FedUpUSA

IRA popped up this morning with an article that makes some of the points I’ve been harping on for a year or so now….

Even as bank securities holdings are rising in aggregate, loan portfolios and assets overall are shrinking at an accelerating pace – evidence, we believe, that deflation remains the chief threat to the global economy. As we said two weeks ago, when the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value. We’ve been talking about the shrinking bank balance sheet for more than 18 months and thankfully this key statistic is starting to get broad attention.

Right.

The problem with this premise is that not only does it destroy the asset base (think savings accounts, CDs, etc) that banks require to have a healthy lending environment, it also drives funds in two corrosive and destructive directions:

1. It encourages carry trades which are inherently destructive because the capital lent leaves the nation where it was borrowed.  That is, it is put to work somewhere else, instead of in the borrowed currency.

2. It forces people out the risk curve and while at the same time it destroys bank capital bases it exposes the capital that wants a low-risk (or “risk free”) home into risk assets where it can be destroyed.

When you look at credit quality of these “assets” (especially MBS) you see a truly frightening picture.  The Fed’s intentional overpayment has masked an enormous valuation:coupon disconnect; the internal credit quality in these things continue to go to hell, yet the coupon has been stable rather than rising to reflect this deterioration.  That shouldn’t happen in a rational market, but there is nothing rational about The Fed’s interference.

Now consider the lowly retail investor who is in a money market fund with his “must not lose” money.  He is earning zero, and many of these funds are at present absorbing fees.  This is causing them to run at a net loss, as any attempt to post a negative interest rate to investors will result in an instantaneous run on the fund.  Yet ZIRP makes it effectively impossible for these funds to return a positive yield.

Remember, without these funds there is no lending base and thus no credit growth.  The perverse impact of ZIRP is that it destroys bank capital bases, as over time people will simply not sit for a zero yield – effectively or otherwise.

As I have noted for the last three years (and which IRA also notes in their paper) the only solution to a debt-overhang economic dislocation is to force the excessive and unpayable debt to default.  These defaults bankrupt the institutions and borrowers that were imprudent, but in doing so they also clear the market.  This also forces yields to rise to reasonable levels, restoring a yield curve that reflects duration and inflation risk, yet allows the capital base of the sound banks to be rebuilt, as they are able to attract deposits, especially time deposits, with reasonable yields on these instruments.

In other words, it attracts capital to the financial institutions – not debased currency or credit.

Only loaned (and thus borrowed) capital promotes economic growth.

The Fed’s puerile thought process is that “all yield is the same”, ”all borrowing cost is the same”, and “all credit source is the same.”  This is a chimera.  The Fed is incapable of producing capital, even by printing.  It can produce credit and it can debase existing money, diluting all existing currency, but it cannot create capital.

Capital is created only by real production in the economy.  No other action creates it.  Yet the loan of capital is what gives rise to the granting of credit without debasement of all existing currency.

The Fed is powerless to do this, but it can destroy the conditions necessary for capital to be lent.

ZIRP does exactly that by ruining the incentives necessary for those with actual capital to be induced to lend that capital.

The Fed should have learned this from Japan, but refused to look at the evidence under their nose.  Instead, Bernanke has continued down a ruinous ivory-tower path born out of his own fertile imagination in relationship to how markets and incentives actually work, conflating the concepts of “money”, “credit” and “capital.”

Addressing this problem and correcting it requires admission that both Paulson and Bernanke, along with Summers and Geithner, were wrong.

In the world of Washington DC where “I screwed the pooch” are four words you will never hear a politician utter, such a sea change will require that either President Obama grow a pair of balls or that he be shackled by a massive shift in power in Washington DC – and those who come in to do so actually understand the difference.

Odds on that event were unavailable at presstime.

Yes, I said CRASH, and I meant it.

Why?

“Events” like this:

SINGAPORE/CAIRO, March 1 (Reuters) – Copper is likely to
climb when trading starts on Monday, lifted by uncertainty over
supply after the world’s top copper producer Chile was pounded
by a massive earthquake, analysts said over the weekend.

The front-month contract opened up more than 8%.

This, despite the fact that the earthquake was hundreds of miles away from the mines in Chile and there was zero damage to them.  Some were offline for a few hours due to power failures, but none suffered any physical or structural damage, nor did their export points and the transportation network between the two.

So why did price spike more than 8% even though all this was known by the market before it re-opened for trading?

No part of the markets are trading on fundamental values, nor on forward business expectations.  They are instead trading as “hot money” repositories where speculators rotate in and out of various instruments literally on a minute-by-minute basis.

This is how crashes happen.

When there is no fundamental value underlying a market there is no floor on price.  Price then becomes one thing and one thing only – the number at which you can find another sucker to take your position from you.

This is how tulip bulbs went nuts in Holland, it is how houses went nuts in California in 2005, it is how tech stocks went nuts in 1999 and it is how oil went nuts in 2008.

But now literally everything has gone this way.

Take European national debt.  We now know that Italy, for example, was cooking their books as early as 1995.  This means that bond buyers overpaid for their bonds and took less coupon than they should have.  This should have resulted in an immediate destruction in the value of those bonds when discovered, but it did not. 

Why? 

Because there was still a bigger fool.

Tech stocks were the same thing in 1999.  These “companies” claimed the global GDP some 100 times over between the IPO-issuers in 1998 and 1999.  This, of course, is impossible.  Yet people kept buying even though mathematically 99% of them had to lose all their money.  Ultimately, they did exactly that.

Oil went to $150 in 2008 even though demand was cratering.  It then collapsed to under $40.  It is now double that, even though we have a record supply on hand, to the point that tankers are sitting around full of crude with nowhere to unload it to, and nobody to buy at the price paid.  Yet the price continues to go higher.

These conditions, historically, always produce crashes.  Each and every time.  Go ahead and look back through history with a dispassionate eye.  Find me a market that displayed a complete disconnect with fundamentals such as this and did not crash. 

You can’t.

The issue for investors, of course, is that it is almost impossible to determine who will finally stand up and blow a whistle that others listen to.  These manias go on longer than anyone would think possible.  Always.  I was stunned in 1999 as the Nasdaq doubled.  Likewise in 2009 I was stunned as prices went straight up on companies that based on any dispassionate analysis are worth zero – for example, every large bank with undisclosed off-balance-sheet exposures (that would be most of them.)

The overnight move in Copper is yet another confirmation point.  Big banks leasing oil tankers to fill up and moor somewhere “waiting for price to go up” was the first indication that this mentality had taken hold last year.  Stocks were the next, of course, and now we have it in copper.

That the “animal idiocy” came just months after the 2008 crash tells me that we’ve learned exactly nothing.  That the idiots in places like CNBS, including most especially people like Kudlow and LIESman, who have seen enough dances to both know and be able to identify this pattern, refuse to discuss what’s going on borders on criminal journalistic misconduct.

If we had indications in the real economy – that is, other than government borrow-and-spend – that we were turning the corner, I’d be a bit more sanguine.  Unfortunately no such indication has appeared, despite literally six months of claims from the media that it’s “just around the corner.” 

No it’s not folks.  What’s around the corner is another collapse, worse than the 2008 one, because the bad debt has been stinking up the joint even more as it decays into a putrid mess.

A dead fish doesn’t get more palatable the longer you leave it out on the kitchen counter.  We’ve learned nothing collectively or in the government regulatory apparatus from the last three years - indeed, government has become drunk on the premise that it can borrow and spend over $1.5 trillion annually to present a false veneer of prosperity and economic improvement. 

But borrowing money doesn’t make your economy more prosperous.  It indeed makes it less so, because you not only have to pay that money back some day, but for the duration of the time you have it outstanding you must also pay interest.

When I see a nation rocked by a massive earthquake and one of its major exports spikes upward by 8% in price when it is known to the market that disruption to that nation’s production of that commodity from the event was zero, that’s the bell being rung to tell you to be damn careful if you think “happy days are here again” - right here, right now.