Notes From Underground: The King of Hearts Syndrome Dominates the Markets

One of the great movies of the 1960s asks who is more insane: Those in the asylum or those who create wars? The present state of central banking can lead one to ask the same question about the overseers of FIAT CURRENCY and those who make investment decisions based on the policies of those academics so in love with their economic models. As the Bernanke victory tour rolls on, the fallback position of the recent anointed savior of the global financial system poses the counter-factual of, “What if we hadn’t acted by embarking on a massive liquidity injection? Aren’t you all satisfied that the unemployment rate is hovering around the defined level of full-employment?”

My question back to Ben Bernanke is posed as another counter-factual. What if you had not MADE YOURSELF the only game in town? By preempting Congress and continually adding liquidity through large-scale asset purchases, didn’t you make it possible for Congress to do nothing since cheap money was providing the stimulus? It was Senator Chuck Schumer who called you the only game in town. But it was IMF chief economist Olivier Blanchard who wrote that the multiplier effect of infrastructure spending was a greater stimulus than mere provision of liquidity. The initial QE program was necessary to prevent the liquidation of assets but the continued efforts of QE2 and QE3 made it easy for Congress to DO NOTHING. Like the counter-factual put forward by Bernanke, the truth is we will never know the outcomes of either hypothesis.

However, the end result is that all the world’s central banks have pursued the Bernanke Doctrine and have built or are building massive balance sheets. The only result has been the continued elevation of risk assets as money crowds into a small pool of assets, especially as sovereign bonds are not available while the ECB, BOJ and the FED crowd out private investors. At the end of October, the fact that all developed country stock markets rallied in harmony reflects the power of the world’s central banks. Why should the SPOOS have been up as much as the European markets and Japan when the DOLLAR was up 1.5% for the month? Every CEO in the U.S. blamed their earnings shortfall on DOLLAR STRENGTH yet it’s actually lower since the end of the first quarter. Yes, the DOLLAR is up 6% on the year but most of that is against the EURO, which shouldn’t have led to a shortfall in all regions. If the DOLLAR was the main culprit, the U.S. equity markets OUGHT to have underperformed in October, except that wasn’t the case. The only reason seems to be that cheap money floats many boats.

Also, if the FED is going to raise rates when inflation rises close to the level of the dual mandate then it will be met with rising WAGES. A stronger dollar and increased wages resulting in an interest rate hike  should be a drag on U.S. equities relative to the rest of the world. But with the world struggling to differentiate between the inmates and the decision makers it makes sense to party on.

In a further testimony to global financial insanity, the Financial Times had an article on its front page, “Beijing Comes to Aid of Eurozone QE Drive With Sales of German Bunds.” The problem for the Bundesbank and ECB is that there is not enough German debt to buy because Germany has been running budget surpluses and therefore not issuing enough bonds to meet the requirements of the ECB‘s QE program. The PBOC and SAFE (State Administration of Foreign Exchange) are selling German and other European sovereign bonds at artificially inflated prices and netting a nice profit at the expense of European taxpayers who will ultimately pay the price for the ECB‘s losses on its portfolio. The article said:

“The Bundesbank has scoured the world for sellers according to one person familiar with the matter, including SAFE. Under pressure to make a return on its reserves portfolio, SAFE has agreed to take advantage of the high prices on offer for low-yielding German Bonds.”

This is what has made the global sovereign bond markets a broken mechanism for pricing credit risk. The ECB keeps buying debt  forcing even Italian two-year notes to a ZERO interest rate. The more the ECB buys, the lower rates go and it has a ripple effect all over the world, resulting in investors purchasing assets at artificial prices. The Chinese are wise to unload their vast reserves with the central banks providing the escape mechanism.

The ultimate effect of the ECB‘s actions is that the global credit become starved for GOOD COLLATERAL and the result of ECB action is to choke the channels of private credit creation. Also, it makes the European bond markets a trade and not an investment for it is too difficult to fight the ECB in an attempt to ascertain real value. And an important note, today is the first day of the month so the ECB has 60 billion euros to buy so be very cautious about any steep rise in yields. Who is insane in the global game of capital flows?

***Tonight the Reserve Bank of Australia (RBA) announces it interest rate decision. The consensus calls for no change and rates to be left at 2%. The recent weakness of the Aussie dollar versus the KIWI and other currencies may keep the RBA on hold but it is worth reading Governor Glenn Stevens statement about the condition of the Asian economies. The other day I made note of the technical importance of the Aussie/kiwi cross-rate at 1.0525. It violated that level in trading after the RBNZ rate decision last week but if the RBA were to CUT rates look for that level to retest. Recent data projects a 35% chance of a rate cut but again the recent AUSSIE weakness will PROBABLY keep the RBA on hold.

Also, the residential construction sector has held up well and the Aussie authorities have tried to slow housing by using macro-prudential tools. A rate cut would act to undermine those efforts.

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13 Responses to “Notes From Underground: The King of Hearts Syndrome Dominates the Markets”

  1. GRU Says:

    King of Hearts….best movie of all time

  2. Alex Says:

    Yra, I’m interested to know what the Chinese will do with the money they receive from their bond sales. What do you think?

    Or perhaps if the Chinese call you up for advice, what would you advise?

  3. yra Says:

    Alex–most probably shoring up their own banks and nothing wrong with taking profits on elevated levels provided by the ECB.Sometimes going to cash as El-Erian writes about today in the FT is not a bad policy—in a fundamental sense why would you hold an asset that is seeking its own value destruction,for if the ECB is successful in creating inflation do you want to own 10 year European debt at such preposterously low levels—the Chinese are no fools when it comes to understanding markets and I learned this in 1998 when I sat with members of SAFE in Chicago when the CME was trying to launch a YUAN contract with the blessings of the Chinese.The CME’s Fred Arditi ,may his memory be a blessing,was a great person to learn from when it came to China and the Chinese had great respect for him.I return the respect to the Chinese when it comes to markets

  4. Alex Says:

    Yra, nice educational answer, thanks

  5. Rob Syp Says:

    everything you wrote is similar to the Dr. Gloom Doom Boom Man

    • yra Says:

      rob syp–you put in the company of someone I have admired and respected for 30 + years–although I don’t read him now as I have a sense where he is going and just wait for him in the Baron’s roundtable

  6. Asherz Says:

    The maiinvestments throughout the financial world because of QE and ZIRP keeps the top spinning at a dizzying pace. An article in the the WSJ 2 days ago trumpeted the following:
    “The bond market is booming again, a sign of investors’ faith in the resilience of the U.S. economy.
    U.S. bond sales by companies with good credit ratings hit $103 billion in October, a record for the month…”
    Horsefeathers. Corporate issuers are locking in low rates and getting while the getting is good as the inmates are running the asylum.
    But there is the other side of the issuer’s locking in low rates. The issue also locking in those same low rates. What happens to the pension funds and savers desperate for yields when interest rates finally go up? What happens to the bloated sovereign balance sheets at that time? The top stops spinning and falls on its side or off the table. Hopefully by then Ben will have sold enough books to make him smile. The same will not be said by his readers.

  7. yra Says:

    Rob Syp–the difference is that my analysis comes from trading the european bonds on an active basis –again the emphasis is trade and not invest because you have to be a MORON to buy a ten year french note for an investment

  8. yra Says:

    Asherz—good post and my patience for victory tours sponsored by adoring access journalists is beginning to wear on me

  9. Joe Says:

    and that school of journalism was on display, in full bloom, at the CNBC GOP debate.

  10. kevinwaspi Says:

    Kudos for another well timed, well constructed analysis of what passes as “policy” in today’s demented world. “My question back to Ben Bernanke is posed as another counter-factual. What if you had not MADE YOURSELF the only game in town? By preempting Congress and continually adding liquidity through large-scale asset purchases, didn’t you make it possible for Congress to do nothing since cheap money was providing the stimulus?”

    You are spot-on with that counter-factual, probably one that will figure prominently in the history books to be written. Given monetary actions by the academic elites;
    1) Why address the tax code?
    2) Why address the federal budget “process”?
    3) Why address the entitlement spending conundrum?
    4) Why address pro growth strategy?
    Congress has received more cover from these monetary ass-clowns than lifetime terms could have given them. Celebrate now, for as we know, “payback is a M—–f—–!

  11. Rob Syp Says:

    Did not mean to insult you in anyway with comparisons to Dr. Doom but yesterday the band played on of Druckenmiller, Ichan, Schiller, El Erian and Faber of how the this Fed induced rally is not going to end pretty. What ultimately can one do other then buying breaks and selling rallies of the market a person chooses to be in?

  12. yra Says:

    Rob –how can that be an insult–he is a giant global thinker

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