The Year in Gold: 2011

2011 was a volatile, roller coaster ride for gold. It saw a price spike up to $1,900/oz, followed by a crash into the end of the year, finishing at $1,566/oz. The price change for the year was +10%. Despite the year end crash, gold outperformed all global stock markets by a wide margin, and beat the S&P 500 for the 11th year in a row. The S&P was essentially flat for the year, the FTSE was down over 5% and the Nikkei down 17%.

Gold vs. Money Supply

From the early 1980s until 2001, the monetary base grew faster than the gold price. That trend reversed when the gold bull market started in 2001 and continued until the US financial crises in 2008. After 2008, the monetary base grew at an even faster rate, but then leveled off in 2009. I find the comparison to the monetary base interesting because in the original Federal Reserve Act, the monetary base was limited by the amount of gold held by the Treasury. That legislative link was broken in 1971. The gold price has fared better against M1 and M2, nearly reaching their peak ratios from 1980 before easing back.

Gold vs. US Debt

I started modeling the gold price against US debt with surprisingly good results. The longest model I have is one going back to 1971 when the official link of the dollar to gold was broken by President Nixon. At that time, the official price was $35/oz.

Using a linear regression of the data back to 1971 (above), I get these predictions:
Two sigma below is $813.24
One sigma below is $1,035.33
The best fit price is $1,247.82
One sigma above is $1,460.30
Two sigma above is $1,682.40

These prices may be the best long term guides IF the United States can get control of its fiscal situation again, which requires control of its political situation again. Unending trillion dollar deficits is not the path to a stable currency and fiscal situation.

The more recent model that coincides with the gold bull market since 2001 has a higher correlation, for now. Using a linear regression of the data back to 2001 (above), I get these predictions:
Two sigma below is $1,423.85
One sigma below is $1,508.73
The best fit price is $1,592.00
One sigma above is $1,675.28
Two sigma above is $1,760.16

These numbers add some perspective to the $1,900 price seen in August, 2011. Of course, markets pay no attention to statistics or models in the short run or even the medium term. Humans don't work that way. I speak from experience. YMMV.

Gold: No More Love

Gold prices, since peaking in August, have been dropping like a burst bubble, and maybe that is what is happening. I am still on the fence about that. After the momentous rise and crash, I was unsure of what was unfolding so I sold half at $1,654. This morning, we bounced off $1,530 again, the spike low from the initial crash.

My debt vs. gold model predicts a best fit gold price of $1,578. This is the first time since early 2009 that the spot price has been below my model price. One standard deviation below would be $1,409. I am content to sit in my physical position for now, until and unless it becomes clear that interest rates are rising and central bank money printing is over. Neither of those conditions is true today. What is true is that speculators have been destroyed and sentiment is in the toilet. Gold gets No More Love...

The Fickle Nickel

More nickel weirdness at Kitco. Here is the Nickel chart I downloaded showing another 33% drop in the price of Nickel. I tried to confirm it at the London Metal Exchange, but the pricing there was showing roughly $8/lb.

I am puzzled about what is going on at Kitco with base metals. Is there a problem with Kitco, a problem with commodity futures markets, or both? A nickel in hand is worth 3/4 in the futures? I am able to make less of "markets" now than ever before. At least I have documented proof of my madness. I think there is an Edgar Allen Poe poem about this affliction.

A Dream within a Dream

I stand amid the roar
Of a surf-tormented shore,
And I hold within my hand
Grains of the golden sand-
How few! yet how they creep
Through my fingers to the deep,
While I weep- while I weep!
O God! can I not grasp
Them with a tighter clasp?
O God! can I not save
One from the pitiless [elliot] wave?
Is all that we see or seem
But a dream within a dream?

UPDATE: Nickel rockets up 55%!!!
More wild gyrations. What's up Kitco?

Land of the Rising Debt

The spectacle of Japanese government debt continues to dazzle. Projections are for debt-to-GDP to reach 230% in 2012. The numbers just make me scratch my head. Japan will borrow half of all budget expenditures. With an average interest rate of around 1% on issued debt, they will still spend roughly half of all tax revenue on interest on their debt. Their debt will pass one quadrillion yen this year.
Here are some recent articles on the Japanese debt situation...
Japan Seeks to Market Record 145 Trillion Yen Bonds in 2012; Kicking the Can Japanese Style
The Endgame: Japan Makes Another Move

Last April, I tried to make some guesses about how the Japanese might make needed adjustments. I have no idea how it will resolve itself. Maybe Japanese debt, unlike Eurozone debt, can grow to the sky without limits. Maybe they can support a debt-to-GDP ratio of 1,000% or more without any problems. After all, yen are just electronic numbers, right?

I can't stop looking at Japanese debt with both a mix of both awe and terror.

UPDATE: another article on Japanese debt, one that has the same title as my blog entry!
Check the post dates, though, and you will see that mine was published first. My title was completely original, which doesn't mean the other guy didn't also have the same original thought. Or did he?!?? Haha.

In a Pickle with Nickels

There is a distinct smell in the air. The pungent odor of deflation and a poorly timed trade.

In April, I suggested loading up on nickels since the metal value at that time exceeded the face value and I expected more QE interventions from the Fed to devalue the dollar even further. Since then, the prices of copper and nickel have plunged in a frightening way. This morning, nickel opened down about 35% and has lost more than 50% since my original article. I am still looking for news that would explain the 1/3 haircut in a single day, so far without success.

The good news is that there was almost no down side risk to hoarding nickels. Even though the metal value has dropped well below face value, they are still worth face value and there is no transaction cost to depositing them back into a bank or credit union.

I am still prepared to wait 10-15 years for a pay off, but I might trade some of them in for I-bonds or silver and to free up storage space. In the short run, it is clear that I was way off base on base metals. Doh!

UPDATE: FLASH CRASH! According to Kitco, the price of nickel is now back to pre-crash levels at $8.38/pound. The price anomaly lasted a good few hours, but has now been erased from existence. I should have taken a screenshot. While prices are still way down from a year ago, the puzzling 35% drop from this morning is gone without a trace. That explains the lack of news but raises a question about what happened to the price reporting.

Jonathon Livingston Siegel

inspired by this post: Siegel's Island

From Wikipedia:
Jonathan Livingston Seagull, written by Richard Bach, is a fable in novella form about a seagull learning about life and flight, and a homily about self-perfection. The book tells the story of Jonathan Livingston Seagull, a seagull who is bored with the daily squabbles over food. Seized by a passion for flight, he pushes himself, learning everything he can about flying, until finally his unwillingness to conform results in his expulsion from his flock.

From Wharton:
Jonathon Livingston Siegel, is a story about a professor learning about life and stock markets, and a homily about the perception of self-perfection. The good professor is bored with the daily squabbles over bank consulting bonuses and tenure. Seized by a passion for equities, he pushes himself, misunderstanding everything he can about investing for the long run, until finally his unwillingness to conform to reality results in his expulsion from his flock.

Turns out, sometimes stocks are for the birds.

November, 2011 Employment situation internals

Here are few internals from the BLS Employment Situation Report for October, 2011.

AVERAGE HOURLY EARNINGS: $23.18, -0.1% MoM

AVERAGE WEEKLY HOURS: 34.3 unchanged

PROFESSIONAL AND BUSINESS SERVICES
TEMPORARY HELP SERVICES
Oct 2011 15,800
Nov 2011 22,300

Go go Huntsman

Simon Johnson covers the Huntsman approach to TBTF and is the only one ready to face them and make them smaller. He is the only candidate for President that seems to be saying rational things about the economy.

Pepper Spray Thanksgiving

What has the USA become? What it is becoming? The National Police are serving up pepper spray as the main course for Thanksgiving.

The U.S. Government — in the name of Terrorism — has aggressively para-militarized the nation’s domestic police forces by lavishing them with countless military-style weapons and other war-like technologies, training them in war-zone military tactics, and generally imposing a war mentality on them. Arming domestic police forces with para-military weaponry will ensure their systematic use even in the absence of a Terrorist attack on U.S. soil… It’s a very small step to go from supporting the abuse of defenseless detainees (including one’s fellow citizens) to supporting the pepper-spraying and tasering of non-violent political protesters.
-- Glenn Greenwald
Salon

Nigel Farage: What Gives You the Right?

Without comment... Link in case the embed doesn't work.

The Italian Job

Over night, the Italian 10 year bond yield jumped over 500 basis points (a basis point is 1/100 of a percent).

It sent shudders through the entire global financial system, tanking equity markets everywhere and setting off a political firestorm in Italy and Euro centers of power. Italy is too big to save. It simply has too much debt and losses on that debt will devastate dozens of Eurozone banks. Emergency meetings are probably under way across Europe and Washington.

I have a hypothesis that the bankruptcy of MF Global forced a large liquidation of Italian bonds, causing big losses, stop loss triggers, followed by margin hikes on the bonds, and more panic selling. The loss of marked to market principal on Italian bonds alone was hundreds of billions of dollars in one night. I'm sure other factors came into play, but I think the death of MF Global was one of the matches that lit the fire.

I only see two ways this can now end. The ECB can start monetizing PIIGS bonds with massive buying, which is currently against the law. Or, each country can set the terms of their own restructuring, and each country will be responsible for recapitalizing their own banks. Either option might work out OK for Italy, but the second would be an ugly, chaotic event for Greece, which would probably be forced off the Euro and back to drachma. The same goes for Portugal and Ireland. Spain is much harder to call.

I've heard over the last few months how leaders need to restore "confidence to the markets". When I hear that, it gets translated in my head to "continue fooling you with lies and fake accounting". In 2008, deep seated corruption and lies came frothing to the surface. Scams and frauds have continued to wash up on the financial shores as they collapse. The missing $600 million in customer accounts at MF Global is just the latest.

However the Italian job plays out, major changes are coming to the Eurozone, maybe sooner than later.

Employment Situation Internals

Here are few internals from the BLS Employment Situation Report for October, 2011.

AVERAGE HOURLY EARNINGS (YOY) Actual: 1.8%
Average hourly earnings YoY at 1.8% with CPI at 3.8% YoY mean a decrease in purchasing power of 2.0% YoY.

AVERAGE WEEKLY HOURS Actual: 34.3 unchanged
Not better, but not worse either.

PROFESSIONAL AND BUSINESS SERVICES
TEMPORARY HELP SERVICES
Oct 2010 27,200
Aug 2011 22,600
Sep 2011 21,100
Oct 2011 15,000

The drop and downtrend in temporary help services is not good. Generally, employers increase their temporary help before hiring new full time workers. This was a weak report but not disastrous.

$15 trillion on deck

The Treasury debt to the penny page showed total US federal debt reached $14,993,709,044,140.78 on October 31, 2011.

The total is now on the cusp of passing $15 trillion. Astronomical.

California's unemployment insurance fund

I've been tracking the California unemployment insurance fund for a couple of years. The fund ran out of money at the end of 2008. Since then, it has been insolvent and borrowing from the federal government to pay unemployment claims. The fund appeared to bottom at -$11.08 billion in April, 2011 and has since recovered to -$8.7 billion in August, 2011. Under the original agreement with the federal government, the state was supposed to start paying interest on borrowed funds in January, 2011, but that was deferred until September, 2011.

The first interest payment of $303 million was paid last month. The LA Times covered the unfolding disaster.

It will have to pony up at least a half-billion dollars in 2012 and even more in coming years. The state, which already is struggling to close a massive budget deficit, probably will be forced to make even deeper cuts to schools, law enforcement and other basic services. In the meantime, California employers in January will be hit with a mandatory surcharge of about $25 per employee to begin paying down the principal on the federal loan.

Surcharges for each employee are likely to slow hiring in an already weak employment environment. California is not the only state with an insolvent UI insurance fund. President Obama is proposing further suspensions of interest owed to the federal government and surcharges from the federal government on employers. There is a deep hole to fill to pay for all of the unemployment benefits paid out over the last few years that will be a drag on employers for many years into the future.

Side note: When I started my first business in 1993, I was surprised to learn that I had to pay unemployment insurance on myself as the single employee in my company. I remember talking to the state UI office to confirm that I could collect unemployment insurance if I laid myself off. It never came to that, thankfully.

Mean vs Median unemployment

source: St. Louis Fed (UEMPMEAN, UEMPMED)

The mean duration of unemployment set another new record in September of 40.5 weeks. The median has been in a tight range the last few months, but inched up in September to 22.2 weeks. While the median has dropped from the peak, it is still at levels much worse than the 1980s recessions and worse than any recession since tracking started in the 1960s.

The story is with the still rising mean. There are millions of people who want to work but had their livelihood destroyed in the 2008 recession. Many may never be employed again -- have become unemployable. Their long term benefits may have run out and they may be stuck trying to get by until they can collect Social Security. It cries out for a new Work Progress Administration. In general, I am not in favor of Keynesian policies, as practiced by D.C. (as opposed to my understanding of the original idea). However, in this case, I think it makes sense. An equivalent funding of a new WPA using the same percent of GDP as in 1939 would cost about 1 trillion a year. The devil would be in the details of executing such a program without horrific waste.

Another look at money supply vs gold

Money Supply vs. Gold Price

I've added the Monetary Base (M0) to the charts. While the M1 and M2 charts show that the gold price has been increasing faster than the money supply, the opposite is shown in the monetary base, which has grown almost 4 times as fast as the gold price since the early 1980s. The Fed has been using the monetary base to execute two QE programs, purchasing well over two trillion dollars worth of MBS, ABS, and treasury bonds. Most of that new cash has ended up back at the Fed in the form of excess reserves, paying 0.25% interest to the banks that keep it there. If there was demand for that money as bank loans in the economy, it could create at least 18 trillion new dollars. Of course, there aren't a lot of credit worthy borrowers who want to take out new loans, and the banks need provisions for ongoing real estate loan losses. That inert money is likely to stay at the Fed until the real economy starts to improve, but the monetary base level is unusual and disturbing.

St. Louis Fed Financial Stress Index

This index is relatively new and is similar to the longer running Kansas City Fed financial stress index. Both have been rising lately, but are not even close to the stress shown in 2008.

The St. Louis FSI is built from the following 18 weekly data series:

Interest Rates:

• Effective federal funds rate
• 2-year Treasury
• 10-year Treasury
• 30-year Treasury
• Baa-rated corporate
• Merrill Lynch High-Yield Corporate Master II Index
• Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:

• Yield curve: 10-year Treasury minus 3-month Treasury
• Corporate Baa-rated bond minus 10-year Treasury
• Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
• 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
• 3-month Treasury-Eurodollar (TED) spread
• 3-month commercial paper minus 3-month Treasury bill

Other Indicators:

• J.P. Morgan Emerging Markets Bond Index Plus
• Chicago Board Options Exchange Market Volatility Index (VIX)
• Merrill Lynch Bond Market Volatility Index (1-month)
• 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
• Vanguard Financials Exchange-Traded Fund (equities)

I've added the FSI to the link list as a useful indicator to watch.

Punch the clown

While reading an Illusion of Prosperity post on Oil and Wages, I was going to comment on how it was unsportsmanlike to beat up on Anthony Mirhaydari at MSN Money and his questionable ideas. I mean, how hard is it to punch a clown?

After reading the article, I decided instead to join in the clown punching fun. Here is what he wrote about the crisis in Europe on October 5, 2011:

As for Europe, leaders continue to make progress toward a definitive solution.

Maybe he is in on the latest weekly emergency meeting, but I have yet to see any progress toward a solution. I see lots of emergency meetings, lots of plans to make plans, lots of ideas tossed out by ministers who don't have the authority to do anything, but no solution. Wasn't this problem solved in the summer of 2010? No. Wasn't it solved by a second Greece bailout in July? No. Does Mr. Mirhaydari know that Dexia, a 500 billion dollar bank is being dismantled by the French and Belgium governments this weekend? No. How about that Italy and Spain were both downgraded two days after his article, or that Belgium is now under downgrade watch due to the Dexia bailout. Banks all across the EU were downgraded in the last few days because there is no solution forthcoming.

The Greek Cabinet approved a new budget with tough austerity measures -- including mass layoffs of public sector workers -- designed to return the country to a primary budget surplus (before interest payments), a necessary first step toward restoring fiscal sustainability.

Greece has been approving austerity measures for a year and a half resulting in a lower GDP and bigger budget deficits. They haven't hit a single target since they entered their death spiral. And as mentioned, they can't meet their budget even if they stopped making all interest payments on their bonds tomorrow. They are beyond bankrupt. How have things changed?

As for Greece's saviors, only Slovakia and the Netherlands need to approve the so-called "July 21" changes to the eurozone bailout fund -- which will give the fund more strength and flexibility. Moreover, ratification of the July 21 agreement is needed before European leaders can push ahead with plans to leverage up the bailout fund with private capital with the help of the European Central Bank, a plan that should be the final nail in the coffin of the crisis.

The latest from Slovakia is that the ruling party is against approving the EFSF, but negotiations are ongoing. It could pass, but lets not count the chickens before they hatch. Even if it is approved, they seems to be no taste in Germany for leveraging it up. It really makes no sense for bankrupt countries to borrow from each other, with leverage, to pay off the bonds they can't afford to pay. The whole thing is a circular cesspool.

Whew, clown punching can be exhausting.

S&P 500 vs. Net Capital Inflow (Z1)

The 2nd quarter of 2011 showed a shocking drop in net capital inflow from the Treasury Department Flow of Funds (Z1). The drop was from 478 billion to 2 billion, a net change of -476 billion or almost half a trillion dollars that fled the US. The last time a drop like that happened was the 2nd quarter of 2008 when the net change was -475 billion. Does S&P history rhyme? We are about to find out.

Steve Jobs RIP

Steve Jobs RIP

A Decade of Rough Sledding

CNN has an article called "Face it, tough times are ahead".

President Obama has repeatedly stated, "We are tougher than the times we live in." Although the president may not have intended to signal a whole new approach to our future, the line has Churchillian implications. Speaking of tough times, he could call on Americans to recognize we face at least a decade of rough sledding, ask us to face the challenges and express confidence that we shall prevail.

The problem with asking Americans to suck it up is that the government is really asking the weak, poor, and least connected to suck it up, shoving the burden of the crimes and mistakes of the financial elite onto everyone else. It won't work. This is not an external enemy that bombed us at Pearl Harbor. These are the white collar confidence men running the banks, insurance companies, and the Federal Reserve. Today, I watched Bernanke give the nod to usurious 30% interest rates charged by banks when asked point blank by the Honorable Senator Bernie Sanders. He doesn't see any problem loaning banks money at 0.25% so they can turn around and lend it to consumers at 30%.

Harvard economist Kenneth Rogoff argues that intentionally inflating the dollar is the "the only practical way to shorten the coming period of painful deleveraging and slow growth."

If only it were so easy. Inflation is a disjointed, asymmetric process. Those with first access to new money spend it at full value. Then it cheapens all existing money as moves through the system. That's the way it works unless you drop it equally and on everyone at once.

I am hardly the only one who foresees a "lost decade." A recent Atlantic magazine article argues that even by 2011, 2012, even 2014, the employment rate may decline very little and describes the current economic climate as "a trauma that will remain heavy for quite some time."

Foresee? I see a lost decade looking back to 2000. I also foresee our second lost decade going forward. And maybe a third if we keep kicking the can.

We've avoided the violent demonstrations seen in Greece, the massive demonstrations against inequality seen in Tel Aviv and the random torching of cars common in riots in Germany, France or Britain. If Obama can speak candidly about the coming tough times and the shortfalls we all will have to accept as part of the cure, he may do better; we most assuredly will.

I disagree that Obama can charm the masses by speaking candidly. Obama either doesn't understand what happened, or more likely does understand, but up to now hasn't wanted to confront the money trust the way Andrew Jackson did. He is an insider, groomed to maintain the status quo. He would not have packed his administration with cronies like Geithner and Summers if wanted to address the real issues.

Updated Gold Price vs. Debt statistics

The monthly model (R-squared = 0.95) going back to 2001, shows some major froth on the upside. The intra-month highs in August and September approached 1900 and reached more than 4 sigma above the linear regression. The closing price on 9/30/2011 was $1,620. Here are the prices predicted by the model:
Two sigma below: $1,335.27
One sigma below: $1,417.52
Best fit: $1,498.20
One sigma above: $1,578.87
Two sigma above: $1,661.13

Expanding the model to yearly prices back to 1971 (R-squared = 0.64), prices are well above trend (predicted best fit price = $1,126.52). The long bull market periods are marked by extreme stress in the financial system. I could be wrong, but the nature of the stress in banks and sovereigns seems much more severe than it did in the 1970s and 1980s. European countries were not going bankrupt in the 1970s while tied to a Euro wide currency. The private debt levels, financial sector debt levels, and sovereign debt levels were not close to what we have now, and no resolution seems to be near. Instead, every effort is being made to sustain the unsustainable. A lot of paper promises are going to be broken. That doesn't mean the gold price hasn't already discounted all of the turmoil to come.

Whether the big gold sell off in September was the start of a bubble collapse or just a correction in an ongoing bull market, I don't know. I think we will know within six months. While I made some good trades during the August and September froth, I also gave some back. Until I have a better understanding of what story gold is telling, I am going to back to the discipline of my statistical models.

Subjective Invective v.8

The G-7 Finance Ministers and Central Bank Governors issued a statement to calm the troubled markets today.

We reaffirmed our shared interest in a strong and stable international financial system, and our support for market-determined exchange rates.

Market-determined exchange rates like pegging the Swiss Franc to the Euro.

Market-determined exchange rates like multiple interventions by the Bank of Japan.

Bank Of Japan Intervention Leaves Trail Of Blood And Gore.

Bank of Japan Ponders Further Intervention

In recent weeks, many central banks have taken aggressive actions to control the values of their own currencies.

If the Bank of Japan continues to follow its precedent of supporting exporters though, the yen may depreciate from here. Yet, if other central bankers (who themselves may be pursuing weak currencies) have their say, the Bank of Japan may be unable to really weaken the yen.

If anything is market-determined in this day and age, it surely is currency exchange rates. Pursuing weak currencies is the hallmark of market-determined exchange rates, or something. I forgot where I was going with this. Oh, right. Forex trading is so easy that an E*Trade baby can do it! Can you feel the sarcasm?

Why $2K - M1 and M2 vs gold price

(Hat tip JD from Calculated Risk for the Why $2K title hilarious)
It has been a while since I compared M1 and M2 to the gold price.

M1 has started to go vertical. I can only speculate why. Maybe people are cashing in investments to have more ready cash available. The vertical nature of M2 supports that idea. A surge in both measurements could be explained by liquidation of stocks, bonds, and other investments, but I am only guessing what is happening.

The historic low for M1/gold price was 0.45 that occurred at the peak gold price on January 21, 1980.
The current M1 ratio is 1.16.
The historic low (in my spreadsheet) for M2/gold price was 2.40 in July 1980.
The current M2 ratio is 5.24.


I expected the current ratios to be lower due to the rise in gold prices, but I did not expect the dramatic rise in M1 and M2.

Since money supply is not tied to anything tangible and money is created mostly by typing into computer accounts at commercial banks and the Fed, does it even make sense to call it money supply? I've heard suggestions that "Number Supply" is a more accurate term for dollars in existence instead of money supply. Perhaps the Fed will create more numbers in their computers after their September meeting. Are you ready for Why $2K?

Consumer Metrics Moonshot

One interesting site I follow sometimes is the Consumer Metrics Institute data on Internet purchases of durable goods. When I first discovered Consumer Metrics, I thought their near real-time methodology was unique and might off deeper insight into what was happening in the broader economy. Over time, the demographics of Internet users turned out to be skewed in some ways and diverged from other broad indices. Still, whatever is going on now with Internet purchases is showing an incredible upward rate of change and deserves some brain cycles for reflection.

There are a couple of possibilities that come to mind. One, Internet consumers on a large scale decided to spend a lot of money online all at the same time because they all came into some new money (tax refunds, raises at work, inheritances). Maybe they all had appliances break over the summer and are replacing them. Anyway, that is one possible theme. A darker idea might be that they are nearly tapped out and decided to buy a bunch of new stuff on credit before declaring bankruptcy within the next six months. There could also be another explanation like the data feed is invalid for some reason or is reporting different information. Consumer Metrics itself seems to take the more positive view that this is a spending phenomenon that will reflect a stronger recovery in the government reported numbers in about 6 months.

Europe Don't Want No Short People

The short sale ban on banks instituted by many EuroZone countries is scheduled to end on Friday, August 26, 2011. The ban has not saved banking shares from being mauled and may have created artificial air pockets under the share prices since there are no shorts to cover as the prices drop. We'll know more next week.

That ban ends of the same day as the Fed Jackson Hole meeting concludes and Ben Bernanke speaks. Maybe Europe is expecting a miracle announcement from Ben.

They got grubby little fingers
And dirty little minds
They're gonna get you every time
Well, I don't want no short people
Don't want no short people
Don't want no short people
'Round here

Boat of Gloat v.1

Bank of America Plans Big Layoffs to Cut Costs

The boat of gloat, the sloop of Schadenfreude, sets sail to Charlotte, NC. It sails to the port of call most deserving and docks to find a large, evil, organization. Evil at the top, mind you, and there is a measure of empathy for the pain the generals are going to inflict on thousands of innocent foot soldiers.

With its stock down more than 50 percent since January, the job cuts by Bank of America may be only the start of a broader restructuring at the company, which is the nation’s largest bank. Brian T. Moynihan, the chief executive of the bank, has said that he hopes to trim quarterly expenses by $1.5 billion. Thousands more job cuts are likely in the months ahead.

But this zombie bank, being propped up at horrific costs to the country by the government, needs to finally be killed. Nationalized, unwound, sold off in chunks. For the safety of the US and the world. The list of criminal and civil violations perpetrated by this organization is too long to list.

UPDATED 9/2/2011:
Looks like the layoffs may now reach 30,000.
Bank of America was also sued today by the FHFA for $30 billion dollars (counting BofA and Merrill Lynch).

UPDATED 9/9/2011:
Looks like the layoffs may not reach 40,000.

This boat's for you!

Producer prices hitting the ceiling?

The producer price index inched up today, led by food and energy. Looking at the long term chart, could we be hitting the ceiling on producer prices where the economy rolls over and dies? This set up looks ominously like 2008 except that oil is currently much lower than in 2008.

I am not saying prices will necessarily fall. The Fed has been very diligent about keeping the dollar going down and prices going up, but the economy may only be able to absorb price increases at a certain rate before tipping back into recession.

Subjective Invective v.7

After a wild week for stocks, what to do?

What to do, indeed.

The article gives two pieces of sage advice from Robert Shiller. First...

Though he believes the stock market is still overvalued by historical averages, he says it is closer to fairly valued than before. He suggests investors move their money "modestly" into stocks.

I get it. If stocks are overvalued, invest modestly. As the saying goes, buy overvalued and sell high. Then, at the end, we get another piece of advice from Shiller...

"I'd be wary of putting too much in the market," says Shiller. "There's a good chance they'll fall. It's hard to predict the market."

Invest modestly, but be wary of putting too much in the market because there is a good chance it will fall. Now, I'm really confused. To be fair to Professor Shiller, he was probably misquoted and taken out of context. At least CNBC is consistent. It's always time to buy stocks!

I found this chart from an article by Charles Hughes Smith comparing the DOW from the 1907 panic (the one that spawned the Federal Reserve) to the 2008 crash. Yowza. Quoting Shiller: "there is a good chance it will fall."

Disclosure: I am not a certified financial anything. This is not investment advice. No stock positions.

Real GDP vs. Real GDP ex-deficit

This is my own twist on the size of deficit spending and what it means. By subtracting the GDP deflated deficit from the real GDP, you can see the huge gap being filled by current deficit spending. Some of the causes are well known: spending on unfunded wars and entitlements is too high, taxes are too low, and the Wall Street created financial crisis. Private and financial debt reached a saturation point in 2007 which was the trigger. What led consumers and financial firms to accumulate so much debt is more complex.

If you agree with the general causes, the solutions should be obvious. But what stands in the way is the political courage to address the issues leading me to name the difference in the lines the Political Fantasy Gap. The gulf between reality and sustainable government revenue is so large that the political body can't cope with it. Instead, the aim is to reduce the growth of the gap by 10% over the next 10 years. America is likely to run out of credit before then, which will be the crisis that forces the gap closed in an uncontrolled way.

Falling Down Exter's Pyramid

John Exter was a member of the Board of Governors of the United States Federal Reserve System. This is a modern version of Exter's Pyramid. From Wikipedia...

In Exter's scheme, gold forms the small base of most reliable value, and asset classes on progressively higher levels are more risky. The larger size of asset classes at higher levels is representative of the higher total worldwide notional value of those assets.

For people wondering why big money is flowing into gold, this is one possible explanation. When the financial system starting falling apart in 2008, (you could argue 2000), there was a sudden realization that mortgage and asset backed securities, the highest level of derivatives on the pyramid, were not money good. They defaulted en mass. To prevent losses, money fled down the pyramid to stocks, bonds, and cash.

The crash of mortgage derivatives and general debt saturation led to falling real estate values which led to more capital fleeing down the pyramid in search of stable returns and preservation. As the bust affected the broader economy, it led to lower profits, layoffs, and a stock market crash. At this point, a lot of big money had fled into treasury bonds. Now, the US has been downgraded, many sovereign countries are on the verge of default, and there is only one place left to go.

Update: The size of the top layer of the pyramid, financial derivatives, is estimated to have a notional value from 500 trillion to 1 quadrillion. A lot of that is supposed to be netted out, but the problem, as we saw with AIG, is that if one counter party can't meet its obligations, one side of a big net position blows up, and the whole chain detonates. A lot of that phantom money just disappears.

Liar Liar

From Zerohedge...

S&P on the verge of crossing 1200 for the 26th time

Stagflationary Mark has been documenting how many times the S&P 500 has crossed the magical 1,200 mark.

With the close today at 1,199, it only needs one small up day to finish above that mystical level for the 26th time.

The first time it closed above 1,200 was on 12/21/1998.

It seems much more special in 2011 than it did 13 years ago. Now, it is true that if you bought and held since 1998, you collected some dividends along the way, but this pesky thing called inflation ate it.

Stocks for the long run! (or not)

Awww, SNAP! (updated thru 5/2011)

The Food Stamp program participation is in a powerful uptrend. Here is the latest raw data as of May, 2011:
Total Participation: 45,753,078
Total as Percent of the US Population: 14.7%

There were about 800,000 new people added to SNAP this month in the state of Alabama.

The GDP Revisions

The most recent BEA GDP release not only was disappointing for 2Q2011 (1.3%), but the revisions were deep and way down, including an 80% downward revision for 1Q2011. Invictus at The Big Picture blog presented this Fed graph showing the shocking changes.

How can the BEA data be that far off over such a long period of time?

CoreLogic Snapshot: One City

I compiled a few very basic statistics from the CoreLogic data of one mid-sized city with about 50,000 parcels of land. This was my first pass at the data and it can be compiled in a more fine grained way. For now, here are couple of quick charts on the assessed values and mortgages. Note this includes both residential and commercial properties which are usually segregated. I was going to include mean and median negative equity values but they aren't meaningful with commercial properties in the mix.


Percentage of parcels with no mortgage: 65%
Percentage of parcels with a mortgage: 35%


Mortgages with positive equity: 80%
Mortgages with negative equity: 20%
Percentage of all properties with negative equity: 6%

Subjective Invective v.6

The Lesser Depression

When the bubble burst, home construction plunged, and so did consumer spending as debt-burdened families cut back.
Everything might still have been O.K. if other major economic players had stepped up their spending
...
In particular, cash-rich corporations see no reason to invest that cash in the face of weak consumer demand.
Nor did governments do much to help.

Except for the massive coordinated monetary policies of all central banks, including about 16 trillion in programs from the Federal Reserve alone. Followed by the massive fiscal stimulus by the US and one by China. Followed by two rounds and 2 trillion more in QE by the Federal Reserve.

The disappearance of unemployment from elite policy discourse and its replacement by deficit panic has been truly remarkable. It’s not a response to public opinion. Nor is it a response to market pressure. Interest rates on U.S. debt remain near historic lows.

Take a look at the historic lows Greek debt enjoyed until, within a short span, it was game over. The problem is no one can predict when the market will turn against a debtor nation with a structural trade deficit. The US might have low rates for the next 10 years, or it might have a bond market meltdown next year.

For those who know their 1930s history, this is all too familiar. If either of the current debt negotiations fails, we could be about to replay 1931, the global banking collapse that made the Great Depression great. But, if the negotiations succeed, we will be set to replay the great mistake of 1937: the premature turn to fiscal contraction that derailed economic recovery and ensured that the Depression would last until World War II finally provided the boost the economy needed.

When banks create too much credit, to the point of debt saturation, the inevitable bust is going to be painful and no amount of trickery can fix it. The answer is not more debt, it is the elimination of debt through payment and default. If you don't allow the debt to deflate, organic growth can't return. More fiscal stimulus won't jump start the economy. Another big world war can eliminate a lot of the work force and create the missing demand you seek, but that is an ugly solution. Kill the debts, not the people.

Autumn of the Empire

A fantastic and sweeping essay offering several viewpoints, sourced books, and themes to explain three recurring phases of empire. An examination of past empires and the final financialized stage of the current US empire. You may or may not agree, but you won't be disappointed.

Most striking and most dramatic is the discovery that each of these long centuries has itself been divided into three phases, choreographically consistent: a merchant phase based on trade, followed by a phase of industrial expansion, and finally a period of financialization, in which economic vitality moves to the banking sector. It is a febrile vitality indeed, burning hot and fading away; the shift to finance is always, in Braudel’s lovely phrase, “a sign of autumn.” And when the finance era runs its course, so does the empire.

This spiral grows, with China possibly in the middle phase of industrialization. Will the 21st century see an ascendant China?

How Investors Use Stories to Tame Uncertainty

In the book, The Soros Lectures: At the Central European University, Soros mentioned funding a new project called the Institute for New Economic Thinking (INET). To see if he followed through with his pledge, I searched and discovered that the Institute was indeed active and providing grants for research.

One of the grants went to David Tuckett, with a background in psychoanalysis and sociology, who conducted interviews of hedge fund managers to learn how they made investment decisions. The research focuses on the use of emotion and "stories about investments". The idea that an emotional experience is inextricably tied to each financial investment decision is fascinating, and also the idea that a rational investor would never make investments in financial assets.

Watch the brief video for an explanation.

Fiat Money Distribution of Power and Wealth

This diagram shows the advantages of being close to the money creation power in a fiat system. The banks and government benefit the most by having the ability to create money and control interest rates. With first access to new money, those nearest to the source of creation are harmed the least by inflation, while those on the other end lose the most purchasing power.

Trade Surplus/Deficit vs. Foreign Owned Securities

Sources:
Census Foreign Trade (http://www.census.gov/foreign-trade/statistics/historical/)
Treasury International Capital (http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/shlhistdat.txt)

Trade surplus/deficit data from the Census shows a very disturbing trend with the US balance of payments showing a strong trend of increasing deficits. The first thought I had was that an increasing reliance on foreign oil imports was the main driver. However, digging into the details, I found that in 1994, oil accounted for 93% of the cost of imported goods. In 2010, oil accounted for only 29% of the cost of imported goods. The US is still a net exporter of services but it doesn't come close to the amount of goods we import.

My next thought was what happens to all of those dollars sent outside the US? There are two main places they can go. They can be used to buy Treasury securities (bills, notes, bonds) and they can buy US assets (land, companies, corporate bonds and stocks). I tracked down the foreign owned US securities form the Treasury International Capital system and found a steady accumulation of US debt and assets by foreigners recycling their dollars (shocker!).

It's not just US jobs that are moving overseas, it is ownership of the US itself. The growth of foreign held US federal debt is one dimension of concern, but more troubling to me is the increasing ownership of US corporations by foreigners (e.g., Anheiser-Busch bought by Belgium based InBev). The US has denied sales of "strategic" companies to foreign interests (e.g. Union Oil), but eventually those dollars have to come back in the form of either debt or equity ownership. The trend is not our friend.

Update: Here is Real Surplus/Trade (inverted) vs. Real Foreign Owned US Securities as suggested:

Yanis Varoufakis

Yanis Varoufakis is a Greek economist from the University of Athens. His blog is packed with media interviews, articles, papers, and what he calls the "Modest Proposal" for a solution to the Eurozone crisis.

I found his interviews and writing refreshing, entertaining, and deadly accurate. I haven't had time to absorb the sweeping changes in the Modest Proposal, but I agree with the starting point, which is that the Euro currency structure as originally conceived has fatal design flaws that are now manifesting now as systemic threats to the currency union. He claims (and I agree) that the sovereign debt problems are rooted in insolvency and not liquidity, and that the Euro banking system is also insolvent.

I found his web site by a link provided on Calculated Risk by commentator Haralambos.

UCLA Anderson Forecast June 2011

I was fortunate enough to attend the UCLA Anderson Forecast this morning. This was the second Forecast event I have attended. The mood was noticeably more subdued compared to a generally upbeat tone at the previous one.

Professor Leamer kicked things off with a "No Recovery" slide. Most of his charts we comparing not against pre-recession highs but against where trend growth would have put the economy today. We are 11% below trend growth on both GDP and employment and it looks increasing difficult to ever get back to trend. In a normal cycle, all lost jobs are recovered after 2 years. This time, we are two years out and millions of jobs have not returned. Dr. Leamer said that over 5 million jobs are permanent displacements, never to return. Permanently lost jobs by his figures:
Manufacturing - 2.5 million jobs
Construction - 2 million jobs
Retail - 800 thousand jobs

The California economy is doing slightly better than many other states. Most job growth has been in hospitality and health care, while most job losses were in government and construction. The government job loss cycle should peak next year, then stabilize, but will be a drag on the economy for the next couple of years.

The focus of this conference was commercial real estate. In general, AAA properties are hot and within 10% of their 2006 highs. Lesser commercial property is slumping. There is a lot of investment money chasing real estate returns. The economists mentioned that pension funds need 7-9% returns to stay sound and can't get there with Treasury bonds that yield 3%. [comment: that might not end well]. Multi-family is expected to boom the next two years as people move out or are kicked out of single family homes. Office space is expected to be weak for years, until employment recovers.

During the first Q&A, a question was asked about the Greek debt. Professor Leamer and panelists agreed that Greece would default, and probably soon. He went on to say that "Uncle Sam was not much better than Uncle Dmitrious" and that after the market dealt with PIIGS, it might turn attention to the US bond market. [comment: While bad, I don't think the US situation is near as bad as Greece]. Professor Shulman stated that Greece would restructure, and that at some point, the US might need to restructure. [comment: I was surprised to hear these comments from the ivory tower].

Keynote speaker was Sam Zell of Equity Residential. Highlights from Mr. Zell:

Consumer over leveraged. Banks over leveraged. Corporate sector strong but unwilling to spend due to uncertainty.
Called Obamacare destabilizing.
Dodd-Frank worse because it did not create any new rules, only directions to make new rules in the future that are not happening.
Called NRLB action against Boeing in South Caroline "shameful".
Deficits unsustainable and unsolvable without growth.
US dollar on verge of losing reserve currency status.
Lots of zombie owners of office space. Way overbuilt.
Lodging - first to fall, first to recover. Said REVPAR was almost back.
Called Western Europe a demographic time bomb. No growth, bad place for RE investment.
Called Asia a tough place to invest. They don't need money, and locals have advantage.
Best real estate investments in Latin America.
Very bullish on Brazil. Reminds him of America in the 1950s.

This was my first time on the UCLA campus. Very beautiful. A really fun time.

Total Credit Market Debt

Thanks to the magic of economagic.com, I spent some time investigating the Total Credit Market Debt (TCMD) from the Fed Flow of Funds report (Z.1).



The first chart shows the TCMD as a percentage of GDP and also the annual percentage changes in TCMD with recession bars shown. It appears that when the annual change in credit rolls over, perhaps a debt/credit saturation point, the economy goes into recession. This is hardly an original idea.



The second chart highlights the exceptions when the annual change in credit rolled over but did not manifest in an official recession. The exceptions were all relatively minor dips and most did not dip into negative territory. In other words, credit was still growing, just at a slower pace. The 1960s dips did enter negative territory but no recession was called. The 1987 event coincided with a massive stock market crash.

The 2008 financial crisis coincided with debt saturation and the steepest plunge in percentage terms for the change in credit seen since at least 1952. It was nearly a 10 full percentage point drop. Also, the change in credit is still negative. People are still de-levering. Myself included. It is hard to quantify how pervasive this change in attitudes is.

I have completely changed my attitude toward banks and debt. It's not like I had a lot of debt to begin with, but now I am anti-debt other than the very few times it can be used productively. In my opinion, the Fed is encouraging credit destruction by squashing rates to 0%. This reduces interest rates across the curve and on interest bearing accounts. It was 0% interest rates that made me pay off my car loan. Where else could I get an immediate guaranteed 3% return?

The change in credit growth, the shear amount of debt to GDP (still around 350%), and perhaps permanent change in attitudes leads me to believe the recovery will be very slow and take a long time.

Subjective Invective v.5

The Magic of Financial Repression

I'm glad I had not eaten recently when I read these words of wisdom from President Obama:

“Save a little bit out of whatever you’re earning, and the magic of compound interest applies,” Obama said.

Just wow. Because the Fed is artificially sitting on short term rates (0 to 0.25%), the rate on my savings account at the Credit Union is 0.10%. Now that is a really magic number. If I saved $1,000 in that savings account, it would earn a cool $1 per year, or 8.3 cents a month.

But it gets better because I have to pay taxes on that $1. After paying state and federal income taxes, that leaves me about 75 cents at the end of the year for loaning the Credit Union $1,000. I don't know, 75 cents doesn't sound like such a great return.

But it gets better because of inflation. With headline CPI inflation running a little over 3% a year, by saving and using the magic of compound interest, I have lost about $29.25 a year in purchasing power.

I haven't done the math, but my guess is that the numbers don't get better after 10 years unless something truly magical happens.

See: Financial Repression

Apprentice to a Failed Philosopher

I've taken a great interest in George Soros recently, and especially his theories on Reflexivity and the Open Society ideas he adopted from Karl Popper. Soros has had an extraordinary life and reading his bio is interesting and entertaining in itself. I am currently reading The Soros Lectures that he gave at the Central European University.

The title of this post is a reference to Soros' self described failure as a philosopher during a certain period of his life. Part of what Soros writes that resonates with me is that I consider myself something of a philosopher, having done a great deal of studying and reading in college. Whether the subject is programming computers (my ostensible profession), investing, or playing chess, I am more of a strategist than a tactician. I have to work at tactics to enjoy success, while strategy comes more naturally.

Whatever you think of the politics of George Soros, I think he offers a lot of food for thought with both his general philosophy and in its application to investing. If I am diligent, I hope to eventually rise to the rank of failed philosopher.

ZSL teaching some investors harsh lessons

While cruising around the Yahoo Finance message boards, I read many posts similar to this one:

I learned a painful lesson with this POS. After making a small gain in SLV calls a few weeks ago, lost it all in 2 days. Turned to this and managed to turn $4k into $0 within 3 days with useless calls. I have to agree this is totally rigged, down big when silver is down, but not last week....up big when silver was down....WTF?!!!! I'll be interested if a class action lawsuit is forthcoming.

ZSL is a double inverse ETF based on the silver price. In other words, it is a way to short silver with leverage. From the ProShares web site:

This ETF invests substantially in financial instruments linked to the performance of commodities and currencies, such as swap agreements, forward contracts, and futures and options contracts, which may be subject to greater volatility than investments in traditional securities.

A derivative monster on steroids. If you hold it for more than one day, the transaction and roll costs will eat you alive. ZSL has usually tracked the double inverse of the silver price pretty well for one day periods. But what really changed this past week is that the short silver trade got very crowded. Everyone wanted to short silver on the way down and bid up the price of ZSL far beyond it's net asset value. That premium gets wrung out through resets in derivative prices and from arbs coming in to take the eager short sellers' money.

Even after the horrendous performance last week, the NAV of ZSL is $18.76 while the closing price was $19.70, a 5% premium. I made a little on ZSL early in the week but got out when the premium started getting too high. You can see an outrageous premium in the Sprott Physical Silver Fund (PSLV) as well, something close to 15%. That is not likely to end well. These premiums can build up for a number of reasons, but Reflexivity is probably the best explanation.

This poor investor thinks the ZSL tracking error is due to fraud.

I called proshares about this fraud, they soooo fawked up, gave some bull@#$% explanation, what ever. But people lost lot of money. When silver 5% down ZSL also down too doesn't make any sence at all. This morning SLV up 2% but this turd is down 10%. Play this POS if you just want to loose money. Total fraud, people have to file class actions about proshares doing too much looting with these 2x and 3x scams. SEC should get rid of all these fancy etfs and toss em into toilet.

While there is plenty of fraud in the operation of stock markets, investment companies, and the SEC, this case is not one of them. This investor is probably making investment decisions with the same expertise shown in his grammar and spelling.

Possible end game gold price targets

Note: This post inspired by Eric Janszen articles at iTulip.com.

There are a number of possible resolutions to the world debt crisis and to the titanic debt of the USA. Going through the political calculations and game theory of the timing and final resolution is frankly beyond my ability. However, with the dollar index and trade weighted dollar near all time lows, one possible resolution to prevent the dollar from an eventual collapse would be for the US to reopen the gold window for foreign creditors to allow them to exchange dollars for gold.

This would simultaneously impose (again) some kind of limit on the trade deficits that can be run by the US. The simplest way to accomplish this is to revalue the gold on the Fed balance sheet. The Federal Reserve Act of 1913 put a limit on the total amount of credit and currency that could be issued by the Federal Reserve. Here is the pertinent part of section 16 of the Federal Reserve Act:

Every Federal reserve bank shall maintain reserves in gold or lawful money of not less than thirty-five per centum against its deposits and reserves in gold of not less than forty per centum against its Federal reserve notes in actual circulation, and not offset by gold or lawful money deposited with the Federal reserve agent.

There may be some argument over the best measure of notes in circulation. The most conservative measure might be M1 which includes currency and checking accounts. But since the FDIC insures savings accounts and CDs, M2 might be a better measure. Wikipedia has common definitions of money supply. I've read arguments that the Fed balance sheet, the total liabilities of the Fed, could be used but that doesn't seem to come close to the definition in the Act.

If the US wanted to stick with the letter of the original act and limit redemption to M1 money stock, which was $1,908,900,000,000 as of May 5, 2011. Restrictions on redemption to M1 would force creditors to wait for their treasury bonds to mature before making claims on US gold. Here is where gold would need to be priced to restore the dollar link to gold based on M1:

$1,908,900,000,000 / 261,499,000 oz (US gold reserves) = $7,299.84 / oz
Apply the 40% reserve to get a current target of $2,919.94 / oz.

However, the thesis is that the purpose of reopening the gold window would be to keep foreign creditors from dumping the dollar. Most foreign reserves are stored in treasury bonds. Treasury bonds are simply frozen dollars that pay interest -- dollars that thaw on a specific date in the future. Total US debt is over $14 trillion, but not all of that debt needs to be redeemable in gold.

I think it is safe to exclude Intragovernmental Debt, primarily the Social Security Trust fund, because those bonds are not marketable and will be paid out as dollar benefits (or legislated away). That leaves the debt held by the public, made up of both foreign and domestic creditors. The number we are looking for is the number for foreign creditors.

For that, we need to look into the Treasury International Capital System (TIC). The total debt held by foreigners as of February, 2011 was $4,474,300,000,000.

$4,474,300,000,000 / 261,499,000 oz (US gold reserves) = $17,110.20 / oz
Apply the 40% reserve to get a current target of $6,844.08 / oz.

But does the US really need to give gold to foreign private citizens that hold treasury bonds? Maybe not. The point is to keep international commerce flowing smoothly. To that end, we can look at only the debt held by foreign sovereigns. The total official foreign holdings as of February, 2011 was $3,186,300,000,000.

$3,186,300,000,000 / 261,499,000 oz (US gold reserves) = $12,184.75 / oz
Apply the 40% reserve to get a current target of $4,873.90 / oz.

The Fog of Currency War

If all of the above conjecture is correct, it will still be a murky and twisty path to arrive at the destination. I don't believe the US will reopen the gold window until and unless it is forced to do so. It would be an admission of the failure of the US and Federal Reserve to manage the dollar. It would discredit the theory of a workable pure fiat currency. It would discredit a couple of generations of academic economists, including Nobel Laureates, and the economics profession. Not that being consistently wrong hurts the career of economists in general, but they might have o amend a few textbooks. It would also come as a shock to the general population who for the most part has little or no understanding of monetary history or the current money system.

If gold was remonetized preemptively at a price higher than the market price, the transition might be made without any major disruption. If it happens in a disorderly way, the market price may overshoot the remonetized price and come back down to a permanently higher and managed level. In that scenario, the US may not have as much control of the final price.

Dual mandate: Inflation expectations, Unemployment, Fed Funds Rate

Sources:
Fed H15 http://www.federalreserve.gov/releases/h15/data.htm
NY Fed http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
BLS

The Fed's dual mandate is theoretically stable prices and low unemployment. There are many different measures of inflation, but one that can be reasonably argued as market based is the difference between the 10 year treasury yield and the 10 year TIPS yield. In the above chart, the difference in yields is labelled inflation expectations. That data is only available back to 2003.

Inflation expectations appear to have completely recovered from the 2008 crash after plunging to depression levels. What has not recovered is the unemployment rate. Based on the recent comments by Bernanke, the Fed is not worried about inflation.

The employment numbers look even more terrible if you look at the raw job numbers that don't ignore people whose benefits have expired. Based on the dual mandate, it is unlikely the Fed will raise rates any time soon. However, if inflation expectations continue to rise, say into the 3-4 percent range, the Fed will have a tough choice to make regarding interest rates.

At the beginning of the graph, you can see the end of the 1% reflation rate set to recover from the 2001 recession. The low rate, held for about 2 years, helped fuel the housing bubble. The even lower rate set by Bernanke has now been in place for over 3 years and I wonder how and where that latent inflation will pop up. We have partial answers right now: stocks, commodities, and metals. Whether those assets will continue to benefit over the next 3 years is an open question.

Adjustment scenarios for JGBs

Reuters reports Japan GPIF to withdraw $78 bln from assets.

The GPIF is likely to raise cash by selling JGBs and other assets in its portfolio as pension contributions and tax income continue to fall short of pension payouts which are growing as Japan's population ages, the newspaper said.

The largest buyer of JGBs, is not just reducing purchases, or failing to roll over maturing bonds, but will be a net seller this year. That is a watershed moment. The Japanese government, with astronomical debt-to-GDP over 200% may be a harbinger of things to come for western governments with heavy debt loads. We've seen bond market failures already for Greece, Ireland, and Portugal at much lower debt levels.

Japan has been given a great deal of slack because it has large net exports, and the unusual fact that it's government bonds are 90% funded internally through pension funds and private purchases. It appears the time is fast approaching when private purchases are no longer sufficient to fund bond issuance. I've been trying to think through possible ways Japan and/or market forces will adjust to this change. How will JGBs be funded in a future where private funding slows down?

Foreign purchases might surge

The shortfall could be met with increased foreign purchases of JGBs, from sovereign wealth funds, hedge funds, or central banks. At current interest rates, the lowest in the western world, it is hard to imagine any large buyer would think Japanese bonds were a good investment. It is possible that foreign central banks might agree to support Japan and purchase some with the goal of averting a global crisis. The Fed in particular has been accommodating of most any request for dollars.

Japanese bond issuance slows due to voluntary austerity

The government of Japan may decide to dramatically reduce spending and reduce deficits. Where spending cuts are made is likely to be a heated political battle, much as in the US.

The BoJ monetizes JGBs

Following a standard operating practice since the 1990s, the BoJ may increase their purchase of bonds in another round of quantitative easing. While events may include elements of each policy and market response to the JGB problem, I view BoJ QE as the most likely and to make up the bulk of any shortfall from private purchases.

The danger of unlimited QE is that the amount monetized becomes absurd at some point. Whether that is 250% debt to GDP, 400%, or when the total tax revenues no longer cover the interest due on outstanding bonds. Something will be a trigger point where either the Japanese people or Japan's trading partners lose faith in the yen. An extreme currency crisis can be only be met with extreme policy choices.

Extreme policy choices

Once a currency crisis has begun, Japan can choose to default on outstanding debt due and preserve some value in the currency, or print money to cover every bad debt leading to hyperinflation. Both choices are painful for the citizens and country and may lead to unknown political consequences. Despite all the advantages accrued to Japan, it may be the first major advanced economy to go over the Keynesian cliff.