Posts filed under “Currency”
Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.
Investment letter – February 17, 2009
On Friday, February 13, Congress passed the $787 billion stimulus plan. I’ll bet every member in Congress stayed up until the wee hours of Friday morning reading every one of the 1,434 pages needed to express the vision of the 110th Congress. About 40% of the total will be discretionary spending on education and job training, highway and bridge construction, modernization of the electricity grid, health and science research, housing programs and extending food stamp benefits. About 24% of the total will be spent in direct aid to states to supplement Medicaid costs, extend unemployment benefits, and expand health care programs for the needy. And almost 30% of the total goes for tax breaks for individuals and families, a temporary alternative minimum tax patch, state tax credit bonds to finance public education facilities, renewable energy incentives, and a $3 billion tax break for General Motors.
This legislation has ignited a contentious debate on whether it is too big or not big enough, or whether it contains too little or too much in tax cuts, at the expense of those who have lost their job or home in this crisis. Even more remarkable, not a single defender or detractor noted the inauspicious date it was passed – Friday the 13th! Yikes! Those who have consistently underestimated the magnitude and scope of the credit crisis, and its impact on the economy, seem impressed and hopeful about the plan’s effectiveness. They believe it is the right medicine to not only arrest the deep economic contraction and serious wave of deflation we’re experiencing, but also believe it will have enough muscle to launch a sustainable recovery. This is stimulus on steroids.
My concern is that this plan is being cheered by those who still don’t appreciate the structural nature of the problems we’re facing. It’s like a doctor who prescribes aspirin for a patient with a fever. Hours later, the fever is down, but the patient is admitted to the hospital with acute appendicitis. The doctor treated the symptom successfully, but not the cause of the fever. The Federal Reserve initially misdiagnosed the problem, thinking it was just a sub-prime mortgage problem that would run its course by the end of 2007. The collapse of Bear Stearns in March 2008 was certainly a wake up call. But over the next few months, two Fed members were more worried about inflation and voted against additional easing. It really wasn’t until the demise of Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Washington Mutual, Wachovia, and of course Lehman Brothers that the Federal Reserve and Treasury Department realized how far behind the curve they were. Unfortunately, they are still behind the curve, and now the patient has more than just a fever. In fact, an emergency room doctor might describe it as multiple organ failure. Large segments of the U.S. banking system are effectively insolvent. The securitization markets remain inoperable. The consumer is still in shock, and the global economy has pneumonia. The triage needed to save and revive the patient goes well beyond the scope of the stimulus plan. Remarkably, the majority of economists and investment professionals still believe all that’s needed is aspirin.
In my September 2007 letter I used the metaphor of a tsunami to describe the convulsion that swept through the credit markets in August 2007. Seismologists usually know within hours whether a 100 foot tsunami traveling 500 miles per hour, or a 2 foot wading wave was created by an underwater earth quake. I noted then we wouldn’t know for a number of months the full economic impact, but the displacement in the financial markets left no doubt that a significant seismic event had occurred. The majority of economists and investment professionals saw it as nothing more than a speed bump. There is the perception that a tsunami is a single giant wave of water that sweeps away everything in its path once it reaches land. As financial market participants have painfully learned since August 2007, a tsunami is actually a series of giant waves, each one causing more destruction. After the first wave hits, survivors feel a sense of relief, as the sea water retreats. But that respite is brief, as the second, third and fourth tsunami waves crash on shore. They seem to arrive without warning.
After the first wave in August 2007, the second wave took Bear Stearns down in March 2008. The third and fourth waves hit in July and September 2008 and brought the financial system to its knees. The fifth wave has pushed every developed economy into recession, creating the deepest synchronized global economic contraction since the 1930’s. Although not yet visible, there is a sixth wave coming, as the global recession creates more losses for banks, prolonging this period of weakness and increasing the risk of a much deeper contraction.
Two weeks ago, the Commerce Department reported that fourth quarter GDP fell at an annual rate of 3.8%, which was the largest drop since 1982. Though bad, that figure grossly understates the degree of actual weakness. Since sales were weaker than production, inventories grew. If sales and production had been in balance, GDP would have been lowered by 1.32%. Instead, the unwanted inventories will cause companies to reduce production in the first quarter. The GDP report measures domestic output, so the Commerce Department subtracts imports to determine domestic production. In the fourth quarter, imports plunged and boosted GDP by 2.93%. The collapse in domestic demand for imports is hardly a sign of economic strength. Without the misleading additions from inventories and imports, GDP would have been down 8.0% in the fourth quarter.
In last month’s letter, I discussed how the slowdown would create excess capacity, forcing companies to reduce investments in new plants, equipment and software. In the fourth quarter, business investment dropped at a 28% annual rate. This is significant since business investment is a key driver of growth, representing up to 15% of GDP, and a big contributor to gains in productivity. The decline in sales volume and increase in excess capacity is forcing companies to aggressively cut costs. In the last five months, almost 2.5 million jobs have been eliminated and the average work week is at a record low of 33.3 hours. Personal income fell .2% in December for the third consecutive month. Personal spending has declined for five consecutive months, after plunging 1% in December.
In the last twelve months, the unemployment rate has soared from 4.9% to 7.6%, and could exceed 9% by the end of 2009. The surge in unemployment will result in higher default rates on every type of consumer credit and lead to more losses for banks. A 1% increase in unemployment leads to a 1% increase in the credit card charge-off rate. The huge jump in unemployment over the last year, and especially the past five months, means banks are facing a big increase in credit card losses. As the unemployment climbs further, more prime borrowers, who tend to have larger loan balances, will be affected. This suggests bank losses could accelerate, as the unemployment rate rises in coming months.
From 2002 to 2006, banks originated an average of $557 billion a year in jumbo mortgage loans, according to Inside Mortgage Finance, and a total of $750 billion of option adjustable-rate mortgages. As of December, the percent of jumbo loans that are at least 90 days delinquent has surged to 6.9% from 2.6% in December 2007. Moody’s Investor’s Service has downgraded 75% of all prime jumbo loans originated in 2006 and 2007 that previously carried the top rating of triple-A. According to LPS Applied Analytics, 28% of option ARM mortgages are delinquent or in foreclosure. More than 55% of borrowers with option ARMs owe more than the value of their home, which means these borrowers have no option to refinance.
A year ago, I noted that it was not a good sign for the banking system or the economy that the Federal Deposit Insurance Corp. was hiring. Although FDIC bank examiners have increased the frequency of examinations for at-risk banks, many are falling into trouble faster than in previous downturns. Of the 25 banks that failed in 2008, 9 collapsed before regulators could respond, including Washington Mutual and IndyMac, two of the largest failures in history.
In recent weeks, the International Monetary Fund increased its estimate of total global banking losses from $1.4 trillion to $2.2 trillion. The IMF said the world’s advanced economies – the U.S., European Union countries, Britain, and Japan – are “already in depression.” The IMF estimates that United States banks have a capital shortage of $500 billion, and that’s if things aren’t worse than expected. Keep in mind that future lending will be reduced $10 for every $1 of capital shortage. A reduction of $5 trillion or more in future lending will dampen economic growth for at least two years.
Prior to August 2007, more credit was created by the securitization markets than through bank lending. Unfortunately, the securitization markets are in worse shape than the banking system, with the volume of securitization down 70% over the last year. In November, the Federal Reserve announced a plan to resuscitate the securitization of auto loans, student loans, and credit card debt. Almost 3 months have passed since the Fed announced its plan, but nothing has been done. Obviously, the complexity and size of the task has proven more daunting than expected. It took years for the securitization markets to develop, and central to that growth was the trust buyers of securitized debt placed in the rating agencies. That trust was destroyed, when investors were told their ‘AAA’ holdings were really junk, virtually overnight.
The collapse of the banking system and almost complete breakdown of the securitization markets represent a structural fissure in the credit creation process. What many economists and investment professionals have failed to understand is that there is no easy or quick fix. By their nature, structural problems take years to repair, not just a few quarters. Unfortunately these are not the only structural problems challenging policy makers.
Efforts to avoid a deflationary depression will probably produce the opposite — a nasty bout of inflation, says John Williams of Shadow Government Statistics, who advises hoarding gold and even Scotch to barter. Alistair Barr reports.
Attention Gold Bugs: Warm up your credit cards! Back in 2007, we ran this terrific chart by JP Koning of the History of the Dow. JP is at it again, this time, devising this fascinating pictograph showing the Recent History of Gold. JP adds: “The Recent History of Gold Wall Chart contains the gold price…Read More
Joshua Rosner is a managing director at the independent research consultancy Graham Fisher & Co., where he advises regulators and institutional investors on housing and mortgage finance issues. Rosner has provided advice on monetary, fiscal, regulatory, and political developments to many of the world’s leading banks, mutual funds, hedge funds, and other institutional investors. Mr. Rosner was among the first analysts to identify operational and accounting problems in the government-sponsored enterprises (GSEs), the peak in the housing market, the likelihood of contagion in credit markets, and the weaknesses in the credit rating agencies’ collateralized debt obligation (CDO) assumptions.
What follows is his most recent commentary on Bank of America:
Ken Lewis must not have listened if his parents told him what mine told me:
-”Don’t buy something you can’t afford”;”
- “Chew before you swallow”;
- “You just got a new toy (Countrywide), you don’t need another now (Merrill)”.
These are lessons our grandparents learned, our parents preached and we forgot. Now, unfortunately, our children will learn it too. Perhaps, for the good of the Republic, the Treasury and our nation’s bankers will as well.
Back stopping Countrywide was premature, buying it was ego driven and, even at the time, buying Merrill seemed plain dumb.
The whole Treasury approach is as dumb as taking equity warrants in a company you may decide is better off in reorganization. How can you teach market participants the lessons of the importance of risk assessment and responsibility if every time a banker blows up his firm you bail him out and then finance his next trade.
Worse yet, Treasury bail’s him out and allows him, without restriction, to use the money to play CDS, not to hedge and put risk back into the market but to speculate.
We need to take large and aggressive action to stop a deflation but the crisis has moved to main street and we can’t keep pretending that bank losses, which will begin to accelerate again (with rising unemployment and commercial losses) can reverse if only we use money to hide them.
We keep hearing DC talk about “when we restructure we must better regulate the large banks”. Hello!?, it has been 18 months since I began loudly calling for the SEC to require more detailed disclosures about the structured holdings of banks and warning of risks for the failure to disclose (see link at bottom). Disclosure is better than regulation and easy to achieve yet we talk as though the Fed and SEC need new powers to achieve these confidence inspiring and risk assessing disclosures.
“A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.
“Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high – despite policy rates close to zero – leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors’ problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions.”
- Professor Nouriel Roubini of New York University
I had breakfast with Nouriel this morning down in Soho (I am in New York today). I thought the above quote was an excellent way to lead off this week’s letter. Some of the more important questions of the moment are whether we face a serious bout of deflation, and if so, what can be done about it. There are market observers who are looking at the graphs which show the meteoric rise in the monetary base (see below) and predict that we will soon see much higher and rising inflation and a seriously falling dollar (accompanied with a large rise in gold). Is inflation everywhere and always a monetary phenomenon, as Friedman taught us? Can we see a large rise in the monetary base that is not accompanied by inflation? As Frederic Bastiat said (roughly), “In economics there is what you see and then there is what you don’t see.” The more important of the two items is what you don’t see. In this week’s letter we talk about what most market observers are not seeing, and why you should be paying attention.
We are going to revisit portions of an important e-letter I wrote earlier this year about the velocity of money. I am updating the charts and adding a lot of new commentary. I cannot overly stress how important this is. If you want to understand the markets, the dollar, gold, and more, you have to have this information down. You will need to put on your thinking cap, as much of what I am writing is counterintuitive and certainly
not considered as received wisdom in much of the financial-commentator media. (Note: this letter will print longer than usual as there are a lot of graphs.)
Also, I am going to make an important announcement at the end of the letter about a new information
service, and I need feedback from some of you.
Richard Russell Tribute
But first, I and some of my fellow newsletter writers (Bill Bonner and Dennis Gartman, among others, are slated to be there) are going to be hosting a special tribute dinner to honor Richard Russell for his outstanding contribution of over 50 years to not only the craft of investment writing but to the lives and investment portfolios of his readers. He is one of my personal heroes as well as a good friend. At 84, his
writing today is better than ever, and now he writes every day, not just once a month! Richard is an institution in the investment writing world, and after talking with his wife Faye he has said he would let us plan the dinner.
Richard has some of the most loyal readers anywhere. I have personally talked to readers who have been reading Dow Theory Letters almost since the beginning (1956), and their enthusiasm for all things Richard has not waned.
We really hope we can get a roomful of Richard’s friends, writing colleagues, and fans who have benefited from his wisdom over the years, to honor him for a life well lived and a true servant’s spirit, as well as being a guide not just in the markets but in life. The dinner will be Saturday evening, April 4, 2009 in San Diego. In order to know how many people we should plan for, please send an email to firstname.lastname@example.org indicating how many tickets you would like. Plan on the tickets being around $200, with any money left over going to Richard’s favorite charity. I actually expect tickets to go rather fast, so let us know as soon as possible. We will get back into contact with you as to the exact time and place. Thanks.
The Velocity Factor
When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And with Christmas looming, the velocity, at least in terms of how fast money seems to go out the door, seems faster than normal. And what about my business? Travel costs are way, way up; and as aggressive as we are on the budget, expenses always seem to rise. Compliance, legal, and accounting costs are through the roof. I wonder how those costs are accounted for in the Consumer Price Index? About the only way to deal with it is, as my old partner from the 1970s Don Moore used to say, is to make up the rise in costs with “excess profits,” whatever those are.
Is the Money Supply Growing or Not?
But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money and how it affects the growth of the economy. Let’s start with a few charts showing the recent high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast, or just about right, depending upon which monetary measure you use.
First, let’s look at the adjusted monetary base, or plain old cash plus bank reserves (remember that fact) held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. Until very recently, there was very little year-over-year growth. The monetary base grew along a rather predictable long-term trend line, with some variance from time to time, but always coming back to the mean.
But in the last few months the monetary base has grown by a staggering amount – by over 1400% on an annual basis, as shown in the next chart from my friend Dr. Lacy Hunt at Hoisington Asset Management. And when you see the “J-curve” in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don’t see that is important.
Now, the same graph but in percentage terms:
Only a week after the Treasury Secretary said that the government bailouts had stabilized the most important financial institutions, plunging stock prices forced the government to step in again.
click for video
Another Crisis, Another Bailout
New York Times, November 24, 2008
Jim Rogers on Bloomberg TV
The U.S. dollar will be “devalued” as policy makers seek to weaken it, undermining the greenback’s role as an international reserve currency, said Jim Rogers, chairman of Rogers Holdings in Singapore.
“They think that if you drive down the value of your money, it makes you more competitive, now that has never worked in history in the long term,” said Rogers. The ICE’s Dollar Index has gained 19 percent since Rogers said in an interview on April 27 he expected a dollar rally “about now.”
The dollar is “going to lose its status as the world’s reserve currency,” Rogers said yesterday in a televised interview with Bloomberg News. “It will be devalued and it will go down a lot. These guys in Washington, they want to debase the currency.”
click for video
Rogers Says Dollar to Be `Devalued,’ Buys Commodities
Ron Harui and Mike Schneider
Bloomberg, Nov. 25, 2008
Vincent Farrell, Jr. is Chief Investment Officer of Soleil Securities, a New York based investment management company. Over his long career on Wall Street, he has worked for numerous distinguished firms. Mr. Farrell graduated from Princeton University in 1969 and received his M.B.A. from the Iona College Graduate School of Business in 1972.
The Mount Washington Hotel is in Carroll, New Hampshire. It is not the hotel featured in the Jack Nicholson movie “The Shining.” That was the Timberline Lodge near Mount Hood, Oregon. So it’s ok to stay in rooms 215 and 217 (or is it 415 and 417 ?) The hotel’s golf club-the course was designed by Donald Ross- has enshrined the locker used by Babe Ruth on his visits there. Because it’s near the Bretton Woods ski area, the conference of Allied world leaders held towards the end of World War II at the hotel was called the Bretton Woods Conference. That is a much better name than Mount Washington Resort Conference. The conference was held in July of 1944. The war was still raging. The D-day Normandy invasion of Europe was barely a month old and the tide of war had changed, but the outcome was not yet assured. The 44 countries that attended had been victims of unenlightened monetary and fiscal policies in the 1930′s and had come to realize international cooperation was necessary. Repeated currency devaluations to increase the competitiveness of exports had led to corresponding actions by other nations and only worsened deflationary spirals. In a sense, WW II was an economic savior as demand for goods was met by labor shortages and inflation fears broke the deflationary mindset.
But few, if any, believed the conditions that spawned the Depression were gone, so at the behest of the U.S. and Britain who had been talking and planning for a few years, the conference to figure a post war economic agenda was held.
The conferees decided on a fixed exchange rate for currencies pegged to gold, with the only currency worth anything after the devastation of the war, the dollar, as the “reserve” currency. In reality, the conferees knew the only country that had an industrial base capable of pulling the world back from the precipice was the United States. The rest of the world was in ruins. The organizations that became known as the International Monetary Fund and the World Bank were created. And it all more or less worked until the world outgrew the supply of gold and the U.S went off the gold standard in 1971.
This article originally appeared in a newsletter: The Objectivist published in 1966 and was reprinted in Ayn Rand’s Capitalism: The Unknown Ideal
An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense – perhaps more clearly and subtly than many consistent defenders of laissez-faire – that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.
In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.
Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.
The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.
What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible. More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term “luxury good” implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.
In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value, will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.