The ABC’s Of The ECB’s QE

In today’s Outside the Box, good friend Ben Hunt informs us that we have entered the cult phase of the Golden Age of the Central Banker:

We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real-world economic problems, but because their favor gives us confidence to stay in the market. I mean, does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10-yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market. Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers.

But, he points out, the cult phase of any human society is a stable phase in the sense that, while change may happen, it will not happen from within:

There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-like omnipotence within this realm, that any internal market shock is going to be willed away.

However, there is a minor catch: external market risk factors are all screaming red.

I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will.

Ben identifies the three most pressing exogenous risks as the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. (You or I might want to expand Ben’s list with one or two of our own favorites; but the point is, it’s a big, bad, volatile world out there right now.) Ben admits that it feels a bit weird to have written on all three of his chosen topics a few weeks before each of them appeared on investors’ radar screens. “Call me Cassandra,” says Ben. (Naw, I’ll stay with Ben.)

I wouldn’t want to steal too much of Ben’s thunder here, but I just can’t help sharing with you the punch line to his piece: “The gods always end up disappointing us mere mortals.”  This is one of Ben’s better pieces, and I really commend it to you as something you need to think about.

Before we examine our collective religious delusions (or at least our central banking delusions), let’s have a little fun. My friend Dennis Gartman (who could be the hardest-working writer in the business) found this gem and shared it with his readers this morning. It is about the supposed lack of environmental concern of the Boomer generation has. And some of you will read it that way.

But I want those of you who are of a certain age (ahem) to realize just how much your world has changed in the last 50 years. If you are young, yes, we really did all the stuff listed below. I personally experienced every one of the rather long list of activities mentioned by the “little old lady.” Major changes in lifestyle since then? No, not really. But I’ll grand you that things are a good deal more convenient and time-saving today. Now sit back and enjoy.

Checking out at the store, the young cashier suggested to the much older lady that she should bring her own grocery bags, because plastic bags are not good for the environment. The woman apologized to the young girl and explained, “We didn’t have this ‘green thing’ back in my earlier days.” The young clerk responded, “That’s our problem today. Your generation did not care enough to save our environment for future generations.” The older lady said that she was right – her generation didn’t have the “green thing” in its day. The older lady went on to explain: “Back then, we returned milk bottles, soda bottles and beer bottles to the store. The store sent them back to the plant to be washed and sterilized and refilled, so it could use the same bottles over and over. So they really were recycled. But we didn’t have the ‘green thing’ back in our day. Grocery stores bagged our groceries in brown paper bags that we reused for numerous things. Most memorable besides household garbage bags was the use of brown paper bags as book covers for our school books. This was to ensure that public property (the books provided for our use by the school) was not defaced by our scribblings. Then we were able to personalize our books on the brown paper bags. But, too bad we didn’t do the ‘green thing’ back then. We walked up stairs because we didn’t have an escalator in every store and office building. We walked to the grocery store and didn’t climb into a 300-horsepower machine every time we had to go two blocks. But you’re right, we didn’t have the ‘green thing’ in our day. Back then we washed the baby’s diapers because we didn’t have the throwaway kind. We dried clothes on a line, not in an energy-gobbling machine burning up 220volts. Wind and solar power really did dry our clothes back in the early days. Kids got hand-me-down clothes from their brothers or sisters (and cousins), not always brand-new clothing. But you’re right, young lady; we didn’t have the ‘green thing’ back in our day. Back then we had one TV, or radio, in the house – not a TV in every room. And the TV had a screen the size of a handkerchief [remember them?], not a screen the size of the state of Montana. In the kitchen we blended and stirred by hand because we didn’t have electric machines to do everything for us. When we packaged a fragile item to send in the mail, we used wadded up old newspapers to cushion it, not Styrofoam or plastic bubble wrap. Back then, we didn’t fire up an engine and burn gasoline just to cut the lawn. We used a push mower that ran on human power. We exercised by working, so we didn’t need to go to a health club to run on treadmills that operate on electricity.” But you’re right; we didn’t have the ‘green thing’ back then. We drank from a fountain when we were thirsty instead of using a cup or a plastic bottle every time we had a drink of water. We refilled writing pens with ink instead of buying a new pen, and we replaced the razor blade in a razor instead of throwing away the whole razor just because the blade got dull. But we didn’t have the ‘green thing back then. Back then, people took the streetcar or the bus, and kids rode their bikes to school or walked instead of turning their moms into a 24-hour taxi service in the family’s $45,000 SUV or van, which cost what a whole house did before the ‘green thing.’ We had one electrical outlet in a room, not an entire bank of sockets to power a dozen appliances. And we didn’t need a computerized gadget to receive a signal beamed from satellites 23,000 miles out in space in order to find the nearest burger joint. But, isn’t it sad, how the current generation laments how wasteful we old folks were just because we didn’t have the ‘green thing’ back then?”

I wonder what our grandchildren will be telling their grandchildren in 50 years… “I remember a time when we actually used combustion engines to drive our cars that belched out dirty gases. We actually had massive electricity-generating power plants and wires everywhere to deliver the electricity, rather than the small, efficient home units that produce free electricity for us now. We used something called glasses to help us see. People actually had to carry their communications devices around, and computers were measured in pounds not ounces. We had to do something called “typing” to write; and while we didn’t have to actually go to places called libraries like our grandparents did, we could and did spend all day searching through a disorganized Internet for what we needed. You weren’t connected biologically to your computer, so getting information in and out of it was a drag.

“People actually got sick and died; and though the situation was getting better, billions of people didn’t have enough food at night. People went to big stores to buy what was needed rather than just ordering it or producing it on the spot. We actually threw garbage away in huge resource-consuming “dumps” rather than completely recycling it into new products at the back of the house. It took like forever to get from one point to another. People actually had to “drive” their car rather than just getting in it and telling it where to go. And people died all the time in those cars – they were so dangerous and uncomfortable. In those days you couldn’t even instantly communicate with anybody by just thinking. You had to push buttons on that clumsy communication device you hauled around, and then talk into it; and if you lost it you were out of touch and out of luck. We didn’t even have intelligent personal robots in those days. It was so Stone Age.”

I could go on and on, but you get the drift. The changes in the last 50 years are simply a down payment on the change we’ll see and live in the next 50.

When I think about central banks and markets and try to figure out how to get preserve and grow assets from where we are today to where we will be in 10 years, it can be a rather daunting and sometimes even a depressing task. But then I think about what the world will be like and how much fun my grandkids are going to have, and I get all optimistic and smiling again.

Have a great week. The future is going to turn out just fine.

Your wondering if we will have flying cars analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

The Swiss Peg cracked because of the flight of capital from Euroland. There is still a risk that the money flows more into treasuries going into the end of the summer. The more unstable Euroland APPEARS, the more capital will flee to the dollar. The higher the dollar, the more PROFIT on US debt for foreign investors.

This is similar to the 1987 Crash that took place in equities. The 1987 Crash was currency driven set in motion by

another BRAIN-DEAD idea of forming the G5 in 1985 to manipulate the dollar lower. It was the Plaza Accord that forced structural changes in Japan known as “reforms” all designed to lower the US Trade Deficit that was not even real. The lawyers in charge looked at the current account and did not understand the more Japanese invested in US government bonds, the inflow appeared in the capital account while the interest payments flowed out of the current account these fools assumed was trade.

The stock market crashed because foreigners perceived the dollar would decline by 40% and sold dollar assets. We are looking at this phenomenon in Euroland. The spread between German 10 year and US 10 Year Treasuries may prove to be the trade of the century later in the year (short Germany Long US). German rates .45% v 1.84%.

….more from Martin Armstrong on January 19th:

Brokerage Houses – Deep Pockets Are Mandatory

Looking At Things Globally – Moving Beyond Human Intelligence

Does the Model Change Its Mind?

The One World Currency & Cryptocurrencies

The Petro Dollar is Dead – Long Live the Dollar

On January 7th CNBC’s Rick Santelli and Steve Leisman engaged in a heated debate that posed an interesting question; is the free market at work keeping interest rates low, or is it the central banks’ put? This made me consider the real question to ask which is: Where would rates be if central banks didn’t exist?

What would happen if the Fed liquidated its balance sheet and sold its $4.5 trillion worth of Mortgage Backed Securities and Treasuries and closed up shop? Some claim, after an initial spike from all that selling, rates would subsequently tumble due to a deflationary cycle that would result from the end of central bank money printing. These people also maintain that rates are currently historically low because of the overwhelming deflationary forces that exist in the economy. Yes, we now see deflation pervading across the globe and that does tend to push down borrowing costs, but I am not convinced rates would remain this low for very long and here’s why.

The level of sovereign bond yields is both a function of real interest rates AND sovereign credit risk. While there is now a deflationary environment causing yields to fall to record lows, the market is still aware if push came to shove central banks would step in and create a perpetual bid for government debt. However, without a central bank in place, global GDP (which has been fueled by asset bubbles) would quickly get eviscerated.

Therefore, faltering GDP in the U.S. would cause bond holders to panic over the Treasury’s ability to pay back the over $18 trillion in debt that it owes — which is now already over 5.5 times the annual revenue collected. To put things in perspective, 5.5 times annual revenue would be similar to a family who brings in just $50,000 a year, and holds a $275,000 mortgage. But as bad as that condition is it would get even worse because faltering GDP–resulting from rapidly rising debt service payments–would send the current half trillion dollar annual deficits soaring back above one trillion dollars in short order.

Markets have an innate understanding that central banks can always make good on the principal and interest payments on sovereign debt. If you don’t believe me, maybe you will believe Alan Greenspan, who said as much on Meet the Press after the U.S. debt was downgraded by Standard and Poor’s in 2011. Clarifying the down grade as more of a hit to America’s “self-esteem”, the former Chairman of the Federal Reserve went on to say, “This is not an issue of credit rating, the United States can pay any debt it has because we can always print money to do that. So, there is zero probability of default.” The truth is central banks stand as the ultimate co-signer of sovereign debt; a co-signer with a printing press. Credit ratings on sovereign debt have become more of a formality, they don’t actually mean anything anymore.

Consider this, Moody’s downgraded Japan’s debt by one notch to A1, from Aa3 in early December of 2014, and bond yields fell almost immediately. Japan’s Five-year yield fell to a record low just two days after the downgrade. Was this the market screaming that Moody’s got the call wrong? On the contrary, the drop in rates was solely driven by the Bank of Japan’s decision to expand its record bond-buying program, thus tightening supply and driving down rates. Think about it, with a debt as a percentage of tax revenue well over 1,000 percent, I have a hard time believing the free market would extend any country, or business for that matter, credit for 10 years at just one quarter of one percent.

The real mental exercise here is to determine what interest rates the free market would assign to sovereign debt if there were no printing presses? The best insight we can gleam to answer this question is to look at what happened to rates in Greece and Southern Europe during 2010-2012. When Greece and these other countries joined the Euro, they forfeited their respective printing presses to the ECB. After the fall out from the 2008 financial crisis, the ECB was initially reluctant to bail out countries with new money. Instead, they suggested Greece and other Southern European countries cut spending to counter mounting deficits brought about by overspending and low tax receipts. Greece’s revenue to GDP actually stood remarkably better than Japan’s, at about 475%. However, without the ability to print its own currency and the ECB’s initial reluctance to rescue Greece, the market’s reaction was profound. The Greek Ten-year Note, which averaged around 5% prior to the crisis, soared to just under 40% by March of 2012. Then, in July of 2012, ECB Chairman Mario Draghi vowed to do “whatever it takes” (read — buy unlimited amounts of Greek debt) to push yields back down. And down yields went, thanks to the ECB’s promise.

Because of the record amount of government debt in the developed world that exists today, there is a significant risk that not only would interest rates rise, but they could actually spiral out of control until an explicit restructuring and default occurred.

But the real conundrum is that current bond holders believe the Fed can monetize trillions of dollars of Treasury holdings without creating inflation and destroying the purchasing power of that debt. This spurious belief has been bolstered by the Fed’s previous QE programs that did not immediately lead to intractable inflation. However, history has clearly shown that a nation cannot habitually monetize massive amounts of debt without suffering runaway inflation. It would be silly to think this time is different. Therefore, having a central bank ready and willing to monetize a significant percentage of a nation’s debt shouldn’t provide any solace to bond holders at all. Soon investors in government debt will come to understand that a default is in store either through restructuring or inflation. And the answer to our question is that interest rates are headed much higher in the near future.

100% of economists predicted yields on the long end of the US treasury curve would rise in 2014. Instead, they dropped all year.

And just two weeks into January of 2015, the 30-year long bond made a new intraday record low of 2.39%, breaking the previous low of 2.44% on July 26, 2012. 

Yield Curve as of 2015-01-14

Larger Image

Huge Rally on Long End 

In contrast to economist predictions, the long end of the yield curve fell 1.49 percentage points (149 basis points). That the equivalent of 6 quarter point cuts, not hikes.

Meanwhile, yields rose slightly on 2-year and 3-year treasuries.

Buying the extreme long end of the curve while shorting 2- and 3-year treasuries would have gained both directions especially if one did the latter on the few small yield rallies that did take place.

Spreads

In addition to the rally on the long end of the curve, every possible spread between 2-year and 30-year treasuries all tightened!

Recession Indicators

If the economy was getting stronger, yields on the long end of the curve would be rising and spreads would be widening as well.

Neither is happening.

The bond market does not believe the recovery will strengthen and neither do I. In fact, I suggest we are on the cusp of recession (something I have admittedly been wrong about before).

Yield Curve Inversion?

With the Fed still holding the short end of the curve near zero, collapsing yields on the long end coupled with tightening spreads to the downside is about as big a recession indicator as one could expect.

The typical sign of recession, an inverted yield curve with 3-month treasuries yielding more than 30-year treasuries (we saw in 2000 and again in 2006-2007) is not going to happen in the absence of rate hikes.

Yet, looking at actual spreads, I do see room for possible inversions on some parts of the curve. For example the 30yr-10Yr spread is only 61 basis points (narrowing from 92 basis points). The 5Yr-3Yr spread is 50 basis points (about half of what it was at the beginning of 2014).

If the Fed does pull off a round or two of tightening, we could see portions of the curve invert, and I would actually expect that.

I have not seen anyone else even discuss the possibility.

Interest Rate Bets

From Bloomberg

• Treasury yields show traders are pricing in deflation for the next two years. The difference between yields on two-year notes and non-indexed U.S. government debt of comparable maturity, an indication of consumer prices called the break-even rate, fell to negative 0.13 percentage points, down from 1.96 percentage points in March 2014.
• Interest-rate derivatives predict the Fed’s policy rate will rise to about 0.43 percent by the end of December, about a third of the 1.125 percent rate central bank officials predicted in December,according to the median of their quarterly forecasts.
• The worldwide bond rally sent the effective yield on Bank of America’s global index of sovereign debt to a record-low 1.2 percent yesterday. Ten-year debt yields fell to 1.51 percent in the U.K., 0.65 percent in France and 0.26 percent in Japan.
• There’s a 67 percent chance the Fed will raise its benchmark rate to at least 0.5 percent by December. At the end of last year, wagers were focused on a September start.

Five Sure Things for 2015?

I strongly suspect one or more allegedly “sure things” for 2015 will not happen.

1. 100% of those surveyed predict S&P will rise. See Ding! Ding! Ding! Pimco Plans a Push Into Stocks With 7 New Equity Strategies; No Forecaster Predicts S&P Decline in 2015.
2. 100% predict yields on the long-end will rise significantly.
3. 0% predict a recession.
4. 67% think the Fed will hike at least 50 basis points by December.
5. Most think the dollar will rally further.

I take the other side of those bets, adding that if the Fed does manage to pull off a couple hikes, they will quickly reverse in 2016 as the entire global economy sinks.

Signs of Weakening Economy

For further discussion regarding the strength of the economy, please see …

• Retail Sales: Retail Sales Post Huge Downward Surprise; Lower GDP Revisions Coming Up; Economists Easy to Surprise
• Retail Sales: Economists Still Upbeat: Retail Sales Drop Seen as “Blip”
• Copper: Copper Plunges to Price Seen February 2006; Copper vs. Gold
• Oil: What’s Behind the Plunge in Oil? Winners and Losers? Boon to Spending or Recessionary?