Saturday, April 16, 2011

Swan Dive...the real picture...Bonds versus Equities...Debt versus Cash

What people, even the smartest in the room, fail to understand about money is that it does not act the way that one would think it would. By its nature it is highly counter intuitive mostly because money plays on our weakest traits and strongest compulsions - it is designed by human frailty to manipulate human frailty. So, its a very hard subject to rationalise.

In a collapse the weakest securities get increased distribution and the most conservative get increased demand. That is what we see here. When the equity market sells-off, yields for the 30 year bonds generally have done so as well. However, when the market crashes or people become disoriented then yields on treasuries totally collapse. During the last several years we have had a steady longer-term trend in the 30 year bond. It is yielding less and less. Even though the QE effort resulted in the yield increase that we see starting in October last year. It is counter-intuitive to most people that this could happen as the program was designed to supposedly lower rates...and Bernanke attested to QE efficacy and success previously for lowering rates. Well, I guess Bernanke does not understand either.

However, we stand at the precipice. Apparently, a precipice that most people do not understand. Today for example, Citibank's FX team came out with an analysis that said that if the debt ceiling were not raised the dollar would collapse. That deduction, on its face, is such a great example of why one should discount any analysis from a big firm. If the debt ceiling is not raised, the government will not be able to issue new debt and that will dramatically curtail the supply of new dollars required to keep our system going. It will result in a stronger dollar NOT a weaker one. These guys actually make the money and don't have a clue, or atleast, pretend they don't. Its clear by their track record that banks like Citi do not know much about managing finances or running a business successfully...their thinking on the debt ceiling represents a ridiculous misunderstanding of how currency systems work and how the financial system revolves around those currencies.

Just look at Japan, their credit and economic risk were pounded by the earthquake and Tsunami and the result was a dramatic strengthening of the Yen. Who in their right mind was lining up to lend Japan money immediately after the earthquake? Not many people, and that's one of the reasons their currency went wacko and nearly bankrupted all the carry trading desks. In the end, the inability of the US to issue and pay its creditors will result in a similar condition as Japan - a shortage of dollars and therefore a very strong demand for them. Remember, without credit there is NO MONEY. Therefore, if the government can not issue credit, its currency will become scarce and expensive. Also, keep in mind that Gold and Silver are really assets in our current system - not currencies and will ultimately suffer the fate of most assets if this were to occur. Much of the disconnected price behaviour in inflation asset and commodities markets is being driven by the non-velocity character of the credit being created by the Fed. This credit is not making it into the economy and intead is getting stuck in pockets what bankers believe are safer and more liquid markets than normal lending or investment creating bifurcated price inflation...So much credit driven buying of markets has been generated by the Fed, that huge mallinvestments have once again been triggered. Not only has the irresponsible and uneven distribution of credit been damaging rather than stimulative, but the results will cause considerably more damage. This is just like in many of the sovereign situations that we have seen historically and are currently seeing throughout the world. Reduced debt issuance or capability = stronger currency.

Tonight's exercise is an explanation of what is happening and why PIMCO and a very many others seem like they are going to have to learn a lesson the very very hard way.

Lets look at the inflationary process starting from the beginning:
  1. Banks issue credit (creates money)
  2. Borrowers buy assets (spends money)
  3. Borrowers pay-off the new credit via the use of  larger and new credit from a bank, this can be direct or in the borrwer being paid by another borrower with more available credit. (creates more money)
  4. Borrowers use surplus credit to pay interest and buy more assets rather than pay full principle off (creates higher prices, depreciates buying power of currency)
The importance in the process is to understand that governments have been very keen on this credit process for years and absolutely rely on rolling over or restructuring credit with new credit. This process has not been lost on the people the government serves or the banks to which the government report. Society has routinely gotten in the practice of paying off one credit or worse one creditor payment with credit from another facility. And now banks simply ignore their responsibilities regarding reserves and have figured out how to issue credit on credit on credit using fractional reserve without the reserve. So, what we have is a huge abundance of credit and very little cash. Further compounding the "availability of cash" problem is that this system only creates new princple - not the money to repay interest. The result is a system that must rely on the concept of "the greater fool" in order to function. Clearly, our central planners do not understand an exponential extrapolation and how it works in real world scenarios.

When a debtor borrows or pays off credit with new credit we usually get credit expansion - inflation. When borrowers can no longer get new credit they are forced to pay off the credit or default and must sell assets as necessary - in this case, we get credit contraction or deflation. So, using this analysis we can see that higher prices are not necessary for inflation but are often a symptom or characteristic of inflation and similarly lower prices are not required for deflation - credit and monetary contraction is what is required - and lower prices are generally a symptom of contraction in credit and money.

So, where are we now? Well, from all the pundits and media, apparently we are expecting a dollar collapse and higher rates. Everyone thinks rates are going up! Everyone thinks that the dollar is going down. But lets look at our example a little bit further. Lets look at the deflationary process:
  1. Bank demands payment on maturing credit (money taken out of circulation)
  2. Borrower seeks to roll obligation into new credit but can not do so (new money not created)
  3. Bank revokes or suspend credit (destroys money)
  4. Borrower must raise capital, restructure or default on credit (unspends money)
  5. Raising capital must be done by selling valuable assets to an entity either with credit remaining or free cash available often at large discounts (new money is not created)
  6. Lower prices for assets trigger other banks to demand payment or collateral from other customers holding similar assets (money taken out of circulation)
  7. Borrowers must sell other assets to raise capital to settle obligations (unspend money)
The result of the exercise is this:
  • Abundance of credit = abundance of money and the pretense of cash.
  • A sustained collapse of available credit becomes a surge in the demand for cash.
  • A shortage of cash that is not callable by a creditor translates into lower prices for assets and higher ones for cash. 
Supposedly, higher interest rates should result in a stronger dollar. However, that is not really the larger cycle. The larger cycle is the Borrowers who need to settle maturing or bank demanded debt need access to cash that has not come from the credit spigot. 97% of the currency in our system has been created via the issuance of credit. It should be no surprise that the dollar has dropped in purchasing power by that same amount.

When a large amount of borrowers, especially sovereign ones, are forced to raise capital because they can no longer roll over debt the dancing has really, officially stopped though the music has stopped playing long before anyone decided to pay attention. When countries can not issue debt to settle previous debt, we have a dramatic of encumberment of cash that simple can not just be erased. There is a simple rule if there is a shortage of something that is in demand that thing will usually gain more purchasing power. That is the case here. Credit has continued to contract, available cash has also and expansion has not occurred. Unencumbered cash is in VERY short supply.

Lets discuss other dynamics. Since we know higher interest rates should result in a higher there anything else that could accomplish the same thing? And the answer is YES. If the ability of the US government to issue debt were constrained that could certainly result in higher interest rates - or would it?

Lets really examine what would likely happen if that were to occur. The government would be forced to into a cycle one step removed from the desperation of devaluation to create an environment where treasury rates would be forced to remain low by a collapsing credit system and collapse of valuable inflationary assets. By its nature this would not need to be an official effort by the government - it would happen regardless of official efforts due to the nature of credit and money. Asset sales in elevated markets funded by constrained credit will result in the fear trade. Even slight fear of valuations, over leveraged and broke institutions like JP Morgan and Citibank. Fear of guarantors at agencies like FDIC. Simple risk management will simply take capital away from assets supported by credit and its insurance to assets of a safer degree. This will also result in a stronger dollar simply because the collapse of credit, creates the inertia to drive this iterative cycle.

What I see in these charts is a hugely powerful rally in bonds that is nowhere near finished. What I see is a way for the government to continue to have access to extremely low rates and to be able to continue to issue new credit and ironically the reason is the fear of what happens when the government can not issue new credit. Fear will, ironically, drive people right into the very thing that they think they want to be furthest away from - US Treasuries. Our friends at PIMCO seem to be the sacrificial lamb here. There is always one in every major market cycle. Bear Stearn's and Lehman in the last one and now PIMCO. The fact that they are short 18% of their portfolio in US bonds puts them under dramatic pressure when they and all their copycat friends start to find out they are wrong. This will definitely intensify the market reaction and their predicament. Ultimately, no matter what happens, if the government can not issue new debt, then credit for everyone will be called, assets will be sold, prices will collapse, more credit will be called and people will be forced to be satisfied going into the safest available credit they can find - US Treasuries

That's what this chart says. That's what the under 5% dollar bulls say to me. That's what the VIX at 14 says to me. The government can not issue debt and desperately needs to have a way to do so. If sacrificing PIMCO, asset bubbles, jobs and banks may be required to accomplish the task - this chart says that is what is going to happen.
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