January - 2010 Economic Brief

REVIEW:

Most people assume that because they are approaching retirement age, they are approaching retirement. That's just not the case for most dentists.

Wall Street gets through year of crisis, rally
This year has been a long, bumpy and winding road for U.S. equity markets. They took a severe hit from the financial crisis, then got back half of what they lost in the stock market rally that followed. As the year ends, the Standard & Poor's 500 sits almost 25% higher than where it was when 2009 began. As for the decade, the index is 23% lower than where it stood 10 years ago. The New York Times (30 Dec.)

From the March, 2009, low the S&P 500 has soared 69 percent in nine months. In doing so it recouped a bit more than 50 percent of its former losses. But it's still 27 percent below its all time high of October 2007 and as mentioned above 23% below where it stood 10 years ago.

The whole rally off of the March 2009 low is characterized by low volume. Hence, I see a high probability that this bull run will finally end and prove to be just a huge bear market rally. The rally since the late October low was especially weak. Volume was not only miniscule, it was also declining markedly. This tells me that the recent break out in prices to new highs for the year was on very thin ice.

Debt is still at historic highs, and there is no end to it in sight. In other words, nothing has really changed. But most people are thinking it has, are they delusional? Yes, I think so.

DEBT:

The first two months of the US government’s current fiscal year have resulted in a record $296.7 billion deficit. During this period, the Federal Reserve grew its balance sheet by about $65 billion, in effect purchasing about 22% of the federal government’s new debt. These purchases clearly show the Fed’s policy of “quantitative easing”.

• This year’s federal deficit is in excess of $1.5 trillion. That’s more than the total national debt for the first 200 years of our country.
• The Congressional Budget Office projects that the federal debt will increase to $17.1 trillion over the next decade.
• Government debt will reach 76.5% of GDP by 2019.





Government spending isn't necessarily always a bad thing. We need our bridges and Internet. But spending for the wrong things can be quite disastrous, as in going to wars that make the situation worse, or bailing out big banks that then pay big bonuses. Government by its size is necessarily more inefficient than locally made decisions that optimize the costs and benefits. My analysis suggests that the American economy has benefited very little compared to the huge expenditures and obligations by our government.

In fact, I would argue that the big bailouts only helped a select few while hurting the competitiveness of U.S. business by adding taxes and requirements on those that did not cause the problems. The benefits of the spending are localized, and the damage will be felt for years and across a wide population through wages that purchase less and tax burdens to pay for the spending. Inflation is the only way out that I can see for the size of the expanding government obligations.

Let’s have a look at a chart James Bullard, president of the Federal Reserve Bank of St. Louis, included in a recent presentation to the National Association for Business Economics.



A lot of people seem to have forgotten something that is very much on Bullard's mind: The growth of the Fed's balance sheet isn't nearly finished. In fact, the Fed has only completed purchasing about half of the $1.75 trillion worth of assets it has promised to buy. The assets are mostly mortgages and mortgage-related securities.

Even though these direct purchases are unprecedented, that's only about 10% of the story. Since the beginning of the crisis, the Fed has lent, spent, or guaranteed $11.6 trillion.

That includes providing a backstop on the entire system of mortgage finance in the United States, a system that currently shows nearly a $1 trillion loss. Since the expansion of its balance sheet got started in earnest last fall, the trade-weighted value of the dollar has fallen 15%.

As Bullard points out, a doubling of the monetary base won't necessarily cause an immediate doubling of inflation... But suppose it takes 10 years? The average inflation rate would still be 7% a year. Nothing in our financial markets is prepared for this kind of inflation. Inflation at these rates would cause the average multiple of earnings for equities to fall by at least 50%. Likewise, we would see high-yield corporate bonds yielding at least 20% – double what they are now. And U.S. Treasuries would probably see their yields triple. The destruction of wealth in the bond markets would be unprecedented in modern finance.

Think about what this means in terms of interest payments. Even with interest rates at all-time lows around the world, the U.S. will spend almost $400 billion on interest to service our existing national debt – that's a 3.3% interest rate. Currently, the U.S. takes in roughly $2 trillion in taxes, half of which come from income taxes. So the interest on our debt is already consuming 20% of all tax receipts, or 40% of all income taxes.

It seems obvious to me this money will never be repaid – could never be repaid. The only real question is how much of a "haircut" our creditors are willing to accept in terms of the loss of purchasing power of the U.S. dollar. So far, inflation remains relatively benign. Our creditors don't seem to be losing very much. But we know this will change and could change rapidly, as the Fed continues to expand its balance sheet with less and less creditworthy assets. At what point will our creditors finally decide they can't finance any more of our deficit spending because we're simply not worth the risk?

Looked at from a different point of view, 2009 has been witness to spectacular government intervention in almost all levels of the economy. This support requires outside capital to facilitate, and relies heavily on the US government’s ability to raise money in the debt market. The fact that the Federal Reserve and US Treasury cannot identify the second largest buyer of treasury securities this year proves that the traditional buyers are not keeping pace with the US government’s deficit spending.

Foreign holders are also expressing concern over new Treasury purchases. In a recent discussion on the global role of the US dollar, Zhu Min, deputy governor of the People’s Bank of China, told an academic audience that "The world does not have so much money to buy more US Treasuries."

Perhaps the most striking example of the new demand dynamics for US Treasuries comes from Bill Gross, who is co-chief investment officer at PIMCO and arguably one of the world’s most powerful bond investors. Mr. Gross recently revealed that his bond fund has cut holdings of US government debt. The fact that he is now selling US treasuries is a foreboding sign.

Pimco makes major shift from government debt to cash
Pacific Investment Management Co.'s Total Return Fund made a big move from government debt to cash, signaling to analysts that the fund's managers anticipate interest rate hikes as the U.S. economy strengthens. The fund has increased its cash position to its highest level since the Lehman Brothers bankruptcy in September 2008. A company spokesman said the firm does not comment on its holdings. However, Pimco chief Bill Gross said recently that Treasuries are overvalued when weighed against the potential for inflation. Bloomberg (17 Dec.)

IMF: Developed nations to carry big, growing debt after downturn
A look at the debt load of the Group of 20 nations reveals trends that might come as a surprise. The International Monetary Fund projected that by 2014, the total government debt of advanced economies in the G-20 will account for 114% of their GDP. Among developing countries, debt will decline to 35% of GDP, the IMF said. The Economist (21 Dec.)

Now enter the news about the financial woes in Dubai and Greece which should remind investors that the major debt problems associated with the global real estate bubble have not been solved. Yet, they continue thinking that things have changed.
Now that sovereign debt problems are surfacing, a few investors are getting concerned about the sustainability of this recovery. After all, the unprecedented global fiscal and monetary response was an experiment. The outcome is unknown. And the underlying problems related to the crisis still exist: Bad debt, reduced wealth and tight credit to name a few.

U.K., France risk losing AAA rating, Fitch says
Fitch Ratings noted the "unpleasant fiscal arithmetic" facing several European nations, saying none of the benchmark AAA countries, including France and Britain, can count on that status for much longer. "The U.K., Spain and France must articulate credible fiscal-consolidation programs over the coming year, given the budgetary challenges they face in stabilizing public debt. Failure to do so will greatly intensify pressure on their sovereign ratings," Fitch said. Telegraph (London) (22 Dec.)

If I have the numbers straight, two years into the worst recession since the Great Depression, consumer debt has fallen by a whopping $120 billion. Against that amount, we have an increase in federal debt closing in on $2 trillion – a clear sign that not only is the government quickly replacing the private sector, but that it is doing so at a rapid rate.

I thought it might be useful to plot the deficit, tax revenues and government outlays on the same chart, just to confirm what we all know – that the government deficit is much bigger than anything we have seen for decades.



You can see the gap between receipts versus spending outlays has widened to the point where the difference between the two becomes a deficit of almost one and a half trillion dollars.


JOBS:



So far, what the data are telling us – besides how serious the unemployment situation is – is that, one-month blips aside, the economy isn’t out of the woods yet.

And given the sheer number of unemployed, the pressure on the economy – and on the government to continue running deficits – will be with us for some time to come.

25 U.S. states use up funds for unemployment benefits
The strain of recession is using up money in state unemployment funds faster than contributions from payroll taxes are coming in. Already, 25 U.S. states have run out of money to pay benefits and have been forced to take loans ($24 billion) from the federal government to avoid cutting off benefits. The Labor Department projected that by 2011, 40 states will have drained their funds for unemployment benefits. The Washington Post (22 Dec.)

And if we focus on California, the story is even more dire. California’s borrowing from the trust fund stands at $5.3 billion, up from $2.6 billion in July. To put this in perspective, the state is borrowing over $100 million a week to meet its unemployment insurance payments.

And yet a much better than expected jobs report came out - Employers only cut 11,000 jobs in November. This is further evidence that the Government doesn't create jobs, people create jobs.




These are the states that have essentially bankrupted their unemployment insurance systems, and are now forced into borrowing from the Federal Unemployment Trust Account. The number of states relying on Federal money, in order to keep sending out weekly checks, has grown from 18 to 26. And the total amount borrowed has zoomed over 100% ¬ from $12.0 billion to $25.1 billion.

This exponential growth trend is clearly not sustainable. We suspect that 2010 will see many state tax rate hikes on employers and employees, in order to fund their respective unemployment schemes. This will only further burden business’s ability to operate profitably, and reduce the take-home pay of already stretched consumers.

Many of us look around and see stores going out of business and friends that can't find jobs, we question whether this somewhat positive news can be backed up by other measures… measures that are subject to much less manipulation by the government reporting agencies.

One such measure is how much taxes are being collected by the government. When businesses are cutting back and employees are earning less, tax revenue drops. So to get this perspective, take a look at the total number of jobs with the total amount of federal government taxes. The basic idea is that tax revenues come from people who are working in businesses that are successful, so there should be a close correlation, and there is.





U.S. companies reluctant to hire, announce job openingsU.S. employers are not laying off workers as much as before, but they also are not hiring much or announcing job openings. The Labor Department's Job Openings and Labor Turnover survey found that companies posted 2.5 million jobs on the last day of October, fewer than September's 2.6 million. For every job opening in October, there were about 6.3 jobless people, the department said. Google/The Associated Press (08 Dec.)


BONDS:

It's not like the government is going to default tomorrow, or that inflation is going to surge overnight. But auctions of 10-year and 30-year bonds are getting progressively worse, with demand dropping as supply ramps up ...
At the last 30-year bond auction, held on December 10, the bid-to-cover ratio came in at 2.45. That was substantially below the recent peak of 2.92. The 10-year note auction, held one day prior, registered a ratio of 2.62. That too was sharply below the recent high of 3.28. Don't forget that the U.S. Treasury has got $118 billion worth of paper to 'sell' this week.

Foreign Central Banks only took down 40.2 percent of the 30-year bonds sold in mid-December. That was down from the 2009 peak of 50.2 percent in July. Their share in the 10-year auction was even worse — just 34.9 percent. As recently as September, indirect bidders were snapping up 55.3 percent of the notes being sold.

Bottom line: Long-term Treasury auctions are getting weaker and weaker. We haven't seen a so-called "failed" auction yet. That's when the bid-to-cover ratio drops below 1 — meaning the government can't even get $1 in bids for every $1 in securities being sold. But that has already happened in the U.K., and I believe it's only a matter of time before it happens here.
As a matter of fact, 2009 has been the absolute WORST year for total return on long-term Treasuries since at least 1973.

Treasury market's slump could fuel mortgage ratesA lack of interest by investors in U.S. government debt could drive up interest rates on home mortgages and stop the housing market's shaky recovery, experts said. The interest rate on the benchmark for home mortgages, the 10-year Treasury, climbed from 3.2% in November to 3.83% on Monday. Freddie Mac said the average rate for 30-year mortgages had risen to 5.05% last week from 4.81% two weeks earlier. Increasing mortgage rates could force home prices down, cut demand on the part of buyers or both. The Miami Herald/Los Angeles Times Service (29 Dec.)

Eric Sprott said that despite investor optimism, payrolls continue to shrink, with unemployment at 10 percent.

The low level of interest rates is artificial, engineered by the Federal Reserve’s bond purchases, he says. Those purchases are scheduled to end by March 31. Once that happens, demand for bonds will drop, pushing interest rates higher, Sprott says.

And rising rates will stifle the economy.

If the Fed decides to resume the bond buying, then the dollar will be in trouble, as investors lose confidence in Fed policy, he says.

If they announce another quantitative easing, trust me, the gold price will go up another 50 bucks that day.

Analysis: Inflation answers to determine timing of Fed's pullback
Answers to questions regarding inflation will help determine when the Federal Reserve will withdraw from stimulus programs. The U.S. central bank has justified its pledge to keep interest rates close to zero by taking comfort in the expectation that inflation appears to be restrained. While that seems to be true on the surf, economists and others are growing concerned. "We have the most potentially inflationary policy I have ever observed in a developed country," said Alan Meltzer, a Fed historian. Reuters (30 Dec.)

Mortgage rates expected to rise when Fed ends bond purchases
Interest rates on home mortgages are set to climb when the Federal Reserve ends its purchases of mortgage bonds, analysts said. The U.S. central bank indicated that it might end the program, through which it bought $1.25 trillion in mortgage bonds, as soon as March. Analysts said the purchases have kept the spread above benchmark interest rates for mortgage bonds much narrower than what private investors would accept. The Fed's withdrawal is expected to push mortgage rates up nearly 0.75 percentage points by the end of 2010. Bloomberg (31 Dec.)

U.S. to put additional $3B to $4B into GMAC, sources say
The U.S. Treasury will inject between $3 billion and $4 billion into GMAC Financial Services, sources said. Discussions between GMAC and the Treasury about an additional capital infusion -- on top of the $13.4 billion it already received -- have been under way for months. Earlier this year, the Treasury said it was prepared to provide GMAC as much as $5.6 billion more to ensure the company can survive another serious economic downturn. The Detroit News (29 Dec.) , Bloomberg (30 Dec.)


BANKS:

Total bank failures so far this year: 140!

'Wake up, gentlemen', world's top bankers warned by former Fed chairman Volcker"... and the link is here. Paul Volcker, a former chairman of the US Federal Reserve, berated the bankers for their failure to acknowledge a problem with personal rewards, questioned their claims for financial innovation ““I wish someone would give me one shred of neutral evidence that financial innovation (i.e. CDS) has led to economic growth — one shred of evidence“ and then went on to criticize them for failing to grasp the magnitude of the financial crisis and belittled their suggested reforms.



Key facts:
Fact #1. Credit derivatives — mostly bets on the failure of large companies — were the primary cause of the AIG collapse and a key factor in Wall Street's nuclear meltdown last year. So in this report, the OCC seems proud to announce that U.S. banks have reduced their holdings in these radioactive credit derivatives — from a peak of $15.9 trillion at the end of last year to $13 trillion on 9/30/09.

But in the NEXT crisis, triggered by rising interest rates, the banks' big nemesis is likely to be interest rate derivatives — those tied to bond yields, mortgage rates, and a variety of other rates.

Fact #2. U.S. banks now hold $172.5 TRILLION in interest rate derivatives, a new record. That's over THIRTEEN times the amount they hold in credit derivatives.

Fact #3. Among all derivatives held by U.S. banks (now at a record $204.3 trillion), interest rate derivatives represent 84.5 percent of the total!
Banks aren't the only ones vulnerable to higher interest rates.
• Credit unions are loaded up with $318.4 billion in home mortgages, plus $103.9 billion in government agencies and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac. Their combined percentage in assets potentially vulnerable to higher interest rates: 50.4 percent of assets.
• Life insurance companies — providers of life, health, and annuity policies — are among the largest holders of corporate bonds: $1.9 trillion worth! Plus, they hold $332.9 billion in mortgages and another $50 billion in municipal bonds. Combined, that's 55.7 percent of their assets in likely interest-sensitive investments.
• Property and casualty insurers — which cover your home, car, or business — are among the largest holders of municipal bonds: $394.1 billion. Plus, they have $272.6 in corporate bonds and another $112.3 billion issued by government agencies and GSEs. Combined total potentially vulnerable to rising interest rates: 58.4 percent.

Analysis: As U.S. economy picks up, rate increase seems likely
Economic reports will clarify the recovery's strength, but it is becoming clear that the U.S. has emerged from its downturn. So the question turns to when the Federal Reserve will decide the recovery is strong enough for interest rates to rise. The Fed might make a move sooner than many expect. "They're going to have to get aggressive," said Northern Trust economist Paul Kasriel. "And they know that." The Wall Street Journal (21 Dec.)


REAL ESTATE:

In September 2008 the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship. At the same time Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth.



Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years.

This tells me that the Treasury Department is convinced that the worst of the burst real estate bubble is yet to come.

Fed is worried by real estate, cheered by holiday sales
The economy is "modestly" improving in most of the U.S., but falling home prices and a deepening crisis in commercial real estate present obstacles to any robust recovery, the Federal Reserve said in its Beige Book. The report states that consumer spending has increased moderately and used-car sales are doing well. The job market continues to be a problem, "with further layoffs, sluggish hiring and high levels of unemployment." The Washington Post (03 Dec.)

U.S. housing recovery hits snag as prices flatten out
After four straight months of increase, house prices in the U.S. stood unchanged in October compared with September, according to the Standard & Poor's/Case Shiller Home Price index. The October index was down 7.3% compared with the same month last year. The biggest losers were Chicago, Atlanta and Tampa, Fla., while the biggest winners were Phoenix and San Francisco. CNNMoney.com (29 Dec.) , Boston Herald (30 Dec.)

About one in four homeowners, or 10.7 million Americans, are considered underwater, meaning their mortgage exceeds their home value, according to real-estate information company First American CoreLogic.

And more than half of all homeowners whose payments had been lowered through modification plans, defaulted again.

Report: Value of U.S. homes decreases less than last year
A decline in the value of U.S. homes slowed dramatically this year compared with 2008, according to an analysis from Zillow Real Estate Market Reports. During the first 11 months of this year, houses dropped $489 billion in value, compared with $3.6 trillion for 2008. The decrease brought with it a drop in the rate of negative home equity, according to the analysis. Reuters (09 Dec.)

The National Association of Realtors reported that sales of so-called 'existing' homes rose 7.4% in November compared to October, due to the $8000 first time buyer tax credit, low mortgage rates and foreclosure bargains. To put this figure in perspective, sales were up more than 40% over year ago levels. First-time buyers accounted for more than half of home sales last month and about one-third of sales were 'distressed' properties. The Federal Reserve is the principal buyer of mortgage-backed securities at this time, and that program will also wind down in the first quarter of 2010. A dramatic increase in foreclosures is predicted for 2010, as well, in Arizona, California, Florida, Michigan and Nevada.

In November, new home sales were down 11% year over year, but for the entire year so far, new home sales are down 24%. Why buy new when so many like-new used homes are on the market?

Sales of new homes in U.S. plunge 11.3% in November
Between October and November, new-home sales fell 11.3% to a seasonally adjusted annual rate of 355,000 units, the U.S. Commerce Department said. The drop marks a 9% decline from November 2008. The median price for new homes increased 3.8% last month from October but showed a 1.9% decrease compared with November last year. Los Angeles Times (24 Dec.)

The fallout in commercial real estate is starting to gain steam. The percentage of commercial MBS loans in special servicing climbed sharply to almost 9% last month. There were $65.2 billion of loans in special servicing at the end of November, a net increase of $8.2 billion, or 14%, from October, according to Trepp.

The $8.2 billion monthly increase was the second largest ever, after a $12.4 billion spike in May following the bankruptcy filing by General Growth Properties. The latest transfers drove up the special-servicing rate to 8.95%, from 7.91% at the end of October. The net number of loans in special servicing climbed by 8%, or 266, to 3,585. The special-servicing rate has now climbed for 19 months in a row and stands 22 times higher than the record low of 0.40% in August 2007. The bulk of the increase has come this year.

Retail mortgages continue to account for the largest percentage of loans in special servicing - 31.8%, or $20.8 billion. Multi-family mortgages come next, at 22%, or $14.4 billion, followed by hotel loans, at 19.2%, or $12.5 billion.

Next crisis to be in commercial real estate, experts say
A crisis looms for the commercial real estate market in 2010, then for the government-debt market, particularly in the U.S., investment managers said. "I think the next shoe to drop, which will be the world's biggest shoe, is the continued decline of the dollar and ultimately the breaking of the U.S. government market, which will set the other markets on another terrible path," said Steve Shenfeld, president of MidOcean Credit Partners. The danger of default on commercial real estate also is a major threat, Shenfeld said. Reuters (07 Dec.)

The following chart is from the National Real Estate Investor. It shows the stunning increase in the number of commercial mortgage-backed securities now in “special servicing”… which is to say, in trouble.




POLITICS and TAXES:

FASB chief to propose allowing banks to move away from GAAP
Robert Herz, chairman of the Financial Accounting Standards Board, is set to call on U.S. bank regulators to consider allowing financial institutions to break free from the Generally Accepted Accounting Principles. "Handcuffing regulators to GAAP or distorting GAAP to always fit the needs of regulators is inconsistent with the different purposes of financial reporting and prudential regulation," Herz said in prepared text. "Regulators should have the authority and appropriate flexibility they need to effectively regulate the banking system." The New York Times (07 Dec.)

U.S. lawmakers reluctant to crack down on credit rating agencies
Credit rating agencies have been seen as playing an integral role in the financial crisis, having given top marks to billions of dollars worth of bonds that became part of the subprime-mortgage meltdown. Not only were rating models scrutinized, but there was concern about a conflict of interest because issuers pay rating agencies to appraise their securities. However, while U.S. lawmakers are overhauling the financial system, rating agencies appear to be left out of the revamp. Lawmakers are reluctant to touch the agencies because they are an essential part of the still-fragile credit machine. The New York Times (07 Dec.)

In the 60s, top marginal rates were 70%. At first blush, today’s top rate of 35% appears to be a bargain. It’s not. Nobody really paid 70%. Back in the 60s and 70s, there were a great many deductions individual investors could take. Under the cover of tax code simplification, Congress eliminated all but a few of those deductions in 1986. The trade-off? The top tax rate was reduced to “just” 28%.

Since 1986, the top tax bracket crept up to 39.6% by 2000. The Bush tax cuts in 2001 dropped the max to 35% and reduced taxes for all Americans. When those cuts expire in 2011, it will amount to a tax increase across the board for the 60% of citizens who pay taxes. In addition:

• Capital gains taxes will go up to 20% from 15%.
• Dividends will be taxed as ordinary income – up from 15% today.
• The death tax will be back with lower exemptions.

What will happen, tax-wise, after 2011 is not difficult to ferret out. Consider:

• This year’s federal deficit is in excess of $1.5 trillion, which is more than the total national debt for the first 200 years of our country.
• The Congressional Budget Office projects that the federal debt will increase to $17.1 trillion over the next decade.
• Government debt will reach 76.5% of GDP by 2019.
• The U.S. is fighting two wars.
• Many states are facing massive deficits.

2010 is an election year. And if you really believe that economic policy and the election cycle in America are not related, you also probably believe that Tiger Woods is innocent.


USX DOLLARS:

Ben Bernanke before he was appointed chairman of the Federal Reserve said, “The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”

There is of course a cost. There may not be one to the US government, but instead, the cost will be borne by everyone who holds dollars and loses purchasing power as a result of Mr. Bernanke creating as many dollars as the government wants to spend. The other word for this cost is inflation.



In every paper money system the people who lose are the people who are not heavily indebted. The people who lose are the people who save and invest.

The people who win are the people who get to manipulate where the new money is injected. So the people who win are the big bankers and the other folks who are going to have all their bad assets paid off in the new money.

If you look at what the Federal Reserve is doing today, they're creating enormous amounts of money – almost $2 trillion in new money in the last 12 months – and they're directly buying all of the bad mortgages from the investment bankers. That's absolutely true. There's a paper record of it.

What there isn't a record of and what we don't know – and why people want to audit the Fed – is the prices the Fed paid for those bad mortgage debts.

I bet you when the Fed is audited, we're going to discover that they paid par, meaning that they were buying paper at $100 that was actually trading at $10 or $15. And they're doing that of course to save the banks.

What they will do to save the banks, and there is already a precedent for it. For example, gold was taken out of daily circulation in 1933, silver in 1965, and copper from the penny in 1982. The same thing as in Rome: the currency has been debased, taxes have soared, regulation has become extremely onerous. But these things have political causes. Speaking of failed empires, one of the reasons the eastern Roman Empire lasted as long as it did was that for some reason – maybe they learned something from the fall of the western empire – their gold Solidus remained a stable and sound money for almost a thousand years after the western Roman Empire dried up and blew away.

The nation must continue to spend its way out this recession until more Americans are back at work… - U.S. President Barack Obama, November 8, 2009

Implications of a Falling Trade Deficit

The collapse of world trade is one of the hallmarks of this new era for the world economy. As part of that collapse, U.S. imports have fallen off, translating into lower trade deficits. It’s notable that the trade deficit has dropped from an annualized rate of $800 billion to just over $400 billion. One of the important implications of a falling trade deficit is that foreigners have fewer dollars available to reinvest in the U.S.

As the U.S. trade deficit rose, the investment into the U.S rose as foreigners recycled our trade dollars back into the U.S. Now, with the U.S. trade deficit falling due to the weaker economy and lower oil prices, foreigners have fewer dollars available to invest in the U.S.

Interestingly, foreign investments in the U.S. have fallen even more than the trade deficit, indicating less interest in investing in the U.S. Given the record U.S. budget deficits that need to be financed, falling foreign investment couldn't come at a worse time. It indicates significant pressure on interest rates.

Among the consequences is that U.S. corporations and citizens will increasingly be called on to fund the U.S. government deficit. That means consumers have less to spend on goods and services, further dampening economic growth. And it means that the Federal Reserve will be required to print the money to cover the huge government deficit. This will be extremely inflationary.

The following chart shows the latest data (Dec 15) on the trade balance through October, with the scale on the right inverted so that the worse the trade deficit, the higher the (red) line.

One of the important implications of a falling trade deficit is that foreigners have fewer dollars available to reinvest in the U.S. The left scale and (blue) line shows the amount of foreign purchases of long-term securities of Treasuries, Agencies, Corporate Bonds and Equities over 12 months.

As the U.S. trade deficit rose, the investment into the U.S rose as foreigners recycled our trade dollars back into the U.S. Now, with the U.S. trade deficit falling due to the weaker economy and lower oil prices, foreigners have fewer dollars available to invest in the U.S., 50% fewer dollars as a matter of fact.

Wanting to avoid an ear-popping, wealth-destroying inflation, one would assume that the USG would now be turning its attention to cutting the spending, no matter how politically unpopular that might be. I mean, we elect our politicians to lead, right? And when the going gets tough, the tough get going, right?

Follow the Money

When I casually looked at the headline announcing the passage last week of a new military appropriations bill of well over half a trillion dollars, I thought it was a typo. It wasn’t. We support our troops… with $636 billion dollars. (And as a related aside, the military budget doesn’t include the $100 billion or so annual cost of dealing with veterans.)

The bill passed the House of Representatives with only 34 dissenting votes, against 395 voting in favor. The funding bill is only meant to support the legions for the first eight months of 2010, but as it doesn’t take into account the new Afghanistan splurge, it won’t even go that far.

Of course the U.S. needs a strong military. But it doesn’t need a strong military in over 130 countries, and in wars we shouldn’t be fighting, can’t afford, and can’t win.

For the record, the spending in this one piece of the U.S. fiscal pie is more than the entire GDP of Poland, Indonesia, Belgium, Switzerland, Sweden, Saudi Arabia, Norway, Austria, and Taiwan. In fact, it is more than the annual GDP of all but 17 of the world’s nations.

Why so little opposition to this mind-numbing level of spending? Why, hell, that would be downright un-American! Come election time, your opponent, no matter if from the right or left, would use it to paste you as being a dang coward for failing to “support our troops.”

I saw that with apologies to my readers that have those sentiments, but if you are one of the ardent patriots who fall in line with the pro-war rhetoric, it’s time to wake up. Beggaring your children’s future by sending troops all over the world, where they are mostly not wanted, FYI, is not just wrong… it’s appalling. But I digress.

Dear Reader,

While there are many themes and subthemes one can follow these days, only a handful rank as truly important. The fate of the king of paper, the U.S. dollar, is one of those themes.

Simply, if the dollar can manage to weather the beating it is taking, then the U.S. government (USG) will really have accomplished something. Specifically, it will have successfully used the nation’s long and storied heritage to convince our trading partners that we remain creditworthy.

Alternatively, if the long con stumbles… watch out below.

I already quoted the Reuters story on a senior Chinese banking official who openly stated that the con is unraveling.

Paid Holidays – $154 billion.

The six-month extension in unemployment benefits included in this bill brings the total duration of benefits possible to two and a half years.

Meanwhile, the big oil countries in the Middle East have announced they are going to cooperate in starting a shared currency, the Gulf, quotes the London Telegraph.


REGULATORY SUPERVISION:

House panel approves financial-overhaul legislation
The House Financial Services Committee approved legislation that would give U.S. regulators the power to audit Federal Reserve decisions and create a regulatory council that could wind down large, systemically important financial institutions. The Wall Street Journal (02 Dec.) , Financial Times (tiered subscription model) (03 Dec.) , Securities Industry News (02 Dec.) , Financial Times/Lex (tiered subscription model) (02 Dec.)

House approves sweeping overhaul of financial regulation
The U.S. House of Representatives approved legislation that would result in sweeping changes for the financial-services industry. The bill strips the Federal Reserve of its authority to write consumer-protection laws and allows government audits of its monetary-policy decisions. The bill also establishes the Consumer Financial Protection Agency. The industry has supported many of the initiatives but raised concern about others. CNBC (11 Dec.), The Wall Street Journal (14 Dec.), Financial Times (tiered subscription model) (12 Dec.)

If actually I believed that influential people could be moved by evidence, that they would change their views if events completely refuted their beliefs. Well, not so fast, the House of Representatives, when — with the meltdown caused by a runaway financial system still fresh in our minds, and the mass unemployment that meltdown caused still very much in evidence — every single Republican and 27 Democrats voted against a quite modest effort to rein in Wall Street excesses.

Check out U.S. Senator Jim Bunning as he delivers his statement at the Senate Banking Committee explaining why he will oppose the nomination of Ben Bernanke to serve a second term as Chairman of the Federal Reserve. He basically burns Bernanke at the monetary stake... and his closing comments... made my hair stand on end. This whole video is worth listening to... and watching... and the link is here. (http://www.youtube.com/watch?v=rka9VbPPMys)

The Commodities Futures Trading Commission (CFTC) is currently preparing an overhaul of the way commodities are traded, supposedly in order to make the markets more supply/demand-driven and less susceptible to “manipulation” by speculators.
This notion has a lot of traction in DC, as speculators have been blamed any time markets get out of whack, as during last year’s run-up in oil prices. President Obama is committed to “making sure it doesn’t happen again,”

Obama’s appointee to chair the CFTC, Gary Gensler, has consistently maintained that he wants some very specific changes, most importantly the imposition of strict position limits on those trading commodity futures contracts, including energy and the precious metals. He may get them.

The most potentially explosive developments, though, could come with gold and silver. Long futures contracts in the metals have generally been spread among a large number of market participants. The corresponding short contracts, however (and there must be a short for every long), have been highly concentrated. Just two U.S. banks are presently short more than 123,000 gold contracts (better than 12.3 million ounces).

What if the CFTC declared that henceforth traders would be limited to a few thousand contracts in any given month? (3,000 is the putative Comex limit, though it is not really enforced.) All those tens of thousands of short contracts would have to be unwound.

A forced unwinding of any market position tends to result in a spike in the price of the underlying asset. Higher gold and silver prices are pretty much baked in the cake if the CFTC does what it says it’s going to do.

It's a Reuters piece headlined "House approves sweeping financial reforms"... and the link is here for you to get the skinny on it. (http://www.reuters.com/article/idUSTRE5B90CY20091211)

Report: Ginnie Mae's taxpayer-backed guarantees fuel high-risk lending
A relatively unknown U.S. agency, the Government National Mortgage Association, has for years given taxpayer-backed guarantees to lenders that engaged in risky and often illegal practices. Commonly known as Ginnie Mae, the agency endorsed until last week the loans of Lend America, a company with a rising delinquency rate that permitted an executive convicted of mortgage fraud to continue running the company. Housing officials let Lend America sell more than $1 billion in mortgages in the form of Ginnie Mae-backed securities. The Washington Post (10 Dec.)

Here's something else that will save the U.S. banks for another year. Apparently the FASB [Financial Accounting Standards Board] has stated that banks can delay [for up to one year] the implementation of a new accounting rule that will force the end to a manipulation banks have been using to hide risky assets known as SIVs [Special Investment Vehicles]. There may be up to a trillion dollars of SIVs that are affected.



GOLD:

It's easy to say gold is a bubble. It's up more than 26 cent in the past six months, so it has to be right? Even with gold's pullback from record highs above $1,225 an ounce this month, right?
Wrong. Despite its latest rally, gold still lags behind the gains other assets and indicators have experienced since 1980. The price of something in a bubble tends to zoom ahead of everything. Gold has in the very short term (26%) but it's only catching up to other assets.
.............................................Jan. '80........Dec. '09.......% change
Total U.S. credit market debt*........$4.40..........$52.50..........1,097%
S&P 500...................................111...........1,100...............892%
U.S. money supply*....................$1.50............$8.40...........462%
U.S. GDP*..................................$2.70...........$14.30...........425%
U.S. Consumer Price Index.............78..............215.8............177%
WTI Crude Oil.............................$32.50...........$76.84...........136%
U.S. Producer Price Index.............85.2
Gold - weekly average, per ounce.$738...........$1,196.............105%
*$-trillions (U.S.)
SOURCE: CENTRAL FUND OF CANADA

Yes, demand for bullion-based exchange-traded funds is brisk. They've grown to about $70-billion (U.S.) in market capitalization since the first one was launched about five years ago. But although they've grown quickly, they're still small relative to the 5 trillion in dollars of gold in the world.

If you think the back of the secular bull market in gold has been broken, you might want to think again.

When the bank pays you nothing in interest, gold goes up. And right now, the bank is paying you nothing in interest.

Why does gold go up when interest rates are low? It's simple... That's the simple version. Let's add one little tiny wrinkle to it, so you can see why gold has become irresistible now...

The forecast for inflation in 2010 is around 2%. Yet the Fed is keeping interest rates near zero. So instead of earning nothing in interest at the bank, you're actually LOSING 2% a year to inflation. That's what's REALLY happening – the REAL interest rate at the bank (minus inflation) is NEGATIVE 2%.

2002 to today

The median real interest rate was -0.4%.
Gold returned +18.5% per year.
The real return on the S&P 500 was -3% per year (not including dividends).

With inflation on the horizon, I don’t know how much of the roughly $67 trillion invested in bonds will be looking for a new home, but it’ll be a big chunk. Where will it go, equities, gold? In short, when real rates are negative, gold soars and stocks stink. And when real rates are positive, gold stinks and stocks soar.

And against gold, the US dollar has fallen… about 35%. (Think of it this way… each dollar could purchase 1/778 or 0.001285 ounces of gold last year and now can only purchase 1/1192 or 0.000839 ounces, which reflects a decline in the value of the dollar relative to gold of 34.7%.)

5 More Good reasons for GOLD

1. Investment demand for gold continues to be extraordinarily strong This is especially true with the rising prospects of a Sovereign Debt crisis. First it was Dubai, now Greece, Spain, Italy, Ireland and Portugal are all suspect. Debt problems in a global crisis have the ability to be contagious. And that can destroy investor confidence in the capital markets of such countries, and in the global economy.

2. The specter of future inflation is building. Recall it is the fear of inflation that tends to drive the metal prices higher. When you answer a liquidity crisis with more liquidity, you're bound to create more bubbles.

3. Declining supply – central banks have moved from net sellers to net buyers. This is a significant structural change in the gold market as central banks have been net sellers for two decades. Central banks looking to diversify their reserves in light of the rampant currency debasement have very few options available, and we would argue gold is the most attractive. It is also important to note new mine supply has essentially just been replacing aging mines. Given the long lead time between finding a deposit and actually moving it through to production is on average around 10 years, new mine supply remains largely inelastic. Adding further pressure on the supply side of the equation is the dearth of new discoveries and the increasingly challenging mine development environment.

4. All‐in costs remain high – aging mines are experiencing declining grades, and new projects tend to be of lower quality, requiring higher and higher metal prices

5. Very low/negative real rates – lowers the opportunity cost of holding hard assets. Most major countries (including the U.S.) continue to support a low interest rate environment; we suspect this will be the case for some time to come as increasing rates may derail recoveries.

1. In constant 1980 dollars, gold should be $2,300/oz. today.
2. Gold is appreciating against all currencies.
3. The U.S. needs foreign capital - lots of it - to fund their debt.
4. We have had a record increase in the money supply.
5. A record $2-3 trillion in bailout money.

Protectionism



China, which has the world's largest foreign exchange reserves worth $2.27 trillion, mostly held in U.S. Treasury bonds.

We've already seen evidence of restrictions on global trade and capital flows. Consider China’s currency policy. Even after recent visits in China by U.S. President Obama and European Central Bank President Jean-Claude Trichet to lobby for a stronger Yuan, the Chinese have remained steadfast on keeping their currency weak.

We are now hearing influential voices in China calling for an increase in its reserves of another 159 million troy ounces of gold, roughly twice annual global gold production. At $1,200 gold, that means they’d have to spend $190.8 billion, which, while a lot, is really not all that much compared to the size of their reserves of U.S. dollars ($2.27 trillion).

It's possible for China to buy gold from the IMF in large volumes in pursuit of asset allocation for its foreign reserves, but that will mean further detachment from dollars of which China holds the most. This puts China in a real dilemma.
A team of experts from Beijing and Shanghai set up a task force last year to study the issue of gold reserves, Ji Xiaonan, chairman of a supervisory board for big state-owned companies under China's state assets commission, was quoted as saying.
"We suggested that China's gold reserves should reach 6,000 tonnes in the next 3 to 5 years and perhaps 10,000 tonnes in 8 to 10 years,"

More Central Bank Gold Activity

The big story the other day was the announced purchase of 30 tonnes of gold by Russia's Central bank

Russian Federation updated their website a couple of days early this month. For November, they reported purchasing another 200,000 ounces of gold for their reserves, which now sits at 19.7 million troy ounces. The Russian Central Bank has also said that it would purchase an addition 32 tonnes [960,000 ounces] in December. This purchase won't show up on their website until around January 20th.


QUOTES OF THE MONTH:

Anyone who says he or she cares about the working class in this country should have walked out on the Democratic Party in 1994 with the passage of NAFTA. And it has only been downhill since. If welfare reform, the 1999 Financial Services Modernization Act, which gutted the 1933 Glass-Steagall Act—designed to prevent the kind of banking crisis we are now undergoing—and the craven decision by the Democratic Congress to continue to fund and expand our imperial wars were not enough to make you revolt, how about the refusal to restore habeas corpus, end torture in our offshore penal colonies, abolish George W. Bush’s secrecy laws or halt the warrantless wiretapping and monitoring of American citizens? The imperial projects and the corporate state have not altered under Obama. The state kills as ruthlessly and indiscriminately in Iraq, Afghanistan and Pakistan as it did under Bush. It steals from the U.S. treasury as rapaciously to enrich the corporate elite. It, too, bows before the conservative Israel lobby, refuses to enact serious environmental or health care reform, regulate Wall Street, end our relationship with private mercenary contractors or stop handing obscene sums of money, some $1 trillion a year, to the military and arms industry. Obama is not the problem. We are. - Chris Hedges

Bankers own the earth. Take it away from them, but leave them the power to create money and control credit, and with a flick of a pen they will create enough to buy it back. - Sir Josiah Stamp, former President, Bank of England

“When the nose of the camel is in the tent, the rest of the camel is not far behind.” - Arabian proverb

The U.S. has no way of avoiding a financial Armageddon. - John Williams, shadowstats.com

With just two weeks to go in 2009, the declines since the end of 1999 make the last 10 years the worst calendar decade for stocks going all the way back to the 1820s, when reliable stock-market records began, according to data compiled by Yale University finance professor William Goetzmann.

"I've been condemned by traditional economists who said that printing money is responsible for inflation. Out of the necessity to exist, to ensure my people survive, I had to find myself printing money. I found myself doing extraordinary things that aren't in the textbooks.” - Gideon Gono, the current Governor of the Reserve Bank of Zimbabwe.


Note to readers:

One may wonder how it is that I accumulate such a mass of information, let alone have the time for this blog. First, it is purely self-interest as I too have to navigate these markets and since I am making the time to do the reading and discovery, why not share it with a larger audience, my colleagues, and so I do. Second, my sources are many and varied and what I do is take the best of the best, cut and paste, and string together a somewhat coherent thesis. I has been said, "When you take stuff from one writer it's plagiarism; but when you take it from many writers, it's research." In reference to my sources this month, they include in no particular order:

Claus Vogt, Doug Casey, Porter Stansberry, Glen O. Kirsch, Steve Sjuggerud, David Galland, Chris Wood, Doug Casey, Brian Rich, Fabrice Taylor, Bob Irish, Bud Conrad, Mike Larsen, Ed Steer, Andrew Gordon, Glen O. Kirsch and Dan Weil, Globe & Mail, CNBC, The Wall Street Journal, Financial Times, Washington Post, Reuters, Security Industry News, Lec, The New York Times, Los Angeles Times, Boston Herald, CNN Money, Detroit News, Bloomberg, Miami Herald, Google/Associated Press, London Telegraph, and the Economist.