Federal Reserve Continues March Down the Primrose Path

Federal Reserve Chairman Ben Bernanke and his army of monetary economists have now had four months to observe the lay-of-the-economic land since winding down their massive $1.2 trillion in mortgage bond purchases.

How do things look? Based on the Chairman's recent comments, not good.

Peer Pressure, Washington Style

When the economic going gets tough and then stays tough for a protracted period there is one institution politicians can be counted on to turn towards for help, and that institution is the nation's central bank.

In the U.S. this political pressure typically involves congressman, and presidents, banging on about how the Fed needs to 'do something'. These politicians, often facing an upcoming election, are making noise so that if monetary surgery fails to deliver a cure (economic growth) it will at lease provide the scapegoat (the central bank).

With the U.S. Congress currently facing historic low popularity and re-election right around the corner, mild-mannered Ben Bernanke is feeling the heat of D.C.'s boiler room. Case in point, Senator Jim Bunning pressed the Chairman during recent testimony on whether he was "out of bullets?", to which Bernanke replied "well, I don't think so." 

What 'bullets' are Jim and Ben referring to?

The Mother of All Bullets

To answer the above question we have the luxury of being able to refer back to the verbatim text of a speech Ben Bernanke delivered in 2002 titled Deflation: Making Sure "It" Doesn't Happen Here (which I've written about previously). 

The economic problem du jour just so happens to be deflation. In the speech, Bernanke outlines detailed steps the Fed could take to combat deflation, which is basically a widespread decline in prices. The last time the U.S. experienced this was during the Great Depression, an area of economic history which Dr. Bernanke is considered to be one of the pre-eminent experts. 

Bernanke's most oft-quoted line from his 2002 speech: "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

Put simply, Dr. Bernanke's deflation prescription is to print a 'ton-o-money'. 

How much money? Given that the nearly $2 trillion printed since the inception of the 2008 financial crisis hasn't created significant inflation concerns, estimates as high as an additional $5 trillion may not be beyond consideration.

QE2: No Longer a Question of If, But When

On Thursday St. Louis Fed President and FOMC voting member Jim Bullard wrote that the U.S. is at risk of Japanese-style deflation and that it should be actively combated by engaging in "quantitative easing" (aka printing money) through Fed purchases of U.S. Treasuries. Bullard had beenconsidered until now one of the Fed's principal 'inflation hawks'.

One interpretation of Bullard's comments is that the Fed is laying the groundwork for 'QE2', the shorthand label which has attached itself to the Fed's latest scheme.

Market Timing QE2

With QE2 fully baked when precisely will it begin?

November congressional midterm elections are a bit of an x-factor for the Fed. Like his predecessor, Bernanke is a Republican. And, again like Greenspan, he was reappointed by a Democratic President. I suspect that, barring another major crisis in the interim, Bernanke & Co. would prefer for QE2 be perceived as apolitical. Consequently, the Fed will likely wait to crank up the printing press until after midterms.

In terms of QE2's implementation, expect an iterative print, evaluate, and then decide to print some more type process. The Fed would probably prefer to trickle QE2 out over an extended period, ala the Bank of England's approach. But, as Bullard suggests, a sudden and rapid deterioration in confidence may force the Fed to go the 'shock and awe' route.

Meanwhile, In Government Debt La-La Land...

In contemplating a new $5 trillion money printing program a reasonable person might be inclined to ask the following question: "if the Fed keeps printing money to buy government bonds, doesn't that potentially create a problem for maintaining the value of the U.S. dollar?"

Uh, yeah.

The prospect of QE2 may be currently driving U.S. Treasuries to rally even further into nose bleed territory as the market contemplates the supply of government debt being squeezed by the Fed even further. And if the Fed doesn't activate QE2 then deflation (or disinflation) could continue to make U.S. Treasuries attractive to investors. So on the surface U.S. Treasuries may at present appear like a win-win trade.

Having said that, printing money at these levels represents a massive and unprecedented financial experiment. Our policy leadership has now guided us into uncharted economic territory and there really is no telling for sure just what will happen.

Nassim Taleb, for one, is calling government debt "the next black swan." In a recent interview he even went so far as to call government debt "a pure Ponzi scheme".

There are several ETF options available for those looking to hedge or play U.S. Treasuries. And if the prospect of massive money printing has you concerned about the future of paper money, then you may want to consider precious metals like gold.

Bill Gross to Government: Quit "Flushing Money Down the Toilet"

PIMCO's Bill Gross, often referred to as "The Bond King", today published his August investment outlook which outlines the economic headwinds (past, present and future) due to slowing population growth.

For anyone not familiar with Gross, he and his colleagues at PIMCO run the world's largest private bond fund with over $1 trillion in assets under management. The U.S. Government sells bonds to finance its deficits, and Gross and PIMCO are big (maybe the biggest?) buyers of those bonds. Put simply, when Gross/PIMCO talk government listens. But don't just take my word for it. Ask Clinton campaign manager James Carville, who had the following to say:

"I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."

Deep Demographic Doo-Doo

Recent demographic forecasts suggest that world population growth will continue to slow and level off around 2050 and then begin to decline.

Should this occur it would be difficult to overstate the implications. As Gross puts it "capitalism itself may be in part dependent on a growing population".

Canada vs. U.S.: A Tale of Two Housing Markets

Americans are often accused of not looking beyond their own borders for sound policy ideas. This is unfortunate, in my opinion, because there is much that we can learn from other countries. Perhaps one such example is Canada's apparently successful approach to housing.

Oh Canada, How Did You Dodge the Housing Bomb?

As part of my week in Vancouver, B.C. at the Agora Financial conference I've been reflecting on the striking differences between the performance of the U.S. and Canadian housing markets the past few years. I wonder how many Americans are aware of the following:

1. Approximately 70% of Canadians own their own home (which is in line with U.S. home ownership).
2. Canada has not experienced a precipitous decline in housing prices.
3. It was unnecessary for Canada to bailout its banks (unlike the U.S.'s nearly $4.7 trillion bailout and counting).

Canada, not China, is the U.S.'s largest trading partner. The huge relative size of the adjacent U.S. economy certainly influences Canada's economic fortunes. One might naturally assume that as goes the U.S., so goes Canada. So why didn't Canada experience a similar housing crash? The answer may be found by reviewing the key differences between their respective housing markets.


Fundamentally Different

There are at least four major structural differences that help explain why the Canadian housing market has managed to remain afloat while the U.S.'s has sunk:

1. Canadian banks keep their mortgages. In the U.S. many mortgages were "securitized", meaning they were sold by the original lender to someone else. When a mortgage is sold the original lender can largely avoid any immediate financial cost if the borrower defaults. However, the new holder of the mortgage (say from Dusseldorf) suffers the immediate financial cost of the default. In contrast, if there is a mortgage default in Canada the original Canadian lender takes the hit. One can argue that the Canadian approach promotes greater mortgage lending accountability.
   
2. CHMC is no Fannie. While it may first appear that Canadian Mortgage and Housing Corporation (CHMC) is the equivalent of Freddie Mac and Fannie Mae, there are several key differences. First, CHMC does not own anywhere near the 50% of total domestic mortgage market that Fannie and Freddie hold. But perhaps more importantly, Fannie and Freddie were publicly traded for-profit enterprises with all the accompanying pressure to meet shareholders expectations. CHMC has one shareholder -- the Canadian government. Even though it also has a mandate to assist low income earners with housing, it took on lower risk than the formerly high flying Fannie Mae. (Legendary Fidelity Magellan manager Peter Lynch kept a photo of Fannie's HQ in his office and ironically suggested that "The stock has been so great they ought to retire the ticker symbol")
   
3. The U.S. has non-recourse states. In the U.S. homeowners in non-recourse states can walk away from their mortgage without any risk that the mortgage lender will come after their other assets. Perhaps not coincidentally states like Nevada, Arizona and California that have been hardest hit by the housing bust are also non-recourse. In Canada borrowers remain personally liable for their mortgage loans. If a Canadian were to strategically default then his/her car, savings, or other assets could be pursued by the bank.
   
4. Canada has no mortgage interest tax deduction. Prior to the crisis I often heard a number of Americans talk about how much they loved their mortgage tax deduction. What many Americans never realized is that this deduction served as a significant incentive to take on large housing debt. A bigger mortgage = bigger interest deduction = lower taxes. Financial reform did not contain any changes to the mortgage interest deduction. However, heavily leveraged America should perhaps think twice about whether the tax code should incentivize incurring huge quantities of mortgage debt.

Can the U.S. import any of Canada's policies? At present it seems unlikely. The securitization genie is completely out of the bottle. And while it may be logical to repeal an incentive to go into massive debt there is a very large constituency of home owners who would lobby hard against dropping the mortgage interest tax deduction. Any change to this tax rule, or a reduction in Fannie's and Freddie's mortgage holdings, would also put additional pressure on a still very fragile (and probably heading lower) U.S. housing sector.

American Myopia?

Returning to the criticism that led off this post, why don't American's take more interest in the policies of Canada or other countries for that matter?

The simple answer perhaps is that success breeds hubris. Americans have somewhat understandably felt that, when compared to the rest of the world, their country has done a lot right for a long time. But I think there is more to the story.

Another reason may be that Americans simply don't get around as much. While a growing number of Americans hold passports, according to a 2008 GAO study only 28% of Americans do so. I don't find it reasonable to compare American passport percentages with say Europeans, where a much higher percentage of citizens hold passports simply due to the fact that many Europeans live in immediate proximity (often within only an hour or two) of several different countries. Perhaps our closest comp is Canada where approximately 53% of Canadians -- or nearly twice as many as Americans -- hold passports.

However, there is some evidence that a more outward looking attitude is taking hold in the U.S. During healthcare reform there was public discussion of foreign approaches, such as the German and Swiss healthcare models which are generally considered to deliver equal or better overall healthcare at a substantially lower cost than the U.S.'s healthcare system. Perhaps more ominously, here at the Agora conference I was discussing Arizona's controversial immigration law with an Arizonian and he referenced ancient Rome and Cicero's writings about what can happen to an empire which fails to control its borders.

'Twas the Night Before Stress Tests, Nary a Euro Bull in the House

I'm attending Agora Financial's excellent 11th Annual Investment Symposium in Vancouver, Canada this week.

Here you can find a fairly wide range of investment ideas and outlooks. From Doug Casey's call that we're in the midst of the "Greater Depression" and all developed country sovereigns will go bust soon, to John Mauldin's suggestion that the 10-Year Treasury may continue to rally driving the yield to perhaps as low as 1.5% next year.

But one thing I have yet to encounter is someone who is bullish on the Euro.

Two conference presenters making the bearish Euro argument are the aforementioned John Mauldin and Rob Parenteau. Both are forecasting Euro-U.S. Dollar parity or lower next year, with Mr. Parenteau suggesting it may come as soon as this August or September. (In December 2009 Rob correctly predicted Greek social unrest in 2010, which unfortunately came true in the form of violent and deadly spring street clashes.)

European bank stress tests are set to be released tomorrow. Like U.S. bank tests last year there have been advance leaks about which banks are set to pass and fail. However, the European bank stress tests are a "black box" because the criteria to "pass" is unknown. This in turn has created a perception that the tests will do more harm than good.

Fundamental to the bearish outlook for the Euro is the belief that a Greek debt "restructuring" (aka default) is inevitable. A Greek default, an implosion of Spain's cajas, or a Hungary/IMF meltdown -- to cite just a handful of possible triggers -- could lead to a chain reaction banking crisis given the web of cross-border debt.

And while recent economic numbers from Europe, such as PMI and German exports, have been positive these figures will come under further pressure in the second half of 2010 as pan-European fiscal austerity measures gain traction.

After the Euro crashed in June to approximately 1.18 vs. the U.S. Dollar, it has rallied sharply. However, it has met resistance at the 1.30 level and failed to surpass its 25 week moving average. While many Euro shorts were squeezed out by the recent up move, the talk at the conference suggests that it is time to put this trade back on.

If you're interested in learning more about the conference including daily updates click here.

Today's Hooey: Claiming Bank Bailouts Are "Profitable" for Taxpayers

CNBC, Reuters, and other media outlets trumpeted Keefe, Bruyette & Woods claim that bank bailouts are profitable for the U.S. government (and hence the U.S. taxpayer).

If it weren't for the report's intellectual dishonesty this news would have made for a nice political headline and taxpayer feel good story.

The glaring problem with Keefe's Mr. Fred Cannon's "profitable" conclusion is that he arrived at it only by ignoring all the other government bailouts during the financial crisis.

Confirmed: XBox-Netflix Software Exclusivity Ends Oct. 1; Netflix on PS3 Won't Require Disc

In the ongoing battle for game platform bragging rights Microsoft's XBox will soon lose one its exclusive features.

Since Netflix's Watch Instantly feature was rolled out to the Big Three gaming platforms Sony PS3 users have complained about having to insert a Blu-ray disc to view Netflix content. In contrast, XBox 360 users can access the popular Netflix feature directly from XBox Live without having to insert a disc.

A source inside Netflix has confirmed that the company is currently in the late stages of testing a software patch that will allow PS3 owners to use Watch Instantly sans disc. 

The software will be provided as part of a PS3 OS update once Microsoft's exclusive deal with Netflix ends on October 1, 2010.

4th of July Remembrance of the Original American Rebel: Thomas Paine

A belated Happy 4th of July to American readers of The PolyCapitalist!

For the American Independence Day holiday George F. Smith has a terrific read  on Thomas Paine, one of history's biggest Royal troublemakers.

Paine is arguably more responsible than any other person for the American Revolution. However, he doesn't seem to get as much historical air time as the other key figures.

I hope you enjoy the read as much as I did, and I suggest finding a chunk of time before diving in as this article is not short.

Genes Dictate Whether You're a Morning or Night Person

New research confirms something I had suspected -- being a morning or night person is a genetic predisposition.

In the pre-modern world it would be advantageous for tribes to have a variety of chrontypes so that someone was awake/alert for threats at all hours of the day. However, as the article explains in the modern world a disproportionate share of rewards go to the morning person.

Thoughts on Krugman's "Myths of Austerity"

An interesting and lively discussion is taking place over at zerohedge.com in response to Professor Paul Krugman's most recent article titled "Myths of Austerity".

I highly recommend perusing the comments that follow Leo Kolivakis's response to both Krugman and Niall Ferguson's alternative view expressed in a video interview on CNN (Krugman also is interviewed on the same program).

Some of the opinions I agree with:

1. Massive government stimulus spending is inefficient in terms of the economic bang for the buck.
2. I would prefer if Krugman spent more time discussing the 'quality' of government stimulus spending vs. always focussing on the 'quantity'.
3. Government investment and support in new technology development (e.g., sustainable energy) and public works (e.g., street lamps) can add economic value.
4. Japan is not necessarily in as bad of shape as the U.S. because, unlike the U.S., it is a surplus country (it produces more than it consumes) and its astronomical debt level (over 2x larger than the U.S.'s Debt/GDP ratio) is owed almost entirely to itself.
5. Most bond investors aren't interested in playing the role of 'vigilante' -- they simply want to earn an appropriate rate of return on their capital and see their principal returned.
6. While in the near-term it may be true that "the big, bad bond vigilantes are simply no match for the Federal Reserve and they know it. Bernanke can squash them like a bug". However, over a longer-term horizon there is not a central bank on earth -- not even the mighty Federal Reserve -- that can win if confidence in that country's scrip is lost.
7. Always framing the economic conversation around 'growth' or 'inflation' distracts from the very worthwhile economic goals of 'stability' and 'sustainability'.
8. "When we are unable to borrow money to buy new crap we will put more effort into maintenance of what we have" -Paul E. Math
9. It is likely that the U.S., unfortunately, will not make the necessary political decisions and take action until another crisis hits due to the short-term outlook and a lack of public pressure and political will.

And if you haven't already read it The Zero Hedge Conflicts/"Full Disclosure" Policy is pretty entertaining.

Is a U.S.- China Economic War On Its Way?

The tone of U.S.-China relations, as evidenced by General Electric CEO Jeff Immelt's provocative “colonization” remarks, are deteriorating rapidly and signaling trouble ahead. Given the importance of this relationship it is important to understand what's at stake and how events may play out.

Sizing Up the Sino-American Relationship

The U.S. has the world's largest economy and the U.S. Dollar is the world’s reserve currency. China has the world’s fastest growing large economy, and it has proven comparatively resilient in the wake of the ‘Great Recession’. China recently passed Japan to become the world's second largest economy, and Goldman Sachs has forecasted that China will overtake the U.S. by 2027.

While the export of manufactured goods to countries such as the United States has been a key driver of China’s growth story, benefits have accrued on both sides of the Pacific. Large U.S. government deficits have been underwritten in part by the thrifty Chinese, and U.S. consumers have snatched up voluminous quantities of low cost Chinese imports.

This seemingly symbiotic relationship, which Harvard Professor Niall Ferguson has termed ‘Chimerica’, avoided close scrutiny during the credit boom years. But amid high U.S. unemployment and a mounting public debt Chimerica is now under a microscope.

China’s “Unfair” Currency Policy

China has been accused of manipulating its currency by pegging the renminbi to the U.S. dollar at an artificially low rate, thereby allowing China to gain an unfair trade advantage. Critics point to China’s more than $2 trillion in largely U.S. dollar denominated foreign exchange (forex) reserves as prima facie evidence that the renminbi is grossly undervalued. Market participants have speculated that if the renminbi were allowed to freely float it would appreciate by 20-40% against the U.S. dollar.

Emerging market and EU officials have joined the U.S. in criticizing China's currency policy. Under pressure, China’s recent announcement that the renminbi would be allowed to float was initially greeted with widespread enthusiasm. However, since the announcement the value of the renminbi has moved within a narrow 0.5% range, remaining effectively unchanged. This has led some critics, such as NY Times columnist Paul Krugman, to accuse China of “playing games”.

A U.S.-China Economic War?

One of history’s unfortunate reoccurring themes is the tendency on the part of political leaders to create foreign scapegoats, particularly when faced with challenging economic times and an uncertain electoral environment. From this perspective surging, recalcitrant China makes for a nearly ideal political target.

Candidates for office can blame the U.S. unemployment problem on “unfair” China competition and the undervalued renminbi. China's large U.S. treasury holdings (estimated at up to $1 trillion, or roughly 20% of all foreign holdings) will also make a convenient target for fear mongers pointing at foreigners as the source of the U.S.’s troubles. Expect increasing criticism of China (reminiscent of 1980s Japan bashing) from politicians, labor groups, talk radio, etc. through this November's mid-term elections and through the next presidential election cycle.

What is the likelihood that the U.S. will go beyond rhetoric and take action? Seeing the renminbi revalued upwards is one of the few policy areas with bipartisan support. President Obama may feel pressure to appear strong and stand up to foreign powers to preserve the American economic way of life. Calls to “do something” will only grow louder in the face of the projected slow employment recovery. In short, formal trade action against China cannot be ruled out.

How would China respond to overt moves by the U.S.? The Chinese government detests foreign pressure. At the same time China's leadership, emboldened for example by the failure of The West to prevent the financial crisis and Google's recent blink, is growing more confident. Looking to flex its new economic and geopolitical muscles, China would almost certainly retaliate in some fashion against any U.S. trade action.

Looking Ahead

Both the U.S. and China possess numerous incentives to avoid a serious breakdown in relations. The economic and political consequences would be devastating for both countries and the rest of the world. The central question is will the U.S. and China be able – or willing – to find a path towards compromise which is also congruent with their respective interests?

It is human nature to underestimate the probability of seemingly unlikely, large-scale events like a U.S.-China trade and currency war. However, students of history know this to be an all-too-frequent mistake.

In considering whether such a conflict can be successfully avoided it is important to remember that policymakers often fail to properly diagnose and head-off the really big problems, such as war and financial crisis. Assurances by officials shortly before the near collapse of the financial system that the subprime problem was "contained" is but one recent example.

What could lead to a more serious escalation of tensions? A WTO ruling, U.S. Congressional action, China’s sale (or further purchases) of U.S. Treasuries, or an Asia Pacific geopolitical event (i.e., Taiwan, North Korea, etc.) are just a few of the possible triggers.

With China in the U.S.'s political crosshairs investors would do well to continue to closely monitor the world’s most important bilateral economic and political relationship. And given the stakes, let us hope that the current U.S.-China trade and currency war doesn't escalate further, for even a mild economic war could be devastating.

World Cup Flashback: The Netherlands vs. Argentina 1998

I'm in Holland right now and people are celebrating the country's sensational victory over Brazil, and salivating at the prospect of a Holland vs. Germany final. The World Cup is a truly great sporting event!

Arguably one of the greatest goals, and what must be THE greatest broadcasting burst of exuberance ever, came 12 years ago during Holland vs. Argentina in the 1998 quarterfinals. One minute to go and the score is tied. To this day the Dutch are still talking about it. Enjoy.

Dennis Bergkamp produced some amazing moments on the pitch. More Bergkamp soccer magic below, including his legendary Newcastle goal at the 2:08 mark: