Archives for December 2014

China’s Zombie Factories Provide Illusion of Work and Prosperity; Rebalancing Chinese Style

Courtesy of Mish.

China has zombie malls and even zombie cities, so zombie factories can hardly be a surprise. And as the malinvestments pile up, so do unrealized shadow bank losses.

The Financial Times reports China Zombie Factories Kept Open to Give Illusion of Prosperity.

In the shadow of a group of enormous smokestacks and abandoned foundries, a peeling sign welcomes visitors to the Wenxi Steel Industrial Park.

Highsee stopped paying its 10,000 employees six months ago. Local officials estimate the plant supported indirectly the livelihood of about a quarter of Wenxi county’s population of 400,000. Highsee was the biggest privately owned steel mill in Shanxi, accounting for 60 per cent of Wenxi’s tax revenues. For those reasons, the local government was reluctant to allow the company to go out of business, even though it had been in serious financial difficulties for several years.

“By 2011 Highsee was already like a dead centipede that hadn’t yet frozen stiff with rigor mortis,” says one official who asks not to be named because he was not authorised to speak to foreign reporters. “More than half the plant shut down, but it was still producing steel even though its suppliers wouldn’t deliver anything without cash up front and it was drowning in debt.”

In the past month alone Chinese media have reported on at least nine large steel mills that appeared to be suspended in limbo after halting production but which are forbidden from going formally bankrupt.

“There are large numbers of companies across China that should go bankrupt but haven’t done so,” says Han Chuanhua, a bankruptcy lawyer at Zhongzi Law Office, a Beijing legal practice. “The government doesn’t want to see bankruptcy because as soon as companies go bust, unemployment spikes and tax revenues disappear. By stopping companies from going bankrupt, officials are able to maintain the illusion of local prosperity, economic growth and stable taxes.”

The outstanding volume of non-performing loans in the Chinese banking sector has increased 50 per cent since the beginning of 2013, according to estimates from ANZ, the Australian bank, but the sector-wide NPL ratio remains extremely low, at just over 1.2 per cent.

In private, however, senior Chinese financial officials admit the real ratio is almost certainly much higher, obscured by local governments trying to prop up companies.

Rebalancing Chinese Style

As part of China's rebalancing effort, growth must slow (or an even bigger crash will come later), and shadow banking losses recognized. So far, all we see is the slowdown in growth.

Even then, China recently cut interest rates hoping to keep the illusion alive (as some might see it), or smooth the transition (as others might see it).

Regardless how one sees it, these closures are at the back end of a collapse in commodity prices as China moves from an investment (malinvestment) driven pattern of growth, to a consumer-driven pattern of growth….

Continue Here > 



Here’s Why Trendlines are Your New Best Friend, Part 3

Here’s Why Trendlines are Your New Best Friend, Part 3

See how trendlines help you make calculated trading decisions

Courtesy of Elliott Wave International

Have you ever seen Donald Duck play pool? Trust us, it isn’t pretty.

Flash Animation

An expert pool player, on the other hand — well, he can just look at the billiards table and imagine lines drawn out, marking the trajectory the cue ball must take to make the shot.

Now, what if you could just look at a financial market’s price chart — and see actual lines drawn out that aim straight for the “pocket” of opportunity?

According to our resident Monthly Commodity Junctures editor and chief commodity analyst Jeffrey Kennedy, you can.

All you need to do is implement a tried-and-true tool of technical analysis known as trendlines. (And let’s just say, what Paul Newman is to the game of pool in the Hustler, Jeffrey Kennedy is to the field of technical analysis in real life.)

In part 1 of our series, we showed you how Jeffrey used trendlines to identify a major break-out point in cocoa back in May 2014. Part 2 played the video of Jeffrey’s April 2014 corn forecast, where he used trendlines to fortify his bearish wave count — right before corn prices embarked on a powerful sell-off to 4-year lows.

Today, we’re returning to that April 2014 Monthly Commodity Junctures video to show you 3 more examples of how Jeffrey used trendlines to “call the pocket” in coffee, sugar, and the U.S. dollar. Roll the tape!

Of coffee, Jeffrey said: “We can expect a counter-trend move back to near the previous fourth wave extreme, roughly say between 170 and 160.

Coffee prices indeed sold off in three waves (i.e. counter-trend action) to the “previous fourth wave extreme” after breaking through the lower boundary of the trend channel:

Of sugar, Jeffrey said: “Once complete, wave (Y) of the larger fourth wave will give way to additional selling to back below the actual 2014 low.”

Here’s what happened to sugar prices after they fell below their trendline:

Of the U.S. dollar, Jeffrey said: “Ideally we’ll begin to see this third wave move [up] develop soon… in a nice, volatile move to the upside.”

The dollar indeed rallied strongly off that trendline:

It’s safe to say, once you truly understand the risk-managing power of trendlines, they will become one of the most valuable tools in your technical toolbox. And nobody can attest to that fact more than Jeffrey Kennedy.

In fact, Jeffery loves trendlines so much, he wrote a book about them. Well, a free eBook — titled “Trading the Line: 5 Ways You Can Use Trendlines to Improve Your Trading.”

As the title of Jeffrey’s eBook states, there are 5 ways trendlines improve your trading:

  1. Trendlines show you the dominant psychology of investors, be it bullish or bearish
  2. They define your risk via support and resistance price levels
  3. They give you advanced warning of potential price breakout points
  4. They help you identify critical moments in time
  5. Trendlines also tell you when the trend has turned

Want to learn how to draw your own trendlines — and gain an advantage you’ve never had before? Right now, we are offering the entire 17-page eBook (including Jeffrey’s carefully chosen charts and analysis) as part of our FREE trader resources. Just join the 325,000-plus members of our Club EWI family.

This article was syndicated by Elliott Wave International and was originally published under the headline Here’s Why Trendlines are Your New Best Friend, Part 3.

See Also:

Here’s Why Trendlines Are Your New Best Friend, Part 1 

Here’s Why Trendlines Are Your New Best Friend, Part 2 

Free Report: 15 eye-opening charts

Download Your Free eBook: Market Myths Exposed:

  • Don’t Get Ruined by These 10 Popular Investment Myths: Part I: The Fundamental Flaw in Conventional Financial and Macroeconomic Theory
  • Part II: Testing Exogenous-Cause Relationships from Economic Events
  • Part III: Myth #3: “Expanding trade deficit is bad for economy — and bearish for stocks.”
  • Part IV: Myth #4: “Earnings drive stock prices.”
  • Part V: Myth #5: “GDP drives stock prices.”
  • Part VI: Myth #6: “Wars are bullish/bearish for stocks.”
  • Part VII: Myth #7: “Peace is bullish for stocks.”
  • Part VIII: Myth #8: Terrorist attacks would cause the stock market to drop.
  • Part IX: Myth #9: “Inflation makes gold and silver go up.”
  • Part X: Myth #10: “Central banks and government policies control the markets.”


Supply, demand and the price of oil

Supply, demand and the price of oil

Courtesy of James Hamilton of Econbrowser

A few weeks ago I offered some calculations suggesting that lower demand for oil might account for about $20/barrel of the dramatic decline in the price of oil since last summer. Here I point to some other evidence consistent with that conclusion.

Last week the IMF’s Rabah Arezki and Olivier Blanchard produced a very useful assessment of the role of supply and demand in the recent oil price decline. They note for example that the IEA’s current estimate of world oil demand growth for 2014:Q3 is 800,000 barrels/day below what the organization had been anticipating as of last June.

Source: IMFDirect.

Source: IMFDirect.

The suddenness of this shift suggests that economic weakness in Europe, Japan, and China made a contribution. In the case of the United States, some of the long-run demand response to the price run-up of the 2000s is still underway, as seen for example in the continuing improvements in fuel economy of new cars sold in the U.S.

Average fuel economy of new passenger vehicles in miles per gallon (from EIA).

Average fuel economy of new passenger vehicles in miles per gallon (from EIA).

But Steve Kopits calls attention to Don Pickrell’s documentation of some important long-term trends in U.S. demand as well. The American population is aging, and older people drive less.

Source: Pickrell (2014).

Source: Pickrell (2014).

In addition, people who don’t have jobs don’t drive as much. Much of the decline in the U.S. labor force participation rate seems due to long-run developments that were in evidence well before the Great Recession.

Source: Calculated Risk.

Source: Calculated Risk.

Another contributing factor to an excess supply of oil was a return of Libyan production between July and October. But the latest estimates are that some of this was lost again last month. And this weekend Libya’s largest oil port was attacked, raising the possibility that more of the country’s exports will again be disrupted.

Source: EIA.

Source: EIA.

But the biggest factor in producing an excess supply of oil has been the success of the U.S. shale oil production. U.S. inventories are well above what’s expected for this time of year.

Source: EIA.

Source: EIA.

At what price would supply and demand be back in balance? I won’t even make an attempt to predict short-run developments for the wild cards like Libya, Iraq, and China. But in principle, the U.S. supply situation should be simpler. At current prices, some of the higher-cost producers will be forced out. It should be a textbook problem of finding the point on the marginal cost curve at which there’s an incentive for the marginal producer to meet desired demand; given a quantity Q demanded on the horizontal axis, find the price P associated with that Q from the height of the vertical axis on the marginal cost curve. The problem is, nobody knows for sure exactly what that marginal cost curve looks like, and sunk costs for existing wells make it hard (and painful for the oil producers) to find out.

Source: IMFDirect.

Source: IMFDirect.

Longer term, I think we can anticipate ongoing geopolitical disruptions in Africa and the Middle East and a resumption of demand growth from emerging economies. That is why I believe that before long the world will once again want that higher-cost oil. But December 2014 doesn’t seem to be the time to try to sell it.

Source: IMFDirect.

Source: IMFDirect.


Spain to Issue €55 Billion in New Debt, 72% to Roll Over Existing Debt; Interest Rate Perspective

Courtesy of Mish.

Spain’s regional and local governments are struggling to pay back debts. The central government has not made much progress either.

El Economista reports 72% of Treasury Issuance in 2015 to Refinance CCAA and Municipalities.

Of estimated €55 billion debt increase for 2015, 72 percent of that amount will be to regional governments and municipalities through new mechanisms created to ease the burden of regional debt and also provide liquidity to local authorities for other policies (through the Fund Management, targeting the most indebted and Economic Promotion Fund for sustainable investments).

The €55 billion debt increase announced Friday is the same as last year, but is €8 billion superior to that which was announced last September.

Debt Increase Year by Year

Guru Huky has some interesting charts in his post Spain will Increase National Debt by €55 Billion.


Since 2008, Spanish debt has increased by €600 billion.

Guru notes “Since 2012 we had a tax increase that completely screwed the middle class of this country. And yet we continue with a cruising speed of new debt generation of more than €50 billion a year.

Interest Rate Perspective

Continue Here

Update Feb. 15, 15

Market Shadows features a variety of articles about the financial markets as well as interesting materials for traders and investors. To receive original articles when posted, please enter your email at the top left of this page. Visit me at Phil’s Stock World (PSW) for instant access to my posts.  

Options trading: Phil Davis constructs option trades to “be the house” (the party earning premiums). Click here for free trial to Phil’s Stock World.


Other approaches to the stock market include algorithms/signal trading (Stock Spotter), trading/investing based on fundamentals in energy (OilPrice), and investing based money supply plus technical analysis (Lee Adler’s Wall Street Examiner). See below for special offers.

Stock Spotter:

Read my three recent interviews with John Ehlers of Stock Spotter to learn more about his and Ric Way’s system for stock trading based on complicated math and cycles:

Try StockSpotter for $16 for 20 days by clicking here and using the promo code XPN4387 for a 20% discount.


Oil Price: Benefit from the latest energy trends and investment opportunities before the mainstream media and investing public are aware they exist. Check out OilPrice’s FREE Energy Intelligence Report here.  For OilPrice’s 5 New Energy Booms, click here for a RISK-FREE trial.


Wall Street Examiner: Get Lee Adler’s regular updates on the machinations of the Fed, Treasury, Primary Dealers and Foreign Central Banks — and how these are affecting the stock market. Try the WSE’s Professional Edition RISK-FREE for 30 days.


Talk Markets: This is a new social media site for stock market lovers. Join here. 


Elliott Wave International:

Click here for EW’s free report — 15 eye-opening charts.

EW’s latest series on Investment Myths:

  • Don’t Get Ruined by These 10 Investment Myths: Part I: The Fundamental Flaw in Conventional Financial and Macroeconomic Theory
  • Part II: Testing Exogenous-Cause Relationships from Economic Events
  • Part III: Myth #3: “Expanding trade deficit is bad for economy — and bearish for stocks.”
  • Part IV: Myth #4: “Earnings drive stock prices.”
  • Part V: Myth #5: “GDP drives stock prices.”
  • Part VI: Myth #6: “Wars are bullish/bearish for stocks.”
  • Part VII: Myth #7: “Peace is bullish for stocks.”
  • Part VIII: Myth #8: Terrorist attacks would cause the stock market to drop.
  • Part IX: Myth #9: “Inflation makes gold and silver go up.”
  • Part X: Myth #10: “Central banks and government policies control the markets.”

Download Your Free eBook: Market Myths Exposed

GDP is not a predictor of stock market performance

GDP is not a predictor of stock market performance

There may be no correlation between economic growth (GDP) and the stock market in the US; and in China too, as shows below. This is because GDP only partially reflects corporate earnings and because earnings are only one factor affecting the performance of the stock market. So what of the frenetic trading around the weekly and monthly economic reports? A lot of noise.

In fact, rainfall is a better predictor of the stock market than GDP. Will Deener writes:

Vanguard examined U.S. stock returns back to 1926 to assess the impact of more than a dozen metrics on the market. Researchers looked at such things as stock valuations (price-to-earnings ratios), economic growth, dividend yields and even rainfall to determine if they were predictors of future stock returns.

Economic growth, or gross domestic product (GDP), showed zero correlation, meaning it has no predictive value in determining future stock values.

On the correlation scale where 1.0 represented very strong predictability, GDP came in at 0.0 — the same level as the trailing 12-month stock returns. Rainfall at least came in at 0.06 on the scale.

“Many popular signals [that investors watch] have had a lower correlation with the future return of stocks than rainfall — a metric few would link to Wall Street performance,” the Vanguard researchers said.

The strongest link

The metric with the highest correlation was p/e ratios at 0.43. In other words, one of the best predictors of stock market performance, say, over the next 10 years, is the starting valuation at the beginning of the period — and the lower the better.

“The starting valuation decides just about everything,” said Pat Dorsey, president of Sanibel Captiva Investment Advisors in Chicago. “GDP tells you nothing about what the market will do.”

In Tell me more of your economic theories, Joshua M Brown shows that the connection between GDP and the stock market in China is not any better. If there is any correlation at all, it would probably be negative:

Tell me more of your theories about Chinese GDP growth and its impact on stock prices…

January 2014:

Screen Shot 2014-12-28 at 8.59.46 AM

April 2014:

Screen Shot 2014-12-28 at 8.58.40 AM

October 2014:

Screen Shot 2014-12-28 at 8.58.19 AM

Chinese stock market, 2014:



Zero Hedge put this in perspective with a cartoon about the “economic growth” in the U.S. US Economic Growth (Summarized In 1 Cartoon):

“Presented with no comment…” ZH

Source: Cagle Post via Sunday Funnies

More on GDP from Investopedia: What is GDP and why is it so important?


The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country’s economy. It represents the total dollar value of all goods and services produced over a specific time period – you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.

Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either by adding up what everyone earned in a year (income approach), or by adding up what everyone spent (expenditure method). Logically, both measures should arrive at roughly the same total.


A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It’s not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices…

Rainfall picture via Pixabay.


The Wall Street-ization of Everything: Airline Edition

The Wall Street-ization of Everything: Airline Edition

Courtesy of 

Tim Wu at the New Yorker:

This fall, JetBlue airline finally threw in the towel. For years, the company was among the last holdouts in the face of an industry trend toward smaller seats, higher fees, and other forms of unpleasantness. JetBlue distinguished itself by providing decent, fee-free service for everyone, an approach that seemed to be working: passengers liked the airline, and it made a consistent profit. Wall Street analysts, however, accused JetBlue of being “overly brand-conscious and customer-focussed.” In November, the airline, under new management, announced that it would follow United, Delta, and the other major carriers by cramming more seats into economy, shrinking leg room, and charging a range of new fees for things like bags and WiFi.

I’m not against the airlines being more profitable. Just wish there were a way for that to happen without the flight sucking more. I’ll pay more for my bag if that’s what Wall Street demands of JetBlue – just please don’t shrink my legroom!

Why Airlines Want to Make You Suffer (New Yorker)

Picture from JetBlue's website. 

The Burning Questions For 2015

John Mauldin makes an unusual recommendation: a face cream containing skin stem cells. I don't see how a topical application of stem cells could possibly work to make skin look younger. Please comment if you've tried the product (link) and let me know how (if) it works. ~ Ilene 

The Burning Questions For 2015

By John Mauldin, Outside the Box

Louis Gave is one of my favorite investment and economic thinkers, besides being a good friend and an all-around fun guy. When he and his father Charles and the well-known European journalist Anatole Kaletsky decided to form Gavekal some 15 years ago, Louis moved to Hong Kong, as they felt that Asia and especially China would be a part of the world they would have to understand. Since then Gavekal has expanded its research offices all over the world. The Gavekal team’s various research arms produce an astounding amount of work on an incredibly wide range of topics, but somehow Louis always seems to be on top of all of it.

Longtime readers know that I often republish a piece by someone in their firm (typically Charles or Louis). I have to be somewhat judicious, as their research is actually quite expensive, but they kindly give me permission to share it from time to time.

This week, for your Outside the Box reading, I bring you one of the more thought-provoking pieces I’ve read from Louis in some time. In Thoughts from the Frontline I have been looking at world problems we need to focus on as we enter 2015. Today, Louis also gives us a piece along these lines, called “The Burning Questions for 2015,” in which he thinks about a “Chinese Marshall Plan” (and what a stronger US dollar might do to China), Abenomics as a “sideshow,” US capital misallocation, and whether or not we should even care about Europe. I think you will find the piece well worth your time.

Think about this part of his conclusion as you read:

Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

Wise words indeed.

A Yellow Card from Barry

What you don’t often get to see is the lively debate that happens among my friends about my writing, even as I comment on theirs. Barry Ritholtz of The Big Picture pulled a yellow card on me over a piece of data he contended I had cherry-picked from Zero Hedge. He has a point. I should have either not copied that sentence (the rest of the quote was OK) or noted the issue date. Quoting Barry:

Did you cherry pick this a little much? 

“… because since December 2007, or roughly the start of the global depression, shale oil states have added 1.36 million jobs while non-shale states have lost 424,000 jobs.”

I must point out how intellectually disingenuous this start date is, heading right into the crisis – why not use December 2010? Or 5 or 10 years? This is misleading in other ways:

It is geared to start before the crisis & recovery, so that it forces the 10 million jobs lost in the crisis to be offset by the 10 million new jobs added since the recovery began. That creates a very misleading picture of where growth comes from.

We have created 10 million new jobs since June 2009. Has Texas really created 4 million new jobs? The answer is no.

According to [the St. Louis Fed] FRED [database]:

PAYEMS – or NFP – has gone from 130,944 to 140,045, a gain of 9,101 over that period.
TXNA – Total Nonfarm in Texas – has gone from 10,284 to 11,708, for a gain of 1,424.

That gain represents 15.6% of the 9.1MM total.

Well yes, Barry, but because of oil and other things (like a business-friendly climate), Texas did not lose as many jobs in the recession as the rest of the nation did, which is where you can get skewed data, depending on when you start the count and what you are trying to illustrate.

My main point is that energy production has been a huge upside producer of jobs, and that source of new jobs is going away. And yes, Josh, the net benefit for at least the first six months until the job non-production shows up (if it does) is a positive for the economy and the consumer. But I was trying to highlight a potential problem that could hurt US growth. Oil is likely to go to $40 before settling in the $50 range for a while. Will it eventually go back up? Yes. But it’s anybody’s guess as to when.

By the way, a former major hedge fund manager who closed his fund a number of years ago casually mentioned at a party the other night that he hopes oil goes to $35 and that we see a true shakeout in the oil patch. He grew up in a West Texas oil family and truly understands the cycles in the industry, especially for the smaller producers. From his point of view, a substantial shakeout creates massive upside opportunities in lots of places. “Almost enough,” he said, “to tempt me to open a new fund.”

As An Aside: This is a little odd, but for a number of years I’ve been recommending a face cream that contains skin stem cells, which I and quite a number of my readers have noticed really helps rejuvenate our older skin. (I came across the product while researching stem-cell companies with Patrick Cox.) It clearly makes a difference for some people. I get ladies coming up all the time and thanking me for the recommendation, and guys too sometimes shyly admit they use it regularly. (It turns out that just as many men buy the product as women.) The company is Lifeline Skin Care, and they have discounted the product for my readers. If you can get past the fact that this is a financial analyst recommending a skin cream, then click on this link

***Stay Ahead of the Latest Tech News and Investing Trends… Click here to sign up for Patrick Cox’s free daily tech news digest. Each day, you get the three tech news stories with the biggest potential impact.***

It is time to hit the send button. I trust you are having a good week. Now settle in and grab a cup of coffee or some wine (depending on the time of day and your mood), and let’s see what Louis has to say.

Your trying to catch up analyst,

John Mauldin, Editor
Outside the Box

The Burning Questions For 2015

By Louis-Vincent Gave, Gavekal Dragonomics

With two reports a day, and often more, readers sometimes complain that keeping tabs on the thoughts of the various Gavekal analysts can be a challenge. So as the year draws to a close, it may be helpful if we recap the main questions confronting investors and the themes we strongly believe in, region by region.

1. A Chinese Marshall Plan?

When we have conversations with clients about China – which typically we do between two and four times a day – the talk invariably revolves around how much Chinese growth is slowing (a good bit, and quite quickly); how undercapitalized Chinese banks are (a good bit, but fat net interest margins and preferred share issues are solving the problem over time); how much overcapacity there is in real estate (a good bit, but – like youth – this is a problem that time will fix); how much overcapacity there is in steel, shipping, university graduates and corrupt officials; how disruptive China’s adoption of assembly line robots will be etc.

All of these questions are urgent, and the problems that prompted them undeniably real, which means that China’s policymakers certainly have their plates full. But this is where things get interesting: in all our conversations with Western investors, their conclusion seems to be that Beijing will have little choice but to print money aggressively, devalue the renminbi, fiscally stimulate the economy, and basically follow the path trail-blazed (with such success?) by Western policymakers since 2008. However, we would argue that this conclusion represents a failure both to think outside the Western box and to read Beijing’s signal flags.

In numerous reports (and in Chapters 11 to 14 of Too Different For Comfort) we have argued that the internationalization of the renminbi has been one of the most significant macro events of recent years. This internationalization is continuing apace: from next to nothing in 2008, almost a quarter of Chinese trade will settle in renminbi in 2014:

This is an important development which could have a very positive impact on a number of emerging markets. Indeed, a typical, non-oil exporting emerging market policymaker (whether in Turkey, the Philippines, Vietnam, South Korea, Argentina or India) usually has to worry about two things that are completely out of his control:

1)   A spike in the US dollar. Whenever the US currency shoots up, it presents a hurdle for growth in most emerging markets. The first reason is that most trade takes place in US dollars, so a stronger US dollar means companies having to set aside more money for working capital needs. The second is that most emerging market investors tend to think in two currencies: their own and the US dollar. Catch a cab in Bangkok, Cairo, Cape Town or Jakarta and ask for that day’s US dollar exchange rate and chances are that the driver will know it to within a decimal point. This sensitivity to exchange rates is important because it means that when the US dollar rises, local wealth tends to flow out of local currencies as investors sell domestic assets and into US dollar assets, typically treasuries (when the US dollar falls, the reverse is true).

2)   A rapid rise in oil or food prices. Violent spikes in oil and food prices can be highly destabilizing for developing countries, where the median family spends so much more of their income on basic necessities than the typical Western family. Sudden spikes in the price of food or energy can quickly create social and political tensions. And that’s not all; for oil-importing countries, a spike in oil prices can lead to a rapid deterioration in trade balances. These tend to scare foreign investors away, so pushing the local currency lower and domestic interest rates higher, which in turn leads to weaker growth etc…

Looking at these two concerns, it is hard to escape the conclusion that, as things stand, China is helping to mitigate both:

  • China’s policy of renminbi internationalization means that emerging markets are able gradually to reduce their dependence on the US dollar. As they do, spikes in the value of the US currency (such as we have seen in 2014) are becoming less painful.
  • The slowdown in Chinese oil demand, as well as China’s ability to capitalize on Putin’s difficulties to transform itself from a price-taker to a price-setter, means that the impact of oil and commodities on trade balances is much more contained.

Beyond providing stability to emerging markets, the gradual acceptance of the renminbi as a secondary trading and reserve currency for emerging markets has further implications. The late French economist Jacques Rueff showed convincingly how, when global trade moved from a gold-based settlement system to a US dollar-based system, purchasing power was duplicated. As the authors of a recent Wall Street Journal article citing Reuff’s work explained: “If the Banque de France counts among its reserves dollar claims (and not just gold and French francs) – for example a Banque de France deposit in a New York bank – this increases the money supply in France but without reducing the money supply of the US. So both countries can use these dollar assets to grant credit.” Replace Banque de France with Bank Indonesia, and US dollar with renminbi and the same causes will lead to the same effects.

Consider British Columbia’s recently issued AAA-rated two year renminbi dim sum bond. Yielding 2.85%, this bond was actively subscribed to by foreign central banks, which ended up receiving more than 50% of the initial allocation (ten times as much as in the first British Columbia dim sum issue two years ago). After the issue British Columbia takes the proceeds and deposits them in a Chinese bank, thereby capturing a nice spread. In turn, the Chinese bank can multiply this money five times over (so goes money creation in China). Meanwhile, the Indonesian, Korean or Kazakh central banks that bought the bonds now have an asset on their balance sheet which they can use to back an expansion of trade with China…

Of course, for trade to flourish, countries need to be able to specialize in their respective comparative advantages, hence the importance of the kind of free trade deals discussed at the recent APEC meeting. But free trade deals are not enough; countries also need trade infrastructure (ports, airports, telecoms, trade finance banks etc…). This brings us to China’s ‘new silk road’ strategy and the recent announcement by Beijing of a US$40bn fund to help finance road and rail infrastructure in the various ‘stans’ on its western borders in a development that promises to cut the travel time from China to Europe from the current 30 days by sea to ten days or less overland.

Needless to say, such a dramatic reduction in transportation time could help prompt some heavy industry to relocate from Europe to Asia.

That’s not all. At July’s BRICS summit in Brazil, leaders of the five member nations signed a treaty launching the US$50bn New Development Bank, which Beijing hopes will be modeled on China Development Bank, and is likely to compete with the World Bank. This will be followed by the establishment of a China-dominated BRICS contingency fund (challenging the International Monetary Fund). Also on the cards is an Asian Infrastructure Investment Bank to rival the Asian Development Bank.

So what looks likely to take shape over the next few years is a network of railroads and motorways linking China’s main production centers to Bangkok, Singapore, Karachi, Almaty, Moscow, Yangon, Kolkata. We will see pipelines, dams, and power plants built in Siberia, Central Asia, Pakistan and Myanmar; as well as airports, hotels, business centers… and all of this financed with China’s excess savings, and leverage. Given that China today has excess production capacity in all of these sectors, one does not need a fistful of university diplomas to figure out whose companies will get the pick of the construction contracts.

But to finance all of this, and to transform herself into a capital exporter, China needs stable capital markets and a strong, convertible currency. This explains why, despite Hong Kong’s pro-democracy demonstrations, Beijing is pressing ahead with the internationalization of the renminbi using the former British colony as its proving ground (witness the Shanghai-HK stock connect scheme and the removal of renminbi restrictions on Hong Kong residents). And it is why renminbi bonds have delivered better risk-adjusted returns over the past five years than almost any other fixed income market.

Of course, China’s strategy of internationalizing the renminbi, and integrating its neighbors into its own economy might fall flat on its face. Some neighbors bitterly resent China’s increasing assertiveness. Nonetheless, the big story in China today is not ‘ghost cities’ (how long has that one been around?) or undercapitalized banks. The major story is China’s reluctance to continue funneling its excess savings into US treasuries yielding less than 2%, and its willingness to use that capital instead to integrate its neighbors’ economies with its own; using its own currency and its low funding costs as an ‘appeal product’ (and having its own companies pick up the contracts as a bonus). In essence, is this so different from what the US did in Europe in the 1940s and 1950s with the Marshall Plan?

2. Japan: Is Abenomics just a sideshow?

With Japan in the middle of a triple dip recession, and Japanese households suffering a significant contraction in real disposable income, it might seem that Prime Minister Shinzo Abe has chosen an odd time to call a snap election. Three big factors explain his decision:

1)   The Japanese opposition is in complete disarray. So Abe’s decision may primarily have been opportunistic.

2)   We must remember that Abe is the most nationalist prime minister Japan has produced in a generation. The expansion of China’s economic presence across Central and South East Asia will have left him feeling at least as uncomfortable as anyone who witnessed his Apec handshake with Xi Jinping three weeks ago. It is not hard to imagine that Abe returned from Beijing convinced that he needs to step up Japan’s military development; a policy that requires him to command a greater parliamentary majority than he holds now.

3)   The final factor explaining Abe’s decision to call an election may be that in Japan the government’s performance in opinion polls seems to mirror the performance of the local stock market (wouldn’t Barack Obama like to see such a correlation in the US?). With the Nikkei breaking out to new highs, Abe may feel that now is the best time to try and cement his party’s dominant position in the Diet.

As he gets ready to face the voters, how should Abe attempt to portray himself? In our view, he could do worse than present himself as Japan Inc’s biggest salesman. Since the start of his second mandate, Abe has visited 49 countries in 21 months, and taken hundreds of different Japanese CEOs along with him for the ride. The message these CEOs have been spreading is simple: Japan is a very different place from 20 years ago. Companies are doing different things, and investment patterns have changed. Many companies have morphed into completely different animals, and are delivering handsome returns as a result. The relative year to date outperformances of Toyo Tire (+117%), Minebea (+95%), Mabuchi (+57%), Renesas (+43%), Fuji Film (+33%), NGK Insulators (+33%) and Nachi-Fujikoshi (+19%) have been enormous. Or take Panasonic as an example: the old television maker has transformed itself into a car parts firm, piggy-backing on the growth of Tesla’s model S.

Yet even as these changes have occurred, most foreign investors have stopped visiting Japan, and most sell-side firms have stopped funding genuine and original research. For the alert investor this is good news. As the number of Japanese firms at the heart of the disruptions reshaping our global economy – robotics, electric and self-driving cars, alternative energy, healthcare, care for the elderly – continues to expand, and as the number of investors looking at these same firms continues to shrink, those investors willing to sift the gravel of corporate Japan should be able to find real gems.

Which brings us to the real question confronting investors today: the ‘Kuroda put’ has placed Japanese equities back on investor’s maps. But is this just a short term phenomenon? After all, no nation has ever prospered by devaluing its currency. If Japan is set to attract, and retain, foreign investor flows, it will have to come up with a more compelling story than ‘we print money faster than anyone else’.

In our recent research, we have argued that this is exactly what is happening. In fact, we believe so much in the opportunity that we have launched a dedicated Japan corporate research service (GK Plus Alpha) whose principals (Alicia Walker and Neil Newman) are burning shoe leather to identify the disruptive companies that will trigger Japan’s next wave of growth.

3. Should we worry about capital misallocation in the US?

The US has now ‘enjoyed’ a free cost of money for some six years. The logic behind the zero-interest rate policy was simple enough: after the trauma of 2008, the animal spirits of entrepreneurs needed to be prodded back to life. Unfortunately, the last few years have reminded everyone that the average entrepreneur or investor typically borrows for one of two reasons:

  • Capital spending: Business is expanding, so our entrepreneur borrows to open a new plant, or hire more people, etc.
  • Financial engineering: The entrepreneur or investor borrows in order to purchase an existing cash flow, or stream of income. In this case, our borrower calculates the present value of a given income stream, and if this present value is higher than the cost of the debt required to own it, then the transaction makes sense.

Unfortunately, the second type of borrowing does not lead to an increase in the stock of capital. It simply leads to a change in the ownership of capital at higher and higher prices, with the ownership of an asset often moving away from entrepreneurs and towards financial middlemen or institutions. So instead of an increase in an economy’s capital stock (as we would get with increased borrowing for capital spending), with financial engineering all we see is a net increase in the total amount of debt and a greater concentration of asset ownership. And the higher the debt levels and ownership concentration, the greater the system’s fragility and its inability to weather shocks.

We are not arguing that financial engineering has reached its natural limits in the US. Who knows where those limits stand in a zero interest rate world? However, we would highlight that the recent new highs in US equities have not been accompanied by new lows in corporate spreads. Instead, the spread between 5-year BBB bonds and 5-year US treasuries has widened by more than 30 basis points since this summer.

Behind these wider spreads lies a simple reality: corporate bonds issued by energy sector companies have lately been taken to the woodshed. In fact, the spread between the bonds of energy companies, and those of other US corporates are back at highs not seen since the recession of 2001-2002, when the oil price was at US$30 a barrel.

The market’s behavior raises the question whether the energy industry has been the black hole of capital misallocation in the era of quantitative easing. As our friend Josh Ayers of Paradarch Advisors (Josh publishes a weekly entitled The Right Tale, which is a fount of interesting ideas. He can be reached at put it in a recent note: “After surviving the resource nadir of the late 1980s and 1990s, oil and gas firms started pumping up capex as the new millennium began. However, it wasn’t until the purported end of the global financial crisis in 2009 that capital expenditure in the oil patch went into hyperdrive, at which point capex from the S&P 500’s oil and gas subcomponents jumped from roughly 7% of total US fixed investment to over 10% today.”

“It’s no secret that a decade’s worth of higher global oil prices justified much of the early ramp-up in capex, but a more thoughtful look at the underlying data suggests we’re now deep in the malinvestment phase of the oil and gas business cycle. The second chart (above) displays both the total annual capex and the return on that capex (net income/capex) for the ten largest holdings in the Energy Select Sector SPDR (XLE). The most troublesome aspect of this chart is that, since 2010, returns have been declining as capex outlays are increasing. Furthermore, this divergence is occurring despite WTI crude prices averaging nearly $96 per barrel during that period,” Josh noted.

The energy sector may not be the only place where capital has been misallocated on a grand scale. The other industry with a fairly large target on its back is the financial sector. For a start, policymakers around the world have basically decided that, for all intents and purposes, whenever a ‘decision maker’ in the financial industry makes a decision, someone else should be looking over the decision maker’s shoulder to ensure that the decision is appropriate. Take HSBC’s latest results: HSBC added 1400 compliance staff in one quarter, and plans to add another 1000 over the next quarter. From this, we can draw one of two conclusions:

1)   The financial firms that will win are the large firms, as they can afford the compliance costs.

2)   The winners will be the firms that say: “Fine, let’s get rid of the decision maker. Then we won’t need to hire the compliance guy either”.

This brings us to a theme first explored by our friend Paul Jeffery, who back in September wrote: “In 1994 Bill Gates observed: ‘Banking is necessary, banks are not’. The primary function of a bank is to bring savers and users of capital together in order to facilitate an exchange. In return for their role as [trusted] intermediaries banks charge a generous net spread. To date, this hefty added cost has been accepted by the public due to the lack of a credible alternative, as well as the general oligopolistic structure of the banking industry. What Lending Club and other P2P lenders do is provide an online market-place that connects borrowers and lenders directly; think the eBay of loans and you have the right conceptual grasp. Moreover, the business model of online market-place lending breaks with a banking tradition, dating back to 14th century Florence, of operating on a “fractional reserve” basis. In the case of P2P intermediation, lending can be thought of as being “fully reserved” and entails no balance sheet risk on the part of the service facilitator. Instead, the intermediary receives a fee- based revenue stream rather than a spread-based income.”

There is another way we can look at it: finance today is an abnormal industry in two important ways:

1)   The more the sector spends on information and communications technology, the bigger a proportion of the economic pie the industry captures. This is a complete anomaly. In all other industries (retail, energy, telecoms…), spending on ICT has delivered savings for the consumers. In finance, investment in ICT (think shaving seconds of trading times in order to front run customer orders legally) has not delivered savings for consumers, nor even bigger dividends for shareholders, but fatter bonuses and profits for bankers.

2)   The second way finance is an abnormal industry (perhaps unsurprisingly given the first factor) lies in the banks’ inability to pass on anything of value to their customers, at least as far as customer’s perceptions are concerned. Indeed, in ‘brand surveys’ and ‘consumer satisfaction reports’, banks regularly bring up the rear. Who today loves their bank in a way that some people ‘love’ Walmart, Costco, IKEA, Amazon, Apple, Google, Uber, etc?

Most importantly, and as Paul highlights above, if the whole point of the internet is to:

a) measure more efficiently what each individual needs, and

b) eliminate unnecessary intermediaries,

then we should expect a lot of the financial industry’s safe and steady margins to come under heavy pressure. This has already started in the broking and in the money management industries (where mediocre money managers and other closet indexers are being replaced by ETFs). But why shouldn’t we start to see banks’ high return consumer loan, SME loan and credit card loan businesses replaced, at a faster and faster pace, by peer-to-peer lending? Why should consumers continue to pay high fees for bank transfers, or credit cards when increasingly such services are offered at much lower costs by firms such as TransferWise, services like Alipay and Apple Pay, or simply by new currencies such as Bitcoin? On this point, we should note that in the 17 days that followed the launch of Apple Pay on the iPhone 6, almost 1% of Wholefoods’ transactions were processed using the new payment system. The likes of Apple, Google, Facebook and Amazon have grown into behemoths by upending the media, advertising retail and entertainment industries. Such a rapid take- up rate for Apple Pay is a powerful indicator which sector is likely to be next in line. How else can these tech giants keep growing and avoid the fate that befell Sony, Microsoft and Nokia? On their past record, the technology companies will find margins, and growth, in upending our countries’ financial infrastructure. As they do, a lot of capital (both human and monetary) deployed in the current infrastructure will find itself obsolete.

This possibility raises a number of questions – not least for Gavekal’s own investment process, which relies heavily on changes in the velocity of money and in the willingness and ability of commercial banks to multiply money, to judge whether it makes sense to increase portfolio risk. What happens to a world that moves ‘ex-bank’ and where most new loans are extended peer-to-peer? In such a world, the banking multiplier disappears along with fractional reserve banking (and consequently the need for regulators? Dare to dream…). As bankers stop lending their clients umbrellas when it is sunny, and taking them away when it rains, will our economic cycles become much tamer? As central banks everywhere print money aggressively, could the market be in the process of creating currencies no longer based on the borders of nation states, but instead on the cross-border networks of large corporations (Alipay, Apple Pay…), or even on voluntary communities (Bitcoin). Does this mean we are approaching the Austrian dream of a world with many, non government-supported, currencies?

4. Should we care about Europe?

In our September Quarterly Strategy Chartbook, we debated whether the eurozone was set for a revival (the point expounded by François) or a continued period stuck in the doldrums (Charles’s view), or whether we should even care (my point). At the crux of this divergence in views is the question whether euroland is broadly following the Japanese deflationary bust path. Pointing to this possibility are the facts that 11 out of 15 eurozone countries are now registering annual year-on-year declines in CPI, that policy responses have so far been late, unclear and haphazard (as they were in Japan), and that the solutions mooted (e.g. European Commission president Jean-Claude Juncker’s €315bn infrastructure spending plan) recall the solutions adopted in Japan (remember all those bridges to nowhere?). And that’s before going into the structural parallels: ageing populations; dysfunctional, undercapitalized and overcrowded banking systems; influential segments of the population eager to maintain the status quo etc…

With the same causes at work, should we expect the same consequences? Does the continued underperformance of eurozone stocks simply reflect that managing companies in a deflationary environment is a very challenging task? If euroland has really entered a Japanese-style deflationary bust likely to extend years into the future, the conclusion almost draws itself.

The main lesson investors have learned from the Japanese experience of 1990-2013 is that the only time to buy stocks in an economy undergoing a deflationary bust is:

a)   when stocks are massively undervalued relative both to their peers and to their own history, and

b)   when a significant policy change is on the way.

This was the situation in Japan in 1999 (the first round of QE under PM Keizo Obuchi), 2005 (PM Junichiro Koizumi’s bank recapitalization program) and of course in 2013-14 (Abenomics). Otherwise, in a deflationary environment with no or low growth, there is no real reason to pile into equities. One does much better in debt. So, if the Japan-Europe parallel runs true, it only makes sense to look at eurozone equities when they are both massively undervalued relative to their own histories and there are expectations of a big policy change. This was the case in the spring of 2012 when valuations were at extremes, and Mario Draghi replaced Jean-Claude Trichet as ECB president. In the absence of these two conditions, the marginal dollar looking for equity risk will head for sunnier climes.

With this in mind, there are two possible arguments for an exposure to eurozone equities:

1)   The analogy of Japan is misleading as euroland will not experience a deflationary bust (or will soon emerge from deflation).

2)   We are reaching the point when our two conditions – attractive valuations, combined with policy shock and awe – are about to be met. Thus we could be reaching the point when euroland equities start to deliver outsized returns.

Proponents of the first argument will want to overweight euroland equities now, as this scenario should lead to a rebound in both the euro and European equities (so anyone underweight in their portfolios would struggle). However, it has to be said that the odds against this first outcome appear to get longer with almost every data release!

Proponents of the second scenario, however, can afford to sit back and wait, because it is likely any outperformance in eurozone equities would be accompanied by euro currency weakness. Hence, as a percentage of a total benchmark, European equities would not surge, because the rise in equities would be offset by the falling euro.

Alternatively, investors who are skeptical about either of these two propositions can – like us – continue to use euroland as a source of, rather than as a destination for, capital. And they can afford safely to ignore events unfolding in euroland as they seek rewarding investment opportunities in the US or Asia. In short, over the coming years investors may adopt the same view towards the eurozone that they took towards Japan for the last decade: ‘Neither loved, nor hated… simply ignored’.


Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

For example, if in 1981 an investor had decided to forego investing in commodities and simply to diversify his holdings across other asset classes, his decision would have been enough to earn himself a decade at the beach. If our investor had then returned to the office in 1990, and again made just one decision – to own nothing in Japan – he could once again have gone back to sipping margaritas for the next ten years. In 2000, the decision had to be not to own overvalued technology stocks. By 2006, our investor needed to start selling his holdings in financials around the world. And by 2008, the money-saving decision would have been to forego investing in euroland.

Of course hindsight is twenty-twenty, and any investor who managed to avoid all these potholes would have done extremely well. Nevertheless, the big question confronting investors today is how to avoid the potholes of tomorrow. To succeed, we believe that investors need to answer the following questions:

  • Will Japan engineer a revival through its lead in exciting new technologies (robotics, hi-tech help for the elderly, electric and driverless cars etc…), or will Abenomics prove to be the last hurrah of a society unable to adjust to the 21st century? Our research is following these questions closely through our new GK Plus Alpha venture.
  • Will China slowly sink under the weight of the past decade’s malinvestment and the accompanying rise in debt (the consensus view) or will it successfully establish itself as Asia’s new hegemon? Our Beijing based research team is very much on top of these questions, especially Tom Miller, who by next Christmas should have a book out charting the geopolitical impact of China’s rise.
  • Will Indian prime minister Narendra Modi succeed in plucking the low-hanging fruit so visible in India, building new infrastructure, deregulating services, cutting protectionism, etc? If so, will India start to pull its weight in the global economy and financial markets?
  • How will the world deal with a US economy that may no longer run current account deficits, and may no longer be keen to finance large armies? Does such a combination not almost guarantee the success of China’s strategy?
  • If the US dollar is entering a long term structural bull market, who are the winners and losers? The knee-jerk reaction has been to say ‘emerging markets will be the losers’ (simply because they were in the past. But the reality is that most emerging markets have large US dollar reserves and can withstand a strong US currency. Instead, will the big losers from the US dollar be the commodity producers?
  • Have we reached ‘peak demand’ for oil? If so, does this mean that we have years ahead of us in which markets and investors will have to digest the past five years of capital misallocation into commodities?
  • Talking of capital misallocation, does the continued trend of share buybacks render our financial system more fragile (through higher gearing) and so more likely to crack in the face of exogenous shocks? If it does, one key problem may be that although we may have made our banks safer through increased regulations (since banks are not allowed to take risks anymore), we may well have made our financial markets more volatile (since banks are no longer allowed to trade their balance sheets to benefit from spikes in volatility). This much appeared obvious from the behavior of US fixed income markets in the days following Bill Gross’s departure from PIMCO. In turn, if banks are not allowed to take risks at volatile times, then central banks will always be called upon to act, which guarantees more capital misallocation, share buybacks and further fragilization of the system (expect more debates along this theme between Charles, and Anatole).
  • Will the financial sector be next to undergo disintermediation by the internet (after advertising and the media). If so, what will the macro- consequences be? (Hint: not good for the pound or London property.)
  • Is euroland following the Japanese deflationary-bust roadmap?

The answers to these questions will drive performance for years to come. In the meantime, we continue to believe that a portfolio which avoids a) euroland, b) banks, and c) commodities, will do well – perhaps well enough to continue funding Mediterranean beach holidays – especially as these are likely to go on getting cheaper for anyone not earning euros!

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It's your opportunity to get the news John Mauldin thinks matters most to your finances.

Important Disclosures

Pictures from Pixabay: refinery here and 2015 here. 

The Keynesian End Game Crystalizes In Japan’s Monetary Madness

Courtesy of David Stockman via Contra Corner 

If the BOJ’s mad money printers were treated as monetary pariahs by the rest of the world, it would at least imply that a modicum of sanity remains on the planet. But just the opposite is the case. Establishment institutions like the IMF, the US treasury and the other major central banks urge them on, while the Keynesian arson squad led by Professor Krugman actually faults Japan for being too tepid with its “stimulus”.

Now comes several new data points that absolutely confirm Japan is a financial mad house—-even as its policy model is embraced by mainstream officials and analysts peering from a distance. Front and center is the newly reported fact from the Cabinet Office that Japan’s household savings rate plunged to minus 1.3% in the most recent fiscal year, thereby entering negative territory for the first time since records were started in 1955.


Indeed, Japan had been heralded as a nation of savers only a generation ago. During the era before it’s plunge into bubble finance in the late 1980s, households routinely saved 15-25% of income. But after nearly three decades of Keynesian policies, Japan has now stumbled into an insuperable demographic/financial trap; and one that is unusually transparent and rigidly delineated, to boot.

Since Japan famously and doggedly refuses to accept immigrants, its long-term demographics are rigidly baked into the cake. Accordingly, anyone who will make a difference over the next several decades has already been born, counted, factored and attrited into the projections.

Japan’s work force of 80 million will thus drop to 40 million by 2060. At the same time, its current 30 million retires will continue to rise, meaning that its retiree rolls will ultimately exceed the number of workers.

Given those daunting facts, it follows that on the eve of its demographic bust Japan needs high savings and generous interest rates to augment retirement nest eggs; a strong exchange rate to attract foreign capital to help absorb its staggering $12 trillion of public debt, which already stands at a world leading 230% of GDP; and rising real incomes in order to shoulder the heavy taxation that is unavoidably necessary to close its fiscal gap and contain its mushrooming public debt.

With its debilitating Keynesian fiscal and monetary policies now re-upped on steroids under Abenomics, however, it goes without saying that nearly the opposite conditions prevail. Most notably, no household or institution anywhere in Japan can earn anything on liquid savings. The money market rate which determines deposit money yields was driven from a “high” of 100 basis points (as ridiculous as that sounds) at the time of the financial crisis to 10 basis points today, which is to say, nothing.

Historical Data Chart

But what is even more astounding is that the yield on the 10-year JGB dipped to an all-time low of 0.31% in recent trading. Given the militant insistence of the BOJ that it will hit its 2% inflation target come hell or high water, it is accurate to say that the official policy of Abenomics is to cause holders of the government’s long-term debt to loose their shirts.

In fact, however, failing to think more than one step ahead, the BOJ actually wants banks, households and other financial institutions to sell their shirts at a handsome profit. That is to say, the BOJ’s bond purchase program is now so massive that it is buying 100% of the government’s gross debt issuance. In practical terms this means the float of public debt is actually being shrunk, and that the government bond market for all practical purposes has been extinguished by the BOJ.

There is nothing left except one relentless bid by the central bank. Recent data from Japan’s government pension insurance fund (GPIF), for example, show that the GPIF alone has already sold several hundred billions dollars worth of government bonds to the BOJ.

Needless to say, this radical monetization of the entire government bond market is an act of financial suicide. The BOJ now dares not stop the printing presses because absent the central bank’s big fat bid, the market would gap up violently. Yet 40% of Japan’s government revenue is already absorbed by servicing its gargantuan public debt. Even a 180 basis point increase in average yields (meaning that the 10-year JGB would still be under 2%) would absorb the remainder. That’s right, 100% of government revenue would be pre-empted by debt service.

This obviously amounts to a fiscal Looney Tunes scenario, but it is nonetheless embedded in the math. Even after the consumption tax increase from 5% to 8%, Japan’s general government is spending about 100 trillion yen per year while obtaining only 50 trillion yen in tax revenue.


As is evident in the chart above, this yawning gap has been building since the early 1990s when Keynesian missionaries converted the local fiscal apparatchiks to the religion of deficit finance. Now, having wasted 25 years figuratively building highways and bridges to nowhere, the Abe government has obtained a mandate not to raise taxes further until at least 2017. This means that the public debt will continue to soar, and that the BOJ will be under unrelenting pressure to monetize 100% of the new debt issues, least it risk a devastating flare-up in yields.

That makes for a juxtaposition that is out of this world. Since the early 1990’s Japanese bond yields have been falling owing to the BOJ’s financial repression, supplemented by the disinflationary boom stimulated on a worldwide basis by central bank fueled credit expansion. For all practical purposes, Japan’s government debt yields are at the zero bound, and, in fact, maturities up to two years are trading at negative yields.

Historical Data Chart

By the same token, the public debt burden has been climbing relentlessly since the early 1980s owing to the embrace of Keynesian fiscal policies, as so vividly demonstrated in the graph below. And now owing to Abenomics, another 7-10% of GDP will be added annually to the public debt in the years just ahead.

Historical Data Chart

The desperate nature of Japan’s debt trap could not be more vividly depicted than in the chart below. In yen terms—-and that’s the metric that drives Japan’s budget receipts—–national income has not experienced any net growth since 2006!  And Abenomics has not altered the picture in the slightest. During the most recent quarter nominal yen GNP was no higher than in January 2013.

Historical Data Chart

In short, Japan’s fiscal equation is caught a brutal vise in which the denominator (GNP) is stranded on the flat line, while the numerator (public debt outstanding) continues to soar. So for the moment at least, Japan has resorted to 100% printing press finance of its public accounts.

But here’s the thing. The BOJ is destroying the yen and absolutely foreclosing the option of international capital inflows in the years ahead—save for short-term speculations by carry-traders in New York, London and the lesser gambling arenas around the globe. Consequently, the sharp fall of the exchange rate since 2012 is at risk for an accelerating plunge the longer the BOJ prints massive amounts of new yen to finance 100% of the government’s deficit.

Historical Data Chart

Currency collapse, in turn, means that the cost-of-living on an economic archipelago that imports 100% of its energy and most of its raw materials is bound to rise, causing real wages to fall. In fact, that marks another fraught in-coming data point. In November, real cash wages plunged by 4.3% on a year/year basis, marking the 17th straight monthly decline and the steepest slide since December 2009.


<img alt="japanrealwaf" size-full="" wp-image-39061"="" data-cke-saved-src="" src="" style="width: 555px; height: 397px;">


Thus, the Keynesian disaster is complete. Massive BOJ money printing to fund the deficit is eroding real wages, thereby mitigating against tax increases capable of closing the fiscal gap and reducing the financing burden. The mad men at the BOJ are also, and simultaneously, obliterating the domestic saver with ZIRP and warding off international investors with a plunging exchange rate. Consequently, there is no honest way to finance the public deficit, meaning that the printing presses will continue to run red hot.

That this policy amounts to a financial suicide mission is obvious enough. But what is truly scary is that Japan’s policy model has been greenlighted and adopted in one form or another by governments and their central banking branches all around the world.


January seasonals after a good year

January seasonals after a good year

Courtesy of 

Savita Subramanian reminds investors that Januarys are a seasonally strong month – especially after the prior year.

January is seasonally strong, especially after a strong year

Since 1929, January has been one of the seasonally strongest months for the S&P 500, with average and median price returns of +1.3%/+1.6% vs. average/median returns of +0.6%/+0.9% for all months (Chart 1). January has also had the second highest percentage of positive returns (64%) after December (75%). Returns have tended to be even stronger following years where the S&P 500 has double-digit gains, as it has so far this year. In these years, returns have averaged +1.8%, with positive returns 68% of the time.

Screen Shot 2014-12-26 at 8.57.34 AM

Josh here – while January is usually great after a positive year, higher 68% of the time by an average of 1.8%,  it’s important to keep in mind that averages are helpful but not predictive. They don’t work every year. Notably, January of 2014 followed an incredibly strong year in 2013, but treated investors to a peak-to-trough 6% selloff from the moment the year began, bottoming on the first day of February.

Like most things, seasonals work often except for when they don’t. And no one tells you which time you’re in – the exception or the norm – in advance.


January in full effect
Bank of America Merrill Lynch – December 23rd 2014

Picture via Pixabay

The Most Hated Rally Ever That Everyone Loves

Some might argue that record fund inflows corresponding to record market highs is a bad sign for the future of the bull. Time to buy an emerging market ETF?

The Most Hated Rally Ever That Everyone Loves  

Courtesy of

A gigantic statistic surfaced this weekend about fund flows this past week, which shattered every weekly record on the books:

Investors in U.S.-based funds poured $36.5 billion into stock funds in the latest weekly period, marking the biggest inflows on record as U.S. stocks surged to record highs, data from Thomson Reuters Lipper service showed on Friday.

The massive cash commitments for the week ended Dec. 24 were the biggest since Lipper’s records began in 1992. Investors pledged entirely to funds that specialize in U.S. stocks, which attracted $39 billion, while funds that invest in non-U.S.shares posted $2.5 billion in outflows.

The demand came from both retail and institutional investors, with stock mutual funds attracting $12.8 billion and stock exchange-traded funds attracting $23.7 billion.

I think it’s safe to say:

a) we can drop the whole “Most hated bull market ever” thing.

b) Wow – stock ETFs took in double what stock mutual funds took in. This is advisors and younger investors putting money to work, not just paint-by-numbers 401(k) contribution.

c) the pure hatred of overseas stocks remains apparent in this data. The degree to which people are willing to chase US stocks while forsaking the stocks from around the world is hitting a fever pitch.


U.S.-based stock funds attract record $36.5 bln inflows in week -Lipper (Reuters) 


2014: The Year Propaganda Came Of Age

Courtesy of The Automatic Earth.

Dorothea Lange Drought hit OK farm family on way to CA Aug 1936

From just about as early in my life as I can remember, growing up as a child in Holland, there were stories about World War II, and not just about Anne Frank and the huge amounts of people who, like her, had been dragged off to camps in eastern Europe never to come back, but also about the thousands who had risked their lives to hide Jewish and other refugees, and the scores who had been executed for doing so, often betrayed by their own neighbors.

And then there were those who had risked their lives in equally courageous ways to get news out to people, putting out newspapers and radio broadcasts just so there would be a version of events out there that was real, and not just what the Germans wanted one to believe. This happened in all Nazi – and Nazi friendly – occupied European nations. The courage of these people is hard to gauge for us today, and I’m convinced there’s no way to say whom amongst us would show that kind of bravery if we were put to the test; I certainly wouldn’t be sure about myself.

Still, without wanting to put myself anywhere near the level of those very very real heroes, please don’t get me wrong about that, that’s not what I mean, I was thinking about them with regards to what is happening in our media today. I’ve mentioned before that I don’t think Joseph Goebbels had anything on US and European media today.

That propaganda as a strategic and political instrument has been refined to a huge extent over the past 70-odd years since Goebbels first picked up on Freud’s lessons on how to influence the unconscious mind, and the ‘mass-mind’, as a way to ‘steer’ an entire people, not just as a means to make them buy detergent. These days, the media can make people believe just about anything, and they have the added benefit that they can pose as friends of the people, not the enemy.

But there is a reason why such a large ‘industry’ has developed on the web with people writing articles that don’t say what the mass media say. That reason for is, obviously, first and foremost that not everybody believes whatever they are told. The problem is equally obvious: not nearly enough people are being reached to make a true difference, and to question the official narratives.

Me, I have no claim to fame outside of the appreciation I get from first, my readers and second, from my colleagues and peers. I get a lot of both, and I thank you for that, but this certainly is not about me. If anything, it’s about trying to live up to the desire for truth in the face of odds squarely stacked against it, and against the people I try to reach out to. Trying to do just 0.1% of what the WWII underground press was about.

A few days ago, I wrote in About That Interview :

The FBI claims they are certain the hackers are North Korean, but they have provided no proof of that claim. We have to trust them on their beautiful blue eyes. I think if anything defines 2014 for me, it’s the advent of incessant claims for which no proof – apparently – needs to be provided. Everything related to Ukraine over the past year carries that trait. The year of ‘beautiful blue eyes’, in other words. Never no proof, you just have to believe what your government says.

And that truly defines 2014 for me. A level of propaganda I don’t recognize, and I don’t think I’ve ever seen before. 2014 has for me been the year of utter nonsense. To wit, it just finished in fine form with a 5% US GDP growth number, just to name one example. Really, guys? 5%? Really? With all the numbers presented lately, the negative Thanksgiving sales data – minus 11% from what I remember -, the so-so at best Christmas store numbers to date, shrinking durable goods in November and all? Plus 5%?

It really doesn’t matter what I say, does it? You have enough people believing ridiculous numbers like that to make it worth your while. After all, that’s all that counts. It’s a democracy, isn’t it? If a majority believes something, it becomes true. If you can get more than 50% of people to believe whatever you say, that’s case closed.

With well over 90 million working age Americans counted as being out of the labor force, and with 43 million on food stamps, you can still present a 5% GDP growth number, if only you can get a sufficiently large number of people to ‘believe’. And you do, I’ll give you that. As far as the media goes, we have achieved the change we can believe in. We may not have that change, but we sure do believe we have, don’t we? And isn’t that what counts? Are congratulations in order?

Well, not where I’m at, they’re not. I should do a shout out to the likes of Zero Hedge, Yves Smith, David Stockman, Wolf Richter, Mish, Steve Keen, Jim Kunstler, and so many others, we’re a solid crowd by now even if we’re neglected, and please don’t feel left out if you’re not in that list, I know who you are. The problem is, we’re all completely neglected by the mass media, even though there are a ton of very sharp minds in this ‘finance blogosphere’. And perhaps we should make it a point to break through that ridiculous black-out in 2015.

2014, in my eyes, has been the year of propaganda outdoing even its own very purpose, and succeeding too. We are supposed to be living in a time of the best educated people in the history of mankind, and everyone thinks (s)he’s mighty smart, but precious few have even an inkling of a clue of what transpires in the world they live in. Talk about a lost generation. Or two.

We really need to question the value of higher education, if all we get for it is a generation of people so easily duped by utter blubber. What do they teach people at our universities these days? Certainly not to think for themselves, that much is clear. And then what is the use? Why spend all that time raising an entire generation of highly educated pawns, sheep and robots? I can think of some people liking that, but for society as a whole, it’s devastating if that’s all higher education is.

And if you would like to raise doubts here, the very existence of finance blogosphere I mentioned before is proof that we indeed have raised a generation of sheep. If we had functioning media, there’d be no need for that blogosphere. We are the people who keep on pointing out where the mass media fail, let alone the politicians, simply by being there and being supported to the extent we are by the few people who escape the sheep mentality.

But that’s not nearly enough. Journalists, reporters, whatever they call themselves, working for Bloomberg, Reuters, CNBC etc. should at the very least quote Zero Hedge on a daily basis, and Mish, and Steve, and Yves, and perhaps even me – though it’s fine if they continue to ignore me, as long as they give the rest their rightful place.

There are many people in the blogosphere who are many times smarter than the people who write for the mass media, and that’s a very simple and hardly disputable fact that needs to be recognized. When you read something in your paper or at your online news provider, it should be second nature to ask yourself: but what would Tyler Durden say, or the Automatic Earth, or Naked Capitalism, or David Stockman?

But we’re nowhere near that, are we? We’ve been fooled with economic stats for years, not just in the US, not even just in the west, but all over, they all grabbed on to the potential of providing people with numbers that have little to do with reality, but that simply feel good. Or even just look good.

Still, boy, have we been, and are we being, fooled. Then again, most of you wouldn’t know, would you? We people tend to discount the future, to see today as more important than tomorrow, and in the same manner we find our children’s future much less important than our own. Because that feels good too. If we are comfy right now, screw them. Not that we’d ever put it into those terms.

But you know, that’s really all old hack by now. 2014 brought us a whole other class of nonsense. And we swallowed it all hook line and entire sinker.

2014 gave us Ukraine. And you just try and find anyone today who doesn’t think Vladimir Putin is and was the evil genius mind behind the whole thing, including the 4500+ people who died there over the past 10 months. Why is it so hard to anyone who doubts that narrative? Because our media told us Putin is the bogeyman. And ‘we’ never asked for any proof. That is, except for those of us in that same blogosphere.

Meanwhile, round after round of sanctions against Russia have been set up and activated by EU and US, causing hardship for both Russian people and European businesses. But why, what exactly is Putin allegedly guilty of?

The US/EU installed a government in Kiev in February (yeah, yap about it), which is still in place, with a bunch of US citizens recently added for good measure – and for profit-. The chocolate prince president was indeed elected months later, but the prime minister – Yats – was handpicked by America, and is still -amazingly – in place. That’s the same government that had it own army murder thousands of its own citizens, and not a thing has been resolved so far.

The whole thing came to a head when MH17 was shot down over the summer. That too was blamed on Putin. Or was it? Well, not directly, nobody said Putin ordered that plane to be shot. Nor did anyone say Russia shot it. There is the accusation that Russian speaking Ukrainian ‘rebels’ did it, but proof for that was never provided in the 6 months since the incident. And there must be a best before date in there somewhere.

Is it possible the ‘rebels’ did it? We can’t exclude it, but that’s for the same reason we can’t exclude the option that little green Martians did it: we don’t know. But even then, even if they did, there’s the question whether that would have been on purpose. Which seems really stretching it: nothing they want would be served by shooting down a plane full of European, Malaysian and Australian holiday goers.

But here we are: no proof and layer upon layer of sanctions. And nary a voice is raised in the west. If one is, it’s to denounce the Russians as bloodthirsty barbarians. Even though there is no proof they did anything other than protecting what they see as their own people. Something we all would do too, no questions asked.

Ukraine defines 2014 as the year western propaganda came into its own. Not just fictional stories about an economic recovery anymore, no, we had our politico-media establishment ram an entire new cold war down our throats. And we swallowed it whole. We may have had a million more years of higher education than our parents and grandparents, but we sure don’t seem to have gotten any smarter than them.

There is a lot of information out there, written by people inspired by things other than monetary incentives or job security or anything like that, people who simply want to get information out that your trusted media won’t give you anymore than Goebbels’ media did in occupied Europe in the 1940s. And you don’t even have to risk your lives to access that information. All you have to do is to get off your couch.

The Automatic Earth is but a small part of a very valuable and fast growing resource that warrants a lot more attention than it’s been receiving to date. A reported 5% US GDP growth print is one reason why, the entire Ukraine fantasy story is another. The blogosphere is full of functioning neurons, which is more than you can say for your papers and online MSM.

As far as media is concerned, 2014 has been downright scary in its distortion of reality. Let’s try and move 2015 a little bit closer towards what’s actually happening.

Russia Debt One Grade Above Junk With Downgrades Coming, How Likely is Default?

Courtesy of Mish.

All three rating agencies are expected to downgrade Russia's debt to junk soon and bailouts to Russian banks are on the rise, but how likely is default?

The Financial Times reports …

Russia trebled the size of its bailout of troubled lender Trust Bank to Rbs99bn ($1.9bn) on Friday, laying bare the growing financial fallout from its currency crisis and the slump in the price of oil, its main export.

The rapidly rising cost makes the rescue of Trust bank, which foundered as the rouble collapsed early last week, the second-largest seen in Russia. It has now consumed a tenth of the money earmarked by the government last week for bank bailouts.

The authorities also said they would spend Rbs320bn ($5.9bn) propping up two other banks. Anton Siluanov, finance minister, said state-owned VTB, the second-largest lender by assets, could receive Rbs100bn before the end of this year and another Rbs150bn in 2015, while Gazprombank could be allocated Rbs70bn.

Trust Bank was the first financial institution to fall victim to the currency crisis as it suffered a run on deposits by customers panicked by the steep drop in the rouble’s value, which at one point on December 16 plummeted to an all-time low of 80 against the dollar.

The central bank said that the state-run Deposit Insurance Agency would provide Trust Bank with up to Rbs99bn. It would give an additional Rbs28bn loan to Bank Otkritie, one of Russia’s largest private lenders, to restructure Trust Bank, with the two then merging by the end of 2020.

Foreign Reserves

Although US and EU sanctions make it difficult for Russian companies to obtain financing, and although the Russian banking system is a mess, sovereign default will only occur if Russia cannot meet its foreign debt obligations.

Russia has about $4000 billion in foreign currency reserves, lowest since 2009, but foreign currency obligations for 2015 total about $120 billion.

On that score, the immediate risk seems slim. In fact, one has to wonder if the impending downgrade to junk is politically motivated.

Regardless, the US severely underestimates the fallout, especially to Europe, should default occur.

Sanctions are economic madness and Obama's claim they are working is preposterous. For further discussion, please see Russia Under Attack: Letter from CEO of Genoil to CEO of JPMorgan Chase on US Foreign Policy Blowback

Continue Here > 

“Hookers & Blow” Lift Britain Over France As World’s 5th Largest Economy

Courtesy of ZeroHedge. View original post here.

Britain has inched out France as the world's fifth-largest economy thanks to what The Telegraph calls "a shake-up" of the national accounts this summer.

UK gross domestic product (GDP) is expected to total $2.828 trillion (£1.816 trillion) this year, compared with French GDP of $2.827 trillion, as The Centre for Economics and Business Research (CEBR) said Britain's acceleration was boosted by the inclusion of sex and drugs to UK growth (as part of new pan-European accounting standards). Official estimates show prostitution added about £5.7bn to the UK economy in 2013, while illegal drugs were worth about £6.62bn. One question – how did they estimate it?

Britain spends more on illegal drugs than it does on Beer or Spirits (liquor)

And more on "Hookers and Blow" than on Vegetables, Milk, or footwear…


The ONS's methodology for calculating how much prostitution is worth to the economy is based on extrapolating figures about the number of sex workers in London for the rest of the UK. However, this survey data, which is from 2004, excludes male prostitutes.

According to one estimate by Andrew Fogg, 42pc of all sex workers in the UK are male, making their omission a significant gap in the ONS's calculations. Other economists have also labelled the attempts to estimate the size of illegal economic activity as little more than "guesswork".

*  *  *

Brings a whole new meaning to the phrase "Buy British"


Things That Make You Go Hmmm: Signing Off

Things That Make You Go Hmmm: Signing Off

By Grant Williams

On Christmas Eve 1979, 27 days before I became a teenager, in a surburban street in Moseley in Britain’s West Midlands, a group of musicians put the finishing touches on their debut album.

The musicians — Brian Travers, Astro, James Brown (no, not that one), Earl Falconer, Norman Hassan, Mickey Virtue, and twins Ali and Robin Campbell — had a unique approach to the music business.

Eighteen months prior to completing their first album, Ali Campbell and Travers had plastered the streets of Birmingham with leaflets promoting the band, which had taken its name from the document issued to people claiming unemployment benefits from the UK government’s Department of Health and Social Security (DHSS). The name of the form — and thus the band — was UB40.

Having advertised themselves and with dreams of making a big splash on Britain’s reinvigorated music scene running wild in their heads, the band had just one remaining item on their to-do list — learn to play their instruments.

The members of UB40 made an agreement to spend the next year doing nothing other than learning their instruments and practising their songs until they felt they were good enough.

(I know, I know! This IS analagous to many modern-day Central Bank policy efforts, but that’s not where I’m going with this, so stop jumping ahead.)

Anyway, after about a year, the band felt competent enough to play in public; and they made their debut on the 9th of February, 1979, in an upstairs room at the Hare & Hounds, a small pub in King’s Heath. They had been “booked” by a friend to celebrate his birthday.

Following on the success of their first gig (apparently, the birthday boy was delighted), the band secured a series of similar shows, all in local pubs, at which they planned to unleash their blend of reggae and dub onto an unsuspecting public who, though they didn’t realise it, had been waiting for UB40 for years.

Remarkably, at one of these pub gigs, Chrissie Hynde just happened to be in attendance, no doubt supping a couple of pints of Throgmorton’s Dubious Explanation (a real ale so thick it’s served by the slice); and she liked what she saw so much, she offered the band a supporting slot on The Pretenders’ upcoming tour of the UK.


Fast-forward to Christmas 1979, and the story of the recording of the band’s debut album burnishes the legend yet further:

(Wikipedia): The band approached local musician Bob Lamb as he was the only person they knew with any recording experience. Lamb had been the drummer with the Steve Gibbons Band for much of the 1970s and was a well-known figure within the Birmingham music scene…. However, as the band were unable to afford a proper recording studio, the album was recorded in Lamb’s own home at the time, a ground-floor flat in a house on Cambridge Road in Birmingham’s Moseley district….

Brian Travers recalled just how basic the recording facilities of the original Cambridge Road “studio” really were:

Because we couldn’t afford a studio and he was the only guy we knew who knew how to record music, we did the album in his bedsit. I remember he had his bed on stilts. So underneath the bed was a sofa and mixing desk. And so we recorded the album there on an eight-track machine, with the same 50p coin going through the electric meter continually because we’d booted the lock off it. And, with it being a bedsit and us being eight in the band, we’d record the saxophone in the kitchen — because there was a bit of resonance off the walls, a bit of reverb — before putting the machine effects on it. While the percussion — the tambourines, the congas, the drums — we’d do in the back yard. Which is why you can hear birds singing on some of the tracks! You know, because it was in the daytime we’d be shouting across the fences “Keep it DOWN! We’re RECORDING!”

Lamb remembered the process fondly:

Nothing was hard work about that album, it was a bit of a dream that sort of fell out of the sky… It was almost effortless to make in that they were so good at the time, and so happy at the time with the success that they got, there was no effort in it.

The title of the album, “Signing Off,” was inspired by the process of the band members ending their claim on UK unemployment benefits — and becoming pop stars.

The LP (Google it, Gen Y-ers), released on August 29, 1980, spent 71 weeks on the UK albums chart, peaking at number 2 and turning platinum (when doing such a thing used to mean something). It was greeted with rapture by Britain’s music press:

(Sounds): Five stars out of five. It is an (almost) perfect album…. It’s rare to find a debut album so detailed, so excellently played and so packed with bite — I sometimes think it hasn’t really happened since The Clash.

The album would go on to make Q Magazine’s “100 Greatest British Albums Ever” (#83, if you’re interested) and is featured in a book somewhat somberly titled 1001 Albums to Hear Before You Die.

I think it’s fair to say I played my part in the success of the band by spending the pocket money I had saved up on a copy of “Signing Off” (though the band have so far not publicly acknowledged my involvement).

Anyway, as I am now signing off from Mauldin Economics, I felt it would be appropriate to take stock of a few of the issues I have covered ad nauseum repeatedly during my two-plus years working with John and his team; and I thought I’d also take those of you unfamiliar with UB40’s debut album through a few of the tracks (and remind those of you who know the band just how spectacular that album was).

Track 2. King — 4:35

The “King” referred to in the second track on “Signing Off” was, of course, Martin Luther King, Jr. The song was short on lyrics but big on impact; however, the undoubted “King” in markets today is once again King Dollar, and the world’s reserve currency is making some serious waves right now, which threaten to cause chaos in world markets.

At this point I’ll throw things over to my friend and partner in Real Vision Television and author of The Global Macro Investor, Raoul Pal, who has been warning of the likelihood of a major move in the dollar for longer than just about anybody. In his most recent report, he explained the ramifications of a dollar bull market in the clearest, most concise way possible:

(Raoul Pal): Debt dynamics, deflation, positioning and technicals all suggest that a dollar bull market of some considerable velocity and length is underway.

When dollar bull markets occur, emerging markets get hit.

When dollar bull markets occur, carry trades get unwound.

When dollar bull markets occur, they tend to usher in disinflationary forces as commodities and goods get re-priced.

The preceding three factors lead to a self-reinforcing of the dollar bull market, creating more of the same in a cycle of liquidation and bad debts, creating more demand for US dollars.

As I said, clear and concise.

I watched Raoul present at the iCIO Summit this past week, and his presentation was compelling, to say the least. As he pointed out in a panel discussion with Mark Yusko, Dennis Gartman, David Rosenberg, and myself, “When currencies begin to trend, they can do so for decades.”

A sobering thought.

A look at the long-term charts of the DXY Index shows just how massive the potential reversal of this trend is; and based on Raoul’s roadmap, the sheer size of the reversal gives us a strong hint of the degree of carnage that will be wrought upon a world in which the dollar carry trade has reached somewhere between $5 trillion and $9 trillion.

Incidentally, one of those estimates is Raoul’s, and one belongs to the BIS, and I bet your first guess as to which is which would have been wrong.

A closer look at a shorter-term chart demonstrates the recent break clearly:

The BIS report to which I refer was published last week, and it was astounding in terms of the sheer size of the dollar carry trade it depicted.

According to the BIS, US dollar loans to China’s banks and companies have jumped to $1.1 trillion — that’s TRILLION — from virtually zero just five short years ago. The annual rate of increase of those loans is a mind-boggling 47%.

However, the fun doesn’t stop there.

Consider Brazil, for example, where cross-border dollar credit now stands at $461 billion, or roughly 20% of GDP. For Mexico those numbers are even more eye-watering. A country with a GDP of just $1.1 trillion has outstanding cross-border dollar credit of $381 billion — or roughly 30% of GDP. Frightening.

Meanwhile, in Russia the same metric has reached $751 billion. Why does this matter? Well, the charts below, which show the appreciation of the US dollar against those three currencies in the last five years, highlight the danger to countries that have been able to borrow seemingly endless amounts of (relatively) stable dollars to finance business operations and expansion.

Lastly — and perhaps most importantly — witness the change in direction of the Chinese renminbi which, after trending higher against the dollar for many years (and, in the process, moving virtually everybody to the same side of the boat in the belief that a stronger Chinese currency was a given), has suddenly started to look as if it may also succumb to the renewed strength of the dollar. The only difference here being that the Chinese may actively be looking now to devalue their currency in light of the ongoing attempt by the Japanese to devaluetheir way back to competitiveness. Few thought this a likely scenario until very recently; consequently, few are positioned accordingly; and when things like that happen in the macro world, you can get some REALLY funky moves.

When currency wars break out, they can get very nasty very quickly.


Under no circumstances should you take your eyes off the US dollar, folks. The sheer number of places where you will witness the knock-on effects of a soaring dollar — chief amongst them emerging markets and the commodity space — will be breathtaking.

I will write at greater length on the likely effects of the dollar’s move on gold in a few weeks, as it warrants a piece all its own; so stay tuned for that one.

In a series of conversations I’ve been fortunate to have had with some of the best macro traders in the world in recent months through Real Vision Television, there has been one overarching takeaway from every one of them: macro is back, and 2015 is shaping up to be an epic year for the guys who trade these fundamental shifts. To a man, after several years of little action in the macro world, they are positively licking their lips at the potential opportunities that are headed their way next year.

One person’s opportunity is another person’s crisis. You have been warned.

3. 12 Bar — 4:24

Track 3 was an instrumental number called “12 Bar,” a reggae reimagining of the 12-bar blues that highlighted Brian Travers’ remarkably good saxophony skills (given his lack of attention to learning to play the instrument before forming the band).

Obviously, during my time with Mauldin Economics, the “bars” which have preoccupied me have been those of the gold variety — and for the most part, their constant movement in an easterly direction.

I have written article after article and given presentation after presentation about the dichotomy between paper and physical gold and have regularly highlighted the magnitude of the flow of gold out of the West and into strong Eastern hands. In the previous edition of this publication (“How Could It Happen?”), I imagined a future in which this stunning relocation of physical gold had finally mattered; and between publishing that piece and penning this one, a couple of interesting things have happened. Firstly, my friend Barry Ritholtz took a big, fat shot at me in a Bloomberg column entitled “The Gold Fairy Tale Fails Again.” Barry’s article (which was entirely consistent with his very public and oft-stated thinking and was, as is always the case with Barry, very well-written) took apart what he sees as the various failed narratives in the gold markets. He began with gold’s link to QE:

(Barry Ritholtz): [T]he most popular gold narrative was that the Federal Reserve’s program of quantitative easing would lead to the collapse of the dollar and hyperinflation. “The problem with all of this was that even as the narrative was failing, the storytellers never changed their tale. The dollar hit three-year highs, despite QE. Inflation was nowhere to be found,” I wrote at the time…

… moved on to the recent SGI:

Switzerland was going to save gold based on a ballot proposal stipulating that the Swiss National Bank hold at least 20 percent of its 520-billion-franc ($538 billion) balance sheet in gold, repatriate overseas gold holdings and never sell bullion in the future. This was going to be the driver of the next leg up in gold. Except for the small fact that the “Save Our Swiss Gold” proposal was voted down, 77 percent to 23 percent, by the electorate….

… then hit upon the recent Indian import restrictions and reports of gold shortages, which Barry clearly feels are spurious, before eventually finding his way to yours truly:

Perhaps the most egregious narrative failure came from Grant Williams of Mauldin Economics. He imagined a conversation 30 years from now about China’s secret three-decade-long gold-buying spree, dating to November 2014. Well, we only need to wait 30 years to see if this prediction is correct.

Now, in response to the lighting up of my Twitter feed after Barry’s article was posted (and my thanks to all those who kindly pointed it out to me), I would say this: Barry is right on all counts.

For now.

I am delighted to be able to call Barry a friend and have absolutely no problem with his calling me out on what I said. Those of us who possess sufficient hubris to deem our thoughts worthy of distribution wider than the inside of our own heads are absolutely there to be taken to task should others disagree with us. We make ourselves fair game the second we hit the wires.

Sadly, none of us actually KNOW anything. How could we? We all take whatever inputs we find and then use them to reach our own conclusions based mostly on probability, and more often than not those conclusions are wrong.

HOWEVER… if your logic is sound and your thought processes rigorous, being wrong is often a temporary state — something that can also be said about being right, of course. In my humble opinion, the issue with gold today is not one of narrative, as Barry suggests, but rather that the extent of the current interference in markets by our friends at the various central banks around the world has meant that being wrong (no matter which part of the financial jigsaw puzzle you may be concerned with) has never been easier — even though being right has never, in my own mind at least, been more assured in the long term, certainly as far as gold is concerned.

As I slumped against the literary ropes, Barry threw one more punch when he suggested that the reader would “only need to wait 30 years to see if this prediction is correct,” but this is where I stop covering up and finally flick a jab or two of my own.

I think the chances of having to wait 30 years to see the gold conundrum resolve itself (in materially higher prices, I might add) lie close to those of Barry’s being invited to give the opening address at the next GATA conference. The evidence is crystal clear that significant quantities of physical gold have been pouring into Eastern vaults (due to both private- and public-sector activity); and gold is, after all, a finite resource. Not only that, but the “weakness” in gold (which remains roughly 500% above its turn-of-the-century low, despite the recent 30% correction) is confined to the paper market.

Whilst this distinction between paper and real gold hasn’t mattered up until now, there will come a day when it absolutely does — to everybody — and at that point, anyone not positioned correctly will be in a world of hurt.

(Charts above and below courtesy of Nick Laird at Sharelynx and Koos Jansen)

Tightness in the physical market has increased consistently as the likes of Russia continue to stockpile ever-increasing amounts of gold and as Chinese imports as well as withdrawals from the Shanghai Gold Exchange maintain a torrid pace. The only missing piece of the puzzle is the lack of any official acknowledgement that the Chinese have been doing the same thing to a far greater degree; and, as I wrote in “How Could It Happen?”, there is a curious demand for absolute proof from those who dispute official figures, whilst the principle of reasonable doubt continues to hold sway on the other side of the argument.

I suspect that imbalance will right itself — possibly very soon — and when it does there will be absolutely no putting the genie back into the bottle.

In the meantime, as Barry so confidently predicted, the Swiss Gold Initiative failed, but that was overshadowed (in my mind at least) by a couple of very interesting developments that were covered beautifully by two of my buddies, Willem Middelkoop (author of The Big Reset — a phenomenal read) and Koos Jansen.

Firstly, Koos reported on the increasing drive to allocate the gold held within the Eurosystem:

(Koos Jansen): [M]ost of the Eurosystem official gold reserves are allocated, and since January 2014 (which is as far as the more detailed data goes back) the unallocated gold reserves are declining, as we can see in the next chart.

Unfortunately we do not know what happened prior to 2014.

Note, allocated does not mean the gold is located on own soil, but it does mean the gold is assigned to specific gold holdings, including bar numbers, whether stored on own soil or stored abroad. Unallocated gold relates to gold held without a claim on specified bar numbers; often these unallocated accounts are used for easy trading… The fact the Eurosystem discloses the ratio between its allocated and unallocated gold and, more important, the fact that the portion of allocated gold is far greater and increasing, tells me the Eurosystem is allocating as much gold as they can.

Secondly, another repatriation request was unearthed — this time made by perhaps the least likely source imaginable:

(Koos Jansen): In Europe, so far, Germany has been repatriating gold since 2012 from the US and France, The Netherlands has repatriated 122.5 tonnes a few weeks ago from the US, soon after Marine Le Pen, leader of the Front National party of France, penned an open letter to Christian Noyer, governor of the Bank of France, requesting that the country’s gold holdings be repatriated back to France; and now Belgium is making a move. Who’s next? And why are all these countries seemingly so nervous to get their gold ASAP on own soil?

Funnily enough, the answer to Koos’ rhetorical question about who’s next was answered just a few days later:

(Bloomberg): The Austrian state audit court says central bank should address concentration risk of storing 80% of its gold reserves with the Bank of England, Standard reports, citing draft audit report. Court advises central bank to diversify storage locations, contract partners.

Austrian central bank reviewing gold storage concept, doesn’t rule out relocating some of its gold from London to Austria: Standard cites unidentified central bank officials. Austria has 280 tons gold reserves, according to 2013 annual report. Austrian Audit Court Will Review Nation’s Gold Reserves in U.K.

Say what you want about the gold price languishing below $1200 (or not, as the case may be, after this week), and say what you want about the technical picture or the “6,000-year bubble,” as Citi’s Willem Buiter recently termed it; but know this: gold is an insurance policy — not a trading vehicle — and the time to assess gold is when people have a sudden need for insurance. When that day comes — and believe me, it’s coming — the price will be the very last thing that matters. It will be purely and simply a matter of securing possession — bubble or not — and at any price.

That price will NOT be $1200.

A “run” on the gold “bank” (something I predicted would happen when I wrote about Hugo Chavez’s original repatriation request back in 2011) would undoubtedly lead to one of those Warren Buffett moments when a bunch of people are left standing naked on the shore.

It is also a phenomenon which will begin quietly before suddenly exploding into life.

If you listen very carefully, you can hear something happening…

Click here to continue reading this article from Things That Make You Go Hmmm… – a free newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore.

The article Things That Make You Go Hmmm: Signing Off was originally published at

Future Shock – The Unsustainable Often Ends Abruptly

Courtesy of Adam Taggart via Peak Prosperity

Here at the penultimate chapter of The Crash Course, everything we've learned comes together into a single narrow range of time we'll call the twenty-teens. 

What this chapter offers is a comprehensive view of how all of our problems are actually interrelated and need to be viewed as such, or solutions will continue to elude us.

Each of the many key trends and threats mentioned earlier in The Crash Course will take many years, if not several decades, to address. And yet, we find them all parked directly in front of us without any serious national discussion or planning. 

With every passing day we squander precious time while the problems grow larger and more costly, if not thoroughly intractable.  Buying time, as the central bankers and politicians the world-over have opted to do, is not a strategy.  Simply hoping for better times has a much different probability for success than having a well thought-out plan. The mark of a mature adult is someone who can manage complexity and plan ahead.  The same description applies to an entire society.  Here at Peak Prosperity, our opinion is that with precious few exceptions, the current political and corporate leadership of this country are not adequately managing the complexity of the situation. And they are not planning ahead. 

Simply put: We've lived well beyond our economic, energetic and ecological budgets. It's time to change that.

It is time, to return to living within our means.  We need to set priorities, set budgets, and stick to both.


Dollar Outlook at the End of 2014

Courtesy of Marc To Market

The US dollar closed higher against all the major currencies during the holiday shortened week. The lack of liquidity may have exaggerated the weakness of Swedish krona and Norwegian krone, the poorest performing major currencies.  Both lost about 1.5% against the greenback. 

The least weak currencies were in the dollar-bloc. The Canadian and New Zealand dollars were practically flat, and the Australian dollar slipped 0.2%. The euro and sterling slipped about 0.5%, while the yen shed 0.7% of its recent gains. 

The lack of participation will continue into the last week of the year.  The general technical condition will not change.   The dollar's bull advance is not over.  Leaving aside the housing market, which has been one of the few US economic disappointments of 2014, the 5% Q3 GDP, coupled with continued improvement in the labor market keeps the Fed poised to raise rates in around the middle of 2015. The prospects of a more aggressive ECB, buying a wider range of assets, including sovereign bonds, will keep the euro on the defensive.   

The euro recorded a marginal new low on December 23 near $1.2165.  This is just above the 50% retracement of the euro's trading range since its launch in 1999 (~$1.2135). The bottom of the Bollinger Band (set 2 standard deviations below the 20-day moving average) is near there as well (~$1.2125).  Further out is the July 2013 low near $1.2045 and the $1.20 psychological level.  On the upside, offers in the $1.2250-75 band may contain upticks. 

Despite unprecedented expansion of the central bank's balance sheet, Japanese inflation fell to its slowest pace in six months (headline and core).   When adjusted for the sales tax increase, Japan's core CPI rose 0.7% year-over-year in November.  The 2% inflation target looks nearly as elusive as the ECB's.   The dollar's recent 5.5% slide in six sessions to almost JPY115.50 shook out many of the recent dollar longs.  As many of these positions are re-established, the dollar's ascent has resumed.  Initial resistance is seen in the JPY120.85-JPY121.00 area.  Above there is the high from December 8 near JPY121.85.  On the other hand, a break now of JPY119.40 will warn of a more complicated correction.  

Sterling was mostly confined to a $1.56-$1.58 trading range from the middle of November through the middle of December.  It has slipped from this box to a lower trading range, and spiked to $1.5485 on December 23.  It has not recovered above $1.5580 since, but this is probably more a consequence of the lack of participation than a genuine technical cap.  Stronger offers are likely in the $1.5600-35 area.  

The Canadian dollar is moving sideways.  The US dollar has been within the range set on December 15 (CAD1.1550-CAD1.1675) for the past nine sessions.  This renders many trend following technical tools less useful.  Over the medium term, we continue to favor a weaker Canadian dollar.    

The Australian dollar recorded new multi-year lows on December 23 when it slipped a little below $0.8090.  Expectations have built for not one but two rate cuts by the RBA in H115.  Many want to sell into an Aussie bounce, but in thin market conditions, the $0.8140-50 area is capping upticks. Stronger selling interest is seen near $0.8200.  

The February crude oil (light-sweet) futures contract will likely spend the last week in the year in the $54-$59 a barrel that has contained prices since the middle of the month.  Barring a significant reversal, December will be the sixth consecutive monthly decline for crude prices.  The 7.27 mln barrel unexpected build of crude stocks according to the EIA in the latest week (consensus was for a 2.5 mln barrel decline) warns of the risk of additional price declines.  That said, we see many forecasts for the price to bottom in early 2015.  We are less sanguine.  Inventories are still rising, and the pace of rig shutdowns will have to accelerate.  

US 10-year yields have been hovering around 2.25% since that surprisingly strong Q3 GDP revision to 5.0%.  It would have to rise above 2.35% to be anything of note.  On the downside, the 2.15% area may tempt Treasury sellers.  

Technically, price gaps are often important.  We identified the significance of two S&P gaps in Q4.  The first was the sharply higher opening on October 21.  It boosted our confidence that the correction that had seen the S&P 500 lose nearly 10% between September 19 and October 15 was over.  The S&P 500 gapped higher again on December 18.   It confirmed our suspicions that the S&P 500 5.5% week-long downdraft ended on December 15 and that the index was on its way to new highs.  While the gains scored in the extremely light volume may be tested, technically there is little reason not to expect more life in the bull.  

Due to the holiday, the Commitment of Traders report was delayed. 

North Korea Internet, Cell Phones Go Dark

Courtesy of ZeroHedge. View original post here.

When it comes to crude attempts at humor, The Interview may (and should) have been a stunning flop, but meanwhile the real comedy continues in the real world, whose absurdity has made any IPO of The Onion impossible.

According to Reuters, North Korea's Internet and 3G mobile networks were paralyzed on Saturday evening, China's official Xinhua news agency reported on Saturday.

The network had not returned to normal as of 2130 local time, Xinhua reported, citing reporters in the country that had confirmed the situation over fixed telephone systems.

The report comes after the North Korean government called Obama a "monkey" and blamed the U.S. for enduring instability in the country's internet infrastructure, after the U.S. blamed North Korea for hacking attack on Sony Studios.

Do you see what happens Larry, when you, supposedly, use all of your crack 16MHz 80286 supercomputers to dictate to Americans what C-grade comedy flops they can and can not watch?

Meanwhile, here is a candid look at what is surely the worst job in the world at this moment.



Drilling Cutbacks Mean Service Companies Forced To Scrap Rigs

Courtesy of Nick Cunningham via

Despite the decline in oil prices, the U.S. is expected to boost production by 300,000 barrels per day in 2015, up to a yearly average of about 9.3 million barrels per day, according to the most recent government estimates.

But the number of oil and gas rigs in operation is already beginning to drop. For the week ending in December 19, the rig count dropped to 1,875 active rigs, down from 1,893 a week earlier. The fall off is an indication that exploration companies are beginning to pare back investments. Pulling back on drilling may result in a lower future production, which could hurt the growth prospects of some oil firms.


However, the slowdown in drilling activity is having a much more immediate and acute effect on a separate set of companies – those supplying the rigs.

Offshore oil contractors such as Halliburton or Transocean have seen their share prices tank worse than exploration companies because their revenue comes from being paid to drill, not necessarily from oil production after wells are completed. That means that when drilling slumps, their profits take an immediate hit. Even worse, exploration companies may see rising profits from existing production as oil prices rebound, but drilling service companies don’t benefit if their drilling contracts had been put on hold or cancelled.

The problem is compounded by the fact that a slew of new offshore oil rigs are set to come into operation – an estimated 200 over the next six years. As Bloomberg reports, these new rigs will mean there could be a surplus of about 140 rigs, meaning offshore oil contractors will have to scrap that many to bring new ones online.

If oil prices stay where they are now – in the neighborhood of $60 per barrel – a deep contraction in shipping rig supply will be inevitable. In 2015, spending on offshore exploration may be slashed by 15 percent, which will mean taking a deep knife to companies providing rigs and contracting. Transocean has already announced that it is idling seven deepwater rigs, along with several other drillships.

However the shakeout may take some time because offshore contractors can resort to using older rigs in order to bring down the rates they are charging, essential to maintaining market share. In order to entice exploration companies to keep up the drilling frenzy, older ships can keep costs lower.

But that may not be a tenable prospect since offshore contractors will feel compelled to put the new and more state-of-the-art rigs into operation. That will force companies with older fleets to start discarding the most dated drilling rigs.

Transocean already took a $2.6 billion impairment charge in the third quarter of this year, due to a “decline in the market valuation of the company’s contract drilling services business.” By scrapping more ships, it expects to write down at least $240 million in the fourth quarter. More may be in the offing – Transocean released an update on the status of its fleet in mid-December, confirming its plans to scrap 11 ships. The statement also added that “additional rigs may be identified as candidates for scrapping.”

Perhaps it is Seadrill, another offshore drilling services company, that has taking the worst of the oil price downturn. The company decided to cancel its dividend in November amid falling oil prices, a move that sent its share price tumbling downwards. Seadrill has seen its shares lose almost 75 percent of their value since July.

As with the rest of the industry, the fortunes of offshore drilling services companies depends on the price of oil. However, unlike the oil majors, which have more diversified interests both upstream and downstream, offshore contractors take it on the chin first when oil prices go down.

Benefit From the Latest Energy Trends and Investment Opportunities before the mainstream media and investing public are aware they even exist. The Free Energy Intelligence Report gives you this and much more. Click here to find out more.

My reading of the FT on China’s “turning away from the dollar”

My reading of the FT on China’s “turning away from the dollar”

Courtesy of Michael Pettis 

The Financial Times ran a very interesting article last week called “China: Turning away from the dollar”. It got a lot of attention, at least among China analysts, and I was asked several times by friends and clients for my response. The authors, James Kynge and Josh Noble, begin their article by noting that we are going through significant changes in the institutional structure of global finance:

An “age of Chinese capital”, as Deutsche Bank calls it, is dawning, raising the prospect of fundamental changes in the way the world of finance is wired. Not only is capital flowing more freely out of China, the channels and the destinations of that flow are shifting significantly in response to market forces and a master plan in Beijing, several analysts and a senior Chinese official say.

While this may be true, I am much more skeptical than the authors, in part because I am much more concerned than they seem to be about the speed with which different countries are adjusting, or not adjusting, to the deep structural imbalances that set the stage for the global crisis. My reading of financial history suggests that we tend to undervalue institutional flexibility, especially in the first few years after a major financial crisis, perhaps because in the beginning countries that adjust very quickly tend to underperform countries that adjust more slowly. As I have written many times before China’s high growth and very large capital outflows suggest to me how difficult it has been for China to shift from its current growth model.

Beijing has been trying since at least 2007 to bring down China’s high savings rate, for example, and yet today it remain much higher than it did seven years ago. Chinese capital outflows, in other words, which are driven by its excessively high savings rates, may have less to do with master planning than we think, and certainly when I think of the most dramatic periods of major capital outflows in the past 100 years, I think of the US in the 1920s, the OPEC countries in the 1970s, and Japan in the 1980s. In each case I think we misinterpreted the institutional strengths and the quality of policymaking.

Any discussion about China’s future role in global finance or about the reserve status of the dollar or the RMB is so highly politicized that you cannot approach the topic in the same way you might approach an article about the Mexican peso, or even the Russian ruble, but I figured that there are a lot of interesting points about which a discussion might anyway be illuminating. To begin with, there is much in the article with which I agree, but also some things with which I disagree. About the latter I have basically three different “sets” of disagreements:

  1. In some cases my interpretation of both the information and the implications provided by the authors is a lot more skeptical than theirs.
  1. The authors provide the views of several analysts concerning the impact on the US bond markets and US economy more generally of reduced PBoC purchases of US government bonds, and these views range from neutral to very negative. I would argue however that in fact these views fail to understand the systemic nature of the balance of payments, in which any country’s internal imbalances must necessarily be consistent with its external imbalances. They assume implicitly assume that PBoC purchases only affect the demand for US government bonds, whereas in fact the flow of capital from one country to another must automatically affect both demand and supply. In fact the impact of reduced PBoC purchases of US government bonds is likely to be net positive, and while this view is probably counterintuitive, and certainly controversial, in another part of the article the authors cite a Chinese official whose statement, had they explored the implications fully, would have explained why.
  1. There is one point that they make which I think is fundamentally wrong, although a lot of people, including surprisingly enough economists and central bankers, have made the same mistake. It is not fundamental to their argument overall, but I think this mistake does indicate the level of confusion that exists about the way reserve currencies work and it is worth drawing out.

The first set of disagreements concern issues on which reasonable people can disagree, and while I have always been on the skeptical side, I also recognize that only time can resolve the disagreements. For example in discussing some of Beijing’s recent activity in driving the internationalization of the RMB the authors say:

What is clear is that Beijing’s intention to diversify the deployment of its foreign exchange reserves is strengthening. Over the past six months, it has driven the creation of three international institutions dedicated to development finance: the Shanghai-based New Development Bank along with Brazil, Russia, India and South Africa; the Asian Infrastructure Investment Bank and the Silk Road Fund.

There certainly have been many announcements in the past few years, not just about new global institutions that are being planned, but also about currency swap agreements and other actions taken by foreign central banks related to RMB reserves, and each of these has created a great sense of excitement and momentum. I have often thought the amount of attention they received significantly exceeded their importance, and while I won’t mention specific cases because that may come across as a little rude, some of the countries whose central banks negotiated currency swap lines with the PBoC are either credit-impaired enough that any implicit extension of credit would be welcome, or are primarily making a political statement. In at least one case the currency swap is denominated in both RMB and the counterpart’s national currency, but is actually settled in US dollars, and so is little more than a dollar loan indexed to RMB.

How certain are today’s predictions?

I am also very skeptical about the long-term importance of the various development banks that are in the works. It is not clear to me that the incentives of the various proposed members are sufficiently aligned for there to be much agreement on their loan policies, nor is it clear to me that all the members agree about their relative status and how policy-making will occur. It is easy enough to agree in principle that there is a lot of room to improve the existing infrastructure of global financial institutions – mainly the Bretton Woods institutions – but that may well be because the needs of different countries are either impractical or so heterogeneous that no institution is likely to resolve them.

We do have some useful history on this topic. The Bretton Woods institutions were established when one country, the US, was powerful enough to ride roughshod over competing needs, and so the misalignment of interests was resolved under very special and hard-to-replicate conditions, but since then it is hard to think of many examples of similar institutions that have played the kind of transformative role that is expected of the institutions referred to in the article. It is not as if proposals to change the global financial system have not been made before – I remember that burgeoning reserves among Arab OPEC members in the 1970s, or Japan in the 1980s, also generated waves of activity – but change is always easier to announce than to implement. This doesn’t mean that the new institutions being proposed will not have a very different fate, of course, but I would be pretty cautious and would wait a lot longer before I began to expect much from them.

There is anyway a more fundamental reason for long-term skepticism. As the authors note the creation of these institutions is driven largely by China and is based on current perceptions about longer-term trends in China’s growth. Historical precedents suggest however that it may be hard to maintain the current momentum. Rapid growth is always unbalanced growth, as Albert Hirschman reminded us, and what many perceive as the greatest economic strengths of rapidly growing economies are based on imbalances that also turn out to be their greatest vulnerabilities. The fact that the US in the 1920s, Germany in the 1930s, Brazil in the 1960s and 1970s, Japan in the 1980s, China during this century, and many other rapidly growing economies generated deep imbalances during their most spectacular growth phases should not be surprising at all, but it is important to remember that all of them subsequently suffered very difficult adjustments during which, over a decade or more, these imbalances were reversed (Germany after the 1930s of course “adjusted” in a different way, but it was already clear by 1939-40 that the German economy was over-indebted and substantially unbalanced).

The reversal of these imbalances involved adjustment processes that turned out very different from the predictions. While the periods of spectacular growth always get most of the attention from economists and journalists, and always create outsized expectations, the real test over the longer term is how well the economy adjusts during the rebalancing period. We can learn much more about long-term growth, in other words, by studying Japan post-1990, or the US post-1930, for example, than we can from studying Japan pre-1990 or the US pre-1930. Until we understand how adjustment takes place, and the role of debt in the adjustment process, the only safe prediction we can make, I suspect, is that the momentum that drives Beijing’s current activity will not be easy to maintain.

A second area in which reasonable people can disagree is on the quality and meaning of recent data. “The renminbi’s progress has been more rapid than many expected,” according to the authors. This may be true by some measures, but there has been a great deal of discussion on how meaningful some of the trade and capital flow numbers are, especially when compared to other developing countries much smaller than China. It is true that the use of the RMB has grown rapidly in recent years according to a number of measures, but so has that of currencies of other developing countries – Mexican pesos, for example – and at least part of this growth may have been a consequence of uncertainty surrounding the euro. We have to be careful how we interpret the reasons for this growth.

What is more, when you compare the share of foreign exchange activity – whether trade flows, reserves, or capital flows – that is denominated in RMB with the share in the currencies of other countries, including other developing countries, what is striking is how remarkably small it still is relative to the Chinese share of global GDP or of global trade. There are obvious reasons for this, of course, but it will be a long time before we can even say that the RMB share is not disproportionately small, and it has a long way to go just to catch up to several developing countries in Latin America or Asia. It is too early, in other words, to decide on the informational content of the growing RMB share of currency trading.

There has also been a lot of debate and discussion about how much of this data represents fundamental shifts in activity anyway. It is clear that a lot of trade is denominated in RMB for window-dressing purposes only – a mainland exporter that used to bill its client in yen, for example, will reroute the trade through its HK subsidiary, and bill the HK sub in RMB before then selling it on to the final buyer in yen. This shows up as an increase in the RMB denominated share of exports, but in fact nothing really changed. There has also been currency activity driven by speculation, or by political signaling, or by the need to disguise transactions, and so on. So much has already been said over the past few years on these issues that I don’t have much to add, but it is worth keeping in my mind as we try to assess the informational content of this data that there may be strong systemic biases in the numbers

How does the RMB affect US interest rates?

I think there is a small but growing awareness of why Keynes was right and Harry Dexter White wrong in 1944 about the use of bancor versus dollars as the global reserve currency. There is a cost to reserve currency status, even though a global trading currency creates an enormous benefit to the world.

When any single currency dominates as the reserve currency, however, the cost can be overwhelming unless the reserve currency country intervenes in trade. The UK paid that cost heavily in the 1920s and less so in the 1930s after it began to raise tariffs (people forget that sterling reserves exceeded dollar reserves during this period), which is why Keynes was so adamant that the world needed something like bancor. It is in light of the debate over the value of reserve currency status that I find the discussion about the impact a shift in the status of the RMB might have on US interest rates the more interesting part of the article. According to the authors:

Not only is China’s desire to buy US debt diminishing, so is its ability to do so. The banner years of Treasury bond purchases, during which holdings rose 21-fold over a 13-year period to hit $1.27tn by the end of 2013, were driven by an imperative to recycle China’s soaring US dollar current account surpluses. But these surpluses are narrowing sharply — from the equivalent of 10.3 per cent of gross domestic product at the peak in 2007 to 2.0 per cent in 2013. In fact, if financial flows are taken into account, China ceased over the most recent four quarters to be a net exporter of capital at all.

Actually if financial flows are taken into account, China has not ceased over the most recent four quarters to be a net exporter of capital. I think the authors are confusing capital exports through the PBoC (increases in central bank reserves) and capital exports more generally. China’s net capital export, by definition, is exactly equal to its current account surplus, and while it is true that China’s current account surplus has narrowed from its peak in 2007 to its trough in 2013, it has risen very rapidly during 2014. In fact I think November’s current account surplus may be the largest it has ever posted.

It is true that PBoC reserves have not increased in 2014, and have actually declined, although this may be mainly because the non-dollar portion of the reserves dropped dramatically in value, so that in dollar terms they have declined, but this was not because net exports have declined and it is not even a policy choice. Because the PBoC intervenes in the currency, it cannot choose whether to increase or reduce its accumulation of reserves. All it can do is buy the net inflow or sell the net outflow on its current and capital account, so the fact that we have seen massive capital outflows from China in 2014 means that it is exporting more capital than ever, but not in the form of PBoC purchases of foreign government bonds.

The trend, in other words, is no longer narrowing current account surpluses and less capital export but rather the opposite. An investor they cite thinks we will see a reversal of this trend: “I absolutely think we are going to see smaller Chinese current account surpluses in the future”, he says, “because of greater Chinese spending overseas on tourism and services and greater spending power at home may lead to more imports.”

I think we have to be cautious here. In order to protect itself from a rapidly rising debt burden, China is trying to reduce the growth in investment as fast as it can. It is also trying to reduce the growth in savings as fast as it can, but there are only two ways to reduce savings. One is to increase the consumption share of GDP, but this is politically very hard to do because it depends on the speed with which China directly or indirectly transfers wealth from the state sector to the household sector. The other is to accept higher unemployment.

Because the current account surplus is by definition equal to the excess of savings over investment, an expanding current account surplus allows China to reduce investment growth at a faster rate than can be absorbed by rising consumption – without rising unemployment. But with Europe competing with China in generating world-record current account surpluses, and with weak consumption in Japan, it isn’t easy get the rest of the world to absorb large current account surpluses.

Put differently, the biggest constraint on China’s export of its savings is not domestic. It is the huge amount of savings that everyone wants to export to everyone else, but which neither China nor any developing country wants to import. Still, I suppose in principle we could see a huge shift in capital flows, with less going to the US and to hard commodity exporters (as commodity prices drop) and more going to India, Africa, and other developing countries. At any rate over the long term the authors are concerned about the impact China will have on capital flows to the US:

All of this leads to a burning question: how convulsive an impact on US debt financing — and therefore on global interest rates — will the changes under way in China have? Analysts hold views across a spectrum that ranges from those who see an imminent bonfire of US financial complacency to those who see little change and no cause for concern. 

The great concern, the authors correctly note, is the idea that the US has come to depend on China to finance its fiscal deficit. If China stops buying US government bonds, the worry is that the US economy may be adversely affected, and even that US government bond market will collapse and US interest rates soar:

A decade ago Alan Greenspan, the then chairman of the US Federal Reserve, found his attempts to coax US interest rates upwards negated by Beijing parking its surplus savings into Treasuries. Arguably, says Mr Power, a bond bubble has existed ever since. “If China is now set to redeploy those deposits into capital investment the world over, does this mean the [Greenspan] conundrum will be at last ‘solved’ but at the cost of an imploding Treasury market?” Mr Power asks. “If so, this will raise the corporate cost of capital in the west and put yet another brake on already tepid western GDP growth.”

Because PBoC purchases of US government bonds are so large, it seems intuitively obvious to most people that if the PBoC were to stop buying, the huge reduction in demand must force up interest rates. But this argument may be based on a fundamental misunderstanding of how the balance of payments works. First of all, greater use of the RMB as a reserve currency does not mean that the PBoC will buy fewer US government bonds. On the contrary, higher levels of RMB reserves in foreign central banks will by definition increase capital inflows into China. In that case either it will force the PBoC to purchase even more foreign government bonds, if the PBoC continues to intervene in the currency, or it will cause some combination of an increase in Chinese capital outflows and a reduction in China’s current account surplus. This is an arithmetical necessity.

If the RMB becomes more widely used as a reserve currency, it could certainly result in lower foreign demand for US government bonds, but not lower Chinese demand. This, however, would not be bad for the US economy or the US government bond market any more than it would be if the PBoC were to reduce its demand for US government bonds. China, and this is true of any foreign country, does not fund the US fiscal deficit. It funds the US current account deficit, and it has no choice but to do so because China’s current accounts surpluses are simply the obverse of China’s capital account deficits. This may not seem like an important distinction in considering how lower demand will affect prices, but in fact it is extremely important because any change in a country’s capital flow can only come about as part of a twin set of changes in both the capital account and the current account.

This is true for both countries involved. There is no way, in other words, to separate the net purchase of US dollar assets by foreigners with the US current account deficit. One must always exactly equal the other, and a reduction in the former can only come about with a reduction in the latter. So what would happen if the PBoC were sharply to reduce its purchase of US government bonds? There are only four possible ways this can happen:

  1. The reduction in PBoC purchases of US government bonds was matched by an increase in purchases by other Chinese institutions or individuals of US dollar assets. This is mostly what seems to have happened in 2014, and because the PBoC intervenes in the currency, fewer purchases of government bonds by the PBoC was not a choice, but rather the automatic consequence of increased foreign investment by other Chinese institutions or individuals. The impact on the US economy would depend on what assets the other Chinese institutions or individuals purchased. If they purchased risk-free US assets there would be no net impact. If they purchased risky US assets there would be a small, barely noticeable increase in the riskless US interest rate, matched by an equivalent reduction in the US risk premium.
  1. The reduction in PBoC purchases of US government bonds was matched by an increase in purchases by other foreigners of US dollar assets. The impact on the US economy would depend, again, on what assets the other foreigners purchased. If they purchased risk-free US assets there would be no net impact. If they purchased risky US assets there would be a small, barely noticeable increase in the riskless US interest rate, matched by an equivalent reduction in the US risk premium.
  1. The reduction in PBoC purchases of US government bonds was not matched by an increase in purchases by other Chinese or foreigners, so that there was a commensurate decline in the US current account deficit. Because the US current account deficit is equal by definition to the excess of investment over savings, there are only two ways the US current account deficit can decline. If there is no change in US investment, US savings must rise, and in an economy with underutilized capacity and unemployment, this will happen as unemployed workers and underutilized capacity are put to work, either to replace imports or to increase exports. Workers with jobs save more than workers without, and companies with less underutilized capacity save more than companies with more because they are more profitable. More profitable businesses and fewer unemployed workers results in higher fiscal revenues and lower fiscal expenses, so that fewer foreign purchases of US government bonds is accompanied by a lower supply of government bonds.
  1. Finally, because the US current account deficit is equal by definition to the excess of investment over savings, the only other way the US current account deficit can decline is if there is no change in US savings, in which case, US investment must decline. Businesses close down American factories and otherwise reduce business and government investment. This causes GDP growth to drop and unemployment to rise.

What determines US savings?

These four, or some combination, are the only possible ways in which the PBoC can reduce its purchases of US government bonds. It is pretty obvious that the best outcome, the third scenario, requires fewer foreign purchases of US assets, as does the worst, the fourth scenario. It is also pretty obvious that what the PBoC does in largely irrelevant. What matters is whether the US current account declines. Because not only are Chinese institutions and other foreigners eager to purchase US assets, and because demand abroad is so weak, the US current account deficit is in fact likely to increase, as foreigners purchase even more US assets. The US current account deficit will only decline if growth abroad picks up or if the US takes actions to reduce its current account deficit – perhaps by making it more difficult for foreigners to invest their excess savings in the US.

If the US were to force down its current account deficit, would US savings rise or would US investment drop – put another way, is a lower current account deficit good, or bad, for the US economy? For most people the answer is obvious. A lower US current account deficit is good for growth. In fact much of the world is engaged in currency war precisely in order to lower current account deficits, or increase current account surpluses, by exporting their savings abroad.

For some analysts, however, a reduction in foreign purchases of US assets would be bad for US growth because, they argue, the US is stuck with excessively low savings rates. Because there is no way to increase US savings, a reduction in foreign purchases of US assets must cause US investment to decline.

These analysts – trained economists, for the most part – are almost completely mistaken. First of all, it does not require an increase in the savings rate for American savings to rise. Put differently, if unemployed American workers are given jobs, US savings will automatically rise even if the savings rate among employed workers and businesses is impossible to change. Secondly, these economists mistakenly argue that the reason the US runs a current account deficit is because US savings are wholly a function of US savings preferences, which are culturally determined and impossible to change. Because these are clearly lower than US investment, it is the unbridgeable gap between the two that “causes” the US current account deficit.

But while the gap between the two is equal to the current account deficit by definition, these economists have the causality backwards. As I show in the May 8 entry on my blog, excess savings in one part of the world must result either in higher productive investment or in lower savings in the part of the world into which those excess savings flow. This is an arithmetical necessity. Because China’s excess savings flow into the US – mostly in the form of PBoC purchases of US government bonds – the consequence must be either more productive investment in the US or lower savings.

If productive investment in the US had been constrained by the lack of domestic savings, as it was in the 19th Century, foreign capital inflows would have indeed kept interest rates lower, and because these foreign savings were needed if productive investment were to be funded, the result in the 19th Century was higher growth. But while it is true that in the US today there are many productive projects that have not been financed – the US would clearly benefit from more infrastructure investment for example – the constraint has not been the lack of savings. No investment project in the US has been turned down because capital is too scarce to fund it. In fact more generally it is very unlikely that any advanced economy has been forced to reject productive investment because of the savings constraint. It is usually poor planning, dysfunctional politics, legal constraints, or any of a variety of other reasons that are to blame.

This means that if China’s excess savings flow into the US, there must be a decline in US savings, and the only way this can happen is either through a debt-fueled consumption boom or through higher unemployment. The analysts interviewed in the Financial Times article argue that if there were an interruption to PBoC purchases of US government bonds, the adverse consequences could range from fairly minor to the extreme – a collapse in the US government bond market – but in fact the only necessary consequence would be a contraction in the US current account deficit. While there are scenarios under which this could be disruptive to the US economy, in fact it is far more likely to be positive for US growth.

As counterintuitive as this may at first seem, several economists besides me have made the same argument, and I provide the full explanation of why fewer foreign purchases of US assets will actually increase both American savings and America growth in Chapter 8 of my book, The Great Rebalancing. What is more, the fact that the US government has put pressure on Beijing to revalue the RMB in order to reduce the US current account deficit is simply another way of saying that Washington is pressuring Beijing to reduce the amount of US government bonds the PBoC is purchasing. After all, if large foreign purchases of US government bonds were good for the US, Europe, China, or anyone else, it must follow automatically that large current account deficits are good for growth and help keep interest rates low.

And this cannot be true. Remember that by definition, the larger a country’s current account deficit, the more foreign funding is “available” to purchase domestic assets, including government bonds. And yet instead of welcoming foreign funds and the associated current account deficits, countries around the world are eager to export as much of their savings as they can, which is another way of saying that they are eager to run as large current account surpluses as they can.

The arithmetic of the balance of payments

In fact there is evidence even within the article that Chinese purchases of US government bonds, far from boosting US growth, either by keeping interest rates low or otherwise, actually causes a reduction in demand for US-produced goods and services. This becomes obvious by recognizing the inconsistency between Chinese behavior and Chinese claims that they are seeking to diversify reserve accumulation away from the dollar. The inconsistency is made explicit when the article cites a famous incident in 2009.

“We hate you guys”, was how Luo Ping, an official at the China Banking Regulatory Commission vented his frustration in 2009. He and others in China believed that, as the US Federal Reserve printed more money to resuscitate American demand, the value of China’s foreign reserves would plunge. “Once you start issuing $1tn-$2tn . . . we know the dollar is going to depreciate so we hate you guys — but there is nothing much we can do,” Mr Luo told a New York audience.    

Mr. Luo, of course, turned out to be wrong, and the value of China’s dollar-denominated foreign reserves did not plunge. On the contrary, if the PBoC had purchased more dollars instead of fewer dollars, it would have avoided some of the currency losses it has taken since 2009. But while it might have been useful to explain why Luo was wrong about the plunging dollar, what really needed explaining is why “there is nothing much we can do”.

Actually China did have a choice as to whether to buy dollars or not. Luo was right about China’s lack of choice only in the sense that as long as Beijing was determined to run a large current account surplus, and as long as purchasing other currencies would have been too risky, or too strongly resisted by their governments, the PBoC did not have much of a choice. In China the savings rate is extremely high for structural reasons that are very hard to reverse. This means that the investment rate must be just as high, or else the gap between the two must be exported. Put differently, if China cannot export excess savings and run a current account surplus, either it must increase domestic investment or it must reduce domestic savings. This is just simple arithmetic, and is true by definition.

With investment rates among the highest in the world, and with much of it being misallocated, China wants to reduce investment, not increase it. Rising investment is likely to cause the country’s already high debt burden to rise. But as in the case of the US, the only way it can reduce its savings is with an increase in consumer debt or with an increase in unemployment.

Because none of the options are desirable, China can only resolve its imbalance between supply and demand if it exports the excess of savings over investment, or, put another way, it must run a current account surplus equal to the difference between savings and investment. But because China is such a large economy, and the gap between investment and savings is so large, this is an enormous amount of savings that must be exported, and China must run an enormous current account surplus that must be matched by the current account deficit of the country to whom these savings are exported. The US financial market, it turns out, is the only one that is deep and flexible enough to absorb China’s huge trade surpluses, and, perhaps much more importantly, it is also the only one whose government would not oppose being forced to run the countervailing deficits.

Had the PBoC tried to switch out of dollars and into Japanese yen, or Swiss francs, or Korean won, or euros, or anything else, it would have met tremendous resistance. In fact it did try to purchase some of those currencies and it did meet tremendous resistance, which is why its only option was to buy US government bonds. I explain why in my book as well as in another one of my blog posts.

Luo’s statement implies very directly that the only meaningful way to protect the PBoC from being forced to buy dollars is not by increasing the use of the RMB in international trade but rather for China to run smaller surpluses. It certainly did have a choice, but because the alternative was so unpalatable, Beijing felt as if it had no choice. China bought US government bonds not because it wanted to help finance the US fiscal deficit but very specifically because if it didn’t it would be forced either to increase domestic debt or to suffer higher unemployment.

This point is a logical necessity arising from the functioning of the balance of payments. Both Lenin andJohn Hobson explained this more than 100 years ago: countries export capital in order to keep unemployment low. If the RMB becomes a reserve currency, Beijing will have to choose whether, like the US, it will allow unrestricted access to its government bonds, or whether, like Korea, it resist large foreign purchases.

If it chooses the latter, the RMB cannot be a major reserve currency. If it chooses the former, the RMB might indeed become a major reserve currency, but this will force China to choose between higher debt and higher unemployment any time the rest of the world wants more growth. The result of a rising share of reserves denominated in RMB at the expense of a declining share denominated in dollars is really Washington’s goal, in other words, and not Beijing’s.

Can China invest its current account surplus at home?

At the beginning of this entry I said that the authors made one assertion that is fundamentally wrong, although so many economists get this wrong that it would be unfair to blame the authors for failing to do their homework. The mistake isn’t necessary to their argument, but I bring it up not just because it is a mistake commonly made but also because it shows just how confused the discussion of the balance of payments can get.

Early in the article the authors cite Li Keqiang’s “10-point plan for financial reform” which includes the following

Better use should be made of China’s foreign exchange reserves to support the domestic economy and the development of an overseas market for Chinese high-end equipment and goods.

They then go on to make the following argument:

As a mechanism towards this end, China is earning a greater proportion of its trade and financial receipts in renminbi. Because these earnings do not have to be recycled into dollar-denominated assets, they can be ploughed back into the domestic economy, thus benefiting Chinese rather than US capital markets.

This is incorrect. The amount that China invests at home and the amount of foreign government bonds the PBoC must purchase are wholly unaffected by whether China’s trade is denominated in dollars, RMB, or any other currency.

There are two ways of thinking about this. One way is to focus on the trade itself. If a Chinese exporter sells shoes to an Italian importer and gets paid in dollars, the exporter must sell those dollars to his bank to receive the RMB that he needs. Because the PBoC intervenes in the currency, it effectively has no choice ultimately but to buy the dollars, and the result is an increase in FX reserves. This is pretty easy to understand.

But what happens if the next time the Chinese exporter sells shoes to the Italian importer, he gets paid in RMB? In that case it is the responsibility of the Italian importer, and not the Chinese exporter, to buy RMB in exchange for dollars. This is the only difference. The Italian importer must obtain RMB, and she does so by going to her bank and buying the RMB in exchange for the dollars. Her bank must sell the dollars in China to obtain RMB, and once again because the PBoC intervenes in the currency, it effectively has no choice ultimately but to buy the dollars. The result once again is an increase in FX reserves.

The other way to think about this is to remember that the change in FX reserves is exactly equal, by definition, to the sum of the current account and the capital account. This is because the balance of payments must always balance. China’s current account surplus is wholly unaffected by whether the trade is done in dollars (the Chinese exporter is responsible for changing dollars into RMB) or in RMB (the Italian importer is responsible for changing dollars into RMB). In either case, in other words, PBoC reserves must rise by exactly the same amount.

What about Chinese investment? It too is wholly unaffected. The current account surplus, remember, is equal to the excess of Chinese savings over Chinese investment. If the current account surplus does not change, and savings of course will not have been affected by the currency denomination of the trade, then domestic investment must be exactly the same.

Academics, journalists, and government and NGO officials who want to subscribe to my newsletter, which sometimes includes portions of this blog and sometimes (as in this case) does not, should write to me, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.


We Just Enjoyed the Last Christmas In America

Courtesy of Charles Hugh-Smith of Of Two Minds

The end of rising wages = the end of mass affluence: we just enjoyed the Last Christmas in America (TLCIA).

As unemployment topped 10%, the January 1975 cover of Ramparts magazine blared: The End of Affluence: The Last Christmas in America. (TLCIA)

The government responded to the high unemployment, rampant inflation and rising budget deficits by manipulating data to mask the politically inconvenient realities of inflation, unemployment and deficits by playing with Social Security Trust Funds, inflation data, etc.–games it continues to play to cloak reality from the media-numbed public.
The economic stagnation, despite various stock market rallies and false starts, essentially lasted 10 years, from 1973 to 1982.
The malaise had a happy ending: huge new oil fields were discovered in Alaska, the North Sea, West Africa and elsewhere, ushering in a renewed era of cheap, abundant petroleum. President Reagan re-set Social Security for a generation and introduced a lower taxes, higher permanent deficits ideology that is now accepted as the only possible way to sustain the Status Quo: deficits don't matter, even when they reach the trillions, because our good friends the Gulf Oil Exporters and Asian exporters will buy all our debt forever and ever, keeping interest low forever and ever.
(And if they drop the ball, then the Federal Reserve prints money and buys trillions of dollars of Treasury bonds. Sweet! We don't need any external buyers, just the Federal Reserve creating money out of thin air.)
Then the U.S. created and launched two revolutionary technologies which both created new wealth around the globe: the personal computer (microprocessor and cheap RAM) and the Internet (TCP/IP, Ethernet, and the commercialization of Tim Berners-Lee's World Wide Web with free browsers) spawning the generation-long boom of the 1980s and 90s.
Those "saves from stagnation" were one-offs; there will be no more supergiant energy finds, nor any equivalents of the Internet expansion cycle.
When the wheels inevitably fell off the Internet/tech boom in 2000, the U.S. did not create a new engine of wealth: it opted instead for a devilishly insidious simulacrum of wealth: debt which rose at an exponential rate throughout the economy.
Borrowed money and phony financial legerdemain (mortgage-backed securities, derivatives based on the MBS, etc. etc.) from 2000-2007 created what I have termed a "bogus prosperity": no actual new productive wealth was created, only a brief and self-liquidating bubble of debt-based housing and stock valuations.
Compare the rate of GDP growth (another unreliable indicator, but all we have) with the astonishing rise in debt:
Meanwhile, wages adjusted for inflation have stagnated for 15 years while asset prices for stores of value such as housing in desirable areas have skyrocketed in terms of median household income:
Real household income has declined in the Bubble Era across the entire income spectrum:
Here is real median household income and labor's share of the economy: both are in structural decline, and inflating asset bubbles has done nothing to reverse either trend.
Why will Christmas 2014 be the last Christmas in America? It's simple: declining wages cannot support an ever-expanding mountain of debt.
The Federal Reserve has played a game for six long years of lowering the cost of debt (i.e. the rate of interest borrowers must pay), which has enabled stagnating wages to support ever heavier debt loads.
There is an endgame in sight to this financial trickery, a point of diminishing returns to lower interest rates: the Fed can't drop rates lower than 0%. Borrowers simply can't qualify for more debt, regardless of interest rates.
The extreme fragility of an economy based on ever-expanding mountains of debt piled on declining incomes is apparent: if the Fed can't raise interest rates even a tiny quarter point without threatening to collapse the unstable pyramid of debt-based affluence/ consumption, what does that say about the fragility of the "growth" (supposedly running at a hot 5% annually) and "prosperity"?
Claiming that a few hundred dollars in lower gasoline costs per household will enable a desert of declining income to bloom is the equivalent of claiming that an inch of rain in Death Valley will transform the desert into a lush tropical rain forest.
Remember the lackluster Christmas of 2014; the endgame of expanding debt will play out as every endgame does: furious moves by central bankers will prolong checkmate but not transform the inevitable loss into a win. Media sound and fury are no substitute for rising real household wages and incomes.


Russia’s Overnight Lending Rate Hits 19%, as Mistrust of Banks Spreads; Ruble Up Again

Courtesy of Mish.

In Russia, the overnight lending rates between banks has soared to 19%, a sign of widespread and warranted mistrust between banks, as one bank has failed. To stabilize the situation, Putin is considering bank deposit insurance up to an amount equivalent rate of about $26,000.

Meanwhile, and although Russia is still burning through currency reserves, the value of the Ruble has been rising.

CNN Money reports Russia Empties the Vault to Prop Up Ruble.

So far this year the central bank has burned through more than $110 billion in foreign currency supplies. That's more than a quarter of what it has in reserves right now.

Spending has ramped up in the last few weeks. Since the start of December, the central bank has blown through more than $21 billion.

That, along with a series of other measures to support the banking sector, has helped to stabilize the ruble.

[Mish comment: Actually, blowing through reserves is destabilizing, but other measures such as the huge hike in interest rates is indeed stabilizing]

Russia is working on a plan to pump one trillion rubles ($18.6 billion) into Russian banks next year, and wants to establish deposit insurance to guarantee savings up to 1.4 million rubles ($26,000).

The ruble climbed nearly 6% against the U.S. dollar on Friday.

Still, Sberbank CIB chief economist Evgeny Gavrilenkov said the central bank's strategy of spending down foreign reserves was "not ideal," and pointed to stresses elsewhere in the financial sector.

[Mish Comment: Once again, I highly doubt the “strategy” is to spend foreign reserves to prop up the ruble. Rather, spending of foreign currently reserves is needed due to declining oil revenues. I suspect there are some seasonal influences in play as well.]

"The liabilities of banks and servicing [refinancing] debt is very costly now, so the banking system is vulnerable," he said.

Continue Here


Nat Gas Tumbles Below $3 For The First Time Since 2012, Plunges 30% In 2014

Courtesy of ZeroHedge. View original post here.

For the past few months, the one silver lining to the energy complex – with crude oil plummeting to levels not seen since 2009 – was nat gas, which soared to the mid-$4s in early November on expectations of a brutal polar vortex for the second year in a row sending heating demand surging. Well, so far the "harsh" weather, which was blamed for the epic collapse in the US economy in Q1 has not materialized, and all those buyers of natgas contracts have been scrambling to sell all of their exposure afraid they may suffer the same fate as their crude trading brethren. End result: as of moments ago, nat gas finally slide under $3, the first time it has done so since 2012!

This also means that while crude oil longs have had a horrible year, with nat gas now down 29% in 2014, and headed for the first annual decline since 2011 as mild weather leaves stockpiles at a surplus to year-ago levels for the first time in two years, yet another commodity is set to ring in margin calls for all those who are not long the USDJPY, pardon the S&P500, where the only trade off to daily all time highs is simply the total collapse of Japan as a nation state.

And since temperatures will be mostly above average in the eastern half of the U.S. through Dec. 30, according to Commodity Weather Group LLC, look for gas to keep sliding. From Bloomberg:

“We haven’t seen a lot of cold weather this winter,” said Carl Larry, a Houston-based director of oil and gas at Frost & Sullivan. “The warmer it stays, the more pressure on natural gas. Gas production is not dropping and demand is not that high.”

Natural gas for January delivery fell 1.6 cents, or 0.5 percent, to $3.014 per million British thermal units as of 9:25 a.m. on the New York Mercantile exchange. Earlier, futures touched $2.98 per million Btu, the lowest since Sept. 26, 2012. Volume was 68 percent below the 100-day average for the time of day.

“This market continues to look oversupplied,” Aaron Calder, senior market analyst at Gelber & Associates in Houston, said by phone on Dec. 24. “We are seeing support at $3 but I would say that once we break that I think $2.70 is probably our lower technical target.”

“Unseasonably warm weather this month now necessitates extreme conditions ahead in order to avert a surplus,” Teri Viswanath, director of commodities strategy for the bank in New York, said in the report.

But while traders will be ok, the one industry that appears set to suffer the most is, once again, shale:

Output from the Marcellus shale formation in the Northeast may climb to 16.3 billion cubic feet a day in January, up 19 percent from a year earlier, the EIA said in its monthly Drilling Productivity Report on Dec. 8.

And now, since the Keynesian angle of "higher commodity prices mean more pent up demand and higher future growth" is finished, expect a major switch in the narrative to "deflation is actually good." Because apparently Austrians are only wrong whenever their being right does not conflict with the official propaganda of making trillionaires out mere billionaires.

Pettis on Strains in China’s Banking System; Avoiding the Fall

Courtesy of Mish.

In his last email of the Year Michael Pettis takes stock of the current state of China's rebalancing. It's an 18 page PDF, with no online link.

Taking Stock of China’s Transition by Michael Pettis

Special points to highlight in this issue:

  • While policymakers almost certainly understand that the interest rate cuts announced by the PBoC two weeks ago will slow the pace of rebalancing, the asymmetry of the change in rates was designed to minimize the adverse impact on rebalancing, and indicate just how complex China’s adjustment is likely to be.
  • Next year will be a very important year for China because possible strains in the banking system and the intensity with which the reformers present their case will give us a better sense both of how much debt capacity the country retains and of how well positioned Xi Jinping and his allies are to implement the needed reforms.
  • The completion of [prior] reforms [under Deng Xiaoping] left China ready for an investment-driven growth model that delivered astonishing increases in wealth. It also delivered unprecedented imbalances. China’s leaders under Xi Jinping will once again have to liberalize the economy and dramatically change the institutional structure of power in spite, once again, of elite opposition.

I should start by saying that I was a little disappointed, but not terribly surprised, by the PBoC’s announcement two weeks ago that it would cut interest rates. The fact that rates were cut, even though many reformers within the administration were very much opposed, exemplifies the challenges that Beijing will face in 2015.

As China’s economy continues to slow, a lot of sectors, especially among the more heavily indebted, are suffering losses and running into cashflow problems. There have been calls by the tradable goods sector to depreciate the currency and even more urgent calls by the capital-intensive sector to cut interest rates. At the same time, however, there is also recognition that either move would slow the pace of rebalancing and increase the risk that China run into debt capacity constraints.

We are going to see this argument replayed many times in 2015.

All the various measures of inflation have dropped this year, with Monday’s data showing that the producer-price index dropped 2.7% in November, completing nearly three years of monthly declines. Consumer prices rose 1.4%, even lower than the 1.6% increase in October. As a result, real lending rates are strongly positive and real deposits rates are also probably positive.

I don’t expect either a sustained housing rebound or stable growth at current levels. The interest rate burden on Chinese businesses and state-related entities has certainly been much higher in 2014 than it was for most of this century.

While the benchmark deposit rate was officially lowered from 3.00% to 2.75%, the upper limit that banks can pay for deposits remained unchanged at 3.30%. It may seem strange to have both a benchmark rate and a “floating range” that establishes a cap, instead of just setting a cap, as was the case until very recently. The official reason for separating the two is that the “floating range” represents a partial liberalization of deposit rates. By widening the floating range, we are told, the PBoC is gradually eliminating the deposit cap until eventually banks will be able to set any rate they want.

Discriminatory pricing Because banks were always allowed to set deposit rates below, but never above, the benchmark rate, so that it was effectively the cap until recently, the logic seems a little faulty, and it is hard see why this represents the gradual liberalization of deposit rates. But there could nonetheless be a real impact on deposit rates that depends on a kind of “benchmark illusion”.

At first, the new deposit rate rules set last week seem to have had the expected effect. Within two weeks, however, three of the big four banks raised rates back to the upper limit, suggesting that the competition for deposits may be pretty fierce.

Continue Here