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Entering the Debt Dimension
Excerpt from Stock World Weekly
We ended last week’s newsletter explaining why we were not betting on an announcement for more quantitative easing by the Fed, although “consensus” economists claimed to be. We argued that additional QE was unlikely, citing our friends (Bruce Krasting, Lee Adler of the Wall Street Examiner, and Jon Hilsenrath - with his direct line to Bernanke). This week, those expecting easing were disappointed; there was no mention of launching any new program for large-scale asset purchases.
But the Fed did extend the period it anticipates keeping interest rates at or near zero percent (ZIRP). (See Wednesday’s press release here) The Fed also plans to continue its program to extend the average maturity of its holdings of securities, Operation Twist, and to maintain its policy of reinvesting principal payments from its existing holdings, including mortgage-backed and Treasury securities. It is currently holding nearly $3Tn in total assets. The returns from those assets are significant, and the Fed’s balance sheet is continuing to grow even after the end of its asset purchase programs.
In response, Bill Gross (co-chief investment officer of PIMCO) tweeted that this announcement was the equivalent of “QE 2.5,” while Bruce Krasting wrote, “Well, we got an inflation target from the Fed. Basically, thinking at the Fed has been eliminated. The process has been automated. Bernanke has convinced the Fed board to adopt Core PCE as a determinate of monetary policy. So long as CPCE stays below 2%, Ben is going to have his foot planted on the monetary metal. It’s ‘full speed ahead’ according to the Chairman. He's pushed things off until 2014 - a very long time from now.” Bruce goes on to explain the major flaw in Bernanke’s reasoning, and how this decision has made him “a slave to a single dopey statistic.” (Bernanke Goes All In)
In Jesse's (of Jesse’s Cafe Americain) words:
“This statement shows a longer term commitment to de facto QE at least. The Fed does not need to further expand its balance sheet just yet, but rather deploy those funds strategically while engaging in swaps with other central banks to counter the financial risks globally.
“I suspect that before they formally announce a further expansion of their balance sheet, the Fed will go 'off-balance sheet' in the easing as financial firms are often wont to do when engaging in opaque accounting. The swaps and noncompetitive bidding for balance sheet assets may be a part of this.
“I do not object to stimulus per se, but rather this type of blunt policy that does not address or repair the problems that led to the financial bubble and collapse in the first place.”
In Jesse's view, and we agree, the “yawning gap between productive labor and mere money manipulation” needs to be closed, and hard choices are required to resolve the unsustainable concentration of both power and risk.
“Demagoguery and deception in support of the status quo seems to be the rule of the day in the financial sector and its associated professions and exclusive clubs.
“Therefore self-regulation, restraint, and reform are a thin bet to say the least. The crisis is more like to continue to expand, and the taint of corruption and crime continue to spread.” (FOMC Statement - Targets 2% Inflation - Highly Accommodative Monetary Policy Until ‘Late 2014’)
One problem with large, public programs such as QE2 is that everyone jumps into the same side of the trade, e.g., going long equites in the famous “Tepper Put” that dominated the markets while QE2 was operating (buy stocks, you can’t lose). Using more low-key, less blatant ways of injecting liquidity into the financial system, Bernanke is continuing to provide stimulus while pretending to be an inflation hawk.
On Friday, Fitch downgraded Italy, Spain, Belgium, Slovenia and Cyprus. Ireland was affirmed at BBB+, but received a negative outlook. Fitch maintained that the European leaders’ “gradualist” approach in tackling the crisis means that Europe will continue to face periodic episodes of severe financial volatility, and this will erode the governments’ ability to repay their debt obligations. “The eurozone crisis will only be resolved as and when there is broad economic recovery. It is evident that further substantial reforms of the governance of the eurozone will be required to secure economic and financial stability, including greater fiscal integration.” (Fitch downgrades 5 eurozone nations)
Chris Martenson argued that it’s time for hard decisions: “Back in the 1930's, Irving Fisher introduced a concept called the ‘debt supercycle.’ Simply put, it posits that when there is a buildup of too much debt within an economy, there reaches a point where there simply is no other available solution but to let it rewind.
“We are at that point in our economy, as are most other major economies around the world, claims John Maudlin, author of the popular Thoughts from the Frontline newsletter and the recent bestselling book Endgame: The End of the Debt Supercycle and How It Changes Everything.
“For the past several decades, excessive and increasing amounts of credit in the system have allowed us to live above our means as both individuals and nations. We've been able to have our cake and eat it, too. Now that the supercycle has ended and the inevitable de-leveraging cycle is staring us in the face, we will be forced to set priorities in a way that has been foreign to our society for over a generation.” (Chris Martenson Interviews John Mauldin: “Time to Make the Hard Decisions)
Greece has been struggling with hard decisions as it attempts to negotiate a “haircut” with creditors. Russ Winter of Winter Watch at Wall Street Examiner commented,
“I spotted some interesting commentary on the maturing March 2012 Greek bonds. After buying at 40-45 cents, it seems the hedge funds are trying to unload in a bid-less 35-cent market. The ECB has the largest stake, bought at 70 cents. This official holder’s dominance of this market, and refusal so far to participate in haircuts, is making the whole exercise futile and severely subordinating any potential non-official holder or future buyer of European sovereign debt.
“Reuters reports that the ECB is split and confused on this issue. The IMF’s Lagarde says, ‘If the level of Greece’s privately held debt is not sufficiently renegotiated, then public creditors will also have to participate.' Apparently, the IMF was also confused as this was retracted or denied. As I wrote in “Stick it to the Local Issued Bond Holders,” this is one of two serious subordination fiascos, the second being a slew of UK-law non-local issues that restrict collective restructuring actions.” (Pushing Non-Official Holders of Local-Issued European Debt into Subordination) (Zero hedge/Bloomberg chart below).
Simon Johnson warned:
“In the event of default (i) any non-official bond holder is junior to all official creditors and (ii) the issuer reserves the right to change law as needed to negate any rights of the nonofficial bond holder.
“We should not underestimate the damage these steps have inflicted on Europe’s €8.4 trillion sovereign bond markets. For example, the Italian government has issued bonds with a face value of over €1.6 trillion. The groups holding these bonds are banks, pension funds, insurance companies, and Italian households. These investors bought them as safe, low-return instruments that could be used to hedge liabilities and provide for future income needs. It was once hard to imagine these could ever be restructured or default.
“Now, however, it is clear they are not safe. They have default risk, and their ultimate value is subject to the political constraint and subjective decisions by a collective of individuals in the Italian government and society, the ECB, the European Union, and the International Monetary Fund (IMF). An investor buying an Italian bond today needs to forecast an immediate, complex process that has been evolving in unpredictable ways.” (The European Crisis Deepens)
People familiar with the story of the MF Global implosion, and the struggles of thousands of people to recover funds from the bankrupt former primary dealer, will have no trouble understanding the problems with recovering assets during bankruptcy proceedings. (MF Global Clients May Lose in $700 Million Bankruptcy Fight) For a recent update, see Zero Hedge's "3 Months After The MF Global Bankruptcy, We Find That $1.2 Billion (Or More) In Client Money Has 'Vaporized.'"
As sovereign nations in the eurozone struggle to acquire funds to service their existing debt obligations and issue new bonds, investors who might be inclined to buy those bonds are finding themselves in an increasingly hostile environment for private bondholders. Non-governmental holders of this debt are likely to find themselves on the wrong side of any negotiated settlement between private creditors and sovereign bond issuers.
Friday saw a stunning development in the Greek drama, with Reuters reporting that Germany “is pushing for Greece to relinquish control over its budget policy to European institutions as part of discussions over a second rescue package” according to a “European source.”
Tyler Durden of Zero Hedge observed, “Sure enough, earlier today Der Spiegel broke the news that the second bailout, which has yet to be re-ratified, and absent Greece meeting demands to cede fiscal sovereignty, is likely a nonstarter, would be increased to €145 billion ‘citing an unidentified official from the so-called troika.’ So whether or not this is true is irrelevant: what matters is that Spiegel released the article in the same series of posts in which it explained just why Germany has full right to demand (via European enforcement mechanisms or however) virtually anything in exchange for the ongoing endless bailout (such as: Merkel macht Wahlkampf für Sarkozy and Griechenland sträubt sich gegen EU-Aufpasser). Which means one thing only: the great propaganda spin machine is now on, and its only purpose is to provide Germany a buffer of ‘having done everything in its power’ to prevent the now inevitable Greek default. Which, incidentally, means that a Greek default is inevitable.” (Cost Of Second Greek Bailout raised To €145 Billion)
Lee Adler of the Wall Street Examiner reviewed last week’s activity by the Fed, and the potential impact on the Dollar.
“Treasury yields reached the top of the recent range and appeared headed for a breakout when along came Ben, with his mighty arms outstretched he lifts up the playing field and tilts it, and back down yields went, in spite of the big week of Treasury auctions and the market facing a big wad of new paper to settle next week. It didn’t matter. Ben gave the all clear on the carry trade for 3 more years, although I don’t know how much carry you can get when 10 year yields are less than 2%. I guess if you use enough leverage…
“We know this is going to blow up sooner or later. All we can do is watch the chart for signs. For now, the trading range that looks like a bottom in yields is intact. And so is the idea that the Fed at least, can make the market do what it wants, when it wants. But I heard that Bill Gross is loading up on Treasuries again, after missing, or being short, through the whole rally. If that’s not a sell signal, what is?...
"Federal withholding taxes, which were going bonkers, are starting to come back to earth but are still way higher than last January. We still don’t know if this is a new uptrend or just a bulge from sources unknown. The timing coincided with the massive ECB Long Term Refinancing Operation equivalent to $600 billion pumped into the world banking system all at once... Whatever the reason, the unexpected windfall for the Federal Gummit has enabled it to significantly cut the size of the debt offerings for the past month. There’s a question as to how long that good fortune will last, but for now, that’s the story."
Looking ahead to next week, Phil remains skeptical of the current rally. “Of course the headline in the WSJ is ‘US Economy Gathers Pace’ because, as you can see from Cramer's bullish rant last night – they're still herding all the lambs in for the slaughter at the top of the market.”
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