A Progressively Maladjusted “Economic Sphere”

Doug Nolan

Friday, March 27, 2015

March 27 – Bloomberg (by Christopher CondonIan Katz): “Federal Reserve officials, fresh from the latest round of tests designed to ensure the safety of the biggest banks, are now peering into the darker corners of the financial system as they assess the risks of another crisis.

One source of concern: tighter regulation of banks is prompting more borrowers to seek funding through the $25 trillion shadow banking system -- money-market mutual funds, hedge funds, brokerages and other entities that face fewer restrictions. ‘These institutions are a significant and growing source of credit in the economy,’ Dennis Lockhart, president of the Atlanta Fed, said…

‘They are part of an interconnected financial system that, in extreme circumstances, is prone to contagion.’ …Worldwide, shadow banking assets have grown, while banking assets stagnated, according to a report by the Financial Stability Board, a global group of regulators. Non-bank financial intermediation grew almost 7% to $75 trillion in 2013, the latest year for which figures are available, while banking assets declined less than 1% to $139 trillion. In the U.S., shadow banking -- also known as market finance -- grew almost 9% to $25.2 trillion in 2013, while banking assets increased almost 5% to $20.2 trillion. ‘One of the oft-cited examples regarding the prowess of the U.S. financial system is our reliance on market finance,’ said Lawrence Goodman, president of the… Center for Financial Stability… ‘It helps grease the wheels of the financial system.’ The grease can also magnify risks.”
So-called “shadow banking” will undoubtedly play a paramount role in the next global financial crisis. It was at the heart of the 2008 fiasco. Yet somehow “shadow banking” has been allowed to inflate unchecked over recent years – at home and abroad (especially in China). How could this be?

There was no credible effort to analyze and grasp the root causes of the 2008 financial and economic crisis. The Bernanke Fed and the Treasury moved immediately to flood the system with liquidity, backstop troubled borrowers and reflate system Credit. It’s been rationalization and justification – not to mention monetization - ever since. Inflating risk asset prices was the cornerstone of Bernanke’s reflationary strategy. Rates were collapsed to zero, providing a competitive advantage to marketable securities (at the expense of savings). The Fed quickly purchased $1.0 TN of Treasury and MBS securities. The Fed and Treasury backstopped and bailed out key players in the “shadows.” Too Big To Fail.

The Federal Reserve has been determined to paint the 2008 crisis as a consequence of poor lending standards. Excessively loose monetary policy has been absolved of responsibility. And distorted financial market incentives apparently were not culprits either.

The Fed has expounded the view of a somewhat exceptional yet classic consequence of lax supervision and egregious mortgage lending. This was most convenient analysis – a framework that allowed the Fed to toughen oversight of the banks. Market-based finance, on the other hand, was given a pass. Central to Fed strategy, after all, was the aggressive reflation of market-based Credit and the securities markets more generally. It was the Fed’s flawed doctrine and policy course that had me first warning back in April 2009 of the likely emergence of the “global government finance Bubble.”

It’s a fascinating dynamic. Importantly, “market-based” finance has evolved to be quite a misnomer. In one of history’s great ironies, securities market prices – and resulting flows of finance – have come under the direction of central government control. The capacity to intervene, manipulate and dictate securities market prices has provided governments historic sway over market forces. And, of course, few participants have qualms with governments inflating securities markets higher. In an update of Minsky’s stages of capitalistic development, I’ve referred to the post-crisis reflationary period as “Government Finance Quasi-Capitalism.”

Traditionally, central banks would adjust bank reserve requirements and short-term funding costs in an effort to regulate bank lending and inflation. Government deficit spending would seek to boost economic activity, incomes and corporate profits. The resulting mix of real growth and inflation would bring about significant effects on securities prices. Moderate annual inflation in the general price level was viewed as greasing the wheels of commerce, bolstering debtors and holders of risk assets alike. Moreover, accelerating consumer price inflation could be countered with measures to tighten banking lending/Credit.

These days, a momentous change in economic doctrine has policymakers openly targeting rising securities prices. It is believed that central bank Credit-induced wealth effects will stimulate spending, system-wide Credit expansion and, eventually, a steady 2% increase in the general price level. What began with the free-market advocate Alan Greenspan in the nineties (stealthily) nurturing U.S. non-bank Credit expansion, has regressed to open global government manipulation of sovereign bond, corporate debt, equities and currency markets.

There are serious flaws in today’s New Age doctrine that ensure spectacular failure. Generally speaking, global policy is pro-Bubble – pro-Credit Bubble, pro-securities market Bubbles, pro-wealth redistribution and pro-global Bubble-induced financial and economic maladjustment. It is pro unsustainable divergence between inflating securities prices and deflating economic prospects.

Fundamentally, market-based Credit is unstable, with this era’s great experiment requiring progressive government intervention and manipulation. Providing robust incentives for leveraged speculation ensures mispriced Credit, loose Credit Availability and boom and bust dynamics. It also ensures an inflating pool of trend-following and performance-chasing finance. 

Incentivizing flows to the risk markets as opposed to savings only exacerbates the proclivity of markets toward destabilizing speculative excess. As we’ve witnessed over the years, mounting market distortions and associated fragilities have been met with only more aggressive policy measures. A breakdown in market pricing mechanisms is celebrated as a historic “bull market.”

Importantly, it has reached the point where the risks associated with a bursting global Bubble overshadow policy discussions and objectives. Policymakers now endeavor to completely repress market self-adjusting and correcting mechanisms (i.e. “quasi-Capitalism”). Bear markets and recessions have become completely unacceptable, as this historic Bubble’s “Terminal Phase” runs its regrettable course.

There’s another profound flaw in today’s monetary experiment: The historic inflation in market-based finance and securities markets has not – will not - translate into a stable rise in the general price level. Indeed, there are sound arguments as to why policies that target inflating risk markets ensure a problematic divergence between securities prices and a general price level. Generally speaking, the global nature of Bubble distortions ensures spending and investment patterns inconsistent with some general increase in consumer prices. Wealth redistribution distorts spending patterns, with much of the U.S. and global population not enjoying spending-inducing increases in incomes and wealth. In short, I contend that targeting and manipulating “financial sphere” prices ensures inevitable “economic sphere” instability and dislocation.

A myth has prevailed that under the current policy regime central bankers control a general price level. Market prices have inflated tremendously, outstanding debt has inflated tremendously, market faith in central bankers has inflated incredibly – and all have converged to foster a historic divergence between inflated market-based finance and general consumer prices that rebuff financial sphere inflation.

Truth be told, global central bankers have lost control of pricing mechanisms – both in the risk markets and with general consumer price levels. But instead of accepting the realities of a failing policy experiment, central bankers have succumbed to only more extreme monetary inflation. Global securities market Bubbles have inflated to historic extremes, while the policy course has shifted to countries manipulating currencies in hope of countering stagnation and deflationary forces (“currency wars”). At this point, a runaway “Financial Sphere” inflation comes at the expense of A Progressively Maladjusted “Economic Sphere.”

The combination of a faltering global Bubble, increasingly powerful deflationary forces and aggressive currency market manipulation has spurred a powerful king dollar dynamic. Last week I argued that an increasingly destabilizing king dollar provoked a pronouncement of True Ultra-Dovishness from the Yellen Fed. The focal point of my market analysis will center on the currency markets, EM and the ongoing impact of Fed dovishness. The market week was inconclusive.

The Yemen meltdown and an abrupt double-digit percentage jump in crude add complexity to the analysis. King dollar enjoyed an extra boost from some safe haven buying. I would add, however, that the now prolonged global Bubble – rife with wealth redistribution and inequities – ensures an increasingly unstable and problematic geopolitical backdrop. Geopolitical risk bolstering the dollar’s safe haven appeal these days becomes fundamental to the self-reinforcing and destabilizing king dollar dynamic. This dynamic cut short the Fed-induced EM currency and market rally attempt. As the rally faded, EM weak-links this week again displayed vulnerability.

After gaining 3.1% Monday, losses in Tuesday’s and Friday’s sessions saw the Brazilian real end the week down 0.6%. The Turkish lira also had early-week gains evaporate. Rallies abruptly gave way to notable late-week selling in Latin American and Eastern European currencies.

Thursday and Friday losses pushed Brazilian equities to a 3.6% loss for the week. The heavily indebted Brazilian corporate and banking sectors came under pronounced selling pressure again this week. It’s worth noting that BNDES (Brazil’s development bank) CDS jumped 30 bps on Friday to 350 bps, rather quickly giving back much of the Fed-Dove rally. Vale CDS blew right through last week’s (pre-Fed) highs to end Friday at a multi-year high 370 bps. Petrobras CDS increased 5 bps this week to an elevated 625 bps, though prices remain below last week’s high of almost 700 bps.

After an unimpressive Fed-Dove rally, Brazilian 10-year (real) bond yields were up 14 bps this week to 13.21%. Ominously, Brazil sovereign CDS remain at elevated levels, ending the week only 18 bps below recent (pre-Fed) 11-year highs. Mexican peso yields jumped 17 bps this week to 5.86% and Colombia yields jumped 20 bps to 6.96%. After rallying on Fed-Dove, Venezuela CDS surged 530 bps this week to 4,697. Ukraine CDS jumped 325 bps to 2,674. Fleeting stabilization at the troubled Periphery…

Turkey’s 10-year (lira) yields jumped 45 bps to 8.34%, surging past last week’s pre-Fed highs. Turkey CDS increased seven to 217 bps. India’s equity Bubble showed vulnerability, with the Sensex index dropping 2.8% this week. Stocks were hit 5% in Egypt, 3% in Saudi Arabia and Kuwait, and 2% in Oman and United Arab Emirates.

Markets were unsettled here at home as well. Some of the more conspicuous Bubbles demonstrated vulnerability. The biotechs (BTK) were hammered for 4.9%, reducing Q1 gains to 17.3%. The semiconductors (SOX) were hit for 5.0%, pushing year-to-date returns down to only 1.1%. The Morgan Stanley High Tech index dropped 3.4%, as the Nasdaq Composite fell 2.7%. The Transports were clobbered for 4.9% and the REITS (BBG) fell 3.2%.

And let us not forget Greece. After trading above 18% last Thursday, Greek five-year bond yields dropped to almost 15% Thursday before ending the week at 15.6%. Greek CDS surged 300 bps Friday to 1,900. Greek uncertainty remains a major market risk.

March 27 – Financial Times (Jan Strupczewski): “Greece is unlikely to exit the euro, either intentionally or accidentally. But it might be forced to introduce an alternative means of payment, in parallel to the euro, to pay some domestic bills if a reform-for-cash deal with its creditors is not secured soon, several euro zone officials said. Athens has lost access to bond markets and international creditors are not willing to lend it more money until it starts implementing reforms. An official familiar with the matter told Reuters this week that without fresh funds, the government will run out of money by April 20. ‘At some point, when the government has no more euros to pay salaries or bills, it might start issuing IOUs -- a paper saying that its holder would receive an x number of euros at a point in time in the future," one senior euro zone official said. ‘Such IOUs would then quickly start trading in secondary circulation at a deep discount to the real euros and they would become a 'currency', whatever its name would be, that would exist in parallel to the euro,’ the official said.”
All in all, it was another unsettled week for commodities, currencies, equities and fixed-income. 

Ten-year Treasury yields traded at the week’s low yield of 1.85% Wednesday and a high of 2.01% Thursday. Thursday trading saw the yen trade at a one-month high versus the dollar. The two-year German bund traded at a record low negative 0.256% in early-Friday trading. After trading below $45.50 Monday morning, crude (WTI) surged 7% to traded near $52.50 on Thursday. Late-Friday selling saw crude sink 5.6% to end the week up $2.30 to $48.87.

March 27 – Financial Times (Peter Salisbury): “Shia Houthi rebels clashed with Saudi military units on Yemen’s northern border on Friday. The rebels vowed to intensify their campaign for control of the country after a second night of air strikes by a coalition of regional Sunni states led by Saudi Arabia. Houthi fighters also clashed with rival militias in the south of the country. As the fighting intensified, president Abd-Rabbu Hadi, who this week fled the southern port city of Aden in the face of the Houthi advance, travelled to Egypt to attend a summit of Arab leaders in Sharm el-Sheikh. The president vowed to call for an Arab ‘Marshall Plan’ to rebuild his country once the Houthis have been ousted. Tensions grew on Friday as Saudi and Egyptian warships deployed to the strategic Bab al-Mandab strait in an effort to stop Houthis taking control of the waterway. Large volumes of Gulf oil and trade flow through the strait, bound for the Suez Canal.”
For some time now, markets have been content to gaze at a Middle East drifting into the abyss. 

Now, with Saudi Arabia involved in military operations in Yemen the stakes have changed – perhaps significantly. The risk of major regional conflict escalation has risen. And with the Iran nuclear talks coming down to the wire, the Yemen crisis comes at a critical time. 

 This surely raises the level of general uncertainty, a backdrop supportive of king dollar and ongoing EM instability. 

Bank resolution

Pre-empting the next crisis

Regulators’ desire to make banks easy to kill is determining how they live

Mar 28th 2015         
.  .

JUST 51 hours separate the closing of the New York Stock Exchange on Friday afternoon from the opening of the Tokyo bourse the following Monday. How bankers wish it were longer.

Regulators want it to be possible for any bank to fail without causing chaos or taking a bail-out from taxpayers. To that end, they are demanding that big financial firms draw up plans that would make it easier to dismember them or start winding them down during the brief weekly hiatus in trading.

That is proving tricky. This week the Federal Deposit Insurance Corporation (FDIC), the American regulator that takes charge of failing banks, rejected the “living wills” of the local subsidiaries of three of the world’s biggest banks: BNP Paribas, HSBC and RBS. Last year it declared inadequate the plans of all 11 of the banks with more than $250 billion in assets in America, including Bank of America, Barclays, Citigroup, Credit Suisse, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS. The second lot have until July 1st to revise their submissions; the first three until the end of the year. If any of the revised plans are rejected, regulators will gain extraordinary powers to stem the growth of the banks in question or break them up.   

The basic problem is that big banks’ operations are too complicated for a quick and easy dismemberment. The FDIC and other “resolution authorities” (Europe’s new one held its first meeting this week) are forcing them to become much simpler. The aim is to make a bank failure akin to that of any other firm in the economy: painful for investors, potentially troubling for staff and suppliers, but far less noteworthy for customers and the wider world.

Regulators want choices they didn’t have during the financial crisis, when nudging a financial firm into bankruptcy was thought likely to unleash pandemonium—a conjecture confirmed when Lehman Brothers foundered in 2008. Since then, many governments have given resolution authorities the power to take over a faltering bank well before the cash runs out.

They will be allowed to run their charges much like an administrator does an insolvent company.

Regulators also intend to impose losses from a bank failure not only on shareholders, but on bondholders too. That would be an improvement on the financial crisis, when bondholders were largely spared for fear of exacerbating the credit crunch. A large part of the money banks use to fund themselves now has to be in the form of “bail-inable” debt, (some of) which is intended to be written off if a bank is close to failure, not just if it is bust. In theory, a regulator would be able to impose enough losses on shareholders and creditors to stabilise a bank over that brief first weekend without troubling depositors or taxpayers. The resolution authority would then have a few months to make decisions on whether to wind down the bank or allow parts of it to keep going.

For all this to work, regulators think banks need to change. Ideally, they would like each operating unit to be able to function independently, with its own dedicated funding and capital.

The watchdogs also want banks to be simpler. They are not keen on rococo corporate structures (cross-shareholdings between units based in assorted offshore jurisdictions, say) which mere mortals can scarcely understand, let alone disentangle in a crisis. “Too complex to resolve” is the new “too big to fail”.

Banks must codify what were once informal relationships between different units. Critical but dull support services—the IT helpdesk, say, or the property-management division that holds the lease on the bank’s head office—must have clear service contracts with other bits of the bank, in case they get sundered in a break-up. Another form of simplification is the agreement 18 global banks struck last October promising not to pull out of derivative contracts abruptly if one them hits the buffers.

American regulators also want banks to be able to go through full-blown bankruptcy without needing to borrow from the Federal Reserve—a Herculean task, given depositors’ and creditors’ tendency to flee troubled banks. So far, Wells Fargo is the only big American bank that the FDIC judges capable of that. It is helped by a comparatively simple corporate structure: its foreign operations are small, and it does hardly any investment banking.

Some bankers concede that drafting living wills has helped them rationalise their businesses by weeding out “junk DNA” in the form of defunct subsidiaries tied to forgotten deals. Others dismiss the exercise, which for many has involved submitting over 10,000 pages of documents, as another pointless regulatory burden. “Our plan says: fire anyone who knows anything about running the firm, sell everything, get smaller,” one gripes.

Asking for each unit to be self-sufficient is pushing towards a less streamlined financial system, bankers complain. “What used to be informal lending between two subsidiaries is now a strict revolving facility,” says the boss of a global bank. This not only adds to administrative costs, but also makes it hard to put capital to the most profitable use. “It stops the easy flow of money across operations,” says the head of regulation at another banking giant. All this will eventually translate into higher costs for customers.

“If banks cannot die in the market, the pressure on regulators will be to make them simpler and smaller,” says Thomas Huertas, a former regulator now at EY, an advisory firm. However, if regulators can be made confident their charges are safe to fail, they might ease up on the red tape.

One senior official speaks of a “pivot” away from ever more regulation once resolution is a credible option for banks.

In the meantime, the regulators themselves have work to do. In Britain and America, both global financial hubs, supervisors have run “war games” to simulate their resolution strategies in a crisis.

But winding down a bank in practice is bound to be much tougher. One pressing question is how much international co-operation there would be. During the crisis, national regulators scrambled to protect “their” bit of global banks, to the detriment of others. Watchdogs have agreed to work together next time. Few expect they will.

The Americas

Peru Is Chavismo’s Next American Target

Corruption scandals give the left an opening in the 2016 presidential election.

By Mary Anastasia O’Grady

March 29, 2015 5:02 p.m. ET 
Lima, Peru

For the citizens of a nation that boasts one of the world’s most spectacular long-run growth spurts since the 1990s, Peruvians are amazingly short on confidence. This country has so far repelled the authoritarian populism that has swept the South American continent since Hugo Chávez came to power in Venezuela in 1999. Its reward has been an average annual economic expansion of 5.1% for 15 years through 2014—including only 1% in 2009, when global growth collapsed, and a mediocre performance last year of just 2.4%.

                                            Peru's President Ollanta Humala Photo: Reuters 
Fast growth has produced a vibrant consumer class that is entrepreneurial and creative. Shopping malls, modern supermarkets and pharmacies now span this city, which is also marked by shiny office towers and small businesses. Demand for private-school education among aspirational middle-class parents is soaring as they reject the failing government system.

Credit has been expanding quickly yet with commodity prices falling and the global economy slowing, growth may not reach 4% this year. That’s too low to meet rising expectations.

Peruvians I talked to are worried that in the next presidential election set for April 2016, a fickle electorate will give in to populism.

Complicating the matter for anyone associated with the establishment are corruption allegations involving President Ollanta Humala’s wife and a former Humala campaign chief.

Local supporters of chavismo, who believe Peru needs a strongman, will make the spurious claim that corruption and the market economy are somehow linked.

All of this means that if the market model is to be preserved, its advocates will need to vigorously defend its moral legitimacy over the next year.

That Peru hasn’t already fallen prey to the nationalism and populism launched by Chávez—thus following some pied piper of its own off a cliff—is best explained by the structural reforms that generated the strong growth. The country has done a reasonably good job of diversifying its exports since 1990. That’s when it began to dismantle a punishing system of import tariffs and quotas, and ended a hyperinflation that reached an annualized 20,000%.
When Mr. Humala ran for office in 2011 he campaigned on a hard-left nationalist, socialist platform. He moderated his message when he faced a runoff against Keiko Fujimori, the daughter of former president Alberto Fujimori. But once he was in power his base expected him to increase the state’s role in the economy and to consolidate power in the spirit of Venezuela’s Bolivarian revolution.

He has done neither, most likely because he knew that going backward on reform would hit his own constituents the hardest. His government has been fiscally conservative, inflation is low, and property rights have been largely respected. The Pacific Alliance, a new trade pact with Colombia, Mexico and Chile is opening markets further.

On a visit to the Journal’s New York offices earlier this month, Peru’s ambassador to the U.S., Luis Miguel Castilla, told me that while mining still makes up a large share of total exports, openness to imports has made the country globally competitive in the export of coffee, fish meal, fish oil and nontraditional agriculture products like asparagus, artichokes and grapes. Today Peru exports footwear, textiles, ceramics, chemicals and liquid natural gas.

The former finance minister also noted that foreign direct investment to Peru increased by a factor of 4.8 between 2004 and 2014, and exports increased 3.1 times. Peruvian gross domestic product almost doubled during those years, and the poverty rate dropped to 24% from 59%.

Still, the downturn in commodity prices is eating into growth and the slowdown that began last year continues. Market forecasts for GDP growth are in the 3% range for 2015. Peru’s economy is performing far better than most in the region, but lackluster is not what Peruvians have come to expect.

The obvious answer to this lethargy is more aggressive trade opening on key products like sugar and corn, more tax cutting and deregulation. But Mr. Humala’s popularity is sagging and he is unlikely to do anything bold. Meanwhile, opponents of economic freedom will turn slower growth into opportunity by linking stagnant incomes in the market economy and corruption.

U.S. readers will understand how this could happen if they think back about how a community organizer from Chicago with less than one term in the U.S Senate used the 2008 housing bust to tap into resentment against crony capitalism and drive an anti-market agenda that has undermined U.S. economic freedom and growth.

Peru’s governing institutions are far more fragile than the U.S.’s. One can envision a Peruvian version of Obamamania if there is a sense that the system is rigged. It won’t take much for a clever demagogue to generate a frenzy of condemnation toward representative government.

It doesn’t have to happen. But to avoid it Peruvians have to counter the claims of the same despotic ideology that has ruined so many of its neighbors. The facts are on their side.

US risks epic blunder by treating China as an economic enemy

Botched diplomacy by the Obama Administration is forcing Britain and other close allies to choose between the US and China

By Ambrose Evans-Pritchard

8:37PM GMT 25 Mar 2015

China's national flag is raised during the opening ceremony of the Beijing 2008 Olympic Games at the National Stadium, August 8, 2008.
US move to block China's world bank is "misguided at every level". Photo: Reuters
The United States has handled its economic diplomacy with shocking myopia.

The US Treasury's attempt to cripple the Asian Infrastructure Investment Bank (AIIB) before it gets off the ground is clearly intended to head off China's ascendancy as a rival financial superpower, whatever the faux-pieties from Washington about standards of "governance".
Such a policy is misguided at every level, evidence of what can go wrong when a lame-duck president defers to posturing amateurs in Congress on delicate matters of global geostrategy.
Washington has enraged Britain by trying to browbeat Downing Street into boycotting the project. It has forced allies and friendly countries across the Far East to make a fatal choice between the US and China that none wished to make, and has ended up losing almost everybody. Germany, France, and Italy are joining. Australia and South Korea may follow soon.

The AIIB is exactly what the world needs. China must recycle its trade surpluses and its $3.8 trillion reserves by one means or another. It can buy US Treasuries, Bunds, or Gilts, perpetuating a global bond bubble. It can make surgical investments abroad to acquire technology for its champions and pursue a narrow national interest.

Or it can recycle the money in concert with other members of the AIIB - with a start-up capital of $50bn - for sewage projects, clean energy, ports, roads, and railways in Asia, helping to plug a $700bn shortfall in infrastructure investment that the World Bank is too small to cover and which is of collective benefit to the world.

Britain recycled its surpluses in the 19th Century by building the world's railways. America did so in the 1950s through the Marshall Plan. China must do likewise, and it is hard to see why the AIIB is considered such a villainous variant.

American officials castigated Britain for breaking ranks and embracing the project, as if it were kowtowing to an enemy. “We are wary about a trend of constant accommodation of China, which is not the best way to engage a rising power,” one US official told the Financial Times.

One is left breathless at the historical folly of such a view in any case. As Henry Kissinger told Caixin magazine this week, the greater danger is that the US fails to accommodate the rise of China in an enlightened fashion, repeating errors made by the status quo powers faced with a prickly Germany before the First World War.

There are echoes of the Korean War in this Atlantic spat, though thankfully the stakes are less violent today. Britain tried to restrain General Douglas MacArthur and Washington's hawks as they sent US forces charging through North Korea to the Yalu River and the Manchurian border in 1950, warning that it would force China to respond.

MacArthur's contemptuous riposte was to liken British reflexes to the betrayal of Czechoslovakia at Munich, of "desiring to appease the Chinese Communists by giving them a strip of Northern Korea." The British experts were right. China threw four armies across the Yalu. America had arrogantly stumbled into a shooting war with the Chinese revolution, a cataclysmic mistake.

General MacArthur misjudged China disastrously

There is no doubt that the AIIB is a direct challenge to the World Bank, just as the new 'BRICS bank' takes aim at the International Monetary Fund. The two China-led bodies are intended to break Western control over global finance through the Bretton Woods institutions.

Yet whose fault is that? Under the Bretton Woods carve-up over the last seventy years, World Bank chiefs are always American by droit de seigneur, and all IMF chiefs are European. The US clings steadfastly to its IMF veto. Capitol Hill has yet to ratify a reform of the IMF quota system that currently gives the US four times as much power as China, or approve a badly-needed expansion of IMF funding.

Jacob Lew, the US Treasury Secretary, admits that this foot-dragging has been costly. “It's not an accident that emerging economies are looking at other places because they are frustrated that the US has stalled a very mild and reasonable set of reforms in the IMF,” he said.

As for the Europeans, they hijacked the IMF for an internal rescue of four eurozone countries, even though EMU is amply rich enough to sort out its own self-created mess. Every emerging market member of the IMF board opposed the original Troika plan for Greece in 2010 on the grounds that it was a rescue for North European banks and for the euro, not a rescue for Greece. They complained that Greece needed immediate debt relief rather than bail-out loans and therefore more debt, and events have proved them entirely right.

It would be a miracle if China were meekly to accept this outdated mockery of world financial governance, and nobody has yet paired the word meek with president Xi Jinping. The most powerful Chinese leader since Mao Zedong - described this week by one party survivor as a "needle wrapped in silk" - will have his way.

Those in Washington who think that China can be pushed around on such matters seem blind to the shifting strategic landscape, as if they still cling to Bush-era illusions of hegemonic power. Mr Obama knows better. It is a mystery why he has wasted so much capital on a debacle.

The only hope for the world in the 21st Century is for the US and China to govern together in G2 condominium. The West must pick its quarrels with care, always going with the grain of its Asian alliance system.

There was pervasive alarm across the Pacific Rim three years ago when China began to flex its muscles: over the Diaoyu/Senkaku islands in the East China Sea, and the Spratlys in the South China Sea. The US was fully justified in acting to stiffen a ring of states from Vietnam, to the Philippines, Japan and South Korea, even if this inevitably had a whiff of military encirclement.

But blocking everything reflexively because it threatens US dominance is stale statecraft, damaging the nexus of alliances on which all else depends.

It is possible that the AIIB will fizzle. China's economy has come off the boil, struggling by an incipient debt crisis. The work force is contracting by three million a year. Productivity growth has failed to keep pace with rising wages. Capital outflows are eating into foreign reserves. The central bank has become a net seller of bonds. The Asian Development Bank said this week that the yuan is now "overvalued".

David Shambaugh, a veteran sinologist at George Washington University, says the Communist Party is in danger of disintegrating. Riddled with corruption, it is relying on naked repression and systemic purges to make up for lost legitimacy. He has even begun to talk of a coup against President Xi.

Mr Shambaugh's warnings have set off a particular storm among China-watchers, since he is not habitually a member of China's doom brigade. He is probably wrong, but authoritarian regimes are brittle, and inherently non-linear.

Robert Kahn from the US Council on Foreign Relations says the White House would be well-advised to stop trying to sabotage the AIIB, allow any country to joins if it wishes, and let the bank "rise or fall on its own merits."

Or Washington might heed the proper lesson from the Florentines. We all know about Niccolo Macchiaveli's compulsive urge to pre-empt all possible threats. He deemed people immutably wicked by nature and therefore prone to be hostile, a bias that brought his princes endless grief.

Less remembered is his peer, Francesco Guicciardini, a man more willing to discern virtue. He regarded such dark views as bad counsel. Most threats fade away of their own accord, or turn out to be harmless. Guicciardini advised "discrezione". Much wiser.

This Stock Market Bubble Will Burst Like An Overinflated Balloon

by: Boris Marjanovic            

  • The stock market is clearly in bubble territory right now, and like all bubbles in history, it will eventually burst.
  • Investor bullishness is near record highs, which is a good indication that the six-year bull market is nearing its end.
  • Once the inevitable and unpredictable crash does occur, it will put further strain on the increasingly fragile U.S. economy.
  • Equity tail-hedging will allow investors to profitably ride the roller coaster of ups and downs of the market.
Financial markets have a long history of speculative bubbles and crashes. From the Tulip Mania in 1637, the South Sea Bubble in 1720, and the Railway Mania in the 1840s, through the stock market boom in the Roaring 1920s, the Nifty-Fifty craze in the early 1970s, the Japanese asset bubble in the late 1980s, and the internet craze in the late 1990s up to the recent real estate bubble that ended in 2007, financial markets - and the greed-blinded investors who populate them - never learn from past mistakes. As soon as one bubble bursts, another begins to form somewhere else - it's a perpetual cycle of irrationality.

The latest bubble has formed in the U.S. stock market, which has been soaring for several years now. Investor bullishness is quickly approaching record levels, even as stock valuations move into territory not seen since the frenzy of the internet bubble 15 years ago. Of course, this bullishness is nothing more than a giant confidence game based on the Fed's easy money policies: the instant investors lose confidence there will be a severe crash. In this article, we'll see just how overinflated this bubble has become and discuss what you can do to protect yourself against its inevitable destruction.

One of the Largest Stock Market Bubbles Ever

The S&P 500 (the proxy index for the U.S. stock market) has been on a massive winning streak, rising over 200% since it bottomed out in early March 2009, making this the fourth-longest bull market in history. But these six straight years of gains have caused stocks to be bid up to unsustainable price levels - creating a huge bubble that will lead to an eventual stock market crash.

For instance, the Shiller P/E ratio currently sits at ~28x, which is how high it got at the peak of the 2007 real estate bubble. That's more than 65% above the historic average of 16.6x. The only times in history that the market has been more overvalued was during the bubbles of 1929 and 1999.

Exhibit 1: Shiller P/E Ratio is More Than 65% Above Historical Norms

Note: The Shiller P/E/ ratio avoids the problems of volatile earnings in the P/E ratio by averaging the inflation adjusted earnings of the last 10 years.
Source: A North Investments, S&P Dow Jones Indices, Robert Shiller

Valuations look even worse when we consider the fact that corporate profit margins are near all-time highs, which actually makes the Shiller P/E ratio lower than it should be. Corporate profits have climbed to nearly 11% of GDP, while their historical average is only 6.5%. That's a pretty wide gap!

But since above average profits tends to attract new competitors - that's how capitalism works, after all - profit margins have a strong tendency to mean-revert in the long run (and when that happens, stock prices get hit hard). In fact, when making adjustments for historic profit margin differentials, the market today has roughly the same Shiller P/E ratio that it had during the internet bubble back in 1999 (which was the largest stock market bubble in history).

Exhibit 2: Corporate After-Tax Profit Margins are at Record Highs

Note: Raw data for U.S. corporate after-tax profits only dates back to 1947.
Source: A North Investments, Federal Reserve Bank of St. Louis

nother great long-term valuation indicator is the ratio of total stock market capitalization to GDP (usually called the "Buffett Indicator"). Warren Buffett has often said that this is probably the best measure of where valuations stand at any given moment because it compares the relationship between the stock market and the economy. In short, any time this ratio rises significantly above its long-term average of about 72%, the stock market is dangerously overvalued and vulnerable to crashes. Today this metric stands at roughly 122%, which means stocks are now even more overvalued than they were at the peak of 2007 real estate bubble - a frightening fact, to say the least.

Exhibit 3: Buffett Indicator is at the Second Highest Level Ever

Note: (1) The Wilshire 5000 is the best proxy for the stock market because it includes almost all publicly traded U.S. based companies. (2) Raw data for the Wilshire 5000 only dates back to 1970.
Source: A North Investments, Federal Reserve Bank of St. Louis

Increasingly Fragile U.S. Economy

The current bull market was (and still is) driven by the Fed's ultra-low interest rate policies after the Great Recession, which forced investors to seek higher returns in stocks. Ironically, this desperate attempt to help revive the U.S. economy has caused stocks, as I showed above, to be bid up to fundamentally-absurd price levels - creating a huge bubble which will inevitably burst, most likely leading to another severe recession.

Of course, recessions are perfectly normal - they're part of the natural economic cycle. But the keyword here is "natural," and what our economic policymakers are doing is anything but natural. Their artificial manipulation of the economic cycle (especially attempts to prevent recessions) tends to, at best, prolong the "boom" and make the subsequent "bust" much worse.

This is because absence of natural fluctuations in the economy causes hidden risks to accumulate (e.g., too much debt) and becomes a catalyst for disaster. In fact, the longer it takes for a blowup to occur, the worse the resulting damage will be. It's a lot like the old practice of preventing small forest fires from taking place; it allows flammable material to build up so that when a fire does happen, it's catastrophically big.

So while, on the face of it, the U.S. appears to be doing quite well right now, it's nothing more than a temporary illusion - the calm right before the storm. Things looked great back in January 2007 as well - the economy was growing, unemployment was low, and inflation was under control. That's as good as it gets economically, but like in 1929, appearances were deceptive. By December of that year, the country officially entered a terrible recession, which nearly crippled the entire global financial system.

The scary fact is that the U.S. is now even more economically fragile than it was eight years ago, making it significantly more vulnerable to future crises. The country has racked up more debt than ever before - over $18 trillion and growing by the second, which doesn't even include the tens of trillions in off-balance sheet obligations related to Medicare, Social Security, and other entitlements.

Moreover, the same mega-banks responsible for the financial meltdown have become even larger, rendering them now "too-bigger-to-fail" than before. The assets of the five largest banks in the country (not including their trillions in off-balance sheet assets) have grown from 43% of GDP before the financial crisis to 51% of GDP at the end of 2014 through a combination of bailouts, mergers, and takeovers.

Given all of this, it's only a matter of time before this increasing economic fragility reaches a breaking point and collapses, bursting the overinflated stock market bubble and plunging the U.S. into another deep recession or, even worse, a depression. And at the rate things are going, the country will eventually dig itself into a hole that it can't climb out of. A Roman Empire-style collapse is not merely a possibility, it's a virtual certainty!

Crashes Happen When We Least Expect Them

There's an old saying that if something can't go on forever, it won't. Likewise, if a stock market bubble can't expand forever, it won't; one day it will burst (although predicting when that day will come is impossible). Given this fundamental truth, you'd expect "rational" investors to be increasingly bearish and risk-averse as the stock market soars to record highs, since it increases the likelihood of an eventual crash. However, the exact opposite seems to be the case - they're becoming increasingly bullish and risk-seeking.

Below is a chart of the S&P 500 versus the CBOE's Volatility Index ("VIX"), also known as the "fear index." Derived from S&P 500 option prices, the VIX is a measure of investors' expectations for stock market volatility over the next 30 days. As a general rule, the higher the VIX, the higher the fear; conversely, the lower the VIX, the lower the fear, which indicates a complacent market. As shown below, the S&P 500 is at an all-time high, while the VIX is near all-time lows. This suggests that investors foolishly expect the good times to continue.

Exhibit 4: VIX is Near Multi-Year Lows Indicating a Complacent Market

Source: A North Investments, Chicago Board Options Exchange ("CBOE")

But the more bullish investors become (i.e., the lower the VIX gets), the higher the likelihood that a crash is just around the corner. This is exactly what happened after the VIX hit an all-time low in February of 2007. Just like today, the stock market was soaring at the time, but then - right when investors' confidence that the bull market would continue was at its peak - everything collapsed like a house of cards on a windy day. And just like the poor, ignorant turkey who wakes up Thanksgiving morning expecting lunch as usual - millions of investors were completely caught off guard when the crash occurred, suffering enormous losses as a result. The moral: Don't be an investing turkey!

Profiting From the Inevitable Crash

The inescapable fact is that sooner or later, the stock market boom must end. Of course, it's impossible to know when precisely this will occur - could be tomorrow or five years from now.

Given this uncertainty, we always have to be prepared for the worst case scenario because, given enough time, it will eventually become a reality. That's why it's important to always have some kind of insurance policy in place to insulate ourselves from unexpected market downturns and, ideally, even profit from them.

One way to accomplish this is to have a sizable amount of "dry powder," or uninvested cash, on hand. The optionality of cash allows you to take advantage of temporary market inefficiencies in order to earn outsized long-term returns. In a now famous example, back during the dark days of 2008 when most companies were strapped for cash, Warren Buffett made some of the best investments of his career acting as a lender of last resort to companies such as Goldman Sachs (NYSE:GS) and General Electric (NYSE:GE). Cash-rich Buffett wouldn't have been able to do those lucrative deals had he been fully invested, and it would have certainly hurt his track record.

However, a large drawback to sitting on cash is that it can take a very long time for attractive investment opportunities to arise (as we've seen during the current bull market, stocks can remain overvalued for years). Moreover, given that 95% of market gains have historically occurred on just 1% of the trading days, an investor who frequently carries a large cash position is very likely to miss most of these significant gains. So, instead of guessing (usually incorrectly) the best times to be in or out of the market, we'd be better off using something called "equity tail-hedging." It essentially allows us to capture the upside of bull markets while limiting the downside risk when markets are falling. Although there are many different ways to construct an equity tail-hedged portfolio, the one I'm about to describe is one of the simplest and most effective.

The way it works is as follows: you allocate 98% to 99% of your annual assets into an ETF (or index fund) that tracks the S&P 500 index. Something like the Spider S&P 500 (NYSEARCA:SPY) is an excellent choice in this case. The remaining 1% to 2% is used to purchase far out-of-the-money put options on that same ETF, which are continuously rolled into new contracts as they approach expiration. The puts will rise in value when the market crashes, and these hedging profits are then reinvested back into the undervalued ETF whose subsequent returns will be much higher.

The beauty of the equity tail-hedging strategy is that it allows us to profitably ride the roller coaster of ups and downs of bull and bear markets. There's no economic forecasting or market timing required (which is a huge waste of time anyway). So, regardless of whether the current bull market bubble continues expanding or whether it bursts - this portfolio strategy is guaranteed to earn attractive long-term risk-adjusted returns.

Summary and Conclusión

The stock market is clearly in bubble territory right now, and like all bubbles in history, it will eventually burst. And this could happen sooner rather than later given that investor bullishness - a classic contrarian indicator - is near record levels right now. One of the best ways to profit from this inherent market uncertainty is to employ equity tail-hedging. This simple strategy allows us to capture the upside of bull markets while also providing downside protection against unexpected market declines. Thus, regardless of which direction the market moves, this portfolio strategy is guaranteed to earn attractive long-term risk-adjusted returns.

One More Rally (and Then a Huge Drop Expected)

By: Brad Gudgeon

Wednesday, March 25, 2015

Last article, I wrote about an important top coming. On March 25, the US Market dropped about 1.4% to 2061. The E-Waves are saying we are not through yet to the upside. I talked about the Bradley Siderograph and Financial Astrology, and used some humor (but I was quite serious...joking on the square so to speak). I also promised to show you some volume figures (this time around it will be the On Balance Volume on the SPY)

March 25th marked the 8 trading cycle low from the bottom on March 13, the Bradley Siderograph turn. The e-waves and cycles are saying that another even more powerful up move is coming and new highs on the S&P 500 are in the stars.

S&P 500 2134-37 is expected by Monday next week, March 30. Thursday and Friday this week should be up huge. There is evidence that yet another minor top is due on April 2nd, but it should mostly be in the NASDAQ and Dow Industrials, not the S&P 500 (but could be). This is based on a recurring 23 trading day cycle top (every act in the market has a reaction in same).

The first chart below shows the daily S&P 500 in macro format, from the time of the A Wave top in early July last year to the projection into April 22 to 1924/25(on the S&P 500). The April 22 projected low is an important signature on the Bradley. It is also 55 trading days (the 10 week cycle +/- a week) past the February 2 low and trading days (the 5 week cycle +/- ) past the 20 week low on March 13. It is also a .618 retracement of the a-b-c "Y" Wave ending on Dec 29, 2014.

Notice also the perfect symmetry of the current channel. The upper red line is just that "Red Lining" the market. The blue rising upper line is where there tends to be reasonable topping formations, especially secondary in nature before a fall of import.

The e-waves at this point get very complex and Z Waves can exhibit x-y-z formations of their own. Notice also the rising wedge formation. The market will fall like a waterfall once this formation is broken in earnest.

S&P500 Daily Chart

The whole formation going into April suggests even higher highs into early May, July and even into late August with a lot of choppiness and huge moves both up and down (I'll get into that later on). The bottom line is I believe we see a 20%+ bear market from late August into late October. But that will only be Wave X of a larger WAVE "B" due sometime in 2017 (Wave Z).

That means higher highs (Wave Y) into 2016 are likely before we see an even bigger drop in a couple of years.

Below is the hourly chart of the S&P 500 and its projection. The pull back on March 25 was just the set-up for a higher high ahead (actually new highs). Elliott termed it an Irregular Flat with strong rally potential. Notice Wave (b) took out the former wave c of (a). This was the whole FED rally last week... gone....poof.

S&P500 Hourly Chart

Below, as promised, I have the daily On-Balance-Volume chart for the SPY. It keeps going down as the market goes up. Eventually, the piper must be paid!

S&P500 Daily Chart 2

There is yet another important Bradley turn due on April 3 along with some other important astro aspects that imply an important turn. April 3rd is Good Friday, so I expect the turn (top) the day before. All in all, I expect next week to be quiet once the rally into Monday occurs. We have month end/beginning month seasonal buying and the end of the quarter buying expected to come in. It is after Easter that I expect the fireworks to the down side to occur in earnest. The next cycle bottom (the 4/8/16 td day low) is due around April 8 +/-. Then we have April 22!

Europe’s Easy-Money Endgame

Hans-Werner Sinn

MAR 26, 2015
Euro monopoly houses

 MUNICH – The euro has brought a balance-of-payments crisis to Europe, just as the gold standard did in the 1920s. In fact, there is only one difference between the two episodes: During today’s crisis, huge international rescue packages have been available.
These rescue packages have relieved the eurozone’s financial distress, but at a high cost. Not only have they enabled investors to avoid paying for their poor decisions; they have also given overpriced southern European countries the opportunity to defer real depreciation in the form of a reduction of relative prices of goods. This is necessary to restore the competitiveness that was destroyed in the euro’s initial years, when it caused excessive inflation.
Indeed, for countries like Greece, Portugal, or Spain, regaining competitiveness would require them to lower the prices of their own products relative to the rest of the eurozone by about 30%, compared to the beginning of the crisis. Italy probably needs to reduce its relative prices by 10-15%. But Portugal and Italy have so far failed to deliver any such “real depreciation,” while relative prices in Greece and Spain have fallen by only 8% and 6%, respectively.
Revealingly, of all the crisis countries, only Ireland managed to turn the corner. The reason is obvious: its bubble already burst at the end of 2006, before any rescue funds were available. Ireland was on its own, so it had no option but to implement massive austerity measures, reducing its product prices relative to other eurozone countries by 13% from peak to trough. Today, Ireland’s unemployment rate is falling dramatically, and its manufacturing sector is booming.
In relative terms, Greece received most of Europe’s bailout money and showed the largest increase in unemployment. The official loans granted to the country by the European Central Bank and the international community have increased more than sixfold during the past five years, from €53 billion ($58 billion) in February 2010 to €324 billion, or 181% of GDP, now.

Nevertheless, the unemployment rate has more than doubled, from 11% to 26%.
There are four possible economic and policy responses to this state of affairs. First, Europe could become a transfer union, with the north giving more and more credit to the south and later waiving it. Second, the south can deflate. Third, the north can inflate. And, fourth, countries that are no longer competitive can exit Europe’s monetary union and depreciate their new currency.
Each path is associated with serious complications. The first creates a permanent dependence on transfers, which, by sustaining relative prices, prevents the economy from regaining competitiveness.
The second path drives many debtors in crisis countries into bankruptcy. The third expropriates the creditor countries of the north. And the fourth may cause contagion effects via capital markets, possibly forcing policymakers to introduce capital controls, as in Cyprus in 2013.
European politics has focused so far on providing public credit to the crisis countries at near-zero interest rates, which eventually may morph into transfers. But now the ECB is attempting to break the impasse through quantitative easing (QE). The ECB’s stated goal is to reflate the eurozone, thereby reducing the euro’s external value, by purchasing more than €1.1 trillion worth of assets. According to ECB President Mario Draghi, the inflation rate, which currently stands at just below 0%, is to be raised to an average of just below 2%.
This would offer southern European countries a way out of their competitiveness trap, because if prices remained unchanged in the south, while the northern countries inflated, the southern countries could gradually reduce their goods’ relative prices without feeling too much pain. Of course, in that case the north needs to inflate faster than by just 2%.
If, say, southern Europe kept its inflation rate at 0% and France inflated at a rate of 1%, Germany would have to inflate by a good 4%, and the rest of the eurozone at 2% annually, to reach a eurozone average of slightly less than 2%. This pattern would have to continue for about ten years to bring the eurozone back into balance. At that point, Germany’s price level would be about 50% higher than it is today.
I do expect QE to bring about some inflation. Given that an exchange rate is the relative price of a currency, as more euros come into circulation, their value has to fall substantially to establish a new equilibrium in the currency market. Experience with similar programs in the United States, the United Kingdom, and Japan has shown that QE unleashes powerful forces of depreciation. QE in the eurozone will thus bring about the inflation that Draghi wants via higher import and export prices. Whether this effect will be sufficient to revitalize southern Europe remains to be seen.
There is a risk that Japan, China, and the US will not sit on their hands while the euro loses value, with the world possibly even sliding into a currency war. Moreover, the southern EU countries, instead of leaving prices unchanged, could abandon austerity and issue an ever greater volume of new bonds to stimulate the economy. Competitiveness gains and rebalancing would fail to materialize, and, after an initial flash in the pan, the eurozone would return to permanent crisis. The euro, finally and fully discredited, would then meet a very messy end.
One can only hope that this scenario does not come to pass, and that the southern countries stay the course of austerity. This is their last chance.

Heard on the Street

The Yuan Strikes Back

By Alex Frangos

March 26, 2015 7:45 a.m. ET

China has made steps toward letting the market determine the exchange rate, but the country continues to keep a firm grip on it.  China has made steps toward letting the market determine the exchange rate, but the country continues to keep a firm grip on it. Photo: Bloomberg News

Someday the Chinese currency might buckle under the weight of a slowing economy. Beijing will make sure this isn’t the year for that to happen.

The Chinese yuan has strengthened mightily in the past couple of weeks, and is now just about where it started the year versus the dollar. That is despite a darkening growth outlook and expectations for increasingly loose monetary policy, factors that normally should exert downward pressure on a currency.

But China is different. While the government has made steps toward letting the market determine the exchange rate, it remains tightly controlled.

This year, it might make economic sense to let the currency slide to give growth a boost, similar to how a weaker currency is benefiting the eurozone and Japan. Some investors are even betting on a major devaluation. A weaker currency would provide relief to exporters after the yuan has strengthened 15% on real, trade-weighted terms over the past two years.

But such a move is unlikely. China prizes stability in most things, and that extends to its currency, too. A fall of a few percentage points against the dollar, as happened last year, or maybe a smidgen more, seems around what Beijing is willing to tolerate.

There is also a wild card this year. The composition of the International Monetary Fund’s quasi-currency known as the special drawing right, or SDR, is up for review starting in May, and China wants in.

China’s Central Bank Gov. Zhou Xiaochuan and other officials have been beating the drum this week about the yuan’s inclusion in the SDR, which serves as an accounting currency and means to move around capital among IMF members. Getting in would be a milestone in China’s effort to position its currency as an eventual rival to the dollar in international finance.

There is nothing to preclude a currency that goes down from joining the small group that is included in the SDR, namely the dollar, euro, yen and pound. But China would hardly want this to be the year when the yuan causes financial-market stress. A devaluation would also risk reigniting the politically-charged exchange-rate debate with the U.S., which holds sway in IMF matters.

The terms of inclusion state that an SDR currency must be “freely usable.” That doesn’t mean China has to fully liberalize its capital account, or even stop intervening in the level of its currency. Mr. Zhou pointed to the Shanghai-Hong Kong Stock Connect program as a sign of progress since 2010, when the IMF rejected the yuan’s inclusion. To convince the IMF, Mr. Zhou will need to deliver more changes, something he has promised.

In the long term, gaining SDR inclusion could strengthen the yuan, as it would become a more viable currency for governments and central banks to hold. Of course, opening more to capital flows would also mean the currency could weaken when the economy slows.

But for now, with China continuing to set a daily exchange rate and intervening in foreign-exchange markets to keep it near that rate, any falls will be guided by Beijing’s hand.

The Housing "Recovery" Is Fabricated Optimism

By Shah Gilani, Capital Wave Strategist, Money Morning

March 26, 2015 
  When I moved to Sarasota in 1999 I was invited by a prominent local to an "un-wedding wedding" to make new friends in town. I accepted the invitation and, not wanting to display my ignorance, avoided asking the burning question, "What's an un-wedding wedding?"

Inevitably I found out what an un-wedding wedding is. It's a full-blown wedding, only the host isn't actually getting married. They want to get married but aren't, and go through the motions anyway.

The truth about the manipulation of celebratory events to fabricate optimism about a desired future reminds me of the state of housing in America today. Here's why…

Celebrating Housing Market's Recovery Is a Mistake

There's no reason to celebrate anything in the housing market's un-recovery recovery.

Past and present manipulations must be continued to prevent collapse, but they won't help economic growth in the United States as they did until 2000. Instead they'll only act as a headwind from time to time.

Take February housing "starts" for example, they were down 17% from January. The annualized single-family starts number for February was 593k units, which was essentially flat from the year-ago February 2013 starts number of 589k.

According to the Commerce Department, "Start of construction occurs when excavation begins for the footings or foundation of a building." David Stockman, the former head of the Office of Management and Budget in the Reagan administration, says slow starts aren't as much weather-related – although February 2013 and 2014 were especially cold months in the East – but about swings in interest rates.

At his DavidStockmansContraCorner.com site in a column titled, "Pulling on a String: The Fed's Spectacular Failure to Stimulate Housing" Stockman explains:

"The seasonal adjustments are supposed to factor in weather," said Stockman. But the raw unadjusted, non-annualized starts number for February 2014 was 40,700. In February 2013, it was 40,600. In 2009, it was 25,000. In 2005, starts were 124,000 and in 2000 they were 88,000 units.

He makes the case that rather than weather being the reason starts fluctuate so much over the same month of different years, Federal Reserve manipulation of interest rates has caused the wild fluctuations.

"In short, in the name of improving upon the alleged instability of the private economy – absent the Fed's expert ministrations – the geniuses in the Eccles building have actually caused the rate of housing starts to gyrate wildly," said Stockman.

Stockman goes on to say that the U.S. economy isn't analogous to a giant bathtub, as Keynesians might suggest, as pouring, "demand into the housing market through what amounts to cheap, subsidized interest rates (from the hides of savers) and, presto, activity rates will soar."

That hasn't happened.

Residual Free Market Props Are Suppressing the Housing Market

New home sales in February rose 7.8%, to a seasonally adjusted 539,000 units. That's the the best number for new home sales in seven years. Still, according to a graph on the NAHB's website, new single-family home sales going back to 1978 shows that current levels of sales are barely approaching 1980 levels. They are more than 50% below average sales from the period between 1980 to 2006.

While new home sales, which make up one-tenth of home sales, on the surface looked robust in February, existing home sales rose a scant 1.2% according to the National Association of Realtors.
That's what I call an un-recovery recovery, or a bum wedding.

Free market capitalism wedded to democracy yields a living, changing economic system that thrives on creative destruction and withers under socialist-style command and control. The Federal Reserve's interest rate manipulations over the past 20 years only prove they are incapable of fostering natural growth in the economy.

The Fed never should have been allowed to manipulate rates so low for so long to inflate the housing bubble in the first place. Fannie Mae and Freddie Mac had to be bailed out, but by now should have been dismantled. They're backing more mortgages now than ever before.

1:17 pm ET Mar 24, 2015

Central Banking

The Inflation Cycle May Have Turned                     

Oil dropped to $46 per barrel in late January and has more or less hung around there. Getty Images
Central banks around the world have been alarmed at how inflation has plummeted in the last year, in many cases into negative territory. Though much of that is due to oil prices, core inflation, which excludes energy and food, has also been disturbingly low.

But there are tantalizing signs that the cycle has turned. In February, U.S. consumer prices rose 0.2% from January, which pulled the annual inflation rate out of negative territory; it’s now zero.

More important, core prices rose 0.16%, which nudged the annual rate up to 1.7% from 1.6%.
It was the second upside surprise to core inflation in a row. The driver in January was firmer service prices, this month it was goods.

There have been scattered signs that inflation has bottomed out elsewhere, as well. In the eurozone, the 12-month inflation rate rose from minus 0.6% in January to minus 0.3% in February, while core inflation ticked up ever so slightly to 0.7% from 0.6%. (Britain is an exception: both headline and core inflation came in lower than expected in February.)
Anecdotal evidence is also piling up. As my colleague Josh Zumbrun has noted, the Billion Prices Project at the Massachusetts Institute of Technology, which skims the Internet every day for up to date pricing information, is signaling a turn.

To be sure, these are tentative signs. Still, they are consistent with some of the fundamentals as well.

The first is oil. It dropped to $46 per barrel in late January and has more or less hung around there.

The futures market is pricing oil for delivery a year from now at $56. Oxford Economics projects that inflation using the price index of personal consumption expenditures (the Federal Reserve’s preferred gauge) will reach 1.7% by the end of this year, assuming crude prices rise by $10 per barrel, and core inflation will hit 2%. (It will rise less, if, instead, oil prices drop $10 from here.)
The dollar is more complicated. Its peak impact on U.S. prices probably still lies ahead. But whatever downward pressure it is exerting on U.S. prices is mirrored by upward pressure on eurozone prices.

In any case, the dollar, too, seems to have stabilized, so the drag it exerts should soon end.

Finally, the European Central Bank’s initiation of bond-buying (or quantitative easing) has delivered a surprising jolt to market sentiment and bought it, and its peers, some badly needed credibility. In the eurozone, the U.S. and Japan, the bond market’s expected inflation rate five years from now has bounced higher since the ECB’s QE began. At the same time, purchasing managers’ indexes suggest the underlying eurozone economy has also perked up.

It’s obviously premature to declare the low-inflation scare over. Even if headline and core inflation have bottomed, they remain a long way from the 2% level most central banks target.
The eurozone’s core inflation rate has been trendless at around 0.7% for the last year. Even if market expectations have moved up, they still price in below-target inflation for years to come.
And the most important long-term drivers of prices are wages and labor costs, and those show little sign of a pickup.

But policy makers and investors need to pay close attention to what happens on the margin, and on the margin, inflation’s looking up. Which is a very good thing.

Are Equities Overvalued?

Michael Spence
MAR 26, 2015

Stock broker nyc

MILAN – Since the global economic crisis, sharp divergences in economic performance have contributed to considerable stock-market volatility. Now, equity prices are reaching relatively high levels by conventional measures – and investors are starting to get nervous.
The question is whether stock valuations are excessive relative to future earnings potential. The answer depends on two key variables: the discount rate and future earnings growth. A lower discount rate and/or a higher rate of expected earnings growth would justify higher equity valuations.
The S&P’s price-to-earnings (P/E) ratio for the trailing 12 months is close to 20, compared to a long-run mean of 15.53 and a median of 14.57. The Shiller P/E ratio – based on average real (inflation-adjusted) earnings from the last ten years – is at 27.08, with a mean and median of 16.59 and 15.96, respectively. And, in February, the forward 12-month earnings P/E ratio, which uses managers’ future earnings guidance, reached an 11-year high of 17.1, with the five- and ten-year averages standing at about 14 and the 15-year average at 16.
The stock market’s recent performance often is attributed to the unconventional monetary policies that many central banks have been pursuing. These policies, by design, lowered the return on sovereign bonds, forcing investors to seek yield in markets for higher-risk assets like equities, lower-rated bonds, and foreign securities.
According to the standard formulation, stock prices tend to revert toward the present value of estimated future earnings (including growth in those earnings), discounted at the so-called “risk-free rate,” augmented by an equity risk premium. More precisely, the forward earnings yield – that is, the inverse of the P/E ratio – is equal to the risk-free rate plus the equity premium, minus the growth rate of earnings. (Of course, markets take detours along the way, driven by, say, irrational exuberance, temporary declines in the impact of value investors, or mistimed contrarian trades.)
Monetary policy may have bolstered stock prices in two ways, either lowering the discount rate by compressing the equity risk premium, or simply reducing risk-free rates for long enough to raise the present value of stocks. In either case, equity prices should level off at some point, allowing earnings to catch up, or even correct downward.
But the monetary-policy story, while plausible, is not ironclad. Indeed, other factors may explain – or at least contribute to – current stock-market trends.
A key factor is earnings growth. In the long run, it is reasonable to expect that revenue growth would be broadly consistent with economic growth – and, as it stands, there is little acceleration on this front. Earnings can grow faster than revenues for a prolonged (though not indefinite) period, if companies cut costs or reduce investment – a trend that would, over time, lower depreciation charges. In theory, corporate-tax cuts could have the same effect.
Furthermore, the economy’s equilibrium conditions could change, so that aggregate earnings would capture a larger share of national income. There is some evidence that this is now occurring in advanced economies, with the proliferation of labor-saving digital technologies and the globalization of supply chains suppressing income growth.
That said, some trends may be having the opposite effect on expectations for earnings growth.

More than two-fifths of the S&P 500’s earnings come from external markets, some of which, like Europe and Japan, are barely growing, while others, like China, are slowing.
The appreciation of the dollar exacerbates the situation for US markets, because it creates headwinds for exporters and causes companies’ foreign earnings, reported in dollars, to decline. And a slowdown in productivity growth, together with excessive leverage and persistent public-sector underinvestment, may be undermining medium-term potential economic growth.
While expectations of faster earnings growth may well be contributing to elevated P/E levels, the current situation is complicated, to say the least. What is certain is that expectations of high earnings growth would have a more durable positive effect on P/E levels than the suppression of the equity risk premium.
The other important factor affecting P/E is the risk-free rate. As monetary policy normalizes – a process that has already begun in the United States – the risk-free rate is expected to rise to a level that is consistent with stable 2% inflation, which, in turn, corresponds with a level of unemployment.
What precisely that rate is, however, remains uncertain – and extremely difficult to determine, given that it is affected by virtually every aspect of the unfolding growth patterns.
Nonetheless, several features of current growth patterns stand out: excess productive capacity, persistent high leverage, declining labor content in goods-and-services production, and an increasingly unequal distribution of income both between labor and capital, and across labor-income segments, with their differential savings rates. Together, these patterns could lead to an extended period in which aggregate demand limits growth. With growth not constrained on the supply side, there would be little inflationary pressure, and the neutral interest rate that is consistent with non-inflationary full employment could simply be lower than it used to be for an extended period.
Where does this leave us? In my view, it is difficult to make a strong case for a significant sustained increase in earnings growth in this environment, meaning that growth alone would not justify current equity valuations. But the lower-discount-rate argument is more persuasive, and is consistent with underlying economic conditions and central banks’ mandates.
That said, in such a complex environment, investors can be expected to reach widely disparate conclusions, which will sustain – if not increase – market volatility.