30% off the previous sticker price! What is the problem? Oh yes, the economy, debt and money.

Debt and Money
What happens to the pound also affects and concerns “the debt”, and that concerns both English and Scottish private banks. The extreme liabilities of the “Scottish” banks HBOS and RBS in fact concern two international private banks with a very large number of English shareholders, as well as Scottish, and very large liabilities in its English operations. The excesses of these two “Scottish” banks (like the excesses of “English” banks) in the run-up to the 2008 crisis, and subsequently, are well documented – but are these automatically sovereign national liabilities?

At present they are treated that way, and the SNP's Alex Salmond has sought to reassure all parties that an independent Scotland would keep bailing out the banks in the same way as the previous UK and in particular by the BOE-Bank of England..The BOE's ownership and a possible “share for Scotland” of the BOE following independence is a highly charged question!

However, the BOE has limits to the money printing feats it can get away with, whatever its ownership. Depending on how England reacts, politically, to a majority Yes vote this ultra-critical question may be very rapidly answered. The answer may also be ultra-radical. If England forces the hand of the Scottish there may be “unexpected events” in this domain.

SNP spokespersons have many times “caressed the option”, or merely hinted at an independent BOS-Bank of Scotland going it alone, but none of them ever mentioned Argentina!

Emotional spin in the patter from the No movement claims that the SNP's Salmond has already but implicitly-only said an independent Scotland “would dishonor its 120 billion GBP share of the UK national debt”. This is supposedly about 8.5% of the total for UK national debt but is unrelated to and vastly smaller than the total of all private bank (and finance sector) debt in both countries.

These amounts of “theoretical debt” are so massive it is not worth bandying figures around – perhaps it is 2 or 3 trillion pounds - and it is mendacious to pretend that the numbers bandied around, of “Salmond reneging on 120 billion” are anything like the real world of private bank (and finance sector) liabilities hanging on the knife edge of “constantly rising” stock exchange values. Neither Scotland nor England could pay these debts in a “worst case scenario” financial market crash as in 2008-2009.

The Wee Haggis and the Oil Derrick
We should not forget the whisky still, either, to print on the new banknotes of the new BOS central bank which has to go it alone due to English petulance and jealousy. Plenty of No vote hard liners are saying that independent Scotland will have absolutely no right to use the pound sterling – named for a city in Scotland! It will have to go it alone. It will be a disaster for Scotland, somewhat like Argentina but it was all the fault of the Silly Scots.

The subject of British-sector North Sea oil of which Scotland controls about 90% of the declining British production is another intensely-worked theme of the Yes and No camps. The No camp has however been less than forthright in simply admitting that for FX-foreign exchange speculators and traders, having oil behind your money is good, and not having it is bad – for England. The traders aren't very bright on the details and in some ways couldn't care less if your oil production is declining and is high-cost. They need to speculate every day and they know you have oil! Whisky revenues and taxation have been somewhat neglected, but are considerable.

By a rather predictable but extreme piece of hypocrisy, outgoing EC chief Manuel Barrosao, whose Commission has endlessly pleaded with oil-rich Norway to join the Union, has curtly said Scotland would not be welcome in the Eurozone or be able to use the euro. This in fact is nonsense. An independent Scotland could use either or both the euro and US dollar. “Dollarized” economies are in no way a rare or threatened species, and plenty of them have no formal relations with the US Treasury Dept to operate and use the dollar in their economies. Plenty of east European EU states which are not members of the Eurozone such as Hungary, Bulgaria, Romania have “euro-ized” their economies without incurring the wrath of the ECB in Frankfurt..

It is sure and certain the SNP wants “Sterlingization” or the continuation of using the GB pound, but if push comes to shove, they have other options. On several grounds, Dollarization may be the better of the “quick and dirty” options but an all-new, all-Scottish money cannot be ignored as a major and serious option enabling Scotland to negotiate with England from a position of strength over bank debt and national debt..These in fact are the key issues – the degree of “sovereignty” attaching to the liabilities of what are international private banks which, when they regularly get into the messes they create themselves, suddenly proclaim their “national identity”.

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