Fighting Contagion with Lies – Dec 2, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Fighting Contagion with Lies: It’s ironic that when central bankers advertise their actions as for the good of economic activity and employment stability, and as being for “the people,” you must now assume the opposite. Bankers are insuring that their own kind survives. That is precisely what was achieved on Wednesday when swap lines opened and money was funneled to and through the ECB to European financial institutions. To ease the pressure of rolling over existing short-term debts, commercial banks quickly utilized hundreds of billions of dollars made available by central bankers from around the world. How much short-term debt is waiting in the wings to be rolled over in this manner? (Only!) two trillion dollars’ worth. Please don’t laugh.

We could point to many of the systemic weaknesses in the European banking system. One weakness we observed with Dexia, before its demise, was the dependence on short-term funding for daily operations. Rather than relying on a broad base of depositors, Dexia and many other banks still today seek short-term money to fund longer-term lending. The problem, of course, is that the source of short term funding can dry up.

Dry up it did, as global money-market funds removed cash from Europe last week. Thus, the cavalry was sent in on Wednesday – immediately after our Weekly Commentary warning of imminent crisis in Europe was published on Tuesday. Our concerns were well founded, and crisis action was indeed taken. No structural pressures have been relieved, but liquidity has rendered everyone content for the time being. Our conclusion: we are a whisper away a from global currency crisis.

When one institution fails, you might think: Tough luck, others will fill the void and over time succeed where the failed institution could not. The challenge, however, is when bank portfolios mirror each other, and the failure of one prompts price discovery for assets held by them all. Such institutions have fought to keep market prices obscured so they can value their assets however they like. To counter this obfuscation, investors can cross reference the going price (in bankruptcy liquidation) with the fabricated price put on the books to pretty up the pig (or PIIGS, in this case).

This highlights one aspect of crisis contagion. Keeping prices undisclosed is critical. Perhaps next week we can explore the importance of collateral and what is being regarded as “eligible collateral.” It may be sufficient to say that the not-so-sweet smell of sewage comes to mind.

Seeking to avoid contagion, several industrial giants in Europe have started playing by a different set of rules. Siemens has been concerned enough with currency stability and domestic banking solvency issues that they recently started their own bank. How would this help them, you ask? By being their own bank, they can leave “excess reserves” or cash balances with the central bank – in this case, the ECB – and thus avoid financial institution weakness or collapse. We find the same inclination with non-industrial players. Deutsche Bank has stuffed the ECB mattress to the tune of 180 billion euros. It seems that financial and industrial giants are skeptical of the enduring nature of the eurozone banking community, and perhaps even the euro as its medium of exchange.

2. The Senate Declares War on America: Changing subjects completely, I would encourage all of you to invest time this weekend in understanding the implications of S. 1867, the National Defense Authorization Act, specifically sections 1031 and 1032 (on pages 359-364). By defining the USA as a battlefield, the President would have the authority to direct military powers domestically, implicating US citizens as potential enemy combatants. Without the legal protections of due process, and without the benefit of habeas corpus, you would be subject to powers known by US citizens only during the Civil War.

You may wish to preserve your net worth through these challenging times, but towards what end if we are at this moment sacrificing freedom for what is being deceptively described as safety? My friends, our politicians are crossing the most important Constitutional lines. Many conservatives actually believe that the fight against terrorism trumps the rule of law. Let me part company and suggest that this is why the law exists – to protect citizens from an overreacting and overreaching political class. If you do not write your elected official next week and express your opposition, I can only assume you suffer from the worst kind of myopia mixed with political amnesia.

Please view the following video featuring Senator Rand Paul:

The current administration has raised concerns over the legality of section 1032; it’s our job as citizens to drive home the legitimacy of these concerns and request that sections 1031 and 1032 be removed from the legislation. As always, do your own reading and do as your conscience demands. Now, to the markets again. . .

3. Monetize or Else! The panic button has been pushed. Last week, Germany ran what constituted a failed auction for its sovereign debt. Of the €6 billion 10-yr bund offering, 35% went unsubscribed at the expected rate.

This gained the immediate attention of EU lawmakers, who determined to “fix” matters post haste. They considered ramping up the ESFS fund to the tune of €1 trillion and enacting amendments to the law granting “lender of last resort” status (monetization privileges) to the ECB. However, once it became clear that these actions were unacceptable, mainly to German lawmakers (who prefer tighter budget rules), foreign central banks, including those of the US, Canada, Japan, England, and Switzerland, along with the ECB, uniformly intervened in what appeared to be an act of desperation. Dollar “liquidity” swap lines were extended into 2013 at 50bps (half the current rate) to the European Banks that have access to the ECB window (pay no mind that the Fed lends to US banks at 75bps).

The announcement sent stock markets soaring, with some indexes gaining nearly 6% during trade on Wednesday. The very next day, however, markets went back to stumbling, supposedly over a lawsuit filed by Massachusetts against several US banks on grounds of mortgage fraud. Aside from this, momentum in the markets may be lacking due to central bank “announcement” fatigue – wearing thin the expectation of QE that never seems to materialize. As we have noted here ad nauseam, the lending system is impaired. Nothing less than full scale QE stands a chance to inspire. The Fed simply needs an excuse to pull the trigger.

By an excuse, we mean a weaker US economy. Given the recent data, this seems to be the direction we are now headed – despite the fairly upbeat “Black Friday” shopping results. New Home Sales disappointed for the month of October (and September’s numbers were revised downward). The November Dallas Fed Manufacturing index fell far short of expectations. Home prices remain in contraction mode, according to the Case-Shiller Composite index, along with mortgage applications (down 11.7% week ending Nov 25). And jobs data for November was unimpressive, despite the lift from temporary jobs surrounding the holidays. The ADP Employment Change (a temp-heavy index) increased by 206,000 jobs while the US non-farm payrolls increased a mere 120,000 – both were a far cry from the 250,000+ needed.

The lack of job creation didn’t stop the BLS from manufacturing another decrease in the unemployment rate, which fell to 8.6%, down from 9.0% in October. Jobless claims rose back into recessionary territory, exceeding once again the 400,000 level for the week ending November 26. On the retail front, growth in the ICSC Chain Store Sales disappointed, slowing from September to November, when one would suppose the opposite within the context of the holiday. The bright spots to note came from Vehicle Sales (still expanding) and various opinion polls (consumer confidence and manufacturing surveys), all of which can be construed as lagging indicators. Putting a summation sign next to the November data, one can assume that the shock (crisis) benefit of lower rates originating in the Treasury market may be over.

That said, the US economy and respective markets are far from “crisis” territory, both in actual and perceptive terms. So it wouldn’t surprise us if the Fed postpones QE until problems here at home accelerate to a more meaningful level (overseas notwithstanding). This presents a conundrum for speculators since stock market weakness may be needed to justify further injections of liquidity. With that in mind, we would expect the upside in stocks to be tempered between now and the next policy meeting (ECB on December 9th and FOMC, December 13th).

Whether the “right amount” (whatever that may be) of volatility will materialize before these dates isn’t clear, as the markets have been prone to wild swings in either direction as of late. If we had to guess, however, we think the Fed will push a QE decision into early next year.

What we can take away from the recent spate of events is that central banks (the PBOC, BoE, FOMC, ECB, SNB, the BoJ, and others) are coordinating their efforts to ease as the crisis spreads. This should come as good news to MWM investors, since the implied or actual central bank “put” in the marketplace should serve as a backstop for the metals, easing concerns over a “deflationary” spiral in the short run.

Best regards,

David McAlvany
President and CEO

David Burgess
VP Investment Management