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Confluence

If history could talk, the first thing it would say is, “Enjoy the tranquil stretches because they’re always temporary.”

The past few years were, in retrospect, a case in point, one of those relatively drama-free periods that lull the unwary into accepting steady-if-unremarkable progress as the new normal. Lubricated by trillions of dollars of new currency – and some blatant government lying about inflation and unemployment – investors took stocks, bonds and real estate up to record or near-record levels, leaving just about anyone with a long position in just about any mainstream asset feeling like things might be okay after all.

Then a bunch of things happened to make “steady progress” the least likely scenario for 2014. In more or less chronological order:

The Fed threatens to check the junkie into rehab
In July, with home prices and stocks both entering previous-bubble territory, the Fed finally began to worry about the impact of all the money it was injecting into the system and announced its intention to scale back the dosage. Since then, the interest rate on 10-year Treasuries has nearly doubled, mortgage rates have jumped from 3.5% to 4.5%, home sales have stalled and stock prices have plateaued. And all before the Fed actually cuts off the supply. Think of this as the tremors an addict feels as he walks up to the rehab center door, anticipating the real pain to come.

Hot money deserts the developing world
This is part of the Fed tapering story but it’s so interesting that it deserves a longer look: When rich countries over-borrow and then create a lot of new currency to keep their banking systems from imploding, a fair bit of that money flows to relatively-cheap or high-yielding assets in less developed countries, which spikes local real estate, equity and currency markets. This is stressful but also an ego boost for countries like Brazil and India that find themselves awash in foreign cash. But when the money flows back out, as it is now doing, there is no upside for the countries thus abandoned. The Brazilian real and Indian rupee have plunged lately, forcing both governments to impose capital controls and/or use their foreign exchange reserves to intervene in the markets. This is only a temporary fix, since foreign currency reserves are finite and won’t last long at current burn rates.

Meanwhile, emerging market stocks and bonds are among the asset classes into which complacent financial advisers have been putting their clients, so the losses over there are about to be felt over here.

The US threatens to bomb the Middle East some more
This is the strangest of all our self-inflicted problems. Despite having zero understanding of who stands for what in Syria – and hence what they’ll do if we help them win – the US seems determined to take sides and is actively trying to round up allies for yet another bombing campaign. (Maybe $105 oil is too cheap and the goal is to bump it up to $150 to help global warming. Viewing it as an environmental strategy makes as much sense as anything else.)

In an interesting (though no more comprehensible than any other part of this story) twist, president Obama has decided, instead of just going ahead and launching the missiles, to submit the plan for congressional approval. Meanwhile, the other big players, including Russia, China, Iran and Israel are weighing in with their own threats and counter-threats. For history buffs this should be a fascinating week.

The debt ceiling game of chicken begins
No one doubts that the debt ceiling will eventually be raised, but apparently both major parties have decided that they can flat-out win on the issue of how and when to raise it. Republicans think they can extract spending restraint (but only on social programs; defense is untouchable while there are still Middle Eastern countries left to bomb), while democrats think they can force a “clean” increase to allow them to go on spending whatever they like with impunity. Each side thinks the turmoil generated by missing the deadline will work in their favor, thus forcing the other side to blink.

So the game is all but guaranteed to go into really messy extra innings, creating uncertainty about pretty much everything the markets hold dear, including interest payments on Treasury bonds. “Default” will appear in lots of headlines before this is over.

Chaos ends when the Fed refills the syringe
So here we have rising interest rates, rising oil prices, troubled emerging markets, another Middle East entanglement (and maybe even a broader war), and a government that for some reason has decided to open its budgetary sausage factory to the press. Not the steady, linear progress to which we’ve become accustomed.

It’s always possible that congress simply refuses to bomb Syria and then turns around and crafts a timely budget, triggering a thunderous relief rally. But more likely is that some or all of the above produce enough uncertainty to spook grossly-overvalued financial markets, leading the Fed to refill the syringe and promise the junkie a nice big fix to make it all better. Nothing is solved, but withdrawal is delayed for a little longer.

28 thoughts on "Confluence"

  1. Pingback: The Küle Library
  2. Gold is a very liquid currency now that it trades in real-time (floating). When bullion circulates, it purges debt as dollars flow to the hands that need it most, in order to service existing fiat based debt. There is no way to purge debt without assets …. unless , of course, you wish to repeat the historical boom-bust cycle on the karmic wheel. Real-time gold must be monetized by the market , however, organically and bottom-up. The elite players cannot do this. It must be grass roots to avoid a dollar crash in the migration process.

  3. The FED exists to free Congress from spending limits imposed by the Earth’s natural systems and resources. The “issues” are merely the focal point of conflict. All politicians and all media depend on perpetual conflict for their careers, political glory or political capital.

  4. I agree that the next few months will be fascinating. However, I have a slightly different take on the five sub-plots in play.

    The Fed reveals its self-serving nature: Because the Fed is beginning to feel like all the other chumps of means in the world who are holding debt claims against a declining empire with a structurally impaired economy, the Fed is backing away from lending fiat to a losing cause. If the economy continues to muddle along then it will look ingenious, if inflation finally takes off at least it will have a lot of bonds to dump Volker-style to raise interest rates, and if there’s a deflationary depression instead then they can be sold at a profit.

    Hot economies cool the fastest: No investor ever goes bankrupt by taking a profit. Buy the rumor, sell the news. Don’t sweat the macro stuff, the new mega-trend is that three quarters of the world’s population is gaining a Western middle class lifestyle.

    The US government distracts attention with another red herring: What’s more distracting than trying to make sense of nonsense? Trying to make sense of hearsay too.

    There isn’t time to discuss fiscal policy when America’s reputation is at stake: That’s what “continuing resolutions” are for.

    CHAOS BEGINS IF THE FED REFILLS THE SYRINGE: It’ll be like riding a roller-coaster with a stuck accelerator.

    1. Bruce said, “No investor ever goes bankrupt by taking a profit.”

      I don’t think the fed has the option of selling at a profit. Aren’t they underwater at present yields/prices?

      1. I wasn’t referring to the Fed. I was referring to general global investors who invested in the emerging/developing markets because of the “rumor” that the rise of a middle class worldwide was the basis for growing corporate profits for years to come. Those who got in at the beginning (circa 2009) made multiples on their money and started taking profits about 6 months ago as that trade got crowded and news of a weakening global economy began. The relatively small rise in interest rates in the US because of possible Fed “tapering” is NOT why they started to sell out, contrary to what the media says. US Treasury rates began to rise months before the Fed’s trial balloon, mainly due to the sale of Treasury bonds by the emerging/developing countries to raise dollars to fund the redemptions of the prescient investors.

        As far as the Fed is concerned, yes its bond portfolio is reportedly “underwater” at this time, but yes it can sell its bonds for a “profit” if the economy tanks and deflation sets in, like in Japan, because the demand for bonds would lift bond prices even higher than what the Fed bought them for. It’s sort of moot, however, because the Fed is required to give any profits it makes to the US Treasury each year. One of my points is that we’re all dealing with funny money that the Fed literally creates electronically so the whole idea of profits to the Fed is basically meaningless. A main objective of the Fed is not really profits but rather to maintain the illusion of the integrity of fiat money. Its power is derived from the peoples’ belief in its credibility.

        1. Are you familiar with the the work of John Hussman? He frequently shows a graph called ‘liquidity preference’. Basically, he says that there is a rock solid relationship on the level of short term interest rates compared to the amount of base money expressed as % of nominal GDP.

          Currently, with base money over $3.5 trillion, and therefore over 20% of nominal GDP, short term interest rates CANNOT be raised, not even 25 basis points, above their current yield, which is near zero. The fed cannot lower short term rates below zero, NOR RAISE them!!!

          Remember for decades how investors fretted at every fed meet whether the fed would raise or lower rates, and by how much? Now they can’t budge them one iota. I don’t think the fed is held in such high regard as you might think.

          1. I hope you’re right about investors not having much confidence in central banks, but the jury seems to still be out on that.

            I should add, however, that the Fed is not “targeting” interest rates as it traditionally did so one can’t judge the change in rates as a failure of the Fed’s methodologies. Traditionally, the Fed did target interest rates (i.e., attempted to peg or limit them) by invoking an open-ended and theoretically unlimited buying campaign of US Treasury bonds (only). The Fed would literally buy as many bonds at whatever price it had to pay to create a certain demand level for Treasuries which is equivalent to saying a certain coupon rate. “Quantitative Easing” (QE) is different. With QE only a certain quantity of dollars are used to buy assets (which currently entails $85 B per month of mostly Mortgage Backed Securities and US Treasuries, not just US Treasuries as they were mandated to do before 2009.) Interest rates can still fluctuate because the Fed is acting only as a very large buyer and not as a complete market maker. It is true, however, that the Fed now owns roughly 30% of all US Treasury bonds in the world (making it a much bigger player than China (8%) and Japan (9%)) and is now buying ALL of the newly issued US Treasury bonds that are sold to fund US government deficit spending. In fact, one reason the Fed may want to “taper” back its bond purchases is to sweep up only the newly issued ones so as to not create an excessive demand for them. The selling of Treasuries held by the central banks of the developing countries, however, is changing that balance and creating a dilemma for the Fed.

          2. How do you interpret the rise in the 10-yr treasury yield (stockcharts.com symbol $tnx)? Even with the fed buying the new issuance, plus gobs of mortgage bonds, entities (presumably foreign) are still dumping treasuries.

            I don’t understand your ‘excessive demand’ comment. Rising yields are indicative of insufficient demand. Lack of demand means that yields must rise to lure in new buyers.

            With all the ‘war’ chatter, you would think there would be a flight to safety, with USA treasury bonds usually being perceived as safest of the safe. Not happening this go ’round.

          3. By definition, deficit spending by the US government implies that the money is borrowed because tax revenues are not enough to fund the expenditures. When QE 3 started the projected annual Federal spending was around $3.7 T, in which $2.6 T was to be obtained from taxation and the the remaining $1.1 T (deficit) was to be borrowed via the sale of US Treasuries (of various durations). Although this is conjecture on my part, the Fed chose to buy 1/12 of that amount each month to effectively offset any excess supply of bonds on the open market thus hoping to maintain interest rates at those current levels (I.e., supply = demand implies no price change.) It was already buying $40 B per month of MBS from “Operation Twist” so it started buying an additional $45 B per month of US Treasuries to match the total bond issuances of the US Treasury. Back in November, 2012 the US Treasury was issuing about $90 B worth of Treasuries each month so that meant the Fed bought $45 B and about $45 B were available for purchase by other entities. As this year has progressed tax revenues have increased some and so deficit spending has dropped proportionally (the “sequester” merely stopped INCREASES in spending, but did not lower the spending.) Annual Federal deficit spending is now projected to be about $850 B so only about $70 B per month will need to be borrowed via Treasury bond issuances, which means the Fed is now buying about $15 B worth of bonds (both MBS and Treasuries) per month more than the US deficit requires, so an “excess demand” – meaning an uneconomic forced demand – on the bond supply is created which tends to increase bond prices and lower yields. That may seem like a good thing (i.e., what the Fed wants) but they really just want to create liquidity to offset the deficit spending; no more, no less. Therefore, IF the Fed actually “tapers” it will probably be on the order of about $15 B per month. The fact that Treasuries are being sold off by foreign entities, thus lowering bond prices and increasing their yields, has nothing to do with the Fed’s intention to match liquidity with deficit spending levels. In fact, all else being equal, interest rates should actually RISE even more if and/or when the Fed tapers because there will even less demand for Treasuries. The Fed just wants out of the hairy situation it’s getting itself embroiled in, and presumably believes the US economy can handle the rise in prevailing interest rates.

            As for your last point, I just think that most of the world doesn’t believe that the US will actually attack Syria. It’s just too stupid even for Washington. Too little upside (none maybe?) and way too much potential downside. I don’t think even Obama wants to attack. I think he wants to make the Republicans deny him on this issue so that they can be intimidated into funding ObamaCare and raising the debt ceiling this Fall without a lot of drama. You wouldn’t want the Republicans to be labeled “obstructionists” would you?

          4. I would view a ‘no’ vote on Syria by either the Senate or House as the equivalent of a Parliamentary System vote of ‘no confidence’. Obama would almost have to resign, especially with the budget ceiling stuff coming due.

          5. Gentlemen. Please allow a mere layman to wade in and feel free to point out any errors I present –

            The Elephant in the room is that the Fed doesn’t manage a functioning market economy (In the true ‘Free Capitalism’ sense of the word). The US ceased to be a capitalist state in 1913 when the government hocked itself into debt to private concerns and handed over control of its money supply. At risk of oversimplifying the situation, what you’re comments amount to are just an exercise in picking apart the bizarre decisions that are made by the Fed in the illusion that ‘a Free market’ exists in there somewhere. It doesn’t. 100% Manipulation does not a market make. The Fed can ‘Target’ interest rates all it wants but the reasoning behind my previous sentences (and the next sentence) is that Dollar bond Yields aren’t already at 96.4%, as they should be. The Dollar has already collapsed. It’s going through it’s death wriggle as I type. This aggressive, but barely veiled, attempt at prolonging the life of the petrodollar by creating upheaval in the ME (For the benefit of vested interests), is the only thing keeping it going. The Fall of Rome condensed into 100 years instead of 400.

            I cease to be amazed at just how destructive central banking is. How a country and it’s citizens get sucked in, time after time, to this merry go round of debt slavery and war, as apposed to a real & free economic markets, is astounding. It’s not as if History doesn’t contain enough warnings.

          6. I agree with you about the framework we’re dealing with but I still find it interesting to understand and follow the decline blow-by-blow, if for no other reason than to try to thoroughly understand its pitfalls.

            Just as “the Founders” understood history so well – specifically, how and why tyrannical governments came about – they were able to construct a form of government that embodied internal constraints to provide protections for the citizenry against government over-reach.

            There will come a time when a new monetary system will need to be formed out of the ashes of the current system and the only way to create a better one is to understand how and why the central banking system doesn’t work for most and leads to tears (“debt slavery and war,” as you say). Furthermore, a strong minority of people are going to need to understand it to appreciate it and accept it.

            I think people continually get sucked in because they don’t understand what the central banking system is and how it is intrinsically corrupt. The Fed of 1913 was this country’s 3rd central bank (the other two were expunged after they managed to screw things up enough). Even President Wilson, who was supposed to be so educated and brilliant (though still held “Progressive” beliefs) was duped until he was too late. He freely admits in several mea culpas that he had been tricked into facilitating an insidious monstrosity on humanity.

            I could go on, but in thinking about all of this history I continue to think that one reason such systems are adopted is not always out of ignorance but rather for pragmatic reasons. Most political-economic systems last about 90 years, or 3 generations, before falling apart or changing significantly. So, the people doing the choosing, if you will, probably don’t care about longevity because they and their children and grandchildren will not be greatly affected by the consequences. That is why the adoption of the US Constitution was so remarkable, because the people involved actually cared about a system that was internally sustainable (Big Asterisk: given the proper attention paid by responsible and educated citizens) and could conceivably last indefinitely even within the framework of the least savory aspects of human nature.

  5. One other problem is that of big players dominating the stock, bond and housing markets. These whales move the market and when things start to look bad, the movement in prices in these markets will be dramatic. It is always hard for whales to sell their positions as Bill of Pimco remarked recently. It is difficult to find buyers of their size to complete the transaction. The markets do not have enough small players that provide stability to markets.

  6. I’d like to point out something:
    Look at your cash… you won’t see any paper dollars of any denomination printed after 2009. The money the Fed is printing is strictly numbers in data entry.
    If everyone goes to get their money out of the bank or stock market, there isn’t enough cash to go around. Get cash into your hands, use some to buy precious metal, and keep cycling that cash, and keep a chunk of it in the house for use in case of a “bank holiday”.

    1. that’s about what I do. and the cash I do keep on hand is mostly $1-5-10s for everyday transactions if a “holiday” comes along. a bunch of 20s & 50s might not be what you want to have.

  7. You would think with Obama being the Nobel Peace Prize winner, the option of him negotiating a deal with Putin and imposing it on the combatants would at least be on the table.

    The only thing that makes any sense to me is that something huge is about to go down, and they need the cover of another war or spiking oil prices to mask it.

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