Euro Risk Due To Possible Return of Italy To Lira - Drachmas, Escudos, Pesetas and Punts?

Euro Risk Due To Possible Return of Italy To Lira - Drachmas, Escudos, Pesetas and Punts?

The European status quo and EU elites are becoming increasingly concerned by popular calls in Italy for Italy to leave the European Monetary Union and the euro "as soon as possible" and return to the lira. 

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Beppe Grillo, the leader of Italy's Five Star Movement has shocked EU elites by launching of a non-binding consultative referendum on the matter which will be put before the parliament.

"We will collect half a million signatures in six months – a million signatures – and we will take our case to parliament, and this time thanks to our 150 legislators, they will have to talk to us” the Telegraph reports Grillo, the popular comedian and increasing popular politician as having said.
Italy's Five Star Movement has thrown down the gauntlet and believes that a return to the lira may be the only way to end the economic depression and indeed save Italian sovereignty and indeed democracy.

Italian Lira

The movement, for whom 25% of Italians voted in last year's general election, and a further 21% in this years European elections, appear to be upping the ante following the failure of the the EU bureaucracy and the ECB to acknowledge demands, last May, for the creation of Eurobonds to support the Euro and the abolition of the EU fiscal compact.

Both measures are staunchly opposed in Germany. They see the creation of Eurobonds as a means to make Germany responsible for the borrowing of struggling peripheral nations.

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Peripheral nations such as Italy, Greece, Spain, Portugal and Ireland argue that they should not be made carry the entire burden of a problem caused, at least in part, by their participation in the monetary union. 

The customary method of devaluing a sovereign currency in order to make their exports more competitive is not open to them.

The fiscal compact requires that Eurozone states keep a balanced budget. According to Ambrose Evans Pritchard, the respected  International Business Editor of the Telegraph, the ”Fiscal Compact is economic insanity. It would force Italy to run massive fiscal surpluses for decades. These would cause an even deeper depression, pushing the debt ratio even higher, and would therefore be scientifically self-defeating."

While it is still early to speculate on the outcome of this process, it is worth considering the implications of the fifth largest economy in Europe jettisoning the Euro.

At the height of the Euro crisis in early 2012 it looked possible that the entire monetary union project might rupture as the interest yielded on the bonds issued by the more vulnerable states began to soar. This has begun to happen again in recent days and Greek bonds have seen a new vicious sell off and 10 year yields have soared to nearly 9% (see below).

That is, investors in the bond markets had come to regard the bonds of Italy, Greece, Spain and others as high risk investments and required a much higher rate of return to compensate for this risk.

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At that time, talk of the creation of a Eurobond was rife but the Germans held fast. It was looking as though these struggling countries would be forced to leave the euro until, at the eleventh hour, ECB governor Draghi stepped in, in July 2012, and announced that the ECB "is ready to do whatever it takes to preserve the euro." 

This was interpreted to mean, among other things, that the ECB would buy bonds of struggling countries if necessary. Without Draghi having to actually do anything, risk was regarded as having been removed, at least temporarily, from the system and there has been a relative calm and confidence in the viability of the single currency since then.

But crisis seems to be surfacing again as seen in the sharp increase in volatility and decline in stock markets and certain bond markets in recent days and again today.

For many Italians, the slow grind of depression has tested their patience beyond endurance. Youth unemployment is at an incredible 46% and industrial production has fallen 25%. Many note that, since joining the euro, Italy - once an industrial powerhouse of Europe - has been unable to compete with Germany due to an overvalued currency.

In Greece the effects of Draghi's pronouncements appear to have run their course and now actions may be required. The stock market has retraced around 50% of its gains since the "Draghi put." It is down a sharp 23.65% this year alone.

There are increasing calls in Greece for a return to the drachma – polls show 33% in favour of a return to the Greek drachma at this time.

The fact that it is impossible for Greece to regain competitiveness and recover from depression while clinging to the euro is becoming increasingly evident. Prominent economists such as Nouriel Roubini, as well as investor George Soros have said as much and influential voices in Greece are now questioning the wisdom of clinging to the euro.

Even uber Keynesians and money printing advocates such as Paul Krugman have previously warned of the euro breaking up and Italy returning to the Italian lira and France returning the French franc.

In Ireland, dissatisfaction is not being expressed through euro skepticism. However, there is certainly a sense that enough austerity is enough. 

Up to 100,000 people took to the streets the weekend before last, to protest the introduction of water meters and privatisation of the water supply. This was a very large turnout by Irish standards and may be the start of the Irish public awakening from their recent apathetic slumber.

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Criticism of the EU and ECB remains muted in Ireland. Although, the recent revelations by former central bank head, Patrick Honohan, regarding the manner in which the losses of reckless European banks were foisted onto the Irish taxpayer, is making even the most hardened euro phile somewhat skeptical. Not skeptical of the EU per se but of a policy of blindly accepting unfair and damaging policies foisted on Ireland.

In Spain and Portugal none of the structural problems that led to the crisis have been solved. And with data from Germany suggesting it is entering recession it may be only a matter of time before the eurozone is in crisis mode once again.

Debt levels remains very high throughout the EU.

In this environment, the ECB is in a much more difficult, some would say impossible position, as the panacea of ultra low interest rates can no longer be administered.

In the fifteen years since the introduction of the euro, we have had six years of austerity and monetary hardship.  If Europeans are faced with more of the same it is likely that disillusionment with the euro project will be inflamed. 

It is hard to envisage an orderly breakup of the EMU. Like Cortez - who burned all but one of his ships before marching inland to take on the Aztec empire - turning back was not factored into the architecture of the monetary union. 

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There are now three real scenarios that could play out in the coming months. 

First, is that the German people, politicians and Bundesbank manage to prevent the ECB from embarking on the ‘bazooka’ of Euro QE. Given huge deflationary pressures, this would likely lead to deflation and an economic depression in Europe and globally.  

The second scenario is that Draghi and the ECB manage to overcome German opposition to euro QE or euro debt monetisation and printing. This would lead to the euro being debased and devalued and falling in value versus major currencies and especially gold.

The third scenario is that Italy or Greece opt to leave the monetary union and revert to their national currency. Their new liras and drachmas see sharp devaluations.

There is also the possibility that we see the deflation first and then the euro or national currency devaluations. It is worth remembering that gold is both a hedge against currency devaluation and inflation and also gold is a hedge against deflation.

Gold has no counterparty risk and cannot go default or go bankrupt , unlike companies and governments.

Conclusion
What should investors and savers in European countries do to protect themselves from the risk of currency debasement and devaluations?

The answer remains obvious and can be seen in the charts above. Gold is an important hedging instrument and financial insurance that will protect people from the potential return to liras, drachmas, escudos, pesetas and punts.

These are the types of scenarios where gold comes into it's own as financial insurance and a store of value.

Get Breaking News and Updates On Gold and Markets Here

GOLDCORE MARKET UPDATE
Today’s AM fix was USD 1,241.00, EUR 972.65 and GBP 769.71 per ounce.
Friday’s AM fix was USD 1,238.00, EUR 966.89 and GBP 769.61 per ounce.
   
On Friday, gold fell $1.70 or 0.14% to $1,237.80 per ounce. Silver slipped $0.10 or 0.58% to $17.28 per ounce Friday. Gold had a second week of gains and rose 1.2% last week, while silver fell 0.40% after the selling on Friday pushed silver lower for the week.

Gold in British Pounds - 2 Years (Thomson Reuters)

Gold in Singapore fell initially prior to rising in later trade prior to London opening when prices were capped again. Silver for Swiss storage or immediate delivery gained 0.5% to $17.40 an ounce. Spot platinum rose 1.1% to $1,272.75 an ounce after ending last week little changed. Palladium rose 0.6% to $761 an ounce, after falling 3.6% last week.

Gold has rallied almost 4% in the past two weeks and reached one month high of $1,249.30 last Wednesday. Futures climbed to $1,250.30 on October 15, the highest price September 11. 

The net long position in futures and options jumped 39% in the week to October 14, snapping the longest run of reductions since 2010, according to CFTC data.

While Asian shares rose today, European stocks fell again, following their longest streak of weekly losses in more than a year. Worse than estimated financial results from large companies added to concerns over the region’s recovery.

European equities have led a global rout that erased as much as $5.5 trillion from the value of shares worldwide as concern over the region’s economic recovery re-emerged, amid speculation that the ECB’s stimulus measures would not be enough to spur growth. 

Stocks pared losses today, due to rumours that the European Central Bank bought short dated French covered bonds.

Gold in Euros - 2 Years (Thomson Reuters)

Government bonds from Italy and Spain fell, extending a selloff from last week. Italy’s 10-year rate climbed another four basis points to 2.54% after increasing 17 basis points last week. Spain’s rose three basis points today to 2.19%.

The S&P 500 rallied on Friday, but it still locked in its fourth straight weekly decline. Its longest bearish run in over 3 years, as investors are becoming wary about the fragile global economy, another European debt crisis and the risks posed by the ebola virus and possible contagion.

See Essential Guide To Gold and Silver Storage In Switzerland

http://www.zerohedge.com/news/2014-10-20/euro-risk-due-possible-return-italy-lira-drachmas-escudos-pesetas-and-punts

Why Abenomics Failed: There Was A "Blind Spot From The Outset", Goldman Apologizes

Ever since Abenomics was announced in late 2012, we have explained very clearly (for example here, here, here, here, here, here and here) that the whole "shock and awe" approach to stimulating the economy by sending inflation into borderline "hyper" mode in a country whose main problem has to do with an aging population demographic cliff and a global market that no longer thinks Walkmen and Sony Trinitrons are cool and instead can find all of Japan's replacement products for cheaper and at a higher quality out of South Korea, was doomed to failure.

Very serious sellsiders, economists and pundits disagreed and commended Abe on his second attempt at fixing the country by doing more of what has not only failed to work for 30 years, but made the problem worse and worse.

Well, nearly two years later, or roughly the usual delay before the rest of the world catches up to this website's "conspiratorial ramblings", the leader of the very serious economist crew, none other than Goldman Sachs, formally admits that Abenomics was a failure, and two weeks after Goldman also admitted that now Japan is informally (and soon officially) in a triple-drip recession, begins the scapegoating process when in a note by its Naohiko Baba,it says that Abenomics failed because all along it was based on two faulty "misconceptions and miscalculations." Ironically, the same "misconceptions and miscalculations" that frame the Keynesian "recovery" debate in every insolvent developed world country which is devaluing its currency to boost its exports and economy, when in reality all it is doing is propping up its stock market, allowing the 1% of the population to cash out and leaving the 99% with the economic collapse that inevitably follows.

So what happened with Abenomics, and why did Goldman, initially a fervent supporter and huge fan - and beneficiary because those trillions in fungible BOJ liquidity injections made their way first and foremost into Goldman year end bonuses  - change its tune so dramatically? Here is the answer from Goldman Sachs.

Blind spot from the outset in “weak yen = export recovery” scenario

A weak yen boosts export price competitiveness, fueling a recovery in export volume that supports a sustained economic recovery via improved corporate earnings, capex recovery, and wage growth. At least, this was the scenario painted when bold monetary easing was launched as the first arrow of Abenomics to induce yen depreciation. Government officials and market participants alike believed for a long time that the yen’s rapid depreciation thereafter would at some point drive an export recovery. However, a tangible recovery in export volume is yet to materialize.

Actually, this is not the first time a weaker yen has failed to revive exports. Since the 1990s, Japan has experienced four phases of yen appreciation followed by  depreciation, but in none of those phases was there any clear correlation between exchange rate and export volumes. Equating yen depreciation with export recovery would appear to invite multiple misconceptions and miscalculations (see Exhibit 1).

Firstly, a weaker yen does not necessarily result in lower export prices (on a local currency basis). Since a weak yen also increases exporters’ input prices, it is  unlikely that export prices will fall at the same rate that the yen declines in value. Export prices also have a more limited impact on export volume than global demand, making the latter a more important determinant for exports.

Odd: nobody could think of any of this before Abenomics was launched resulting in the largest domestic misery in Japan in over three decades?

The combination of these two misconceptions has led to a miscalculation about the latest phase of yen depreciation. Export prices have not decreased as much as in past yen depreciation phases and global demand has lacked vigor. Fiscal austerity, chiefly in the US and Europe and implemented around the same time as Abenomics, has weighed on activity, resulting in a muted global economic recovery. This alone is a key factor behind the miscalculation of the export recovery scenario, in addition to which Japan’s export volume has been less responsive to global demand than before.

Let the scapegoating begin: here are the two misconceptions why, according to Goldman, Abenomics failed:

Misconception 1: Export prices do not fluctuate as much as forex

It appears to be commonly accepted that a strong yen increases export prices and lowers export volume, negatively impacting the Japanese economy, whereas a weak yen lowers export prices, raising the price competitiveness of Japanese products and in turn spurring an export recovery, with positive implications for the economy. We see two misconceptions here. First is that export prices do not fluctuate as much as forex. When the yen is strengthening, prices of Japanese products rise on a local currency basis and price competitiveness falls, while the opposite is true when the yen is weakening. However, in past yen depreciation phases, export prices on a contract currency basis have only fallen by around 30% of the rate of yen depreciation. Looking at the 12-month average, excluding extreme forex movements, the fluctuation in export prices is minor (see Exhibit 2).

Given that imported input costs fall and that hiking export prices undermines competitiveness when the yen is strong, the gap between the rate of yen appreciation and the degree of increase in export prices is large. In phases of yen depreciation, yen-based input prices rise, so covering higher costs does not require export prices to fall as much as the yen declines in value.

Miscalculation 1: Export prices have not fallen as much as in past phases of yen depreciation

One miscalculation regarding the current phase of yen depreciation is that the decline in export prices relative to how far the yen has weakened has been milder than in past phases of yen depreciation. This is because rising crude oil prices and other fuel-related costs have inflated manufacturers’ input prices by 6.1% on aggregate since September 2012 and manufacturers have not been able to lower export prices and at the same cover the higher input costs. When the yen weakened in 1995-1998 and between late 1999 and early 2002, manufacturers’ input prices fell only marginally despite higher import prices driven by the weak yen. This made it easy for manufacturers to lower export prices to factor in the weaker yen. Conversely, when the yen depreciated between 2004 and 2007,  manufacturers’ input prices rose 20% on aggregate on sharply higher crude oil prices, and they were able to hike export prices (see Exhibit 3).

We see other factors behind the narrower decline in export prices this time. One is external considerations regarding government-led efforts to rapidly weaken the yen since the launch of Abenomics. The US has supported the BOJ’s quantitative and qualitative easing as a means of helping Japan escape deflation. However, concerns about the yen’s sharp depreciation are evident within the US. In January this year, US Treasury Secretary Jacob Lew made comments seeking to curb excessive yen weakness, saying that Japan would not see long-term growth if it overly relies on the forex rate. More recently, on September 22, William C. Dudley, president of the Federal Reserve Bank of New York, said that if the US dollar were to gain substantially in value then trade figures would worsen, impacting economic growth. Partly because US midterm elections are looming, there is consideration on the Japanese export industry side not to cause trade friction by using the weak yen to lower export prices and provoke a backlash from the US auto industry and other exportrelated sectors. We believe this stance is also intended to give Japan an advantage in remaining negotiations with the auto sector in the final stages of Trans-Pacific Partnership (TPP) talks. Therefore, we think one reason the 25% fall in the value of the yen has not led to lower export prices is foreign diplomacy and trade friction considerations.

It is also possible companies have not ventured to lower export prices. The Development Bank of Japan (DBJ) has conducted a survey asking manufacturers why they have chosen to keep manufacturing functions in Japan. Interestingly, 54% of respondents cited mother factories (for production of core components) and 27% high-value-added production as key factors after management and R&D. Mass production of commodity products was a low 7.6%. An even higher percentage, more than 60%, cited product and service quality and performance as sources of their competitiveness, while a mere 1% said the currency afforded them a competitive advantage. Products still manufactured in Japan for export tend to offer high-value-added with strengths in terms of quality and performance, or are essential core components with high price and volume elasticity (i.e., products whose sales volumes increase if local sales prices fall), as opposed to mass-produced items. We think Japanese companies may also feel they can preserve the brand image of Japanese products as offering high-value-added and high  performance by maintaining a certain local sales price. For the above reasons, we think Japanese companies in the latest phase of yen depreciation have likely adopted a strategy of securing yen profits arising from the currency’s lower value without cutting export prices (See Exhibit 4).

Misconception 2: The key determinant of export volumes is global demand, not prices

The second misconception is the commonly held belief that export volumes will recover if prices of Japanese products fall in export markets. Even in past yen depreciation phases the correlation between export prices (contract currency basis) and export volumes has changed from time to time, meaning lower export prices do not always translate into higher export volumes. From the end of 1999 in particular, although export prices dropped sharply as the yen weakened due to the BOJ’s zero interest rate policy and quantitative easing, export volumes also slid in the face of cooling overseas demand resulting from the bursting of the IT bubble.

In short, overseas demand is the key determinant of Japan’s real exports. Indeed, exports and our Global Leading Indicator (GLI), a gauge of global economic trends, are closely correlated (see Exhibit 6).

Miscalculation 2: Elasticity of export volume versus global demand falls, global demand softens

A major miscalculation in the latest phase of yen depreciation is that global economic recovery has been muted owing to fiscal austerity undertaken mainly in the US and Europe during 2013. That the export volume reaction to global demand has been weaker than in the past has acted as a further headwind against the Japanese export recovery scenario. Comparing our export volume model calculations, in which export prices and GLI are explanatory variables, with actual export volume, we note that the latter has been constantly below the former since around the March 2011 earthquake (see Exhibit 7).

We see several reasons why Japan’s export volume has not kept pace with the global economy: (1) Japanese companies have offshored production; (2) Japanese products are now less competitive than overseas products from other Asian economies and elsewhere; and (3) Japanese companies have adopted a strategy of emphasizing quality and brand and decided not to lower prices to gain global share (see Exhibits 8 and 9).

We think exports have failed to recover during the latest yen depreciation phase due to several misconceptions and miscalculations: (1) Yen weakness does not necessarily result in a decline in export prices and this has been the case more so this time; (2) the impact of lower export prices on export volume is far more limited than global demand (GLI) in the first place; (3) despite the correlation between GLI and export volume, the offshoring of production and lower competitiveness of Japanese products have resulted in export volume being consistently below GLI since the March 2011 earthquake; and (4) the lackluster US and European economic recoveries have raised the risk of a further slowdown.

There is more, but the point is clear: we hear your apology loud and clear, Goldman, and we accept it - after all you couldn't possibly tell the truth two years ago when this Keynesian insanity, which incidentally is being tried everywhere around the globe and will have the same results, was about to begin.

And now, where is Abe's Imodium? He is going to need it.

http://www.zerohedge.com/news/2014-10-18/why-abenomics-failed-there-was-blind-spot-outset-goldman-apologizes

Japanese Stocks Tumble After BoJ Bond-Buying Operation Fails For First Time Since Abenomics

Having rotated their attention to the T-bill market in Japan (after demand for the Bank of Japan's cheap loans disappointed policymakers) in an effort to ensure enough freshly printed money was flushed into Japanese markets, the BoJ now has a major problem. For the first time since QQE began, Bloomberg reports the BoJ failed to buy all the bonds they desired. Whether this is investors unwilling to sell (preferring the safe haven than stocks or eu bonds) or that BoJ has soaked up too much of the market (that dealers now call "dead") is unclear. Japanese stocks - led by banks - are sliding as bond-demand sends 5Y yields (13bps) to 18-month lows.

Umm, Tokyo, we have a problem...

Bank of Japan bought 2.62t yen ($25b) of Japan’s treasury-discount bills from financial companies today, compared with the 3t yen that the BOJ offered to acquire.

This is the first time the central bank failed to meet its purchase target for t-bills since at least April 2013, when Governor Kuroda stepped up quantitative easing

*  *  *

Markets are not happy - Nikkei is 300 points off today's highs...

led by banks collapsing to 18-month lows

and bond yields are sliding

and the yield curve flattens

*  *  *

And remember, the Japanese bond market (the largest in the world) is now "dead" according to dealers:

The Bank of Japan’s unprecedented asset purchase program has released a creeping paralysis
that is freezing government bond trading, constricting the yen to the
tightest range on record and braking stock-market activity.

...

“All the markets have been quiet,” said Daisuke Uno, the Tokyo-based chief strategist at Sumitomo Mitsui Banking Corp. “We’ve
already seen the BOJ dominance of JGBs since last year, but recently
participants in currency and stock markets are also decreasing as those
assets have traded in narrow ranges.”

...

“The flows on both the buying side and selling side continue to fall,”
said Takehito Yoshino, the chief fund manager at Mizuho Trust &
Banking Co., a unit of Japan’s third-biggest financial group by market
value. “Falling volatility is a very serious problem for traders and
dealers who are unable to get capital gains.”

http://www.zerohedge.com/news/2014-10-17/japanese-stocks-tumble-after-boj-bond-buying-operation-fails-first-time-abenomics

Russian shoe retailer to pay China in rubles

Russia’s biggest mid-range footwear retailer, Obuv Rossii, is to buy from Chinese suppliers in rubles instead of yuan, offsetting the high cost of currency conversion. It joins Gazprom Neft as one of the first Russian companies to use ruble contracts.

“The signing of the first contract to settle contracts in rubles with Chinese suppliers is the next step in building cooperation with our partners in the country,” Anton Titov, the chief executive and main shareholder, said in a statement posted on the company’s website Thursday.

The four-year contract is worth $9.8 million (400 million rubles) and will begin in November. VTB, Russia’s second largest bank, which has been operating in Shanghai since 2008, will oversee the transactions with New Rise, one of China’s largest export credit agencies, based in Chengdu, Sichuan Province.

The Siberian shoe company has been doing business in China since 2010, and is one of Russia’s top five shoemakers and retailers. The company is growing rapidly, with revenues expected to hit between $170-220 million (7-9 billion rubles) in 2007.

Footwear sales in Russia more than doubled in the last decade. In 2013 sales increased by 9 percent, and in 2012, sales grew by 12 percent. Sales are forecast to reach 767 billion rubles by 2018, up from 359 billion rubles in 2007, more than doubling in the 10 years, according to data from Euromonitor International.

RIA Novosti / Vladimir Astapkovich

Moving East

The tense geopolitical standoff with the West over Ukraine has led to sanctions against some of Russia’s largest state companies which block them from long-term capital borrowing. It has soured business with EU and US partners.

Exports from Russian state own companies are worth $230 billion per year, or 44 percent of total goods exported, according to VTB CEO Andrey Kostin.

This has forced Russian companies to consider other alternatives than dollar and euro loans, mainly from Asian markets.

Kostin has spoken out about the need for Russia to 'de-dollarize' its economy, and said international settlements could be made in rubles, and not dollars, within three years.

“The West’s isolation of Russia encourages us to use the nuclear weapon of finance- the dollar,”Vedomosti business daily quotes Kostin as saying.

“To minimize risks, Russian exporters should ‘immediately’ switch settlements into rubles,” Kostin said.

Another reason to switch to ruble payments is because of the currency’s weakening state.

The ruble continues to slide to new record lows, both against the dollar and the euro. It has lost nearly 20 percent against the dollar this year, and less against the also weak euro, but still at record lows, passing the 52 ruble per euro mark on Friday.

Gazprom is also "considering" more actively pursuing settlements in rubles in international transactions, company spokesman Sergey Kupriyanov told Vedomosti.

In October, Gazprom Neft, the oil subsidiary of state gas company Gazprom, announced it would begin selling crude oil to China in rubles.

Obuv Rossii planned to hold an initial public offering on the Moscow Exchange in 2013, but decided to postpone it due to unfavorable market conditions. The company hoped to raise between $1.5-2 billion. The footwear retailer was founded in 2003 and is headquartered in Novosibirsk. It operates 430 stores across Russia and has about 1 million customers annually.

http://rt.com/business/196728-russian-shoe-retailer-china-rubles/

This Time 'Is' Different - For The First Time In 25-Years The Wall Street Gamblers Are Home Alone

Submitted by David Stockman via Contra Corner blog,

The last time the stock market reached a fevered peak and began to wobble unexpectedly was August 2007. The proximate catalyst back then was the sudden recognition that the subprime mortgage problem was not contained at all, as Bernanke had proclaimed six months earlier. The evidence was the surprise announcement by the monster of the mortgage midway - Countrywide Financial - that it would be taking huge write-downs on its $200 billion balance sheet.

At the time, it had not quite invented the term “fortress balance sheet” per JPMorgan’s later hyperbole, but the market overwhelmingly believed that the orange man—–Angelo Mozillo—-ran a tight ship; that the proponderant share of its business was in “safe” Freddie/Fannie originations and guaranteed paper; and that any losses from the sketchier subprime mortgage business that it had recently entered would be covered by its loan loss reserves and the massive earnings on its GSE book of business. Only now do we know that Countrywide was a house of cards that has cost(so far) its reluctant suitor, Bank of America, upwards of $50 billion in write-offs, losses and settlements.

It is in the nature of bubble finance that markets do not recognize disasters lurking in plain sight. Prior to the August 2007 swoon, Countrywide still had a market cap of $15 billion. Indeed, at that point the combined market cap of Bear Stearns, Freddie Mac and Fannie Mae, Lehman Brothers, AIG and GM, just to name the obvious, was upwards of one quarter trillion dollars!

Markets were most definitely not in the classic “price discovery” business. That is, they were not discovering information about the speculative rot under housing prices or the dealer lots bulging with unsold cars or freshly minted subdivisions where subprime residents were delinquent on both their mortgage and car loans or the adjacent strip malls that had no tenants and no customers.

Instead, the stock market had discovered the “goldilocks economy” - a pleasant place of subdued inflation, measured growth and perpetually rising stock and real estate prices. The most notable point was the belief that the Fed had delivered this salutary state of affairs owing to its enlightened management of the macro-economy, and that this condition could be sustained indefinitely.

Bernanke had somewhat immodestly called this the Great Moderation, and it was reflected in the stock market averages and the capitalization rates they allegedly embodied. Not incidentally, the market had risen nearly continuously for 55 months, and the “buy the dip” brigade of the dotcom era had come back from the dead. So dips got shallower and the setbacks less frequent.

That may sound like the recent past, and it was. The forward consensus of sell-side analysts was that S&P 500 earnings (ex-items) for 2008 would come in around $110 per share or at about 14X based on the July interim high of $1550 per share. Likewise, the NASDAQ had recovered from its thundering crash of 2000-2001 and had climbed by nearly 100% in the four and one-half years through early August 2007.

Needless to say, goldilocks turned out not to be all that. When the macro-economy buckled under the weight of crashing housing and real estate prices, a plunge in home and commercial real estate construction, a severe liquidation of auto and durable goods inventories and the evaporation of phony financial sector profits, the dips became a deathly plunge, and the “attractively valued” 14X market ended up something else altogether.

As it happened, S&P 500 earnings ex-items came in at about $55 per share for 2008, or half of Wall Street’s hockey-stick projections as of August 2007. And if honest accounting, as embodied in GAAP earnings reported to the SEC is considered, the outcome was only $15 per share.

Self-evidently, the stock market was no longer a discounting mechanism by the end of the second Greenspan Bubble in late 2007 when the Great Recession officially commenced. It had essentially become a casino where the hedge funds and day traders made short term bets in a rigged market. In effect, the Greenspan Put had become institutionalized by the liquidity flood that had accompanied the Fed’s slashing of interest rates from 6% to 1% during the 30 month period after the dotcom crash of 2000. There could no longer be any doubt, at least by the lights of Wall Street, that the central bank had a “put” under the market.

By now it seems indisputable that central banks “puts” are a magnificent elixir for stock market gamblers—so long as confidence is maintained and our monetary central planners have the tools and wits to short-circuit the “dips” before they become runaway crashes.In the section from the Great Deformation below, I described how the Fed reacted aggressively to thwart the correction that commenced in August 2007 when the subprime crisis began to manifest its ugly fangs.

As it turned out, the stock market rallied by another 10% before hitting a final peak in October 2007. Moreover, the Fed continued its campaign to put a floor under the market for another 11 months after the peak—even as the credit and stock market bubbles festered and the underlying macro-economy steadily deteriorated. During this interregnum, the Fed capitulated to Wall Street as symbolized by its panicked response to Jim Cramer’s famous rant described below.

But it was ultimately for naught. The market suffered a devastating 55% collapse in the 18 months after the unavoidable correction of the Greenspan Housing Bubble commenced in August 2007. Stated differently, central bank bubbles can be fueled and coddled for an extended period, but ultimately reality sets in.

So here we are once again, and it is once again claimed that this time is different. The 65 month rise of the S&P 500 bears all the hallmarks of a central bank fueled casino—- even more completely than the 2003-2007 run. Also once again, the market is said to be “attractively valued” and that next years earnings(ex-items) at $125 per share represent only a 15X PE multiple. So after the “healthy correction” of the past week or so, it is purportedly time once again to buy the dip.

Except this time is indeed different, but not in a good way. When Bernanke & Co. stalled off the August 2007 correction for nearly a year, they still had plenty of dry powder. The federal funds rate was 5.25% and the Fed’s balance sheet was only $850 billion.

But now, however, we are on the far side of the great monetary experiment known as ZIRP and QE. The money market rate is at the zero bound and has been pinned there for 69 months running—a stretch never before experienced even during the Great Depression. Likewise, the Fed’s balance sheet has grown by 5X to nearly $4.5 trillion—again a previously unimaginable eruption.

These conditions undoubtedly explain the “buy the dips” joy ride pictured above. And they also probably explain why actual LTM GAAP earning at about $102 per share on the S&P 500 are exactly where they were in the fall of 2007—-at the tippy top of the historic range at 19X. But no one cared then— nor apparently do they now.

But what is profoundly different this time is that the Fed is out of dry powder. Its can’t slash the discount rate as Bernanke did in August 2007 or continuously reduce it federal funds target on a trip from 6% all the way down to zero. Nor can it resort to massive balance sheet expansion. That card has been played and a replay would only spook the market even more.

So this time is different.  The gamblers are scampering around the casino fixing to buy the dip as soon as white smoke wafts from the Eccles Building.  But none is coming. For the first time in 25- years, the Wall Street gamblers are home alone.

CHAPTER 23

THE RANT THAT SHOOK THE ECCLES BUILDING

How the Fed Got Cramer’d

After climbing steadily for four and a half years, the stock market weakened during August 2007 under the growing weight of the housing and mortgage debacle. Yet in response to what was an exceedingly mild initial sell-off, the Fed folded faster than a lawn chair in a desperate attempt to prop up the stock averages. The “Bernanke Put” was thus born with a bang.

The frenetic rate cutting cycle which ensued in the fall of 2007 was a vir- tual reenactment of the Fed’s easing panics of 2001, 1998, and 1987. As in those episodes, the stock market had again become drastically overvalued relative to the economic and profit fundamentals. But rather than permit a long overdue market correction, the monetary central planners began once more to use all the firepower at their disposal to block it.

The degree to which the Bernanke Fed had been taken hostage by Wall Street was evident in its response to Jim Cramer’s famous rant on CNBC on August 3, 2007, when he denounced the Fed as a den of fools: “They are nuts. They know nothing . . . the Fed is asleep. . . . My people have been in the game for 25 years . . . these firms are going out of business . . . open the darn [discount] window.”

In going postal, Cramer was not simply performing as a CNBC commentator, but functioning as the public avatar for legions of petulant day traders who had taken control of the stock market during the long years Greenspan coddled Wall Street. What the Fed utterly failed to realize was that these now-dominant Cramerites had nothing to do with free markets or price discovery among traded equities.

AUGUST 2007: WHEN THE FED CAPITULATED TO FINANCIAL HOODLUMS

The idea of price discovery in the stock market was now an ideological illusion. The market had been taken over by white-collar financial hoodlums who needed a trading fix every day. Through Cramer’s megaphone, these punters and speculators were asserting an entitlement to any and all gov- ernment policy actions which might be needed to keep the casino running at full tilt.

If that had not been clear before August 2007, the truth emerged on live TV. The nation’s central bank was in thrall to a hissy fit by day traders. In a post the next day, the astute fund manager Barry Ritholtz summarized the new reality perfectly: “I have two words for Jim: Moral Hazard. Contrary to everything we learned under Easy Alan Greenspan, it is not the Fed’s role to backstop speculators and guarantee a one way market.”

Yet that is exactly what it did. Within days of the rant which shook the Eccles Building, the Fed slashed its discount rate, abruptly ending its tepid campaign to normalize the money markets. By early November the funds rate had been reduced by 75 basis points, and by the end of January it was down another 150 basis points. As of early May 2008 a timorous central bank had redelivered the money market to the Wall Street Cramerites. Although the US economy was saturated with speculative excess, the Fed was once again shoveling out 2 percent money to put a floor under the stock market.

This stock-propping campaign was not only futile, but also an exercise in monetary cowardice; it only intensified Wall Street’s petulant bailout de- mands when the real crisis hit a few months later. Indeed, on the day of Cramer’s rant in early August 2007, the S&P 500 closed at 1,433. The broad market index thus stood only 7 percent below the all-time record high of 1,553, which had been reached just ten days earlier in late July.

Ten days of modest slippage from the tippy-top of the charts was hardly evidence of Wall Street distress. Even after it drifted slightly lower during the next two weeks, closing at 1,406 on August 15, the stock market was still comfortably above the trading levels which prevailed as recently as January 2007.

Still, the Fed threw in the towel the next day with a dramatic 50 basis point cut in the discount rate. Although no demonstration was really needed, the nation’s central bank had now confirmed, and abjectly so, that it was ready and willing to be bullied by Cramerite day traders and hedge fund speculators. The latter had suffered a “disappointing” four weeks at the casino; they wanted their juice and wanted it now.

Needless to say, the stock market cheered the Fed’s capitulation, with the Dow rising by 300 points at the open on August 17. The chief economist for Standard & Poor’s harbored no doubt that the Fed’s action was a deci- sive signal to Wall Street to resume the party: “It’s not just a symbolic ac- tion. The Fed is telling banks that the discount window is open. Take what you need.”

The banks did exactly that and so the party resumed for another few months. By the second week of October the market was up 10 percent, enabling the S&P 500 to reach its historic peak of 1,565, a level which has not been approached since then.

Pouring on the monetary juice and signaling to speculators that it once again had their backs, the Fed thus wasted its resources and authority for a silly and fleeting prize: it was able to pin the stock market index to the top rung of its historic charts for the grand duration of about six weeks in the fall of 2007. There was no more to it, and no possible excuse for its panic rate cutting.

HOW THE FED GOT CRAMER’D

The Fed’s abject surrender to the Cramerite tantrums in the fall of 2007 was rooted in ten years of Wall Street coddling. Mesmerized by its new “wealth effects” doctrine, the Fed viewed the stock market like the famous Las Vegas ad: it didn’t want to know what went on there, and was therefore oblivious to the deeply rooted deformations which had become institu- tionalized in the financial markets. The sections below are but a selective history of how the nation’s central bank finally reached the ignominy of being Cramer’d by financial TV’s number one clown.

The monetary central planners only cared that the broad stock averages kept rising so that the people, feeling wealthier, would borrow and spend more. It falsely assumed that what was going on inside the basket of 8,000 publicly traded stocks was just the comings and goings of the free market— and that this was a matter of tertiary concern, if any at all, to a mighty cen- tral bank in the business of managing prosperity and guiding the daily to-and-fro of a $14 trillion economy.

But what was actually going on in the interior of the stock market was nightmarish. All of the checks and balances which ordinarily discipline the free market in money instruments and capital securities were being evis- cerated by the Fed’s actions; that is, the Greenspan Put, the severe repres- sion of interest rates, and the recurrent dousing of the primary dealers with large dollops of fresh cash owing to its huge government bond purchases.

This kind of central bank action has pernicious consequences, however. By pegging money market rates, it fosters carry trades that are a significant contributor to unbalanced markets. Carry trades create an artificially en- larged bid for risk assets. So prices trend asymmetrically upward.

The Greenspan Put also compounded the one-way bias. For hedge fund speculators, it amounted to ultra-cheap insurance against downside risk in the broad market. This, too, attracted money flows and an inordinate rise in speculative long positions.

The Fed’s constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By peg- ging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and re- hypothecated existing securities; that is, pledged the same collateral for multiple loans.

The Fed’s peg on short-term rates thus fostered robust expansion of the shadow banking system, which as indicated previously, had exploded from $2 trillion to $21 trillion during Greenspan’s years at the helm. This vast multiplication of non-bank credit further fueled the “bid” for stocks and other risk assets.

Fear of capital loss, fear of surprise, fear of insufficient liquidity—these are the natural “shorts” on the free market. The paternalistic Dr. Green- span, trying to help the cause of prosperity, thus took away the market’s natural short. In so doing, he brought central banking full circle. William McChesney Martin said the opposite; that is, he counseled taking away the punch bowl, thereby adding to the short. Now the punch bowl was over- flowing and the short was gone.

Speculators were emboldened to bid, leverage their bid, and then to bid again for assets in what were increasingly one-way markets. As time passed, more and more speculations and manipulations emerged to capi- talize on these imbalances.

“Growth stocks” were always a favored venue because they could be bid- up on short-term company news, quarterly performance, and rumors of performance (i.e., “channel checks”). During these ramp jobs, which ordinarily spanned only weeks, months, or quarters, traders could be highly confident that the Fed had interest rates pegged and the broad market propped.

Financial engineering plays such as M&A and buybacks came to be es- pecially favored venues because these trades tended to be event triggered. Upon rumors and announcements, these trades could generate rapid replication and money flows. Again, speculators were confident that the Fed had their back, while leveraged punters were pleased that it had seconded to them its wallet in the form of cheap wholesale funding.

At length, the stock market was transformed into a place to gamble and chase, not an institution in which to save and invest. Since this gambling hall had been fostered by the central bank rather than the free market, it was not on the level. That means that most of the time most of the players won and, as shown below, the big hedge funds which traded on Wall Street’s inside track with its inside information won especially big and un- usually often.

Needless to say, frequent wins and hefty windfalls created expectations for more and more, and still more winning hands. As the Greenspan bub- bles steadily inflated—both in 1997–2000 and 2003–2007—these expecta- tions morphed into virtual Wall Street demands that the Fed keep the party going. Wall Street demands for a permanent party, at length, congealed into the presumption of an entitlement to an ever rising market, or at least one the Fed would never let falter or slump.

Finally, this entitlement-minded stock market became a blooming, buzzing madhouse of petulance, impatience, and greed. Cramer embodied it and spoke for it. By the time of his rant, the Fed had become captive of the monster it had created. Now, fearing to say no, it became indentured to juicing the beast. After August 17, 2007, there was no longer even the pretense of reasoning or deliberation about policy options in the Eccles Building. The only options were the ones that had gotten it there: print, peg, and prop.

One of the great ironies of the Greenspan bubbles was that the free market convictions of the maestro enabled the Fed to drift steadily and irreversibly into its eventual submission to the Cramerite intimidation. It did so by turning a blind eye to lunatic speculations in the stock market, dismissing them, apparently, as the exuberances of capitalist boys and girls playing too hard. By the final years of the first Greenspan bubble, however, there were plenty of warning signals that there was more than exuberance going on. Hit-and-run momentum trading and vast money flows into the stocks of serial M&A operations were signs that normal market disciplines were not working. Indeed, the M&A mania was a powerful indictment of the Fed’s prosperity management model.

These hyperactive deal companies with booming share prices were be- ing afflicted ever more frequently with sudden stock price implosions that couldn’t have been merely random failures on the free market. Yet, as in the case of the subprime mania, the central planners undoubtedly read the headlines about these recurring corporate blowups and never bothered to connect the dots.

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