Two Dollar Fallacies

Martin Feldstein

28 February 2013

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CAMBRIDGEThe United States’ current fiscal and monetary policies are unsustainable. The US government’s net debt as a share of GDP has doubled in the past five years, and the ratio is projected to be higher a decade from now, even if the economy has fully recovered and interest rates are in a normal range. An aging US population will cause social benefits to rise rapidly, pushing the debt to more than 100% of GDP and accelerating its rate of increase. Although the Federal Reserve and foreign creditors like China are now financing the increase, their willingness to do so is not unlimited.
Likewise, the Fed’s policy of large-scale asset purchases has increased commercial banks’ excess reserves to unprecedented levels (approaching $2 trillion), and has driven the real interest rate on ten-year Treasury bonds to an unprecedented negative level. As the Fed acknowledges, this will have to stop and be reversed.
While the future evolution of these imbalances remains unclear, the result could eventually be a sharp rise in long-term interest rates and a substantial fall in the dollar’s value, driven mainly by foreign investors’ reluctance to continue expanding their holdings of US debt. American investors, fearing an unwinding of the fiscal and monetary positions, might contribute to these changes by seeking to shift their portfolios to assets of other countries.
While I share these concerns, others frequently rely on two key arguments to dismiss the fear of a run on the dollar: the dollar is a reserve currency, and it carries fewer risks than other currencies. Neither argument is persuasive.
Consider first the claim that the dollar’s status as a reserve currency protects it, because governments around the world need to hold dollars as foreign exchange reserves. The problem is that foreign holdings of dollar securities are no longer primarilyforeign exchange reserves” in the traditional sense.
In earlier decades, countries held dollars because they needed to have a highly liquid and widely accepted currency to bridge the financing gap if their imports exceeded their exports. The obvious candidate for this reserve fund was US Treasury bills.
But, since the late 1990’s, countries like South Korea, Taiwan, and Singapore have accumulated very large volumes of foreign reserves, reflecting both export-driven growth strategies and a desire to avoid a repeat of the speculative currency attacks that triggered the 1997-1998 Asian financial crisis.
With each of these countries holding more than $200 billion in foreign-exchange holdings – and China holding more than $3 trillion – these are no longer funds intended to bridge trade-balance shortfalls. They are major national assets that must be invested with attention to yield and risk.
So, although dollar bonds and, increasingly, dollar equities are a large part of these countries’ sovereign wealth accounts, most of the dollar securities that they hold are not needed to finance trade imbalances. Even if these countries want to continue to hold a minimum core of their portfolios in a form that can be used in the traditional foreign-exchange role, most of their portfolios will respond to their perception of different currencies’ risks.
In short, the US no longer has what Valéry Giscard d’Estaing, as France’s finance minister in the 1960’s, accurately called the “exorbitant privilege” that stemmed from having a reserve currency as its legal tender.
But some argue that, even if the dollar is not protected by being a reserve currency, it is still safer than other currencies. If investors don’t want to hold euros, pounds, or yen, where else can they go?
That argument is also false. Large portfolio investors don’t put all of their funds in a single currency. They diversify their funds among different currencies and different types of financial assets. If they perceive that the dollar and dollar bonds have become riskier, they will want to change the distribution of assets in their portfolios. So, even if the dollar is still regarded as the safest of assets, the demand for dollars will decline if its relative safety is seen to have declined.
When that happens, exchange rates and interest rates can change without assets being sold and new assets bought. If foreign holders of dollar bonds become concerned that the unsustainability of America’s situation will lead to higher interest rates and a weaker dollar, they will want to sell dollar bonds. If that feeling is widespread, the value of the dollar and the price of dollar bonds can both decline without any net change in the holding of these assets.
The dollar’s real trade-weighted value already is more than 25% lower than it was a decade ago, notwithstanding the problems in Europe and in other countries. And, despite a more competitive exchange rate, the US continues to run a large current-account deficit. If progress is not made in reducing the projected fiscal imbalances and limiting the growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall more rapidly and the interest rate on dollar securities to rise.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.


The Investment Case for Gold - Part 2

John Hathaway
Portfolio Manager and Senior Managing Director

February 28, 2013

The investment case for gold, in our opinion, rests squarely on the prospect for U.S. sovereign credit, and by extension, the value of the U.S. dollar. The prospect, in short, appears poor. Therefore, we find that the rationale for gold remains solid. In fact, it seems stronger than ever.
One could argue that there has been a bull market in bearish commentary regarding U.S. fiscal issues and that therefore, worst cased outcomes have already been priced in at roughly $1575/oz. (2/28/13) Three years of steadily rising equity prices could suggest that there is an argument opposite to the bearish case which will only be fully evident years from now.
What follows is a compendium of my beliefs, observations, inferences, opinions and perceptions that lead me to conclude that the gold price is headed substantially higher in terms of all paper currencies. The thesis rests on considerations which I feel are categorically ignored by mainstream commentary. In our opinion, gradual, and to most, imperceptible evolutions of economic and political realities preclude a return to “normalcycles of economic growth. We believe that expectation is a web of fantasy produced by major financial institutions, government officials, academia, and made possible by the complicity of an uninformed public.
We view assessing the long term direction of the gold price correctly as a big part of our job as the manager of a gold strategy. It is our view that the lengthy correction from the 2011 peak is nearly over, and that a solid base for future advances has been established. Any price that attempts to go parabolic, as gold did in August of 2011, is bound to suffer from a hangover (as noted several times by John Mendelson of ISI) and we believe that gold’s hangover is in its final stages. All sentiment measures that we monitor are at rock bottom levels. The demoralization of gold investors is a sign, however painful and understandable, that further downside risk is minimal.

In 2002, we wrote in our website article “The Investment Case for Gold” that the rationale rested “on the notion that the overvaluation and excessive supply of the U.S. currency has funded a decade’s worth of uneconomic investment and unsustainable consumption.” The only revision that we would make today to our statement of ten years ago is that another decade of overvaluation and excessive supply has come and gone with no resolution of the basic problem. Economic rot has been repackaged in sovereign credit, which it could eventually corrupt.
What is the case for further upside? During the crash of 2008, we argued in our website articleIs Gold Still in a Bull Market? (October 2008) that the consequences of massive Fed intervention would cause alarm among investors and broaden interest in gold as an alternative to paper currencies. Then, as now, it was necessary to reckon the basis for a further advance in gold that had not already been articulated:
What will drive a further advance in gold? Let’s start with the implausible assumption that the worst of the credit crunch had been already discounted when gold scaled $1000. Let’s also assume an even greater stretch that the Paulson bailout succeeds in restarting the wheels of lending and commerce. Finally, let’s toss in an end to the decline of asset prices and the commencement of a bull market in equities. The unequivocal precondition for these felicitous events would be the transformation of the dollar and other paper currencies as we know them. The socialization of credit in the U.S. may well work the miracles as its proponents claim, but not without stiff costs. We suspect that two inescapable costs will be inflation and negative real interest rates as far as the eye can see. Both of these outcomes are friendly to gold. Neither is likely to improve the credit rating of the dollar or increase the desire of non U.S. investors to increase their holdings of U.S. Treasuries.
We believe that a future downgrade of U.S. sovereign credit is a strong possibility. It would defrock U.S. Treasuries of their safe haven status. In the late 1970’s, they were dubbedcertificates of confiscation”. We fully believe they will once again be referred to in a similar manner as a direct result of current and still to come interventions by the government to shore up financial markets.

Those who seek to find the rationale for owning gold in the growth of the Fed and other central bank balance sheets, future inflation, the prospects for a deflationary collapse, the flight to safety or other macroeconomic themes only touch on ephemeral aspects of the forces that drive the bull market in gold. The narrative for gold has evolved several times since the bull market began in 1999. At first, central bank selling and producer hedging was the focus of most commentary. The attack of 9/11/01 added a geopolitical dimension. In 2006 and 2007 a thirst for “hard assets premised on emerging market growth co-opted the investment thesis. The crash of gold during 2008 was explained by the specter of deflation. The dollar price of gold rose from its bear market low of $250 in 1999 to more than $700 according to several different narratives as voiced by conventional wisdom. Post the 2008 meltdown, media commentary on gold flourished. High profile investors proclaimed the merits. Quantitative easing with implications for future inflation dominated investment thinking. The sovereign debt crisis in euro land and the 2011 showdown over the debt ceiling in Congress culminated the frenzy. The bull market, unnoticed by most for the previous eight years, became front page and hostage to popular perceptions.
To be caught up in a debate dictated by the explanations of mainstream commentary is, in our opinion, a waste of time. The rationale for further advances is destined to change. What needs to be addressed, as in any investment analysis, is not what is on the tip of everybody’s tongue, but rather what is it that has not been articulated; positive or negative.
The DNA of the bull market in gold is bad money, which in turn is evidenced by negative real rates of interest. In our view, one only needs to return to the notion of an overvalued and over abundant dollar for a starting point. Is the dollar less over valued and in less oversupply than it was ten years ago? Will it become more or less so during the coming decade?
Gold at roughly $1575 most certainly reflects the negative evolution of dollar fundamentals since 2000. Gold’s advance suggests that the dollar is worth substantially less, but in terms of what? The dollar buys 80% less gold than it did ten years ago. It buys 25% less of the DXY basket of foreign exchange than ten years ago. Because however reported, inflation remains tame and most do not seem to grasp or feel the dollar’s loss of value.
In addition to reflecting history, the dollar-gold price also discounts the future. The dollar’s decline versus gold is, in our opinion, a market expression of uncertainty as to its future purchasing power. In this sense, the dollar’s crash in gold terms is similar to a previously highly valued equity that investors have soured on. The multiple has contracted. Former cheerleaders are forced to become value players. The facts have to be reconsidered. We believe the rise of gold should be considered a warning.
At the moment, capital markets are calm. Stocks have doubled over the past three years. Interest rates are at historic lows. The world economy, according to most, is on the mend. The Obama regime appears to have consolidated power in its second term. Optimists seem to have the upper hand.
According to the recently published Congressional Budget Office (CBO) ten year base line projections, the budget deficit will shrink to 2.5% of GDP in just three years from the current 7%. Stated in dollar terms, the $1.15 trillion deficit of 2012 will become only $433 billion in 2015. The economy will grow at 3.1%, 3.5%, and 5.9% in nominal terms. Tax receipts will rise and spending will be held in check. Interest on ten year treasuries will not rise above 3.5% by 2015. Interest on 90 day treasuries will not rise above 20 bps, as promised by the Fed. Inflation will remain tame and the interest component of the consolidated budget will rise from $223 billion to only $273 billion (For details, go to CBO website-Baseline Budget Projections). If this forecast turns out to be accurate, gold is no place to be.
We have our doubts and believe that the CBO ten year forecast will miss the mark by a wide margin. Looking back at prior forecasts, in 2001 the CBO baseline projection called for a ten year cumulative surplus of $5.6 trillion. Instead, there was a cumulative deficit of $9 trillion. The real question is whether the miss will be on the upside (smaller deficits) or downside (much bigger deficits). The upside case is based on economic growth. A healthy private sector and a deleveraged consumer sector would more than offset the well- advertised problems of the public sector. After all, the private sector is much larger (2/3 of GDP) than the public sector (1/3 of GDP). A move towards less dependence on foreign energy would shrink the troublesome trade deficit, and that seems to be happening. There is a renaissance in American manufacturing. Perhaps a restructuring of the public sector still lies ahead which could lead to a more efficient government with unimagined benefits for the private sector. Is the prospect conceivable? Maybe, but count us as skeptics.

The case for a miss on the downside is the prospect of sputtering global economic growth or even a recession on nobody’s horizon. That would balloon the 2013 deficit and force even more money printing. We are fairly certain that economic growth is destined to sputter and would not be surprised by a recession.
Shown, the mechanism that activates or stifles investment demand is real interest rates. Positive real rates are bad for gold, negative real rates good. The condition that applies today is negative real rates; a condition that we believe is likely to continue for years to come. The inability of capital to earn a competitive return in liquid investments that are free of credit or duration risk opens a very wide door for capital to migrate into gold. 90-Day treasuries are the competition for gold, not ten year treasuries (duration risk) or the stock market (multiple risks of other kinds) or “alternativeinvestments such as fine art, real estate or farmland (liquidity risk). Below, we provide a long term chart of the inverse correlation between gold and real interest rates. It should be noted that the relationship depicted is based on the CPI as if the official government measure of inflation were the gospel. It is useful only as an illustration. We believe the CPI does not accurately measure the true rate of inflation, which we believe to be higher. For more on the real rate of inflation, please refer to John Williams’ Shadowstats service.

It is certainly possible that the correction in the gold price is discounting a return to competitive real interest rates, but we don’t think so. When it comes to cornering a market, the Fed is no slouch. They have taken a page right out of the book written by the Hunt brothers who cornered the silver market in 1980. Owing to a strategy of manipulating long term interest rates lower to help revive the housing industry, the Fed now owns more than 40% of all Treasuries with a maturity greater than 5 years (Peter Tchir-TF Market Advisors in Business Insider 2/10/13). Compared to what the Fed has done, the outrageous scheme of the Hunt brothers was small potatoes. Unwinding these positions will be difficult and not, we believe, without adverse consequences. For the Hunts, damage was limited to their creditors and their personal net worth. What will happen to long term interest rates when the Fed is no longer buying the lion’s share of Treasury issuance? At stake is the economy, employment, and asset valuation to mention a few possibilities for collateral damage.
Interest on gross federal debt is projected by the CBO to be $224 billion in 2013 and $272 billion in 2015; more or less proportional to the projected increase in debt outstanding of $16.5 trillion currently to $18.5 trillion in 2015. The blended interest rate across all maturities is 1.7%. Even though Treasury debt outstanding has tripled since 1998, the sum total of all interest paid by the Federal government on that debt has barely budged. A return to competitive real interest rates seems highly difficult given these facts. Each swing of 1% on $ 17 trillion is $170 billion. A blended interest rate, for the sake of argument, of 4% across the yield spectrum instead of 1.7% would add $390 billion to the projected budget deficit. We believe that a free market blended interest rate of 4% is conceivable only if measures to check the rise of government spending are credible. If the credibility of austerity/efficiency measures yet to come remain suspect, the market interest rate on federal debt in our opinion will be much higher than 4%, absent government intervention. Evidence of progress will be revealed in the remaining years of the Obama administration. Investors who choose to maintain positions in gold can be excused for their skepticism.

It seems to us that government finances and the economy are in no position to afford real interest rates that would allow 90-day Treasuries to compete with gold. Those who are trashing gold must be convinced that government spending will be revamped and that the credit outlook for the U.S. will show material improvement over the intermediate term.

We disagree with the current bearish consensus on gold. It is not the first time in the past 14 years that we find ourselves almost alone in our stance. We believe the repercussions and consequences of the current posture of the Fed balance sheet, zero interest rates, manipulated long term interest rates, unprecedented liquidity in the banking system, which seems unlikely to be withdrawn on a timely basis (thereby risking high inflation), and manipulated currency exchange rates remain unknown and unarticulated. The narrative for gold is highly likely to undergo another transformation during the next two years, most probably having to do with the negative consequences of the foregoing. While the private sector may be poised to do well, bad economic policy and bad money could constitute serious headwinds to sustainable real economic growth.
Gold can provide insurance against the very plausible possibility that the credit of the U.S. government will be no better, and quite possibly worse in four years than it is today. We are comfortable with our gold positions on that basis alone.
We also find comfort in the fact that gold seems as contrarian at this moment as it did in 1998 and in 2008. A few sentiment readings, as compiled by 13-d Research illustrate the point:

  • Market Vane’s bullish gold consensus dropped to 49% in February, the lowest reading on record and only seen previously for a single day at the important gold bottom in 2008.
  • the ISI (Daily Sentiment Index) dropped to 3%, a new record low since the index was started in 1987.
  • GLD’s bullion holdings dropped 1.55% on 2/20, evidence of capitulative selling.
  • finally, speculative Comex shorts rose to the highest on record:

Source: Meridian Macro

We count ourselves among the few that perceive a steady and stealthy erosion of the present and future purchasing power of what is commonly described as “money”. The degeneration of the utility of currency is almost never considered as a factor in economic forecasting. However, it destroys capital and inhibits and misdirects investment. We believe that the erosion has been camouflaged by a debasement of the slew of government and private sector yardsticks purporting to measure that purchasing power. For the most part, the yardsticks, such as the CPI, have been crafted and contorted by bureaucrats and PhD’s in a way that is unintelligible to most, and to our thinking, meaningless against the test of common sense. What is reflected in the dollar price of gold, despite the meandering rationalizations of conventional wisdom, is the ongoing and potential future loss of utility in the dollar as the cornerstone of global credit. In our view, the next stage of the bull market in gold will be marked by a widely shared awareness of the lost purchasing power of paper money. Such an outcome is, after all, the design of Fed policy which has set upon a course that could prove extremely difficult to alter. When the fog clears and, as we expect, the dollar’s loss of value becomes broadly palpable, we look for the gold price to advance to new all- time highs against all paper currencies. 

© Tocqueville Asset Management L.P.

This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.

Italy and "Ro, Ro"

by Doug Noland

March 01, 2013

It was a relatively quiet Monday, with the Dow flirting with all-time highs.Initial reports from the Italian election had the front-running coalition, led by Pier Luigi Bersani, coasting to victory. Italian 10-year bonds were rallying sharply, with yields sinking as much as 27 bps to 4.17%. The euro was gaining about 1%, trading above 1.33 versus the dollar and above 125 against the yen. Basically, it was business as usual for highly speculative global markets, as the bulls chuckledtold you so!” That is, before all hell about broke loose in the currencies.

Various exit poll projections began painting a quite different picture of what had transpired with Italy’s electorate. The presumptive Prime Minister’s (Bersani) left-leaning coalition was not receiving the expected support. Instead, the big election surprise was the strong performance of comedian Beppe Grillo’s Five Start Movement

Worse yet, Silvio Berlusconi, the disgraced former Prime Minister not long ago given up for dead, was proving himself the cagey cat with nine lives. His right-leaning coalition was doing better-than-expected, with a chance to deny Bersani (perhaps even in alliance with Monti) a majority in Italy’s Senate. And, perhaps worst of all for European leaders and the markets, Caretaker Prime Minister Mario Monti’s coalition was looking like an election disaster. It became a distinct possibility that no party would garner sufficient control in the two houses of Parliament to appoint a leader for a new Italian government.

Suddenly, complacency gave way to trepidation of a “hung parliament” and the potential for an “ungovernableItaly (the world’s third largest debtor nation!). At least in the currencies, the reaction was rather swift and ferocious. After trading above 1.330, the euro sank to 1.305 to the dollar by the end of the day.  

The really stunning move, however, was in the euro/yen. After trading above 125 in the morning, the euro/yencrosstraded below 119 by late-afternoon. The yen rallied more than 4% against the euro and, curiously, almost 3% against the dollar.

The Wall Street Journal and others have highlighted the recent big macro hedge fund profits achieved by betting aggressively against the yen. Monday’s Italian election-induced reversal in the yen kicked the yen bears in the teeth. It will now be interesting to see if the yen reversal marks a key inflection point for the globalrisk on backdrop that has captivated the investing and speculating world in recent months – and provoked ebullient predictions of a new bull market.

So, one might ask, why is the Italian election a big deal for Europe, the euro, the yen, globalrisk on” and the supposed new bull” in U.S. equities? This past summer, the Draghi Plan (Outright Monetary Transactions/OMT) singlehandedly transformed European securities from the leveraged speculating communities’ preferred shorts to their must-have longs. This reversal of speculative finance (“hot money”) dramatically altered financial conditions throughout Europe, while strongly bolstering the flagging euro currency (not to mention confidence in European financial institutions). Importantly, Draghi (with help from the Fed and global central bankers) removed the near-term tail-risk catalyst impeding globalrisk on” - and held a potentially problematic global systemic crisis at bay.

Crisis risk in Europe was viewed as having been taken off the table, while the Fed’s $85bn monthly QE would also pressure the dollar and generally support speculation and inflating global risk markets (pro-“risk on”). Meanwhile, the new Abe government in Japan was seen supporting radical monetary stimulus to weaken the yen and jumpstart the moribund Japanese economy. For more than two years, the prospect of a bout of European-inducedrisk off” had bolstered the safe haven appeal of the yen. Now, the big sophisticatedmacrohedge funds saw their long-awaited opportunity for a big one-way bearish play against Japan’s susceptible currency. The Japanese wanted their currency lower and global risk markets were in a favorable state of “risk on” that itself created an overhang pressuring the yen (along with other perceived safe havens). At the same time, selling yen to finance higher yielding securities in stronger currencies also worked to bolster globalrisk on.” 
On the back of the Draghi Plan backstop and resultingrisk on,” Italian yields dropped from August highs of 6.5% to recent lows of 4.13%. Spain’s 10-year yields sank from 7.60% to a low of 4.87%. For Portugal, yields collapsed from about 14% to less than 6%. Similar drops profoundly altered the financial environment for Ireland and even Greece – if not economic fundamentals throughout the region. 
After trading as low as 4.17% Monday, Italian 10-year yields surged as high as 4.93% Tuesday when the election outcome had become clear. Italy bond yields closed Friday at 4.79%, up 34 bps for the week. Spain’s 10-year yield traded as high as 5.59% Tuesday, before ending the week down 5 bps to 5.10%. Portuguese yields traded as high as 6.54% before closing the week 8 bps higher at 6.30%. 

Post-election headlines have been telling: From the Financial Times: “Fears ECB Bond Scheme Has Its Weakness;” “Italian Poll Disarms ECB’s Bazooka;” “Voters in South Europe Grow Weary of Austerity;” and “The Vandal that Wants to Sack Rome’s Politicians.” And from Reuters: “Italy Election Punches Hole in ECB’s Euro Defenses” and “Grim Jobless, Debt Figures Underscore Italy’s Crisis.”

Thursday from Reuters (Paul Carrel): “A dramatic anti-austerity vote leaves Italy lying outside the fortress the European Central Bank constructed around the euro zone last year and vulnerable to a market attack. This week's election leaves slim prospects for a durable, reform-minded government in Rome and exposes a flaw in the bond-buying defense plan the ECB put together last September - a weakness that could see the euro zone crisis roar back to life. After vowing to dowhatever it takes to save the euro, the ECB’s Italian chief Mario Draghi launched a plan - dubbed Outright Monetary Transactions (OMT) - in September which promised potentially unlimited buying of a struggling country’s bonds… The catch is Draghi is ready to do whatever it takeswithin our mandate’. To satisfy this caveat, the scheme requires a country whose bonds the ECB buys to sign up to a European aid program with debt-cutting conditions attached.”

The markets have confidently dismissed the ECB’sconditionality clause. When Draghi stated we’ll do “whatever it takes” while stayingwithin our mandate,” the markets heardwhatever it takes” and immediately stopped listening. The markets viewconditionality” as having been necessary at the time to garner support at the ECB for a commitment to open-ended market intervention. The assumption is that Draghi would resort to aggressive market intervention as necessary to support European bonds and the euroone way or another. This may be way too complacent.

Reuters quoted ECB Executive Board member Benoit Coeure: “If yields go up because of political events, there is not much the ECB can do, that’s not related to monetary policy whatsoever.” Also from Reuters: “Sources close to the ECB are conscious of the risk of contagion from Italy to Spain, but insist it will not intervene to help Italy if it does not have a credible government capable of the reforms required for support in the debt market.” Facing a potentially difficult situation, the Italian Draghi this week stated, “We do not act to help governments. We act to help maintain the flow of credit to real firms and households. Governments need to address the structural problems in their economies.”

The Bundesbank has been adamantly opposed to the OMT market backstop from day one. Mr. Weidmann has been outspoken in his questioning the legality of the ECB providing monetary financing (“printing” and bailouts) for troubled debtor countries.

The backdrop turns further complicated after the strong anti-German tone to Italian campaign rhetoric. The Italian electorate essentially voted against EU imposedausterity” they believe is being dictated by Berlin. Berlusconi and Grillo ran campaigns critical of both the loss of sovereignty to European mandates and the euro currency more generally (Grillo has called for a public referendum on the euro). Friday from Bloomberg: “CDU [Merkel’s party] lawmaker Klaus-Peter Willsch says if the majority of Italians cannot be convinced to stand by EMU rules, the country must be allowed to return to its own currency, Handelsblatt says… Monetary union will only survive if it benefits all its members.” President Napolitano canceled a scheduled meeting with the candidate running against Chancellor Merkel in Germany’s September elections, after Peer Steinbrueck was quoted as saying he was “horrified that two clowns won the election.” One can ponder the outcome if Germany’s Bundestag is ever called upon to vote for what would be a very large bailout package for Italy.

There are serious long-term ramifications for the rise of anti-European integration populism in Italy and throughout Europe. For now, the pressing issue is whether Italy can cobble together a functioning government. Grillo’s independent Five Star Movement actually received the most votes of any individual party. He has nothing but acrimony for the establishmentessentially calling for the downfall of the traditional dominating political parties. Grillo has had particularly harsh words for Bersani, while stating that he will not join a coalition with either Bersani or Berlusconi. Meanwhile, Bersani and Berlusconi despise each other. And new corruption charges against Berlusconi have his supporters livid. New elections may be necessary, although it doesn’t appear Bersani, Berlusconi or Grillo prefer that route for now. Complicating matters, the term of Italy’s President (Giorgio Napolitano) – who has a traditional role dissolving parliaments, calling for new elections and brokering alliancesends next month. Some type of “loose” – and likely dysfunctionalcoalition government seems likely.

Beyond the short-term, there is increasing risk that the Italian people at some point completely rejectausterity” and call for a return of the lira. Friday’s data highlighted the problem. The Italian unemployment rate was up another 40 basis points in February to a worse-than-expected 11.7%, the high since 1992 (youth unemployment almost 40%). Italy’s PMI Manufacturing index dropped 2 points to a worse-than-expected 45.8. In Italy and throughout the euro-zone, the lack of economic response to dramatically loosened financial conditions and strong securities markets has been striking. Friday data had euro-zone unemployment up to a record high 11.9% - and counting

Disconcerting economic developments were not limited this week to continental Europe. Talk turned to “triple dip recession” after the U.K. manufacturing index for February unexpectedly dropped to 47.9. Canada reported the weakest GDP growth (0.6%) in almost two years. China’s manufacturing indices were weaker-than-expected, perhaps indicating an economy more vulnerable than generally assumed. There were also more rumblings of rising home prices and Chinese resolve in tightening mortgage finance. India reported weaker-than-expected Q4 GDP (4.5% vs. estimates of 4.9%). 

Meanwhile, automaticsequesterbudget cuts went into effect Friday here in the U.S. And whether it is the U.S., China, India, Brazil or “developingeconomies more generally, I remain troubled by this dynamic of marginal economic growth in the face of ongoing rapid Credit expansion. I believe this creates heightened vulnerability to a reemergence of global de-risking/de-leveraging dynamics.

The world’s markets have enjoyed six months of powerfulrisk ongains. There has been a veritable flood of “money” into equities and global risk markets more generally. In the U.S., in particular, talk of a new bull market has coaxed previously cautious holdouts back into equities. And I have no reason to believe the bulls will give up their strong market position/domination without one heck of a fight. Yet markets do have an inflection point – “risk on succumbing to “risk off” – tone to them.

Indicative of a change in trend, volatility has become more pronounced throughout the markets. It has become particularly treacherous throughout the currencies. And after gaining almost 10% in January, Italian stocks now post a 2013 decline of 3.7%. With the exception of the U.K., most European bourses have given back much or all of early-year advances. The same can be said for many keydevelopingmarkets. India’s Sensex index is now down 2.6% y-t-d. Brazil’s Bovespa has lost 6.7%, while Mexico’s Bolsa is up just 70 bps. 

Mostemergingcurrencies were under pressure this week - and thus far for 2013 overall. Eastern Europe’s equities and currencies were on the defensive again this week. The Goldman Sachs Commodities index fell 2.4% this week (up 0.3% y-d-t) and is now about 5% below mid-February trading highs
U.S. stocks again held their own this week, as the chasm between fundamental prospects and securities market prices widens further. Safe havenTreasuries and bunds (and gilts?) enjoyed notably robust demand this week. The bulls were pleased with assurances that chairman Bernanke is not about to flinch on his “moneyprinting operation. And, you know, I see no reason not to expect next week to provide anothernew and exciting adventure” in the workings of speculativehighfinance.