By Charles Hugh Smith, OFTWOMINDS
Since virtually all asset classes rose together, why can’t they all fall together, too?

Go to my main site at www.oftwominds.com/blog.html
for the full posts and archives.

More articles from Charles Hugh Smith….

The Daily Reckoning

So what if the possibility of a major wipe-out in shares looms? Let’s all buy houses! Today’s Daily Reckoning will continue the discussion we began yesterday. But before we can sort out what Australian investors should do in another major bust, let’s review what happened overnight.

First up is gold’s 1.27% decline in the futures markets. We’ve written about this in a special note that goes out later today. If you miss that note here’s the short version: don’t worry. The fear that China won’t buy IMF fold is a red herring. China is buying plenty of gold. But you might be surprised to find out who the seller is.

What shouldn’t surprise you is that fewer Australians are taking out mortgages to buy new homes. That’s what happens when prices rise, interest rates head up, and the government stops shovelling tax payer money into the market. You can only “bring forward” (steal) so much demand from the future.

The number of people taking out loans to buy new homes fell by nearly 8% in January, according to the Australian Bureau of Statistics. First home buyers fell as a percentage of new lending to 20.5%. That’s down from the high of May last year of 28.5%. And here in Victoria, only 525 Victorians borrowed money to buy a new home in January (see the table on page 10).

Don’t be discouraged, though. The Reserve Bank agrees with the realtors and housing industry spruikers that there is a housing shortage in Australia. RBA assistant governor Philip Lowe said in a speech in Sydney yesterday that constraints on home building are restricting the supply of homes in Australia. The shortage is one factor keeping prices up. Nothing was said about the lending boom.

Lowe said that, ”With population growth above average, and growth in the housing stock below average, it is not surprising there has been upward pressure on housing costs…If we are to build more dwellings, we need to ensure that planning guidelines and infrastructure provision can accommodate this.’”

Blah blah blah. We’re not going to rehash all of this again. But if anything, Australia has already sunk too much of its national capital into housing. Maybe investors have over-invested and locked out first time buyers while also damaging affordability. Who knows?

The river of liquidity that has floated Aussie house prices higher has its source waters overseas in the wholesale borrowing by Aussie banks from foreign lenders. This is what accounts for the financial sector’s massive share of Australia’s net foreign debt. Another global credit squeeze (the implosion of the shadow banking system) would block off those head waters. And where would that leave Aussie housing?

This is not to say or imply that homeownership is an unworthy goal. Yale Economist Robert Shiller points out in New York Times article that home ownership can promote good citizenship, a broad sense of equality, and even a sense of personal liberty in a society. That’s why in Australia and America, homeownership is THE personal financial dream.

But Shiller also points out those are cultural and not financial values. The desirability of homeownership shouldn’t be confused with the financial wisdom of it. The more leveraged a housing investment it is, the more vulnerable you are to getting wiped out on falling asset price falls. This is why nearly 16 million Americans are underwater on their mortgages.

In the mortgage boom years from 2004-2004, it wasn’t hard to get a loan-to-value ratio of 90% or higher with less than a 5% down payment. You didn’t have any equity. But the animal spirits of the housing bull encouraged people to believe prices would just keep going up.

They didn’t, of course. And instead of having equity, most of the borrowers ended up with a big mortgage and a falling asset. This is what soured so many mortgage backed securities and collateralised debt obligations. And the fact that Americans can walk away from underwater mortgages – letting the bank seize back the house, which is the collateral on the loan – in some ways made the financial gamble sensible for people. Maximum upside, zero downside.

You can’t walk away from the loan in the same way in Australia. But that doesn’t’ mean Australians aren’t gambling on higher house prices. Loan-to-value ratios are coming down as banks get more cautious (this restricts new lending as well). But they are still high. And first home buyers remain especially over-leveraged – facing higher interest rates on variable rate loans.

But you know all that. So we won’t yammer on about it. We’re just saying…house aren’t safe as houses, no matter what the RBA says.

So what is safe? Well, as a reader pointed out yesterday, cash isn’t bad. Here’s one response to yesterday’s essay:

Hi guys,

I read you latest anti-deflationist polemic today. You raised many good points.

However, you conclude that the beginning of hyperinflation may be deflation.

I think you need to tell your readers that timing is absolutely critical. Because all longs on the inflation trade may well be utterly destroyed and wiped out.

It may well be that as the meltdown unfolds, there will be a sudden and massive asset implosion that will destroy many. In this case, the governments’ RE-actions will be rather slow and ineffective initially. Hyperinflation probably comes AFTER the meltdown. So Prechter is quite possibly right.

To own cash before the governments react to the implosion may well position people to make “once in a century” purchases of hard assets. Those who can time it will do more than survive.

You guys really need to outline several scenarios IN DETAIL, with the time-flows and mechanics in DETAIL.

Cheers

John Pope

It’s a good point. We’ll deal with it tomorrow. Although it’s going to be hard to predict the future…in detail. That won’t stop us from trying! Until then.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• General Motors: A Forerunner for What’s to Come for the Broader Economy
• House Prices Always Go Structurally Higher in Australia
• Are Aussie House Prices in a Bubble?
• Aussie Housing Market Actually Leads the U.S. by Three Years
• Underlying Demand During a Housing Shortage

More articles from The Daily Reckoning….

Casey B. Mulligan submits:

The elasticity of housing supply is the effect on the flow of home building (measured as a log change — think of it as a percentage change) of the inflation-adjusted purchase price of housing (also measured as a log change).

The elasticity has long been studied in economics; one of the seminal studies was published by Professors Topel and Rosen in 1988.

Read more…. »

Today I was thinking about tightening cycles in emerging markets; and more specifically, about that in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted toward food and energy costs across the BIICs. Indonesia, India, and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil, and India, 19%, 16%, and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 pos), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China, and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilized.

To date, inflows are not properly sterilized, as evidenced by the ongoing accumulation of reserves and rising money supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest-rate differential between the 2yr forward government rate for each respective BIIC country versus the 2 yr forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe that this appropriately represents the sterilization efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging market space. In fact, in my view this is the riskiest part of the emerging market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

Read more….

Gold fell sharply in a short period of time yesterday in US trading – falling from $1,127.35/oz to $1,103.45/oz to close with a loss of 1.26%. It has range traded from $1,105/oz to $1,109/oz so far in European trading this morning. Gold is currently trading at $1,105.70/oz and in euro and GBP terms, gold is trading at €811/oz and £739/oz respectively. Oil at over $82 a barrel would be expected to lead to inflation hedging buying but is not supporting gold today.

Read more….

India s wholesale price based food inflation eased to 17.81 per cent for the week ended Feb 27 compared with 17.87 percent from the previous week.

Read more….

Zero Hedge

In a letter to Larry Summers and Tim Geithner, Senator Sherrod Brown warns the administration to not simply place more Wall Street cronies in filling the three vacancies at the Federal Reserve, which will open up once Fed vice chairman Donald Kohn leaves this coming June. Instead of mere” maximum liquidity” automatons, Brown wants the new Fed members to be “committed to transparency, consumer protection and lowering the unemployment rate.” Furthermore, Brown demands that “we need economic policy makers who possess
the foresight to identify harmful economic trends, the courage to speak
out about the necessity of addressing these practices before they
inflict lasting damage to our economy, and the wisdom to listen even if
their views are challenged.” Alas, as transparency and rationa thought, coupled with proactive defensive actions means game over for the Fed, these conditions are an immediate deal killer, with the result being that the only affirmative criteria for new Fed membership is the endorsement of Lloyd Blankfein and current Fed Director Jamie Dimon. With the yield curve merely at record wides, there is certainly enough room for the current 2s10s spread of 282 to at least double as the American middle class still has a little money that can be stolen, in space or time, by Wall Street, with the Fed’s endless blessings. Everything else is smoke and mirrors.

Full letter from Senator Brown, via Huffington Post:

March 10, 2010

The Honorable Timothy Geithner
Secretary
United States Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

The Honorable Lawrence Summers
Director
National Economic Council
The White House
1600 Pennsylvania Avenue, NW
Washington, D.C. 20500

Dear Secretary Geithner and Director Summers,

I write to you today to express my concern about the vacancies at
the Federal Reserve, both on the Federal Open Market Committee (FOMC)
and soon in the Vice Chairman’s office. This is the financial
equivalent of leaving open vacancies on the United States Supreme
Court, and it is essential that we fill these positions.

As Chairman of the Senate Banking Committee’s Subcommittee on
Economic Policy, with jurisdiction over the Federal Reserve System’s
monetary policy functions, I am acutely aware of the importance of
monetary policy at the Fed. Both the full Banking Committee and the
Economic Policy Subcommittee have examined the causes of the financial
crisis and the resulting effects on lending, access to credit, and
employment. The evidence presented to the Committee about the role that
Fed policy decisions played in the financial crisis and the economic
downturn has led me to conclude that the Fed’s monetary policy has
focused almost entirely on controlling inflation rather than maximizing
employment and that the Fed has too often put banks’ soundness ahead of
its other responsibilities. In light of this experience, there are
several other important qualifications that I would urge you to
consider in selecting the new Vice Chairman and new members of the FOMC:

1. Recognition of the causes of the financial crisis before it occurred.

Many economic experts, including some at the Federal Reserve, failed
to anticipate the impending economic crisis. However, there were
exceptional people who sounded alarms about the rapidly inflating
housing bubble, the proliferation of subprime lending, and the
packaging, selling, and investing in toxic financial products by Wall
Street. Unfortunately, regulators, including the Fed, ignored or
attempted to discredit many of these courageous individuals, rather
than heeding their warnings. We need economic policy makers who possess
the foresight to identify harmful economic trends, the courage to speak
out about the necessity of addressing these practices before they
inflict lasting damage to our economy, and the wisdom to listen even if
their views are challenged.

2. Demonstrated dedication to protecting consumers and maximizing employment.

For years, the Federal Reserve’s monetary policy has maintained an
almost single-minded focus on inflation. This has been detrimental to
the Fed’s other core missions, particularly maximizing employment and
protecting consumers. The results of this fixation speak for
themselves. The national unemployment rate is more than double the
Fed’s statutorily mandated 4 percent unemployment target. The Fed also
failed to act on repeated warnings about predatory mortgage lending and
credit card abuses. Consumer protection experience is particularly
important if the new consumer protection entity were to be housed at
the Fed. Our economy will benefit from renewed attention to all of the
Fed’s priorities.

3. Commitment to releasing e-mails related to the Fed’s involvement in the AIG bailout.

A growing number of experts – including economists, academics, and
former regulators – have called upon the Federal Reserve to release all
e-mails, internal accounting documents, and financial models related to
AIG’s collapse. The American taxpayers now hold the majority of AIG
shares, and they have a right to know how their money is being spent.
Providing greater detail about the AIG bailout is particularly
important because that episode continues to taint the Fed’s reputation.
Focusing on candidates committed to full transparency related to this
particular economic event would help to restore the Fed’s stature and
credibility in the eyes of many Americans.

The American public has lost a great deal of confidence in the Federal
Reserve. Selecting a Vice Chair and FOMC members with the above
qualifications will send the message that the Federal Reserve has
learned from the financial crisis, and that the Fed’s weaknesses are
being addressed with more than just cosmetic changes.

I would be happy to discuss specific candidates with you at your
convenience. Thank you for considering my views, and I look forward to
working with you to address these vacancies at the Fed.

Sincerely,

Sherrod Brown
United States Senator

More articles from Zero Hedge….

By Karl Denninger, The Market Ticker

50% of the federal budget right now goes to entitlements.

This last month we posted a record $220.9 billion budget deficit.  We took in $107 billion but spent $328 billion.

Isn’t that special.  We only funded 32% of expenditures?

Remember – entitlements were half of that $328 billion.

So let’s see if we can do the math here.

Entitlements were about $164 billion last month in spending.  The rest was, of course, the rest.

But we only took in $107 billion.

So even if we eliminated all entitlement spending we still did not have enough money to cover the rest.

Yeah.

If you want to know why the market is floating higher it’s for the same reason you feel all giddy and special when you strike out on the town with your shiny plastic.  You have magic cards!

It doesn’t matter if you have a job, it doesn’t matter if you have any money in the bank, so long as you have magic cards.

For how long does the United States continue to have magic cards?

Remember, from my ticker the other day, the federal government is directly spending 9% more of GDP today than it was just two years ago.

The market and economy are absolutely dependent on the Federal Government continuing to do so.  Should the government not be able (or willing) to continue to do so, S&P 666 or DOW 6,489 will look like a bull market.

Now add to this that the continued spending in this fashion inevitably will cause interest rates to rise.  It simply must, whether that interest rate increase comes from actual Treasuries, or whether it comes from dollar devaluation and thus causes oil – and by extension virtually every other price in the market – to rise at a meteoric rate.

Oh, and if they choose the second (inflation)?  Then, as I discussed earlier, that entitlement spending, which is set to go parabolic anyway as the boomer retire, will have an afterburner attached to its backside due to the fact that all of these programs are indexed to “inflation”, with Medicare in particular being indexed at several multiples of inflation.

But for today, folks, it’s “Rally On Garth” – even though all of the above is not conjecture, it’s mathematical fact and inevitably must come to pass.

More articles from the Market Ticker….

Australia consumer inflation expectations came in at 3.2% in March meeting the previous reading for February.

Read more….

The Daily Reckoning

Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

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• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

More articles from The Daily Reckoning….