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Tuesday December 2, 2008 - 22:32:36 GMT
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Can you say 1% Treasury Bond Yield?

Key News
• Russia’s central bank probably doubled spending of foreign reserves to defend the ruble from its biggest weekly plunge against the euro in more than four years. (Bloomberg)

(Chart unavailable in text format.)
• The Canadian dollar recovered some ground versus the U.S. dollar on Tuesday but remained range-bound and at risk of pressure from falling oil prices and political uncertainty in Canada. (Reuters)

"The great question is whether the government will succeed in reinstilling the inflationary spirit of reckless abandon in American lenders and borrowers.  Debasement is what the authorities are driving toward.  It’s why they keep inventing new [lending] facilities.”
        Jim Grant

FX Trading – Can you say 1% Treasury Bond Yield? 
The Fed’s announcement that it will start buying Treasury bonds, along with everyone else in the world it seems, pushes the Fed into official Quantitative Easing (QE) territory. 

 (Chart unavailable in text format.)

A recent article, dated October 10th, carried in the Financial Times by Graham Turner, from GFC Economics, helps explain why this was needed [our emphasis]:

“But, as we saw in Japan, that may well not be enough. The recapitalisation of banks in 1998 is often cited as a successful intervention that turned the corner for Japan. That is not true. The stock market did not hit its lows until April 2003.

“The tide only turned when long term interest rates were pegged down at low levels too, with the Bank of Japan buying government debt. This is the essence of quantitative easing. The Ministry of Finance was also allowed by the US administration to intervene in the currency markets and drive the yen down.

Clearly the latter is not an option for the world economy. But driving down both short and long term rates is a far better policy weapon than the current stream of government initiatives, which will wreak havoc with the public sector finances.

Today’s partial recapitalisations of banks are not the answer because they will accelerate the slide into a debt trap. In the absence of radical monetary easing, the increased government borrowing to fund quasi nationalisations will ensure bond yields remain elevated. We are repeating many of the mistakes made by successive Japanese governments during the 1990s. They allowed the JGB curve to steepen and that delayed the much needed decline in borrowing costs. It would be better if governments in the West simply nationalised struggling banks outright. But even this still has to be funded through quantitative easing, otherwise, there will be classic crowding out as idenitified by Keynes.

“Indeed, Japan saw its public sector debt burden soar from 65% to 175% of GDP between 1990 and 2005. This increase in public spending was not Keynesian. For much of this period before the BoJ started buying government debt aggressively, it caused bond yields to remain elevated relative to short rates. Lending rates did not fall quickly enough, and Japan became embedded in a cycle of debt deflation.”

So maybe there is a plan behind Helicopter Ben’s seemingly ongoing debasement. 

We get asked often why this weight of dollars thrown onto the market won’t push the dollar down the proverbial rat hole.  And our answer, right or wrong, is that this is a relative game.  And because the US banking system, as bad as it is, still lacks the exposure of the dollar’s main competitors. 

“Notwithstanding all the problems in the US banking system, the size of banks’ balance sheet is much smaller in the US than in many other countries.  For example, total bank liabilities are around 650% of GDP for Switzerland, 430% for the UK, 320% for the Euroland, 150% for Japan and 85% for the US.  Investors should keep this fact in mind,” writes Morgan’s Stephen Jen.  [Our emphasis]

But what about the return of inflation, won’t that be bad for the dollar?  Well it might!  But given the increased potential for major debt default to come, i.e. high yield corporate bonds and EM countries, the major deleveraging phase seems far from over.  And as we know, consumers are finally getting scarred enough to start saving and the banks are still too damaged (or frightened) to lend.  Thus the money multiplier is plunging.  This should keep inflation at bay for a while—deflation is the real concern now.  And news global guru favorite China is in trouble only adds to this concern.  After all, China was supposed to be the White Knight to ride in on its massive reserve horse to save the rest of us heathens. That ain’t going to happen is our bet!

Again from Mr. Jen at Morgan [our emphasis]:

“We looked at the trajectories for M2 of Japan and the US.  During Japan’s QE period, its M2 expanded from around 125% of GDP to more than 140%.  In the US, M2 has expanded from 53% to 57% of GDP since September. While the latter is a sharp surge, M2/GDP is not substantially higher than it was during 2003, when the Fed drove the FFR towards 1.00%.  Indeed, most of the surge in the figure comes from the anticipated sharp drop in 4Q nominal GDP. To summarise, while base money has increased dramatically (by 34% since August), M2 has grown by only 2.7%.

“The reason for this, of course, is that the ‘money multiplier’ (MM) has collapsed, reflecting a severe breakdown in the ability and the willingness of the bank and non-bank entities in the US to intermediate capital to the extent they had done prior to the crisis.  The collapse in the US MM is significantly more severe than in the case of Japan, during which time Japan’s MM fell from around 10 times the size of the BoJ’s balance sheet to around 6.5 times (a fall of 35%).  In the US in the last two months, we have seen the US MM falling from more than 9 to around 7 (down 22%).” 

So, the US money multiplier collapsing faster than Japan’s did…hmmm.  Maybe that explains why Helicopter Ben is breaking out all the tools in his box. 

Reader Q&A:

Q: Quick thoughts on the implications of the Chinese yuan shift that is showing up on the charts? Bullish/bearish for what? Bonds? Stocks?

 (Chart unavailable in text format.)

A: We think it is bullish for bonds (not corporate) and bearish for stocks.  It portends big problems for China.  Hot money is likely running out for cover; a bit of “Chinese capitulation,” so to speak.  We think that is what sparked yesterday’s moves higher in bonds and stocks.  We think it will be ongoing as China spirals downward beyond expectations. 

Jack Crooks
Black Swan Capital LLC


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