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It's Europe, stupid


The recent collapse in stock prices and Treasury yields in the U.S. was not related to any direct evidence that the U.S. economy was headed for a double-dip recession. It was mainly driven by fears of a European sovereign debt crisis that could potentially lead to a massive bank failure and a collapse of the Eurozone economy. With Europe already weak, a financial crash would likely bring the economy to its knees, and that in turn would be a serious drag on the U.S. economy. The chart above, which compares the S&P 500 index to its Eurozone counterpart, illustrates the dynamics. The recent Stoxx decline correlates highly (0.85) to the decline in the S&P 500, but the Stoxx index has fallen almost 20% more than the S&P 500 in the past six months. If investors are running scared here, they are in full-blown panic mode in Europe.


As the above chart shows, a Greek default/restructuring on its $500 billion of debt is a foregone conclusion; the only issue now is how serious the haircut will be. The likelihood of a Portuguese ($225 billion of debt) or Irish ($160 billion of debt) default/restructuring is less, but still a haircut of some magnitude is expected. The chances of an Italian default are not much higher than that of a BAA-rated company, but the size of Italian debt outstanding ($2.3 trillion) is what makes the market shudder. Pick even relatively small haircuts on the total debt of these four countries (just over $3 trillion) plus maybe Spain ($920 billion), and you quickly come up with losses that could wipe out the capital (about $600 billion) of Europe's 20 largest banks, which collectively own over $4 trillion of PIIGS debt. The numbers are scary indeed.


This chart of swap spreads offers some consolation. Eurozone swap spreads are quite high, signaling serious systemic risk and investor's attempts to avoid bank counterpart risk, but they are not catastrophically high like they were in late 2008. Plus, U.S. swap spreads remain at low, normal levels, which is a good indication that U.S. banks are almost entirely insulated from the consequences of a Eurozone sovereign debt default.

I refer back to a post I made a month ago, in which I argue that "most of the bad effects of too much debt have already happened." The money borrowed by Greece, Italy, et. al., has already been squandered on non-productive activities. Governments have misused scarce resources, and that is why their economies are relatively weak. Defaults don't necessarily lead to weaker economies, since debt is a zero-sum game: a restructuring of Greek debt means a loss for the holder of the debt, but a gain for the Greek government, since it is relieved of some of its debt burden. The Greek economy won't shrink just because it defaults; it is still full of people, offices, factories, and machinery that will go on producing. The worst thing about the threat of a default is that everyone wants to avoid taking the loss, and fear and panic can produce an economic slowdown—this is the phase Europe is in right now. The one good thing that will surely come from this is that governments will be forced to reform their spending habits. The era of Big Government is slowly drawing to a close.


Meanwhile, the 6% growth of real retail sales over the past year disproves any suggestion that the U.S. economy might be entering a double-dip recession.

Consumer confidence collapse is overstated


According to the University of Michigan's measure of consumer confidence, consumers today are more rattled about the state of the economy than they were at the depths of the "great recession" two and a half years ago. If that's not sentiment hyperbole, I don't know what is. The state of the economy is manifestly better now than it was then, but the bad news has been hyped to the max, as this survey suggests.

Start with Nancy Pelosi's claim that Republicans and Tea Partiers were bent on destroying the world as we know it. Add in the threat of default by countries such as Greece and Italy and perhaps Spain, which could in turn trigger the collapse of the entire European banking industry and possibly bring about the end of Western civilization. Spice things up with soaring gold prices and a Fed that has resorted to extraordinary measures to ease the supply of credit, while the background chorus wails that we're on the verge of another housing price collapse. Austrian economists meanwhile insist that we ain't seen nothin' yet. Top things off with the first-ever downgrade of U.S. Treasury debt, and a president who seems clueless about what to do as his approval ratings sink.

In short, if you wanted to work yourself into a frenzy of dread, there is no shortage of bad news with which to do it. But you have to ignore a whole lot of good news in the process. For starters: the economy has been growing for two years, adding some 2 million jobs; unemployment claims this year have averaged 415K per week, down over one-third from the levels two years ago; retail sales are at record highs, up 8.5% in the past year; corporate profits are at record nominal and real highs; swap spreads (a key measure of systemic risk and the health of the banking system) are at normal levels today when at the end of 2008 they were signaling potential calamity; and high-yield credit spreads (see chart below) have fallen by two-thirds from their recession highs, when as many as half the companies in the U.S. were expected to be out of business within five years. Let me simply suggest that the facts do not support the angst reflected in today's confidence report.


More thoughts on the FOMC's new policy


The Fed's decision earlier this week to announce that its target interest rate would remain "exceptionally low" for at least two years was not only unprecedented in the annals of central banking, but would have been previously inconceivable. So the impact and import of the announcement has taken a few days to sink in. Today's disastrous 30-yr T-bond auction provided the first evidence that the world does not like what it sees. 30-yr yields jumped almost 20 bps on the auction results, and the 10-30 spread has reached its widest for the year, now only 15 bps shy of the all-time high reached last November on the eve of the launch of QE2.

The Fed's extreme and unprecedented efforts to provide monetary stimulus to the economy are undoubtedly contributing to the market's deep sense of unease, with Europe being the biggest source of concern for the moment (more on that in a subsequent post). What is disconcerting is that this new twist to Fed policy is also contributing to rising inflation expectations, even as the economy struggles. Is aggressive monetary stimulus really necessary? Worth the risk of igniting higher inflation? Will it work, or will it just create more bubbles and distortions?

QE2 didn't have any immediate effect on the economy or on the money supply, because banks decided to hold on to the extra reserves the Fed dumped into the banking system, but it probably helped weaken the dollar. But now, the promise of two years or more of super-low funding costs will almost certainly galvanize the banking industry and the institutional investment community. Banks stand to make handsome profits with an outsized and semi-permanent gap between their funding costs and their loan portfolio, and they can even make hay by buying Treasury notes and bonds, since the Fed is basically guaranteeing that the yield curve will be positively sloped for at least two years. Institutional investors can borrow at rates only slightly higher than the funds rate, and use the proceeds to leverage themselves into a variety of attractive situations—anything that promises to yield more than 1% or so.

The Fed is encouraging everyone to take on more risk by borrowing, leveraging up, moving out the yield curve, or shifting money from relatively riskless CDs to riskier bonds, stocks or commodities, and I have to believe that they will be successful. Not many will want to look this gift horse in the mouth. Sooner or later we should see faster growth in the money supply, a weaker dollar, stronger commodity prices, higher real estate prices, higher stock prices, and—of course—higher inflation. Whether we will see a stronger economy is the real question.

In a sense, the Fed is gambling that the promise of cheap money will trump the concerns that have kept markets and businesses depressed: fears of rising tax and regulatory burdens, of another real estate collapse, of a sovereign default or two, and of a Eurozone banking collapse. By weakening the demand for money, this gambit should at the very least result in faster nominal GDP growth by increasing the velocity of the existing money supply; it's the composition of that faster growth (i.e., how much is real and how much is inflation) that is the unknown at this point. There will be less hoarding of money, more risk-taking, and more lending and borrowing. But will the money be directed to productive, job-producing activities, or just to consumption and speculative activities?

I'm willing to bet that we will see at least some pickup in growth, if for no other reason than I think that at least some of the increased risk-taking the follows from this new policy will prove productive.

Federal budget update


The Federal budget numbers for July came in a bit better than expected, with the result that the 12-mo. deficit fell from $1.26 to $1.23 trillion. Thank goodness for small favors: the budget deficit is now running at about 8.2% of GDP, which is down from a post-War high of 10.4% at the end of 2009. The improvement is due to the fact that revenues have grown at just under 9% over the past year, while spending has grown by just under 3%.

Note to would-be optimists: the recently concluded budget deal would allow for spending to rise by at least 4-5% per year going forward (contrary to press reports, nobody was ever talking about actually cutting spending). Thus, the main hope right now for continued improvement in the budget outlook is for the economy to continue adding jobs, since a rising employment base is generating more income taxes. As the chart above shows, it is not unusual at all for revenues to rise at a fairly strong pace as the business cycle advances; it doesn't take higher tax rates to generate rising tax revenues—just a bigger economy will do the trick.

With the Fed in hyper-expansive mode, and given the inability of monetary policy to create growth out of thin air, what we are likely to see in the next few years is an acceleration of nominal GDP growth (e.g., modest real growth plus faster inflation). While this won't push living standards up by much, it should result in higher federal revenues as incomes rise and as people find themselves moving up to higher tax brackets. And of course, higher inflation will erode the burden of our $9.9 trillion of federal debt outstanding, even as it pushes Treasury yields and borrowing costs higher. So there is some reason to think that the budget outlook won't spiral out of control, as long as Congress takes steps in coming years to rein in the growth of entitlement spending (e.g., by raising the retirement age, by indexing social security payments to inflation rather than nominal wage growth, by privatizing social security, and by introducing market incentives to healthcare market and eliminating tax preferences and deductions).

Thoughts on gold


In inflation-adjusted terms, gold prices in the past century have been higher than they are today for less than two months, from mid-January 1980 through early March 1980. The peak nominal price of gold ($850/oz.) occurred on January 21, 1980, and would correspond to about $2,450 in today's dollars, according to my calculations using the CPI. If history repeats itself, gold could gain another 35% or so briefly, after already rising over 700% in the past 10 years, before becoming one of the worst investments in the world for the next decade or two.

Gold is riding the crest of a perfect storm these days. Geopolitical turmoil is all around us, with even the staid streets of the U.K. beset by mindless violence. Several of Europe's most venerable countries are teetering on the brink of default. Almost every major central bank in the world is trying hard to get inflation to move higher. In inflation-adjusted and trade-weighted terms, the dollar is at an all-time low against a large basket of currencies. The Fed has just announced that it will keep short-term rates unusually low for at least the next two years, thus inviting rampant speculation and leveraging. Gold is the traditional safe haven for political and monetary risk, and there is plenty of both to go around.

Indeed, it's hard to imagine conditions being more favorable for gold. Except for one thing, which is that it is becoming quite expensive relative to other goods and services. It has only rarely been more expensive to buy gold. Some say it could go to $2500 or even $5000 per ounce, but no one really knows. As a value investor, I look at the potential upside (35%) versus the potential downside (-80%?) and I shy away. The risks are very disproportionately skewed to the downside. What could trigger a gold collapse, and could it happen soon? I doubt that any gold-killing development is going to surprise us soon, but when it does (and it inevitably will happen), it could be the news that inflation is making an obvious comeback. That would be enough to get central banks to reverse course by raising interest rates.

The real meaning of today's FOMC announcement

By indicating that it is likely to keep the federal funds rate "at exceptionally low levels ... at least through mid-2013," the Fed has done more with a few words than it could have done with a QE3, while avoiding the need to monetize more of the Treasury's voluminous debt issues. This is big news.

By promising to keep short-term rates near zero for at least the next two years, the Fed has driven a stake through the heart of money demand. Why hold on to money if it is going to pay you almost nothing for the next two years? Why not borrow all you can (institutional investors can borrow money at close to the funds rate) and buy anything that promises to pay at least a positive yield? The 25 bps collapse in the 10-yr Treasury yield in the hour following the FOMC announcement was the market's way of understanding this. Two years of almost-zero borrowing costs means that you can "sell the curve" (bondspeak for betting on a flatter yield curve, or borrowing short and investing long) with impunity.

Initially, bond yields fell on the news that the Fed sees so much weakness in the economy that it is ready to all but guarantee very low rates for years to come. But on reflection, what the Fed has done is to jumpstart simmering inflation expectations, which will eventually steepen the long end of the curve. The Fed can control short-term rates at will, and rates out to 5 and 10 years by extension, but it can't control rates much beyond 10 years, and it certainly can't control 30-yr rates. Already today we have seen the 10-30 spread widen by almost 10 bps, reaching a new high for the year. The bond market's knee-jerk reaction to surprise Fed announcements is often wrong, and this is a case in point. Same with the equity market: the S&P 500 fell 3% in the first 30 minutes following the FOMC announcement, and has now bounced back by 5% and looks set to close the day with solid gains.

Although weakening money demand and stimulating borrowing and leveraging is not necessarily a good thing for the dollar (understandably it has fallen since the announcement), it is not necessarily a bad thing for equities. Corporate profits have been stellar, and earnings yields are pushing 8%, so borrowing money at almost-zero to buy equities is a license to print money.

Today's FOMC announcement was one of the most convincing ways to encourage people all over the world to spend their dollars and borrow more that I can imagine.

Why we don't need a QE3

Today the FOMC is meeting, and because the world's equity markets suffered a near-meltdown yesterday, all eyes are on the Fed. Will they come to the rescue with another round of quantitative easing? I sure hope not.

With the benefit of hindsight, Quantitative Easing, as practiced by the Fed in late 2008 and from Oct. '10 through Mar. '11, was justified since at the time it helped satisfy the world's intense demand for highly liquid, dollar-based safety. A failure to satisfy a surge in the demand for dollars would have been deflationary, since it would have resulted in a shortage of dollars. The need for more dollar-based liquidity can be seen in certain market-based indicators prior to each round of quantitative easing.


The above chart is arguably the best measure of the value of the dollar relative to our trading partners, since it adjusts the dollar's nominal value for changes in relative inflation. As it shows, the dollar rose prior to the onset of each round of Quantitative Easing, signaling that the world's demand for dollars was exceeding the Fed's willingness to supply dollars. Following each round of QE, the dollar's value fell, which in turn suggests that the Fed ended up over-supplying dollars to the world. Unfortunately, the dollar is now at its lowest level ever. There is no sign now of any shortage of dollars or unsatisfied demand for dollar liquidity. Just the opposite: the world is awash in dollars. More dollars would only depress its value further, resulting in rising inflation.


This chart shows the market's forward-looking inflation expectations, and is derived from the yields on 5-yr TIPS and 5-yr Treasuries. First, recall that 1997 was the year that S.E. Asian currencies plunged against the dollar. Huge devaluations created an intense demand for dollars at the time, but the Fed ignored this and remained in a tightening mode through early 2001. Inflation expectations plunged as a growing scarcity of dollars led to a very strong dollar in early 2002 and eventually to the U.S. economy's flirtation with deflation in 2002-2003. Second, note that QE1 and QE2 both came at a time when inflation expectations were falling, a sign that the Fed needed to respond to an emerging scarcity of dollars. Today, however, inflation expectations are rising, and that argues strongly against another round of quantitative easing.


This next chart just makes the point again. Not only were sensitive market-based indicators signaling the need for quantitative easing, core inflation measure were also. The core CPI suffered some significant declines in the months preceding the onset of each round of quantitative easing. Currently, however, most measures of inflation are rising, and that argues strongly against another round of quantitative easing.

There is a common thread to most of the world's economic and financial problems these days, and that is excessive government intervention in markets and excessive government spending financed by debt. Decades of policies designed to make housing more affordable gave us the housing bubble, and policies and government subsidies geared to make it easier for people to get mortgages gave us the subprime mortgage crisis. Together, they almost brought down the global banking system. Generous government pensions and early retirement have bankrupted Greece, and our own social security and medicare systems are critically under-funded thanks to politicians' inability to resist the urge to increase benefits without regard for costs or the discipline of free-market price mechanisms.

It's time for policymakers to take a deep breath, step back, and let markets sort things out for a change. No matter how smart they may be, technocrats can't match the collective wisdom of free markets. Please, no more quantitative easing, no more extensions of unemployment benefits, no more taxes, no more regulations, no more mandates, no more stimulus. Victor Davis Hanson explains this more eloquently than I can:

We are witnessing a widespread crisis of faith in our progressive guardians of the last 30 years. ... We are living in one of the most unstable — and exciting — periods in recent memory, as much of the received wisdom of the last 30 years is being turned upside down. In large part the present reset age arises because our political and cultural leaders exercised influence that by any rational standard they had never earned.

If the Fed screws up enough courage to take a pass on QE3 today, I for one will breath a huge sigh of relief.

UPDATE: Following its meeting, the FOMC's statement noted that the economy had weakened considerably, but refrained from announcing another quantitative easing program. Instead, the statement said that it likely would keep short-term interest rates "at exceptionally low levels ... at least through mid-2013." Markets are reacting with apparent disappointment (yields down and equity prices down, both reflecting weaker growth expectations), but it's not unusual for the market's initial reaction to a monetary disappointment to be wrong. The market was hoping for additional easing, and so is disappointed by the lack of a QE3. In my view, no additional easing is good news for the dollar, and that in turn is likely to prove good for the economy.

A genuine selling panic




If genuine mass panic signals a bottom in equity prices, then this is shaping up to be a great buying opportunity. The Vix index has only been higher twice in history: during the peak of the Lehman crisis/financial panic in Oct. '08, and during the great market crash of Oct. '87. The combination of a very high Vix (panic) and a very low Treasury yield (recession/depression fears) has only been worse during the Lehman/financial crisis. This might not be the exact bottom, but we must be getting pretty close.

Adding to the panic, I believe, is the perception that the White House is clueless. Obama's speech earlier today was abysmal. Once again he blamed Republicans and the rich for refusing to cooperate. Once again he insisted that the way to fix things is to extend unemployment benefits, extend the payroll tax cut, and build more infrastructure. These things have been tried and they have failed miserably. Is there no one Obama trusts who can better advise him on how to get out of this mess?

The unintended consequences of the Treasury downgrade

Last month I had a post on the likely consequences of a Treasury downgrade, and it now looks prescient. Those who are unfamiliar with the law of unintended consequences might have thought that a Treasury downgrade would make Treasuries less attractive, driving up their yield. Now we know that just the opposite has happened: Treasury yields have plunged in the wake of the downgrade. But there's more to the story, since the plunge in Treasury yields has been accompanied by a surge in the yields of junk bonds. The explanation for why this has happened is in the post referenced above. The short answer is that a Treasury downgrade has reduced the average quality of the world's bond portfolios, and many of those portfolios are being forced to sell their low-quality bonds and buy more Treasuries in order to bring their average quality back up to where they want it.

Spanish and Italian yields plunge


The ECB started buying Italian and Spanish debt in size today, and yields have plunged. This chart of 2-yr yields compares Italy (orange line) to Spain (white line). This is marginally good news, since it has sharply lowered their default risk, but of course it does nothing to fix the underlying problem, which is that both countries (like ours) suffer from an excess of government spending. Big government consumes a big amount of an economy's resources in an inefficient manner, thus reducing an economy's ability to grow. The damage has been done, and it can only be reversed if government spending is reduced. The only good side to this global crisis of big government is that it has drawn the attention of electorates all over the world who will now be challenged to put things right.

The downgrade: let the elections begin!

S&P's downgrade of U.S. government debt was without doubt an historic event, and for all the obvious reasons, not least of which is that this was unprecedented, and it throws a wrench into every theory of efficient markets. If U.S. debt is not without risk, then where in the world can highly liquid and risk-free investments be found?

Of course, markets knew even before the downgrade that U.S. fiscal policy was on an unsustainable course. The downgrade added nothing to the world's understanding of the increasingly fragile outlook for U.S. finances. It was clear long ago that something had to change, but for years the majority of the politicians of both parties had steadfastly refused to acknowledge the problem.

The greatest impact of the downgrade will be on the future course of U.S. politics, because the downgrade sets the ground rules for next year's elections. The question around which all political discussions will revolve for the next 15 months is this: is the U.S. government's fiscal problem one of too much spending, or insufficient taxation? This election will be about the proper role of government, and that is an issue that is long overdue to take center stage.


To properly set the stage, I offer the chart above. Importantly, I would note that spending as a % of GDP is set to increase significantly absent any attempts to reform entitlement programs, most notably ObamaCare and Social Security. Meanwhile, revenues have been increasing at a 10% annual rate for over a year even as the economy posts only meager growth and tax rates have not risen at all. In my view, the problem is clearly one of too much spending, but this is an issue which needs to be decided by the electorate next year.


If there is any obvious cause of the revenue shortfall that we are experiencing, the above chart points the finger to the weak recovery. Income taxes have fallen more than anything, and this is a direct function of the fact that total employment has fallen by more than 6 million in the past three years, and the unemployment rate is over 9%. Get the economy on a faster growth track, with more people working and paying taxes, and federal revenues will almost certainly boom. The revenue side of our fiscal problem has its roots firmly planted in an anemic recovery.

The solution to our fiscal problem has its roots firmly planted in partisan politics. What is the best way to boost growth and thus solve the revenue side of our fiscal problem? Spend more or tax more? Should spending as a % of GDP increase, or should it decrease? Should government do more or do less?

As a supply sider, I believe that there is no reason to raise tax rates. In fact, I would argue strongly that tax rates should be held steady or reduced, especially corporate taxes. As a student of how the world works, I believe that more government is not the solution to our problems, since government can never be as efficient as the private sector. Less government, especially considering how much it has grown in the past few years, and how much the economy has struggled, is the solution.

But I'm not in charge, and the people will have to decide in November 2012 which direction we should take. The next year or so will be one of the most exciting and eventful times in decades. Let the elections begin!