The Fed And DC's Next Move

I don't think many realize the complicated, twisted, interconnected situation we are in right now and figuring out how all of this plays out is beyond difficult.  A vast majority of those in risk assets right now have been conditioned for two years that you buy anything and just hold it.  Don't sell, don't buy protection, just sit on hands while fully invested. The longer this game goes on the smarter they feel.  They are truly oblivious to the world around them.

Anyone who has traded long enough knows the worst thing that can happen to you when starting out is to make money.  You begin to think things are easy and ignore the warning signs.  As Bill Fleckenstein says, "nonsense becomes knowledge."  Those who have not participated in this market or worse tried to short this market are frustrated beyond words right now.  We spend our days studying why the market is wrong and arguing with those who are "right."

I truly believe we have an amazing opportunity ahead of us.  The fiat currency based, debt fueled, rampant fraud financial system is near collapse.  The ponzi scheme has outlived its shelf life.  As investors, the opportunity is to make a lot money.  As a society, the opportunity is to reset our moral and financial compass.  Recession is a normal part of the economic cycle.  It is no different than a forest fire that results from excessive, unsustainable growth.  Not until the excess is removed, can new life form.

Depressions are to a society, what recessions are to an economy.  Talk to anyone from the great depression and you see someone who values money, hard work, the little they have in their lives.  Our society has lost its moral and financial compass.  We need a reset.  Since the 2008 financial crisis we have not removed the excess in our economy. Consumers have not learned how to live within their means.  We are literally using debt to pay debt.  We may have finally run out of a greater fool to hold up the system.

If you are in cash and not participating I think time is better spent understanding the world we truly live in.  I suspect in the not so distant future we will look back at this time as the quiet before the storm.  We know about the headwinds.  We know the banks are insolvent.  We know the economy is on life support.  The question is though, what course does the Fed and Federal government choose to take us on.  As hated as Bernanke is, he understands the tough choices facing him.  As political as DC is, they understand their endless budget deficit game is coming to an end.   Those in power do not go down without a fight, without deceit, without one last effort to hide the truth.  Every week we witness a different regime in the Middle East being brought down, yet their strategy to hold onto power is no different.

Gold and silver are the new flight to safety trade.  They have replaced the USD and possibly US Treasuries.  The Fed and Federal government must face the threat of losing reserve currency status and higher, uncontrollable interest rates beyond one year maturity.  The printing press cannot be removed.  Bernanke and DC are capable of anything to retain power.  Keynes believed "gold was a barbarous relic."  The demand for gold and silver is so strong that future markets are in historic backwardation.  The Comex is literally ready to blow up and JPM is massively short silver.

The Middle East is erupting right now.  Regimes are changing and the threat to oil, the fuel of the global economy is rising.  Every passing day countries are slowly moving military assets into the region.  The global economy will do all it can to protect the flow of oil.  Iran will not sit and watch the world move in while their own people revolt.  Al Qaeda is losing importance in the region and desperately wants another base to operate out of. Israel is facing renewed threats from Hamas and Hezbollah.

The US is experiencing its own revolution.  Although peaceful, that can change fast. Wisconsin was the beginning but protests have spread to other states.  The global revolution started in Tunisia and very quickly grew throughout the Middle East.  Never underestimate the power of those with nothing.  They will fight to the end for they have nothing else to lose.

China is fighting massive inflation and eventually another Tiananmen square.  Bernanke is exporting inflation and hoping that will pressure the Chinese to strengthen the RMB. Their choice is either high inflation or weaker growth.  Bernanke wants jobs back from China.

• If the Fed continues QE they risk pushing bond yields to unsustainable levels.  

• If the Fed ends QE, who will buy treasuries?  Ending QE will take pressure off China to revalue the RMB something neither Bernanke nor DC wants.

• If the Fed continues QE they will strengthen gold and silver which will put more pressure on those like JPM and on the future of the fiat currency system.  

• If Fed ends QE there will be no stimulus left for the economy and it will double dip just like it was going to last summer.

• If the Fed continues QE they will raise interest rates putting more pressure on bank balance sheets, on the 500 trillion interest rate derivative market and choke off what little demand is left in the economy.

• If the Fed ends QE they will no longer be able to inflate the US economy.

This post has become far too long as this is no easy question to be answered.  Do we see war in the Middle East?  Are gold and silver the best long term investments?  Will the global revolution move fast enough to stop more reckless moves by world leaders?  I'll leave you with Hank Paulson's quote about the 2008 financial crisis for comfort on our leaders ability to make the right decisions.


"We had no choice but to fly by the seat of our pants, making it up as we went along."

The Fed And DC's Next Move

Tuesday's Market

I've been a little quiet in the posting category.  I spent the entire weekend and then some editing code for a new site that will launch next week and expand upon the blog.  More to come on that in the following days.

Today's market action was nice to see for a change.  As always, down days have massive volume versus up days.  Anything is possible, and this market may set new highs in a few days again but the risk / reward is getting far more skewed to the risk side of the equation.

The bond market caught somewhat of a bid today but still is not showing any real bullish tendencies.  The 2 year auction today saw a bid to cover around 3.03 versus the 3.40 trend of late so that does not bode well for treasury demand, especially with the recent run up in yields.  The implications to risk sensitive assets (swaps, housing, CRE, etc) are huge and the Fed has to be careful how much they push future QE.

The USD is done, put a fork in it.  Precious metals are the new reserve currency, flight to safety.  I won't call them a flight to safety trade, because they really are not a trade. They are another form of currency.  When you go all cash in your trading account, that is not considered a trade, nor should owning precious metals.   Ever hear anyone talk about how their cash balance takes a hit when the USD is weak or rejoices when the USD is strong?  For some precious metals is a trading vehicle but for most it is a hedge against a dying fiat currency system.

Copper has really begun to roll over as are emerging markets, DOW Transports, Utilities. The VIX was up huge today and the AD line was heavily in the declining category.  The only thing catching a bid is oil and the headwinds from rising prices will hurt the cash strapped consumer.

Libya is only going to grow in violence with Gaddafi now preparing to be a martyr.   Bahrain is continuing to boil over and I read reports that Iran may see protests as early as Tuesday or Wednesday of this week.  The global revolution is even happening in the US. First Wisconsin now Ohio and Indiana. Expect many other states to protest just how the budget gaps will be filled.

Ireland elections are on Friday and no one seems to be talking about it.  Angela Merkel was handed quite the set back in this weekend's elections as well.  Neither bode well for senior bondholders staying whole.  Italy had to close its stock market today, Japan has been put on credit watch negative, Spain is acknowledging how bad their banks are finally, The UK is contracting (oh yeah, Japan too), Korea is a seeing a bank run (oh yeah Ireland too).  I am sure I missed something but you get the point.


If this market is going to turn, don't think the dip buyers will give up without a fight.  A majority of traders and investors have made money for two years by literally doing nothing but holding stocks.  It was an easy way to make money and they won't give up without a fight.  They will pour money into any weakness as they have been conditioned. They will focus on the Bernanke put which in reality expires soon unless QE3 is hinted at in the next few weeks. Today had the sign of a buy the dip trade working yet again but failed. It may still work but one thing  is for sure, one day it won't work.  Stay focused on the issues that the media is not covering.  The issues are real and the opportunities to profit from them are very large indeed.

Tuesday's Market

Data Overload And The Global Economy

The stock market is going to face data overload at the opening bell on Tuesday.  How the market reacts will be interesting.  Perhaps the dip will get bought.  It's become laughable at this point how inefficient this market has become at pricing in reality and risk.   The amount of risk hitting the global economy is mind boggling right now.

• South Korea is experiencing a run on their banks.

• On Tuesday Iran will send two navy ships through the Suez canal for the first time since 1979, while Israel views this move as provocative.  

• Ireland elections are on Friday which threaten to force senior bondholders to incur a loss. Irish banks are experiencing an accelerating bank run and have resorted to issuing debt to themselves and then using that debt as collateral for additional funding.

• Libya is falling into civil war which puts about 2% of oil production in jeopardy.

• Revolutions continue in Bahrain, Algeria, Yemen.  Saudi Arabia is now surrounded by revolutions.

• Iran is facing their own very serious revolution since the 2009 uprising.  Iran will not fall like Egypt fell.  It's been very quiet in Iran the past few days and one has to wonder when that country will erupt.  It's quite possible Iran sending ships through the Suez canal is meant to deflect attention from their own efforts to suppress the pending protests.

• The USD is falling while gold and silver rally.  The USD reserve currency and fiat currency as a whole are dying.

• Oil has risen over 10% in the past 48 hours.  If oil moves higher or at least holds these levels, the impact to the global economy will be devastating.  

• Moody's just downgraded Japan to credit watch negative from stable.

• China is raising reserve requirements to slow growth.

• Equity markets have seen a parabolic rise on dwindling volume and rising margin.  Margin debt now stands at pre Lehman levels.

• Food and energy inflation is rising to an unsustainable level worldwide.

• The US is experiencing its own revolutions in Wisconsin and now Ohio as the reality of massive budget gaps is realized.

• The US appears to be headed for a government shutdown as the debt ceiling fight lingers and the clock ticks.

Data Overload And The Global Economy

Treasury, USD And The Fed

The Fed continues to ignore inflation which is truly mind boggling.  They know it is here, they want it but they refuse to acknowledge it.  Bernanke will quote the TIPS break even (TIPS minus Treasury Yield of similar maturity) as the inflation expectation yet ignore all other signs as demonstrated in today's FOMC minutes.  

"Despite further increases in commodity prices, measures of underlying inflation remained subdued and longer run inflation expectations were stable."

The Fed is playing a very dangerous game here with the bond and currency markets. Today saw the biggest threat in the ongoing Middle East crisis with Hezbollah ready to wage war on Israel and Iran sending their navy through the Suez canal for the first time since 1979.  The flight to safety trade, albeit short was very concerning as bonds and the USD did not catch a bid, but rather precious metals.  Precious metals are quickly becoming a new currency.  At least 20% of US states are passing legislation that would allow another currency in addition to the USD.  

It's quite possible the days of the USD being the reserve currency have passed.  The implications are massive.  Equally massive is the bond market and the signal it is giving to the Fed and DC.  It is concerned about inflation. It is concerned about the lack of Fed credibility.  It is concerned that DC continues to put politics ahead of fiscal policy.  The market is speaking and Bernanke appears ready to continue his aggressive and reckless policies.

10 Year Treasury

Appears to be consolidating ahead of another leg down.  The implications to housing are massive.  A 100 bp move equates to roughly a 11% drop in home prices.  

5 Year Treasury

The National Debt is rolled about every four years.  With 14 trillion in debt, a 100 bp move in yield equates to $140 billion USD additional interest expense.  Imagine tacking on another $140 billion in debt?  There will be no more stimulus to the economy.  The Federal and State governments will now drag economic growth.  

2 Year Treasury 

The short end of the curve had stayed low but not anymore.  The yield curve is flattening as the shorter maturities rise faster.  So not only do banks face a flattening curve but higher rates throughout all maturities.

USD - Need I say more?  It cannot catch a bid.  The world is speaking and they no longer believe in the strength of the US economy.  A sad day indeed.

My apologies if I sound like an alarmist.  As a father of two children, I truly worry about the future facing them.  I worry about the massive levels of unemployment that are ignored through government accounting and spin.  There are many people hurting in this country and throughout the world.  A global revolution has begun.  Let us hope that they and the markets can speak loud enough to force a true "change we can believe in."

Treasury, USD And The Fed

Treasury Yields

Treasury yields continue to move up across the yield curve.  The shorter end of the curve is seeing an even larger move of late causing a bear flattening where rates are moving up while the curve is flattening.  The bond market is clearly signaling a number of concerns from inflation fears to the Fed's monetary policy to the US Fiscal irresponsibility.

Based on Fed policy and a sluggish at best macro story, many in the interest rate derivative market will be caught on the wrong side of the trade and the implications could be pretty significant.  Below are a few charts of the two year, five year and ten year.

If this trend continues it will play an even larger role in the Fed decision making regarding future QE.

Two Year Treasury

This morning it already took out prior lows and has failed not only at the 200MA but a three year trend line.  From a technical standpoint it appears more weakness (higher yields) are to come.

Five Year Treasury

QE2 was focused on this maturity for a number of reasons and it is showing renewed weakness.  What's most scary about this chart is the reality that the US debt is rolled approximately every four years and this part of the curve causes the most interest rate risk to the US.  Rolling the 14 trillion in debt is no similar than a consumer transferring credit card balances month after month to new cards.

Ten Year Treasury

Last week it looked like a successful test of the three year trend line would cause a bounce but that appears to not be the case now.  Ten year treasury yields have a direct correlation to thirty year fixed mortgages and housing prices.

Treasury Yields

2011 Federal Budget and Deficit

2011 Budget Proposal - 3.7 Trillion

2011 Revenue Forecast - 2.0 Trillion

2011 Budget Deficit - 1.7 Trillion

(The 2011 deficit was forecasted to be 900 Billion in the 2009 budget)

"The president proposed trimming the deficits by $1.1 trillion over a decade" - Reuters

2011 Federal Budget and Deficit

They Just Don't Get It

This is not politically biased commentary.  Honestly, they are all lacking any form of leadership and morality.   I just saw that Obama wants to spend $53 billion on high-speed rail.  Two simple questions:

• How do we pay for it?  The bond market doesn't seem interested in extending further credit.

• With so many people out of work who will use it?  

Our country is starving for true leadership.

Clearly we have none on either side of the aisle.

They Just Don't Get It

Fed - Extended Period

The Fed has clearly stated its policy regarding the Federal Funds rate with each monetary statement

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."


Let's take a look at other rates which are less controllable by the Fed as witnessed by changes since August 2 when hints of QE began surfacing.

1 Month: gained 1 bp (basis point)
6 Month: gained 2 bp
2 Year: gained 21 bp
5 Year: gained 63 bp
10 Year: gained 67 bp
30 Year: gained 67 bp

So the shorter end of the curve the Fed has managed to keep rates low but as you move further out on the curve rates have clearly moved up in the face of a monetary policy intended to keep rates low.  If you remember when Bernanke gave his 60 Minutes special he clearly says at 6:45 in the video - "What we are doing is lowering interest rates..."

Clearly QE in the eyes of the Fed is not working and they know that.  They have shifted the bar of success to equity performance but don't lose site of the Fed's failure to achieve a low interest rate environment for an extended period.  They have in fact lost control of the yield curve beyond one year.

• Recently Fitch issued a report that 30% of commercial real estate that needs to be rolled in 2011 do not meet their standards.  

• Residential mortgage is negatively impacted by rising 10 year yield.

Regardless of what Bernanke may say publicly about the success of QE they understand its failures and they understand the extreme negative impact rising interest rates will have on future growth, bank balance sheet risk and credit formation.

Listen to Bernanke in the video below discuss employment.  He's very concerned and this was only two months ago.  Either QE is going to occur for the 4-5 years he says it will take for unemployment to come down to acceptable levels or the Fed will be looking for a way to save face while exiting future QE.  If this move in rates continues, the bond market may very well set future monetary policy and NOT the Fed.

Fed - Extended Period

Would you lend this company money for 10 years at 3.6%?

National Debt Clock

You have to love the irony.  I put this post up and for the first time ever I see a credit counseling google add appear.

QE Head Winds

QE is a mighty force.  In ordinary times, global food riots and contraction in the labor force (36,000 jobs added does not cover the 150,000 needed for population growth) would cause a fierce sell off in equities.  Not in these abnormal times where the perceived deep pockets of the Fed keep a perpetual bid in the market.

The day QE ends there is a very high probability the race to the exits will be swift and fierce.  Investors are asking themselves how long can this go on.  The vast majority are saying QE2 will not end in June but rather continue indefinitely.  Perhaps the majority are correct although group think rarely works.  The Fed's ultimate goal with QE was to drive demand back into the economy.  Whether it be perceived inflation (x will cost more tomorrow so I'll buy it today) or perceived wealth the theory is growth in demand causes growth in the economy thus causing more demand until finally the economy is self-sustaining.

In the process the banking system is generating income by playing the role of broker between the Fed and Treasury.  So on the surface, from an academic standpoint it sounds good.  Like everything in life though there are unintended consequences.  These miscalculations or unforeseen problems can negate the benefit of the original plan.   One such problem is surfacing rapidly and if not addressed will create another shock to an already fragile banking system.

An economy grows through the creation of credit and the banking system is the heart of credit formation.  The US economy is held hostage right now as the banking system, conservative in nature takes its time to return to health.  The banking system has a balance sheet with vast exposure to residential and commercial real estate.  Should there be another leg down in that sector of the economy the banking system will be challenged as it was in 2008.

Unfortunately for the banking system, home prices have begun their second leg down once the final tax credits wore off in October 2010.  This new leg down could experience a rather vicious  cycle.  Studies have shown a strong correlation between the level of negative equity in a home and one's decision to strategically default.  The industry is currently working through a massive shadow inventory that will cause pricing pressure for years.   The more prices fall, the more the shadow inventory grows due to strategic defaults and thus the problem grows.

The last thing the industry needs right now is anything that puts additional downward pressure on price.  Unfortunately due to the Fed's QE monetary policy and horrific US fiscal policy a very real threat has risen in the form of higher interest rates.

Here's an example.  The debt service on a $300,000 mortgage at 4.75% for 30 years is $1,564 per month.  The debt service on the same mortgage at 5.00% is $1,610.  In other words that buyer in a 5.00% interest rate environment can now afford a home 3% lower in price.  Over the past three months, the ten year treasury has risen 100 basis points in yield.  That's four times the example above.

Should this trend continue the bank balance sheet risk and reduction in wealth affect from one's home will have massive implications to an already fragile economy.  The economy will be faced with a reduction in demand and in the formation of credit.  Two very strong headwinds and two which easily can outweigh the benefits of the original goals of QE.

QE Head Winds

The Future Of QE

One thing that is certain is some day QE will end.  Either because the economy is truly self-sustaining or because someone forces the Fed's hand, possibly even the Fed.   Too many people use the blanket excuse "the Fed will just print money."  The reality is, 90% of those who say that don't even understand what it means.

It is truly amazing how the Fed has conditioned all of us.  If you are bullish, you are leveraged and unhedged.  You believe in the power of the Bernanke put. If you are bearish you have been beaten up pretty badly and are now simply managing risk and limiting any exposure to the short side.

Something will occur that is unforeseen that will stop QE and in a timeline different than what the majority think.  I say that for the simple reason that the majority is always wrong.  There will be some event that no one factored in.  With QE the Fed expected a weak dollar and lower yields.  Lower yields is what they sold as the benefit of QE but the opposite has happened.  The Fed did get their weak USD but its impact has reached far beyond exports.

US manufacturing data has been solid the past few months as was the trade portion of the Q4 GDP report.  Beyond the headlines though something that has stood out are rising prices.  The Fed knows of these price increases and their negative impact on the consumer.  They can't come out and say that though.  They are in the business of conditioning us to believe all is well.  I think the Fed made a huge miscalculation with their QE policy.

They underestimated the impact that QE would have on input costs.  Costs are rising so fast right now that margins are being squeezed.  For manufacturers of discretionary items, passing along these prices are next to impossible so costs will have to be reduced including lower payrolls (notice today's reported productivity gains at the expense of labor). Non-discretionary items will see prices passed along to the extent it is possible. Name brands though are losing market share to the generic brand sitting on the same shelf, so pricing power is limited.  Games will be played by selling smaller size products for the same price to hide inflation, but it's there and the consumer will be taxed.

The piece the Fed truly underestimated and what I suspect is the event that possibly forces the Fed's hand are global food riots.  What started as peaceful demonstrations have truly grown both in size and method.  Just two nights ago I watched protestors in Egypt picking up the trash to maintain the integrity of their community.  Tonight, the media is banned and molotov cocktails, rocks and gun fire litter the street.  Yemen saw 20,000 protestors come out tonight, Saudi Arabia had a small protest, Algeria, Tunisia had a successful protest, the list goes on.  Watch for this movement to grow faster than anyone ever expected.  I don't know of anyone who had this on their 2011 prediction list.

When QE2 was announced in August of 2010, it was a monetary policy to "inflate" the economy.  One of its many unintended consequences is the foreign policy nightmare is has created.  Global security is now at risk.  As the 2008 financial crisis taught us, many bad decisions are made during a crisis.  Watch for things to unfold and the poor decision making to continue.

The Future Of QE

US Debt - Is It Too Late Already?

I'm not an economist (would I admit it if I were anyway?).  So this post is more back of the envelope thinking.  The budget deficit is forecasted in 2011 to be 1.5 trillion dollars or roughly 10% of US GDP.  Let's just assume politicians could do the right thing and somehow balance the budget in 2011.  This means government would be a 10% drag on GDP (possibly more depending on the multiplier).  Imagine a 10% reduction in GDP?  That would reduce tax receipts and thus cause a deficit again.  Let's assume the deficit is reduced from 1.5 trillion in 2011 to 1 trillion.  That is still a massive drag, not stimulus on an economy that two years after recession still cannot grow absent government spending.   As odd as this sounds perhaps the only chance the US has at any meaningful debt reduction in FY 2011 is if the Fed continues to expand its balance sheet through additional QE.  Problem with that though is at some point the bond market will demand higher yield causing higher debt service for the existing debt that is currently rolled about every four years.

So with the looming debt ceiling being reached there will be lots of talk about not raising it but that seems simply impossible.  One really has to wonder have we already reached a point of no return from a fiscal standpoint.   This economy is very fragile right now and susceptible to any shock event.  The government is in little to no position financially to stimulate beyond QE.  In our current financial environment any debt reduction most likely will reduce GDP, reduce tax revenue while increasing the need for emergency unemployment while further limiting an already constrained consumer.  Debt reduction is truly needed unless our true plan is to do what Iceland did and simply default.  

Unfortunately our economy has nothing currently to truly grow.  Imagine if during the crisis of 2008, the trillions used for bailouts instead were used to truly invest (sorry Obama but your investment is still spending) in alternative energy.  Products that the US could play a lead role in developing and exporting.  It would have been a tough few years but we would have worked through many of the inefficiencies in our economy today.  Our debt level may even have been higher but we would have an economy poised for true demand not spending driven growth.  Unfortunately, a great opportunity was wasted due to failed and misguided leadership on both sides of the aisle.  

US Debt - Is It Too Late Already?