The FOMC and the Markets – Something Has Changed

by Pater Tenebrarum

Still “Patient”, but too Upbeat for the Stock Market

As a look at the WSJ’s FOMC statement tracker reveals, the Fed currently sounds quite upbeat about the US economy. Given that organs of the State are usually the last to recognize a trend (in this case the trend of a subdued, but better than elsewhere US economic performance), this should be taken as a warning sign that the trend may be close to reversing.

There was only one word for liquidity junkies in the statement: the term “patient”, in the context of the widely anticipated, but continually postponed, rate hike. While the Fed ponders rate hikes, US macro data have begun to weaken rather noticeably of late. Not to an extent yet that would be worrisome, but they offer a strange contrast to the upbeat FOMC statement. Also, the Fed keeps stressing that it sees the recent collapse in inflation expectations as “transitory” (it may well turn out to be), again removing a reason for waiting much longer with a rate hike. Meanwhile, central banks from Canada to Singapore are cutting their administered interest rates, or are adopting a dovish stance (New Zealand, Australia), or are engaging in outright money printing (ECB, BoJ). Bond yields keep plummeting all over the show, including those on treasuries, which benefit from still offering a sizable spread pick-up in today’s world of ZIRP, NIRP and negative yields on government bonds.

As a result of having communicated the impending interest rate hike so persistently, the Fed is practically forced to follow through, as it would otherwise endanger its vaunted “credibility”. This is not what stock market participants want to hear in light of the less benign macro-environment and the not overly convincing revelations of the current earnings season.

Who could have known? The strong dollar actually eats into the profits of US multinationals. Interestingly, even some unemployment related data may well be at a turning point, in spite of unemployment being known as a lagging indicator of the economy. The main reason why it is worth pointing this out is that the US stock market exhibits a well-established negative correlation with initial claims data.

Here is a recent chart of initial and continuing claims; both appear set to head higher, which would actually not be too surprising considering that the bulk of US jobs growth since the 2008/9 crisis was produced by the shale oil producing states. It is a good bet that their jobs situation will once again be determined by the oil price, and the oil price keeps hitting new lows.

Unemployment claims data – bottoming out?  – click to enlarge.

As a little aside to the oil market: as of last week’s CoT report, speculators were still net long nearly 287,000 WTI crude oil contracts. Although surveys show that bearish sentiment on crude oil has become quite pronounced, the speculative positioning in this market belies that view. It looks to us like some of the sellers – the net long position has declined from an all time high of approx. 490,000 contracts to today’s level – have been replaced by bottom fishers. It should be noted that although a lot of longs have given up relative to the all time high in net long positioning, the current level is what used to be a record high a mere three years ago. So historically, the current positioning is still revealing a foaming-at-the-mouth bullish attitude, which is more than passing strange. As a result, it should perhaps not be too surprising that the oil market has yet to find even a short term low (admittedly, its inability to put together a bounce lasting longer than a day or two does surprise us a bit).

A Rare Event

Yesterday the stock market began to slide as soon as the FOMC statement hit the wires. This is worth noting, because it hasn’t happened in an eternity that the market falls both the day before and on the day of the statement’s release. We don’t even remember when something like this happened the last time. In terms of the echo bubble it is definitely a first.

Mirabile dictu…the market falls around the FOMC meeting – click to enlarge.

Stock market bulls have reason to be concerned. For instance, margin debt is still close to a record high, but its actual peak occurred several months ago, usually a warning sign, especially when it happens after a very large increase in said debt. Also, as the updated Rydex data below show, traders continue to be “all in” and bears have practically given up completely, with Rydex bear assets all but disappearing. In other words, almost no-one is looking down – and yet, the market appears vulnerable both from a technical and fundamental perspective (however, we must add to this that the evidence is not clear cut – many sector charts continue to look good, and the fundamental picture is at most displaying a few small cracks so far).

Rydex money market fund assets, bear assets and the bull/bear ratio. These data represent a microcosm of market sentiment, and it presumably just doesn’t get any more lopsided than this. We only had to adapt our annotations slightly – for instance, bear assets are currently plumbing new all time lows, but some traders have hopped on the fence, as evidenced by a small rise in money market fund assets.

Conclusion:

Market participants were able to look beyond the end of QE 3-4 as other central banks started to go on a printing spree, creating carry trade flows into dollar-denominated assets (e.g. foreign inflows into US stocks have gone bananas, which is by the way also a warning sign). However, now that the Fed is announcing that it is optimistic on the economy, market participants may be having second thoughts – after all, the ZIRP policy was a major driver of debt-funded stock buybacks and a vast bout of re-leveraging in numerous financial markets. At the same time, it should be clear that loose monetary policy has distorted prices, which in turn has undoubtedly caused a lot of capital misallocation in the economy (some of the more adventurous shale oil investments are testament to that). If loose monetary policy is indeed about to be reversed, a great many things could in fact go into reverse as well, possibly faster than generally expected.

The stock market has largely been driven by an expansion of multiples in recent years – overall, actual earnings growth wasn’t all that great, even with stock buybacks flattering per share earnings. The median stock in the US market has never been as highly valued as it is today. It is difficult to rationalize buying at such extreme valuations, and if monetary pumping no longer lends support to the market, it may not be a good time to throw caution to the wind. It’s not as if there were no warning signs in evidence after all – essentially almost all of last year was a big warning sign, with trend uniformity crumbling and high yield debt diverging from stocks. We believe 2015 is likely going to be a quite volatile year.

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Alexis Tsipras’ Open Letter

By Alexis Tsipras

Most of you, dear Handesblatt readers, will have formed a preconception of what this article is about before you actually read it. I am imploring you not to succumb to such preconceptions. Prejudice was never a good guide, especially during periods when an economic crisis reinforces stereotypes and breeds biggotry, nationalism, even violence.

In 2010, the Greek state ceased to be able to service its debt. Unfortunately, European officials decided to pretend that this problem could be overcome by means of the largest loan in history on condition of fiscal austerity that would, with mathematical precision, shrink the national income from which both new and old loans must be paid. An insolvency problem was thus dealt with as if it were a case of illiquidity.

In other words, Europe adopted the tactics of the least reputable bankers who refuse to acknowledge bad loans, preferring to grant new ones to the insolvent entity so as to pretend that the original loan is performing while extending the bankruptcy into the future. Nothing more than common sense was required to see that the application of the ‘extend and pretend’ tactic would lead my country to a tragic state. That instead of Greece’s stabilization, Europe was creating the circumstances for a self-reinforcing crisis that undermines the foundations of Europe itself.

My party, and I personally, disagreed fiercely with the May 2010 loan agreement not because you, the citizens of Germany, did not give us enough money but because you gave us much, much more than you should have and our government accepted far, far more than it had a right to. Money that would, in any case, neither help the people of Greece (as it was being thrown into the black hole of an unsustainable debt) nor prevent the ballooning of Greek government debt, at great expense to the Greek and German taxpayer.

Indeed, even before a full year had gone by, from 2011 onwards, our predictions were confirmed. The combination of gigantic new loans and stringent government spending cuts that depressed incomes not only failed to rein the debt in but, also, punished the weakest of citizens turning people who had hitherto been living a measured, modest life into paupers and beggars, denying them above all else their dignity. The collapse of incomes pushed thousands of firms into bankruptcy boosting the oligopolistic power of surviving large firms. Thus, prices have been falling but more slowly than wages and salaries, pushing down overall demand for goods and services and crushing nominal incomes while debts continue their inexorable rise. In this setting, the deficit of hope accelerated uncontrollably and, before we knew it, the ‘serpent’s egg’ hatched – the result being neo-Nazis patrolling our neighbourhoods, spreading their message of hatred.

Despite the evident failure of the ‘extend and pretend’ logic, it is still being implemented to this day. The second Greek ‘bailout’, enacted in the Spring of 2012, added another huge loan on the weakened shoulders of the Greek taxpayers, “haircut” our social security funds, and financed a ruthless new cleptocracy.

Respected commentators have been referring of recent to Greece’s stabilization, even of signs of growth. Alas, ‘Greek-covery’ is but a mirage which we must put to rest as soon as possible. The recent modest rise of real GDP, to the tune of 0.7%, signals not the end of recession (as has been proclaimed) but, rather, its continuation. Think about it: The same official sources report, for the same quarter, an inflation rate of -1.80%, i.e. deflation. Which means that the 0.7% rise in real GDP was due to a negative growth rate of nominal GDP! In other words, all that happened is that prices declined faster than nominal national income. Not exactly a cause for proclaiming the end of six years of recession!

Allow me to submit to you that this sorry attempt to recruit a new version of ‘Greek statistics’, in order to declare the ongoing Greek crisis over, is an insult to all Europeans who, at long last, deserve the truth about Greece and about Europe. So, let me be frank: Greece’s debt is currently unsustainable and will never be serviced, especially while Greece is being subjected to continuous fiscal waterboarding. The insistence in these dead-end policies, and in the denial of simple arithmetic, costs the German taxpayer dearly while, at once, condemning to a proud European nation to permanent indignity. What is even worse: In this manner, before long the Germans turn against the Greeks, the Greeks against the Germans and, unsurprisingly, the European Ideal suffers catastrophic losses.

Germany, and in particular the hard-working German workers, have nothing to fear from a SYRIZA victory. The opposite holds. Our task is not to confront our partners. It is not to secure larger loans or, equivalently, the right to higher deficits. Our target is, rather, the country’s stabilization, balanced budgets and, of course, the end of the grand squeeze of the weaker Greek taxpayers in the context of a loan agreement that is simply unenforceable. We are committed to end ‘extend and pretend’ logic not against German citizens but with a view to the mutual advantages for all Europeans.

Dear readers, I understand that, behind your ‘demand’ that our government fulfills all of its ‘contractual obligations’ hides the fear that, if you let us Greeks some breathing space, we shall return to our bad, old ways. I acknowledge this anxiety. However, let me say that it was not SYRIZA that incubated the cleptocracy which today pretends to strive for ‘reforms’, as long as these ‘reforms’ do not affect their ill-gotten privileges. We are ready and willing to introduce major reforms for which we are now seeking a mandate to implement from the Greek electorate, naturally in collaboration with our European partners.

Our task is to bring about a European New Deal within which our people can breathe, create and live in dignity.

A great opportunity for Europe is about to be born in Greece on 25th January. An opportunity Europe can ill afford to miss.

An Entire Generation of Fund Managers is Unprepared For the Next Crisis

by Phoenix Capital Research

Last week we touched upon the “white elephant” in the room: that the biggest, most important bubble investors should worry about is in bonds, NOT stocks.

Consider the following…

The financial system is based on debt. US Treasuries, the benchmark for an allegedly “risk free” rate of return, is the asset against which all other assets are priced based on their relative riskiness.

This “risk free” rate has been falling steadily for over 25 years.

The Wall Street Journal estimates that a third of traders have never witness a rate hike. However, the real problem is far greater than this.

Bonds have been in a bull market for over 30 years. Forget rate hikes… an entire generation of investors and money managers (anyone under the age of 55) has been investing in an era in which risk has generally gotten cheaper and cheaper.

This, in turn, has driven the rise in leverage in the financial system. As the risk-free rate fell, so did all other rates of return. Thus investors turned to leverage or using borrowed money to try to gain greater rates of return on their capital.

The ultimate example of this is the derivatives market, which is now over $700 trillion in size. This entire mess is backstopped by about $100 trillion (at most) in bonds posted as collateral.

This formula of ever increasing leverage works relatively well when the underlying asset backstopping a trade is rising in value (think of the housing bubble, which worked fine as long as housing prices rose). However, if the asset ever loses value, you very quickly run into trouble because you need to post more as collateral to backstop your trade. If you can’t do this easily, the margin calls start coming and you can find yourself having to unwind a massive position in a hurry.

This is how crashes occur. This is what caused 2008. And it’s what will cause the next crisis as well.

Despite all of the rhetoric, the world has not deleveraged in any meaningful way. The only industrialized country to deleverage since 2008 is Germany.

This is not unique to sovereign nations either. As McKinsey recently noted, there has been no meaningful deleveraging in any sector of the global economy (the best we’ve got is households and financial firms which have basically flat-lined since 2008).

In the simplest of terms, the 2008 collapse occurred because of too much leverage fueled by cheap debt. This worked fine until the assets backstopping the leveraged trades fell in value, which brought about margin calls and a selling panic.

The big problem however is that NO ONE got the message that leverage was a problem. Instead, everyone has become even MORE leveraged than they were in 2008. And they did this against an ever-smaller pool of quality assets (the Fed and other Central Banks’ QE programs have actually removed high grade collateral from the financial markets).

Thus, we now have a financial system that is even more leveraged than in 2007… backstopped by even less high quality collateral. And this time around, most industrialized sovereign nations themselves are bankrupt, meaning that when the bond bubble pops, the selling panic and liquidations will be even more extreme.

The next round of the crisis is coming, and it’s going to make 2008 look like a picnic.

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Signs That The Economy Is Weakening

by Lance Roberts

"Sign, sign, everywhere a sign
Blockin' out the scenery, breakin' my mind
Do this, don't do that, can't you read the sign?" - Five Man Electrical Band

For months now I have been discussing that despite the "hopes" that this time is different, there is little chance that the U.S. can remain an island of economic prosperity in the sea of global deflation. To wit:

"While none of this analysis suggests that a domestic recession is imminent, it does suggest that the hopes that the U.S. can "decouple" from the rest of the world's deflationary drags are likely misplaced. As shown in the chart below, the U.S. economy has historically been unable to achieve accelerating rates of economic growth when both the EuroArea and Japanese economies have been weak."

"The implications to investors are important. The current growth in domestic profits is one of the last remaining footholds of market "bulls." With valuations now expensive, interest rates near zero and yield spreads flattening, the risks to the markets have risen substantially. While this doesn't seem to be the case as markets push up against all-time highs; it is worth remembering that we saw much the same in early 2000 and 2007. This time is likely no different, only the timing and catalyst will be."

The following series of charts all suggest that current hopes of surging economic growth in the U.S., over the next several quarters, will likely be met with disappointment. I have added brief comments, but primarily you should judge for yourself.

LEI Coincident To Lagging Ratio

The coincident-to-lagging ratio is like a "book-to-bill" ratio for the economy. It is hard to suggest that the economy is "firing" on all cylinders when this ratio is languishing at levels normally indicative of a recessionary economy.

ISM Composite

While the ISM composite survey is near the top end of its range, there are clear signs that the ratio will likely subside in the months ahead. I have mapped the normal cycles of the index in the past. It is important to remember that the ISM survey is a "sentiment" survey that tends to lag actual inputs like new orders and backlogs.

Durable Goods

Speaking of orders, durable goods (ex-aircraft) are showing considerable signs of weakness domestically. The demand for goods has weakened significantly over the last couple of months in particular despite the hopes that falling oil and gasoline prices would buoy spending. (I wrote several articles dispelling this myth see here, here and here.)

Imports vs. Exports

The surging dollar and weak consumer demand are also being reflected in import and export activity. 

Shipping

The rising weakness in demand for goods and products can be clearly seen in the decline in the shipping index.

Copper

Copper, a component used in virtually every facet of manufacturing, production, and consumption, also suggests that economic demand is weakening.

National Activity vs. Economy

We can see this more clearly by looking at the major components of the Chicago Fed National Activity Index (CFNAI) as compared to the relative economic indicators.

Inflation

The 5- and 10-year breakeven inflation rates continue to suggest that underlying economic strength is much weaker than headline statistics suggests.

These charts all clearly suggest that the real economy is likely weaker than currently believed. In addition, current data would likely already be printing lower growth rates had it not been for revisions a couple of years ago that added more questionably measured components such as "intellectual property."

However, while I am not suggesting that a recession is imminent, i am suggesting that the risk to investors has risen markedly over the last few months. The rising financial instability in the Eurozone, particularly following the Greek elections, combined with the global deflationary tide puts currently extended financial markets in jeopardy.

There is little question that the markets will eventually suffer a rather nasty mean reversion. However, bull markets don't end simply due to old age, it requires a catalyst. The problem remains that throughout history the "catalyst" that finally triggers a market reversion and coinciding economic recession are rarely identified in advance.

This is why I point to the signs. The signs are everywhere that the market is currently a "bug in search of a windshield." It will eventually find one, and as the old saying goes, the last thing that goes through the mind of the bug is its ***.

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Greece Is Once Again a Victim of Democracy

by Bill Bonner

Tempests Everywhere

And then democracy comes into being after the poor have conquered their opponents, slaughtering some and banishing some, while to the remainder they give an equal share of freedom and power.

– Socrates, Plato’s The Republic

A snowstorm battered the East Coast of the US today. Politics rocked southern Europe.

Sitting here on the edge of the beach, overlooking the Pacific Ocean, a gentle breeze stirring the trees… birds singing… surfers carrying their boards across the sand…

… it’s hard to imagine the tempest in North America, let alone the swirling clouds over the Parthenon. The radical left-wing Syriza coalition party won in Greece.

Once again, Greece is a victim of democracy.

Greece’s elderly president Karolos Papoulias warily eyes Alexis Tsipras as he is about to be sworn in as the country’s new prime minister.

Photo credit: Aris Messinis / AFP

Austerity? What Austerity?

What this means, exactly, is anybody’s guess. The Wall Street Journal struggled:

“Within minutes of the close of the polls, Germany’s powerful central-bank chief, Jens Weidmann, pushed back.

“It is clear that Greece will remain dependent on support and it’s also clear that this aid will be provided only when it is in an aid program,” he said in an interview with television broadcaster ARD.

A message on British Prime Minister David Cameron’s usual Twitter account, meanwhile, warned that the Greek result will “increase economic uncertainty across Europe.”

Increased uncertainty is a good bet.

Meanwhile, the papers reported that Europe’s apparatchiks were working overtime to accommodate the new government so as to keep the system functioning. Also reported was that Greek voters were fed up with “austerity.”

As to the first bit of news we have no doubt. All the powers-that-be don’t want to become the powers-that-used-to-be. They’ll do whatever it takes to hold on to their authority. It’s the second bit of news that makes us say, “Huh?”

Not that we haven’t heard it before. The Greeks… the Spaniards… the Italians… the Portuguese… the French – they’re all supposed to be tired of “austerity.” But what austerity?

According to our sources, the Greek government currently spends 59% of GDP – a figure even higher than in France. Like France, Greece has plenty of civil servants enjoying a cushy life at taxpayer expense. And in the private sector, too, the cronies get their favors, privileges and tax breaks… while as much as half of tax revenue goes uncollected.

Which is probably a good thing. Were it not for the black market, and tax evasion, the Greek economy would probably fall apart. Elsewhere it is reported that 45% of GDP is collected by the Greek government. The difference between collecting 45% and spending 59% is apparently the source of the problem. But we’re not sure. All of the numbers we see are a little fishy.

Many of the data that are readily available are a bit outdated. However, this slightly more up-to-date chart of government spending in absolute terms shows that spending has increased substantially in the summer of 2014 – click to enlarge.

Clever Legerdemain

It was thanks to fishy numbers that Greece was admitted to the EU in the first place. The European Union insists on a certain standard of financial integrity, or it won’t let you in. (Fearing that it might have to bail you out later.)

Greece managed to get in thanks to the clever legerdemain of Goldman Sachs, which disguised some of the nation’s debts. Then, with no more fear of getting paid back in Greece’s dodgy drachma, lenders were happy to open their wallets to Greek borrowers.

Government debt increased from 100% of GDP as recently as 2006 to 177% this year. Spend, spend, spend. Pensions. Health care. Education. And why not guns, too? Greece is even one of the biggest military spenders (as a percentage of GDP) in NATO. This is austerity?

Real austerity is what you get when you spend no more than you make… minus what you need to pay to service yesteryear’s excess spending. Real austerity is what you get when lenders wise up, realize you’ll never pay them back, and don’t lend you anymore money.

Real austerity is what you have when the Germans say nein to any more financial support. Real austerity is not what the Greeks have. And not what Greek voters voted against. It’s what they need. Austerity is what we all need.

The ratio of Greece’s government debt to GDP has increased greatly, as the nominal value of economic output has plummeted. For one thing, malinvested capital was liquidated, for another, Greece’s domestic money supply declined sharply as depositors fled and the banking system became effectively insolvent (it was then recapitalized via a bailout). Since there still remain huge amounts of non-performing loans on the banks’ books, bank credit is likely to remain scarce for the time being – click to enlarge.

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The Swiss Franc Will Collapse

by Keith Weiner

I have worked to keep this piece readable, and as brief as possible. My grave diagnosis demands the evidence and reasoning to support it. One cannot explain the collapse of this currency with the conventional view. “They will print money to infinity,” may be popular but it’s not accurate. The coming destruction has nothing to do with the quantity of money. It is a story of what happens when interest rates fall into a black hole.

Yields Have Fallen Beyond Zero

The Swiss yield curve looks like nothing so much as a sinking ship. All but the 20- and 30-year bonds are now below the water line.

Swiss yield curve – click to enlarge.

Look at how much it’s submerged in just one week. The top line (yellow) is January 16, and the one below it was taken just a week later on January 23. It’s terrifying how fast the whole interest rate structure sank. Here is a graph of the 10-year bond since September. For comparison, the 10-year Treasury note would not fit on this chart. The US note currently pays 1.8%.

Swiss 10 year government bond yield – click to enlarge.

The Swiss 10-year yield was as high as 37 basis points on Friday January 2. By the next Monday, it had plunged to 28, or -25%. By January 15—the day the Swiss National Bank (SNB) announced it was removing the peg to the euro—the yield had plunged to just 7 basis points. It has been nonstop freefall since then, currently to -26 basis points.

What can explain this epic collapse? Why is the entire Swiss bond market drowning? Drowning is a fitting metaphor. In my dissertation, I describe several harbingers of financial and monetary collapse. The first is when the interest interest rate on the long bond goes to zero. I discuss the fact that a falling rate destroys capital, and that lower rates mean a higher burden of debt.

If the long bond rate is zero then the net present value of all debt (which is effectively perpetual) is infinite. Debtors cannot carry an infinite burden. As we’ll see, any monetary system that depends on debtors servicing their debt must collapse when the rate goes to zero.

I think the franc has reached the end. With negative rates out to 15 years, and a scant 33 basis points on the 30-year, it is all over but the shouting.

Not Printing, Borrowing

Let’s take a step back for a moment, and look at how the recent chapter unfolded. It began with the SNB borrowing mass quantities of francs. Most people say printed, but it’s impossible to understand this unprecedented disaster with such an approximate understanding. It’s not printing, but borrowing.

Think of a home buyer borrowing $100,000 to buy a house. He never gets the cash in his bank account. He signs a bunch of paperwork, and then at the end of the day he has a debt obligation to repay, plus the title to the house. The former owner has the cash.

It works the same with any central bank that wants to buy an asset. At the end of the day, the bank owns the asset, and the former owner of the asset now holds the cash. This cash is the debt of the central bank. It is on the bank’s balance sheet as a liability. The bank owes it.

This is vitally important to understand, and it can be quite counterintuitive. If one thinks of the franc (or dollar, euro, etc.) as money, and if one thinks that the central banks print money, then one will come to precisely the wrong conclusion: that there is nothing owed, and indeed there is no debtor. In this view, the holder of francs has cash, which is a current asset. End of story.

This conclusion could not be more wrong. Certainly, the idea of the central bank repaying its debt is absurd. By law, payment is deemed made when the debtor pays in currency—i.e. francs in Switzerland. However, the franc is the very liability of the SNB that we’re discussing. How can the SNB pay off its franc liabilities using its own franc liabilities as means of payment?

It can’t. This is a contradiction in terms. Thus it’s critical to understand that there is no extinguisher of debt in the regime of irredeemable paper currency. You may get yourself out of the debt loop by paying in currency, but that merely shifts the debt. The debt does not go out of existence, because paying a debt with an IOU cannot extinguish it. Unlike you, the central bank cannot get itself out of debt.

However, it can service its debt. For example, the Federal Reserve in the U.S. pays interest on reserves. Indeed, the bank must service its debts. It would be a calamity if a payment is missed, if the central bank ever defaulted. The central bank must also maintain its liabilities, which is what it uses to fund its assets. If the commercial banks withdraw their deposits—and they do generally have a choice—the central bank would be forced to sell its assets. That would be contrary to its policy intent, not to mention quite a shock to brittle economies.

Make no mistake, a central bank can go bankrupt. This may seem tricky to understand, as the law makes its liability legal tender for all debts public and private. A central bank is also allowed to commit acts of accounting (and leverage) that would not be tolerated in a private company. Regardless, it can present misleading financial statements, but even if the law lets it get away with that, reality will have its revenge in the end. The emperor may claim to be wearing magnificent royal robes, but he’s still naked.

If liabilities exceed assets, then a bank—even a central bank—is insolvent and the consequences will come soon enough. The cash flow from the assets will sooner or later become insufficient to pay the interest on the liabilities. No central bank wants to be in a position where it is obliged to borrow, not to purchase asset but to service a negative cash flow. That is a rapid death spiral. It must somehow push down the interest rate on its liabilities (which are typically short term) to keep the cost of financing its portfolio below the revenue generated on the assets.

This becomes increasingly tricky when two things happen. One, the yield on the asset goes negative. Thus, the even-more-negative (and even more absurd) one-day rate of -400 basis points in Switzerland. Two, the issuance of more currency drives down yields even further (described in detail, below). Events force the hand of the central bank. It goes down a path where it has fewer and fewer choices. That brings us back to negative interest rates out to the 15-year bond so far.

The Visible Hand of the Swiss National Bank

So the SNB issued francs to fund its purchase of euros. Next, it spent the euros on whatever Eurozone assets it wished to buy, such as German bunds.

It’s well known that the SNB put on a lot of this trade to keep the franc down to €0.83 (the inverse of keeping the euro down to CHF1.20). It also helped push down interest rates in Europe. The SNB was a relentless buyer of European bonds.

That leads to the question of what it did in Switzerland. The SNB was trading new francs for euros. That means the former owner of those euros then owned francs. These francs have to stay in the franc-denominated domain. What asset will this new franc owner buy?

I frame the question this way deliberately. If you have a 100-franc note, you can put it in your pocket. If you have CHF100,000, you can deposit it in a bank. If you have CHF100,000,000 (or billions) then you are going to buy a bond or other asset (depositing cash in a bank just pushes it to the bank, which buys the asset).

The seller of the asset is selling on an uptick. He gives up the bond, because at its higher price (and hence lower yield) he now finds another asset more attractive on a risk-adjusted basis. Risk includes his own liquidity risk (which of course rises as his leverage increases). As the SNB (and many others) relentlessly push up the bond price, and hence push down the yield, the sellers of the ever-lower yielding bonds have fresh new franc cash balances.

The Quantity Theory of Money holds that the demand for money falls as the quantity rises. If demand for money falls, then by this definition the prices of all other things—including consumer goods—rises. It is commonly held that people tradeoff between saving money vs. spending money (i.e. consumption). The prediction is rising consumer prices.

I emphatically disagree. A wealthy investor does unload his assets to go on an extra vacation if he doesn’t like the bond yield. A bank with a trillion dollar balance sheet does not dole out bigger salaries if its margins are compressed. So what does trade off with government bonds? If an investor doesn’t want to own a government bond, what else might he want to own? He buys corporate bonds, stocks, or rental real estate, thus pushing up their prices and yields down.

And then, in a dysfunctional monetary system, you can add antique cars, paintings, a second and third home, etc. These things serve as surrogates for investment. When investing cannot produce an adequate yield, people turn to non-yielding non-investment assets.

The addition of a new franc at the margin perturbs the previous equilibrium of risk-adjusted yields across all asset classes. Every time the bond price goes up, every owner of every franc-denominated asset must recalculate his preferences. The problem is that the SNB does not create any more productive investment opportunities when it spills more francs into the Swiss financial system. Those new francs have to chase after the existing assets.

Yields are falling. They necessarily had to fall.

An Increasing Money Supply and Decreasing Interest Rate

The above discussion describes the picture in every developed economy. Interest rates have been falling for 34 years in the U.S., for example.

In a free market, the expansion of credit would be driven by a market spread: available yield – cost of borrowing. If that spread is too small (or negative) there will be no more borrowing to buy assets. If it gets wider, then banks can spring into action.

However, central banks distort this. Instead of the cost of borrowing being a market-determined price, it is fixed by the central bank. This perverts the business model of a bank into what is euphemistically known as maturity transformation—borrowing short to lend long. It’s not possible for a bank to borrow money from depositors with 5-year time deposit accounts in order to buy 5-year bonds. The bank has to borrow a shorter duration and buy a longer, in order to make a reasonable profit margin.

If the central bank sets the borrowing cost lower and lower, then the banks can bid up the price of government bonds higher and higher (which causes a lower and lower yield on the long bond). This is not capitalism at all, but a centrally planned kabuki theater. All of the rules are set by a non-market actor, who can change them for political expediency.

The net result is issuance of credit far beyond what could ever happen in a free market. This problem is compounded by the fact that the central bank cannot control what assets get bought when it buys bonds. It hands the cash over to the former bond holders. It’s trying to accomplish something—such as keeping the franc down in the case of the SNB, or preventing bankruptcies, in the case of the Fed—and it has no choice but to keep flooding the market until it achieves its goal.

In the US, the rising tide eventually lifted all ships, even the leaky old tubs. The result is a steeper credit gradient, and the bank can eventually force liquidity out to its target debtors.

The situation in Switzerland makes the Fed’s problems look small by comparison. Unlike the Fed, which had a relatively well-defined goal, the SNB put itself at the mercy of the currency market. It had no particular goal, and therefore no particular budget or cost. The SNB was fighting to hold a line against the world. While it kept the franc peg, the SNB put pressure on both Swiss and European interest rates.

Something changed with the start of the year. We can understand it in light of the arbitrage between the Swiss bond, and other Swiss assets. The risk-adjusted rate of return on other assets always has to be greater than that of the Swiss government bond (except perhaps at the peak of a bubble). Otherwise why would anyone own the higher-risk and lower-yield asset? Therefore, there are three possible causes for the utter collapse in interest rates in Switzerland beginning 10 days prior to the abandonment of the peg:

The rate of return of other assets has been leading the drop in yields

Buying pressure on the franc obliged the SNB to borrow more francs into existence, fueling more bond buying.

The risk of other assets has been rising (including liquidity risk to their leveraged owners)

#1 is doubtful. It’s surely the other way around. It’s not falling yields on real estate driving falling yields on bonds. Bond holders are induced to part with their bonds on a SNB-subsidized uptick. Then they use the proceeds to buy something else, and drive its yield down.

One fact supports conclusion #2. Something forced the SNB to remove the peg. Buying pressure is the only thing that makes any sense. The SNB hit its stop-loss.

The rate of interest continued to fall even after the SNB abandoned its peg. Why? Reason #3, rising risks. Think of a bank which borrowed in Swiss francs to buy Eurozone assets. This trade seemed safe with the franc pegged to the euro. When the peg was lifted, suddenly the firm was faced with a staggering loss incurred in a very short time.

The overreaction of the franc in the minutes following the SNB’s policy change had to be the urgent closing of Eurozone positions by many of these players. The franc went from €0.83 to €1.15 in 10 minutes, before settling down near €0.96. For those balance sheets denominated in francs, this looked like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would you do, if your positions instantly lost so much? Most people would try to close their positions.

Closing means selling Eurozone assets to get francs. Then you need to buy a franc-denominated asset, such as the Swiss government bond. That clearly happened big-time, as we see in the incredible drop in the interest rate in Switzerland. Francs which had formerly been used to fund Eurozone assets must now be used to fund assets exclusively in the much-smaller Swiss realm.

In other words, a great deal of franc credit was used to finance Eurozone assets. This is a big world, and hence the franc carry trade didn’t dominate it. When those francs had to go home and finance Swiss assets only, it capsized the market. And the entire yield curve is now sinking into a sea of negative rates.

A beautiful cemetery in Switzerland, where the Swiss franc could be interred one day.

Photo credit: dicconbewes.com

The Consequences of Falling Interest

Meanwhile, unnaturally low interest is offering perverse incentives to corporations who can issue franc-denominated liabilities. They are being forced-fed with credit, like ducks being fatted for foie gras. This surely must be fueling all manner of malinvestment, including overbuilding of unnecessary capacity. The hurdle to build a business case has never been lower, because the cost of borrowing has never been lower. The consequence is to push down the rate of profit, as competitors expand production to chase smaller returns. All thanks to ever-cheaper credit.

Artificially low interest in Switzerland is causing rising risk and, at the same time, falling returns. The Swiss situation is truly amazing. One has to go out to 20 years to see a positive number for yield—if one can call 21 basis points much of a yield. It’s not only pathological, but terminal. This is the end.

In Switzerland, there is hardly any incentive remaining to do the right things, such as save and invest for the long term. However, there’s no lack of perverse incentives to borrow more and speculate on asset prices detaching even further from reality. Speculation is in its own class of perversity. Speculation is a process that converts one man’s capital into another man’s income. The owner of capital, as I noted earlier, does not want to squander it. The recipient of income, on the other hand, is happy to spend some of it.

We should think of a falling interest rate (i.e. rising bond market and hence rising asset markets) as sucking the juice (capital) out of the system. While the juice is flowing, asset owners can spend, and lots of people are employed (especially in the service sector).

For example, picture a homeowner in a housing bubble. Every year, the market price of his house is up 20%. Many homeowners might consider borrowing money against their houses. They spend this money freely. Suppose a house goes up in price from $100,000 to $1,000,000 in a little over a decade. Unfortunately, the debt owed on the house goes up proportionally.

With financial assets, they typically change hands many times on the way up. In each case, the sellers may spend some of their gains. Certainly, the brokers, advisors, custodians, and other professionals all get a cut—and the tax man too. At the end of the day, you have higher prices but not higher equity. In other words, the capital ratio in the market collapses.

To understand the devastating significance of this, consider two business owners. Both have small print shops. Both have $1,000,000 worth of presses, cutters, binding machines, etc. One owns everything outright; he paid cash when he bought it. The other used every penny of financing he could get, and has a monthly payment of about $18,000. Both shops have the same cost of doing business, say $6,000. If sales revenues are $27,000 then both owners may feel they are doing well. What happens if revenues drop by $3,500? The all-equity owner is fine. He can reduce the dividend a bit. The leveraged owner is forced to default. The more your leverage, the more vulnerable you are to a drop in revenues or asset values.

Falling interest, and its attendant rising asset prices, juices up the economy. People feel richer (especially if their estimation of their wealth is portfolio value divided by consumer prices) and spend freely. Unfortunately, it becomes harder and harder to extract smaller and smaller drops of juice. The marginal productivity of debt falls.

Think about it from the other side, the borrower. The very capacity to pay interest has been falling for decades. A declining rate of profit goes hand-in-hand with a falling rate of interest. Lower profit is both caused by lower interest, and also the cause of it. A business with less profit is less able to pay interest expense. Who could afford to pay rates that were considered to be normal just a few decades ago? It is capital that makes profit, and hence capacity to pay interest, possible. And it is capital that’s eroded by falling rates.

The stream of endless bubbles is just the flip side of the endless consumption of capital. Except, there is an end. There is no way of avoiding it now, for Switzerland.

How About Just Shrinking the Money Supply?

Monetarists often tell us that the central bank can shrink the money supply as well as grow it, and the reason why it’s never happened is, well… the wrong people were in charge. I disagree.

To see why, let’s look at the mechanism for how a central bank expands the money supply. It issues cash to an asset owner, and the asset changes hands. Now the bank owns the asset and the seller owns the cash (which he will promptly use to buy the next best asset). A relentlessly rising bond price is lots of fun. It’s called a bull market, and everyone is making profits as they reckon them (actually consuming capital, as we said above).

How would a contraction of the money supply work? It seems simple, at first. The central bank just sells an asset and gets back the cash. The cash is actually its own liability, so it can just retire it. And voila. The money supply shrinks. Not so fast.

There is an old saying among traders. Markets take the escalator up, but the elevator down. Central bank buying slowly but relentlessly bid up the price of bonds. Tick by tick, the bank forced it up. What would central bank selling do? What would even a rumor of massive central bank selling do? Bond prices would fall sharply.

The problem is that few can tolerate falling bond prices, because everyone is leveraged. Think about what it means for everyone to borrow and buy assets, for sellers to consume some profits and reinvest the proceeds into other assets. There is increasingly scant capital base supporting an increasingly inflated—as in puffed-up with air, without much substance—asset market. A small decline in prices across all asset classes would wipe out the financial system.

Market participants have to be leveraged. Dirt cheap credit not only makes leverage possible, but also necessary. How else to keep the doors open, without using leverage? Spreads are too thin to support anyone, unlevered.

Banks are also maturity mismatched, borrowing short to lend long. The consequences of a rate hike will be devastating, crushing banks on both sides of the balance sheet. On the liabilities side, the cost of funding rises with each uptick in the interest rate. On the asset side, long bonds fall in value at the same time. If short-term rates rise enough, banks will have a negative cash flow.

For example, imagine owning a 10-year bond that pays 250 basis points. To finance it, you borrow at 25 basis points. Well, now imagine your financing cost rises to 400 basis points. For every dollar worth of bonds you own, you lose 1.5 cents per year. This problem can also afflict the central bank itself.

You have a cash flow problem. You are also bust.

The Bottom Line

The problem of falling rates is crushing everyone, but raising the rate cannot fix the problem. It should not be surprising that, after decades of capital destruction—caused by falling rates—the ruins of a once-great accumulation of wealth cannot be repaired by raising the interest rate.

I do not see any way out for the Swiss National Bank and the franc, within the system of irredeemable paper money. However, unless the SNB can get out of this jam, the franc is doomed. I can’t predict the timing, but I believe the fuse is lit and the powder keg could go off at any time.

One day, a bankruptcy will happen. Soothing voices will assure us it was unexpected. Then another will happen, perhaps triggered by the first or perhaps not. Then the cascading begins. One party’s liabilities are another’s assets. ABC’s bankruptcy wipes out DEF’s asset. Since DEF is leveraged, it cannot absorb much loss until it, too, is dragged under.

Somewhere in the midst of this, people will turn against the franc. Today, it’s arguably the most loved paper currency. However, I don’t think it will take too many capital losses in Switzerland, before there is a selling stampede. The currency will fall to zero, in a repeat of a pattern that the world has seen many times before.

People will call it hyperinflation (I don’t prefer that term). Call it what you will, it will be the death of the franc. It will have nothing to do with the quantity of money.

Two factors can delay the inevitable. One, the SNB may unwind its euro position. As this will involve selling euros to buy francs, the result will be to put a firm bid under the franc. Two, speculators will of course know this is happening and eagerly front-run the SNB. After all, the SNB is not an arbitrager buying when it can make a spread.

It is a buyer by mandate (in this scenario) and must pay the ask price. Even if the SNB does not unwind, speculators may buy the franc and wait for it to happen. And of course, they could also buy based on a poor understanding of what’s happening, or due to other perverse incentives in their own countries.

Bankruptcies aside, the franc is already set on a hair-trigger. Something else could trip it and begin the process of collapse. There is little reason for holding Swiss francs in preference to dollars. The interest rate differential is huge. The 10-year US Treasury pays 1.8%. Compare that to the Swiss bond which charges you 26 basis points, and the difference is over 208 points in favor of the US Treasury. Once the risk of a rising franc is taken out of the market (by time or price action) this trade will commence. A falling franc against the dollar will add further kick to this trade. A trickle could become a torrent very quickly.

I would not be surprised if the process of collapse of the franc began next week, nor if it lingered all year. This kind of event is not susceptible to a precise prediction of when. What is clear is that, once the process begins in earnest, it will be explosive, highly non-linear, and over quickly (I would guess a matter weeks).

I plan to publish a separate paper revisiting my Gold Bonds to Avert Financial Armageddon thesis in light of the Swiss crisis. I will save for that paper my assessment of whether or how gold bonds can provide a way out for the Swiss people trapped in the terminal phase of irredeemable paper money.

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A peg in a poke

by The Economist

Currency markets have suddenly become a lot more volatile

THE year is only a few weeks old but already there has been turmoil in the foreign-exchange markets. On January 28th Singapore eased monetary policy, allowing its currency to fall to its lowest level against the dollar since 2010. The Swiss have abandoned their policy of capping the franc against the euro and the European Central Bank (ECB) has unveiled a big programme of quantitative easing (QE), sending the euro to an 11-year low against the dollar (see chart). Meanwhile, a rate cut from the Bank of Canada has pushed the loonie down to around 80 American cents, from 94 cents a year ago.

The main reason for this sudden surge of volatility seems to be a divergence in monetary policy: no longer are central banks moving in the same direction. “There are two huge forces at work,” says David Bloom, a currency strategist at HSBC. “The ECB and Bank of Japan are printing money and devaluing their currencies while the US economy is growing strongly. Anyone who stands in the middle risks getting crushed.”

The Swiss were caught in the middle. Their cap involved creating Swiss francs and using them to buy euro-denominated assets, but they clearly balked at maintaining this policy in the face of QE in the euro area. A much stronger franc, however, will add to the deflationary pressures in the domestic economy.

Falling commodity prices mean this is a potential problem for much of the rich world. A stronger currency can be the difference between low inflation and outright deflation. But currencies are a zero-sum game: if the euro and yen weaken, something must gain. So foreign-exchange markets become a little like a game of pass-the-parcel, in which countries try to offload the threat of deflation somewhere else.

Meanwhile, emerging-market currencies, which took a bit of a battering in 2014, have been recovering. The Brazilian real, the Indian rupee and the Turkish lira have all risen by more than 10% against the euro since mid-December. Simon Derrick, a currency strategist at BNY Mellon, a fund-management group, says there are signs of a “carry trade” at work, with traders borrowing money cheaply in euros and investing in higher-yielding currencies in the developing world.

Volatility is a bit like a bouncy castle: sit down on one side and it will pop up somewhere else. Central banks have intervened heavily in the bond markets, bringing yields down to historic lows. Equity markets have also been boosted by the conviction that central banks will remain supportive. And corporate bond markets have been pretty steady; low government-bond yields have caused income-seeking investors to buy corporate debt and defaults have been very low.

So it is unsurprising that volatility is appearing in other markets—most dramatically in oil and now in currencies as well. However, sudden currency moves can be devastating for companies and individuals who have borrowed abroad. Many east Europeans took out mortgages in Swiss francs to take advantage of lower interest rates and are nursing big losses after the franc’s sudden rise.

Mismatching assets and liabilities by borrowing in a foreign currency is rarely a good idea. Of course, many of those home-owners will have been tempted to take out a Swiss-franc mortgage because of the franc’s peg to the euro. Therein lies the problem with currency pegs. They may eliminate volatility in the short term, but at the cost of a very big currency move if the peg gives way. The problem was faced on an even bigger scale by Thailand in the 1990s with its dollar peg, and by Argentina, which abandoned a currency board in 2002; that shift necessitated the forcible conversion of dollar deposits into pesos, the so-called corralito.

Pegs require a lot of discipline. If monetary policy in the target country changes, the pegging country has to follow suit, regardless of the consequences. Other economic priorities have to be subordinated to the currency target. The strain often proves too much, as it did when Britain left the European exchange-rate mechanism in September 1992.

A single currency is an extreme version of a peg. And Greece’s new government is chafing at the constraints imposed by being part of the euro zone. (Some of those constraints may be unnecessarily onerous but that is another matter.) Greek bank shares have been tanking on fears of capital flight. If the strains prove too much, the result may involve leaving the euro and capital controls—a Greek corralito. That would only reinforce 2015’s growing reputation for currency spasms.

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The Longer Outlook in ….. Gold

by Greg Harmon

Gold has a long and storied history. It has been prized by kings for centuries. Empires were built on it. It has backed entire countries. It has been used to monitor economic growth and inflation. And when there is global conflict it is seen as source of safety for capital. But much of that history, is history. In crisis money flocks to US Treasuries or the US Dollar now. I suppose that if the US were in crisis then Gold might make a comeback.

Many pundits have made a name for themselves during the big 10 year bull market run in Gold that went from 2001 until 2011. Unfortunately they still espouse on the virtues of Gold like nothing has changed. But in terms of its actual usefulness it is now pretty limited. That does not stop sentiment and emotional buying though. And It probably never will. And as one of the most active contracts in the futures market it trades well with technicals. So even with no real value or scarcity, what does the chart say about its future? Its at a crossroads.

The monthly chart above shows only the last ten years. The full move from 2001 until 2011 is measured by the blue Fibonacci lines. The smaller move following the retracement in 2008 is shown with the red lines. These Fibonacci retracements can play a major role for traders.

There are a few things that stick out from these levels. First there are two retracements that are tightly bound at 1286 and 1303. This can help explain the magnetic like pull of the 1300 level. The second thing to note is that the break lower at the end of the year retraced to the 61.8% level on the shorter move.

This is a major retracement and weakness below this level would suggest a much deeper correction. So it is promising that it has moved higher back towards the 50% level into the end of January. On the broader scale the 38.2% retracement held it for a long time. And the move back toward that level is also promising. It would be a shallow retracement if it were to reverse higher from this point. But there is no reversal yet.

Aside from the Fibonacci’s there is the 100 month SMA that has come into play recently. It has acted as support the last few months and could contribute to the bottoming process. But there is also the falling channel in pink that has been active for 2 years. Notice that the latest move higher is testing the top of the channel. Also note that the channel is falling in the direction of the correction, more like a pennant than a bear flag. This type of price action often leads to a reversal.

Finally the momentum indicators are diverging from the price action. Not strongly, but the MACD is is leveling and has been so for a year, while the RSI has been in a slight upward trend for the last 18 months.

But all the indicators mean nothing if the price does not confirm. It would take a solid break and hold over 1340 to confirm a bottom and reversal higher. Then a move over 1450 would strengthen the trend and look for a major move higher. But a break of the channel to the downside, and below 1140 would look for an acceleration of the downtrend and a target of the 61.8% retracement of the broad move to 893. Until then look for the slow downward drift to continue, maybe as far as 1090.

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Greece's fight against "fiscal waterboarding" will halt economic recovery

by Sober Look

We are about to witness a historic showdown between the major euro area institutions and Greece. Greece's newly appointed finance minister Yanis Varoufakis, a staunch bailout critic, will lead the negotiations on debt haircuts. On the other side will be the creditors: the International Monetary Fund and the European Commission - with additional support from the ECB. Private bondholders may get dragged into the fight as well (although many of them are Greek banks who will do what the government tells them). A number of Eurozone politicians have already expressed skepticism about any debt forgiveness for Greece. But Varoufakis is likely to focus on the argument that Germany has to take a great deal of the blame for the situation in which Greece now finds itself - calling the imposed austerity measures "fiscal waterboarding". Here is a good quote from Strafor:

Stratfor (via Forbes): Another version, hardly heard in the early days [of the Eurozone crisis] but far more credible today, is that the crisis is the result of Germany’s irresponsibility. Germany, the fourth-largest economy in the world, exports the equivalent of about 50 percent of its gross domestic product because German consumers cannot support its oversized industrial output. The result is that Germany survives on an export surge. For Germany, the European Union — with its free-trade zone, the euro and regulations in Brussels — is a means for maintaining exports. The loans German banks made to countries such as Greece after 2009 were designed to maintain demand for its exports. The Germans knew the debts could not be repaid, but they wanted to kick the can down the road and avoid dealing with the fact that their export addiction could not be maintained.

The debate will also focus on the fact that Greece has done an amazing job in cutting its debt/GDP ratio - in spite of the falling GDP.

Source: @RBS_Economics

Greek government bond yields spiked on Syriza's escalating rhetoric as well as on the right-wing anti-austerity party (Independent Greeks) becoming Syriza's new coalition partner. Think about it - the only thing the two parties have in common is their hatred for the Eurozone and the fiscal pain that was imposed on Greece.

The Greek government bond yield curve has become more inverted as markets price in principal reductions that are likely to apply evenly across the curve (which is what typically causes such inversion).

It is expected that if such haircuts are applied, they would hit both official and unofficial accounts (including bonds held by the ECB). Debt forgiveness would also cut principal on the government bonds held by Greek banks - who are some of the largest holders. That's why shares of Greek banks got decimated today. New bank bailouts will be required if there is any hope for credit availability to the private sector. For now most credit activity will come to a grinding halt - and with it any hopes for economic recovery.

Source: @WSJGraphics

The overall equity market fell over 9% today as government officials halt privatization and extend an olive branch to Russia (see story).

The newly elected government may ultimately get its debt forgiveness. But in the process the damage done to the nation's private sector will be severe - just as Greece begins to come out of a deep depression that rivals some of the worst downturns in global history.

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