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One In 5 Households Now On Food Stamps.

ChuckButler — Mon, 29 Apr 2013 17:02:07 GMT

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In This Issue.

* U.S. GDP disappoints.

* Currencies & metals rally.

* Kiwi gains VS dollars U.S & A$.

* PIMCO likes Norwegian krone fundamentals..

And, Now, Today's Pfennig For Your Thoughts!

One In 5 Households Now On Food Stamps.

Good day. And a Marvelous Monday to you! Well, I told you on Friday, that the rain was coming our way, and we had a rain soaked weekend, but, I didn't know it was going to be so darn cold, and raw. We're almost to May, folks! This is not supposed to be what the weather is like for this time of year! But, all my complaining won't change anything, so I just need to settle down, and take it one day at a time, eh?

Sort of like what we've done with the Eurozone for almost a year now, for it was about a year ago, that I started telling you that the relative calm was coming over the Eurozone, and that the threat of a major sovereign default was dissipating. But, we had to take it one day at a time, for around every corner there lurked a debt ridden country and their problems obtaining financing. And now one year later, not much has changed in the Eurozone. The problems have moved from Italy and Spain to tiny Cyprus, but no matter how time Cyprus is, these occurrences remind the markets that the Eurozone and euro is not out of the woods.

Speaking of Italy. it now appears that their political mess is going to get worked out, and to reward them for working that out, Italy's bond auction today saw their borrowing costs drop to the lowest level in over 2 years! This news has really goosed the euro by about 1/2-cent this morning. And with the euro moving higher, it allows the other currencies to also get off the porch and chase the dollar down the street.

OK. The markets really were not happy with Friday's U.S. data and the reaction or response to Friday's print of 1st QTR GDP, which did not meet the consensus for growth at 3.2%, instead printing at 2.5%... Now. 2.5% growth is far better than the .4% that the 4th QTR printed. Right? Yes! But is it sustainable? Well, in my opinion, no. I think what you have to do, is look under the hood here. I looked at something called domestic final sales, which to me is nothing more than a measurement of domestic demand, and that component was up 1.9% in Q1. And that's right in line with what it has been for the past two years! So. Inventory accumulation was up big. Is any of this registering with you like it is me, that it's not sustainable? Add in the increased taxes on consumers, and the proof that the economy is already slowing down, from recent economic data, and I think you'll agree that this strong showing (relative to what we've seen in the past 5 years) is a one-and-done.

And maybe that's why the markets were not enamored with the number. But, the more likely reason was that it was just like the reaction to a stock of a company that has good earnings, but. doesn't meet expectations. The markets expected 3.2% growth, and they didn't get it.

On Friday morning, I told you that the Chinese renminbi / yuan had been allowed to appreciate to a record level (a 19-year high VS the dollar). OK. So there I was reading Dennis Gartman's letter on Friday morning, that always arrives just as I'm sending the Pfennig to the legal beagles for approval, and I see he's talking about the Chinese renminbi / yuan. Let's listen in. "We note that the dollar is making new multi-year lows relative to the Chinese renminbi. The Obama Administration, just as the Bush Administration did all too often during its tenure in office, has complained bitterly that China's currency is "undervalued" and thus gives China a huge advantage in global trade, but clearly that argument is losing its validity. if it had any to begin with. Since the spring of last year, the renminbi / dollar rate has gone from 6.40 to 6.1650, or a 3.7% increase in value. In a world of foreign exchange, a sustained movement over the course of one year of this sum is material. However, we shall expect to hear nothing from the Treasury, or from Commerce, regarding this shift and will instead hear that China has to do even more to stabilize global trade."

I thank Dennis Gartman for allowing me to use his excellent view of how we treat China, even though they have gone about allowing their currency to gain VS the dollar for the past 8 years (except 2008). I read Dennis Gartman almost every day.

OK. So. The Currencies and metals are stronger this morning. Again we've had to take this stuff one day at a time for some period of time now, given the way the markets change their minds on a dime. One day, they believe something, and the next day something else. And then when we get down to an annual review, there hasn't been much movement at all. But, in reality, for a diversified investor that's using currencies and metals as a diversification tool to have a portion of their investment portfolio outside of the dollar, not much movement is like manna from heaven.

Gold is up $10 this morning. You should have seen the way Gold flip-flopped from positive ground to negative ground and back on Friday. Or maybe you're a Gold watcher, and you saw it. I bet if you're a Gold watcher, you're a Gold watcher, watching Gold go around. (did you start singing? I bet you did!) Then you were worn out completely by the end of the day! I have a story for the TTWT section in today's letter, that plays well with just why investors look to own Gold. But you'll have to wait, that is unless you skip ahead, because I've got more to talk about this morning before I head to the Big Finish.

Well. Looky at the New Zealand dollar / kiwi this morning. Trading over 85-cents! WOW! The kiwi has been gaining not only VS the U.S. dollar, but also against its kissin' cousin across the Tasman, Aussie dollar (A$). This HUGE move by kiwi was fueled by the Reserve Bank of New Zealand (RBNZ) leaving rates unchanged but talking hawkish, and. the slower than expected U.S GDP report last Friday. One of the reason kiwi is gaining against A$'s is that as we've talked about for some time now, the markets are pushing the Reserve Bank of Australia (RBA) to cut rates, while the same markets believe the RBNZ has room to hike rates. Right now there's a 50 BPS spread in official cash rates (that's 1/2%) in favor of the A$, but that spread could be narrowing as we move through 2013, and that's what's got kiwi moving against the A$.

Of course, we've talked about the RBA and the markets will to have them cut rates this year, and Chuck's point of view that a rate cut is not needed in Australia. So, we don't have to get into that again, but just remember, that I've put it all out there for everyone to view, and in my opinion no rate cut is needed in Australia. We'll see if the RBA has the intestinal fortitude to stand up to the markets.

The A$ is up by 1/2-cent this morning, as it gets dragged along with the rest of the currencies. I say dragged along because the threat of a rate cut is hanging over the A$ like the Sword of Damocles right now. And the fact that the IMM futures positions showed a 20,000+ drop in long A$ positions last week. The rest of the currencies only had what I would call, modest gains or losses from the previous week's holdings. So, the A$ is going to have to work hard to get through this gauntlet of bad news.

Well. I saw this story headline flash across my screen this morning, and since it caught my eye, I was assured that you would want to see it too! HA! Here's the headline: "PIMCO Makes AAA Rated Norway in Retreat the Favorite". So, the story goes on to talk about how the Norwegian krone hasn't really performed well this year, but that hasn't stopped PIMCO from taking a flyer on the krone. Let's listen in to Thomas Kressin, head of European Foreign Exchange at PIMCO. "From a relative domestic fiscal position and relative interest rate position, Scandinavian currencies still look appealing. We are reconsidering entering a long position." And then the boys and girls over at Citigroup issued a statement that "the krone is more attractive than the euro"

Now, doesn't that ring a bell? Which reminds me of an old joke. Any way. Isn't this the stuff I've been telling you for some time now about the Norwegian krone? That one day, the markets will wake up, have a V-8 moment, and realize that the krone's fundamentals are far better than those of the euro, and the krone should not be tarred with the same brush used on the euro? I certainly hope so, because I think I've said it and written it so many times that I'm sure some people think I've lost it, for I keep repeating myself.

Well, the U.S. data cupboard gets restocked today, with two of my fave reports. Personal Income and Spending. Right now, the "experts" believe that Personal Spending will be flat for March, and given the rot on the economy's vine starting with March, I would have to think the "experts" will get it right this time. That could mean that Personal Income is greater than Spending, which doesn't happen that often folks.. But it certainly would be great if it did!

The rest of the week is chock-full-o-data, ending with the Jobs Jamboree on Friday. Between now and Friday, we'll see stuff like the S&P Case/Shiller Home Price for Feb (such old data, eh?) Consumer Confidence, the ISM Manufacturing Index, Vehicle Sales, and a Fed FOMC rate decision on May 1st. So, buckle up, this could be like Mr. Toad's Wild Ride this week.

Then There Was This. This is the story that I said earlier today played well with the reason to look to own Gold. This was sent to me by colleague, Aaron, who found it on CNSNews.com. The latest available data from the United States Department of Agriculture (USDA) shows that a record number 23 million households in the United States are now on food stamps.

The most recent Supplemental Assistance Nutrition Program (SNAP) statistics of the number of households receiving food stamps shows that 23,087,886 households participated in January 2013 - an increase of 889,154 families from January 2012 when the number of households totaled 22,188,732.

The most recent statistics from the United States Census Bureau-- from December 2012-- puts the number of households in the United States at 115,310,000. If you divide 115,310,000 by 23,087,866, that equals one out of every five households now receiving food stamps.

As CNSNews.com previously reported, food stamp rolls in America recently surpassed the population of Spain. A record number 47,692,896 Americans are now enrolled in the program and the cost of food stamp fraud has more than doubled in just three years."

Chuck again. Sad but true, eh? And the Gov't keeps recruiting people to enroll in the program. Do I need to say more about that's not how I was raised, or my dad, or my grandfather? Oh well, it is what it is, right?

To recap. The Currencies & Metals are stronger this morning as the tide has shifted back in their favor after a weaker than expected GDP print on Friday. Kiwi is outperforming the A$ these days, as rate outlooks for the two country are narrowing the spread that currently exists. PIMCO thinks the Norwegian krone is a buy, and Citigroup likes the krone's fundamentals. And Dennis Gartman shares his thoughts with us on China.

Currencies today 4/29/13. American Style: A$ $1.0345, kiwi .8555, C$ .9860, euro 1.3085, sterling 1.5525, Swiss $1.0650, . European Style: rand 9.00, krone 5.8180, SEK 6.5360, forint 228.75, zloty 3.1630, koruna 19.6495, RUB 31.08, yen 97.75, sing 1.2340, HKD 7.7615, INR 54.24, China 6.2208, pesos 12.09, BRL 1.9985, Dollar Index 82.16, Oil $93.35, 10-year 1.66%, Silver $24.41, and Gold. $1,476.12

That's it for today. Well, after beating the #6 and #5 teams in the state Thursday & Friday nights, Andrew and Alex's water polo team ran into a real problem playing the #1 & #2 teams on Saturday. But they finished 4th in the Tournament, and head into the state playoffs this weekend. Alex did score 3 goals this weekend, so good for him! It was so rainy and cold this weekend, that it didn't seem like a weekend at all! Our Blues start the playoffs at home tomorrow night against the defending Champion, LA Kings. Go Blues! It was spooky driving along our river road the other day, with the flood water lapping up against the curbs. But! I think it's supposed to dry up and warm up this week! YAHOO! And with that. I hope you have a Marvelous Monday!

Chuck Butler
President
EverBank World Markets
1-800-926-4922
1-314-647-3837

Sorting Out the Decade

JohnMauldin — Sat, 15 Dec 2012 22:36:12 GMT

In today's Outside the Box I bring you two pieces that, at first glance, may not seem to have much to do with each other. First, Bill Gross, PIMCO managing director, runs down the fierce structural headwinds that our hard-pedaling global economy faces over the next decade. I am going to deal at length with not only his GDP projections for the rest of the decade but those of Grantham and others in the last two Thoughts from the Frontline of this year. This is a challenging environment for traditional portfolio construction, but it’s par for the course as we slog through the secular bear market I was first writing about in 1999.

Then Charles Gave instructs us on the distortions in the measurement of risk that have been introduced as the "plain, boring and well-meaning economists working in the entrails of the world central banks" have supplanted the Marxist avant garde in the world's shift away from “scientific socialism” to "scientific capitalism."

However, when you think about it, these pieces dovetail in a very convincing – and somewhat frightening – manner. Because what they add up to – if the econocrats are yanking the rug out from under a capitalist system that is already reeling, as Gross says, from debt and deleveraging, a slowing of the locomotive of globalization, and dislocations in technology and demographics – is a profound, ongoing challenge to you and me as investors. Gross and Gave have their own ideas about how we get through this. I don’t agree with all their conclusions – this letter is not called Outside the Box for nothing – but I offer these essays because they’ll make us think through our own presuppositions. However you view their analysis, they do reinforce the idea that we're all going to have to be not only careful but very nimble.

I post this note from 35,000, feet flying back from Cleveland to Dallas. American Airlines has now put internet on nearly all of their domestic flights, and I find the time I spend read and respond without interruption up here some of the more productive time I get. Which is good, since the record shows that I have been on some 110-plus different planes this year, most of which were AA. (Lately, when I am asked where I live, I just say my closet is in Dallas.)

It is not just me but other “road warriors” who have noticed that the staff of AA have markedly stepped up their personal service levels (as opposed to United, when they were in similar financial difficulties). More than a few of their employees have gone far out of their way to make my difficult travel schedule a little bit easier and smoother, from frontline staff to their back-office phone mavens, who often perform a little bit of magic rearranging my schedule. And as they add newer planes to their fleet, seat 5B has almost become my home office. So here’s a tip of the hat to them and all the service people who make life on the road better. And may your own road be a little smoother these holidays.

I spent last night at Dr. Mike Roizen’s home before seeing a few doctors at the Cleveland Clinic. I rode in a limo with him to a speech in Youngstown, Ohio, and we had time to visit at length. Mike has become one of my dearest friends, and our times together are easy ones, deeply treasured. Without this peripatetic life I would not have so many good friends, far and wide. It is the best perk of traveling.

Mike is on the board of the Cleveland Clinic, and he is deeply worried about the fiscal cliff. Even assuming the “doc fix” is passed, as it always is, without an alteration or repeal of the current law, the Cleveland Clinic will be faced with an almost 9% budget cut on January 1. They will lose money on every Medicare and Medicaid patient they see. There are no good solutions other than deep budgets cuts. And since the largest portion of their budget is salaries?...

The CC is held up (rightly so) as one of the most efficient medical organizations in the world. They have no fat to cut. I met the lady, in my walking around at the clinic, who cut $24 million in energy costs and another $2 million in trash-removal costs, at some considerable effort and investment. They leave no dollar stone unturned in the pursuit of efficiency.

Mike and I talked deep into the night and much of the next day, when we could, about our healthcare system. It fills me with deep concern. I have asked Mike to give us an outline of his speech today for an Outside the Box. His five-step “solution” has lowered healthcare costs for the 43,000 CC staff and all firms that have adopted their plan. When you look at his numbers, you understand why the US spends more money on healthcare than Europe. We are indeed that much less healthy. The CC has found out that paying each staff member $2,000 to adopt a healthier lifestyle lowers overall costs by even more than that.

Smoking cigarettes may be your personal choice and God-given right, but it costs the American healthcare system and taxpayers multiple tens of billions. And the same goes for four other lifestyle habits. Want to live long and prosper? And be smarter and have better sex? Just eat right, exercise and avoid a few items. I hope Mike gets me that essay soon, as I want all my closest friends (that would be you!) to stay around with me for a long, long time.

Have a good week. I am looking forward to the holidays and home and family. And while I try to get exercise on the road, my home gym is still the best.

Your ready for a few good nights’ sleep in my own bed analyst,

John Mauldin, Editor
Outside the Box

Strawberry Fields – Forever?

Bill Gross, Managing Director, PIMCO

Living is easy with eyes closed
Misunderstanding all you see
I think I know I mean a yes
But it’s all wrong
That is I think I disagree

Strawberry Fields Forever

The Beatles

You didn’t build that............... 332

I built that ................................... 206

Well, I guess that settles it: you didn’t build that after all. Or maybe you did, but not all of it. Or maybe like the convoluted John Lennon above “you think you know a yes, but it’s all wrong. That is you think you disagree.” Whatever. Rather than an economic mandate, November’s election was more of social commentary on the Republicans’ habit of living with eyes closed. Their positions on what Conan O’Brien labeled “female body parts” – immigration, gay rights and student loans – proved to be big losers, and they will have to amend rather than defend those views if they expect to compete in 2016. I suspect they will. Political parties are living social organisms that mutate in order to survive. We will see straight talking Chris Christie or Hispanic flavored Marco Rubio leading the Republican charge four years from now versus a reenergized Hillary Clinton. It should be quite a show with a “No Country for Old (White) Men” caste to it.

But whoever succeeds President Obama, the next four years will likely face structural economic headwinds that will frustrate the American public. “Happy days are here again” was the refrain of FDR in the Depression, but the theme song from 2012 and beyond may more closely resemble Strawberry Fields Forever, as Lennon laments “It’s getting hard to be someone but it all works out.” Why is it so hard to be someone these days, to pay for college, get a good-paying job and retire comfortably? That really was the economic question of the 2012 election towards which very few specifics were applied from either side. “There’s a better life out there for us,” Governor Romney bellowed to a crowd of thousands in

Des Moines, Iowa just days before the election, but in truth he never told us how we were going to achieve it or, importantly, why we weren’t realizing it in the first place. The president’s political mantra of “Forward” was even more vague.

Their words were mum if only because the real cause of slower economic growth lies hidden in a number of structural as opposed to cyclical headwinds that may be hard to reverse. While there are growth potions that undoubtedly can reduce the fever, there may be no miracle policy drugs this time around to provide the inevitable cures of prior decades. These structural headwinds cannot just be wished away as we move “forward” whether it be to the right, the left or dead center. Last month in a major policy speech at the New York Economic Club, Fed Chairman Ben Bernanke concurred that the U.S. economy’s growth potential had been reduced “at least for a time.” He in effect confirmed PIMCO’s New Normal which has been in place for three years now, laying the blame in part on the financial crisis, diminished productivity gains, and investment uncertainty due to the near-term fiscal cliff. We do not disagree. However, there are numerous other structural headwinds that may reduce real growth even below the New Normal 2% rate that Bernanke has just confirmed, not only in the U.S. but in developed economies everywhere.

They are:

1) Debt/Delevering

Developed global economies have too much debt – pure and simple – and as we attempt to resolve the dilemma, the resultant austerity should lower real growth for years to come. There are those that believe in the “Brylcreem” approach to budget balancing – “a little dab‘ll do ya.” Just knock a few percentage points off the deficit/GDP ratio, they claim, and the private sector will miraculously reappear to fill the gap. No such luck after 2–3 years of austerity in Euroland, however. Most of those countries are mired in recession and/ or depression. Political leaders there should have studied the historical evidence presented by Carmen Reinhart and Ken Rogoff in a critically important paper titled, “Growth in a Time of Debt.” They conclude that for the past 200 years, once a country exceeded a 90% debt/GDP ratio, economic growth slowed by nearly 2% for both developed and developing nations for an average duration of nearly a decade. Their work displayed below in Chart 1 shows the result in the United States from 1790–2009. The average annual U.S. GDP rate growth, while clearly influenced by the Great Depression, was -1.8% once the 90% barrier was exceeded. The U.S., by the way, is now at a 100% debt/GDP ratio on the basis of the authors’ standard measuring yardstick. (Note as well the 5_% average inflation rate during the same periods.)

In addition to sovereign debt levels which were the primary focus of the Reinhart/Rogoff studies, it is clear that financial institutions and households face similar growth headwinds. The former needs to raise equity via retained earnings and the latter to increase savings in order to stabilize family balance sheets. The combined need to increase our “net national savings rate” highlighted in last month’s Investment Outlook is a long-term solution to the debt crisis, but a near/ intermediate-term growth inhibitor. The biblical metaphor of seven years of fat leading to seven years of lean may be quite apropos in the current case with the observation that the developed world’s growth binge has been decades in the making. We may need at least a decade for the healing.

2) Globalization

Globalization has been an historical growth stimulant, but if it slows, then the caffeine may wear off. The fall of the Iron Curtain in the late 1980s and the emergence of capitalistic China at nearly the same time was a locomotive of significant proportions. Adding two billion consumers to the menu made for a prosperous restaurant, increasing profits and growth in developed economies despite the negative internal effects on employment and wages. Now, however, these tailwinds are diminishing, producing an airspeed which inexorably slows relative to the standards of prior decades. Is it any wonder that markets now move up or down as much on the basis of policy changes coming out of China as opposed to the U.S. or Euroland? If China and the accompanying benefits of globalization slow, so too may developed economy growth rates.

3) Technology

Technology has been a boon to productivity and therefore real economic growth, but it has its shady side. In the past decade, machines and robotics have rather silently replaced humans, as the U.S. and other advanced economies have sought to counter the influence of cheap Asian labor. Almost a century ago, Keynes alerted the economic community to a “new disease,” what he called “technological unemployment” where jobs couldn’t be replaced as fast as they were being destroyed by automation. Recently, Erik Brynjolfsson and Andrew McAfee at MIT have affirmed that workers are losing the race against the machine. Accountants, machinists, medical technicians, even software writers that write the software for “machines” are being displaced without upscaled replacement jobs. Retrain, rehire into higher paying and value-added jobs? That may be the political myth of the modern era. There aren’t enough of those jobs. A structurally higher unemployment rate of 7% or more is the feared “whisper” number in Fed circles. Technology may be leading to slower, not faster economic growth despite its productive benefits.

4) Demographics

Demography is destiny, and like cancer, demographic population changes are becoming a silent growth killer. Numerous studies and common sense logic point to the inevitable conclusion that when an economic society exceeds a certain average “age” then demand slows. Typically the dynamic cohort of an economy is its 20 to 55-year-old age group. They are the ones who form households, have families and gain increasing experience and knowhow in their jobs. Now, however, almost all developed economies, including the U.S., are gradually aging and witnessing a larger and larger percentage of their adult population move past the critical 55-year-old mark. This means several things for economic growth: First of all from the supply side, it means productivity and employment growth rates will slow. From the demand side, it suggests a greater emphasis on savings and reduced consumption. Those approaching their seventh decade need fewer cars and new homes as shown in Chart 2. Almost none of them have babies (thank goodness!). Such low birth rates and a significant reduction in demand have imperiled Japan for several lost decades now. A similar experience will likely turn many developed economy “boomers” into “busters” within the next several years.

Investment Conclusions

I’m fond of reminding PIMCO’s Investment Committee that you can’t buy GDP futures – at least not yet. Hypotheses about real growth rates, no matter how accurate, must be translated into investment decisions in order to justify the discussion. Before doing so, let me acknowledge that these structural headwinds can and will likely be somewhat countered by positive thrusts. Cheaper natural gas and the possibility of reversing or even containing the 40-year upward trend of energy costs may be a boon to productivity and therefore growth. There is talk of the U.S. being energy independent within a decade’s time. Housing as well may be experiencing a multiyear revival. In addition, unforeseen productivity breakthroughs may be just over the horizon. How many gloomsters could have forecast the Internet or any other technical breakthrough before it actually happened? Jules Verne we are not.

But if a 2% or lower real growth forecast holds for most of the developed world over the foreseeable future, then it is clear that there will be investment consequences. Shown below, as recently published in a TIME Magazine article by Rana Foroohar, is a PIMCO list of future Picks and Pans based upon these ongoing structural changes:

Picks

· Commodities like Oil and Gold

· U.S. Inflation-Protected Bonds

· High-Quality Municipal Bonds

· Non-Dollar Emerging-Market Stocks

Pans

· Long-Dated Developed-Country Bonds in the U.S., U.K. and Germany

· High-Yield Bonds

· Financial Stocks of Banks and Insurance Companies

The list to a considerable extent reflects the view that emerging economy growth will continue to be higher than that of developed countries. Their debt on average will remain much lower, and their demographic age much younger. In addition, the inevitable policy response of developed economies to slower growth will be to reflate in order to minimize the impact of the aforementioned structural headwinds. If successful, reflationary policies will gradually move 10 to 30-year yields higher over the next several years. The 30-year Treasury hit its secular low of 2.50% in July and such a yield may seem ludicrous a decade hence. Investors should expect future annualized bond returns of 3–4% at best and equity returns only a few percentage points higher.

As John Lennon forewarned, it is getting harder to be someone, and harder to maintain the economic growth that investors have become accustomed to. The New Normal, like Strawberry Fields will “take you down” and lower your expectation of future asset returns. It may not last “forever” but it will be with us for a long, long time.

The Control Engineers and the Notion of Risk

Charles Gave, GaveKal

There is a great movie scene where Harpo and Groucho Marx meet in the “socialist restaurant.” Groucho says, “this food is disgusting and inedible!” To which Harpo replies, “and on top of that, the portions are far too small!” So by the late 1930s and the golden era of the Marx Brothers, it was already obvious that socialism was bad fare in high demand. Yet it took another half century for “scientific socialism” to be finally discredited in rivers of blood, murder and poverty. With the economic disasters wrought by socialism, one might have assumed that policymakers would accept that the future cannot be forecasted. The role of economists, governments and central banks is to promote a stable monetary and legal framework for the risk-takers (entrepreneurs, money managers etc.) to make their decisions as rationally as they could.

Unfortunately this has not happened. Instead, in a new and improved declination of Friedrich Hayek’s "fatal conceit," we seem to be moving away from “scientific socialism”to "scientific capitalism" – where the overconfident and overeducated control-engineers are no longer members of the avant garde of the proletariat, but plain, boring and well-meaning economists working in the entrails of the world central banks. My intent is not to show why these economists will fail (bigger and brighter minds such as Hayek, Mises, Friedman, etc. have already done this) – but rather to review the impact that the misguided manipulation of the price of money (exchange and interest rates) is having on the notion of risk.

In standard financial theory, most practitioners use the volatility of underlying assets as a measure of risk. To some extent, quantitative easing policies have had their biggest impact on this measure. Not only are prices totally artificial for a number of assets (government debt chief amongst them), but the volatility of these prices is also completely meaningless. Volatility no longer indicates the risks involved in holding certain assets, but instead measures the amount of the manipulation that the poor prices are enduring. For example, no-one today could say with a straight face that there is any information in the volatility of the euro-swiss exchange rate, or that this zero volatility adequately measures the risks that a Swiss based investor takes in buying euro-denominated assets.

So as a direct consequence of the manipulations of our well-meaning "control engineers" of market prices, today’s volatility readings have absolutely nothing to do with the underlying risks. From here, it is hard to escape the following conclusions:

· This will lead to the next disaster, for major financial accidents typically find their source in a misconception of risks, rather than a misconception of returns (e.g., Greek bonds are just as risky as German bonds, levered US mortgage bonds are as safe as houses, etc).

· Building a rational portfolio, where risks can be properly hedged, is almost impossible when market signals have disappeared (explaining the recent difficulties of so many macro and CTA hedge funds?).

Staying with the above ideas, consider that all the quantitative models and statistical techniques like “value at risk” will prove to be hopelessly wrong when true volatilities re-emerge (as they always do!). And when that occurs, who doubts that many financial institutions will, once again, find themselves in the line of fire. After all, as Karl Popper explained: "In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable". The sum of the risks in an economic system over time is a constant and the only question confronting economists is whether we should prefer to take our risk in small doses, or in a massive injection (as occurs when a fixed exchange rate system breaks down, or when a debt restructuring happens etc...)?

So in a world of “suppressed volatility,” the only smart thing a long-term investor can do is to buy the assets which have been sold because of their higher volatilities. This obviously is equities, and in particular, the very long duration equities of companies in technology, healthcare, energy, etc. A well-diversified portfolio of such shares will be volatile, but investors will likely see their money back over time and then some.

In fact, strange as it may seem, the only way to reduce the risk today is to own assets that still sport a "market price" – which will thus automatically have a very high volatility compared to the other assets exhibiting a very low, but artificial volatility. To reduce risk today, one has to build a very volatile portfolio! This is partly because a lot of non-volatile assets are extraordinarily risky. For example, I cannot think of more dangerous assets to own today than French or Japanese government bonds. I could easily imagine Groucho looking at a menu of JGBs and OATs and exclaiming, “these assets are terrible and have no yield”, only for Harpo to reply, “and their aren’t enough for everybody.” This last line will change rapidly when reality hits. Because economic history teaches us that no policymaker can control volatility for ever. The real hedge for portfolios today no longer is government fixed income, or even gold, but is instead volatility strategies.

The Problem with Pensions

JohnMauldin — Sat, 07 Aug 2010 01:44:00 GMT

August Surprise from Obama?
The Problem with Pensions
Whither China?

Sadly, I find myself with more than enough time to compose yet another Thoughts from the Frontline in an airport, as a flight booking error has me at JFK for six hours instead of fishing in Maine. Details for those interested or amused at the end. But it does allow me to offer you a peek into a very sobering report on how badly underfunded public pension are. The situation is worse than you think. Then we will close with a eye-opening report on China from the gracious Simon Hunt, who is allowing me to reprint his latest missive in toto. You really want to read this one. And we start with this rumor from Reuters, just in. Read this and weep. It comes from James Pethokoukis.

Political Risk: An August Surprise from Obama?

"Main Street may be about to get its own gigantic bailout. Rumors are running wild from Washington to Wall Street that the Obama administration is about to order government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more than what their homes are worth. An estimated 15 million U.S. mortgages - one in five - are underwater with negative equity of some $800 billion. Recall that on Christmas Eve 2009, the Treasury Department waived a $400 billion limit on financial assistance to Fannie and Freddie, pledging unlimited help. The actual vehicle for the bailout could be the Bush-era Home Affordable Refinance Program, or HARP, a sister program to Obama's loan-modification effort. HARP was just extended through June 30, 2011.

"The move, if it happens, would be a stunning political and economic bombshell, less than 100 days before a midterm election in which Democrats are currently expected to suffer massive, if not historic losses. The key date to watch is August 17, when the Treasury Department holds a much-hyped meeting on the future of Fannie and Freddie."

Normally I blow this type of stuff off. But Pethokoukis is a serious journalist with a solid pedigree and a long list of inside contacts, which you can see at the link below.

I hope this is just a rumor. Seriously. You want to tax renters (about 35% of us) to help pay for mortgages for people who entered knowingly into a business transaction that sadly did not end well? I truly feel sorry for them. I have several very good (and responsible) friends who are in trouble, and I understand the issues. They just bought at the wrong time. But what about my investment in a start-up that failed? People who are behind on credit cards? If you bought a new car, you are underwater the moment you drive the car off the lot. Help for those? Where does it end? Hundreds of billions of debt that our children will have to pay? Say it ain't so, Joe. You can read the whole blog if you have adult beverages or blood-pressure medicine nearby. http://blogs.reuters.com/james-pethokoukis/2010/08/05/an-august-surprise-from-obama/

The Problem with Pensions

A report just out from the Center for Policy Analysis, by Courtney Collins and Andrew J. Rettenmaier (solid academic types from Mercer University and Texas A&M respectively), that indicates that state and local pension funds are drastically underfunded.

I first wrote about public pension problems in 2003, suggesting that pensions would soon be underfunded by $2 trillion, as a long-term secular bear market would dampen returns. Turns out that I am once again proven to be a wild-eyed optimist. Quoting from the executive summary:

"Many state and local government pension plans' liabilities are calculated using discount rates that are not commensurate with the risk they may pose to taxpayers. Accounting standards allow pension funds to calculate their liabilities using a discount rate comparable to the expected rate of return on the funds' assets. This typically high discount rate tends to reduce the size of a pension plan's accrued liabilities. However, pensioners have a durable legal claim to receive their benefits and consequently, it is more appropriate to use a lower discount rate in calculating the plans' accrued liabilities.

"Due to the use of high discount rates, the liabilities of state and local government pension plans are underestimated. For example, recent reports by the Pew Center on the States and others indicate that assets will cover about 85 percent of the pension benefits owed to participants. But other studies that adopted lower discount rates have found liabilities may actually be 75 percent to 86 percent higher than reported. As a result, taxpayers' role as insurer may be much greater than anticipated."

You can read the whole report and see how your state is doing at http://www.ncpa.org/sub/dpd/index.php?Article_ID=19634

Turns out that, by the authors' calculations, state and local pensions are underfunded by $3 trillion (with a T). Of course, some states are much worse off than others. The report has numerous graphs but the following one tells us a lot. It is the unfunded liabilities as a percentage of state GDP.

In the paper (less than 20 pages) they cite the work of Novy-Marx and Rauh and another paper by Biggs. They all use very different methodologies but come up with roughly the same $3 trillion underfunding.

First, understand that in most states the law will not allow for adjustment of pensions. Taxpayers are completely on the hook. That money WILL be found at the expense of either higher taxes or reduced services (such as health care, roads, or police).

Second, the hole is getting deeper each year. Most pensions assume they are going to get an 8% return on their investments. This in a time of a slow economy for years ahead (as I have shown elsewhere), very low bond yields, and a stock market that I think is still in a long-term secular bear market for another 6-7 years, which suggests a continuation of the current sideways, volatile market.

What if instead of getting an 8% return, total returns were 5%? That would mean the hole would be getting deeper by about $75 billion a year. And what if people lived longer, as is clearly the trend, as the actuaries keep changing the longevity tables every few years for the better? (Which for this 60-year old is a very good thing!)

Why use an 8% assumption? Because if you used more conservative numbers, as the academic studies suggest, you would have to make larger current contributions to the pensions, when state and local governments and schools are already in fiscal trouble. So what do the pension plans do? They hire "consultants" who tell them they can expect 8%, as shown by all the nice models and papers that back up their "advice." Note that if you were a consultant who said you should use a 5% discount rate, you would not be hired. Hmmm, where have we seen that phenomenon before?

My friend Paul McCulley (of PIMCO, who I hope to see tonight) quipped that the ratings agencies were supplying fake IDs at a teenage drinking party, when it came to the subprime mortgage ratings. The pension consultants are providing a similar service to their clients, who are told what they want to hear, pay large fees for the privilige, and thereby increase the risk to taxpayers and reduce the current pain for politicians.

This is going to end in tears for many states and municipalities. I mean real tears. Pension funding in some states will be required by law to consume 25-30% or more of tax revenues. That is going to mean much higher taxes or reduced services. I would seriously consider checking how your state and locality are funded. You might not want to retire to a place that is on a collision course with serious pain. Just a thought.

Whither China?

Now let's turn to China. I received this report from Simon Hunt (who is based in London, and who makes my travel schedule look positively pedestrian). Besides being an expert on the copper market he is a serious student of China, travelling there often. He has developed a number of very insider contacts over the years. The more I read Simon, the more I take seriously his analysis. He is very contrarian, but he seems to be getting a lot of things right. So let's see what he has to report back from his latest visit to China.

CHINA VISIT: ECONOMIC REPORT

By Simon Hunt

In all likelihood, China has entered the most critical and taxing period since the country was reopened to the outside world in the 1970s. Domestically, there are a slew of issues, any one of which could create instability. These issues include:

Home affordability
Leadership instability
A potential if not actual housing bubble
The rising income and wealth differential between those who have made it and those who have not
The country's continued dependence on exports as its principal driver of growth
Cheap credit, which punishes savings and encourages investment/speculation
The misallocation of capital that springs from the previous factor
Local/provincial government indebtedness
A new assertiveness and arrogance at all levels
Policy making that focuses on short-termism without addressing structural and longer-term issues, etc.
Impact of rising wages
Energy intensity
Role of foreign companies
Resource dependability - water, raw materials, etc.

The list could go on, but these issues are evolving at a time when the global environment is fraught with difficulties and uncertainty, making policy making within China that much more complex. The infighting within the leadership, which goes beyond the normal tensions that often occur during the period leading up to a change in leadership (due in 2012), is making policy management more difficult and has led to conflicting views being expressed by various factions, in the media.

Few can know the full story of what goes on within the State Council, but there appears to be a battle royal being fought over the real estate sector. There are those within the leadership who are concerned that average home prices have gotten too high for most first-time buyers (see our previous visit report). They want to see average prices fall by 10-20% across the country. Against this group are not just real estate developers but local governments and many others within Beijing. This group, of course, depends for much of their revenue, or in the case of developers, their profits, on rising land and building values. In fact, local governments depend on land sales for one-third of their revenues. In 2009, land sales brought in RMB 1.6 trillion, compared with a total budget income of RMB 3.3 trillion. Moreover, land is the most-used collateral for bank loans; its value is thus crucial to the credit edifice.

Many local governments have not adhered fully to the new restrictions imposed by the central government on the real estate sector. This has infuriated those in Beijing who are determined to encourage a fall in home prices. In effect, what is being seen is a battle between central and local governments. In our view, this is a fight that central government cannot afford to lose.

The scale of speculation in real estate is enormous. There ia a total of 64.5 million apartments and houses lying purchased but vacant in urban China, about five times the surplus in the USA, according to an economist from the Chinese Academy of Social Sciences.

A report written by the National Bureau of Economic Research in July this year provides interesting data on China's housing market. Real housing prices have risen by 140% since the first quarter of 2007. In the first quarter of this year, house prices rose by a record 41%, since when it appears that prices have stabilised but not fallen. Price increases have not been driven by any shortage in housing. In five of the eight markets that the authors of the report studied, the net new number of housing units provided since 1999 was at least as large as the net increase in the number of households. In the three others, the relatively modest gap does not explain the huge rise in home prices.

In Beijing, there has been an almost eight-fold increase in land values since 2003, but since the end of 2007 land prices have nearly tripled. The impact of rising land prices on home and apartment prices has been equally great. From 2003 to 2007, the ratio of land-to-house values hovered between 30% and 40%, but since then it has doubled to just over 60%. The report also found that when a central government state-owned enterprise (SOE) was a winning bidder for land, prices rose by about 27% more than if they had not been involved, thus showing the influence that SOEs bring to bear on land values, an influence that grew in 2009 when they became more active. A separate report shows that so far this year 82% of Beijing's land auctions have been won by SOEs.

Price-to-rent values in Beijing and seven other large markets across the country have increased from 30% to 70% since the start of 2007, and current price-to-rent ratios imply very low user costs of no more than 2-3% of house value. Very high expected capital gains appear necessary to justify such low user costs of owning. The report continues with calculations suggesting that even modest declines in expected appreciation would lead to large price declines of over 40% in markets such as Beijing.

In summary, against a background of cheap money and plenty of credit, house prices across the country have become unaffordable to most first-time buyers. In Beijing, for instance, average house prices have been between 14 and 15 times incomes for the past three years, but rose to 18.5 times in the first quarter of this year. If average home prices do not fall significantly across the country, the risk is that Beijing will be forced to tighten policy another notch. A softening in monetary policy is likely only if average home prices fall within the 10-20% range.

This is what the policy fight is all about, because if these price developments continued unchecked the leadership would risk encountering social instability. Workers everywhere are demanding higher wages. The demands are not just amongst the SMEs and foreign companies, but within the SOEs. We understand that a significant number of SOEs have seen de facto strikes, just not in name. The workers clock in, go to their stations, put down their tools, and clock out without doing any work.

The list of grievances is long, with rising wages being one. How government deals with this situation remains to be seen. We were reminded that in 1989 it was only when the workers joined the students that an explosive situation developed. No one is expecting anything remotely similar, but these developments do illustrate the tensions lying beneath the surface which the leadership is having to grapple with.

Politics in China is all about maintaining social stability. The demographics of the country are forcing the leadership into a new economic model, which will be partially driven by the level of average wages over the coming five years being at least double that of the last five years.

Dr Clint Laurent of Global Demographics has consistently stated that China's statisticians have overstated the country's birth rates since 1990. This implied, as he said in a paper in 2005, that China's labour force would peak at 770 million in 2008, falling to 690 million by 2025. Another major consequence is that the important age group of 20-39 peaked in 2000 at 458 million and by this year will have fallen by 4%.

The consequences of these demographic changes are immense. First, wage inflation will be a given, not just in the private and foreign sectors but amongst the SOEs, as we mentioned earlier. Second, it means that manufacturers will introduce automated machinery to reduce the workforce (the new booming sector) and improve productivity. Third, rising wages lay the foundation for better consumer spending; though households, as in the past, will have to cover the losses racked up by local governments, according to Michael Pettis, a visiting professor in Beijing. Fourth, disposable income in the rural sector is improving. This development, combined with subsidies granted to rural households for buying a range of household appliances, has lifted the demand for these products in rural areas. Nonetheless, it is human nature that when a gift is offered there is a rush to buy, so how long the subsidies will affect sales of appliances is a moot point.

Finally, policy makers know that the time has come when the country's dependence on exports for growth must be replaced by domestically driven growth that focuses on consumer spending and not fixed-asset investment. Local coastal governments, however, will fight to see that exports from their regions continue to drive their own growth; but their success will depend on global trade.

Much of the surge in exports so far this year has been due to the replenishment of inventory within the distribution and sales channels and to the expected increase in export prices out of China. Inventory replenishment has now run its course in Europe and the USA. Given the expected slowing of consumer spending in the US in the second half of this year, some inventory liquidation might actually be seen. Even so, exports from China should weaken sharply by year-end.

The move to de-peg the RMB from the US$ gives Beijing the flexibility to either appreciate or depreciate the currency depending on global conditions. Any appreciation will be modest given the small margins that most exporters enjoy. If our profile of the world economy is even half correct, we should expect to see the RMB depreciate against the US$ and other currencies post-2012.

Wage inflation threatens to feed into general inflation. Food prices remain quite stable overall for now, but there is a risk that they will be rising by year-end. Vegetable prices are rising sharply, according to friends who shop every week. Meat prices are stable for the time being, but wheat prices had risen well above the government's sale price of RMB1800, to over RMB2350, when we last looked. Friends fear that food prices will be rising in the fourth quarter, with some economists predicting that CPI will be increasing at a 5% rate by then. We are told also that the cost of getting an electrician, plumber, etc. in to do odd jobs has doubled over the last year in Beijing and other major cities. Our general take is that China is on the threshold of seeing an overall increase in the cost of living. Whether it shows up in official numbers or not, households will feel it.

A long-term concern is whether China has key resources to maintain the growth profile that the country has experienced over the last 40-odd years. Water may well be a key constraint. China's water-resource capacity is only ¼ of that of the world average. In other words, the country has 20% of the world's population but only 7% of global water resources. The problem is compounded by the dispersion of those resources. The area around the Yangtze River accounts for 36.5% of the country's land mass, but holds 81% of its water. North of the Yangtze River lies 64% of the country's territory, but only 19% of its water resources.

A World Bank report shows that more than half of China's 660 cities suffer from water shortages; and 90% of cities' groundwater and 75% of their lakes and rivers are polluted. These are examples of the physical constraints on growth. China's rapid pace of industrialisation has left the country with severe burdens and a massive clean-up, not just in urban areas but throughout the countryside. Water is a global depreciating resource, as William Houston and Robin Griffiths showed in their book Water: The Final Resource. History also shows that wars are fought over access to water.

Local government indebtedness is being exposed as a potential time-bomb, as one friend remarked to the writer. Whatever the correct figure, it is large and is in the range of RMB6 trillion to RMB11.4 trillion, equivalent to 71% of the country's nominal GDP. Some reports suggest that banks will have difficulty recouping about 23% of what they have loaned out. The China Banking Regulatory Commission has told banks to write off nonperforming project loans by the end of this year.

No one should be surprised by these numbers. Back last October we were told - and we reported - that one-third of the fiscal stimulus and bank lending never went into the real economy. There are likely to be more hidden black holes. One consequence is that credit is tight, with receivables mounting across a wide swath of manufacturing.

Markets will sense some of these uncertainties. In line with falling global equity markets, which should start very soon, the Shanghai and other Chinese stock markets are likely to fall sharply by year-end. This will take the stuffing out of consumers' willingness to buy large-ticket items like cars and appliances. Already, so we hear, inventories of these items are growing within the distribution systems, with production levels likely to fall over coming months.

Many companies believe that the weakness now being seen is seasonal. But others, whose opinions we respect, believe that weakness will be seen at least until year-end. Prices of raw materials, semi-fabricated products, and finished goods are likely to start falling very soon. Instead of accumulating inventory, stocks within the entire manufacturing and distribution systems will be slashed, repeating to a lesser degree what occurred in the second half of 2008. Construction activity will continue to slow, notwithstanding the continued high rate of completions, consumer spending will slow also, exports will be weak in the fourth quarter, and growth of fixed-asset investment will be lower. By year-end, the psychology of businessmen and consumers will have shifted from optimism towards pessimism in line with movements in the Shanghai stock market. Real business activity will be pretty flat in the fourth quarter. The latest PMIs from the Government's Logistical Office and from the HSBC both indicate a slowing economy. The former is geared more to the SOEs and the latter to the private sector. The HSBC sub-index of new orders fell from 49.7 in June to 47.9 in July.

In summary, we doubt there will be any easing of policy until average house prices fall into the 10-20% range. China is transiting into a very difficult period as focus shifts towards sustainable domestic growth and away from short-term measures to defend the 8% GDP mantra. This transition is occurring when the existing leadership is preparing to give way to the new set in 2012, when social stability could be threatened if there are policy mistakes, when the rest of the world is starting to stand up to China's increasing assertiveness, and when foreign companies are questioning their future in China. China will muddle through, but it won't be an easy ride.

Maine, Bloomberg, and Europe

I sit in a very hard plastic seat at JFK in New York. This is not in the plan I had. Trey and I arrived early at La Guardia to get our morning flight to Bangor at 9:30 am. The baggage man had a little trouble checking us in, then told us our tickets were for 9:30 that night. That couldn't be true. But it was. And there were no seats on any other plane to Bangor. The only option was to go to JFK and take a Jet Blue flight to Portland and drive for five hours, instead of catching the usual float plane.

Trey took it like a trooper. This is our 5th trip to Maine for the Shadow Fed fishing camp (Camp Kotok), and it seems that every time something has gone wrong with the flights. This is not even the worst. Trey has come to expect problems. Normally I have great luck, but when changing from American things just seem to happen.

Update: Now in Maine. Jet Blue lost my luggage. But 24 hours later they found it and they are being stand-up guys and delivering it 226 miles away. Stuff happens, but it is nice when a company does the right thing.

The fishing was great today. Trey and I caught 35 fish, and he leads 18-17. But hopefully tonight I get my special electronic lure and can break out tomorrow. Great weather. And better company. The camaraderie with a lot of guys who have been doing this is one of life's true pleasures. Too many friends to mention.

Sadly, you won't get to see any of it because Bloomberg decided at literally the last minute not to broadcast, after spending a boatload of money on a monster remote truck and sending a full crew (who are very nice men and women). Go figure

Oh, and non-farm payrolls was boring, if disappointing. This is not an economy with any spark. I am quite intrigued by the fact that the group of economists assembled here, who hold very diverse political and economic views, are quite concerned and think we should extend the Bush tax cuts for a year or at least until the economy is back on track. Today's employment numbers certainly will add to that sentiment.

It's time to hit the send button. There is a lobster calling my name. Have a great week.

Your just grateful for life analyst,

John Mauldin

The dollar holds on..

ChuckButler — Mon, 08 Feb 2010 14:42:14 GMT

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......................................................
In This Issue..

* The Dollar holds on...
* Pimco is buying Brazilian bonds...
* Surprising data from the Economist...
* Chuck's thoughts from Orlando...

And Now... Today's Pfennig!

The dollar holds on..

Good day... Chuck spent an extra day in Florida, so he stayed home to recuperate today. I made it home Saturday night, and was a bit shocked by all of the ice and snow which covered my truck at the airport. I heard so much about the winter storm which rocked the east coast that I forgot to check the weather here at home. I am a bit behind this morning, as I stayed up a bit celebrating the Saints victory with friends.

The dollar bulls were celebrating again on Friday, as the dollar rally continued. The recent strength in the US$ will probably continue this week, as it looks like it will be fairly uneventful as far as data releases. We won't have any reports out in the US today, and tomorrow will only bring the wholesale inventory number. Wednesday we will see December's trade balance along with the monthly budget statement for January. Both of these numbers will likely reflect an ever-growing deficit here in the US, with a 50 billion dollar monthly budget deficit, and a trade deficit just below 35 billion.

Thursday we are scheduled to see the retail sales numbers for January along with the weekly jobs data. And on Friday the only piece of data we will get is the U of Michigan confidence number which is expected to show a slight improvement. So with no 'major' reports scheduled for the week, the dollar will likely stay in a fairly tight range.

Only three currencies managed to move higher vs. the dollar Friday, the South African rand, Canadian dollar, and Norwegian krone. These are all commodity currencies; and will continue to benefit from a stronger global economy. The rally of the South African rand was helped by a statement by one of their central bank members who suggested the South African economy was basically unaffected by the global recession. South African Central Bank Deputy Governor Xolile Guma suggested that rates may be heading higher in South Africa, as further stimulus measures weren't needed.

Another commodity based currency, the Brazilian real managed to hold steady vs. the US$ on Friday, and is beginning to move higher in European trading. I read a news story this morning which suggested Brazil's biggest banks are betting on interest rate increases by mid March. The Brazilian central bank will be meeting on March 17th, and many now believe it will become the first Latin American country to raise rates. If rates do move higher in March, it will be the first increase since September of 2008. An interest rate increase will make it very hard for the government to keep a lid on the appreciation of the Brazilian real.

Higher interest rates are one of the reasons Pimco's co-chief investment officer El-Erian has been suggesting investments in Brazil. El-Erian has been trumpeting Brazilian bonds as one of his top picks for 2010. Interest in these bonds is heavy, as they were one of the top topics of conversation among investors at the Orlando Money Show. Chuck mentioned them in a couple of his presentations, and attendees were eager to learn more about these short term bonds with pretty good yields. I know the phones were busy on the desk Friday, and many of these calls were probably people wanting to talk to Don Ries regarding these short term Brazilian bonds. If you are interested, just call the desk and Don will give you the details, but please be patient, the yields on these bonds shouldn't be falling dramatically over the next few days.

I got a chance to do some research on the flight home from Orlando, and was surprised by some economic data which I ran across in the Economist magazine. As you all are aware, the debt problems in Greece has really gripped the markets lately. The mainstream news media has, in my opinion, blown this whole Greece thing way out of proportion. Chuck continues to try and explain how the problems in Greece are no more of a threat to the EU than the problems in California are to the US (more thoughts on this from Chuck in a second). But back to the data which was a real eye opener for me on the plane.

The Economist magazine had a chart which compared economic data for over 50 developed countries. Which country do think had the worst budget balance as a % of GDP in 2009? Greece? Spain? No, it was the UK!! Yes, Britain's budget deficit was 14.2% of their GDP in 2009 according to the Economist. This compares to Greece which had a budget deficit of 13% of GDP, and Spain which ran a deficit of 11.8% of GDP in 2009. The combined Euro area had a budget deficit of just 6.9% of GDP, but from all of the media hype you would think the debt problems with the PIGS was so massive that a default was all but guaranteed. The data shows that investors should be more concerned about the debt levels in the UK than those in Greece or Spain!

And do you know the only other country which reported a double digit budget deficit as a % of GDP for 2009? It was the US which ran a deficit equaling 10% of GDP in 2009. Yes, the US is one of only 4 countries with a double digit deficit. Even Venezuela had a better deficit number than the US. But you won't read much about it in the press, they are too busy concentrating on the destruction of the Euro and the problems with the PIGS.

As I mentioned earlier, Chuck had to spend an extra night down in Florida and he sent me these thoughts to share with readers this morning:

"Chris...
Here I am in my hotel room, Saturday night. The Money Show ended today, with my last presentation only drawing about 50 people, in a HUGE room... It really made me re-think my decision to stay the extra day to do that presentation! For, here I am, everyone else has gone home, and I'm left to my thoughts... Uh-Oh, I hear you saying... And you should! For I am going on a long diatribe to discuss what I feel to be one of the gross misunderstandings by people, investors, markets... EVER!

Oh, sure, this misunderstanding I'm talking about would have to be quite the misunderstanding to be greater than: The Tech Bubble, The Housing Bubble, The raping and pillaging of our hard earned money with Unconstitutional taxes, and so on... So, maybe, I'll have to pull that statement back a notch or two!

The misunderstanding I'm talking about here is the complete ignorance of what is going on in this country, and why one country gets knocked around for having problems that are miniscule when compared to the other country that gets rewarded!

First... I'm going to quote my friend, David Galland, regarding deficits...

"One stark and sobering way to frame the crisis is this: if the United States government were to nationalize (in other words, steal) every penny of private wealth accumulated by America's citizens since the nation's founding 235 years ago, the government would remain totally bankrupt.

And this.

Furthermore, with the budgetary equivalent of a straight face, the Office of Management and Budget reports in its long-term, inter-generational budget projection that the United States government will experience massive, non-stop deficits for the next 70 (SEVENTY) years, requiring the issuance of tens of trillions of dollars of additional debt. The OMB does not project even one year of surplus during the entire seventy year budget period."

Now... I'll quote Bloomberg.com...

"Jan. 20 (Bloomberg) -- Everyone seems to know the current path of federal fiscal policy is a deathtrap over the long term. What's peculiar is the relative inattention to the balance sheets of state and local governments.

Hidden behind accounting fictions, the politically unspeakable reality is that public employee pension systems are under-funded by more than $2 trillion. Add more than $1 trillion in unfunded health-care benefits for retired public employees, and state governments face protracted structural deficits ranging from challenging to insurmountable."

So... Now we know that the deficit path we are on, is NOT going to change... And that the states in the U.S. are in deep dookie!

And that brings me to the trade that has been going on for two months now, regarding investors all over the world, punishing the euro, for the problems of the states called Portugal, Italy, Greece, and Spain, or... The so-called PIGS! The Euro-state that most investors point to is Greece... Which, as I told you on Friday, accounts for 2% of the Euro-zone's total GDP....

A friend of mine, at THE Business newspaper of the world, sent me a note on Friday, and said "Hey, Chuck ... was just reading today's Pfennig and saw your comment about the size of Greece compared to EU, and the size of Calif compared to the US.
Did a bit of research for you and .... Calif's economy is about $1.6 Trillion (as of Jan 2007), according to US Dept of Commerce. US economy, according to CIA fact book, is about $14.25 trillion on 2009 estimates.
Thus, Calif is about 11% of the US economy - roughly speaking, given that the dates are slightly mismatched, and who knows how accurate these Gov't organizations are.
But any event, it's clearly much bigger than Greece's impact on the EU."

So... California, which I would consider to be bankrupt, I mean for crying out loud, the state sent IOU's to people last year instead of cash for their tax returns, is 11% of the U.S. problem... But we have to add to that, the research we went through above... The states of New York, Michigan, Illinois, and so on! This is a debt debacle folks!

Now... I'm not saying that the PIGS problem isn't a big deal... It is! But bigger than the U.S. problem? NO!

So... The dollar should not be rewarded... And neither should the euro... But the problem here is that these are the two most liquid currencies in the world... So, the normal trade is the sell one, and buy the other, as they are the offset currencies to each other... So... I would think that you would take the lesser of two evils, don't you?

OR... If that doesn't float your boat, you probably are eligible to join the legions of people that are finding that Gold is the best replacement for either!

Thank you for your time this time till next time... "

I always appreciate it when Chuck sends me his thoughts; he asks me to phill in for him, but then ends up writing most of the pfennig for me anyway! I think he is bang on with his thoughts on the misdirection the administration and the media is pushing on the US citizens. They have used the problems with the PIGS to try and take our attention away from those right here at home. So far they have been successful, but double digit budget deficits in the UK and US will eventually force us to stand up and take notice. The administrations of the UK and US will eventually have to deal with these budget problems, and their currencies will be taken to the woodshed just as the Euro has been taken down recently.

So on to the currency wrap-up...

Currencies today 2/8/10: American Style: A$ .8660, kiwi .6873, C$ .9347, euro 1.3652, sterling 1.5555, Swiss .9308, European Style: rand 7.765, krone 5.987, SEK 7.4486, forint 200.16, zloty 2.9964, koruna 19.13, RUB 30.54, yen 89.29, sing 1.4226, HKD 7.7705, INR 46.81, China 6.8266, pesos 13.21, BRL 1.8803, dollar index 80.28, Oil $71.22, 10-year 3.56%, Silver $15.08, and Gold... $1,066.19

That's it for today... WHO DAT?? What a game last night. I spent the evening at a friends house, watching the Super bowl and imbibing in a bit too much food and beverages. As happens more and more, a couple of folks came over to let me know they are Pfennig readers and proud EverBankers! Like Chuck, I really didn't care which team came out as the winner which made it fun to watch. Congratulations to all the Saints fans, it looked like a Fat Tuesday down in the French Quarter. The game was certainly entertaining, and the commercials were no match for the excitement on the field, which is the way it is supposed to be. We are supposed to get a few more inches of snow today, and some heavier stuff tonight; so Chuck will have a challenge getting in tomorrow morning; but he drives a big heavy SUV so my money is on him getting in just fine. Hope everyone has a good start to your week, and a Marvelous Monday!

Chris Gaffney, CFA
Vice President
EverBank World Markets
1-800-926-4922
1-314-647-3837

If PIIGS Could Fly

JohnMauldin — Tue, 02 Feb 2010 15:45:00 GMT

I wrote about Greece in last week's letter. Then I ran across this column in the Financial Times by my friend Mohammed El-Erian, chief executive of Pimco, and someone who qualifies to be introduced as one of the smartest men on the planet. It is short and to the point. (www.pimco.com)

Then, somehow my London partner, Niels Jensen of Absolute Return Partners found the time to write a letter while we were running around Europe. As we had a lot of conversations with some very key players, and a lot of debate, the letter reflects a lot of what we learned, as well as further documents the serious straits that European nations face in the coming years due to their debt and deficits. It is not just a US or Japanese problem. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

And finally, many of you are probably familiar with TED Talks. If you are not, you should be. They basically get very smart, creative people to come in and do short talks Tiffani just sent me one of their latest videos. 13 minutes. It blew me away. The world of Minority Report is here, 40 years ahead of schedule. All I could do was just say "Wow!" Its young men like this that should make us all optimists that somehow we will figure out how to get through all this. http://www.ted.com/talks/view/id/685

John Mauldin, Editor
Outside the Box

Greece part of unfolding sovereign debt story

By Mohamed El-Erian

Global investors worldwide are starting to pay more attention to what is unfolding in Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a few months ago.

With time, they will see Greece as part of a much larger investment theme that is a direct outcome of the global financial crisis: the 2008-09 ballooning of sovereign balance sheets in advanced economies is consequential and is becoming an important influence on valuations in many markets around the world.

As realisation spreads of this key sovereign investment theme, it is important to be clear about what Greece is, and what it is not.

At the simplest level, think of Greece as Europe's big game of chicken, with the operational question for markets being two-fold: who will blink first, the Greek authorities, donors or both; and will they blink in time to avoid truly disorderly debt and market dynamics that also entail significant contagion risk.

Let us start with Greece where, under any realistic scenario, a meaningful internal adjustment is needed.

There is no solution to the country's debt issues without a deep and sustained policy effort. Yet, given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient.

If unaccompanied by extraordinary external assistance, it would entail such contractionary fiscal measures as to raise legitimate socio-political problems.

External assistance is needed to support the meaningful implementation of internal policies. And it has to be consequential in scale and durability, as well as timely and well-targeted.

Understandably, such assistance faces headwinds on account of donors' moral hazard concerns (vis-à-vis Greece and beyond); of donors' understanding that a Greek bail-out would not be a one-shot deal; and of donors' own domestic budgetary considerations.

Because of this, I suspect that at least three of the following four conditions are needed to force the hand of European donors, and that is assuming that Greece provides them at least with the fig leaf of commitment to meaningful internal policy actions.

First, evidence that Greek markets are being severely impacted by funding concerns. With the recent surge in borrowing costs and the disruptions in the normal functioning of government and corporate markets, this condition is clearly already met.
Second, evidence that other peripherals in Europe – such as Ireland, Italy, Portugal and Spain – are also being impacted. This is happening, as signalled by the gradual widening in market risk spreads.
Third, evidence that other providers of capital are sharing the burden of financing Greece. Tuesday's €8bn bond issuance to private creditors is consistent with this.
Fourth, evidence that the Greek financial disruptions are starting to undermine core European countries. Evidence here is limited to the weakening of the euro, which, as yet, cannot be viewed as disruptive (indeed, some view it as helpful for Europe).

Notwithstanding this last condition, we are much closer today to the point where donors' hands will be forced. Yet investors should remain wary, as this would offer, at best, only a short-term tactical opportunity. Greater clarity as to what Greece can deliver in internal adjustment should remain the primary driver for long-term investment opportunities.

Investors should also remember that "market technicals" remain tricky and now constitute a meaningful marginal price setter. The shift in the investment characterisation of Greece, from being primarily an interest rate exposure to a credit exposure, has happened in such a way as to allow for little orderly repositioning. Many investors are trapped and the phenomenon has been accentuated by the recent evaporation of market liquidity.

Where does all this leave us?

Over the next few days, we are likely to get some combination of Greek and European donor announcements aimed at calming markets, reducing volatility, and reducing contagion risk. But the impact on markets is unlikely to be sustained as both sides face multi-round, protracted challenges which contain all the elements of complex game dynamics.

No matter how you view it, markets in Greece will remain volatile and more global investors will be paying attention. In the process, this will accelerate the more general recognition that sovereign balance sheets in many advanced economies are now in play when it comes to broad portfolio positioning considerations.

And now to Niels Jensen's piece.

If PIIGS Could Fly

By Niels Jensen

The Absolute Return Letter - February 2010

"A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy..."

Alexander Fraser Tytler, Scottish lawyer and writer, 1770

Travelling with John Mauldin

It was always naïve to believe that a crisis so deep and profound was going to go away with a whimper; however, an increase of more than 50% in global equity prices can be very seductive, and nine months of virtually uninterrupted gains have led many to believe that the problems of 2008-09 are now largely behind us.

Well, not quite everybody. Friend and business partner John Mauldin remains a sceptic. I have had the pleasure of travelling across Europe with John over the past week or so and, as the week progressed, my mood swung decisively towards a state where Prozac would probably be the most appropriate remedy.

Now, John and I do not agree on absolutely everything. For example, I believe – and have believed for a while – that he is too bearish on equities. But, before we go there, allow me to share with you the essence of John's views which can be summed up quite nicely by two charts, courtesy of BCA Research.

In John's opinion – and I do not disagree – we are still only in the second or third innings of the de-leveraging process (chart 1). Years of excessive debt accumulation cannot be reversed in 18 months, and it will take at least another 5-6 years to play out, possibly longer.

The other part of John's argument – and again it is hard to disagree – is that it remains an open question how much de-leveraging has in fact taken place. As you can see from chart 2, US sovereign debt has risen as fast as private debt has declined (and the picture is similar in many other countries), providing support for the argument that all we have achieved so far is to move liabilities from private to public balance sheets, effectively burdening tomorrow's taxpayer.

The basket case named Greece

In the last few days, developments in Greece have totally overshadowed other events. As I write these lines, the 10-year Greek government bond trades a shade under 7%, now yielding a whopping 370 basis points more than the corresponding Bunds. At the same time, and not at all surprisingly, Greek credit default swaps – measuring the cost of insurance against a Greek sovereign default – have exploded (chart 3).

When I was in Zurich with John last week, I bumped into the famous Swiss investor, Felix Zulauf, who pointed out to me that Greece has in fact been in default in 105 of the last 200 years, so never say never. Having said that, Greece cannot be allowed to default, as the implications would be catastrophic. Bond investors would immediately pick apart the next country in line, and it is almost certainly going to be one of the other PIIGS – Portugal, Italy, Ireland or Spain. Bailing out Greece is just about manageable, but having to save all of them would overwhelm the EU. Swift action must therefore be taken, moral hazard or not.

Back in early January, the research team at Danske Bank in Copenhagen produced a most interesting research paper[1], revealing how desperate the fiscal outlook is for many EU members. Table 1 illustrates the path of debt-to-GDP between now and 2020, assuming no change to current policy.

Now, we all know what cannot happen, will not happen. There is a reason the EU, via its stability pact, set the debt-to-GDP ceiling at 60% for its euro zone members. Obviously, with the low interest rates we currently enjoy, one could argue that a higher debt-to-GDP ratio could be sustained, and that is essentially correct as long as interest rates remain low; however, you leave yourself seriously exposed, should rates rise which they almost certainly will as sovereign debt increasingly becomes junk. .

Danske Bank then went one step further in its analysis. In order to illustrate the magnitude of the problem, they calculated how aggressive the fiscal tightening would have to be in order for the euro zone member states to comply with the stability pact by 2020. Table 2 below indicates how much the deficit must be reduced every year for the next five years in order to bring debt-to-GDP to 60% by 2020. Greece, being in the most precarious position, would need to shave 4% off its budget every year. We all know that is not going to happen because that would spell depression.

In the short term, Greece needs to find over €50 billion before the end of the year to refinance debt which is about to mature. The question is not so much whether it will fail in its endeavour but what price it will have to pay. An already fragile Greek fiscal situation could be further undermined, if Greece is forced to pay 7% going forward which it can hardly afford.

Is Spain next?

Towards the end of last week it became apparent that there might be some appetite for rescuing Greece, although few details are currently available. However, I am not convinced that there is a strong consensus in favour of a rescue package. Most of the positive vibes have come from Spain, whereas Germany and France have been decidedly less forthcoming. It is perhaps not surprising that it is the Spanish who seem most eager to bail Greece out, considering that they could very well be the next victim of the bond market's invisible hand.

In the last few days, Spain has gone out of its way to demonstrate its commitment to greater fiscal discipline in general and to the stability pact in particular. The government has just proposed for the retirement age to be increased from 65 to 67 (to be introduced gradually from 2013), and a fiscal programme designed to reduce the annual deficit to 3% of GDP by 2013 has been presented. The problem for Spain is that words are cheap. Few commentators believe that 3% is a realistic target given the depth of Spain's problems at the moment. Don't hold your breath.

The outlook is very grim

The outlook goes from murky to unbelievably grim, if one includes off-balance sheet items such as social security, pension and health liabilities, which have been promised to us over the years by well meaning but financially inept governments (see chart 4). As Societe Generale's Dylan Grice puts it:

"I don't see how our governments can pay these liabilities. EU and US net liabilities add up to around $135 trillion alone. That is four times the capitalization of Datastream's World equity index of about $36 trillion, and forty times the cost of the 2008 financial crisis."[2].

I also note that Greece, not included in the chart, stands at 875% debt-to-GDP when including off-balance sheet items!

The bond market will ultimately determine when enough is enough. As President Clinton's campaign strategist James Carville once put it:

"I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."

It can play out in a couple of different ways. Either bond investors will go on strike until they feel that they are being sufficiently rewarded for the higher risk associated with sovereign debt following the credit crunch or governments will implement budget curtailments designed to bring the debt escalation under control again, but that will be detrimental to economic growth. My bet is that the latter outcome will ultimately prevail but not until the bond market forces the hand of our governments.

The end game for Japan?

The first country to really feel the pinch could very well be Japan; in the bigger context, Greece is just the appetizer. Japan's debt-to-GDP ratio has grown from 65% in the early 1990s when their crisis began in earnest to over 200% now. Fortunately for Japan, the high savings rate has allowed shifting governments to finance the deficit internally with about 93% of all JGBs held domestically[3]. This is the key reason why Japan gets away with paying only 1.3% on their 10-year bonds when other large OECD countries must pay 3-4% to attract investors.

Now, predicting the demise of Japan has cost many a career over the years. Despite the ever rising debt, and contrary to many expert opinions, the yen has been rock solid and bond yields have remained comparatively low. I often hear the argument from the bulls that the Japanese situation is sustainable because they, unlike us, are a nation of savers. Wrong. They were a nation of savers.

Looking at chart 5, it is evident that the demographic tsunami has finally hit Japan. The savings rate is in a structural decline and the Ministry of Finance in Tokyo may soon be forced to go to international capital markets to fund their deficits. I very much doubt that non-Japanese investors will be as forgiving as the Japanese, and that could force bond yields in Japan in line with US and German yields. Herein lies the challenge. Japan already spends 35% of its pre-bond issuance revenues on servicing its debt. If the Japanese were forced to fund themselves at 3.5% instead of 1.3%, the game would soon be up.

Why stock markets go up

Despite the grim outlook, the world's stock markets have produced brilliant returns over the past nine months. This has provoked some of the best and brightest in our industry (most recently Mohamed El-Erian, CEO of Pimco[4]) to declare that there is a dis-connect between the economic reality and the picture painted by Wall Street.

I am not convinced. Firstly, global equities reached extremely depressed levels back in February 2009, and the recovery, however muted it may ultimately turn out to be, has stopped the bleeding in most large companies, giving investors an excuse to accumulate stocks again (smaller companies is a different story altogether, but that is a story for another day). What matters to the likes of Coca Cola, Rolls Royce and Volkswagen is not so much how the domestic economy performs, because the leading lights of industry today are becoming increasingly detached from the domestic economy. Ever more important to those companies is the global stage, and the global outlook is considerably more upbeat than, say, the US, UK or German growth prospects.

Secondly, equities usually do very well in the very late stages of recession and early stages of recovery. I refer to our July 2006 Absolute Return Letter for an in-depth analysis of this, which you can find here.

Thirdly, valuations are not prohibitively high. Many bears refer to the stock market (whether European or US) as being very expensive at current levels, but that is plainly untrue. Based on 2010 projected earnings, most OECD markets are either in line with or 10-20% below historical averages (see table 3). Only in emerging markets can you reasonably argue that current P/E levels are not cheap relative to the long term average.

In 2009 there have been massive flows of capital towards emerging markets – and towards Asia in particular – and valuations have been driven up as a result. It is hard to argue that those markets are yet in bubble territory, if one uses the valuations in table 3 as a benchmark; however, by pegging their currencies to the US dollar, Asian countries have effectively adopted a monetary policy which is entirely unsuitable for economies growing as fast as they do. That is how bubbles have been created in the past and why Asian equity markets should be monitored closely for signs of overheating in the months to come.

Conclusion

Summing it all up, the fate of global equity markets is very much in the hands of bond investors. Under normal circumstances, this is the best time to be in equities. But these times are not normal, so do not expect that the outstanding performance of 2009 will be repeated in 2010. If international bond markets calm down again – and that may happen, at least temporarily – equities can probably post further (but modest) gains in 2010; however, the end game is approaching. If bond investors do not revolt in 2010, they probably will in 2011, so playing the economic recovery through equities is a dangerous game.

As far as the bond market is concerned, as often pointed out by Martin Barnes at BCA Research, if you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before. As John Mauldin puts it, we are operating on the patient without anaesthesia.

The big challenge will be to get the timing right. These situations can run for longer than most people imagine. Japan's crisis has been widely predicted for almost a decade now, and the ship appears to be as steady as ever. As I suggested earlier, the key to predicting the timing of Japan's demise – because there will be one – may very well be embedded in the savings rate, which could quite possibly turn negative in the next few years.

The Dubai crisis taught us that markets are in a forgiving mode at the moment and, before long, Greece could very well find some respite from its current problems. But then again, ultimately, governments will find – just like millions of households have found over the years – that you cannot spend more then you earn in perpetuity. The enormous debt levels being created at the moment will haunt us for many years to come and we may have to wait a long time to see the PIIGS fly again.

Footnotes:

[1] 'Debt on a dangerous path', 4^th January, 2010, by Danske Bank. You can find the entire report here.

[2] 'Popular Delusions', Societe Generale, 12^th November, 2009

[3] Source: http://econompicdata.blogspot.com/2009/12/real-lost-decade-japanese-gdp-edition.html

[4] Source: http://www.investmentpostcards.com/2010/01/16/el-erian-markets-not-facing-reality-of-slow-economy/

Should the Fed be Responsibly Irresponsible?

JohnMauldin — Mon, 20 Jul 2009 20:44:00 GMT

This week I offer two short essays for your reading pleasure in Outside the Box. The first is from Ambrose Evans-Pritchard writing in the London Telegraph. He gives some more specifics about the situation in Europe I wrote about this weekend.

He ends with the following sober quote: "My awful fear is that we will do exactly the opposite, incubating yet another crisis this autumn, to which we will respond with yet further spending. This is the road to ruin." This is a must read.

And the second piece? Last week in Outside the Box we looked at an "Austrian" (economic) view of the inflation/deflation debate from my friends at Hoisington. This week we look at the 180 degree opposite with Keynesian aficionado Paul McCulley, who argues that the Fed should be Responsibly Irresponsible and target higher inflation. This essay has brought some rather heated arguments in print and from some of the people who will be with Paul and me at the annual Maine fishing trip. And you can bet I will put them all together with a little wine to see how the argument ensues. I will report back.

And Paul ends with a great and what is a quite controversial line, "Yes, as Bernanke intoned, there are no free lunches. But no lunch doesn't work for me. Or the American people. While it is true, as Keynes intoned, that we are all dead in the long run, I see no reason to die young from orthodoxy-imposed anorexia."

And finally, this one last note on European banks: "European banks including Societe Generale SA and BNP Paribas SA hold almost $200 billion in guarantees sold by New York-based AIG allowing the lenders to reduce the capital required for loss reserves." (Bloomberg). Want to think about the US taxpayer paying to bail out Europeans banks? Think that might be a tad controversial? This could be explosive.

John Mauldin, Editor
Outside the Box

Fiscal ruin of the Western world beckons

By Ambrose Evans-Pritchard

For a glimpse of what awaits Britain, Europe, and America as budget deficits spiral to war-time levels, look at what is happening to the Irish welfare state.

Events have already forced Premier Brian Cowen to carry out the harshest assault yet seen on the public services of a modern Western state. He has passed two emergency budgets to stop the deficit soaring to 15pc of GDP. They have not been enough. The expert An Bord Snip report said last week that Dublin must cut deeper, or risk a disastrous debt compound trap.

A further 17,000 state jobs must go (equal to 1.25m in the US), though unemployment is already 12pc and heading for 16pc next year.

Education must be cut 8pc. Scores of rural schools must close, and 6,900 teachers must go....Nobody is spared. Social welfare payments must be cut 5pc, child benefit by 20pc. The Garda (police), already smarting from a 7pc pay cut, may have to buy their own uniforms. Hospital visits could cost £107 a day, etc, etc....

No doubt Ireland has been the victim of a savagely tight monetary policy – given its specific needs. But the deeper truth is that Britain, Spain, France, Germany, Italy, the US, and Japan are in varying states of fiscal ruin, and those tipping into demographic decline (unlike young Ireland) have an underlying cancer that is even more deadly. The West cannot support its gold-plated state structures from an aging workforce and depleted tax base.

As the International Monetary Fund made clear last week, Britain is lucky that markets have not yet imposed a "penalty interest" on British Gilts, given the trajectory of UK national debt – now vaulting towards 100pc of GDP – and the scandalous refusal of this Government to map out any path back to solvency.

"The UK has been getting the benefit of the doubt, both in the Government bond market and also the foreign exchange market. This benefit of the doubt is not going to last forever," said the Fund.

France and Italy have been less abject, but they began with higher borrowing needs. Italy's debt is expected to reach the danger level of 120pc next year, according to leaked Treasury documents. France's debt will near 90pc next year if President Nicolas Sarkozy goes ahead with his "Grand Emprunt", a fiscal blitz masquerading as investment.

There was a case for an emergency boost last winter to cushion the blow as global industry crashed. That moment has passed. While I agree with Nomura's Richard Koo that the US, Britain, and Europe risk a deflationary slump along the lines of Japan's Lost Decade (two decades really), I am ever more wary of his calls for Keynesian spending a l'outrance.

Such policies have crippled Japan. A string of make-work stimulus plans – famously building bridges to nowhere in Hokkaido e_SEmD has ensured that the day of reckoning will be worse, when it comes. The IMF says Japan's gross public debt will reach 240pc of GDP by 2014 e_SEmD beyond the point of recovery for a nation with a contracting workforce. Sooner or later, Japan's bond market will blow up.

Error One was to permit a bubble in the 1980s. Error Two was to wait a decade before opting for monetary "shock and awe" through quantitative easing.

The US Federal Reserve has moved faster but already seems to think the job is done. "Quantitative tightening" has begun. Its balance sheet has contracted by almost $200bn (£122bn) from the peak. The M2 money supply has stagnated since January. The Fed is talking of "exit strategies".

Is this a replay of mid-2008 when the Fed lost its nerve, bristling over criticism that it had cut rates too low (then 2pc)? Remember what happened. Fed hawks in Dallas, St Louis, and Atlanta talked of rate rises. That had consequences. Markets tightened in anticipation, and arguably triggered the collapse of Lehman Brothers, AIG, Fannie and Freddie that autumn.

The Fed's doctrine – New Keynesian Synthesis – has let it down time and again in this long saga, and there is scant evidence that Fed officials recognise the fact. As for the European Central Bank, it has let private loan growth contract this summer.
The imperative for the debt-bloated West is to cut spending systematically for year after year, off-setting the deflationary effect with monetary stimulus. This is the only mix that can save us.

My awful fear is that we will do exactly the opposite, incubating yet another crisis this autumn, to which we will respond with yet further spending. This is the road to ruin.

What If?

By Paul McCulley, Managing Director, PIMCO

The whole world, it seems, is wrapped around the axle about exit strategies from putatively unsustainable policies: (1) the Fed's bloated balance sheet, with some $800 billion of excess reserves sloshing 'round the banking system, in the context of an effective zero Fed funds rate; and (2) the Treasury's huge budget deficit, unprecedented in peace time and set to stay huge, implying a Treasury debt/GDP ratio approaching 100% within a decade's time.

For some, usually with Monetarist roots, this combination of policies is a classic brew for a major bout of inflation (eventually, it is always stressed). For others, usually with Austrian tendencies, this policy brew is a deflationary force, as it will provoke foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment. And, I'm quite sure, there are some with a foot in both camps.

So it's not easy to actually define conventional, or consensus, wisdom. In fact, many of my Keynesian brethren seem to be struggling with what to do, arguing against any further near-term fiscal stimulus, or at least unless enacted simultaneously with long-term fiscal restraint. Indeed, I recently publicly uttered something along these lines, though I hedged myself by saying long-term fiscal responsibility rather than restraint (responsibility is in the eye of the beholder, while restraint is more categorical).

In any event, there does not seem to be any serious consensus as to how the policy mix should be adjusted, if at all, despite clear and present evidence of massive unemployment and underemployment, which is putting downward pressure on nominal personal income (the product of fewer jobs, fewer hours and decelerating wages, almost to the zero line). This is not the stuff of a self-sustaining revival in aggregate demand. Thus, my tentative conclusion is that maybe the consensus professional economist view is that America should simply accept that it's going to have its version of Japan's lost decade, the Calvinist aftermath of the preceding sin of booming growth on the back of ever-increasing leverage and mal-investment.

But if that sobering view is indeed the new consensus, shame on my profession! There is another way. And, irony of ironies, it is not a new way, but rather an old way, one defined by no less than Paul Krugman in 1998 and Ben Bernanke in 2003, when lecturing Japan about what to do. I have enormous respect for the intellectual horsepower of both men, and what they preached back then deserves a re-preaching, even if I'm the humble preacher that must take the pulpit.

Krugman in May 1998

In a delightfully wonkish paper,¹ using the enormous horsepower of the IS-LM (investment savings-liquidity preference money supply equilibrium) framework, he made a powerful case for what Japan should do to bootstrap itself out of the deflationary swamp. I'll spare you the wonkish part and cut to his commonsensical conclusion.

In the midst of deflation in the context of a liquidity trap, with the central bank's policy rate pinned at zero, it is not enough for the central bank to print money, accommodating massive fiscal policy stimulus, he argued. Not that this is not a necessary policy action. It is. But it is not sufficient, Krugman pounded the table, because if the public believes that the central bank will, in the future, un-print the money – in today's jargon, implement an exit strategy from money printing – then the printed money will simply be hoarded, rather than spent, because deflationary expectations will remain entrenched.

To get the public to spend the money, Krugman argued, the central bank should make clear that the printed money will remain printed, shifting deflationary expectations to inflationary expectations. In his famous conclusion, actually advice to the Bank of Japan, Krugman declared (his italics, not mine):

"The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs."

In a follow-up (similarly wonkish) paper² in 1999, Professor Krugman refined his argument, stressing that the core of his thesis could be implemented through a credible inflation target that was appreciably higher than the prevailing negative inflation rate in Japan. Thus, he was not so much arguing that the Bank of Japan should act irresponsibly, but rather act irresponsibly relative to orthodox, conventional thinking, which itself was irresponsible, in that it emphasized the need for an eventual exit strategy from liquidity trap-motivated money printing.

To get out of the trap, he emphasized, the central bank needed to radically change expectations to the notion that there was no exit strategy, at least until inflation was appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.

Naturally, the Bank of Japan didn't listen to Krugman at the time; orthodoxy is as orthodoxy does. In March 2001, however, the Bank of Japan did serve up a small beer from the Krugman still, adopting Quantitative Easing (QE), re-enforcing its zero interest rate policy (ZIRP) with an explicit target for massive creation of excess reserves, committing to retaining that policy until the year-over-year core CPI moved above zero on a "stable" basis. A very small beer indeed.

But to its credit, the Bank of Japan tiptoed the reflationary walk, sticking with QE for five years, exiting in March 2006, after the year-over-year core CPI had turned positive in November 2005. A small beer is better than no beer.

Bernanke in May 2003

Professor Bernanke became Fed Governor Bernanke the prior year, making his most famous speech in November 2002, "Making Sure 'It' Doesn't Happen Here,"³ detailing the Fed's anti-deflationary toolbox. That's the speech that the markets are using as a roadmap for Chairman Bernanke's present anti-deflation policy path (it's actually been quite a good roadmap!). But a speech in May 2003, "Some Thoughts on Monetary Policy in Japan,"⁴ is equally important, I think, because it provides a roadmap for what the Fed might do if present anti-deflation policies prove to be inadequate to the task.

The speech is not quite as wonkish as Krugman's May 1998 missive, but is still robustly analytical. Perhaps that's why my profession and the media do not give it the attention it deserves. But Mr. Bernanke's speech does have strong Occam's Razor conclusions, and they are eerily the same as Krugman's, perhaps even stronger.

No, Mr. Bernanke did not advocate to the Bank of Japan that it credibly commit to acting irresponsibly, Krugman's clever turn of phrase. In fact, as noted above, Krugman didn't really, either; he simply wanted the Bank of Japan to act responsibly, which would be deemed irresponsible in the context of orthodox thinking. Both men know how to think outside the proverbial box!

At the time, Mr. Bernanke was a table-thumping advocate for the Fed to adopt an explicit inflation target. But in Japan, he upped that analytical ante by advocating that the Bank of Japan adopt a price level target, not an inflation target.

And there is a huge difference. An inflation target "forgives" past deflation (or below inflation target) sins. In contrast, a price level target does not forgive those sins, but rather demands that the central bank atone for them by explicitly pursuing sufficient inflation to restore the price level to a plateau that would have been achieved if those sins had not been committed. More specifically, he advocated that the Bank of Japan should (his italics, not mine):

"... announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.

A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation."

This is very powerful stuff! Mr. Bernanke knew he was breaking some new ground, at least from the mouth of a sitting policymaker. In actuality, he was drawing on some powerful academic work of Eggertsson and Woodford,⁵ which laid out the case that a price level target would likely have a more powerful effect on inflation expectations than simply an inflation target above the prevailing level of inflation (or in Japan's case, deflation). How so? A price level target pegged at the starting point of a period of deflation – or below target inflation – implies that the central bank is explicitly committed to reflation, meaning that in the short-to-intermediate term, the central bank will explicitly aim for an inflation rate that is higher than its long-term "desired" rate.

Mr. Bernanke recognized that such a policy could unmoor long-term inflation expectations, creating a deleterious rise in long-term interest rates. But in his view, this was a risk worth taking, in part because he felt that a central banker with strong communications skills could draw a distinction between (1) a one-time reflation to correct a deflated price level back up to a level that would have been achieved in the absence of deflationary sins and (2) the central bank's long-term inflation objective. But he acknowledged it would be tricky.

But his case didn't rest simply on skilled central bank communications. While he felt that generating a positive shock to short-to-intermediate inflation expectations would have the effect of reducing real interest rates (remember, the real rate is the nominal rate minus inflation expectations), he did not think that effect was assured and even if it was, he did not believe it would be sufficient to stimulate private sector aggregate demand robust enough to reduce Japan's output gap. Thus, he advocated explicit cooperation between the fiscal authority and the monetary authority, with the latter subordinating itself to the former. And you thought Krugman was radical!

While the passage on this topic⁶ in Bernanke's speech is a bit long, it is so powerful that I think it deserves a full hearing. Here it is:

"My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

Under this plan, the BOJ's balance sheet is protected by the bond conversion program,⁷ and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.

Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.

Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.

Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position."

Powerful, powerful stuff!

And Now to the USA at Present

The United States is not presently suffering deflation in goods and services prices, although the core CPI has dipped slightly below the Fed's putative 2% "target." So the extreme measures that Krugman and Bernanke advocated for Japan do not translate fully to the United States. But they do translate a lot more than the consensus is even willing to discuss in politically correct circles.

America is in a liquidity trap, driven by private sector deleveraging borne of asset price deflation, meaning that private sector demand for credit is axiomatically flat to negative, despite a Fed funds rate pinned against zero. The only source of credit demand growth in the United States is the Treasury itself.

And until the deleveraging process runs its course, consensus agrees that there is nothing wrong with such bloated Treasury demand for credit: In a recessionary foxhole, Keynesian religion dominates all other economic religions. But not all believers are equally devout, as noted at the outset, with many against any further ramping up of Keynesian stimulus, at least without a contemporaneous move to ensure long-term fiscal responsibility, so as to prevent a deleterious increase in long-term Treasury interest rates.

So what should Washington do, if and when – and I stress "if and when"; I'm not making a forecast here! – private sector aggregate (nominal) demand growth looks like it's going to languish in Japan style for the indefinite future? The answer: Take one cup of Krugman's advice for Japan and two cups of Bernanke's advice for Japan – responsibly act irresponsibly relative to orthodoxy.

Yes, as Bernanke intoned, there are no free lunches. But no lunch doesn't work for me. Or the American people. While it is true, as Keynes intoned, that we are all dead in the long run, I see no reason to die young from orthodoxy-imposed anorexia.

"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
"Thinking About the Liquidity Trap," http://web.mit.edu/krugman/www/trioshrt.html
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
http://www.federalreserve.gov/boarddocs/speeches/2003/20030531/default.htm
Gauti Eggertsson, and Michael Woodford (2003). "The Zero Bound on Interest Rates and Optimal Monetary Policy," http://www.columbia.edu/~mw2230/BPEA.pdf
In this case, Bernanke was drawing on his own work, a no-punches-pulled academic essay from December 1999, "Japanese Monetary Policy: A Case of Self-Induced Paralysis." For the wonks amongst you that haven't read it, I strongly urge that you do so!
Elsewhere in the speech, Bernanke lays out a framework, via an interest rate swap arrangement, for the fiscal authority to assume any losses for the central bank from interest rate risks on its bond purchases, so as to bury that political red herring. As an economic matter, such losses are of no importance when looking at the consolidated balance sheet of the monetary authority and the fiscal authority: If government bond prices go down, the central bank loses money from a mark-to-market accounting perspective, but the fiscal authority makes exactly the same amount from a mark-to-market accounting perspective.

The New, New Normal

JohnMauldin — Sat, 06 Jun 2009 01:08:43 GMT

The New, New Normal
A Different Perspective on Health Care
Staying Rich in the New Normal
Eastern Europe, Maine and Tulsa

We are coming to a critical inflection point, perhaps the most critical point that we have had in 70 years for the US and to a great extent the global economy. The choices we make (or that Congress and the Fed make for us) will affect not just our investment portfolios but business and our jobs for a very long time. Last week I talked about the three paths we face as a nation. I want to go back to that theme and expand upon it. You need to clearly understand what the risks are so that you can interpret the actions and data that will be coming at us in the next few quarters. I am feeling a little tired today, so I am going to take the liberty to reproduce Bill Gross's latest comments as well, which are somewhat in line with my own.

A Different Perspective on Health Care

But before we jump into the letter, I want to acknowledge the very large response I got from readers about the cut and paste I did about the differences between the national health care systems of Canada and Great Britain the health care system of the US. To say that I touched a raw nerve is an understatement. I should also admit that I learned a great deal from some very cogent and thoughtful letters. I often write about the problems with using selective statistics in gauging the economy. I have learned that you can do the same with health care statistics.

There are many letters I could quote, but let me give you a counter for the statistics from last week from Raoul Pal of Spain. And of course, there are other statistics that can be brought in to make almost any case you want. But I found these to be very thought-provoking.

"Using the Economists World in Figures I think there is a very interesting and maybe appalling story to tell. In its simplest terms a healthcare system is there to extend the longevity of live of the population. It is the single best and simplest way to judge it because we can all find examples of where one country is better than another but the longevity stats don't lie. When we use that framework the picture is incredibly different. The US has many of the best doctors and medical care in the world but it doesn't work for the population as a whole and therein lies the problem.

"According to the Economist the total US spend on healthcare is 15.4% of GDP including both state and private . With that it gets 2.6 doctors per 1,000 people, 3.3 hospital beds and its people live to an average age of 78.2

"UK - spends 8.1% of GDP, gets 2.3 doctors, 4.2 hospital beds and live to an average age of 79.4. So for roughly half the cost their citizens overall get about the same benefit in terms of longevity of life.

"Canada - spends 9.8% of GDP on healthcare, gets 2.1 doctors, 3.6 hospital beds and live until they are 80.6 yrs

"Now if we look at the more social model in Europe the results become even more surprising:

"France - spends 10.5%, 3.4 docs, 7.5 beds and live until they are 80.6

"Spain - spends 8.1% , 3.3 docs , 3.8 beds and live until they are 81

"As a whole Europe spends 9.6% of GDP on healthcare, has 3.9 doctors per 1,000 people, 6.6 hospital beds and live until they are 81.15 years old.

"The list goes on. The truth is that in many cases as is pointed out the healthcare system is better in the US than in some other countries BUT US citizens must therefore get ill more often than any other country in the West in order to achieve the truly appalling statistic that they are the 41 longest living nation on earth with France, Spain, Norway, Switzerland, Italy, Austria, Andorra, Holland, Greece and Sweden all featuring in the top 20 longest living nations and the UK and Germany at 22.

"This is the big failure of the US system. It is unforgivable. You may get a better chance of recovering from certain diseases but as a whole you will die younger in the US than most developed countries. ... Something is severely broken."

I had many letters from all over the world on this issue both pro and con. And some very lively discussions with health professionals. One pointed out to me that the uninsured in the US when they need a doctor often go to an emergency room for what should be a $50 office visit and end up with a $5,000 bill, which does not get paid and runs up insurance costs for those who do have it. As Dr. Mike Roizen points out in his many books, simply eating right, exercising and other common sense things would cut out much of our health care costs. When one-third of children in elementary schools are overweight, we need to get a grip on what we are doing to the next generation.

In the US, many of us are worried about government rationed health care. Others are worried that they have no access to health care at all. It is a very complicated issue. Let's hope that whatever Congress does really does help. And that the coming revolution in new medicines and procedures gets here as soon as it can for all of us. And now to this week's main story.

The New, New Normal

Last week I outlined three possible paths for the economy based upon the political choices we make about the budget deficits.

First, there is the benign path, where we more or less roll back the Bush tax cuts, and do not increase spending for new programs. The fiscal deficit falls into a manageable range. We repeat the Clinton years where spending is help below increase in revenue so that over time the budget gets balanced. While a large tax increase would have negative consequences for the overall economy, it is far better than the other two paths strictly from the perspective of growing the economy as much as possible. This path also has a very small probability.

The second path is that the Obama budget is passed, the Bush tax cuts go away and we have a decade of projected trillion dollar deficits. By the way, those deficits assume 3% growth rates, low unemployment, low interest rates and very large health care savings, and a withdrawal from Iraq and Afghanistan. The deficits are likely to be MUCH larger then the CBO forecasts. This on top of exploding entitlement expenditures in the middle of the next decade, which are underscored in the opinion of more conservative analysts (including me).

The third path is the same as above expect that large new taxes are passed in order to bring the deficit to a manageable size relative to the growth of GDP. This means that a tax increase over and above those projected by the Obama administration of around $700 billion a year (about 5% of GDP!). Deficits would still be in the $3-400 billion range, but from a funding perspective, it could be done.

The second path is one that will end in heart ache. I do not think that the world or even US investors can buy multiple trillions of dollars of debt for more than a few years without rates rising significantly. That, as Gross points out, will affect both businesses and mortgage borrowers. It is a disastrous train wreck.

The third path is the more likely. I think (hope?) there are enough economically conservative Democratic that will realize the problems of trillion dollar deficits. But they do want a fully nationalized health care, and thus they will pass enough in taxes to pay for it. If they are going to do it, this is their one chance, as Republicans are likely to do better in the 2010 elections and get enough votes to push back any real tax increases other than letting the Bush tax cuts expire.

As outlined last week, it will be a combination of a VAT and taxes on health benefits. There is no other real source for the massive amounts of money needed. It will be a disguised tax on the middle class.

I do not believe they will want to wait until 2010 and an election year. Passing such a huge tax increase is very problematical from the standpoint of a growing economy. It will almost surely put us back into a recession. But it will not be a train wreck. As investors and businesses, we can survive and figure out how to deal with the realities of the new, new normal economy. It will be one in which growth is lower than what we are used to and unemployment is higher. Think Europe.

It will be difficult to ever go back. Perhaps new technologies and industries can develop and help get us back on a path to higher growth later in the next decade. We did survive the 70s, after all.

Now, let's turn to this latest column from Bill Gross, Managing Director of PIMCO. Next week I hope to be back to full speed.

Staying Rich in the New Normal

By Bill Gross

"Behind every great fortune lies a great crime."
Balzac

Balzac was on to something 200 years ago, but to be fair to modern day multi-millionaires, the only real way to accumulate wealth prior to the 18th century was to steal it, or tax it, I suppose, as was the case with kings and their royal courts. It was only with the advent of capitalism and annual productivity gains that entrepreneurs, investors, and risk-takers with luck or pinpoint-timing could jump to the head of the pack and accumulate what came to be recognized as a fortune. Still, the negative connotations persist. I remember a cocktail party in the early 80s where a somewhat inebriated guest engaged me in a debate about the merits of capitalism. "You're filthy rich," he said, which struck me as most unfair from a number of angles. First of all, he hadn't seen anything yet, I thought, and second, I wasn't quite sure where the "filthy" came from. Resentment that he'd missed out on my presumed good deal, I suppose, and in the process using a hackneyed phrase that was bitter and biting, yet had some context of historical sociological relativity. Still, he might have been on to something there - not about me, hopefully, because I've always felt that while PIMCO has prospered, it's only because its clients have benefitted even more so - but about the developing sense of one-sided, perhaps off-sided wealth generation that was to dominate the next several decades. Granted, we had Bill Gates and Steve Jobs and other true capitalistic dynamos who benefitted society immeasurably. But growing percentages of fortunes were being made by those who could borrow or aggregate other people's money. Because our economy was still in a relatively early stage of leveraging, those who borrowed money and used it to invest in higher-risk yet higher-return financial or real assets didn't require a lot of skill, they just needed to be able to convince a bank or an insurance company to lend them some money. After that, the secular wave of leverage would be enough to multiply their meager equity many times over and carry them to a beach where a fortune awaited them much like a pirate's buried treasure.

I remember as a child my parents telling me, perhaps resentfully, that only a doctor, airline pilot, or a car dealer could afford to join a country club. My how things have changed. Now, as I write this overlooking the 16th hole on the Vintage Club near Palm Springs, the only golfers who shank seven irons into the lake are real estate developers, investment bankers, or heads of investment management companies. The rich are different, not only in the manner intoned by F. Scott Fitzgerald, but also in who they are and what they do for a living. Whether some or all of them are filthy is a judgment for society and history to make. Of one thing you can be sure however: over the next several decades, the ability to make a fortune by using other people's money will be a lot harder. Deleveraging, reregulation, increased taxation, and compensation limits will allow only the most skillful - or the shadiest - into the Balzac or Forbes 400.

Readers who are interested in such things as the Forbes annual list of hoity-toities will have noticed that more and more of them are global, not U.S. citizens. The U.S., in other words, is not producing as much wealth in proportion to the rest of the world. Its fortune-producing capabilities seem to be declining, which might suggest that its relative standard of living is doing so as well. If so, the implications are serious, not just for Donald Trump but for wage earners and ordinary citizens, as reflected in their income levels and unemployment rates. Stockholders, 401(k) investors, and yes, bond managers will be affected too. Last week's furor over the possibility of an eventual downgrade of America's AAA rating demonstrates that only too clearly. On the night of May 20, Standard & Poor's announced a downgrade watch for the United Kingdom and since the U.S. and U.K. are Siamese-connected, financially-levered twins, the implications were obvious: the U.S. might be next. In the space of 48 hours, the dollar declined 2%, and U.S. stocks and long-term bonds were down by similar amounts. Such a trifecta rarely occurs but in retrospect it all made sense: a downgrade would cast a negative light on the world's reserve currency, and since stocks and bonds are only present values of a forward stream of dollar-denominated receipts, they went down as well.

The potential downgrade, while still far off in the future in PIMCO's opinion, seemed dubious at first blush. While country ratings factor in numerous subjective qualifications such as contract rights, military might, and advanced secondary education, the primary focus has always been on the objective measurement of debt levels, in this case sovereign debt, as a percentage of GDP. Yet, as shown in Table 1, both the U.S. and the U.K. entered the Great Recession with attractive ratios compared to such grievous offenders (and AA rated) as Japan.

Yet as the markets recognized rather abruptly last week, both countries seem to be closing the gap in record time. To zero in on the U.S. of A., its annual deficit of nearly $1.5 trillion is 10% of GDP alone, a number never approached since the 1930s Depression. While policymakers, including the President and Treasury Secretary Geithner, assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery's corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington's hat. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America's debt to GDP level to over 100%, a level that the rating services - and more importantly the markets - recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those "sixteen tons" in Tennessee Ernie Ford's famous song of a West Virginia coal miner. "You load sixteen tons and whattaya get? Another day older and deeper in debt." Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations. The fact is that supply-side economics was a partial con job from the get-go. Granted, from the 80% marginal tax rate that existed in the U.S. and the U.K. into the late 60s and 70s, lower taxes do incentivize productive investment and entrepreneurial risk-taking. But below 40% or so, it just pads the pockets of the rich and destabilizes the country's financial balance sheet. Bill Clinton's magical surpluses were really due to ephemeral taxes on leverage-based capital gains that in turn were due to the secular decline of inflation and interest rates that at some point had to bottom. We are reaping the consequences of that long period of overconsumption and undersavings encouraged by the belief that lower and lower taxes would cure all.

The current annual deficit of $1.5 trillion does not even address the "pig in the python," baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure - a number that resembles Latin American economies such as Argentina and Brazil over the past century.

So the rather conservative U.S. government debt ratio shown in Table 1 will likely be anything but in less than a decade's time. The immediate question is who is going to buy all of this debt? Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion - almost four times last year's supply. Prior to 2009, it was enough to count on the recycling of the U.S. trade/current account deficit to fund Treasury borrowing requirements. Now, however, with that amount approximating only $500 billion, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board - which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds. Well, you've got the banks and even individual investors to sponge up some of the excess, but a huge, difficult to estimate marginal supply will have to be bought. The concern is that this can be accomplished in only two ways - both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile "greenshoots" recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publically announced and near daily purchases of Treasuries and Agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of Agency mortgages has been the primary reason why capital markets - both corporate bonds and stocks - are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed's balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don't count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect "new normal" GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the "new normal" may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn't as much concerned about the return on his money as the return of his money.

I want to emphasize that we will get through all this, one way or another. Some paths will make it easier than others. But it is very important that you understand what the options are, and build a game plan to deal with them. Over the next few months, I will spend some writing time going into some ideas.

Eastern Europe, Maine and Tulsa

For the next month I will actually be home, then in mid-July off to London and I think Eastern Europe. I am reading through some old International Living issues to help me decide where to actually go. For those with an interest in living in another country, or just like to dream, you should check it out. It is a lot of inexpensive fun. To learn more click here: https://www.web-purchases.com/ILV/LILVK5E1/landing.html

Then Maine in August with my youngest son, and of course Tulsa for Amanda's wedding August 22.

As noted above, I am a little out of sorts, but expect to be back in full swing soon. Have a great week.

Your hoping we can at least Muddle Through analyst,

John Mauldin

The Thinking Behind the Stimulus and Bailout Programs

JohnMauldin — Mon, 30 Mar 2009 22:03:24 GMT

It is important to understand the thinking of those who are in fact making the decisions at the Fed and Treasury. In today's Outside the Box, Paul McCulley, Managing Director at PIMCO, gives us some insight into the thinking that is driving the massive stimulus and bailout programs. Whether or not you agree, it is important to have a handle on what is actually happening and the thinking behind it.

As a bonus, let me give you a link to David Kotok's excellent and very clear analysis of the Public-Private Investment Program (PPIP). The PIPP is basically a call option financed by the US tax-payer. David shows us why as tax-payers we should be concerned. You can read it for your self http://www.cumber.com/commentary.aspx?file=032909.asp&n=l_mc. Have a great week!

John Mauldin, Editor
Outside the Box

Comments Before the Money Marketeers Club
Playing Solitaire with a Deck of 51, with Number 52 on Offer

New York City - March 19, 2009

Thank you, Dana, for that wonderfully kind introduction. It is a deep honor to be speaking before this august club for the fourth time. When I look at the list of speakers over the last 50 years, I am very humbled.

As I've mentioned before when here, this forum is one of the very few for which I actually write a speech. Not that I actually deliver it the way I write it – that might be congenitally impossible for me! – but because I want to be held accountable, to be forced to both own and eat my own words. And to re-read them again and again, before speaking yet again.

Looking Backward
In May 2004,¹ just before the Fed embarked on a tightening process from 1% Fed funds, my axe to grind was that the conventional wisdom of a constant neutral real Fed funds rate was wrong. Put more wonkishly, as I'm wont to do, I challenged the notion of a constant constant in the Taylor Rule.

As all in our profession know, John Taylor conveniently assumed that if the active cyclical terms in his Rule – (1) the gap between actual inflation and targeted inflation and (2) the gap between actual and potential GDP (Gross Domestic Product) – drop out, because inflation is at target and GDP is at potential,² then the real Fed funds rate should approximate the potential real growth rate of the economy, determined by demographically-driven labor force growth and productivity growth. That's the constant term in the Taylor Rule, and John assumed it to be constant.

I took issue with this concept of the constant in Taylor being constant on two key fronts, one a matter of theory and the other a matter of practicality.

On the theoretical front, I have always made a distinction between cash and capital or, in the words of today, the difference between capital and liquidity. I've always believed in the capitalist notion of no risk, no reward. Thus, I've always struggled with the notion that government-guaranteed cash, or liquidity, if you prefer, should pay a positive after-tax real rate of return.

Yes, I believe nominal cash yields should be high enough to offset the inflation rate, which is an implicit tax. And since we tax nominal returns, I have also always believed that the nominal cash yield should be high enough to not only offset the implicit inflation tax, but also the explicit tax on the inflation tax. But I've never believed that cash should generate a real after-tax return. Again, no risk, no reward.

Cash always trades at par, at least in nominal terms, and that's a very precious attribute. You can have it if you want it. But if you do, you should not get paid for it, but rather pay for it, in the form of forgoing any after-tax real return. If you want a positive after-tax real return, you gotta take some risk, summarized best, perhaps, by the possibility of your investment trading south of par.

Which means that I did and do believe that a positive neutral after-tax real rate of interest does exist, even if it is not constant. But for me, unlike John, it's the after-tax real rate of interest on high grade, long-term, private sector debt obligations.

Back in May 2004, I posited that we should use the long-term swap rates as a proxy – the credit risk of the AA global banking system. (Note I said system, not any individual bank.) That after-tax real rate of return should, I argued, be consistent with John Taylor's assumption – widely embraced in our profession – that there is a functional connection between potential real growth rates and real interest rates. Thus, John and I were actually in the same analytical church, but we were sitting in very different pews, singing from a different hymn book.

We both wanted to tie the neutral real rate to the potential real growth rate of the economy. But he focused on the overnight risk-free rate, which the Fed directly controls, while I focused on the long-term private sector rate, determined by the market. Translated, John was and is a Fed funds man while I was and am a financial conditions man.

Which brings me to my practical beef with John: I don't believe that the neutral rate – whichever one you choose – is constant, but rather time-varying, a function of changes in broad financial conditions. With my colleague, and good friend, Ramin Toloui, I wrote a lengthy essay on this issue this past February.³ No need to replow that plowed ground again tonight, except to say that the financial crisis over the last year proves my point in spades.

Be that as it may, most of you thought I was singing way off key back in 2004. And truth be told, I felt that at the margin too, as I recognized my theoretical construct implied a very steep yield curve, an open invitation for entrepreneurial financial operators to lever to the eyeballs into the carry trade.

Thus, I openly acknowledged that if the Fed were to embrace my notion of a neutral zero after-tax real rate on cash, then it would be necessary to put regulatory limits on the use of leverage by financial intermediaries. At that time, policy makers were doing just that with the GSEs (Government Sponsored Enterprises), putting limits on growth of their balance sheets. I was encouraged by this.

But falsely so, as the next several years demonstrated painfully, with unbridled growth in the Shadow Banking System, a term I coined in August 2007 at Jackson Hole. Recall, Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed's discount window to protect against runs or stop runs. But since they don't have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies.

The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions.

And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed's desire. I was proven spectacularly wrong.

It was the Forward Minsky Journey, as I lectured here last time. And it ended in the Minsky Moment, defined as the moment when bubbly asset prices – made so by the application of ever-greater leverage – crack, kicking off the imperative for deleveraging, notably by the Shadow Banking System. We can quibble about the precise month of the Moment. I pick August 2007, but would not argue strenuously with you about three months either side of that date.

Whatever moment you pick for the Moment, we have, ever since, been traveling the Reverse Minsky Journey, violently shifting the IS Curve back to the left, with an even steeper slope. This prospect implied, I argued 16 months ago, that the Fed would inevitably cut the Fed funds rate dramatically, in more-than-mirror image of the hiking process, as financial conditions would refuse to ease in sympathy with the Fed's intentions.

In turn, I forecast that by the next time you invited me here again, the Fed funds rate would likely be at or below the 2½% level that I had so petulantly forecast back in May 2004. I also forecast that I might be contemplating buying a second home, after never having owned more than one.

Looking Forward
Which brings us to today, with the nominal Fed funds rate pinched against zero. I simply wasn't bold enough in my forecast last time here. And while I haven't bought a second home, I am indeed contemplating buying one. I'd like for it to be in a certain city a few hundred miles south of here, but that's a decision above my power grade, even if below my pay grade. But I digress.

What I want to discuss with you tonight is just how simple the solution to our current global economic and financial crisis is on paper, contrasting that to just how difficult and complex the solution is in reality.

The present crisis, in textbook terms, is a case of the dual, mutually reinforcing maladies of the Paradox of Thrift and the Paradox of Leverage. In many respects, they are the same disease: what is rational at the individual citizen or firm level, notably to increase savings out of income or to delever balance sheets, becomes irrational at the community level.

If everybody seeks to increase their savings by consuming less of their incomes, they will collectively fail, because consumption drives production which drives income, the fountain from which savings flow. Likewise, if everybody seeks to delever by selling assets and paying down debt, or by selling equity in themselves, they can't, as the market for both assets and equity will go offer-only, no bid.

Both of these maladies require that the sovereign go the other way, (1) dis-saving with even more passion than the private sector is attempting to increase savings, thereby maintaining nominal aggregate demand and thus, nominal national income; and (2) becoming the bid side for the levered private sector's offer-only markets for assets and equity. It really is that simple, at least on paper, as Keynes and Minsky wisely taught.

The problem with the desirable textbook solution is that it suffers from constrained political feasibility. Actually, dealing with the Paradox of Thrift is practically much easier, even if less critically important, than dealing with the Paradox of Deleveraging. While Congress may belly-ache and wrangle incessantly about the precise size and composition of fiscal stimulus packages, it is safe to say that but for a few wing nuts, we are all Keynesians now in the matter of cracking the Paradox of Thrift.

In contrast there is limited political consensus for using the sovereign's balance sheet and good credit to break the Paradox of Deleveraging. Put differently, while we may all now be Keynesians, we are not all Minskyians. What is ineluctably needed involves socializing the losses of a banking system – both conventional banking and shadow banking – after the spectacular winnings of the Forward Minsky Journey were privatized. It simply doesn't sit well politically. In fact, it stinks to high heaven.

Thus, to quote my partner Mohamed El-Erian, we must contemplate a scenario in which the economically desirable solution is not politically feasible, while that which is politically feasible may not necessarily be economically desirable. Last Sunday, on 60 Minutes, Ben Bernanke addressed this nasty reality directly when he said that perhaps the most severe risk we face is the lack of political will.

I applaud him, both for doing the interview, speaking directly to the American people, and for speaking the truth. But that doesn't necessarily mean that the truth will set us free. As Kris Kristofferson wrote long ago, and Janis Joplin made famous, we cannot dismiss out of hand the proposition that freedom is just another word for nothing left to lose.

I trust not. But the honest answer is that we honestly don't know. We are living in a world of hysteresis, in which outcomes become path-dependent, where multiple outcomes are possible, where both policy input and economic/financial outcomes become hostage to serial correlation. How's that for talking wonkish?

Concluding Comment
Seriously, let me conclude by once and again quoting Mohamed, who observes that what we are experiencing is not a crisis within the market-driven, democratic capitalist system of most of our careers, but rather a crisis of the system itself. This is not a spat within a marriage, but rather a test of the sustainability of the marriage itself. It's playing solitaire with a deck of 51.

Fortunately, the 52^nd card is now on offer, if only policy makers are willing to seize it and play it: Competitive Quantitative Easing (mixed with Credit Easing, in some cases). Usually, when we think of competitive global policies, we think of them in a negative way, as in competitive hiking of tariffs or competitive currency depreciation. While different in execution, these two forms of competition are economically very similar, a competitive attempt to secure a larger piece of a too-small global aggregate nominal demand pie.

In contrast, Competitive Quantitative Easing (QE) offers scope for growing the global aggregate demand pie, with an endogenous enforcement mechanism.

How so? First, let's consider what QE is all about. In an oversimplified nutshell, it involves a central bank voluntarily surrendering for a time its independence from the fiscal authority, taking the short-term policy rate to the zero neighborhood, thereby obviating any need to control growth in its balance sheet. For those of us in the room old enough to remember the jargon -- and there are more than a few! -- QE obviates any need for the central bank to keep "pressure on bank reserve positions," so as to hit a positive target for its policy rate.

It's not quite that simple, I recognize, for central banks that are allowed to pay interest on excess reserves, as is now the case with the Fed. Conceptually, with the ability to pay interest on excess reserves, a central bank could "go QE" and still peg a positive policy rate.

But that's a technicality without great substance at the moment, notably with the Fed, whose target range for the Fed funds rate is 0–.25%. Close enough to zero for me! Thus, the Fed is practically unconstrained in how big it can grow its balance sheet.

Which, in turn, sets the stage for the Fed to voluntarily work corporately with the fiscal authority -- Congress and the Treasury -- to monetize longer-dated Treasury securities, facilitating a huge expansion in Treasury debt issues at exceedingly low interest rates. Ordinarily, we would be aghast at such a prospect, as every bone in our bodies would scream that such an operation would, in the long run, be inflationary.

And our bones would be right. The very reason for central bank independence within the government – but not of the government – is precisely to prevent the central bank from being the handmaiden of the fiscal authority, who inherently wants to spend more than it taxes, running deficits, overheating the economy in an inflationary way.

But if and when the dominant macroeconomic problem is a huge output gap, borne of deficient aggregate demand, fattening the fat tail of deflation risk, the argument for strict central bank independence goes into temporary submission. Note, I said temporary, not permanent. There is no more sure way, in the proverbial long run, to destroy the purchasing power of a currency than to let vote-seeking politicians have the keys to the fiat-money printing press.

But there can be extraordinary and exigent circumstances when it does make sense for a central bank to work cooperatively, if not subordinately, with the fiscal authority to break capitalism's inherent debt-deflation pathologies. Indeed, none other than Chairman Bernanke made the case forcefully in May 2003, speaking in Japan about Japan (my emphasis, not his):

The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say "no" to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.

Thus, the Fed's announcement just yesterday that the central bank would be buying up to $300 billion of Treasuries, primarily in the two- to ten-year maturity range, is fully consistent with both what Mr. Bernanke said six years ago and with evident debt-deflationary pathologies, both here in the United States and around the world.

Indeed, what intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, "go QE," then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie.

Note I said "correlated" not "coordinated." There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies.

Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith's invisible hand!

To be sure, the ECB (European Central Bank) has difficulty with the concept of QE, in part because Euroland represents monetary union without political union and, thus, fiscal policy union. Put differently, if the ECB wants to be accommodative of more Keynesian fiscal policy stimulus, de facto monetizing it, what fiscal authority does the ECB call to cut the deal?

It's an open question, but my sense is that about ten big figures higher from here for the Euro, the ECB would find the answer!

Thank you, again, for the great honor of being here tonight.

Paul McCulley
Managing Director

¹ "Comments Before The Money Marketeers Club: A Brave New World," Global Central Bank Focus, May 2004
² Or if you prefer, unemployment is at its full employment level.
³ "Chasing the Neutral Rate Down: Financial Conditions, Monetary Policy, and the Taylor Rule," Global Central Bank Focus, February 2008

Housing stats show more rot on the housing vine....

ChuckButler — Thu, 26 Feb 2009 15:26:51 GMT

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......................................................
In This Issue..

* US$ continues to be propped up...
* SEK moves up vs. the US$...
* Japanese yen falls....
* Gold prices come down ...

And Now... Today's Pfennig!

Housing stats show more rot on the housing vine....

Good day.. And good morning! It has been a while since Chuck turned over the reigns of the Pfennig to me, so I'm a bit out of practice. But there was a lot of movement in the currency markets over the last 24 hours, giving me plenty of Pfennig fodder. I'll get right to it.

The 'Safe Haven' status of the US$ continued to prop it up yesterday as bad housing data in the US scared investors. Sales of previously owned homes fell 5.3% in January, after rising slightly last month. And even worse for US homeowners, the median price of a home fell to $170,300, down nearly 26% from its peak in July 2006. These numbers reflect a worsening housing market which will weigh on the US economy through most of 2009. The inventory of unsold homes did fall, but still stands at 3.6 million. At the current rate of sales, it would take 9.6 months to exhaust the excess supply of homes. And this is assuming no more homes come into the market. The housing downturn will continue well into 2010, and will likely keep the US economy in the doldrums.

So the negative housing data sent the dollar up yesterday with investors moving money back into the temporary safety of US treasuries. Readers know just how temporary we believe this 'rush to apparent safety' will be; but Chuck and I aren't the only ones thinking this way. Ty Keough sent me the following quote from bond guru Bill Gross:

From Bill Gross' "Investment Outlook March 2009" at www.pimco.com

We entered this crisis with certain economic and financial strengths relative to all other nations. Our reserve currency status was the primary one. Which means that we can write checks in our own currency and they are accepted all over the world. This privilege, however, can be and is being abused.

Global willingness to accept American dollars is being tested. Granted, the U.S. currency has appreciated strongly against its counterparts during most of this crisis, but technical short covering as opposed to a flight to quality may have been the dominant consideration. Watch the dollar. If it falls hard, there may be nothing policymakers can do to restore the ensuing financial chaos.

This When I left last night, only the Brazilian Real was up vs. the US$, but overnight the Asian and European markets turned around as investors moved out of dollar holdings and back into the currencies. The dollar's strength was mainly due to risk aversion, and Bernanke's assurance that there is still a preference to keep the financial sector in private hands calmed investors nerves. Both Bernanke, and Treasury Secretary Geithner stated they are not looking to 'nationalize' US banks. But with amount of money the US taxpayers have already invested into these financial institutions, we are already well down the 'nationalization' path. Just yesterday the Treasury announced yesterday that America's 19 biggest banks have six months to raise new capital after a mandatory review of their balance sheets, or they must accept taxpayer money on government conditions. Sure sounds like a move toward nationalization to me!

The Swedish Krona, which Chuck has been talking about for some time, was the biggest gainer last night, appreciating over 1% vs. the US$. Both Sweden and Norway have solid economic fundamentals, and their bank's balance sheets have remained fairly clean. Both currencies have been sold off due to the financial problems of Iceland and Eastern Europe, but these two currencies look like bargains in today's market.

The biggest loser in the markets yesterday was the Japanese Yen, which continues to fall from grace. The yen is off to its worst start in a decade vs. the US$ as Japanese economic data continue to disappoint. After peaking on January 21 at 87.13 yen/$, the Japanese currency has fallen almost 9% vs. the US$ and is quickly approaching 100 yen/$. GDP in Japan shrank at an annual 12.7% pace last quarter and the trade deficit widened in January to the most in 20 years. Exports from Japan plunged 46 percent according to reports released from the Finance Ministry last night. Sales to the US fell 52.9% as US consumers cut back their purchases of Japanese automobiles and electronics. Japan is facing its worst postwar recession which looks like it will continue to deepen. The yen had been the beneficiary of the reversal of the carry trade, but with most of the carry trade now reversed, the currency is beginning to reflect the underlying economic data, which is not supportive. The fall of the yen could certainly be a precursor of what is in store for the US$, as the 'safe haven' flows will dry up and investors will begin to look at the underlying economic fundamentals of the US.

A rare piece of good news from down under had the Australian dollar rallying a bit vs. the US$ overnight. Australia's dollar rose after fourth quarter wage growth unexpectedly accelerated. This data could push the central bank to slow down the pace of interest rate cuts, making the Australian dollar more attractive on interest rate differentials. The jump in the price of Gold should also help the Aussie dollar recover.

I read a research piece yesterday from Nomura Holdings which suggested the Australian dollar will gain 15% by the end of 2009. In the piece, Simon Flint the head of global foreign exchange research for Nomura suggests the emerging market currencies will turn around in April as we start to see a global economic rebound. Flint believes investors will break out of their 'paralysis of fear' in April and start to move funds back into the emerging markets. The biggest gainers according to Flint will be the Brazilian real, Korean won, and the Australian dollar.

Those of you wishing you would have invested in Gold as it approached $1,000 have a good buying opportunity as gold slid again. Next month's copy of EverBank's Review and Focus was delivered to us from the printer, and in it Chuck writes about the advantages of holding Gold. Gold is truly an 'uncertainty hedge', and will protect investors in the case of inflation or deflation. EverBank's pooled accounts are an excellent way to invest in the precious metals as it is the most efficient way I know of to hold the metals.

But several callers worry about the possibility of US government confiscation of their precious metals and what would happen to their investment in the pooled accounts. First of all, I don't think we will see another confiscation of gold by the US government. The last time this happened, the dollar was on the gold standard. This meant the US government had to control the price of gold in order to control the value of the US$. Today's dollars are not backed by gold, and therefore the government has no need to try and manipulate the price of gold. What would they gain by confiscating gold? It would equate to the government stealing property, which none of us would put up with.

But if you are still concerned, we also offer you the ability to purchase gold or silver coins and bars which can be shipped to you. With today's uncertain economic situation, every investor should hold some precious metals in their portfolios.

Currencies today 2/26/09: A$ .65, kiwi .5107, C$ .8004, euro 1.2760, sterling 1.4271, Swiss .8595, rand 9.949, krone 6.8714, SEK 8.8751, forint 235.37, zloty 3.6829, koruna 22.23, yen 97.99, sing 1.5365, HKD 7.7537, INR 50.48, China 6.8392, pesos 14.9025, BRL 2.3558, dollar index 87.59, Oil $43.46, Silver $13.45, and Gold... $943.90

That's it for today... Chuck is spending a long day at the Siteman Cancer center. Hopefully he will come back with some good news. Christine is here with breakfast (Chuck usually brings us breakfast on Thursdays so he made sure Christine picked it up for us). The weather is teasing us again today, with temperatures shooting up to 60 degrees. But this weekend we are supposed to get a couple inches of snow. The joys of St. Louis weather!!

Hope everyone has a Tub Thumpin Thursday!

Chris Gaffney, CFA
Vice President
EverBank World Markets

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Housing stats show more rot on the housing vine....

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