Is the Money Supply Contracting?

The bottom line is that although growth is slowing in MZM which is our preferred broad liquidity indicator, there is no indication that money supply growth is cntracting (e.g.negative).

Theories abound. We like to look at the data.

There are various interpretations and we look into almost all of them.

But we like to keep an eye on the data, and skip arguments that are long on rhetorical flourishes and short of hard analysis.

A monetary deflation is possible. A price deflation in response to slack aggregate demand is not only possible it is happening. We are in a recession. Demand is decreasing. And money supply growth should be decreasing in sympathy with that.

We could even tell you how to cause a monetary deflation, and are confident we could do it. Raising short term interest rates to 20 percent would probably do the trick pretty handily. Right now they are a negative number, however.

There are also theories that the banks are hoarding cash and the money supply figures are no longer valid. The money is flowing to Europe and not into the US economy.

Well, we can look into this, but it does not seem to be borne out by anything we have looked at in more than one dimension yet. We have an open mind.

But we're short on economic creationism and long on hard data and analysis in our book.

Thinking the Unthinkable: Are the Markets Warning of a US Debt Default?

As we have previously stated, right now the US is on the path to a devaluation and a selective default on its debt and currency. No one can say 'how and when' with certainty. But surely it seems probable that there is a stop and a stumble in the growth of this mother of credit bubbles somewhere ahead.

Perhaps it may be more credible if one reads a similar speculation in the financial magazine Barron's.

Some have suggested that devaluation no longer has meaning, preferring depreciation. Why? Because what would one devalue the dollar against, as it is tied to no external standard? The Dollar is its own standard as the reserve currency of the word.

A bit of a technical nuance perhaps, a holdover from when money was related to independent stores of value. But we think the dollar can be devalued against the expectation of the marketplace that the growth of the money supply will keep pace with the net productive output of the US, and real relative purchasing power, and represent a store of value with some small variance for inflation.

It is always a mistake to assume that there are no external standards, no dissenting views, that things are merely what we say they are and should be, for everyone.

The standard is the 'full faith and credit of the United States.' And if that confidence is broken, the reversion to fundamental 'external' values may be impressive.

Unthinkable? Every currency that has ever been has eventually been destroyed and undergone a transformation. Even the US dollar has undergone evolutions and incarnations.

But few things are inevitable. The world may choose to create a one world currency, under the control of the Fed and the Central Banks, which is a prelude to One World Government. This would be one way to extend the existence of a fiat regime. Kill off all the alternatives, by force. A regime of the will to last a thousand years.

In the short term we may again see rallies in the bonds and dollar because of a flight to quality and a short squeeze on dollars, particularly in Europe. This is due to lags in the effects of a credit cycle decline on its various components.

Demand for dollars spikes in a flight to quality and debt payment squeezes such as that being experienced by some European banks, and then declines more slowly than the supply of dollars can ramp up in a declining credit cycle, leading to a 'liquidity crunch.'

This is particularly confusing to most casual thinking on economics. It helps if you really think about what a dollar represents, what money really is, to someone outside the system holding 'real goods' for sale.

At some point the ramp up of dollars meets and exceeds demand, and the cycle of inflation begins again. If the situation is particularly dire, the currency may be devalued to speed its supply as the US did in 1933. But without a new Bretton Woods type currency fix an inflation alone is much more likely.

As an aside, we think the Europeans should declare a force majeure and allow all non-euro debts, even in private contracts, to be settled in euros as part of a formal rejection of the US dollar as the world's reserve currency.

But these are all exogenous developments. For now, within a degree of probability, the US is on the road to a significant failure of its currency and debt, most likely through a nasty bout of inflation, selective bankruptcies, and ultimately the reissue of a new currency.

Searching for relative safe havens of value for wealth, as it had been in the 1970's, may be the premiere investment theme for the rest of this decade, and some part of the next.

Barron's
UP AND DOWN WALL STREET DAILY
Uncle Sam's Credit Line Running Out?
By RANDALL W. FORSYTH
NOVEMBER 11, 2008

The yield curve and credit default swaps tell the same story: the U.S. can't borrow trillions without paying a price.

WHAT ONCE WAS UNTHINKABLE has come to pass this year: massive bailouts by the Treasury and the Federal Reserve, with the extension of billions of the taxpayers' and the central bank's credit in so many new and untested schemes that you can't tell your acronyms or abbreviations without a scorecard.

Even more unbelievable is that some of the recipients of staggering sums are coming back for a second round. Or that the queue of petitioners grows by the day.

But what happens if the requests begin to strain the credit line of the world's most creditworthy borrower, the U.S. government itself? Unthinkable?

American International Group which originally had to borrow what was a stunning $85 billion from the Fed to keep it from cratering in September, upped the total Sunday to $150 billion.

Monday, Fannie Mae reported a $29 billion third-quarter loss, far in excess of forecasts, raising the specter that the mortgage giant may need more money after the Treasury pledged to inject $100 billion in preferred stock financing in September.

Meanwhile, American Express received Fed approval to convert to a bank holding company, joining the likes of Morgan Stanley and Goldman Sachs, that have a direct pipeline to borrow from the Fed or the Treasury's TARP, the $700 billion Troubled Assets Relief Fund.

And, of course, Detroit is looking for a credit line from Washington. General Motors (GM) Friday warned it could run out of cash next year without a government loan. GM plunged another 23% Monday, to 3.36, as several analysts helpfully recommended selling shares of the beleaguered automaker that already had lost more than 85% of their value.

Visiting the White House Monday, President-elect Obama pressed President Bush to support emergency aid for GM and other automakers. The prospect for federal aid for GM ironically weighed on its shares as one bearish analyst said the price of the bailout could be a wipeout of common holders.

Be that as it may, it's all adding up. If the late Sen. Everett Dirkson were around today, he might comment that a trillion here, a trillion there and pretty soon you're talking about real money.

Trillions are no hyperbole. The Treasury is set to borrow $550 billion in the current quarter alone and $368 billion in the first quarter of 2009. "Near-term pressures on Treasury finances are much more intense than we had thought," Goldman Sachs economists commented when the government announced its borrowing projections last week.

It may finally be catching up with Uncle Sam. That's what the yield curve may be whispering. But some economists are too deaf, or dumb, to get it.

The yield curve simply is the graph of Treasury yields of increasing maturities, starting from one-month bills to 30-year bonds. The slope of the line typically is ascending -- positive in math terms -- because investors would want more to tie up their money for longer periods, all else being equal. Which it never is.

If they expect yields to rise in the future, they'll want a bigger premium to commit to longer maturities. Otherwise, they'd rather stay short and wait for more generous yields later on. Conversely, if they think rates will fall, investors will want to lock in today's yields for a longer period.

The Treasury yield curve -- from two to 10 years, which is how the bond market tracks it -- has rarely been steeper. The spread is up to 250 basis points (2.5 percentage points, a level matched only in the past quarter century in 2002 and 1992, at the trough of economic cycles.

Based on a simplistic reading of that history and the Cliff Notes version of theory, one economist whose main area of expertise is to get quoted by reporters even less knowledgeable than he, asserts such a steep yield curve typically reflects investors' anticipation of economic recovery. (LOL, nicely phrased - Jesse)

Never mind that the yield curve has steepened as the economy has worsened and prospects for recovery have diminished. Like the Bourbons, the French royal family up to the Revolution, he learns nothing and forgets nothing.

As with so much other things, something else is happening this year.

The steepening of the Treasury yield curve has been accompanied by an increase in the cost of insuring against default by the U.S. Treasury. It may come as a shock, but there are credit default swaps on the U.S. government and they have become more expensive -- in tandem with an increase in the spread between two- and 10-year notes.

This link has been brought to light by Tim Backshall, the chief analyst of Credit Derivatives Research. The attraction of investors to the short end of the Treasury market is "juxtaposed with the massive oversupply and inflationary expectations of the longer end," he writes.

Backshall is not alone in this dire assessment. Scott Minerd, the chief investment officer for fixed income at Guggenheim Partners, a Los

Angeles money manager, estimates that total Treasury borrowing for fiscal 2009 will total $1.5 trillion-$2 trillion. That was based on $700 billion for TARP, a $500 billion-$750 billion "cyclical deficit," an additional $500 billion stimulus program and some uncertain amount for the Federal Deposit Insurance Corp.

Minerd doubts that private savings in the U.S. and foreign purchases of Treasury debt will be sufficient to meet those government cash. That leaves the Fed to take up the slack; that is, monetization of the debt.

However it comes about, Backshall's charts of the yield curve and the spread on U.S. Treasury CDS paint a dramatic picture. Both the yield spread and the cost of insuring debt moved up sharply together starting in September.

Let's recall what happened that month: the Fannie Mae-Freddie Mac bailouts, the AIG bailout and the Lehman Brothers failure. The two lines continued their parallel ascent with the announcement and ultimate passage of the TARP last month. And evidence mounted of an accelerating slide in growth.

Cutting through the technical jargon, the yield curve and the credit-default swaps market both indicate the markets are exacting a greater cost to lend to Uncle Sam. And it's not because of anticipated recovery, which would reduce, not increase, the cost of insuring Treasury debt against default.

All of which suggests America's credit line has its limits.

At the beginning of the Clinton Administration in the early 1990s, adviser James Carville was stunned at the power the bond market had over the government. If he came back, Carville said he would want to come back as the bond market so he could scare everybody.

President-elect Obama may come to think Clinton had it easy by comparison.

AMEX: We Are All Banks Now

November 11, 2008
American Express to Be Bank Holding Company
By THE ASSOCIATED PRESS

WASHINGTON — The Federal Reserve on Monday granted a request by the credit card giant, American Express, to become a bank holding company, giving it access to low-cost financing from the Fed.

The Fed said it had approved the application for American Express and a related company, American Express Travel Related Services, to become bank holding companies.

The approval represented the latest reshaping of the financial services industry, which is undergoing its worst credit crisis in decades.

In announcing the action, the Fed cited “emergency conditions.”

The Fed’s approval for American Express was similar to the decision it made in September to transform the country’s two biggest investment banks, Goldman Sachs Group and Morgan Stanley, into bank holding companies.

That move bolstered the two institutions after the collapse of another investment bank Lehman Brothers, which became the largest bankruptcy filing in history. Goldman and Morgan Stanley gained the ability to borrow federal money and build a stable base of deposits in hopes of reassuring investors and other banks.

AmEx last month reported that its profit fell 24 percent in the third quarter as cardholders restrained their spending and had more trouble paying off debt.

Meredith Whitney on the Banks

11-5-08 Meredith Whitney Interview on CNBC with Maria Bartiromo (video)
(Thanks to Mr. Mortgage for the transcript below)

Maria: What changes with an Obama Presidency for the banks?

Whitney: Financials and the economy are so far off the tracks its hard to see anything helping right now. One thing they talked about was mortgage modifications - trying to get money to consumer.

None of this makes banks have a higher appetite for risk so you don’t see a lot of money coming into system aside from govt subsidies. So the banks will make less if they modify your loan. They will be siting on sludgier assets. That doesn’t create new capital to get back into the system.

Higher taxes are assoc with Dem’s but there it less to tax…one good thing about all of this.

Maria: You were the first to point out the upset in financial industry - please tell us where we are in cycle?

Whitney: We are in a new part of cycle. We have digested the fact that the securitization is not coming back. Securitization made up 85% of mortgages and 50% of credit cards. Market is not coming back. Contraction of capital is one thing. But what happens going forward is contraction of the overall mortgage market - this has never happened before.

Banks are not lending. Originations are down big in Q3. Loan balances getting smaller. Credit cards make up over $2 trillion in available credit lines being pulled out of system. Credit is being taken away form those that got credit in the past 15 years. Never in America had we seen this before. This is a more destructive market for consumer. This is not factored into market.

An economy that has already been impacted by market and unemployment going to double digit levels is another wild card for banks.

Banks just will not make a lot of money and the street is still expecting them to make a lot more money. My estimates are 30-70% below the street and i think I am too high.

Maria: 70% below the street - oh my. Its going to be tough to make those up - the street still expects them to make lot?

Whitney: Banks asset base gets smaller so revenue gets smaller. They can’t cut costs fast enough to keep up with declining revenue. Credit costs increase and you are running faster to collect on loans. So you just have a protracted period of negative operating leverage.

Many of the banks, especially the two brokers, expense structure grew so fast over the past several years that their expense structure is built for a 06-07 revenue environment and their revenue will be like 01-02 revenue environment.

Maria: How much of this is priced in how much will this be a surprise? stocks are down so significantly.

Whitney: Citi, UBS, Wells Fargo, JP Morgan and BofA at all these levels est are coming down dramatically. Nobody is immune. Believe it or not, analysts think losses will be more milder than they really will be.

One difference between my estimates and the rest of the street has been a higher loss curve estimates for losses than others. But my loss estimates are actually lower than the reported numbers. I think we are in for a rude awakening. That may result in a slow grind down in these stocks.(When the financials bottom, the stock markets will be at a bottom and not before. We have much further to go. This is going to look like the post 1930 grind down to a bottom, at about 70-80% of the peak in real terms. Expect 10 to 20% kickback rallies every few months. The wild card is how successfully the Fed and Treasury can create inflation to mask it. - Jesse)

I don’t think you will see massive capital destruction like we saw with huge write downs but I will bet a lot of money banks will come back for a lot more money on the next 9-months again so you will be diluted further. Now, from Obama you will see more regulation. They are a highly regulated utility with less dividend. You should expect Citi and others to cut dividend.

Citi already cut but nobody is allowed to raise under TARP. But earns will be so much lower alot of companies will not be able to support dividends so yes they will cut again.

Maria: How significant of a fall will be see in these stocks?

Whitney: I think Citi goes to the single digits. (Good bellwether - Jesse)

Maria: Who is best position and will go higher?

Whitney: There are many I like and I hope they can hold onto being independent, but stock prices are far too high.

I think you know JPM and BAC survives. There are alot of attractive companies.

Wells Fargo at $20 is attractive. They have a $20 billion offering in the works and that stock is still hovering near $30! That stock still has a ways down to go. (We were thinking more like 10 - Jesse)

Wells Fargo is gonna be a great company and will be a survivor but consensus estimates are on Pluto. They will have a (equity) supply jam in terms of extra capital into the market and you will see a great chance to buy a great stock you want and at much lower prices. (If we hit a bottom we would rather have commodity companies like oil and mining with good cash flows to support high yields - Jesse)