Gold, the EU and the Fed

Central bankers hate gold. That’s surprising given that they collectively own the lions share of what’s out there. The record is pretty clear however, most of the majors have sold gold over the past few decades. Today they have even more reason to hate it. It makes them look bad. This chart shows that both the Euro and the dollar are losing the race against gold as a store of wealth.

That the Euro is hitting all time lows against gold is an old story. But the move has gone parabolic of late, including a 3% pasting today

A very high percentage of Europeans own some gold. Much more than Americans. Younger people who don't own gold have parents that do. They are more aware of gold as an asset class and something to turn to when there is trouble. Therefore the collapse of the Euro against gold is much more relevant then the fall in the EURUSD. EURGOLD is probably the best barometer of how desperate Europeans see their collective financial future. This does not bode well for consumer or business confidence.

The US Fed is adding to the misery of the EU Central bankers. They are part of the problem, not part of the solution. They are contributing to the appreciation of gold at a time when the Euro is weak versus the dollar. This creates the exponential price action in EURGOLD.

Many things are influencing gold of late. Inflation in China, nuts shooting cannons, a melt down of Europe’s financial picture and of course the biggest of all is the Fed and its effort to create inflation as a policy goal. What does this story from the WSJ do for gold?

It’s a good bet that Ben Bernanke and his talking heads will get their way. Actual inflation, and even worse, expectations of inflation will rise. Gold will rise against the dollar as a result. It’s an equally good bet that the Euro is headed lower against the Buck. So the measuring stick that Europeans look at is going to get even more stretched. I wonder if those European central bankers (and a few political leaders) are hating Ben for adding to their woes.

BABS are a Cali Subsidy

The Build America Bond program will be a topic of discussion today when Obama meets with Congressional Republicans. Like the Bush tax cuts the enabling legislation for BABS is set to expire in a month. I don’t think the BABs extension is going to meet with any opposition. While it is a side show to the tax issue; BABs is probably more important. If it isn't extended there is going to be a blowout in the tax-exempt Muni market. Should that happen you can kiss off any hopes of extending the economic recovery. Failure to extend BABs would trigger a (new) fiscal crisis for California. That would quickly spread to a few other key states.

BABs are taxable securities that offer municipal/state issuers a 35% subsidy on interest costs. The subsidy was supposed to be revenue neutral at the federal level. The theory was that the average tax revenue would be close to the 35% paid out. It hasn’t worked like that. The BABs bonds paid a nice yield and were gobbled by investors whose tax rate was closer to zero than the 35%. So the cost falls on the taxpayers and adds to the deficit. So which states are lining up deals that are fleecing federal taxpayers? Mostly Dead Beats (excluding Texas).

BABs creates a tax arbitrage at the expense of taxpayers and to the benefit of (largely tax exempt) investors. The subsidy works. It allows states to pay up in yield while at the same time achieve a net interest cost that that is acceptable. The WSJ had this to say about a Cali BABs deal last week:

The BABs were said to have attracted twice as many bids as the amount on offer, even after the state increased the size of the deal by $525 million because of the strong investor demand.

This comment from the California Treasurer’s spokesman says it all:

"California's struggling? Hardly. We're not struggling. We're succeeding. We're doing a job that's vital to California's fiscal and economic health, and doing it at the best possible price for taxpayers."

If you were a taxpayer in Cali this statement would probably be accurate. But federal taxpayers are being bled to death in support of Cali.

How important is the BABs program to the stability of municipal finances in America? What might happen should Washington fail to pass an extension that keeps the window open a bit longer? Consider this comment from the Bond Buyer:

If the Build America Bond program expires at the end of this year, long-term tax-exempt bonds could lose their latest pillar of support.

I agree, except I would be more blunt. If BABs is not extended the Muni market will get smoked. The epicenter of the fire will be California, followed very quickly by New York. Knowing that, D.C. is going to kick BABs down the road. If they don’t, about $3 trillion in stimulus money spent over the past few years will have been wasted. If Cali/NY tank,  all the lights go out. We are much more economically fragile than we lead ourselves to believe.

Drop Dead in the Future? What About Today?

The surprising (to me) result of the Irish bailout is the related agreement by EU leaders to force bond-holders to face a haircut should an EU state become “insolvent” after 2013. I think this was done in an effort to placate the many voices that are saying “no” to the state bailouts. It sounds as if the leaders are responding; “We will fix this problem now, but in the future will let the chips fall on the bondholders back.”

That may sound like a reasonable approach. I see some unintended consequences. From the WSJ:

Creditors of euro-zone countries that face insolvency after 2013 will see their bond holdings restructured.

Okay, we get that. After 2013 holders of bonds of troubled countries get hit. But what happens between now and 2013? Again from the Journal:

Ms. Merkel has stressed in that the proposal would affect only bonds issued from late 2013.

Wait a second. If bonds issued after late 2013 are at risk, does that mean that bonds issued before 2013 are not at risk? That sure is what it sounds like to me.

The bond market is going to call this bluff. There are Greek, Irish and Spanish bonds that are trading at 9%, 7% and 5% respectively that are the buy of a lifetime if I am reading this right. Who wouldn’t want to buy a nice 9%, ten-year Greek bond that was also guaranteed as to payment by the big hitters of the EU? A “fully” guaranteed bond would trade closer to 3% than 9%.

So I am left confused by this development. Other questions:

-If the “at risk” provisions for all existing EU sovereign debt is somehow eliminated you have to ask; who is making the promise that all that debt is money good? The ECB? I would think not. We are talking of a few trillion Euros if you add in Spain and Italy. You need a big stick to guarantee that nut.

-What the hell is going to happen in 2013? By setting a “date certain” situation where the status of a borrower changes from one day to the next is just begging for a crisis. Depending on the circumstances one of the countries could be blocked out of the credit market overnight. This plan is a set-up for failure, not success.

It’s possible that I (and the Journal) are reading this wrong. We shall see. It will show up in bond prices and CDS spreads. This could also be something that later gets clarified. That will be interesting. The headline for that might be:

Merkel Changes Direction

“Current Debt Not Secure”

I think the EU finance ministers botched this up by including the, “Drop Dead In the Future” policy. The markets will provide it’s own vote. There may be a knee jerk up move for the Euro. Relief? I don’t like this development. I would fade any rally.

Hot Money

A few years ago the issue of Americans with Swiss banking accounts exploded onto the headlines. The US Justice Department held no prisoners in its effort expose and resolve the problem. It nearly crippled UBS in the process. It ended with changes in Swiss law.

The consequence has been that NO US PERSON can open account outside the United States without agreeing in advance that every aspect of the account will be reported to the IRS. The door is closed for hot money outside the USA. That is a very positive development. Every country should follow the shining example of the USA. We have set a new standard for disclosure. The world would be a better place if American standards and practices were followed around the globe.

But there is one aspect to this puzzle that has bugged me for the last few years. My question is;

“What happened to the 2/9/2009 letter addressed to Treasury Secretary Tim Geithner from the Mexican Finance Minster, Agustin Carstens, requesting information from the US banks on accounts maintained by Mexican nationals in US banks?”

Back in 09 Time magazine had a story on this titled, “Foreign Tax Cheats Find U.S. Banks a Safe Haven”. From that article:

the U.S. effectively serves the role of Switzerland for Mexico, which suffers from rampant tax evasion..  Much of the estimated $42 billion a year of illicit funds flowing out of Mexico each year (not including drug cartel money) ends up in U.S. banks

The letter from the Mexican finance minister seems straight forward enough:

"The exchange of information on interest paid by banks will certainly provide us with a powerful tool to detect, prevent and control tax evasion, money laundering, terrorist financing, drug trafficking and organized crime,"

Who could argue with a proposal that would accomplish all those worthwhile goals? The language from the IRS on reporting interest income on foreign account holders is the problem:

Interest on Deposits
Generally, no withholding (or reporting) is required on interest paid to foreign persons on deposits if such interest is not effectively connected with the conduct of a trade or business in the United States. For this purpose, the term "deposits" means amounts that are on deposit with a U.S. bank, savings and loan association, credit union, or similar institution, and from certain deposits with an insurance company.

In May of this year Switzerland signed tax treaties with a number of neighboring EU countries. UBS lost $40b worth of deposits as a result. The other public and private Swiss banks lost deposits as well. One can assume that US banks would suffer from similar withdrawals of foreign money should America follow Switzerland’s example.

I am left wondering what happened to the Mexican letter to Geithner. I can’t trace a resolution to Mexico’s formal request. If anyone reading this can point me to how this was resolved, I would appreciate it. If it wasn’t resolved, and the US is still a safe haven for hot money I have to ask; Why?

The "Fixes"

It’s not just the Bush tax cuts that expire at the end of the year. The maximum lending limits at Fannie Mae, Freddie Mac and FHA  were set to expire. The Build America Bond (“BAB”) program is another. They both have been “fixed”. We kicked the can down the road (again) while no one was looking.

Way back in 2008 when we were really in a financial crisis there was no private mortgage market. The banks were all in the crapper and they were not lending a dime. Without a viable mortgage market there would have been a complete collapse. The maximum lending limits of the D.C. mortgage providers were set at levels designed to support the bottom end of the housing market. In response to the crisis the HERA legislation allowed for a very significant, but temporary, increase in the statutory lending limits. Those temporary increases were supposed to be reversed as of 12/31/2010. They weren’t reversed. They were extended.

These critically important extension of federal subsidies to the mortgage market were lumped into a number of other fixes necessary to keep the government moving for another year (Sen. Byrd’s grandchildren get $197k?). The language that “fixed” the problem can be found at this site. The specific wording is at the bottom, in sections 143-146. There was no debate on this. Washington just passed the trash.

The Bond Buyer reported on Wednesday that BABs were going to “fixed” as well. The BABs program is another child of 2008 and the HERA stimulus program. The history is not unlike the Agency debt limit issue. In 2008 there was not much of a Muni market left. States were being locked put of the credit markets. Without capital they could not fund projects. The BABs legislation created a new security to allow the states to tap a different capital market. States were permitted to issue taxable bonds. These bonds had higher yields than traditional Muni bonds as they were not tax protected. To offset the cost, the Treasury department is reimbursing the states for 35% of the interest bill. With the federal subsidy the states were again able to issue debt.

Two years later the Muni market is in much better shape. But it is still on weak legs and D.C. desperately needs the states to spend money to support the economy. So the BABs legislation will be extended for another year. The municipalities are issuing billions of long-term bonds under the program. The federal subsidy will be doled out for 20 to 30 years as a result.

I don’t think there was much choice in the extensions of the emergency steps taken back in 08. If mortgage limits were dropped in the key area on both coasts from the ~$750,000 limit back to the pre-emergency levels of ~$450,000 the real estate market would collapse. Should that have happened we would have been in a deep dark recession in just a few months.

Similarly, we would be dead if the Muni market shut down. If state borrowers were forced to pay fair market rates for debt, they would not borrow. As a result they would not spend. Deep cutbacks in key states would have followed. Unemployment would shoot up in that scenario. Absent the BABs program a number of states/cities would have been forced into insolvency.

Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.

Some say that legislative gridlock is a good thing for the markets. History suggests this is correct. 2011 may prove an exception to the rule. There are too many things on the plate.

Speaking of which, enjoy that other plate that is front of you today.
bk

Wired

I know a fellow who used to run a decent amount of equity money. His specialty was retail stocks. He had a good track record. He took maximum advantage of the quarterly income reporting cycle of a few medium sized, well know big box retailers. He played that game from both the short and the long side. If you catch that right you can make some good money.

This group hired a number of part-timers around the country. These people would sit outside a specific store with a hand counter and measure traffic. Traffic does not equal sales. But if you have hard numbers on traffic your estimate on sales will be better than most.

So they had an edge. They earned it and benefited from it.

Could you define the information they obtained as “material”? Sure you could.

Could you define this information as "non-public"? Sure you could.


Should we be in the process of unfolding the onion of what has been defined as insider trading there is going to be a very big surprise. I think that all successful hedge funds and big investors have “counters” that are gathering/reviewing data. They all have (or try to have) an edge. What do you think they are paid 2&20 for?

I have said this forever. If you’re a small investor relying on public information you don’t have a chance. The S&P is ‘unched’ for a decade. Wired money made a few hundred percent.

My EU Solution

Ambrose Evans-Pritchard at the Telegraph wrote about Portugal recently. It’s not a pretty story, but well worth reading. His conclusion is that Portugal will follow Ireland very soon. AEP ends his piece with:

Any better ideas out there?

I will give it a shot. But first let me say that I do not believe in plans that push problems down the road. I think we would all be better off to let nature rule on the economies. We have already had far too much intervention. Between bailouts, dangerous fiscal policies and downright whacky monetary policies it is hard to determine what is real in the global economy. A good chunk seems to be on permanent life support. That said:

To address the European sovereign debt problem a very big bazooka is required. It is a trillion dollar (equivalent) problem (including Spain, but excluding Italy). No one has that kind of money. For there to be a “solution” to the EU debt problems there has to be a new Brady Plan. It would require cooperation and involvement by all of the big global players including the IMF, Switzerland and China. It would require sacrifice by the countries affected; there would be costs to all EU countries. Lenders and bondholders would have to pay a price.

The Brady Plan relied on zero coupon bonds to securitize the principal of a sovereign borrowers debt. In 1989 Mexico restructured $50 billion of external debt. Holders got a new instrument in exchange for their un-payable old ones. The new bonds had an interest rate that was both favorable to Mexico, but still profitable to the banks (Libor + 13/16th or a fixed rate of 6.5%). The principal of the new bond was guaranteed by a 30 year zero coupon bond issued by the US Treasury. Over a short period of time Mexico’s problems went away and they prospered for many years (so did Brazil and a number of others). Mexico was no longer faced with any rollover risk. The principal had been defeased. They had a stable/predictable debt service cost of the old debt.

It is very hard to recreate the Brady Plan in 2011. The simple reason is that interest rates are too low and zero coupon securitization would cost too much. Outside of the market rate restriction there is the question of who would be the issuer of the new zeros? The USA is not the right answer this time.

In 1989 30-year interest rates were 9+%. Using the miracle of compound interest a 30-year Treasury zero cost only 9.5% of par. Mexico was able to secure the principal on $50b of debt at a cost of only $4.5 billion. Today that zero would cost closer to 30%. Two solutions. The zero must be 40 years and the implicit interest rate must be at 6%. The present value of that theoretical zero is $9.72 today. Using this number, $1 trillion of sovereign bonds could be secured with approximately $100b. That is progress.

Who would be an acceptable issuer to the marketplace of the zeros? My candidate is the IMF. The IMF would love to issue 40-year bonds at a fixed rate of interest, but they most certainly would not be willing to pay 6% to achieve it. A fair rate for this today would be 4.5% so there is a cost of 1.5% that has to be addressed. The cost in the first year comes to a manageable $1.5b (.01% of EU-GDP). But that miracle of compound interest works in reverse as well. Over the 40-year period it comes to a total of $81b. Who would pay this subsidy? In my opinion the cost should be allocated among the EU members. I propose that it be done annually, on pro-rata basis based on GDP. Yes, that implies that Germany and France would carry the heaviest weight. But they also have the most to win (and lose). Germany’s cost would be ~$500 mm in 2011, ~$30b over forty years. What would the alternative cost? Many multiples.

The next hurdle: Assume that Greece, Ireland Portugal and Spain are in need of a $1T recap. Assume the percentages of that are Greece-10% Ireland 10% Portugal 5% Spain-75%. Assume finally that the cost of the zero is 10% of par. You get these capital requirements to initiate the restructuring:

Greece=10b
Ireland=10b
Portugal=5b
Spain=75b
Total=100b

These are daunting numbers. Coming up with this much money is essential to the transaction. This will prove to be the thorniest part of the “fix”.

Each of the countries has reserves that could be used to fund a portion of the capital required. For example, Spain has $25b of reserves available. Reserves are necessary for any country to manage liquidity. A trouble borrower like Spain must have adequate reserves, therefore the amount that each country could come up with is limited. However, post the proposed restructuring the countries will not have any maturities of debt. Their re-financing of future maturities will have been largely eliminated. Therefore they can manage with a lower net reserve position. I believe that each of the countries have the capacity to fund 10% of the required capital. That still leaves a very big hole.

$90b is not such a big number these days. This amount could come from the big surplus countries in the EU. The problem that I see is that this approach creates a political stumbling block. This money could also come from the IMF. But again, I am concerned with the optics of over reliance on the IMF. I would prefer to see that this money is raised from sources outside of the EU/IMF. My two candidates for this are Switzerland and China (the “S&C” loans).

Both countries have very deep pockets of reserves. Coming up with the $90b is not an issue. They both have big stakes in the outcome. Yet, selling this will be difficult. I point again to the fact that post a restructuring the credit profile of the countries will be dramatically improved. Their ability to service the S&C loans should not be in doubt. Therefore the loans are “money-good”. That said, it may be necessary for a broader EU guarantee on the S&C loans.

China would not want to do this. They have plenty of cash, but they may require trade concessions as an inducement. Should something like this happen China would ascend to the top of the list of global Kingmakers. This would blunt some of the criticism that they face on the currency issue. How much would they pay to buy some peace on this issue? Plenty.

Switzerland does not want to do this. Again, liquidity is not the issue; it is politics. In my opinion it is high time that Switzerland step up to the table. I do not want the Swiss (or the Chinese) to take risks on their reserves. I want them to use them to facilitate a broader solution. The Swiss have already spent massive amounts in an attempt to stop the CHF from appreciating against the Euro. If the EU blows up the CHF will soar. This outcome would be broadly negative to the Swiss economy.

I want another role for Switzerland. I want them to be the fiduciary that manages the financial paper work. There is no cost to this; they might even make a buck. Their role would go a long way toward giving the program the necessary respectability.

I feel very strongly that Switzerland must get involved and be part of a solution. They have had a free ride for a decade. It is now time for them to step up to the plate. If they resisted this responsibility I would like to see the EU retaliate with a broad increase in tariffs. A carrot and a stick.

Now the market side of this: I would propose that an exchange offer for new Capital Protected Bonds (“CPBs”) be voluntary. Most of the debt is held by banks. The fact that they would have no future capital risk would mean they could leave the bonds on the shelf forever and never face a write down. I would propose pricing on the CPBs to be close to that of Germany. That concessionary rate is justified as there is no principal risk.

If a holder of a sovereign Spanish bond chose not to participate in the restructuring they would not get paid cash at maturity. They would get a new 5-7 year bond (the “Exchange Bonds” or “EBs”) that have a yield set at EURBOR plus 1. There would be a market price for the EB paper. The holder of the original sovereign bond could sell the new EBs for cash. This would probably imply a loss. Tough luck. If they want to avoid a potential loss they have the alternative to participate in the CPBs.

This ties the knot on virtually all existing debt. Either it is rolled into the CPBs or it is exchanged for the new EBs. Functionally this has the effect of subordinating all of the existing debt. The countries involved will have “clean” balance sheets. They should be able to fund existing trade and current account imbalances from the market. Should that prove to be a trouble spot I would consider that there be EU guarantees on the new working capital debt. I do not think this step will be necessary.

The banks will hate this plan. I say, “tough luck”. They are collectively part of the problem and therefore should be part of the solution. There is a silver lining for the banks. The new securities (CPBs and EBs) will create a whole new trading opportunity for them. Give them something new to trade and they will shut up. I would not tolerate much opposition from the banks.

Summary

-This proposal avoids all losses to current holders of trouble sovereign debt. It restructures liabilities for many years. It could eliminate a substantial portion of the principal indebtedness of the borrowers. The portion that was not exchanged for CPBs would also be automatically pushed forward by a significant period of time. Debt service cost would be stabilized. Rollover risk will be eliminated.

-There is no incremental cost to the IMF.

-China and Switzerland have to step up to the global stage and play their role. They face little economic risk from this proposal, they would benefit from the stability/trade deals that would follow.

-The troubled borrowers would still have to face up to the need to reduce deficits. The amounts and pace of those adjustments will be less draconian than those that the IMF has currently required. While I doubt the countries involved would rejoice at this outcome it is far better than any other alternative they are currently facing.

-Note that there is no role for the USA in this proposal. Very deliberate by me. The US has no resources, no moral authority given its debt profile and its involvement would likely prove counter productive given the political gridlock that is soon to envelop D.C.

Damned Either Way

It’s a pretty good bet that Congress and the Administration are going to try to come up with a solution on what to do with the expiring Bush tax cuts and the AMT (Alternative Minimum Tax) before the Thanksgiving holiday. Time is running out and hard choices have to be made.

If we “do nothing” and let the taxes sunset our budget deficit profile will improve significantly. On the flip side, if we raise taxes across the board on Jan 1 the economy will hit a wall. We are damned if we do and we are damned if we don’t.

The Administration has said it wants all tax increases to be pushed into the future for at least two years. Congress (I thought) was of a similar mind. There is now some doubt as to what they are collectively thinking. I believe that in the end, our legislators will roll over and give Obama what he wants; two more years to kick the can down the road.

The Congressional Budget Office looks at the impact of any legislation. Doug Elmendorf, the boss at the “non-partisan” CBO gave a speech on Friday on the topic of what to do with taxes. It’s not a pretty picture. Consider this slide that attempts to define the consequences on employment of a variety of actions the government could take.

Two observations:

A) Reducing taxes in 2011 has the least ‘bang for the buck’ in terms of creating long-term full employment. Given that this is the least effective alternative you have to wonder why it is being considered.

B) Except for reducing taxes none of the other options are politically feasible for the foreseeable future. We have congressional gridlock. There will no stimulus package in 2011 from our new legislators. So extending the Bush tax cuts is the only option. And that is why it will become law.

Of course nothing is free. If we don’t get our house in order and eliminate what was promised to be temporary cuts by Bush, the deficit will go up. By how much? According to the CBO it will double:

In summary, look forward to a patch on taxes that accomplishes very little in terms of future growth, one that has the least efficacy in addressing the underlying unemployment problem and the one that will insure that a fiscal explosion is not so far off in our future. I think Elmendorf sums it up pretty well:

Just a question: When do we address the question of the “Fundamental disconnect”? We haven't done that at anytime in the past. We aren't going to do it in the present. We will only do it in the future if there is a crisis that forces us. The conclusion is that another crisis is inevitable because what we are doing is unsustainable. I wonder if our congressional leaders read the stuff from the CBO. If they are, they are ignoring it.

It’s the ‘Bernank’ that done it!

Bernanke has made himself (and thereby the entire Federal Reserve) the lightening rod for domestic and international inflation. What a dumb PR move that was. There are any number speeches by Ben and his cohorts where they stuck there neck out and said, “inflation is our goal”. Ben & Co. are going to eat those words. If you ask ten people if INFLATION is ‘good’ or ‘bad’ nine of them would say it's BAD. It is the way we grew up. Ben is doing something bad.

A very small percentage of the population actually understands what the Fed is doing. Far more people have watched the YouTube cartoon explanation of QE than have listened to/read Bernanke. But a great number are aware that the Fed is engineering some inflation. So when they get hit in the head with some big price increase the first thing they are going to say is, “It’s the ‘Bernank’ that done it!”

Consider me as a case in point. I already pay a ridiculous $1,629 a month for health insurance. But today I get this nice letter from United Health telling me that the good folks at the NY State Insurance Commission have approved a 12.5% increase for just the next six months. I am looking at a 25% YoY increase in healthcare cost.

That NY State is granting 25% rate increases is a crime in my opinion. That Obama Care created a three-year window of maximum gouge opportunities for the likes of UNH is also a crime. The problems with health care and the cost of insurance can’t really be blamed on Ben and the Fed. But I suspect that many folks are going to blame him anyway. After all, he’s the one who wants inflation, so when we get it, the fingers of blame are going to be pointed in his direction.

There are millions of Americans who are getting letters like this. You will see stories in the MSM in the next week or so. "Insurance Companies Gouge Customers" is a good Thanksgiving story. It’s even possible that the crooks in Albany will be called on the carpet for allowing such an egregious increase in a basic cost of living. The boys at UNH will defend what they have done and just blame the increase on INFLATION in the cost of health care at every level.

I (begrudgingly) accept that Bernanke and the rest of the merry folks at the Fed don’t really want inflation that just eats up consumers. They want to see inflation from the demand side as evidence that the economy is in fact growing. But it is not going to go down like that.

Over the next few months we will see a number of big jumps in basic costs. Food, health care, insurance, transportation, gas and electric are all going up in price. We may not see the evidence so clearly in the headline numbers. My 25% increase in health care will not show up. That does not matter. Tens of millions of people will feel this pinch. There will be no blaming of OPEC, or China this time. The blame is going to be placed squarely on the shoulders of Bernanke and his vocal enthusiasm for ‘the’ inflation.

I will tell you that I was damn mad to see my annualized insurance bill go up by 25%. A lot of others will soon feel the same when they get a similar letter. Or when they look at their next electric bill, the cost of vegetables or even the price of a pair of jeans. A good number will say in anger, “It’s the ‘Bernank’ that done it”.

Bernanke has tied his success to a rise in inflation. America is going to absolutely hate that. Even greater public distrust of the Fed will inevitably follow. Politicians will jump on the bandwagon (they always do). The end result will be that QE will be a disgraced policy and the Fed will be weakened for a long time. Ben will get his inflation, he is also going to lose his job.

The Problem With Munis: CDS

Big dump in Muni world of late. As previously noted there are many factors influencing pricing. Declining credit quality and increasing supply are the big issues. But there is more at play in this story than just the traditional fundamentals. The wild card is our old friend CDS.

There are today two ways to play the long side of taxable Munis. The easy and old-fashioned way is to simply buy them. Once you own them you get a semi –annual yield; in return you assume the risk of default of the issuer.

Alternatively one could just buy a Treasury bond and write a CDS contract on the municipality in question. In this transaction you would get (A) the yield on the Treasuries and (B) a stream of income from writing the CDS contract. The risk parameters are similar to actual ownership of the muni bond. If there is a default, the CDS writer assumes the loss.

Now consider the current pricing for Illinois GO bonds. (example from Bond Buyer)

Five year yield on IL Muni=2.85%
Five year yield on Treasuries=1.53%
Five year return on writing IL CDS=2.91%

Do the math. You could either invest your money at 2.85%, or you could concoct the same economic result through a CDS contract and get a net yield of 4.44%. Not hard to figure out which one make more sense.

Of course it is not so easy to write CDS. You must be a big player to do something like this. Warren Buffet and Goldman can do it. So can a bunch of others. But the list is still pretty short.

Market makers are not investors. They are arbs. When powerful street players see market holes like this they just try to exploit it until it is gone. The question at hand is, “What side of the market is wrong?” Either (I) Muni yields will rise to eliminate the spread, (II) CDS pricing will fall, or (III) both sides of the equation will move toward the center and a more efficient price will be established.

My bet on the outcome? Muni yields are set to go higher. Demand for Muni CDS protection will remain firm. When a street player writes a CDS contract for a Muni what do they do to lock in a gain and offset the risk? Simple, they just short the underlying Muni bond.  The net result of the CDS demand is that bond prices fall and yields rise.

What Did Ben Say??

Did Bernanke just make a mistake? I think he might have. In a speech in Frankfurt he had this to say about his (and the rest of the Fed’s) thinking on inflation:

The Committee remains unwaveringly committed to price stability and does not seek inflation above the level of 2 percent or a bit less that most FOMC participants see as consistent with the Federal Reserve's mandate.

This sentence is open to some fairly wide interpretation. I think Ben was referring to inflation as something that is evaluated over an extended period of time and is best measured by the GDP deflator.

But that is not how the market may read it in a few months. A CPI print of .3 or even a .4 is not at all out of the cards at some point over the next Q. Multiply .3 X 12 and you get a running rate for inflation at 3.6%. While that is not what our boy Ben may have meant, that is how the market will read it. Ben has put out to the market that he might call off QE if inflation starts to get going toward 2%. He was pretty clear that he was prepared to back off in the speech:

The Committee stated that it would review its asset-purchase program regularly in light of incoming information and would adjust the program as needed to meet its objectives.

For me, it's a sure thing that we are going to see hot inflation prints in the next few months. There has been too much action in the broad commodities market for it not to show up. When it does people are going to be looking to Ben and calling his bluff. I read this comment by Ben as backing off. I would not be a buyer of long duration.

Emerald Isle and the Golden State

There is an eerie calm that has descended on the Irish story. IMF and EU folks are ‘up country’ taking a look-see and kicking some bank tires. The market for Irish debt has stabilized and the local equity index has improved at the prospect of some sort of deal that will “fix” the problem. Even the Euro has had its head lifted at the prospect.

I understand that a bailout of Ireland and Portugal is better for the markets than a crash and burn, but I am surprised at the euphoric atmosphere as we get closer to the biggest sovereign blow up in a very long time.

Speaking of sovereign blowups there is one happening in the US Muni market. There are a number of factors hitting Muni’s of late. Some are technical, some yield curve related. But there is more happening than just these things. It reminds me a bit of what happened to Ireland before they were forced to fold. Some things hanging on the market:

-There is a large 30 day supply of ~$23b. The highest in seven years.

-Treasury long-term yields have seen a very big back up since the announcement of QE-2.

-Philadelphia and San Francisco have been downgraded. This is very “upsetting” to Muni players.

-There is uncertainty regarding what the tax brackets will be in 40 days. If you don’t know what your tax rate is it is hard to figure if you should invest in Muni’s.

-There is uncertainty regarding the Build America Now Bond program. The uncertainty (it also expires in 40 days) is adding to the anxiety in the market.

-Hamtramck, Michigan has requested permission to file bankruptcy, always upsetting. Even more upsetting is that their request has been denied. This muni has been broke for years, but rather than go bankrupt and wipe out the un-payable liabilities the plan if for a bailout. A dangerous precedent as it just puts more debt pressure at the State level.

These are all good reasons for a backup. But this has been a hell of a backup. Two listed funds in the Muni space tell a scary story. The folks who own this just gave up two years of income.

It is not just selected issues. The whole space is getting clocked, and it is happening fast:

An argument can be made that Muni’s will stabilize as the regulatory/taxes issues are resolved. The supply issue is somewhat self-correcting as issuers that have no urgent financing needs are pulling deals off the calendar. But consider the muni yield curve for both California and a general price index:

 

As you can see, short-term yields are near zero but rise pretty quickly in both graphs. The California index is much steeper than the general. This is a measure of too much supply and credit quality concerns. It is reasonable to expect that Cali has a steeper curve to climb. The Cali yield curve is a barometer of where the general index is headed. It is now probable that Cali will get steeper too. A guess where this is headed:

The curve for all Muni paper will get steeper. Weak credits like NY/Il/CA will see the curve steepen from two to five year maturities versus the current ten-year peak. Should this happen Muni’s will be forced to pay up big time to roll maturities. Some may face prohibitive pricing. Given that the worst and biggest borrowers have the largest populations a disruption in the financing markets for these biggies would translate into big cutbacks in employment. It is not possible for that to happen without it ripping a big hole in total GDP and pushing unemployment north of 10%.

We know we have D.C. gridlock. There will be no new stimulus program that bails out the states. A bailout that was directed to California at the expense of Texas is not going to go over at all. I would call that a non-starter. That being the case what is the only option left? Simple, the Fed buys Muni’s. Of course that would be the very last act before the cliff.

Ireland is being dragged and kicked into a bailout. The bond market forced them into it. When yields screamed to peak near the two-year (just a week ago) the jig was up. California will be no different. If the two year cost of money rises to ~80% of the 20 year yield we will have a crisis and a bailout.

I used to think that following muni pricing was like watching paint dry. No action. That may change. The steepness of the muni curve may well drive headlines and markets for a bit. I’ll be watching.

FDIC’s Bair: "Bury the Losses"

Sheila Bair has turned a corner in her support of the bankers. On the critical issue of accounting clarity she made these remarks today to a bunch of CPA’s. I hear she got a standing ovation from that audience. Her words:

Fair Value Accounting

Another ongoing regulatory process is FASB's proposal to substantially revise the accounting standards for financial instruments. Under the proposed rule, banks would be required to measure substantially all of their financial instruments at fair value on the balance sheet.

While we understand that the objective of the rule is to make financial statements more transparent, we believe that its effect could be to undermine financial stability by making bank performance more procyclical. In short, we do not believe that a bank – whose business strategy is to hold loans and deposit liabilities for the long term – should be required to measure them at fair value on the balance sheet.

70% of all Americans own some stocks. It is hard to avoid the financials if you’re in a fund, so the consumer’s new champion, Elizabeth Warren, should take up the issue of clarity on bank financial statements. That would be a cat-fight I would like to see.

US to EU – Drop Dead?

It would appear that we are just a few hours away from some form of Irish bailout. Portugal is a sideshow, but in worse shape than Ireland. So two fixes are due by Friday. While not a total surprise this is happening at lightening speed. I want to make an obvious but very important point:

The Market did this and will do it again.

A week ago spreads on Irish debt got pushed to levels where a bailout is required. On paper they do not need a bailout this week. They have minimal borrowing requirements and technically could just ride out the storm. But Irish yields could not stay at 9% for long. It just adds to the cost of the next guy in line. The next up in the domino chain is Spain, behind that is (incredibly) Italy and should those tiles fall even France becomes suspect.

That chain of events simply can’t be allowed to happen. I will make a prediction: Should Italy fall prey to the markets in a similar fashion as Ireland the dominoes will be falling on every continent.

Italy does not deserve a loss of confidence, but that is irrelevant. Once money starts moving it is very hard to stop. I think every finance minister is aware of this. But I see a big speed bump in the process ahead. That bump is the USA.

When Greece went tapioca last May the EU responded with a $145B (equivalent) support package. Of that, $40 came from the IMF. The US is 17% of the IMF but because there are dirt bags like Venezuela who don’t pony up their share the US is on the hook for ~20% of the Greek deal. Back in May this was sort of a ho-hummer. Some minor opposition:

"It is simply unfair—as a matter of principle—to force American taxpayers to use their hard-earned money to prop up failed policies in relatively wealthy nations," Rep. Todd Tiahrt, a Kansas Republican.

A lot has changed since last May. The opposition to US involvement will not be muted in November. Geithner and Obama are well aware of that fact.

The talk is for a EUR ~100b deal for Ireland. Throw in Portugal and you get EUR 120b or a total deal not so far from that for Greece (total=$160b). The US share of the deal could come as high as $15b if the IMF plays a similar role as in Greece.

This is a rounding error and should not be considered. But it will. The IMF involvement in an Ireland/Portugal bailout will not go over so well with the Tea Party set. But I fear it will get much worse. I think there is a case for the Fed to get involved at some point. They may be forced to open up swap lines to EU Central Banks as part of a broader restructuring of EU debt. Consider this info from the CIA on total external debt.

Note that Ireland has a mountain of external debt that is not Public Sector debt. This is largely the domestic banks. There are cross border assets on the books of these banks. Therefore on a net basis the external debt is not as large as it appears. However in order to address the Irish problem this mountain of assets has to be reshuffled. That will prove to be far more difficult than a narrow bailout of the Irish government bond market. For it to be accomplished in an orderly fashion it will require that large amounts of liquidity be made available. In the past that has always brought the US Fed into the picture.

If a US role is required it will come at a great cost to the Administration. If the Fed gets involved there will be hell to pay. If the USA balks at a critical moment, the EU effort will fail in the market eyes. At that point the market will go into full predator mode. A lot is riding on what should not be such a big deal. But that is the way of things.

Japan and the US Ten-Year

A bond trader I know sent me this at the end of the week. He is obviously in the bull camp:

I expect the 10yr UST to be closer to 1.50% than to 2.50% by this time next year. Deflation, deleveraging, and risk-aversion will likely continue for closer to a decade than a few years. Add in QE and the Fed’s desire to keep rates low, and we should see a yield curve with even lower yields than today in the coming years.

A significant argument in favor of this outcome is Japan. We are following their path in so many ways. From the bond guy:

The US situation in 2010 is not all too different from Japan’s in 1990 – yes there are differences, but many similarities, and most importantly, our “solutions” are nearly identical to what Japan tried. Japan has wound up with 2 decades of deflation and a 10yr yield that hit 1% for the first time in 1998, and now sits at 0.95%.

This general view of the future is widely held. It’s hard to ignore the fact that in many ways we are mirroring Japan. I see the similarities, but I also see the differences. For me, there are enough of those differences to come to a different conclusion. A few to consider:


Store of Wealth
Looking at the long-term graph of USDJPY says it all on this key issue. The US has had policies that encouraged deficits; this results in a chronically weak currency. This dynamic is very supportive of bond prices in Japan. True, investors get little return, but they also get an FX gain. If a country that measured its financial reserves as a store of future purchasing power the dollar loses hands down.

The US continues to follow a weak dollar strategy. Therefore by comparison we lose to Japan on the store of wealth issue. That does not support long term US yields at sub 2%.

Debt and who owns it
Japan has a GDP of~$5T and public sector debt of ~200% so they are swamped with debt. US public sector debt is ~$13.7T or 93% of GDP. This “favorable” comparison has been pointed to again and again as evidence that the US can handle a much higher PS debt. I’m not convinced. Consider the ownership of Japanese debt. 5% is foreign owned.

On the other end of the spectrum is the US. The following is a list of holders as of late. The US debt to public is $9.1T, of that 4.2T or 46% is in foreign hands. We have 9x’s as much debt in hands outside the country. This reality is not supportive of a long-term bull market in bonds. Hostile bondholders are going to be a factor against sustained low rates. Do you see anyone on this list that might get hostile?

Reserves
The US functionally has none. The CIA puts the number at $140b. But when you have $4.2T of foreign creditors that much in reserves only covers about one year of interest. There is no margin for error. Japan has $1T+ in reserves. It has enough money outside the country to buy in all of the debt held by non-residents and still have a ½ trillion to spare. Again, if you were running the “Fund for Future Generations” you would be willing to accept a lesser return from a borrower that had the ability to pay you back 2Xs over versus the other who had not a foreign penny on the shelf.

The typical response to this is, “The US can print as much as they want”. True, but it is this “compelling” logic that makes the US a fundamentally bad credit. One that will be forced to pay more for borrowed money than Japan.

Demographics
This issue has nothing to do with market rates in any short-term period. But it is a powerful long-term one. Japan has had stable/declining population while the US continues to grow. This factor will come to bear at some point. The increasing population in the US supports growth, with growth will come natural inflationary pressure. That is not an environment where interest rates can remain low for an extended period.

My friend the bond guy thinks there is a play in the ten-year area. He looks for the curve to flatten as deflation and POMO do their work. He provided this graph of what has happened so far:

Looking forward, there is all the reason in the world to think that THIS FLATTENING WILL CONTINUE, even if on QE alone, further pushing down rates in the 5-10yr part of the curve…

To me this is a crowded and dangerous assumption. I am not suggesting that one should short bonds. That is a risky bet that has a very significant negative carry to hold. I never recommend negative carry trades.

On the flip side I consider a buy/hold to maturity of the ten year at the current yield to be one of the dumbest investments the market(s) have ever offered. The best way to play bonds is not to play them at all. Find another sandbox. The one filled with bonds is dirty; some big dog took a crap in it.

Taxes, the Deficit, QE and the Long Bond

David Axelrod, the new WH Senior Adviser (what does that title mean?) leaked an e-mail today that a “compromise” had been reached on what to do with taxes for the next few years. All of the Bush tax cuts will be extended for another 24 months. AMT will also get “patched” up for a few years. So the great public debate on this critical issue actually never happened. The outcome was not really in doubt. That said, this is a pretty big deal. Consider this graph from the CBO:

The graph shows the impact of extending and patching versus a base line estimate of the deficit. If we extend/patch the deficit goes up by $147b in 2011 and by $208b in 2012. So the compromise that was not discussed or debated will cost us $355b over two years. Poof!

As a result of this non-legislating the deficit will go up by more than half of all of Ben Bernanke’s $600b QE. Yes, he will be buying more than Treasury will be selling for the next seven months. But right after that Timmy G. will have at least another trillion and a half of wood to chop over the following eighteen months.

The old adage of “Don’t fight the Fed” is probably wise as you look at their massive buy program. But after a few months we are going to get numb to the constant POMO operations. At around that same time people will be looking at the Fed’s dwindling buying power and the wave of supply around the corner. The news on taxes today just makes the problem worse. Would you lend those prolific spenders your reserves? At a negative return?

Bernanke's announcement eight days ago knocked the long bond off its feet. The Fed committed less buying power to the 17-30 year maturities than was anticipated. But the 30 year has been trading like a wet sack of cement ever since QE-2 was announced. That price action is not all about some overestimates on the Fed’s intentions. Those bad bets were washed out after the first 24 hours. At this point the bond is pricing in a market sentiment that says, “If the Fed isn’t buying it, don’t own it.” I can’t think of a worse market response to the cauldron of trouble that Ben has cooked up.

Perfect Storm – February 2013?

I wish I could get a penny for every dollar that is going to be paid to lobbyist to fight the various recommendations of the Fiscal Commission. As advertised, they basically took no prisoners save a small portion of the older population that would starve without a monthly SS check. I think this exception was in response to the deficit panel being referred to as the “Cat Food Commission”. They may have dodged that bullet, but just about every other group in society is going to have a gripe.

-The mortgage deduction would be largely gone. There are a dozen industry groups that will rain on that parade.

-Social Security would be “socialized”. Some say SS is a third rail. We are about to see that in action. A big savings comes from a recalibration of COLA increases. So right away you have 60mm Americans apposed to this.

-$1.1 Trillion of tax deductions would be done away with. Think of all the tax lawyers and accountants that will line up to cry about this one.

-Get this. Federal workers would be required to put up half of their retirement contributions versus the 1/14 that they currently pony up for. You can imagine the howls we will get on that.

-The military budget gets a hatchet job. So the entire military industrial complex will rise up with one voice to appose it.

-My quick read of the proposals confirms my prior expectations that anyone in America who is under 45 should just bend over now. Most of the pain of the fiscal commission will be felt a few decades out. This group of folks is getting creamed and as far as I know they have no advocate. As this plan gets rolled out I suspect that the opposition from younger people will rise to a level that will make the US look like France.

But none of these things really matter. What's important is to focus on this critical comment:

4. Don’t Disrupt a Fragile Economic Recovery
Start gradually; begin cuts in FY 2012.

Gradually indeed. There is a total of a whopping $17 billion of cuts in mandatory payments through January 1, 2014.

Next week there will be a great debate on what to do with the Bush tax cuts. Actually I don’t expect much debate at all. Our legislators hate to raise taxes and I don’t think they have the guts to do it now. They will point to the big unemployment numbers and pass the tax trash for 24 months. They will defer the hard choices on income taxes and the critical AMT.

Then there is good old Ben Bernanke. As of now his plan is to finish QE-2 next June. QE-1-Lite (the top up) will, in theory, be an evergreen program. But after 24 months the MBS portfolio will have been substantially reduced and the monthly prepays and related POMO Treasury buys will be significantly less than we are getting today. I think there is no stomach in America for a QE-3. The global (and now domestic) hostility to this crazy experiment makes the possibility of a 3pete decidedly slim.

So mark your calendars. Sometime early in 2013 we will self immolate as all of the promised steps of belt tightening, budget cuts, smaller government, smaller social payouts hit. At the same time taxes will be going up for every single wage earner regardless of what they make. High earners will get butchered. To top it off Big Ben will have to be throwing out a hefty sized anchor at pretty much the same time. The markets will surely see it coming.

The last transition of executive power was in the midst of an economic panic. Based on the timetable and the proposals in front of us we are setting up for a repeat. We will get the answer to that next week when the tax issue is pushed forward a few years. My bet is that hard choices on spending, monetary and tax policy will all be kicked down the road 25, 26 months. I wonder if our leaders understand that?

Hot Employment – Cold Bernanke?

I was surprised with last week’s Non-farm Payroll numbers. They were much hotter than I expected. My own number was (as usual) in the bear camp. I was looking for a flat to down number. I don’t really have much faith in the numbers we are getting. That said, the data showed a lot of new jobs were created. From David Rosenberg yesterday:

The raw data showed that 919,000 payrolls were somehow created in October, which therefore would have made this the second strongest October in the last 11 years — in October 2009, the tally in the raw nonfarm payroll data was 646,000 even though the economy then was accelerating at a 5% annual rate. The data bear no resemblance to the reality of an economy barely growing at all in real per capita terms.

I share David’s view that the numbers do not add up given the broader macro picture. So I was left scratching my head. I still am, but I would like to add something to the discussion and pose a question. Two recent emails:

A new address for me. I woke up 6 weeks ago and said fuck it. Put my stuff in storage and moved to Houston. I got a place to stay and a job. So I am starting over, again.
Ian

BK: Ian is a plumber who worked for a big construction company south of Tampa Fl. Steady work as Fl. boomed. Then he got laid off and maxed out unemployment waiting for a recovery that did not happen. He scrambled for cash work to stay alive. When the benefits ran out the only option was to move to where there was work.

Simon got a job after nearly two years. For years he helped people to get a mortgage. Now he is working for a company that has customers who can’t pay their mortgage. He doesn’t make as much as he used to but at least he has benefits.
Aunt Edna

Do these comments mean anything? Not really. Two stories in the wind of 130mm. These two people were motivated to change what they were doing when the crunch came. The crunch was the end to EU benefits.

Over the next few months close to 5 million people will be looking at the end of their checks. There will be a range of outcomes as this happens. Some will not find work and their status will be tenuous. Others will figure out how to get by with less and find work off the books. Still others will take jobs that are available even if they have paychecks well less than they did two years ago. This has the potential to create some tremendous “noise” in the economy. It also might create some head fakes in the markets.

Consider a scenario where the end of EU pushed a good number of people back into the workforce over the next few months. Yes, they would be taking jobs at the Wal-Mart and Duncan Donuts, but they show up as newly employed. On NFP Friday the only thing that counts is the top line number. I pose the question: What happens if we get hot numbers that average 250k for the next three months as the EU issue sorts itself out?

My first thought is that this could be an explosive combination with Mr. Bernanke’s QE. If just 20% of the 5mm find something to do for a paycheck over the next six months while our boy Ben is pouring gas on the fire the economy will flare up for a bit. An improvement in the jobs picture will be very noticeable in the bond market. It could be the basis of a hiccup in all manner of commodities prices. The most significant would be in the cost of energy, food and gold. Should things work out like this it would shine a terrible light on QE. The policy would be indefensible given the backdrop of an improved labor picture and a sharp ramp up of consumer prices. Bernanke would be forced by the markets and the public to back off and moderate the QE program. He has said they would fine tune QE as information on the economy becomes available. Most people read that to mean that QE-3 was a sure thing. It could also mean that he would back off if there is demonstrable evidence that QE was not really necessary.

But here is the real world scenario. Forget about some noise we may get from a few months of distorted employment numbers. What is really happening is that a very significant number of the 5mm will be hitting the skids in slow motion. Their consumption will fall substantially and we will probably see an increase in food stamps at the same time payrolls are rising. Those that do get a job will have after-tax income not too far from the unemployment checks they were getting. Net-net disposable income will be in decline. In this outcome the best that one could hope for is a few years of growth a point or so above zero.

There are many possible paths in the future. Something along these lines is just one. Should something like this happen we would find ourselves sometime this spring or summer with a busted and disgraced QE effort. ZIRP might still exist but the Fed’s ability to push the economy further using monetary policy will be exhausted. I can’t imagine that QE will end quietly. It will go out with a bang. When it is gone it will not return for a long while.

Bernanke got head faked a few months ago when Greenspan said that the economy had, “Hit an invisible wall”. He over reacted and teed up QE as a result. Once it was out there it was impossible for him to back off, even though the economic evidence suggested caution. As a result, we get a half assed QE compromise that will accomplish little but to stoke some commodities fires.

QE-1 was an emergency measure that achieved the objective of stabilizing the economy during the “emergency” of two years ago. We may very well find ourselves in another emergency later in 2011. The economy may need a shot in the arm. But the botched introduction of QE-2 will make it impossible for Bernanke to roll out a sequel.

Bernanke is an academic. He has no experience in markets and therefore has no sense of market timing. He completely blew the timing on this one. QE-2 will go down in history as a failed policy effort that backfired. When/if we need QE in the future it will not be available as a policy tool. Bernanke’s botch job has tied the Fed’s hands for at least a decade.

On QE & Supply-A Dated Perspective

In December of 1974 I was kid on an FX desk for a Swiss Bank in NYC. History gave me a lucky break. The dollar was in the crapper at the time. Too much debt and no plan to deal with it was the problem then. To stabilize the dollar and shore up a weak international balance sheet president Ford announced that Treasury would auction off gold. Because Switzerland was a big player in the gold biz my bank was involved. I ended up having a role in the process. Along the way I made some observations that have stuck with me. I look at QE and what lies before us and wonder if history might repeat itself.

Back in 74 the gold price plunged on the news. The dollar finally found some demand. Equity markets rejoiced.  I attended meeting at Treasury on the gold sales. I got to meet some real players. The initial assumption was that the gold price was in for a long-term plunge. There simply was not enough buyers for the AU that was coming up for sale.


We could not have been more wrong. The first auction was over subscribed. Each following auction was for larger amounts and saw bigger demand. This continued for a few years until the next bombshell came. In 1978 the IMF announced that it too would sell gold. (The US told the IMF to do this).

From 1975 to 1980 the US Treasury and the IMF sold a combined 42 million ounces (1300 tonnes). What did the price of gold do while all that selling was going on?

The price of gold went up nearly every week for five years. The more the US sold the more the market demanded.

The numbers back then look silly by today’s standard. The whole 42mm oz were sold for a measly $25b. But numbers were different back then. For example, the Dow closed 1974 at 580. Today it is 20X’s higher. I would use the same multiplier to value the scale of those long ago gold sales. The current value in gold terms is still only $60b. But the comparison to the size of GDP and money supply makes its impact closer to $500b. Therefore it isn't so different in size than Mr. Bernanke’s QE-2 program.

My lesson from this history is that when governments are selling something of value it just increases the demand until the government selling is ended. Can history repeat itself? In reverse? 

In 2011 the Fed will be buying dodgy securities at the highest prices in history. The market is anticipating the coming demand and driving up prices on the assumption that there will not be enough sellers when the real POMO action starts.

What happens if those auctions are blowout successes? What if the Fed stands up one day and says, “We will buy $25 billion”, and the market offers them $150b? What if each of these big POMO buys sees a B.T.C. of 3 or 4 Xs? What if the big holders like China, Hong Kong, Korea, Singapore, OPEC and Russia say, “If they are buying, we are selling”.

Put yourself in a position of foreign CB that holds boodles of unwanted Treasuries. Now, in comes the Fed buying huge slugs at premium prices. Those same big holders all hate QE and the negative impacts they are feeling from it. How many of those CB’s will just vote with their feet? One or two and this turns into a rout.

The first few big POMO buys will probably not be conclusive. We need to get a few under our belt. However, should we see a pattern where the supply of paper that comes out at the auctions overwhelms the Fed's buying interest we are going to have a very big problem on our hands.

There are many who have said that the US financial system will end on the day that there is failed Treasury auction. I have never believed in that. The Fed is there to print money and insure that there will be no failure. But it will be an interesting muse of history if the US financial system comes under a big strain as a result of some spectacularly successful auctions. But those reverse auctions would result in holders lining up to either wash their hands of US paper or to reduce what the own by significant amounts.

Street to Treasury on QE

The Treasury Borrowing Advisory Committee met on November 3, the same day at the Fed’s QE announcement. I’m not sure who the “presenting member” is who made the following comments. They are all fat cat bankers and big hedge fund types. Here’s the list: I thought the minutes of the meeting had some interesting thoughts on the Fed’s move.  The most significant observation is that QE just shortens the average life of the public debt:

The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.

Okay, let’s put this issue to bed. Whatever benefits (if any) QE may bring us could have been accomplished without the Fed. Treasury could have just changed the mix of its debt issuance and substantially eliminated sales of 10+ year coupons for a year or so. Changing the mix would have had the impact of starving the long end of supply and therefore have kept long-term rates low. The problem:

The Fed and the Treasury are independent institutions, with two different mandates that might sometimes appear to be in conflict.

Yeah, Fed and Treasury are different. But this is a case where we need to elevate the debate to a level above both of those organizations. This is not going to end up being bad for the Fed or bad for Treasury. It is going to end badly for the country as a whole and for all its citizens. So there is no conflict between Treasury and the Fed. The conflict is with the Fed and the people.

I was struck by this comment:

Members noted that the Fed was essentially a "large investor" in Treasuries.

The Fed is an investor? That’s a funny use of the word. The Fed electronically creates money and then uses it to buy bonds. But this is equivalent to buying something with 100% leverage. When you buy something with 100% debt you don’t really own it and you are not an investor. You are just a short-term player. The conclusion:

The Fed's behavior was probably transitory.

I doubt there is anything “transitory” about the Fed’s move. What they are doing will end up being a permanent increase in their holdings. There will be nothing transitory about it. But the advisory committee sees it different and thinks they should not alter their debt issuance as a result of Fed POMO:

Treasury should not modify its regular and predictable issuance paradigm to accommodate a single large investor.

A “Big Investor” sounds like a good thing. But really it is a pain in the ass. The big players have a seat at the table and often dictate policy. Ask Carl Icahn. Or better yet, ask the Chinese. They were big investors in Agency Bonds. So big, they forced Treasury to functionally guaranty $6T of paper. The Fed being a big investor is a significant disadvantage to the country as a whole. That will especially be true when the bonds come due and they have their hands out and saying “Sorry Charlie, no roll over”. Don’t expect the Fed to be benevolent when inflation comes roaring back. When the Fed is forced to tighten, it is Treasury (AKA the taxpayer) who will pay the biggest price.

The presenting member thought that over the medium term (one to two years), QE2 would force Treasury yields lower and would likely lead the curve to flatten in the five- to ten-year sector. Meanwhile, the risk premium in 30-year bonds would likely increase given concerns about inflation and the value of the U.S. dollar.

The risk premium on the 30-year has been widening ever since QE was announced. As the program unfolds there will be more weakness. The 30-year is, and will be, the ultimate measure of the success of QE, not the S&P. I think it is headed into the crapper.

The presenter further noted that rate volatility will decline as market rates approach zero, with realized volatility in the long-end remaining higher as uncertainty and re-inflation fears increase.

Traders only trade things that are volatile. If they don’t move you can’t make money. So future market angst will be taken out on the long-bond. A consequence of QE is going to be some wild price action in the long end. Good for traders, bad for confidence. Speaking of confidence how about this warning of things to come.

The member noted that there was the potential for an extreme market reaction associated with the Fed's exit from potential purchases.

Extreme market reaction? It will be a blowout that will take 30% off the equity indexes in a short period of time. Rates will back-up so quick the economy will tank. It’s likely that when this happens we will suck down a good portion of the rest of the world too. The foreign CB’s already hate QE-2. Wait till Bernanke tries to reverse direction. There will be a hell of a howl.