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Archive for March 23rd, 2010

The Contrarian Trade of the Decade: the U.S. Dollar 

By Charles Hugh Smith

Just as a speculative thought experiment: perhaps the great contrarian trade of this decade is cash/the U.S. dollar.

The majority of economic observers seem convinced that the dollar is doomed, and not in some distant future. The basic reason for this unanimity is the reasonableness of the basic thinking, which goes like this:

The Federal Reserve and the U.S. Treasury are “printing money” and flooding the economy with easy money and credit, and the result of this debasement of the nation’s currency will be rampant inflation.

In other words, if a nation greatly expands its money supply without expanding its production of goods and services, then all that surplus money ends up chasing scarce goods and services, and you get inflation: the same sum of currency buys less and less goods and services.

This is the goal of State policy, according to the standard line of thinking: The only way the Federal Reserve and the Treasury can “save” the debt-burdened U.S. economy is by creating high inflation, which enables debtors to repay debt with “cheaper” dollars. Everyone who owns debt or low-yield bonds will lose huge chunks of their assets, but for no-asset debtors, inflation will be the cat’s meow.

But perhaps this thinking is wrong on virtually every important count.

I am indebted to my tireless and insightful blogging colleague Mish for an understanding of money supply: True Money Supply. Here is Mish’s chart of three ways to calculate money supply, and he argues persuasively for TMS1 as being the most accurate:

While the Federal Reserve successfully goosed money supply in their massive “quantitative easing” campaign, money supply is no longer expanding at a fast clip.

The critical distinction between printing press and credit is rarely discussed: is money literally being printed or is it credit-based? The distinction has profound consequences. If a government prints stacks of currency and then distributes the freshly conjured money via helicopter drops (in the visually compelling imagery of Fed Chairman Ben Bernanke’s famous “helicopter drop” quip), then the money supply has been expanded and distributed into the economy where it then leads to inflation if the production of goods and services lags money growth.

But if a government–for instance, the U.S. Treasury–prints bonds and sells those bonds to raise cash to distribute in the economy, that is not “printing money.” The Treasury bonds are traded for cash presented by purchasers; the money already exists and is simply being transferred to the State for distribution into the economy.

If money is being created via the magic of fractional reserves (that is, via bank credit), then it does not flow into the economy if those banks do not lend it and if consumers do not borrow it. As Mish has repeatedly observed, banks cannot be forced into lending nor consumers into borrowing.

It seems the money “created” by the Federal Reserve and lent to private banks at near-zero interest rates is simply sitting in the banks as reserves to offset their continuing horrendous losses. As a result, it is not flowing into the economy, and thus it cannot trigger inflation.

In contrast, a State such as Zimbabwe does run its printing presses to create money, and this explains why it suffers from hyper-inflation.

It can be argued that the billions of dollars the Fed orders into existence and then trades for Treasury bonds (i.e. to buy T-Bills) is in fact “freshly created money” that flows into the economy via Federal deficit spending. True, but then the question becomes, do these purchases of Treasuries add enough to the $13 trillion U.S. economy to offset the reduction in credit as people and businesses either pay down debt or write off uncollectable/bad debt?

According to the Wall Street Journal (Drought of Credit Hampers Recovery), consumer credit outstanding has shrunk some $119 billion, or 4.6%, from its peak in July 2008, to $2.46 trillion.

Add in the mortgages paid down, paid off or written down in excess of new mortgages issued, corporate debt retired or written off, etc. etc., and it seems the deleveraging that is underway in both consumer and corporate balance sheets is reducing credit and money supply by hundreds of billions of dollars.

The Fed purchasing $300 billion or even $500 billion in Treasury bonds simply doesn’t pump enough money into a deleveraging $13 trillion GDP-economy to create inflation. It merely offsets some of the destruction of credit going on at every level of the economy.

Thus you can have a central bank shoveling credit-created money into private banks where it sits, never entering the economy at all. How can that create inflation? Indeed, as has often been noted by Mish and others, this is what has happened in Japan for the past two decades: the central bank shovels money into private banks, who either engage in “carry trade” activities (borrowing at near-zero interest and then moving the money overseas to earn a decent yield elsewhere for easy profits) or they stash the funds to offset their ongoing losses in defaulted/impaired portfolios.

Those portfolios of impaired assets in Japanese, U.S. and European banks–just how much are they worth in a transparent “marked to market” setting? How many trillions of dollars in mortgage-backed securities, household debt, corporate debt and defaulted/impaired sovereign debt do these banks hold? If they had to sell those assets in an open market, how much would they fetch? How big would the losses be?

Nobody knows, but we can guess the losses are easily in the tens of trillions of dollars. The accounts of banks keeping defaulted mortgages on the books are legion; Japan has played the “waiting for better asset prices” game for decades, and now U.S. banks are playing the same game: accepting interest-only payments of a few hundred dollars from homeowners as an accounting gimmick to keep the loan on their books as “performing.”

This artifice does nothing to clear the actual bad debt.

And how about all those impaired off-balance sheet liabilities? Regulators are not only allowing financial institutions to continue marking assets to fantasy, they are also allowing them to continue holding assets off their legitimate balance sheets.

The ever-astute Karl Denninger of the Market Ticker blog has relentlessly exposed these frauds and accounting tricks.

Since we live in a credit-based monetary system and economy, then income and collateral are the foundations of credit/borrowing. Unfortunately for those wishing for vast expansions of borrowing to fuel inflation, real estate collateral is not just impaired, it has fallen to historic lows. We can only wonder what this chart would look like if all real estate was truly marked to market:

The point is that the collateral represented by the average U.S. household’s primary store of wealth–their home–is near-negligible. Why? As noted above, houses are still being valued far above their true market value, so any reduction in value comes straight off the equity.

For example, a house valued at $300,000 on the bank’s books justifies the $270,000 mortgage being held at full value. The homeowner supposedly has $30,000 in equity/ collateral. But if the house is actually marked to market at $250,000, the owner’s collateral vanishes and the bank’s “asset” (the mortgage) also declines in value.

Second, suddenly-prudent lenders won’t lend more than up to about 75% of loan-to-value (except for the Fantasyland 3%-down payment loans backed by FHA, which are fast-defaulting). So much of the homeowner’s equity is untouchable. The only collateral which is available to borrow against is that above 25%–perhaps 10% of the total vaulation of all homes in the U.S.

And since some 33% of all homes in the U.S. are owned free and clear (50 million mortgages, 25 million homes owned outright), then the “owners equity” is largely in the hands of those without mortgages. We might infer that anyone who resisted the temptations to use their house as an ATM machine via a home equity line of credit (HELOC) either does not want/need to borrow against their home or they are unable to for other reasons (such as low income, poor credit, etc.).

Put all this together and we can deduce that those homeowners who might desire to extract some equity from their homes via borrowing have no collateral left to borrow against.

What about other collateral, such as income? As we all know, functional unemployment/underemployment is around 17%. According to the BEA, personal income has declined by over $200 billion from 2008 to 2009. (Subtract government transfers and the number is more like $600 billion.)

The BEA table reveals that “Net increase in household liabilities” hit $1.8 trillion in 2006 and $1.4 trillion in 2007, and then fell to $146 billion in 2008. Households are no longer borrowing (adding liabilities). Meanwhile, savings jumped from $178 billion in 2007 to $470 billion in 2009.

Mortgage debt rose by $1.1 trillion in 2005, $1 trillion in 2006, $686 billion in 2007–and then fell by $106 billion in 2008. No data is available yet for 2009, but you can bet both mortgage debt and new liabilities continued plummeting.

So household incomes have fallen, meaning there is less collateral for new borrowing, and new liabilities and mortgages have both collapsed from nearly $3 trillion in 2006 to $46 billion in 2008. Yes, from $3 trillion in new borrowing in 2006 to a total of $46 billion in 2008.

That is deleveraging, and adding $300 billion in money supply via Federal Reserve buying of T-Bills is offsetting a meager 10% of that decline in household credit.

Now that we’ve seen that housing and income collateral have fallen off a cliff and are not recovering, and that households are deleveraging ($3 trillion they were borrowing in 2006 has fallen to a mere $46 billion–more or less statistical error or pocket change in a $13 trillion economy)–then we might ask if those who still have assets would wish to leverage them into more borrowing/debt.

The vast majority (83%) of other financial assets are held by the top 10% households. here is a chart I reprinted recently in The Stock Market As Propaganda (March 10, 2010).

Equities (stocks) currently represent about $11.4 trillion of the total $33.3 trillion in financial assets. Business assets and real estate make up the remaining $20 trillion in total assets. According to the BEA, total household assets fell from $63.9 trillion in 2007 to $52.9 trillion in 2008–a decline of $11 trillion.

The recent stock market rally and “recovery” in housing has caused a blip up in total assets, which now appears to be rolling over.

Since the bottom 80% of U.S. households only hold 7% of financial assets ($2.3 trillion spread amongst 105 million households), then their ability to leverage their declining income and modest assets into huge dollops of new debt is somewhere between low and zero.

Recall that households added $3 trillion in new borrowing in 2006 alone. So those heady bubble days of credit/money supply growth are gone for good.

Since the top 10% households own $27 trillion in financial assets, we might ask what need they would have for new debt.

We might also ask what might happen if nobody comes forward to buy $1.5 trillion in new Treasury debt every year (money needed to fund the Federal deficit of $1.5 trillion a year) at very low yields. I outlined the high probability of this happening in The Trouble With Bonds (March 18, 2010).

Interest rates will rise. Recall that the Fed does not set yields for Treasury bonds; that is set by the bond market (supply and demand). The only way for the Fed to influence the yield of T-Bills is to buy them outright, as it has been doing heavily of late. Since every other major nation is also selling bonds to fund deficits, then we can anticipate some lively competition for investor’s cash.

In the standard view that “governments just print money,” then why governments sell bonds is never explained. Why don’t all governments just print up money and spend that? Why go to all the trouble of selling bonds to raise cash to fund deficits? It comes down to the distinction between credit-based systems and currency-based systems.

Inflation is impossible in credit-based systems when credit is being paid down/destroyed/ written off and banks are wary of lending/risk and consumers refuse to (or cannot) borrow.

We might also ask what might happen to stocks, bonds and real estate valuations if interest rates rise: they tank as I explained in What If (Almost) All Assets Fall Together? (March 11, 2010).

As a side-effect, the meager assets of the bottom 90% of U.S. households would fall, and the “smart money” might well decide selling out before further declines occur is the wisest capital-preservation strategy.

Since so much debt is dollar-denominated, then there will be demand for dollars to pay down debt. That is the essence of deleveraging.

And since other assets will be falling as interest rates rise and risk aversion returns with a terrible vengeance, then “cash will be King.” Dollars will rise in value, and the best and safest return on capital will be money-market funds or short-term notes.

Rather than doom the dollar, these trends suggest the dollar could rise in purchasing power and demand for years to come. I know this is contrarian, but ponder the distinction between “printing money” and selling bonds/attempting to expand credit in a credit-averse, collateral-impaired system.

This might be one of the most important bits I write this decade. Or then again, maybe not. Only time will tell. Before chastizing me for rampant hyperbole–”most important story of the decade, bah”–please consider The Most Important Chart of the Century. Now the chart is extremely important, and I recommend reading this story, but the century is a bit young to declare “the chart of the century.” One wonders what the “chart of the century” would have been in 1910, and how prescient we would find it in hindsight.

Let’s say this is one of the most important charts of the past 50 years, which is entirely supportable.

The charts simply shows that adding debt no longer adds to GDP. So even if the Fed were able to force banks to lend to poor credit risks and deleveraging borrowers lost their sanity and added to their liabilities, then the economy still wouldn’t grow/”recover.” The “reflating the credit bubble” game is over.

It’s Gonna Be Like Christmas! (Health Care)

Posted by Karl Denninger

Oh boy are some folks in for a surprise…..

“It’s just going to be like Christmas,” said DeCarlo Flythe, who lost health coverage for his family when he was laid off almost three years ago. “It’s going to be great. You know, no worries (about) the bills. We are going to go ahead and pay our co-pay and be alright.”

You got the $10,000 for the policy and another $10k for the out-of-pocket deductibles, right?

Yes, I know if you are lower-income you’ll get subsidies.  But that being laid off thing might become more-permanently laid off, you see, since if you go back to work your employer will have to either pay a fine (annually) or pick up the majority of that $10k in cost.

If your value in the marketplace is $20/hour, with a 2,000 hour man-year of work (50 weeks x 40 hours/week) your economic value in the economy is $40,000 (gross.)  From this your employer is going to have to take $10,000 out to avoid being fined, which means you now make $15/hour.  Then you pay taxes (FICA and Medicare) on that.  You’ll likely get back the rest of your federal income tax (especially if you have a family) but your out-of-pocket medical expenses will still be that $10,000 either way.

So now you’ve got $30,000/year less about $2,300 in Medicare and FICA tax, and from that you subtract the co-pays and deductibles of $10,000.  You’re left with about $18,000 to live on, or about $1,500 a month for your family of four.

This sounds like “Christmas”?

The clue-stick coming to whack these folks upside the head just as did the people who said “I don’t have to worry about putting gas in my car or paying my mortgage!” will lead to some rather extreme emotions, I suspect, when the truth becomes apparent.

UPDATE:

Obama Pays More Than Buffett as U.S. Risks AAA Rating

March 22 (Bloomberg) — The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

The $2.59 trillion of Treasury Department sales since the start of 2009 have created a glut as the budget deficit swelled to a post-World War II-record 10 percent of the economy and raised concerns whether the U.S. deserves its AAA credit rating. The increased borrowing may also undermine the first-quarter rally in Treasuries as the economy improves.

“It’s a slap upside the head of the government,” said Mitchell Stapley, the chief fixed-income officer in Grand Rapids, Michigan, at Fifth Third Asset Management, which oversees $22 billion. “It could be the moment where hopefully you realize that risk is beginning to creep into your credit profile and the costs associated with that can be pretty scary.”

Moody’s Warning

While Treasuries backed by the full faith and credit of the government typically yield less than corporate debt, the relationship has flipped as Moody’s Investors Service predicts the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.

“Those economies have been caught in a crisis while they are highly leveraged,” said Pierre Cailleteau, the managing director of sovereign risk at Moody’s in London. “They have to make the required adjustment to stabilize markets without choking off growth.”

Advanced economies face “acute” challenges in tackling high public debt, and unwinding existing stimulus measures will not come close to bringing deficits back to prudent levels, said John Lipsky, first deputy managing director of the International Monetary Fund.

Unprecedented Spending

All G7 countries, except Canada and Germany, will have debt-to-GDP ratios close to or exceeding 100 percent by 2014, Lipsky said in a speech yesterday at the China Development Forum in Beijing. Already this year, the average ratio in advanced economies is expected to reach the levels seen in 1950, after World War II, he said.

Obama’s unprecedented spending and the Federal Reserve’s emergency measures to fix the financial system are boosting the economy and cutting the risk of corporate failures. Standard & Poor’s said the default rate will drop to 5 percent by year-end from 10.4 percent in February.

Bonds sold by companies have returned 3.24 percent this year, including reinvested interest, compared with a 1.55 percent gain for Treasuries, Bank of America Merrill Lynch index data show. Returns exceeded government debt by a record 23 percentage points in 2009.

Berkshire Hathaway

Berkshire Hathaway’s 1.4 percent notes due February 2012 yielded 0.89 percent on March 18, 3.5 basis points, or 0.035 percentage point, less than Treasuries, composite prices compiled by Bloomberg show. The Omaha, Nebraska-based company, which is rated Aa2 by Moody’s and AA+ by S&P, has about $157 billion of cash and equivalents and about $52 billion of debt.

P&G, the world’s largest consumer-products maker, saw the yield on its 1.375 percent notes due August 2012 fall to 1.12 percent on March 18, 6 basis points below government debt. The Cincinnati-based company, rated Aa3 by Moody’s and AA- by S&P, makes everything from Tide detergent to Swiffer dusters.

New Brunswick, New Jersey-based Johnson & Johnson’s 5.15 percent securities due August 2012 yielded 1.11 percent on Feb. 17, 3 basis points less than Treasuries, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The world’s largest health products company is rated AAA by S&P and Moody’s.

Yields on bonds of home-improvement retailer Lowe’s in Mooresville, North Carolina, drugmaker Abbott Laboratories of Abbott Park, Illinois, and Toronto-based Royal Bank of Canada have also been below Treasuries, Trace data show.

‘Avalanche’

“It’s a manifestation of this avalanche, this growth in U.S. Treasury supply which is under way and continues for the foreseeable future, and the comparative scarcity of high-quality credit,” particularly in shorter-maturity debt, said Malvey, whose Lehman team was ranked No. 1 in fixed-income strategy by Institutional Investor magazine from 1998 through 2007.

Last year’s $2.1 trillion in borrowing by the government exceeded the $1.08 trillion issued by investment-grade companies, the biggest gap ever, Bloomberg data show. Malvey said the last time he can recall that a corporate bond yield traded below Treasuries was when he was head of company debt research at Kidder Peabody & Co. in the mid-1980s.

While Treasuries are poised to make money for investors this quarter, they are losing momentum. The securities are down 0.43 percent in March after gaining 0.4 percent last month and 1.58 percent in January, Bank of America Merrill Lynch indexes show.

Benchmark 10-year Treasury yields will reach 4.20 percent by year-end, up from 3.69 percent last week, according to the median forecast of 48 economists in a Bloomberg News survey. Two-year yields will rise to 1.77 percent, from 0.99 percent.

Relative Yields

Investors demand 0.60 percentage point more in yield to own 10-year Treasuries than German bunds of similar maturity, Bloomberg data show. A year ago, debt of Germany, whose deficit is 4.2 percent of its economy, yielded about half a percentage point more than Treasuries.

President Obama’s budget proposal would create bigger deficits every year of the next decade, with the gaps totaling $1.2 trillion more than his administration projects, the nonpartisan Congressional Budget Office said this month. Publicly held debt will zoom to $20.3 trillion, or 90 percent of gross domestic product, by 2020, the CBO forecast.

There’s “a lack of a long-term plan to deal with the federal budget deficit,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “At some point in time the market may lose its patience.”

Balance Sheets

Deutsche Bank and Barclays Plc, two of the 18 primary dealers of U.S. government securities that are obligated to bid at the Treasury’s auctions, say balance sheets of high-rated companies make them more attractive than Treasuries.

Corporate borrowers are reducing debt at a record pace. Companies in the S&P 500 cut their liabilities by $282 billion to $7.1 trillion in the fourth quarter from the prior three months, Bloomberg data show. That represents 28 percent of assets, the least in at least a decade.

Investors are accepting smaller premiums to lend to companies, with yields on bonds rated at least AA falling to within 107 basis points of Treasuries on average, Bank of America Merrill Lynch indexes show. That’s down from the peak of 515 basis points in November 2008, and approaching the record low of 36 in 1997.

Adding to Corporates

New York Life Investment Management is adding to bets the difference in yields will continue to shrink.

“As the balance sheet of corporate America continues to improve and the balance sheet of the government deteriorates, that spread should narrow,” said Thomas Girard, a senior money manager who helps invest $115 billion at the New York-based insurer. “There is some sort of breaking point. The federal government can’t keep expanding its borrowing without having to incur some costs.”

For all the concern about U.S. finances, Treasuries are unlikely to lose their role as the world’s borrowing benchmark, said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. The U.S. has the biggest, most liquid securities markets, said Cheah.

Speculating that Treasuries may lose their privileged position is “not a bet I want to put on,” said Cheah, who worked at Singapore’s central bank. Yields on 10-year notes are about half their average since 1980.

Losing its Status

The last time there was talk of the U.S. losing its status as the world’s benchmark for bonds was in the late 1990s, when the government began amassing budget surpluses in 1998 for the first time in almost three decades. The amount of Treasuries outstanding dropped 8 percent to $3.4 trillion in 2000, the biggest annual decline since 1946.

Treasury supply resumed growing in 2001 after two rounds of tax cuts proposed by President George W. Bush led to deficits. Outstanding Treasury supply rose 53 percent to $4.5 trillion in 2007 from 2000 as the U.S. borrowed to finance tax cuts intended to revive a slumping economy. The amount has since risen 64 percent to $7.4 trillion.

More is on the way. The U.S. will sell a record $2.43 trillion of debt in 2010, according to the average forecast of 10 of the 18 primary dealers in a Bloomberg survey.

At the same time Treasury sales are rising, the cash position of the largest corporations is swelling. Companies in the S&P 500 held a record $2.3 trillion as of the fourth quarter, Bloomberg data show.

Growing Supply

High-rated corporate bonds due in three to five years are most likely to yield less than Treasuries, according to Deutsche Bank’s Pollack. The growing supply of Treasuries with those maturities will make government debt a bigger proportion of indexes that fund managers measure their performance against, he said. Managers betting Treasury yields will rise may diversify into corporate debt, Pollack said.

“There’s no natural law that says a Treasury has to yield less than a corporate,” said Daniel Shackelford, who is part of a group that manages $18 billion in bonds at T. Rowe Price Group Inc. in Baltimore. “It wouldn’t be the first time that I would scratch my head and say ‘this doesn’t make sense, the market’s behaving irrationally.’ And it can go on for much longer than you may think.”

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Bryan Keogh in London at bkeogh4@bloomberg.net