Financial Review

Financial Review for Friday February 24, 2012

DOW  – 1 = 12,982
SPX + 2 = 1365
NAS + 6 = 2963
10 YR YLD – .01 = 1.98%
OIL +1.86 = 109.69
GOLD – 6.50 = 1774.60
SILV +.04 = 35.51
PLAT – 13.00 = 1717.00
We’ve almost made it through the first two months of the year and if you haven’t noticed, things are getting better. This is not to say that everything is good or even great, just that things are getting better. And of course, there is the caveat that things might get worse and that could happen fast and it could be severe, but for this specific moment in time, things are getting better. Some people would like to deny this; they claim this getting better notion is a false meme; we’re being manipulated into believing that things are getting better when they are not. Despite the presence of bright sunlight, we know that the darkness of night is right around the corner; and even cold, hard numbers are unconvincing. Let’s look at the numbers: the S&P 500 has doubled in less than 3 years, and it’s up more than 8% year to date; just this week home sales showed strength and inventories dropped, the unemployment rate has been steadily dropping and the initial claims for jobless benefits fell to the lowest level since March, 2008; and consumer confidence in January moved to its best level in a year.
Maybe these numbers don’t apply to you personally; fair enough. And it’s easy to claim the markets are flying blind because the economic numbers are distorted; which is true, but this is not the first month or even the first year that the numbers have been distorted. If you can move past the politics of denial the numbers tell a story and rather than deny the facts (however imperfect), let’s dig for deeper understanding. What is the source of this move? How might this all play out?
For several months we’ve been telling you that the European sovereign debt crisis would follow the Federal Reserve’s Playbook from 2008. I can now say with some confidence that QE3 has begun. Check the Fed’s balance sheet and you will see unadjusted M2 (money supply plus “near money” savings, cd, money market) is jumping higher. The Fed has been buying and there are new assets appearing on their balance sheet. It isn’t being called QE3 and several Fed leaders have stated that no stimulus is needed because the US economy is improving, but the reality is that the real reason the economy is improving is because we have QE3.
Remember last November, when the Super Coalition of Central Bankers announced their coordinated actions to enhance capacity to provide liquidity support to the global financial system. The ECB, the Bank of England, Bank of Japan, Bank of Canada, and the Swiss National bank and the Fed all agreed to pump cash into the Euro-banks. They did this by way of unlimited dollar swaps.
Right before Christmas, the ECB gave another nice gift to the Euro-banks in the form of the LTRO, the Long Term Refinance Operation, which handed over close to 500-billion-euro. And don’t forget that the next tranche is scheduled for this coming week and it could be up to 1-trillion-euro.
Meanwhile, the Federal Reserve buys 90% of all 20 and 30-year maturity US bonds; and the Fed is the backstop for mortgage backed securities and they have been increasing their purchases of MBS. The Fed has made clear they will prop up the mortgage market. And don’t forget the Fed’s ZIRP, Zero Interest Rate Policy, now in its fourth year and headed to an unprecedented 6 year engagement.
Do you really think we would have near record low interest rates on 30 year mortgages without the Fed’s Operation Twist program? And if we didn’t have record low mortgage rates, wouldn’t we have much higher default rates in housing, and wouldn’t that lead to much higher toxic assets on the balance sheets of US banks big and small?
And what do you think would have happened if Bernanke and the FOMC had not committed to two more years of zero interest rates? Of course, part of the problem is that the market latches on to zero interest rates and refuses to let go. There is no exit strategy at this time for the Fed.
And if the Fed and its foreign counterparts had not juiced the Euro-banks, there is a strong probability we would have seen a liquidity crunch by now.
So, even if we don’t come out and call it QE3, there has been a huge dose of central bank intervention and the economy has received a massive injection of stimulus. It is difficult to measure the exact impact of the stimulus on the market’s positive performance since the start of the year. Is it 50%? 80%? 95%? Without the latest round of Fed stimulus, we wouldn’t be talking about the market’s positive performance; we might be talking instead about the crash of 2012. You may disagree with the concept of central bank intervention but it works – at least in the short term.
Over the long term, the results aren’t quite as positive. There is a price to pay for juicing the economy. We’ve heard this refrain before…, boom-bust-boom-bust – it’s a rhythm unique to central banking. Unfortunately we can’t cure debt with more debt. There is a problem with debt; it grows though compounding, which means it grows exponentially. The only thing in nature that grows exponentially is cancer, and eventually it consumes the host. As debt grows exponentially it is manifest through inflation and if inflation grows significantly faster than economic growth, the result is hyper-inflation. When hyper-inflation happens, money stops being an effective medium of exchange and commerce grinds to a halt.
We’re already starting to see signs of inflation, and the problem is that the economy must now grow faster than inflation, which means that the Fed must juice the economy and it is doing that – and the unpleasant side effect is inflation. And so we have a vicious cycle. I don’t claim to know the intent of Chairman Bernanke but any central bank intervention must ultimately seem as futile and absurd as Sisyphus rolling a boulder up a hill.
On the flip side is deflation. When people expect falling prices, they become less willing to spend, and in particular less willing to borrow. When prices are falling, just sitting on cash becomes an investment with a positive real yield and borrowing, even for a productive investment, means the loan will have to repaid in dollars that are worth more than the dollars you borrowed.
And the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap. Everything just freezes. A new approach is to cut everything – the austerity move; which means economic contraction surpasses falling prices. The trick is to have economic growth greater than price growth. The typical central bankers’ response to a credit freeze is to inflate with wild abandon.
Of course, this process is not so easy. Someone must pay for someone to collect. In this case, the taxpayers pay and the bankers have their hands out. And the stimulus is addictive.
The ink is barely dry on the deal to enslave Greece and the International Monetary Fund is begging for more money.  The G20 is meeting this weekend in Mexico and the IMF wants to raise as much as $600 billion-dollars in extra resources to help deal with the fallout from the Euro-zone debt crisis. And this is on top of the ECB’s bailout funds.
We’ve seen the playbook. We know how the story ends.
Let’s go to the Mail bag:
First, thank you for the finest financial program I’ve ever heard. If there is a solution to today’s banking – investment woes it must begin with defining the problem. Education is the key, and you provide the fundamentals so well.

I’ve concluded that unfunded liabilities will amount to broken promises or be re-negotiated. What I am not sure of (and neither is anyone else that I have talked to) is am I personally and legally obligated to pay my part of the national debt? Back when I purchased I bonds I noticed the term “Public Debt” at the top of the document instead of National debt.

Am I personally accountable for not reigning in career professional political hacks who run up a debt “in my name?”

There are many different ways to categorize debt, including secured or un-secured debt. For example, I borrow money to purchase a shiny new bicycle, the lender might hold the title to the bicycle as collateral on the debt. If I don’t pay, they take my bike. With bonds there are sometimes fees, revenues, or taxes pledged to pay the debt, or it may simply be a general obligation to pay which means they are backed by the full faith and credit of the United States or municipality or whoever the issuer might be, that means the bond is backed by all legally available funds of the issuer and the debt can be paid from the issuer’s general fund but not necessarily from ad valorem taxes.
Are you personally responsible for public debt? It depends on how the issuer feels about it. For example, we recently have seen municipalities that have issued full faith and credit bonds, and now they can’t pay. Jefferson County Alabama decided to stop paying on their general obligations because they were draining cash for essential services. Meanwhile, Rhode Island put bondholders ahead of its citizens.
So, if a government doesn’t pay its debts, then they won’t have credit in the future. For example, going back to the 1820’s, Greece has defaulted on its debt six separate times. Something the European Union failed to consider when they were writing the Maastricht Treaty. In Greece, it looks like bondholders will take a hit and citizens will take an even bigger hit.
The quick answer is that you are not personally liable for public debt. The US Treasury will not itemize the debt and send you a bill to pay a bond when it comes due. Likewise, if you own a bond, you can’t go around to various citizens and demand payment. Conversely, if you own a stock and the company collapses, you do not have personal liability for debts incurred by the company. But of course, the public must pay debt, and we do pay debt by replenishing the general fund of the issuer – usually by paying taxes or cutting services.
So you are publicly accountable for the debt, but you are not personally accountable.
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