The FOMC Decision – Some Advance Kremlinology
We have tried to get an idea of what to expect from the FOMC on Wednesday, but must admit we couldn't really make up our mind. One line of argument goes 'Ben Bernanke will try to shock the markets by doing much more than most people currently expect'.
Both Rosenberg and Fleckenstein are quite capable analysts of the economy and financial markets, so it is certainly worth considering what they are saying. Here is what we like about their idea, aside from the reasons they have laid out themselves: First of all, it is notable for being a minority view at the moment. This is at least our opinion from observing anecdotal evidence and a recent Bloomberg survey confirms that the vast majority of economists expects 'only' a variation of 'Operation Twist' ('OT') to be announced, whereby the Fed will simply alter the term structure of its balance sheet by selling shorter term and buying longer term debt. The aim would be to lower long term interest rates (this is to say, the operation would tend to flatten the yield curve).
The relating the result of the survey begins with an unintentionally funny statement – it declares the expected Operation Twist 'dead on arrival' as far as the likelihood is concerned that it might actually help the economy. Very true, but it's still funny. It seems the Fed is losing its nimbus as an omnipotent entity that can 'jump-start the economy' at will.
„Federal Reserve officials tomorrow will probably announce a program for monetary easing that will do little to help 14 million unemployed Americans find work, according to economists in a Bloomberg News survey.
The Federal Open Market Committee will decide to replace short-term Treasuries in its $1.65 trillion portfolio with long- term bonds, according to 71 percent of 42 surveyed economists. The move, known as “Operation Twist” for its goal to bend the yield curve, will probably fail to reduce the 9.1 percent unemployment rate, 61 percent of the economists said. Among those, 15 percent predict it will be “somewhat harmful.” [we don't know about you dear readers, but we found this lough-out-loud funny, ed.]
Operation Twist is among a few untested policy tools that Chairman Ben S. Bernanke has said the Fed could use as risks to the U.S. recovery rise and unprecedented easing falls short of fulfilling the Fed’s mandate for full employment. The yield on the 10-year Treasury note already fell to a record low this month on concerns global growth is flagging and Europe’s sovereign-debt crisis will intensify.
“It’s better than nothing but it’s obviously not going to be a knockout blow or a game changer for the economy,” said Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York. The FOMC began its meeting at around 10:30 a.m. in Washington and plans to release a policy statement tomorrow at about 2:15 p.m.
Feroli estimates the Fed will reduce longer-term yields by about 0.1 percentage point by announcing a swap of $300 billion to $400 billion in Treasuries, selling securities with one to three years remaining maturity, and purchasing mostly those with seven to 12-year maturity. [another knee-slapper; how exactly is this 'better than nothing'? ed.]
There are several things one must consider here. The Fed has evidently prepared the ground through its various mouth-pieces to tweak expectations in the direction the survey reveals. The chief leaker Jon Hilsenrath at the WSJ has mentioned 'Operation Twist', the cutting of the interest rate paid on excess bank reserves (namely, to zero), and 'explicit targets' as the things likely to be discussed. What the 'explicit targets' refer to are targets for the unemployment rate and 'inflation' (i.e., the rate of change of CPI) that would trigger a change in policy – in short, it would be a 'guarantee' of loose policy until one or both of these targets were met. We can call this one the non-chess version of the 'Evans gambit'. Moreover, Hilsenrath's downplays the 'palace revolt' by the three dissenters Plosser, Fisher and Kocherlakota.
It follows from the survey that if the Fed wanted to get a big reaction out of the stock market and other 'risk assets', it would have to do more than just 'OT'. As David Rosenberg relates, it is well known that Ben Bernanke is a big believer in manipulating the stock market – on the mistaken idea that rising stock prices somehow 'increase wealth' and induce people to spend more, which is held to be good for the economy. Spending, it must be remembered, is the be-all and end-all in Bernanke's view of the economy. He is of course not outside of the mainstream with that view. Seriously, most of today's mainstream economists believe that we can consume ourselves back to prosperity.
Production is not given much consideration in this view of the world – it is simply assumed that the means of production are so to speak 'lying in wait' and will swing into action as soon as there is 'enough spending'.
In addition to all of the above, we must consider that normally, the September FOMC meeting is a routine one day meeting, but not this time. The lengthier meeting may be due to a perceived need to bring the dissenters on board, but Hilsenrath's remarks seem to rule that out (apparently the only firmly committed opponent of Bernanke's policies was Thomas Hoenig, who is about to abscond into retirement and won't even take part in the debate). In short, the most likely reason for the two day meeting is that the FOMC will discuss all sorts of interventions, in order to finally come up with a cocktail that is deemed potent enough to 'work'.
Lastly, so far Ben Bernanke has done everything he promised he would do in his famous 2002 'anti-deflation' speech. It is actually quite amazing that we still don't simply take him at his word and are looking for reasons why he might do anything different. :)
To summarize, Messrs. Rosenberg and Fleckenstein may well turn out to be correct.
The consensus view on the other hand also has some arguments going for it. An article in the NYT looks at why 'The Fed Runs The Risk of Doing Less Than Expected' (the NYT would of course see this is a risk…). It lists all the well known reasons arguing for relative monetary chastity at the present moment, from the political headwinds the Fed is facing due to the obvious failure of the 'QE's' to achieve any tangible results, to the objections of the dissenters, to the idea that the 'Fed will want to milk the announcement effect' for as long as possible (this latter point has the most merit in our view, because we know Bernanke believes strongly in the 'announcement effect').
As we have noted many times before, we are beginning to think that the structural damage the last credit boom has wrought may well have been so grave that the economy's pool of real funding is now in serious trouble. Putting it differently, the degree of discoordination in the economy's productive structure, the amount of capital malinvestment and the amount of capital consumption that have attended the last iteration of the boom may have severely impaired the economy's capacity to create real wealth. If this is in fact the case, then it won't matter how much more monetary pumping is thrown at the depression. The effects will simply be weaker and weaker with every new round, with seeming recoveries becoming ever more fleeting.
Alas, what interest us ahead of the FOMC is the likely short term market reaction (days to weeks), mainly for tactical reasons. Considering the possibilities discussed above, we would think that 'OT' has been fully priced in by now. It seems likely that 'OT' alone would actually be dismissed as 'not enough' by traders of so-called 'risk assets' such as stocks and commodities. On the other hand, if Messrs. Rosenberg and Fleckenstein are correct, then we can probably expect a fairly sizable short term rally in said risk assets. If that were to happen, then we think the bigger such a rally turns out to be in the very short term, the more likely it will be nothing but yet another wiggle in an ongoing bear market.
As an aside to this, we would like to point readers to a post at 'Reformed Broker' where the narrowness of the recent stock market advances is discussed. We have mentioned this phenomenon in the past in the context of the 2007 top – when rallies are driven by only a handful of big cap momentum stocks, they must be considered highly suspect – however we should add that we think that this may characterize what happened at the July top better than the current situation, since the 'momentum leaders' have failed to mask the broader market's weakness this time. Too many of them have fallen by the wayside since July (see NFLX or GOOG as pertinent examples).
Still, we thought it was worth passing these thoughts on, since they describe a phenomenon that we think investors should be aware of.
Should the FOMC 'disappoint', it seems likely that the ensuing sell-off could be quite steep and 'force its hand' a short while later – with regards to this, we certainly agree with Bill Fleckenstein. A further sell-off would leave the market severely oversold, which would make it more likely for new inflationary measures to have a large positive effect on prices. From the point of view of bulls this outcome should actually be preferred, while bears would probably be better served by a rally that leaves the market closer to an 'overbought' state (unless it just crashes, which remains a possibility, even though it is one with a very low probability. One should however not dismiss it out of hand).
The SPX finds itself poised just below the 50 day moving average ahead of the FOMC decision. We should note here that we still don't like the looks of this chart. Both our 'possible paths' remain in the contest, see this chart – click for higher resolution.
On Monday we commented on industrial commodities, specifically copper and crude oil and their ominous looking charts. In the meantime, both markets have indeed broken to lower levels, with copper showing more alacrity in falling (like Falstaff). Crude Oil may actually still be said to have held within its wedge, but only barely. Perhaps the slight divergences between stocks, copper and crude oil will turn out to be short term meaningful. We would note though that at the summer 2010 low, copper diverged from stocks by making a higher low, while at present it seems to be busy diverging to the downside.
Copper waves good-bye to another lateral support level – click for higher resolution.
Crude oil weakens as well, but it's only a tentative breakdown from the wedge so far. Here is Monday's annotated chart – click for higher resolution.
The Greek Debt Can
It is actually a bit tiresome that Greece won't just go away, but it remains a potential trigger for upcoming short term market moves as well. It appears from the latest news that the telephone conference with the 'troika' went well enough to entice it to send a delegation back to Athens for further discussions, while Greek finance minister Evangelos Venizelos in turn is going to visit the IMF in Washington. From this we conclude that the Greek debt can is readied for one more kick down the road.
To our mind throwing the money into the super-massive black hole thought to reside at the center of the Milky Way galaxy may actually be slightly more productive. The markets are no longer trying to guess whether Greece will default – they are trying to guess what the post default recoveries will be.
The only reason we can discern for releasing yet another bailout tranche is an attempt to buy more time in order to prepare for the post-default contingencies.
Note by the way that several of the smaller euro area nations could still bring the entire plan to grief. It appears for instance that Slovakia's government will have a hard time to get parliament to ratify the latest bailout agreement. Slovakia resents the Greek bailout, as the country has overcome considerable economic and fiscal problems in the past on its own. Moreover, we would note that Slovakia has consistently erred in the direction of pro-free market reforms and has established one of the most unhampered economies in the entire EU (for instance, it has a 19% flat tax, which speaks volumes about economic freedom). Since Slovakia's economy is highly dependent on the car industry, it has a tough time at the moment as well, and Slovakian citizens who have borne many sacrifices when the country was in trouble previously don't see why they should now bear even more sacrifices in support of spendthrift Greeks. While this is bemoaned as a 'lack of solidarity' elsewhere in the EU, we sympathize with the position. After all, the Greek government first lied about its deficit, then got a giant bailout the conditions of which it consistently failed to meet and now it is supposed to receive yet another bailout even though the financial markets have evidently consulted their collective abacus and come to the conclusion that paying back its debt has become an arithmetical impossibility.
It is of course true that in reality, the bailout is aimed at bailing out Greece's creditors rather than Greece itself, but that hardly makes the situation any better. On the contrary, this propping up of unsound credit is a colossal waste of resources in favor of those who took risks they should have thought twice about.
Be that as it may, it appears from what we have seen thus far that any news of further can-kicking will be regarded as 'positive' by the financial markets (yes, we know, it's not logical), while conversely, the uncertainties over the manner in which an outright default may redound on the euro area's banking system keeps markets on edge every time the can kicking exercise threatens to be terminated.
Greece's economic data are actually 'improving' in that the rate of change of the regression is slowing. Alas, the public debtberg is too big relative to this economic performance, and always has been – click for higher resolution.
There is tragically quite a lot of human suffering that accompanies these ugly economic data, which is all the more reason to bring the debt back to a manageable level via a default. As a recent example of the desperation that is finding expression behind the bleak numbers, consider this on the sharp rise of suicides in Greece.
Italy's Government Miffed
'Italy rejects S&P downgrade!', the NYT informs us. We find this tendency to anthropomorphize entire cities or countries quite funny. It sounds almost as though 'Italy' were some gal who's cross with her boyfriend, S.P. Downgrade. In reality, it is of course a real person that 'rejects' the downgrade, namely Silvio Berlusconi, the 'locust hunter'. We can be reasonably certain that S&P won't lose any sleep over it. However, we are by now well acquainted with how such things tend to progress. Next in line is Moody's, which was hitherto thought to be the first ratings agency likely to downgrade Italy's government debt further. For now, Moody's is merely lying in wait, but one of these days it will strike. Now, apart from the danger that Uncle Silvio's righteous wrath may become more intense when that happens, there are many investors that have to abide by certain rules as to what kind of debt they may hold. Usually when the credit rating agencies disagree, the decisive point is which rating the majority of them have dispensed (i.e., what two out of the three are saying is what counts).
So the next downgrade will be a bigger deal than this one is, as it may result in some forced selling (the extent is hard to gauge – it may not be significant, as Italy's debt isn't in any danger of becoming 'junk' just yet).
More importantly though, the euro area's banks and insurers are stuffed to the gills with Italian debt, simply because there is so much of it. In spite of a 'risk on' day in euro-land on Tuesday, Italian debt actually kept selling off.
We may rest assured that such adverse moves in the value of the banks' portfolios will utterly escape accounting recognition, i.e. there won't be any marking to market. Alas, this is precisely the banking system's biggest problem, a problem which we have highlighted on account of the EBA's famed 'stress test', which managed to destroy any remnant of confidence there may once have been by merely lifting the rug a little bit and allowing us a glimpse of what's underneath.
The selling wave in euro-land bank stocks accelerated shortly after the publication of the stress test results on July 17, as can be seen below:
The EuroStoxx Bank Index. In mid July the EBA stress test led to a confused 'hope' bounce, followed by an accelerated crash after people actually found the time to go through all the details – click for higher resolution.
The method of allowing banks to sweep unrealized losses on assets under the rug has the obvious advantage that they don't all have to declare themselves insolvent at once, but it also increases uncertainty over the ticking time bombs that are hidden from the prying eyes of investors (actually, ever since the stress test results were published, they are slightly less hidden, but that has proved to be only a marginal improvement compared to the status quo ante). The fact of the a priori insolvency of a fully lent up fractionally reserved banking system has so to speak been thrown into somewhat starker relief by the sovereign debt crisis in Europe, even if current accounting practices are not up to the task of fully disclosing this state of affairs.
Jonathan Weil has written an excellent article at Bloomberg that discusses the mess pliable accounting standards boards (like FASB and IASB) have created by moving away from the demand that stricter accounting principles be adhered to. It is entitled '' and well worth reading in its entirety. Says Weil:
“The last time the world had a major banking crisis, fair-value accounting rules were near the top of the list of scapegoats most likely to be denounced by government and industry leaders. Not so this go-around.
Today many of Europe’s largest financial institutions are seemingly on the brink again, driven by fears of pent-up losses stemming from the sovereign-debt debacle. Only you don’t hear much criticism of fair-value reporting anymore. That’s probably because the accounting mandarins gutted many of their fair-value rules in response to the financial system’s near-meltdown three years ago. This hasn’t made banks safer. It has given politicians and bankers one less culprit to blame, though.
Fair-value accounting – or the notion that financial instruments should be recorded at market value on companies’ books rather than at historical cost – made for a popular whipping boy in 2008, both before and after the collapses of Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc.
Companies supposedly were being forced to write down their assets to temporarily irrational prices, or so the story went. Critics said the practice exacerbated market downturns. The boards that write accounting standards for Europe and the U.S. responded by passing emergency amendments to their rules to give the world’s banks and insurance companies a break. Predictably this has only made matters worse in the long run, by hurting investor confidence in some of the numbers financial companies are reporting now.”
We would add here that truly conservative accounting rules would stipulate that bank assets should be recorded at either fair market value or their historical cost, whichever is lower. This should be so because if there is anything truly worth criticizing about 'pure' fair value accounting it is the illusionary profits that are recorded on unrealized paper gains when things go well during an inflationary boom.
These profit delusions have been used to create a giant Potemkin village of ruddy bank health prior to the crisis, not to mention that they were used as the basis for calculating banker bonuses (the latter may seem like a minor quibble compared to the systemic risk that was created, but it was a major motivate in the abandonment of conservative accounting principles).
In other words, we would go one step further than Weil, who says that “the problem with fair-value accounting now is investors don’t get enough of it. Those banks that are destined to blow up will do so regardless.”
We would say it is not merely fair value accounting investors don't get enough of. It is truly conservative, prudent accounting that investors don't get enough of. Book values should neither be inflated when assets have fallen in price, nor when they have risen. Only realized profits should be booked as such.
Let us not forget that in a fractionally reserved system, the commercial banks are able to create loans and deposits from thin air, i.e. their own inflationary activities create illusionary profits for themselves that are invariably given back in their entirety once a debt-deflationary bust strikes. A return to prudent accounting rules would without a doubt make bank officers far more circumspect about the risks they are willing to take – something which we all should actually regard as a de minimus requirement for banks operating with fractional reserves, especially when tax payers are regularly required to bail them out and pay for their losses.
Euro Area Credit Market Charts
Below is our usual collection of charts of CDS spreads, bond yields, euro basis swaps and a few other charts. Prices in basis points, with both prices and price scales color-coded where applicable. The most notable development on Tuesday was the continued rise in Italian yields, otherwise most markets remain stuck in a high level nervous holding pattern.
5 year CDS on Portugal, Italy, Greece and Spain – note, CDS on Italy's, Spain's and Portugal's debt continued to increase on Tuesday – click for higher resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria – only small moves here – click for higher resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – still triangulating, but CDS on Slovenia are beginning to break out from the triangle – click for higher resolution.
5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – all still drifting higher – click for higher resolution.
10 year government bond yields of Ireland, Greece, Portugal and Spain – all yields inching higher once again – click for higher resolution.
10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note. We can issue a 'red alert' on Italy again – 5.72% is uncomfortably high – click for higher resolution.
Three month, one year and five year euro basis swaps – the euro-doom indicators are taking another small step into the abyss – click for higher resolution.
Our proprietary index of euro-area bank CDS (an unweighted index of 5 year CDS on the senior debt of BBVA, Deutsche Bank, Societe Generale, BNP Paribas, Intesa Sanpaolo, Unicredito, and Monte dei Paschi di Siena) – another 11 basis points were added on Tuesday. This is our new 'most scary chart in the world' – click for higher resolution.
A long term (weekly) chart of our euro-land bank CDS index – on a weekly basis it's at a new high (the high just above 400 basis points was made intra-week) – click for higher resolution.
Inflation adjusted yields – down in Europe, up in the US. This is as it should be, as the Bernank is about to pump again – click for higher resolution.
5 year CDS on the 'Big Four' Australian banks. Still triangulating, but this strikes us as a bullish chart – which by implication is bearish for 'risk' – click for higher resolution.
Charts by: Bloomberg, StockCharts.com, Greek Governmrnt
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
4 Responses to “Waiting for a Trigger And the Illusions of Bank Accounting”
Most read in the last 20 days:
- Gold Price Skyrockets in India after Currency Ban – Part III
When Money Dies In part-I of the dispatch we talked about what happened during the first two days after Indian Prime Minister, Narendra Modi banned Rs 500 and Rs 1000 banknotes, comprising of 88% of the monetary value of cash in circulation. In part-II, we talked about the scenes, chaos, desperation, and massive loss of productive capacity that this ban had led to over the next few days. Indian prime minister Narendra Modi – another finger-wagger, as can be seen in this...
- Gold Price Skyrockets in India after Currency Ban – Part II
Chaos in the Wake of the Ban Here is a link to Part 1, about what happened in the first two days after India's government made Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes illegal. They can now only be converted to Rs 100 (~$1.50) or lower denomination notes, at bank branches or post offices. Banks were closed the first day after the decision. What follows is the crux of what has happened over the subsequent four days. India's prime minister Nahendra Modi, author of the...
- Gold Price Skyrockets in India after Currency Ban – Part IV
A Market Gripped by Fear The Indian Prime Minister announced on 8th November 2016 that Rs 500 and Rs 1,000 banknotes would no longer be legal tender. Linked are Part-I, Part-II and Part-III updates on the rapidly encroaching police state. The economic and social mess that Modi has created is unprecedented. It will go down in history as an epitome of naivety and arrogance due to Modi’s self-centered desire to increase tax-collection at any cost. Indian jewelry...
- A Note on Gold and India – What is Driving the Gold Price?
Hidden Motives It is well-known that India's government wants to coerce its population into “modernizing” its financial behavior and abandoning its traditions. The recent ban on large-denomination banknotes was not only meant to fight corruption. Obviously, this very bad Indian has way too much cash. Just look at him, he looks suspicious! Photo via thenewsminute.com In fact, as our friend Jayant Bhandari has pointed out, fresh avenues for corruption ...
- India's Currency Debacle – An Interview with Jayant Bhandari
A Major Crisis Last week Jayant Bhandari related the story of the overnight ban of certain banknotes in India under cover of “stamping out corruption” (see Gold Price Skyrockets In India after Currency Ban Part 1 and Part 2 for the details). Banned 500 rupee banknotes The problem is inter alia that the sudden ban of these banknotes has hit the Indian economy quite hard, given that 97% of all transactions in the country are cash-based. Not only that, it has...
- Will the Swamp Swallow Trump?
Permanently Skewed TRUMP HOTEL, New York – Trump’s rambling army – professionals, amateurs, camp followers, and profiteers – is marching south, down the I-95 corridor. There, on the banks of the Potomac, it will fight its next big battle. Lieutenants in Trump's army: Bannon, Flynn & Sessions Photo credit: Drew Angerer / AFP Here at the Diary, we do not like to get involved in politics. But this is a special time in the history of our planet – a...
- There Are Two Types of Credit — One of Them Leads to Booms and Busts
Stumped by the Bust In the slump of a cycle, businesses that were thriving begin to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs. What has caused the bust? The modern-day economic orthodoxy continues to be unable to provide...
- All Aboard! Trump’s Express Train to the Future
Free Money! BALTIMORE – Last week, the Dow punched up above 19,000 – a new all-time record. And on Monday, the Dow, the S&P 500, the Nasdaq, and the small-cap Russell 2000 each hit new all-time highs. The last time that happened was on the last day of December 1999. Ironically, two events that were almost universally expected to trigger large stock market declines were followed by quite rapid and strong gains. Would the market have fallen if Hillary Clinton had won...
- Attaining Self-Destruct Velocity
Bad Monday Some Monday mornings are better than others. Others are worse than some. For one Amazon employee, this past Monday morning was particularly bad. No doubt, the poor fellow would have been better off he’d called in sick to work. Such a simple decision would have saved him from extreme agony. But, unfortunately, he showed up at Amazon’s Seattle headquarters and put on a public and painful display of madness. Good-bye cruel world! On this our planet,...
- Gold Bull Market Remains Intact – Long Term Fundamentals Outweigh Short Term Market Gyrations
A Strong First Half of the Year, Followed by Another Retreat In early 2016 gold had a big bull run. The precious metal rose close to 25% this year, pushed higher in a summer rally that peaked on July 10th. Gold experienced a bumpy ride over the remainder of the summer though, as investors became increasingly concerned about a potential rate hike by the Federal Reserve. Uncertainty returned to gold market and has intensified further since then. Initially, gold rallied sharply...
- Too Early for “Inflation Bets”?
The Trump Trade After 35 years of waiting... so many false signals... so often deceived... so often disappointed... bond bears gathered on rooftops as though awaiting the Second Coming. Many times, investors have said to themselves, “This is it! This is the end of the Great Bull Market in Bonds!” The long bond's long cycle – red rectangles indicate when the post 1980 bull market was held to be “over” or “over for sure” or “100% over”, etc. We have...
- About that Economic Inequality
Illusory Riches, Obvious Impoverishment I address this essay to two groups. One group is those among the liberty movement, who believe that there’s nothing wrong with inequality. These are often Objectivists, who unknowingly defend a regime that artificially suppresses working people. And suddenly, you feel much lighter... The other group is those among the Left who still call themselves liberals. They say they don’t like inequality, but nevertheless...