Month: May 2014

While the “use of armed [unmanned aircraft systems] is not authorized,” The Washington Times uncovering of a 2010 Pentagon directive on military support to civilian authorities details what critics say is a troubling policy that envisions the Obama administration’s potential use of military force against Americans. As one defense official proclaimed, “this appears to be the latest step in the administration’s decision to use force within the United States against its citizens.” Meet Directive 3025.18 and all its “quelling civil disturbances” totalitarianism…

As The Washington Times reports,

Directive No. 3025.18, “Defense Support of Civil Authorities,” was issued Dec. 29, 2010, and states that U.S. commanders “are provided emergency authority under this directive.”

 

“Federal military forces shall not be used to quell civil disturbances unless specifically authorized by the president in accordance with applicable law or permitted under emergency authority,” the directive states.

 

“In these circumstances, those federal military commanders have the authority, in extraordinary emergency circumstances where prior authorization by the president is impossible and duly constituted local authorities are unable to control the situation, to engage temporarily in activities that are necessary to quell large-scale, unexpected civil disturbances” under two conditions.

 

The conditions include military support needed “to prevent significant loss of life or wanton destruction of property and are necessary to restore governmental function and public order.” A second use is when federal, state and local authorities “are unable or decline to provide adequate protection for federal property or federal governmental functions.”

A U.S. official said the Obama administration considered but rejected deploying military force under the directive during the recent standoff with Nevada rancher Cliven Bundy and his armed supporters.

“Federal action, including the use of federal military forces, is authorized when necessary to protect the federal property or functions,” the directive states.

 

Military assistance can include loans of arms, ammunition, vessels and aircraft. The directive states clearly that it is for engaging civilians during times of unrest.

There is one silver lining (for now)…

“Use of armed [unmanned aircraft systems] is not authorized,” the directive says.

And the full Directive is below…

Dod

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The word “recession” is being used less and less in news stories as the world becomes complacently confident that the central planners have ‘fixed’ the business cycle. Of course, the unpopularity of the R-word was matched only by the pre-recession lows in 2007/8 before the last collapse in the US economy. In the same way that there can be no bubble when everyone is talking about bubbles… when no one is talking about recessions, we wonder what that means?

 

 

Of course, if we don’t mention it – it won’t happen…

Chart: Bloomberg

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Early in the year everyone in finance, absolutely everyone, said that it was only a matter of time before the 10Year, then at 3.0% would rise to 3.5% if not higher. As a result, everyone got short. A few months into the year, the great recovery story has not only failed to materialize but Q1 GDP printed at its worst since 2011. And while equities, which these days are traded more by central banks and algos than actual institutional and retail investors, have been quick to accept the scapegoating of the “harsh weather” as the excuse for the economic slide. Bonds, have been very much unwilling to accept this excuse, and just yesterday dropped to a level not seen since the spring of 2013: 2.40%, making bonds some of the best performing assets year to date. This has left everyone expecting “pleasant” inflation not only with very unpleasant P&L losses, but scrambling to explain why they were so very wrong in their call.

Today, for the first time, one bank, Citigroup, has been kind enough to offer a mea culpa, saying “fair value of long-term rates may be lower than we and other market participants may have judged them to be at the beginning of the year.” That said, this tongue-in-cheek apology is wrapped by yet another justification for why rates are where they are (hint: Citi, clearly, has no better idea than anyone else, especially considering their previous forecasts on the matter), and why – all else equally priced to perfection – should finally begin to rise.

We hope to revisit this topic at the end of the year and again compare the result to what the gradually changing consensus says today. In the meantine, here is Citi’s mea culpa:

The 10 bp decline in 10-yr Treasury yields this week has intensified the debate around the slide in Treasury yields since the beginning of the year.

 

The first leg down in yields – through to the end of the first quarter – could be attributed to the significant growth disappointment; the Citi Growth Index plunged in Q1 as growth surprised to the downside. Since then, however, we have seen rates slide even as the indices have recovered (Figure 2).

 

We review some plausible explanations for continuing rally. Our assessment is that:

• The reduction in the significant short base in the market has prevented rates from increasing in response to the improvement in growth data. Based on the indicators we track, the short base has declined materially and rates should become more responsive to further improvements in economic data.
• Offsetting this bearish development, fair value of long-term rates may be lower than we and other market participants may have judged them to be at the beginning of the year. Consensus economist forecasts called for a 3% growth year. Despite improving growth data, it remains to be seen whether we can actually sustain those growth rates over successive quarters. If growth does not sustain well above trend levels, the market would need to reassess fair value of long-term rates.
• We remain neutral on duration. While the position clearing is encouraging, rates are not sufficiently misaligned with fair value at current growth trends. We recommend two alternatives to an outright short duration position: long 5-year breakevens and a 2y1y-3y1y steepener.

 

Some further drill down on the real reason why bond yields have slid:

Growth disappointment drives fair value reassessment

 

2014 should have been the breakout year for growth. The fiscal drag from sequestration and tax hikes was fading. Household net-worth had increased by a remarkable $10 trillion; almost 75% of personal disposable income affording an opportunity to consume out of wealth. Expectations were that GDP growth would substantially exceed the 2.2% trend level as estimated by the CBO. Specifically, the Fed and private sector forecasters were looking for growth in the 3% range.

 

Instead we got a negative quarter. Since headline growth numbers are dramatically affected by inventory adjustments, we prefer to look at our Growth Index as a measure of the underlying trend in growth1. By this measure the underlying growth trend in Q1 was ~2% and has subsequently improved to 2.8%.

 

While this is a notable improvement, it has to be viewed in the context of the tailwinds going into the year. We estimate that wealth effect impulse from the equity and housing market rally itself should have generated close to 3% growth. This should have been supplemented by the still low rate levels which should have boosted growth well above 3%.

 

The fact that growth has continued to come in below expectations suggests that rate levels are not as stimulative as we would have expected. If we take the 30-year mortgage rate as an indicator of the representative borrowing rate2, it averaged 4% over 2013 compared to the current 4.1% level. Perhaps mortgage rates need to be lower than 4% to stimulate the desired growth!

 

While we are reassessing our yield-curve fair value methodology, it does appear that a 4.1% mortgage rate may not be absurdly low given the current growth momentum. Our Growth Index (currently 0.12) would need to get to 0.3 or higher on a sustained basis to signal that current yield levels are very stimulative and need to move higher.

Still, here is the strawman: shorts are supposedly covering.

Positioning: clearing out the short base

 

It is no secret that many investors came into the year short duration on the back of very strong data – our Growth Index topped out at 0.4% in mid-February – and the stock market rally. This weight of positions has capped Treasury sell-offs in response to the improving growth data.

 

There is evidence that the short base is being cleared. This is evident in the CFTC positioning data but also in two other measures that we track; the estimated duration positioning of large money managers and a monthly duration survey that we conduct. All three measures indicate a considerable lightening of the short base from two and three months ago.

 

The close out of short positions has probably exacerbated the decline in Treasury yields in response to the general data weakness. With lighter positions, rates  are more likely to respond to data strength. This is a bearish development.

So a bearish assessment based on an estimate based on a survey in which the respondents reply the way they wish others would reply so that someone takes the first step, with nobody actually acting, or, said otherwise: actions speak louder than surveys?

We’ll know soon enough if this is yet another incorrect assessment. For now all we know is that the hedge fund community is not only underperforming the S&P500 for the 6th year in a row, but is outright losing money so far in 2014.

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Even the soothsayers and Abenomics spin doctors expected a downdraft after Japan’s consumption tax was jacked up to 8% from 5%, effective April 1. But not this.

The tax hike had been pushed through parliament by Prime Minister Shinzo Abe’s predecessor. It was supposed to save Japan. But no one wants to pay for government spending. The tax proved to be so unpopular that Prime Minister Noda and his government were unceremoniously ousted at the end of 2012.

Japan is in terrible fiscal trouble. Half of every yen the government spends is borrowed, now printed by the Bank of Japan. Expenditures can’t be cut, apparently, and government handouts to Japan Inc. had to be increased. Yet something had to be done to keep the gargantuan deficit from blowing up the machinery altogether, and it was done to those who spend money.

The consumption tax is very broad, impacting goods and services bought by businesses and individuals, from haircuts and vegetables to construction materials. So the 3-percentage-point increase would be levied on much of the economy.

But here is the thing: money that people and companies keep in the bank earns nearly nothing, and even a crappy 10-year Japanese Government Bond yields less than 0.6% per year. But if buyers frontloaded major purchases by a few months or even a year to beat the consumption-tax increase – buying that refrigerator or heavy-duty truck a year earlier than they normally would, for example – they’d save 3% of the purchase amount. That’s pure income. And tax-free for individuals. The biggest no-brainer in Japanese financial history.

Every company and individual frontloaded whatever was sufficiently practical and substantive, and whatever they could afford. It started late last year and culminated in the January-March quarter. As a result, GDP soared at an annual rate of 5.9%, a phenomenal accomplishment for Japan.

The Japanese have been through this before. Ahead of the prior consumption-tax hike from 3% to 5% effective April 1, 1997, consumers and businesses went on a buying binge of big-ticket items. The economy boomed for a couple of quarters, then woke up with a terrific hangover as spending on durables by businesses and consumers ground to a halt, and the economy skittered into a nasty recession that lasted a year and a half!

But this time, it’s different. On March 23, about a week before the tax hike would take effect, the Nikkei polled corporate executives as they were still floating on a sea of optimism from all the money that rampant frontloading was bringing in faster than they could count. They weren’t concerned: 70.2% said that sales would remain stable or decline no more than 5% in fiscal 2014, which started April 1; 55.4% said the economy, supported by strong consumer spending, would improve by September, and 74.3% saw that happening no later than December. So no big deal.

Alas, the Ministry of Economics, Trade, and Industry just released a dose of reality. Total retail sales in April plunged 19.8% from March and were down 4.4% year over year. But this includes sales of perishable and small items not suited for frontloading, and convenience-store sales (which rose a smidgen). In stores where people buy durable goods, such as appliances, watches, or cars, sales were awful.

At “large retailers,” sales swooned 25.0% from March and 5.4% year over year. At supermarkets, where people also buy some durable goods, sales fell 3.9% year over year – people even stocked up on non-perishable food and beverages. At department stores, where people buy jewelry, designer clothing, or French purses, sales fell 10.6% year over year. It wasn’t just retail. Sales between businesses – nearly 2.5 times the value of retail sales – plunged 20.4% from March and 3.7% year over year. In short, it was the largest decline in sales since March 2011, when the Great East Japan Earthquake and tsunami that killed over 19,000 people, brought commerce to a near-standstill.

Those sales were in prices that had been inflated by 3%. That tax-hike money doesn’t stay with the seller but is turned over to the government. In actual merchandise sales, the scenario is 3 percentage points worse. So sales at, for example, large retailers on a comparable basis dropped 28%, not 25%.

At the end of January, the Japan Automobile Manufacturers Association (JAMA) forecast that passenger and commercial vehicle sales would dive 9.8% in fiscal 2014, to 4.85 million units, the lowest since earthquake year 2011. JAMA’s prediction was pooh-poohed as catastrophist.

Turns out, the good people at JAMA are optimists; vehicle sales got demolished in April. As measured by registrations, all categories plunged: new cars -60.3% from March; mini cars (with tiny 500cc engines) -48.9%; trucks of all sizes, including minis -58.0%. Total vehicles sales, retail and commercial, cars, trucks, and buses plummeted 63.3% to 345,226 units, down from 939,761 units in March.

It was the worst performance since the 292,043 units that were sold April 2011, the first full month after the horrific earthquake. Even March 2011 had been better as the first ten days had been tracking normally. Here is the chart of that epic collapse in total vehicle sales:

Most of the vehicles sold in Japan are made in Japan – despite decades of screaming by US automakers, which have yet to get their foot in the door. This means production schedules are going to get cut, hours will be reduced, component purchases will be whittled down…. And the whole chain reaction of a large complex manufacturing sector slowing down will worm its way into the statistics over the coming months. Same as in 1997.

The slowdown will add to the slowdown already underway in business and consumer spending on durable goods. And all the hype about the phenomenal January-March quarter and how Abenomics was performing miracles, and how consumers were finally starting to spend is already turning into furious spin-doctoring as economists are fanning out to explain that this time, it’ll be different, that April was just a blip, that all this frontloading won’t lead to a long recession, as it did last time.

And on May 30, the hapless Japanese consumers woke up to find out officially what they’d already figured out on their own: inflation in April had soared 3.4% for all items from a year earlier, with goods prices up a dizzying 5.2%. But their incomes have been stagnating. The wrath of Abenomics is hitting them: inflation without compensation. Inflation mongers will be ecstatic, but this can’t possibly be good for the Japanese people, or the economy. 

China’s actions “discourage” Japanese corporations from doing business there, said the Japanese government, and that’s exactly what has been happening for months. In a most dramatic way and where it hurts China the most. Read….. Exodus of Japan Inc. Slams China

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The mainstream media is latching on to the idea that all is not well in the world of ‘markets’. The FT’s Gillian Tett notes that, as we have vociferously explained, almost every measure of volatility has tumbled to unusual low levels, “this is bizarre,” she notes, “financial history suggests that at this point in an economic cycle, volatility normally jumps.” But investors are acting as if they were living in a calm and predictable universe, “[Investors in] the options markets are not pricing in any big macro risks. This is very unusual.” In reality, as Hyman Minsky notes, market tranquility tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash. Tett concludes, that pattern played out back in 2007… and there are good reasons to suspect it will recur.

 

No matter what asset clas you espy, volatility levels are at or near record low levels (record high levels of complacency)…

 

In case you needed one more warning – the period from initial crash in vol to melt-up in vol was around 15 months in 2007, the current period since April 2013’s crash in vol and the sustained low vol period is 13 months…

 

But as The FT’s Gillian Tett notes,

This is bizarre. Financial history suggests that at this point in an economic cycle, volatility normally jumps; when interest rate and growth expectations rise, asset prices typically swing (not least because traders start betting on the next cyclical downturn). And aside from economics, there are plenty of geopolitical issues right now that should make investors jumpy.

But investors are acting as if they were living in a calm and predictable universe…

“There is no demand for protection [against turbulence],” observes Mandy Xu, an equity derivatives strategist at Credit Suisse. “[Investors in] the options markets are not pricing in any big macro risks. This is very unusual.”

Why?

If you want to be optimistic, one possible explanation is that the economic outlook has turned benign.

 

But there is a second, less benign possible reason for low volatility: markets have been so distorted by heavy government interference since 2008 that investors are frozen. One issue that may account for the pattern, for example, is that tougher regulations have prompted banks to stop trading some assets. Another is that ultra-low interest rates have made investors reluctant to deploy their cash in public, liquid markets.

 

And there could be a more subtle issue at work too: investors are so unsure what to make of this level of government interference that they are unwilling to take any big bets. Far from being a sign of sunny confidence in the future, ultra-low volatility may show that investors have lost faith that markets work.

 

In reality, nobody knows which of these explanations holds true; I suspect that government meddling and low interest rates are the key factors here…

And that is a problem… as Tett concludes…

while ultra-low volatility might sound like good news in some respects (say, if you are a company trying to plan for the future), there is a stumbling block: as the economist Hyman Minksy observed, when conditions are calm, investors become complacent, assume too much leverage and create asset-price bubbles that eventually burst. Market tranquility tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.

 

That pattern played out back in 2007. There are good reasons to suspect it will recur, if this pattern continues, particularly given the scale of bubbles now emerging in some asset classes. Unless you believe that western central banks will be able to bend the markets to their will indefinitely. And that would be a dangerous bet indeed.

In the meantime, BTFWTF!!

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