CURRENCY WARS: Debase, Default, Deny!
In September 2008 the US came to a fork in the road. The Public Policy decision to not seize the banks, to not place them in bankruptcy court with the government acting as the Debtor-in-Possession (DIP), to not split them up by selling off the assets to successful and solvent entities, set the world on the path to global currency wars. MORE>>
CURRENCY WARS: Misguided Economic Policy
The critical issues in America stem from minimally a blatantly ineffective public policy, but overridingly a failed and destructive Economic Policy. These policy errors are directly responsible for the opening salvos of the Currency War clouds now looming overhead. Don’t be fooled for a minute. The issue of Yuan devaluation is a political distraction from the real issue – a failure MORE>>
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Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
Year III of the Long Slump is when we confront the Primat der Politik in tooth and claw, the phase when states become erratic, victims fight back, and dissident intellectuals start to inflict damage on failed orthodoxies. The dog that hasn't barked yet is the jobless army in Spain, the 43pc of youths without work. Bark it will when the €420 dole extension expires in February
Policy levers in the US, Europe, and Japan remain set on uber-stimulus with the fiscal pedal pressed to the floor and rates near zero everywhere, yet OECD industrial output has not regained the peaks of 2007-2008 by a wide margin. Leading indicators are tipping over again. We are one shock away from a liquidity trap.
The East-West trade and capital imbalances that lay behind the Great Recession are as toxic as ever. Surplus states are still exporting excess capacity with rigged currencies -- the yuan-dollar peg for China and, more subtly, the D-Mark-Latin peg within EMU for Germany.
Dangerously high budget deficits of 6pc, 8pc, or 10pc of GDP in countries with dangerously high public debts near 100pc may have prevented an acute depression, but they have not prevented the weakest rebound since World War Two, and they cannot continue, whatever the assurances of New Keynesians and pied pipers of debt.
Cyclical bulls may see the surge in 10-year US Treasuries -- and therefore mortgages rates -- as a sign that growth is about to blast off: structural bears suspect it may be the first convulsive shudder of bond vigilantes dismayed at the easy willingness of Washington to spend $1.4 trillion above revenues next year, with no credible plan to contain the monster thereafter.
Can bond yields rise on "sovereign risk" even as core prices grind lower towards deflation? Yes, they can, and this baleful possibility is not in the textbooks.
Ben Bernanke made a fatal error by launching QE2 too early, with an incoherent justification, by dribs and drabs for fine-tuning purposes. The QE card cannot easily be played a third time. If he now tries to print money on a nuclear scale to crush all resistance and hold down Treasury yields, he risks exhausting Chinese patience and invites the wrath the Tea Party Congress.
Pudding bowl haircuts will set off the next wave of distress for Europe’s banks as they try to refinance $1 trillion by 2012, in competition with hungry sovereigns. Gold may slip at first as casino funds cut leverage to meet margin calls, before punching higher to €1300 an ounce as investors seek gold bars in a precautionary move. Talk of capital controls will grow louder.
Convergent incomes and divergent growth – that is the economic story of our times. We are witnessing the reversal of the 19th and early 20th century era of divergent incomes. In that epoch, the peoples of western Europe and their most successful former colonies achieved a huge economic advantage over the rest of humanity. Now it is being reversed more quickly than it emerged.
What is unprecedented is not convergence, but the scale. Suppose China were to follow Japan’s path during the 1950s and 1960s. Then it would still have 20 years of very fast growth in front of it, reaching some 70 per cent of US output per head by 2030. At that point, its economy would be a little less than three times as large as <br/>that of the US, at PPP, and larger than that of the US and western Europe combined. India is further behind. At recent rates of growth, India’s economy would be about 80 per cent of that of the US by 2030, though its gross domestic product per head would still be less than a fifth of US levels
What is unprecedented this time is not convergence, but the scale. Suppose China were to follow Japan’s path during the 1950s and 1960s. Then it would still have 20 years of very fast growth in front of it, reaching some 70 per cent of US output per head by 2030. At that point, its economy would be a little less than three times as large as that of the US, at PPP, and larger than that of the US and western Europe combined. India is further behind. At recent rates of growth, India’s economy would be about 80 per cent of that of the US by 2030, though its gross domestic product per head would still be less than a fifth of US levels. China is today where Japan was in 1950, relative to US levels at that time. But its output per head is far higher in absolute terms, since US levels have themselves risen threefold. Today, China’s real GDP per head is roughly where Japan’s was in the mid-1960s and South Korea’s in the mid-1980s. India’s are where Japan was in the early 1950s and South Korea in the early 1970s.
In short, today’s divergent rates of growth between successful emerging economies and the high-income economies reflects the speed of the convergence of incomes between them. This divergence in growth is staggering. In an important speech by Ben Bernanke in November the chairman of the US Federal Reserve, noted that in the second quarter of 2010, the aggregate real output of emerging economies was 41 per cent higher than at the start of 2005. It was 70 per cent higher in China and about 55 per cent higher in India. But, in the advanced economies, real output was just 5 per cent higher. For emerging countries, the “great recession” was a blip. For high-income countries, it was calamitous.
The great convergence is a world-transforming event. Today, the west – defined to include western Europe and its “colonial offshoots” (the US, Canada, Australia and New Zealand) – contains 11 per cent of the world’s population. But China and India contain 37 per cent.
The present position of the former group of countries will not be sustained. It is a product of the great divergence. It will end with the great convergence.
Where are global currencies headed in 2011? After three years of huge, crisis-driven exchange-rate swings, it is useful to take stock both of currency values and of the exchange-rate system as a whole. And my best guess is that we will see a mix of currency wars, currency collapses, and currency chaos in the year ahead – but that this won’t spell the end of the economic recovery, much less the end of the world.
The continuing success of the floating exchange-rate system does not imply a smooth ride in 2011. For starters, we can certainly expect a continuation of the so-called currency wars, in which countries strive to keep their exchange rates from appreciating too rapidly and choking off exports. Asian governments will probably gradually “lose” their battle in this war in 2011, allowing their currencies to appreciate in the face of inflationary pressures and threats of trade retaliation.
As for currency collapse, the most prominent candidate has to be the euro. In an ideal world, Europe would deal with its excessive debt burdens through a restructuring of Greek, Irish, and Portuguese liabilities, as well as municipal and bank debt in Spain. At the same time, these countries would regain export competiveness through massive wage reductions. For now, however, European policymakers seem to prefer to keep escalating the size of bridge loans to the periphery, not wanting to acknowledge that private markets will ultimately require a more durable and sustainable solution. No risk factor is more dangerous for a currency than policymakers’ refusal to face fiscal realities; until European officials do, the euro remains vulnerable.
Currency chaos is the safest bet of all, with sharp and unpredictable swings in floating exchange rates around the world. During the mid-2000’s, there was a brief window when some argued that currencies had become more stable as a corollary of the “Great Moderation” in macroeconomic activity. Nobody is saying that now. The floating exchange-rate system works surprisingly well, but currency volatility and unpredictability look likely to remain an enduring constant in 2011 and beyond.
Japanese Prime Minister Naoto Kan said on Nov. 4 the U.S. was following a “weak-dollar policy” through its plan to buy Treasuries.
Chinese central bank adviser Xia Bin said the Fed’s quantitative easing amounted to “uncontrolled” money printing.
Currency traders that seek profits by borrowing in nations with low interest rates to fund purchases in countries with higher yields are losing more money than at any time in at least a decade.
The strategy lost 2.5 percent in 2010 as the dollar -- a favorite for financing the trades because of record low U.S. rates -- appreciated, according to an index compiled by UBS AG, the world’s second-largest foreign-exchange trader. That’s more than the 0.98 percent drop in 2008 when the collapse of Lehman Brothers Holdings Inc. caused credit markets to freeze and the worst performance for so-called carry trades since at least 1999 when UBS began releasing yearly figures.
Falling demand for carry trades may help the greenback extend a rally that drove IntercontinentalExchange Inc.’s U.S. Dollar Index up 4.5 percent from its 12-month low on Nov. 4. Gains in manufacturing and retail sales are leading investors to buy the dollar, rather than sell it to fund other investments.
“The U.S. will look reasonably better compared to other economies,” said Mitul Kotecha, Hong Kong-based head of global foreign-exchange strategy at Credit Agricole CIB, a unit of France’s second-biggest bank. “Bond yields will move higher, and that will certainly reduce substantially the attraction of the dollar as a funding currency.”
After a hiatus of more than one year, the Federal Reserve is likely to expand a select group of dealers to help with hefty Treasury debt sales and the central bank’s monetary-policy operations, according to traders and dealers familiar with the matter.
Demand for safe-haven Treasurys has eased over the past couple of months as optimism over the economic outlook sparked more buying interest in riskier assets such as stocks. That means dealers need to play a bigger role in underwriting Treasury sales to avoid the risks of weak auctions.
Lackluster participation by primary dealers could force the government to pay higher interest rates to issue debt, which in turn would hurt the broader economy by raising rates for consumers and companies. Treasury yields are benchmarks for mortgage rates and a variety of other borrowing costs for consumers and companies.
“Adding a few more dealers makes sense. It is more efficient for the government to place their debt and there will be more liquidity for the market,” said James Caron, global head of interest-rate strategy at Morgan Stanley in New York, a primary dealer. “From a selfish perspective as a primary dealer though, it means more competition.”
Currently, there are 18 primary dealers in the U.S. government bond market, including Goldman Sachs, Barclays, HSBC, Morgan Stanley, J.P. Morgan and BNP Paribas. They trade directly with the Fed and are obligated to underwrite Treasury auctions. (See the full list.)
Becoming a primary dealer raises a company’s status in the industry, potentially boosting trading revenues from the Treasury market while helping the firms expand business in the broader fixed-income markets, including corporate bonds, mortgage-backed securities and municipal debt.
Several banks have applied to join the pool over the past year, including French bank Societe Generale SA, Canadian bank Scotia Capital, the investment-banking arm of the Bank of Nova Scotia, and MF Global, the world’s largest broker of exchange-traded futures and options that is headquartered in New York.
The Fed hasn’t added any new dealer to the pool since July 2009 when Nomura Securities International Inc. became the 18th member. Several banks have applied but the approval process has been lengthened after the central bank tightened rules for prospective dealers in January 2010, including an increase of capital requirements from $50 million to $150 million.
As 2011 kicks off, the U.S. economy looks the healthiest it has in years, but that doesn’t mean the recovery won’t face strong headwinds. Five risks in particular could crop up in the first half. Individually, none is likely to derail growth, but each could raise anxiety in equity, credit and currency markets.
1) The continuing resolution fails. The U.S. government is on track to run out of money by early March. Congress must raise the debt ceiling in order for Treasury to keep borrowing. Fiscal hawks, particularly newly elected Tea Party members, are threatening to hold hostage the government’s ability to fund itself unless spending cuts are enacted quickly. While no one refutes the need for Washington to pare down its budget, closing down the federal government could upset the Treasury markets. The resulting spike in rates would negate the Federal Reserve’s goal of keeping long-rate low to help growth and promote hiring.
2) Continued Fed bashing. Speaking of the Fed and Congress, another concern is how serious are threats from Capitol Hill to rein in the Fed’s independence. Again, the risk to the outlook is the reaction by financial markets. The first glimpse of tension could occur Friday when Fed chairman Ben Bernanke is scheduled to testify to the Senate Budget Committee on the 2011 outlook.
3) Businesses don’t hire. One key support to a brighter outlook is the idea that businesses will increase hiring at a rate fast enough to bring down the jobless rate in 2011. That pace is generally considered to be somewhere north of 150,000 per month.
What if companies do not follow the game plan, possibly because demand is not strong enough to suit them? If job growth stays at the 100,000 per month seen in 2010, look for consumer confidence and spending to fall back.
4) Home prices fall significantly. Once the government tax credit ended in mid-2010, home prices resumed their decline. If that drop accelerates–perhaps because job growth doesn’t pick up or long-term rates pop up–expect a double whammy on growth.
First, falling home values will make households feel less wealthy, another potential drag on consumer spending. Second, declining home values will only worsen the homebuilding and mortgage situations.
5) Gasoline jumps to $5 a gallon. Gas prices are already at about $3 per gallon and winter is usually the weakest time for gas prices. The recent surge in crude oil has raised the possibility that gasoline could hit $4 by the peak summer driving season. The big danger is that saber-rattling in the Middle East or an unexpected refinery shutdown could push prices closer to a sawbuck a gallon. Given that Americans use about 378 million gallons of gas per day, each dollar rise in gas prices, if sustained, means $2.6 billion a week must be diverted toward the gas pump and away from other spending.
Clearly, none of the obstacles is a sure bet, but the risks do play into one another. Rising energy costs, for instance, could leave businesses with less cash for hiring. And each bears watching. They represent potential dark clouds that could dim a relatively sunny outlook for the first half of 2011.
The latest posting today of the National Debt shows it has topped $14 trillion for the first time.
The U.S. Treasury website today reported that as of last Friday, the last day of 2010, the National Debt stood at $14,025,215,218,708.52.
It took just 7 months for the National Debt to increase from $13 trillion on June 1, 2010 to $14 trillion on Dec. 31. It also means the debt is fast approaching the statutory ceiling $14.294 trillion set by Congress and signed into law by President Obama last February.
Some Republicans in the new Congress have said they'll seek to block an increase in the Debt Ceiling unless a plan is in place to significantly reduce federal spending and unfunded government liabilities on entitlement programs such as Social Security and Medicare.
White House economic adviser Austan Goolsbee warned yesterday that it would be "catastrophic" if the U.S. Government were to default on its financial obligations.
"That would be the first default in history caused purely by insanity," said Goolsbee of plans to block an increase in the Debt Ceiling.
Below we highlight the 2010 returns (in local currencies) for equity markets around the world. As shown, the average country saw its major equity market index gain 15.33% in 2010. Sri Lanka's stock market gained the most at 96.01%, while Bermuda declined the most at -44.87%. Six other countries along with Sri Lanka gained more than 50% in 2010 -- Bangladesh (82.79%), Estonia (72.62%), Ukraine (70.20%), Peru (64.99%), Lithuania (56.49%), and Argentina (51.83%).
Looking at just the G-7 countries, Germany did the best at 16.06%, followed by Canada (14.45%), the US (12.78%), and the UK (9%). The three other G-7 countries -- France, Japan, and Italy -- all declined last year. Of the BRICs, Russia gained the most at 22.70%, followed by India (17.43%), Brazil (1.04%), and China (-14.31%). While some are calling for developed markets to start outperforming emerging markets in 2011, the results below show that trend beginning to unfold in 2010.
Let’s take a look at the situation after the October data from the Case-Shiller home price index has come in:
You see all major metropolitan areas peaking between March and May 2010 (the end of the first-time home-buyer tax credit). After only 8 months in positive territory, the overall index comprising 20 cities is back into the red (-1% in October). 14 out of 20 regions now show declining house prices.
Prof. Robert Shiller (one of the creators of the index) pointed out that 6 out of 20 cities in the index have hit new lows (even lower than in early 2009). He said that the economy would face “serious worries” if house prices kept falling this fast.
Why did he say “this fast”? To understand, you have to look at the annualized rate of change of the last 3 months. And it is not a pretty picture:
While the 10-city index dropped an annualized 8.8% in the three-month period from July to October 2010, the 20-city index fell at a rate of 10.4%.
The annualized three-month rate of change gave an early warning sign went it went into negative territory in June 2006, while both the 10-city and 20-city only showed declining house prices in January of 2007.
Equally, the three-month rate of change signaled a trend reversal in April, May and June of 2009, while the overall index did not turn positive until February 2010.
Investors would have been wise to heed these signals – both on the way down and on the way up. As declining house prices were the trigger for the biggest financial crisis since the Great Depression it is only a matter of time until financial markets react to the new realities of house prices: a double-dip.
[1,3] Source: StandardandPoors.com, own calculations.
 Prof. Robert Shiller, in: online interview with Wall Street Journal, December 29, 2010
With a $4.7 trillion bailout under their belts and no harm done to their billion-dollar bonuses, don't expect Wall Street bankers to be chastened by the 2008 financial crisis. Below we list eight things to watch out for in 2011 that threaten to rock the financial system and undermine any recovery.
1) The Demise of Bank of America WikiLeaks founder Julian Assange is promising to unleash a cache of secret documents from the troubled Bank of America (BofA). BofA is already under the gun, defending itself from multiple lawsuits demanding that the bank buy back billions worth of toxic mortgages it peddled to investors. The firm is also at the heart of the robo-signing scandal, having wrongfully kicked many American families to the curb. If Assange has emails showing that Countrywide or BofA knew they were recklessly abandoning underwriting standards and/or peddling toxic dreck to investors, the damage to the firm could be irreparable.
2) Robo-signers Wreaking Havoc With lawsuits abounding, new types of fraud in the foreclosure process are being uncovered daily, including accounting fraud, fake attorneys, destroyed promissory notes and false notarization. The crisis not only calls into question the legality of untold foreclosures, it also calls into question the value of trillions of dollars worth of mortgage-backed securities held by banks, pension funds, federal, state and local governments. The only government report on the topic by the feisty Congressional Oversight Panel for the TARP acknowledges that "it is possible that 'robo-signing' may have concealed deeper problems in the mortgage market that could potentially threaten financial stability."
3) MERS Madness
In addition to outright fraud, numerous state Supreme Courts have questioned the legal standing of the Mortgage Electronic Registration or "MERS" system. MERS is listed as the mortgagee for 60% of U.S. mortgages. It is an electronic clearinghouse created by industry to bypass the property registration system developed in precolonial days to ensure that the King could not easily rob the subjects of their land. Wall Street turned to MERS to speed securitizations (and now foreclosures), but its legal standing is now in doubt and its shoddy processing of documents has major ramifications for the securitization process as well. Look for a rotten "MERS fix" in the new Congress. Let's hope it gives consumer advocates some leverage to demand justice for Americans being robbed by the new Kings on Wall Street.
4) Flash Crash Calamity The "flash crash" of May 2010 rattled the markets and caused a stunning 700 point drop in the Dow within minutes. Regulators think they know what occurred, but they are moving too slowly to put the brakes on hair-trigger trading. Seventy percent of Wall Street trades take place in milliseconds, so it is no surprise that mini-flash crashes are becoming a constant. With traders now gearing up to trade on raw news feeds and Twitter, we can anticipate even more volatility. A small financial transaction tax targeting high-volume, high-speed trades is long overdue. It would throw sand in the roulette wheel and raise much needed revenue for the federal government.
5) Bigger Behemoth Banks The Federal Reserve is planning to "stress test" the big banks again. The same 19 banks that underwent the first stress tests in 2009 will be tested again, but this time the Fed says it won't release the results. Why not? Banks with toxic mortgages and mortgage-backed securities on their books and concomitant legal exposure to "put back" law suits are being kept afloat by accounting tricks, TARP and Fed loans. Honest stress tests of still weak financial institutions may well result in sales and buyouts that will further consolidate the already concentrated banking industry and create larger and more unwieldy "too big to fail" behemoths -- backed by the guarantee of the American taxpayer.
6) Foreclosure Tsunami Housing foreclosures may top nine million in 2011 and [[Goldman Sachs]] predicts the number will reach 12 million in the next few years. The result will be another significant drop in home prices in 2011 and even more families underwater. Civilized nations see the forcible migration of a city the size of New York as an economic and humanitarian catastrophe, but not the United States. The Obama administration and Congress have callously refused to take meaningful action to aid families facing foreclosure even in the face of widespread predatory lending and rampant foreclosure fraud. The only hope now for millions of American families is aggressive action by the 50 state Attorneys General who are actively investigating foreclosure fraud. Whether they have the guts to wrestle a settlement out of the big banks that slows the foreclosure machine and offers families meaningful options has yet to be seen.
7) Bankrupt Cities and States Meredith Whitney, a research analyst who correctly predicted the credit crunch, is now warning that over 100 American cities could go bust next year. She anticipates billions worth of municipal bond defaults and warns: "next to housing this is the single most important issue in the U.S. and certainly the biggest threat to the U.S. economy." States are also in dire straits. The economic shock of mass unemployment on top of years of population decline, deindustrialization and the like have left cities unable to meet their obligations to taxpayers and retirees. With the austerity nuts in charge of the House, it may take a bankruptcy of a major player to prod an appropriate federal response to this looming disaster.
8) Gas Prices above $4.00 The price of energy and other commodities shifted into high gear in late August when the Federal Reserve Chairman decided to stimulate the economy with quantitative easing. Speculators quickly began bidding up the value of asset classes like crude oil, metals and food commodities. In December, the Commodities Futures Trading Commission failed to apply position limits to these commodities, delaying rules that would crack down on speculators and aid consumers who are already seeing big price hikes at the pump. Without swift action, skyrocketing gas prices will further tank an already stalled economy.
As we hope for the best in 2011, let's prepare for the worst. The big banks are sure to deliver.