Zero Hedge

Diablo 3: A Case Of Virtual Hyperinflation

Tyler Durden — Wed, 22 May 2013 02:34:32 GMT

Submitted by Peter C. Earle via the Ludwig von Mises Institute,

As virtual fantasy worlds go, Blizzard Entertainment’s Diablo 3 is particularly foreboding. In this multiplayer online game played by millions, witch doctors, demon hunters, and other character types duke it out in a war between angels and demons in a dark world called Sanctuary. The world is reminiscent of Judeo-Christian notions of hell: fire and brimstone, with the added fantasy elements of supernatural combat waged with magic and divine weaponry. And within a fairly straightforward gaming framework, virtual “gold” is used as currency for purchasing weapons and repairing battle damage. Over time, virtual gold can be used to purchase ever-more resources for confronting ever-more dangerous foes.

But in the last few months, various outposts in that world — Silver City and New Tristram, to name two — have borne more in common with real world places like Harare, Zimbabwe in 2007 or Berlin in 1923 than with Dante’s Inferno. A culmination of a series of unanticipated circumstances — and, finally, a most unfortunate programming bug — has over the last few weeks produced a new and unforeseen dimension of hellishness within Diablo 3: hyperinflation.

Austrian Economics and Inflation

In casual use, the term “inflation” is used in conjunction with price increases. From the perspective of the Austrian School of economics, though, that phenomenon is a secondary effect of increases in the money supply. As Henry Hazlitt wrote,

When the supply of money increase[s], people have more money to offer for goods. … Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A “price” is an exchange ratio between a dollar and a unit of goods. When people have more dollars … [goods] rise in price, not because [they] are scarcer than before, but because dollars are more abundant.[1]

Furthermore, inflation is not simply an increase in the supply of money within an economy; it is the increase in that portion (if any) not backed by a commensurate increase in specie: most common in history, market commodities like gold or silver. Thus fiat currencies are, unless tightly controlled as to the amounts being created versus being destroyed (with the latter typically only occurring due to wear), notably susceptible to inflation.

As virtual currencies are digitally-created and not commodity-backed — therefore, not particularly dissimilar from real world currencies in this day and age — those such as Diablo 3’s gold are de facto fiat currencies.

Sinks, Faucets, and Inflation

In virtual economies, the primary instruments used to control the money supply are “faucets” and “sinks.” Faucets are ways through which game currency is injected into the game. This generally involve players receiving currency from the game system itself, as opposed to other players. In such situations, the received currency is created anew. Sinks are ways through which game currency is removed from the game. This generally involve players paying currency into the game system itself, as opposed to other players. In such situations, the paid currency is destroyed.[2] Examples of faucets and sinks in Diablo 3 are included below:

Faucets

Drops — When a player defeats a foe, they often receive a reward of virtual gold or a good saleable into virtual gold;
Rewards — The game involves the player undertaking “Acts,” and within each act are a number of “quests.” For completing these, players are typically awarded virtual gold;
Buyers — Players can sell items to “in-game” (computerized, non-human) buyers, receiving virtual gold.

Sinks

Repairs — Over time, a player’s equipment will become damaged in combat and suffers wear-and-tear, requiring periodic restoration from an in-game craftsman in exchange for virtual gold;
Forging — Players pay virtual gold to an in-game blacksmith for weapons;
Rakes — Using the gold auction house costs players both a listing fee and a transaction fee, removing virtual gold from the economy;
Consumables — Players can purchase potions, scrolls, and other items from vendors for virtual gold.

Diablo 3 was rolled out in May 2012, and there seem to have been early concerns among players that gold sinks within the game were insufficient. One site noted,

[M]ost of us (probably including Blizzard) assumed that the Blacksmith would be widely used — he was, after all, the only major gold sink in the game … but dropped items alone selling in the [auction house] have been enough to satiate the appetite [of players] and crafting is … a waste of [gold] when one could easily buy an optimal item from the [auction house] rather than pumping 50 to 170K of gold into [a Blacksmith-crafted weapon.][3]

The establishment by Blizzard of a real money auction house (“RMAH”) alongside a virtual gold auction house in the game provided players with an incentive to both farm the game for real world profits and to pursue arbitrage opportunities. The RMAH was also created, at least in part, to disincentivize players from patronizing third party markets outside the game. Nevertheless, bots — automated game participants whose sole purpose is to farm the game world for items to sell — quickly emerged.

Although its anonymity may make it subject to skepticism, several weeks after the game’s debut a source claimed that there were at least 1,000 bots active 24/7 in the Diablo 3 game world, allegedly “harvesting” (producing) 4 million virtual gold per hour.[4] Most of the gold generated by the ruthlessly productive, rapidly adapting bots found its way to third party vendors in a black market which undercut the prices in the sanctioned, in-game auction houses.

The combined effect of heavy bot activity and insufficient sinks immediately impacted the gold markets, and inflationary pressures were soon apparent. An exasperated player complained in August 2012:

I purchased most of my gear for around 5 mil [gold] early on. I’ve been farming for awhile [and] have saved around 30 million gold [but now] I can’t upgrade the gear I have ... Where is all this money coming from? Why is everything so expensive?[5]

And as in real world economies, the price effects of money inflation often arise unevenly. With gold prices falling, prices began spiking in certain goods. Another player noted with curiosity:

[Y]esterday Fiery Brimstone was 150K, now almost 300K. Each time I hit refresh it seems to be going up a bit[.][6]

Gold Floors vs. Black Markets

The RMAH had minimum and maximum dollar amounts for in-game gold transactions: $0.25 minimum, $250 maximum. Market participants were also limited to dealing in increments of a certain size, called a “stack.” The “stack” was initially set to 100K gold. But as gold prices fell owing to rapidly building supply, the stack size was changed in August 2012 to 1 million. This practice, known as redenomination, is a fairly standard (if cosmetic) method of addressing inflation, but was viewed by some players as tacit devaluation.[7]

If you’re changing the [price] of gold from 0.25 per 100,000 to .25 per 1,000,000 I would like to cancel my gold auctions before you do that. You’re completely shifting the market in less than a day, and those of us that have auctions listed that will be affected by this change cannot cancel them until after the patch hits, which is potentially too late.[8]

To be clear, at the time at which the redenomination was introduced, gold was still trading above the floor rate. But being artificial, caps and floors not only prevent markets from clearing, but give black markets a target to undercut, to say nothing of offering players an opportunity to avoid the 15 percent fee — another intended gold sink — levied upon transactions within the auction house. Another player predicted,

[T]his [change] will likely have 2 effects … [it] could kill the private 3rd party market for gold and hopefully discourage botting … [but] because the real money price of gold is decreasing on the RMAH … [g]old will become cheaper as botters flood the market in an attempt to unload their massive surplus of gold before it becomes absolutely worthless. … This decision will further destabilize the economy [as in the gold auction house] prices shoot from 100,000 gold to 1,000,000 gold … [or] 10,000,000 gold to 100,000,000 gold. … The same would happen if the [Federal Reserve] decided to suddenly release a flood of currency into the U.S. economy[.][9]

By early 2013, the gold price had fallen to the exchange floor set by the game managers — $0.25/million — and players began to show signs of concern. One asked,

[Are] there any plans of lowering the floor of gold[?] … It has been at .25 for about 2 weeks now … should I sell my gold now before it gets lowered?[10]

A Delirium of Stacks

Hyperinflation is the economist’s equivalent of an astrophysicist’s quasar cluster or a marine biologist’s dolphin “stampede”: a rare exhibition of a unique set of circumstances which arise infrequently and are closely studied when they materialize. Such events are exotic enough that they become legendary: many individuals knowing little about monetary policy are aware of the recent outbreak in Zimbabwe, or familiar with the defining instance in the post-WWI Weimar Republic.

Economically, the tipping point in the transformation of inflation into hyperinflation is characterized by a profound drop in the outstanding demand for money: when holders of money expect the supply of money to increase — particularly without any sense of timing, bounds, or other guidance — monetary demand in the present drops in favor of surrendering money for vendibles.

The focus of possessors of money, therefore, devolves into an effort to capture known, present purchasing power against the likelihood of its decline in the near future. Saving, in any event, delaying consumption, is chastened; and if a cycle of declining purchasing power and rapidly rising prices ensues, ultimately the propensity to hold money declines precipitously and may fundamentally disappear.

This was demonstrated when, in a message board entry prefaced by stating “Sell Equipment before Patch 1.0.5 Hits!” (a patch is a piece of software added to an operational program or application as bugs are found, changes desired, or ways of improving performance discovered), a player warned that,

Blizzard just announced that the drop rates for [certain] items are going to be doubled … if you haven’t already, you should consider converting your current gear to cash … since real $ [are] the best hedge against gold devaluation[.][11]

If historical cases of hyperinflation — real, and now virtual — have one thing in common, it is the instinct among its victims to blame the symptoms rather than the disease. The Austrian economist Hans Sennholz noted that during the German hyperinflation, “intrigue and artifice” were believed to be at work.[12] Similarly, a handful of Diablo 3 players, frustrated about the decimation of their purchasing power, expressed increasing suspicion of manipulation and conspiracy theories.

[W]hy [are] certain items priced [s]o astronomically high? Many of them are not even that good yet cost 100’s of millions of gold. … I have about 45,000,000 gold saved up [and] check every few days to see if I can get any upgrades that are worth the gold, but … everything is vastly overpriced … clearly controlled by the gold sellers.[13]

And, predictably, any number of baleful remedies were proposed.[14]

While RMAH prices for virtual gold rallied occasionally, the prevailing direction of black market prices for virtual gold was inexorably lower as third party sellers undercut the in-game gold floor. In February 2013, Patch 1.0.7 was rolled out, introducing a range of new gold sinks intended to sop up ever-increasing virtual gold; they included new weapons and items not eligible for sale on the RMAH. One month later, with gold prices continuing to decline, a player made the following diagnosis:

[A]dditional gold sinks [are] unfortunately comparable to spitting on a fire ... [they] do nothing to limit the core issue which is that players are earning gold faster than they [want] to spend it. Repairing is not a … good gold sink as it works best [for] players who are [dying]. … Crafting is the same, works well on players who can get the items to craft with … but leaves players with limited gold supply out of the picture. … The amount of gold that drops … needs to be nerfed, and not softly.[15]

The effort appears to have been futile, as the growth of the virtual gold supply continued to grow.

Several competing definitions for hyperinflation exist, with the strictest — an increase of 50 percent in one month — defined by economist Philip Cagan in his 1956 book The Monetary Dynamics of Hyperinflation. By his definition, the Diablo 3 economy appears to have entered hyperinflation between February and March of 2013, when the black market price of gold fell from $0.20/million to $0.05/million — a decline of over 75 percent in a few weeks. At around that time, a player commented that he was

watching the markets collapse and gold become worthless. … So you feel rich that you have a billion or two in gold[?] … [W]ell guess what, you aren’t … there is nothing you can invest in to hold value. The only thing worth anything has become $$$.

With a sardonic irony that markets sometimes display, real world currencies had assumed the role of commodity gold, and virtual gold had gone the way of all flesh and fiat currencies.

This, however, was still only the penultimate stage. On May 7th 8th, 2013, Blizzard rolled out Patch 1.0.8, which contained the seeds of the last, hyperbolic surge of gold superabundance. One change was the altering of the gold stack size from 1 million to 10 million per $0.25: a simultaneous redenomination and 90 percent devaluation (sitting, as the price was, at the RMAH floor) of virtual gold, targeting black market rates of roughly 4 cents per 10 million. In addition, a bug within the patch allowed users to cancel transactions in the auction house before completion, essentially allowing them to double their gold on demand.

In just a few hours, the already gold-swamped economy saw trillions more created: a mammoth deluge of, by then, worthless virtual gold chasing finite goods, driving prices upward in leaps and bounds. It was, at last, the hyperbolic blow-off characteristic of real world hyperinflationary episodes. Some of the price increases (in Diablo 3 gold) are shown below:

	2013 avg price	1-6 May avg price	7-8 May price
radiant star amethyst	17.4M	41.2M	85.8M
radiant square ruby	187K	260K	337K
flawless square topaz	491	5,170	8,700
star emerald	764K	1.1M	1.6M
tome of jewelcrafting	694	3,400	3,100

And in a noteworthy departure from real world hyperinflation, rather than resorting to barter (which frequently takes the form of food for skilled labor), as runaway inflation became hyperinflation, many chat channels — through which some measure of trade was consummated — seem to have fallen empty: without a need to eat or clothe oneself in the virtual world, some players simply appear to have turned away

Aftermath

Blizzard quickly closed the in-game auction houses and audited transactions which took place during the blowout, banning players who took advantage of the bug and donating the proceeds of certain sales to charity. The gold stack size was also moved back from 10M to 1M. One week later, on May 15th, the above-cited items were quoted at the following, approximate virtual gold prices: radiant star amethyst, 26.1M; radiant square ruby, 375K; flawless square topaz, 8,600; star emerald, 797K; tome of jewelcrafting, 1,350.

In May of 2012, the price of virtual gold was approximately $30/100,000 or $0.0003/gold. As this article was completed — and bearing in mind that these prices may be erroneous, stale, or merely indications of interest — one site showed Diablo 3 gold being offered by four third party sellers at an average price of $1.09/20M, or $0.0000000545/gold: one ten-thousandth its market price one year earlier.In the RMAH, virtual gold was priced at $0.39/1M.

Remembering that game economies are private and players are voluntary members, there’s no explicit mandate to ensure rigid inflation control as one often sees (however rarely pursued) in public economies. That said, knowing that gaming experiences can be upended by economic missteps, there is a clear business interest for gaming firms in keeping virtual currencies and the greater economies as a whole stable.

Frequently, hyperinflationary episodes have ended by substituting a currency outside the political and central banking control of a nation for the sovereign currency. During the early 1990s, during Serbia’s hyperinflation,

[t]he authorities could not print enough cash to keep up. On Jan 6th, 1994, the dinar officially collapsed. The government declared the German mark legal tender … [which] end[ed] the hyperinflation.

Two obvious solutions for managers of virtual economies include more vigilant bot restrictions and close — indeed, real-time — monitoring of faucet output, sink absorption, prices, and user behaviors. More critically, though, whether structured as auctions or exchanges, markets must be allowed to operate freely, without caps, floors, or other artificialities. Unrestricted (real) cash auctions would for the most part preempt and obviate black markets.

One also surmises, considering the level of planning that goes into designing and maintaining virtual gaming environments, that some measure of statistical monitoring and/or econometric modeling must have been applied to Diablo 3’s game world. The Austrian School has long warned of the arrogance and naïveté intrinsic to applying rigid, quantitative measures to the deductive study of human actions. Indeed; if a small, straightforward economy generating detailed, timely economic data for its managers can careen so completely aslant in a matter of months, should anyone be surprised when the performance of central banks consistently breeds results which are either ineffective or destabilizing?

By no means does this analysis intend to equate the actions of virtual gaming firms with the policies of governments or central banks, or to malign their indisputably talented managers, designers, and programmers. While their actions may ultimately generate similar outcomes, central planners seek and wield power whereas the actions of commercial gaming interests are undertaken to compete with other online entertainment providers by delicately balancing opportunities for newer players with the need to continually challenge experienced players.

By all accounts Diablo 3 is a great game; one hopes that with this episode passed, it will reacquire its former glory. But while decision-makers at online gaming firms can and should be forgiven for not anticipating the perilous and unpredictable torsions of rapidly expanding money supplies, the events of the last week provide a stark reminder of the power and inescapability of the laws of economics.

Visualizing The Cost Of Mining Gold

Tyler Durden — Wed, 22 May 2013 01:59:56 GMT

There are over 3 billion ounces of gold in the world's deposits. The Top 50 of these mines alone contain over one-third of the total gold. North America is the 'cheapest' place to produce gold and Africa the most expensive. Gold producer profits are getting squeezed from both directions: lower gold prices and rapidly inflating costs...

The Pentagon Admits: The "War On Terror" Will Never End

Tyler Durden — Wed, 22 May 2013 01:26:12 GMT

Submitted by Michael Krieger of Liberty Blitzkrieg blog,

It is hard to resist the conclusion that this war has no purpose other than its own eternal perpetuation. This war is not a means to any end but rather is the end in itself. Not only is it the end itself, but it is also its own fuel: it is precisely this endless war – justified in the name of stopping the threat of terrorism – that is the single greatest cause of that threat.

- Glenn Greenwald from his recent article: Washington Gets Explicit: Its “War on Terror” is Permanent

So last Thursday at a hearing held by the Senate Armed Services Committee, we found out what many of us already knew. That the “war on terror” is never going to end. Indeed, it was never supposed to end. This never-ending “war” on a fantastical enemy provides the American oligarch class with too much money and too much power to ever make it worthwhile for the establishment to shut down. It matters not to them that this civil liberties destroying fraud has been going on for my entire post-college life and, if they have their way, for the remainder of it. It matters not to them that the “war on terror” itself has done more to destroy the Constitution and vital essence of this nation than any terrorist act ever could. No, it matters very little indeed. What matters to them is money and power, and the “war on terror” provides them with boatloads of both.

My favorite excerpts from Glenn’s article are below:

On Thursday, the Senate Armed Services Committee held a hearing on whether the statutory basis for this “war” – the 2001 Authorization to Use Military Force (AUMF) – should be revised (meaning: expanded). This is how Wired’s Spencer Ackerman (soon to be the Guardian US’s national security editor) described the most significant exchange:

“Asked at a Senate hearing today how long the war on terrorism will last, Michael Sheehan, the assistant secretary of defense for special operations and low-intensity conflict, answered, ’At least 10 to 20 years.’ . . . A spokeswoman, Army Col. Anne Edgecomb, clarified that Sheehan meant the conflict is likely to last 10 to 20 more years from today – atop the 12 years that the conflict has already lasted. Welcome to America’s Thirty Years War.”

That the Obama administration is now repeatedly declaring that the “war on terror” will last at least another decade (or two) is vastly more significant than all three of this week’s big media controversies (Benghazi, IRS, and AP/DOJ) combined. The military historian Andrew Bacevich has spent years warning that US policy planners have adopted an explicit doctrine of “endless war”. Obama officials, despite repeatedly boasting that they have delivered permanently crippling blows to al-Qaida, are now, as clearly as the English language permits, openly declaring this to be so.

It is hard to resist the conclusion that this war has no purpose other than its own eternal perpetuation. This war is not a means to any end but rather is the end in itself. Not only is it the end itself, but it is also its own fuel: it is precisely this endless war – justified in the name of stopping the threat of terrorism – that is the single greatest cause of that threat.

In response, I wrote that the “war on terror” cannot and will not end on its own for two reasons: (1) it is designed by its very terms to be permanent, incapable of ending, since the war itself ironically ensures that there will never come a time when people stop wanting to bring violence back to the US (the operational definition of “terrorism”), and (2) the nation’s most powerful political and economic factions reap a bonanza of benefits from its continuation. Whatever else is true, it is now beyond doubt that ending this war is the last thing on the mind of the 2009 Nobel Peace Prize winner and those who work at the highest levels of his administration. Is there any way they can make that clearer beyond declaring that it will continue for “at least” another 10-20 years?

And then there’s the most intangible yet most significant cost: each year of endless war that passes further normalizes the endless rights erosions justified in its name. The second term of the Bush administration and first five years of the Obama presidency have been devoted to codifying and institutionalizing the vast and unchecked powers that are typically vested in leaders in the name of war. Those powers of secrecy, indefinite detention, mass surveillance, and due-process-free assassination are not going anywhere. They are now permanent fixtures not only in the US political system but, worse, in American political culture.

Each year that passes, millions of young Americans come of age having spent their entire lives, literally, with these powers and this climate fixed in place: to them, there is nothing radical or aberrational about any of it. The post-9/11 era is all they have been trained to know. That is how a state of permanent war not only devastates its foreign targets but also degrades the population of the nation that prosecutes it.

This war will end only once Americans realize the vast and multi-faceted costs they are bearing so that the nation’s political elites can be empowered and its oligarchs can further prosper. But Washington clearly has no fear that such realizations are imminent. They are moving in the other direction: aggressively planning how to further entrench and expand this war.

Newly elected independent Sen. Angus King of Maine said after listening to how the Obama administration interprets its war powers under the AUMF:

This is the most astounding and most astoundingly disturbing hearing that I’ve been to since I’ve been here. You guys have essentially rewritten the Constitution today.”

Former Bush DOJ official Jack Goldsmith, who testified at the hearing,summarized what was said after it was over: Obama officials argued that “they had domestic authority to use force in Mali, Syria, Libya, and Congo, against Islamist terrorist threats there”; that “they were actively considering emerging threats and stated that it was possible they would need to return to Congress for new authorities against those threats but did not at present need new authorities”; that “the conflict authorized by the AUMF was not nearly over”; and that “several members of the Committee were surprised by the breadth of DOD’s interpretation of the AUMF.” Conveying the dark irony of America’s war machine, seemingly lifted right out of the Cold War era film Dr. Strangelove, Goldsmith added:

Amazingly, there is a very large question even in the Armed Services Committee about who the United States is at war against and where, and how those determinations are made.”

Nobody really even knows with whom the US is at war, or where. Everyone just knows that it is vital that it continue in unlimited form indefinitely.

1984 really was an instruction manual for the people in power. Terrifying.

So You Want To Work In JPMorgan's Legendary Gold Vault? This Is Your Chance

Tyler Durden — Wed, 22 May 2013 00:51:52 GMT

For all those whose lifelong ambition has been to work with the recently reappointed joint Chairman/CEO of JPMorgan in the firm's legendary and infamous gold 'clearing' operation (whose formerly classified New York, the largest in the world, and London vault locations were exposed here and here), today is your lucky day:

But more important than what the firm is looking for, is what is willing to provide. Information. Such as:

JPM currently holds a 45 % market share of the London Clearing: not quite a monopoly but close enough
The London clearing transacts approx $ 40 bn value in metal transfers each day on behalf of participants in the London market
It conducts Location swaps: literally, what it sounds like
The firm has consignment agreements in India, China, Thailan, and... Turkey: the infamous gateway to Iran?
The firm's gold clearing and physical desk engages in liquidity management between London, Zurich and... the Bank of England?

h/t Ro

"The Math Is Stacked Against Japan - It's Not 'If', It's When"

Tyler Durden — Tue, 21 May 2013 23:40:05 GMT

As the BoJ prepares to thrill us with even moar in its latest policy meeting (or not as we discussed earlier) and with Amari et al. now jawboning JPY to some extent to control the out-of-control chaos in JGBs, it is perhaps worth taking 20 minutes to comprehend just what all this extreme policy action means. The following brief presentation covers it all in a Kyle-Bass-ian facts-and-fallacies manner, Christine Hughes sums it all up perfectly, for Japan, "The Math Is Stacked Against Japan - It's Not 'If', It's When."

Global Assured Destruction, Or How Bernanke Now Holds The Entire World Hostage

Tyler Durden — Tue, 21 May 2013 22:49:05 GMT

The one headline we have been waiting for for over four years has just hit:

BOK KIM SAYS WORLD MAY FACE RATE RISK IF U.S. EXITS FROM QE

Not when, if. And there you have it: if the Fed exits, the world (and most certainly Japan) gets it. Thus, for the sake of the children (who will have inhert about $100 trillion in debt but don't worry: debt is an asset as some "analysts" will promise) Bernanke can never exit. QE...D

And since never is a litte longer than 2016/2017, at some point in the next few years Bernanke will be the proud owner of all marketable Treasury paper. All of it.

How To Arbitrage The People's Bank Of China

Tyler Durden — Tue, 21 May 2013 22:39:15 GMT

Since there are now numerous hard proofs that China’s export data (and to some extent import data as well) were significantly distorted recently, we naturally wonder the incentives behind the distortion and the detailed mechanism of these manipulations. As BofAML notes, there are four reasons why the distortions have risen so sharply since Q4 2012 but the various arbitrages (described in actionable detail below) between onshore and offshore currencies and interest rate differentials (and the role of gold in this) remain in place to make judging China's real trade growth as much art as science.

Via BofAML,

In the starting period of using RMB for trade settlement (2010-2011), people might not learn the trick on how to benefit from the differential between CNH and CNY exchange rates. And the differential was quite small before October 2012 when markets perceived a significant RMB/USD depreciation. Only since 4Q12 several preconditions were ripe for massively manipulating trade data.

First, RMB/USD started appreciating again.
Second, the China’s economic growth started rebounding. These two preconditions made it attractive to bring in hot money via over-reporting exports.
Third, the differentials between CNH/USD and CNY/USD got widened in 4Q12 with CNH/USD becoming more expensive than CNY/USD, making it’s profitable to do arbitrage (more details below).
Fourth, people were experienced enough to use RMB trade settlement to carry out relatively complicated arbitrage.

Arbitrage the CNY-CNH exchange rate differentials

Demand for RMB assets in offshore markets has picked up since 4Q12 on a better growth outlook and the introduction of new investment tools such as RQFII, causing CNH/USD (RMB traded offshore) to be more expensive than CNY/USD (RMB traded onshore). At the peak in January, CNH was 0.6% more expensive than CNY. Consequently, arbitrage opportunities between CNY and CNH arise if people can manage to bring CNY to offshore RMB centers like Hong Kong. The trick is seemingly complicated, but actually the arbitrage is quite simple. Let’s use an example to reveal the mechanism of this arbitrage.

1. In mainland China, an arbitrager could borrow US$1.0mn and convert to CNY at exchange rate 6.20 (so he gets RMB6.2mn);

2. He could import something with minimum transportation costs such as gold from Hong Kong and settle the imports with the borrowed RMB6.2mn. In this way, this RMB6.2mn flows to Hong Kong and becomes CNH;

3. He then instructs his business partners (or his Hong Kong subsidiaries) to converts the RMB6.2mn to USD in HK. Assuming USD/CNH is 6.15, he gets US$1,008,130;

4. Finally he exports the previously imported gold which is settled in USD. In this way, US$1,008,130 flows into mainland China and the arbitrager completes the whole deal with a profit at US$8130 (perhaps less than that due to some transport and custom fees).

Arbitrage the differentials between CNH and CNY interest rates

Another arbitrage can gain purely from the interest rate differentials between CNH and CNY. Note interest rates for RMB are different onshore and off-shore. An arbitrager can gain by borrowing CNH at low rates, converting CNH to CNY and depositing CNY at higher rates. Currently the spread could be around 70bp. Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks (the time needed for getting CNH loans in Hong Kong), he then deposits RMB1.0mn in a bank with deposit rate at 3% and ask the bank to issue L/C for him;

2. With the L/C, his Hong Kong partners could get RMB1.0mn loans from HK bank for one year. The arbitrager then export something with minimum transportation costs to Hong Kong and the RMB1.0mn is sent to mainland China. He repays the RMB1.0mn.

3. His profit is calculated as follows. The revenue is the differential between the onshore RMB deposit rate and the offshore RMB financing costs. Currently the spread is around 70bp after deducting related costs, so the revenue is RMB7000. His cost for borrowing RMB1.0mn for one month is 2500. So his risk-free net return is RMB4500.

Arbitrage on interest rates differential and RMB appreciation

The most complicated arbitrage can gain from RMB appreciation, the interest rate differentials between onshore RMB and offshore USD, and the differential between CNH/USD and CNY/USD. Note that 1yr RMB deposit rate in China is now 3.0% but 1yr dollar lending rate in HK is lower than 2% (LIBOR +100bp). Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks, he then put RMB1.0mn as 1yr time deposits in a bank at 3% and ask the bank to issue L/C for him;

2. Assume USD/CNH is 6.15. With the L/C, his Hong Kong partners could get 1yr dollar loans of US$162,602 (=1000,000/6.15) at 2% from a HK bank.

3. The arbitrager then exports something with minimum transportation costs to Hong Kong and the US$162,602 is sent to mainland China. Assuming USD/CNY is at 6.2, he can get RMB1,008,132. He repays the original RMB loan at the amount of RMB1002,500 (RMB2,500 is interest payment) and obtain an immediate profit at RMB5632 which he will also put in 1yr deposit.

4. One year later, his time deposits will be valued at RMB1,035,801 (with interest payment). Assuming CNY/USD appreciated 2%, he can convert his this to US$171,774.

5. He imports the goods from Hong Kong he exported a year ago by paying US$165854 (=162602*1.02). In this way he moves US$165854 to HK to repay his loans (principal plus interest payment).

6. His net profit (in one year) is US$5920.

Outright hot money inflow

In the above three cases of arbitrage, the person could even raise prices of exports which were previously imported to bring in hot money. When people believe the Chinese economy is safe (especially as growth recovers) and CNY/USD will appreciate, they have the incentive to take in hot money to benefit from higher interest rates in China (than USD rates) and CNY/USD appreciation.

Beware These Unseen “Friction” Costs!!

Capitalist Exploits — Tue, 21 May 2013 22:16:31 GMT

Brokers, placement agents, middle men, promoters, consultants, financial intermediaries…call them whatever you wish. They have existed in the financial space since man invented a way to exchange one thing of value for another.

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Some do a fine job, provide a valuable service and deserve every penny they earn. In my experience however, and that of Mark and many of our friends who invest in private equity, these people, the deserved ones that is, are a very small fraction of those inhabiting this space. I’ve met hundreds of middle men and can count on one hand those I trust and value.

In the private equity space they are abundant. MAN are they abundant. In fact, I think we currently have a bubble in middle men. Doubt me? Hop onto LinkedIn and you’ll find every Tom, Dick and Sheryl hard at work putting Nigerian scam artists to shame. To be fair, they may represent real deals which in-and-of-themselves are not shams, but beware the costs. Many “represent” millions in capital, yet like those “trusty” Nigerians, who also represent gobs of dough, somehow they just need that little itty-bit of additional capital from you and I to “pull it over the line.”

I bring this up because of an amusing interaction I had recently with one such individual. I’d like to think that shining a light on some of these creatures lurking under slimy rocks may help other investors recognize these clowns when they see them. It may also serve as one of the red flags I previously spoke about for investors seeking an entrance into private equity deals.

Firstly, you’ll likely have already come across some of them; they’re quite possibly the guys “endorsing” you for your skills on LinkedIn. WTF..?

I’m confused, some guy I’ve never met and don’t know from Adam, just endorsed me for “Strategic financial planning” skills. As confusing as this is, what really gets me is why I’ve not been endorsed for my great pancake making skills. My kids reckon I’m the best there is, and they actually know me and have witnessed said incredible pancake making abilities. The guy on LinkedIn…not so much!

Now these guys are nothing like brokers at all, but rather more akin to back alley abortionists peddling their wares, complete with the rusty, blood-stained “tools” from the last botched job. They litter the world of private equity like plastic bags on a Maputo high street, and frankly annoy the sh*t out of Mark and I.

A story to illustrate absurdity…

Onto my tale. I was recently put in touch with a gentleman of the type I described above, it turned into the stuff of high comedy.

Now, the underlying business was actually OK, which was why I gave the time of day to him to further explain the deal terms. However, the structure of the deal was such that the “promoter” got a fat chunk of the cash out of the gate, travel expenses (which were obscene), and sundry other expenses, which I showed to Mr. back alley boy, that amounted to fully 60% of the investors capital! I kid you not! Even more amazing to me is that this clown had in fact already found an investor of sufficiently low intellect to invest in the deal, taking out the majority of the offering. A 7-figure sum. I pity the sod. Something about “fools and their money” comes to mind.

This particular investor now requires a 150% return in order to simply break even. This, on an investment which is high risk to begin with, and where it’s entirely possible to lose 100% of his money. Of course the promoter was doing his damndest to make the deal sound like a low risk, HUGE upside, fit for widows and orphans opportunity. He tried to weasel his way out of the facts when I presented them to him, but I was having none of it. In frustration he simply walked away saying I didn’t understand the deal. Oh, I understood…and that of course was the problem.

This was one of the more extreme cases I’ve seen of friction costs, but I will say that it’s pretty common for your investment dollar to be “attritioned” or “frictioned” to the tune of 15% or more on many deals I’ve reviewed. On a $100,000 placement you’re looking at losing $15,000 right out of the gate if you don’t pay attention.

You will almost NEVER be shown these details, but will need to closely examine the deal to find them out. Small print etc. folks. Look for font size 8 and read diligently.

As an investor it’s crucial to understand the cost of capital for any business you are looking at getting involved in. Additionally, ferreting out the true cost of capital for a business, and whether you are getting hosed or not, is important in order to understand the true state of accounts in the company.

Some points:

Find out how much capital hits the balance sheet. Unless its a “friends and family” round you’ll likely have placement fees somewhere. No problem, but analyze them and make sure that they make sense.
Always ask whether they have their own capital on the line, how much, and ask for proof and full disclosure of compensation to those involved in the transaction. Let me tell you there is a vast, Grand Canyon wide difference between having your own cash on the line and that of a client, friend, associate, or whatever you want to call “the other guy”… you know, the one who is actually putting up the capital.

Kyle Bass mentions the, “give a shit factor”, and it is remarkably high when putting your own cash on the line. I should know, I’ve been “dumb enough” my entire adult life to be the guy putting his own capital to work and only getting paid when I’m right, and taking it on the chin when I’ve screwed up. It has frustrated me many times to have watched middle men walk away with larger sums than I…even after they never put a single dime on the line. No need to follow my path though, you can always become a mini-Bankster yourself.

Good luck out there, watch ceaselessly for this nonsense and make sure you ask the question first and foremost if any fees are being paid and to whom. Full disclosure should be given. So, next time some back alley abortionist lies to you, do us all a favour and punch them in the face.

- Chris

“Money talks and bullsh*t walks” – Sam Zell

Bank of Japan Policy Meeting Preview - Chance Of A Bond Crash?

Tyler Durden — Tue, 21 May 2013 21:58:58 GMT

Excerpted via Bill Blain of Mint Partners,

The current Bank of Japan policy meeting is possibly the most important thing going on this week (even more so than Bernanke's comments perhaps). If, as is distinctly possible, they don’t do anything to reinforce the immediacy of the Kuroda QQE package, we could be looking at bond markets reacting in a most "unfavorable manner". The effect would be to reinforce the latest round of 'fear-on' bond selling – certainly over the short-term, and the damaged sentiment could impact stocks also.

...

That's why the Bank of Japan policy meeting today/tomorrow will be so interesting. Can it nurture and sustain real growth? Devaluing yen to benefit exporters does seem to be working - look at recent Yen corporate results. However, now we've got the rest of Asia looking to balance Japan's competitive devaluation. We still need to see how the other side of Abe-onomics works: rebuilding Japan. How vulnerable is the BoJ game? The Nikkei may be massively higher, but interest rates and JGB's remain stubbornly volatile and high - a factor conflating the global bond worries... if the Fed is going to end QE and Japan's QE squared isn't working, then bond players will quite rightly capitulate.

There is probably not much the BoJ can say at this meeting – it’s got to give the policy (of massive QE) time to work. That leaves markets highly vulnerable to a sense of disappointment tomorrow. On the other hand, we've long said.. "Don't fight Kuroda!"

...

Whatever happens in the Japan story; how much longer the Fed keeps up the buying, and the implications on Global QE remain the main themes and drivers of the current market. The question is, for how long might markets be put on the back foot by the continued weakness in JGB and knock on effects. [let alone Europe]

...

Back in the bond market, over the last few days the search for yield does seem capped. There have been some stumbles in new issues, and we're encountering reluctance from buyers to engage some excellent client offers for the highest yielding names like Greece or Slovenia. We've seen limited interest in relative spread trades - for instance privately placed Canada risk at a significant spread over the underlying provincial names. That all tells me the bond market is nervous.

IRS' Lois Lerner To Plead The Fifth Before House Oversight Committee

Tyler Durden — Tue, 21 May 2013 21:32:42 GMT

For an affair that numerous media outlets will have you believe has been spun out of all proportion, and that it really is the conservatives fault that the IRS was targeting them, it is somewhat ironic that the IRS official who opened up the entire Pandora's box with her targeted apology two weeks ago, and who learned in 2011 about the improper targeting of political groups yet lied under oath to Congress to the contrary, has decided to plead the Fifth and will invoke her right not to testify on Wednesday for fear of self-incrimination, according to her lawyer. But this would mean that... she may have something to hide? And that would be rather problematic for the media's spin cycle, although we are confident it will take just a few minutes of deep though in the proper channels, before this all too overt admission of guilt is somehow spun as the IRS being the unwitting targets of an aggressive McCarthyesque campaign seeking to discredit the government's impartial tax collector whose only noble purpose is to enable the government to get even bigger.

From the LA Times:

Lois Lerner, the head of the exempt organizations division of the IRS, won’t answer questions about what she knew about the improper screening — or why she didn’t disclose it to Congress, according to a letter from her defense lawyer, William W. Taylor III. Lerner was scheduled to appear before the House Oversight Committee on Wednesday.

“She has not committed any crime or made any misrepresentation but under the circumstances she has no choice but to take this course,” said a letter by Taylor to committee Chairman Darrell Issa (R-Vista). The letter, sent Monday, was obtained Tuesday by the Los Angeles Times.

Perhaps she could clarify what circumstances those are: maybe the same ones that forced her to bow out of the Western New England Law School commencement speech?

Taylor, a criminal defense attorney from the Washington firm Zuckerman Spaeder, said that the Department of Justice has launched a criminal investigation, and that the House committee has asked Lerner to explain why she provided “false or misleading information” to the committee four times last year.

Since Lerner won’t answer questions, Taylor asked that she be excused from appearing, saying that would “have no purpose other than to embarrass or burden her.” There was no immediate word whether the committee will grant her request.

Wait, criminal investigation? Does this mean that the administration will offer yet another deferred-prosecution deal whose terms will involve harsh mandatory lifetime pensions and onerous full benefits upon retirement? Surely not even a corrupt, co-opted, drenched in scandals administration is that inhumane.

And on that note, we leave you with...

The Housing Unrecovery Is Here: Lumber Enters Bear Market

Tyler Durden — Tue, 21 May 2013 21:08:53 GMT

Despite the incessant belief that this must be too-much-new-supply-driven (as opposed to a lack of demand for new home construction), Lumber futures (after hitting limit down once again today) have now officially entered bear-market territory. Front-month lumber prices are down 23% from their highs in mid-March and given the 2-month lead that correlates so well to the market, it seems things are a little ahead of themselves in 'housing recovery' land.

It seems lumber futures are the best proxy for trading the real economy...

We wonder when the broad equity market will wake up to that?

not like we haven't seen this hysteria before... (can this really go on for another year before reality hits?)

Of course, a plunge in lumber prices will not help all those new mills that are apparently coming back on line now...?

Or is simply that Lumber prices reflect a reality no one is quite comfortable with yet?

Charts: Bloomberg

And The New US Debt Ceiling Is...

Tyler Durden — Tue, 21 May 2013 20:38:56 GMT

The grace period between February and mid-May, when the US spent like a drunken sailor without regard for even structural limitations, and raked up over $300 billion in debt, or said otherwise when it was without an official debt limit, is over as of this weekend as we reported, and starting Monday the clock has been reset and wound up to the amount of the debt previously incurred in the phantom period. Courtesy of today's Daily Treasury Statement we now know that the new and improved debt target ceiling, at which the US immediately finds itself is: $16,699,421,095,673.60.

As a reminder, since the US is automatically at the debt ceiling where it was four months ago but magically got a a $300 billion reprieve despite all the talk of austerity because no bipartisan agreement could be reached, the total amount of US debt will not change until Labor day, at which point all the various Treasury gimmicks to incur less debt expire and either the US is forced to start prioritizing debt, or it defaults outright.

And as we pointed out, early September is when the fun really starts: it will be just after the Jackson Hole conference where Bernanke will be absent for the first time, and just before the September FOMC meeting at which Bernanke will most likely announce some, if not substantial, tapering of QE, and when the Tepper theory that QE is good but less QE is gooder.

So enjoy the no-volume, hypnotic levitation until then, but load up on Sept VIX calls: that's when the fun starts all over again.

19 Out Of 19

Tyler Durden — Tue, 21 May 2013 20:05:28 GMT

The Dow completes its 19th week in a row with a green close on a Tuesday - there are no superlatives left. As a gentle reminder, since February 1st, the Dow has gained 9.85%; absent Tuesdays it is up a mere 0.5%. Despite equity strength, bonds rallied, VIX rallied, the USD ranged violently (Fed's Bullard and Dudley) to end unchanged, and commodities drifted lower on another dismally low volume day. Correlations between stocks and the rest of risk-assets have completely broken down today.

19-in-a-row...

It's been a hell of a six months on Tuesdays...

Treasuries did not buy into the rotation...again...

VIX futures roll tomorrow and likely had some effect (and we saw notable volume in higher up calls - though more like rolls than outrights) but VIX remains absolutely agnostic of the last 40 SPX points...

FX markets ended the day oddly unchanged - despite some very notable swings on the back of Fed's Bullard and Dudley's comments...

Commodities in general drifted lower today...

Stocks (once again) were in a world of their own for much of the post-EU close... cross-asset-class correlations completely disappeared this afternoon as stocks wee notably bid beyond every other risk asset

Charts: Bloomberg and Capital Context

Bonus Chart: A Gentle reminder... HY has stopped its run...

and locally... SPY is 6 sigma rich to HYG (arb delta is around 3xHYG vs 1xSPY)

"The Approximate Present Does Not Approximately Determine The Future"

Tyler Durden — Tue, 21 May 2013 19:29:30 GMT

Chaos Theory turns 50 years old this year, celebrating half a century of flapping butterfly wings in Brazil creating tornadoes in Texas. That most famous example is especially appropriate, since it was a meteorologist named Edward Lorenz who first outlined why seemingly consistent and knowable systems can still go wildly wrong. As it turns out, as ConvergEx's Nick Colas reminds us, small errors in measurement or observation at the start of a time series can significantly change how things look at the end. In the current low volatility, one-variable central bank driven global equity markets, Chaos Theory may seem a quaint relic of past crises. However, its central lesson – that complex interrelated systems create unexpected outcomes from seemingly benign inputs – is still relevant. Students of economics like to think of their discipline as scientific, just like physics or other hard sciences. They would do well to embrace the intellectual honesty neatly encapsulated by the central lessons of Chaos Theory.

Via ConvergEx's Nick Colas:

If I asked you to name a famous weatherman, I doubt you’d come up with Dr. Edward Lorenz of the Massachusetts Institute of Technology. No, he’s no Al Roker or Jim Cantore in terms of fame or fortune. He never stood in the middle of a hurricane to report for the Weather Channel or walked through a devastated trailer park after a tornado.

Dr. Lorenz’s contributions, however, have a far wider reach because he is the researcher who came up with what we know today as ‘Chaos Theory’. Here’s brief history of the man and his discovery:

Edward Lorenz was born in West Hartford Connecticut in 1917, attending Dartmouth (BA 1935) and Harvard (Master’s 1940). He served as a meteorologist for the U.S. Army Air Corp. during World War II and earned two degrees from the Massachusetts Institute of Technology during and after the war.
At the time, weather forecasting was considered pretty simple stuff. Take enough inputs from today’s climate and you should be able to forecast tomorrow’s weather pretty closely. Simple, but not especially effective. And potentially deadly for an air force during times of war, even the “Cold” one which followed the armistices of 1945.
Lorenz thought that the linear approach was wrong, and started working on non-linear algorithms to forecast the weather from his new seat as a MIT professor. In the mid 1950s, he started to use an early computer – the Royal McBee LGP-30 – to help with the calculations. Its clock speed was 120 kHz, about 100,000 slower than an iPhone 5. It weighed 740 pounds. But it was better than doing thousands of calculations by hand.
To speed up the calculations of the many iterations required for his research, Lorenz truncated the number of decimal places for the inputs to his model. He then went back and added more detail to those same inputs – 2.212 became 2.212175 – to see if he got a more fine-tuned response. To his surprise, those little tweaks created very different outcomes in his models. Small changes to the “Base state” – today’s weather conditions, for example – could result in radically different expectations for the weather in just a few days time.
Lorenz published a paper on this phenomenon in 1963 – 50 years ago – titled “Deterministic Nonperiodic Flow.” Yeah, not a very catchy name… And according to a summary about the 50th anniversary of the paper in Physics Today, it garnered fewer than 20 citations in the dozen years after its publication.
Lorenz’s observations begin to catch real traction only in the mid-1970s, when a paper titled “Period Three Implies Chaos” (Li and Yorke, 1975) gave his ideas a catchy name and a new audience: mathematicians and physicists.

In 1972, Lorenz gave a talk which he titled “Predictability: Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?” This famous observation is almost as well-known as the term “Chaos Theory” itself, and serves to explain the basics of Lorenz’s discovery. Three quick points here:

Lorenz’s 1962 paper summarized his findings this way: “For those systems with bounded solutions, it is found that nonperiodic solutions are ordinarily unstable with respect to small modifications, so that slightly different initial states can evolve into considerably different states.”
He later summarize “Chaos” more concisely as “When the present determines the future, but the approximate present does not approximately determine the future.
In totally laymen’s language, Chaos Theory says that if you want to forecast the future you need to know everything about the present. And by “Everything” we mean all knowable characteristics of today, in infinite detail. Even if you have a great set of formulas in a comprehensive model about how those many variables interrelate, your predictions will run afoul of ‘Chaos’ – the ability of an overlooked (and typically small) characteristic of the starting point to have a large effect on the outcome.

In the world of economics and capital markets, Chaos Theory clearly resonates. The Financial Crisis of 2007-2008 and its follow-on travails all have the gentle flutter of the butterfly’s wings somewhere at their core. Small issues – a marginal residential development in Scottsdale, a deal by Greek monks for some Athenian commercial real estate – quickly cascade to become the tornado in Texas. Or New York, or London, for that matter.

What I find most striking is the current market psychology that seems to think all the butterflies are dead, or at least safely in their pupae. Observed volatility for stock prices, as measured by the S&P 500 Index, are trending lower over the last 10 and 20 days, even as the market itself reaches new highs. Implied volatility in options contracts are trending lower as well.

It not just the math of volatility that I find most puzzling, but the notion that central bank policy is all that matters to economic and market outcomes. I get the fact that the last few years have been humbling for everyone from risk-averse investors (who missed the move in risk assets) to policymakers who shovel liquidity into an economic system which still struggles to create jobs or growth. But it seems very much like commentators and market participants desperately want to believe the world behaves according to simply rules. “Just buy the equity market whose central bank has the largest bond buying program” is essentially the only piece of investment wisdom needed for the last 48 months. And counting…

I keep coming back to Lorenz’s statement that "The approximate present does not approximately determine the future." We know our approximate present very well, at least in the U.S.:

A slow growth economy
An accommodative central bank
Only one other large economy (Japan) with the appetite to follow our lead in buying large quantities of long dated bonds
A seemingly “Self sustaining” rally in stocks, where there is enough momentum to pull at least a few new buyers into the mix. And low enough interest rates to provide few alternatives to investors.

At the same time, Chaos Theory is clear: this does not approximately determine the future. There are more than enough variables out there – the butterflies flapping away – which can change outcomes. Don’t get me wrong – this is not meant to be a doom and gloom closing thought. If stock markets exhibited ‘normal’ volatility, it would be far easier to defend current price levels. You could leave the butterfly net at home. The problem is that current market price action –that slow steady grind higher – indicates marginal buyers don’t fret very much about the future. No matter how little we really know about it.

Additional Reading

Original 1963 paper: http://eaps4.mit.edu/research/Lorenz/Deterministic_63.pdf

50th Anniversary in Physics Today: http://www.physicstoday.org/resource/1/phtoad/v66/i5/p27_s1?bypassSSO=1

Chart Of The Day: S&P 500 vs EBITDA

Tyler Durden — Tue, 21 May 2013 18:58:33 GMT

When it comes to the corporate bottom line, there is a reason why the smart money has long since given up on Net Income, Earnings Per Share or any other such equity-specific variant: it is the one metric traditionally gamed by management teams who know that legacy investors and algos look solely at EPS (whether it has beat or missed expectations) in making kneejerk reactions whether to buy or sell stock upon an earnings release, thus setting the momentum tone for the next quarter. Instead, what fixed income investors, the buyside in general, and what little is left of "sophisticated" traders have historically focused on is EBITDA, and in some special cases, such as the New Normal, when the bulk of corporate cash goes to fund buybacks, EBITDA per share (to normalize for TEV changes over time). The reason is that EBITDA ignores such balance sheet components as net interest (a key reason why companies are reporting better than expected EPS in a collapsing interest rate environment), as well as the corporate tax rate. In short: EBITDA is the closest non-GAAP indicator to actual cash flow and/or bottom line profit as one can get.

Which is why we thought most readers would be rather surprised to learn what the result of a simple Bloomberg query comparing S&P500 EBITDA per share (BBG mnemonic TRAIL_12M_EBITDA_PER_SHARE) to the S&P looks like.

For one: not only is corporate LTM EBITDA per share not at all time highs (it is well off the record levels seen in 2008), but it is at levels last seen in January 2007.

But perhaps most surprising is what happens when on juxtaposes the S&P500's EBITDA level relative to the actual S&P. The stunning result is charted below:

If there is any good news in the chart above it is that EBITDA growth is still positive... Just barely. A chart showing the Year over Year change in LTM EBITDA shows the true story of the "recovery" - EBITDA per share growth, or true corporate bottom line growth, peaked in 2011, and has been declining ever since even as the actual number of shares has been collapsing due to the furious stock buyback activity everyone is well aware of.

At this rate we expect annual corporate cash flow growth to hit zero and turn negative in a few short months. We can't wait to see how this particular collapse in corporate fundamentals is spun roughly at the time the S&P is expected to hit 1750.

INTRoDuCiNG EURO CRiSiS CouTuRe 2013...

williambanzai7 — Tue, 21 May 2013 18:45:06 GMT

Goldman Confirms 'Recovery' Hopes Have Gone As 'Slowdown' Deepens

Tyler Durden — Tue, 21 May 2013 18:34:55 GMT

With US Macro no longer the clean dirty shirt, the 'hope' of a recovery from the Spring swoon has faded rather quickly according to Goldman's latest Global Leading Indicator (though obviously not David Kostin). The modest April pick up - driven mainly by sentiment indicators as opposed to hard data - has faded as the reality of economic deterioration was more pronounced as both the Philadelphia Fed headline and the New Orders less Inventories components (the advanced proxies for Goldman's Global PMI aggregate) fell to the lowest level in more than six months. The S&P GSCI Industrial Metals Index also made new lows and fell for the third month in a row. The CAD and AUD TWI Aggregates weakened, driven primarily by a weaker AUD, and US Initial Claims also worsened from last month. But apart from that... as Goldman notes, the decline in momentum was a bit more substantial in May than many had expected.

Goldman's Leading Indicator momentum (blue) suggests global industrial production's short-term pick up will fade rapidly...

as the Swirlogram indicates a deepening slowdown...

Of course, none of this matters, as the bank's 1750 PT for year-end S&P 500 seems to believe that H2 will be all good...

Charts: Goldman Sachs

Tuesday Humor: The Story So Far

Tyler Durden — Tue, 21 May 2013 18:02:36 GMT

Presented with no comment...

(h/t Monty Pelerin's World blog)

Is It Time To Buy Apple As A Valuation Play? The Contrarian That Called The Top In Apple Weighs In

Reggie Middleton — Tue, 21 May 2013 17:55:34 GMT

All who have followed me over the last three years know I've taken a very strong stance on the mobile computing wars, their prospective winners, losers and the benefits/pitfalls to be had from such intense competition. Outside of possibly Goldman Sachs , the most controversial, blindly beloved company that I've called a short on was Apple. Now that I think of it, Apple has Goldman beat hands down. After first warning of impending margin compression with 18 quarters of October 2010, I've been reviled by every fanboi this side of the Valley. Now, it's vogue to say #MarginCompression!

For those who are not the type to pay for analysis, the following video and graphic contains everything you'd ever want to know about Apple past, present and potentially future. For those of you who are willing to pay for quality analysis, I answer the question that should be on everyone's mind, "Is it time to now buy Apple as a deep value play?" After all, the move that I've warned about has came and gone, or has it. Subscribers, see download links at the bottom of this article.

Click the graphic once to view, twice to enlarge to printer quality...

Reggie Middletonss Ultimate Apple Value Infographic

Subscribers, download the Q3 2013 valuation reports (click here to subscribe).

The update from two months ago is also of value for those who haven't read it. It turns out that it was quite prescienct!

Farage Bashes Tax-Advantaged Hypocritical European Politicians

Tyler Durden — Tue, 21 May 2013 17:33:54 GMT

With Tim Cook being fried on Capitol Hill, it is perhaps ironic that the issue of taxes is front-and-center in the European parliament today. However, as usual, the always-willing-to-tell-the-truth Nigel Farage points out the gross hypocrisy of a political elite calling for higher taxes (on the wealthy and more broadly in peripheral nations) when the reality is that the higher-ups in the European parliament have their marginal tax rates capped at 12%. Of course, none of that matters because stocks are rising and interest rates are falling; but perhaps the 60% of Greek youth or 57% of Spanish youth, as we discussed here, might be intrigued at the new normal idea of 'fair share' in Europe.

And I hope that the taxpayers all over Europe listen to this. If we look at the EU officials who work for the European Commission and the European Parliament, the highest category [the most common grade is AD12] are people that earn a net take home pay of just over 100 thousand pounds a year. And yet under EU rules they pay tax of 12 per cent. It is tax fraud on an absolutely massive scale.

And Mr Barroso I would say to you, how can that be deemed to be fair? How can people out there struggling - the 16 million people unemployed in the eurozone - how can they look at these institutions, not only paying people vast sums of money but allowing them tax and pension benefits on a scale not seen anywhere else in the world? So I suggest we have a bit less of this high moral tone.

And what have these officials given us? Well, they were the architects of the euro, which is a complete disaster. Their obsession with global warming which chimes very strongly here means we are despoiling our landscapes and seascapes with these disgusting wind turbines and driving up energy prices.

Dudley Terrified By "Over-Reaction" To QE End, Says Fed Could Do "More Or Less" QE

Tyler Durden — Tue, 21 May 2013 17:12:39 GMT

Up until today, the narrative was one trying to explain how a soaring dollar was bullish for stocks. Until moments ago, when Bill Dudley spoke and managed to send not only the dollar lower, but the Dow Jones to a new high of 15,400 with the following soundbites.

DUDLEY: FED MAY NEED TO RETHINK BALANCE SHEET PATH, COMPOSITION
DUDLEY SAYS FISCAL DRAG TO U.S. ECONOMY IS `SIGNIFICANT'
DUDLEY: FED MAY AVOID SELLING MBS IN EARLY STAGE OF EXIT
DUDLEY: IMPORTANT TO SEE HOW WELL ECONOMY WEATHERS FISCAL DRAG

Here is a funny one:

DUDLEY SAYS HE CAN'T BE SURE IF NEXT QE MOVE WILL BE UP OR DOWN

Read "up." And the punchline:

DUDLEY SEES RISK INVESTORS COULD OVER-REACT TO 'NORMALIZATION'

Translated: the Fed will never do anything that could send stocks lower - like end QE - ever again, but for those confused here is a simpler translation: Moar.

Full Dudley speech:

Lessons at the Zero Bound: The Japanese and U.S. Experience

Remarks at the Japan Society, New York City

As prepared for delivery

It is a pleasure to have the opportunity to speak today at the Japan Society.1 Our countries have very close relations and this is particularly true at the central banker level. I just got back from the BIS last week where I had a chance to spend some time with Governor Kuroda.

Today, I will discuss the challenge that we both have been working to solve—how best to conduct monetary policy when short-term interest rates are already pinned close to zero, but the economy is still operating well below its potential. This has required considerable learning. After all, until Japan’s experience began in the 1990s, no major country had actually faced this problem since the Great Depression of the 1930s.

As the first nation to experience the zero bound in modern times, Japan was an early pioneer in developing unconventional tools and strategies. Its experiences, both good and bad, along with lessons from other periods such as the Great Depression, have helped to inform the policies adopted by the United States (U.S.) and other nations in recent years. The evolution of policy in Japan, in turn, has been informed, in part, by the experience of the U.S. and other nations.

So what have we learned to date? Let me highlight six key points.

First, and most importantly, managing expectations is critical in the execution of monetary policy at the zero bound. This includes expectations about the central bank’s objectives for inflation and the economy, and expectations about how the central bank will use its tools in the future to achieve these goals.

Second, in managing expectations, good communication is essential. Expectations will not be well anchored when communications are muddled or inconsistent, or when a central bank acts in ways that are not consistent with its guidance.

Third, actions speak louder than words alone. Thus, there is an important role for asset purchases that ease financial conditions to support growth and keep inflation expectations well anchored.

Fourth, the policy instruments interact so that policy as a whole exceeds the sum of its parts.

Fifth, at the zero lower bound, risk management becomes extremely important. In particular, because the costs of getting stuck in a liquidity trap with chronic deflation are high, a central bank should put substantial weight on avoiding this outcome.

Sixth, the constraints imposed by the zero bound limit what monetary policy can accomplish by itself. This increases the importance of complementary fiscal, financial, and structural policy actions. Credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth are very important.

As always, what I will say here today represents my own views and not necessarily those of the Federal Open Market Committee (FOMC, Committee) or the Federal Reserve System.

Review of the experience in Japan and the United States

Let me start by briefly reviewing the experience of Japan and the United States. As you all know, Japan’s rapid economic ascent and investment boom came to an abrupt halt in the early 1990s with the bursting of a gigantic bubble in equities and real estate.

Asset price deflation resulted in a huge decline in wealth. This led to a sharp fall in demand, a balance sheet squeeze for both businesses and households, and a large increase in problem loans for Japanese financial intermediaries. By some measures—such as the loss of wealth relative to the size of the economy—this was a bigger shock than the U.S. experienced in 2008. Growth slowed sharply and inflation fell.

The Bank of Japan (BoJ) responded by reducing overnight interest rates from a peak of more than 8 percent in early 1991 to ½ a percent by the fall of 1995.2 Most studies of this period suggest that policy was generally appropriate given economic forecasts at the time, but too tight relative to the actual outcomes.3 Economic forecasts for Japan—both by the official community and by private sector agents—were consistently more optimistic than the actual outturns. It is noteworthy that as late as January 1995—on the eve of deflation—10-year Japanese Government Bond (JGB) yields were still at 4.7 percent.

With the benefit of hindsight, we now understand that the disinflationary consequences of the asset price bust and financial stress where vastly more powerful than was widely realized at the time. As we later saw in the U.S., the forces of contraction and disinflation operated through many different channels—not just directly on household wealth, for example, but also through the impact of the asset price bust on the health of financial intermediaries and the supply of credit to households and businesses.

Over time, the Japanese banking system came under mounting stress. This was a slow-motion crisis, as the assets were mainly loans that were not marked-to-market. Accounting practices and regulatory forbearance allowed banks to delay charging off bad loans and recapitalizing at the cost of impairing the availability of credit to new potential borrowers. A full-blown banking crisis finally materialized in 1997. Although some banks were recapitalized in 1999, the full regulatory response took several more years.

The monetary and fiscal stimulus that was provided helped Japan avoid a deep recession. But expectations about future nominal income growth for both households and businesses ground lower over time. With inflation expectations sinking, inflation-adjusted real interest rates rose, and Japan became mired in deflation.

While deflation is ultimately a monetary phenomenon, structural elements were also important. Long-term demographic factors added to the deflationary pressures and structural rigidities, and credit supply problems constrained the reallocation of resources to growth sectors. These structural factors made it substantially more difficult to escape the deflation trap.

The Bank of Japan was active during this period. From the late 1990s onwards, it pioneered an extremely broad array of innovative tools—many of which were later adopted, in amended form, by the Fed and other major central banks. These included forward guidance on the future path of the policy rate, quantitative easing through purchases of government securities and private assets including asset-backed securities, equities and real estate investment trusts (REITs), a more quantitative inflation objective, and funding for bank lending.

From my perspective, Japan’s experience with forward guidance for the policy rate, asset purchases and a more formal inflation goal are particularly instructive, as this helped inform the later use of such tools in the United States.

In early 1999, the Bank of Japan said it would maintain its zero interest rate policy until “deflationary concerns” were “dispelled.” This commitment was lifted in August 2000, and the BoJ raised the policy rate by a quarter-point. However, the BoJ was subsequently obliged to reverse course, and reintroduced forward guidance in March 2001. This guidance was tied to the realization of a new inflation objective.

With deflation intensifying, the Bank of Japan embarked on a quantitative easing (QE) program in 2001 designed to increase the size of the monetary base. The Bank of Japan engaged in purchases of JGBs that were large in scale, but confined to short-dated maturities. This reflected a view that such purchases primarily acted through the liabilities side of the central bank's balance sheet—pushing up the amount of reserves in the banking system. Because the growth of the monetary base was deemed the goal of policy, it was logical to purchase short-dated assets, which could be allowed to run off once a sustainable recovery was in place.

The downside of this approach was that the purchases did not change the composition of the private sector’s balance sheet very much because the policy essentially resulted in the exchange of one short-term risk-free asset for another. As a consequence, the purchases had only modest direct effects on financial conditions.4

Starting in 2006, when the initial wave of QE ended, the BoJ began to formalize its inflation goal in numerical terms. This was initially expressed as an “understanding of medium- to long-term price stability” based on individual policymakers’ views. The inflation objective went through several iterations before being defined in 2012 as a Committee “goal” of a positive range of 2 percent or lower, with a lower interim goal of 1 percent.

Following the onset of the global financial crisis in 2007-2008, Japan resumed QE, and gradually tightened the link between its policy actions and its objectives. By January 2012, the BoJ had committed to keep rates at the zero bound and to continue purchasing assets until the 1 percent goal was “in sight.”

Several prominent Japanese experts have argued that there was a “start-stop” aspect to monetary policy during the 1990s and 2000s with reversals in policy beginning before deflationary expectations were eliminated.5 Fiscal policy also reversed abruptly on several occasions before economic recovery was firmly established. While Japan did enjoy a period of respectable real per capita growth in the mid-2000s, escape from deflation proved elusive.

More than a decade after Japan’s bubble burst, the U.S. housing bubble burst. This exposed extensive vulnerabilities in our financial system and triggered a global financial crisis.6 Unlike Japan, we had the advantage of being able to learn from another nation’s recent experience. We applied what we understood to be the lessons from Japan, though with hindsight, perhaps not in every respect as completely as we could have.

In particular, Japan’s experience reinforced the lessons of the Great Depression here in the U.S. and made us sensitive to the disinflationary force of an asset price bust and financial crisis. We recognized that we had to be very aggressive to prevent deflation and deflation expectations from becoming well entrenched.

The Federal Reserve reduced short-term interest rates to nearly zero by late 2008—a little over a year and a half after the initial shock hit in August 2007. Immediately upon reaching the zero bound, we provided additional stimulus by expanding our balance sheet and deploying forward guidance on the policy rate. These actions, in the context of a strong commitment to both our inflation and employment mandates, succeeded in preventing deflation expectations from taking hold, even though real outcomes were disappointing. We also took steps to formalize our 2 percent inflation objective.7

The Fed’s large-scale asset purchase programs differed from those originally undertaken in Japan both in theory and in practice. They were concentrated in longer-term securities—Treasuries and agency mortgage-backed securities. This reflected a different perspective on how purchases affect financial conditions and the economy, as well as the different structure of our financial system.

Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand. The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct—not the goal—of these actions.

The U.S. also moved relatively quickly to recapitalize core financial institutions—partly as a result of good judgment, but also because the intense pressures of a capital markets-based financial system forced us to confront these issues. The Supervisory Capital Assessment Program (SCAP) in early 2009 identified and addressed the potential capital shortfalls of the major U.S. bank holding companies in a stressed scenario. The SCAP forced the banks to recapitalize either through the use of private funds or the injection of government convertible preferred equity from the TARP program.

However, our policy approach was far from perfect. Comparing actual growth to the growth projections by FOMC participants in the Summary of Economic Projections shows that we were consistently too optimistic about growth over the 2009-2012 period. As a result, with the benefit of hindsight, we did not provide enough stimulus. Perhaps, if we had paid more attention to the persistent divergence between growth forecasts and outturns in Japan in the 1990s, we might have been more skeptical about the prospects for a strong economic recovery, even with a more aggressive monetary policy regime.

Also, we could have done better in communicating our intentions and goals. We put too much emphasis, too early, on the exit. At an earlier stage, we should have put greater emphasis on our commitment to use all our tools to the fullest extent possible for as long as needed to achieve our dual mandate objectives.

Our policies also had a “start-stop” aspect to them that may have undercut their effectiveness. For example, until September 2012, our large-scale asset programs generally specified the total size of the program, with a purchase rate and an expected ending date. This created a void when the programs ended and made our policy response sporadic and hard to forecast. This limited the scope for market prices to adjust in anticipation of our future actions in ways that would help stabilize the economy.

Another shortcoming was in our use of forward guidance with respect to the path of short-term interest rates. Although calendar-based guidance worked reasonably well in influencing expectations about the future path of short-term rates and thus the shape of the yield curve, it was clumsy in a number of respects. For example, if we moved the forward date guidance out in time, did this reflect a change in our reaction function, the amount of desired policy stimulus or greater pessimism about the outlook?

Of course, as we have learned, we have acted to rectify these shortcomings. For example, our asset purchases are now outcome based, tied to the goal of substantial improvement in the labor market outlook, and our forward guidance on short-term rates is tied to unemployment and inflation thresholds rather than to a calendar date.

The Japanese authorities have also capitalized on our joint experiences and actions. Thus, we have witnessed a convergence in the monetary policy regimes of our two countries.

Today, the two regimes are quite similar in three important respects. Both the Fed and the Bank of Japan place considerable emphasis on an explicit inflation objective, commit the central bank to use all available tools to achieve its objectives, and use forward guidance on interest rates and large scale purchases of long duration assets as the main tools to achieve these objectives.

Although there are still some important distinctions in how policy is conducted, much of these relate more to differences in legal frameworks and the current starting point for economic activity and inflation rather than fundamental differences in philosophy. For example, the BoJ’s asset purchases are broader than the Fed’s, extending to equity ETFs (Exchange Traded Funds) and REITs. This option is not available to the Federal Reserve because the Federal Reserve Act sets tighter limits as to the types of assets that the Federal Reserve can purchase.

Similarly, current circumstances in the two countries are different, with deflationary expectations still in the process of being dislodged in Japan. The BoJ needs to push up inflation expectations, whereas in the U.S. the current level of inflation expectations is consistent with the long-term objective of the Fed. Therefore, the BoJ, relative to the respective sizes of the two economies, has adopted a purchase program that is more aggressive that the U.S. program. This is true whether measured in terms of the amount of duration being pulled out of the market or purchases as a share of total issuance.

Lessons learned

As I mentioned earlier, there have been at least six major areas where there has been significant learning, which has influenced the evolution of policy. Let me turn to them.

The importance of managing expectations

Managing expectations is always central to monetary policy. However, at the zero bound this is even more critical than usual.

There are two aspects of this. First, keeping inflation expectations anchored at levels consistent with the central bank’s medium-term inflation objective—2 percent on the personal consumption expenditures deflator in our case—is vitally important. Once deflation expectations become well entrenched, it is very difficult to change them. And, because inflationary expectations are an important driver of actual inflation outcomes, deflationary expectations can be self-fulfilling in driving actual deflation outcomes. Also, if inflation expectations were allowed to fall, this would raise the level of expected real interest rates, making monetary policy less accommodative.

Conversely, a central bank does not want medium-term inflation expectations to climb above levels consistent with its inflation objective. If inflation expectations were to become unanchored to the upside, that could damage credibility and result in higher risk premia for financial assets and tighter financial market conditions. Thus, a policy that maintains medium-term inflation expectations in line with our inflation objective is most consistent with our mandate.8

Second, at the zero bound, the ability to provide credible forward guidance—both in terms of the future path of the policy rate and the future path of the balance sheet— becomes the predominant vehicle by which a central bank’s actions affect financial market conditions. If this expectations channel did not work, then it would be very difficult to provide additional monetary accommodation because short-term rates cannot be reduced materially.

In the U.S., in recent months we have communicated that short-term rates are likely to stay very low for a long time; our balance sheet is likely to increase further in size and then stay large for a long time; and that we will not be overly hasty in tightening monetary policy once the recovery gets well established. By doing this, we are influencing expectations about the likely future path of short-term rates and the interest rate term premium. By utilizing the expectations channel in this way, we have been able to make policy more accommodative and generate easier financial market conditions.

Good communication is essential

To manage expectations well, both credibility and good communication is essential. This means explaining clearly the policy framework, the relationship between the use of tools and the central bank’s mandated objectives at the zero bound, and how the use of these tools will evolve with changes in the outlook.

In this regard, a central bank’s credibility is crucial. Only if a central bank does what it promises to do will expectations be solidly anchored. Of course, this does not mean mechanically following a set policy trajectory regardless of how the outlook changes, but it does mean that the stance of policy over time must evolve in ways consistent with the criteria established in the guidance.

It is important to communicate how policy will respond to changing economic circumstances over time. This is particularly important when the outlook changes, because expectations about how policy will respond can be an important self-stabilizing element of monetary policy. In this regard, a framework that ties the use of policy tools explicitly to economic outcomes has many advantages.

Good public communication is also important. For example, press conferences offer an opportunity to ground the policy actions and stance in a framework that is explicit about how the central bank plans to achieve its mandated objectives.

Asset purchases are an effective tool

Credibility requires taking action in the present as well as providing guidance for the future, and we are fortunate to have learned that asset purchases can indeed be an effective tool to support growth, employment and inflation expectations at the zero bound. While I believe that managing expectations is crucial, I am somewhat skeptical of the view that forward guidance on the policy rate alone is sufficient in these circumstances. This is particularly the case when guidance extends out several years in the future. Promises about future actions may be seen as not fully credible given the potential for changes in a central bank’s leadership and policy committee and the degree of uncertainty about economic conditions that will prevail far out in the future.

In recent years, we have developed considerable positive experience providing accommodation through changes in the size and composition of the central bank balance sheet. Taking interest rate risk and mortgage prepayment risk out of private hands has proven to be effective in easing financial conditions, increasing wealth and lowering private sector borrowing costs.9 The impact of purchases may be attenuated to some degree by deleveraging and ongoing adjustments in markets such as real estate. But it is material even in these circumstances, and builds over time as these needed adjustments proceed.

The sum is greater than its parts

Another important insight is that each of the components of policy—the current stance in terms of the policy rate and the balance sheet, expectations about the future stance, the degree of commitment to future policy, and the clarity of communications—all interact. Our tools are more powerful used in combination, and, when their use is explicitly tied to the outcomes we seek to achieve. As a result, the sum is more powerful than the component parts.

Risk management is particularly important

Risk management is particularly important at the zero bound. At the zero lower bound, once you are caught in deflation, it is very hard to get out. Thus, policymakers need to put considerable weight on this risk and conduct monetary policy with sufficient aggressiveness to ensure that they avoid such an outcome.

It is also true that we have less experience with the monetary policy tools used at the zero bound. As a result, there is greater uncertainty around the efficacy and costs of these tools. This pushes in the opposite direction of being more cautious.

This means that risk management is essential—what are the costs of being wrong in either direction? Sometimes a cautious, incremental approach may not always be the right strategy.

Limits to monetary policy

At the zero bound, monetary policy encounters additional constraints. These fall into three broad buckets.

First, there are costs associated with non-conventional tools. This means they cannot simply be used without limit, though the appropriate limit will vary based on the outlook and balance of risks. The most obvious example of this is our large-scale asset purchase program. As the balance sheet increases in size, the potential costs increase in terms of market functioning, risks to financial stability, and the path of future remittances to the U.S. Treasury.

Second, there is a limit on how far the expectations channel can be exploited. As I discussed earlier, since the current FOMC cannot bind future FOMCs and the economic outlook is highly uncertain, it isn’t reasonable to expect that policies that affect expectations many years in the future will have a powerful impact today. I believe that the effectiveness of the expectations channel decays as the length of the horizon extends.

Third, monetary policy is only one leg of the stool necessary to generate a vibrant and sustained economic expansion. In particular, as noted earlier, the health of the financial system is critical. For without it, the monetary transmission channels will be impaired and monetary policy will be less effective in influencing the cost and availability of credit. Similarly, it is critical that fiscal policy be set appropriately. This means the short-term impulse needs to be properly calibrated to the current set of economic circumstances (not too much restraint) and the long-run budget trajectory needs to credible and consistent with fiscal sustainability. Finally, removing structural impediments that hinder growth and economic rebalancing are also important. In the case of the U.S., this could include changes in immigration policy, infrastructure investments that remove bottlenecks and job training programs that improve the quality of human capital.

Implications for U.S. monetary policy

Undoubtedly, we will continue to learn as we seek to implement monetary policy most effectively.

Let me give a few examples of how my own thinking may evolve. In terms of our asset purchase program, I believe we should be prepared to adjust the total amount of purchases to that needed to deliver a substantial improvement in the labor market outlook in the context of price stability. In doing this, we might adjust the pace of purchases up or down as the labor market and inflation outlook changes in a material way. For me, the base case forecast is not the sole consideration—how confident we are about that outcome is also important.

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

We are also learning about how best to prepare for the eventual normalization of monetary policy. For example, we may need to update our thinking with respect to the so-called exit principles that we published in June 2011 in order to bring them up to date with developments since then, and ensure they do not unnecessarily constrain our ability to conduct policy in the most effective way today.

Those exit principles stated that we would first stop reinvesting, then raise short-term interest rates, and finally sell agency mortgage backed securities over a three-to-five year period. This seems stale in several respects. In particular, how does one time the end of reinvestment given that we now have economic thresholds that govern the timing of liftoff? Also, the thresholds are thresholds, not triggers. Thus it is hard to link the timing of the end of reinvestment to the unknown liftoff date for short-term rates.

More broadly, it may be desirable to update our thinking around the path and composition of the balance sheet over time, in light of our capacity to shape this path in a way that mitigates potential costs and risks. For example, the agency MBS portfolio is substantially larger today than it was when the original exit principles were devised. To the extent that the Committee wants to reduce the risk of disrupting market functioning during normalization, it could decide to indicate that it will avoid selling the MBS portfolio during the early stages of the normalization process. Moreover, to the extent that the Committee wants to mitigate the risk of a sharp increase in long-term rates, it could judge that it would prefer not to commit to agency MBS sales. Expectations about future MBS sales or actual sales have the potential to generate or amplify such an upward spike in long-term rates. If the Committee believes that it could be costly in terms of credibility to incur a period of no remittances to Treasury—a notion I am personally somewhat skeptical about—avoiding MBS sales would also reduce this risk. Indeed, the Committee might conclude that it was better on all three counts to allow the agency MBS securities to run off passively over time.10

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire. There is a risk is that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month.11 Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.12

Based on what we have learned to date at the zero bound, I believe that it will be important for us to anchor all our communication around the core principle: The path of the policy rate and the size and composition of the balance sheet over time will be driven by our unbending commitment to our dual mandate objectives of maximum sustainable employment in the context of price stability. [ZH: also known as sending the S&P500 and the Russell 2000 to new daily highs every day until the end]

As you can see, there will be much more to learn as we go. Thank you for your kind attention. I would be happy to take a few questions.

Germany Fires Live Ammo In Sino-European Trade War ... At Brussels

testosteronepit — Tue, 21 May 2013 17:10:57 GMT

Wolf Richter www.testosteronepit.com www.amazon.com/author/wolfrichter

The solar-panel industry, once fattened by taxpayer subsidies and false hopes, has been in a death spiral around the world. In the US, a slew of photovoltaic standouts like Solyndra went under, taking billions of subsidies and investor capital with them. In Germany, it has been just as brutal. Even large companies are licking their wounds.

Bosch Solar Energy AG will shut down production early next year, after having burned through €2.4 billion; 3,000 jobs are at risk. Siemens is trying to shed its solar units, if it can find a buyer. Victims of Chinese companies that flooded world markets with cheap solar panels. But even Chinese companies are going bankrupt, including one of the big four, Wuxi Suntech, subsidiary of US-listed Suntech Power.

Companies in the US and Europe complained about these cheap imports, and anti-dumping proceedings were initiated. In Europe, it started last summer. And last week, reports surfaced that the European Commission was ready to act. On June 5th, if no solution materialized, the Commission would slap Chinese-made solar panels, cells, and wafers with punitive import duties of on average 47%.

It was part of the Commission’s campaign to defend the sacred European soil against cheap imports of all kinds – despite the EU’s widening trade surplus (€22.9 billion in March). It has already initiated 31 trade investigations, 18 against China alone. Last week, the Commission fired another shot, launching an investigation into anti-competitive behavior by Chinese telecom equipment makers Huawei and ZTE, China’s high-tech crown jewels. But the 47% punitive duties on solar panels were the harshest measure yet in the trade war, hitting €21 billion worth of Chinese imports.

China accused the EU of protectionism. It “would seriously harm China-Europe trade relations,” Ministry of Commerce spokesman Shen Danyang said at a news conference. “Provoking trade friction with China” would be like “dropping a boulder on one’s own foot”; it certainly wouldn’t help Europe escape from its economic crisis, he said ominously.

Even Greek Prime Minister Antonis Samaras, who happened to be in Beijing, was drawn into the fray when Chinese Premier Li Keqiang asked him to stop the EU’s protectionist attacks.

While Samaras may not be much of a factor, Germany is. And it has been lining up the big guns. But they’re not directed at China, though German solar-panel makers suffered perhaps the most from Chinese competition. They were effectively silenced by Germany Inc., which is now furiously firing round after round – at Brussels.

On Sunday, it was German Economy Minister Philipp Rösler, who warned of a trade war with China and lambasted the European Commission for its decision to start an anti-dumping procedure against Chinese telecom equipment makers. A “grave mistake,” he called it. And punitive duties against Chinese solar makers where “the wrong instrument,” he said. “The German industry is deeply worried, and rightly so.” The Commission must do “everything” to prevent an escalation of the trade war. It “must rely on a negotiated solution and dialogue, not on threats,” he said.

Even pretexts are good, for example when Anton Börner, president of the Federation of German Wholesale, Foreign Trade and Services (BGA), claimed to be worried about thousands of jobs in the industry of PV panel installers, which might be pushed out of existence by higher panel prices. But Germany Inc. isn’t worried about panel installers. It’s worried about exports!

Börner acknowledge that: German equipment manufacturers whose technologies are used in the production of solar panels in China would be harmed. And he was worried about a further escalation and broadening of the trade war. “Other industries must now tremble,” he said.

Ulrich Grillo, president of the Federation of German Industries (BDI), admonished the Commission to exhaust “all options to find a negotiated solution” before launching anti-dumping cases against China. “German industry with its high proportion of exports is dependent on open markets.”

That’s the European dilemma. With many countries mired in recession, and some sinking into depression-like conditions, the Commission wants to protect certain industries. While it can’t protect Spanish companies from German competition, it can protect them from Chinese competition. Given how much German solar-panel makers have suffered under Chinese pressure, and how many billions in subsidies and investments have gone up in smoke, the Commission might have counted on German support.

But for Germany Inc., China is one of the two big economic engines that are still pulling. Exports to the Eurozone, particularly to top trade partner France, have stalled, and the industry is looking to China for growth. Chinese money is also flowing into Germany as Chinese companies are on a shopping spree, paying top euros for 98 firms in 2012, including Putzmeister, a world brand for concrete pumps [my article on the aftermath]. Germany Inc. sees in China an escape route from the economic mayhem of the Eurozone; it sees a booming market with over twice the population of the EU. For Germany Inc., China is the future – and Europe a drag. One more treacherous rift across Europe.

And here is my interview with Voice of Russia. Read..... ‘ECB’s Desperation Is Taking On Epic Dimensions’

Latest Stolper Fiasco: Goldman Stopped Out On Long EURHUF, 2.86% Loss In One Month

Tyler Durden — Tue, 21 May 2013 17:01:54 GMT

Curious how to trade those Goldman recommendations, such as today's uberbullish "strategic" call seeing nothing but blue skies all the way through 2015? Here is a quick reminder courtesy of your friendly FX wizard, Goldman's Tom Stolper.

Trade Update: Close Long EUR/HUF Recommendation after stop is hit

On April 18 we recommended going long EUR/HUF. Our view has been that higher US yields would hurt a number of EM currencies (including the HUF). We also thought that ongoing monetary easing in Hungary would further compress interest rate differentials, leading to a gradual weakening in the currency. Although both macro drivers materialized, the HUF strengthened, contrary to our expectation.

We clearly underestimated the degree of risk premium for weaker economic outcomes already embedded in the currency. In the short life of the recommendation, a number of positive catalysts have emerged, including a strong GDP print and a smooth outcome in the ongoing budget negotiations with the EU.

Our broader fundamental view has not changed, but having just hit our recommended stop of 290, we recommend closing the position with a potential 2.86% loss (including negative carry of about 32bp in total).

If there is still any confusion: do what Goldman does (i.e., trade against its client), not what Goldman says.

Guest Post: Centralization And Sociopathology

Tyler Durden — Tue, 21 May 2013 16:31:28 GMT

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Concentrated power and wealth are intrinsically sociopathological by their very nature.

I have long spoken of the dangers inherent to centralization of power and the extreme concentrations of wealth centralization inevitably creates.

The Master Narrative Nobody Dares Admit: Centralization Has Failed (June 21, 2012)

The Solution to Concentrated Power: Decentralize, Diffuse and Devolve Power (June 22, 2012)

To Fix Healthcare, Let 100 Solutions Bloom (February 26, 2013)

Longtime contributor C.D. recently highlighted another danger of centralization: sociopaths/psychopaths excel in organizations that centralize power, and their ability to flatter, browbeat and manipulate others greases their climb to the top.

In effect, centralization is tailor-made for sociopaths gaining power. Sociopaths seek power over others, and centralization gives them the perfect avenue to control over millions or even entire nations.

Even worse (from the view of non-sociopaths), their perverse abilities are tailor-made for excelling in office and national politics via ruthless elimination of rivals and enemies and grandiose appeals to national greatness, ideological purity, etc.

As C.D. points out, the ultimate protection against sociopathology is to minimize the power held in any one agency, organization or institution:

After you watch these films on psychopaths, I think you'll have an even greater understanding of why your premise of centralization is a key problem of our society. The first film points out that psychopaths generally thrive in the corporate/government top-down organization (I have seen it happen in my agency, unfortunately) and that when they come to power, their values (or lack thereof) tend to pervade the organization to varying degrees. In some cases, they end up creating secondary psychopaths which is kind of like a spiritual/moral disease that infects people.

If we are to believe the premise in the film that there are always psychopaths among us in small numbers, it follows then that we must limit the power of any one institution, whether it's private or public, so that the damage created by psychopaths is limited.

It is very difficult for many people to fathom that there are people in our society that are that evil, for lack of a better term, and it is even harder for many people in society to accept that people in the higher strata of our society can exhibit these dangerous traits.

The same goes for criminal behavior. From my studies, it's pretty clear that criminality is fairly constant throughout the different levels of our society and yet, it is the lower classes that are subjected to more scrutiny by law enforcement. The disparity between blue collar and white collar crime is pretty evident when one looks at arrests and sentencing. The total lack of effective enforcement against politically connected banks over the last few years is astounding to me and it sets a dangerous precedent. Corruption and psychopathy go hand in hand.

A less dark reason for avoiding over centralization is that we have to be aware of normal human fallibility. Nobody possesses enough information, experience, ability, lack of bias, etc. to always make the right decisions.

Defense Against the Psychopath (video, 37 minutes; the many photos of political, religious and secular leaders will likely offend many/most; if you look past these outrages, there is useful information here)

The Sociopath Next Door (video, 37 minutes)

As C.D. observes, once sociopaths rule an organization or nation, they create a zombie army of secondary sociopaths beneath them as those who resist are undermined, banished, fired or exterminated. If there is any lesson to be drawn from Iraq, it is how a single sociopath can completely undermine and destroy civil society by empowering secondary sociopaths and eliminating or marginalizing anyone who dares to cling to their humanity, conscience and independence.

"Going along to get along" breeds passive acceptance of sociopathology as "the new normal" and mimicry of the values and techniques of sociopathology as the ambitious and fearful (i.e. almost everyone) scramble to emulate the "successful" leadership.

Organizations can be perverted into institutionalizing sociopathology via sociopathological goals and rules of conduct. Make the metric of success in war a body count of dead "enemy combatants" and you'll soon have dead civilians stacked like cordwood as proof of every units' outstanding success.

Make lowering unemployment the acme of policy success and soon every agency will be gaming and manipulating data to reach that metric of success. Make higher grades the metric of academic success and soon every kid is getting a gold star and an A or B.

Centralization has another dark side: those ensconced in highly concentrated centers of power (for example, The White House) are in another world, and they find it increasingly easy to become isolated from the larger context and to slip into reliance on sycophants, toadies (i.e. budding secondary sociopaths) and "experts" (i.e. apparatchiks and factotums) who are equally influenced by the intense "high" of concentrated power/wealth.

Increasingly out of touch with those outside the circle of power, those within the circle slide into a belief in the superiority of their knowledge, skills and awareness--the very definition of sociopathology.

Even worse (if that is possible), the incestuous nature of the tight circle of power breeds a uniformity of opinion and ideology that creates a feedback loop that marginalizes dissenters and those with open minds. Dissenters are soon dismissed--"not a team player"-- or trotted out for PR purposes, i.e. as evidence the administration maintains ties to the outside world.

Those few dissenters who resist the siren song of power soon face a choice: either quietly quit "to pursue other opportunities" (the easy way out) or quit in a blast of public refutation of the administration's policies.

Public dissenters are quickly crucified by those in power, and knowing this fate awaits any dissenter places a powerful disincentive on "going public" about the sociopathology of the inner circle of power.

On rare occasions, an insider has the courage and talent to secure documentation that details the sociopathology of a policy, agency or administration (for example, Daniel Ellsberg and The Pentagon Papers).

Nothing infuriates a sociopath or a sociopathological organization more than the exposure of their sociopathology, and so those in power will stop at nothing to silence, discredit, criminalize or eliminate the heroic whistleblower.

In these ways, centralized power is itself is a sociopathologizing force. We cannot understand the present devolution of our civil society, economy and ethics unless we understand that concentrated power and wealth are intrinsically sociopathological by their very nature.

The solution: a culture of decentralization, transparency and open competition, what I call the DATA model (Decentralized, Adaptive, Transparent and Accountable) in my book Why Things Are Falling Apart and What We Can Do About It.

Herbalife Hires PWC As New Accountant; Will Reaudit 2010, 2011 And 2012

Tyler Durden — Tue, 21 May 2013 16:13:44 GMT

Following the dismissal of KPMG over insider trading 'issues', Herbalife has just announced it will be hiring PricewaterhouseCoopers as their new auditor:

*HERBALIFE HIRES PRICEWATERHOUSECOOPERS :HLF US
*HERBALIFE SAYS PWC TO RE-AUDIT FY10, FY11, FY12 :HLF US

Indications point to a modest rise from the pre-halt close of $49.87.

Full Press Release below:

Herbalife Engages PricewaterhouseCoopers LLP As Auditors

May 21, 2013, LOS ANGELES—(BUSINESS WIRE)— Herbalife Ltd. (NYSE:HLF), today filed a Form 8-K indicating that the Audit Committee of its Board of Directors has engaged PricewaterhouseCoopers LLP (“PwC”) as the Company’s independent auditors. PwC will commence work immediately to re-audit the Company’s consolidated financial statements for the fiscal years ended December 31, 2010, 2011 and 2012. PwC will also review the Company’s condensed consolidated financial statements for the first quarter of 2013. The engagement of PwC was made after an extensive evaluation process by the Company’s Audit Committee.

As previously announced, the change in auditors was the result of KPMG LLP’s (“KPMG”) resignation as Herbalife’s independent auditors, due to the impairment of KPMG’s independence resulting from its now former partner’s alleged unlawful activities. As stated by KPMG, their resignation was not related to Herbalife’s financial statements, its accounting practices, the integrity of Herbalife’s management, or for any other reason.

“We are very pleased to have engaged PwC to serve as the Company’s independent auditor. They will begin work immediately to re-audit the Company’s December 31, 2010, 2011 and 2012 consolidated financial statements. Investors should rest assured that the Company will be working to assist PwC in any way necessary to facilitate their work,” said the chairman of Herbalife’s audit committee Leroy Barnes.