War and Peace

Obama’s surprise Nobel peace prize has caused a reality rift in the US; On the right, Peggy Noonan writes that the Nobel peace prize has always been “an award by liberals for liberals”. She can’t believe Reagan didn’t get one. Yeah, Reagan. The guy who called the Soviet Union “the evil empire” and pushed for the star wars program to militarize space. Bret Stephens wants to give one to Harry Truman. You know, the guy who killed 300,000 civilians by dropping the bomb on Hiroshima and Nagasaki. No serious historian puts forth the claim that this barbarous act was necessary to get Japan to surrender. On the left, Howard Zinn asks, how can you give a Nobel peace prize to a man who’s continued two disastrous wars?

Meanwhile, Australia’s central bank has reversed the course of slashing rates to raise their overnight loan rate by a quarter point. Glenn Stevens, Australia’s chief central banker, warns of the danger of being ‘too timid’ in raising rates. Australia, it seems, wants to avoid the pitfall of being the world’s carry trade sop. Could that award be coming the US? If so, the strategy of borrowing in dollars, then dumping them to buy stocks or bonds in other currencies will weigh on the dollar’s value. The dollar hit a 14-month low recently.

US Fed chief Bernanke and Treasury Secretary Geithner talk of wanting to maintain a ‘strong dollar’ but actions speak louder than words. It seems more plausible that what is wanted is a steadily weakening dollar, which will make the government’s large and escalating debt easier to pay.

The average worker is likely to see continued pain from such a strategy, as wages continue to fall. Colorado has decreased its minimum wage, as their standard is tied to the CPI, and deflation slightly reduced the CPI last year, mostly due to falling oil prices. However, the weaker dollar places pressure on import prices, such as the prices of goods at Wal-mart and other low-cost retailers relied upon by the lowest-paid workers in the US. During a recession, prices and wages tend to fall, but not necessarily by the same amount. However, certain prices are rising again. Oil is now at $75, and gold is over $1060. We could easily see the worst of both worlds, stagnating economy combined with inflation.

The Fed has injected trillions of dollars of money into the economy, in a bid to prevent deflation. But all that money has to go somewhere; so far it seems to have gone into the stock market, and commodities like copper, oil, and gold. It’s hard to believe that the Fed could reverse course anytime soon and start raising rates like Australia. Imagine what a rate increase would do to the still-weak economy. Without one, the dollar will continue to slide.

Maybe the Nobel peace prize should be given to the economy. As the dollar loses value, the US will find it difficult to finance the imperial adventures in Iraq and Afghanistan; at least, that is my hope, though it hasn’t happened yet.

Price Levels

Everyone’s attention seems to be focused on whether we’ll see deflation or inflation in the US economy (and in the global economy) as we move forward.

On the deflation side, we have the moribund housing market, falling or stagnant consumer spending, along with falling incomes and rising unemployment, and on the inflation side we have truly massive money creation led by the Fed, followed by the Treasury, and finally by the Federal government in the form of federal stimulus packages, all on borrowed money.

Which of these two forces will prove to be more powerful?

I live in San Francisco, one of the more expensive urban centers in the country. In my neighborhood, I see flyers posted that say “One Hour Massage, $40”. It caught my attention because I think that price is half to a third the price you would have paid two years ago. Basic economics: if goods and services won’t sell at a given price, then the price will fall.

The bond market may provide us with a clue, as bond investors are highly concerned about inflation. The yield on the bellwether 10-yr US Treasury bond has been dropping rapidly. Since mid August, the yield has fallen from 3.8% to close below 3.2%. This may mean that bond investors are taking a stand on deflation, but it may also mean that investors see the rally in the stock market ending soon, and they’re getting back into Treasuries for a safe haven. The surge in gold prices to close above $1,000 for six days seems to lend support to the safe haven thesis, but it also could support the inflation thesis.

Oil and copper are also important signals to the strength of the global economy. Both seem indecisive after strong gains this year. The same can be said for the CRB commodities index, which is up 25% from its low this year, recorded back in March.

Given all this indecision, we may see a bifurcation, with certain commodities and services rising while others fall. We await, with bated breath, the next round of economic developments. The latest labor market data indicate that the US economy shed 263,000 jobs last month, for a total of about 7.2 million jobs lost so far during this recession. That is a truly stunning number, made all the more serious when one considers that the economy must create 150,000 jobs or so each month in order to simply keep pace with population growth.

I'll Be Off For the Rest of the Week

Treasuries are up today, pushing the yield back down to 3.55%. Still too high. With the ten year US Treasury note at that yield, a lot of other interest rates are going to be higher. Still a lot of volatility in this market; today's swing was 2.55%. A lot of movement for any market in one day.

How can the Fed possibly re-inflate this impossibly flaccid credit bubble with high rates?

Commodities took a pause; gold is back under $970, oil retrenched to $66, copper's down to $2.22. A bit of backfilling is in order. I wonder when the next big move up will happen. Next week?

Meanwhile, banks are doing their best to resist honesty and transparency. Here's a piece about their off-balance sheet assets. Isn't it a bit absurd that a corporation would have off-balance sheet assets? What possible rationale could there be for keeping an asset off the books besides lying about its true value?

I'll be traveling for the rest of the week. Have a great weekend!

Treasuries Crumple... Again!

Crash... recover... crash.

The price of the bellwether 10-year US Treasury note cratered Thursday, recovered Friday, and now has crumpled again, sending the yield skyrocketing to close at 3.715%.

This is exciting stuff. It's like a pitched battle is being waged over Treasury notes. The yield is like the front line. Meanwhile, the kings of the commodities (oil, copper, gold, silver) are all up sharply. Oil is above $68, gold is above $975, silver is above $15.60 and copper has shot up to $2.30. (Check out NYMEX for a good source on all these commodity prices.)

Remember, this may be a harbinger of higher interest rates, signaling a loss of confidence in the dollar, which would mean the Fed would have a very hard time using monetary policy to stimulate the economy.

What will happen is that interest rates will rise as investors edge away from the dollar and US treasury debt. That will deepen the recession. (Why do I say recession instead of depression? Habit, I guess. There is no technical distinction in economics. There is a joke (sort of): a recession is when your neighbor loses his job. A depression is when you lose yours.) The best strategy for dollar depreciation is investing in hard assets with no debt or leverage whatsoever.

Now Treasuries Recover!

This is getting exciting.

After a massive sell-off that sent the yield on the bellwether 10-year Treasury note skyrocketing to an intraday high of 3.75%, investors snapped up the debt Friday, sending the yield back down to close at 3.465%. That is one wild ride.

Remember that the Fed would like to see the yield below 3%. A rapid increase in the yield is the market's way of rejecting the Fed's monetary stimulus.

It's interesting that the market had such a rapid snap-back. No doubt some investors were seeking bargains. Was one of those investors the Fed?

The dollar is coming apart. Was this a warning shot or the beginning of the final conflict?

Stay tuned...

Treasuries Crumple!

The price of the bellwether 10-year US Treasury note cratered yesterday, sending the yield skyrocketing.

This chart (^TNX) shows the yield of the 10 year US Treasury note. (As the price of a bond falls, the yield rises)

Look at the pattern of the last few days. The yield is up rather sharply. Keep in mind that this 10 year Treasury yield drives a lot of other interest rates, including mortgages. People often think that it's the Fed that controls interest rates. Not really. The Fed influences interest rates, and has been struggling to influence the yield on the 10 year US Treasury note, but the Fed is only one player in a big and very complex game. Sure, the Fed is one of the few players that can (semi) credibly print money at will, which is what they do when they want to push the 10 year Treasury yield down. They print money, then spend it buying Treasuries, which pushes prices up and yields down.

The Fed is losing a massive, behind-the-scenes battle. The Fed must keep this yield under control. But it must do it quietly. If investors get to thinking the Fed is the only buyer of Treasuries, they will sell, sending the price down even further. Also, it looks as though foreign central banks, which hold a lot of US Treasury debt, are starting to quietly edge toward the exit, and see the Fed's buying sprees as a good opportunity to sell off some of their holdings. The more money the Fed creates to manipulate markets, the more precarious becomes the state of the dollar, because it becomes more and more obvious that the plan is to inflate away the debt.

About the size of this market: check out the Treasury direct website. The total US Federal government debt is about $11.3 trillion. The US stock market, by comparison, is about $9.3 tril, as measured by the Wilshire 5000.

If money really begins to flee the US Treasury market, where will it go? Keep in mind that when someone sells a US Treasury note, they are paid in dollars. If the idea is to avoid the depreciation of the dollar, then the money must go into another currency or asset that is outside the ability of the Fed to depreciate. The obvious candidate is gold, but I expect we'll see continued movement into the Euro (note that the Euro is up strongly against the dollar recently, which tells us that many investors don't buy the rally. If the worst was over, why would the dollar be falling against the Euro?)

Repo Fee

The Treasury reports that as of Friday, a new fee will be levied on participants in the Repo market of 3%. This is an interesting development; it's pretty unusual for the government to place any kind of punitive fee on any financial market. Why are they doing it?

A "repo" or "sale and repurchase agreement" is a kind of fixed rate short-term lending that uses debt or equity as collateral. A common form of debt to use is US Treasury debt.

An example of a repo transaction would go like this. Say I'm a bank with $10 mil in Treasury debt, and say I'd like to make an investment, but I also want to keep the Treasuries on my balance sheet. I can use a repo to sell the Treasuries to another bank, agreeing to repurchase the Treasuries some time later, for a set amount. Let's say I agree to repurchase the debt 100 days later for $10,0136,986.30. (This would imply that the yearly rate is 5%) I pay $136,986.30 to the lender for giving up my illiquid Treasury debt but knowing I could buy it back later at a fixed price. Why would I do it? Perhaps I have an idea in mind for an investment which would have a higher yield, but I need money to do it, not Treasury debt. Why not simply sell the Treasuries in the bond market and buy them back later? If I did that, there would be no entry in my balance sheet, and say I need to keep the Treasuries on my balance sheet because they are my reserves, and I must keep a certain ratio of reserves to deposits.

Repos are in fact commonly used by banks to have their cake and eat it, too. Banks can lend their reserves at a proft (thereby reducing their reserve ratio, which banks always want to do) and they can keep the Treasuries on their books as if they own the Treasuries, when in fact the bank no longer owns the Treasuries (at least for the term of the repo). The implied interest rate on repos (called the "repo rate") is usually a bit below the federal funds rate, currently at zero.

The unusual thing that began to happen on a large scale during the credit crunch of the fall of 2008 is that many of the buyers of repos (the lenders) did not return the Treasury debt on time. In fact, the total of all the late repos added up to $5 tril (there's a good discussion on the Naked Capitalism blog). There's no real penalty for this, but one question we might ask is: why?

Are the lenders unable to come up with the Treasuries? What did they do with them? Could they have done a repo on the Treasuries they just bought?

The Treasury will place a fee of 3% on the late repos. Because rates are so low, this will probably push the repo rate into negative territory. (Hey, just what Greg Mankiw wanted!) So if the repo rate is negative 3%, the math on my $10 mil repo changes. I now buy back my $10 mil in Treasury debt for only$ 9,917,808.72. Wow, free money! I get to make my investment (hope that works out) and I get to make an easy profit of over $82 grand!

Will the negative repo rate spur banks to make more repos, and hence to make more loans? Perhaps that's the goal of this policy change. My guess is that there will be unforeseen consequences. Who will rush to take the money-losing side of the repo? If there is no counterparty, then the repo market could be diminished, which may have the effect of raising reserve ratios, further contracting the money supply. Most economists these days are against a contraction in the money supply during a recession, especially "The Great Recession".