By Charles Hugh Smith, OFTWOMINDS
China’s “nuclear option”–selling its vast stash of U.S. Treasuries to wreak havoc on the U.S. economy and interest rates–has been downgraded by the flood of U.S. investors who have exited stocks in favor of Treasury bonds.

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

More articles from Charles Hugh Smith….

Zero Hedge

Seeing Past The Hologram, by Mike Krieger of KAM LP

There is no distinctly American criminal class – except Congress.

- All quotes by Mark Twain

We Need Real Confidence to Return, Not Confidence in a Ponzi Scheme

Last week I pointed out that what I got from Banana Ben’s speech in Jackson Hole was that he realized any major public statement of interference in markets was too risky at this point following his announcement at the last meeting to keep the balance sheet steady by reinvesting MBS proceeds into treasury securities.  The operative word in this sentence being “public.”  Anyone that believes this means the Fed and government will just take a back seat and do nothing behind the scenes is deluding themselves.  Washington D.C. and the Fed still fail to comprehend how to increase standards of living in the real world, rather they remain completely addicted to the short-term buzz of printed money heroin as it flows through the house of cards they have created.  They also think that the only thing that really matters in an economy is “confidence.”  As Madoff can attest to, that is indeed the case when you are running a ponzi scheme and since the U.S. government is basically that I can understand where they are coming from.

 I agree that confidence is a huge part of any healthy economy; however, I do not define confidence in the way these arrogant bureaucrats do.  They think confidence comes from rising asset prices, including stocks and homes.  They think this is enough to spark growth in the real economy.  This is nonsense.  The confidence that is needed more than anything else today is two-fold.  First, confidence that there is the rule of law and there will be the rule of law in the future.  The second is that the money issued by the government will maintain its purchasing power over time.  As I have made clear on various occasions, I do not have confidence in either of these things based on how the government has responded to the crisis.  I do not like buying physical gold.  I do not like feeling the need to write these emails every week to warn people.  I wish I could employ capital into businesses and the real economy.  I hope that one day I will be able to do so, but at the moment I do not trust my government and I certainly don’t trust the fascist Federal Reserve.  So I will hoard what I have as the government prints and let the storm pass me by.  I am not the only one.  People are collectively starting to understand this.  So what happens when the big, smart money takes itself out of the investment and capital allocation game because they don’t trust anything?  What happens when the government’s response to this is to print money to keep up the spending habits of people with no jobs or people with government jobs that produce no goods for the economy?  You get the worst case scenario and that is exactly what is staring us straight in the face.

Is a Trade War with China Coming?

The quicker the dollar is devalued the better.  This is not to say that I think dollar devaluation is a good thing.  It is to say we are past the point of avoiding it.  We could have taken the pain in 2008, but instead it was extend and pretend all over again.  Now the debt and promises are too big.  The behind the scenes manipulations are too entrenched.  There is no avoiding a devaluation relative to things people need (food and energy) and capital goods that are imported.  The best thing would be to get it over with and then change policies and restore the rule of law.  The problem with this is that the main currencies the dollar needs its major adjustment against are those in emerging Asia and China.  What has prevented the realignment from happening in a quick and healthy way is China’s refusal to allow the yuan to appreciate.  This creates a situation where Central Banks throughout emerging Asia take steps to prevent their “free-floating” currencies from adjusting either.  If China does not change its policy I fear that what we are looking at a trade war with China after the November elections.  I think Congress and the Administration will start to introduce aggressive policies to discourage Chinese goods and encourage goods made at home.  Think it can’t happen?  We are a lot closer than you think.  This all goes back to my “think local” theme.  While I am inherently a fan of free trade we do not have free trade in any sense whatsoever.  We have policies that are geared to advantage the multi-national corporations at the expense of the U.S. citizen.  The U.S. consumer has merely been spending borrowed money.  This gave an illusion that the U.S. was benefiting from the global multinational corporate rigged market whose model mainly thrives on companies moving abroad to exploit the labor arbitrage caused by a combination of what was a labor surplus (no longer it seems) and a rigged currency.  As more people realize this, more pressure will be placed on politicians and ultimately this will overpower the corporate lobbyists and a trade war of sorts will begin.  Then the chaos could really ensue as we engage in a trade war with our biggest creditor!

Seeing Past the Hologram

The past couple of weeks have been extraordinarily interesting and some of the moves appear to be extremely important.  Although a lot of people like to point to the treasury market and then extrapolate out as to what this means to equities and the ability of the government to increase spending, I think this is the most USELESS market in the world to watch.  If anything is a hologram and a PR tool it is the U.S. treasury market.  How can people with a straight face come out and extrapolate anything from a market where the Federal Reserve is buying the debt of its own government!  The Fed is merely the fiat drug dealer to a government addicted to spending and false promises.  The equity market is the second most useless market in my opinion.  There is no doubt in my mind that a huge part of the government’s “strategy” to build confidence is to keep this thing from doing what it should be doing.  Thus, I am not surprised at all that since I last wrote the S&P500 was +1.6%, -1.5%, flat, and then +3.0%.  So what you have seen is high volatility with no real direction.  How can anyone have confidence this that thing is for real?

So what markets do I watch?  I get the most from the FX markets and the commodity markets.  While these markets are no doubt manipulated heavily as well, I think this is where the players that really understand the macro are playing.  The first currency I check in the morning is the dollar/yen.  The reason for this is that the yen is back to the highs of 1995 and if it does not stop appreciating around this level I think the Bank of Japan is going to absolutely panic.  While the yen has not broken higher yet as market participants are afraid of such intervention, unless the BOJ does something extreme soon the market may test their resolve and push this thing further.  I guess the main point I am trying to make is that with the Chinese yuan NOT strengthening and the yen threatening to break out we could be in for some major fireworks.  Meanwhile Japanese 10 year government bond yields have really started to spike lately (chart GJG10 Index on Bloomberg).  Something big is happening in the land of the rising sun.  In the back of my head I think that any panic move from the BOJ could be the spark that breaks government bond bubbles globally and ushers in a period of massive global commodity driven inflation as every country tries to devalue their way to prosperity.  Essentially, a fiat money version of the 1930’s beggar thy neighbor policies.  When this begins the rush into gold and silver that we have seen thus far will look like a trickle.  I don’t think people will be able to find supply anywhere near the quoted price on comex (or as some like to call it “crimex”).

This brings me to silver which potentially experienced a game changer last week.  I can’t remember the last time silver bounced back almost immediately after every attempted raid.  I am starting to wonder how much physical silver is available.  What we do know is that Central Banks do not store silver to manipulate markets.  Even if it doesn’t break out right now, there is no asset in the world that has more upside than silver.  Don’t buy SLV either.  Buy physical silver not something with JPM as a custodian. 

I also continue to watch food prices very closely.  Wheat, which has come off of its high now seems to have found a base at a price that is 50% higher than the end of June.  Corn prices are threatening to break above resistance at levels 30% where they were at the end of June.  Rice looks like it could have a long way to go on the upside as it is only 20% off of its June low.  If I were a foreign government I would be using this opportunity to buy every single grain of rice I could in order to feed my people when things get dicey in the months ahead.  After strong performance in recent months lean hogs and live cattle also look set to make another push to the upside.  How people in the investment world still focus on the government inflation statistics is beyond me.  It was the rampant commodity inflation, trucker strikes and food riots that played a key role in ending the game in 2008.  This is because it forced the emerging markets to raise rates and cool growth as the Western world imploded under a pile of debt.  It seems the whole play is starting again and people remain focused on deflation.  Deflation in some things yes I agree (discretionary things like homes, technology, stock prices, etc), but not in the things you NEED to buy!!!

Onto oil which is also exhibiting some strange moves.  The Asian benchmark Tapis has not experienced the recent volatility and weakness that WTI has and is currently trading at $80/b.  The Asian price is the one I really pay attention to since that is where the demand growth resides.  The spread between the two now is back above $6/b, which is toward the high end of the range for the past two years.  This tells me that one price is wrong and the spread should narrow.  Given what I think about currency debasement and lack of appropriate investment in the space I think WTI should rally.  We shall see…

A Primer on the Federal Reserve

For those that read my commentary on the Federal Reserve as an immoral an fascist institution and think to themselves “what is this guy talking about,” I have attached a video from G Edward Griffith (the author of The Creature from Jekyll Island).  It’s a great description of how the Fed was formed and who it answers to when push comes to shove.  http://video.google.com/videoplay?docid=6507136891691870450#

Also in case you weren’t aware of the power grab that the “Financial Reform” legislation allowed the Fed, read this Bloomberg article. 

http://www.bloomberg.com/news/print/2010-09-02/bernanke-meets-buffett-in-new-role-conceived-to-protect-markets.html

All the best,
Mike

More articles from Zero Hedge….

Zero Hedge

You will pardon us for posting two excerpts from David Rosenberg today, but this one is a must read, and explains more clearly than anything written on the matter why America is currently, and without doubt, in a depression, due primarily to ongoing secular changes in consumer and investor behaviour, something not experienced during mere recessions. As such any intraday or short-term bounces in the stock market that merely confirm that there was a liquidity injection by one player or another, or a successful short squeeze engineered by the wily folks at the custodian firms or due to simple headfakes, are completely irrelevant (especially with record implied correlations), as the long-term trend has only one way to go in the long-run. Down. Of course, those who believe they can time the moment when the last lingering support pillar collapses and everything tumbles down, are more than welcome to keep trying their top-ticking. We are confident that when the mass exodus begins, the HFT liquidity “support” of the market will be alive and well, and provide everyone with a perfectly acceptable exit price level…

WHAT IS A DEPRESSION ANYWAY?

A depression, put simply, is a very long period of economic malaise. A series of rolling recessions and modest recoveries over a multi-year period of general economic stagnation as the excesses from the prior asset and credit bubble are completely wrung out of the system. In baseball parlance, we are in the third inning of this current debt deleveraging ball game.                                     

You know you’re in a depression when interest rates go to zero and there is no revival in credit-sensitive spending. 

The economy is in a depression when the banks are sitting on $1.3 trillion of cash and yet there is no lending going on to the private sector. It’s otherwise known as a liquidity trap.    

Depressions usually are caused by a bursting of an asset bubble and a contraction in credit, whereas plain-vanilla recessions are typically caused by inflation and excessive manufacturing inventories. You tell me which fits the bill today.

When almost half of the ranks of the unemployed have been looking for a job fruitlessly for at least six months, you know you are in something much deeper than a garden-variety recession. True, we can’t see the soup lines; the soup lines are in the mail — 99 weeks of unemployment cheques for over 10 million jobless Americans. Don’t be lulled into the view that we are into anything remotely close to a normal economic cycle.

Basically, in a depression, secular changes take place. Attitudes towards debt, discretionary spending and homeownership are altered for many years, or at least until the scars from the traumatic experience with defaults and delinquencies fade away. That is why, as per last week’s data releases, we saw existing home sales slide to 15-year lows and new home sales to record lows despite the fact that mortgage rates have tumbled to their lowest levels in modern history. There is no economic model that would tell you that declining  mortgage rates should lead to lower home sales.

In a depression, radical changes occur in terms of social norms and spending behaviour. In recessions, people don’t cancel their life insurance policies – as one example. But in a depression, tragically, that is what happens – almost 35 million Americans now have no such coverage, up from 24 million five years ago. This reflects the focus by households to pay down their debts at all costs and how companies have bolstered profits – by eliminating benefits.

More fundamentally, in a recession, the economy is revived by government stimulus. In depressions, the economy is sustained by government stimulus. There is a very big difference between those two states.    

After all, we are now in a situation where every 1-in-6 Americans is now receiving some form of government assistance — more than 50 million Americans, from food stamps, to Medicaid, to extended jobless benefits, are on one or more taxpayer-supported programs. That transcends the definition of a recession.

In a recession, everything would be back to a new high 33 months after the initial decline. This time around, everything from organic personal income to employment to real GDP to home prices to corporate earnings to outstanding bank credit are still all below, to varying degrees, the levels prevailing in December 2007.

Let’s be clear: After all the monetary, fiscal and bailout stimulus, the economy should be roaring ahead, as would be the case if the economy were coming out of a normal garden-variety recession. The fact that there has been no sustained response to all these efforts by the government to turn things around is a testament to the view that this is not actually a traditional recession at all, but something closely resembling a depression. That, my friends, is exactly what the bond market is signaling, with Treasury yields rapidly approaching Japanese levels.  

For all the chatter about whether the recession that started in December 2007 ended sometime last year, here is what you should know about the historical record. The 1930s depression was not marked by declining quarterly GDP data every single quarter. In fact, the technical recessionary aspect to the initial period following the asset and credit shock goes from the third quarter of 1929 to the first quarter of 1933.

What is important to know is this; in that initial four-year economic downturn, from 1929 to 1933, there were no fewer than six — six! – quarterly bounces in GDP data. The average gain in these up-quarters was 8% at an annual rate! But because they proved not to be sustainable, the National Bureau of Economic Research (NBER) refused to declare that the recession officially ended, even though the stock market rallied 50% in the opening months of 1930 on the belief that the downturn was about to end. False premise. And guess what? We may well be reliving history here. If you’re keeping score, we have recorded four quarterly advances in real GDP, and the average is only 3%.

I can understand how emotional the debate can get over whether or not we have actually just stumbled along some post-recession recovery path or whether or not this is actually a depression in the sense of a downward trend in economic activity merely punctuated with noise that is influenced by recurring rounds of government intervention. The reality is that the Fed cut the funds rate to zero, as was the case in Japan, to little avail. Then the Fed tripled the size of its balance sheet – again with little sustained impetus to a broken financial system. Government deficits of nearly 10% relative to GDP, or double what FDR ever ran during the 1930s, have obviously fallen flat in terms of providing and lasting impact to the economy.  

This is going to sound like a broken record but it took a decade of parabolic credit growth to get the U.S. economy into this deleveraging mess and there is clearly no painless “quick fix” towards bringing household debt into historical realignment with the level of assets and income to support the prevailing level of liabilities. We are talking about $6 trillion of excess debt that has to be extinguished either by paying it down or by walking away from it (or having it socialized). Look, we can  understand the need to be optimistic, but it is essential that we recognize the type of market and economic backdrop we are in.

The markets are telling us something valuable when (after a period of unprecedented government bailouts, incursions and stimulus programs) we had a 2-year note auction that saw the yield dragged to new record low of 0.46%. Instead of lamenting over how attractively priced equities must be in this environment, market strategists and commentators would bring a lot more to the table if they tried to decipher what the macro message is from this price action in the Treasury market. Conducting stock market valuation analysis based on unrealistic consensus earnings assumptions does nobody any good, especially when these estimates are in the process of being  cut.

If the Treasury market is correct in its implicit assumption of a renewed contraction in the economy, then we could well be talking about corporate earnings being closer to $60 or $65 in the coming year as opposed to the current consensus view of almost $90. In other words, we may wake up to find out a year from now that whoever was buying the market today under an illusion of a forward multiple of 12x was actually buying the market with a 17x multiple.

How’s that for a reality check?

More articles from Zero Hedge….

Zero Hedge

The below chart shows all three key correlation metrics relevant to today’s market: ES, AUDJPY (or FX carry), and the UST butterfly (or Treasury curve funding). In essence in a perfectly closed system, all three should track perfectly, absent massive exogenous inflows of capital into one or more of the three, which would result in dramatic dislocations. And today’s action is showing precisely this kind of dislocation: currently ES is indicating a “richness” of about 15 ES points, or almost 1.5%. For all who believe that today did not see about $150 billion of new inflows into stocks alone, this is today’s convergence arb, in which the long leg could be any combination of the AUDJPY and 2s10s30s butterfly, while the short leg is, naturally, ES. Yesterday, the spread closed almost 60% at which point we suggested unwinding. We don’t see why today should be any different, and the positive feedback loop algos should be proven right for once, with absolutely no fundamental validation.

More articles from Zero Hedge….

Zero Hedge

The SSTF has (finally) released its June trading results. June is a big
month for the Fund. Every June they aggregate all of their cash
positions and reinvest the proceeds in newly issued securities with
maturities from one to fifteen-years. There a few observations I would
like to make regarding these results. First a look at the trading
blotter. I will reuse sections of this report later on so don’t get hung
up now on these big numbers.

There were a total of 36 separate transactions during the month. Not a
big deal for your average day trader. But consider the size of these
deals. The total turnover for the month was $612 Billion. That ain’t
hay. The total assets held by the Fund were about $2.6 T so SS turned
over the equivalent of 25% of its book in just one month. Two
observations:

-I constantly see reports in the media on SS that argue that there is no
money in the TF. That the assets are not real. That there is no
liquidity in the securities held by the Fund. That it is a Ponzi
accounting scam. A look at the June results prove that those claims are
all false. The extreme naysayers of SS should look at this and wake up.
These are very real assets. They are liquid.

-From the CBO to other government officials to Wall Street and most
other economists we are getting a measure of the nations debt that is a
function of the Debt Held by the Public. The CBO thinks our debt is 53%
of GDP because they conveniently forget about the intergovernmental
accounts (where SS fits in). The total IG account is $4.5T and has trust
funds that are comprised substantially of special issue treasury
securities.

Both sides of this need to wake up and smell the coffee. These debts are
very real. They are legally as binding as those securities held by the
Chinese Central Bank. When we talk about our debt these should be
included. Our debt is not 53% of GDP. It is 92%. Debate over.

The Fund acquired a strip of newly issues securities with its excess
cash. The maturities range from 1-15 years. As you can see from the
following the entire $270 billion of new investments was set at one
common rate of 2-7/8%. This is the arithmetic average of all Treasury
maturities beyond four years. What this means is that the TF is immune
from the investment death trap of ZIRP. Consider the first investment of
$14.996 billion with a maturity of one year. The fund gets a return of
2-7/8 on that. The fair market rate was just 25bb. The difference on
this one transaction? It comes to a tidy $395mm. Who would not like a
risk free investment and earn 2-5/8 over market? I would love to buy
into that. But this “special deal” is only available to the TFs. Why is
it that they get such a good return?

-I conclude that the TF is costing us much more than just the payroll
taxes that are collected. To get a real sense of the cost you have to
add in the interest. Our economy has to pay that as well. The total
interest tab in 2010 will be ~$118 billion. The average yield on the
portfolio is 4.7%. The recent fair market rate on an eight-year average
life Treasury investment would be about 2.2%. The Fund is enjoying an
above market yield of 2.5% currently. That comes to $63 billion a year.
The formula that sets the interest rates is now 50 years old. It should
be reviewed. It is no longer a viable methodology. Our short term
financial position is being impaired so that SS can “look better” long
term. We are kidding ourselves.

The flip side of this is that the Fund’s % income is declining even with
the formula that beefs up its results. Look at all the high coupon
stuff that has rolled off. The folks at the TF must be sad to see these
bonds mature. They have been living off of this fat income for years.
Consider the $29.7b of 5.5% bonds the Fund has been holding for
fifteen-years. That money was re-invested at 2-7/8%. The difference over
the next 15 years comes to a whopping $800mm per year or a total loss
of revenue of $11 billion. And that is just one small portion. The bonds
that came due and a graph of the interest rates the fund has realized
in the past:

The Fund has projected that this rate will return to 6% on average. I
don’t think they consulted with Ben Bernanke on this. Ben is going to
keep rates at artificially low levels for years. Even though the Fund
benefits from a dumb 50-year old formula their revenues are going down.
In a few years the numbers will be off “plan” and people will be
scratching their heads wondering why.

The TF receives interest from Treasury in December and June. For June it
was $59B. They will get a similar number in December. So for the full
year % will be $118b. The assets of the Fund will rise in the year by
about $80b. This is the fundamental problem with the Fund. They are
losing money in their operations, but still show a growing surplus due
to interest income. But we know that the interest is (A) declining and
(B) it is artificially supported by a half century old methodology.

In June the Fund took in $56.8 billion in payroll taxes. They paid out
$63.1 billion in benefits (includes $4.4 B of RR benefits). This is the
only number you need to know. On a cash basis the Fund is losing
billions every month. For June it was $6.3b. The interest income that
hides this problem is just noise.

For the record; my numbers for July, August and September. It comes to a
shortfall of $21 for the Q. By way of comparison Q3 2007 was in surplus
by $10.6B. And some say the Fund has not “turned the corner”. Another
thing we are kidding ourselves about.

July: +50.9 (PR), -58.7 (benefits). Net: -7.8B
August: +50.9 (PR), -58.6 (benefits). Net: -7.7B
September: +53 (PR), 58.8 (benefits). Net: -5.8B

More articles from Zero Hedge….

Richard Suttmeier submits:

The yield on the 10-Year US Treasury continues to trade around my quarterly pivot at 2.495. A new monthly pivot is 2.562 with my semiannual risky level at 2.249. Gold is trekking towards its all time high at $1266.5 set on June 21st with my semiannual and monthly risky levels at $1260.8 and $1263.8. Crude oil has a new monthly pivot at $74.45. The euro remains below its 50-day simple moving average at 1.2789. The Dow shows a new monthly pivot at 10,164 for September with today’s value level at 9,876. The miss-interpretation of economic data.

Read more…. »

Zero Hedge

As part of the Fed’s latest QE iteration, it has already been made clear that despite initial disclosures that the Fed would stay in the 2-10 Year bound of Treasurys, Ben Bernanke is now also gobbling up the very long end of the curve. For all those who are, therefore, still confused why bonds continue to surge to record levels, don’t be: when there is a guaranteed bidder just below you in the face of the Fed, and who you can turn around and sell to at will, there is no pricing risk. The problem, from a bigger stand point, is what happens when the Fed is actively buying up 30 Year bonds with impunity and the much desired (by the Fed) inflation still does not appear? Well, the Fed then, in Michael Pento’s opinion, will begin to purchase stocks and real estate. And as all those who enjoy comparing the US to Japan can attest, outright purchases of securities by the Japanese government is a long-honored tradition in the ongoing fight with deflation in Japan. However, and as the recent BOJ (lack of) intervention demonstrated, Japan never could do anything with the required resolve, and bidding up one stock here and there would never achieve anything. Which is why in this interview with Eric King, Michael Pento makes the case that as opposed to the occasional market intervention via the President’s Working Group, Bernanke will soon make stock purchases an outright policy of the Federal Reserve as its last ditch attempt to engender inflation before the hundreds of billions of Commercial Real Estate and other bank debt start maturing in 2011/2012. Bernanke is running out of time and he knows it. And once the Fed becomes the bidder of last resort in stocks, all bets are off, as the Central Bank will become the defacto only market in virtually every risky category. And the only safe vehicle, once the market then begins to price in Fed driven asset-price hyperinflation, will be gold.

Pento also provides some perspectives on the Fed’s balance sheet, which he anticipates will expand in a “great fashion”, but a much bigger concern to the recent Euro Pacific Capital addition, is the possible surge in M2: “That base money can expand, M2 which is currently running around 8.5 trillion all the way up to nearly 25 to 30 trillion dollars of money supply and that’s enough obviously to send prices through the roof.” All Bernanke needs to do is light the “alternative asset purchasing” match and all those who wonder what left field hyperinflation could come out of, will get their answer.

Of course, it wouldn’t be a Pento interview without a requisite smack-down, in this case of Dennis Gartman, whose call to sell gold denominated in euros at the very bottom of the recent gold correction needs no further commentary: EUR-denom gold has jumped well over 10% since Gartman said to get out. Pento adds the following: “There is so much misinformation out there, Dennis Gartman was out there saying gold has lost its inflation hedging properties: this is just ludicrous and insane. I can tell you that gold will never lose its inflation lure, and that’s precisely why I’ve stepped up my purchases of gold., I see what the monetary base is doing, I can clearly see Bernanke’s next step to vastly increase the size of the balance sheet and the monetary base. So for me, it’s 100% an inflation hedge.”

Pento also goes into explaining why housing is facing a “deflationary depression,” and a further collapse in pricing, why inflation benefits only those closest to the money, i.e., the banks and the military complex, why it destroys the middle class (we are sure Buffett ca. 2003 could say something about that too… the current, far more senile and captured Uncle Warren, not so much), the impact on discretionary purchases, on unemployment, real incomes, and all other items which tend to “follow the money.”

Lastly, Pento concludes with an analysis of what would have happened had the government allowed the deflationary depression to occur two years ago, without the tens of trillions in bank bailouts. We protracted, and elongated the depression. But instead of having the benefit of falling prices, you have rising prices.” And if Pento is right, the price rise has only just begun.

Full King World News interview here.

More articles from Zero Hedge….

By Karl Denninger, The Market Ticker

As is my usual practice…..

Developments in Financial Markets and the Federal Reserve’s Balance Sheet
The Manager of the System Open Market Account (SOMA) reported on developments in domestic and foreign financial markets during the period since the Committee met on June 22-23, 2010. He also reported on System open market operations during the intermeeting period, noting that the Desk at the Federal Reserve Bank of New York had engaged in coupon swap transactions in agency mortgage-backed securities (MBS) to substantially reduce the number of the Committee’s earlier agency MBS purchases that remained to be settled.

We made sure that those who sold us things they didn’t have didn’t get called on it.  Isn’t that grand?  (PS: What do you call selling something you don’t actually own – and can’t acquire?)

In addition, the Manager briefed the Committee on the System’s progress in developing tools for possible future reserve draining operations. The Federal Reserve successfully conducted two more small-value auctions of term deposits to confirm operational readiness for such auctions at the Federal Reserve and at the depository institutions that chose to participate.

Who were those that "chose to participate"?  Oh yeah, that’s right, we dont’t get actual minutes – what we get is another fraudulently-claimed load of bilge.

There were no open market operations in foreign currencies for the System’s account over the intermeeting period.

…. that we’re willing to admit to……

Staff Review of the Economic Situation
The information reviewed at the August 10 meeting indicated that the pace of the economic recovery slowed in recent months and that inflation remained subdued.

Translation: There was no recovery.  Not now, not before, and certainly not on a forward basis.

In addition, revised data for 2007 through 2009 from the Bureau of Economic Analysis showed that the recent recession was deeper than previously thought, and, as a result, the level of real gross domestic product (GDP) at the end of 2009 was noticeably lower than estimated earlier. Private employment increased slowly in June and July, and industrial production was little changed in June after a large increase in May. Consumer spending continued to rise at a modest rate in June, and business outlays for equipment and software moved up further. However, housing activity dropped back, and nonresidential construction remained weak. Additionally, the trade deficit widened sharply in May. A further decline in energy prices and unchanged prices for core goods and services led to a fall in headline consumer prices in June.

The government lied previously, and still is.  We of course used this as an excuse, and still are.

Private nonfarm employment expanded slowly in recent months. The average monthly gain in private payroll employment during the three months ending in July was small, considerably less than the average increase over the preceding three months.

When adding in the population of new entrants to the workforce, employment did not expand at all, it actually FELL.  But we won’t tell you that, because that’s would be "truth", and we’re allergic.  Severely.  Oh, we’re missing our epipens too.

The unemployment rate moved down in June from its level earlier in the year, and was unchanged in July, as declining civilian employment was accompanied by decreases in labor force participation. Initial claims for unemployment insurance remained at an elevated level over the intermeeting period.

We don’t count people who have given up on finding a job as "unemployed."

The output of high-technology items and other business equipment continued to rise.

Yeah, Intel says so too.  Oh wait….

Indicators of household net worth–such as stock prices and house prices–were little changed, on net, over the intermeeting period. Consumer confidence fell back in July, with households expressing greater concern about their personal finances and the outlook for the recovery.

Our lies are not working as well as they used to.

The housing market, which had been supported earlier in the year by activity associated with the homebuyer tax credits, was quite soft for a second consecutive month in June. Sales of new single-family homes rebounded some in June after their sharp drop in May, but they remained at a depressed level. Sales of existing homes fell for a second month in June, and the index of pending home sales suggested another decline in July.

The government cheese ran out.  Damn.

Inflation remained subdued Deflation accelerated in recent months.

Nominal hourly labor compensation–as measured by compensation per hour in the nonfarm business sector and the employment cost index–rose modestly during the year ending in the second quarter. Average hourly earnings of all employees rose slowly over the 12 months ending in July. Output per hour in the nonfarm business sector declined in the second quarter after rising rapidly in the preceding three quarters. On net, unit labor costs remained well below deflated below their level one year earlier.

In the emerging market economies (EMEs), incoming data generally pointed to a moderation of economic growth, albeit to a still-solid pace, with a notable slowing in China in the second quarter.

China has better liars than we do.  They also use bullets on truth-tellers more often.  (Those in the US telling the truth often have "heart attacks."  Funny coincidence, that….)

In contrast, Mexican indicators suggested that economic activity rebounded in the second quarter after contracting in the first quarter.

The Mexican drug gangs are shooting more people, which is leading to a pickup in demand for guns and ammunition.  This is expected to spur economic activity and reduce competition for jobs.

Over the intermeeting period, investors appeared to mark down the path for monetary policy in response to weaker-than-expected economic data releases and Federal Reserve communications that were read as suggesting that policymakers’ concerns about the economic outlook had increased.

Investors are losing confidence in our lies too.

Reflecting the same factors, yields on nominal Treasury coupon securities fell noticeably on net. Treasury auctions were generally well received, with bid-to-cover ratios mostly exceeding historical averages. Yields on investment- and speculative-grade corporate bonds decreased, and their spreads relative to yields on comparable-maturity Treasury securities declined moderately. Secondary-market bid prices on syndicated leveraged loans rose a bit, while bid-asked spreads in that market edged down.

Net-interest margin is collapsing. Incidentally, this is threatening to expose the naked swimmers among our banks – and their insolvency.

Broad U.S. equity price indexes increased slightly, on net, as generally positive corporate earnings news and an easing of investors’ worries about the potential effects of fiscal strains in Europe were partly offset by concerns about the strength of the economic recovery. Most firms in the S&P 500 reported second-quarter earnings that exceeded analysts’ forecasts.

"Work harder, get paid less, or be fired and we’ll send your job to a slave labor camp in China!" – the new mantra of American business.

Gross bond issuance by U.S. investment-grade nonfinancial corporations rebounded in July from relatively subdued levels in May and June.

There’s always a greater fool….

Prices of commercial real estate appeared to have increased in the second quarter, though the number of transactions was small.

One building sold – from Guido to Guido’, for the purpose of establishing a fraudulent mark on the price.

Nonetheless, commercial real estate markets remained under pressure. Delinquency rates for securitized commercial mortgages continued to rise in June, and commercial mortgage debt was estimated to have contracted by a sizable amount again in the second quarter. However, investor demand for high-quality commercial mortgage-backed securities (CMBS) reportedly was robust, although issuance of CMBS remained muted.

Oh crap – we printed three sentences of truth!

Consumer credit contracted again in the second quarter, as revolving credit continued to decline and nonrevolving credit edged down.

Consumers are done with this BS and are choking on debt.  Having been hosed twice in ten years, they’re refusing to do it again.

Commercial banks’ core loans–the sum of commercial and industrial (C&I), real estate, and consumer loans–continued to contract in June and July.

That’s called "default".

Securities holdings by banks increased substantially in recent weeks.

But the banks are buying stocks!  (Ed: are they using depositor funds to do that, or are they using Fed-printed money?  Either is a problem, no?)

Staff Economic Outlook
In the economic forecast prepared for the August FOMC meeting, the staff lowered its projection for the increase in real economic activity during the second half of 2010 but continued to anticipate a moderate strengthening of the expansion in 2011.

See, we still lie!  Are you going to believe us?

Overall inflation deflation was projected to remain subdued increase substantially over the next year and a half.

Fixed it for ‘ya.

Weighing the available information, participants again expected the recovery to continue and to gather strength everything to go to hell and continue toward Lucifer’s cradle in 2011. Nonetheless, most saw the incoming data as indicating that the economy was operating farther below its potential than they had thought, that the pace of recovery had slowed decline had advanced in recent months, and that growth would be more modest during the second half of 2010 Lucifer had been chortling with glee than they had anticipated at the time of the Committee’s June meeting.

Fixed it for ‘ya.

 

Committee Policy Action
In their discussion of monetary policy for the period ahead, Committee members agreed that it would be appropriate to maintain the target range of 0 to 1/4 percent for the federal funds rate.

I threatened them to get them to all fall in line - as soon as they got to Jackson Hole they started talking though.  Bastards.

Mr. Hoenig dissented because he thought it was not appropriate to indicate that economic and financial conditions were "likely to warrant exceptionally low levels of the federal funds rate for an extended period" or to reinvest principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. Mr. Hoenig felt that the "extended period" expectation could limit the Committee’s flexibility to begin raising rates modestly in a timely fashion, and he believed that the recovery, which had entered its second year and was expected to continue at a moderate pace, did not require support from additional accommodation in monetary policy. Mr. Hoenig was also concerned that these accommodative policy positions could result in the buildup of future financial imbalances and increase the risks to longer-run macroeconomic and financial stability.

Mr. Hoenig has a brain, and what he really expressed is that the economy cannot stabilize until the excess debt is removed, and that can’t happen as long as the FOMC is tampering with the bond market.  Therefore, until rates rise, there will be no recovery.

We don’t dare print that, however.

Yes, this is all tongue-in-cheek. 

Maybe.

More articles from the Market Ticker….

Even though the overnight interest rate has been stuck near zero for 20 months, are there options available to the Federal Reserve or the U.S. Treasury to bring longer-term yields down further? I have been looking into this question with Cynthia Wu, an extremely talented UCSD graduate student. We present our findings in a new research paper, some of whose results I summarize here.

Our starting point was a framework developed by Vayanos and Vila (2009), who interpret the term structure of interest rates as arising from the behavior of risk-averse arbitrageurs. This model is one way to capture formally the portfolio balance channel that Fed Chairman Bernanke indicated is central to the Fed’s understanding of how nonstandard monetary operations might affect the economy. Vayanos and Vila’s framework has previously been applied to our question by Greenwood and Vayanos (2010) and Doh (2010). One of our contributions is to develop specific measures of how the available supplies of Treasury securities of different maturities might be expected to influence the pricing of level, slope, and curvature risk of the term structure. Although I began as a skeptic of the claim that bond supplies would make much difference, we found pretty strong evidence that historically they have. For example, we found that over the 1990-2007 period, we could predict the excess return from holding a 2-year bond over a 1-year bond with an R² of 71% on the basis of the level, slope, and curvature of the yield curve along with our 3 Treasury supply factors.

One of the challenges plaguing this kind of research is the problem of endogeneity. There may be a correlation between bond supplies and interest rates, but is that because bond supplies affect interest rates, or because the Treasury or the Fed are responding to interest rates in deciding which maturities of Treasury securities to sell or buy? Our solution to this problem is to pose the empirical question in terms of a conditional forecast. Suppose you already knew today’s level, slope, and curvature of the term structure of interest rates, and in addition to those values, I tell you today’s 3 Treasury supply factors. How would the latter cause you to change your forecast of next month’s interest rate for any given maturity? Our finding is that the Treasury factors make a statistically significant contribution across the yield curve.

We can summarize the implications of that forecast in terms of the following scenario. Suppose that the Federal Reserve were to sell off all its Treasury securities of less than one-year maturity, and use the proceeds to buy up all the longer term Treasury debt it could. For example, in December of 2006, this would have required selling off about $400 B in bills and notes or bonds with less than one year remaining, with which the Fed could have effectively retired all Treasury debt beyond 10 years. The figure below summarizes the implied average change in forecast for the 1990-2007 period as a result of this change for interest rates of various maturities. Yields on maturities longer than 2-1/2 years would fall, with those at the long end decreasing by up to 17 basis points. Yields on the shortest maturities would increase by almost as much. While our estimates imply that the Fed could make a modest change in the slope of the yield curve, it would not make any difference for the average level of interest rates.

Predicted change in next months yields (quoted in annual percentage points) as a function of weeks to maturity in response to Fed converting all its short-term holdings into longest available maturities, average values over 1990-2007. Source Hamilton and Wu (2010).

We then extended the framework to the case when, as at present, short-term interest rates are as low as they could go. Even though short term interest rates have been near zero since the end of 2008, longer term yields have continued to vary from week to week, as shown in the solid lines in the graph below. Our interpretation is that these fluctuations in longer-term yields come from investors’ beliefs that short-term interest rates are not going to be stuck at zero forever. We suppose that investors attach a probability to escaping from the zero lower bound at various future dates, and that, when we do, short-term rates and the rest of the yield curve will revert to a dynamic behavior similar to that exhibited prior to 2007.

Actual (solid) and predicted (dashed) behavior of selected interest rates, weekly from March 7, 2009 to August 10, 2010. Rates shown (in order from top to bottom) are the 30 year, 5 year, 1 year, and 3 month.

We were then able to describe interest rate dynamics since the beginning of 2009 in terms of the historically estimated parameters along with three new coefficients, which correspond to the average short-term interest rate as long as we’re stuck at the zero lower bound, the average new short-term interest rate once we escape from the zero lower bound, and a fixed probability of escaping in any given week. The red dashed lines in the figure above represent the predicted values from this model. This simple framework seems to do a pretty reasonable job of explaining interest rate movements over the past couple of years.

Moreover, the framework gives us the information we need to assess the effects of nonstandard open market operations under a zero-lower-bound regime. The figure below shows how our model implies that the forecasting relation described above would be different under the zero lower bound. The experiment here is the same as before– the Fed sells off all its short-term Treasury holdings and buys an equivalent amount of long-term debt. However, under the zero lower bound, the effect on short-term interest rates all but disappears as a consequence of investors’ beliefs that near-zero short-term interest rates are likely to persist for some time. Quantitative easing– buying the longer-term securities with newly created interest-bearing reserves– would have the same effect in our framework.

Predicted change in next months yields (quoted in annual percentage points) as a function of weeks to maturity in response to Fed converting all its short-term holdings into longest available maturities. Solid line: predicted response over 1990-2007. Dashed line: predicted response in 2009-2010. Source Hamilton and Wu (2010).

Hence our estimates imply that whereas an asset swap by the Fed could not reduce interest rates in normal times, under the present situation, it would succeed in driving overall interest rates lower. To take an illustration, the Fed’s combined $1.1 trillion in mortgage-backed securities plus $300 B in new longer term Treasury purchases might have succeeded in driving 10-year yields 50 basis points lower than they would have otherwise been.

Although our estimates imply that the Fed could do more than it already has, in many ways the U.S. Treasury is the more natural institution to implement such a policy. According to the theoretical framework that motivated our measures of the Treasury risk factors, the average slope of the yield curve arises from the preference of the U.S. Treasury for doing much of its borrowing with longer term debt. For reasons presumably having to do with management of fiscal risks, the Treasury is willing to pay a premium to arbitrageurs for the ability to lock in a long-term borrowing cost. If the Treasury has good reasons to avoid this kind of interest-rate risk, it is not clear why the Federal Reserve should want to absorb it.

But, according to our estimates, if the Fed wanted to absorb more of this risk, it could reduce the slope of the yield curve further by doing so.

The full paper is available here.

Read more….

Zero Hedge

Former TCW Total Return Bond Fund maven Jeff Gundlach, who since December has been running his own money at OakTreet-blessed DoubleLine, has just moved from “overweight” to “small underweight” on Treasurys. The gradual shift out of USTs is in line with the bond manager’s forecast made in June when the 10 Year was 3.1% that yields would drop another 60 bps to 2.5%. Yet the main catalyst for the selling is driven by the inability of the 10 Year to make a new record low, unlike both the 2 and 5 Years, both of which are trading at historical tights, no doubt facilitated by the Fed’s gradual encroachment of ever to the right of the entire yield curve. As Bloomberg reports: “this “divergence in behavior across the yield curve is very significant,” said Gundlach, who oversees $4.8 billion in assets in Los Angeles as chief executive officer of DoubleLine. “So while the fundamentals for low rates remain compelling, the message of the market action suggests that much of these now widely recognized fundamentals are reflected in Treasury bond prices.” We are confident that given enough time, and enough fiat linen printed, the entire curve will eventually be one flat line as the Fed (and Pimco) are now the marginal buyers of any resort in their attempt to make homeownership with zero money down, an interest-free endeavor. After all, you can’t have growth unless the animal spirits are rekindled, and this kind of direct intervention is the only thing the Keynesian acolytes at the Marriner Eccles building know how to do well. So where is Gundlach investing next:”We moved the proceeds from the Treasury sales into a mix of corporate bonds, including our first allocation to below investment grade corporate bonds.” Of course, with even traditional MBS and UST investors now actively gobbling up HY, we are very concerned that when the inevitable flush in the B2/B space occurs, and it always eventually does, there will be no marginal buyers of anything less than IG. But with a market as broken, technically driven and centrally planned as ours, who even pretends to think about what tomorrow may bring…

More from Bloomberg:

Yields on 10-year notes were 3.12 percent when Gundlach made his prediction on June 23 during a speech at a Morningstar Inc. conference in Chicago. The yield touched a 19-month low of 2.4158 percent on Aug. 25. Ten-year note yields, which fell 5 basis points today to 2.48 percent, reached a record low of 2.04 percent on Dec. 18, 2008.

The notes’ prices tumbled the most since June 2009 on Aug. 27 after Federal Reserve Chairman Ben S. Bernanke said the central bank will provide additional stimulus as needed during opening remarks to central banks at a symposium in Jackson Hole, Wyoming. The two-year note yield touched a record low of 0.4542 percent on Aug. 24.

“This is a long-term bottoming process, which could very well take several weeks or even a few months more to play out,” Gundlach said in an interview. “We moved the proceeds from the Treasury sales into a mix of corporate bonds, including our first allocation to below investment grade corporate bonds since the launch of the Core Fixed Income Fund on June 1,” which invests in different sectors of the global fixed income markets. The fund is up 5 percent since its inception through Aug. 27, he said.

The five-year Treasury note yield touched a 20-month low on Aug. 25 of 1.2775 percent, just 9 basis points shy of its record low of 1.1852 percent, reached on Dec. 17, 2008.

An “underweight” position in Treasuries means that a firm owns a smaller percentage of the securities in its portfolios as is contained in benchmark indexes used to measure performance. “Overweight” means the firm owns a greater percentage.

In the meantime, we are confident that the other major bond powerhouse, Pimco, will be more than happy to bid up everything that Gundlach wishes to part ways with. The former, which is now effectively the Fed lite, has no other choice, than to frontrung and mimic the Fed in every single action, as with over $1.2 trillion in assets, there are just no players of sufficient size left that it can transact with. To say that this will all end in guaranteed tears is an understatement.

More articles from Zero Hedge….