Appaloosa's David Tepper Returns To CNBC This Friday January 21st

Long time readers know that we are David Tepper fans, if for no other reason than his fantastic communication skills. We directed you to watch the interview he gave on CNBC last September (which you still can do here). In that interview, he told you in no uncertain terms to buy because the Fed was intent on making everything go up, inflationary consequences be damned.

Mission Accomplished.

This Friday, he's back to drop more knowledge.

[HT: LB}

Human Freedom Relies On Gold Redeemable Money

I think the title of this post is pretty close to a piece Congressman Howard Buffett wrote in the first half of the 20th century (yes, Warren Buffett's father - they have slightly different political leanings).

In any case, I felt it was an apt title to the below video from Charlie Rose where he discusses gold, inflation, "quantitative easing", and dollar debasement with a few folks including Greenlight Capital's David Einhorn (whom we are a big fan of), Jim Grant (again, we're huge fans), the Chairman of Barrick Gold and John Hathaway of Toqueville Asset Management. Enjoy.

Jim Grant - "gold is money."



HT: TB

"This Is True, The Plumber Is Clearly Smarter Than The Ben Bernanke"

I can't think of one thing that I disagree with in this. As an aside, I love when people use extraneous "the"s. Such as, "The Ben Bernank"[sic].



HT: O

St. Louis Fed President James Bullard On Deflation Risk

James Bullard, one of the Fed's few "inflation hawks" (which is a relative term when we're talking about people who's job it is to debase our currency, so being a hawk on the Fed really just means he's not as overwhelming an inflationist as some of his colleagues) is - out of left field - warning about deflation. Strangely, his argument is that the easy money language of the Fed "extended period of time", etc. is what is driving this. However, really what he's saying is that the interest rate isn't what matters at this point in a deflation cycle, that the Fed needs to be more forceful and adopt further quantitative easing. Interest rate movements simply incent borrowing and money creation whereas QE causes it explicitly.

Folks, QE2 is nearly upon us.

If you think Bernanke, an avowed currency debasor, isn't the puppetmaster coordinating this - even to the point of using one of his biggest inflation hawks to lead the debasement charge - then you are fooling yourself. By the way, Bullard is not just saying the fed needs further quantitative easing, he's saying they need to make an open-ended commitment to QE, they need to explicitly state their QE as part of ongoing policy, and that it should probably be a lot. Not QE2, but QEForever.

The first time around, the Fed simply did "a lot" but didn't make it open ended and explicit enough. Bullard says the Fed won't make the same mistake twice.

Folks, get your AU and AG now. We are entering crazy-land - these guys literally have no idea about the implications of what they are talking about.

BTW, they would not do this unless they were really, really worried about the state of the economy. I watch this and am legitimately frightened.



[HT: TD]

David Einhorn Complete Ira Sohn Conference Speech

As we discussed here and here, at yesterday's Ira Sohn Conference, David Einhorn gave a speech entitled "Good News for the Grandchildren" about why sovereign debts, huge structural budget deficits, and debt monetization/QE/quantitative easing will matter for our generation and will have to be dealt with well before our grandkids' time.

It was an excellent speech. Below is the unabridged version. Enjoy. Think gold.


David Einhorn - Greenlight Capital - Ira Sohn Conference Speech 2010 - Good News For The Grandchildren

Inflation Nation - Prepare For The Coming Hyperinflationary Dollar Collapse

Dammit.

TILB has been trying to post less frequently and to have those infrequent posts avoid frustrating topics such as the destruction of our economic and social future. You can understand that.

I've established many times over that nobody cares, so why even keep banging the gong...particularly when it seems I'm banging it with my forehead instead of a mallet?

As an aside, friend of TILB and thief (before I invented it) of the phrase Tooth Fairy Economics Tom Woods makes several appearances in this video as do several other TILB mancrushes like Ron Paul, Peter Schiff, Mark Faber, and Uncle Jimmy Rogers.

This is the best video I've seen since Chris Martenson's Crash Course collection (someday I'll post about that video collection - if you haven't watched it yet, you must stop everything you're doing and spend a few hours watching immediately - link here).

I've been meaning to sit down and write more about the value of money, why price deflation is the natural course of the world (a good thing, btw!), and why not all GDP is created equal, but honestly, it's an emotional drain to reflect on and write about these ideas and it requires more of my head banging the gong. But I'll get to it, because while I'm sure nobody reads this, much less cares, I find the anguish and process of putting myself through it strangely beneficial.

In any case, watch this video and watch the Crash Course. As the great Cypress Hill has warned us so many times, "when the shit goes down, you better be ready...YOU BETTER BE READY!!" Indeed



PS: Please do me a favor and buy some actual, physical gold. It's for your own good.

Hayman Advisor's Kyle Bass: The Pattern Is Set

As we've said many times, we hate us some dollar and we hate us some yen even more than the dollar. The euro is an enigma. Other fiat currencies are subject - long-term - to the same issues. That leaves us with gold. Apparently Hayman's Kyle Bass agrees with us. This should come as no surprise to long-time TILB readers as we've highlighted Kyle's work/talks several times.

Below is the text of Hayman's most recent letter to its clients following the European debacle this weekend. TILB's immediate reaction was "holy shit, I don't want to own the euro", in spite of most Wall Street participants claiming this was a great showing of support for the euro. Our view was this "show of support" was more akin to a roadmap for self destruction. The euro's rally than recent retrenchment seems to support our initial take.

We lifted the below text it from First Adaptor's blog (click here for First Adaptor). Make sure to follow First Adaptor on Twitter.

The Pattern is Set - Betting the Bank on a Keynesian Free Lunch by Kyle Bass

--------------------------------------------------------------------------------

Dear Investors:

With the avalanche of announcements over the weekend out of Europe and the IMF (and even the US Federal Reserve), I think it is important to communicate our views. The Lisbon Treaty explicitly prohibits direct monetization of fiscal deficits (i.e. printing money out of thin air in order to perpetuate deficit spending) because central bankers are (or I guess at least "were") aware it is the path to severe inflation or even hyperinflation. Just as the Romans did time and time again, the EU has now decided to change from the rule of law to the rule of man when it suits them. With none of the sixteen members of the currency union forecasted to be in compliance with the Maastricht Treaty (the foundation on which the EMU is built) in 2010, today's actions further attempt to eliminate the natural policing role that markets play with respect to egregious economic behavior. It looks like there will be no consequences for fiscal profligacy... no negative implications for continuing to spend far beyond one’s means... there will be nothing but moral hazard for running massive deficits as member countries can now hold hostage the entire EU (as Greece has done).

The ECB’s monetary policy action simply adds to the moral hazard that was originally created on the fiscal side of the problem. The pattern is now set. This is exactly how very smart people meeting together in order to "solve" a debt crisis frequently (and now permanently, it appears) mistake a solvency crisis for a liquidity crisis. From now on, it seems everything will be deemed to be a liquidity crisis that will be met with more "bail-outs" and debt financed spending. This will eventually break traction in a violent way and facilitate severe inflation or even hyperinflation. The one thing the EU taught us this weekend is that paper money will be worth less (maybe much less) in the future.

Germany weakened itself as it has now abandoned the core bargain of the Euro (which was that they would never be responsible for another country’s debt) by opting to be the largest guarantor of a new loan program that essentially makes European countries joint and severally liable for emergency funds for the worst fiscal offenders in the EU. It has begun a process of ceding its fiscal sovereignty to the over-indulgent countries. I still cannot believe Germany has done this. No wonder Merkel’s government is so unpopular. Meanwhile, I guess that Trichet must have decided on the lesser of two disastrous outcomes for fear that the very existence of their European Union was being called into question. He must have believed this to be the case as it would be the only rational reason to agree to such drastic measures – despite his blanket opposition to such policies just days ago and against the explicit wishes of the Bundesbank, Germany’s central bank.

We believe that there is a “Keynesian End” to the policy du jour that governments can solve all their fiscal and economic problems with more debt and more cross guarantees (aided and abetted by desperate central bankers). We at Hayman believe this theoretical endpoint is reached when debt service exceeds government revenues. Of course, any particular country has certain fixed expenses beyond debt service; therefore, the real endpoint occurs significantly in front of our definition. Outside of Greece and “Club Med” countries, Japan will begin to grace the front pages of newspapers very shortly. Japan has already reached a point where its central government tax revenues are eclipsed by debt service and social security payments alone. Coupled with its debt and demography problems, the world's second largest economy is about to enter a real bond crisis.

Attached is a Bank of International Settlements working paper that I highly suggest you read [TILB - link to referenced working paper here]. Please pay particular attention to the chart on the top of page 11 and remember the numbers you are seeing are as a percentage of GDP and NOT government revenue. This paper takes a very conservative view of interest rates (it essentially assumes they stay flat from the low levels of a few months ago – regardless of changes to debt levels or savings rates) and extrapolates current fiscal projections and even assumes pretty robust global growth. Even in this somewhat utopian scenario, the Keynesian End arrives in many of the world's countries much sooner than is popularly believed.

The competitive devaluation will begin in full force with Japan needing a weaker Yen to grow exports, the US needing a weaker dollar in order to double our exports (under the current Obama plan), and the EU really needing a weaker euro in order to grow their own exports. It is no wonder that Bretton Woods failed so miserably in prohibiting “cheating” via currency weakening. It is also no wonder that the IMF and World Bank were created at that very same meeting in 1944.

We have also attached a chart showing total IMF commitments to member countries as a percentage of each respective country’s IMF quota. The magnitude of the initial EUR 30 billion commitment to Greece trumps all other commitments made throughout this crisis by multiples. This does not even include the EUR 250 billion announced for the broader Eurozone this weekend. By granting Greece more than 30x their quota, they are making a mockery of their own rulebook.

This weekend, the EU and the IMF effectively went all-in with a bad hand in the highest stakes game of financial poker ever played with the world. We believe the agreement released was nothing more than a Potemkin agreement in order to placate bond investors. In the end (and there will be a reckoning for many countries) nations, including the United States, need to dramatically cut spending and get their fiscal balances in order. Unfortunately, our elected officials are on the hamster wheel of electoral cycles and are not able to make tough decisions like this as they would likely not be re-elected without a “sea change” in public opinion towards government spending and deficits. We are therefore on the path to significant currency devaluation around the world that will likely result in significant inflation. We increased our holdings of gold on Monday morning as well as taking other steps to position ourselves for the most likely outcome over the next few years. Interestingly enough, based upon the market reaction in the last 36 hours, it seems the law of diminishing returns applies to bailouts as well.

Sincerely,

J. Kyle Bass
Managing Partner

Kyle is clearly cut from the Austrian cloth.

Visualizing President Obama's Budget Cuts

An oldie but a goodie. Lord, I hate our government.

Keynesianism Is So Nuanced

[This will be a multi-part series that discusses inflation, what money is and why it has value. We begin with some basics through the lens of Keynesianism's "attractiveness".]

I was on an email string recently about The Carnegie Endowment for International Peace's Uri Dadush. I made the statement that Dadush is simply a Keynesian, albeit one that is well connected and understands there are many difficult challenges that need to be addressed. In response to my email, a long-time friend of TILB and fellow liberty loving free marketer - though he is still finding his legs with regards to understanding the implications of his beliefs - responded to me that he has spoken at length with Dadush and that he's more nuanced and "complex" than being simply called a Keynsian. Here's a quote from Dadush's recent FT OpEd:

There are ways to mitigate the pain. For example, Germany and other countries could adopt more expansionary fiscal policies for a while. Or, more powerfully, the wider euro area could adopt more expansionary monetary policies for several years. Today, this second option is anathema as the “inflation fundamentalists” will have none of it.

Nuanced? I guess.

Here's what my friend said (mind you, he's an avowed libertarian - though he's still figuring himself out so to speak) - light editing for privacy reasons or clarification:

I met with the guy for 2 hours, and I would not classify him as such [a "strong Keynesian with fairly mainstream opinions"]. If anything, he is complex – and clearly what he says on CNBC and in NY Times oped is not what he can say behind closed doors. While Keynesian, he is not a classically academic Keynesian, sitting in a library dealing with only theory. He counsels governments facing massive social unrest and high unemployment, and he approaches his work with a much deeper appreciation for the human situation than we can. So while espousing money creation below, he was also very pragmatic with me about the moral hazard of this choice, the continued low interest rates, our over-reliance on debt, etc.

I am sympathetic with his situation. We often throw around our ideas without considering the reality of what will inevitably happen – at least in the short term – if our ideas were implemented. I know you will vehemently disagree with me on this, but the fact is that – again, in the short term – what you and I want ideally is economically wishful thinking and politically impossible. Yes, the opposite will bankrupt the world, and we are largely already insolvent. There’s no argument there. Should we suddenly balance our budget, shrink government dramatically, stop stimulus, war, and over-regulation, the result could be 50-60-70% unemployment rates – in the short run. I do believe the LT benefits of Austrian economics are obviously far superior to the Keynsian ponzi scheme.

However, no one talks about the transition, and what it would really mean for us. If you take a heroin addict, and suddenly “reform” him with complete withdrawal and going cold turkey, he will often die from this. His body cannot handle the shock.

Uri had just met with the Italian Finance Minister prior to seeing me – I can imagine that conversation. How do you convince someone like that that what he really needs is to leave the EU, get on the gold standard, balance his budget, cut taxes – and face assassination b/c 100 million are thrown into convulsions?

My point is that Uri deals with the reality of our current situation, while we do not. We read letters and books, then pontificate and rant without a good understanding of what it really means. It will kills us eventually, yes. But it will be a long, slow death probably instead of a quick one.

Lastly, I’ve read Ron Paul, Murry [sic] Rothbard, etc. They all talk about how wrong things are – and I agree with them. I have yet to see a transition plan, so if you know of anything they have written on how to get off the system we are currently addicted to, I’d love to read it.

I decided not to send him a reply by email. Instead, I decided to bring the discussion to TILB, as it's a more productive forum for this sort of thing. To be direct, I disagree with a number of his assertions.

In my opinion, what you described is in fact classic Keynesianism. No self respecting Keynesian would claim that running large deficits and printing money is a long-term viable solution or economically healthy approach. That is simply the tag line non-Keynsians use to belittle the Keynsian approach. It's the politicization the word "Keynesian" but not the reality. Dadush is a classic, behind-the-desk academic Keynesian. He provides advice based in theory as does every other economist, Austrian or otherwise.

The Keynesian argument is always more nuanced or "complex". The argument is generally that goverment needs to implement aggressive and targeted public spending policies during difficult economic periods because taking the hard medicine in the middle of a recession would (they believe) be too painful and counterproductive. By putting it into human terms it becomes very powerful (for obvious reasons) even if - in my opinion - the Keynsian trade is to attempt to avoid some human pain today in exchange for accepting much more human pain in the future.

What's here is tangible and it matters more to voters than tomorrow's pain.

So if we can just take a few easy money bong hits and confuse our body into thinking it's healthy, we can take the hard medicine then. We'll do what needs to be done, but just not yet. Tomorrow. Always some day in the future.

As you know, the issue is that the recession is not the problem, the recession is the cure. It's the cure to profligacy; a recession is simply a period of excess savings that offsets periods of excess spending and consumption.

Switching from a societal bias toward spending to one of savings is painful because society was confused by the profligacy into setting up a structure that serves society's apparent "needs" as if the profligate period is normal. The profligacy is full of false/unsustainable demand signals that trick people into creating/investing in the wrong kinds of businesses or in the wrong amount. The longer the cure is postponed by inflicting more easy money and socialist disease (e.g., Dadush's prescription), the more painful the necessary recession will be because the imbalances are greater and become more depended on.

It's not just imbalances as defined as switching from spending/borrowing to saving/investing. It's that entire industries were created to serve an unsustainable consumptive demand rather than productive advancement. It requires more than just saving new capital, but shifting existing capital from entire industries and possibly geographies to others. A human toll is left in the wreckage of these corrections. It is, however, unavoidable.

What is avoidable is compounding the problem through continued interference with the needed correction.

Bernanke/Bush/Obama's current postponement means the next recession (assuming we are - in fact - past "this one") will feel worse than this one. Their fight of postponement is really an attempt to induce even more capital to become malinvested toward less productive industries and to have us become even more dependant on unsustainable behaviors. So there will never be a period in which the hard medicine can be comfortably consumed because the hard medicine IS the recession and the imbalances it wants and needs to address continue to grow in the meantime. So avoiding taking the hard medicine means avoiding curing the disease; allowing it to metasticize, take root, grow and spread.

You know me well and you are correct: I do vehemently disagree with your statement. Short of a major North American landwar, there is virtually no scenario in which a society as productive as ours would experience anything like "50-60-70%" unemployment rates, even if one mistakenly changes the whole system in one yank.

Ron Paul and others have addressed transition plans. They logically begin with the easiest part: balancing the budget while cutting taxes. By taxing less and borrowing less, capital remains in private (productive) hands and out of public (unproductive) hands. Sounds hard, but if you are of the opinion that most of government is value-destructive, it's actually easy. First, bring the troops home and end the American military empire abroad (foreign military bases). Those two actions are somewhere in the $500 billion to $750 billion annually of savings (1/3 to half of our expected deficit this year and 100% of our deficit from three years ago). Other than for providing a platform for safe living and investment, military is a non-productive expense, by definition. Then end most of the "Department ofs", as I call them. Dept of Education, Dept of Interior, Dept of Energy, Dept of Homeland Security, etc. and slash the size of those you keep, emphasizing of course a strong defense (not offense - defense). This is key, bringing home the military does not mean having a weaker defense. It means changing the nature of it and allowing us to invest in true defense rather than wasting investment on overseas bases.

These cuts are - importantly - phased in but transparent and forecast so that the change is digestible.

That's the easy part. The harder part (though made much, much easier by having already shifted to a smaller government that runs a balanced budget) is moving to a harder currency. This involves ending the Fed and installing free banking, which means a banking system that doesn't "create" money with customer deposits. My personal view is the only way to do that is a slow, planned, well understood phase-in. It might take two decades to let happen so that the adjustment is manageable. I believe the huge benefits reaped from freeing capital from government hands would unleash such a lollapalooza of positives on society that shrinking the banking system would actually shift from an economic headwind to a tailwind by the latter years of the process.

As a final aside, in contrast to your assertion, I am not actually a government-installed-gold-standard man, because it relies on government to be well behaved. I am for market-based money, but that's a discussion for another day.

Liberty Quote Of The Day: Jens O. Parsson

Jens Parsson discusses how the persistent debasement of money kills society in his 1974 book "Dying of Money: Lessons of the Great German and American Inflations". The below quote is reminiscent of Murray Rothbard's description of the early "fun" portions of an inflation as a "heady wine" (click here for Rothbard's in-depth essay on German hyper inflation).

In any case, Parsson makes the point that monetary inflation always ends in a trail of tears, because it is addictive and requires an increasing volume of inflated money in order to keep the party going. As soon as the spigot is turned off, pain comes, so the spigot is never turned off. In fact, it is provides a constantly accelerating flow and ultimately either tragically deluges society in an out of control hyperinflation or, if discipline is somehow re-instituted, ends in a painful deflationary liquidation. Read on for Parsson's quote:

"Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and an ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation."

- Jens O. Parsson, Dying of Money: Lessons of the Great German and American Inflations (1974)

[HT: LB]

Ebullio Capital Management Loses 95% In Two Months - Then Acts Like It's No Big Deal

Wow. We really don't know where to begin. TILB received an email from someone saying a manager lost 86.25% in the month of February. When TILB opened the attachment (see below), we noticed that, in fact, the manager had lost 95% in the first two months of 2010. For those of you familiar with the perils of negative compounding, the difference between losing 85% and losing 95% is an additional 67% of losses. So, we scrolled down and, wala, the manager - Lars Steffensen - actually lost 70% in January as well.

But that's not the worst of it.

His February monthly commentary basically brushes over the fact he's down 96%, as if it's just another couple of bad months! He’s literally insane. He talks about how helpful his hedges were, albeit a little too far out of the money, but that they were "money well spent," yada yada yada.

Dude! You just had a month of -70% followed by a month of -85%. In fact, in February, you actually lost more than 100% of the entire fund on metals positions alone.

He even goes on to give a fucking monthly commentary on the macro picture. Who cares what you think, dude? You’re not even talking about the fact you’ve lost 19 out of every 20 cents in 60 days. Look at this:

Since our getting long against conviction play early January 2010, we have been doing some thinking and come to the conclusion that the Japan scenario has at least been tried and tested in the real, civilized world, whereas the hyperinflation (discounting Weimar Germany and various kleptocratic African quasi States) has not.

Dude, you were down 95%. Why are you giving market commentary? What world do you live in?

After searching further back into my email box, I found this old hedge fund industry rag news snip-it on Ebullio from fall 2009:

Opalesque Exclusive: Ebullio plays hard in the commodity markets as it now owns most of the tin traded on LME - fund up 24% YTD
Thursday, October 15, 2009

By Benedicte Gravrand, Opalesque London:
We heard last week that an investor had been buying around 90% of the tin traded on the London Metal Exchange (LME), in the form of physical stocks and contracts.

Since early summer, the dominant position has caused the tin market on the LME to become "disorderly" and distorted prices, Reuters reported.

Rumors abounded but nobody knew for sure who the mystery buyer was. Then the revelation came: it was......................

TILB cannot believe they didn't lose every investor they had. Amazing. Let us know what you think.

Ebullio Capital Management February 2010 Monthly Update

The Anatomy Of A Failed T Bill Auction

So, the auction didn't actually "fail", per se. But this excellent Seeking Alpha piece breaks down a very strange Treasury Bill auction earlier this week. Very little buying from traditional sources forced primary dealers and - perhaps - The Fed to step into the breach. Here is an excellent breakdown on what was a very weak Bills auction yesterday.

We recommend clicking the above Seeking Alpha link and reading the article in its entirety, in order to understand how a Treasury auction works and what makes for a "strong" vs. a "weak" auction. What happened on February 23rd was unquestionably "weak", though to be fair, zero percent interest rates wouldn't drive me to bid either.

Here is a partial description from his article:

Now here’s where things get odd.

Of the competitive bids (meaning those bids coming from folks who care about yield), roughly 70% went to Primary Dealers (investors who HAVE to buy the debt and who usually turn around and try to sell it afterwards). To put this number into perspective here is the percentage of competitive purchases made by Primary Dealers in the last four 4-week Treasury issuances:


Date of 4-Week Treasury Auction
Primary Dealers as % of Competitive Buys

January 5 2010
42%

January 12 2010
70%

January 20 2010
60%

January 26 2010
67%

February 2 2010
51%

February 9 2010
51%

February 17 2010
61%

February 23 2010 (yesterday)
70%

You’ll note that during the stock market correction that took place during the end of January/beginning of February, Primary Dealers didn’t need to buy many Treasuries since investors were fleeing stocks and buying short-term Treasury debt as a safe haven.

You’ll also notice that yesterday’s auction featured MORE buys from Primary Dealers than almost any of those occurring in 2010. Remember, Primary Dealers HAVE to buy Treasuries. So to see them buying a high percentage of Treasuries at debt auctions means that few investors who can pick and choose what to buy are actually looking to buy US debt.

In plain terms, a debt auction that features a high percentage of competitive buys coming from Primary Dealers is BAD NEWS. It means investors generally aren’t buying US debt. It also means that foreign governments (those who have funded US debt auctions for decades) aren’t buying much anymore either.

So the fact we’ve have three short-term auctions in which more than two thirds of competitive buys came from Primary Dealers is worrisome to see the least.

Now here’s where it gets even worse.

Of the remaining competitive buys (about $8.86 billion), only 32% came from Direct Bidders or those who bought debt directly from the Treasury: orders that can easily be tracked. The other 68% ($5.9 billion) came from Indirect Bidders: folks who we cannot track.

Even more bizarre, only $5.9 billion in Indirect Bidder competitive buys were ACTUALLY OFFERED. So we had a 100% acceptance rate for Indirect Bidder competitive buys.

Let’s put this in perspective:

Date of 4-Week Treasury Auction
Indirect Bidder Acceptance Rate

January 5 2010
71%

January 12 2010
22%

January 20 2010
77%

January 26 2010
43%

February 2 2010
63%

February 9 2010
87%

February 17 2010
82%

February 23 2010 (yesterday)
100%

This means that the Treasury took up EVERY single cent of competitive bids coming from indirect buyers. Remember, indirect buyers are usually assumed to be foreign governments (even the Treasury website admits this).

If this was the case yesterday, then foreign governments barely bought much of anything in yesterday’s auction (only 19% of total debt issued). Moreover, it implies that Primary Dealers (those having to buy) had to gorge on the auction to make up for the fact that few if any foreign governments are interested in buying our debt anymore (including even short-term debt).

Or…

One could potentially argue that this indirect buying came from the Fed covertly buying under the guise of an indirect bidder (the Treasury recently changed the definition of what qualifies for an indirect bidder to make it more vague). It IS rather odd that every single cent of competitive bidding coming from indirect buyers was filled. It’s almost as if the indirect buyers knew precisely WHAT yield to accept… OR were simply trying to take up the slack in what was already a VERY weak auction.

I cannot tell you which of the above is true. Heck, neither of them could be and something completely different could be happening. But regardless, something very, VERY strange is going on in US debt auctions.

I wrote earlier this year that bonds, not stocks, would be the big story of 2010. We’re only into February and there are already some very unusual things happening on both the long (30 year) and the short (4 week) ends of the Treasury curve. And with the Fed’s Quantitative Easing Program scheduled to end in March, things are about to get a whole lot more interesting (barring of course an extension of the QE or QE 2.0).

Keep your eye on US Treasuries. Stocks, despite being so popular with investors are usually the LAST to get what’s coming down the pike. And investors just parked $30 billion for a month with Uncle Sam at virtually NO YIELD yesterday.

Put another way, someone(s) is/are willing to not make money just for the sake of insuring return OF capital (the US can always print money to return it) rather than any return ON capital.

[HT: TD]

Japanese Collapse: The Pending Sovereign Ruin

As we have been saying for some time, Japan is well past the point of no return. The country faces financial collapse brought on by two decades of unbelievable profligacy. With 10 year JGB rates at 1.5% or so vs 3.5% for the rest of the G-7, Japan's cost of financing is unbelievably cheap despite having debt to GDP of nearly 200% (vs. just over 100% for Greece and about 80% for the US, both of whom are wildly over indebted). Japan has managed to pull this off for a variety of reasons including a) they've run a large trade surplus; b) they've been dealing with price deflation that has allowed even very low nominal interest rates to still be positive real interest rates; and c) 95% of Japan's sovereign debt is financed internally.

Japan's population began shrinking a few years ago and the demographics are such that new retirees are outnumbering new workforce entrants, leading to a dis-savings trend (you save during your working years and spend during your retirement years), meaning that the ability to internally fund Japan's debt is evaporating (simply rolling the existing debt will be increasingly difficult, much less continuing to run deficits, which Japan's is >10% of GDP). Replacing that internal funding with external funding is a non-starter because if Japan's cost of funding were to exceed 3%, nearly 100% of Japanese federal tax receipts would be consumed by interest expense. So going to the external market and competing at G-7 type interest rates would quickly lead to total collapse.

As such, Japan's central bank (the BOJ) will almost certainly have to monetize the debt, leading ultimately to a hyper-inflationary depression. Japan knows this. It has burned through six ministers of finance in the past 18 months (akin to Secretary of the Treasury), the fifth of which committed suicide rather than resigning. On top of that Japan's currency has stayed remarkably strong, staggering its export oriented economy.

We predict much higher rates (ultimately greater than 10%) and a much weaker Yen (surpassing 150 to the dollar and possibly 200). This will devastate Japanese savings, force austerity and likely make Japan default or rework its sovereign debt. Assuming this happens, hopefully it happens soon enough that the US has enough time to reflect on Mad Scientist Bernanke's experiment as conducted by Japan and we choose to retrench and not pursue these horrible, suicidal crippling policies of deficits and inflation.

The piper will ask to be paid someday. Be ready.

Anyway, enjoy the slide deck.

Japan - Past the Point of No Return - Katsenelson

HT: TD

The Singularity

We believe the world is walking a tight rope of low rates driven perceived safety. Reality is something uglier. Click here for our definitive take on The Singularity risk.

Bread Is Money And Money Is Bread

"We have free markets."

This mantra is unquestioned around the world in the context of The United States of America. Nobody prevents you from buying the vast majority of products you desire and nobody prevents you from selling the vast majority of products. In broad terms, you can generally do what you wish with your money.

So, the mantra is true: we have free markets.

Or, perhaps before answering the question, we should allow our mind to churn a bit.

When asked by Congress and when giving speeches, Chairman Bernanke affirms his belief in the need for free markets. I am certain if you asked if he was in favor of price fixing, he would laugh at you and say, "of course not. The freer the better, (with certain 'protections')."

And yet, as chairman of the Federal Reserve, he is of course the world's largest price fixer. He controls the monopoly printing control of U.S. dollars and he controls the price and availability of these dollars. He controls who gets newly printed dollars and who does not. These dollars are backed only by the Full Faith and Credit of the United States, rather than by anything tangible. As such, these unbacked currencies are referred to as "fiat" money, as they are commanded into society be fiat, rather than choice.

Bernanke controls the price of dollars through Fed Funds rate implementations (and other similar tools) and he controls the availability in any number of manners, but suffice it to say a dollar's legal name is a Federal Reserve Note, so each dollar is theoretically a liability of the Fed and thus created always and everywhere by the Fed (banks sort of also create dollars through fractional reserve banking, but this is with the Fed's explicit blessing and under the Fed's control).

The price and supply of dollars is not set via market forces, it is set via the collective decision of a dozen or so bureaucrats sitting in the Washington, DC headquarters of the Federal Reserve.

In practice, the majority of those bureaucrats has never dissented from the opinion of the Fed Chairman, so Bernanke effectively dictates the price and supply of money with the advice of mandarins.

Luckily, money's not a very important instrument, so this seems like it shouldn't cause problems.

Everyone knows that is a ridiculous statement, but have you ever thought about what "money" is? I don't mean "dollars," I mean "money," in all its forms.

Money is simply a store of value, of man's productive output. When man innovates and produces above his cost of capital, money becomes more valuable because the same amount of money can now acquire more, different, and/or better things.

Money is exchangeable for goods and services and thus money represents some amount of claim on goods and services. As such, things like bread, milk and financial advice are all embodied in money. It is a fractional claim on everything.

Each transaction in life represents two sides of the same coin. While we generally think of a transaction as money buying bread, another way to think of it is of bread acquiring money. As such, bread is money and money is bread. They are claims on each other. In essence, every good and service is a claim on some amount of other goods and services and money is simply the trusted lubricant in the transaction.

This brings us back to Chairman Bernanke's seemingly benevolent dictatorship of the price and supply of money.

Because bread is money and money is bread, what is Bernanke actually controlling the price and supply of? Is he only price fixing dollars?

Obviously not. He is using an incredibly blunt (albeit convenient) mechanism - the dollar - to price fix everything in the economy.

If you've never thought of the nature of money before, this should scare the absolute shit out of you.

One guy is in charge of all of this?

Further, the Fed is a largely independent body of unelected officials with no meaningful transparency or accountability to We The People. We have handed the economic nuclear football to a bearded Princeton theoretician and told him it would be grand if he didn't use it, or at least use it responsibly.

This is truly insane.

It also means we live in anything but a free market. We live in a market that is manipulated at all times and in damnable ways. Not only are dollars not created and priced via natural supply/demand dynamics, they are a form of money that is manipulated and used to the benefit of certain special interests at the expense of everyone else in an opaque system.

Given this backdrop, in some sense it is almost amazing these United States have been as successful as they have.

I attribute the success we have had to a few things, not least of which is the reality that every country on Earth (that I am aware of) uses a similar or worse methodology for creating and pricing their imposed form of money, so the dollar has not served as a meaningful comparative disadvantage. In fact, its status as the global reserve currency - which is now waning - has been a substantial advantage as it imposed our price control structure onto many nations and global transactions and allowed us to export a good portion of our inflation.

We also have historically had greater freedom from governmental control in other aspects of life than most nations, giving us a further competitive advantage of more freedom, even if incomplete. That gap too is waning as certain other countries grow their freedom and we are actively and aggressively shrinking ours.

Importantly, we built our reputation as a nation of freedom during a time that predated the Federal Reserve and had a reasonably well enforced classical gold standard. We still lean on this reputation today.

The fact that other countries have been more evil than we have is not exactly the stand on which we should endeavor to hang our hat.

We should understand the long-term implications of what it means to live in a society that suffers from governmental imposed price fixing in every market. Some implications are as follows:
1) we suffer a drought relative to freedom that we should have;
2) we can know for a fact that our scarce resources are misallocated and scarce investment capital is maldirected as time and time again has shown the optimal system for directing resources and capital is a reliable price system;
3) the long-term governmental incentive to inflate the currency supply is overwhelming as this form of taxation is largely hidden from sight and fiat money allows it limitlessly. Monetary inflation thus leaves elected officials less accountable than if a more straightforward tax was required. This monetary system thus helps (in the short- to medium-term) the government finance things that are difficult to pay for with new taxes due to their unpopularity like war and freedom encroaching bureaucracy;
4) certain private industries and citizens benefit - these beneficiaries are in essence the early holders of newly printed dollars before they've cycled through the system and impacted prices (e.g., banks, bank borrowers, and wealthy investors) at the expense of holders that see the new money later in the process (e.g., fixed income retirees and middle class workers);
5) we risk our competitive advantage to countries that are willing to be more free than us. Increases in true freedom have everywhere and always improved the lot of the people (see modern day China, for example); and
6) someday we should expect that the build-up of problems caused by the system lead to the system's failure. What that entails is potentially awful. Historically massive wealth loss, poverty, political upheaval, class warfare and actual war are on the menu.

So, have we actually lived in a free market economy during the last few decades, waking every morning to an improving society?

No, we have not. The market will continue to fight against the current system until it breaks, as freedom once held cannot be suffocated, it can simply be constrained. Market freedom is a core freedom and it demands the right to carve its own path.

We now know that bread is money and money is bread - that money, is in fact a small part of everything that can be acquired. We know that as new money is brought into circulation, it dilutes the per unit (e.g., per dollar) claim we have on all goods and services. We know the perverse incentives of fiat money and the near certain direction that fiat money's supply will progress.

With those important pieces of information, you should perhaps ponder whether you prefer holding a money that is 38 years old (the fully unbacked dollar came into being in 1971, after the pseudo-gold backed dollar suffered its demise upon Nixon's command) or whether you prefer a form of money that has been freely selected by individuals in every geography on Earth in which it existed for the last 6,000 years.

Perhaps fiscal discipline will return and monetary discipline will follow. Perhaps government officials will choose to tax less and spend even less in the coming years, easing the pressure on the Fed to debase. Perhaps the Fed will see the folly of its ways and halt or reverse the printing press actions of the past year. Perhaps these things will all happen in the next two or three years before our debt gets past the point of no return.

Perhaps.

But I know my preference:

Gold.

[For more on the meaning of money, read Francisco D'Anconia's brilliant speech linked here]

David Rosenberg Calls For Gold $2600

To the moon.

Enjoy.

Inflation Vs. Deflation: Peter Schiff Gives The Definitive Interview

Peter Schiff apparently agrees with The Singularity thesis. This is the best interview I've heard about the inflation/deflation argument.

Schiff comes out on the side of inflation. He notes that deflationists are right, but only if they price assets in gold which is what their set of comparable history is relative to. Gold can't be printed and so credit collapses and their natural outcomes should be measured against that benchmark, rather than fiat currency.

Schiff also addresses why the U.S. will not be "fortunate" enough to have the Japan outcome (as TILB has said several times, Japan is our upside case). The differences are stark and important: Japan was a creditor nation, Japan had huge government and private savings, Japan had a budget surplus, Japan was a net exporter, the rest of the world didn't slow down with Japan, Japan's underlying economic engine remained robust throughout the period, etc., etc.

Enjoy.

The Singularity: A World Walking The Tight Rope Of Low Interest Rates

[What follows is a thought piece I spent two weeks writing and sent around to some colleagues on Sunday October 18th. It has been modified slightly to take some associate's names out. TILB believes the outcome of rising rates would be unusually horrible for risk assets and, frankly, our society in general.]

“Are you getting it? Armageddon it! Ooh, really getting it? Yes, Armageddon
it!”

- Def Leppard

We have spent a great deal of time reflecting on the lessons learned over the past two years. As I've contemplated those lessons and considered Hatch's recent point that after this recent risk-rally, it appears that market participants' behavior is seemingly unchanged, I began thinking about what we should do to prepare/adjust for the risks that remain in the world (assuming any do). I have many views about this but want to address one in particular.

Humans have a fairly well defined collective “nature” and we are all challenged to deal with our own tendencies within our nature. We have a tendency to self deceive – particularly in situations where we’ve already put ourselves out to the world as having taken a view. Among other things, we have a desire to be right, a desire to be liked, we anchor to the past – especially the recent past – and we act emotionally and generally as a herd. I suffer from all of these, especially self deception.

It's part of life.

Hopefully I have some advantage in dealing with my own tendencies simply by acknowledging them, being aware of them, and realizing that self-deception doesn’t help with my even greater desire to be right. When I frame something through those combined lenses, it helps me stop deceiving so that I can get on the side of “right”.

That’s me. But collectively it’s not possible for man to suppress its aggregate nature and so we muddle along doomed to commit the same mistakes over and over again. The mistakes may not be identical on the surface but they’re identical at their core. This reality was reinforced by Seth Klarman at a conference I saw him speak at back in 2004 or 2005 when he fielded the question (paraphrasing), "do you worry that with the rise of hedge funds and everyone looking for inefficiencies that you're not going to find fat pitches anymore; that the market has become more efficient?" with the following response, "I'm not worried that human nature has changed."

Exactly.

So what is it about human nature pre-2007 that led to the “crisis”. This doesn’t need to address the true “core” problems that I see of fiat money, fractional reserve banking, and unintended consequences of certain policy and regulatory actions. Instead, let’s look at the nature of the foundation those skewed incentives created and how those building blocks were set to crumble in the first place.

In summary, we had a lack of respect for risk, perhaps engrained from 25 years of a generally painless experience for capital (recency bias) where the speedbumps that were approached seemed to be flattened out by the all-seeing, all-knowing Federal Reserve. Howard Marks said that, "the fear of loss is to capitalism as fear of hell is to Catholicism." Collectively, our balance between fear and greed was eroded by this apparent government-gilded safety net and the scales tipped out of whack. This manifested itself in a variety of ways including too much leverage, too little diligence, too much faith in government, too much moral hazard, prices that appreciated too far above the associated intrinsic worth of the assets they represented, too much illiquidity, etc.

I think back on 2006 and remember having conversations over and over where smart investment managers told us that “spreads were too narrow” in the credit world. In fact, despite our repeated asking, we could find almost nobody who would admit to buying at then prevailing prices. This lack of opportunity caused these managers to hold cash or, more often, drift out of their competency in credit analysis into other areas like public equities, LBOs, etc. We spent a little time trying to figure out who was actually buying these assets but frankly did not do a thorough job. What bothered me about this was that I felt like this was a consensus view and my strong preference is to be contrarian.

I have been noodling on the paradox of what it means for me to agree with the consensus - perhaps it is possible that a consensus view point can actually be contrarian? My conclusion is it can. When very large unnatural forces impact the market, an artificial, "unseen" consensus may be created that opposes the traditional "seen" consensus, allowing the seen consensus to actually be contrarian.

I refer to the unnatural forces creating the artificial, unseen consensus as "dumb money". It is dumb in the sense that is not invested with risk-adjusted return generation as its north star; it serves some master other than unfettered economics, be it regulatory or political. In that regard, it is mindless and dumb.

As I mentioned, the view that credit spreads were too tight was a consensus view. However, a thorough research job would have shown us that there was, in effect, an enormous regulatory bid. It was a bid from ABS in the form of CDOs, CMBS, CLOs, RMBS, etc. This was and remains purely a regulatory game where assets that do not have the most attractive properties from a regulatory capital standpoint (e.g., sub-prime no doc mortgages, 2nd lien small cap bank lending to an LBO company, BBB tranches of other ABS) are pooled and re-crafted to rate very well from a regulatory standpoint. Generally 75-85% of these pools of unattractive regulatory assets receive an attractive regulatory treatment (A rated or better) and the balance of the assets are held by unregulated owners that are willing to take low- or un-rated risk.

When you think about this, it is a fascinating reality: buyers had all kinds of incentives that had little to do with the quality or price of what they were buying and a lot to do with interference in markets by regulators and government that drove buyers toward assets for unnatural reasons. In essence, they were price insensitive and it led to unsustainable outcomes.

So we learned a lesson: Follow the Dumb Money. It leads you to the excess (and perhaps to opportunities for shorting).

So Where is the Dumb Money Today?
All of the above was a preamble to establish the case that human nature is fundamental, it causes recurring problems, and the problems are identifiable if we’re willing to hunt down the Dumb Money’s most recent activities. We saw in the recent credit bubble a regulatory Incentive Caused Bias that led buyers to overpay for high ratings and over-trust ratings agencies. Where is Dumb Money today?

It has bothered me for some time that the "seen" consensus view point seems to believe higher rates and more inflation are inevitable. It bothers me because I completely agree with it. I operate more comfortably in a contrarian circle and yet here I find myself rubbing shoulders with the masses. Perhaps it's simply another form of self-deception but I believe we are witnessing a volume of Dumb Money buying ("unseen" consensus) that registers near the right tail on an all time scale. And the Dumb Money ring master is us - the US taxpayer - via our body politic and our printing press operations at the Federal Reserve.

One of the causes of truly great inflations is that in the early stages of rapid money-printing, the price of a typical consumer's basket of goods doesn't immediately respond one for one with monetary creation. The economist Murray Rothbard was a student of past inflations. He refers to that phase of apparent central bank induced nirvana of rapid money-printing and stable prices as a "heady wine" for those operating the printing presses*. It reinforces the logic and encourages a continuation of the practice and, by the time the inevitable result is obvious, it is too late and often too politically difficult to cease, much less unwind. Today we have a Chairman of the Fed that has all but promised to continue debasing the currency by interfering with the Treasury and Agency markets ("quantitative easing" or QE) and is in the process of fulfilling a nearly $2 trillion execution of his QE thesis. Two. Trillion. And I doubt he'll be able to stop there.

Today, I believe the Dumb Money is in sovereign debt, specifically US Treasury Bonds.

Similar to when AAA CLO tranches were issued at par paying 20 bps over LIBOR, Ten Year U.S. Treasuries today are priced to yield 3.3% - not exactly a glorious return, even if inflation is subdued. A while back, Jim Grant coined the term “return free risk” to describe Treasuries at these levels. I believe that return free risk extends well beyond simple Treasury Bonds but before we get to that, let’s talk about why these are the home for today’s Dumb Money buyers.

In a world of global trade imbalances, a dollar-based reserve currency, deleveraging and defaults, Treasuries hold a special place. Combined with unusually favorable capital treatment at regulated institutions, the artificially steep yield curve created by the Fed has given banks a taxpayer gift to put a bid on longer bonds. Near term deflationary fears have a foot on the head of the short end. Foreign central banks – flush with IOUs from the Fed (“dollars” exported by our trade imbalance) – have to buy Treasuries or other dollar denominated assets every single day. Capital raised by banks must find a home and when those banks either lack quality borrowers or are uncomfortable lending precious capital out (or both) they buy Treasuries. Scared by the run on commercial paper last year, money market funds have shifted toward Treasuries. Capital market participants have shifted away from risk assets and toward Treasuries. Etc., etc., ad nauseum. Most importantly, the Fed itself has announced that it will purchase hundreds of billions of Treasuries and even more of Agencies (the sellers of which then take the newly printed dollars from the Fed and themselves buy Treasuries).

In summary, there are a slew of buyers for U.S. government issued debt (including, confusingly, the government itself) and in the current environment of fear of “risk” assets, “risk free” assets have caught a hell of a bid. Most of these buyers are buying for reasons that have nothing to do with absolute value. They are mindless, Dumb Money buyers.

While the inflationary 1970s taught investors that fixed income securities could be “certificates of confiscation”, Greenspan and Bernanke’s Great Moderation brought us a slightly different lesson: From Oct. 1, 1982 through Sept. 30, 2009 (which is three generations, in Wall Street measurements), the Merrill Lynch 7-10 Year U.S. Treasury Bond Index returned 10.0% p.a. Over the last 1, 5 and 10 year periods, it earned 8.0%, 5.7% p.a. and 6.8% p.a., respectively. Stocks as measured by the S&P 500 did not manage to differentiate themselves, besting bonds over the 28 year period by just over 1% per annum, but trailing massively over the 1, 5 and 10 year timeframes.

As such, we have generations of Wall Streeters that have grown to appreciate and believe in the risk free return of U.S. Treasury Bonds, adding stickiness to their bid and reinforcing the mantra of “risk free” (another recent mantra, “home prices never decline nationally”). We have trade partners that are addicted to American IOUs ("dollars"), we have banks and insurance companies that are junkies for any regulatorily blessed capital rebuilding efforts and are now riding the yield curve dragon hoping to catch that old high, we have scared Boomers trying to preserve their precious retirement, we have a Fed that is encouraging the buying of Treasuries and that has itself become the global marginal buyer of Treasuries and Agencies. For the time being, the freshly printed money that is funding the Fed's purchases has not multiplied and filtered out to society, at least on a scale that has frightened the average American. We are in Rothbard's "heady wine" phase and so the process continues. As the merry-go-round spins, non-value oriented buying pressure is unnaturally manipulating prices, keeping them artificially high and yields artificially low.

The Dumb Money is in U.S. Treasury Bonds. They provide virtually no return and a ton of risk. They are, indeed, return free risk.

But, by definition, either this buying cycle will end voluntarily or a special dose of inflation will take hold. And when either of those occurs, what happens to rates?

Unlike other asset classes, U.S. Treasury Bonds denominated in dollars hold a special place in the world. They are considered the global Risk Free Return and are the benchmark for virtually every other asset class on Earth. Even to this day, despite the debacle of the past few years, homebuyers make their purchase decisions not on the economic return a house can generate, but on monthly payment affordability. That affordability is directly tied to Treasury yields and thus, homeowners are effectively short rates (or long long-duration bonds). Commercial real estate, when cap rates are in the 6-8% range as they are today, are attractive only if Treasury yields stay low. Today's price to earnings multiples of 17x or 18x (vs. historical averages of 15x) are implicit bets on low rates, all else being equal. Discount rates and WACC calculations for most people actually embed the 10 Year U.S. Treasury Bond into their calculation. Yield curve junkies are betting on stable or flattening curve-structure. How would floating rate borrowers perform in a rising rate environment, many of whom are skirting bankruptcy now on the backs of a sub 1.0% LIBOR?

And what about the U.S. Federal Budget? The average maturity on the Treasury’s debt is 50 months or so, meaning that the bulk of our issued debt has a four and a quarter year maturity or less, reflecting the U.S. Treasury’s attempt to take advantage of the most attractive end of the yield curve. Despite lower average rates, for the fiscal year-to-date through August (a September FYE), interest expense for the Treasury was $367 billion, eating up 20% of receipts.

We have built an entire world around the foundation of low rates. This is the thread that ties. The Singularity. This is the risk that could cause every asset in our portfolio to get face-punched, as diversity vanishes into the ether and the singularity saddles up.

If debasement activities continue much longer, inflationary expectations will take hold and rates will rise. They must to offset the losses created by monetary inflation, otherwise lenders will not lend and the government will not be able to finance itself. So rates will rise. Perhaps by a lot.

Imagine yourself in a world where instead of a 2s/10s yield curve of 0.9%/3.3%, we were in a world of 3%/6% or 6%/10%. What does that world look like? I’ll take a crack:

- Corporate profits suffer as financing costs skyrocket and customers pull back;
- P/Es contract massively and stocks get re-rated downward;
- Spreads widen on credit securities and absolute rates obviously back-up, leading to a severe decline in the value of credit securities;
- Homeowners get obliterated;
- Corporate borrowers get obliterated;
- Commercial real estate gets obliterated;
- This leads to giant holes in bank balance sheets;
- The annual Federal deficit gaps wider by nearly two-thirds of $1 trillion on U.S. Treasury interest alone (5% of GDP). That incremental deficit is the size of the entire deficit we suffered under Bush2 when we already thought the deficit size was unsustainable. Interest expense alone could theoretically consume nearly half of all Federal tax receipts. How do you ever recover from that?

As such, the Federal Reserve faces a Faustian bargain with a choice between letting nature take its course and walking away (allowing the deflation and liquidation phase of the cycle that the market demands) or to monetize aggressively. What do you think the Fed will do in that scenario? Abandon the Treasury and allow her to default? Monetizing is the Occam’s Razor outcome, despite the problematic result of reinforcing the higher rate regime. Bernanke has said again and again that he will not late the “mistakes” of the past recur. He has already and will continue to use freshly printed money to fill the money supply vacuum left by damaged, deleveraging banks. The government may struggle to find enough buyers to take on the new supply of debt the deficit would demand, forcing Bernanke to either let the Treasury deal with its own problems or to monetize the debt.

He will monetize.

As dollar holders rationally begin to question the value of their currency and the sustainability of its purchasing power, commodity prices will rise to reflect a weak dollar and the velocity of money will accelerate as demand for money diminishes**. Interest rates will rip, financial assets will face valuation headwinds, levered entities that need to refinance, sell or deal with floating rate obligations will spiral toward bankruptcy. The singular thread that ties virtually all asset classes is low rates. We need to be prepared for the pain that will occur when higher rates aggressively yank that thread and unravel the world.

Worst of all, this is a self feeding cycle that will persist as long as deficits grow as a percentage of output or the government continues to monetize debt. If nobody steps in to break the cycle (e.g., Volker), at some point utter devastation results.

I will go out on a limb and state that if rates rise too much and the monetization cycle loses control, a number of non-investment risks that can be difficult to mitigate may arise. These include the erosion of the dollar’s reserve currency status, cessation of tax-exempt status for not-for-profits, overtly confiscatory behavior by governments, much higher tax rates, a challenged system of fractional reserve banking, and the potential for civil unrest. Some of these are unavoidable and difficult to mitigate. But we should try.

How Can We Prepare?
As we consider preparing for the more pure investment ramifications of this outcome, the vast majority of preparations should not be around profiting, but instead should be built around preservation of purchasing power and asset protection/defense. From a macro standpoint, printing new money shifts a portion of every existing dollar's purchasing power to the hands of the person holding the newly printed dollar (the government and banks). This means the government will likely steal more and more of society's purchasing power through this particularly unconstitutional tax. Simply treading water from a purchasing power standpoint will take yeoman's work because we'll be fighting this backdoor wealth confiscation headwind. What are some steps we can take?
- Aggressively shift our equity exposure into high quality, unlevered, low capex businesses. Businesses with global or purely foreign operations may be preferred
- Immediately diversify a meaningful portion to non-U.S. domiciled custody, outside the grasp of our government if true tail risk arises (the new country’s stability must be considered as well). This is low cost, super high value insurance for a magnitude 10 Earthquake on the Richter scale. Seems like a no-brainer.
- On the margin, move our asset allocation toward cash and move “cash” toward select commodities and select foreign currencies as our "new cash". Don't be tricked into believing that just because our "new cash" seems to move everyday relative to the dollar means they have a special risk. Prices constantly move relative to the dollar for everything which means the dollar intrinsically holds the same risk. It just so happens that oil is quoted in dollars rather than dollars being quoted in oil. But the fundamental relative risk is the same, particularly if the dollar’s reserve currency status dissipates. Within commodities, focus on fixed or diminishing resources such as precious metals and energy resources, (maybe agricultural land).
- Avoid all Treasuries and, if we must hold some, keep it all in TIPS even beyond implied inflation levels where we might normally sell (recognizing that we are reliant on the CPI calculation, which is dangerous).
- Prepare for a distressed cycle - huge opportunity.
- Short long-duration Treasuries, perhaps through long-dated, well out of the money puts. Do it in a size that moves the needle and is perhaps surprisingly far out of the money. Long-dated is key. The issue is they are expensive today.
- Short a basket of credit spreads that are too tight, perhaps some sovereigns too - the U.S. isn't the only country going down this road.
- Economic unions like the Euro bloc could be blasted apart as different countries desire massively different monetary and fiscal policy actions.
- Raise the cost of our money yet further - we should be increasingly selective with investing "new cash". The implication of this is that perhaps we need to prune our portfolio and exposure even further and build our new cash exposure.

Where Are We Now?
It is impossible to assess exactly where we are now and when this interest rate/inflation risk might manifest itself. We can’t know with certainty that rates will rise – Japan has defied this experience for twenty years (as an aside, Japan faces this risk as well, perhaps moreso). I have been saying for some time that I think Japan is the U.S.’s upside scenario. In any case, Japan has two advantages on us: 1) they began with a lower level of government debt as a percentage of GDP; and 2) they began with a much higher personal savings rate with which to internally finance newly issued debt (they also had a bigger bubble which meant the deflationary headwinds were bigger to begin with).

I think the U.S.’s peculiar situation is that, because we’ve acted much more aggressively faster, we have already begun to scare off the marginal central bank buyer. The Chinese have aggressively curtailed Treasury purchases. For instance, for the four months through July 2009, China only purchased $33.6 billion of Treasuries (and actually was a net seller during the months of June and July). The oil exporting nations have only added $3 billion to their aggregate $189 billion Treasury portfolios through July.

Stepping into their shoes has been the U.S. Federal Reserve. The left pocket (the U.S. Treasury) is issuing bonds and the right pocket (The U.S. Federal Reserve) is buying bonds with newly printed money. In March, the Fed authorized $300 billion of Treasury purchases, $200 billion of agency debt (Fan and Fred) and $1.25 trillion of agency MBS. In the last week of September alone, the Fed reported buying $5 billion of Treasuries, $3 billion of agency debt, and $39 billion of agency MBS. Its 29 week average for these purchases has been $35 billion per week. Since the late March authorization was put in place, the Fed has bought $291 billion of Treasuries (out of $300b authorized), $700 billion in MBS ($1.25T authorized), and $130 billion of agency debt ($200b authorized). This totals $1.1 trillion and the Treasury bond specific buying authorization is basically used up, though the agency capacity is still ample to last another several months. Of course, the Fed can expand its authority at any time.

The point is, we’ve had $1.1 trillion of money brought forth by the Fed and put into the world over the last six months. The run-rate of the Federal deficit is not shrinking – so how can the Fed stop? Who will step into their shoes?

Imagine what the world would look like if that $1.1 trillion did not exist today.

And so we watch.

But one thing we know is this rate of monetization cannot continue indefinitely without being hugely inflationary, which leads to rising rates. We also know that if the Fed were to suddenly stop, marginal buyers that can step into the Fed's shoes do not seem to exist at today's yields. So a cessation would also lead to rising rates. The Fed’s obvious hope is that they can restart the economy (despite worsening employment and default trends) so that someone can replace their buying or so that the government can cut spending / raise tax receipts and bring the deficit back to more manageable levels. They would then theoretically slowly but steadily unwind their QE, somehow without tipping the economy back into crisis mind you, and take the inflationary risk out of the room. I suppose anything is possible, but I am skeptical.

Further, it is quite possible that we actually suffer from continued deflation, which would seem to justify low nominal rates. The issue, of course, is that a) this is bad for risk assets in general in a society as levered as ours; and b) if we suffer continued deflation, the ensuing inflation will be even worse because it will provide Bernanke cover for even more aggressive debasement tactics. He's playing with fire in a dry forest, but he obviously believes nothing major will come of it.

When this heady wine phase passes and the hangover comes, I hope we are prepared. We have no excuse not to be. It is the most obvious risk in the world, but we have been numbed to it by three decades of apparent stability. The Dumb Money is trying as hard as it can to keep the music on and the party going. However, the more drinks we have, the less fun tomorrow morning will be.

It is time to prepare.

* Rothbard's more full quote is from his book The Mystery of Banking and it reads as follows: "Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

"It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little."

** "Demand for money declining" may seem non-intuitive, but what we are really saying is that people who sell things demand more money for the same good or service or, described from the inverse, that consumers will prefer goods and services that can be purchased today to the risk of holding dollars for more expensive goods and services tomorrow.

Bernanke OpEd In Tomorrow's WSJ: The Fed's Exit Strategy

This article just hitting the WSJ website. Good luck tightening, Ben.

We don't normally post articles in their entirety, but given the Fed's mission here is to communicate policy strategy to the public at large, we provide it uncut below.

The Fed's Exit Strategy
By Ben Bernanke

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.

Inflation Vs. Deflation And The Race To Debase The Dollar

Wall Street boutique dealer, BTIG, circulated the following story from China yesterday a.m.:

Neptune Orient Lines Ltd., China Cosco Holdings Co. and 12 other container lines agreed to raise rates on Asia-U.S. routes, seeking to end a price war caused by slumping demand, overcapacity and "panic." The lines decided on a $500 increase for carrying a 40-foot box from Aug. 10 as a "voluntary guideline," the Transpacific Stabilization Agreement said in an e-mailed statement yesterday. The companies will also raise fuel levies and may add peak season surcharges, the group said. Container lines will try to raise rates again after an April increase collapsed amid rising competition and a 20 percent drop in demand, the TSA said. Spot market Hong Kong-Los Angeles rates have slumped to as low as $900, according to Lloyd's List, as U.S. retailers pare orders for Asian-made furniture and toys on weak consumer -spending. - Bberg

Today, the same dealer friend at BTIG circulated the following:

TOKYO (Nikkei)--Amid still-faltering exports, rates on container ships from Asia to North America have been dropped for the first time in three years, reaching six-year lows.

In just-ended negotiations with businesses, shippers -- including Japanese firms Nippon Yusen KK (9101), Mitsui O.S.K. Lines Ltd. (9104) and Kawasaki Kisen Kaisha Ltd. (9107) -- agreed to reduce rates by 20-40% for the fiscal year ending May 2010. The major reason is sluggish exports of automobiles and housing-related products from Asia to the U.S. in the wake of the economic recession.

The new rate on service to the U.S. west coast, such as Los Angeles, is 1,000 dollars to 1,500 dollars per 40 feet container. It is 2,300 dollars to 2,800 dollars for the Midwest region, such as Chicago, and 2,000 dollars to 3,000 dollars for the east coast, including New York.

Marine transport from Asia to North America started plunging around November last year and continued its double-digit year-on-year losing streak until April. Even though shippers have revamped routes and reduced services, there are still more vessels available than needed.

Major Japanese and overseas shippers bled huge red ink in the January-March quarter because of the harsh business environment for container ship operations. They intend to seek a rate hike if demand recovers for shipments to North America. A clause included in many contracts allows renegotiation for higher rates in the second half of fiscal 2009.
(The Nikkei July 10 morning edition)

These stories are directly in conflict with each other (or, perhaps, they are perfectly in sync with each other since there is little chance the cartel manages to keep all the participants in line). TILB forwarded those BTIG emails and posed the following question to a handful of friends: "Deflation or Inflation?"

TILB friend and Fed watcher extraordinaire, J-Thrill, responded as follows [bracketed statements are from TILB]:

The main thing holding back inflation now is low velocity/Money multiplier [i.e., banks are not lending/demand by quality borrowers is low]. If V/MM comes back with low interest rates = we’ll get 70’s inflation or worse. The Fed has expanded their balance sheet at an unprecedented rate and to the extent the debt they guarantee goes bad, it’s pure inflation. I think that money creation number is probably going to be 2 Trillion from loan losses.

In the early 80's, there was a similar capacity utilization deficit, but inflation persisted until Volcker stamped out inflation with higher rates and restrained M3. I think the low inflation during the 90’s was due to China’s massive low cost import increase to the U.S. and was a free gift to Greenspan (he concedes this). If (when) China’s [currency] strengthens and they continue to make better stuff over time, it will cause inflation for us, but a weak dollar should help our exports. The question is, do we really want to regain the position of the lowest cost tube sock manufacturer to “gain” jobs by killing our currency? I do not. When we start exporting cars to China, you should go long the dollar.

Please pardon a brief digression. As TILB has been known to say in real life (as opposed to the blogosphere), Americans worried about having lost jobs to China need not worry. What we have "lost" are the lowest returning, worst parts of the worst businesses to China, et al. We agree with J-Thrill: we do not want those "jobs" back; government edicts be damned. TILB much prefers our scarce resources be directed at higher value industries by the collective actions of the many rather than commanded toward lower value industries by the whims of a ruling elite.

Our government does not get it (nor do most governments). They think jobs can be saved by "protecting" our manufacturing base. Long run, this will kill jobs from a macro standpoint and lead to malinvestment of scarce resources (directed away from a natural, likely to be more productive use and toward an unnatural, likely to be less productive use). The jobs "saved" will be an illusion since it will cost other better jobs elsewhere (That Which Is Not Seen) leading to a less dynamic economy.

In any case, back to "Inflation or Deflation?" J-Thrill included the following fun graphs that layout the inflation/deflation back and forth quite well.

First, we have measured and reported Urban CPI actually hitting a negative number. - (deflation):



Here, we have capacity utilization at historic lows. - (deflation):



Here, we show the St. Louis Fed's report on the monetary base, which after growing slowly and steadily for decades has more than doubled in the past year (or, as we are wont to say, "it took 100 years to print the first trillion dollars and then it took a few months to print the next trillion; don't worry though, things are fine"). - (inflation)



This final graph shows that net exports have been very negative since the end of the early 90s recession but has corrected a huge amount in the last year (though still very negative). The graph does not clearly lead to a conclusion on inflation vs. deflation. However, it hints. You can extrapolate quickly that we have been sending hundreds of billions of dollars annually to foreign countries for years and years. Those foreign nations have been kind enough to provide epic amounts of low interest seller financing. Perhaps we'll pay them back with newly debased dollars? - (inflation) Further, it indicates that domestic demand for imported goods has fallen off a cliff (that's the reason for the recent inflexion rather than a burst of exports). - (deflation)