We Can Inflate Too …

Perhaps it is a coincidence that we get these news so shortly after James Bullard forwarded his ideas as to how the ECB could most effectively join the global inflatathon. In any case, ECB board member Peter Praet – hitherto regarded as a 'hawk' – let it be known that the ECB too has a 'toolkit' at its disposal that can be 'expanded' to inflate the euro area back to economic Nirvana. What a surprise!

According to Reuters:

“The European Central Bank could expand its monetary policy toolkit if needed to respond to threats to price stability, and must ensure the euro zone economy does not enter a downward spiral, ECB Executive Board member Peter Praet said on Wednesday.

"We have an objective: price stability," Praet, who is in charge of the economics portfolio on the ECB's six-member executive board, told a conference in Washington.

"If that objective is at risk, we have the possibility … to expand the range of (monetary policy) instruments if we think it's necessary for that objective," he said.”

(emphasis added)

We already mentioned a year ago for the first time that we eventually expect the ECB to use declining consumer prices, or even a mere slowdown in the rate of increase of consumer prices as 'measured' by CPI as an excuse to step up inflationary policies.  After all, the 'price stability' policy is held to mean that consumer should increase on average by 2% per year. 'Stability' in other words means 'constant inflation'. Falling prices are held to be evil, and this is very likely what Praet actually refers to when he speaks of the euro area economy potentially entering a 'downward spiral'.

The 'Evil' of Falling Prices

It has been reported that the pace of consumer price inflation in the euro area fell to 1.4% in April, so we are already in a state of 'semi-evil' so to speak – a devaluation of the monetary unit that is not rapid enough for the taste of the central planners. The idea behind their 'price stability' quackery is that consumers will simply stop spending if prices begin to fall, in expectation of lower prices tomorrow.

According to this theory, not a single computer, cell phone or flat-screen TV should have been sold over the past three decades. After all, their prices have been falling rapidly and without respite. Moreover, the industries associated with producing these gadgets and their suppliers should have been in a permanent state of depression. Somehow that didn't happen, but the idea that falling prices are 'evil' and produce an 'economic downward spiral' is as popular as ever with central bankers and the courtier economists who pen apologias and paeans to central banking socialism day in day out.

Meanwhile, the details of the EU's new 'inflation' report reveal that prices are finally falling ever so slightly in Greece. Greece of course needs lower prices very urgently – one of the reasons for its economic downfall failure to recover is that the inflationary boom that has ruined the country after it joined the euro area has driven prices to levels that have made Greece's industries uncompetitive. Its large tourism industry is especially under strain and falling prey to the far more enticing prospects offered to tourists by e.g. neighboring Turkey. The ECB probably believes this 'lack of price stability' is bad, but in Greece's case it is just what the doctor ordered. It is of course true that existing debt will become more difficult to service, but given that 25% of all loans held by Greek banks are already non-performing, it seems unlikely that the situation can get much worse on that front. On the contrary, if Greece regains a measure of competitiveness due to falling prices, some of the currently non-performing assets may become current again.

Consumer price inflation in the EU: not high enough for the ECB (Reuters / Eurostat).

For a more detailed discussion as to why the 'price stability' policy is as misguided as it is dangerous, see this previous article: “The Errors and Dangers of the Price Stability Policy”.

On the Road to Ruin

Reuters has published an extremely interesting article on Shinzo Abe, the father of so-called 'Abenomics'. His economic policy is in essence little more than a warmed-up hoary inflationism, the quack cure that governments have employed throughout history in attempts to 'fix' their economies. It always 'feels good' in the beginning, as asset prices rise and numerous economic activities are set into motion that would never be considered absent the inflationary policy. What happens in the end is best summarized in the conclusion to a speech Fritz Machlup once delivered on the consumption of capital in Austria during the interwar period:

“Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all these achievements, she was on the verge of ruin.”

The main difference is perhaps that Japan is on the verge of ruin already, at least its government is. On the other hand, Japan also still has a lot of wealth that can be consumed and destroyed by Abe's policies. The de facto insolvency of the government is not an obstacle to additional wealth destruction, quite the contrary in fact.

Japan's current economic policy also has strong mercantilist overtones, as the devaluation of the currency is held to help its export sector. That this is to the detriment of everyone else in Japanese society as a rule remains unmentioned in the press, as it remains unmentioned that the export sector can at best hope to increase its profits temporarily, namely until prices and wages in Japan have adjusted to the devaluation. On the whole, Japan will end up poorer than it was prior to devaluation – and that is without considering the growing potential for a crisis that utterly destroys its currency and makes its outstanding stock of debt worthless.

Japan-Style National Socialism

However, as the Reuters article points out, 'Abenomics' is really not much more than an afterthought to Abe's true agenda, an add-on he thought of because a number of polls indicated that it would be politically more opportune to pursue the 'reflation' of the economy first.

His real goal however is to alter Japan's constitution in order to make it more similar to that of pre-war Japan. He and his clique of closest supporters call themselves 'true conservatives', but it would be more fitting to call them 'nationalists'. In fact, the overall political agenda is best described as national socialist.

Abe is following in the footsteps of his grandfather Nobusuke Kishi, a wartime cabinet minister and later prime minister. Below are a few pertinent excerpts from the Reuters article; note how Abe's comeback is shrouded in mysticism – he visited a 'shrine deep in the mountains' to be 'reborn'. In short, he is a true Führer personality, blessed from on high.

“Conservatives see the 1947 pacifist charter, never once altered, as embodying a liberal social order imposed by the U.S. Occupation after Japan's defeat in World War Two.

[...]

Abe's unlikely comeback was engineered by a corps of politicians who called themselves the "True Conservatives," many of whom share his commitment to loosening constitutional constraints on the military and restoring traditional values such as group harmony and pride in Japanese culture and history.

While the cultural-political agenda is what drove them, Abe and his backers also came to realize that voters cared most about the economy, so this time, they made it the top priority.

[…]

Months after resigning in September 2007, Abe visited Kumano Shrine deep in the mountains of western Japan, known since ancient times as a place of healing and resurrection. Few thought then he would be politically reborn as one of the country's most popular leaders. "It is said that if you make a pilgrimage there, you will be restored to life," said one government source close to Abe. "I said, ‘Let's go there and you will surely come back.'"

[…]

Soon after his resignation, Abe and other LDP conservatives set up the True Conservatives Association. Its goals were to protect tradition and culture, revise the "post-war regime", protect national interests and earn international respect.

Central to the group's world view is a belief that the constitution, drafted by U.S. Occupation officials in February 1946, not only restricted Japan's right to defend itself but also eroded traditional mores by emphasizing individualism and citizens' rights over social harmony and duty to the state.

[…]

"The constitution puts individual rights too far out in front," said Komori, who with Kasai later became core members of a more recent corporate-executive support group for Abe, the Cherry Blossom Association. "Mr. Abe is extremely sensitive to the merits of restoring that sort of Japanese spirit. I was in great agreement with that," he told Reuters.

[…]

While Abe and his allies remained committed to their conservative agenda, the failure of his first administration had taught them one scarring lesson: Voters care more about pensions and pocketbooks than changing the constitution and reviving patriotic education. The program of drastic monetary easing that became central to "Abenomics" took root in Abe's agenda after the triple disasters of March 11, 2011 – a mammoth earthquake, tsunami and nuclear crisis.

In June of that year, senior LDP member Kozo Yamamoto set up a group calling for a 20 trillion yen ($200 billion) reconstruction program to be funded by debt purchased by the Bank of Japan. Yamamoto invited Abe to head the group. It later morphed into an association urging the central bank to set a 4 percent inflation target – considered an extreme notion to which the BOJ was staunchly opposed. Abe accepted the role, and through his association with the group and its mentors such as Yale University professor Koichi Hamada, became a convert.

[…]

Unlike during his first term, cabinet ministers rarely speak out of turn. Abe is kept front and center in the media through interviews, news conferences and Facebook postings. Abe spends considerable effort wooing media executives but shuns the brief daily stand-up Q&A sessions with reporters that tripped him up the first time.

For all the change in style, those close to Abe say his ultimate goal remains unchanged. "He intends to be in office for four or five years and in the end, he wants to revise Article 9 of the constitution," said another government source. The pacifist clause, if taken literally, bans Japan from maintaining a military, but has been stretched to allow armed forces now bigger than Britain's.

This time Abe is pushing first for procedural changes to the constitution's Article 96 to lower the hurdle for revisions. Currently, Article 96 requires that amendments be approved by two-thirds of the members of each house of parliament, followed by a majority of voters in a public referendum. The LDP wants to change that to a simple majority in parliament, followed by the public vote.

Critics say such an amendment would leave the constitution vulnerable to easily shifting political winds.”

(emphasis added)

In summary, Abe and his allies are militarist nationalists pursuing a socialist economic program. Note the frequent assertions that the current constitution is too focused on individual rights, which are held to be 'too far out in front'. Instead, the Abe group wants the focus to shift to 'duty to the State', which is allegedly more in keeping with the 'Japanese spirit'. Now that they have resurrected the pre-war monetary policy of Korekiyo Takahashi, which helped finance the massive armament of Japan's military in the run-up to Word War II, they want to take the next logical step and enlarge the military – which requires the renunciation of the constitution's pacifist 9^th paragraph. As an aside to the inflationary policy, it is noteworthy that Yale University professor Koichi Hamada is apparently responsible for cooking up this part of 'Abenomics'. Readers may recall in this context that the chief of Argentina's central bank, Mercedes Marco del Pont is also Yale-educated and not only has driven the Argentine peso to the verge of a hyper-inflationary collapse, but espouses what can only be called extremely bizarre notions about inflation and its causes. It seems Yale produces a great many monetary cranks.

What is perhaps most disturbing about all of this is that the US are said to be in favor of the changes Abe plans, especially the re-militarization of Japan:

“Japan's security ally, the United States, would likely welcome an easing of the constitution's constraints on Japan's military.”

This is quite possibly the result of fiscal deliberations – if Japan expands its military, it is probably reckoned that it will shoulder more of the cost of defending the Pacific region against imaginary enemies. The fact that Abe also plans to cut down individual rights is likely regarded as a secondary problem. Actually, it is probably not regarded as a problem at all, which is sad testament to the fact that the values that were espoused by the founders of the US have come to be regarded as political obstacles rather than a blessing worth standing up and fighting for.

Conclusion:

The Japanese electorate has fallen for a snake oil seller who promised to revive the economy with methods that have failed spectacularly throughout history. Not only that, he successfully concealed his true intentions from voters, which essentially boil down to restricting individual rights in favor of Etatism and rearming and expanding Japan's military. What for would one want to expand one's military, if not war? Abe is bad news in every respect.

Shinzo Abe, nationalist and inflationist: blessed from on high since his pilgrimage to a famous shrine deep in the mountains.

(Photo credit: AFP)

Abe's role model: Nobusuke Kichi, a member of the 'Imperial Rule Assistance Association' and Japan's minster of commerce and industry from 1941 to 1945 and prime minister from 1957 to 1960.

(Photo: Wikimedia Commons)

The Misguided Urge to Close Loopholes

As 'Der Spiegel' reports, there are efforts underway in the EU to close the tax loopholes used by multinational corporations to quite legally avoid taxes. Allegedly it is a 'tough battle' as a few member states are not very happy about these plans. Recently Apple's CEO was forced to defend his company's use of such loopholes in front of a very hostile Congress. Everybody seems agreed that tax loopholes are somehow bad. But are they really?

Ludwig von Mises reportedly once remarked that 'tax loopholes allow capitalism to breathe'. In a speech he delivered in 1951 at a conference in White Sulphur Springs, West Virginia, he remarked that so-called 'loopholes' are actually simply the law. One should not even call them 'loopholes'.

“What is a loophole? If the law does not punish a definite action or does not tax a definite thing, this is not a loophole. It is simply the law. . . . The income-tax exemptions in our income tax are not loopholes. The gentleman who complained about loopholes in our income tax . . . implicitly starts from the assumption that all income over fifteen or twenty thousand dollars ought to be confiscated and calls therefore a loophole the fact that his ideal is not yet attained. Let us be grateful for the fact that there are still such things as those the honorable gentleman calls loopholes. Thanks to these loopholes this country is still a free country.”

(emphasis added)

Murray Rothbard had this to say in 'Man, Economy and State':

“Many writers denounce tax exemptions and levy their fire at the tax-exempt, particularly those instrumental in obtaining the exemptions for themselves. These writers include those advocates of the free market who treat a tax exemption as a special privilege and attack it as equivalent to a subsidy and therefore inconsistent with the free market. Yet an exemption from taxation or any other burden is not equivalent to a subsidy. There is a key difference. In the latter case a man is receiving a special grant of privilege wrested from his fellowmen; in the former he is escaping a burden imposed on other men. Whereas the one is done at the expense of his fellowmen, the other is not.  For in the former case, the grantee is participating in the acquisition of loot; in the latter, he escapes payment of tribute to the looters. To blame him for escaping is equivalent to blaming the slave for fleeing his master.

It is clear that if a certain burden is unjust, blame should be levied, not on the man who escapes the burden, but on the man or men who impose it in the first place. If a tax is in fact unjust, and some are exempt from it, the hue and cry should not be to extend the tax to everyone, but on the contrary to extend the exemption to everyone. The exemption itself cannot be considered unjust unless the tax or other burden is first established as just.

Thus, uniformity of treatment per se cannot be established as a canon of justice. A tax must first be proven just; if it is unjust, then uniformity is simply imposition of general injustice, and exemption is to be welcomed. Since the very fact of taxation is an interference with the free market, it is particularly incongruous and incorrect for advocates of a free market to advocate uniformity of taxation.”

(emphasis added)

Now this is the proposal and general attitude the EU should adopt. It would immediately curb illegal tax evasion and an economic recovery would likely ensue shortly.

Nigel Farage on the Taxation Question and the Privileges of the Eurocrats

The always dependable Nigel Farage has strongly criticized the EU's plans to increase tax collection by all means available. In the course of his speech he inter alia attacked the privileges the eurocrats have granted to themselves.

What we found especially interesting is the revelation that the professional eurocrats not only enjoy huge salaries and generous perks, they also pay almost no tax. In fact, their tax rate amounts to a de minimis 12%. It would be a worthy project to strive to lower the taxes of rest of the citizenry that pays for their upkeep to the same level.

Nigel Farage speaks out on the drive to close tax loopholes and the special privileges enjoyed by the eurocrats.

In this context note also that the Eurocracy has quietly decided to kill the attempt to slim the bureaucracy down by simply ignoring a provision of the Lisbon treaty (and wouldn't you know, they use a 'loophole' in the treaty to do so!):

From the outside, it looks as though the  European Union is hopelessly divided. Northern member states demand budgetary discipline while those in the south bemoan drastic austerity measures. Furthermore, the Franco-German alliance is brittle, to the point that a planned policy paper on the future of the European common currency area – to be written jointly by German Chancellor Angela Merkel and French President François Hollande — has yet to materialize.

Astoundingly, however, the 27 EU member-states can still reach consensus. At the EU summit meeting this Wednesday, leaders are set to rubber stamp an agreement that has been reached on the quiet in recent weeks — that of ignoring the Lisbon Treaty provision that calls for a reduction to the size of the European Commission.

Currently, there are 27 commissioners on the European Union's executive body, one for each country in the club. With Croatia set to become the 28th member on July 1, the European Council on Wednesday plans to allow Zagreb to send a commissioner to Brussels for the rest of Commission President José Manuel Barroso's term.

Yet what looks to be little more than a routine resolution is actually the public face of a much more sweeping ruling set for passage at the summit. The formulation "one commissioner per country" is to be maintained beyond the year 2014, as SPIEGEL ONLINE learned from EU diplomats. It will be valid not only for the incumbent Commission, but also for the next Commission to be installed following European elections in May 2014.

It is a move which flies in the face of the intent of the Lisbon Treaty, which went into effect on Dec. 1, 2009. Article 17, paragraph 5 of the treaty states: "As from 1 November 2014, the Commission shall consist of a number of members, including its President and the High Representative of the Union for Foreign Affairs and Security Policy, corresponding to two thirds of the number of Member States." European leaders, however, want to make use of the clause in the treaty which allows the European Council to alter that number.”

(emphasis added)

Is it any wonder that EU citizens are increasingly turning against the 'European project'?

EU commission: when it comes to its own privileges, it knows very well where to find the necessary loopholes.

(Photo via Reuters)

Bad News Finally Have an Effect

Even though the market moves in the US were fairly large and volatile, the action became a great deal more pronounced when Japan started trading. At first there was such a heavy sell-off in JGBs that the market was (once again) briefly halted. The Nikkei did its usual thing and tried to move higher.

Then the HSBC 'Flash' PMI for China was released (details here – pdf) and showed that manufacturing in China has slipped back into contraction, to a 7 month low of 49.6.

This is what the China PMI chart with the latest flash estimate added looks like (keep in mind that HSBC only measures private sector activity, its PMI data therefore differ from the official data which include the state-owned sector).

China flash PMI – a decline to 46.9 in May, a 7 month low – click to enlarge.

That was not what traders in the Japanese stock market wanted to hear apparently. The Nikkei, which is always more volatile than the US market, produced a huge 1,125 point intraday swing, a move of roughly 8% on the day.

The Nikkei, hourly. Now that's volatility – click to enlarge.

The JGB market in which yields had initially spiked to 1%, recovered its losses as traders moved into bonds in the usual knee-jerk fashion (in contrast to what happened earlier in the US). 

JGB overnight: first a big sell-off, then a full recovery – click to enlarge.

Conclusion:

This market action is what is known as a 'warning shot'. In all likelihood stock markets won't just go straight down now, although it is certainly high time that a sizable correction occurred. Usually though a first sharp break in a persistent uptrend tends to get bought, at least initially

However, there was valuable information in the Nikkei's behavior. Hitherto stock markets have ignored weak macro-economic data and have moved solely  on the promise of more central bank liquidity (Ambrose Evans-Pritchard had a few interesting remarks on that). The swoon in the Nikkei however only began in earnest after the Chinese PMI data were released – that was the 'trigger' for the long awaited correction.

In other words, for the first time in many months a stock market has reacted negatively to weaker economic data. This could be very significant in our opinion, even while conceding that the market was more than ripe for a correction and would likely have found a different excuse to sell off if this one hadn't come along.

Nevertheless, our experience is that often when a trend reverses, data that have been ignored for a long time are suddenly viewed as very important. It is therefore likely that the time when weak economic data points could be safely ignored by stock market traders is coming to a close.

Charts by: Finviz, Markit/HSBC, FX Empire

To Taper or Not to Taper

Ben Bernanke's testimony in combination with the release of the Fed minutes – although neither contained anything we didn't already know and haven't already heard ad nauseam for months on end – were used as an excuse to sell US stocks for a change (not only stocks, but hitherto stocks have been completely impervious to this stuff, so this is noteworthy).

That left the DJIA and the SPX with somewhat ominous looking daily candles, as the indexes had at first surged to new highs after Bernanke's prepared remarks were released (he mentioned that to withdraw stimulus 'too early' was  risky in his view).

SPX daily – Wednesday's daily candle looks slightly ominous – click to enlarge.

DJIA 5 minute chart, 2 days. A new high after Bernanke's prepared remarks were released, followed by a 270 point swoon – click to enlarge.

The Fed minutes contained the usual bla-bla (some committee members want to 'taper' QE, which they have been saying since it started – we know who they are and that they have de facto no influence on the policy; others want to continue or even increase the asset purchases). Later on a John Hilsenrath article was released that contained the following 'clarification':

“When the Fed ended a buying program in 2011, it shut it off all at once. When it shut off another bond buying program in 2009 and 2010, it did it in predetermined, predictable and “tapered” steps. When the Fed raised short-term interest rates from 2003 to 2006, it raised them in gradual and very predictable steps.

This time, when the Fed shuts off bond buying, it won’t be abrupt and it won’t be predictable. The term “tapering” — which implies a predictable gradual process — probably doesn’t describe the plan very well any more, and you’re unlikely to hear Fed officials describing it like that. Instead, the Fed will take a step and then see what happens. Officials also want to avoid the market blowup that happened in 1994, when it took one step and the market assumed that meant a succession of additional steps.

“A step to reduce the flow of purchases would not be an automatic, mechanistic process to end the program,” Mr. Bernanke said. In other words, if the Fed takes a step to reduce the program and the economy falters, it could sit still for a while or even dial purchases back up.

The Fed effectively wants the markets to experience the same uncertainty it experiences about policy and the economy when officials walk into a meeting, and it wants to condition the market to avoid jumping to conclusions about what it will do next. As officials keep saying, it will depend on the economy.

And on the key question of when it will start, Mr. Bernanke said the first step could be “in the next few meetings,” but that too will depend on how the economy performs.

As a friend of ours remarked: now we know there will be no tapering of the talk to taper the taper talk.

An Interesting OTC Options Anecdote

Incidentally, Barron's magazine had an interesting little article this week in which it was noted that a number of hedge funds have reportedly bought large amounts of SPX call options over the counter in order to 'catch up' with the market's rally. Barron's apparently believed this to be bullish:

“Be bullish. That's the overarching message from the options market as it fills with talk of two major developments that suggest the stock market will keep rallying to new record highs.

Major hedge funds are reportedly buying, or have bought, massive amounts of Standard & Poor's 500 index calls in the over-the-counter options market. The calls would increase in value if the index, now at about 1,664, rises to 1,725 by year's end. The funds reportedly missed the stock market's rally and are playing a vicious game of catch-up.

Though it is difficult, if not impossible, to penetrate the veil of secrecy that surrounds the OTC markets, evidence in the listed options market suggests investors are clamoring to buy bullish calls. The CBOE Volatility Index (VIX), which should decline when stock prices rise, is increasing. Traders said the unusual behavior means that the banks selling OTC calls to big hedge funds are buying the VIX to hedge their positions.

Also, evidence suggests that big funds are not alone in making bullish bets in the options market. The implied volatility of August calls on the S&P 500 – essentially the options market's expectation that a security's price will change – has sharply increased since March.

At the end of the first quarter, investors could buy bullish S&P 500 calls without paying a greed premium because expectations were low that the stock market would advance. Now, the price of August calls on the S&P has surged by as much as 100% by some measurements, according to one strategist.”

(emphasis added)

Admittedly in the current environment with the Fed adding $85 billion in additional money to the economy every month, such risky bullish bets may well still work for a while. However, we have a more nuanced view of this than Barron's. While the markets are distorted by the Fed's interventions, the 'classical' interpretation of such activities and data is as follows: Normally when the premium of index calls rises over that of puts, it is actually high time to become very cautious. Higher priced puts are the norm, as index options are widely used to hedge portfolios. It is generally not bullish when fund managers who have been among the very few sitting out a big rally suddenly buy the riskiest instruments they can find at premiums that are 100% higher than two months ago in order to 'catch up'. It is a sign of capitulation.

Bonds Curiously Unimpressed

Interestingly, the US treasury bond market did not profit from the stock market's intra-day swoon. That is slightly unusual; it may be an indication that the swoon in stocks was seen as a temporary aberration, or it may be a further sign that well-worn correlations are one by one breaking down. In any case, it is something one will have to keep an eye on.

The yield on the 10-year treasury note rose in spite of the stock market's swoon – click to enlarge.

Conclusion:

A correction may finally be in the works. A one day swoon can of course easily turn out to be entirely meaningless – the main reason why it is worth paying attention to it is the action in the Nikkei overnight, which we discuss in Part Two. The Nikkei's decline was actually 'qualitatively different', as worries about central bank policy were not what triggered the selling. 

The fact that hedge funds are clamoring to buy index calls and are paying up for them should certainly give one pause. It is at the very least a datum that is of medium term concern and it joins the long list of other extremes in positioning and sentiment that could recently be observed.

As an aside, although gold sold off as well after the publication of the Fed minutes (which is probably the dumbest reason to sell gold ever), we were impressed by the fact that gold stocks held up quite well and managed to close slightly in positive territory. This is a strong sign that gold stocks are likely to continue to move inversely to all 'risk assets' once recent trends reverse. As we have often argued in these pages, this is as it actually should be. Gold mining happens to be one of the few economic activities that actually thrive in times of waning economic confidence. This is because gold mining margins tend to rise along with gold's real price during economic contractions.

Charts by: StockCharts, BigCharts

Dereliction of Duty

Once upon a time, during the reign of King Greenspan, sub-prime was the rule of the land. Someone asked his majesty what happened to the risks of these mortgages, to which the maestro replied, "the banks are very sophisticated and they know how to spread the risk around so there is no need to worry" (not an exact quote but that was his message).

Now we know the risk never went away, it was just hidden by despicable rating agencies and passed onto lazy investors who never did their own due diligence. Aside from a few hedge funds who catapulted to rock star status by betting against the loans, the country and the world paid a very dear price for Greenspan's dereliction of duty as the regulator.

There are three major changes since Greenspan's days: 1) the demise of private label mortgage backed securities (same as the dominance of agency MBS), 2) the rise of all cash transactions mainly from investors and 3) Federal Reserve intervention via its QE operations.

What happened to mortgage risk today? More importantly, pertaining to the real estate market, are we are building a solid foundation or are we looking forward to another disaster?

Default Risk Disappears

Pertaining to mortgage risk and its effects on the real estate market, the cash transactions have to be considered as very positive. Even though they are not really cash, just financing from a different source, they are not directly secured by the underlying properties. They are instead an equity interest in the funds or public companies such as Blackstone or Silver Bay. There cannot be mortgage risk when there are no mortgages. If the single family real estate market is to collapse in a similar manner as the bursting of the sub-prime bubble, the properties in the hands of Wall Street should be able to handle the losses. The value of these companies may suffer, but it should not trigger a wave of foreclosures to affect a declining market in a downward spiral. This type of investor is also more capable of absorbing a loss than a hand-to-mouth sub-prime borrower.

Default risk was probably the biggest flaw of the sub-prime bubble. It brought down all the borrowers who had no ability to repay the loans and investors who bought these loans strictly because the rating agencies told them they were AAAAA rated mortgages. Ironically, default risk may have gone extinct. Borrowers no longer have to worry, because a mortgage is now an entitlement. In other words, if a borrower cannot pay, it is the government's responsibility to try to modify the loan, offer incentives, maybe even pay down the loan before finally foreclosing if all other options fail. By then, the borrowers will have been living rent free for so long that all down payments will have been recovered and then some. For an investor, agency MBS are guaranteed by the treasury. It really does not matter anymore whether it is a mortgage product or a treasury product. They are one and the same.

Pre-Payment and Interest Rate Risk

What about pre-payment risk? With the lowering of mortgage rates, refinances have accounted for over 70% of all lending activities for the last few years. For the previous holders of agency MBS, it did not matter whether the borrowers prepaid voluntarily to take advantage of low rates, involuntarily via foreclosure, or refinanced with the assistance of one of the programs such as HARP;  the old high yielding loans are continuously prepaid. Fixed income investors receiving prepayments have been destroyed. They have no choice but to accept much lower yields for similar instruments or be forced into higher risk investments. With rates so low, prepayment is probably not much of a risk factor going forward, but that may not be desirable. Rising interest rates would make the bond holders hope for prepayment.

The only major risk left is interest rate risk. Since the launch of QE3 on the week ending September 19, 2012, the Bernanke Fed has purchased $563.5 billion in agency MBS. This is a pace of $862 billion per annum. The 30 year fixed rate mortgage has gone from 3.38% in September 2012 to 3.7% as of this week. Clearly, if this trend continues, QE3 is not achieving the desired results in spite of practically purchasing all agency originations. There have been rumors recently that the Fed may be tapering its purchases. Are they suggesting rates are low enough?

Mortgage interest rates are in the hands of Bernanke or his successor. Interest rate risk, therefore, is mainly a policy risk because it is not influenced by the market but rather by policy decisions. In addition, refinance volume is now supported by programs such as HARP 1 and HARP 2. The Treasury can decide whether Freddie and Fannie should foreclose on defaulting borrowers, or forgive part of their loans as they are contemplating now.

Conclusion

In summary, mortgage risk nowadays is all about policy risk. It is policy that is supporting the market. Regardless of which way I approach the subject of real estate from, all roads lead me right back to government intervention. Considering the cost, who other than the Fed would believe QE can be for infinity. I conclude that the underlying risk is far greater today than it has ever been. If rates continue to increase, what can Bernanke do as an encore?

Average 30 year fixed rate mortgage rate since 2008 – via Federal Reserve of Saint Louis Research – click to enlarge.

Fed's Monetary Pumping 'Just Right'

After a few public appearances of the two or three remaining 'hawks' among the regional Fed presidents  – among them Charles Plosser, who once again noted he favors a 'tapering' of the money printing policy (Plosser made the almost unpardonable comment that he thinks 'central banks do not create wealth') – it was the doves' turn.

Charles Evans of the Chicago Fed was at his most hawkish in many months, by noting that the Fed's current pace of money printing is 'just right'. How does he know it is 'just right'? Well, as a monetary bureaucrat he has special insights we mere mortals as a rule don't have. The 'incoming data' prove his case. He even sees the future: in what might be called this year's version of the famous 'green shoots', he expects the US economy to attain 'escape velocity' in 2014. Will it leave the planet?

“The U.S. Federal Reserve has the appropriate level of monetary accommodation in place, allowing the economy to reach "escape velocity" next year, a top Fed official said on Monday.

"We continue to face powerful headwinds in the fiscal situation and the global economy," Chicago Federal Reserve Bank President Charles Evans told the CFA Society Chicago. But "the U.S. economy seems to be performing pretty well right now," he added, with the labor market improving, consumer spending up and housing stronger.

By 2014, GDP growth should be somewhere between 3 percent and 4 percent, allowing the recovery to be self-sustaining, he said.”

(emphasis added)

We will of course only know if the recovery becomes 'self-sustaining' if we follow the US economy on its upcoming trip into outer space. What constitutes a 'non-self-sustaining' economy in Evans' book? Presumably that is an unruly market economy that is for mysterious reasons bereft of the proper measure of 'animal spirits' and therefore in urgent need of a larger pile of its medium of exchange. This 'shot in the arm' in the form of more money will then lead to the coveted 'self-sustaining' state. We think Mr. Evans urgently needs to read 'Fiat Money Inflation in France'. What tends to happen to an economy that is pumped up by monetary inflation is that it immediately contracts again once the monetary pumping ends. Then we will hear that even more inflation is required.

Kocherlakota's Roundtrip and Bullard's Ideas for the ECB

Narayana Kocherlakota has completed his round-trip from presumed 'hawk' in 2010 to the by far most dovish member of the FOMC in 2013. After arguing a month ago that 'inflation is too low' and would therefore justify even bigger doses of money printing, he now blows off any concerns people may have about the developing asset bubbles the Fed's policies have set into motion. In a speech delivered last Friday he noted:

“[...] currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.”

(emphasis added)

Of course when the inevitable crash in junk bonds and stocks arrives, we will also hear that even more monetary accommodation is needed.

James Bullard is now evidently a member of the dole of doves as well, and he even has ideas about Europe and how it might be able to join the happy world-wide inflationist  'effort' (which will soon be augmented by Mark Carney at the BoE, where an experiment in 'NGDP targeting' is likely to be put in place).

According to Marketwatch:

“The Federal Reserve should continue with its present bond-buying program and adjust the rate of purchases in view of incoming data on growth and inflation, said St. Louis Fed President James Bullard on Tuesday. In a speech to an economic conference in Frankfurt, Bullard said the Fed's bond buying, commonly known as quantitative easing, is the best policy option at the moment and has been effective.

He rejected calls by some, inside and outside the Fed, for the central bank to do nothing, saying this risks the mildly deflationary situation experienced by Japan. Other tools, like cutting the interest the Fed pays for banks to park reserves at the central bank, or to "twist" short-term government debt on the Fed's balance sheet into longer-term debt, would have only minor effects, he said. Bullard said European leaders should consider a quantitative easing program if more easing is desired. The program should be GDP-weighted, as there is no European-wide government bond market, he said.”

(emphasis added)

Let's all happily inflate together! We wonder if the ideas Bullard is providing to Super-Mario will be falling on fertile ground. There is good reason to believe that the answer is yes. Won't a 'GDP weighted' bond monetization program be a good way of escaping the charge of 'monetary financing of government spending'? Especially since such purchases would be effected in the secondary market anyway? At present such a plan would likely not be considered due to resistance by the German Bundesbank and its dwindling band of allies on the ECB's board. Just wait though for the economic downturn in euro-land to worsen and stock markets to falter again. Then the resistance will likely melt away. Besides, the ECB can always point to developing deflationary pressures: since its mandate is to preserve price stability, it can justify a more intensive money printing scheme by the alleged need to avert deflation.

Conclusion:

The often talked about 'tapering' of 'QE' may well arrive in the event that macro-economic data strengthen. Right now they are weakening however, and so there is little reason to expect the pace of printing to slow down in the near term. Once the inflationary policy ceases, the malinvestments of the prolonged easy money period will be due for liquidation. This prospect is unlikely to be relished by severely overbought stock and bond markets.

We conclude that any 'pause' in the 'QE' policy is likely to be short-lived.

Addendum:  'QE2' Asteroid to Miss Earth by a Smidgen

A massive asteroid named 'QE2' is set to pass the planet on May 31, and will only miss us by what is considered a tiny distance in astronomical terms.

“It's 1.7 miles long. Its surface is covered in a sooty black substance similar to the gunk at the bottom of a barbecue. If it impacted Earth it would probably result in global extinction. Good thing it is just making a flyby.

Asteroid 1998 QE2 will make its closest pass to Earth on May 31 at 1:59 p.m. PDT.

Scientists are not sure where this unusually large space rock, which was discovered 15 years ago, originated from. But the mysterious sooty substance on its surface could indicate it may be the result of a comet that flew too close to the sun, said Amy Mainzer, who tracks near-Earth objects at Jet Propulsion Laboratory in La Cañada Flintridge. It might also have leaked out of the asteroid belt between the orbits of Mars and Jupiter, she said.

[…]

"This is a really big asteroid, similar in size to the one that killed off the dinosaurs, and it's getting very close to us," she said. "Fortunately we've been tracking its orbit very carefully so we know with great certainty it won't hit us. "We don't need to panic, but we do need to pay attention," she said.

(emphasis added)

Not to worry though, if the calculations of 'QE2's orbit turn out to be flawed and it does hit us after all, Paul Krugman is set to assure us a mighty boost to GDP is going to follow in its wake due to massive reconstruction spending. In fact, Kurgman probably thinks that a direct hit by 'QE2' is just what the doctor ordered for the moribund economy. It may even be better than war with space aliens.

QE2's scheduled flight path. That's awfully close and if it gets any closer, it may well break quite a few windows.

(Illustration source unknown)

The Eater of Children

The EU's monetary and economic affairs commissar Olli Rehn is concerned that his reputation as the enforcer of austerity gives the wrong impression about the true nature of Olli, deep down. As the NYT reports, he wants to 'peel off' the label that has been stuck on him. One very big concern of his is to avoid the impression that he is somehow not a Keynesian.

“The European Union's top economic policy maker and scourge of debt-fueled budget deficits, is fed up with austerity. Or at least with being tarred by a term that "is clearly used to label somebody as an unworthy person who is almost eating children."

With more than 26 million Europeans out of work and the economies of the 27-nation bloc shrinking over all for six quarters in a row, Mr. Rehn, the commissioner for economic and monetary affairs, has become a lightning rod in recent months for swelling anger across Europe against the harsh belt-tightening policies generally known as austerity.

But in an interview, Mr. Rehn, 51, described himself as a "doctrinaire agnostic in terms of economic policy" who has read and found much of value in the writings of the British economist John Maynard Keynes, whose name is synonymous with the idea of economic stimulus in times of crisis.”

(emphasis added)

The NYT's Krugman fan club must be breathing a sigh of relief at this revelation. The austerity enforcer is a Keynesian after all! We are not surprised that Rehn finds “much of value in the writings of the British economist” - there are barely any bureaucrats/politicians in the world who don't. After all, Keynes provided them post facto with the intellectual justifications for their disastrous interventionist policies in the 1930s, which have been used to defend interventionism ever since.

Why They Are All Good Keynesians

As Keynes noted quite openly in the foreword to the German edition of his 'General Theory':

“The theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory. Since it is based on fewer hypotheses than the orthodox theory, it can accommodate itself all the easier to a wider field of varying conditions. Although I have, after all, worked it out with a view to the conditions prevailing in the Anglo-Saxon countries where a large degree of laissez-faire still prevails, nevertheless it remains applicable to situations in which state management is more pronounced. For the theory of psychological laws which bring consumption and saving into relationship with each other, the influence of loan expenditures on prices, and real wages, the role played by the rate of interest—all these basic ideas also remain under such conditions necessary parts of our plan of thought.”

(emphasis added)

Keynes correctly remarked that the Anglo-Saxon tradition of economic and political liberalism (in the classical sense) had never taken root in Germany. It was supported by many in Germany in the 1840s to 1870s, but increasingly suppressed and superseded by mercantilist and socialist ideas, which were ultimately adopted and brought to their logical conclusion by German nationalism. By the time the 'General Theory' was published in Germany, the Nazi dictatorship and its Zwangswirtschaft (literally: 'coerced economy') were already fully established. Liberal ideas had been completely eradicated in Germany. 

Ironically, the hoary inflationist ideas of the chartalists (and their preeminent theorist Georg Friedrich Knapp), which Keynes supported and heartily recommended, had already been fully implemented during the early years of the Weimar Republic and brought utter economic ruin to Germany. And still the Germans were willing receptacles for the witchcraft clothed in pseudo-scientific jargon that Keynes peddled.

No government wants to relinquish the ability to inflate money and credit and the ability to spend more than it takes in. Almost every government remains convinced of the correctness of mercantilistic doctrines (a trade surplus is 'good', imports are generally bad and must be suppressed), in spite of the lip service given to free trade. It is only the pressure from industry groups that keeps the commitment to free trade intact; it nevertheless goes against the grain of what politicians and bureaucrats generally believe, as is proved day in day out by a plethora of evidence. Protectionism remains a 'populist' policy. It remains popular because most people don't realize how injurious it is to their own interests. Lastly, no government wants to admit that an unhampered free market economy would be better suited to the goals it officially wants to attain than various forms of central economic planning and interventionism. After all, if not for interventionism, there would not be much for governments to do. Their current bloated size could not possibly be justified in a true free market economy.

In fact, there would be no job for someone like Olli Rehn. An unhampered free market economy obviously would have little use for a 'monetary and economic affairs' commissar. His job after all is to hamper it. Therefore we do not doubt for a second that he means it when he says that he sees 'much of value' in what Keynes wrote.

As regards his role as the enforcer of austerity commitments: let us not forget that it was the financial markets that forced governments to think about reducing their spending and reviving the limits of the Maastricht treaty. They would never have done it without such pressure.

EU monetary and economic affairs commissar Olli Rehn: Don't worry mates, I'm a Keynesian too.

(Photo credit: AP/Yves Logghe)

The Out of Touch Eurocracy

Not a day passes without the citizens of the EU witnessing new absurdities being imposed by the apparatus of compulsion and coercion in Brussels. The decrees emanating from the EU's center of power of course have to be read by the cold light familiar from morgues these days, as the bureaucrats in their wisdom have felt it necessary to ban the incandescent light bulb in the wake of  heavy lobbying by industry. The pretext was that they needed to 'save the planet'  and who can be against saving the planet?

Following on the heels of the solar panel duties madness that risks a trade war with China, the EU's commissars have now decided that the producers of olive oil require their protection – this time under the pretext of safeguarding the interests of consumers. Consumers will of course end up paying through the nose for this nonsense.

According to a recent Reuters report, the “EU finds time to tell restaurants how to serve olive oil”:

“Critics ridiculed European Union bureaucrats on Saturday for taking time off fighting the euro zone's debt crisis to impose strict new rules on how restaurants serve olive oil. From January 1, 2014, eateries will be banned from serving oil to diners in small glass jugs or dipping bowls, and forced instead to use pre-sealed, non-refillable bottles that must be disposed of when empty.

The European Commission said the move is designed to improve hygiene and reassure consumers the olive oil in restaurants has not been diluted with an inferior product. But critics say the rules are a sop to Europe's olive oil producers, and will only add to the frustration felt by many towards a bloated EU bureaucracy regarded as out of touch with the concerns of ordinary Europeans.

"If the European Union was logical and properly run, people wouldn't be so anti-Europe. But when it comes up with crazy things like this, it quite rightly calls into question their legitimacy and judgment," said Marina Yannakoudakis, a British Conservative member of the European Parliament.

The Commission said its proposal was supported by 15 out of 27 EU member governments, including the continent's main olive oil producers – Italy, Greece, Spain and Portugal – which are among the countries worst affected by the euro crisis. "The fact that the EU is the world's major producer of olive oil – for up to 70 percent of the olive oil globally – perhaps this is even more than just a good consumer story for European citizens," commission spokesman Oliver Drewes told reporters.

Yannakoudakis said the Commission's defense of the plans highlighted how out of touch their priorities were. "The economic crisis in these countries isn't because of olive oil, it's because of the euro, and they should be concentrating on solving that problem," she told Reuters by telephone.

Germany opposed the plans in a vote by EU government officials behind closed doors, while Britain – which regularly cites perceived meddling from Brussels as the reason for its strained relationship with Europe – abstained.

German newspaper Sueddetsche Zeitung described the plan as "the weirdest decision since the legendary curvy cucumber regulation", referring to now-defunct EU rules on the shape of fruit and vegetables sold in supermarkets.

The regulations are based on rules in force in Portugal since 2005, and are part of an EU initiative to help olive oil producers hit by rising operating costs and falling profits in recent years.

But Enzo Sica, owner of Italian restaurant Creche des Artistes close to the EU quarter of Brussels, said the rules would prevent him from buying his extra virgin olive oil direct from a traditional supplier in Italy. "They say they're thinking about consumers, but this will increase costs for us and our customers as well. In this time of crisis, surely they should be worrying about other things rather than stupid stuff like this."

(emphasis added)

Well, it is not quite as weird as the Kafkaesque cucumber and banana curvature regulations were (they were actually forced in that rare instance to backtrack after a public outcry), but it comes close. Once again a small clique of producers is to be protected on the back of the great mass of consumers. EU commissar Oliver Drewes asserts that since Europe is such a big producer of olive oil, protecting olive oil producers is “even more than just a good consumer story for European citizens.”

Orwell couldn't have put it better. A 'good consumer story'?  What planet does Mr. Drewes hail from? What can consumers possibly gain by having to pay more for something they were evidently perfectly happy with the way it was? As always in such cases, there is a small coterie of winners, but society at large loses out.

Jugs containing olive oil: henceforth 'verboten' in restaurants across the EU. According to the commissars in Brussels, it is better for consumers to raise their costs and waste large amounts of olive oil by ordering that it can only be served in sealed containers.

(Photo source unknown, The Web)