The Fed’s Mortgage Favoritism

When the central bank buys private assets, it distorts markets and undermines its claim to Independence.

By Jeffrey M. Lacker And John A. Weinberg

Oct. 7, 2014 6:42 p.m. ET

Modern central banks enjoy extraordinary independence, typically operating free from political interference. That has proved critical for price stability in recent decades, but it puts central banks in a perpetually precarious position. Central-bank legitimacy will wane without boundaries on tools used for credit-market intervention.
Since 2009 the Fed has acquired $1.7 trillion in mortgage-backed securities underwritten by Fannie Mae and Freddie Mac , the mortgage companies now under government conservatorship. Housing finance was at the heart of the financial crisis, and these purchases began in early 2009 out of concern for the stability of the housing-finance system. Mortgage markets have since stabilized, but the purchases have resumed, with more than $800 billion accumulated since September 2012.
We were skeptical of the need for the purchase of mortgage assets, even in 2009, believing that the Fed could achieve its goals through the purchase of Treasury securities alone. Now, as the Fed looks to raise the federal-funds rate and other short-term interest rates to more normal levels, that normalization should include a plan to sell these assets at a predictable pace, so that we can minimize our distortion of credit markets. The Federal Open Market Committee’s recent statement of normalization principles did not include such a plan. For this reason, the first author, an FOMC participant, was unwilling to support the principles.
The Fed’s MBS holdings go well beyond what is required to conduct monetary policy, even with interest rates near zero. The Federal Reserve has two main policy mandates: price stability and maximum employment. In the past, the pursuit of higher employment has sometimes led the Fed (and other central banks) to sacrifice monetary stability for the short-term employment gains that easier policy can provide. This sacrifice can bring unfortunate consequences such as the double-digit inflation seen in the 1960s and 1970s.
But during the Great Moderation—the period of relatively favorable economic conditions in the 1980s and 1990s—a consensus emerged that, over time, the central bank’s effect on employment and other real economic variables is limited. Instead, the central bank’s unique capability is to anchor the longer-term behavior of the price level. Governments came to see that entrusting monetary policy to an institution with substantial day-to-day independence could help overcome the inflationary bias that short-term electoral pressures can impart.
The independence of the central bank cannot be boundless, however. In a democracy, the central bank must be accountable for performance against its legislated macroeconomic goals.
What is essential for operational independence is the central bank’s ability to manage the quantity of money it supplies—that is, the monetary liabilities on its balance sheet—because this is how modern central banks influence short-term interest rates.
A balance sheet has two sides, though, and it is the asset side that can be problematic. When the Fed buys Treasury securities, any interest-rate effects will flow evenly to all private borrowers, since all credit markets are ultimately linked to the risk-free yields on Treasurys. But when the central bank buys private assets, it can tilt the playing field toward some borrowers at the expense of others, affecting the allocation of credit.
If the Fed’s MBS holdings are of any direct consequence, they favor home-mortgage borrowers by putting downward pressure on mortgage rates. This increases the interest rates faced by other borrowers, compared with holding an equivalent amount of Treasurys. It is as if the Fed has provided off-budget funding for home-mortgage borrowers, financed by selling U.S. Treasury debt to the public.
Such interference in the allocation of credit is an inappropriate use of the central bank’s asset portfolio. It is not necessary for conducting monetary policy, and it involves distributional choices that should be made through the democratic process and carried out by fiscal authorities, not at the discretion of an independent central bank.
Some will say that central bank credit-market interventions reflect an age-old role as “lender of last resort.” But this expression historically referred to policies aimed at increasing the supply of paper notes when the demand for notes surged during episodes of financial turmoil. Today, fluctuations in the demand for central bank money can easily be accommodated through open-market purchases of Treasury securities. Expansive lending powers raise credit-allocation concerns similar to those raised by the purchase of private assets.
Moreover, Federal Reserve actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises, dampening incentives for the private sector to monitor risk-taking and seek out stable funding arrangements.
Central bank operational independence is a unique institutional privilege. While such independence is vitally important to preserving monetary stability, it is likely to prove unstable—both politically and economically—without clear boundaries. Central bank actions that alter the allocation of credit blur those boundaries and endanger the stability the Fed was designed to ensure.
Mr. Lacker is the president of the Federal Reserve bank of Richmond, where Mr. Weinberg is the director of research.

China currency push takes aim at dollar

David Marsh, Special for USA TODAY  5:25 p.m. EDT October 7, 2014

Protests over democracy in Hong Kong may be preoccupying the Chinese leadership, but a subject of still greater international importance is being played out this week behind closed doors in Washington. China is bidding to enter the heart of global finance by establishing its currency, the renminbi, as part of an ubiquitous monetary unit used in official transactions around the world.

The issue of whether the Chinese should be part of the International Monetary Fund's Special Drawing Right, the composite reserve currency used in official financing, is highly technocratic, but the political questions at stake go to the core of world money and power – and will be discussed, in the background, at the annual meetings of the IMF and World Bank in Washington this week.

The decision on a new SDR structure, to be made in the next 15 months, will influence how China and its currency can play a bigger part in driving world trade, investment and capital flows. The renminbi could eventually challenge the dollar and its pivotal position in world money — which is why the U.S. government and Federal Reserve are examining this with intense interest.

China is unlikely to mount an open campaign to enter the SDR, grouping the main reserve currencies, the dollar, the euro (linking countries in European monetary union led by Germany and France), the Japanese yen and British pound, and is valued at around $1.5.

Beijing would prefer the question of recalculating the composition of the SDR, which comes up for review in 2015, to follow market developments, reflecting a big increase in demand for renminbi financing from private banks, central banks, traders, corporations and asset managers.

Many hurdles remain. These include the renminbi's lack of formal convertibility for transactions that shift capital inside and outside the country, where Beijing is reluctant to abolish all controls. In addition, China still has to release more statistics to the Fund about its monetary reserves and other matters. However, Chinese measures over the past three years to liberalize and internationalize its currency, and a big increase in financial market interest in China, are pointing toward a broadening of the SDR's composition from January 2016.

An additional factor is China's own action to galvanize emerging market economies toward reforming word monetary arrangements. This includes the five-nation Brics group's decision to set up the New Development Bank in Shanghai, potentially challenging the IMF and the World Bank.

As the world's No. 2 economy after the U.S., China believes it is close to earning the status of a reserve money, the first time that an emerging market currency would attain this position.

Chinese entry into the "magic circle" has been advanced by the British government's September decision to issue renminbi-denominated bonds, the first big government to take such a step, and allow the proceeds to be held as reserves by the Bank of England.

The main conditions for the renminbi to pass the SDR test are that it should be widely used in trade and be "freely usable" in international payments and asset management. Although a long way behind the dollar, the renminbi has made impressive strides recently and is challenging the euro in several key fields.

Next year's planned review will touch, too, on the opportunity for the SDR to play a greater role on financial markets, for example in denominating bond issues. The SDR has lost ground as a financial vehicle in the past two decades, reflecting the surging importance of international private sector capital markets. But with the addition of the renminbi, it may be about to make a comeback.

David Marsh is Managing Director of Official Monetary and Financial Institutions Forum, a London think-tank.

France cautions Germany not to push Europe too far on austerity

France's Manuel Valls also warned David Cameron that Europe is "not ready for an upheaval of its institutions", offering no concessions on EU treaty terms

By Ambrose Evans-Pritchard, International Business Editor

8:30PM BST 06 Oct 2014

France's boyish prime minister, older than he looks, is losing his patience with EU austerity demands
France's boyish prime minister, older than he looks, is losing his patience with EU austerity demands Photo: AFP

France has denounced the eurozone’s austerity regime as deeply misguided and issued a blunt warning to Germany and the EU institutions that demands for further belt-tightening may set off a political backlash, endangering European stability.
“Be careful how you talk to the countries in the South, and be careful how you to talk to France,” said the French premier, Manuel Valls. “The adjustment has been brutal and it has turned millions people against Europe. It is putting the European project itself at risk.”
Mr Valls said Europe’s fiscal rules have been overtaken by deflationary forces and a protracted slump. “You cannot enforce the Treaty rigidly in these circumstances. The austerity policies are becoming absurd, and we have to examine the situation,” he told journalists in London.
The reformist French premier said the eurozone’s failure to recover risked leaving the region on the margins of the world economy, stuck in a Japanese-style trap. France had pushed through €30bn of fiscal cuts from 2010 to 2012, and another €30bn since then in an effort to comply with EU deficit rules, only to see the gains overwhelmed by the economic downturn.  

The deficit will remain stuck at 4.3pc of GDP in 2015. A further €50bn of cuts are coming over the next three years. “If they make us reach a 3pc deficit, the country will be totally on its knees. It’s not possible,” he said.
The warnings came amid reports the European Commission may strike down France’s draft budget for 2015, refusing to give Paris two extra years until 2017 to meet the 3pc limit. Brussels is also threatening “infringement proceedings”, a process that could ultimately lead to fines.

This would put the new Juncker Commission on a dangerous collision course with both France and Italy, two of the eurozone’s big three, now closely aligned in a joint push for EMU-wide reflation and New Deal policies.

Mr Valls said France and Britain were defending Europe’s “civilizational mission and values”, together bearing the costs of military intervention in Africa and the Middle East, and this should be taken into account when judging budget breaches. “We are acting for the rest of Europe. Our military costs are more than we thought for Libya, Iraq and the Sahel,” he said.
Despite warm words for his British military allies, Mr Valls played down hopes that France might give ground on Treaty concessions for the UK before any referendum on EU membership. “We will listen to David Cameron but I don’t think Europe is ready for an upheaval of its institutions. It is dangerous to open the Treaties,” he said.
Mr Valls was in London to promote his pro-business agenda to City bankers, and to combat what he called “deplorable French-bashing”, reacting acidly to comments by Andy Street, managing director of John Lewis, who derided France as “sclerotic, hopeless and downbeat” after visiting Paris. “He must have drunk too much beer,” said Mr Valls.
France’s 75pc tax rate for the rich will be swept away by the end of the year, ending a public relations disaster that brought in little revenue, if any. France will no longer turn to more taxes to plug its deficits. “We have to cut public spending,” he said.
British opinion has been slow to grasp the radical shift in policy since President François Hollande’s volte-face earlier late last year, starting with a concordat with French business leaders, and culminating in the choice of Mr Valls to lead his Socialist government. The Valls team has burned its bridges with erstwhile supporters on the party Left. Key figures have been purged or have resigned in protest. The Socialist old guard is up in arms over the new economy minister, Emmanuel Macron, a former Rothschild banker.
It is far from clear whether Mr Valls can push his far-reaching measures through the French parliament, though he won a vote of confidence last month. His party campaigned for the status quo in 2012 and lacks a clear mandate for radical action.
“When we came to power, we made a strategic error. We didn’t tell the French people what the condition of the country really was: the level of the deficit, the debt and the trade balance,” he said.

“The welfare state and everything the Left stands for has been blown up by the shock of globalisation, which was much greater than people realised. When we were beaten, we fell back on our Old Left ideology. We spent 10 years failing to prepare, and now we have to push through our ideological revolution while in government, which is much more difficult,” he said.
Mr Valls plays down any suggestion that he is pursuing an Anglo-Saxon market agenda. “We will not get rid of the 35-hour working week. We are not a Thatcherite government,” he said. Yet his aim is to slash the size of the French state from 56pc of GDP to average European levels, a drastic overhaul of the French model.
Some have compared him with Germany’s Gerhard Schröder, who pushed through the Hartz IV reforms early in the last decade. These put a lid on wages and helped Germany regain export market share. But there is a big difference. Germany was able to do this during a global boom. All of southern Europe was losing relative competitiveness through high inflation at the time. Several economies were overheating.
The rub is that reforms are usually contractionary in the short-run. Mr Schröder has since admitted that he could not have won political backing for his bitter medicine without breaching EU deficit rules, allowing fiscal stabilisers to cushion the blow. France is trying to do it at a time of austerity, with half of Euroland in or near recession, and against powerful deflationary forces. “The situation is very different,” said Mr Valls.
As sweet revenge, France will have the upper hand again in Europe’s affairs soon enough. It has a high birth rate, while Germany is on the cusp of an ageing crisis and slow decline. “In 15 years' time, France will probably be ahead of Germany. We will be first,” said Mr Valls.

Getting Technical

Fat Lady Is About to Sing, According to the Charts

Today’s rally doesn’t erase the bearish signals from recent market action, including small stock weakness.

By Michael Kahn           

Oct. 8, 2014 4:14 p.m. ET

“It ain’t over till the fat lady sings” applies to technical analysis just as well as it applies to basketball and opera. No matter how bad we think market conditions are, until it actually breaks down all we have is a warning. As the story goes, when the fat lady’s song is over, the curtain falls and the show, or bull market, is over.
With the events over the past few days, the fat lady seems to be on the stage starting her aria.
Last week, I wrote here that one of the most important technical features in the market broke to the downside (see Getting Technical, “Will Stocks Suffer Death By a Thousand Cuts?,” Oct. 1). The Standard & Poor’s 500 index moved below the bull market trendline drawn from the key November 2012 low.
It was a bearish event, but in the age of the Federal Reserve’s bond buying and low interest-rate programs, breakdowns over the past few years were immediately erased. Last Friday’s September jobs report and ensuing rally once again looked to trap the bears and send the market back up.
Despite today’s Fed-induced rally, this time the reality was different. Action this week reversed that rally, and sent the market to fresh closing lows. The breakdown was confirmed (see Chart 1).

Chart 1

Standard & Poor’s 500

Chart watchers noted other factors, including resistance at the 50-day average keeping a lid on Friday’s rally. And even as the market gained last week on economic news, the number of stocks hitting new 52-week lows remained quite high. The rally, though impressive on the charts, was far from inclusive. The rising tide did not raise all boats.
The Nasdaq did not fare much better, although it has not broken its major trendline. But it, too, turned lower at its 50-day average, and Wednesday it set a lower intraday low for the current decline.
Bulls rightly question whether this is a full-market breakdown because the S&P 500 and Nasdaq are both above their 200-day averages. Whereas the 50-day average is the proxy for the short-term trend, the 200-day is the proxy for the long-term trend. Big stocks indexes, therefore, still have an argument that they have not broken down.
Small stocks have been weak all year, and over the past few days the Russell 2000 moved below a very important support floor before turning higher Wednesday afternoon (see Chart 2). The index is now trading close to a 52-week low itself, and that tells us that a whole class of stocks is in anything but a bull market.

Chart 2

Russell 2000
While the capitalization-weighted S&P 500 struggles with its own technical demons, an exchange-traded fund based on its equal-weighted version, the Guggenheim S&P 500 Equal Weight ETF dipped below its own 200-day moving average intraday Wednesday before bouncing.
The “regular” S&P 500 is swayed more by its biggest member stocks. The equal-weighted version gives each stock an equal voice, and its weakness further proves that stock strength is centered on a shrinking slice of the market. Narrow leadership is not healthy.
I would like to close with a chart of the New York Stock Exchange composite index. Because it is less widely followed than the S&P 500 or Russell 2000, I believe it gives us a better idea of technical patterns and trends. The reason is that there is little arbitrage happening between the cash index, futures and ETFs. A bearish event on the NYSE composite is more likely to really be bearish, and that is what I see now.
The index completed and confirmed a double top pattern in development since May (see Chart 3). Last week’s failed breakdown below support from the August low was itself erased with renewed selling, and prices are solidly below their former bull market trendline and marginally below their 200-day average.

Chart 3

NYSE Composite
Topping patterns take many forms, and often they are distorted in the more popular indexes. The NYSE composite shows a textbook version that cannot be ignored.
With that said, the market was flirting with short-term oversold conditions. Sentiment was arguably fearful enough to spark contrarians and bottom-fishers into action, so the tinder was dry for a snapback rally. The Fed’s meeting minutes did indeed light that spark Wednesday afternoon.
But I am not offering views for day traders. The overriding technical condition has deteriorated to the point where investors should take a step back.
Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.

The Dollar Is Killing Gold, But For How Long?

  • The dollar has recently been strong compared to other currencies.     
  • This relative dollar strength has lead to gold taking a massive hit.        
  • The strength of gold relative to the dollar, has not fundamentally changed, and will eventually triumph.

The past few months have been fantastic for those investing in the dollar. Returns have been solidly positive, and other currencies are seeing huge problems (the Yen, especially). While this has been taking place, gold has been hit hard and seen a large decrease over the past few months. I plan to show that this correction is unwarranted and that the strength of the dollar relative to other currencies does not translate to weakness of gold relative to the dollar.

The Historical Relationship Between Gold and the Dollar

(click to enlarge)

As we can see in the data going back to 1998, the gold spot price and the US Dollar Index show a strong negative correlation. When the dollar rises, gold falls, and vice versa. When the dollar falls, gold sees tremendous gains for the most part. What we have seen since 2012, curiously, is a generally steady US Dollar Index, but gold seriously underperforming relative to historical norms.

The sustainability of this trend is questionable at best, but it is clear that the future of gold depends heavily on the future of the dollar. What is not explained, though, is why gold sees such unwarranted gains when the dollar index sees only modest declines. It is my contention that the strength of the dollar relative to foreign currencies does not dictate fully the price of gold. That is, a debasement of the dollar also must be factored in to explain the outsized gains.

Future Expectations for the US Dollar Index

(click to enlarge)

The US Dollar Index has been flashing overbought signals since July, and Monday's large loss may be indicative of finally reaching a top. The dollar has done quite well, but these gains have been based on the relative weakness of other currencies, most notably Japan (more on that below). While the dollar has certainly been more stable than these other currencies, we are seeing right now too much of a flight to safety that is inevitably going to turn (and may have already begun to do so).


Japan's Involvement

(click to enlarge)
It is clear looking at this chart that recent dollar strength is due to weakening of the Yen. While Japan is getting hammered, the US Dollar has looked relatively safe. Of course, the money printing in the US has been enormous over the past several years, so we know that compared to what the dollar was before 2008, this current dollar is far less valuable. Still, because of the fact that the dollar index has been rising, gold has been hit hard. This implies that the relative strength of the dollar directs the price of gold, but as I showed before, this alone is not enough to explain gold's price movements. The price of gold in dollars should have only be lightly affected by how the dollar looks relative to other currencies in the long term. This short-term boost of the dollar looks great for now, but the debasement of the dollar will eventually prevail and lead to higher gold prices.

Near-term Gold Expectations

(click to enlarge)

Gold has been hit especially hard over these past three months, but based on RSI we may be finally experiencing a tipping point. The RSI is indicating oversold, and the gain we saw on Monday may be indicative of a reversal. Yes, the death cross is still there, but I don't think that this will last. US Dollar gains are looking to top right now, and the dollar is incredibly weak relative to gold due to debasement.

Summary and Action to Take

I am still firmly convinced that gold is set to take off in the long term. The dollar has been debased badly, and the base/gold ratio is the highest that it has ever been.

(click to enlarge)

Anyone investing in the fundamentals of gold over the long term ought to be loading up, as this is potentially the greatest buying opportunity ever seen against the dollar. I am invested in gold bullion and also have long-term call options against Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ). I also own shares of Royal Gold (NASDAQ:RGLD) as they have a nice dividend and are a nearly risk-free way to play the gold market with higher returns than owning gold itself.

Global economy

The European Crisis Is Going Global – and We're Along for the Ride

By Peter Krauth, Resource Specialist, Money Morning ·

October 8, 2014

After printing $4 trillion since 2008, we've little to show for it.

Endless debates about the effectiveness of QE, or its lack thereof, haven't spawned better decisions, especially in Europe. Think periphery nations like Greece, Spain, Portugal, and Italy.

Better yet, take a look at the stock market, where worries about Europe's economy rattled investors. It's certainly not a pretty picture...

Recently one European national leader offered a somewhat unique response for dealing with the financial crisis and debt bubble.

It appears an unorthodox, yet sound, approach on the surface. But when you scratch beneath, it turns out just the opposite is true.

Developed economies would do well to consider the true state of this country's example of a "model" recovery before an even more catastrophic, debt-ridden future arrives, and erupts...

Iceland Isn't Greece... It's Worse

The country I'm talking about is Iceland.

With a population of just under 320,000, its economy lacks diversity, with fishing, aluminum, and energy as its dominant sectors.

Something it does have is the world's oldest functioning legislative assembly, the Alþingi, established in the year 930. That's a long time to have practiced democracy.

You'd expect that experience could have saved this tiny country's economy, but as it turns out Iceland has a lot more in common with the birthplace of democracy: Greece.

And unfortunately, the parallels are eerily similar.

Greek households, it's estimated, have lost $215 billion of wealth in the last seven years. Unemployment still runs near 27% with 44% of incomes below the poverty line.

Debt to GDP currently sits at 175% (EU's highest) and its latest annual deficit is 12.7%.

Bailed out by $332 billion in "rescue" loans from the European Union and International Monetary Fund, Greece is now saddled with a national debt of $470 billion. That's nearly half a trillion dollars, for a nation whose economy represents 1.4% of the entire EU.

Most of that money, by the way, goes to repay mainly German and French banks that were highly invested in Greek debt. The country's output has shrunk by a staggering 25% in the last six years.

This didn't have to happen to Greece. So why did it?

When Greece over-borrowed and over-spent in the past, it had its own currency, the drachma. So, floating exchange rates with other currencies effectively devalued the drachma, which decreased domestic demand for pricier imports. It also lowered the costs of Greek labor and exports, spurring foreign investment in the country, as well as tourism.

It was the free market at work - Adam Smith's classic "invisible hand," as it were. But now Greece is handcuffed with the euro as its currency. That's a large reason things went south in Greece; devaluing its currency is no longer an option.

So the Greeks will instead suffer under austerity for years, perhaps generations, along with a shrinking economy and soaring unemployment.

The "Opposite" Road to Recovery for the Icelandic Economy

Iceland, however, took the opposite route... sort of.

In 2008, overextended Icelandic banks also collapsed under the weight of their inflated mortgage "assets." Its financial sector shrank to a mere fifth of its former self.

The country let its banks fail and imposed capital controls. Deposits held in Iceland by foreigners are stuck. Foreign-held bank debt was sacrificed.

Some bankers were investigated and then charged with fraud; at least one went to jail.

Iceland was able to take a different route because it has sovereignty and could decide its own future.

The Icelandic krona dropped in value by half, its people accepted agonizing reforms, and the economy has posted better than 3% growth. There's even a risk the economy is overheating, with forecasts for 2014 and 2015 of 3.1% and 3.4% growth respectively.

Not being part of the EU and having its own currency allowed Iceland to make its own rules and decisions.

On the surface, Iceland appeared to do what Greece had done in the past when it used the drachma - default and devalue.

Or so it seemed...

Instead of austerity, Icelandic politicians resorted to capital controls.

The nation's central bank took on a massive IMF bailout in order to help (somewhat) prop up the krona. That's why Iceland's "recovery" from the crisis looks so impressive, for now.

But the bailout has caused national debt to triple, with currently over 17% of taxes going to pay its interest alone. Unemployment is low, but so are living standards, while prices have skyrocketed with inflation. And the now much weaker currency makes for costly imports, a needed lifeline for this tiny - and remote - nation.

Real estate prices have been devastated thanks to vanishing demand and high mortgage rates, leaving homeowners to deal with negative amortization loans. Remember those?

The IMF would like us to believe Iceland's debt-to-GDP is at a manageable 84%.

At the Clinton Global Initiative Symposium in New York, Iceland's President Ólafur Ragnar Grímsson said "When you look at Iceland and how we have recovered in six years, we have recovered more than any other European country that suffered from the financial crisis."

Things looked so good, Iceland lost its appetite to join EU, even withdrawing its negotiating team from discussions. But Grímsson failed to mention that debt-to-GDP is 221% when you count outstanding bank liabilities. On that basis, only one country is worse: Japan at 227%. Even Greece is better at 175%.

The Nordic nation's top central banker has raised the idea of relaxing capital controls. But foreigners hold some $7.4 billion in Icelandic accounts, and many would want to leave, exposing banks to serious risks.

This "Volcanic" Eruption Will Rip Through Markets

Iceland has already endured difficult economic times, but its massively inflated debt has only softened the blow for the time being. The country is still running annual budget deficits, so odds are increasing they'll have to eventually default on a crushing debt load.

What lessons can we learn from all of this?

What Jim Rickards said about Iceland in The Death of Money holds true for the United States: "...They should have accepted considerable short-term pain and administered real structural reform rather than just paper over with still more debt."

That would have led to a true and robust recovery with capital properly allocated, instead of being misdirected thanks to artificially low rates.

As it turns out, despite a somewhat different approach, Iceland is actually no better off than anywhere else. And it's only a matter of time before its economy erupts like the country's second-highest peak: the volcano Bárðarbunga.

Here's the thing... we're now all sitting under a similar "volcano."

Read This, Spike That

Is It Scary Time for the Stock Market?

Could stocks have a hard landing? Are Yum! Brands and GoPro in particular trouble?

By John Kimelman

Updated Oct. 9, 2014 6:26 p.m. ET

For months, many stock-market soothsayers have been prophesizing about a coming correction. Until recently, Mr. Market hasn’t taken that talk all that seriously.
But now, things do feel a bit different. The stock market’s long run of low volatility has given way to a week of big swings in the indexes; the latest one saw the Standard & Poor’s 500 index fall 2.07% on Thursday. In the past few weeks, the VIX, a widely viewed measure of market fear, has jumped from around 12 to almost 19.
In a story that appeared on Fortune’s Website Wednesday, following a strong up day for stocks, veteran writer Shawn Tully argued that when “stocks are this pricey, history tells us that prices swirl downwards in a continuous whirlpool that usually lasts about a year and goes to extremes.”
He writes that investors shouldn’t “count on a benign, downward drift of 10% or 15%, just enough to bring the kind of ‘healthy correction’ and ‘new buying opportunity’ that equity strategists are always touting. When you start from these levels, the fall is more often brutal than soft.”
What’s his proof?
Since 1876, he writes, U.S. stocks have experienced eight contractions that hammered prices from between 30% to 60%, in round numbers. “In the post-World War II era, where we have complete data, the crashes tended to follow similar patterns: Equities peaked with extremely high PEs, as measured by the Shiller Cyclically Adjusted Price-Earnings ratio (or CAPE), which adjusts for big swings in earnings that can greatly distort PEs based on today’s highly erratic profits.”
Tully argues that a CAPE of 26 tells us that “stocks are pricey—unless you think equities aren’t particularly risky. It also doesn’t help that the dividend yield is far, far below its historic norm at 2%.
“We don’t know if a crash is imminent, or if investors are happy with low yields and the modest capital gains that, at best, they can expect at these prices. It could break either way. But if a crash is coming, it will probably mirror those of the past,” he concludes.
A scan of the financial press also revealed some troubling stories about a few stocks.
A Lex column in the Financial Times argues that the Chinese market, once a source of profits and share-price gains for Yum! Brands, is now hurting the stock, which has lost about 15% of its value in the past three months. (Subscription required to view.)
Yum is best known for fast-food brands such as KFC, Pizza Hut, and Taco Bell.
“The market has salivated over Yum’s China business for much of the past decade. And with good reason,” the FT writes. “The country has grown to account for half of sales, from around one-tenth a decade ago. Sales outside the US and China have been flat; the US has been on a steady decline.”
But now operating margins in China have been on a steady decline, from 18% in 2009 to 11% last year.
“The slide in China is unsurprising,” writes FT. “Yum is not alone in its pursuit of the Chinese consumer.
Competition has forced up costs and put pressure on a fragmented supply chain already inadequately policed. And so, in July, one of Yum’s meat suppliers was exposed selling out-of-date and dirty product. The impact has been severe.”
The FT writes that Yum thinks that the effects will wear off after six to nine months, based on previous experience. “But this is part of the problem. China food scares are all too frequent. The company had similar scandals in 2005 and 2013. Even now, the brand may recover. But the latest scandal has emphasized the company’s big overseas weakness: lack of supply chain control. Should this indigestion keep repeating, low margins may move from being one-off to structural.”
But FT isn’t calling for anyone to short the stock. By contrast, StreetAuthority’s David Sterman argues that investors should bet against shares of GoPro, which produces a line of high-definition wearable cameras seen on ski slopes across America.
The stock, which went public earlier this year, has more than doubled in the past three months. The company’s June initial public offering was priced at $24 a share, and four months later shares are trading hands at $89.
“Yet as shares of GoPro keep rising, a simple question comes to mind: Is the company a hardware manufacturer, a social media site or a video editing software firm?,” writes Sterman.
Sterman contends that the main reason why this stock has shot up is technical – a tight supply of shares relative to demand. “There are just 20 million shares in the public float, which means that GoPro’s bulls are in a scramble to acquire a scarce amount of shares. And GoPro’s bears are having a very hard time locating shares to borrow as they attempt to short the stock. Meanwhile, the fact that more than 10 million shares of GoPro trade hands daily -- more than half of the float -- tells you that the stock holds greater appeal to traders than investors, many of whom see this as a momentum play and not a fundamental valuation opportunity.”
But Sterman adds that the supply-and-demand factor behind these shares can easily work the other way.
“When GoPro announces Q3 results later this month, management will be extremely tempted to sell more shares -- while they are richly-valued. Indeed over the past few years, we’ve seen many companies pull off IPOs, watch their shares soar and then quickly announce secondary offerings,” Sterman writes. “They’d be crazy not to, as shares have soared nearly 300% in just four months. In addition, millions of shares will enter the float in December as the lock-up period expires, altering the supply-and-demand imbalance in a big way.”
In addition, the competition should kick in soon enough. “It’s been widely noted on other financial sites that consumer electronics tend to invite me-too products from rivals, often at lower prices. That can lead to a downward spiral in gross margins and growth rates,” concludes Sterman.
I’ll close with a few words about JPMorgan Chase (JPM). If the stock merely traded on its nonearnings headlines, it would well be in the dog house. If billions of dollars of fines assessed against the company in the past year weren’t enough, JPMorgan had to confess recently that Russian hackers has accessed key contact information of 76 million household accounts and seven million small business customers.
Yet with all that embarrassing news, the company’s shares have gained 8% in the past three months while the S&P 500 index has been flat during that period.
And a piece by The Street points out that JPMorgan remains the bank stock most loved by analysts.
“Twenty nine analysts have Buy ratings on JPMorgan shares, while nine have Hold ratings and just one has a Sell rating, according to data compiled by Bloomberg,’’ writes The Street. “That adds up to a better consensus rating than any other U.S. bank among the 10 largest institutions, based by assets, including the three other U.S. banking giants, Citigroup, Bank of America, and Wells Fargo.”

Economic Atonement

Peter Schiff

Oct. 7, 2014 11:32 AM ET


  • The economic sins of 2014.                
  • The sins of omission: economists claiming that the sluggish US economy was due to weather, when it was not.                
  • The sins of commission: Janet Yellen of the Federal Reserve and Jim Yong Kim of the World Bank President.

Last Friday was Yom Kippur, the day when Jews around the world ask forgiveness for their transgressions from the year past. Rabbis remind the penitent to dwell on their sins of omission, in which they did nothing when a more thoughtful and proactive action was needed, and sins of commission, in which they actively participated in an unjust action. And while not all economists are Jewish, Gene Epstein the economics editor at Barron's, offered his thoughts on how this applies to the group.

While Gene is certainly on to something, I think he could have gone much further in his finger pointing. Increasingly, economists are calling the tune to which businesses and consumers dance. Since their words and opinions matter, they may consider seeking forgiveness for what they have said, and what they have not.

Sins of Omission

Despite clear evidence that elevated prices in stocks, bonds and real estate remain a direct consequence of zero percent interest rates and quantitative easing, the crowd has asserted again and again that the prices are justified by the surging U.S. economy. There is very scant evidence upon which to base such an opinion.

Most economists have held very tightly to the view that was widely shared at the end of 2013; that 2014 will be the year that the U.S. economy finally shakes off the malaise of the Great Recession. And even though the script has failed to live up to these expectations, the economists haven't seemed to notice.

During the First Quarter of this year, the economy contracted at an astounding annual pace of 2.1%. But economists and politicians were very insistent that the severe miss was solely a result of the difficult winter. Although severe winters can be a drag on an economy (my research shows that the 10 roughest winters over the last 50 years knocked about two points off the normal first quarter GDP), the snow could not fully explain a five point miss from what had been forecast by the consensus at the end of 2013. But that's exactly what they did.

This omission was compounded by their reaction to the 2nd quarter rebound, which showed the economy expanding by 4.6%. But while the crowd was ready to dismiss the very weak first quarter GDP as being a weather-related anomaly, they were not willing to acknowledge the role played by the same anomaly in artificially boosting second quarter GDP. My research, based on figures from the Bureau of Economic Analysis, has shown that strong second quarter rebounds almost always follow sub-par weather-related first quarters. This makes intuitive sense as well. Activity that is delayed in winter gets unlocked in spring. But economists look at the second quarter as if it represents the entire year. But already plenty of evidence has emerged that should sow doubts on the remainder of the year.

Even with the strong second quarter, economists are choosing to gloss over the fact that growth in the entire first half came in at just 1.25%, far below the projections that most have for the calendar year. To get to 2.5% GDP growth, which would be typical of a weak year, not the first year of a long-awaited recovery breakout, GDP would have to come in at 3.75% for the entire second half. To hit 3% for the year, second half growth would need to be 4.75%.

But this will have to occur without the tail winds of Fed QE support and at a time of heightened geopolitical concerns, and a housing and stock markets that look increasingly weak and vulnerable to correction. As a result, economists should take off their rose-colored glasses and ratchet down their full year estimates to conform more closely to reality. But that is not happening.

Sins of Commission

Rather than seeing, hearing, and speaking no evil, some leading figures are much more culpable in spreading bad information. While this list could prove lengthy, here are the top two offenders.

Fed Chairwoman Janet Yellen - In her September press conference, Yellen made the stunning assertion that the Fed's balance sheet, which in recent years has swelled to a gargantuan $4.5 trillion, will likely be reduced in size to "normal levels" by the end of this decade. While most accept this statement at face value, Yellen must know the absolute inability of the Fed to deliver on this promise.

To bring its balance sheet back to pre-crises levels of around $1 trillion, the Fed must sell about $3.5 trillion of debt over the next five years, or a pace of about $700 billion per year. This is a negative equivalent of about $58 billion per month in QE. Additionally, Yellen has claimed that this can be done without actively "selling" assets, and without tipping the economy back into recession. This claim is so fantastical that it must be considered active deception, a grave sin indeed.

First, if QE was necessary to inflate asset prices and create a wealth effect to drive consumer spending and power the recovery, how can the process be reversed without unwinding its effects and producing an even larger recession than the last? If the recovery is already stalling with interest rates still at zero, how can it gather more upward momentum if the Fed raises rates back to normal levels?

Secondly, if the Fed does not actively sell bonds into the market, it must hope to draw down the balance sheet by simply allowing older bonds to mature. This ignores the fact that the maturation process is far too slow to accomplish the task by the end of the decade, and it assumes that the Fed will not have to buy any new Treasury or Mortgage-backed bonds over that time. But in order to provide financing for ongoing Federal budget deficits, or to stimulate the economy if there were another economic downturn, the Fed would have no choice but to start buying again with both hands.

Since the current "recovery" is already 15 months longer than the average post-war recovery, it would be illogical to assume that we can make it through the next five years without another recession.

Of course, by affirming its intention not to actively sell any of its holdings, Yellen is attempting to defray any concerns the markets might have over the impact such sales would have on bond prices.

Lost on everyone, including Yellen herself, is that the impact on the markets is the same regardless of how the Fed's balance sheet shrinks. Even if the Fed allows bonds to mature, the Treasury would then be forced to sell an equivalent amount of bonds into the market to repay the Fed. The fact that a distinction without a difference reassures anyone shows just how delusional market participants remain.

World bank President Jim Yong Kim - In an interview at September's Clinton Global Initiative, the World Bank president urged the European Central Bank to follow the same "successful" experiments in quantitative easing that had been pioneered by the Federal Reserve. As proof of the policy's success, Kim pointed to the stronger GDP growth that is expected in the US in 2015 and 2016. In other words, he is attempting to prove his point not by what has happened thus far, but by what the consensus expects to happen in a year or two. This is no way to argue a point. Dr. Kim is a smart guy and I suspect he knows this, hence another sin of commission.

It would be difficult to make the case that six years of Quantitative Easing has created a healthy US economy. In addition to the subpar first half of 2014 GDP growth, the labor market, consumer sentiment, and wage growth all show signs of stagnation. So Dr. Kim has no choice but to hang his hat on a bright future that he, and most mainstream economists, expect to be right around the corner.

But dressing up a future possibility as a current certainty is a major foul in the business of economic forecasting. Dr. Kim, and others who have made similar claims, should fast an extra day.