11/03/2014 01:38 PM

Monetary Fallacy?

Deep Divisions Emerge over ECB Quantitative Easing Plans

By Anne Seith

 Photo Gallery: A Growing Rift Between Central Bankers
To prevent dangerous deflation, the ECB is discussing a massive program to purchase government bonds. Monetary watchdogs are divided over the measure, with some alleging that central bankers are being held hostage by politicians.

At first glance, there's little evidence of the sensitive deals being hammered out in the Market Operations department of Germany's central bank, the Bundesbank. The open-plan office on the fifth floor of its headquarters building, where about a dozen employees are staring at their computer screens, is reminiscent of the simple set for the TV series "The Office". There are white file cabinets and desks with wooden edges, there is a poster on the wall of football team Bayern Munich, and some prankster has attached a pink rubber pig to the ceiling by its feet.

The only hint that these employees are sometimes moving billions of euros with the click of a mouse is the security door that restricts access to the room. They trade in foreign currencies and bonds, an activity they used to perform primarily for the German government or public pension funds. Now they also often do it for the European Central Bank (ECB) and its so-called "unconventional measures."

Those measures seem to be coming on an almost monthly basis these days. First, there were the ultra low-interest rates, followed by new four-year loans for banks and the ECB's buying program for bonds and asset backed securities -- measures that are intended to make it easier for banks to lend money. As one Bundesbank trader puts it, they now have "a lot more to do."

A Heated Dispute

Ironically, his boss, Bundesbank President Jens Weidmann, is opposed to most of these costly programs. They're the reason he and ECB President Mario Draghi are now completely at odds. Even with the latest approved measures not even implemented in full yet, experts at the ECB headquarters a few kilometers away are already devising the next monetary policy experiment: a large-scale bond buying program known among central bankers as quantitative easing.

The aim of the program is to push up the rate of inflation, which, at 0.4 percent, is currently well below the target rate of close to 2 percent. Central bankers will discuss the problem again this week.

It is a fundamental dispute that is becoming increasingly heated. Some view bond purchases as unavoidable, as the euro zone could otherwise slide into dangerous deflation, in which prices steadily decline and both households and businesses cut back their spending. Others warn against a violation of the ECB principle, which prohibits funding government debt by printing money.

Is it important that the ECB adhere to tried-and-true principles in the crisis, as Weidmann argues? Or can it resort to unusual measures in an emergency situation, as Draghi is demanding?

A Mixed Record in Japan and the US

The key issues are the wording of the European treaties, the deep divide in the ECB Governing Council and, not least, the question of what monetary policy can achieve in a crisis. Is a massive bond-buying program the right tool to inject new vitality into the economy? Or does it turn central bankers into the accomplices of politicians unwilling to institute reforms?

The question has been on the minds of monetary watchdogs and politicians since the 1990s, when a German economist working in Tokyo invented the term "quantitative easing." Its purpose was to help former economic miracle Japan pull itself out of crisis after a market crash.

The core idea behind the concept is still the same today: When a central bank has used up its classic toolbox and has reduced the prime rate to almost zero, it has to resort to other methods to stimulate the economy. To inject more money into the economy, it can buy debt from banks or bonds from companies and the government.

The Bank of Japan finally began to implement the concept, between 2001 and 2006, but the country sank into years of deflation nonetheless. After the financial crisis erupted, central bankers in Tokyo tried a second time to acquire government bonds on a large scale, in the hope that earlier programs had simply not been sufficiently forceful. Between 2011 and 2012, the central bank launched emergency bond-buying programs worth €900 billion ($1.125 trillion).

Finally, in 2013, the new prime minister, Shinzo Abe, opened up the money supply completely when he had the central bank announce a virtually unlimited bond buying program.

A Higher Debt-to-GDP Ratio than Greece

But the strategy, known as "Abenomics," worked only briefly. After a high in 2013, in which Abe proudly proclaimed that Japan was "back," industrial production declined once again. With a debt-to-GDP ratio of 240 percent, much higher than that of Greece, investments declined again, despite the flood of money released under Abenomics.

Businesses and private households were simply too far in debt to borrow even more, no matter how cheap the monetary watchdogs had made it. The banks, for their part, still failed to purge all bad loans from their books, because the central bank was keeping them artificially afloat. "For decades, the Japanese government did not institute the necessary structural reforms," says Michael Heise, chief economist at German insurance giant Allianz.

Ben Bernanke, the former chairman of the US Federal Reserve, demonstrated that under different circumstances quantitative easing could indeed work. After the collapse of investment bank Lehman Brothers, Bernanke, a monetary theorist, spent close to $1.5 trillion to buy up mortgage loans, corporate bonds and US Treasury bonds.

A second program was launched in 2010, followed by a third in 2012. This time the Fed decided that the program would continue until unemployment had declined to 7 percent. Bernanke's successor, Janet Yellen, only put an end to the latest round of quantitative easing last week.

During this period, the Fed, through its emergency measures, has inflated its balance sheet by about $1 trillion to $4.5 trillion, and the economy is now falling into step once again.

Unemployment has dropped from 10 to 6 percent, and the annualized growth rate in the third quarter was 3.5 percent. Many observers believe that this alone proves that Bernanke's mega-experiment was a success.

Relatively strong consensus only exists over the fact that the Fed, with its massive intervention, quickly returned many credit markets to normality after the crisis erupted by buying up securities that suddenly no one else wanted. But have the quantitative easing programs also stimulated the economy in the long term?

In a study, the Fed itself concludes that its programs reduced the unemployment rate by 1.5 percent in 2012. Other studies found that long-term interest rates on government and corporate bonds declined significantly as a result of the Fed's buying spree. Still others question the efficacy of the programs, especially more recently.

So who's right? "It's nearly impossible to measure that," says Clemens Fuest, president of the Center for European Economic Research, "if only because we don't know what would have happened without the programs."

Strong Side Effects

The lack of certainty has led many economists to believe that the effects of the bond buying programs were not all positive. On the contrary, the longer the central bank pumps up the markets with its injections of liquidity, they warn, the stronger the policy's side effects get.

Because yields on many investments declined along with borrowing rates, more and more market players ignored the risks associated with many halfway lucrative business opportunities.

In Europe, for example, bond traders and other investors began buying up Greek, Spanish and Italian government bonds after the debt crisis had subsided, so that some of the former crisis-ridden countries are now paying even lower interest rates on new borrowing than before. Meanwhile, in the United States, corporate debt securities known as junk bonds became the latest trendy investment.

Junk bonds come with an enormous risk of default, but they are also considered very high-yield investments. The market blossomed, at least until recently. But what this means for the US economy may not become apparent for several years. More than $700 billion in junk bonds will mature by 2018, and "a large number of companies will suddenly have great trouble finding follow-up financing," warns Allianz economist Heise.

On the global exchanges, the mood among investors was long delirious. In June, the Bank for International Settlements, an international organization of central banks, noted a "puzzling disconnect" between the boom and actual economic developments. Because debt has also been growing worldwide, the financial system is, in a certain sense, even more fragile than before the crisis, said Jaime Caruana, the bank's general manager.

Whether this is true could become apparent in the next few weeks. Once the Fed has stopped its ongoing injection of liquidity into the economy, many observers fear severe withdrawal symptoms in markets and exchanges.

Growing Pressure for ECB President to Act

Nevertheless, ECB President Draghi is coming under growing pressure to hazard the risky experiment in the euro zone. The region's economy is stagnating and inflation continues to decline. "If the central bank did nothing to counteract the threat of deflation, it would be like withholding treatment from a patient with pneumonia because of the potential side effects," argues Joachim Fels, chief economist with investment bank Morgan Stanley.

The only problem is that the recipe for cheap money is no longer showing much effect in Europe today. In September, ECB President Draghi offered banks four-year loans at ultra-low interest rates, under the condition that the institutions would pass on the funds to the economy through lending. But the amount of borrowing that ensued -- €82.6 billion -- was significantly less than anticipated.

The demand for credit is simply too low in many places. The economy is ailing as a result of a lack of investment and low consumption rates, because households and businesses in a number of countries are still in too much debt. Countries like Italy and France are also dragging their feet with important reforms that could make their industries competitive once again.

A 'Largely Pointless Exercise'

If the ECB does launch a buying program for government bonds, another problem arises. To avoid coming under the suspicion of trying to provide funding primarily to crisis-ridden nations, it will probably have to acquire the bonds of all euro-zone countries. For the ECB itself, the most likely approach is to simply base its bond-buying program on each country's initial contribution to the ECB, known as the capital key.

But then the central bankers would also have to buy large numbers of German bonds, which would be a "largely pointless exercise," as Willem Buiter, the chief economist at US bank Citigroup, puts it. Interest rates on some German government bonds are already in the negative range.

Buiter can readily be described as a proponent of active monetary policy, and yet he too believes that this approach only works if accompanied by structural reforms. Monetary policy alone isn't enough to combat persistent stagnation, he says, "which is what the euro zone is heading for."

It's no surprise that the ranks of skeptics are also growing within the ECB. Bundesbank President Weidmann has long warned that the central bank cannot be allowed to become a "sweeper" for policymakers. Now German ECB Supervisory Board member Sabine Lautenschläger is coming to his defense, saying that the purchase of government bonds could only be a "last resort" in the event of a deflationary spiral, essentially the final ammunition of monetary policy. The critics of further quantitative easing measures also include the Executive Board members from Luxembourg, Austria, the Netherlands and Estonia.

It was US economist Melvyn Krauss who proposed a compromise in the German financial newspaper Handelsblatt last week that many central bankers read with interest. According to Krauss, the ECB could exclude from a bond purchasing program countries that Brussels had admonished for deficit violations. In this way, quantitative easing would become an "enticement" for politicians to institute reforms.

Will Krauss's proposal produce a consensus? Europe's central bankers remain skeptical. "I don't see the south accepting this," one of them said, referencing to Southern European countries.

Translated from the German by Christopher Sultan

November 3, 2014 2:04 pm

Cracks in the Brics start to show

A shared feeling that the west has run things for too long masks deep divergences in world views
James Ferguson illustration
Historians may record that Brics mania reached its height during the 2014 football World Cup in Brazil. President Dilma Rousseff used the occasion to host a summit of the leaders of the five Brics: Brazil itself, Russia, India, China and South Africa. The formation of a new Brics development bank was announced, with its headquarters in Shanghai.
The only thing that spoiled Ms Rousseff’s Brics party was that it took place against the backdrop of the spectacular defeat of the Brazilian national team in the tournament – 7-1 to Germany. A few months later, it is beginning to feel as if the Brics may ultimately prove as much of a disappointment as the host side.

There are three big emerging problems with the Brics story. The first is economic. Three of the five nations involved – Brazil, Russia and South Africa – are floundering economically. This year’s Indian election was also fought against a backdrop of several years of disappointing economic growth. Of the Brics, China alone is still growing at more than 7 per cent a year – but it is in the midst of difficult reforms. Shared dynamism was meant to be the basis of the Brics story – but it has been lost, at least for the moment.
The second difficulty is political. When the Brics were booming, it was natural to argue that their political systems were also functioning well. Now that several are in trouble, political weaknesses such as corruption are more apparent.
The third problem is to do with the incoherence of the group. Although the Brics clearly do aspire to be a voice for the non-western world, they are a very disparate group. Developments in Brazil or South Africa shed no light on the future of China – a country that is so large and powerful that it is really in a category of its own. Meanwhile Russia is mired in a deep and unique crisis in its relations with the west.
Even where real similarities do exist between the countries, they are no longer particularly positive. I spent last week in South Africa, and was struck by how its problems parallel those of Brazil. In 2010, the year Ms Rousseff was first elected, the country was growing at 7.5 per cent a year. But this year growth is likely to be less than 1 per cent. In South Africa, economic growth this year will probably be 1.4 per cent; far less than the more than 5 per cent forecast in the national development plan.

In both countries, stunning natural beauty and the potential for a beguiling lifestyle are undermined by a pervasive fear of crime. The first four items on a nightly news bulletin I watched in Johannesburg were all to do with different murder cases – including the murder of the goalkeeper of the national football team. In both nations, a sizeable underclass lack basic services and decent housing, while middle-class complaints about unreliable infrastructure mount. Even posh areas of Johannesburg have been hit by power and water outages in recent weeks.

Complaints about corruption are a central theme of politics in both Brazil and South Africa – and that is true of the other three Brics, as well. In China, President Xi Jinping has made a campaign against graft a central theme of his administration. In India, Prime Minister Narendra Modi’s ascetic image and promise to clean up government were central to his electoral victory this year. In Russia, meanwhile, President Vladimir Putin’s opponents have dubbed his United Russia the “party of crooks and thieves”.


Lower Oil Prices Carry Geopolitical Consequences 


Editor's Note: The recent drop in global oil prices is affecting economies around the world. This series examines the reasons behind the falling prices and their effects on major energy consumers and producers. Part One discusses the structural changes in the oil market, particularly the growth in supply and the decline in demand. Part Two will examine the countries likely to be most troubled by price drops, while Part Three will look at the countries likely to gain the most.

Since mid-June, the price of Brent crude oil has fallen by nearly 25 percent -- going from a high of $115 to about $87 a barrel -- and structural factors are causing concern among global oil producers that oil prices will remain near current levels through at least the end of 2015. This concern has caused several investment banks to slash their oil price outlooks for the immediate future. Stratfor believes that oil supplies will stay high as energy production in North America increases and OPEC countries remain hesitant or unable to cut production significantly.

Moreover, in the short term, the Chinese economic slowdown and stagnant European economy will limit the potential for growth in oil demand. These factors could make it harder for global oil prices to rebound to their previous levels.
Oil is the most geopolitically important commodity, and any structural change in oil markets will reverberate throughout the world, creating clear-cut winners and losers. Countries that consume large amounts of energy have been coping with oil prices above $100 per barrel since the beginning of 2011 as most of the developed world has been trying to emerge from financial and debt crises. A sustained period of lower oil prices could provide some relief to these countries. Major oil producers, on the other hand, have grown accustomed to high oil prices, often using them to underpin their national budgets. Sustained low oil prices will cause these oil producers to rethink their spending.

The amount of oil production that has come online over the last four months is staggering. The United States has increased its production from 8.5 million barrels per day (bpd) in July to an estimated 9 million bpd. Libyan oil production has increased from about 200,000 bpd to more than 900,000 bpd. Saudi Arabia, Nigeria and Iraq have all increased production in recent months, and OPEC's production is at the highest level in two years. To put this into perspective, the International Energy Agency's projection for global oil demand growth for 2014 is only 700,000 bpd -- roughly half of the total production increase mentioned above.

Price of Brent Crude
Looking to 2015, the growth prospects for energy production in North America continue to be positive. Even after production grew by about 1 million bpd in 2012, 2013 and again in 2014, the U.S. Energy Information Administration expects U.S. oil production to increase by another 750,000 bpd in 2015. Moreover, the Energy Information Administration consistently has underestimated production growth from tight oil (oil extracted from formations that are not naturally very permeable).

Production Cuts Remain Unlikely

The only OPEC members with enough flexibility to reduce oil production voluntarily are the United Arab Emirates, Kuwait and Saudi Arabia. None of the other members are in a financial position to take oil production offline. Libya, Algeria, Iraq, Iran, Nigeria and Venezuela all need maximum oil output and high prices to finance their budgets and social spending programs. Notably, Libya's OPEC governor called on the bloc to cut production by 500,000 bpd to buoy prices but made no mention that his country would take part in such a cut. Saudi Arabia, meanwhile, seems to have taken the opposite position, prioritizing a greater market share over higher prices.

Saudi Arabia's status as OPEC's swing producer has historically meant that Saudi Aramco will reduce production to create higher oil prices. But with U.S. production increasing so quickly and prices that are still relatively high, Riyadh has little interest to do so: A significant reduction in oil production might not increase the price of oil enough to make forgoing the additional exports worthwhile. Riyadh found itself in the same position in the 1980s when it cut production only to discover that its control over international oil prices was limited. The Saudis have been hesitant to play the same card ever since, instead exerting a small influence on prices while continuing to produce at high levels.

More broadly, during the last four decades the Saudis -- as well as the Emiratis and Kuwaitis -- have amassed large wealth funds, enabling them to simply sit back and weather a period of low oil prices.

This means that if oil prices continue dropping, it will fall largely to U.S. producers to slow production expansion. North America's tight oil production costs vary considerably from basin to basin, but so long as oil prices do not continue falling -- and they appear to have bottomed out in the mid-$80 per barrel range -- almost all tight oil production will remain profitable, and drilling will continue to increase. The U.S. oil rig count, a rough indicator of impending oil production, remains near record levels, indicating that the recent downturn in oil prices has not dampened interest in drilling.

In fact, in the short- to mid-term, production prospects outside North America will be rather bleak. Most of the recent production increases elsewhere around the globe were due to one-off events, such as the revival of Libya's production. There are only a few other changes -- such as Iranian exports becoming unconstrained or Saudi Aramco dipping into its spare production capacity -- that could put significant volumes of oil back on the market. In fact, it is more likely that large-scale production will go offline in places such as Nigeria and Libya. All of these possibilities limit the potential of a more drastic decline in oil prices.

Low Demand is Likely to Linger

On the demand side, a bullish oil market is unlikely. North American oil consumption is structurally in decline and has been since the mid 2000s. Electric vehicles, natural gas and other alternatives will continue to penetrate the North American oil market, albeit very slowly. The European oil market exhibits the same patterns seen in North America, but in Europe the structural decline is occurring amid slowing economic growth; many of Europe's more developed economies, such as that of France, are at effectively zero growth.

Meanwhile, China's economy will continue to descend from the peaks of its post-2008 investment and construction boom. The decline of housing markets and related industries nationwide is at the heart of China's economic slowdown and will in large part determine China's overall economic health during the next one to two years. Although a collapse in China's housing market in the next 12 to 18 months is not expected, should one occur, it would send China's economy into a tailspin and subsequently dampen demand for oil. However, Stratfor does not anticipate that Beijing would allow this to happen. The central government will likely enact more stimulus similar to previous economic measures, such as large-scale public infrastructure projects driven by state-led investment.

China's demand for oil could remain relatively strong in the absence of economic collapse, but China's increases in demand are likely to be more moderate than usual at an estimated 400,000 bpd over the course of the year. Increases in demand in the rest of the world combined will likely be no more than that figure. Meanwhile, global oil supplies do not appear likely to decline in the coming months. Therefore, there is every reason to believe that oil prices will stay lower than $100 per barrel for much of 2015, unless Saudi Arabia and OPEC change their minds about production cuts.

All eyes watching oil markets will turn to OPEC's semiannual meeting Nov. 27 to look for any shifts. If there are none, the lower price of oil will continue to have significant geopolitical consequences for consumer and producer countries alike.

China’s Repressed SMEs

Yu Yongding

NOV 3, 2014

    .Bank of china people standing

BEIJING – Financial repression – government policies that create an environment of low or negative real interest rates, with the goal of generating cheap financing for public spending – has long been a key feature of Chinese economic policy. But, with funding costs for businesses trending up, this is finally starting to change.
Early this year, the State Council, China’s cabinet, made lowering funding costs for businesses, especially small and medium-size enterprises (SMEs), a top priority. For its part, the People’s Bank of China (PBOC) has engaged in cautious monetary loosening, which includes freeing up more funds for lending by banks that allocate a certain proportion of their total loan portfolio to SMEs. The PBOC, through its “pledged supplementary lending” program, has also started lending directly to banks that have promised to use the funds for social housing construction.
But, so far, efforts to lower funding costs have had a limited impact. Indeed, the weighted average interest rate on bank credit to nonfinancial enterprises remains close to 7%, while economic growth has edged down from 7.4% year on year in the last three months to 7.3% in the current quarter.
The situation may not be dire yet, but it is far from ideal – especially at a time when the Chinese authorities are pursuing structural reform. The PBOC now faces a dilemma. If it loosens monetary policy further – by, say, cutting banks’ reserve requirement ratio – the momentum for restructuring could be lost; and there is no guarantee that the additional liquidity would flow into the real sector.
But if the PBOC refuses to budge, the combination of high interest rates and slow growth may send the economy into a tailspin.
In fact, the PBOC has little choice but to engage in monetary-policy loosening. But it can avoid the pitfalls of such an approach by placing it within a broader, more comprehensive strategy that accounts for the underlying causes of the increase in funding costs for businesses.
The first factor driving up funding costs is the outsize profitability of China’s commercial banks – more than 23%, on average, for the top five last year – which account for some 35% of total profits earned by the 500 largest Chinese companies. Indeed, the average for banks is nearly four times that for Chinese companies as a whole, for which the average profit is just over 6%.
Moreover, slowing economic growth, tighter prudential regulation, and increased liability have made banks much more risk-averse, driving them to demand a significantly higher risk premium from borrowers, who must now not only provide collateral, but also find third parties to guarantee the loans. In many cases, banks are requiring a second group of guarantors to guarantee the first group. This growing aversion to risk makes it particularly difficult for SMEs to borrow from commercial banks, forcing them to turn to the under-regulated shadow banking sector.
Meanwhile, real-estate developers and local government financing vehicles (LGFVs), which offer banks a false sense of security and guarantee of profitability, have acquired a major share of financial resources. And financial institutions, especially banks, have been using a substantial portion of their funds for financial arbitrage. By reducing the amount of funding available to regular firms, especially SMEs, such activities drive up the average interest rate on loans.
Interest-rate liberalization is exacerbating the situation. China has already removed all controls on interest rates on loans. And, though it continues to guide interest rates on deposits, banks can easily evade these regulations by selling depositors off-balance-sheet wealth-management products, on which returns are not capped. Increases in the cost of funds’ sources increase the costs of the funds’ uses – that is, credit to enterprises.

Read more at http://www.project-syndicate.org/commentary/china-financial-repression-high-borrowing-costs-by-yu-yongding-2014-11#vSzsZgHYDWPz2eAH.99

Heard on the Street

The ECB’s Numbers Game

Draghi Confirms Intent to Expand Balance Sheet

By Paul J. Davies

Nov. 6, 2014 12:58 p.m. ET

European Central Bank President Mario Draghi confirmed he expects the central bank’s lending and bond-buying policies to grow the balance sheet by almost €1 trillion. Bloomberg News  

Mario Draghi finally has a number. He’s just not quite ready to say how he will hit it.

The president of the European Central Bank confirmed that he expects its lending and bond-buying policies to grow the balance sheet by almost €1 trillion ($1.25 trillion). This is roughly what the market had believed Mr. Draghi meant in vaguer comments at previous monetary policy press conferences.

Now it can be sure. The president formalized the target of getting the balance back to its size at the beginning of 2012 by finally inserting the line into his prepared remarks. Then, in later answers to questions, he was explicit that the reference date was March 2012, after the second round of the ECB’s long-term refinancing operation.

The balance sheet was just shy of €3 trillion then. It is just above €2 trillion now.

That, along with Mr. Draghi’s generally dovish tone, helped firm European stocks and push the euro even lower against the dollar. While modest, the gains continue to see markets doing the ECB’s work for it, meaning the central bank can still bide its time on even more aggressive actions like those unveiled last week by the Bank of Japan .

Also, in spite of, or maybe because of, reports of differences among council members about where ECB policy should be, the central bank’s November meeting produced “unanimous” support for Mr. Draghi’s approach from the governing council.

Unfortunately, still open is the tricky question of how the ECB is going to get to the €3 trillion mark. Markets have been underwhelmed by the idea that policies announced so far can do it. These have included direct lending from the ECB to national banks through additional refinancing operations and purchases of covered bonds and asset-backed securities.

Still off the table are actual purchases of sovereign debt, or outright quantitative easing. The ECB’s governing council did say, though, that it is united in its commitment to additional unconventional measures if inflation fails to rise from its stubborn low of just 0.4% in October. That was a marginal improvement on September’s 0.3%, but far from the ECB’s 2% target.

Yet such pledges are still just that. And the inflation number, rather than Mr. Draghi’s balance-sheet one, is the target the ECB really needs to hit.

The Fed's Lost Grip on Interest Rates


Now the market will turn its focus to interest rates.

Will the Fed raise rates next year? If so, what effects will that have?

The Fed is ultimately reactive, exerting little, if any, control in the long run. Low rates are here only as long as the Fed can manage them.

At that point, it is time to look out.

Here's what will cause us nightmares, and what we can do to avert a crisis in our investments…

Americans Tighten Their Belts… While Their Government Races Toward Disaster

The International Center for Monetary and Banking Studies recently published its 16th annual Geneva Report. It's authored by a group of senior economists and former senior central bankers.

The report highlights a sustained increase in (especially) government debt in the developed world, as well as in China. Any deleveraging in the last few years has been minor, mostly limited to the private sector.

It goes on to caution the importance of low rates to stave off another crisis, while pointing out that, as the graph below shows, world debt has mushroomed from 160% of national income in 2001, to 200% in 2009, only to climb further to 215% last year.

interest rates

As a group, the report's authors expect interest rates worldwide to remain low for a "very, very long time," so that all borrowers (governments, companies, and individuals) will remain solvent and keep paying the interest on their debts.

So too does Ben Broadbent, deputy governor of the Bank of England, saying interest rates could remain "permanently" low.

All of this echoes what the Fed's been saying for years in order to reassure and stimulate the markets: there is no rush to raise rates.

None of this is really any surprise to us. But it's not quite that simple….

The Fed's Dangerous Catch-22

As we discussed recently, many expect the Fed to raise rates next year (more on this below), while Europe and Japan recently pushed their rates below zero to help fight off deflation.

Sweden's central bank, the Riksbank, recently cut its own key interest rate to 0% from 0.25%. Swedish central planners there think inflation is still too low, and want a monetary policy that's "even more expansionary" as they target 2% inflation.

In mid-October we heard noise from two regional Fed presidents, John Williams and James Bullard, countering expectations for the Fed to take its foot off the gas. First Williams of the San Francisco Federal Reserve said, "If we really get a sustained, disinflationary forecast … then I think moving back to additional asset purchases in a situation like that should be something we should seriously consider."

Next, the St. Louis Fed's Bullard said it might make sense for the Fed to delay ending its bond-purchase program to halt lowered inflation expectations, and that, "We could react with more QE if we wanted to."

Much more intriguing, however, is research by Citigroup on just how much stimulus the markets need.

Their report estimates that zero stimulus would lead to a 10% drop in equities every quarter, and that central banks need to inject some $200 billion quarterly just to sustain market levels.

Strategists at Bank of America Merrill Lynch figure that another 10% drop in U.S. stocks could lead to a fresh new round of stimulus, QE4.

With all these conflicting signals, what's an investor to expect, really?

Well, now that the end of bond-buying is official, let's look at the Fed's next nemesis: interest rates.

Look for Interest Rates to Do This

The CBO (Congressional Budget Office) estimates that, should interest rates return to normal levels by the end of this decade – just over five years from now – the country's annual debt payments will surge to over $840 billion annually, double current levels.

Precious little will be left over for useless government programs and vote buying.

My own view is we'll likely see rates rise next year, but even then only by token amounts.

Expect increases in the 0.1% to 0.15% range, with the Fed taking its sweet time before ending the hikes, which are likely to top out in the 2% to 3% area only several years from now.

The Fed knows that the Treasury simply cannot afford anything more.

That approach will allow the Fed to save face, keeping its promise to raise rates, while having minimal impact on debt payments and lessening the risk of deflation.

What should concern investors is the serious and growing risk of a currency or bond crisis.

The Geneva Report points out that record debt and slowing growth form a "poisonous combination," potentially leading the global economy into yet another crisis.

Although we can't know exactly the point where just one more snowflake initiates the avalanche – to use Jim Rickards' analogy in The Death of Money – that point exists nonetheless.

And we're getting closer to it, not farther.

Ever-growing debt will trigger a bond crisis, with bondholders deciding "enough is enough" and dumping their bonds wholesale. It's a crisis of confidence that will devastate the bond market, causing yields to surge.

This is why, ultimately, the Fed doesn't control rates.

Newly issued bonds will then have to pay much higher interest to compete with prevailing yields. And that will crush the government's ability to keep up with servicing its debt payments.

I foresee two scenarios holding true through this.

Cash will lose purchasing power thanks to inflation, and real estate will see headwinds as higher interest rates make homes more costly and revenue properties less profitable. Real estate bought with little or no mortgage is clearly preferable.

Ultimately, gold and silver remain your top hard asset choices to counter the coming bond crisis.

Remember, the Fed will do its best to keep rates low. Which is exactly its quandary, since the runaway debt created by extended low rates will cause the next crisis.

Even the Fed isn't omnipotent. Market forces will teach them that lesson.

viernes, noviembre 07, 2014



Legal/Regulatory | White Collar Watch

Banks’ Cycle of Misbehavior

By Peter J. Henning

November 3, 2014 1:13 pm

A UBS branch in Zurich. UBS is one of many global banks found to have committed a corporate violation and settled the case only to face an inquiry into a new violation.Credit Steffen Schmidt/Keystone, via Associated Press

The latest round of global banks’ taking reserves for investigations into manipulation of foreign exchange rates calls to mind Ronald Reagan’s famous retort in a debate: “There you go again.”

It seems to be a never-ending refrain: Misconduct by traders and bankers is uncovered, multiple regulators mount investigations, and then millions, or even billions, of dollars in penalties are paid, all to little apparent effect.
The problem is that the misconduct never seems to abate, shifting instead from one unit to another inside companies whose thousands of employees are under relentless pressure to produce profits. So the intended message from all the expected big settlements seems to go largely unheeded.
Citigroup, Royal Bank of Scotland, and Barclays all announced new reserves last week totaling more than $2 billion to deal with investigations into foreign exchange rate manipulation, while HSBC added $378 million on Monday. The cases involve collusion in the $5.3 trillion daily foreign exchange market to affect rates. These come on top of announcements from Deutsche Bank and JPMorgan Chase that they had each added about $1 billion to their reserves for the expected cost of settlements.
We have seen settlements with prosecutors and regulators for this kind of misconduct before, no doubt reached in the hope that the penalties would deter future violations. In late 2012, a UBS subsidiary pleaded guilty to manipulating the London Interbank Offered Rate, or Libor, while the parent company reached a nonprosecution agreement with the Justice Department that required it to pay over $1.5 billion. A few months earlier, Barclays entered into a deferred prosecution agreement with federal prosecutors for its Libor manipulation that resulted in over $450 million in penalties.
But as The New York Times reported last week, federal prosecutors are threatening to reopen cases involving other violations that could subject banks to even higher penalties and broader compliance efforts. The Justice Department has extended agreements with UBS and Barclays for manipulating Libor that would have expired this year because of evidence the banks also manipulated foreign currencies.
When banks settle a case, a typical provision in the agreement allows the Justice Department to reinstate charges if there is any future violation of the law. Most important, admissions by the bank as part of the settlement can be used against it as evidence later, essentially stripping the bank of any possible defenses if the case were to proceed further. There is little chance, then, that a bank could fight the charges, so it would have to agree to a new settlement with more onerous terms and a new penalty.
But simply extracting more money out of the banks does not seem to have had much of an effect on their operations, apart from increased spending on compliance. The past year has seen record-breaking settlements with Bank of America and BNP Paribas for violations related to mortgage-backed securities and the economic sanctions laws, but whether those penalties have any real effect on how other banks operate is certainly an open question.
No doubt the Justice Department is frustrated by repeated instances of corporate misconduct, with banks like JPMorgan, Barclays and UBS subject to multiple settlement agreements for violations. But prosecutors appear to have few tools available to coerce banks to change corporate cultures that put profits ahead of compliance with the law — at least short of putting one out of business.
BNP Paribas had to plead guilty to a criminal charge of conspiring to violate the economic sanctions law, a rarity in resolving a case with a bank. Even then, the Justice Department worked to limit the fallout from the conviction with other regulators before announcing the case. That way, the bank’s global operations were not hamstrung by the loss of operating licenses or exclusion from important lines of business that might be expected after a guilty plea.
The government is not required to minimize the collateral consequences of a conviction, and individuals are usually required to fend for themselves if they are convicted of a crime. But the foreign exchange inquiry involves a number of leading global banks, each with thousands of employees worldwide. So there is no realistic possibility that federal prosecutors will seek a conviction that may threaten the continued existence of one of the banks.
Regulators could also try to obtain greater compliance by bringing more prosecutions of individuals for their role in the violations. But it is unlikely that any senior executives will be caught up in a manipulation case because they are far removed from the trading that affected foreign exchange rates.
So anyone charged with a violation will be much further down the corporate ladder.
Moreover, there may be obstacles to pursuing cases against individuals who worked outside the United States, which may limit how much of an effect prosecutions can have on the cycle of misbehavior at foreign banks.
Charges were filed in 2012 in Federal District Court in Manhattan against two former UBS traders, Tom Hayes and Roger Darin, for their role in manipulating Libor. In early October, Mr. Darin, a Swiss citizen who worked in offices in Singapore, Tokyo and Zurich, asked the court to dismiss the case because he does not have any connection to the United States. A brief filed with the court asserts that “if the government’s sweeping theory is accepted, then federal law could be used to prosecute any foreign national, acting outside the United States, who has affected any piece of financial information that can be accessed through the Internet.”
Federal prosecutors have been successful in recent years in pursuing cases against foreign executives for antitrust violations when their products are sold in the United States, with some receiving prison terms. Libor is not a product, however, but only a benchmark used in setting interest rates. Similarly, foreign exchange rates were established by a “fix” based on prices for currency trades over a 60-second period each day.
Although manipulation of the exchange rates certainly affects transactions in the United States, it is not clear whether someone with no direct contact with a customer in this country comes within the jurisdiction of American courts. If Mr. Darin succeeds in his argument that he falls outside the grasp of the Justice Department, that may seriously crimp efforts to pursue cases involving individuals at foreign banks with no ties to this country.
The government has imposed billions of dollars in fines over the past few years for corporate violations, part of an effort to show that no company is “too big to jail.” The greater hurdle is whether global banks will ever go far enough to truly reform their cultures and make compliance with the law something more than an easily ignored motto. And it is one that prosecutors and regulators may not have the tools to overcome.

Gold Crashes, Wall Street Doesn’t: What Now?

Metals & Mining Monday

Louis James, Chief Metals & Mining
Investment Strategist

Dear Reader,

Two weeks ago, we warned readers that various indicators were signaling a near-term market crash in mainstream equities. We warned that if it happened, even gold could get whacked briefly due to the resulting liquidity squeeze. That’s not what’s happened—yet.

However, gold melted down significantly last week anyway, falling even lower than last December’s low, bringing it all the way back to prices not seen since 2010.

So did we get everything wrong?
Perhaps, but that remains to be seen. Upbeat Fed statements and encouraging US GDP numbers conveniently appearing the week before a mid-term election don’t persuade me that our wise politicians and their appointees have saved the global economy and everything is fine now. Our technical friends and other analysts we respect still say mainstream markets look poised for a fall.

Marin Katusa’s new book, The Colder War, tells us that Putin would love to play the role suggested by Nietzsche, pushing Western economies into a crash—not just because objects on the verge of falling deserve to be pushed, but because it advances the agenda he’s been pursuing relentlessly for decades.
Still, we understand how nerve-racking it can be when markets don’t go the way we want them to. It’s no surprise that many readers have written in with questions about our gold-centric investment strategy. Jeff Clark has boiled these down to a few main concerns, which he tackles in his Q&A article below.
I hope nervous readers find Jeff’s answers persuasive, because this is a time when it would be easy to panic and make the wrong moves—particularly realizing losses on good companies that have what it takes to pull through.

As we’ve said many times, when it comes to investing in the resource sector, one is either a contrarian or one becomes road kill, and this takes great courage and discipline.
Those attributes are being tested—and may be tested even more sorely if a broader market crash takes metals prices even lower.

That would, of course, be a spectacular buying opportunity, precisely because so few people will take it. Easy to say, tough to do, and not the first time we’ve said it. But that doesn’t make it any less true.

Louis James
Senior Metals Investment Strategist
Casey Research
Jeff Clark, Senior Precious Metals Analyst

With the price of our favorite metal fluctuating so strongly last week, we’ve had a lot of good questions sent our way. Without further ado, let’s have a look at them…
Question: If you’re right about possible deflation, won’t the gold price fall?
Initially, probably so. But it won’t stay there. One reason is because the Fed and other central bankers won’t sit idly by—they’ll print even more money, and will keep doing so until they get the inflation they want.

But it isn’t just inflation vs. deflation; it’s crisis. And crises usually bring fear.

Look how gold has responded whenever fear—as measured by the VIX—has been high and the broader stock market fell.
During these eight periods of high systemic risk, gold rose every time but one. This doesn’t mean it won’t sell off in the next one, especially in the initial phases of a downturn, but it does show that gold is strong when fear is high.
Question: If the Swiss Gold Initiative passes, won’t the gold price explode higher?
It will almost certainly impact the price, but probably not as much as some articles project. The initiative, among other things, would require the Swiss National Bank (SNB) to hold at least 20% of its total assets in gold (it’s currently around 7%). The referendum was brought forth by Luzi Stamm, a representative of the Swiss People’s Party, which is concerned that current Swiss monetary policy (a quintupling of its balance sheet since 2009) is potentially disastrous for the country. The vote is November 30, and if it passes, Switzerland would need to purchase roughly 1,500 tonnes, or 48+ million ounces. 

That’s a lot of gold, and it would surely be positive for the price. Perhaps it could be the spark that turns the industry around. It could even have a ripple effect and influence other countries to pursue similar requirements. 

However, the SNB would have five years to meet the 20% requirement, so the buying wouldn’t occur all at once. With the demand spread out, the effect on the price would probably be limited to the initial news of its passage. It would definitely add support to the market, though, as 48 million ounces is nearly two-thirds of annual global production. 

The Swiss government could also reduce its balance sheet to help meet the 20% requirement, which would lower the amount of gold it would need to purchase, though we wouldn’t hold our breath on that. And if the referendum doesn’t pass, gold could potentially dip, but we’d expect it to be minimal since there hasn’t been much of a run-up in the price from the initiative. 

Polls give a slight edge to the initiative passing, though many politicians vehemently oppose it. One stipulation is that the Swiss National Bank would “not have the right to sell its gold reserves.” This and the limit it would impose on its ability to print money are restrictions the Swiss government desperately doesn’t want to adhere to. 

Which is exactly why it should pass. I like this chart our friends at Miles Franklin put together:
Not what you’d think from the Swiss, eh? Stay tuned on this…
Question: How much gold do you think China has?
Bud Conrad recently returned from speaking at a conference in Tianjin, China, and among other things shared this chart from Koos Jansen with the audience.
Combining jewelry holdings, domestic mining, known imports, and likely reserves, China probably has somewhere around 15,000 tonnes of gold inside the country. This equates to almost a half billion ounces, and is almost triple what it had not 10 years ago. 

This is just an estimate, but either way that’s a lot of bullion—and I think it leads to control of the gold market in the very near future.
Question: If interest rates rise, won’t gold fall?
I tire of this claim from mainstream economists. The argument goes that as rates rise, the demand for gold decreases because you can get a high rate of return on your money elsewhere, and because it costs money to store gold. 

But history clearly shows that it’s not the interest rate per se that influences gold, but the real rate. The real rate is the return after inflation—generally regarded as the 10-year Treasury minus the CPI. If that rate is negative, then the atmosphere for gold is bullish, regardless of how high interest rates may be. Some of the highest rates in modern history occurred in the late 1970s—and gold recorded one of its biggest bull markets on record. The real rate was negative because inflation was higher than interest rates. Gold has shown that it clearly responds more to inflation indicators than interest rates. 

This mainstream view is shortsighted for other reasons. The influence of interest rates overlooks consumer demand for gold. The World Gold Council reports that 58% of global gold demand is linked to consumption and grows when GDP increases, a situation that generally coincides with rising interest rates. Also, monetary tightening and easing cycles are not the same everywhere. If the Fed raised interest rates, other countries with a strong affinity to gold may maintain or even lower their rates.
Question: Can’t you admit you’re wrong about gold? It’s been falling since 2011, and now your 2014 Crash Report says it could fall further!
Yes, it has taken longer than we thought. No, it isn’t any fun. We’re investors too, so we have some of the same feelings and reactions others do. 

Someone is on the wrong side of the gold trade—the gentleman who wrote this question, or me. Nouriel Roubini, or Casey Research. 

It feels like we’re the ones who are wrong. But that’s normal; bear turns in the markets never “feel” good. Investors should be guided by reason, not emotion, and the reasons for owning gold right now are bigger than just persevering until the start of the next bull phase. 

Central bank actions—historic money printing, runaway debt levels, interest-rate suppression—were initially positive for gold, but their impact has faded. There are multiple reasons why that’s the case, but I think our investment in precious metals is now based less on those actions and more on the risk those actions have introduced into the system. And those risks are expanding, not shrinking, despite some positive economic indicators. In other words, the need for insurance has escalated. 

Here are some questions that shed light on the multitude of risks we’re exposed to right now… 

  • What if banks begin lending out the money the Fed has loaned them?
  • What if the Fed decides it needs another round of QE, regardless of what it calls it?

  • What if interest rates rise, whether initiated by the Fed or pushed higher by the markets?

  • What happens when—not if—the stock market enters a correction and mainstream investors begin losing money? What if the average investor remembers 2008 and decides to bail? How will the Fed react if this coincides with the end of QE?

  • What will be the mainstream reaction if the real estate market goes flat or reverses? How would the Fed respond?

  • What happens if the economy does grow—and kick-starts inflation?

  • What happens if the debt load overwhelms the Fed’s printing efforts? Will it give up or double down?

  • What if a developed country selectively or fully defaults on its debt?

  • What if we reach a tipping point where other countries tire of the nonstop currency dilution and slow or reverse their treasury purchases?

  • What happens if the markets lose confidence in the Fed or other central banks’ abilities to manage their respective economies and markets?

  • What if politicians don’t institute serious fiscal reforms, and Fed interventions are reduced to nothing more than monetizing deficit spending by causing inflation?

  • How would global central bankers respond if deflation takes root?

  • What happens if the geopolitical conflicts deteriorate and lead to war?

  • What happens when—not if—control of the gold market shifts to China, away from North America and the Comex?

The point is that we face increased systemic risk. The concern is that central bankers have painted themselves into a corner, and there is no easy exit from their policy mistakes. Since these issues have not been dealt with effectively and political leaders show no sign of doing so, systemic risk has greatly increased. Sooner or later there must be a reckoning—the math doesn’t work, and history has demonstrated the outcome of such fiscal crises numerous times. 

Even if precious metals prices temporarily slip further, keep in mind that it’s less about the exact price and date of the bottom for this market and more about how you will protect yourself against the risks outlined above—they are real, in spite of what we read in mainstream headlines. If any transpire, they will wreak havoc on your investment portfolio and your ability to maintain your current lifestyle. That’s worth insuring. 

This is the major reason why I haven’t given up on gold, and why you shouldn’t, either. It’s not a speculation on rapid gains, but essential wealth insurance. In fact, the need to own gold is greater now than it was in 2008. 

Invest accordingly.