Do Central Bankers Dream of Endogenous Sheeple?

While your blogger is mending from a rather bad cold compliments of his brood of young dependents, they being the reason for working and worrying as hard as we sometimes do, we are pleased to present an extended excerpt from a favorite publication targeted at the Central Banking crowd, appropriately named Central Bank News.

Central bankers seem to be an affable group of fellows. Clubbable, as the British might say. A bit on the reserved side, their cocktail parties must seem like Economic Department soirées, without the occasional pleasant-on-the-eyes graduate assistant. Efficient, bureaucratic types such as T. S. Eliot must surely have had in mind when writing The Lovesong of J. Alfred Prufrock.

"...I am not Prince Hamlet, nor was meant to be;
Am an attendant lord, one that will do
To swell a progress, start a scene or two,
Advise the prince; no doubt, an easy tool,
Deferential, glad to be of use,
Politic, cautious, and meticulous;
Full of high sentence, but a bit obtuse;
At times, indeed, almost ridiculous--
Almost, at times, the Fool."

The stuff of good bureaucrats and effective military staff, with a touch of the common mailman. Excepting embellishment that indolent recuperation has allowed, this is verbatim, as those-who-know have written it. You can't, and really do not need to, make this stuff up.

Central Banking Publications
29 January 2008

"We are not panicking, are we?" ask the central bankers. (They don't KNOW yet? - Jesse)

Ben Bernanke has come in for a lot of stick for allegedly panicking in the face of stock market collapses but other central bankers are not acquitting themselves very well either.

Many of them were on duty – but off the record – at Davos last week. Messrs Trichet of the ECB, Geithner of the New York Fed, Carney of the Bank of Canada, Knight of the BIS and a gaggle of others. All stressed the extreme gravity of the situation. But they seemed completely at a loss when it came to policy responses. (Let's see, shall we prevaricate and cut rates, or jawbone and cut rates? - Jesse)

It must be better to cut rates decisively now, said one, even if we have to raise them again later. The costs of precipitating a banking collapse are so horrendous they far outweigh the risks of a little increase in moral hazard and the risk of stimulating inflation. Others nodded sagely. (Collapse? OMG, the Wall Street bonus money was at risk! - Jesse)

The old system that they thought they understood and to a degree managed has gone, said another. “Everything is on the table”; “the extent of this crisis is very far-reaching”. They welcomed initially the repricing of risk but this has gone far beyond that with the losses of the monoline insurers put at up to $150bn. (Everything? - Jesse)

Faced with what threatens to become not just a credit crunch but the biggest banking crisis in a generation, all they have are their poor little interest rate tools. They are all one-club golfers, after all. No wonder there is a new mood of humility about. (Bet me - Jesse)

Bernanke under fire

When at its emergency video conference convened by Ben Bernanke at 6 pm on Monday 21 January, the Federal Open Market Committee decided to lower rates by 75 basis points to 3.5%, the biggest single cut since 1982, it took the decision “in view of a weakening of the economic outlook and increasing downside risks to growth.”

Ed Yardeni, a well-known Fed watcher, says the FOMC statement should have read: “The Fed chairman panicked on Monday… He convinced all of us to vote for the rate cut except cranky old Bill Poole.”

Accusations of panic came from George Soros, the FT, The Economist and many other quarters. And far from cheering markets, only a few days later the Fed came under pressure to cut again by at least another 50 basis points at its regular meeting. What is going on? (Neo-Keynesians are such rate cut sluts - Jesse)

The first big cut came at the end of a day which saw shares in Asia and Europe plunge as investors dismissed President Bush’s plans for a fiscal boost, unveiled on Friday, 18 January, as largely irrelevant. After the overnight losses on Asian exchanges, European bourses followed suit. On January 21, The FTSE 100 lost 5.5% to 5,578, its biggest drop since the World Trade Centre attacks. the DAX was down 7.2% to 6,790 whilet the CAC 40 tumbled by 6.83% to 4,744.

The Fed top brass – people like Don Kohn and Tim Geithner – knew full well that they would be accused of a knee-jerk reaction to the markets, validating the growing view that Bernanke was following Greenspan in holding monetary policy in thrall to a Wall Street standard. But they were driven to act by fear of a cumulative and rapid collapse. ("Uh, can we have a heads-up for the next imminent collapse? - Jesse)

Yet it later transpired that the global stock market rout of 21 January may well have been triggered, not by fears of a US downturn as by the actions of one bank – Société Générale of France – as it frantically sold shares to unwind positions entered into by its rogue trader Jerome Kerviel in the course of accumulating losses initially put at €4.8bn ($7bn). (Le cover story? - Jesse)

Informed of this belatedly by the Banque de France, the Fed somewhat lamely insisted that they would have done the same if they had known at the time. (Yeah, and next time we'll tell mom. - Jesse)

What price central bank cooperation?

Central bankers were just breathing a collective sigh of relief that over Christmas and the New Year the collective action to relieve market tensions announced on 12 December had actually succeeded. Then they were hit by a new phase of the crisis – the sudden deterioration in the economic outlook for the United States, the stock market collapse, the SocGen affair, the monoline insurance crisis and widening losses at leading banks. ((But meanwhile the Fed was telling US 'all is well?' - Jesse)

Christian Noyer, the governor of the Banque de France, might say he is “not at all worried” about Société Générale, despite it falling victim to the biggest fraud in banking history. (Its only money. Yours! - Jesse)

But when the French central bank admitted that it had known about the fraud since the weekend (19-20 January), there were raised eyebrows in other central banks. Why weren’t we told?

Noyer’s late call to the Fed – and to how own government

On Monday 28 January Christian Noyer admitted that he was informed of the crisis on Sunday 20 January but delayed informing his government until the following Wednesday because he wanted to avoid the danger of leaks as the bank sold the position on the market. (Cherchez le Goldman Sachs. - Jesse)

Moreover, he insisted that SocGen’s actions in selling its positions had no influence on the Federal Reserve’s decision: “I consider that this affair has nothing to do with the monetary policy of the Fed,” he said. “It was a striking action but one that they took based on their judgment of the economic situation in the United States and so has nothing to do with European markets.” (Psych! - Jesse)

“The Fed does not decide its monetary policy actions, particularly not its exceptional ones, because of the situation on European markets in one day. That’s nonsense.” Thus central banks have started the year on the back foot, increasing moral hazard and giving a public demonstration of how not to cooperate. (Life imitates high school. - Jesse)

Sarkozy/Lagrande to lead calls for tighter regulation

When in doubt, call for more regulation. Inevitably, continental central bankers and politicians have seized on the banking crisis to call for more regulation. Noyer has already highlighted three areas in which the regulation of rating agencies needs to improve in the wake of the credit crunch: the degree of transparency in rating methods and the overall role of rating agencies in the securitisation process; whether to change the metric used for rating bonds and structured products and introducing a specific rating for liquidity risk. (Non-competitive! We risk losing important financial business to better organized crime - Jesse)

But regulation of ratings agencies and hedge funds are seen as yesterday’s agenda. Newsmakers expects France to use its presidency of the EU in the second half of this year to press hard for much greater harmonisation of financial regulation in the EU, including London…” (les renegade roast-boeufs, les vaches folles. LOL - Jesse)

Sovereign wealth funds hit back

Heads of the top sovereign wealth funds from the Gulf states, Russia and other emerging markets were in fighting mood in Davos.

Leading the calls for tighter regulation and codes of conduct was Larry Summers, the former US treasury secretary. What would happen in a 1992-type situation, he asked, if SWFs were involved in speculating against a currency as George Soros speculated successfully against the pound? It would create intolerable diplomatic tensions. We need ex ante assurance that this type of situation will not happen. That is why we need a code of conduct. (The IMF and World Bank have exclusive franchises for that - Jesse)

Not so, retorted the funds. We have always been and remain responsible investors. We do not need any of your codes of conduct imposed on us.

On the contrary, it is up to you in the heartland of your famous capitalist system to get your act together. You have lectured us for decades on the need for tighter bank regulation, anti-money-laundering rules and so on and now you are in a bigger mess than we ever got ourselves into. It is your banks who are coming cap in hand to us because they made such a mess of their business under your much-touted regulatory regimes. Get your own houses in order…. (After all we have stolen from you, and this is the thanks we get? - Jesse)

It is the revenge of the emerging markets."

Daily coverage of general central banking developments is available to subscribers through our website: Central Bank News

In Luke 16:19-31, when the beggar Lazarus dies he went to Heaven, while the rich man, Dives, went to Hell. Dives wanted to warn his brothers and asked Abraham if Lazarus could be sent back to tell them. Abraham refused. "If they hear not Moses and the prophets, neither will they be persuaded, though one rose from the dead."

What more can we say? Sleep well.

Crash: the Rally that Fails as Hallmark of Major Market Dislocations

Market dislocations (aka crashes) are among those things that are not well defined and difficult to understand, especially for those who have never experienced them directly. But like true love, you know it when it happens and don't tend to forget it.

Simply put, a market dislocation is when a sustained bubble (eg. Ponzi scheme) begins to wobble and fall apart, and the realization comes generally that it is collapsing, with all participants remaining invested heading for the exits in a mass panic. It can be in real estate, financial assets, shares in a venture or cash flows from a project, stamps, matches, and even tulip bulbs.

These patterns of collapse tend to have a common framework. The challenge is separating a market dislocation from an ordinary correction. In our work, we have arrived at some hallmarks that characterize a market dislocation, which as you know is always a low probability event.

The setup for a market dislocation begins with a sustained increase in price (the Ramp) to a significant new high (the Top) over a period of time which is multiples of the subsequent decline. US equity markets saw such a top late last year in October. From there the first assault in confidence occurs as profit taking, creating a decline more significant than the declines serving as corrections up to the Top. It is usually an initial decline of ten percent or greater. Often we get an uncharacteristic decline

The rally back from this first low not exceed the Top (obviously) and is referred to as the Second High (with the TOP being the first or highest high). It can be equal to the TOP.

The next low must set a lower low, ruling out a double bottom. It is preferable but not necessary that the Lows be noticeably lower than the Highs. The lower the lows, the more likely that the dislocation will mark the start of a bear market rather than just a market clearing event like the Crash of 1987.

It is not uncommon to reach this point, and the vast majority of times will merely be an A-B-C correction. The next step is a critical differentiator, the Failed Rally. If there is a bounce of 2 to 5 percent that fails to gain momentum, and drops back to a lower low, and fails to rally again from there, it sets up a higher than normal probability of a market dislocation which we define for our purposes as a market decline of 30 percent or greater within a one year period.

If you have been paying attention, you may have noticed that we never spoke about timeframes. How many days from the first Top to the first low, and then to the second high, and so forth? We have this information in our database, but we do not use it in generating the CrashTrak model per se. We consider market time to be highly relative and variable. What it may have taken a day to be communicated to the broader market participants in 1929 may have taken only an hour in 1987, and only minutes or even seconds in 2008. So we have seen a significant increase in the reaction time of markets which would almost certainly affect timeframes.

Second, and mostly overlooked, the responses of market regulators and the financial authority have increased in power and sophistication, and in some ways remarkably so. This is not your grandfather's Fed or market anymore. They are smarter and more capable of distorting and forestalling events. We believe that they cannot stop a primary trend, but they can delay or defer it, and sometimes significantly so.

Lastly, we are seeking to apply this model to a wider variety of market dislocations. Everyone knows about 1929 and 1987, but what about 1932, 1937, and a slow grind like 1973-74? We don't think ignoring the time periods is all that revolutionary, especially if you consider the long standing use of Point and Figure charts, which are also based on patterns of price action. Still, we have to admit we do keep an eye of sorts on the dates, and map out what we call windows of opportunity. We're in one now, and will be so until about mid-February.

Even in its most high probability moments relatively speaking, a market dislocation is still a very low probability event. We want to make this very clear.

Let's see what happens.

Société Générale - The Lone Trader Theory

After a rogue trader cost the French bank €5 billion, many are left to wonder about the lucrative but risky equity-derivatives business. Is this all a clever cover story for 'les SIVs de merde,' or did a lone bank trader, not even a central banker, wielding his Mannlicher-Carcano trading platform, almost take out the entire world's financial system without a proper bonus, a golden parachute, or even a corner office?

After a rogue trader cost the French bank €5 billion (equivalent 7.1 billion americanos), many are left to wonder about the lucrative but risky equity-derivatives trade. One of the biggest frauds in financial-services history apparently was carried out by a 31-year-old trader in Société Générale's Paris headquarters, whom multiple news sources have identified as Jerome Kerviel. The trader "had taken massive fraudulent directional positions"—bets on future movements of European stock indexes—without his supervisors' knowledge, the bank said. Because he had previously worked in the trading unit's back office, he had "in-depth knowledge of the control procedures" and evaded them by creating fictitious transactions to conceal his activity.

The fraud was discovered Jan. 20, a Sunday, which meant Société Générale had to start unwinding the positions Jan. 21 just as global equity markets were tanking on fears of a U.S. recession. "It was the worst possible time," says Janine Dow, senior director for financial institutions at the Fitch (LBCP.PA) ratings agency in Paris. SocGen, which also announced a nearly $3 billion 2007 loss related to U.S. mortgage-market woes, has had to seek a $5.5 billion capital increase and could even become takeover prey.

Previously, Double-Digit Growth

While those facts seem fairly straightforward, a host of troubling questions still need to be answered: How could SocGen, which ironically was just named Equity Derivatives House of the Year by the financial risk-management magazine Risk, have failed to detect unauthorized trading that it acknowledges took place over a period of several months? Do banks need to tighten the controls put in place after rogue trader Nick Leeson brought down Barings Bank in 1995? Or is the red-hot business of equities-derivatives trading just too tricky to control?

SocGen's equities-derivatives business, the biggest at any institution in the world, has posted double-digit growth the past eight years and until now has been hugely profitable. Fitch estimates the business generated about $1.7 billion in profits during 2006, or about 20% of the bank's net earnings. Backed by elaborate algorithmic models, trading instruments with exotic names such as Himalaya and Altiplano have generated an average 40% return on equity for the bank, more than twice the rate for its retail banking business.

Yet SocGen's derivatives operation is relatively small, with fewer than 2,500 employees including about 300 traders and roughly 750 middle- and back-office employees, according to a 2006 investors' presentation by the bank. The rogue trader apparently spent several years in a back-office job before realizing a long-held dream of moving to trading.

An Inevitable Scandal?

Maintaining strict separation between inherently risky trading activities and careful back-office controls is a key tenet of banking regulation, says Axel Pierron, a Paris-based consultant with Celent, a financial-services advisory group specializing in information technology. But, Pierron says, "In derivatives trading, there's not as strong a separation between trading and back office as in other parts of the bank." Letting employees move from the back office to the trading floor is uncommon but generally not prohibited by banking regulations or banks' own rules, Pierron and other banking specialists say.

Some risk-management experts contend that such a scandal was inevitable, given the global boom in trading exotic securities. "This stuff happens more than people may like to admit," says Chris Whalen, director of consulting group Institutional Risk Analytics. Banks increasingly are moving away from traditional banking into riskier trading activities, he says. SocGen's problem was "a rogue business model, it's not a rogue trader."

Yet others point out that SocGen's risk-management practices were some of the best in the industry. "The control procedures that SocGen had in place are much better than those at Barings," says Richard Portes, a professor at the London Business School. "Every bank will be reevaluating their procedures, but it's not clear if there are ways to improve them. There hasn't been a broad failure of risk management across the board, just one guy who knew how to beat the system."

Although SocGen is the global equity derivatives leader, other banks are heavily involved in the business, including the global No. 2 player, crosstown rival BNP Paribas (BNPP.PA), German giant Deutsche Bank (DB), and New York-based Goldman Sachs (GS). The French banks got a huge head start in equity derivatives because of sophisticated mathematical models developed at French universities. Now, the math for SocGen is looking ugly indeed.

Next Week: The CFTC and SEC: Making Société Générale Look Like NASA

Hat tip for the original story to BusinessWeek: Société Générale's Fraud: What Now?

Hat tip for 'creative' input to: rasputin, meg-abear, sean_of_the_zurich_gnomes, rodd saito, and denverdave.

High Priests of Finance Review Société Générale Markets Fraud

From Times Online
January 24, 2008

Société Générale hit by €5bn trading fraud
The French bank disclosed today that a rogue trader had defrauded it of almost €5 billion, prompting it to seek emergency funding

Patrick Hosking, Banking and Finance Editor

The French bank Société Générale stunned financial markets today by revealing that it had been the victim of one of the largest frauds by a rogue trader — losing four times as much as Nick Leeson, the man who sank Barings.

The second-biggest French bank said that it had lost €4.9 billion (£3.7 billion) as a result of the rogue trades by a Paris-based trader who concealed his positions through "a scheme of elaborate fictitious transactions".

SocGen was forced today into an emergency €5.5 billion capital-raising to shore up its ravaged balance sheet.

It said that it was in the process of dismissing the unnamed trader, who had "confessed to the fraud".

Daniel Bouton, SocGen's chairman said today that "four or five" of his managers and supervisors had resigned and a legal investigation was now taking place.

An offer from Mr Bouton to resign was rejected by the board.

Mr Bouton apologised to shareholders and said, “This was a lone man who built a concealed enterprise within the company, using the tools of Societe Generale, and who had the intelligence to escape all control procedures."

The fraud appears to be one of the biggest in history, dwarfing the £827 million lost by Mr Leeson, whose rogue trading led to the collapse of Barings in 1995.

The trader had been with the bank for about six years and was a relatively junior employee. According to Mr Bouton, he was paid less than €100,000 including bonus, a small wage for anyone in investment banking.

"He was trading relatively small positions," said Mr Bouton. "He was at the lower end of the scale."

SocGen said the rogue trades - effectively huge bets on European stock markets going up - were placed in 2007 and 2008 but hidden from managers. They were first discovered on Friday evening after a "fishy" trade made in December was investigated.

The bank took the first three days of this week desperately attempting to unwind the positions in what proved to be hostile conditions as markets plunged. If they had gone up, the positions might have made gains for the bank, Mr Bouton said.

As it was, they turned into "gigantic and collossal" losses.

Analysts said SocGen's unwinding of the massive rogue positions on Monday would have contributed to the violent slump in share prices and may therefore have played a part in the shock decision by the US Federal Reserve to slash American interest rates.

"There's a very strong link between the equity futures market and the cash equities market," said one equity strategist at a major bank. "It may have influenced Fed thinking."

The trader managed to conceal his positions through his knowledge of the administrative side of the bank, "the middle office", where he worked for three years until 2005.

The bank said: "Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle office, he managed to conceal these positions through a scheme of elaborate fictitious transactions."

SocGen described the fraud today as "exceptional in its size and nature".

The Mother of All Bull Markets

An absolutely amazing chart, if you think about it, and its implications. Recall that as the price goes up, the yield comes down.

Yes, there is a double entendre in that title.

US recession, Fed Funds Cut to 2.25%

NEW YORK, Jan 22 (Reuters) - UBS now sees the United States in a recession in the first half of 2008, as the persistent housing slump and financial market woes have spread into the broader economy, the investment bank said on Tuesday.

UBS also revised its forecast on how far the Federal Reserve would slash the key federal funds target rate to 2.25 percent later this year in a bid to revive growth.

U.S. gross domestic product is expected to contract 1.0 percent in the first quarter and 1.5 percent in the second quarter before growth in the second half of the year, UBS said in a research note on Tuesday.

Meanwhile, UBS said the Fed would lower the fed funds target to 2.25 percent before the end of the third quarter, compared with its earlier forecast of 3.25 percent.

The bank said in a research note that it does not expect the U.S. central bank to opt for an intermeeting rate cut "without a crash in the equities market."

(Does the recent inter-meeting rate cut and crash in progress count, or should we be looking for another one later on? J.)

Economic Recession Unlikely

Economic Recession Unlikely: Congressional Budget Office
Wed Jan 23, 2008 9:24am EST

WASHINGTON (Reuters) - The current U.S. economic slowdown will not turn into a recession and the economy will likely rebound next year as housing and financial market turmoil fades, the Congressional Budget Office forecast on Wednesday.

"Although recent data suggest that the probability of a recession in 2008 has increased, CBO does not expect the slowdown in economic growth to be large enough to register as a recession," the nonpartisan congressional budget analyst said in a new forecast.

"CBO expects the economy to rebound after 2008, as the negative effects of the turmoil in the housing and financial markets fade," the budget and economic report to Congress said.

Saving Private Greed

Fed Emergency Rate Cut of 75 Basis Points
First emergency rate cut since the 9/11 terror attacks.

WASHINGTON (Reuters) - The Federal Reserve on Tuesday slashed a key interest rate by a hefty three-quarters of a percentage point, the biggest cut in more than 23 years, after a two-day global stocks rout sparked by fears of a U.S. recession.

The move, a rare one made between the U.S. central bank's regularly scheduled meetings, took the federal funds rate governing overnight lending between banks down to 3.5 percent, its lowest level since September 2005. The Fed also lowered the discount rate it charges on direct loans to banks to 4 percent.

"The Fed is very, very, very worried," said John Tierney, an analyst at Deutsche Bank in New York.

The Fed's bold bid failed to instill confidence in shaken financial markets as U.S. stocks, playing catch-up with sell-offs around the world, fell sharply at the open. The Dow Jones industrial average (.DJI) was down about 1.1 percent in late morning.

Prices for U.S. government bonds slipped, while the dollar fell sharply against the euro.

"The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed said, referring to its policy-setting Federal Open Market Committee.

"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," it said.

What Is Driving the Price of Gold?

As regular readers know, we keep a number of spreadsheets with economic data on them, to help us in tracking various measures of the markets and the economy. One of the things we like to do is to look for intermarket correlations using some relatively good multivariate regression software.

We last took a look at the price of gold a few years ago, and not surprisingly found a high correlation to M3. Since the Fed no longer supplies this data, we thought it might be interesting to see what a fresh analysis turned up for this leg of the gold bull market.

The spreadsheet we used contains weekly data on 35 categories of economic and market measures since January, 2003 which is 265 observations and more than enough for statistical validity. Most of the data comes from the St. Louis Federal Reserve official database.

We aren't going to go into the methodology we used to find correlations, as it gets a bit technical and very tedious. Let's just say its all about finding the prime candidates, and then trying a significant number of 'better or worse' fits. The measure of 'fit' used is the R-Square Adjusted which is expressed as a percentage. The higher the percentage, the more the model explains the price of gold. And before the quant geeks come out of the woodwork, we stipulate that we have simplified and rounded both the equations and the concepts for more generalized readers.

The US dollar is the most obvious factor to check as a driver for the price of gold (in dollars), but our analysis showed that the dollar only explains about 58% of the price of gold since 2003. Money supply is the next most obvious factor. Since we no longer have M3 available as data, we went a different broad measure of money supply, Money of Zero Maturity, MZM. It is what the Fed refers to as the best measure of liquidity in the system, and is M2 less small-denomination time deposits plus institutional money funds. If it included eurodollars and net repos, it would be roughly equivalent to M3.

As you can see from this equation, the Price of Gold (POG) equals .261 times the Money of Zero Maturity supply NSA (Not Seasonally Adjusted). Since .261 is a positive number, we say the correlation is positive, meaning as MZM goes up, the price of gold will go up. The actual number itself means little since we are comparing the price of gold in dollars versus the MZM in billions. The R-Square Adjusted is about 89% which is a very high correlation for a single variable.

POG = 0.26 * MZM NSA billions - 1281
R-Square Adjusted 89%

The way we would state the above result is that the Price of Gold is positively correlated with MZM (NSA) to about 89% from 2003 to today. While the money supply as measured by the broad liquidity measure MZM is increasing, the price of gold will be increasing over time, with an accuracy of about 89%. You could say that each billion in MZM results in about 26 cents to the price of gold, but that is a little misleading since its happening over such a long period of time.

Now, 89 percent sounds good and it is for one variable. As the usual suspects go, liquidity supply of the US dollar is the prime candidate. But we wanted to add some of the other suspects in combinations, to see if we can improve on that without getting ridiculous. When we worked many years ago at Bell Labs, we sometimes saw techs taking projects like this to an impractical degree of fineness, certainly well beyond anything that might be applied to the practical problem at hand. We used to call it "trying to measure the depth of the ocean with a micrometer."

Without getting into too many details, about 50 software runs later we arrived at the following best fit for the price of gold since 2003.

POG = 0.1607 MZM NSA billions + 34.3 EFF + 12.3 Moody's Baa - 740
R-Square Adjusted 94.6%

EFF is the Effective Fed Funds Rate. This is the market expectation of what the Fed Funds rate as expressed as a volume weighted average of all the actual transactions. Moody's Baa is the interest rate for Baa corporate bonds. Its a measure of perceived riskiness in the corporate environment.

So we would say that the price of gold is positively correlated to the growth in the liquid money supply (MZM) and negatively correlated to the higher short term official interest rates and positively correlated to corporate risk. with about 95% accuracy. Makes sense? Passes the red face test? Pretty much we think.

So, if you think on the whole that MZM will keep increasing and the Fed will be lowering short term rates, with a dash of corporate risk in the mix, the price of gold should continue to do well over the long run. Since these variables also feed into the valuation of the US dollar as expressed as DX, without the noise of currency manipulation, we should see a similar negative correlation to the dollar over time.

Well, you might say, that's all very well and good if you are a long term holder of gold for five or more years AND things remain as they are, but what about the shorter term price of gold?

We've been doing a lot of work in this area, and most of it would become incredibly complicated very quickly if we tried to explain it here. Let's just say that the relationship to money supply and EFF is definitely still there, but with a great deal more noise in the model, even if the statistical sample is no smaller than one year. This is where DX comes back into play as a modifier and adds something to the mix. By introducing a risk variable like VIX we have been able to take the R-Square up to 94%.

The market place of buyers and sellers obviously sets the price of gold. As the saying goes, in the short run it's a voting machine (with appropriate antics) and in the longer term its a fundamental discounting machine; what drives it in the short term is somewhat different from what drives it in the longer term.

One might ask, "why don't you factor in Central Bank gold sales?" Prior to 2003 we think they were a significant factor in the price of gold, and several people did quite a bit of work in this area. Since 2002 the data leads us to believe that central bank gold sales have had an increasingly weak and temporary effect on the direction of the price of gold. Why engage in complexity when the data analysis is so straightforward without it?

In summary, the data indicates that since 2003 the price of gold in US dollars is strongly related to the growth in a broad money supply measure like MZM or M3. What the market thinks the Fed intends to do with short term interest rates and therefore money supply growth, Effective Fed Funds, is also a powerful factor. Finally, the perception of riskiness in the business world has a smaller but significant effect, as we see in using Moody's Baa rates and also the VIX.

We expected DX to play a stronger role in driving this leg of the gold bull market, but apparently it is playing a role only in the short term wiggles. If it is money supply expansion and lower short term interest rates that has been driving the price of gold for the past five years, with a bit of riskiness tossed in for spice, then the outlook for the price of gold over the forseeable future looks bright. In some future pieces we will touch upon deflation and credit crunches, but for now those remain possibilities and not certainties.

So what drives the price of gold? In this case, as in so many other financial questions, it always seems that we must follow the money.

Why is Bank of America Buying Countrywide Financial?

There is plenty of room to question the decision by Bank of America, "the US's biggest bank by stock market value," to proceed with an acquisition of troubled mortgage lender Countrywide Finanical, since they took a two billion dollar cash position at a considerably higher price, when the company appeared to be healthier, and are now buying the rest of the company at a cheaper price in an all stock transaction.

Herb Greenberg does his usual excellent job of digging into the deal and providing a reasonable range of speculations as to the motivations: The Real Story on Countrywide Cont'd - Herb Greenberg

To summarize:

1. The Fed brokered or facilitated the deal because Countrywide was on the verge of insolvency which would have had a significantly negative impact on the financial markets, a la LTCM. Bank of America had significant skin in the game already because of their two billion cash already in, AND significant counterparty entanglements that might have jeopardized BAC itself should CFC have failed.

a. Moody's had just downgraded thirty tranches of Countrywide's mortgage debt. Similar downgrades preceded the American Home Mortgage bankruptcy. It was well known that Countrywide was in capital and cash flow difficulties.

b. As counterparties go, they do not get much bigger than Countrywide when it comes to holding US mortgage debt. One can only speculate at this point what sort of entangling obligations CFC had with mortgage reinsurers AND the Credit Default Swaps that may have be put on Countrywide (in huge multiples of their book value).

There is little doubt in our minds that the Fed helped to broker the deal. Unlike Hank, we don't think necessarily that the Fed 'promised' anything as part of the deal, any moreso than they had done with LTCM. But we have an open mind on this topic. The Fed seems to be taking quite a bit of opaque assets on, judging by the recent precipitous drop in their Treasuries holdings in the past few weeks, to be supplanted by "other loans and repos." But this begs the question, Why Bank of America, and why now?

We'd like to add two reasons for this acquisition based on our experience in the M&A business, in our own case as both acquisitor throughout the 90's specializing in valuing high tech startups in Boston and Northern California, and as an acquiree, having sold our own company to a tech behemoth in late 1999.

1. Never, ever, discount the impact of egos and momentum in corporate decision-making, especially in a poorly managed company where personalities and not principles rule the day. We do not know enough about Ken Lewis and BAC to make any judgement here, but we can't rule it out either. They are the right size and structure for it.

Some have suggested that the company did the deal to try and salvage their two billion cash initial investment. If this is true chalk one up for egos and poor management. That initial position was a sunk cost. Period.

2. Is Bank of America paying in what they consider to be an overvalued currency? Their first tranche was cash. But the acquisition itself is for stock, as in their own stock. Let's take a look at a chart of Bank of America:

Compare the chart of Bank of America with that of Countrywide Financial. Perhaps BoA received a much closer and better look at CFC as a big investor, and decided not to acquire some of the key pieces of the operation, and avoid any of the pending litigation for various lending infractions, but decided it was strategic to buy the whole thing (with stock). Plausible? Kind of.

Or is BAC looking at its own balance sheet, its own stock price, and thinking, 'there but for a little time and disclosure goes our own stock price, down to pre-bubble levels. At 7 dollars equivalent CFC might have been 'cheap' at least compared to the 40 it was worth before it imploded. But if BAC's stock follows a similar course, then at 3 dollars equivalent and two billion dollars it looks a whole lot cheaper.

As a veteran CEO once told us, "You may think I'm paying too much for this company, based on your valuation. But in order to say that you'd have to know more about what my own stock is worth than I do, since that's what I'm buying it with." By the end of 2000, we could not help but see his point, and agree.

Yield Curve Inversion Ends, Corporate Welfare Abates

Its official. According to the Fed's economic database maintained by those hard-working folks at the St. Louis Federal Reserve, the yield curve inversion which we have seen since the middle of 2006 has just ended last week. According to the NY Fed:

An article forthcoming in the Federal Reserve Bank of New York’s Economic Policy Review—Signal or Noise? Implications of the Term Premium for Recession Forecasting—sheds new light on the sources of the yield curve’s success in predicting U.S. recessions.

As authors Joshua Rosenberg and Samuel Maurer explain, studies have shown that when the yield curve inverts—that is, when short-term interest rates rise above long-term interest rates—a recession has followed in twelve months. One view holds that the ability of the yield curve’s slope to predict recessions stems from interest rate expectations: the markets anticipate an easing of monetary policy in response to an upcoming deterioration in the economic outlook, and the decline in expected future short-term rates drives down current long-term rates.

So if recessions begin about twelve months after the inversion, it looks to us as though we've been in one since about mid - 2007.


And speaking of reversions to the mean, the spread between Baa corporates and the market yield of the Ten Year Treasury are once gain returning to something a little more 'normal.' We'll let you draw your own conclusion as to why corporate bonds of the more risky nature were so underpriced risk-wise by the markets for so long. Looks like that coincided with the reflation of the stock market bubble, and the growth of the subprime mortgage bubble. But of course, the Fed couldn't see it, didn't do it, weren't there, noway, nohow, my dog ate the risk spread, etc. in this age of innocence by the claim to managerial stupidity, ignorance, and general malfeasance.

As the neo-Keynesian academics, and logical positivists like Chairman Greenspan fundamentally have established, "Moral hazard be damned; the whole of economic law shall be do what thou will.'

Is This the Big One, Elizabeth?

On the television sitcom Sanford and Son protagonist Fred Sanford, played by veteran comedian Redd Foxx, would clutch his chest and say, "This is the big one! You hear that, Elizabeth? I'm coming to join ya, honey!" faking a heart attack in key dramatic moments, often when he was shocked (or cornered in his scheme) by unforeseen events.

With regard to the US equity markets, we're sure that many a punter had that same thought cross their mind when the major indices failed at overhead resistance, fell down to support, and then broke further plunging hard into the close. Is this it? Is this the big one?

The markets took three hard body shots today. First, the pending home sales number came in at a negative 2.6% this morning, on top of some truly gruesome financial results from KBH homes. Secondly, a rumour swept the markets today that Countrywide Financial, prince among subprime mortgage companies, was going to be in bankruptcy because of a capital funding crunch, taking CFC down another chunk in the 80% drop it has seen since its heyday last year. At one time CFC was even one of the primary dealers, those anointed among financial institutions on the best buddy list and elite crew that borrows directly from the New York Federal Reserve. Third, and taking down the markets to the floor, the esteemed CEO of AT&T, Randall Stephenson, told a group of investors that "ever since Q3 ended, the company has seen an up tick in non-paid disconnects in both broadband and traditional access (wireline) subscribers. Mobile is still growing strong—people aren’t canceling their cell phones just yet—but the market is obviously spooked."

Well, anyone who doesn't think the US housing business is in the tank has been on an extended vacation from reality. And although we don't know that CFC will be declaring bankruptcy anytime soon, with an 80% haircut in their stock in less than a year, what does it matter? They are dead men walking.

The AT&T news was a bit much, not so to hear that AT&T is struggling with their consumer business, but rather that consumers are hitting the wall with basic phone services, although we suppose a phone isn't viewed as the necessity it used to be. If it had been their mobile business that was tanking, then by God we might have seen the Crash of 2008 today, since all those texting youngsters would have undoubtedly been responsible for bankupting their poor parents.

We don't know if this is the big one or not. But as usual, we think we know what to look for, and have a couple charts to illustrate our signposts. The first chart is the long term weekly chart of the SP 500. Since this reflationary reinflating of the stock indices began in 2003, the SP 500 has not broken the 100 week moving average on a weekly close. Not one time. Ok, interesting, but not decisive.

We also like to watch the cumulative measure of NYSE Highs and Lows, as illustrated in this next chart. As one can see, the 360 day moving average has proven to be a reliable indicator of trend changes in the SP 500. Again, there is nothing written in stone, but if we get a confirming break of the moving average by the highs and lows, together with the break of the long term moving average by the SP500, then the probability becomes very high that the market is at a key turning point, and a new bear market has come back to town.

One of THE most reliable indicators of recession, hardly ever without fail, is that shortly before a recession formally commences, the stock market will have a 10+% correction. Further, the stock market will reach a clear trough and begin to rally before the recession is over.

Well, we're there, on the 10% correction at least. Now we'll have to see how deep this rabbit hole goes. Is this IT? Maybe, if IT is a bear market. Probably not, if IT is a market crash. Big crashes are always very long odds. But with the financials leading the way lower, and the dollar following, its a bit dicey. If corporate bonds join in to this fun fest, we'd keep in mind another of Fred Sandford's familiar sayings: "Beauty may be skin deep, but ugly goes clear to the bone."

Fed Policy Actions in Anticipation of Economic Recession

We've been studying and updating spreadsheets correlating market performance and various monetary aggregates and interest rates and spreads lately, in the hopes of gaining more understanding of what we think the Fed is doing. From time to time we like to share a chart because it might have some particular interest in and of itself to others.

Here is a chart of several of the primary monetary aggregates during the Greenspan - Bernanke chairmanships. We think they clearly demonstrate the Fed's anticipation of economic recessions which are also indicated according to the official NBER ruling. Keep in mind that economic weakness can be apparent long before the date on which the NBER formally declares (well after the fact) that the economy had entered a formal recession.

Although the chart is a bit dense with data, and not immediately and easily understood, it worth looking at it a bit, to get the idea of how the Fed reacts to an economic slowdown, and how the monetary aggregates react to the policy decisions by the FOMC Believe it or not this is a simplified version, not including interest rate spreads and stock market indices. Eyeballing charts like this is a first phase in our economic detective work, where we turn up suspects for more rigorous analysis using statistics and spreadsheets. But it does contain the big picture if you have the eye for it.

Does the Fed have a perfect control over the money supply and the economy? Certainly not! The analogy would be to that of a ship's captain. The ship travels in various conditions, and the captain does not personally propel the ship, does not maintain a perfect control sometimes to their dismay and that of the passengers, and may encounter previously unknown conditions. But in keeping with our analogy, we'd like to observe that both the captain and the Fed have quite a bit of influence over where the ship or the fiat money supply might be heading, and what routes they might take in getting there.

There is little doubt from our study that the Fed has seen a recession on the horizon, and is trying to balance the deflation of the housing bubble against an economic slowdown that becomes overly severe. Like a ship's captain, sometimes the tides and tradewinds are with you, and sometimes they are against you, and this will influence which actions you take to achieve your objectives. Let's wish Captain Bernanke well, as he steers us between the Scylla of Recession and the Charybdis of Currency Debasement.

National Elections - Change in the Air

We've been privately arguing for some time that change is in the air, and the pat formula of Clinton vs. Romney/Guliani is a not going to be the sure thing that many thought. The Obama and Huckabee surprises in Iowa were no surprise to us. Why?

Change is in the air. The Bush presidency has alienated most of the nation, if one judges by popularity polls, to a degree not seen since the Nixon presidency. For those of us old enough to actually remember it, the national discomfort with the republican party was profound, far surpassing the particular angst about the excesses of Nixon's imperial presidency (for the record we've been republicans since 1964).

We came into this looking for the outside candidate (likely the traditional term dark horse candidate will receive little use anymore). In the 1976 election, Jimmy Carter came seemingly out of nowhere, the obscure governor of Georgia, to take the election as the candidate of change. The nation wanted someone as different from Nixon as they could find. Different, but we're not naive enough to think that these fellows have not all been vetted by the power elites to some extent. Mr. Smith may still go to Washington, but he's got at least one of the boys on his shoulder whispering advice. John Kennedy certainly had this, as a change candidate of profound proportions we hardly even realize today. They don't always have to listen once they get in office.

So now we come to 2008. Of the outside candidates, Obama, Huckabee, and Ron Paul have the greatest appeal as something different. Although the Ron Paul internet phenomenon is amazing, and reassuring, we don't think Ron Paul has enough support to be a viable candidate for any mainstream party, and would like to think he will not run as a third party candidate unless something happens. On that note, Obama reminds us of Robert Kennedy's presidential campaign for change against Lyndon B. Johnson, another imperial president, but of the democratic flavour.

Edwards positions as the change candidate, but is establishment enough to be thought of as a comfortable alternative if Obama cannot be the choice for some reason for the Democrats. He talks change, but is comfortable. If for some reason Obama falters, Edwards can most benefit perhaps. After all, Roosevelt was a patrician who betrayed his class.

Hillary, on the other hand, is the candidate of the status quo. The seeds for our current dilemna were nourished if not sown during the Clinton presidency. She is not the candidate of change. She is the candidate of the machine. She and Rudy are the most divisive candidates, and this is hurting their appeal to an electorate that is tired, and seeking a change.

As for the Republicans, Romney was the annointed, in the spirit of W's pre-primary coronation, but it appears he does not have broad appeal, and is the antithesis of change. Fred Thompson and Rudy Guiliani were brought in as back-ups, but their lack of appeal has been astonishingly predictable. The primary weakness of the power elite is the lack of diversity in their inputs, their disconnect from reality at market turns so to speak.

McCain the maverick has been courting the war wing heavily, but has the reputation as a change agent (and some Republicans might say loose cannon). Ironically, we think Huckabee might be the most like Bush in that he appeals to the evangelicals, but has a fiscal and tax policy tailored by the doyens Wall Street, that has gotten little play so far. Still, he looks like a change at first glance.

This election will be ugly, and it will get uglier in the news, and in the emails that get tagged around this time every four years. We won't be discussing it much, because politics (and religion) are outside of the purview of this blog, and this election will be mixing it up with politics, religion and race. The deomographic polls we have seen show that Obama swept all the groups except for the over 60 crowd. As the last to get it, they will never believe that change can occur until it happens.

But joys of discussing politics, and religion and race aside, the economic and fiscal policies of the candidates are of paramount interest, not only for the economy, but also for the equity markets, and now. Let's take a look at the stock market in the watershed year in which Jimmy Carter was elected.



In looking at chart analogs such as this, its important to remember that we don't put much weight on the actual timeframes or durations. For us its all about price action. Information flows at different speeds, and environmental factors and influences pro and con operate with different strengths. Its the price action that matters most in our method. This distinguishes our approach from most pundits, including the nice folks from whom we obtained this chart. Our take on it would be that as an Obama presidency becomes more likely, and his fiscal change message becomes stronger, the stock markets are going to sell off, and probably significantly. We're probably already seeing some of this profit taking now.

New Hampshire on Tuesday will be important. We don't think Huckabee will do well given the lack of evangelical support, and McCain may do extremely well, positioning him as the other alternative to the annointed Romney. We wonder if Hillary has the machine to win in New Hampshire, or at least make a decent showing so the comeback kid card can be played.

But make no mistake, if the change candidates come out on top, we might see a replay of the year in which Jimmy Carter came to power in the markets, as the boys cash in their chips ahead of the uncertainty of new tax laws driven by a Democratic change president with a Democratic congress behind him.

US Dollar Index Long Term Chart

While this is not our favorite, nor the best representation of the US dollar,

the DX index is the most well known and widely traded US dollar currency index.

Non-Farm Payrolls Preview - December 2007

Net Non-Farm Payrolls SA = +124,160 versus a consensus of 70,000

Birth Death Model aka Imaginary Jobs = +58,000

Remember that the Birth Death Model is added BEFORE the seasonal adjustment.

Net Non-Farm Payrolls NSA = -167,000

Please notice that there is often a very significant tinkering factor in the seasonal adjustment, since jobs creation is a highly variable number according to the time of the year. If we were inclined to fudge the numbers, this is where we would start.

SA = Seasonally Adjusted
NSA = Not Seasonally Adjusted

There is a Really Big 'But'

The Bureau of Labor Statistics likes to come out with a current month number that is the 'headline' but quietly adjusts a few of the prior months, generally lower. No one pays attention to these revisions on Wall Street, but they are absolutely essential to understanding the true employment picture in the US. BLS occasionally also revises the entire sequence back a few years, when it turns out they have overcounted the total population (see The True Unemployment Figure, or Ghosting the Inconveniently Poor for details). If we were inclined to gild the lily a bit, the adjustment of prior months is a good place to move jobs forward in time, robbing October and November to pay December so to speak. Conversely, posting a weak number in the current month is a nice ploy IF you adjust the prior month higher (true pros will swipe those jobs from the month twice removed which almost no one looks at. See The Conservation of Fake Jobs in Statistical Methods Quarterly).

The Number Worth Watching

The best indicator of the jobs performance of the economy is the twelve month moving average of net non-farm payrolls jobs seasonally adjusted, aka Jesse's Non-Bullshit Payrolls Indicator (NBPI).

Nine out of ten americans might notice that jobs growth has been in a trend decline since early 2006, and the situation is moving towards recession at a brisk pace. These are quantitative, not qualitative measures of jobs, e.g. service positions such as serving vegetables (like ketchup) on those freedom fries is equivalent to a highly paid manufacturing position.

Practical Matters: Bet the Over/Under?

The ADP employment report showed that the private sector added approximately 40,000 jobs in December according to their survey. If we add about 15,000 jobs for the government sector, which ADP does not include, then that gives us 55,000 which is a little light of consensus. We don't think ADP has a birth - death model either which adds imaginary jobs. Since BLS will be adding 58,000 or so, we *might* get a decent number over the consensus.

How would the Feds like to play this? And don't think they don't. The Jobs report has been subject to extensive pre-release executive review since the days of LBJ. We aren't sure, but if we were betting we'd say a weakish number with an upward revision to November that brings it up to a very respectable number. That will blunt the concern about the economy, and still give stocks some assurance of a Fed 25 bp cut, without tanking the dollar which, after all, is the name of the game, at least for now.

Let's see what happens.

US Stock Market in Presidential Election Years

Here's a link to a set of charts showing stock market performance for the years in which there was a presidential election with a Republican incumbent since 1892 from StockIndexTiming's web site. He also includes the year before and after, which is useful and we thank them for this work.

Stock Market Performance in Election Years with Republican Incumbents Click on this link, then scroll down to see the charts.

We're not big on comparisons since there are so many different variables to consider. But the theory would seem to be that if it is in their power, big business will step in at some point and boost the stock market this year, to help keep the November elections from destroying the Republican party.

Here's one example, 1932, in which business was NOT able to turn the markets significantly higher in time to secure the election for the Republicans, but did manage to put in a mid-year bottom and rally, although they could not make it stick. There are those (hat tip to ContrarianBear at WallStreetBear.com) who predicted, very early on in his presidency, that George W. Bush would be remembered as a second Hoover. Let's see if that analogy holds true.

The Chinese and other nations and central banks may be a significant exogenous factor (economist jargon for wild card) in this scenario.

P.S. Here's a fun fact posted after the close of trading. Bloomberg says that today was the worst first trading day of the year for stocks since 1983, AND that the Dow came within 1/10 of one percent of setting the worst opening day of trading since 1932. Poetic.