Global Liquidity Is Drying Up 12-15-14 Macro Watch - Richard Duncan

Global Liquidity is getting tight. Consequently, our global economic raft is once again beginning to sink.

• Commodity prices are falling,
• The consumer price inflation numbers are weakening in all the major economies and
• Asset prices (particularly overvalued equities prices) look increasingly vulnerable to a sharp correction.

Without a fourth round of Quantitative Easing the global economy could well be sucked down into a deflationary whirlpool next year.

I have recently uploaded three Macro Watch videos analyzing the outlook for global liquidity:

1. The Outlook For Global Liquidity Points To Deflation Ahead;

2. Analyzing The Five Largest Central Banks; and

3. FX Reserves, The Dollar Crisis & The Outlook For Global Liquidity.

To measure global liquidity, I took the total assets of the five largest central banks (the People’s Bank of China, the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England) plus the total foreign exchange reserves of the world’s other central banks and projected this data out to the end of 2016 based on current central bank guidance. Here’s what that looks like:

Looking out to 2015 and 2016:

• the Fed’s balance sheet flattens out since Quantitative Easing has (supposedly) ended.
• The BOJ’s assets increase at the rate of Yen 85 trillion a year.
• The ECB’s assets expand back to the level reached in 2012.
• The numbers for the PBOC are my estimates and assume that China’s central bank will continue accumulating large amounts of foreign exchange reserves in order to prevent the country’s huge trade surplus from pushing up the value of the Yuan.

Now, by adding all of those assets together, we can calculate the annual percent increase in global liquidity, as shown below:

1. Notice that at present (the end of 2014), global liquidity has only increased by 5% relative to one year ago.
2. At the peak of the crisis, in 2008 and 2009, global liquidity expanded by 25% to 40% a year.
3. During 2011, it grew by 15% to 20%.
4. Even before the crisis began, global liquidity grew by 15% during much of 2004 and 2005.

Therefore, the current growth rate of only 5% is very much less than what the global economy and the financial markets have grown accustomed to.

Looking ahead, thanks to printing by the BOJ and the ECB, the growth rate will pick up to 8% or 9% at the end of 2015, but then move back down again to 7% by the end of 2016. As the base grows larger, it becomes necessary to print more and more money every year to prevent the growth rate in global liquidity from slowing. And, of course, if the growth rate does not remain high, the additional liquidity ceases to provide sufficient monetary stimulus to keep the global economy inflated.

After 2016, if we assume that the BOJ and the ECB eventually end their quantitative easing programs, the growth rate of global liquidity will slow rapidly and soon come to a relative standstill. Global asset prices and the global economy were reflated after 2008 by an unprecedented amount of fiat money creation by the world’s central banks. If that monetary stimulus ends, asset prices are very likely to deflate again and the global economy is likely to begin spiraling back toward depression.

Ultimately, it may prove impossible to keep the global economic bubble inflated, but the Fed almost certainly won’t allow it to deflate without at least attempting QE 4 and possibly QE 5, 6 and 7.

I believe it’s only a matter of time before the Fed turns back on its printing presses.

Until then, beware of falling asset prices.

FLOWS - 6 Years Of Central Bank Liquidity Injections

This Is What 6 Years Of Central Bank Liquidity Injections Look Like 12-09-14 Zero Hedge

Curious how over the past 6 years we got to a point where the market is now so irreparably broken, even the BIS couldn't take it anymore and threw up all over the the world's central bankers? Then look no further than the following chart summarizing 6 years of global central bank liquidity injections that have made it imperative to use quotation marks every time one writes the word "market"

Source: BlackRock

FLOWS - Austrian Money Supply Growth Sending Early Warning

SOURCE

The U.S. Money Supply Decelerates in October, the Risk of an Economic Bust Just Went Up 11-16-14 Forbes

The U.S. money supply as represented by TMS2 (True “Austrian” Money Supply), our broadest and preferred U.S. money supply aggregate, posted a year-over-year rate of growth of 7.7% in October, down from an 8.3% rate in September. Now down 880 basis points (53%) from the current boom-bust monetary inflation cycle high of 16.5% posted in November 2009, this is the lowest year-over-year rate of growth in TMS2 since the 6.9% rate seen in November 2008 (month 4 in this 75 month long and counting inflation cycle). As a result, although we are not yet ready to declare that the economy is staring at an imminent bust in the face, this decelerating trend in the rate of monetary inflation is bringing us ever so closer to one. To investors and speculators alike, we say time to be especially cautious.

Here’s the current growth rate in TMS2 in the context of the last 20 year experience…

Defined by how we measure boom-bust monetary inflation cycles (by the year-over-year rate of change in TMS2, cycle trough to trough), here is how the current inflation cycle – what we have termed the Bernanke Risk-On Boom – Bust-to-Be – stacks up against the inflation cycles that gave us the Tech Boom-Bust and the Housing Boom-Bust turn Credit Bust turn Great Recession…

As readers of THE CONTRARIAN TAKE are aware, given the size of the monetary largesse injected into the economy during this inflation cycle, this kind of deceleration in the rate of monetary inflation is a huge yellow light for both the economy and markets. If it continues, a bust awaits. As we have written in the past…

…once an economy is subjected to a bout of monetary inflation, whether that be via direct central bank money creation or via money (and credit) creation by the fractional reserve banking system, an unsustainable, artificial economic boom is born, whereby malinvestments (bubbles if you like) are created that sooner or later must be liquidated. And whether that bust takes the form of a hyperinflationary bust or a deflationary bust, bust we will get. The form the bust takes will depend on the course of the inflation. If the central bank/banking system pursues an inflationary course, by throwing continual and importantly ever larger doses of money (and credit) into the economy, the bust will take the form of a hyperinflationary bust – a collapse in the value of the currency and with that a breakdown of the entire economy. If instead the central bank/banking system ends its money creation activities or even moderates that increase in a material way, the bust will take the form of a deflationary bust – a healthy liquidation of the malinvestments made during the boom and with that a commensurate fall in the prices of those same malinvestments.

What’s more…

…the greater the monetary infusions into the economy and financial markets, and thus the more they permeate the same economy and markets, the more malinvestments will be created and therefore the broader and deeper the eventual liquidation will be.

In other words…

…the bigger the monetary boom, the bigger the bust.

Yes, at 7.7%, the year-over-year rate of growth in TMS2 is not sporting the same sub 5% year-over year rates that ushered in the last two busts.  But consider this: The latest installment of the Federal Reserve’s QE asset purchase program is history with the last $15 billion in asset purchases now complete. Over the last 12 months, that program accounted for roughly three quarters of the growth in TMS2. And while the U.S. banking system, the other money creation engine in the economy, has of late been helping to offset the money creation void being vacated by the Federal Reserve, it is going to have to really step it up to ward of a continuing deceleration in the overall the rate of money creation. If not, we could very well be staring a bust directly in the face.

As for market investors and speculators, consider also this: As we wrote here and here, the financial markets have seen the lion’s share of the monetary inflation this cycle, more so than in any cycle in history.  That makes them especially vulnerable to a deceleration in the rate of monetary inflation, more so than at any other time in history…

A friend of THE CONTRARIAN TAKE took a shot at what’s in store for the money supply, factoring in both Federal Reserve and U.S. banking system dynamics. We think it’s well worth a read.

We will have a lot more to say about this same topic in our next post.

For the logic behind the formulation of the True “Austrian” Money Supply (TMS) and it’s superiority to mainstream money supply measures, read Money Supply Metrics, the Austrian Take.

For a link to TMS series definitions, along with sources, notes and supporting academic references, see True “Austrian” Money Supply Definitions, Sources, Notes and References.

For a perma-link to the data series itself, where we track monthly money supply metrics for the U.S., Eurozone, Japan and U.K. currency blocks, see True “Austrian” Money Supply.

FLOWS - Drying Up Quickly On Multiple Front

SUMMARY

• FLOWS REDUCTION: $316bn hit to the cartel’s revenues which previously:
  • Boosted liquidity,
  • Spurred asset prices and helped to
  • Kept borrowing costs down,
  • The $316bn figure would be much higher if other big oil exporters including Russia, Norway, Mexico, Kazakhstan and Oman are taken into account.
• 40% fall in Brent crude since mid-June will reverse trend and for the first time in 20 years Opec nations will be sucking liquidity out,
• ASSET BUYING REDUCTION: In 2012 Opec petrodollar flows into liquid investments such as US Treasuries, high-grade corporate bonds and equities stood at $500bn. Next year, they could drop below $100bn if prices average $78 a barrel,
• US$ LIQUIDITY SQUEEZE : The US is importing less oil than it used to, meaning fewer dollars are being sent abroad: some analysts have said this could lead to a shortfall in dollar liquidity,
• SHIFT IN INVESTMENT PATTERNS: The main impact of the reduction of petrodollar flows will be less on liquidity than on investment patterns. What a sovereign wealth fund might put their money into will be different to what an asset manager might favour.
• FORCED ASSET SELLING: If stressed oil producers are forced to sell assets to fund gaps in their domestic budgets, that “could in theory be a good deal messier”

FLOWS - Drying Up Quickly On Multiple Front

A Dramatic Change in the Liquidity Environment

GavKal 12-02-14

CHINA -Reverses Direction and Begins Easing

China Central Bank Cuts Interest Rates to Support Growth 11-21-14 Bloomberg Brief

China cut benchmark interest rates for the first time since July 2012 as leaders support growth in the world’s second-largest economy.

The one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, while the one-year lending rate was reduced by 0.4 percentage points to 5.6 percent, effective tomorrow, the People’s Bank of China said on its website today.

Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990. The cut in the benchmark lending rate follows

• Liquidity injections and
• Targeted cuts to reserve requirements.

Although the PBOC scrapped controls on most borrowing costs in July 2013, banks still use benchmark rates as a guide for loans including mortgages

ECB - Draghi Laying QE Foundations

Draghi Speech Raises Chances of Fresh Action in December 11-21-14 Bloomberg Brief

ECB President Mario Draghi may be laying the groundwork for an announcement at his press conference in December to broaden the types of assets the Governing Council purchases under its quantitative easing program.

Draghi emphasized the need for a timely reaction this morning. He said,

“We will use all means... to return inflation towards our objective — and without any undue delay.”

He added,

“We will do what we must to raise inflation and inflation expectations as fast as possible.”

By contrast, he seemed in no rush to accelerate the pace of purchases at the monthly press conference in November. He has left open the door to announcing the purchase of new types of assets.

The ECB president said today,

“We would step up the pressure and broaden ever more the channels through which we intervene, by altering the size, pace and composition of our purchases.”

Draghi appears to find the status quo unacceptable. He told the audience,

“Over shorter horizons, however, indicators have been declining to levels that I would deem excessively low.”

Draghi seems to be using the latest round of weak data as an excuse to increase his dovishness. He cited the weakness in the PMI survey

The BOJ Ups The Ante

Definition

Yenergize: to energize the economy by creating Yen.

Three months ago, I wrote a blog with the title, “Japan’s Horrible GDP Data May Be Good For Stocks”. There, I suggested that Japan’s economy was so weak that the Bank of Japan (BOJ) would probably have to increase the size of its fiat money creation program (which it calls Quantitative and Qualitative Easing or QQE for short). I wrote:

“…if the BOJ does expand QQE still further, then the Yen will weaken, Japanese corporate profits will improve and the stock market will rise. This is a scenario where, at least for a short while, it would once again be relatively easy to make money in Japan. I believe this week’s horrible GDP report has made this scenario increasingly probable.”

Earlier in the year, there had been a number of hints from the BOJ that QQE might be increased, but since those had occurred some time back, market speculation about additional QQE had begun to die down. So the markets were flabbergasted on October 31st, when the BOJ did announce it intended to increase its Yen creation and asset purchases from Yen 60 – 70 trillion a year to Yen 80 trillion (approximately US$725 billion a year).

Coming only two days after the Fed ended the third round of Quantitative Easing in the United States, the BOJ’s announcement was timed to have maximum impact – and it did. The Japanese stock market jumped 5% that day and the Yen moved sharply lower. Two weeks later, the Nikkei Index is at a seven year high, while the Yen is at a seven year low.

So, what happened? Why was more QQE necessary? The simple answer is that more QQE was necessary because the initial round of QQE had run out of steam. Although the Bank of Japan would never admit it, QQE works by pushing down the value of the Yen. But, 19 months after the program was initially launched, the Yen had stopped falling, the stock market was flat, the economy was weakening and the inflation rate had started to move back down toward deflation. Therefore, the BOJ either had to up the ante or admit defeat. It decided to up the ante and energize (or perhaps we should say Yenergize) the economy by creating even more Yen.

Now what? Japan’s economy faces very severe challenges. Japanese wages are too high to allow goods made in Japan to be competitive against goods made in countries with much lower wage costs, such as China. After the Fukushima nuclear disaster, Japan’s energy import bill skyrocketed and threw the country’s trade balance into deficit. The population is not only ageing, it is actually shrinking. Japan has been struggling against deflation since the mid-1990s. And, Japanese government debt to GDP is nearly 250%. In April, the government increased the consumption tax to put its finances on a more sustainable footing, but that tax hike knocked the wind out of the economy and threatened to throw it back into recession. Therefore, the economy badly needed another jolt of stimulus to prevent a new slump.

Now, thanks to the expansion of QQE to Yen 80 trillion a year, the economy is likely to rebound. The lower Yen will improve the competitiveness of Japanese exports and corporate profits. That, in turn, will boost the stock market and create a wealth effect that will help drive domestic economic growth.

Unfortunately, printing more Yen is only a short-term fix, not a long-term solution, for Japan’s woes. It will only benefit the economy so long as the Yen continues to depreciate. Six months or a year from now the BOJ may have to up the ante again with another monetary jolt. Once a country begins printing money to stimulate the economy, it is very difficult to stop.

This saga is likely to end very badly, eventually (unless the BOJ ultimately cancels all of the government bonds it has acquired through QQE). Meanwhile, the near term outlook has improved - for the economy, for Japanese stock prices and for Prime Minister Abe, who has staked his career on defeating deflation and reviving the economy. According to press reports, the Japanese Prime Minister will announce snap Parliamentary elections next week and postpone the second stage of the consumption tax hike, which had been scheduled for next October. If these reports prove true, investors are very likely to welcome the news and push the Japanese stock market higher still.

FLOWS - Liquidity, Credit and Debt

From Despair to Euphoria (and Back?) 11-01-14 Richard Duncan

When I wrote my last blog, “Very Scary”, on October 14th, the stock market was very shaky. Bloomberg reported that $744 billion had been wiped off equity values just since October 8th. Things became very much scarier the next day. When the markets opened on October 15th, panic set in. The Dow fell as much as 470 points, and bond yields collapsed. The yield on the 10-year US government bond fell from above 2.2% to 1.86% nearly as soon as the market opened. CNBC’s savvy bond market watcher, Rick Santelli, said he had never seen anything like it. The Fed had long signaled that it would end the third round of Quantitative Easing in October and the markets were terrified by the thought of what would happen to stocks when the Fed stopped pumping money into the financial markets.

The following morning (October 16th) stocks were moving down sharply again. The NASDAQ was down more than 10% from its September high, while the S&P was off 9.8% from its peak. Then, in the blink of an eye, everything changed. In a live TV interview, St Louis Fed President James Bullard recommended extending QE. The Dow jumped 120 points so quickly that it looked like a computer error must have occurred. The following day, the chief economist of the Bank of England revealed that the first interest rate hike in the UK was likely to be delayed relative to earlier expectations. On October 20th, the European Central Bank announced it had begun buying covered bonds to boost the Eurozone’s economy. And on October 28th, Sweden’s central bank cut its policy interest rate to zero percent for the first time in history.

By this point, stocks had recovered most of their losses from earlier in the month. On October 29th, the Fed put on a brave face and announced that it had decided to end QE 3, as scheduled. But, then, two days later, the Bank of Japan stunned the financial world by announcing that it would increase its Quantitative Easing program from Yen 60 - 70 trillion a year to Yen 80 trillion a year, an amount equivalent to US$727 billion.

Within the space of two weeks, market sentiment flipped from despair to euphoria. By the end of trading on October 31st, both the Dow and the S&P had hit new record highs. The Yen fell to its lowest level against the dollar in nearly seven years, while the Nikkei index jumped to its highest level since November 2007. The strong dollar pushed oil down 9% during October and gold fell to its lowest level since 2010. What a couple of weeks!

So, what next? As you know, I believe central banks (primarily the Fed) have been driving economic growth by printing money and pushing up asset prices, thereby creating a wealth effect. Stocks came very close to crashing mid-month on the thought that QE was about to end. But, James Bullard restored calm by strongly implying that the Fed was prepared to step back in with more QE if necessary. Then all the other central banks chipped in, one way or the other (the BOJ most dramatically), to send a strong signal that they would not allow the global bubble to deflate.

But, here’s the thing. Without more – in fact, without much more – fiat money creation by the Fed (a.k.a. QE 4), the global bubble is going to deflate, or, at least, that’s how it looks to me.

The following chart was taken from my latest Macro Watch video, which was called “Analyzing The Five Largest Central Banks”. It shows the annual percent increase in Global Liquidity projected out to the end of 2016.

It shows that, without more Quantitative Easing from the Fed, global liquidity will expand by only

• 6% during 2016, compared with
• 20% in 2012,
• 30% in 2009 (at the peak of the policy response to the crisis), and
• 15% in 2004 and 2005 (the years leading up to the crisis).

This chart was made before the BOJ announced the expansion of its QE program, but even incorporating that, the growth in global liquidity will still be less than 7% in 2016. That will not be enough to keep the global economic bubble inflated. Only another very large round of Quantitative Easing by the Fed will achieve that. It will be fascinating to watch how much longer stock prices will continue to levitate without additional policy intervention to keep them afloat.

Not for long is my guess.

EU - European Central Bank united on €1tn Liquidity Injection

EU - Mario Draghi's efforts to save EMU have hit the Berlin Wall

FLOWS - Bank of Japan opens the floodgates

Bank of Japan opens the floodgates 11-02-14 Gavyn Davies, FT

JAPAN shocks on Halloween as ABE-NOMICS is replaced with BANZAI-NOMICS

Soon, the sun may no longer be able to afford to rise in Japan! A country already addicted to fatal levels of morphine, the tiny island has been placed on life support as hospice enters the fatal end.

Shocked former US Congressional Budget Office head and Congressman David Stockman spelled it out:

"The BOJ will now escalate its bond purchase rate to $750 billion per year - a figure so astonishingly large that it would amount to nearly $3 trillion per year if applied to a US scale GDP. And that comes on top of a central bank balance sheet which had previously exploded to nearly 50% of Japan’s national income or more than double the already mind-boggling US ratio of 25%... Specifically, in order to go on a stock buying spree, Japan’s state pension fund (the GPIF) intends to dump massive amounts of Japanese government bonds (JCB’s). This will enable it to reduce its government bond holding - built up over decades - from about 60% to only 35% of its portfolio.

Effectively the government is monetizing its debt and pumping up the stock market through the GPIF which is the largest pension fund in the world.

Japan adopted ZIRP and QE before other world economies even knew what it meant. These "experiments" never worked for them (nor anyone) so like every Keynesian addict resorts to when their current dose is not achieving the high it once did, it immediately doubles the injection. Japan, like the US must learn you can't recreate the past but must structurally change for the future. Unfortunately rational thinking normally doesn't work with an addict.

Stockman tries to put this lunacy into perspective for the layman:

"Notwithstanding the massive hype of Abenomics, Japan’s real GDP is lower than it was in early 2013, while its trade accounts have continued to deteriorate and real wages have headed sharply south. So there is no recovery whatsoever—-not even the faintest prospect that Japan can grow out if its massive debts. The latter now stands at a staggering 250% of GDP on the government account and upwards of 600% of GDP when the debts of business, households and the financial sectors are included. And on top of that there is Japan’s inexorable demographic bust—–a force which will shrink the labor force and squeeze even further its tepid growth of output as far as the eye can see.

Stated differently, Japan is an old age colony which is heading for bankruptcy It has virtually no prospect for measurable economic growth and a virtual certainty that taxes will keep rising —since notwithstanding the much lamented but unavoidable consumption tax increase last spring it is still borrowing 40 cents on every dollar it spends.

SII - WEAKENING LIQUIDITY FLOWS

Though we have weakening liquidity flows in the US (TAPER has ended) Friday's JAPANESE QQE ANNOUNCMENT Injects Trillions of YEN into the Global Carry Trade.

We now consider this Q3 MACRO Call COMPLETED

HALLOWEEN MASSACRE - Japan's Insane Monetary Announcement

Japan's BOJ Kuroda

Headlines:

• USDJPY rose 2.7% today - biggest day in 18 months back to Oct 2007; +3.7% on the week - bighest week since Dec 2009
• Nikkei +7.7% today - biggest day since March 2009; +10% on the week - biggest week since Dec 2009
• Russell 2000's up over 6% - best month in 15 months
• Russell +1.2% year-to-date
• Nasdaq at March 2000 highs
• 5Y yields up 12bps on the week - biggest increase in 6 months
• 2Y yields up 11bps on the week - biggest increase in over 3 years
• 5s30s flattened 10bps on the week - biggest flattening in 7 months
• Silver -6.1% on the week - worst week in 16 months
• Gold -4.7% on the week - worst week in 16 months

 David Stockman via Contra Corner blog,

This is just plain sick. Hardly a day after the greatest central bank fraudster of all time, Maestro Greenspan, confessed that QE has not helped the main street economy and jobs, the lunatics at the BOJ flat-out jumped the monetary shark. Even then, the madman Kuroda pulled off his incendiary maneuver by a bare 5-4 vote. Apparently the dissenters - Messrs. Morimoto, Ishida, Sato and Kiuchi - are only semi-mad.

Never mind that the BOJ will now escalate its bond purchase rate to $750 billion per year - a figure so astonishingly large that it would amount to nearly $3 trillion per year if applied to a US scale GDP. And that comes on top of a central bank balance sheet which had previously exploded to nearly 50% of Japan’s national income or more than double the already mind-boggling US ratio of 25%.

In fact, this was just the beginning of a Ponzi scheme so vast that in a matter of seconds its ignited the Japanese stock averages by 5%. And here’s the reason: Japan Inc. is fixing to inject a massive bid into the stock market based on a monumental emission of central bank credit created out of thin air. So doing, it has generated the greatest front-running frenzy ever recorded.

The scheme is so insane that the surge of markets around the world in response to the BOJ’s announcement is proof positive that the mother of all central bank bubbles now envelopes the entire globe. Specifically, in order to go on a stock buying spree, Japan’s state pension fund (the GPIF) intends to dump massive amounts of Japanese government bonds (JCB’s). This will enable it to reduce its government bond holding - built up over decades - from about 60% to only 35% of its portfolio.

Needless to say, in an even quasi-honest capital market, the GPIF’s announced plan would unleash a relentless wave of selling and price decline. Yet, instead, the Japanese bond market soared on this dumping announcement because the JCBs are intended to tumble right into the maws of the BOJ’s endless bid. Charles Ponzi would have been truly envious!

Accordingly, the 10-year JGB is now trading at a microscopic 43 bps and the 5-year at a hardly recordable 11 bps. So, say again. The purpose of all this massive money printing is to drive the inflation rate to 2%. Nevertheless, Japanese government debt is heading deeper into the land of negative real returns because there are no rational buyers left in the market - just the BOJ and some robots trading for a few bps of spread on the carry.

Whether it attains its 2% inflation target or not, its is blindingly evident that the BOJ has destroyed every last vestige of honest price discovery in Japan’s vast bond market. Notwithstanding the massive hype of Abenomics, Japan’s real GDP is lower than it was in early 2013, while its trade accounts have continued to deteriorate and real wages have headed sharply south.

So there is no recovery whatsoever—-not even the faintest prospect that Japan can grow out if its massive debts. The latter now stands at a staggering 250% of GDP on the government account and upwards of 600% of GDP when the debts of business, households and the financial sectors are included. And on top of that there is Japan’s inexorable demographic bust—–a force which will shrink the labor force and squeeze even further its tepid growth of output as far as the eye can see.

Stated differently, Japan is an old age colony which is heading for bankruptcy. It has virtually no prospect for measurable economic growth and a virtual certainty that taxes will keep rising —since notwithstanding the much lamented but unavoidable consumption tax increase last spring it is still borrowing 40 cents on every dollar it spends.

So 5-year JGBs yielding just 11 bps are an insult to rationality everywhere, and a warning that Japan’s financial system is a disaster waiting to happen. But even that is not the end of it. Having slashed its historic holdings of JCBs, the GPIF will now double it allocation to equities, raising its investment in domestic and international stocks to 24% each.

Stated differently, 50% of GPIF’s $1.8 trillion portfolio will flow into world stock markets.  On top of that—the BOJ will pile on too—-tripling its annual purchase of ETFs and other equity securities. This is surely madness, but the point of the whole enterprise explains why the world economy is in such extreme danger. A Japanese market watcher caught the essence of it in his observation about the madman who runs the bank of Japan,

“Kuroda loves a surprise — Kuroda doesn’t care about common sense, all he cares about is meeting the price target,” said Naomi Muguruma, a Tokyo-based economist at Mitsubishi UFJ Morgan Stanley Securities Co., who correctly forecast more stimulus today.

That’s right. Its 2% on the CPI…..come hell or high water.  There is not a smidgeon of evidence that 2% inflation is any better for the real growth of enterprise, labor hours supplied and economic productivity than is 1% or 3%.  Its pure Keynesian mythology. Yet all the world’s central banks are beating a path toward the same mindless 2% inflation target that lies behind this morning’s outbreak of monetary madness in Japan.

Folks, look-out below.  As George W. Bush said in another context…..this sucker is going down!

Charting Banzainomics: What The BOJ's Shocking Announcement Really Means 10-31-14 Zero Hedge

Still confused what the BOJ's shocking move was about, aside from pushing the US stock market to a new record high of course? This should explains it all: as the chart below show, as a result of the BOJ's stated intention to buy 8 trillion to 12 trillion yen ($108 billion) of Japanese government bonds per month it means the BOJ will now soak up all of the 10 trillion yen in new bonds that the Ministry of Finance sells in the market each month.

In other words. The Bank of Japan’s expansion of record stimulus today may see it buy every new bond the government issues.

This is what full monetization looks like.

More from Bloomberg:

The central bank is already the largest single holder of Japan’s bonds, and the scale of its buying could fuel concerns it is underwriting deficits of a nation with the heaviest debt burden. The BOJ could end up owning half of the JGB market by as early as in 2018, according to Takuji Okubo, chief economist at Japan Macro Advisors in Tokyo.

“Kuroda knows when to go ALL in,” Okubo wrote in a note. “The BOJ is basically declaring that Japan will need to fix its long-term problems by 2018, or risk becoming a failed nation.”

The unprecedented efforts to stoke inflation could scare bond investors, said Chotaro Morita, the chief rates strategist in Tokyo at SMBC Nikko Securities Inc.

Kuroda said earlier this month that while the BOJ holds only about 20 percent of Japan’s outstanding government bonds, the Bank of England holds approximately 40 percent of U.K. government debt.

We wish Japan the best of luck in avoiding becoming a "failed nation."

Then again there is something to be said about a nation which is now desperately, and obviously to everyone, tryingto unleash hyperinflation... and, for now at least, is failing.

Japan risks Asian currency war with fresh QE blitz 10-31-14 Ambrose Evans-Pritchard, Telegraph

The Bank of Japan is mopping up the country's vast debt and driving down the yen in a radical experiment in modern global finance

FLOWS - Liquidity, Credit & Debt

The Chart That Explains Why Fed's Bullard Wants To Restart The QE Flow 10-19-14 Zero Hedge

Remember when the Fed (and their Liesman-esque lackies) tried to convince the world that it was all about the 'stock' - and not the 'flow' - of Federal Reserve Assets that kept the world afloat on easy monetary policy (despite even Bullard admitting that was not the case after Goldman exposed the ugly truth). Having first explained to the world that it's all about the flow over 2 years ago, it appears that, as every equity asset manager knows deep down (but is loathed to admit for fear of losing AUM), of course "tapering is tightening" - as the following chart shows, equity markets are waking up abruptly to that reality. So no wonder Bullard is now calling for moar QE - he knows it's all there is to fill the gap between economic reality and market fiction.

Tapering is Tightening.... as the flow of Fed free money slows... so equity performance suffers.

Of course it's not just the Fed (as Citi shows below) but for now the ECB seems unable to pull the trigger and the BoJ is hitting both political and market sentiment limits on its craziness.

And we better get moar... because the gap between perception and reality is huge...

Charts: Bloomberg and @Not_Jim_Cramer

FLOWS - Liquidity, Credit & Debt

RICHARD DUNCAN

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FLOWS - Liquidity, Credit & Debt

Very Scary - 10-15-14 Richard Duncan

The correction in US stocks has begun. It’s likely to become significantly worse during the months ahead. In this new age of fiat money, Liquidity determines the direction in which asset prices move and Liquidity is drying up. That is because the third round of Quantitative Easing is coming to an end this month. When the first round of Quantitative Easing ended, stocks fell. When the second round of Quantitative Easing ended, stocks fell. Therefore, it should not surprise anyone that stocks have begun to fall again this time.

There is more at stake here than just stock prices, however. If stocks continue to slide, the United States could well fall back into severe recession; and economic contraction in the US would almost certainly throw the global economy back into crisis. Here’s how things stand.

Since the end of 2008, the Fed has printed $3.5 trillion and injected it into the financial markets by buying government bonds and mortgage-backed securities. This injection of new money artificially inflated stock prices and property prices. Household sector Net Worth rose by $25 trillion (or by 46%) as a result. Consequently, many people felt richer and they spent more. In this way, the Fed boosted consumption and drove economic growth.

With QE 3 now ending, the force of gravity is reasserting itself and stock prices have begun to fall back to earth. Bloomberg News reported that approximately $744 billion has evaporated from equity values since October 8th. And this could be just the beginning. If the stock market selloff continues, then Net Worth will contract significantly; people will feel poorer and spend less. And that will send the US back into recession. Keep in mind, the US economy is none too strong to begin with. As I wrote last time, the economy only expanded at an annualized rate of 1.2% during the first half of this year.

Any slowdown in the US economy would deal a very severe blow to the rest of the world. Last week, the IMF lowered its forecast for global economic growth yet again. It has cut its current-year growth forecasts nine out of 12 times in the last three years. Europe is on the brink of recession. Even Germany has stopped growing. Deflation in Europe may only be a few months away. The inflation rate has been moving down steadily to an annual rate of only 0.3% last month. Japan’s economy has not grown over the past 12 months despite very aggressive money creation by the Bank of Japan. China is slowing rapidly and the world has begun to pray that the great China bubble doesn’t implode in the near future. Brazil and Russia are in recession. Global commodity prices are plunging. Brent Oil slid 4% yesterday to the lowest level since 2010, after the International Energy Agency cut its forecasts for oil demand growth to its weakest in five years. And, remember, all of this weakness in the global economy was occurring before the recent selloff in US stocks began. Imagine how ugly things will become if US stocks fall a further 20% from here.

The Fed had better think twice – or even three or four times – before it allows that to happen. Indeed, it seems that they have already begun to have second thoughts about ending QE. Today, Reuters reported, “The head of the San Francisco Federal Reserve Bank on Tuesday said he would be open to another round of asset purchases if inflation trends were to fall significantly short of the U.S. central bank’s target.” This was the first hint that the Fed is prepared to launch a new round of Quantitative Easing, QE 4, as I have long suspected that they would be forced to do.

So here’s how it looks most likely to play out to me. Stock prices are likely to continue falling during the next couple of weeks, even with the Fed still injecting roughly $650 million a day into the financial markets until the end of October. If so, the sense of panic among investors will continue to mount. Then, things will become worse after that if the Fed really does stop injecting new money into the markets on October 31st. As stock prices fall and Net Worth evaporates, we will begin to get louder and more frequent hints from the Fed that QE 4 is a growing possibility. And, eventually, the Fed will drop such a strong hint that it will have no choice but to deliver. On that day, US stocks will soar. Soon thereafter, QE 4 will begin. Its scale will be as large as necessary to make the S&P Index move up to new record highs by the end of 2015 or soon thereafter. Higher stock prices will continue to make the global economy expand.

The global economy remains an economic bubble. Without the injection of more Liquidity by the Fed, that bubble will deflate into crisis. Therefore, more Fed-injected Liquidity it will have. Just don’t call this Capitalism.

Happy Halloween!

FLOWS -Market "Depth" is a Key Consideration

"Another Reminder How Addicted Markets Still Are To Liquidity" 10-17-14 Deutsche Bank's Jim Reid via ZH

The recovery from the lows after Bullard spoke yesterday is another reminder how addicted markets still are to liquidity. Indeed in today's pdf we reprint and  update a table from our 2014 Outlook showing the various phases of the Fed's balance sheet expansion and pausing over the last 5-6 years and its impact on equities and credit. We have found that the relationship broadly works best with markets pricing in the Fed balance sheet move just under 3 months in advance. We've also included our oft-used chart of the Fed balance sheet vs the S&P 500 to help demonstrate this. So end July / early August 2014 was always the time that this relationship suggested markets should enter a new more difficult phase.

With this lag, the table rather neatly shows the pulsing reaction of credit and equities to the growth and pauses in the growth of the Fed balance sheet around the Lehman demise, QE1, QE2 and QE3. After the initial emergency expansion of the Fed balance sheet in 08 where risk assets still declined (they would have declined much much more without it) we have alternated between aggressive balance sheet growth and large to huge risk-on on one hand, and small balance sheet run-off and risk-off on the other. This period post the end of July is just the latest evidence that this pattern is real. So we still think central bankers hold the key to markets going forward and there seems to be a hint of change in the Fed.

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FLOWS -Market "Depth" is a Key Consideration

E-Mini Liquidity Has Crashed 40% In The Past Quarter, JPMorgan Finds 10-20-14 Zero Hedge

Confused why one second the market is down 1%, and then moments later, upon returning from the bathroom, one finds it up by the same amount on negligible volume? Simple: there continues to be zero liquidity. Although, not just in equities, but in bonds as well, something this website - and the TBAC and Citi's Matt King - has warned for over year. It is the lack of bond liquidity that led to last week's dramatic surge in bond prices as Bloomberg noticed overnight.

So for those curious just how bad bond liquidity is now, here is JPM's Nikolaos Panigirtzoglou with the explanation:

For the safest bond markets, bid-ask spreads typically remain very narrow in good times and bad, and shifts in liquidity conditions are best captured by changes in market depth. Our fixed income research measures market depth by averaging the size of the three best bids and offers each day for key markets. Figure 3 shows two such measures, for 10-year cash Treasuries (market depth measured in $mn) and German Bund futures (market depth measured in number of contracts). Again, these measures appear consistent with deterioration in market depth i.e. the ability to transact in size without impacting market prices too much. The recent deterioration in market depth has been more acute for USTs than Bunds, also evidenced by the large daily moves in UST yields in recent days.

Yeah, ok. Nothing new: wondering who the culprit is, look no further than the Fed which now owns 35% of all 10 Year equivalents across the curve, a liquidity shortfall for everyone else that will only get worse if and when the Fed embarks on QE4 (just a matter of time), as we explained last May in "Desperately Seeking $11.2 Trillion In Collateral, Or How "Modern Money" Really Works."

But what about equities: turns out here things are worse. Much worse. About 40% worse according to JPM's take of CME data:

An alternative liquidity measure comes from the CME, which reports a quarterly measure of “market depth”, that is, the transaction cost of trading in reasonable size across a selection of futures markets (e.g. for Mini S&P500 futures, 500 contracts lot). This measure shows how deep the market is in terms of the quantity of orders resting on the best bid and best offer, i.e. number of contracts at best bid-ask spread in the limit order book. The quarterly change in this measure between June and September as % of its average over the past three years is shown in Figure 4. Over the past quarter there has been significant deterioration in the market depth for S&P500 and Crude Oil futures but an improvement for agricultural commodity futures. There has been no material change in the market depth for FX, i.e. euro and yen futures contracts, over the past quarter. The market depth metric for these contracts continues to be at the very top of the past three years’ range.

JPM's sugarcoated conclusion: "Market depth metrics appear to have deteriorated across all asset classes." Which is perfectly ok when the market is rising: it means that tiny buying volume can lead to outsized returns. Where it becomes a huge problem, as last week showed, is when the central planners lose control, for whatever reason, and the market finally sells off. That's when one's faith in St. Janet and the CTRL-Priory of Eccles is truly tested.

FLOWS - Liquidity, Credit & Debt

This is a major concern.

Its ALL ABOUT the RATE OF CHANGE

FLOWS - Liquidity, Credit & Debt

Why the Federal Reserve Will Launch Another Round of QE Richard Duncan

In November 2002, Fed Governor Ben Bernanke introduced the concept of Quantitative Easing to the world. In a speech entitled “Deflation: Making Sure It Doesn’t Happen Here”, he explained that the Fed could prevent deflation from taking hold in the United States by creating money and using it to acquire government and agency (i.e. Fannie Mae and Freddie Mac) bonds. He proclaimed that this “unorthodox monetary policy” would be particularly efficacious if carried out in combination with an expansionary fiscal policy.

With this speech, Bernanke reassured the banking industry and the rest of the speculating community of the Fed’s omnipotence. In doing so, he encouraged even more aggressive credit creation and risk-taking. As a result, the credit bubble, which had already grown quite large, became very much larger. When it imploded six years later, Fed Chairman Bernanke, in cooperation with Treasury Secretaries Paulson and Geithner, responded to the crisis using the exact policies Bernanke had described in 2002.

The Fed began printing very large amounts of money and using it to buy very large amounts of government and agency debt. The Treasury began borrowing and spending trillions of dollars, which it was able to finance at very low interest rates thanks to the Fed’s purchases of government debt. This combination of very aggressive fiscal and monetary stimulus prevented a new great depression and the horrific collapse in prices that would have accompanied it.

Therefore, while it should not be forgotten that Bernanke bears much blame for allowing this crisis to occur, it must also be acknowledged that he was correct when he declared the Fed would be able to prevent deflation through the aggressive use of unorthodox monetary policy.

Many financial commentators have noticed that bank reserves held at the Fed have increased by $2.9 trillion since early 2009. As this is equivalent to 83% of the amount of money the Fed has created during that period, they have concluded that almost all of the money created through QE has been stuck in the banks and therefore has had no impact on the economy whatsoever. This interpretation is incorrect, however.

Between 2009 and 2013, the government borrowed approximately $5.8 trillion to finance its budget deficits. During that time, the Fed acquired $1.9 trillion worth of government bonds. If the Fed had not bought those bonds, either the government would have had to spend $1.9 trillion less, which would have removed $1.9 trillion of aggregate demand from the economy, or else the government would have had to borrow the $1.9 trillion from the financial markets.

That would have drained liquidity from the system and pushed up interest rates (resulting in old fashioned Crowding Out). Higher interest rates would have pushed the collapsing property market down even further and damaged the economy in countless other ways. QE allowed the government to boost aggregate demand through deficit spending and to finance its deficit spending at very low interest rates.

The Fed also bought $1.7 trillion worth of agency debt or, in other words, the mortgage-related debt issued and guaranteed by Fannie and Freddie. That pushed up the price of those bonds and drove down their yields. By acquiring that debt at a much higher price than would have otherwise prevailed, the Fed helped restore the solvency of the crippled financial industry, which was then teetering on the edge of the abyss.

By pushing down the yield on mortgage-related debt, the Fed stopped the collapse in property prices and later, under QE 3, brought about their rebound. Higher property prices helped reflate the economy by pushing up household sector net worth. If the Fed had not bought $1.7 trillion worth of mortgage-related debt, the yield on that debt would have remained high (or moved higher), the owners of that debt would have been stuck with impaired assets and the property market would have weakened further instead of rebounding.

In these ways, QE greatly strengthened the economic fundamentals of the United States. Recognizing this, equity investors drove the stock market higher each time a new round of QE was announced. Surging stock prices also served to reflate the economy.

Between the rebound in property prices and the sharp rise in stock prices, household sector net worth increased by $25 trillion (or by 45%) from the low it reached in 2009. It is now 17% above its pre-crisis peak. This increase in wealth was the result of Quantitative Easing. What else could possibly explain it? That surge in net worth clearly created a wealth effect that allowed much more consumption and, therefore, economic growth, than would have been possible otherwise.

It was not a coincidence that net worth rose by $25 trillion at the same time that the central bank was creating unprecedented amounts of fiat money and using it to acquire financial assets. It is certain that QE reflated the US economy by pushing up asset prices. It is not at all certain, however, that the economy will remain “reflated” when QE ends in October. In fact, the odds are quite high that it will begin to deflate again.

Should that occur, the Fed would then have to decide whether to do nothing and allow everything it has accomplished to unravel in a process most probably leading back to severe recession and deflation or else to launch yet another round of Quantitative Easing. I believe it will be an easy decision for the Fed to make. After all, what’s a few trillion dollars more (shared) among friends?

FLOWS - Liqudity, Credit & Debt

Don't be Fooled! 09-30-14 Richard Duncan

It was reported that the US economy grew by 4.6% during the second quarter. But don’t be fooled.The US economy is far weaker than that headline number suggests.

In large part, the second quarter was strong because the first quarter was so weak. In that quarter, GDP contracted by -2.1%. During the first six months of 2014, the economy grew by only 0.6%, which translates into an annualized rate of only 1.2%. To put that into perspective, take a look at the following chart, which shows the US GDP growth numbers going back to 1980.

There were only six years out of the past 34 when the economic performance of the Unites States was worse than it was during the first half of this year.

OK. It’s true that the very harsh winter caused the economy to be particularly weak at the beginning of this year. Therefore, it is almost certain that the economy will be considerably stronger during the second half of the year than it was during the first. Nevertheless, it is clear that the economy is suffering from something more than just cold weather.

Notice how much more slowly the economy has been growing during this decade than in the past. The economy grew by an average annual rate of 3.2% during the 1980s and the 1990s. So far during this decade, it has expanded by an average annual rate of only 2.0% - despite the massive government life support infusions it has received since the global economic crisis began. Over the last five and a half year, the budget deficit has exceeded $6 trillion, the Fed has injected $3.5 trillion of newly created money into the financial markets and the Federal Funds rate has been held at zero percent. That kind of stimulus should have created an economic boom of the first degree. That fact that it didn’t should serve as a warning that something is very fundamentally wrong with the US economy.

The financial markets have chosen to ignore the economy’s fundamental weakness and, instead, have seized on the strong second quarter GDP number as proof that the long-awaited US economic recovery is, at last, upon us. This belief, combined with the approaching end of the third round of Quantitative Easing and weak economic numbers out of Europe and Japan, have produced a meaningful bull market in the US dollar.

Over the last couple of months, the dollar has gained 7% to 8% against both the Euro and the Yen.

This big move in the dollar is starting to have interesting implications. First, when the dollar strengthens, commodity prices (including the price of gold and silver) tend to weaken. That is what we are seeing now. The Thomson Reuters CRB Commodity Index, which measures a basket of commodities has fallen 10% since July. Many commodities are already under pressure due to either a surge in new supply (oil, corn, wheat) or weakening demand from China (most metals). Consequently, the currencies of the commodity-producing countries (such as Australia and Brazil) are taking a hit.

This strong dollar trend may continue for some time. If it does, some really exciting investment opportunities could arise. The market consensus view is that the Fed is going to stop its program of Quantitative Easing just as the European Central Bank launches one in Europe and the Bank Of Japan accelerates its Yen printing program in Japan. So long as this remains the consensus view, the downward pressure on the price of gold, silver, most other commodities and the currencies of the commodity-producing countries could continue until they are all considerably oversold.

The strong dollar trend is built on the belief that the US economy will become stronger as we move into 2015. I believe this view is mistaken. With QE 3 ending later this month, the US stock market is likely to experience a significant correction between now and next spring. When it does, the US economy will weaken again and that will cause the dollar to fall.

In that scenario, where the US economy moves back toward recession, the global demand for commodities would also weaken. Therefore, while commodity prices would benefit from a weaker dollar, they would suffer from reduced global demand. Global deflationary pressures would probably intensify.

What would happen after that would depend on the central banks. Ultimately, I believe the Fed will have to return as the Printer-Of-Last-Resort and launch he fourth round of Quantitative Easing on an aggressive scale. If I am right, when QE 4 is announced, the dollar will weaken further, while the price of gold, silver, most other commodities, and the currencies of the commodity-producing countries would all rebound sharply.

As they say, timing is everything. Getting the timing right on these moves in currencies and commodities is going to be tricky. But, don’t allow yourself to be fooled. The US economy is much weaker than the second quarter GDP number would suggest. Therefore, the current strong dollar trend, while is could last for some time, is not underpinned by strong foundations.

FLOWS - Liquidity, Credit & Debt

The global economy has been unable to recover from the economic crisis that began in 2008. The following chart explains why.

The blue line shows the ratio of total credit to GDP in the United States. From 1950 to 1980 that ratio averaged around 150% of GDP. After 1980, however, credit began to grow much more rapidly than the economy. Consequently, credit to GDP expanded from 150% of GDP to 370% in 2008. It is easy to understand how rapid credit growth causes the economy to expand. When credit increases consumers have more money to spend; businesses become more profitable and expand their investments; the government receives more tax revenues and can spend more; and asset prices keep inflating, causing a wealth effect that allows even more consumption. For nearly three decades, therefore, credit growth drove economic growth in the United States, and the expanding US trade deficit drove the global economy.

Now notice the red line that runs from the top left to the bottom right. It represents the Federal Funds Rate, the interest rate set by the Fed. It has declined very sharply since the early 1980s, when it peaked at 18%. As the Fed cut interest rates, borrowing became more affordable and the reduction in borrowing costs explains why credit was able to expand so dramatically.

By 2008, the Federal Funds Rate had already been reduced to 2%, near the all-time low. When Lehman Brothers collapsed and AIG, Fannie Mae and Freddie Mac had to be nationalized, the Fed slashed the Federal Funds Rate to zero percent. But even that did not bring about a revival of credit growth and the economy contracted by 8.2% during the fourth quarter of that year.

At the beginning of 2009, the Fed, unable to cut interest rates any further (0% is the floor), introduced a new, unorthodox monetary policy tool to stimulate the economy: Quantitative Easing. Since then, the Fed has injected $3.5 trillion of newly created money into the financial markets by acquiring government bonds and mortgage-backed securities. As a direct result of that policy, household sector net worth increased by $25 trillion (or by 45%) between 2009 and the end of 2013. That increase in wealth enabled the economy to grow, albeit at an unusually weak rate averaging around only 2% a year over the past four and a half years. Credit growth, which had been the driver of economic growth, has yet to recover, however. The ratio of total credit to GDP has remained flat at approximately 350% since 2010.

The third round of QE is scheduled to end next month. Moreover, the Fed has signaled that it is likely to begin increasing the Federal Funds Rate by the middle of next year. The end of QE 3, in itself, represents a tightening of monetary policy. By ending the injection of newly created money into the financial markets, the Fed will be removing the one thing that above all others has generated economic growth in recent years. It is uncertain that the economy will continue to grow without it.

The odds of a new recession will become very much greater if the Fed actually does begin raising the Federal Funds Rate. The cost of borrowing would increase and that would cause credit growth to slow and the ratio of credit to GDP to decline. A reduction in credit growth would deal a severe setback to the economy.

It is difficult to see how the economy will begin to grow again unless credit growth accelerates. However, it is difficult to see how credit growth could pick up given the very high level of credit to GDP that we already have. In order for the US economy to take on more debt, either the number of people employed must expand or wages must increase. Neither of those things is happening on a great enough scale to allow the American public to service the interest expense on more debt. The US labor force participation rate is declining, median income continues to fall and average hourly earnings are increasing by less than 1% a year in real, inflation-adjusted, terms.

As I have written before, I believe that our economic system should be called Creditism instead of Capitalism because credit growth has been THE driver of economic growth for decades. I hope this discussion on the relationship between interest rates, credit and economic growth helps to explain my fear that Creditism is in crisis and, perhaps, incapable of generating any further economic growth.

To learn more about how the global economic crisis will affect you, subscribe to my video-newsletter, Macro Watch:

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FLOWS - Liqudity, Credit & Debt

This Is The Chart Everyone Is Watching 09-24-14 Zero Hedge

Less central bank liquidity

In Figure 8 below we show what has probably been one of our most used charts of the last year or so. It looks at the relationship between the size of the Fed balance sheet and the S&P 500 (as a proxy for risk generally). As you can see, since the Fed balance sheet was used as an aggressive policy tool post-GFC, the graph suggests that the S&P 500 is well correlated with its size with the former leading the latter by 3 months. For the past 5 years or so the times where we have seen strong performance from risk assets have broadly coincided with periods where the Fed was aggressively expanding its balance sheet. In the periods where the balance sheet wasn’t increasing we generally saw a more challenging environment. So as we have highlighted recently the wobbles seen during the summer months may in part have been due to the imminent end to asset purchases next month (given the 3-month lag in the relationship) and arguably demonstrate the potential challenges facing investors in a world where liquidity is less freely available.

However...

Here we’ve focused only on the actions of the Fed. Since the GFC it’s not just the Fed that has increased the size of its balance sheet. In Figure 9 we track the YoY growth rate (in dollar terms) of the four main central banks globally (Fed, ECB, BoJ, PBoC). We can see that pre-crisis overall balance sheet growth was fairly strong due to the expansion in China. We then get the post-GFC boost from the Fed and to a lesser extent the ECB. We can see that central bank balance sheet expansion seems to have come in waves since then following the various different forms of policy accommodation and QE. Having reached a peak of around 13% in Q1 this year with the growth rate declining since. With the Fed balance sheet likely to be static as of next month much might depend on the BoJ and the ECB from a global liquidity standpoint.

China’s actions are less predictable and it could be they react to slower growth by expanding the money base.

However, as of today, they appear far more predictable. Recall: "Get To Work Mr. Chinese Chairman": China Set To Fire Its Central Bank Head, Unleash The Liquidity Floodgates

So, Deutsche Bank's conclusion: "Overall we would argue that markets might experience a few more bumps in the road as the global liquidity picture is not as supportive as it has been."

FLOWS - Liquidity, Credit and Debt

Lurking Beneath The Taper: More Trouble In Repo Land 09-18-14  Alhambra's Jeffrey Snider via Contra Corner blog,

Since we are now in the middle of the final month of a quarter, checking repo stats shows what we have come to expect of a fragile liquidity system. Once again, repo fails spiked sharply in the latest weekly statistics from FRBNY as primary dealers and the Fed’s own repo “fix” fail to affect the “resiliency” that FOMC members appear desperate to attach.  However, since the repo market is far, far away from the everyday nobody pays much attention.

The problem with liquidity is always that it’s not what you see today when all seems well and abundance is seemingly effective, it is actually what to expect when you need it most.  From the standpoint of central banks, that has been their operating assumption (at least as portrayed publicly) since the nineteenth century.  The Federal Reserve itself was dedicated on the principle of currency elasticity, which is exactly this point – to be that liquidity when it is most needed as private markets shy away.

Unfortunately, modern incarnations of these central banks still mostly apply nineteenth century rules, policies and even understanding to a 21st century banking system that does not so easily follow generic incantations of simplistic theory.  

The “money supply” right now is no such thing, as money has vanished from banking. 

Liquidity itself is not dependent on “money supply” so much as the means and channels for flow. 

That was a lesson learned the hard way by those that assured everyone in 2007 that all was “contained.”

The message of resiliency is then a main part about incorporating those shortcomings into the current framework. When Janet Yellen proclaims that markets are so “resilient” that she would prefer they not even bother about such negativity she means to say that the Fed is more than aware of flow and liquidity and has taken that to heart.  Indeed, they instituted the reverse repo program (actually it was just an expansion of existing lines) last year to live up to elasticity doctrine in the real “currency” of the modern bank: collateral.

There has been a noticeable uptick in reverse repo usage in the past few months, but nothing that would suggest anything awry.

Outside of the surge in May, there is a seeming straight line upward trend that was established all the way back when the Fed first tapered in December.  In that important respect, there does seem to be some correlation with reverse repo usage and the repo market.  That includes the very important changes that have taken hold of repo volumes in US$ terms.

While focus is often placed on UST collateral, MBS repo was at least astride UST in terms of size and volume.  That changed quite a bit after QE3 began as you would expect given how QE strips the “market” of needed and usable securities.  However, we can also see this same imprint in the UST repo market as well.

Again, that makes sense given that QE4 was instituted to take UST collateral, a topic that has gained actual attention in the past eighteen months (including a very needed adjustment to the Open Market Desk policy almost from the start).  From these figures we can reasonably assume that where QE was impactful in turning repo volumes lower, its taper has accomplished the opposite.

In addition to the very real concerns of secular stagnation and asset bubbles, rather than how the economy actually exists right now, these repo “costs” are a major factor in the impetus toward the monetary exit.  However, like everything else with monetary intrusion, simply ending the manipulation is not the same as never having undertaken it.  In another example erasing the figment of monetary neutrality, there is a clear diminishment in repo capacity and thus “resiliency” on this side of the QE taper.

The change in repo volume since the middle of 2014 has been significant, but only just now approaching levels that would be considered “normal” last year (and before).  Yet, for all that additional volume there has been a repeated signal of distress through fails.  There was the major episode in June just as repo volume had turned upward, and then again in July as the same occurred.  And, as I noted at the beginning, we are now in the third major instance of a fails problem (without any corresponding surge in reverse repo usage that was “supposed” to occur if the Fed’s “fix” were anything like one).

What we are left with is much worse than when this all started.  The problem of QE in repo terms was that it not only stripped usable collateral from dealer inventories and from other holders where it might be used as supply, it has seemingly diminished the entire repo market’s capacity to withstand even a relatively minor increase in volume.  What was normal in 2013 seems to create something of a stir in function in 2014. That these are mostly clustered around quarter ends continues the systemic weakness that has been apparent in every major market “event” of this period, adding to the judgment that “resilience” is nothing but PR and wishful thinking.

The problem for “markets” is that this is a primary liquidity conduit indicating significant and persistent degradation under, again, very benign conditions.  In my analysis, there is no doubt that QE is the primary culprit here and that its removal is not “allowing” a healing process to begin but instead revealing the damage.  With the Fed’s reverse repo program having no input whatsoever, it just adds to the weight of evidence that policymakers don’t really know what they are doing and are just making it up as they go.

With compliant media that gives total deference to orthodox economics, the speeches and soundbites are enough reassurance to stave off much needed inquisition.  For now.

FLOWS - Liquidity, Credit & Debt

World Recession 09-12-14 Richard Duncan

The global economy is sick and getting sicker. No one would suspect this based on what is being reported in the mainstream media. The financial cheerleaders there would have you believe that all is well and getting better. It’s not. Here are the facts.

Yes, the US economy grew by 4.2% during the second quarter. But it shrank by 2.1% in the first quarter. If you go to the website of the Bureau of Economic Analysis you will find that, during the first half of the year, the economy grew by only $78 billion, or by 0.5%. That means the economy expanded by only 1% on an annualized basis. That is pathetically weak considering that during those six months, the government borrowed and spent $201 billion more than its income, while the Fed created $350 billion and injected it into the economy by acquiring financial assets. Nor does the economy appear particularly strong thus far in the third quarter. At the end of last week, it was reported that personal spending, which makes up 70% of the economy, contracted by 0.1% during July.

The US economy is weak. Most of the rest of the world is weaker. Japan’s economy has barely grown over the past 12 months despite money creation on a truly extraordinary scale by the Bank of Japan. Last week it was reported that economic growth in the Eurozone came to a near standstill during the second quarter, increasing just 0.2% compared with the first quarter and by just 0.7% compared with one year earlier. Quarter on quarter, the German and Italian economies both contracted by 0.2%, while the French economy was flat. Only the UK economy reported solid growth of 3.2% compared with one year earlier. Even still, the UK economy has only now just surpassed its pre-crisis peak size, which it reached in early 2008. The Eurozone unemployment rate is 11.5% and deflation is a growing threat. In August, prices rose by only 0.3% year on year.

As for the BRICS, three out of the five are in or near recession. During the second quarter (compared with one year earlier), Brazil’s economy shrank by 0.9%, while Russia’s expanded by only 0.8% and South Africa’s by only 1.0%. Judging by reported data, China’s economy is still booming at an annual rate of 7.5%. However, maintaining such high rates of growth through credit-fuelled, government-induced malinvestment may eventually come at the price of an all-out depression there in the not too distant future. Of all the BRICS, India appears to be in the strongest position, with 5.7% growth. However, it is very dependent on foreign capital, which may soon dry up.

Very low and falling government bond yields are also telling us that something is terribly wrong with the global economy. The yield on the 10-year Japanese government bond is 0.5%. Ten-year German government bond yields fell to a record low of 0.87% this week. US 10-year Treasury bonds now yield only 2.34%. Spain’s economy is in crisis, but the yield on 10-year Spanish government bonds is only 2.23%, 11 basis points less than US government bond yields. The Italian government can sell ten-year debt at a yield that is only slightly more, 2.45%. The world has never before seen such low interest rates.

Interest rates are low because the supply of money is greater than the demand for money. As I have written many times before, since we stopped backing money with gold, there is no longer any difference between money and credit. After the collapse of the quasi-gold standard Bretton Woods System, credit grew very rapidly for decades. That credit created a great global economic boom characterized by asset price inflation and an extraordinary expansion of industrial output. However, globalization depressed wages in the developed nations. Therefore, income and purchasing power did not keep pace with the expansion of output. Capacity across all industries became excessive relative to effective demand. Now, there are very few viable investment opportunities left. That is why the demand for money/credit is so weak and why interest rates are so low. The continuing decline in interest rates on government bonds is a clear sign that this situation is becoming worse.

The global economy is entering a new downturn. The end of the third round of Quantitative Easing in October is very likely to make matters worse.

FLOWS - Liquidity, Credit & Debt

For Wonks Only September 2014 - William H. Gross

The unmodeled (for lack of historical example) experiment that all major central banks are now engaged in is to ask and then answer: What growth rate of credit is enough to pay prior bills, and what policy rate/amount of Quantitative Easing (QE) is necessary to generate that growth rate? Assuming that the interest rate on outstanding debt in the U.S. is approximately 4.5% (admittedly a slight stab in the dark because of shadow debt obligations), a Fed governor using this template would want credit to expand by at least 4.5% per year in order to prevent the necessary sale of existing assets (debt and equity) to cover annual interest costs. That is close to saying they would want nominal GDP to expand at 4.5%, but that’s another story/ Investment Outlook.

How are they doing? Chart 1 shows outstanding credit growth for recent quarters and all quarters since January 2004. The chart’s definition of credit includes the standard Fed definition of private non-financial credit (corporations, households, mortgages), public liabilities (government debt), as well as financial credit. The current outstanding total approximates $58 trillion and has been expanding at an average annual rate of 2% for the past five years, and 3.5% for the most recent 12 months.

Put simply, if credit needs to expand at 4.5% per year, then the private and public sectors in combination must create approximately $2.5 trillion of additional debt per year to pay for outstanding interest. They are underachieving that target in the U.S., which is the reason why GDP growth struggles at 2% real or lower and nominal GDP growth seems capped at 4.5% or lower. Credit creation is essential for economic growth in a finance-based economy such as ours. Without it, growth stagnates or withers. Its velocity/turnover is critical as well.

The velocity/turnover of credit mentioned above, in turn, is a function of price or the yield of credit. No central banker knows what that appropriate yield/price is and so Yellen/ Carney/Draghi/Kuroda walk up forward interest rates carefully so as not to cause a credit collapse. As a general rule, the projected return on financial assets (relative to their risk) must be sufficiently higher than the return on today’s or forward curve levels of cash (overnight repo), otherwise holders of assets sell longer-term maturities and hold dollar bills in a mattress – lowering velocity and creating a recession/debt delevering. We are dangerously close to the crossing of the lines between long-term asset returns and forward levels of cash yields, which currently rest at 2.5%+ in 2017 and beyond. If the forward levels are not validated, however, the danger is lessened.

Today’s levels of interest rates and stock prices offer a historically unacceptable level of risk relative to return unless the policy rate is kept low – now and in the future. That is the basis for The New Neutral, PIMCO’s assumption that the fed funds rate peaks at 2% or less in 2017 versus others’ assumptions (Taylor, Fisher, Lacker, the market) that it goes much higher. BOE’s Carney, by the way, believes his country’s New Neutral is 2.5%, a level consistent with PIMCO’s 2% in the U.S. If so, existing asset prices in the U.S., while artificially high and bond yields artificially low, may continue to be so unless the Fed oversteps its interest rate line.

This global monetary experiment may in the short/intermediate term calm markets, support asset prices and promote economic growth, although at lower than historical levels. Over the long term, however, economic growth depends on investment and a rejuvenation of capitalistic animal spirits – a condition which currently does not exist. Central bankers are hopeful that fiscal policy (which includes deficit spending and/or tax reform) may ultimately lead to higher investment, but to date there has been little progress, as seen in Chart 2. The U.S. and global economy ultimately cannot be safely delevered with artificially low interest rates, unless they lead to higher levels of productive investment.

“For Wonks Only” Speed Read

1. Cross your fingers, credit growth is a necessary but not sufficient condition for economic growth. Economic growth depends on the productive use of credit growth, something that is not occurring.

FLOWS - Liquidity, Credit & Debt

GROWING UNALLOCATED - SHRINKING US$

FLOWS - Liquidity, Credit & Debt

Japan’s Horrible GDP Data May Be Good For Stocks Richard Duncan

Japan reported horrible GDP numbers this week. During the second quarter, Japan’s economy shrank by 6.8% on an annualized basis. This followed an equally unusual expansion in economic growth of 6.1% during the first quarter. The sharp rise in the first quarter and the slump in the second quarter were both caused by an increase in Japan’s national sales tax (from 5% to 8%), which took effect in April. Consumers loaded up on goods during the first quarter before the tax was introduced. They then spent much less during the second quarter to avoid the higher prices. Overall, Japan’s economy was more or less flat over the 12 months ending June 30th.

A three-percentage point increase in the sales tax was bound to have a significant negative impact on Japan’s economy. Nevertheless, with a budget deficit of more than 7% of GDP and a government debt to GDP ratio of nearly 250%, the government felt compelled to take some step to increase its revenues.

The government has also become very aggressive in its fight against deflation. Prices in Japan started falling in 1995 and falling prices have made Japan’s government debt problem even worse than it appears on the surface. If prices were rising, as they typically do in most countries, the government’s debt would be gradually inflated away. However, with prices actually falling, the opposite occurs. In real terms, the government debt becomes larger each year.

In order to attempt to put an end to deflation, Japan’s central bank, the Bank of Japan (BOJ), launched an extraordinarily aggressive program of fiat money creation in April 2013. This program is called Quantitative and Qualitative Easing, or QQE for short. Relative to the size of Japan’s economy, QQE is about three times larger than the Fed’s Quantitative Easing program was at its peak. Since the launch of QQE, the Bank of Japan’s assets have increased by 66%. Fiat money creation on this scale is extreme when compared with the experience of any other developed country since World War II. Moreover, the central bank has committed itself to continue creating fiat money at the current pace until inflation moves up to 2% and until the public comes to believe that inflation will remain at that level.

Thus far, QQE has been effective in pushing up prices. When it began, core CPI (consumer price inflation, excluding fresh food) was negative at minus 0.4%. By June this year, (excluding the effect of the consumption tax hike) it reached 1.3%. However, the main way in which QQE pushed prices higher was by pushing the Yen lower. The Yen fell by about 20% against the dollar once the market came to believe that the BOJ would introduce QQE. The lower Yen made the cost of imports rise and that lifted the overall price level in Japan. But, this process will only continue to push prices higher if the Yen continues to decline; and that is not happening. The Yen has been roughly flat now for the last year. Including the effects of the tax hike, CPI rose 3.6% in June. But those effects will disappear entirely next April once the tax hike ceases to distort the price data. The fact that the effect of both the weaker Yen and the tax hike are only temporary, suggests that the BOJ may have to increase the amount of money it creates still further later this year in order to keep the inflation rate rising.

On August 1st, the Governor of the Bank of Japan, Haruhiko Kuroda, delivered a speech entitled, “Japan’s Economy: Achieving 2 Percent Inflation”. In it, he made the case that QQE is working and that inflation in Japan will move up to and remain at 2% starting sometime next year. I was not persuaded that the current fundamentals of Japan’s economy support that conclusion.

However, he also stressed the BOJ’s determination to achieve that outcome. He said, “I would like to emphasize that, under QQE, given the Bank’s clear and strong commitment to the 2 percent inflation target, it is a matter of course that the Bank will make adjustments if necessary to ensure the target is achieved.” By using the words “make adjustments if necessary”, Governor Kuroda is telling the world that the BOJ will not hesitate to increase the amount of fiat money it is creating through QQE if that is necessary to reach the 2% inflation target.

QQE may ultimately be successful in raising inflation and inflation expectation to 2%, but I am not sure that it can succeed in keeping them there. What is much more certain, however, is that if the BOJ does expand QQE still further, then the Yen will weaken, Japanese corporate profits will improve and the stock market will rise. This is a scenario where, at least for a short while, it would once again be relatively easy to make money in Japan. I believe this week’s horrible GDP report has made this scenario increasingly probable.

One final note: I am now uploading a new Macro Watch video approximately every two weeks. To subscribe to Macro Watch, click on the following link:

http://www.gordontlong.com/RichardDuncan/Macrowatch.htm

FLOWS: Liquidity, Credit and Debt

What’s Worrying The Fed? 07-31-14 Richard Duncan

Before I launch into this week’s topic, let me mention that at the bottom, you will find a link to a speech I made recently: How Capitalism Died & Where That Leaves Us. The production quality of this video is particularly good, so I hope you’ll watch it. But, before you do, let me tell you what the Fed’s worrying about these days.

Now that the Fed has announced that QE will end in October, the financial markets are very keen to know when it intends to begin increasing interest rates. This is a very sensitive subject, fraught with danger. When the Fed began increasing interest rates in 1994, it caused near panic in the bond market and a significant stock market selloff. So Janet Yellen and her colleagues on the Federal Open Market Committee, which sets interest rates, understand that they must weigh their words very carefully when discussing their intentions on this issue.

All they are saying at this stage is that “the current target range for the federal funds rate likely will be appropriate for a considerable period after the asset purchase program ends….” and “economic conditions may, for some time, warrant keeping the federal funds rate below levels that the Committee views as normal in the longer run.”

Decoded, that means they don’t plan to increase interest rates any time soon and that, even after they do begin, it is likely that rates will remain unusually low for a very long time.

The Fed is reluctant to even talk about raising interest rates because it understands that the economy remains very weak. While it is true that the unemployment rate has come down more quickly than anticipated (it is currently 6.1%), that headline number masks a great deal of weakness that still persists in the labor market. Nine and a half million people are unemployed and roughly that many more are underemployed or, in other words, working part-time jobs because that’s all they can get. Making matters worse, wages are stagnant. According to a recent Fed report, “Over the past five years, the various measures of nominal hourly compensation have increased roughly 2 percent per year, on average.” And that is before inflation. After inflation, wages have barely budged since 2009.

What’s really troubling the Fed, however, is a racking fear that the economy will start moving back into recession as soon as QE3 ends – just as it did after QE1 and QE2 came to an end. And, they are certainly right to be worried. The Fed has been driving economic growth by printing money and pushing up asset prices. That has worked, but asset prices are now overvalued and there’s a very real chance that they will slump again as soon as the Fed stops pumping new liquidity into the financial markets.

Therefore, like me, the Fed must consider any expectations concerning a near-term rise in interest rates as premature, if not entirely unrealistic. The economy has been very weak even with 0% interest rates and massive liquidity injections through Quantitative Easing. It is disturbing to imagine what would happen if interest rates actually started to rise.

OK, now, for a good overview of how we got into this mess and how things really stand, click on the following link to watch my speech:

http://www.richardduncaneconomics.com/watch-richard-duncans-speech-how-capitalism-died-where-that-leaves-us/

FLOWS - Liquidity, Credit & Debt

Creditism & the threat of a New Depression Recovery Will Take Longer Than We Will Live

No one explains our 'Creditism' system better (We no longer have Capitalism. That system required 'capital' before new credit could be created).

Once the link between dollars & gold broke, all the constraints on how much credit could be created were removed .

Total credit first went through one trillion dollars in 1964 in the United States, & over the next 43 years, it expanded from one trillion to fifty trillion .. "We had a fifty-fold expansion in credit in the United States in 43 years ... The ratio of debt to GDP went from 150%, all the way up to 370%.

So it’s easy to understand how rapid credit growth drives economic growth. But the day always comes, as the Austrian economists remind us, when credit can’t expand any further, and that’s when the Depression begins, and that’s what started to occur in the financial crisis." .

Duncan emphasizes that in recent years credit has not been expanding at the same pace of the last several decades, therefore the economy has been weak .. will there be a recovery after the inevitable credit bust? . "Well, when Rome fell, there was a recovery, but it took a thousand years.

I don’t believe anyone alive today would still live long enough to see the recovery that would follow a New Depression."

FLOWS: Liquidity, Credit & Debt

The Fed’s New Magic Trick 07-15-14 Richard Duncan via Rich Dad

In this age of fiat money, Liquidity determines whether asset prices move up or down. The Fed understands this. That’s why it has been printing money and injecting that Liquidity into the financial markets. It’s goal has been to push up asset prices in order to drive the economy by creating a wealth effect that allows Americans to keep spending more even though median income continues to drop. The Fed has recently employed a new tool to allow it to better manage the level of Liquidity in the financial markets: Reverse Repos. Today, I will explain how the Fed’s use of Reverse Repos has impacted the stock market during the second quarter and how it is likely to impact it during the rest of this year.

I have developed a Liquidity Gauge to measure whether Liquidity is excessive or inadequate. It compares the amount of fiat money the Fed and other central banks are pumping into the markets with the amount of money the government is removing by borrowing to fund its budget deficit. When Liquidity is excessive, asset prices tend to rise; and when it is inadequate, asset prices tend to fall. Here is the Liquidity Gauge for 2014 based on quarterly estimates.

Notice that during the second quarter, there was a great deal of excess Liquidity ($308 billion). However, Liquidity is set to turn negative in the third quarter and then there will be a very significant Liquidity Drain in the fourth quarter (-$131 billion). As I explained in my March 1st blog, Treacherous Markets Ahead, the very high levels of Liquidity in the second quarter posed the risk of creating a stock market bubble by mid-year; while the subsequent drain of Liquidity threatened to cause a stock market crash and a recession during the second half of the year.

I can now see the Fed has used Reverse Repos to smooth out the level of Liquidity between the second quarter and the second half. In this way, they contained the stock market boom during the second quarter (although the S & P 500 Index still went up nearly 5% during those three months). And, they may also succeed in pushing back the Liquidity Drain closer to the end of the year or even to early next year.

Here’s how the process works. In a Reverse Repurchase Agreement, the Fed sells Treasury bonds that it owns (with an agreement to buy them back later). It receives cash in exchange for the Treasury bonds it sells. In that way, it drains Liquidity from the financial markets. In other words, this transaction has the opposite effect of Quantitative Easing (which injects cash into the financial markets). Later, when the Fed buys back its Treasuries, it will pay cash, thereby injecting the Liquidity back into the financial markets. The effect then will be similar to the effect produced by QE.

The following chart makes clear what the Fed has been up to.

The level of Reverse Repos on the Fed’s books increased from less that $100 billion throughout 2013 to an average of $200 billion in the first quarter of 2014 and to an average of roughly $250 billion during the second quarter. By increasing its Reverse Repo agreements by $150 billion, the Fed was able to remove some of the excess Liquidity during the first part of the year. And now, if the Fed runs these Reverse Repos back down to the 2013 level by buying back its Treasuries, it will be able to inject $150 billion (or more) of additional Liquidity into the financial markets during the second half of the year, thereby potentially offsetting the Liquidity Drain that would have otherwise occurred.

You’ve got to give these people credit. It looks as though they found the right tool to manage their most immediate challenge, that is, preventing a second quarter boom followed by a second half bust. That said, Reverse Repos will only take them so far. With Quantitative Easing scheduled to end in October, the Liquidity Drain will still strike sometime near year end. When it does, without some new liquidity-injecting trick by the Fed, interest rates are likely to begin to rise, the property market and the stock market are likely to begin to fall and the US economy is likely to begin to move back into recession.

So watch this space. In early 2015, the Fed may resort to another round of Quantitative Easing, QE 4, or they may pull a new rabbit out of their hat. One way or the other, these magicians of money are determined to keep the global economic bubble inflated.

So far, they’ve put on a very impressive performance.

FLOWS - Liquidity, Credit & Debt

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FLOWS: Liquidity, Credit & Debt

MONETARY MALPRACTICE - Current QE Experiment is Simply Not Working!!

Is Earth Round or Flat IceCap Asset Management - JUNE 2014

The Global Hunt for Taxes

Back in his day, Christopher Columbus was known as a swashbuckling adventurer willing to risk his life and limb for a boat ride. His thirst for adventure discovered many things, including the fact that the earth is round, and not flat.

Then in 2005, American journalist Robert Friedman declared the opposite in that the world isn’t actually round, but flat as a pancake. His best selling book explored how technology was changing the way people, businesses and countries do business.

Yet today, a mere 9 years later, legions of financial analysts, economists, elected and unelected officials are declaring the world is neither flat nor round, but a bunch of individually, wrapped islands completely separate, independent and unaffected by anything outside of their respective borders.

Call us old-fashioned, but we lie squarely on the side of Christopher Columbus. Yes, the world is indeed round and what goes around, comes around so to speak. Financially speaking, it’s our view that it is impossible today for any major country to function independently from anyone else. Economically, if most countries are doing well then it is highly likely any laggards will be dragged along for the ride too.

Of course, the opposite is also true. If the majority of the big economic countries are not doing well, then it is highly likely the rest will follow them down the garden path

Today, most major countries are struggling. In Europe for example, recent GDP data shows the old world growing at +0.8%. Hardly the acceleration needed to declare victory over the debt crisis. Italy in particular, is really struggling with what now looks like another return to recession, while everyone’s favourite socialist country – France, also disappointed with no growth to speak of at all.

Meanwhile, emerging market countries – the darlings of the pre-2008 crisis continue to grow, but at half the rate of what they regularly achieved previously during their boom years.

There is some good news. The United Kingdom has now officially returned to the same level it was prior to the 2008 crisis. And then there is America – the self proclaimed economic engine of the world.

At first glance, America seems to be firing on all cylinders. Over the last 4 years, the country has averaged +2.4% growth. Measured another way, the American economy increased from $13.8 Trillion to $15.6 Trillion, for a total 4 year gain of $1.8 Trillion.

At second glance, during the exact same time frame the US Federal Reserve printed money totalling $3.3 trillion. While viewing the data in Chart 1 on the next page, we ask you to really think about what you are seeing. Essentially, using a money printing machine to produce $3.3 Trillion only helped to grow the US ecoAfter 4 Yearsnomy by $1.8 trillion.

Obviously, the Americans didn’t quite get the bang for their buck they were expecting, and this is the point we make – despite trillions in Dollars, Pounds, Yen and Euros of economic stimulus, world economic growth remains a rather big disappointment.

As there are always consequences, the major consequence of massive money printing followed by low economic growth is the one few investment analysts, economists, and big bank investment committees speak about. Now, whether the reason for this silence is a business decision, lack of product to express the view, or even plain ignorance, the fact remains the connection isn’t being made. And worse still, it isn't being communicated to the majority of investors around the world.

Maybe this lack of communication can be blamed on Christopher Columbus, or Robert Friedman. More likely however, the real target of blame is the current culture imbedded in the financial industry that central bankers do know what they are doing and eventually they will deliver the world from its current economic funk.

In fact, the current state of economic, monetary and fiscal policies has become so severely warped and twisted that for the first time ever, we have economics and business graduates that have spent their entire academic career in a period with 0% interest rates, money printing and subsidized lending.

Think about this for a moment, our future leaders have established their entire economic and monetary belief system during the most bizarre economic moment in the history of the world. To them – this is normal. In many ways, it’s very much the same as the film “The Truman Show” where unknown to him, Jim Carey lives his entire life within a manmade bubble, only to eventually discover his entire belief system was manufactured by the director and producers of the show.

In our opinion, it’s rather quite obvious that the world’s policy makers absolutely know that the economic and financial world isn’t quite up to par. In some ways they should be congratulated and maybe even admired for stoically making many very bold decisions. In other ways, they should read their report card and admit their failures.

Just because you sit in the corner office and make bold decisions, doesn’t mean you are right. The corporate world is famous for firing under performing workers. Those that make bad business decisions rarely find themselves with the opportunity to continue making even more bad business decisions. It’s mind boggling that the world’s central bankers are not treated the same way.

In our mind, it’s become rather obvious that current stimulus plans are not working. Rather than scrap the madness and start over, our world political and economic leaders insist on a rather bizarre analysis that what they are doing is actually correct. But the reason for its ineffectiveness is that they haven’t done enough of it. In other words, yes the central banks and governments of the world have certainly dug themselves into a pretty deep hole. Yet, instead of trying to climb out or shout for help, they ask for more shovels – dig deeper! Chart 2 on the next page shows the amount of money printing that has been initiated since 2008. Considering that the previous 100 years produced no money printing by the world’s major countries, the current amount is rather shocking to say the least.

And this brings us to the consequences of all of this digging by our central banks. Despite massive amounts of stimulus, global growth remains stagnant. The reason for the lacklustre rebound is due to businesses and individuals slowly withdrawing their money from the economy.

Many people have commented that all the world really needs is a little more confidence. Once people and companies become more comfortable they’ll start to spend again. This view is 100% correct – but what’s missing from this analysis is the reason confidence is declining. The reason for the decline is due to the very policy actions of our governments and central banks to help restore confidence. Their actions are actually causing people to have less confidence – talk about irony.

When it comes to money, no magic formula or pixie dust can be applied to make it behave differently than it should. Individuals and companies both live in a world where you can only spend what you make. If you spend more than what you make, you need to borrow to make up the difference. Eventually, you will have reached your borrowing limit and then you have to start repaying your debt, or if you cannot repay – you default on your loans, and whoever lent you the money takes a loss. Simple enough.

Governments also use money and rarely spend less than what it collects in taxes. The difference of course is referred to as a deficit, and the only way money math works is to borrow money to equal the difference.

Yet, this seemingly perpetual access to debt has proven to be an open ticket for most governments to evolve into spendthrift characters of the worst kind. Months, years and decades of deficits and borrowing have literally pushed the natural laws of money and mathematics to the limit. With many countries having reached this limit, the inclination is to keep the money party going – which of course is the reason for 0% interest rates, money printing, bank bailouts and robbing savings from the poor to pay the rich.

While most media outlets only focus on the growth story of our world, we find it interesting that very few ever discuss the debt story. There are many reasons for this. For starters, you can see growth but you cannot see debt. When you see a nice car parked in front of a nice house, full of a nice family who takes nice vacations, most people say “wow, it must be nice to be rich.” Since you cannot see the debt used to become so nice, perhaps you should be saying “wow, they must have a lot of debt.”

As most countries continue to spend more money than they collect in taxes, the amount of debt continues to grow. And, this brings us to the global hunt for taxes. Because our economies are growing slower than our debt levels, the only other way for governments to improve their financial lot is to either reduce spending or to increase taxes.

FLOWS: Liqudity, Credit & Debt

The ECB Is Worried and It Should Be 06-09-14 Richard Duncan

The ECB Is Worried and It Should Be

The economy of the Eurozone is barely growing. The size of the economy is still 2% smaller than it was before the crisis of 2008 struck. The unemployment rate is 11.7%. Bank lending continues to contract. Now, deflation is becoming a growing threat. Prices rose just 0.5% in May compared with one year earlier. Moreover, the ongoing economic hardship in Europe is fuelling a powerful political backlash that threatens to tear the entire European integration project apart. Anti-European Union parties gained a shocking number of seats in last month’s European parliamentary elections.

On June 5th, the European Central Bank (ECB) announced an aggressive package of policy measures designed to encourage banks to lend in order to kick-start the economy and to prevent deflation from taking hold in the Eurozone area.

1. It cut its official lending rate by 10 basis points to 15 basis points (i.e. effectively 0%).

2. It announced that it would begin to charge banks 10 basis points for any excess reserves the banks held at the central bank.

3. It offered to lend up to Euro 400 billion to the banks at very low interest rates for four years if the banks agreed to relend that money to small and medium sized businesses. Importantly, it specified that loans for mortgages or to governments would not qualify for the low rates offered in this program.

4. Finally, the ECB stated that it was considering buying asset-backed securities (a form of Quantitative Easing) and that it would take even more aggressive steps if necessary (a hint that it could even begin to buy government bonds the way the Fed and the Bank of Japan are doing).

Will these measures be effective? Here are my thoughts:

Cutting the official interest rate by 10 basis points (#1) will have no impact whatsoever. Those rates were already extremely low. Consider QE (#4) is not introducing QE. Talk is cheap. The market wants to see action. If the ECB did begin QE, it would cause the Euro to fall and that would help the economy grow by boosting exports. It would also reduce the chances of deflation. “Considering it” is not the same thing as doing it.

Charging the banks 10 basis points on the deposits they hold as excess reserves with the ECB is an important step. This is the first time a major central bank has imposed “negative interest rates” on bank reserves. Let’s think about this. Banks are always eager to lend money, but only to people and companies capable of paying the money back. The reason the banks have deposited so much cash with the central bank is because there are no additional creditworthy borrowers. So, now the banks will have to decide whether they will lose more than 10 basis points by lending the money. If they would lose more than 10 basis points, they will simply pay the ECB 10 basis points. That way they will lose less. It will be very interesting to see which choice they make.

The third measure has the best chance of success. This measure will reward the banks for lending by offering them the opportunity to borrow money from the ECB at very low interest rates at a fixed rate for four years. It is a variation on the Bank of England’s Funding For Lending Scheme, which has been effective in boosting lending in the UK. The difference, however, is that under the ECB’s plan (which it calls Targeted Long Term Refinancing Operations, or TLTRO) mortgage loans do not qualify, whereas in the UK they do. This is interesting because it shows that the ECB is not willing to drive economic growth by inflating a new property bubble, whereas that is exactly how the Bank of England has orchestrated the rebound in the UK economy. It will be interesting to see whether TLTRO will be effective. The problem remains that there are just not any additional creditworthy borrowers out there.

The ECB has hoped that the announcement of these measures would cause the Euro to weaken relative to the US dollar. In the days leading up to the ECB press conference, the Euro did, in fact, weaken from 1.39 to the dollar to as low as 1.35. However, on the day of the announcement, it actually rebound to 1.36. This must have come as a disappointment for the ECB. It looks to me as though that disappointment will deepen over the weeks and months ahead, as the Euro could very possibly strengthen further from here.

ECB President Mario Draghi said he did not expect these measures to show meaningful results for three to four quarters. By that time, it is quite possible (even probable) that the Fed will have backtracked on its plans to end Quantitative Easing in the US. The market has been led to believe that US QE would end by the fourth quarter of this year. If it does not (and I believe that it won’t), then the dollar will weaken significantly from here; and that means the Euro will rise. If things play out this way, then the ECB will have to do more than just consider printing money and buying assets, it will actually have to do it.

More on Market Watch Services

FLOWS - Asset Shortages and Liquidity Becoming An Increasing Problem

"Liquidity Is Becoming A Serious Issue" As Japan's Bond Market Death Goes Global 06-16-14 Zero Hedge

While we noted last week the death of the Japanese bond market as government intervention has killed the largest bond market in the world; it is now becoming increasingly clear that the dearth of trading volumes is not only spreading to equity markets but also to all major global markets as investors rotate to derivatives in order to find any liquidity.

Central planners removal of increasing amounts of assets from the capital markets (bonds and now we find out stocks), thus reducing collateral availability, leaves traders lamenting "liquidity is becoming a serious issue."

While there are 'trade-less' sessions now in Japanese bonds, the lack of liquidity is becoming a growing problem in US Treasuries (where the Fed owns 1/3rd of the market) and Europe where as JPMorgan warns, "some of this liquidity may be more superficial than really deep."

The instability this lack of liquidity creates is extremely worrisome and likely another reason the Fed wants to Taper asap as DoubleLine warns, this is "the sort of thing that rears its ugly head when it is least welcome -- when it’s the greatest problem."

As Bloomberg reports,

Japan's bond market is dead... and so is its stock and FX markets...

The Bank of Japan’s unprecedented asset purchase program has released a creeping paralysis that is freezing government bond trading, constricting the yen to the tightest range on record and braking stock-market activity.

...

“All the markets have been quiet,” said Daisuke Uno, the Tokyo-based chief strategist at Sumitomo Mitsui Banking Corp. “We’ve already seen the BOJ dominance of JGBs since last year, but recently participants in currency and stock markets are also decreasing as those assets have traded in narrow ranges.”

...

“The flows on both the buying side and selling side continue to fall,” said Takehito Yoshino, the chief fund manager at Mizuho Trust & Banking Co., a unit of Japan’s third-biggest financial group by market value. “Falling volatility is a very serious problem for traders and dealers who are unable to get capital gains.”

The US is getting that way as the Fed owns one third of the market...

and the world shifts to derivatives trading to find liquidity...

The boom in fixed-income derivatives trading is exposing a hidden risk in debt markets around the world: the inability of investors to buy and sell bonds.

While futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year.

And Europe is not much better...(via Bloomberg)

Some cracks emerged in Europe last month, when investors dumped Italian, Spanish and Greek debt on speculation political parties opposed to the European Union would gain seats in parliamentary elections and derail the euro area’s recovery.

As the selloff intensified and liquidity decreased, the disparity in yields of 10-year Italian bonds between buyers and sellers based on bids and offers doubled to 6 basis points, or 0.06 percentage point, on May 23, the highest this year.

Market participants are growing increasingly weary...

“That has to bite and prevent dealers from supplying the balance sheet they did in the old days,” Gregory Whiteley, who manages government debt at Los Angeles-based DoubleLine Capital LP, which oversees about $50 billion, said by telephone June 10.

...

“Liquidity is becoming a serious issue,” Grant Peterkin, a money manager at Lombard Odier, which oversees $48 billion, said in a June 11 telephone interview from Geneva. The worry is that when investors try to exit their positions, “there may be some kind of squeeze.”

As we warned previously, these are phantom markets...

“It’s the sort of thing that rears its ugly head when it is least welcome -- when it’s the greatest problem.”

And is forcing traders into the derivatives markets...

As bond trading has slumped, the notional value of over-the-counter contracts soared fivefold in the past decade to a record $710 trillion, based on the latest data from the Bank for International Settlements compiled by Deutsche Bank AG.

...

Volume on Italian futures, which give buyers the right to purchase the nation’s debt at a future date and price, has soared more than 800 percent since trading of the contracts began in 2009, data compiled by Bloomberg show. By contrast, average daily trading in Italy’s $2.43 trillion market for government bonds, Europe’s largest, has tumbled 57 percent in the past decade, according to the Ministry of Finance.

...

For 10-year note futures, a total of 140.4 million contracts have traded in the first five months of the year, approaching last year’s total of 149.8 million, the most on a year-to-date basis going back to 2007, according to CME Group Inc.

Weekly trading of Treasuries with maturities between seven years and 11 years has fallen to $96.3 billion, a 32 percent drop from a year ago, data compiled by the New York Fed show.

“This is a global phenomenon,” Yvette Klevan

No one knows how badly this will end...

“There is risk that people won’t be prepared,” Richman said by telephone June 9. “The move in yield could be quicker and more dramatic than it has in the past. That’s something we are on the lookout for.”

...

“Investors in Japan assume that the BOJ will continue to buy JGBs vigilantly next year and the year after,” said Makoto Yamashita, the chief Japan rates strategist at Deutsche Securities, a primary dealer. “They take it for granted they can sell those bonds bought expensively to the BOJ as more and more notes disappear from the secondary market. It’s too frightening to think what might happen when the BOJ tapers.”

And with that not only have the central planners broken the largest and historically most liquid markets in the world but have forced investors into leveraged derivatives positions (in order to find liquidity for their exposure-seeking) which themselves are entirely over-promise (relative to the underlyings) and under-collateralized with any quality collateral. As we concluded previously...

Assume tomorrow the real black swan appears and all the liabilities: traditional and shadow, promptly demand collateral delivery. Well, the $11 trillion shortage would mean that risk values of, for example the S&P, would be haircut by a factor of, say, 75%. Or back to the proverbial 400 on the S&P500.

Still think owning real high quality collateral, not of the paper but of the hard asset variety such as gold, is a naive proposition, best reserved for fringe lunatic, tin foil hatters and gold bugs?

Go ahead then: sell yours.

FLOWS - In A Sea Of Money Printing, What Happened To All The Liquidity?

In A Sea Of Money Printing, What Happened To All The Liquidity? 06-13-14 Zero Hedge

Volatility is depressed, micro dominates and as Goldman notes several of the key emerging themes of the last few years have lost their discovery value. There are many questions that investors should be asking as the second half of 2014 approaches (and the much hoped for 'recovery' picks up steam); but perhaps the most important one given the taper is "In a sea of liquidity, what happened to all the liquidity?" The supply of stock and volumes are down. Did you know Verizon’s current market cap is larger than Russia’s float?

Via Goldman Sachs,

Despite the market reaching all-time highs, the backdrop for trading activity remains depressed. US cash equity trading volumes have declined 50% since their Oct-2008 peaks, the VIX is back to sub-12 levels and the total supply of tradable stocks has declined by roughly 25% in the last decade (Exhibit 1). Layered on top of this is the impact of the well-publicized shift to passive investing where turnover is 10X lower than active management (Exhibit 1).

With the market awash in liquidity from central bank easing (and low rates) this frustration remains acute among investors. We note the following:

Outside of the United States, only four countries have more than 50 stocks with over a $10 bn market cap (Japan, the United Kingdom, China and France). The picture is similar when looking at trading volumes; just four countries have over 50 stocks that trade over $20 mn/day, which include Japan, China, the United Kingdom and Canada. See Exhibit 2.

Over two-thirds of the world’s market cap is in the top five markets. In order to reach the market cap of the United States, one would need to sum the next 2-14 countries (including those listed on the Euronext and OMX).

Only three of the countries included in the MSCI Emerging Market index have total market caps that are larger than Apple (the largest stock in the United States). Scorecard: Johnson & Johnson is larger than South Africa, Verizon is larger than Russia and Delta Airlines is larger than Greece. See Exhibit 4 for other comparisons.

And then there's Japan...

FLOWS - Central Banks Draining Equity Liqudity

"Cluster Of Central Banks" Have Secretly Invested $29 Trillion In The Market 06-16-14 Zero Hedge

Another conspiracy "theory" becomes conspiracy "fact" as The FT reports "a cluster of central banking investors has become major players on world equity markets." The report, to be published this week by the Official Monetary and Financial Institutions Forum (OMFIF), confirms$29.1tn in market investments, held by 400 public sector institutions in 162 countries, which "could potentially contribute to overheated asset prices." China’s State Administration of Foreign Exchange has become “the world’s largest public sector holder of equities”, according to officials, and we suspect the Fed is close behind (courtesy of more levered positions at Citadel), as the world's banks try to diversify themselves and "counters the monopoly power of the dollar."Which leaves us wondering where are the central bank 13Fs?

While most have assumed that this is likely, the recent exuberance in stocks has largely been laid at the foot of another irrational un-economic actor - the corporate buyback machine. However,as The FT reports, what we have speculated as fact for many years now (given the death cross of irrationality, plunging volumes, lack of engagement, and of course dwindling credibility of central planners)... is now fact...

Central banks around the world, including China’s, have shifted decisively into investing in equities as low interest rates have hit their revenues, according to a global study of 400 public sector institutions.

“A cluster of central banking investors has become major players on world equity markets,” says a report to be published this week by the Official Monetary and Financial Institutions Forum (Omfif), a central bank research and advisory group.The trend “could potentially contribute to overheated asset prices”, it warns.

...

The report, seen by the Financial Times, identifies $29.1tn in market investments, including gold, held by 400 public sector institutions in 162 countries.

...

China’s State Administration of Foreign Exchange has become “the world’s largest public sector holder of equities”, as the report argues is “partly strategic” because it “counters the monopoly power of the dollar” and reflects Beijing’s global financial ambitions.

...

In Europe, the Swiss and Danish central banks are among those investing in equities. The Swiss National Bank has an equity quota of about 15 per cent. Omfif quotes Thomas Jordan, SNB’s chairman, as saying: “We are now invested in large, mid- and small-cap stocks in developed markets worldwide.” The Danish central bank’s equity portfolio was worth about $500m at the end of last year.

Read more here

So there it is... conspiracy fact - Central Banks around the world are buying stocks in increasing size.

To summarize, the global equity market is now one massive Ponzi scheme in which the dumb money are central banks themselves, the same banks who inject the liquidity to begin with.

That would explain this.

That said, good luck with "exiting" the unconventional monetary policy. You'll need it.

FLOWS - Liquidiy, Credit & Debt

The Simple Reason Treasury Yields Are Going Lower: Half A Trillion More Demand Than Supply 06-10-14 Zero Hedge

Back in April 2013, when looking at the dynamics of global treasury supply and demand (and just before the TBAC started complaining loudly about a wholesale shortage of quality collateral), we made the simple observation that between the (pre-tapering) Fed and the BOJ, there would be a massive $660 billion shortfall in supply as just under $1 trillion in TSY issuance between the US and Japan would have to be soaked up $1.7 trillion in demand just by the two central banks.

A year later, bonds yields continue to defy conventional explanation, with ongoing demand for "high quality paper" pushing yields well below where 100% of the consensus said they would be this time of the year, and in this cycle of the so-called recovery, because for the improving economy thesis to hold, the 10Y should have been well over 3% by now. It isn't.

As a result, a cottage industry sprang up in which every semi-informed pundit and English major, voiced their opinion on what it was that was pushing yields lower, and why bids for Treasury paper refused to go away even as the S&P hit record high after record high.

And just like in April of last year, the simplest explanation is also the most accurate one. According to a revised calculation by JPM's Nikolaos Panigirtzoglou, the reason why investors simply can't get enough of Treasurys is about as simple as its gets: even with the Fed tapering its QE, which is expected to end in October, there is still much more demand than supply, $460 billion more! (And this doesn't even include the ravenous appetite of "Belgium" and the wildcard that is the Japanese Pension Fund arriving later this year, bids blazing.) This compares to JPM's October 2013 forecast that there would be $200 billion more supply than demand: a swing of more than $600 billion! One can see why everyone was flatfooted.

As Bloomberg summarizes, “Everybody was expecting supply to come down, but maybe it’s coming down sooner” than anticipated, said Sean Simko, who oversees $8 billion at SEI Investments Co. in Oaks, Pennsylvania. “There’s a shift in sentiment from the beginning of the year when everyone expected rates to move higher."

Here is JPM's math:

QE-driven demand looks set to decline as the Fed tapers. Assuming Fed tapering is completed by October, and no change in BoJ policy, bond purchases by G4 central banks should decline by $500bn vs. 2013 to around $1,080bn this year. All these components of bond demand are shown in Figure 1. The 2014 bar encompasses the projections explained above. In total, bond demand is expected to stay flat vs. last year as an improvement in private sector demand offsets Fed tapering.

How does this compare with bond supply? After peaking in 2010, government bond supply is on a declining trend due to declining government budget deficits.  Spread product supply is also declining driven by European credit supply, which is contracting in both the Corporate and Agency bond space, and securitized products in the US (ABS and non-Agency MBS), which are also contracting. In these supply estimates we only included external rather than EM local debt, as the latter tends to be dominated by local EM investors. We still expect bond supply to decline by $600bn in 2014 to $1.8tr. The balance between supply and demand, i.e. excess supply, looks set to  narrow from +$200bn in 2013 to -$460bn in 2014, a swing of more than $600bn (Figure 4).

Our estimates for bond supply and demand are in notional amounts rather than market values, so a gap between the two is a meaningful concept and should close via market movements. Indeed, the correlation between the estimated gap in Figure 4 and bond yield changes is 0.56, which is significant. Mechanically, the decline in the excess bond supply in 2014 vs. 2013 would imply that the yield of the Global Agg bond index should fall this year by around 40bp by simply looking at what happened before in years with similar excess bond demand to the one projected for this year, i.e. in 2008, 2011 and 2012.

The simple conclusion:

The Global Agg bond index yield has fallen by 30bp so far this year, so most of the projected decline has happened already.

Well, yeah... assuming JPM's massively downward revised estimate of global bond supply is accurate. What happens if instead of $460 billion in excess demand there is $1 trillion, or more? What is the equilibrium rate then?

And there you have it: no crazy de-unrotations, no short squeezes, no unicorn magic voodoo: simple supply and demand.

Furthermore, while we await the demographic hit to arrive sometime in 2017 which will once again send US Treasury issuance soaring as a result of a need to fund budget deficits from a welfare state caring for an aging population, the biggest wildcard until then is just what the US current account will do in the coming years.  Curiously, that also happens to be Bank of America's chart of the day:

The savings gap: The US current account balance, at -1.9% of GDP, is often seen as the trade shortfall. But by definition, it is the gap between savings and investment. Simply put, if we are not saving enough to finance investment, we will need to borrow capital from abroad to fund that gap. The result: a capital account surplus or an offsetting current account deficit. With savings undershooting investment for roughly the past thirty years, the current account has been in negative territory and foreign capital inflows (netted against US outbound capital flows) have bridged that shortfall.

What is ironic here, is that if JPM is accurate in its supply/demand calculation, one of the main reasons why bond yields are tumbling has everything to do with the decline in the US trade, and thus, current account deficit. Because if the US needed more external funding, then it would be able to issue more debt, which would then result in greater supply, and higher prevailing yields. In the meantime, however, since the US government's funding needs, at least for the next 3 years that is, are lower than at any point since Lehman, one can argue that, at least based on declining supply of Treasurys (and US funding needs), the prevailing yield will drift ever lower, making life for the spinmasters (those whose livelihood depends on convincing mom and pop that sliding bond yields is not indicative of a slowing economy) a living hell for the foreseeable future.

FLOWS - Liquidiy, Credit & Debt

The Most Important Number In The World - 05-30-14 Richard Duncan

My finance professor at business school once told my class that the most important number in the world of finance is the yield (i.e. the interest rate) on the 10-year US government treasury bond. US government bonds are considered risk-free. The interest rate at which all other bonds can be sold is determined by this risk-free rate on US government bonds plus a risk premium, which depends on the credit worthiness of the debt issuers. Therefore, when the yield on the government bond rises, the interest rates on mortgages, corporate bonds, credit cards and student loans also rise. Similarly, when the yield on the government bond falls, the cost of all borrowing falls.

Most financial analysts expected the government bond yield to rise significantly this year. Instead, it has fallen sharply. This week, it fell to 2.40%, an 11 month low. May will be the fifth month in a row that yields have fallen. In this blog, I would like to give you my explanation for why interest rates are falling.

In business, everything has a price; and that price is determined by supply and demand. Interest rates are the price a borrower is willing to pay to borrow money. In the past, when gold was money, the supply of money did not change (or it changed very slowly). So, then, it was only changes in the demand for money that caused interest rates to rise and fall. For example, if the economy was growing rapidly, businesses would tend to borrow more to take advantage of the profitable investment opportunities the booming economy presented. The business sector’s increased demand to borrow money would cause the price of borrowing (interest rates) to rise. And, by the way, after some time, the higher interest rates would make investing less profitable, so the economy would slow again.

Using another example, if the government borrowed a lot of money to finance a large budget deficit, that government demand for money would push up interest rates. Higher interest rates would make it less profitable for the business sector to borrow and invest. In such an instance, it was said that government borrowing was “Crowding Out” the business sector, and thereby damaging the economy’s growth prospects.

These days, the situation is more complicated. Once the government stopped backing dollars with gold in 1968, the supply of money was no longer fixed because the government was free to create as much money as it thought desirable. So, now, it is both the demand for and the supply of money that determines interest rates. In other words, to understand why the interest rates on government bonds are now falling, we must consider not only how much money the government is borrowing, we must also consider how much money the government is supplying (i.e. creating) through Quantitative Easing (QE).

When we look at it that way, it becomes immediately apparent why interest rates are currently falling. During this quarter (the second quarter of 2014), the government expects to have a large budget surplus of $78 billion. That means the government will not have to borrow any money at all on a net basis this quarter. Meanwhile, the Federal Reserve will create $145 billion through QE and inject it into the financial system by acquiring bonds. Therefore, the government supply of money will greatly exceed its demand for money this quarter. That, in my opinion, is why the yield on government bonds is falling.

Falling interest rates help the economy expand by making investments more profitable and by causing property and stock prices to rise. Unfortunately, this favorable balance between the government demand for and supply of money will disappear during the third quarter. The government is expected to once again have a large quarterly budget deficit, which will require it to borrow more. However, the Fed, which is tapering its QE program, will supply a great deal less new money. Consequently, the balance between the government demand for and supply of money will once again turn unfavorable, and that is likely to cause government bond yields to start rising again. By the fourth quarter, when QE is scheduled to end altogether, the balance between the government’s demand for and supply of money will become very unfavorable. That could cause interest rates to move considerably higher. If so, business investment would suffer, property and stock prices would probably fall sharply and the economy would very likely move back toward recession.

That is the scenario I consider most probable for the second half of this year. If it unfolds as I expect, I believe the Fed will be forced to launch a new round of Quantitative Easing, QE4, to prevent a severe new deflationary global economic downturn. If the Fed does inject additional liquidity through QE4, it would very likely push bond yields lower and stock prices and property prices higher again.

In this new age of fiat money, Liquidity (or, in other words, the balance between the government’s demand for and supply of money) determines the direction in which stock prices, property prices and commodity prices move.

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Buyers historically confuse PRICE with VALUE.

In the Bond Market PRICE is what you pay for the PAPER.

VALUE is the YIELD the paper delivers.

THE FED's "MANAGED" ASSETS APPRECIATION STRATEGY

GOAL: Finance the Government Debt

OBJECTIVES: Increase Attractiveness of Debt

1. Manipulate Interest Rates which over time inevitably distorts Price Discovery and consequentially Mispricies Risk
2. Drive Up Financial Asset Prices (Stock Prices and Bond Prices) through Fed Buying,
3. Higher Stock Prices:
   1. Higher Borrowing Collateral Values fostering Increasing Borrowing,
   2. Higher Stock Prices reduce Dividend Yields Making Bond Yields Attractive,
4. Higher Bond Prices:
   1. Higher Bond Prices means lower government financing payments,
   2. Bond Yields higher than stock dividends mean bond buying.
5. Higher Overall Asset Prices (Real Estate etc):
   1. Increases Collateral Borrowing Power,

RESULTS: Financial Repression

REMEMBER: Its about protecting and increasing Collateral Values ( ie more lending and stop potential defaults)

Volatility is all about Liquidity 05-22-14 Zero Hedge

The S&P 500 tried to pull back yesterday, but as usual the late day trading pushed the loss to just 65 bps.  This has become the normal market.  In 2012, volatility puttered at 12.77%.  In 2013 it fizzled down to 11.07%.  YTD we have crept up to 11.73%.   These metrics tell you to expect daily gains and losses to be +/- .75%.  Very Exciting.

What does this market remind me of?  I would say the nearest example is 2004-2006 when volatility cycled between 10-11%.  What do these two periods in time have in common?  Extremely easy monetary policy provided by the Fed.

The most powerful chart to show you the impact of Fed provided liquidity plots realized volatility against the steepness of the yield curve as measured by the spread between the 10y and 2y treasury rates.  As the fed keeps the front part of the curve low through the Fed Funds rate, the steepness is held high.  A steep yield curve induces investors to borrow at cheap shorter rates and buy riskier assets to earn a spread.  Party on while the Fed provides the punch bowl.

The current steepness of the yield curve is a great indicator for future market volatility

The red line above is the steepness inverted, so higher numbers represent the curve flattening or the Fed taking punch away from the party.  Low numbers say party on.  The blue is the trailing 90 day realized volatility of the S&P 500.  When the Fed says to party, the volatility stays abnormally low.

Key point to make in this chart is that the red line is two years behind the blue line so the red line starts at 1/31/1977 while the blue line starts in '79.   This implies that the tightening of monetary conditions or reduction in market liquidity takes about 2 years time in order for volatility to pick up.  If the curve can remain steep for another two years, then how large will the volatility dislocation become when the Fed does ease off the gas pedal?  Most punch bowls are provided for 2 years or less.  Right now we are in the 6th year of zero interest rate policy with a strong indication that they will maintain it well into 2015.  Maybe this time the volatility will come even before the Fed eases off the pedal?

FLOWS - Liquidity, Credit & Debt

What Drives Capitalist Growth? 05-15-14 Richard Duncan

I would like to ask my readers to think about our economic system and how it creates economic growth. I believe this will be useful in understanding the impediments that will have to be overcome in the years immediately ahead if economic growth is going to continue.

Over the last 250 years, Capitalism has transformed the world. One way or another (some would say “by hook or by crook”) it has found a way to make profits grow and capital accumulate. Decade after decade, capitalist economies have grown by developing new production techniques, opening new markets (by force if necessary), finding new sources of cheap labor or, if need be, by demanding and receiving government support.

Many prerequisites must be in place for capitalism to take hold and to begin generating economic growth. There must be societal acceptance of such a system. There must be a sufficient supply of raw materials, including labor. Property rights must be secure. And there must be entrepreneurial talent. But the precondition that I want to draw attention to today is Effective Demand.

Here’s a definition of Effective Demand: “Wants, needs and desires backed up by the ability to pay.” And I have put “backed up by the ability to pay” in bold because that, of course, is the limiting factor. There may be no limit to human wants, needs and desires, but there clearly are limits to the ability to pay for them.

For capitalism to produce economic growth, investments must generate profits; and at least part of those profits must be saved and reinvested as new “capital”. One way for businesses to become more profitable is to reduce the wages they pay to their employees. Beginning in the 1980s most large US manufacturing companies began to push down the amount they paid to their employees by moving their factories to low wage countries like China and Mexico.

The problem with this strategy is that if all companies reduce the wages of their employees, then no one would have enough income to buy the products that the companies make, in which case profits will fall. In other words, there would be insufficient “Effective Demand” to allow the economy to generate profits and growth.

Between 1990 to 2008, this problem of insufficient Effective Demand in the United States (and in many other developed economies) was overcome by increasing the amount of credit ordinary people were allowed to borrow. Credit as a ratio of GDP grew from 220% in 1990 to 370% in 2008. With greater access to credit, Americans were able to continue spending more every year even though wages for most people ceased going up. Credit provided the Effective Demand that allowed the economy to grow.

That came to an end in 2008 when millions of Americans could no longer afford to continue paying the interest on all of their debt. When they defaulted they were cut off from additional credit. That caused Effective Demand to contract. And the contraction of Effective Demand threw the United States and the world into the worst economic slump since the Great Depression.

At that point, the government had to step in to prevent economic collapse. The US government and other governments around the world greatly increased the amount of money they borrowed and spent, thereby becoming the next source of Effective Demand. Part of the money governments borrowed came from the world’s central banks, which created trillions of dollars worth of fiat money over the past six year. That fiat money was one more source of Effective Demand. And, as a result of the increase in government debt and fiat money creation enough Effective Demand was generated so that our economic system was able to keep generating more profits and accumulating more capital and economic growth.

Where will the Effective Demand come from next? The governments of most of the developed economies are rapidly reducing the size of their budget deficits. The US budget deficit, for instance, is less than half the size it was at the peak of the crisis. Moreover, the US central bank, is winding down its Quantitative Easing program of fiat money creation, which is scheduled to end in November this year.

So, where will the next source of Effective Demand come from? As I look around the world, I can’t see any new source. Without increasing Effective Demand, profits and capital will begin to shrink and the global economic crisis will resume.

Capitalism, or whatever you wish to call our economic system, has been extremely resourceful in developing new sources of Effective Demand decade after decade. So, it will be very interesting to see how it responds to the approaching shortfall that now seems to threaten it. Let’s watch and see what happens. My bet is that Quantitative Easing won’t end this year. I expect the Fed will be forced to continue providing the Effective Demand that has been fueling economic growth in recent years. There does not seem to be any other alternative source.

FLOWS - Japan

Japan’s Extraordinary Monetary Experiment Richard Duncan

Japan’s economy, the third largest in the world, is in serious trouble. The Bank of Japan (BOJ), the country’s central bank, has embarked on what may well be the most aggressive monetary experiment in history to try to save it.

In this blog, we’ll glance at the grave economic problems confronting Japan and examine the BOJ’s strategy for overcoming them. Let me tell you from the beginning that I believe there is more to the BOJ’s plan than has been announced publicly thus far.

This subject is important because if the BOJ’s strategy works, the rest of the world is likely to adopt it; that would be a game changer.

Let’s start with Japan’s economic problems:

• Japan’s economy has not grown at all in nominal terms since 1993.

• Its population is shrinking. The workforce is expected to contract by 0.6% a year during this decade and by 0.8% a year during the next decade.

• 25% of the population is over 65 years old.

• Japan began experiencing deflation in 1995 and, on an annual basis, prices have fallen more often than not since then.

• After the bubble economy popped in 1990, government deficit spending has prevented the economy from collapsing into depression. The budget deficit has averaged 6% a year since 1993.

• Consequently, the ratio of government debt to GDP has climbed from 60% in 1990 to nearly 250% now.

• To bring the deficit under control, the government increased the “sales tax” form 5% to 8% on April 1st this year. Consumption will decline as a result. That may cause the economy to fall back into recession.

• Japan has traditionally run large trade surpluses. It now has a significant trade deficit. This happened because Japan closed its nuclear power stations after the meltdown of the Fukushima nuclear plant in 2011. It must now import much more oil and gas.

Against this very troubling background, the BOJ launched its extraordinarily aggressive program of fiat money creation at the end of 2012. It announced that it would create about Yen 60 – 70 trillion (the equivalent of roughly $600 -700 billion) a year for two years, thereby doubling the monetary base.

This program is similar to the Fed’s program of Quantitative Easing, but it is three times larger relative to the size of Japan’s economy than the Fed’s program was (at its peak) relative to the size of the US economy.

The BOJ uses the money it creates to buy Japanese government bonds. By the end of this year, it is expected to own Yen 190 trillion worth of Japanese government bonds or 16% of the total.

The BOJ’s policy clearly boosted Japan’s economy during 2013. The creation of so much fiat money caused the Yen to depreciate by 30% by the end of 2013. The weaker Yen improved the export earnings and profits of Japanese corporations, and thereby fuelled a stock market boom.

The Nikkei rose 60% in 2013. Higher stock prices created a wealth effect, which, combined with some fiscal stimulus last year, brought about a nice pick up in GPD growth, which accelerated to 4% during the first half of the year.

However, this policy appears to have run out of steam. The Yen stopped falling at the beginning of 2014 and the stock market is down 11% so far this year. Moreover, the April sales tax hike will cause a significant economic slowdown. Without further policy action, the economy is going to go right back into the doldrums.

Therefore, I believe the BOJ will soon announce that it will begin printing even more fiat money each month. That should cause the Yen to begin falling again. If so, prices will continue to rise (inflation) and corporate profits will improve further and the stock market rally will resume.

You must be thinking, “This can’t be sustainable. It can’t be possible for a country to print its way to prosperity.” If this were the entire plan, you would be right. But, I believe there is more to this plan than has been announced thus far. I believe that the BOJ will eventually simply write off all the Japanese government bonds that it has acquired. After all, it did not really cost the BOJ anything to buy them. They were purchased with fiat money that the BOJ created from thin air.

If I am right, when the BOJ does write off 30% to 40% of Japan’s government debt, Japan’s economic prospects will be dramatically improved. The amount of interest that the Japanese government has to pay on its debt will fall very sharply and the government will be able to continue stimulating the economy with large budget deficits without risking a fiscal crisis.

I believe this is what the Japanese policymakers are planning to do. It is the best option they have. Moreover, I think it will work.

When it does work, I believe the US Federal Reserve, the Bank of England and the European Central Bank will follow suit and write off the assets they have accumulated with the trillions of dollars worth of fiat money they have created since this crisis began.

If they do, government finances will be greatly improved everywhere and the outlook for our economic future will be much brighter.

FLOWS: Liquidity, Credit & Debt

For anyone who is interested in understanding my views on the global economic crisis, this is the video I would recommend watching, if I could only recommend one. In it, I am able to address almost all of the ideas I have tried to convey through my books and speeches over the past ten years. The pace is relaxed and the production quality is very good. It was filmed in a beautiful suite in the Trump Tower in Chicago.

The interview was organized, produced and conducted by Tim Verduin. Tim is the CEO of The Resilience Group, an insurance and financial services agency located in Crown Point, Indiana. I thought he asked all the right questions.

1 Hour & 2 Minutes Video

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ECONOMIC OUTLOOK WITH RICHARD DUNCAN

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FLOWS - Liquidity, Credit & Debt

A TREACHEROUS MARKET AHEAD

The stock market may be in for a nasty plunge. The second quarter has gotten off to a very bumpy start and the odds are that there is much worse to come.

Valuations are stretched due to the liquidity that the Fed has been injecting into the financial markets through Quantitative Easing. But QE is being wound down and is due to end by November. It looks like the smart money has begun to get out of stocks before the liquidity dries up. The NASDAQ is now down 8% from its year-to-date high; and the Dow, while still only 2.5% below its all time high, had three triple-digit down days last week.

This skittish behavior now is all the more worrying because the liquidity in the financial markets will continue to be quite excessive through the end of this quarter. Even with “tapering”, the Fed will still inject $145 billion into the markets during Q2. Meanwhile, the government, which normally removes a great deal of liquidity from the markets by borrowing to fund its budget deficits, probably won’t have a budget deficit during the second quarter. It’s likely to have a surplus since Americans pay taxes in April. Therefore, the government won’t have to borrow much, if anything at all, this quarter.

The problem with liquidity only arrives in the third quarter. QE will be reduced to $85 billion then, while the government will have to borrow approximately twice that amount to fund its third quarter budget deficit. Then, in the fourth quarter, liquidity conditions become considerably worse. The Fed will only inject $20 billion as QE comes to an end, while I estimate the government will have to borrow something like $240 billion. From that quarter on, there will be a significant liquidity drain.

The fourth quarter is still some time off, however. If the markets are this nervous now, when there is still so much excess liquidity, just imagine what could happen when the liquidity dries up and then begins to be drained from the financial markets by government borrowing.

The risks are all the greater given that market valuations are already expensive. The Shiller Cyclically Adjusted PE Ratio (the CAPE ratio) shows the Dow to be on 25 times earnings, well above its average since 1881 of 16.5 times. And, more broadly, the ratio of Net Worth to Disposable Personal Income (i.e. Wealth to Income) is also flashing a bright red warning signal that asset prices in general may be unsustainably high. Since 1952, that ratio has averaged 525%. During the NASDAQ bubble it peaked at 615% and then fell sharply when that bubble popped. It hit an all time high of 660% in 2006 during the property bubble; and then fell sharply again during the subsequent crisis. By the end of last year, it had climbed back to 639%. That suggests we may be nearing the limit of how far the Fed can drive up asset prices and net worth through fiat money creation.

I had thought that excess liquidity might push the stock market even higher during the second quarter, before the evaporation of liquidity caused a big selloff sometime during the second half. In this scenario, I had imagined that, as liquidity dried up in the third quarter, the yields on government bonds and mortgages would rise, causing the stock market and property market to fall. It’s too early to rule this scenario out. Things may still play out that way.

However, the market action over the past two weeks suggests a different scenario is also possible. In this scenario, stock investors panic and get out of equities even before the liquidity drain begins to push up interest rates. They then use the cash they receive from selling stocks to invest in “safe haven” government bonds, pushing bond prices up and bond yields down even further.

In either scenario, the Fed would most probably feel compelled to reverse course on tapering QE and announce that it will continue creating fiat money on into 2015. The alternative would be to accept a new recession caused by a stock market crash. I don’t believe the Fed would dare allow that to happen.

So, it looks to me that it is only a matter of time before the Fed has to extend QE. When it does, stocks will surge, net worth will recover and recession will once again be averted – for a while. But, a lot of bad things could happen to the stock market between now and then.

The market may yet recover its composure and, fuelled by excess liquidity, move higher over the next couple of months. It seems to me, however, that the risk-reward tradeoff is becoming less and less favorable by the day. The old stock market adage is “Sell in May and go away”. This year, it’s just possible that May may be too late.

FLOWS - Liquidity, Credit and Debt

TREACHEROUS MARKETS AHEAD

MACRO WATCH - Q2 OVERVIEW

THE FED & ITS CHALLENGES

ITS ABOUT THE "RATE OF CHANGE" (ROC)

MACRO WATCH - Q2 2014

TREACHEROUS MARKETS AHEAD

This quarter there are seven videos, (with 130 charts and slides).

Here’s what they cover:

1. Treacherous Markets Ahead. I believe the stock market may be particularly tricky during the rest of this year. Liquidity will shift from being very excessive in the second quarter to being scarce in the third. Therefore, the markets could first experience a boom and then a bust. I also discuss how the Fed is likely to respond.

2. The Fed & Its Challenges. The challenges that the Fed faces over the short-term, the medium-term and the long-term are very different. Each requires a unique response. The Fed must try to prevent an asset price bubble over the next three months. During the second half of the year, it must attempt to prevent a stock market crash and recession. Over the long run, its challenge will be to continue driving the economy by pushing up asset prices, even after asset prices have become dangerously inflated.

3. Austrian Economics: Right & Wrong. No one explained the role credit plays in creating economic booms and depressions better than the Austrian Economists. In this video, I explain why it is crucial that our generation draws the right conclusions from what they taught. This one’s going to provoke some controversy.

4. What Drives Currencies? Trade imbalances, interest rate differentials, fiat money creation and central bank policy do. I discuss each of these and explain what they tell us about which way the major currencies are likely to move from here.

5. China’s Economic Crisis. China’s economic growth model is in crisis. Export-led growth is coming to an end. Investment-driven growth is unsustainable. Credit-fuelled growth is destabilizing. In this video, I explain why a sharp slowdown in China’s GDP growth is inevitable and what that will mean for the rest of the world.

6. Credit Growth Update. In this age of fiat money, credit growth drives economic growth. This video reviews the latest credit data from the Fed’s fourth quarter Flow of Funds statistics. We find that credit growth is not accelerating and will remain too weak to generate economic growth. That suggests the Fed will have to carry on driving the economy by creating money and pushing up asset prices.

7. Economic Update. The US economy weakened during the first quarter. US imports have stopped growing. The US current account deficit is correcting. In short, the driver of global economic growth has gone into reverse. That explains why the global economy is so weak.

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ECB APRIL MEETING - No Easing

SIGNALS:

• Negative Deposit rates (likely FIRST STEP- They are currently zero)
• Large-scale bond purchases (we anticipate this to be UST's if it happens)
• Key measure is inflation which is too low at 0.5% versus 2% EU target.

The governing Council pointed to the economic recovery to justify inaction.

• The first reading on the composite PMI survey for the monetary union remained buoyant at 53.2 in March.
• The decline in the unemployment rate provides additional evidence of economic growth. It fell to 11.9 percent in February from 12 percent in January

LIKELY REAL REASON FOR DEALY

Draghi said the 24-member board—which includes Germany's ultracautious Bundesbank—was "unanimous in its commitment" to deploy "unconventional instruments" at its disposal if inflation stays too low for too long.

Mr. Draghi "has elevated the threat level about further action. "I don't think you can be any more dovish without actually doing something" said Nick Matthews, economist at Nomura International."

No ECB easing despite fear of stagnation Danske Bank

 Mario Draghi’s biggest fear for the euro area is protracted stagnation. Nevertheless, the ECB did not ease today.

 An interesting part of today’s ECB meeting was that the Governing Council discussed a quantitative easing (QE) programme. Last month , Draghi slightly opened the door for this, as he mentioned QE while listing a number of easing measures. Today , he was much more direct and said the Council is ‘unanimous on unconventional tools’.

 The ECB also discussed negative deposit rates as well as

• A narrowing of the rate corridor and related to this Draghi said that
• ‘the ECB has not yet finished with conventi onal measures’.

 Hence, it seemed that Draghi tried to use his old strategy of verbal intervention but it had only a marginal market influence. Could it be that markets are starting to get tired of soft words and now want action?

 At the latest meeting , Draghi focused on the recovery and how things had start ed to look better but today focus was back on inflation. The message from Draghi seems to be that another negative surprise on inflation w ou l d lead to more easing , as this is very likely to change the ECB’ s outlook for inflation. So far , it i s too early for the ECB to conclude whether the outlook has changed and i t maintained its wait - and - see approach.

 In our view , the ECB is too optimistic on inflation and we will get more negative surprises. Based on Drag hi’s communication today, we expect th is to lead to further easing.

 In our view the timing is still very unsure. We think the ECB’s inflation forecast is too optimistic for Q2 but in coming months base effects are likely to lead to higher inflation, which would buy the ECB some time. Hence , it could be that the ECB will remain on hold until H2. Moreover, the tool is also very uncertain. Although the Governing Council is now considering a QE programme , it looks as though it has not found a preferred tool to use in fighting low inflation.

 As expectations going into today’s meeting were lighter than previous meetings in 2014, the disappointment o f unchanged policy has not had a great influence o n the fixed income market. German 10Y moved marginally during the E CB meeting and most selling pressure was observed at the front of the Euribor and Eonia curve, as we now h av e confirmation of unchanged liquidity dynamics in the next maintenance period , including the usual volatile period of Easter. However, as QE was a m ore explicit subject at today’s meeting , peripheral spreads are tighter on the day.

Draghi: ECB Open to Further Easing 04-03-14 WSJ

Euro Weakens After Central Bank Chief Says Officials Discussed Possibility of Asset Purchases

FRANKFURT—The European Central Bank opened the door Thursday to the kind of extraordinary stimulus measures it has long resisted, even as its counterparts in the U.S. and elsewhere are winding down theirs, reflecting mounting fears about threats to Europe's economic recovery.

President Mario Draghi's revelation that the central bank had discussed negative interest rates and large-scale bond purchases—if needed to keep persistently low inflation from undermining growth—caught financial markets by surprise.

The ECB, as expected, held its main lending rate at the record low of 0.25%, where it has been since November. But the euro weakened at the ratcheting up of the rhetoric concerning the possibility of action as early as next month.

Mr. Draghi said officials had discussed asset purchases, known as quantitative easing, as well as setting a negative rate on bank deposits parked at the ECB—moves that could help bolster the economic recovery and push up prices. The annual inflation rate in the euro zone is just 0.5%, far below the bank's target of just under 2%.

"We don't exclude further monetary-policy easing," Mr. Draghi said at his monthly news conference. He also peppered his comments with much more aggressive language than he has used in recent month.

The ECB is "resolute" in its determination to keep its easy-money policies in place, he said, and "to act swiftly if required."

And whereas a handful of ECB members have signaled an openness to more action in recent days, Mr. Draghi put the weight of the full ECB behind it.

He said the 24-member board—which includes Germany's ultracautious Bundesbank—was "unanimous in its commitment" to deploy "unconventional instruments" at its disposal if inflation stays too low for too long.

After he spoke, Spanish and Italian government bonds extended their recent rallies, with Italy's 10-year bond yields falling to an eight-year low.

Mr. Draghi "has elevated the threat level about further action," said Nick Matthews, economist at Nomura International. "I don't think you can be any more dovish without actually doing something," he said. "Dovish" is used to describe central bankers who are more worried about weak growth than they are about inflation.

Mr. Draghi's comments suggest reducing interest rates would be a first step.

A negative deposit rate—it is currently zero—would force financial institutions to pay to park their excess funds at the ECB, which may encourage them to lend more to the private sector. Denmark has deployed negative rates since 2012, but it would be largely unchartered territory for a major central bank such as the ECB.

Quantitative easing is more complicated in the euro zone than in the U.S., where the Federal Reserve has deployed the policy and continues to do so, albeit at a scaled-back pace. Asset purchases in the U.S. filter quickly to its economy because relatively more borrowing there is done through the capital markets, Mr. Draghi noted.

The Bank of England has accumulated about £375 billion ($622 billion) in government bonds since 2009, but hasn't made any new purchases since November 2012. The U.K. economy has expanded much more vigorously than the euro zone's in recent years, and inflation is significantly higher.

But the euro zone has 18 national bond markets to deal with, making it hard to design a policy for the entire region. And the euro bloc is much more reliant on bank lending than the U.S., meaning that even if the ECB bought private and public debt, this may not be quickly transmitted to the economy.

Still, the ECB had a "rich and ample discussion" on quantitative easing and other measures, Mr. Draghi said, and will continue to study it.

Pressure on the ECB to act has grown since a report released Monday showed that inflation softened to just 0.5% in March, a more than four-year low.

A surprisingly weak inflation figure of 0.7% in October triggered the ECB rate cut last November. But Mr. Draghi said the central bank wants more time this time to gauge the longer-term outlook.

He noted that Easter occurs later this year than in 2013. That means typical price rises for such things as holiday-related travel will occur in April rather than March. Officials are also eyeing the effect of the relatively strong euro on consumer prices, he said.

This sets up the April inflation report as a key one for the ECB, analysts said.

ECB Vice President Vitor Constancio said on Tuesday that the central bank expects "that the low figure of inflation in March will be corrected" in April.

If that fails to happen, however, the ECB may move as early as next month, Mr. Matthews said.

The Organization for Economic Cooperation and Development reported Thursday that deflation risks in the euro area have risen, with Greece, Cyprus and Spain already suffering from it. The Paris-based think tank called on the ECB to consider "additional nonconventional measures" if the problem intensified.

Typically, low inflation is a good thing. It keeps long-term interest rates anchored and provides a stable environment for households and business to spend and invest.

But when it is too weak, consumers may put off purchases, hoping they will get a better deal if they wait. It also makes it harder for households, firms and governments to service their debts, because wages and tax revenue don't rise as much.

These risks intensify when prices fall outright for a prolonged stretch, known as deflation. Japan has struggled with these effects for two decades.

Mr. Draghi rejected, as he has numerous times before, fears of deflation in Europe.

Still, even too-low inflation carries risks. The closer inflation is to zero, the easier it is for an adverse shock from the economy or geopolitical uncertainty to push the rate into negative territory.

For this reason, major central banks such as the ECB and Fed aim to keep inflation around 2%.

So far, the euro zone has seen little ill effect from low inflation and the recent high value of the euro. The economy has expanded, if slowly, since exiting a lengthy recession last spring.

Business surveys and consumer spending reports suggest the recovery gathered some pace during the first quarter, led by Europe's largest economy, Germany.

Still, Mr. Draghi cited the economy as his biggest fear, and emphasized the need for government efforts to make labor markets more flexible. The longer high unemployment persists, the greater the chances that it will become structural rather than temporary, he said.

"The protracted stagnation…even right now it's pretty severe," he said.

FLOWS - The Unsustainable Eventually Ends For Reasons That Were Always Self Evident

THE WEALTH EFFECT IN A 70% CONSUMPTION ECONOMY

FRIDAY FLOWS - More Liquidity Needed to Stem a Recession

A RECESSION AHEAD - UNLESS LIQUDITY RATES INCREASED

The economic growth expectations for the world in 2014 just plunged to fresh lows at a mere 2.78% - that is 15% "less" growth than was expected a year ago. The world's equity markets are up 25% "more" than at the start of 2013. Thus, our dysfunctional dystopian world where 'less' economic growth is 'more' wealth-creating. Long live the central bank utopia...

GLOBAL LIQUIDITY GAUGE

Submitted by Lance Roberts of STA Wealth Management,

FOMC Asset Purchases And The S&P 500 03-27-14

FLOWS - Credit, Liquidity and Debt

The China Crisis Richard Duncan

China's economy is tipping into crisis because its economic growth model of export-led, investment-driven growth has taken China as far as it can. In a global economy that is barely growing, there is no one left for China to export more to. The end of the Great China Boom will have a profound impact on every corner of the globe. Here's what's happening.

In the past, very rapid credit growth in the United States fuelled the US economy and pulled in sharply increasing amounts of imports each year. Surging US demand created a bonanza for the global economy as the rest of the world expanded its investment and industrial production to satisfy orders from the United States. No country benefited more than China.

• Chinese exports to the US rose from $15 billion in 1990 to $440 billion in 2013
• Chima's trade surplus with the US rose from $10 billion to $318 billion over the same period.
• China's cumulative trade surplus with the US over those years amounted to $3.3 trillion. As that money entered China's banking system as deposits, it supplied the funding required to build the factories that produced the goods that the Americans wanted to buy.
• Investment increased at a phenomenal pace, averaging 13.3% a year (in real, inflation-adjusted term) between 1990 and 2012.

With exports and investment booming, China's economic growth exploded. The size of its GDP grew from $350 billion in 1990 to $8.2 trillion in 2012. And, as China's economy grew, it pulled in huge amounts of imports from around the world - raw materials from Australia, South-East Asia, Africa and South America; oil from the Middle-East and Russia; and advanced machinery from Germany and Japan. China became the world's second engine of growth.

China's economy was peculiarly lopsided, however. Investment amounted to 49% of GDP in 2011, whereas household consumption amounted to only 35% of GDP. That is twice the world average for investment and less than half the global average for consumption.

This imbalance between investment and consumption illustrates how dependent China's economy is on demand from the rest of the world.

Export-led, investment-driven growth worked miracles for China for three decades. But the conditions that existed between, say, 1985 and 2007, are no longer in place today. During those years, total debt in the United States increased from $9 trillion to $50 trillion; and the ratio of total debt to GDP rose from 150% to 370%.

Today, the growth of total debt in the US is less than 2% a year (adjusted for inflation). That is too little to generate meaningful economic growth there. Consequently, imports into the US are depressed. Goods imported were flat in 2013 relative to 2012. Therefore, the growth in world trade is weak and the global economy is verging on recession. In this environment, it is not possible for China to continue growing its exports at a double-digit annual pace. During the first two months of this year, China's exports actually contracted by 1.6% compared with the first two months of last year.

China has responded to the crisis in global growth by investing more in domestic infrastructure and by radically expanding domestic credit. Bank loans have increased by 135% since the crisis began and lending by the shadow banking system has grown even more rapidly. However, there is a limit as to how many highways and bridges that China can build. Moreover, the longer the credit binge continues the greater the probability of a systemic banking crisis becomes.

With global demand for Chinese exports saturated, any further investment in factories will only result in losses since China already has enormous excess industrial capacity across almost every industry. Ongoing massive investment in infrastructure is increasingly wasteful. And, the wild lending spree underway is increasingly destabilizing.

To put it mildly, China is in trouble. And that spells trouble for the rest of the world. As a result,

• The global economy is likely to slow further,
• The price of commodities such as copper, iron ore and coal are likely to continue to fall.
• The commodity-exporting economies, like Australia and Brazil, are likely to suffer as a consequence, and their currencies are likely to continue to weaken.
• With Chinese demand for imports slowing (or falling), global deflationary forces should increase and if China allows its currency to depreciate (which is a growing possibility), those deflationary forces would intensify.
• In this scenario, interest rates (i.e. bond yields) would be likely to move lower rather than to rise as most analysts currently expect.
• Corporate profits would also come under pressure, increasing the chances of a sharp stock market selloff.

The scenario outlined above is more likely to play out gradually rather than overnight. China still has a great deal of scope to stimulate its economy by running very large budget deficits the way Japan has done for the last 24 years. Moreover, in all probability, the Fed and other central banks would respond to this risk of global recession by significantly increasing the amount of fiat money they print each month.

Therefore, while I don't expect the crisis in China's economic growth model to produce an immediate crisis in the global economy, I do believe that it will create very significant headwinds for the rest of the world during the years immediately ahead. This is another reason why Quantitative Easing is unlikely to end any time soon.

PATTERNS - Beware When the Fed's Asset Quarterly (13 Wk) ROC Goes Negative

FLOWS: Its the 2nd Derivative

FLOWS - Liqudity, Credit & Debt

The Liquidity Gauge Explains Why QE Won’t End in 2014

Central bank forward guidance and communication are all fine and good, but it is liquidity that moves the markets.  When liquidity is plentiful asset prices tend to rise and when it is scarce asset prices tend to fall.  What investors require, therefore, is a simple way to measure and forecast liquidity, a liquidity gauge.

A liquidity gauge for the United States is relatively easy to construct.  When the government borrows dollars to fund its budget deficit, it absorbs liquidity.  When the Fed creates dollars through Quantitative Easing, it injects liquidity into the financial markets.  During 2013, the government absorbed $680 billion to fund its budget deficit, while the Fed injected just over $1 trillion through QE.  The difference between what the government absorbed and what the Fed injected was $320 billion of excess liquidity. 

That is not the full story, however.  The Fed was not the only central bank creating fiat money and buying dollar assets last year.  In order to prevent their currencies from appreciating, many central banks around the world created their own money and used it to buy the dollars entering their economies as a result of their trade surpluses with the United States. Once they had acquired the dollars, they invested them in US dollar assets to earn a return.  This, then, was a second source of liquidity.  It can be measured by the increase in foreign exchange reserves.  In 2013, foreign exchange reserves increased by approximately $700 billion. Roughly 70% of those reserves were US dollars.  This second source of liquidity thus added another $500 billion or so to US liquidity, bringing total liquidity to $1.5 trillion and excess liquidity to $820 billion.

When total liquidity (i.e. Quantitative Easing combined with the amount of dollars accumulated as foreign exchange reserves) is larger than the budget deficit, there is excess liquidity and asset prices tend to rise.  But when total liquidity is less than the budget deficit, there is a liquidity drain and asset prices tend to fall.   The $820 billion of excess liquidity in 2013 was the most ever recorded. That explains why the stock market rose nearly 30% and why home prices rebound by 13%.

This liquidity gauge also explains past booms in asset prices.  Although QE only began in late 2008, central banks outside the US have been accumulating large amounts of dollars as foreign exchange reserves since the 1980s.  The previous two peaks in excess liquidity occurred in 2000 at the time of the NASDAQ bubble and in 2006 at the time of the property bubble.  The excess liquidity caused those bubbles.

The liquidity gauge becomes a useful tool for investors when it is used to forecast future levels of liquidity.  That is also relatively easy to do.  The Congressional Budget Office publishes it projections for the budget deficit and the Fed has provided a tentative taper schedule that provides estimates of how much fiat money it will create each month during 2014.  All that is missing is the amount of dollars that will be accumulated as foreign exchange reserves.  Here, estimates of the US current account deficit can serves as a proxy.  Since 1970, the amount of dollars accumulated as foreign exchange reserves has been similar to the size of the US current account deficit during most years.

Plugging in estimates for the budget deficit, the Fed’s taper schedule and estimates for the current account deficit on a quarter by quarter basis for 2014 suggests that liquidity will remain excessive during the first half of the year, but that a liquidity drain will begin in the third quarter and become significantly worse in the fourth quarter.  If this analysis is correct, asset prices are likely to fall during the second half – unless the Fed provides more Quantitative Easing than it is currently signaling.

Given that the Fed has been driving the economic recovery by inflating the price of stocks and property, it is unlikely to allow falling asset prices to drag the economy back down any time soon.  To prevent that from happening, it looks as though the Fed will have to extend QE into 2015 and perhaps significantly beyond. 

If you are an investor in the stock market, you may be in for a wild ride during the rest of this year. Think ROLLERCOASTER: slowly up, up, up, up and then, whoosh, way down fast. And, then, up again. Here’s why.

Liquidity determines the direction of asset prices; and the level of liquidity in the markets is going to change abruptly between the second and third quarter of this year. According to my calculations, liquidity will shift from being abundant – even excessive – in the second quarter to being tight in the third quarter and, then, very tight in the fourth quarter. This sudden change in liquidity conditions could whipsaw the markets.

Click to Play

The Fed has begun tapering Quantitative Easing. Nevertheless, it still intends to create $145 billion new dollars during the second quarter. It will inject that liquidity into the markets by acquiring financial assets. On the other side, the government is unlikely to absorb any liquidity at all during that period. Americans pay their taxes in April. Therefore, the US Treasury will probably have all the cash it needs and won’t have to sell any new (liquidity-absorbing) bonds during the second quarter. That’s going to leave a lot of excess liquidity sloshing around the financial markets between now and the end of June. And, when there is excess liquidity, stock prices tend to rise.

By the third quarter, it will be a different story, however. The Fed will print much less and the government will borrow much more. During those three months, the Fed intends to create only $85 billion, whereas the government could have to borrow $180 billion or more. With the government borrowing more than the Fed is printing, there will no longer be any excess liquidity. In fact, there will be a liquidity drain. The markets have been spoiled by a great deal of excess liquidity since the end of 2012 when the Fed launched QE 3. They are going to find the reduction in liquidity very unpleasant. Bond yields are likely to begin moving up and stock prices are likely to begin moving down. It is in such moments that stock market panics often take hold.

If investors do manage to maintain their nerve throughout the third quarter, they may find it considerably more difficult to remain calm during the fourth. The Fed has signaled that it will only print $20 billion during those three months, while the government is likely to have to borrow something like $240 billion to fund its budget deficit. (The budget deficit tends to be highest during the fourth quarter.) With the government sucking out much more liquidity than the Fed is pumping in, liquidity will be drained from the markets. In that environment, bond yields will rise. That will push up the cost of mortgages, causing the property market to take a hit. All this would be too much for the stock market to bear. If share prices don’t fall in Q3, then, in the scenario being described here, they seem very likely to fall in Q4. Falling home prices and stock prices would cause a big drop in household sector wealth. Consumption would decline and the US would tumble back into recession, pulling the rest of the world down with it.

I write “would” instead of “will” because I don’t believe the Fed will allow that scenario to play out. The Fed has worked very hard to push up asset prices in order to make the economy grow. I don’t believe they will allow liquidity to tighten to the point where asset prices tumble again and drag the economy back into recession. That means that sometime during the third quarter, if not before, the Fed is going to have to announce it will stop tapering QE. That announcement may prove to be the biggest financial news story of the year.

If I am right about this, then stocks are likely to move higher – and perhaps significantly higher – between now and mid-year. They will then begin to correct – and, again, perhaps quite significantly - during the third quarter. At that point, the Fed will ride to the rescue by announcing that it will continue its program of Quantitative Easing on into the indefinite future. Stocks will rally again on that news.

This rollercoaster scenario is the one that strikes me as the most likely as of now. Of course, the future’s not ours to see. Things change unexpectedly. Big disruptions appear out of nowhere. So, we’ll have to wait and see. However, given what we know now, it looks to me that liquidity is going to tighten substantially. That suggests that either the stock market is going to buckle or, more probably, the Fed will backtrack again and keep its printing presses working overtime.

More on Market Watch Services

HALTING A COMING US RECESSION

Weak US Credit Growth Means…

• Weak US Imports
• Weak Global Trade
• Weak Global Economic Growth

…… And More Quantitative Easing

$2.3 TRILLION IN TOTAL US Y-o-Y CREDIT GROWTH REQUIRED

US BUDGET DEFICIT - GOOD NEWS IS BAD NEWS

US IMPORTS - GOOD NEWS IS BAD NEWS

EXTREMELY WEEK WORLD TRADE - Houston We Have A Problem!

SUB 3% WORLD GDP GROWTH

CONCLUSION

Fed needs to increase liquidity rate $500B to $1T by 2nd half 2014 or the US experiences a recession and a dramatic correction in the US fiancial markets.

FLOWS: Liquidity, Credit and Debt

FLOWS: Shrinking Government Deficits A Potential Recession Problem

Back To Normal – But Worse Richard Duncan 02-15-14

The Congressional Budget Office (CBO) has just published its projections for the US budget deficit and economic outlook for the next ten years. This annual document is a very important source of information for anyone who wants to understand how the economy is likely to evolve over the next decade. This year, “The Budget And Economic Outlook: 2014 to 2024” is 175 pages long. In this blog, I will highlight some of the most interesting and important aspects of this report.

The Budget Crisis Is Over

• The budget deficit peaked at $1.4 trillion in 2009. By 2012, it was still $1.1 trillion. Last year, it fell very sharply to $680 billion. The CBO now forecasts it will be $514 billion this year and $478 billion in 2015.
• When the economic crisis erupted in 2008, the government’s tax revenues collapsed and its spending (i.e. outlays) surged. Consequently, the budget deficit skyrocketed to 9.8% of GDP in 2009. This year the budget deficit is projected to be only 3.0% of GDP. The government’s revenues will amount to 17.5% of GDP. Government outlays will be equivalent to 20.5% of GDP. All three of these measures (the deficit, revenues and outlays) will be quite close to their average for the past 40 years. In other words, the government’s budget has returned to normal.
• The CBO forecasts the deficit will be 3.0% of GDP this year and 2.6% of GDP next year. To put that in context, during the eight years of the Reagan Presidency, the US budget deficit averaged 4.1% of GDP a year.
• Government spending fell by $83 billion in 2013 compared with 2012. Moreover, at $3,454 billion, it was $64 billion less than in 2009. Put differently, after a big jump at the peak of the crisis in 2009, government spending has remained quite flat since then.
• The Fed handed over $76 billion of its profits to the government in 2013. It is expected to give the government roughly $90 billion more in both 2014 and 2015. That is the equivalent of 0.5% of GDP per year. It’s amazing how much money you can make when you make the money!
• Fannie Mae and Freddie Mac contributed a profit of $97 billion to the government last year. Without the contributions from the Fed and from Fannie and Freddie, the budget deficit would have been 25% larger in 2013, $853 billion instead of $680 billion.

The Wars Are Over (Almost)

• “Since September 2001, lawmakers have provided almost $1.6 trillion in budget authority for operations in Afghanistan and Iraq and for related activities.” (See page 64.) Just imagine the technological breakthroughs, medical miracles and wealth that would have been created if the government had invested $1.6 trillion in genetic engineering, biotech, nanotech and solar energy instead!
• Defense spending fell by $46 billion or by 7% in 2013 to $625 billion or 3.8% of GDP. It is expected to decline to $604 billion or 3.5% of GDP this year and to $603 billion or 3.3% of GDP in 2015. Going back to 1974 (the year my data begins) and perhaps as far back as 1939, defense spending as a percentage of GDP has only been less than 3.3% during the six years between 1997 and 2002, when it ranged between 2.9% and 3.2% of GDP.
• Based on current legislation, defense spending will decline steadily to 2.7% of GDP by 2023. That would be $707 billion spent that year, only a 13% increase over ten years. Let’s hope those spending restraints hold. However, in light of the pressure that the military (and the corporations that supply the military) will put on Congress, it is very unlikely that they will.

Much Slower Economic Growth Ahead

• From 1950 to 2012, the US economy grew at an average annual rate of 3.3%. However, between 2009 and 2012, it only grew by 1.1% a year. The CBO expects the economy to expand by 3.1% to 3.4% between 2014 and 2016, but then to grow much more slowly after that, with an average growth rate of only 2.2% between 2018 and 2024.
• The CBO now estimates that the economy’s real potential growth rate is only 2.1% per year between 2014 and 2024, compared with its potential growth rate of 3.3% per year between 1950 and 2013. That is a very sharp slowdown in the economy’s potential to grow.
• The main reason for the slowdown in potential growth is that the growth in the labor force is expected to be much less than in the past, as the baby boom generation retires. During 2013, the number of people employed increased by an average of 190,000 per month. That number is projected to decline to only 67,000 per month between 2018 and 2024. If the CBO’s projections for the growth in the workforce are correct, I fear that such a slowdown will create an economic environment that is even more difficult than the CBO anticipates.
• According to the CBO, US GDP will be $17.5 trillion at the end of 2014. It will then grow by roughly $1 trillion a year in nominal terms, reaching $27 trillion in 2024. The CBO forecasts that gross government debt will be $17.7 trillion at the end of 2014, or roughly 100% of GDP. That ratio is expected to remain at approximately 100% of GDP through 2024, putting gross debt at $27 trillion that year.

In closing, I would like to warn the reader that I believe this CBO report overstates the current health and future outlook for both the budget and the economy. Quantitative Easing became the driving force for the economy in 2013. QE pushed up asset prices and created a wealth effect that allowed Americans to spend more. That increase in consumption made the economy grow and generated higher tax revenues, making the budget deficit lower than it otherwise would have been. If QE ends this year, as the Fed has indicated, the economy could go back into recession. That would cause the budget deficit to be much larger than currently projected. So, keep that in mind. The CBO’s forecasts generally prove to be too optimistic.

Nevertheless, the Budget And Economic Outlook is a very useful document. I plan to discuss its implications in greater detail in the next issue of Macro Watch.

EMERGING MARKET CONVULSIONS

02-01-14 Richard Duncan Rich Dad

Emerging Markets went into convulsions last week as foreign capital headed for the exits. Equities and currencies took a significant hit in most of the developing economies around the world. This near panic was set off by growing concerns about the Federal Reserve’s plans to reduce Quantitative Easing (QE) in the United States.

Argentina was the hardest hit. The Argentine peso fell 20% in January (and 15% in just one day). Brazil, India, Indonesia, Hungry, Russia, South Africa, and Turkey were also affected.

So, here’s what happened. Most of the countries impacted import more than they export. Therefore, they must attract foreign capital to finance their trade deficits (much like a family that spends more than it earns must borrow money to finance that gap). Most of the time, it is easy for the Emerging Markets to attract plenty of foreign capital. Foreign investors are generally keen to invest in the Emerging Markets to profit from the higher interest rates and the faster rates of economic growth those economies tend to offer. After the global economic crisis began in 2008, the flow of capital into the Emerging Markets accelerated for two reasons. First, as interest rates fell to historic low levels in the developed economies, the higher interest rates on offer in the Emerging Markets became increasingly attractive. The second reason is that the Fed and the central banks of Japan, England and the Euro Zone created trillions of dollars worth of new fiat money. A significant amount of that new money found its way into the Emerging Markets.

Then what went wrong? The thing that changed is that the Fed has announced that it intends to gradually reduce the amount of money it creates each month and to end its program of Quantitative Easing (i.e. money printing) altogether before the end of 2014. Last year, the Fed created $85 billion every month. In January, that was reduced to $75 billion and in February the amount will be reduced again to $65 billion.

While $65 billion is still an enormous amount of money to be created in only one month, investors are looking further ahead. They sense that money will become tight later this year if the Fed continues to taper QE, as it has signaled that it will. They understand that tighter financial conditions will damage the growth prospects of the Emerging Market economies and cause asset prices there to fall. Therefore, foreign investors are taking their money out now rather than waiting around to be the last to leave the party.

So, even though there is a great deal of excess liquidity in the developed economies, and even though the Fed is expected to add $65 billion more to that pool of excess liquidity in both February and March, money is fleeing the Emerging Markets; and this outflow of money is damaging the economic prospects of those countries and causing asset prices there to fall.

The outflow of capital is causing the Emerging Market currencies to depreciate. With their currencies depreciating, those countries must pay more for the goods they import; and the rising cost of imports is causing inflation to increase. Consequently, the central banks in those countries are being forced to raise interest rates to combat the rising inflation. Higher interest rates, however, will cause those economies to grow more slowly.

With foreign capital departing, there is generally little that the economic policymakers in those countries can do to prevent their economies from being hit. Many of them feel increasingly bitter about their helplessness in the face of global capital flows over which they have very little control.

What, then, should Emerging Market investors (and the people who live in the Emerging Market countries) expect next? Unfortunately, things will probably get worse before they get better. As we have seen many times before, when the tide of global money goes out, companies and banks begin to fail. Such bankruptcies tend to exacerbate the panic, causing even more capital outflows. Panic is contagious. It tends to spread to all corners of the world before it burns itself out.

So when will this Emerging Markets selloff end? I believe it will end when the Fed announces that it will stop tapering QE. I believe the Fed will make that announcement before the middle of this year. If it does not, liquidity conditions in the United States will begin to tighten and tighter liquidity will threaten to throw the US back into recession. If I am right, QE will not end in 2014. Instead, the Fed will end up creating another $500 billion to $1 trillion in 2015.

If this scenario unfolds as outlined above, then foreign investors will turn keen on the Emerging Markets again by mid-year when the Fed signals it will extend QE. At that point, they will send a new flood of liquidity gushing back into the developing world. If so, asset prices there will once again surge.

To me, this seems the most probable scenario. Unfortunately, a lot of damage may be inflicted on those economies (and on those who invest in those markets) between now and then.

A Synopsis

Macro Watch: This week I would like to give you a quick overview of what you will find in this issue of Macro Watch and to encourage you to subscribe. This time, there are six videos.

INTRODUCTION

• The first video is a four-minute Introduction.
• You can watch it by clicking on the link at the bottom of this blog.

VIDEO 2 - SITUATIONAL ANALYSIS: US ECONOMY

• The second video takes stock of the current state of the US economy
• demonstrates how the Fed has been driving the economy by pushing up asset prices.
• We look at retail sales, industrial production, capacity utilization, job creation and disposable personal income, among other indicators.
• Generally, the last couple of data points have shown improvement; but that improvement has been very weak when compared with past economic recoveries.
• Next, details are provided of how Quantitative Easing (QE) has pushed up the price of stocks and property to create a wealth effect and drive the economy.

• This video ends with a discussion of how much higher asset prices can inflate.

VIDEO 3 - CREDIT GROWTH TRENDS

LIQUIDITY DRIVERS ASSET PRICES

CREDIT DRIVES ECONOMIC GROWTH

DEBT (LEVERAGE) DRIVES PROFITS

• The third video analyzes the latest trends in credit growth, using the most recent Flow of Funds data from the Fed.
• We want to know “Will Credit Growth Accelerate?”
• That’s because credit growth now drives economic growth.
• What we see is that government borrowing is slowing down quite sharply.
• On the other hand, there are also signs that momentum is building in household sector debt due to a pick up in mortgage lending.
• Overall, however, it appears that credit growth (adjusted for inflation) will remain below 2% a year through 2015.
• That suggests that more QE will be required if the United States is to stay out of recession.

VIDEO 4 - The Fed & Liquidity

• Video four discusses “The Fed & Liquidity”.
• Last month, the US central bank announced it would begin to gradually reduce the amount of fiat money it creates.
• This video considers why the Fed decided to “taper” at this time.
• It also presents the Fed’s tentative “taper schedule” and analyzes what this schedule suggests about the outlook for liquidity over the next two years.
• This is done through the framework of my Liquidity Gauge, which I believe is very useful in predicting the future direction of asset prices.

VIDEO 5 - GLOBAL LIQUIDITY GAUGE

• The fifth video looks at liquidity conditions in 2014 and the prospects for asset prices.
• This analysis examines the outlook for liquidity on a quarter-by-quarter basis in 2014.
• It finds that liquidity is likely to remain excessive and supportive of further asset price appreciation during the first half of the year.
• By the third quarter, however, it appears that liquidity will become tight and that there will be a significant liquidity drain by the fourth quarter. Should that occur, asset prices would most probably fall, possibly dragging the US (and the rest of the world) back into recession.
• The conclusion here is that the Fed is likely to continue with QE for much longer than it is currently signaling. This video also looks at the prospects for interest rates, stocks, property, commodities and currencies through 2015.

VIDEO 6 - GLOBAL DEFLATION

• The final video examines the growing threat of global deflation by analyzing economic conditions and policies in the US, Japan, the UK, the Euro Zone and China.
• GDP trends, fiscal policy, monetary policy and credit growth are evaluated for each country.
• The conclusions are worrisome.
• Should the Fed really end QE in 2014 as it has suggested it would, it would increase the chances that deflation will take hold on a global basis.
• This is another reason QE is likely to be extended into 2015 and perhaps well beyond.

So, that’s Macro Watch: First Quarter 2014.

• It is one hour and 40 minutes long,
• Is comprised of 182 charts and slides.

I hope you will consider subscribing. The price is US$500 per year, but I am offering the Gordon T Long Community a 20% discount. To subscribe for US$400 per year, click on the following link and use the coupon code “flows”.

FLOWS - Macro Situational Assessement

Fed in no position to pull plug on QE yet.

For all its talk of cutting back on the monetary stimulus, the US Federal Reserve may be in no position to end its monthly bond purchases in 2014, feels Richard Duncan.

After much deliberation, the Fed decided to trim monthly bond purchases to USD 75 billion from USD 85 billion from this month. The original plan last year was to pull the plug on the bond purchases by the end of this calendar.

However, economic data continues to give conflicting signals, with the latest employment figures pointing to weakness in the economy. That could hold the Fed back from tightening the liquidity tap for fear of choking nascent growth.

Duncan expects asset prices to start going down only after the Fed ends its quantitative easing (QE), the technical term for its monetary stimulus.

He expects yen to depreciate in the coming months and Nikkei to move higher.

Below is the verbatim transcript of his interview on CNBC-TV18 India

Q: The World Bank and the International Monetary Fund (IMF) have put out a fairly positive view of the global economic growth in 2014. What is your idea of US growth? Will it continue to be robust and therefore the tapering programme will be maintained as planned?

A: It is important to understand why the economy is showing signs of picking up and that is because quantitative easing (QE) has driven up the stock market by 30 percent last year and also pushed home prices up 13 percent last year. So, that has caused household sector net worth to climb USD 21 trillion from its post crisis low and it is 12 percent higher than it was before the crisis started. This has created wealth effect; its fueling consumption and supporting economic growth.

However, if quantitative easing ends later this year then it’s likely that interest rates will then go up, stock prices would fall, property prices would fall and the US could very well go back into recession. So, for that reason I do not think they are going to end quantitative easing at the end of 2014 as it is suggested. I think it is going to continue on in 2015 and probably beyond.

Q: A word on Europe, we have seen the end of recession or so it seems. Will there be a recovery or do you see the European Central Bank (ECB) indulgence some kind of quantitative easing probably by some other name – long term refinancing operation (LTRO) or some other name?

A: Few days ago Christine Lagarde, the Managing Director of the International Monetary Fund (IMF) warned the global economic crisis is not over and she pointed out in particular the growing threat of global deflation. In Europe the inflation rate last month was only 0.8 percent. It’s well below where the ECB would like it to be and on top of that the European economy remains mired in recession and well below the level of gross domestic product (GDP) that it was before the crisis started.

I do think more stimulus of one kind or another is required in Europe - a further rate cut, more LTRO and ultimately even asset purchases, the way the Fed has been doing.

Q: Given that you are expecting quantitative easing in both these major economic groups. How does this leave asset allocation if the global economy is going to remain reflated? How will smart money move. Does it move back to emerging markets or does it remain in favour of developed markets?

A: The best way to play this in general is when central banks are creating lot of money you can expect asset prices to go up and when they stop creating a lot of money then asset prices are likely to go down. So, the trick is to try to anticipate in advance what the policy makers are going to do and that is what my work revolves around.

I have a video newsletter called ‘macro watch’ and it focuses on predicting credit growth and liquidity and government policy in order to anticipate how those things are going to impact asset prices.

Q: For the next six months what are you advising asset allocators, what should the prudent strategy be now?

A: It varies on country by country basis with Abenomics in full swing the Bank of Japan is creating three times more money relative to the size of Japan’s economy as the Fed is relative to the size of the US economy. So, it seems quite likely that the yen is going to continue to depreciate and the Japanese stock prices will continue to appreciate.

On the other hand in the US, for instance there will still be a lot of excess liquidity during the first half of 2014 because the Fed only intends to taper gradually. Liquidity will only start to become tight in the Q3 and then it will become very tight in the Q4.

So, the trick is going to be to try to anticipate whether the Fed is going to stick with its current taper schedule or whether they going to expand, extend quantitative easing in 2015 because as I expect, and when they announced they will extend in 2015, we will once again see a nice rally in stock prices and we will see bond yields fall and the dollar weaken.

Q: What does this mean for a country like India; foreign institutional investors (FIIs) flows were very robust in 2013. How much do you expect would come in 2014 and what is your assessment of the economy, is that on the mend?

A: The most important driver of the rest of the world is the US economy. When the US economy is growing strongly – that creates growth all around the world. In particular, when the US current account deficit, the trade deficit in other words, when it widens that is good for the rest of the world because the rest of the world can sell more to the US.

But looking out for the next three years it looks as if the US current account deficit is going to become smaller largely because of shale oil revolution; the US is importing less oil and exporting more petroleum products so that is going to mean a smaller current account deficit, less liquidity being thrown on the global economy, less Asian exports going into the US. Therefore it is going to create a difficult environment for the rest of the global economy.

Q: What will be the fund flows into Indian market look like in 2013?

A: I suppose in the first half of the year as people discount what they believe will be the end of quantitative easing - the fund flows will be tight but later as it becomes clear that there will be more quantitative easing than people currently anticipate, the fund flows will revive for India and for other emerging economies as well.

WATCH VIDEO INTERVIEW

FLOWS - Macro Situational Assessement

THE UNITED STATES

The US economy makes up 21% of global GDP. Annual per capital GDP is $51,700. The country's population is 314 million and is forecast to grow by 17 million (or 5.3%) by 2018.

The US Current Account deficit is 2.7% of GDP, down sharply from 5.8% in 2006. The government's budget deficit was 8% of GDP in 2012, but forecast to be only around 4% of GDP in 2013. The government's gross debt to GDP is 103%. The Fed, the US central bank, is creating $85 billion of fiat money a month, which is approximately 6% of GDP per year. The economy grew by 2.8% in 2012.

Main Issue: How to wind down - and eventually end - Quantitative Easing, without causing a stock market crash, a property market crash and a new, severe global recession.

CHINA

China's economy is the second largest in the world. It accounts for 10% of global GDP. Per capita GDP is $6,100. The country's population is 1.35 billion and is forecast to increase by 41 million (or 3%) by 2018.

China's Current Account surplus is 2.4% of GDP, down sharply from 10% of GDP in 2007. The government's budget deficit was 2.2% of GDP in 2012 and gross government debt was 26% of GDP. It should be noted, however, that the finances of the provincial governments may be a cause for serious concern. The PBOC, China's central bank, is not creating fiat money in a QE-style operation. However, it has accumulated $3.7 trillion in foreign exchange reserves since 1990 by creating an equivalent amount of fiat money. The economy grew by 7.7% in 2012.

Main Issues: China's economic growth model of very rapid investment growth and export-led growth is in crisis because the Americans, the Europeans and the Chinese themselves do not have sufficient income to absorb China's current industrial output. Extremely rapid credit growth since 2009 threatens to end in economic disaster.

JAPAN

Japan's economy is the third largest in the world, accounting for 8% of global GDP. Per capita GDP is $46,700. The country's population is 128 million. It is forecast to shrink by 2 million (or 1.7%) by 2018.

Japan's Current Account surplus was 1.0% of GPD in 2012, down significantly from 4.9% in 2007. The government's budget deficit was 10% of GDP and gross government debt was 238% of GDP in 2012, much larger than any other industrialized country. Despite this very high level of government debt, it should be noted that the Japanese government can still borrow at extremely low interest rates, only 0.6% per annum on 10-year government bonds. The Bank of Japan, the central bank, is creating the equivalent of $70 billion per month or 14% of GDP per year - even more than the US central bank relative to the size of the US GDP. Japan's economy grew by 2.0% in 2012.

Main Issues: Very high government debt levels, double digit budget deficits, declining global export competitiveness (especially relative to China and Korea), and a shrinking and rapidly aging population.

GERMANY

Germany's economy accounts for 5% of global GDP. Its per capita GDP is $41,900. The country's population is 82 million. It is forecast to decline by 1 million (or 1.2%) by 2018.

Germany's Current Account surplus was 7% of GDP in 2012 and it has averaged more than 6% of GDP per year since 2005. That makes Germany's trade surplus one of the main sources of the global imbalances destabilizing the world economy. The government's budget was balanced in 2012 and the government's gross debt to GDP amounted to 82%. Being part of the Euro Zone, Germany's monetary policy is controlled by the European Central Bank. The German economy grew by 0.9% in 2012.

Main Issues: German banks have made large loans to many of its crisis-hit European neighbors. It is now having difficulty recovering those loans. Moreover, Germany's large Current Account surplus is generating still more liquidity that must either be lent abroad or allowed to enter the Germany economy. Lending abroad could produce yet more non-performing loans, while allowing the money to enter Germany could cause asset price inflation and an economic bubble there.

BRAZIL

Brazil's economy accounts for 4% of global GDP. Its annual per capita GDP is $11,400. The country's population of 198 million is expected to increase by 8 million (or 4.3%) by 2018.

Brazil's Current Account has swung from a surplus of 1.6% of GDP in 2005 to a deficit of 2.5% of GDP in 2012. The government's budget deficit was 2.7% of GDP and its gross government debt was 68% of GDP in 2012. The economy grew by 0.9% last year.

Main Issues: Brazil's economy is heavily dependent on commodity exports. Its manufacturing industry is being undermined by more competitively priced imports from China.

THE UK

The UK economy accounts for 3% of global GDP. Per capita GDP is $39,000. The country's population is 63 million and is expected to increase by 3 million (or 4.7%) by 2018.

The UK's Current Account deficit was 3.8% of GDP in 2012. The government's budget deficit was 7.9% of GDP and the government's gross debt to GDP was 89% in 2012, twice as high as in 2007. The Bank of England has suspended its QE program for the time being. However, it did aggressively create fiat money and buy government bonds between 2008 and 2012; and, as a result, it now holds roughly 30% of the government's debt - a much larger share than in any other country. The UK economy grew by 0.2% in 2012.

Main Issue: The UK economy is very heavily reliant on the Finance industry, which is unstable at best, and a giant Ponzi scheme at worst. Future banking crises could lie ahead.

INDIA

India's economy makes up 3% of global GDP. Its annual per capita GDP is $1,500. The country's population is 1.25 billion and is expected to surge by 100 million (or 8%) by 2018.

India's Current Account deficit is 4.8% of GDP and has deteriorated steadily since 2006. The government's budget deficit was 8% of GPD and gross government debt to GDP was 67% in 2012. The economy grew by 3.2% in 2012.

Main Issues: India is challenged on a number of fronts. Its inflation rate, at 11%, is a serious problem. The government's budget deficit has averaged nearly 8% a year since 2005. Finally, the country's persistent Current Account deficit has to be financed by importing capital. This makes the country vulnerable to domestic asset price inflation if too much foreign money comes in, and vulnerable to a sudden spike in interest rates should that foreign money rush out.

Note: The data cited above was sourced from the IMF and the United Nations Statistics Division. The % share of global GDP numbers are for 2011. All other data refer to 2012 unless otherwise indicated.

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FLOWS - Wealth Effect & US Household Net Worth

The Fed is driving the economy by pushing up stock prices and home prices so that Americans will have more money to spend even though the median income is falling.

It has the tools and, it appears, the determination to continue doing this. I believe the Fed’s goal is to:

1. Push up stock prices by about 10% to 15% a year,
2. Push up home prices by about 10% a year.

They have a good chance of succeeding at this for the next couple of years. That should be good news for investors. Now, for the details. Here’s how it works.

• The Fed can control the interest rate on government bonds and mortgages by printing dollars and buying bonds until the bond prices rise and the bond yields fall to any level the Fed desires.
• The “desired level” is that level at which property prices and stock prices rise just enough to drive the economy (through creating a wealth effect that supports consumption), but not so much that a massive new bubble forms in the stock market and the property market.
• In the past, this would have been impossible because so much fiat money creation would have caused very high rates of inflation. It is possible now, however, at least for the time being, because

Globalization is very deflationary and that is offsetting the inflationary pressures caused by fiat money creation.

'TAPPING ON THE BREAKS' TO SIT EVERYONE DOWN

Back in April, with the yield on the 10-year government bond below 1.7%, interest rates were too low and they were causing property and stock prices to climb too rapidly. To prevent a new bubble from forming, the Fed began suggesting it would soon start to taper its pace of bond purchases. The market immediately responded to that threat by selling bonds. That caused the yield on the 10-year bond to rise to 3.0% even before the Fed had actually done anything. The Fed did not want interest rates to rise that sharply. It feared that interest rates at that level would cause asset prices to stop rising – or maybe even fall. So, on September 18th, it pushed back its tapering timeframe. As a result, the 10-year bond yield fell back to 2.6%. It is clear that the Fed will continue printing $85 billion a month and buying bonds until the 10-year bond yield falls to its desired level (as defined above). The chances look good that the Fed is going to be able to get what it wants, i.e. higher asset prices. And that should keep alive the favorable investment environment that investors have benefited from since QE 3 was announced one year ago.

The Fed played a leading role in creating this global economic crisis.

Despite that, I also believe that their current policy of Quantitative Easing is now practically the only thing preventing this credit bubble from collapsing into a severe depression.

A HOT AIR BALLOON

We are all in a hot air balloon that was created by the Fed, and we are floating miles above solid ground. We blame the Fed for getting us into the hot air balloon but, at the same time, we’re praying that the Fed will keep our balloon inflated – because the alternative involves crashing to our deaths. There are those who say that the fall is inevitable, therefore the sooner we get it over with the better. That is a view that can only be supported by people who badly underestimate how far we have to plunge. Otherwise, it would be akin to asserting that since death is inevitable we should all commit suicide today.

A correct understanding of how vast the distance is between us and the ground demands that every effort be made to keep us afloat for absolutely as long as possible. My view is that if we can stay afloat long enough, we might just have time to build another means of transportation to take us off this balloon and safely where we want to go. That hope may prove to be merely a fantasy. Even so, even if the worst can’t be averted forever, I would still prefer to enjoy the view for a few more years before that time arrives. And, by the look of things, the Fed seems to feel the same way.

September 15th is the fifth anniversary of the bankruptcy of Lehman Brothers. Let’s consider what’s changed during the five years since the meltdown of the financial sector brought the world to the brink of a new great depression.

• The US government’s debt has increased by approximately $7 trillion or by 125%.
• The US mortgage market was essentially nationalized when Fannie Mae and Freddie Mac were put into “Conservatorship”, but Fannie and Freddie remain unreformed.
• The banking industry is much more concentrated than ever before. The four largest banks control roughly a third of all the deposits in the country.
• The derivatives industry remains inadequately regulated. More the $600 trillion worth of derivatives still trade Over-The-Counter with little transparency or oversight.
• The Volcker Rule banning banks from speculating for the own account has become law, but that law has not been implemented.
• Roughly 1.5 million manufacturing jobs (more than 10% of the total) have disappeared in the US.
• Median Income in the US (adjusted for inflation) has fallen back to where it was in 1989.
• Household Net Worth, however, is at an all time high of more than $70 trillion.

So, what should we conclude from these facts? The obvious conclusion is that Creditism has survived and that the bankers still rule!

Our economic system has evolved from Industrial Capitalism, a system in which wealth was primarily derived from the manufacturing process, to Creditism, a system in which wealth is primarily derived from credit creation.

• During the age of Industrial Capitalism the “Captains of Industry” controlled the political power.
• Now the Bankers do.

It should not be forgotten that whoever creates the wealth controls the political power.

Practically, what does this mean for our future? In the near term, it probably means that property and stocks prices are going to continue going up. The Financial Industry, the dominant political power, can be counted on to make sure that policies are enacted by the government that will benefit the Financial Industry. And, what the Financial Industry requires above all else in order to make money is for credit to expand.

If credit expansion is going to be sustainable, however, whoever borrows the money has to have the means of eventually repaying it.

Since 2008, it has been the $7 trillion increase in government debt that has allowed credit to expand.

Now that the budget deficit is falling sharply (by approximately 40% this year) due to sequestration and higher taxes, the government will borrow much less. That means some other sector of the economy will have to be encouraged to, incentivized to, in short, made to borrow much more. And that sector will have to be the Household Sector – in other words, people like you.

But the median income of the Household Sector is falling. So, if that sector is going to be able to service the interest expense on its new debt, the value of its assets (homes and stock portfolios) will have to be made to increase. As those assets appreciate in value, their owners will be able to borrow against them and, thereby, be able to pay the interest on the money they borrowed earlier.

So, as I see it, the Financial Industry will use all its immense political influence to make sure that the government (including the Fed) takes whatever actions necessary to force home prices and stock prices to continue to rise.

At present, Quantitative Easing is having the desired effect of pushing up asset prices. I expect this to continue. The Fed will soon begin to “taper” its pace of fiat money creation from its current rate of $85 billion a month, but it is very unlikely (in my opinion) to taper so much that asset prices stop rising.

Creditism is an economic system that requires credit growth to survive. It is managed at the macro level by the government, over which the Financial Industry holds dominate political sway.

This system is inherently unstable and, in all likelihood, unsustainable over the long run. That said, it would probably be a grave mistake to bet on it collapsing any time soon. Therefore, it would be wise to attempt to understand how this system works and how it is likely to evolve from here.

SOMETHING QUITE EXTRAORDINARY

An extraordinary thing has happened. The United States budget deficit improved dramatically in FY2013; and it did so without hurling the US economy into a severe recession.

• Taxes went up and government spending went down.
• As a result, for the fiscal year ending 30 September 2013, the government's budget deficit fell by 38%, or by $409 billion, to $680 billion from $1,089 billion in FY2012 (and from a peak of $1,413 billion in 2009).
• This was the first year since 2008 that the budget deficit was less than $1 trillion.

As a percentage of GDP, the budget deficit declined by 2.7 percentage points from 6.8% of GDP in FY2012 to 4.1% of GDP in FY2013. It peaked at 9.8% of GDP in FY2009.

Under normal circumstances such a sharp reduction in the budget deficit would have caused the GDP to be at least 2.7 percentage points lower (and probably closer to 4.0 percentage points lower, taking into consideration the multiplier effect) than it otherwise would have been. The increase in taxes would have reduced personal consumption, while the reduction in government spending would have directly reduced the size of the economy. This would almost certainly have thrown the economy into recession.

The fact that the US economy still managed to grow by an average of 1.6% during the last four quarters can only be explained by one thing: Quantitative Easing. During FY2013, the Fed created nearly $1 trillion of fiat money, an amount roughly equivalent to 6% of GDP. It injected that money into the economy by buying government bonds and mortgage backed securities. In this way, QE pushed up asset prices, most notably the price of stocks and property; and rising asset prices created a wealth effect that fuelled consumption and economic growth - despite the severe government austerity.

Before discussing the budget in greater detail, I would like to point out here that

It is very important for investors to monitor the size of the US budget deficit relative to the size of QE. The government's budget deficit sucks liquidity out of the economy. QE pumps it in. When QE is larger than the budget deficit - as it is now - there is a great deal of excess liquidity that tends to push asset prices higher.

I have developed a "Liquidity Gauge" to measure the extent to which liquidity is excessive or inadequate. For a full explanation of the Liquidity Gauge and how it can be used as a tool to anticipate the direction of asset prices, please see Macro Watch, Fourth Quarter 2013: http://www.richdad.com/Resources/Rich-Dad-Financial-Education-Blog/November-2013/announcing-macro-watch-richard-duncans-video-news.aspx

Now, back to the budget. Here are some of the budget details that I believe are important and interesting.

• Government spending declined for the second year in a row in FY2013. This was the first time that government spending has fallen two years straight since 1955.

• Total government spending fell by 2.4%, or $84 billion, to $3,454 billion. That amount was equivalent to 20.8% of GDP. That was lower than the 22.0% of GDP recorded in FY2012, but still above the 40-year average of 20.4%.

• Defense spending fell by 7.2%, or $47 billion, to $608 billion. This was the second year of decline, after growing at an annual rate of 6.2% over the previous five years.

• Spending on unemployment benefits declined by 25%, or $24 billion, to $80 billion.

• Spending on Homeland Security increased by 21%, or $10 billion, to $57 billion.

• Interest expense on the government's debt increased by 16%, or $56 billion, to $416 billion.

• Spending related to Veterans Affairs increased by 12%, or $14 billion, to $138 billion.

• Outlays for Medicare rose by $11 billion or by 2%. This was a slower rate of increase than the 5% average over the previous five years.

• Fannie Mae, which had returned to profitability, repaid $50 billion to the government.

• Government revenues increased by 13%, or $325 billion, to $2,774 billion, a new all time high.

• As a percentage of GDP, government revenues rose from 15.2% in FY2012 to 16.7% of GDP in FY2013. However, they remained below the average over the past 40 years of 17.4%.

• Individual income taxes increased by 16%, or by $184 billion, to $1,316 billion.

• Payroll taxes rose by 12%, or $103 billion, to $948 billion due to the expiry of the temporary 2-percentage point reduction put into place during the crisis.

• Corporate taxes increased by 12.9%, or $31 billion, to $274 billion.

• The Fed handed over $76 billion of its profits to the Treasury Department. This was less than the $82 billion it gave the government in FY2012. This drop came as a surprise to me since the Fed should have earned more, given the much larger size of its balance sheet in FY2013.

Looking ahead, the Congressional Budget Office has forecast that the government's budget deficit will fall further in FY2014 to $560 billion or 3.4% of GDP. The decline in the budget deficit since FY2012 represents a very significant improvement in the United States finances over a very short period of time. The economy has weathered this fiscal austerity much better than could have been expected. Its next challenge will be to weather the end of the Fed's monetary largess. Things could soon get rough. QE tapering is fast approaching.

ECHO BOOM - The Capital Flow Proxy Index

EM Capital-Flow Proxy Index Suggests Slower Pace 01-07-14 Bloomberg Brief

The trend in private capital flows to emerging markets (EM) economies appears to follow a rhythm of extended periods of successively larger capital inflows then followed by sudden sharp declines that erase a significant portion of the prior period’s gains. In a typical capital-flow up-cycle, higher expected returns on EM assets begin to gradually attract capital to EM economies, with global fund managers often taking a wait-and-see approach before committing large sums to EM assets and investment strategies. This built-in inertia gives rise to a gradual adjustment in portfolio allocations to EM assets, thus creating a timeline of long runs in capital flows to EM economies. When market conditions eventually turn less favorable, the unwinding of speculative positions often triggers a major reversal in capital inflows and a serious decline in the performance of EM assets.

Estimates by the Institute of International Finance show that net private capital flows to EM economies were quite weak in the 1980s, evidently reflecting investor concern about the Latin American debt crisis at that time. Net private capital flows to EM economies began to pick up in the first half of the 1990s, but enthusiasm for EM assets tumbled later in the decade in the wake of the Asian and Russian financial crises.

It wasn’t until 2003 that net capital flows to EM economies began to pick up in earnest, rising nearly six-fold to more than $1.2 trillion per annum in 2007 from an average of around $200 billion in 1999-2002. In the fallout from the global financial crisis, EM net private inflows plummeted by nearly 50 percent to $600 billion in 2008-09 before regaining much of their lost ground once global financial stress was alleviated and global investor risk appetite recovered in 2010-13.

If there is evidence of momentum in capital flows to EM economies, this information may prove useful in forecasting the future trend in flows and could help investors in deciding whether to remain fully invested in EM -related investment strategies. Due to the scarcity of high-frequency flow data necessary for portfolio-management purposes (balance of payment statistics are often reported with a considerable lag), we decided to take a different approach to tracking EM capital-flow momentum.

We found that because EM capital flows tend to be driven by relative expected returns on EM bonds, equities, and currencies as well as global commodity prices, we could construct a high-frequency composite index that both tracks the returns on EM assets and, in the process, serves as a proxy measure of the trend in EM capital flows.

Assets and strategies that perform well tend to attract more capital from overseas, while assets and strategies that perform poorly tend to compel global investors to exit such trades and allocate their funds to other (safer) assets and strategies. Nevertheless, there is likely to be some slippage in the relationship between EM capital flows and daily EM asset-price performance, and as such we would not expect our proxy measure to give us a precise fix on EM capital flows on a high- frequency basis.

A proxy capital-flow measure based on the current trend in asset-price performance should best be viewed as a contemporaneous measure of net private capital flows to EM economies, not a leading indicator of the path that capital flows are likely to take in the future. To the extent that EM capital flows exhibit significant trend persistence or upside momentum, however, the lagged trend in our EM capital-flow proxy index might offer a hint as to the likely direction that EM capital flows will take in the future.

As such, the recent poor performance of EM asset prices suggests that EM capital flows are likely to run at a slightly slower pace in the early months of 2014. We see two potential hurdles for EM capital flows in 2014.

First, U.S. longer- term interest rates may move higher as Fed tapering begins, which implies that EM-related assets and strategies will be negatively affected.

Second, if Chinese GDP growth were to soften significantly as some analysts fear, EM asset prices and our capital-flow proxy index would probably move lower in tandem. If E m -related asset prices were to take a hit in response to the weakening in China’s demand, there may be significant negative spillover effects to the G10 economies, a risk that does not appear to be priced into G10 asset prices at the present time.

The Schematic below is from Gordontlong.com as reference to the above.

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FLOWS - Global Deflation

FLOWS: Liquidity, Credit and Debt

We have now strategically added

Richard Duncan's "Liquidity Gauge"

THE GLOBAL DEFLATION THREAT

"Here’s the bottom line. You are going to hear a lot of talk about Fed tapering. And, sometime between now and March, the Fed will begin to reduce the amount of money it creates each month. This could cause the stock markets around the world to have a significant correction. My suggestion is to be prepared for a selloff, but don’t panic. There is a very big difference between tapering QE and ending QE. I believe the Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation."

Global Deflation is becoming an acute threat. Consequently, while the Fed may soon begin to “taper” the amount of money it creates each month, it is unlikely to stop printing money altogether any time soon.

Today, I will discuss how the risk of deflation will influence the Fed’s decision-making process over the next few years.

Chart 1 shows the Personal Consumption Expenditure Price Index (excluding Food & Energy), otherwise known as the Core PCE Index. It is the inflation index for the United States that the Fed monitors most closely.

In October 2013 (the most recent data available), the index was up only 1.1% compared with one year earlier. The rate of inflation has been lower than this during only eight months since records began in 1960. Moreover, as you can see in the chart, the recent trend is downward, suggesting the possibility of even more disinflation in the US during the months ahead.

Keep in mind that this weakness in US consumer prices is occurring even though the Fed is creating $85 billion a month and pumping it into the economy. I’ll come back to the US in a moment, but first consider Japan (Chart 2) and the Euro Area (Chart 3).

As you can see in Chart 2, consumer prices in Japan began falling in 1995. Since then, the country has experienced deflation during 12 out of the last 19 years. This year the Consumer Price Index (CPI) is expected to rise by 0.5%. However, the Japanese Central Bank is printing money much more aggressively than even the Fed. The US central bank is currently printing new money roughly equivalent to 6% of US GDP per year, while the Bank of Japan (BOJ) is printing something closer to 18% of Japan’s GDP. Given that scale of fiat money creation, it is very surprising that inflation in Japan is still barely positive.

Finally, consider the Euro Area, shown in Chart 3. The European Central Bank (ECB) is not creating fiat money through a program of Quantitative Easing, as are the Fed and the BOJ. But, in light of the pronounced downward trend in consumer price inflation during 2013, they have begun to consider it. The ECB’s key policy interest rate was cut from 0.5% to 0.25% in November; and ECB Governor Draghi has made it clear that the ECB has numerous policy tools it could employ, if necessary, to insure price stability.

Against this background of global disinflation, it is unlikely that the Fed will be able to stop printing money any time soon. Here’s why.

There are three kinds of inflation:

1. Consumer Price Inflation
2. Commodity Price Inflation; and
3. Asset Price Inflation

As we saw in Chart 1, consumer price inflation excluding food and energy in the US has rarely been lower than it is now.

Commodity prices are falling sharply. The high commodity prices of a few years ago have resulted in a surge of new supply for many types of commodities; and that new supply is driving prices down. The Jefferies CRB Commodity Price Index has dropped 25% since mid-2011.

Asset prices, on the other hand, are inflating sharply. The reason they are inflating is because the Fed is printing money and using it to acquire assets. The S&P 500 stock index is up 25% this year and US home prices have risen by 13% over the past 12 months. This increase in asset prices has driven up the “Net Worth” of the household sector by 11% over the past year to $77 trillion, creating a wealth effect that has allowed those Americans who own assets to spend more. Their spending has added to aggregate demand. Without the increase in aggregate demand brought about by QE and its impact on asset prices, the United States would most probably be experiencing deflation now.

If the Fed ends QE altogether, asset prices will fall and aggregate demand will fall. Then, the chances are high that consumer prices will fall as well. Falling prices make it very difficult for people and businesses to repay their debts. That increases the danger that the economy will spiral into a debt-deflation depression. Deflation is the Fed’s worst nightmare.

So, here’s the bottom line. You are going to hear a lot of talk about Fed tapering. And, sometime between now and March, the Fed will begin to reduce the amount of money it creates each month. This could cause the stock markets around the world to have a significant correction. My suggestion is to be prepared for a selloff, but don’t panic. There is a very big difference between tapering QE and ending QE. I believe the Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation.

The Fed will have to continue printing more than $500 billion during both 2014 and 2015 in order to continue pushing up asset prices. At this point, only higher asset prices will make the US economy grow and only higher asset prices will stave off deflation.