Europe Continues Its Slide Toward the Precipice

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

The Finnish finance minister has said all eurozone countries are making contingency plans in case the currency union breaks up. With debt downgrades, bond market anomalies, troubled bailouts, and austerity packages with their associated riots becoming the new EU norm, their worries are obviously justified.

Last night, Moody's downgraded Italy's government bond rating two notches from A3 to Baa2. This is just above junk status. Moreover, the outlook is negative with further downgrades possible in the near future.  So what happened in the Italian government bond auction this morning?  Did buyers  demand higher interest rates to buy Italy's increasingly risky debt as basic economic principles would predict? No they didn't. Italy sold €3.5 billion of three-year bonds at an average yield of 4.65%, much less than the 5.3% it had to pay last month.  How is this possible? Apparently Italian banks couldn't resist an urge to grossly overpay for their governments newly issued debt. The ECB was most certainly backing them up behind the scenes. If this is how Italian banks do business, can we assume that they're solvent?

There is little need to pose that question for Spanish banks. Recent data indicate that they borrowed €365 billion in June from the ECB — a record amount. This compares to €325billion in May. These numbers indicate that Spanish banks have been closed out of the interbank lending market (a good indication of insolvency). The highly troubled Spanish banking sector, which has €3 trillion in debt on its books, will be receiving an immediate infusion of €30 billion in bailout funds from the EU and another €45 billion in November. This represents 2.5% of its total debt and that amount is supposed to fix the problem. The actual funds needed will be many times that. It is impossible to say exactly how much because the financial numbers for Spanish banks are not reliable.

Spain seems to be following Greece's descent into a self-reinforcing economic collapse. This week Prime Minister Rajoy announced further budget cuts of €65 billion over the next two years.  VAT was raised from 18% to 21%. Almost a quarter of the Spanish work force is unemployed, even worse than Greece's 22.5%. Spain though seems to be making a more serious effort at fiscal austerity than Greece. According to reports in the German daily Rheinische Post, the troika on its latest visit found that the Greek government failed to implement 210 of the 300 budget savings requirements it had agreed to in exchange for its bailout money.

While interest rates are pushing against unsustainable levels in Spain and Italy, they have gone to theoretically impossibly low levels in northern Europe. Negative interest rates first appeared in government debt in Denmark and the Netherlands last December. Then Germany paid negative rates on some of its short-term bonds starting in January. This week, France sold six-month Treasuries at a yield of -0.03% and two-year bonds at -0.001%. Below zero yields are a sign of severe market stress.

The euro this week has traded below 1.22 to the U.S. dollar, but is slightly higher today. Investors should watch the 1.20 level. If the euro breaks and stays below this area of support, it could drop to parity with the dollar. The major central banks would intervene to prevent this though, so the ride down wouldn't be smooth.

Stock markets reacted bullishly in late June and early July to the news of further bailouts in the EU. Most traders didn't ask where the money would come from, nor if the plans were even legally possible. They may not be. The German constitutional court will be ruling whether or not Angela Merkel's promises to participate in the ESM (European Stability Mechanism) can go forward.  Even if they rule favorably, there is little actual money committed to the ESM. More money printing (and the ECB has already done quite a bit) is the only option left to fund the various bailout schemes to save the euro. Of course, it's logically absurd that a fiat currency could be saved by producing excess amounts of it. The same is true for trying to solve a debt crisis by taking on more debt.  But hope reigns eternal in the land of euro make believe.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

S&P 500 Joins Global Bear Market

 

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Markets opened October with almost all assets declining everywhere. The S&P 500 entered bear territory on Tuesday.  Few assets other than treasuries and the U.S. dollar are doing well, as is typical during a credit crisis.

The big talk on Monday, the first trading day of October, was about the S&P 500 making a new closing low for the year. The intraday low was only slightly lower than the previous one in early August, so peak to trough the index was off 19.8%. The big drop on the opening on Tuesday created a 20% loss, putting the S&P 500 officially in a bear market.

The small cap Russell 2000 already entered bear territory on August 8th. The Russell had another mini-crash on Monday, dropping 5.4% on the day. That was its fourth mini-crash since August. Mini-crashes are common during credit crises, but not at other times.

The selling on Tuesday first showed up in Asia with the Hang Seng in Hong Kong losing 3.4% to close at 16,250 and South Korea's KOPSI dropping 3.6%.  The ugliness then spread to Europe with the German DAX, the French CAC-40 and the UK FTSE down more than 3% during the  trading day. U.S. stocks opened then opened lower with the Dow losing more than 200 points in early trading.

As usual in Europe, banks were at the epicenter of the market quake. Franco-Belgium bank Dexia was down 22% at one point. Deutsche Bank (DB) was down more than 6% in Frankfurt after announcing it would miss its profit target for the current year.  American banks have not avoided the carnage affecting financial stocks elsewhere; just take a look at Bank of America (BAC) and Morgan Stanley (MS), both trading at two-year lows.

While the behavior of banking stocks makes it clear that a credit crisis is taking place, falling commodity prices clearly indicate that the global economy is turning down. Copper prices fell as low as $3.01 a pound early Tuesday. Copper sold for well over $4.00 at its high in February and dropped sharply throughout September. Oil is also indicating weakness, with WTI crude closing at $77.61 on Monday. It traded as low as the $75 range on Tuesday. Oil is heading into a period of seasonal weakness and this is likely to exaggerate any price drops. Next strong support is around $70 a barrel.

Money continues to move into safe haven treasuries. The 10-year yield was as low as 1.725 before selling began in the bond market. The U.S. dollar index traded just under 80 at its high. The euro, which moves opposite to the dollar, hit a low of 1.31.62 Tuesday. Further weakness should be expected until there is some resolution to the debt crises in the EU.

 In bear markets, the bigger trend is down, but this is frequently accompanied by huge volatility. This is what has taken place since August and until there is a good reason that the trend should change, investors should expect that prices will be moving lower.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Market Going Down With the Ship?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


This morning the Baltic Dry Index, a measure of freight rates for international shipping, was at 1700. It hasn't been at this level since April 2009, only four months after its Credit Crisis low and only one month after the stock market was at its bottom. 

Bloomberg News noted a week ago that the index had dropped continuously for the longest period in nine years. Yes, the current drop in the preceding seven weeks (from a high of 4209 in late May) has been bigger than anything seen during the Credit Crisis. The last drop of this magnitude was in August 2001 in the middle of that years recession. Lack of shipping activity from China, the engine for global economic activity, was cited as the main cause for the falling index. Charter rates for all types of ships tracked in the index are falling.

Prices for dry bulk shipping, which doesn't include energy commodities, tend to be very sensitive to economic activity. A sharp drop in rates indicates a significant drop in global trade. Based on historical charts it looks like the Baltic Index can lead, be coincident or lag movements in economic data and the stock market. The index seems to be most closely correlated with prices of industrial commodities and the industrial sector of the global economy. While this is not the largest component of the U.S. economy (the service sector is four times larger), it is the key sector in developing economies. It was manufacturing though that had the biggest rebound in the U.S. since last year. The service sector has remained lackluster.

The stock market will likely be following the Baltic Index down, although perhaps not with such a precipitous decline. The Index has dropped almost 60% since late May. With the exception of the small cap Russell 2000, none of the major stock indices have had even a 20% drop - at least not yet.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Outlook for U.S. Treasuries

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Treasuries rallied the last week of February, which should be expected in a strong dollar environment. The rally in the U.S. dollar that started in early December (around the time that news of the problems in Greece began to surface) is ongoing and this will continue to be bullish for U.S. government bond prices and bearish for interest rates while it lasts. Inflation expectations cause the opposite outcome however. These two competing forces help explain why longer dated treasury interest rates have been trading in a bullish pattern since May 2009, but after a brief initial burst upward have traded sideways since that time. Current conditions indicate that a breakout rally to higher rates will probably have to wait a while longer.

In the intermediate and long-term, there are a number of significant risks to U.S. treasuries as well as most other government's bonds for that matter. Direct default is now on the table for smaller economies like Greece. Indirect default through inflation and currency devaluation is the risk for the major economies, such as the U.S., UK, and Japan. Some top mainstream economists, such as Nobel Prize winner Joseph Stiglitz and chief economics commentator for the Financial Times Martin Wolf, have recently made the case that the U.S. can't default on its debt because it owns a printing press. While this is technically true, it doesn't mean the paying back a bond investment with money that is worth much less than it was at the time when it was lent isn't a type of default. Why would anyone want to buy a government's bonds under such circumstances? Bill Gross, managing director at the world's largest bond fund PIMCO, refers to this type of default as stealth-default.  Gross has made the case that the risk of either type of default of government debt will cause government debt and corporate debt to have similar interest rates in the future. This would cause interest rates on government bonds to rise relative to corporates in the next few years.

In the short-term though bad economic news along with the strong dollar should keep U.S. treasury interest rates from rising. There have been a host of negative economic reports in the last couple of weeks on the banking sector, consumers, housing, and durable goods. The ISM Manufacturing Index released on March 1st was a disappointment and its component parts provide an excellent representation of the current push-me pull-you factors on U.S. interest rates. While manufacturing is still in an expansionary mode, new orders and production (indications of future activity) declined sharply and this is a bearish for interest rates. However, the prices paid component, which represents inflation, was the highest number in the February report as it was in the January report. This is bullish for interest rates.  

While the Federal Reserve has frequently announced that U.S. economy is in recovery, it has always followed this up with a statement about how it is going to keep interest rates low for a prolonged period of time. This would not be necessary in an economy that was actually recovering. When the Fed is talking out of both sides of its mouth, investors should pay attention to what it is doing and ignore what it is saying. A prolonged period of low interest rates is inflationary and this means long-term treasury rates will be going up. The only question is when.

Disclosure: None

NEXT: A Snapshot of the Energy Markets

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

China is Selling its U.S. Bond Holdings

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


China was a net seller of U.S. treasuries in December. It was also a net seller in November. Figures from the U.S. Treasury department indicate that China lost its position as top holder of U.S. government debt to Japan at the end of 2009. Despite China's selling, foreigners overall were nevertheless net purchasers of U.S. treasuries and notes in December. They were however net sellers of U.S. corporate debt for the seventh straight month in a row.

Chinese lending to the U.S. government was a key source of funding to support the U.S. spending spree in the first decade of the 2000s.  This is what allowed the U.S. to run budget deficits of around $400 billion in 2003, 2004 and 2008. These deficits were a record at the time and were considered outrageous. The U.S. is now facing a deficit of around $1.6 billion in fiscal 2010 - four times larger. Even if the Chinese substantially increased their lending to the U.S., it isn't likely they could do so by enough to fund this amount of U.S. borrowing. If the last two months of 2009 are any indication, it looks like China is not going to increase its purchases of U.S. treasuries at all, but will be selling them instead.

There is no other major external source for funding for the U.S. deficit. Every large economy has its own economic and bailout problems that it needs to worry about. The EU, which has flat GDP growth, will be putting together a bailout of Greece this week. Italy, Portugal, Ireland and Spain are waiting in line and will be looking for handouts in the future. Great Britain also has a weak economy and has been funding its operations with money printing. Japan has still not recovered from its 20-year economic malaise.  The U.S. has to compete with the needs of these countries for international capital.

There are two likely outcomes that will allow the U.S. to fund its deficit. Higher interest rates on U.S. government debt will bring more money into the U.S. bonds. Rates would have to be a lot higher than current levels though to bring in enough money though. The other option is more money printing or quantitative easing - the U.S. government purchasing its own bonds. Some combination of the two will take place. U.S. treasuries already lost 3.9% in 2009; bigger losses should be expected in 2010. Inflation protected TIPS were up 10% on the year however (not nearly as much as inflation sensitive gold's 25% rise). It looks like U.S. bond investors were already anticipating this year's funding problems last year.

Disclosure: None.

NEXT: The U.S. Imports Inflation

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The First Trading Day of 2010 - The Message From the Market

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Observant investors can find moneymaking opportunities if they pay attention to what takes place during the first four trading days of the year. This idea was already part of market lore over a hundred years ago and was confirmed by academic research decades ago. The reason the beginning of the year is more important is that more investment money gets allocated or reallocated on those days than at other times. Whether we like it or not, investing is influenced by a quarterly calendar with the beginning of the first quarter having outsized significance. Which parts of the market money flows into or out of as annual trading begins indicates the aggregate opinion of investors on each sector of the market and the various asset classes. If you want to know what they are thinking, follow the money.

The best way to approach this analysis is with a top down approach. First look at how the major asset classes - stocks, bond, commodities, currencies - are trading. For U.S. stocks you can look at the four major indices: the Dow Jones Industrial Average, the S&P 500, the Nasdaq and the Russell 2000 or their respective ETFs, DIA, SPY, QQQQ (actually the Nasdaq 100), and IWM. For stocks outside the U.S., EFA (Europe, Far East and Australia) and EEM (emerging markets) can be used. For bonds, intermediate maturity U.S treasuries are a good place to start. IEF can be used for treasuries in the 7 to 10 year range.  Overall commodity performance is best tracked through DJP, which is the ETN for the Dow Jones AIG Commodity Index. The two major commodities gold and oil should also be watched. Either their spot prices or GLD and USO can be used to do this. For a quick read on currencies, DXY gives the performance of the trade-weighted dollar.

This initial cursory view can then be refined further based on what assets are doing best or by an investor's particular interests. For stocks, the next step is to look at performance by country, market cap and the nine major sectors of the market. This can then be refined one more step by looking at sub-sectors for the sectors that have done the best. In the end, investors should look for opportunities in the top performing countries and sectors by market cap size (small, mid or large). While stocks are the most complex to analyze, commodities and currencies are the easiest because there are only a small number of them. The performance of each one them can be ranked and it is immediately apparent which ones are the best. Keep in mind seasonal factors can create bullishness or bearishness though, especially for commodities. Bonds are of course more complicated since they can be government or corporate, have a number of maturities and exist in a number of countries.

As can be seen below, based on the first trading day of the year, money was flowing into almost all markets. Stock markets outside the U.S. did the best with emerging markets being the strongest. Small cap stocks did better than large caps. Commodities generally did better than stocks. Interest rates were barely changed. The U.S. dollar lost ground, while other major currencies rallied.

STOCKS:               DIA             Up        1.5%
                               SPY             Up        1.7%
                               QQQQ        Up        1.4%
                               IWM            Up        2.5%
                               EFA             Up        2.6%
                               EEM            Up        3.0%

BONDS:                 IEF              Up        0.3%

COMMODITIES:   DJP             Up        2.0%
                               GLD            Up        2.3%
                               USO            Up        2.4%

CURRENCIES:      DXY           Down    0.5%

Please see 'The Second Trading Day of 2010 - The Message From the Market' to find out more.

Disclosure: Long gold.

NEXT: The Second Trading Day of 2010 - The Message From the Markets

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Interest Rate Rally Portends Inflation in 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


U.S. treasuries closed out 2009 with their biggest loss since 1978. It was the first loss since 1999 and only the fourth loss in 31 years. Interest rates at the long end of the curve are now almost double what they were at the height of the Credit Crisis. It was quite a turnaround from the end of 2008, when bonds managed to rally and survive the market slaughter that took down almost every asset class. 2009 witnessed a complete turnaround when treasuries went down and almost every other asset class went up. The rally in bonds in 2008 and the severe drop in interest rates was used as a key piece of evidence for those who argued the deflation would be a problem. They ignored that inflation-sensitive gold and farmland were the other two assets that had gone up in price that year (gold was up again in 2009 with a 25% gain - it's ninth straight annual gain; final figures for farmland are not yet available).

Very short-term interest rates are still close to zero in the U.S. As long as Fed Funds stay at that level, 3-month T-bills will not be much higher. Long-term rates themselves were kept down by the Fed purchasing 10-year treasuries as part of its quantitative easing program. This ended on October 31st. Once the Fed was no longer propping up the government bond market, December became one of the worst months for treasuries in a long time.  The case for deflation, although  questionable from the start, collapsed right along with treasury prices. Deflationary environments are characterized by low short-term rates and low long-term rates, as was the case in Japan starting in late 1990s and the U.S. during the 1930s Depression. The yield on the 10-year Japanese government bond fell below 1% in 2003, not far above the near zero rates on shorter dated paper. Rising long-term rates indicate inflation and the bigger the spread between them and short-term rates, the higher future inflation is likely to be. That spread is now already wide and widening even further in the U.S.

The problem isn't isolated to one side of the Atlantic either. Rates for 10-year gilts in the UK are already over 4% and are higher than government bond rates with the same maturity in Italy. The UK is engaging in major money printing and its policies are perhaps even more inflationary than those of the U.S. The yield on the 10-year U.S. treasury at the end of 2009 was 3.84%. The 30-year yield was 4.64%. This was not the high for 2009 though. That took place in June when the 10-year yield was around  4.00% and the 30-year yield around 5.00%. It was already clear by then that deflation was not going to happen. Nevertheless, the Federal Reserve, the Treasury and a number of prominent economists continued to maintain otherwise. The same thing happened in Weimar Germany, with the equivalent cast of characters claiming deflation was a problem - not inflation - right up to the point where prices exploded. There is no reason the script should be different this time. It rarely is.

Inflation is devastating for long-term bonds. Their prices have to drop substantially, so yields can go up enough to induce potential purchasers to buy them. These were some of the worst investments during the 1970s (until the final peak in interest rates in 1980, when they became excellent investments). Back then, the average investor's only option to deal with a dropping bond market was to stay away from it. Now we have the ETFs TBT and TMV, which have portfolios that represent leveraged shorts on long-term U.S. treasuries. Long-term treasuries are approaching resistance on the charts, so a pull back should be expected in early 2010. This could prove to be an excellent buying opportunity.

DISCLOSURE: Long gold, farmland, TBT and TMV.

NEXT:

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Manipulation Fails, Gold Rallies Back

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

The old tricks of the authorities to game the gold market and support the U.S. dollar are no longer working. The IMF gold sale, used at least half a dozen times in the last two years, barely dented the price of gold yesterday and gold is rallying nicely this morning and trying to push above its high from last week. The U.S. dollar is dropping and is at 76.05 at the moment. If it drops below 76.00, it could fall all the way to 71.50 this fall. The inability of the dollar to rally during the Fed meeting this time is a sign of extreme weakness and an indication that the usual behind the scenes manipulation supporting the dollar is no longer working.

While the U.S. mass-media repeatedly publishes stories about there being no inflation, there can't be any inflation and even if there is inflation, it won't show up for years, gold is telling a different story. Just yesterday this quote could be found in the Wall Street Journal, "Still observers say many buyers believe inflation will remain low for years to come." The financial press is filled with similar remarks on a daily basis. Insiders don't believe this for moment, which is why gold is hitting record highs. These stories are meant to keep the public uninformed about what is really going on in the economy and financial system.

The source of inflation is the U.S. government's huge deficits and the need to continually print new money to cover them. This is constantly covered up by mainstream press reporting as well. Just this morning a story from a major online service about the huge bond auctions this week had the following quote, "Solid demand at auctions of different maturities this summer suggest today's two-year sale should be fairly well received." Media coverage has been filled with stories citing solid demand for U.S. treasuries in the last many months. Just where is this solid demand coming from?

In the second quarter, the U.S. Fed directly bought 48% of the new treasuries sold. It is quite likely that it 'influenced' the purchases of much of the rest. One mainstream financial paper stated U.S. households increased their holdings of treasuries by 2.5 times during 2009 so far (and this wasn't a comedy piece). The statistics that includes household holdings of treasuries also include hedge fund purchases however. Hedge funds are much more likely to have purchased massive amounts of treasuries, but somehow this logical conclusion couldn't be reached, perhaps because it would lead right back to the Fed. The large U.S. banks, all of whom have connections to the Fed, have also increased their purchases of treasuries significantly. There have also been reports from alternative Internet sources about how the Fed has been faking foreign purchases of treasuries by funneling them through off-shore money havens.

Whatever the actual percentage of new treasury purchases by the Fed is, and you can assume that it is well above 48%, it is all being done with printed money... lots of printed money. There has been no case in history of massive money printing by a government that didn't subsequently result in a lot of inflation. I have yet to see this mentioned in mainstream media coverage. It looks like the truth will soon be told by gold and the U.S. dollar. Gold is on the verge of a massive breakout and the U.S. dollar on the verge of a massive breakdown. The next few weeks could be quite interesting.

NEXT: Fed Decision Today; Dollar, Bonds and Gold

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

When the Lender of Last Resort Becomes the Only Resort

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog:

In the current credit crisis, central banks and governments in the U.S. and Europe are making the transition from supporting the financial system to becoming the financial system. There seems to be no ruined financial company that governments won't bail out (at least if its large enough or if the impact of its failure would have some significance), nor any limit to the amount of money that central banks will lend. The complete dependency relationship on governments that now exists among financial institutions is the ultimate outcome of Moral Hazard - banks have repeatedly been bailed out in the past, so they take on greater and greater risks until a total systemic failure takes place requiring a government takeover.

The latest bank bailouts include UBS last week and ING this weekend. After UBS declared a surprise profit, the Swiss government announced it would be injecting up to $60 billion into the bank and would get a 9% stake in return (apparently the Swiss government doesn't even believe their accounting figures). The UBS bailout was predicted long ago by the New York Investing meetup. The Dutch government today announced it would be giving ING Groep NV $13.4 billion in exchange for non-voting preferred stock, but would nevertheless be getting two seats on the board. Yesterday, the Korean government announced a blanket $100 billion backing for its bank's foreign currency debts.

As for cash injections into the financial system, these hit a record last week in the U.S. with banks and dealers direct borrowing from the Fed reaching $438 billion per day. This was up from the $420 billion per day the week before. The only Fed program that had less lending last week was the one that allows banks to purchase asset backed securities ($123 billion versus $139 billion the previous week). The U.S. Treasury sold $499 billion in T-bills for the Fed's Supplementary Finance Account to support all of this lending. Meanwhile, the Bank of England started implementing a new framework to provide emergency funds to banks. The new facility cuts the penalty for banks borrowing funds directly from it overnight. Why go elsewhere under those conditions? Ditto in the U.S. where funds from the Fed are plentiful and cheaper than can be gotten elsewhere.

If only one government was engaging in increased lending, a case could be made that it could borrow the money from other more financially sound countries. However, in the current crisis, all the developed countries are increasing available funds substantially. They do so by selling bonds. But if everyone is selling more bonds, who's left to buy them? Only an increase in the supply of the world's major currencies can make this possible, which means they are all being devalued in this crisis. By how much, only time will tell.

NEXT: The Fed Should Be Careful What It Wishes For

Daryl Montgomery

Organizer, New York Investing meetup

http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Inflation Versus Deflation Argument - Part 5

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

If the deflationists aren't really discussing consumer price inflation, what is it that they are really talking about? To figure this out, it is helpful to seperately analyze the two components of the deflationist argument, bank credit and money supply, since they operate in very different ways and combining them obfuscates the picture.

Since people don't take out a bank loan to buy a quart of milk or a tank of gas, but they do borrow to buy a house and financial instruments, there is a direct relationship between bank credit and asset prices. The effects of increases or decreases in bank credit are likely to show up relatively quickly in prices for real estate, bonds, and stocks. Only much lately are they likely to impact consumer prices and even then they will represent only one of many components (currency exchange rates being potentially far more important).

This proposed direct relationships between credit and asset prices and currency and consumer prices seems to be well supported by real world observations. In the late 1920s U.S. there was a massive increase in credit and strong bull markets in housing, stocks, and bonds, yet consumer prices were dropping. Even though the U.S. currency didn't float at the time, capital was flowing into the New York from around the world and if the value of the dollar had been market driven, it's exchange rate would have been rising. A similar picture exists for Japan in the 1980s, although there was an even more massive asset bubble and the Yen was experiencing a far more significant rise that the U.S. dollar would have had in the 1920s.

In contrast, the U.S. in the 2000s was a period of declining currency values, the dollar peaked in 2002 and lost more than a third of its value by 2008. Bank credit expansion during this period led to massive bubbles in real estate and related debt instruments, with the S&P testing its 2000 bubble high in late 2007. When bank credit began its severe retraction, prices for real estate, non-government bonds, and stocks had significant drops. Consumer prices on the other hand accelerated higher. One major reason was the rising price in commodities. Since commodities are priced in dollars, they will go up if the U.S. dollar goes down.

The other component of the deflationist argument, money supply, has an obvious lagged effect on consumer prices. Changes can show up many years later. An examination of a money supply chart from the 1970s illustrates this quite clearly. M3 growth peaked in 1971, yet U.S. consumer price inflation didn't have an intermediate term peak until 1974 and the final high wasn't reached until 1980. The large rise in M3 in 2008 isn't likely to have its full impact on consumer inflation until some time in the 2010s.

Since deflation inevitably follows serious inflation, the deflationists at some point will be correct that there will be deflation in the United States. Worrying about deflation now though is like closing your windows and turning up your heat in May because you are worried about a cold winter coming.

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:http://investing.meetup.com/21/Files

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

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