Europe's €500bn money funds risk AAA downgrade if they 'break the buck'

Negative interest rates in Europe are causing havoc for the money market industry, threatening its long-term survival

By Ambrose Evans-Pritchard

7:08PM BST 30 Sep 2014


Standard & Poor's said the €500bn nexus of funds in the eurozone is facing serious stress Photo: REX

Europe’s giant money market funds are struggling to stay afloat as negative interest rates drain the industry’s lifeblood, with many at risk of crippling downgrades by the rating agencies. 

Standard & Poor’s said the €500bn nexus of funds in the eurozone is facing serious stress, increasingly unable to generate profits since the European Central Bank cut its deposit rate to -0.02pc and pulled down short-term rates across the spectrum of maturities.
“Pressure is building for these funds,” said Andrew Paranthoiene, the agency’s credit director.

“We’re observing portfolios on a weekly basis. If there is any deviation from our credit metrics, a rating committee would determine if rating action was appropriate. In our view, any loss of capital means that the 'safety of principal’ has been breached,” he said.
Standard & Poor’s rates all its European money market funds at AAA(m). Industry experts say it is unclear whether the funds could function for long at a lower rating, given the nature of their business as ultra-safe depositories of corporate cash.
Some funds have already begun to signal that they may not be able to repay investors’ money in full. BlackRock is activating a Reverse Distribution Mechanism, allowing it to repay investors fewer shares than they originally purchased in its ICS Euro Government Liquidity Fund, citing “challenging trading conditions” since the ECB cut rates. 
The company said this does not imply that the fund will necessarily yield a negative return, and insists that it is not tantamount to “breaking the buck” - the term used in the industry when a fund falls below par of 100 - since the value of each share will remain constant. BlackRock is the world’s biggest asset manager with $4.6 trillion under its control. Other companies with money market funds in Europe are taking similar steps.
“We believe investors are being fleeced,” said one industry insider. “They don’t yet seem to have understood that their capital is being eroded and that they are likely to incur losses if they want to redeem their shares. Of course it is breaking the buck.”

It is a very rare occurrence for a money market fund to fall below par. It was a major shock to confidence when the Reserve Primary Fund in the US announced in September 2008 that it had “broken the buck” due to exposure to Lehman Brothers.
The picture in Europe is entirely different. “It is a yield issue, not a credit issue,” said Susan Hindle from the Institutional Money Market Funds Association (IMMFA). Yet it is a problem nevertheless, the first clear evidence that negative rates can be double-edged.
It is no longer clear whether the funds can safely eke out a positive return as the ECB’s negative rates spread through the financial system. The EONIA overnight rate is currently -0.017pc. Even three-month Euribor is just 0.08pc.
The money market funds place their cash in a mix of short-term debt instruments, with some at the overnight rate. The average maturity is 45 to 60 days. They are not allowed to lend beyond 397 days.

The point of the industry is to provide corporations with a safe place to park cash, with enough liquidity for instant extraction if need be. The funds spread the money across a very wide spectrum of assets and are therefore safer than bank accounts. They can take on more risk but this erodes their financial purity.
The funds play a key role in the financial system. One of the reasons the US Federal Reserve never cut rates below zero was concern about the knock-on effects for America’s $2.1 trillion money markets. 
Marc Ostwald, from ADM Investor Services, said the ECB’s negative rate may backfire.

“Corporate treasuries are sitting on a huge amount of cash. The real worry is that they decide to lock up the money for six months or more in longer-term debt to get a positive yield. It could end up discouraging investment,” he said.
IMMFA said the money market industry could still thrive even if returns are negative, given that banks are repelling money and there is almost nowhere else to turn. “It may well be the least bad option relative to what is on offer,” it said.

Turmoil in Hong Kong and in Bond-Fund Land

What will political protests mean for China and global investors? And is the Bond King dead?

By John Kimelman           

Sept. 30, 2014 6:50 p.m. ET

Investors have a new geopolitical hot spot to worry about. And this one could potentially trump others in Ukraine and the Levant because it involves China, the world's second-largest economy and an engine of global growth in recent years.
For five days, downtown Hong Kong has been taken over by pro-democracy protesters who are seeking additional electoral rights from the Chinese government and don't seem inclined to back down.
While Hong Kong itself is a small player in the global economy and markets, a number of financial writers are seeking to handicap the protest's likely impact if China gets drawn into the expanding political crisis.
As Paul Davidson of USA Today writes, "The protests in Hong Kong are not yet sparking fears that the region will become the next trouble spot for the global economy, but such concerns will grow if the conflict intensifies and ensnares China."
Davidson writes that the unrest, if it continues, could disrupt Golden Week, an early October holiday during which Chinese tourists flock to Hong Kong. "Jewelry and other luxury retailers in the region could see reduced sales, hurting their stocks and Asian stock indexes more broadly." He writes that U.S. stock markets could be modestly affected.
But sources who talked to Davidson referred to Hong Kong's status as a major financial center that supplies capital to China. "An escalation of the protests could chill U.S. investment in China, further crimp China's economic growth and ripple across the global economy," he writes.
In addition, Davidson adds, there is the possibility that the demonstrations could spread to China, though that seems like a bit of a stretch.
The highly influential Mohamed El-Erian, the chief economic advisor at Allianz, has also weighed in on the Hong Kong protest's likely impact on global markets.
"Will the tensions in Hong Kong be the straw that breaks the global economy's back?," he asks in a column for Bloomberg View. "The answer is far from straightforward."
El-Erian writes that "some are quick to use history to dismiss any lasting economic impact, both domestic and global, of the Hong Kong protests. They rightly point to the repeated ability of the Chinese government to quash internal protests, and without altering the country's growth trajectory. For them, it is only a matter of time until the current civil disobedience in central Hong Kong dissipates."
But he points out that this time could be different. "First, the combination of the Internet, social media and better mobility makes it easier to coordinate and sustain protests, while also reinforcing individuals' confidence in meeting their aspirations."
El-Erian contends that the Chinese government is likely to prevail over the protest movement in Hong Kong. "But in doing so, it will probably be inclined to slow certain economic reforms for now, seeking instead to squeeze more growth from the old and increasingly exhausted model—similar to how Brazil's government responded to protests there ahead of the World Cup a few months ago. And while this would be part of a broader political strategy to defuse tensions and avoid an immediate growth shock to both China and the global economy, it would undermine the longer-term economic vibrancy of both."
Meanwhile, the commentary continues to flow almost as heavily as the bond assets in the wake of the surprise announcement late last week that Bill Gross, a co-founder of Pimco and the most influential bond-fund manager of the past 30 years, was leaving Pimco for Janus Capital, a small fry in the bond-fund world. (Gross is also a longtime member of the Barron's Roundtable.)
Neil Irwin, a New York Times columnist, concludes that the news of Gross' departure from Pimco, along with the decision of California's pension fund, Calpers, to exit hedge-fund investing, signals the "end of the cult of the lone genius who can, through superior mental circuitry, outsmart the entire rest of the financial world and earn superior returns for his or her investors."

"It has been a long time coming. The advent of low-cost index mutual funds—and more widespread understanding of their advantages—has squeezed out the active stock-pickers of the not-too-distant past," Irwin writes.
Irwin is on fairly firm ground, but he is also guilty of overreaching a bit in eulogizing the notion of the investment guru. While there's been a big shift in recent years toward index investment and away from active stock-picking, there will always be a sizable share of investors who seek to beat a market, not just mirror it, and thus seek out talented managers.
Perhaps Irwin hasn't noticed that billions of dollars have been flying out the door at Pimco since the word was out that Gross was leaving. Conversely, Janus Capital has been receiving a flood of new bond assets.
It would be naïve to think that guru-chasing was not involved here.

Doubling Down On Inflation

  • The August job numbers were not an anomaly - the economy continues to be worse, despite what the financial media states.
  • Zero percent interest rates and trillions of dollars of stimulus hasn't been and will not be the solution.
  • The more Japan and Europe follow suit, the worse off their economies will be.
The release of disappointing August payroll numbers should have been a jarring wake-up call warning Wall Street that the economy has been treading on thin ice. Instead, the alarm clock was stuffed under the pillow, and Wall Street kept sleeping.

The miss was so epic, in fact (the 142,000 jobs created was almost 40% below the consensus estimate), that the top analysts on Wall Street did their best to tell us that it was all just a bad dream. Mark Zandi of Moody's reacted on Squawk Box by saying, "I don't believe this data." The reliably optimistic Diane Swonk of Mesirow Financial told Reuters the report "sure looks like a fluke, not a trend."

But the opinions of those that really matter, the central bankers in charge of the global economy, are likely taking the report much more seriously. Given that this is just the latest in a series of moribund data releases, such as news today that U.S. mortgage applications have fallen to the lowest levels in 14 years, caution is justified. Unfortunately, very little good comes from central bank activism.

Recent statements from Fed officials across the United States and recent actions from ECB president Mario Draghi reveal their growing resolve to fight too-low inflation, which they believe is the biggest threat to recovery. There are many things that are contributing to the global woes. But low prices are not high on the list.

Since the markets crashed in 2008, central banks around the world have worked feverishly to push up the prices of financial assets and to keep consumer prices rising steadily. They have done so in the official belief that these outcomes are vital ingredients in the recipe for economic growth. The theory is that steady inflation creates demand by inspiring consumers to spend in advance of predictable price increases. (The flip side is that falling prices "deflation," strangles demand by inspiring consumers to defer spending). The benefits of inflation are supposed to be compounded by rising stock and real estate prices, creating a wealth effect for the owners of those assets, which subsequently trickles down to the rest of the economy. In other words, seed the economy with money and inflation, and watch it grow.

Thus far, the banks have been successful in creating the bubbles and keeping inflation positive, but growth has been a no-show. The theory says the growth is right around the corner, but like Godot, it stubbornly fails to show up. This has been a tough circle for many economists to square.

Two explanations have emerged to explain the failure. Either the model is not functioning (and higher inflation and asset bubbles don't lead to growth), or the stimulus efforts thus far, in the form of zero percent interest rates and quantitative easing, have been too timid. So either the bankers must devise a new plan, or double down on the existing plan. You should know where this is going. The banks are about to go "all-in" on inflation.

Despite their much ballyhooed "independence", central bankers have proven that they operate hand in glove with government. They are also subject to all the same political pressures and bureaucratic paralysis. There is an unwritten law in government that when a program doesn't produce a desired outcome, the conclusion is almost never that the program was flawed, but that it was insufficient. Hence, governments continually throw good money after bad. The free market discipline of cutting losses simply does not exist in government.

This is where we are with stimulus. Six years of zero percent interest rates and trillions and trillions of new public debt have failed to restore economic health, but our conclusion is that we just haven't given it enough time or effort.

My theory is a bit different. Maybe zero percent interest rates and asset bubbles hinder rather than help a real recovery? Maybe they resurrect the zombie of a failed model and prevent something viable and lasting from gaining traction? This is a possibility that no one in power is prepared to consider.

But what if they succeed in getting the inflation, but we never get the growth? What if we are headed toward stagflation, a condition that in the late 1970s gripped the U.S. more tightly than Boogie Fever? It may come as a surprise to the new generation of economists, but high inflation and high unemployment can coexist. In fact, the two were combined in the 70s and 80s to produce "the Misery Index."

But according to today's economic thinking, the Index should not be possible. Inflation is supposed to cause growth. If unemployment is high, they say there is no demand to push up prices. But it's the monetary expansion that pushes prices up, not the healthy job market.

The tragedy is that if the policy fails to produce real growth, as I am convinced it will, the price will be paid by those elements of society least able to bear it, the poor and the old. Inflation and stagnation mean lost purchasing power. The rich can mitigate the pain with a rising stock portfolio and more modest vacation destinations. But they won't miss a meal. Those subsisting on meager income will be hit the hardest.

Many economists are now trying to make the case that the United States had hit on the right stimulus formula over the past few years, and is now reaping the benefit of our bold monetary experimentation. They continue the argument by saying Europe and Japan were too timid to implement adequate stimulus, and are now desperately playing catch-up. But this theory is false on a variety of fronts.

First-off, the U.S. is not recovering, but decelerating. Annualized GDP in the first half of 2014 has come in at just a shade over one percent, which is lower than all of 2013, which itself was lower than 2012. The unemployment rate is down, but labor participation is at a 36-year low, and wages are stagnant. We have added more than $5 trillion in new public debt, but have very little to show for it. We are not the model that other countries should be following, but a cautionary tale that should be avoided.

It is also spectacularly wrong to assume that the problems in Europe and Japan can be solved by a little more inflation. Higher prices will just be a heavier burden for European and Japanese consumers, not an elixir that revitalizes their economies. The problems in Europe, Japan, and the U.S. all have to do with an oppressive environment for savings, investment, and productivity that is created by artificially low interest rates, intractable budget deficits, restrictive business regulation, antagonistic labor laws, and high taxes. Since none of the governments of these countries have the political will to tackle these problems head-on, they simply hope that more monetary magic will do the trick.

So as the Fed, the ECB, the Bank of Japan, and all the other banks that follow suit, push all their chips into the pot, and hope that a little more inflation will save us from the abyss, we can wish them luck. It's going to take a miracle.

Germany Fights on Two Fronts to Preserve the Eurozone

Geopolitical Weekly

Tuesday, September 30, 2014 - 03:01 

By Adriano Bosoni and Mark Fleming-Williams

The European Court of Justice announced Sept. 22 that hearings in the case against the European Central Bank's (ECB) bond-buying scheme known as Outright Monetary Transactions (OMT) will begin Oct. 14. Though the process is likely to be lengthy, with a judgment not due until mid-2015, the ruling will have serious implications for Germany's relationship with the rest of the eurozone. The timing could hardly be worse, coming as an anti-euro party has recently been making strides in the German political scene, steadily undermining the government's room for maneuver.

The roots of the case go back to late 2011, when Italian and Spanish sovereign bond yields were following their Greek counterparts to sky-high levels as the markets showed that they had lost confidence in the eurozone's most troubled economies' ability to turn themselves around. By summer 2012 the situation in Europe was desperate. Bailouts had been undertaken in Greece, Ireland and Portugal, while Italy was getting dangerously close to needing one. But Italy's economy, and particularly its gargantuan levels of government debt, meant that it would be too big to receive similar treatment. In any event, the previous bailouts were not calming financial markets.

As Spain and Italy's bond yields lurched around the 7 percent mark, considered the point where default becomes inevitable, the new president of the European Central Bank, Mario Draghi, said that the ECB was willing to do whatever it took to save the euro. In concert with the heads of the European governments, the ECB developed a mechanism that enables it to buy unlimited numbers of sovereign bonds to stabilize a member country, a weapon large enough to cow bond traders.

ECB President Mario Draghi never actually had to step in because the promise of intervention in bond markets convinced investors that eurozone countries would not be allowed to default. But Draghi's solution was not to everyone's taste. Notable opponents included Jens Weidmann, president of the German Bundesbank. Along with many Germans, Weidmann felt the ECB was overstepping its jurisdictional boundaries, since EU treaties bar the bank from financing member states. Worse, were OMT ever actually used, it essentially would be spending German money to bail out what many Germans considered profligate Southern Europeans.

In early 2013, a group of economics and constitutional law professors from German universities collected some 35,000 signatures and brought OMT before the German Constitutional Court. During a hearing in June 2013, Weidmann testified for the prosecution. In February 2014, the court delivered an unexpected verdict, ruling 6-2 that the central bank had in fact overstepped its boundaries, though it also referred the matter to the European Court of Justice. Recognizing the profound importance of this issue, the court acknowledged that a more restrictive interpretation of OMT by the European Court of Justice could make it legal.

The German judgment suggested that three alterations to OMT would satisfy the Constitutional Court that the mechanism was lawful. Two of the three changes, however, are problematic at best. One alteration would limit the ECB to senior debt, a change that would protect it against the default of the sovereign in question but also risk undermining the confidence of other investors who would not be similarly protected. The second alteration would make bond buying no longer "unlimited," constraining the bank's ability to intimidate bond traders by leaving it with a rifle instead of a bazooka.

A New German Political Party

The group of academics who organized the petition kept busy while the court deliberated. The Alternative for Germany, a party founded in February 2013 by one of their number, economics professor Bernd Lucke, and frequently known by its German acronym, AfD, has made significant gains in elections across Germany. Founded as an anti-euro party, the party came very close to winning a seat in the Bundestag, the lower house of the German parliament, in the September 2013 general elections, a remarkable feat for a party founded just six months before. It made even larger gains in 2014, winning 7.1 percent of the vote in European Parliament elections in May and between 9.7 and 12.2 percent in three regional elections in August and September. 

Germany is currently ruled by a grand coalition, with German Chancellor Angela Merkel's center-right Christian Democratic Union party (and its sister party, the Bavaria-based Christian Social Union) sharing power with the center-left Social Democratic Party. This has resulted in the Christian Democratic Union being dragged further to the center than it wanted to be, creating a space to its right that the Alternative for Germany nimbly entered.

Originally a single-issue party, the Alternative for Germany has begun espousing conservative values and anti-immigration policies, a tactic that worked particularly well in elections held in eastern Germany in the summer. Its rise puts Merkel, a European integrationist, in a quandary that will become particularly acute if the Alternative for Germany proves capable of representing Germans uncomfortable with the idea of the country financially supporting the rest of Europe.

Since the beginning of the European crisis, Merkel has proved masterful at crafting a message that combines criticism of countries in the European periphery with the defense of bailout programs for those same countries. But while Merkel has become accustomed to criticism from left-wing parties over the harsh austerity measures the European Union demanded in exchange for bailouts, she had not counted on anti-euro forces mounting serious opposition in Germany. Merkel is not alone in this, of course: center-right parties across Europe, from David Cameron's coalition in the United Kingdom to Mark Rutte's People's Party for Freedom and Democracy in the Netherlands, have seen Euroskeptical populism emerge to their right, eating into their traditional voter platforms. 

This anti-ECB sentiment in Germany has swelled during 2014, as Draghi's attempts to increase the eurozone's low inflation have departed further and further from economic orthodoxy. German conservatives have greeted each new policy with displeasure. The German media has called negative interest rates "penalty rates," claiming they redistribute billions of euros from German savers to Southern European spenders. On Sept. 25, German Finance Minister Wolfgang Schauble spoke in the Bundestag of his displeasure with Draghi's program to buy asset-backed securities. Judging from the German hostility to even "quantitative easing-lite" measures, the ECB's attempts to rope Germany into further stimulus measures could prove troublesome indeed.

Institutional and Political Challenges for Berlin

All of the measures the ECB has announced so far, however, are mere appetizers. Financial markets have been demanding quantitative easing, a broad-based program of buying sovereign bonds in order to inject a large quantity of money into the market. Up to this stage, three major impediments have existed to such a policy: the German government's ideological aversion to spending taxpayers' money on peripheral economies; the political conception that quantitative easing would ease the pressure on peripheral economies to reform; and the court case that has been hanging over OMT (the only existing mechanism available to the ECB for undertaking sovereign bond purchases). Notably, the OMT in its original guise and quantitative easing are not precisely the same thing. In the original conception of OMT, the ECB would offset any purchases in full by taking an equivalent amount of money out of circulation, (i.e., not increasing the money supply itself). Nonetheless, any declaration that OMT is illegal would severely inhibit Draghi's room for maneuver should he wish to undertake full quantitative easing.

This confluence of events leaves Merkel nervously awaiting the decision of the European Court of Justice. In truth, she is in a no-win situation. If the Luxembourg court holds OMT illegal, Draghi's promise would be weakened, removing the force that has kept many sovereign bond yields at artificially low levels and permitting the desperate days of 2011-2012 to surge back. If the European Court of Justice takes up the German court's three suggestions and undercuts OMT to the extent that the market deems it to be of little consequence, the same outcome could occur. And if the European Court of Justice rules that OMT is legal, a sizable inhibitor to quantitative easing will have been removed, and the possibility of a fully fledged bond-buying campaign will loom ever closer, much to the chagrin of the German voter and to the political gain of the Alternative for Germany.

When analyzing the significance of this case, it is important to bear in mind that Germany is an export-driven power that must find markets for its exports to preserve cohesion and social stability at home. The eurozone helps Germany significantly — 40 percent of German exports go to the eurozone and 60 percent to the full European Union — because it traps its main European customers within the same currency union, depriving them of the possibility of devaluing their currencies to become more competitive.

Since the beginning of the crisis, Germany has managed to keep the eurozone alive without substantially compromising its national wealth, but the moment will arrive when Germany must decide whether it is willing to sacrifice a larger part of its wealth to save its neighbors. Berlin has thus far been able to keep its own capital relatively free of the hungry mouths of the periphery, but the problem keeps returning. This puts Germany in a dilemma because two of its key imperatives are in contradiction. Will it save the eurozone to protect its exports, writing a big check as part of the deal? Or will it oppose the ECB moves, which if blocked could mean a return to dangerously high bond yields and the return of rumors of Greece, Italy and others leaving the currency union?

The case will prove key to Europe's future for even deeper reasons. The European crisis is generating deep frictions in the Franco-German alliance, the main pillar of the union. The contrast between Germany, which has low unemployment and modest economic growth, and France, which has high unemployment and no growth, is becoming increasingly difficult to hide. In the coming months, this division will continue to widen, and Paris will become even more vocal in its demands for more action by the ECB, more EU spending and more measures in Germany to boost domestic investment and public consumption.

This creates yet another dilemma for Berlin, since many of the demands coming from west of the Rhine are deeply unpopular with German voters. But the German government understands that high unemployment and low economic growth in Europe are leading to a rise in anti-euro and anti-establishment parties. The rise of the National Front in France is the clearest example of this trend. 

There is a growing consensus among German political elites that unless Berlin makes some concessions to Paris, it could have to deal with a more radicalized French government down the road. The irony is that even if Berlin were inclined to bend to French wishes, it would find itself constrained by institutional forces beyond its control, such as the Constitutional Court.

Germany has managed to avoid most of these questions so far, but these issues will not got away and in fact will define Europe in 2015; the Alternative for Germany, for example, is here to stay. Meanwhile, the Constitutional Court will keep challenging EU attempts at federalization even if this specific crisis is averted, and the Bundesbank and conservative academic circles will keep criticizing every measure that would reduce German sovereignty to help France or Italy. Though it is impossible to predict the European Court of Justice's final ruling, either way, the dilemma will continue to plague an increasingly fragile European Union.

Editor's Note: Writing in George Friedman's stead this week are Stratfor Europe Analyst Adriano Bosoni and Economy Analyst Mark Fleming-Williams.

Why this October could be a turning point for markets

Why this October could be a turning point for markets
       Brendan McDermid | Reuters

While often a scary month, this October has an especially long list of demons for markets to contend with-from the major shift in U.S. monetary policy and a global economic slowdown to a host of percolating geopolitical hazards, from Kiev to Hong Kong to Brasilia.

This week alone, there is a European Central Bank meeting Thursday, where it is expected to detail its asset-backed purchase program, coming just as the Fed is stepping back. There is also the September employment report Friday, a key data point for the Fed, and there are general elections in Brazil over the weekend.

Markets enter the month on a wave of heightened volatility, and are already showing signs of being spooked by the Fed and concerns about European and Chinese growth.

"October is historically a turnaround month, where the markets tend to turn around after weakness but often the weakness carries on into October. Maybe, we have to get to the middle of the month-until we get some Chinese data and then we turn around. We think stocks are probably headed higher from here to year end," said Jeff Kleintop, senior vice president and chief global investment strategist at Charles Schwab.

October is a critical turning point for Fed policy and in a highly choreographed wind down, the Fed Oct. 29 is expected to announce it is finishing its quantitative easing-the controversial bond buying program that many strategists say has added liquidity and helped provide a strong backdrop for stock market gains.

The Fed then begins a slow walk toward its first rate hike sometime next year, so each piece of economic data is even more important than usual since that is what is guiding the Fed's hand.

"This is the first time in years that we're looking forward to the next year, and people are starting to think about allocations and investments ... and you're highly confident you're facing an interest rate hike," said John Briggs, head of cross asset strategy at RBS. Briggs said the market's "buy the dip" mantra may no longer stand. "We don't know what kind of rate hike cycle we'll see, but we're fairly certain it's going to begin next year."

While strategists see potential bumps for stocks as Fed policy shifts, they also mostly see a higher end to the year.

Economists mostly expect the first Fed rate hike in midyear 2015, but that could shift depending on the economy. That puts the onus on U.S. data, starting this Friday with the September employment report, expected to show 225,000 jobs were created and an unemployment rate, barely changed at 6.1 percent.

JP Morgan (JPM) chief economist Bruce Kasman said October data will be a critical stage setter for the fourth quarter, following on two positive quarters for U.S. growth after the first quarter's dismal weather-related slump.

"We're turning to the fourth quarter, which is an important quarter as to how its playing itself out...The issue now is do we sustain the momentum. We've had a good run and I think it's impressive how the U.S. has held up through the late summer," he said.

Kasman said he is watching to see how much a lift the consumer will get from lower inflation, largely due to lower gasoline and other energy prices, and whether there is weakness coming into the economy from overseas.

"I'm concerned with the fact that we've had three times in this expansion growth pick up for a couple of quarters, and each time it's turned back over," he said. "We want to see if something new is kicking in here, as we go into the fourth quarter."

A highlight of the third quarter has been the strong performance of the U.S. greenback, with the dollar index up nearly 8 percent-its best quarterly gain in six years. The dollar has ridden the tail wind of a better U.S. economy, compared with weakness in Europe, Japan and China-and it has made strong strides against the euro and the wilting Japanese yen.

It is now also making gains against emerging markets currencies, some of which are especially hurt by the direct hit their commodities dependent economies are taking from the stronger dollar.
The dollar has also risen, while Treasury yields have stayed relatively low, amid a quarter rife with geopolitical events-any one of which could impact markets. The sanctions against Russia for its actions against Ukraine continue to be a worry for the weakened European economy.

Air attacks by a U.S.-led group on Islamic extremists in Iraq and Syria have not affected energy markets, but traders are watchful for any impact. This week's demonstrations by citizens seeking democratic elections in Hong Kong raises longer term questions about a simmering political issue in China and reforms there.

Markets have also reacted negatively to success in the polls of incumbent Brazilian President Dilma Rousseff, who is running against Marina Silva, a candidate seen as a stronger proponent of reform and growth policies.

"There are a lot of things that are happening around the world right now that don't add up to a macro story, but do run some risks of turning into something under certain circumstances," Kasman said.
The dollar strength is expected to continue, and it could be a headwind for some markets in the fourth quarter. Strategists point to oil, with Brent down 15 percent in the third quarter, and gold, down more than 8 percent.

October kicks off Wednesday with a series of other important reports, including ISM manufacturing data, construction spending, ADP (ADP) private payroll data, and September auto sales.

Kleintop said the risk in Friday's jobs report is that it shows a pickup in wage inflation. "That's something the hawks would jump on right away and say there's a more robust labor market," he said. A stronger labor market could push the Fed to raise rates sooner.

While he expects China data to surprise on the upside, Kasman said the risk is China will surprise to the downside. "We're focused on the U.S. and China as the two big drivers. One delivering upside surprise, and the other delivering downside surprise," he said.

One positive for U.S. markets could be the corporate earning season. Alcoa (AA) reports Oct. 8, and major banks release earnings the following week.

"I think the expectations are pretty low-6 or 7 percent. I think we'll hit that and probably exceed that. I think you'll hear from some companies about what's going on overseas. Things are a little weaker but some of the consumer oriented companies in the U.S. will say things are looking better," said Kleintop. "I think the real catalyst is more around what's going on in Europe."

Kleintop said the expectations of double digit earnings growth for European companies, however, appear overly optimistic and could be a problem for markets.

Time To Buy The Dip In Gold?

The dollar index rallied to a multi-year high today, but was quickly turned back lower. The USD index is the most overbought it has been in years. The dollar has followed a very predictable pattern during every previous move to such extreme overbought levels (RSI 70+).

(click to enlarge)

Likewise, gold is oversold according to technical momentum indicators and is due for a rally.

Gold has strong support in the $1,180 to $1,200 range and may test this support before bouncing.

(click to enlarge)

Furthermore, the gold price is now near the tipping point for mine cuts and closures. Most miners simply can't turn a profit at current price levels. In some cases, it is costing miners more to pull an ounce out of the ground than it costs to buy the finished product in the open market.

Can you think of other products that you can buy at a price point below the cost to produce? Simply put, the market is out of whack and these conditions cannot persist for long. Lower gold prices are already causing some mine closures, along with lack of funding and overall disinterest in the sector.

In the first five months of 2014, U.S. mine production was 85,400 kilograms, down 4% from the 89,200 kg of gold bullion produced in the first five months of 2013.

While supplies are starting to decline, it is estimated that roughly 10% of miners have decided to close miens or suspend operations. Imagine if prices remain at current levels or drop lower in the coming months. There simply will not be enough supply to keep up with the continuing robust demand. Anyone that has taken Economics 101 understands the ramifications of lower supply with steady or increasing demand.

Bullion sales started picking up in the past month. Data for August shows gold sales stronger at 36,369 ozs compared to 25,103 ozs in July, with silver sales also up strongly at 818,856 ozs compared to 577,988 ozs in July. Month-to-date for September, gold Eagle sales across all coin sizes have already reached 43,200 oz compared to total gold eagle sales of 25,000 oz in August. This is also well ahead of September 2013, when total gold eagle sales for the month only touched 13,000 oz.

But of course the real demand is coming from central banks around the globe that remain net buyers. China and Russia in particular have been buying gold aggressively over the past few years. This is continuing, despite sharp declines being reported in Hong Kong. This is due to a shift in transaction to the new gold exchange in Shanghai. Total demand from China in 2014 is likely to be near the record levels from 2013, not down double-digits as some with an anti-gold bias have been inaccurately reporting.

There is a growing movement away from the U.S. dollar and it is only a matter of time before price discovery moves from banker-controlled Western markets to the East. China and Russia continue to purchase gold aggressively and once China announces updated reserves, the true extent of their buying will be known to the public. This could be the spark that lights the fuse for gold!
The following chart gives a good indication of just how aggressively Russia has been purchasing gold in recent years. If only we had a similar chart for China, we would see gold reserves spiking off the chart.

(click to enlarge)

Lastly, both gold futures expiration and options expiration are now passed. Short-sellers with the ability to manipulate prices often hold down the gold price until these dates pass. This allows their short trades to rack up profits, while the call options they sold to unsuspecting investors expire worthless.

I believe we are witnessing one of the last great buying opportunities in precious metals. When prices start moving higher again, there will be little time to jump aboard the train. The downside risk at this juncture pales in comparison to the upside potential.

Even more exciting is the profit potential from select, best-in-breed mining stocks. Relative to the metals, mining stocks are currently the most undervalued they have been since the start of the bull market. I expect leverage of 2 to 4 times the advance in the underlying metals once a new uptrend begins.

(click to enlarge)

For example, if silver doubles back to its 2012 high of $35, we are likely to see quality silver stocks advance by 200% to 400%. These numbers may sound extreme, but this type of leverage has been commonplace throughout the current bull market. Of course, it cuts in both directions, which fuels the high levels of volatility in this sector.

Smart money has been moving into precious metals during dips in recent months and many view the sector as one of the last places to find real value. Stocks, bonds, real estate and nearly every other asset class has been inflated to lofty levels by the FED's easy money policies since 2009. These markets may continue higher a bit longer, but the easy fruit has already been plucked and the upside is limited in my view.

Therefore, I believe this is an opportune time to book profits in tech stocks, REITs, etc. and begin shifting your wealth into precious metals. Investors should consider doing this is tranches, rather than trying to call an exact market bottom.

I like holding physical bullion in my possession first and foremost. I will be adding to my silver bullion holdings this week. Additional funds will be going into a few hand-picked junior mining stocks with new discoveries, strong growth profiles and short-term catalysts that I believe could send their share price soaring. I also remain bullish on royalty and streaming companies that are able to mitigate downside risk, while keeping upside potential wide open.

I am still waiting for our technical models to give the green light that a bottom is in place, but it appears we are getting close. Buying opportunities like this do not come along very often and we are heading into the Indian Festival season and highest seasonal period for gold. With the normal increase in the gold price not occurring in September, the potential for a price spike in October-February has increased substantially.

(click to enlarge)

So, is it time to buy the dip in gold and silver? In my opinion, not quite yet, but we are getting very close.

Fed Rate Policies Aid Foreign Banks

Lenders Pocket a Spread by Borrowing Cheaply, Parking Funds at Central Bank

By Ryan Tracy And Jon Hilsenrath  

Sept. 29, 2014 1:52 p.m. ET

The Federal Reserve is changing the way it controls interest rates. Agence France-Presse/Getty Images
Banks headquartered outside the U.S. have been unlikely beneficiaries of the Federal Reserve's interest-rate policies, and they are likely to keep profiting as the Fed changes the way it controls borrowing costs.
Foreign firms have received nearly half of both the $4.7 billion in interest the Fed paid banks so far this year for the money, called reserves, they deposit at the U.S. central bank, and the $5.1 billion it paid last year, according to an analysis of Fed data by The Wall Street Journal. Those lenders control only about 17% of all bank assets in the U.S.
Moreover, the Fed's plans for raising interest rates make it likely banks will see those payments grow in coming years.
Though small in relation to their overall revenues, interest payments from the Fed have been a source of virtually risk-free returns for banks including Deutsche Bank , UBS AG  and Bank of Tokyo-Mitsubishi UFJ, according to bank regulatory filings. U.S. banks including J.P. Morgan Chase& Co., Wells Fargo & Co. and Bank of America Corp.  are also big recipients of Fed interest payments, according to the filings.
"It is a small transfer from U.S. taxpayers to foreign taxpayers," said Joseph Gagnon, a former Fed economist at the Peterson Institute for International Economics. The transfer, he added, was a side effect of Fed policy, not a goal.     
Behind the payments is a complex interplay between new government regulatory policies and new methods the Fed has developed to control short-term interest rates.
The Fed has pumped nearly $3 trillion into the banking system since the 2008 financial crisis, increasing banks' reserves, in efforts to stabilize markets and boost economic growth.
Since 2008, it has paid banks interest of 0.25% on those reserves. The Fed affirmed this month that the rate it pays on reserves will be the primary tool it uses to raise short-term borrowing costs from near zero when the time comes, likely next year.
In part because regulatory requirements discourage domestic banks from holding more cash reserves than they need, many of the reserves created by the Fed are held by foreign banks.
In the past, the Fed influenced interest rates by increasing or reducing money in the banking system through small amounts of short-term bond trades with banks. This caused the Fed's benchmark federal funds rate to rise or fall, influencing other borrowing costs across the economy, such as those on mortgages, credit cards and business loans. Because there is so much money in the financial system now, that old method won't work and the Fed plans to rely primarily on adjusting the interest rate on reserves to change the fed funds rate and other borrowing costs.
The interest payments will increase over time as the Fed raises rates. The Fed remits most of its profits to the U.S. Treasury, and the rising cost of the interest payments could put downward pressure on the amount the central bank sends to taxpayers each year, the Fed has said.
Some observers say this could become a political challenge for the Fed, especially the payments it makes to foreign banks.
"The fact is that the Fed is going to be paying very large amounts of interest to banks," said William Poole, a senior fellow at the Cato Institute and former president of the Federal Reserve Bank of St. Louis. "It's highly likely that some politicians will notice that and given the proclivity of some politicians anyway to demagogue issues, the Fed is going to have some political explaining to do."
Some Fed officials also have expressed concern about how these payments will look. "I think the optics are very difficult to defend and might get us into trouble," James Bullard, president of the Federal Reserve Bank of St. Louis, said in an August interview with MarketWatch.
Wall Street Journal calculations show foreign bank holdings of U.S. reserves held at the Fed have increased from less than 20% of the total before the financial crisis to nearly 50% today.
Since 2009, they have earned roughly $5 billion by borrowing dollars cheaply, often at less than 0.10%, in short-term funding markets and depositing those funds at the Fed for 0.25%, according to the Journal analysis. That estimate doesn't take into account the costs of raising money through other means, overhead and taxes, which affect net income.
A spokeswoman for one bank engaged in the trade, Bank of Tokyo Mitsubishi, said that the growth of excess reserves parked at the central banks is a natural consequence of the Fed's policy. "The share of excess reserve balances held by BTMU has been in alignment with its business footprint in the U.S.," she said.
The foreign banks with the largest reserve balances at the Fed as of June 30, Deutsche Bank and UBS, didn't respond to requests for comment. A Chinese official close to Bank of China said it has been parking funds at the Fed in order to help it comply with liquidity requirements in its home market.
The foreign banks' activity is "entirely legitimate because they are providing a financial service and they are taking a spread," said Lou Crandall, chief economist at research firm Wrightson ICAP.
Big U.S. banks say the trade looks unattractive to them, largely because of U.S. capital requirements.
All big banks must fund their assets, including cash, with a minimum percentage of investor equity, or capital. Outside the U.S., banks are generally required to maintain a ratio of equity to assets of at least 3%.
Big U.S. banks must maintain equity of at least 6%, so they are less inclined to hold extra cash simply to park it at the Fed for a tiny spread.
In addition, the biggest foreign banks can generally report capital levels at the end of every quarter, rather than calculate them every day as the largest U.S. banks do. That means that on most days, foreign banks can park huge amounts of money at the Fed without worrying about its impact on their capital requirements.
U.S. banks also have to worry more than foreign banks about deposit insurance fees, which are assessed at higher rates for banks holding large amounts of U.S. assets, such as cash at the Fed. Foreign banks don't pay as much in those fees because they hold fewer deposits in the U.S. than domestic banks do.
Foreign banks have other reasons for being active in short-term U.S. dollar funding markets, beyond gains from Fed deposits. Many were caught short of dollars during the financial crisis, making it appealing for them to have increased their dollar holdings to avoid a repeat.
The Fed has experimented with an alternative, known as reverse repo trades, that would allow it to control interest rates via payments mainly to U.S. money-market mutual funds, rather than foreign banks. However, Fed officials are wary of this new tool and said this month they intended to limit its use.
U.S. bankers privately don't complain about missing out on the low-margin trade. There are "better uses of our time," one U.S. banker said, referring to activities that could generate a larger profit.
—Lingling Wei contributed to this article.

Debt: Still An Issue

Sep. 30, 2014 5:12 AM ET

by: John M. Mason


  • A new report by the International Center for Monetary and Banking Studies has a new warning about the world's debt situation: world debt is still rising in relation to GDP.
  • Economic growth is slowing in some areas while others are in process of raising interest rates; both threaten to make the debt situation worse.
  • All solutions seem to be problematic in one way or another. Investors need to consider the consequences of each of the policy choices available.

A new report, the 16th annual Geneva Report, commissioned by the International Center for Monetary and Banking Studies, carries a warning about the debt situation in the world.
This report documents "the continued rise of debt in both advanced and emerging economies at a time when most talk is about how the global economy is deleveraging…"

Not only is the amount of global debt high, and rising, but slowing nominal GDP (coming from both slower real economic growth and disinflation or possible deflation) is raising the total burden of world debt, public and private.

Total debt in the world "has risen from 160 percent of national income in 2001 to almost 200 percent after the crisis struck in 2009 and 215 percent in 2013." The report goes on, "The global debt-to-GDP ratio is still growing, breaking new highs."

The concern - the Federal Reserve seems poised to raise interest rates - and economic growth is severely lagging in major parts of the world, like in "the eurozone periphery in southern Europe and China…."

The world just cannot seem to slip out of its debt problems. Re-read, "This Time is Different" by Carmen Reinhart and Kenneth Rogoff. Either deleveraging has declined or stopped or economic growth has stagnated or both. And, if the burden of the debt even remains the same, let alone "growing, breaking new highs," the warning coming out of this report is: beware. The world is still looking for "good" statistical releases, but it seems that when we do get a bunch on new releases that point to an optimistic outcome, they are soon dashed by another bunch of new releases that indicate things are not going that well.

President Obama believes the economy is doing OK and he is just staying to "the facts" as he reiterated on television this past weekend. Obama's job ratings for managing the economy remain mired in the 37 percent to 43 percent range. Another view is that there is a secular stagnation going on in the United States, but also in much of the rest of the world. In this view there are structural problems in most economies and until these structural problems are ironed out the United States, and the rest of the world, will not be able to perform well at all.

For example, if one looks at the projections for economic growth over the next four to five years provided by the members of the Open Market Committee of the Federal Reserve System, one only sees stagnation. The range of annual growth rates for real GDP runs from 1.8 percent to 2.6 percent, way below the average rate of growth of the United States in the last forty years of the twentieth century.

Forecasts for Europe and elsewhere is not encouraging. In terms of a lower debt burden, the United States has shown one of the better recoveries, particularly as household debts as a share of income have stopped rising, although public debt is not doing as well. However, like the economic growth results, the United States debt situation is one of the better ones in the developed world, although that is not saying much when one looks at the condition of the rest of the world.

The authors of the Geneva Report point to one other thing that has given people confidence in the current situation. They state that "the value of assets has tended to rise alongside the growth of debt, so balance sheets do not look stretched." The concern here is what happens when interest rates begin to rise - in the United States - or, anywhere? The basic fear here is that a rise in interest rates would cause asset values to decline. And, declining asset values would place balance sheets at risk.

Furthermore, as some have argued, the value of assets may be inflated due to the excessively easy monetary policy that has been at play in the world connected with the extraordinarily low interest rates. If asset values are overvalued, their prices would even be more exposed to rising interest rates than otherwise. A reversal of asset prices could force "a credit squeeze." In addition, there is a fear that if US interest rates begin to rise, it might cause the value of the US dollar to go even higher. The rising value of the US dollar could force then a reversal of the flow of funds that has been going into "carry trade" in emerging markets. This would further threaten growth in emerging countries.

Investors are increasingly deciding that their losses in the foreign exchange market eclipse their gains from the interest rate differential, prompting them to cut and run. Were market participants to unwind their carry trades in unison, selling EM assets to buy dollars, the process would exacerbate the market conditions that they were fleeing.

Finally, there is the concern about the banking systems. Concerns have been raised about banks in the eurozone and the quality of their assets. Additionally, there are worries about many bank loans in China. And, in the United States, commercial banks are still being merged into other commercial banks at a pace that indicates regulator encouragement, rather than just normal M&A activity. It does not seem as if the banks of the world have fully recovered from the previous crisis.

So, it appears as if debt is still a major issue in the world today… and, the slowly recovering economies are doing little or nothing to ease this burden.

In the Geneva Report there is a suggestion that interest rates be kept low… for as long as possible. Given the results of their study, the authors conclude that central banks are still under pressure to protect asset values as much as possible. Keeping interest rates low would, of course, help to keep asset values high. But, and this is something many economists hope for, faster economic growth would help people reduce debt and higher rates of inflation would help to reduce the real burden of the debt.

Given this outlook, the prescription is for central banks to do whatever they can to create an inflationary environment with faster economic growth as well as rising prices. But, in my experience, faster economic growth and rising prices just tend to encourage people to take on more debt.

If governments and central banks have little or no discipline, how can people and businesses expect to have any discipline? Obviously, once you enter this cycle, it is awfully hard to break out of it.

How should investors operate in this kind of environment? My advice, think like a hedge fund.