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The Lull Before The Storm: What’s Coming in 2011


Gonzalo Lira

This week – what with Christmas on one end and the new year’s celebration on the other, and everthing in between covered in snow – nothing much is gonna happen: It’s a week that’s about as dead as Dillinger. So I figured I should take stock of where we are – and more importantly, where we’re going.

To me, the biggest macro-economic story of 2010 was Europe: It’s falling apart, and there doesn’t seem to be anything that’s going to stop this collapse.

The second biggest macro-economic story of the year – though not by much – was the successful monetization of 75% of the U.S. Federal government deficit by Ben Bernanke and the Federal Reserve. I use the word “successful” in a morality-free, completely pragmatic sense: Bernanke achieved monetization with minimal market disruption. In fact, a lot of people would argue that QE-lite and QE-2 were not policies of debt monetization – that is how successful Bernanke has been. (Talk about “reality distortion field”! Steve Jobs ain’t got nuthin’ on Benny!)

This “success” has allowed the U.S. Federal government to continue to avoid making necessary, critical budgetary decisions – paradoxically accelerating the U.S.’s deteriorating fiscal situation.

The third biggest macro-economic story of 2010 has been the inexorable rise in commodity prices. Everyone’s been paying attention to silver and gold, but the real story has been industrial metals – especially copper – and agricultural commodities – especially grains – especially wheat – and corn, corn, corn!

To be sure, there were other important stories in 2010 – the Mortgage Mess, Wikileaks, Wayne Rooney. But these three issues – auguries of EMU collapse, successful Fed monetization, and commodity price rises – are the ones that mattered on a macro-economic level this past year.

In 2011, every other financial story will be either a cause or consequence of one of these three issues: Guaranteed.

Now then – to specifics:

Europe

Europe is in deep shit – there’s really no polite way to say it.

Back in the spring of 2010, Greece went down the tubes, as its sovereign debt collapsed in price, and its ability to borrow money from the open markets – and thereby continue to operate – for all intents and purposes ceased.

Then in November/December of 2010, the Irish sovereign debt also began to tumble, as it became increasingly clear that Ireland simply does not have the wherewithal to backstop its disproportionately large – and insolvent – banking sector. Angela Merkel’s less than clever words in an interview (to the effect that Irish debt holders might have to take a haircut) sparked a rise in Irish debt yields, squeezing Ireland’s ability to borrow fresh cash to keep its insolvent banks afloat – thereby creating the need for a rescue package from the IMF, the UK, the European Union, and the European Central Bank.

What was painfully apparent in 2010 was that the Eurozone and the European Union had no mechanism to handle a crisis in one of its member states. Nor is it moving forward to correct the single biggest weakness of the euro scheme – namely, the ability of each member state to issue its own debt.

In May of 2010 – over a decade since the introduction of the euro – the EU finally came up with a mechanism to salvage the broken economy of one of its member states, the European Financial Stability Facility (EFSF). Stability Facility: Even its very name sounds cartoonish and silly – which fits with the general cartoonishness of the European crisis response, first to Greece, then to Ireland.

The concept of the EFSF – at least in theory – is for the member states to contribute to a €440 billion fund. In reality, the EFSF has no money, but rather, it will issue debt. Therefore, what’s really happened in the case of Greece and Ireland is that their bad debts were taken over by the EFSF – so in a sense, no one has been bailed out: Rather, the bad debts have been transferred to the European Monetary Union as a whole.

This is the European model of bailouts: In exchange for handing over their fiscal sovereignty and having tough austerity measures put in place – but without harming a single hair on the head of a single sovereign bond holder – Greece and Ireland had their debts taken over by the EU. In other words, collectivising the bad debts, in exchange for tighter central control from Brussels.

Which is fine – for the smaller countries with their smaller economies, and their weaker political pull.

But what about a big country? What about a country like – oh, I dunno – Spain?

Possible EMU Collapse: What To Pay Attention To In 2011

After the Greek and Irish bailouts, it looks like Portugal and possibly Belgium are up next in this perverse game of musical chairs played to the tune of sovereign debt –

– but these smaller countries are dwarfed by Spain: Spain, as I argued here, is where the European game is really at.

As I pointed out, Spain is twice the size of Greece, Ireland and Portugal combined – Spain is roughly half the size of Germany – Spain has a fiscal deficit of over 11% of GDP for 2010, and a total debt of over 80% of GDP, data here (I am counting the accumulated debt of comunidades autónomas, which is so far 10.2% of GDP and steadily rising; data here) – Spain has an unemployment of over 20% –

– in short, Spain is trouble.

Not “Spain is in trouble” – that’s obvious, but that’s not my point: Spain is trouble. Trouble for the German banks that own so much of the Spanish debt. Trouble for Germany, which is propping up its insolvent banks (What, you think German politicians are any less craven than American politicians?). Spain is trouble for the European Union, for what a German banking crisis might mean for the EU as a whole and as an institution.

More than anything, Spain is trouble for the European Financial Stability Facility, because Spain is too big to be saved – and there’s really no way to finesse that hard fact.

You know what a lynchpin is? Actually, I didn’t – I had to look it up. According to the dictionary, a lynchpin is “a pin passed through the end of an axle to keep the wheel in position”. Hence the figure of speech: Without a lynchpin, the wheel comes off, and the whole vehicle crashes.

In the case of Europe, the lynchpin can come off awfully fast – think of Ireland. A few impolitic words from Angela Merkel, and suddenly the Irish bond market panics. Suddenly, Ireland is teetering on the brink of insolvency, unable to meet its funding needs. And that was Ireland – all due respect to those wonderful people, but we’re talking a GDP of a paltry $227 billion. Ben Bernanke takes a morning dump bigger than that. What’s Ireland’s $227 billion when compared to Spain’s economy of $1.5 trillion?

Spain:

During 2011, Spain will be the flash-point – so you want to keep one eye on Spanish sovereign bond spreads, and one eye on Brussels:

When Spanish debt spreads over German bunds creep into the 3.5% to 4% range, you know trouble is coming. And when the Spanish spread decisively crosses 4.25% over the German 10-year, then you know trouble’s arrived – and it won’t be leaving town ’til it’s had its chance to run riot in the streets.

How the EU and the ECB handle an eventual Spanish sovereign debt crisis will determine the very future of the European Union.

Because there will be a Spanish sovereign debt crisis – it’s inevitable. The Spanish balance sheet is not improving fast enough, even with so-called “austerity” measures, because even though the Spanish government might be cutting spending, the comunidades autónomas – roughly analogous to states or regions – are expanding their budgets in order to take up the slack, and thereby increasing the Spanish deficit. Don’t believe me? Check the figures I just cited.

So when Spain goes into crisis – which should take place no later than August 2011, and perhaps as early as this coming March – the European Union’s collective and institutional reaction to this crisis event will determine whether a smaller, healthier European Monetary Union continues to exist, or whether the whole concept of EMU is ripped to shreds by events.

If the EU and the ECB are clever, and brave, and humble in the face of failure, then they’ll expel Greece, Ireland, Portugal, Spain and Italy from the European Monetary Union. The euro will remain the currency of the stronger economies – France, Holland, Germany – while the weaker economies will go back to their original currencies, and immediately devalue so as to kickstart their economies.

If, however, the European Union and European Central Bank leadership proves to be stupid, cowardly, and arrogant – as is very likely, considering their confused, self-defeating actions and reactions to the Greek and Irish crises – then there will be some sort of European-wide convulsion, when the bond markets panic, and leave Spain locked out of any funding.

This is the key event of 2011: Whether the European Monetary Union survives. Unless Brussels gets its collective shit together and realizes it has to cut the weaker economies loose from the euro, odds are high the euro goes the way of the dodo.

The U.S. Fiscal Situation – Local, State and Federal

There is a limit to sympathy: You can feel sorry for someone – but only up to a point. Insofar as the United States’ fiscal situation is concerned, that point has been reached, at least for me: I can no longer feel sorry for the American people.

Americans want more services and entitlements, but with less taxes – and then they’re all surprised when their local, state and Federal governments cross the edge of insolvency, and into the nightmare land of feverishly staving off bankruptcy.

During 2010, the Federal government debt finally crossed the 100% of GDP mark – and continued rising non-stop. Actually, the debt’s growth accelerated. Why? Because the Bush tax cuts of 2001 – implemented when there was an expectation of surplus, with clear sunset provisions, and no massive war expenditures – were extended by the mindless Republican Congress and the spineless President, Barack Obama.

So the U.S. Federal government will continue to add to the debt, at the rate of 10% per year for 2011, 2012, 2013 and 2014, according to the CBO.

Some might argue with the 2013 and 2014 extrapolations – okay, fine, I’ll concede them: But that still leaves the U.S. Federal government with a debt burden of 120% of GDP by 2012 – those are Greek levels of debt. And even if by some miracle tax receipts increase after 2012, so that the deficits in 2013 and 2014 are not 10% of GDP, what will they be? 7% of GDP? Maybe even 5% of GDP? Whoop-dee-fucking-doo – so total debt by 2014 will be only 130% of GDP, instead of 140%.

And that’s not counting the State and Local governments.

In late 2010, we finally started to notice something which has been festering for years, like one of those yucky worms that winds up eating your brains and driving you mad: The financial condition of the U.S. States and municipalities – they’re bankrupt.

For fiscal year 2010, the states’ combined budget shortfall is $191 billion. Of that figure, $68 billion is offset by the Recovery Act – Obama’s stimulus. Currently, the 2011 combined deficit of the States will be in the neighborhood of $160 billion – but that doesn’t seem credible, considering the ongoing unemployment. Regardless, $59 billion of those will be offset by the Recovery Act – which still leaves at least $100 billion up in the air. (Source for figures is here.)

However you look at it, the States have a huge collective hole in their budgets. And this hole is going to get worse, before it gets any better – just like the Federal government’s massive yearly deficit.

Which brings me to Federal Reserve policy in 2010 – specifically the announcement and implementation of further rounds of “Quantitative Easing”.

Call it QE, call it “liquidity injections”, call it “interest rate stabilization”, call it “Fed balance sheet expansion”, call it “monetary accomodation” – whatever clever name you give it, it’s basically money printing, plain and simple: The Federal Reserve “implements” QE by simply creating money out of thin air, then going out and buying bonds with that new money. Actually, it’s even better than printing money – no bothers with printing presses and such.

There were two rounds of QE in 2010: QE-lite in the early summer, whereby the Fed reinvested the excedent of it Mortgage Backed Security holdings into Treasury bonds, which will total between $200 and $300 billion between August 2010 and August 2011; and QE-2, whereby the Fed began purchasing Treasuries directly, in $75 billion monthly increments over the eight months between November 2010 and June 2011, Benny and the Fed reserving for themselves the right to continue – or expand – their Treasury bond purchases as the drones as the Eccles Building see fit.

Now, why did Ben Bernanke and His Federal Reserve Fools implement QE-lite and Quantitative Easing 2? The (mainstream) answer is, As a way to prop up the U.S. economy by keeping interest rates low via liquidity. The (mainstream) reasoning is, By keeping interest rates low, Benny and the Fed want to encourage borrowing, and thereby reactivate the economy. Which is fine, as analyses go.

But let’s ask a different question – an It’s a Wonderful Life counterfactual history question:

If Benny and the Fed had not been there to buy up Treasury bonds via QE-lite and QE-2, what would the U.S. Treasury Department have had to do, in order to fund the Federal government?

In other words, Would the Federal government have been able to finance itself without Federal Reserve purchases? Without QE-lite and QE-2?

It all depends on the numbers: What’s the Treasury shortfall, and what’s the size of QE-lite and QE-2.

Well – and this is just back-of-the-envelope numbers – the Federal government deficit is about $1.3 trillion. Meanwhile, between August 2010 to August 2011, QE-lite ($200 to $300 billion) and QE-2 ($800 billion) will add up to at least $1 trillion in Treasury bond purchases by the Federal Reserve.

So . . . a $1.3 trillion shortfall . . . and $1 trillion in money printing . . .

Now you get the picture – in 2010, the Federal Reserve successfully began monetizing over 75% of the U.S. Federal government’s yearly deficit.

Not only that, they did it with minimal market disruption – and in the case of the equities markets, Fed monetization actually improved those markets: Just like really expensive make-up applied to a dead guy, Bernanke’s monetization gave a false sense of corporate health and vigor to the stock market.

Bernanke’s successful monetization of the bulk of the U.S. Federal government deficit in 2010 was not a one-off: It will continue unabated for the foreseeable future – horrible public policy tends to follow Newton’s laws of motion.
That was the story of America’s finances in 2010: The United States officially became a Banana Republic – with nukes.

American Insolvency, and The Morphine of QE: What To Pay Attention To In 2011

The upshot of the Fed’s successful monetization has meant that politicians on Capitol Hill and Pennsylvania Avenue have not had to make any real budget decisions: Because of Bernanke’s “success” with deficit monetization, he has created the conditions whereby the American political leadership can irresponsibly postpone the fiscal Day of Reckoning.

This will have the pernicious effect of unleashing positively huge Federal government spending during 2011.

Look at the evidence: The budgetary questions in Washington are not either/or – they are both/and: Stimulus spending and Bush tax cut extensions and never-ending wars and health care reform and the creation of a police-state. The clowns in Washington have been able to eat their cake and have it too, with nary a thought as to cutting spending.

Ben Bernanke’s successful monetization of 75% of the new Treasury debt issuance is the direct cause of this policy mentality.

It’ll only be a matter of time before the bankrupt States take advantage of this both/and mentality – and in no time at all, the political pressure from the States to have the Federal government bail them out will become an overwhelming clamor: Especially as pensions – and therefore pensioners, who always vote – become increasingly affected.

Therefore – as a direct byproduct of Bernanke’s “successful” monetization of the U.S. Federal deficit, and the resultant lack of need on the part of the political class to make true budgetary decisions – I am confident in predicting that in 2011, there will be another round of “stimulus”.

Don’t act so surprised: The State budget bailout package will be a “little” stimulus in the $400 to $500 billion range – but it will be explained away as being both “necessary” and “targeted”, with the explicit aim of propping up the bankrupt States and municipalities. This “targetting” will make it politically popular, and therefore insure its passage.

Now, the Fed’s monetization of the deficit should have some incidence on the Treasury bond market – shouldn’t it?

Here – I confess – I’m at a bit of a loss:

On the one hand, Treasury bond yields ought to rise, as the Federal government continues to spend like there’s no tomorrow, and slowly but inexorably positions itself to take over State and municipal liabilities, especially pension liabilities (which is what’s really killing the State balance sheets).

On the other hand, since the Federal Reserve is the buyer of 75% of the debt the Treasury Department issues, the Fed ought to be able to squeeze yields whichever way it wants to – which is exactly what it seems to have done: During 2010, the 10-year Treasury bond yield fluctuated between 2.41% (in October) and 4.01% (in April); today as I write it’s at 3.50% even. (Source is here.)

This would seem to prove that the Fed has the yield curve well in hand – therefore, if this really is the case, then the Treasury bond market is useless as a sign of anything. Just like the equities market, Treasuries are a rigged game that signify nothing.

What asset class is reacting more or less rationally to what has been going on in Europe and the United States? Commodities.

Commodities

Commodities rose drastically all throughout 2010: Every single commodity class, every single one of them rising by double digit percentage points – at least.

You can talk to me about wheat rising because of wildfires in Russia, oil rising because of the BP spill in the Gulf of Mexico, copper rising because of the trapped miners in Chile, silver rising because JP Morgan tried to do like the Hunt brothers, gold rising because a lot of Chinese want gold for their teeth fillings instead of porcelain, corn rising because Martha Stewart and Nigella Lawson simultaneously declared it their favorite ingredient –

– or I could argue that commodities of all classes are rising because the markets are afraid of Treasury bond weakness and continued irresponsible monetary policy, so they’re looking for a safe haven to replace Treasuries.

Occam’s Razor teaches us to always pick the simpler explanation. Commodities of all classes have been steadily rising – is it because a whole host of various causes have led these myriad commodities all to rise?

Or is it because a single common cause is driving them all up?

Now, I think that commodities are rising because of market fear of the U.S. fiscal. I can argue that position from the commodities’ side of the equation – no sweat. But I just can’t prove my case when I cross over to the Treasuries’ side.

I can’t prove it because there has not been the movement in Treasury bonds which would signal that that is the case. I could point to Treasury yields rising 100 basis points since the October – but that’s a weak-ass evidence, even if you deign to call it “evidence”. A decisive break-out in yields above 4% on the 10-year over the next two-to-three months – that would be sort of compelling. But a drift up from 2.5% to 3.5% at the end of the year? That’s nothing.

My own thinking is, the reason there hasn’t been a drastic, unequivocal fall in Treasury bond prices is because of the aforementioned Fed grip on yields: It is neither the Fed’s intent nor in its interest to have Treasury bond yields widen. What with a 75% market position in new debt issuance, it ought to be a snap for Benny and the Fed to keep yields low.

Therefore, I think that market participants are going into commodities for safe haven, even as they are exiting Treasuries. I do not think there is a correlation between commodities’ rise and equities’ rise: I think equities are the speculative play, with the market riding the bubble Bernanke is blowing, whereas commodities are where the market is going as the safe haven play. Strange but true – all because of Bernanke’s manipulation of the Treasury yield, and cornering of the Treasury market.

I think this is happening – but I hate to rest my argument on such an inference, a teleological inference: I sound like a fucking conspiracy theory windbag – “The Fed is doing it! The Fed is manipulating T-bond prices! The Fed is behind The Conspiracy!” Fuck that bullshit – but then again, that’s what it looks like to me: The Fed manipulating the Treasury bond yields to the point where they sit on their hind legs and beg for a crunchy cookie.

Ultimately, for this discussion, it doesn’t really matter why commodities have been implacably rising over the last 12 to 18 months – the fact is, they have been rising. So let’s pay attention to that.

Commodity Price Rise: What To Pay Attention To In 2011

I know I have the reputation for being the crazed hyperinflationista – but you don’t have to buy any of my dollar-hyperinflation arguments to acknowledge the fact that, a., commodity prices have experienced a sustained and enormous rise in their prices, and b., this sustained rise in the prices of commodities will inevitably hit consumers at all levels of the economy.

Therefore, I would expect food, heating oil and gas prices to rise considerably over the winter of 2011 – that is, now. This will be a knee to the ‘nads of the American economy – indeed, to the world economies.

There’s really not much more to say, about the issue: A sharp rise in consumer spending on essentials would shove the American and world economies firmly back into recession, this time potentially with negative growth.

What happens after that? It depends on the fools at the helm of the good ship S.S. Depression II.

Bottom Line in 2011

My thinking is, the EMU situation will come to a head this year, likely before the summer, and it will be because of Spain.

As to commodities, their strong, steady rise in price will reach the wider economy starting this winter, and shove it down into a recession, likely deeper than the last one. (Possibly – even likely – this slow-down will trigger the Spanish crisis.)

The wild card in this trio is Bernanke and the Fed: Extend QE-2 indefinitely, as they’ve hinted, or grow some balls and force the Congress, the White House and the political establishment to get serious and cut spending? No surprise, my money is the Eunuchs of the Eccles Building extend QE-2, and continue with their 75% monetization of new Treasury issuance.

So bottom line: It’s looking like 2011 is gonna suck. But hey! At least two of these three story-lines are gonna come to their respective climaxes this year – so 2011 might well suck, but at least it’ll be exciting!

(I take my cheer where I can find it.)

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