As Argentina Peso Plummets To Record, BofA Warns Of Looming Economic Crisis

After spending time in Argentina, BofA’s Marcos Buscaglia is concerned… The perception of many locals is that the risks of an economic/currency crisis before year-end have increased significantly. This compares to a view they had before of a muddle-through till the 2015 presidential elections. Policy decision-making is ever more concentrated, and the administration has radicalized, but the severe economic downturn will change political incentives in 2015, in BofA’s view. With the official peso rate at record lows once again, the black-market Dolar-Blue tumbled to over 14/USD – a record low indicating dramatic devaluation ahead (which of course, sends ARS-denominated stocks surge to record highs).

 

Imagine the headlines on CNBC Argentina… think of the wealth effect…

 

as markets price in massive devaluation… 14.04 Black-market Peso…

 

A more recent snapshot of the “Dolar Blue” collapse:

Not pretty, and as BofA warns, Argentina: on a slippery slope?

We spent three days in Buenos Aires last week, meeting government officials, economists, political analysts, market participants, corporates and members of the opposition parties. Below are our main takeaways.

A presidential election that seems too far away

The most striking change compared with our previous visits is that now many of the locals we spoke to think it likely Argentina will undergo an economic/currency crisis before the transfer of power to a new administration in December 2015. Previously, the consensus seemed to be of a muddling through or a small contraction at the worst. In this sense, the presidential elections seem farther away now in economic terms.

What do we mean by economic/currency crisis? We expect the demand for pesos to fall and the demand for dollars to increase. The default will likely increase external restrictions as well as the fiscal deficit and monetary financing. This would mean higher inflation and pressure on the peso and on reserves. Deteriorating sentiment and a wider gap between the official and the parallel FX rates would dent investment, spending and hiring decisions even more. This will likely further hurt fiscal revenues, which will require more peso issuance, and so forth.

What would be the catalysts to trigger a downward fall? We think there are several potential negative news items in coming weeks, while the only potential positive – but surprising – news would be an unexpected remedy to the default.

The local media report a dispute between central bank (BCRA) President Fabrega and Finance Minister Kicillof. Fabrega’s resignation would spur demand for USD, in our view. In addition, unions are pushing for a reopening of wage negotiations. Wages are increasing slower than inflation, so a new round of wage hikes would not be surprising. It is reported a general strike will be called for this Thursday by dissident Peronists unions. In addition, events that cement the view that the absence from voluntary debt markets will be more protracted may destabilize demand for pesos.

In our view, the social situation seems precarious, and the many we spoke to did not rule out additional social conflicts toward year-end. December has been turbulent in recent years. In 2013, amid widespread electricity cuts and a police strike, there were lootings in many provinces. The social situation has not improved since then: employment has dropped and disposable income is probably falling at low double digits yoy at this point.

External conditions tightened

External conditions have not only tightened due to lower expected financing from abroad in coming months, but also because export prices have dropped sharply and because farmers are restricting grain exports. By our estimates, farmers exported about $520mn less in the four weeks after the default compared to before the default.

 

On top of this, grain exports are likely to drop next year. Since May/June, soybean, wheat and corn prices have dropped by 20%. At the current international prices and the current exchange rate, planting wheat and corn is not profitable in many areas, according to some locals we met. If there is no sufficient weakening of the peso in coming weeks, the harvest may contract in 2015 compared to in 2014. [ZH: Which would be devastating for Gartman’s short Grains trade]

Central bank started moving, where will it end?

BCRA started allowing the peso to weaken, sending it from 8.28 to 8.40 per USD last week, not surprisingly during the first week in which it showed a decline in reserves. In a country where locals compare their ex-ante expected return from peso term deposits with the expected weakening of the peso, the move made clear that returns from term deposits were negative once measured in dollars. In sum, we think the small moves made by the BCRA increase the demand for USD rather than reduce it. This happened in December 2013/January 2014. As a result, pressure for a larger devaluation likely will increase after this move. We think that BCRA will resist a larger FX move as much as possible, but it may have difficulty avoiding a larger devaluation if reserves keep falling.

It takes only two to tango

Local political analysts characterize the current government’s decision process as highly centralized in Cristina Kirchner, with an increased access to her by Kicillof over other members of the administration. Moreover, they believe the government actions in the pari passu case should be understood in political rather than economic terms. According to this view, Cristina Kirchner does not have a candidate for the 2015 presidential elections, so they believe she is more concerned about her legacy than about the elections. Right or wrong, their view is that by fighting the holdouts, she thinks she gains more for her future political career than by giving up to holdouts.

Negotiations with holdouts in 2015 are still feasible

The many we we met expect the government will be able to pass the bill to implement local payment of Exchange Bonds (EB) and to offer a voluntary swap into local law. Most opposition members said they will not vote in favor of the bill, so the real question is whether the government can keep its rank and file united. Although there seem to be some cracks in the government coalition, the combination of electoral rules and fiscal distribution rules makes representatives dependent on the national government, so are unlikely to block this bill.

There is some disagreement among local economists and political analysts over whether the government will be ready to negotiate with holdouts in January once the Right Upon Future Offers (RUFO) clause expires. The RUFO is not the only impediment to negotiations. It seems local laws and the will to negotiate with all holdouts simultaneously – and not just with the plaintiffs of the pari passu case – also weigh on the government’s decisions. We are in the group that believes that the pressure from slumping activity will make the chances of some negotiations with holdouts more feasible in 2015, but these may take the form of a new offer to all holdouts rather than staying with the plaintiffs of the pari passu case.

Massa and Macri on the rise

Many locals believe that Argentina’s economic difficulties will be negative for Daniel Scioli’s chances of carrying the presidential elections. This is in stark contrast with our April 2014 visit amid the adjustments and negotiations with creditors, when Scioli was the favorite. Some recent polls show Mauricio Macri and Sergio Massa may have gained ground against Scioli.




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President Obama Slams “Cynics”, Tells World “Nobody Else Can Do What We Do” – Live Feed

He’s back from vacation and the teleprompter is hot… cynics – bad, economy – awesome, deficit – cut, most powerful military in the world, we have best universities… energy independent… USA USA USA… “no other nation can do what we do.” “The United States is and will remain the one indispensible nation in the world…”

 




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Stuck in the Middle with Merkel? Upcoming German State Elections

German politics will become more interesting starting this weekend.  On Sunday, the largest state in the former East Germany, Saxony will hold its local election.  The key issue is how does the anti-euro Alternative for Germany (AfD) do.  

In May, much to the chagrin of Chancellor Merkel, the AfD garnered enough vote to secure representation in the EU Parliament.  In Saxony, it actually polled better than in the country as a whole (10% vs.7%).  We argued at the time that the votes for anti-EMU parties (like the AfD, but also the UKIP) cannot be taken at face value, as polls show that not all supporters were as anti-EMU as the candidates campaigning.  Those parties were siphoning or channeling protest votes in general. 

Saxony is a case in point.  The AfD recognizes that its anti-EMU position is not playing as well in Saxony and have toned that rhetoric down.  Instead, they have been emphasizing their conservative social platform instead.  These issues include promoting discipline in schools, opposing using the government to empower women, resisting pressure to use gender neutral language, and rejecting forcing schools to including handicap children.  It wants to strengthen protection for families and opposes efforts to ease citizenship for foreigners.

In some ways, the AfD is similar to the US Tea Party.  Many of the AfD supporters appear to have been more comfortable in the major center-right parties, like the Christian Democrat Union (CDU) or the Free Democrat Party (FDP).  However, the CDU did not secure a majority and hence has to govern in a coalition with Social Democrat Party (SPD).  Merkel has made some concessions to the SPD on social issues, which the AfD supports do not agree with.  At the same time, the FDP have imploded and did not secure enough votes to be represented in the Bundestag, the lower chamber of parliament.   

The AfD then is a challenge to Merkel’s right, in a similar fashion as the US Tea Party is challenge to the traditional conservative leadership of the Republican Party.  A chief difference is that the Tea Party, at least up until now, has sought to capture control of the Republican Party, rather than splinter and form a new party. 

The AfD needs to garner 5% of the vote in Saxony to be represented in the local government, and the recent polls suggest it will be close.   Polls indicate it may get 5-7% of the popular vote.   However, even if it gets the 5%, this is still a let down from how it did in the state in the EU parliament election.  This should be a warning to other protest parties that the cathartic experience may not be repeated.  This may also impact their negotiating position within the EU parliament.

While the election in Saxony sees a challenge to Merkel from the right, on September 14 the elections in Thuringia and Brandenburg elections will pose a challenge from the left.  This is particularly true of Thuringia, the birthplace of Martin Luther, Bach and Goethe.  The incumbent government is the same coalition as on the national level–CDU-SPD.  However, the weaker economic performance of the state is seeing support for the former Communist party, now the Left, increase.  There is an outside chance that it captures a plurality of the vote, especially if disgruntled SPD voters support it rather than casting their lot with the CDU.

Such an outcome could help influence the national politics.  The Left advocates controversial programs like bank nationalization and caps on income.  This is not to say such policies would be enacted by Merkel on the federal level, but they could help shape the debate.

The other state election on September 14 is in Bradenburg, which is also the home of the federal capital Berlin.  It is currently governed by an SPD-Left coalition.  In the 2009 election, the coalition drew 60% of the vote.  Polls suggest it will not do quite as well this time, but will still garner sufficient support to remain the governing coalition.

A strong showing by SPD, Left and Greens in state elections can influence the future of German politics.   The demise of the FDP is what forced Merkel and the CDU to form a coalition with the SPD after last year’s election.  The SPD had little choice, as well.  The national leaders rejected a coalition with the Left, but it may have been more pragmatic than ideological.  The combined SPD, Green, Left vote was shy of the majority needed to govern. 

The next national election is in 2017.  One of Merkel’s critiques of her predecessor and benefactor Kohl, was that he overstayed his welcome.  She had intimated, according to press reports, that she might not complete her current term, seemingly interested in a larger European role or a global role (as in UN).  However, such speculation has quieted, and it is now expected that she will not only complete her current term, but stand for another.  A pincer movement by her opposition, the AfD on the right and the SPD, Greens and Left on the other side, may get her to reconsider the lesson from Kohl’s experience.

Lastly, while staying in the realm of politics, and looking down field a bit, recall that Lithuania will join the monetary union at the start of 2015, and this will trigger a change in the voting at the ECB.  The changes will mean that the national central bank governors will not all vote at each meeting, and this includes Germany.  As a German candidate, Weber, was to have been Trichet’s successor before he unexpectedly resigned, a German will likely succeed Draghi.  Weidmann is the obvious choice.  There is some speculation that Draghi may not complete his term, perhaps becoming the next Italian president.    Our European contacts  do not give much credence to such speculation, but it is important for investors to know of such scenarios. 




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It Begins: Council On Foreign Relations Proposes That “Central Banks Should Hand Consumers Cash Directly”

… A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money

      – Ben Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here, November 21, 2002

A year ago, when it became abundantly clear that all of the Fed’s attempts to boost the economy have failed, leading instead to a record divergence between the “1%” who were benefiting from the Fed’s aritficial inflation of financial assets, and everyone else (a topic that would become one of the most discussed issues of 2014) and with no help coming from a hopelessly broken Congress (who can forget the infamous plea by a desperate Wall Street lobby-funding recipient “Get to work Mr. Chariman”), we wrote that “Bernanke’s Helicopter Is Warming Up.”

The reasoning was very simple: in a country (and world) drowning with debt, there are only two options to extinguish said debt: inflate it away or default. Anything else is kicking the can while making the problem even worse. Because while the Fed has been successful at recreating the world’s biggest asset bubble (in history), it has failed to stimulate broad, “benign” demand-pull inflation as the trickle down effects of its “wealth effect” have failed to materialize 6 years after the launch of the Fed’s unconventional monetary policies.

In other words, a world stuck in the last phase before complete Keynesian collapse, had no choice but to gamble “all in” with the last and only bluff it had left before admitting the economic system it had labored under, one which has borrowed so extensively from the future to fund the present that there is no future left, has failed.

The only question left was when would the trial balloons for such monetary paradrops start to emerge.

We now know the answer, and it is today.

Moments ago a stunning article appearing in the “Foreign Affaird” publication of the influential and policy-setting Council of Foreign Relations, titled “Print Less but Transfer More: Why Central Banks Should Give Money Directly to the People.” 

In it we read the now conventional admission of failure by Keynesians, who however, unwilling to actually admit they have been wrong, urge the even more conventional solution: do more of the same that has lead to the current financial cataclysm, only in this case the authors advocate no longer pretending that the traditional monetary channels work but to, literally, paradrop money. To wit:

To some extent, low inflation reflects intense competition in an increasingly globalized economy. But it also occurs when people and businesses are too hesitant to spend their money, which keeps unemployment high and wage growth low. In the eurozone, inflation has recently dropped perilously close to zero. And some countries, such as Portugal and Spain, may already be experiencing deflation. At best, the current policies are not working; at worst, they will lead to further instability and prolonged stagnation.

 

Governments must do better. Rather than trying to spur private-sector spending through asset purchases or interest-rate changes, central banks, such as the Fed, should hand consumers cash directly. In practice, this policy could take the form of giving central banks the ability to hand their countries’ tax-paying households a certain amount of money. The government could distribute cash equally to all households or, even better, aim for the bottom 80 percent of households in terms of income. Targeting those who earn the least would have two primary benefits. For one thing, lower-income households are more prone to consume, so they would provide a greater boost to spending. For another, the policy would offset rising income inequality.

A third, and most important outcome, would be the one we have forecast from the beginning of this ridiculous central bank experiment: “hyperinflation” (which is not simply runaway inflation as it is often incorrectly designated –  it is outright evisceration of the prevailing monetary system), which has been avoided for now, but which is inevitable in a world in which only the wholesale destruction of the fiat reserve currency is the one option left to inflate away the debt overhang.

So without further ado, here is the first official trial balloon – the article that one day soon will be seen as the canary in the paradropmine, and the piece that will finally get the rotor of Bernanke’s, now Yellen’s infamous helicopter finally spinning. Highlights ours:

Print Less but Transfer More: Why Central Banks Should Give Money Directly to the People

From Foreign Affairs, by Mark Blyth and Eric Lonergan

In the decades following World War II, Japan’s economy grew so quickly and for so long that experts came to describe it as nothing short of miraculous. During the country’s last big boom, between 1986 and 1991, its economy expanded by nearly $1 trillion. But then, in a story with clear parallels for today, Japan’s asset bubble burst, and its markets went into a deep dive. Government debt ballooned, and annual growth slowed to less than one percent. By 1998, the economy was shrinking.

That December, a Princeton economics professor named Ben Bernanke argued that central bankers could still turn the country around. Japan was essentially suffering from a deficiency of demand: interest rates were already low, but consumers were not buying, firms were not borrowing, and investors were not betting. It was a self-fulfilling prophesy: pessimism about the economy was preventing a recovery. Bernanke argued that the Bank of Japan needed to act more aggressively and suggested it consider an unconventional approach: give Japanese households cash directly. Consumers could use the new windfalls to spend their way out of the recession, driving up demand and raising prices.

As Bernanke made clear, the concept was not new: in the 1930s, the British economist John Maynard Keynes proposed burying bottles of bank notes in old coal mines; once unearthed (like gold), the cash would create new wealth and spur spending. The conservative economist Milton Friedman also saw the appeal of direct money transfers, which he likened to dropping cash out of a helicopter. Japan never tried using them, however, and the country’s economy has never fully recovered. Between 1993 and 2003, Japan’s annual growth rates averaged less than one percent.

Today, most economists agree that like Japan in the late 1990s, the global economy is suffering from insufficient spending, a problem that stems from a larger failure of governance. Central banks, including the U.S. Federal Reserve, have taken aggressive action, consistently lowering interest rates such that today they hover near zero. They have also pumped trillions of dollars’ worth of new money into the financial system. Yet such policies have only fed a damaging cycle of booms and busts, warping incentives and distorting asset prices, and now economic growth is stagnating while inequality gets worse. It’s well past time, then, for U.S. policymakers — as well as their counterparts in other developed countries — to consider a version of Friedman’s helicopter drops. In the short term, such cash transfers could jump-start the economy. Over the long term, they could reduce dependence on the banking system for growth and reverse the trend of rising inequality. The transfers wouldn’t cause damaging inflation, and few doubt that they would work. The only real question is why no government has tried them.

EASY MONEY

In theory, governments can boost spending in two ways: through fiscal policies (such as lowering taxes or increasing government spending) or through monetary policies (such as reducing interest rates or increasing the money supply). But over the past few decades, policymakers in many countries have come to rely almost exclusively on the latter. The shift has occurred for a number of reasons. Particularly in the United States, partisan divides over fiscal policy have grown too wide to bridge, as the left and the right have waged bitter fights over whether to increase government spending or cut tax rates. More generally, tax rebates and stimulus packages tend to face greater political hurdles than monetary policy shifts. Presidents and prime ministers need approval from their legislatures to pass a budget; that takes time, and the resulting tax breaks and government investments often benefit powerful constituencies rather than the economy as a whole. Many central banks, by contrast, are politically independent and can cut interest rates with a single conference call. Moreover, there is simply no real consensus about how to use taxes or spending to efficiently stimulate the economy.

Steady growth from the late 1980s to the early years of this century seemed to vindicate this emphasis on monetary policy. The approach presented major drawbacks, however. Unlike fiscal policy, which directly affects spending, monetary policy operates in an indirect fashion. Low interest rates reduce the cost of borrowing and drive up the prices of stocks, bonds, and homes. But stimulating the economy in this way is expensive and inefficient, and can create dangerous bubbles — in real estate, for example — and encourage companies and households to take on dangerous levels of debt.

That is precisely what happened during Alan Greenspan’s tenure as Fed chair, from 1997 to 2006: Washington relied too heavily on monetary policy to increase spending. Commentators often blame Greenspan for sowing the seeds of the 2008 financial crisis by keeping interest rates too low during the early years of this century. But Greenspan’s approach was merely a reaction to Congress’ unwillingness to use its fiscal tools. Moreover, Greenspan was completely honest about what he was doing. In testimony to Congress in 2002, he explained how Fed policy was affecting ordinary Americans:

“Particularly important in buoying spending [are] the very low levels of mortgage interest rates, which [encourage] households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures. Fixed mortgage rates remain at historically low levels and thus should continue to fuel reasonably strong housing demand and, through equity extraction, to support consumer spending as well.”

Of course, Greenspan’s model crashed and burned spectacularly when the housing market imploded in 2008. Yet nothing has really changed since then. The United States merely patched its financial sector back together and resumed the same policies that created 30 years of financial bubbles. Consider what Bernanke, who came out of the academy to serve as Greenspan’s successor, did with his policy of “quantitative easing,” through which the Fed increased the money supply by purchasing billions of dollars’ worth of mortgage-backed securities and government bonds. Bernanke aimed to boost stock and bond prices in the same way that Greenspan had lifted home values. Their ends were ultimately the same: to increase consumer spending.

The overall effects of Bernanke’s policies have also been similar to those of Greenspan’s. Higher asset prices have encouraged a modest recovery in spending, but at great risk to the financial system and at a huge cost to taxpayers. Yet other governments have still followed Bernanke’s lead. Japan’s central bank, for example, has tried to use its own policy of quantitative easing to lift its stock market. So far, however, Tokyo’s efforts have failed to counteract the country’s chronic underconsumption. In the eurozone, the European Central Bank has attempted to increase incentives for spending by making its interest rates negative, charging commercial banks 0.1 percent to deposit cash. But there is little evidence that this policy has increased spending.

China is already struggling to cope with the consequences of similar policies, which it adopted in the wake of the 2008 financial crisis. To keep the country’s economy afloat, Beijing aggressively cut interest rates and gave banks the green light to hand out an unprecedented number of loans. The results were a dramatic rise in asset prices and substantial new borrowing by individuals and financial firms, which led to dangerous instability. Chinese policymakers are now trying to sustain overall spending while reducing debt and making prices more stable. Like other governments, Beijing seems short on ideas about just how to do this. It doesn’t want to keep loosening monetary policy. But it hasn’t yet found a different way forward.

The broader global economy, meanwhile, may have already entered a bond bubble and could soon witness a stock bubble. Housing markets around the world, from Tel Aviv to Toronto, have overheated. Many in the private sector don’t want to take out any more loans; they believe their debt levels are already too high. That’s especially bad news for central bankers: when households and businesses refuse to rapidly increase their borrowing, monetary policy can’t do much to increase their spending. Over the past 15 years, the world’s major central banks have expanded their balance sheets by around $6 trillion, primarily through quantitative easing and other so-called liquidity operations. Yet in much of the developed world, inflation has barely budged.

To some extent, low inflation reflects intense competition in an increasingly globalized economy. But it also occurs when people and businesses are too hesitant to spend their money, which keeps unemployment high and wage growth low. In the eurozone, inflation has recently dropped perilously close to zero. And some countries, such as Portugal and Spain, may already be experiencing deflation. At best, the current policies are not working; at worst, they will lead to further instability and prolonged stagnation.

MAKE IT RAIN

Governments must do better. Rather than trying to spur private-sector spending through asset purchases or interest-rate changes, central banks, such as the Fed, should hand consumers cash directly. In practice, this policy could take the form of giving central banks the ability to hand their countries’ tax-paying households a certain amount of money. The government could distribute cash equally to all households or, even better, aim for the bottom 80 percent of households in terms of income. Targeting those who earn the least would have two primary benefits. For one thing, lower-income households are more prone to consume, so they would provide a greater boost to spending. For another, the policy would offset rising income inequality.

Such an approach would represent the first significant innovation in monetary policy since the inception of central banking, yet it would not be a radical departure from the status quo. Most citizens already trust their central banks to manipulate interest rates. And rate changes are just as redistributive as cash transfers. When interest rates go down, for example, those borrowing at adjustable rates end up benefiting, whereas those who save — and thus depend more on interest income — lose out.

Most economists agree that cash transfers from a central bank would stimulate demand. But policymakers nonetheless continue to resist the notion. In a 2012 speech, Mervyn King, then governor of the Bank of England, argued that transfers technically counted as fiscal policy, which falls outside the purview of central bankers, a view that his Japanese counterpart, Haruhiko Kuroda, echoed this past March. Such arguments, however, are merely semantic. Distinctions between monetary and fiscal policies are a function of what governments ask their central banks to do. In other words, cash transfers would become a tool of monetary policy as soon as the banks began using them.

Other critics warn that such helicopter drops could cause inflation. The transfers, however, would be a flexible tool. Central bankers could ramp them up whenever they saw fit and raise interest rates to offset any inflationary effects, although they probably wouldn’t have to do the latter: in recent years, low inflation rates have proved remarkably resilient, even following round after round of quantitative easing. Three trends explain why. First, technological innovation has driven down consumer prices and globalization has kept wages from rising. Second, the recurring financial panics of the past few decades have encouraged many lower-income economies to increase savings — in the form of currency reserves — as a form of insurance. That means they have been spending far less than they could, starving their economies of investments in such areas as infrastructure and defense, which would provide employment and drive up prices. Finally, throughout the developed world, increased life expectancies have led some private citizens to focus on saving for the longer term (think Japan). As a result, middle-aged adults and the elderly have started spending less on goods and services. These structural roots of today’s low inflation will only strengthen in the coming years, as global competition intensifies, fears of financial crises persist, and populations in Europe and the United States continue to age. If anything, policymakers should be more worried about deflation, which is already troubling the eurozone.

There is no need, then, for central banks to abandon their traditional focus on keeping demand high and inflation on target. Cash transfers stand a better chance of achieving those goals than do interest-rate shifts and quantitative easing, and at a much lower cost. Because they are more efficient, helicopter drops would require the banks to print much less money. By depositing the funds directly into millions of individual accounts — spurring spending immediately — central bankers wouldn’t need to print quantities of money equivalent to 20 percent of GDP.

The transfers’ overall impact would depend on their so-called fiscal multiplier, which measures how much GDP would rise for every $100 transferred. In the United States, the tax rebates provided by the Economic Stimulus Act of 2008, which amounted to roughly one percent of GDP, can serve as a useful guide: they are estimated to have had a multiplier of around 1.3. That means that an infusion of cash equivalent to two percent of GDP would likely grow the economy by about 2.6 percent. Transfers on that scale — less than five percent of GDP — would probably suffice to generate economic growth.

LET THEM HAVE CASH

Using cash transfers, central banks could boost spending without assuming the risks of keeping interest rates low. But transfers would only marginally address growing income inequality, another major threat to economic growth over the long term. In the past three decades, the wages of the bottom 40 percent of earners in developed countries have stagnated, while the very top earners have seen their incomes soar. The Bank of England estimates that the richest five percent of British households now own 40 percent of the total wealth of the United Kingdom — a phenomenon now common across the developed world.

To reduce the gap between rich and poor, the French economist Thomas Piketty and others have proposed a global tax on wealth. But such a policy would be impractical. For one thing, the wealthy would probably use their political influence and financial resources to oppose the tax or avoid paying it. Around $29 trillion in offshore assets already lies beyond the reach of state treasuries, and the new tax would only add to that pile. In addition, the majority of the people who would likely have to pay — the top ten percent of earners — are not all that rich. Typically, the majority of households in the highest income tax brackets are upper-middle class, not superwealthy. Further burdening this group would be a hard sell politically and, as France’s recent budget problems demonstrate, would yield little financial benefit. Finally, taxes on capital would discourage private investment and innovation.

There is another way: instead of trying to drag down the top, governments could boost the bottom. Central banks could issue debt and use the proceeds to invest in a global equity index, a bundle of diverse investments with a value that rises and falls with the market, which they could hold in sovereign wealth funds. The Bank of England, the European Central Bank, and the Federal Reserve already own assets in excess of 20 percent of their countries’ GDPs, so there is no reason why they could not invest those assets in global equities on behalf of their citizens. After around 15 years, the funds could distribute their equity holdings to the lowest-earning 80 percent of taxpayers. The payments could be made to tax-exempt individual savings accounts, and governments could place simple constraints on how the capital could be used.

For example, beneficiaries could be required to retain the funds as savings or to use them to finance their education, pay off debts, start a business, or invest in a home. Such restrictions would encourage the recipients to think of the transfers as investments in the future rather than as lottery winnings. The goal, moreover, would be to increase wealth at the bottom end of the income distribution over the long run, which would do much to lower inequality.

Best of all, the system would be self-financing. Most governments can now issue debt at a real interest rate of close to zero. If they raised capital that way or liquidated the assets they currently possess, they could enjoy a five percent real rate of return — a conservative estimate, given historical returns and current valuations. Thanks to the effect of compound interest, the profits from these funds could amount to around a 100 percent capital gain after just 15 years. Say a government issued debt equivalent to 20 percent of GDP at a real interest rate of zero and then invested the capital in an index of global equities. After 15 years, it could repay the debt generated and also transfer the excess capital to households. This is not alchemy. It’s a policy that would make the so-called equity risk premium — the excess return that investors receive in exchange for putting their capital at risk — work for everyone.

MO’ MONEY, FEWER PROBLEMS

As things currently stand, the prevailing monetary policies have gone almost completely unchallenged, with the exception of proposals by Keynesian economists such as Lawrence Summers and Paul Krugman, who have called for government-financed spending on infrastructure and research. Such investments, the reasoning goes, would create jobs while making the United States more competitive. And now seems like the perfect time to raise the funds to pay for such work: governments can borrow for ten years at real interest rates of close to zero.

The problem with these proposals is that infrastructure spending takes too long to revive an ailing economy. In the United Kingdom, for example, policymakers have taken years to reach an agreement on building the high-speed rail project known as HS2 and an equally long time to settle on a plan to add a third runway at London’s Heathrow Airport. Such large, long-term investments are needed. But they shouldn’t be rushed. Just ask Berliners about the unnecessary new airport that the German government is building for over $5 billion, and which is now some five years behind schedule. Governments should thus continue to invest in infrastructure and research, but when facing insufficient demand, they should tackle the spending problem quickly and directly.

If cash transfers represent such a sure thing, then why has no one tried them? The answer, in part, comes down to an accident of history: central banks were not designed to manage spending. The first central banks, many of which were founded in the late nineteenth century, were designed to carry out a few basic functions: issue currency, provide liquidity to the government bond market, and mitigate banking panics. They mainly engaged in so-called open-market operations — essentially, the purchase and sale of government bonds — which provided banks with liquidity and determined the rate of interest in money markets. Quantitative easing, the latest variant of that bond-buying function, proved capable of stabilizing money markets in 2009, but at too high a cost considering what little growth it achieved.

A second factor explaining the persistence of the old way of doing business involves central banks’ balance sheets. Conventional accounting treats money — bank notes and reserves — as a liability. So if one of these banks were to issue cash transfers in excess of its assets, it could technically have a negative net worth. Yet it makes no sense to worry about the solvency of central banks: after all, they can always print  more money.

The most powerful sources of resistance to cash transfers are political and ideological. In the United States, for example, the Fed is extremely resistant to legislative changes affecting monetary policy for fear of congressional actions that would limit its freedom of action in a future crisis (such as preventing it from bailing out foreign banks). Moreover, many American conservatives consider cash transfers to be socialist handouts. In Europe, which one might think would provide more fertile ground for such transfers, the German fear of inflation that led the European Central Bank to hike rates in 2011, in the middle of the greatest recession since the 1930s, suggests that ideological resistance can be found there, too.

Those who don’t like the idea of cash giveaways, however, should imagine that poor households received an unanticipated inheritance or tax rebate. An inheritance is a wealth transfer that has not been earned by the recipient, and its timing and amount lie outside the beneficiary’s control. Although the gift may come from a family member, in financial terms, it’s the same as a direct money transfer from the government. Poor people, of course, rarely have rich relatives and so rarely get inheritances — but under the plan being proposed here, they would, every time it looked as though their country was at risk of entering a recession.

Unless one subscribes to the view that recessions are either therapeutic or deserved, there is no reason governments should not try to end them if they can, and cash transfers are a uniquely effective way of doing so. For one thing, they would quickly increase spending, and central banks could implement them instantaneously, unlike infrastructure spending or changes to the tax code, which typically require legislation. And in contrast to interest-rate cuts, cash transfers would affect demand directly, without the side effects of distorting financial markets and asset prices. They would also would help address inequality — without skinning the rich.

Ideology aside, the main barriers to implementing this policy are surmountable. And the time is long past for this kind of innovation. Central banks are now trying to run twenty-first-century economies with a set of policy tools invented over a century ago. By relying too heavily on those tactics, they have ended up embracing policies with perverse consequences and poor payoffs. All it will take to change course is the courage, brains, and leadership to try something new.




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JPMorgan Sees 50% Chance Of ECB QE By Year-End, Will Ease More Next Week

Wondering why US and European stocks knee-jerked higher in the last hour – wonder no more. JPMorgan released a report stating they expect the ECB to ease next week, masking some policy changes next week to make TLTROs more attractive and even a slight disappointment in data may trigger sovereign QE (30% chance next week and 50% by year-end).

Of course, the kicker in all of this discussion of QE is that the ECB is already doing it – willing to buy whetever bonds European banks buy via repo agreements (with no haircut) – and with yields already at record lows (or negative) in the face of record-high ‘real’ financing costs for non-financials, the exuberance appears misplaced.

 

Via JPMorgan,

ECB to ease next week, as QE debate intensifies  

  • We expect the ECB to make some policy changes next week to make TLTROs more attractive
  • These changes are a holding operation, as the ECB assesses the incoming data
  • Three data points will be key to watch and even a slight disappointment may trigger sovereign QE
  • Apart from the data, the level of opposition on the Governing Council is currently hard to gauge
  • We think the chances of sovereign QE are over 30% by year-end and almost 50-50 next year

 
We now expect the ECB to take some further policy steps at next week’s meeting. The ECB could try to boost the attractiveness of the upcoming TLTROs by cutting the entire interest rate corridor by 10bp, but removing the 10bp spread it was going to charge above the refi rate for the funds and, albeit with a lower likelihood, by increasing the initial allowances above 7% of banks’ real economy loan books (excluding mortgages). This means that banks will be able to lock in even more funding for up to four years at an even lower interest rate of just 0.05%. Making this announcement next week would support take-up at the first TLTRO in mid-September by reducing some incentives to wait for the December tender. In addition, we think that Draghi will make a more definitive statement about what the ABS purchase programme will look like. It is possible that the ECB goes beyond the current plan to buy ABS by also purchasing other private assets, but we are not convinced by this.
 
The key assumption underlying this new forecast is that sovereign QE remains controversial. If that is true, then the rationale for these relatively small policy changes would be to buy time and allow a bit more wait-and-see, which is something the Bundesbank would be able to support, in our view. For the same reason, the Bundesbank may agree to Draghi ramping up the rhetoric about sovereign QE, for example with a statement that “the Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate, including large-scale purchases of private and public assets, should it become necessary.” This statement would make clearer what unconventional instruments would mean. But, this statement would be more data dependent than the one made in June about possible ABS purchases and the hope would be that it has a significant impact in itself.
 
But, while we still do not expect the ECB to actually deliver a sovereign QE programme, we think that the likelihood has increased substantially and that things could move very quickly. In particular, we think that the likelihood has increased to almost 50% next year and that it is now over 30% by year-end.

Uncertainty in the data and the Governing Council

To avoid QE, we think that three things need to happen in the data over the next 1-2 months.

  • First, the official activity data must realign themselves with where the surveys currently are, with IP in particular needing to bounce in July/August.
  • Second, the surveys themselves must start to show signs of stabilization and give hope that they could move higher again.
  • Third, inflation expectations in financial markets must at the very least stabilize after the recent falls.

If there is disappointment in these areas, with the second and third probably being the most important, then things could move pretty quickly. For now, our current forecasts are consistent with improvement in the first two areas, which marginally tilts the balance against QE.
 
We would however emphasize that the level of uncertainty is very high at present, both in terms of how the macro-economy evolves but also in how far the Governing Council has already shifted towards sovereign QE. The first version of Draghi’s speech was certainly very dovish and it did argue that monetary policy should play a central role in boosting aggregate demand. But, it can be read as calling on other policymakers to help boost growth as monetary policy is unable to do it alone. In this sense, it did not clearly signal that the ECB needs to go beyond the measures that it announced in June and that it has yet to implement.
 
The revised version of the speech of course signals much greater concern and hence a much higher likelihood of sovereign QE, even if other policymakers respond slowly. What prompted this last minute change? We believe it was the combination of signs that growth is weakening and the rapidity with which market-based measures of inflation expectations have recently fallen. In particular, when growth weakens, the ECB tends to be much more intolerant of low inflation, high unemployment and inflation expectations edging lower. Crucially, if inflation expectations fall, it undermines the anchoring of the ECB’s medium-term inflation forecast and would be seen as an expression of doubt in the central bank’s willingness and/or ability to meet its mandate. In our view, this underlies the urgency signalled by the final version of Draghi’s speech and means that the evolution of the data in the near-term will be crucial.
 
Apart from the data, there is also uncertainty about where the Governing Council currently stands. The Bundesbank is unlikely to have shifted its fundamental concern about moral hazard and its view that governments should do more. But, it has not been fighting the idea that growth is slowing in the Euro area and in Germany, and it will recognise the importance of inflation expectations remaining anchored. It has also recognised recently that many Euro area countries have made progress in the necessary adjustments and it views some of the current headwinds to growth relating to external factors. For this reason, we are less sure how strong the Bundesbank’s opposition to QE would actually be. We do think however that the Bundesbank will at least try to play for time by allowing some ECB easing next week and then hoping that growth improves and that market-based measures of inflation expectations stop falling (after all they are still close to 2%). If the latter happens, it can point to the Survey of Professional Forecasters, which did not show any decline in early August. What is less clear, in our view, is where the rest of the Governing Council stands and whether Draghi is willing to do sovereign QE without explicit Bundesbank support. For sure, Draghi appears to be putting a real challenge to the Governing Council and it is quite clear in which direction Draghi would like to go. As a result, we note that all ECB governors will now have to reveal their real views on the issue.

*  *  *

But will it help at all?

These are “market” rates… i.e. what real risk is being priced at away from the hand of Draghi…

 

*  *  *

The kicker in all of this discussion of QE is that the ECB is already doing it – willing to buy whetever bonds European banks buy via repo agreements (with no haircut)… so just who is this for?




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…And The Market Breaks (Again)

Surprise…

  • *BATS: ROUTING TO NASDAQ OPTIONS MKT SUSPENDED AS OF 11:06:07 ET
  • *BATS INVESTIGATING OPTIONS MKT ISSUE
  • *NOM ISSUES WITH OPRA DATA IN SYMBOL RANGE HD-HO
  • *BX OPTIONS ISSUES WITH OPRA DATA IN SYMBOL RANGE GP-HN
  • *NASDAQ OPTIONS MARKET, BX OPTIONS HAVING ISSUES ON SOME SYMBOLS

Via BATS Options Status

 

Which might help explain this…




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White Hawk Down – UN Helicopter Shot Down In South Sudan

Time for some more ‘humanitarian’ airtsrike non-boots-on-the-ground ‘advisors’… As AP reports, The U.N. mission in South Sudan says one of its helicopters has crashed, and a U.N. official told The Associated Press that it appears the aircraft was shot down. While not quite Mogadishu (yet), the UN is “deeply concerned” about the crew as the widespread and massive violence between rebels and the national army in South Sudan that has raged since December continues to rage.

 

As AP reports,

The U.N. mission said on Twitter that an Mi-18 cargo helicopter crashed Tuesday near Bentiu, which is hotly contested between the government and rebels.

 

The U.N. said it is deeply concerned about the fate of its crew.

 

A search and rescue team has been sent to the crash site.

 

The U.N. official, who insisted on anonymity because he was not authorized to speak to the press, said contact with the helicopter was lost at about 3:19 p.m. and that it was apparently shot down near Bentiu.

*  *  *

Red line?




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(Un)Comfortable Myths About High Yield Debt

Submitted by Pater Tenebrarum of Acting-Man blog,

Update on Global High Yield Debt Issuance Volumes

Here is a small addendum to our recent articles on the corporate debt bubble (“A Dangerous Boom in Unsound Corporate Debt”) and the associated derivatives-berg, which is intended to hedge both the credit and interest rate risk this credit boom has given rise to (“A Perilous Derivatives-Berg”).

We recently combed through John Hussman's weekly commentaries, one of which contained an up-to-date chart of global high yield debt issuance per quarter from Q1 2006 to Q2 2014. Both global issuance volume and the number of deals are depicted on the chart. As you can see, we have long left all previous records in the dust.

 

hi-yield

Global high yield debt issuance in USD billion per quarter, plus the number of offerings, via John Hussman.

 

 

How Compressed Risk Premiums Unwind

This low-grade debt bubble is undoubtedly going to prove to be the Achilles heel of the current inflationary boom period – even though many market participants strenuously deny it by relying on the 12 month default forecasts published by rating agencies (which show not even the smallest cloud on the horizon – in other words, it's all good). As the next chart shows, risk premiums have become extremely compressed. Mr. Hussman had something very interesting to say on that particular topic, namely:

“As we saw in multiple early selloffs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.

 

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss.

 

Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all.

 

Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.”

(emphasis added)

This is an important observations regarding the connection between news releases and financial markets. The news are actually rarely the cause of market movements (which more often than not makes the attempts in the financial press to “explain” day-to-day market movements incredibly comical).

Market participants only use news as triggers when it suits them, in other words, when they seem to confirm what they were going to do anyway. The important point is not whether news emerge that are seemingly associated with market moves; the important point is the degree of overvaluation and leverage.

 

Hi Yield, effective

Effective yield of the Merrill US high yield master II index – currently at 5.5%. Similar levels of return-free risk were on offer in 2005-2007 – click to enlarge.

 

 

Comforting Myths

Hence there rarely seems to be a “reason” for why market crashes happen. Market observers are e.g. debating to this day what actually “caused” the crash of 1987. It is in the nature of the beast that once liquidity evaporates sufficiently that not all bubble activities can be sustained at once any longer, bids begin to become scarce in one market segment after another. Eventually, they can disappear altogether – and sellers suddenly find they are selling into a vacuum.

Once this happens, the usual sequence of margin calls and forced selling does the rest. Risk premiums normalize abruptly, and there doesn't need to be an obvious reason for this to happen. Mr. Hussmann inter alia cites Kenneth Galbraith's description of the crash of 1929 in this context. Galbraith correctly remarked that when the crash occurred, no-one knew that a depression was lying dead ahead. The crash itself would have been in the cards regardless of what happened later. Anything could have broken the bubble, as Galbraith put it. The crash merely adjusted a situation that had become unsustainable.

After an extended credit boom, leverage can be assumed to have seeped into every nook and cranny of the markets.  In the stock market, we see it in record high margin debt and the tiny cash reserves held by mutual funds and other investors. In fixed interest rate securities, investors are encouraged by low volatility and the seeming absence of risk to lever up, as their returns on newly issued debt begin to shrink along with falling interest rates. In so doing, the risks are usually judged by looking at market history. In every bubble, a new myth emerges that seemingly justifies such investment decisions.

In the housing bubble, the myth of choice was that house prices could never fall on a nationwide basis. After all, history showed it had never happened before. It was held that eventually, problems may emerge in some regions or some sub-sectors of the credit markets, but they would remain localized and “well contained” (the favorite phrase employed by assorted officials when the bubble began to fray at the edges). In the current bubble the myth of choice is that “past crises have shown that defaults on high yield corporate debt never exceed certain manageable levels”.

Why is this a myth? After all, it is a historically correct view. It is a myth for one reason only: in all of history, there has never been a bigger bubble in junk debt than now (just as the real estate and mortgage credit bubble were unique in their extent). Therefore, economic history actually has little to say about the current situation, except for the general statement that compressed risk premiums have a tendency to one day readjust out of the blue and quite abruptly. Economic history can definitely not be used to assert that the risks are small. They are in fact huge and continue to grow.

 

Conclusion

Compressed risk premiums can never be sustained “forever”. They are so to speak sowing the seeds of their own demise. Most market participants believe they will be able to get out in time, but that is never the case – in fact, it is literally impossible for the majority to do so, because someone must buy what others sell (by definition, this means someone will be caught holding the bag when the tide goes out). In reality, it is ever only a tiny minority that manages to sell near the market peak, not least because investors have assimilated the lesson that “every dip is a buying opportunity”. This will be true until it one day isn't anymore (the search for reasons will then predictably yield the well-known phrase “no-one could have seen it coming”).




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Doctor Fed, You Are Wanted In The San Francisco Housing Ward, Stat

We have previously explained why the San Francisco market is such an important bellwether of overall liquidity and prevailing economic euphoria, directly supported by not only the Fed’s “wealth effect” printing and the second tech bubble, but also Chinese capital flows out of the mainland and into US real-estate. Which is why the latest update on San Fran housing dynamics should make those looking for the housing inflection point somewhat nervous as said inflection point now appears to be almost a year old.

Specifically, after posting a 25.7% Y/Y increase in home prices last September, as of June the pace of home price increases is precisely half that, or 12.9%, and also a signfiicant drop from the 15.6% reported in May.

Why is this notable? Because the only three previous times when there was such a sharp contraction in the pace of San Fran home price appreciation, either the dot com bubble, the housing bubble, or the European sovereign debt bubble had just burst. For now, we leave what is going on in San Francisco as merely a question mark, because clearly the Fed’s grand “reflation at all costs” experiment is nowhere near over…




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