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Pentonomics - Central Bankruptcy - Why QE3 is Inevitable
Posted by Michael Pento on 06/13/2011 at 3:46 PM

As the U.S. economy seemingly limps out of the Great Recession most analysts now assume that the Federal Reserve will soon join the tide of other central banks and bring an end to the current era of unprecedented monetary expansion. Markets expect that Fed will begin withdrawing liquidity this summer, not too long after this latest round of the quantitative easing comes to an end. But this is simply a delusion.

 

There are many political and economic reasons why the Fed will find it extremely difficult to absorb the liquidity that it has relentlessly pumped into the economy since the beginning of the financial crisis. But its biggest problem may be that the ammunition it carries on its balance sheet is insufficient to the task.

 

In order to withdraw liquidity the Fed must sell most, if not all, of the assets on its balance sheet. The questions are: what types of assets will it sell, how fast will they sell them, who will buy, and what price will the market bear?

 

In December 2007, before the Great Recession began the Fed had an equity ratio of around 6% on a balance sheet that totaled approximately $900 billion. The assets it held at that time were almost exclusively comprised of short term Treasury debt. This had been the norm for the vast majority of Fed history. Given the size of the Treasury market and the bankability of its short term debt, the value of such a portfolio was considered virtually bulletproof.

 

But beginning in late 2008, as financial institutions careened towards insolvency, the alphabet soup of Fed lending facilities (TAF, TSLF, PDCF and the CPFF just to name a few) bought all kinds of assets that the Fed never before held. Through quantitative easing efforts alone, Ben Bernanke has added $1.8 trillion of longer term GSE debt and Mortgage Backed Securities (MBS). (In fact, the Fed now holds more of these mortgage instruments than their entire balance sheet before the crash.) This has drastically changed the complexion of the assets it must now sell.

 

But as the size of the Fed's balance sheet ballooned, the dollar amount of capital held at the Fed has remained fairly constant. Today, the Fed has $52.5 billion of capital backing a $2.7 trillion balance sheet. While the size of the portfolio expanded three fold (and the quality of its assets diminished), the Fed's equity ratio plunged from 6% to just 2%. Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30 to 1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51 to 1! If the value of their portfolio were to fall by just 2% the Fed itself would be wiped out.



Tags:  fedqe3quanititative easingrecessionstimulus
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Pentonomics - Training Wheels Off, Crash Helmets On
Posted by Michael Pento on 05/20/2011 at 12:09 PM

Based on many pronouncements by economic policy makers, reams of articles by the top financial journalists and near continuous discussion on the financial news channels, it appears that the quantitative easing juggernaut that has steamed the high seas of macroeconomics for the last three years is finally pulling into port...supposedly for the last time. According to the dominant narrative, QEI and QEII helped stabilize the economy during the Great Recession and now the Federal Reserve is ready to take the training wheels off. If so, the economy may need a helmet because there is virtually no chance that it can avoid major contractions without central banking support. 

It is ironic, but there is no doubt that the proposed removal of artificial stimulus would be the best thing for the country in the long term. But very few observers understand how it will inflict short term pain. So confident is the Fed that earlier this week, St. Louis Fed President James Bullard indicated that any notion of additional quantitative easing is off the table. In fact, he said the central bank may tighten policy in 2011 by allowing its balance sheet to shrink. Investors would do well to remember that Bullard was the first Fed official to support the second round of bond purchases now known as QEII. It is likely that he will make a similar reversal if the economy shows any signs of weakening in the months ahead.

Fed policy makers like Bullard are guilty of reckless optimism if they believe the economy has truly healed. The evidence of a pending slowdown is abundant. The Empire State's business conditions index decreased 10 points from April to just 11.9 in May. Meanwhile, the prices paid index rose sharply, with about 70% of respondents reporting price increases for inputs, and none reporting price reductions. That inflation index advanced 12 points to 69.9, its highest level since mid-2008. And things are even worse in Philadelphia. The Federal Reserve Bank of Philadelphia's general economic index fell to 3.9 in May from 18.5 a month earlier.

Turning to the labor front, the four week moving average of initial jobless claims rose to 439,000 last week, from 437,750 in the week prior. Of course, the real estate market continues in its malaise. According to the National Association of Realtors, April existing home sales dropped to an annual rate of just 5.05 million. Prices continue to set new post crash lows, with prices down 5% YOY. Despite the fact that the government still accounts for nearly the entire mortgage market and the Fed has rates near zero percent, inventory of existing homes jumped from 3.52 to 3.87 million units and the months' supply climbed from 8.3 to 9.2. Does it sound like the economy is ready to get up on its own two feet?

But the Fed is under pressure to do something about the growing inflation threat. Year over year increases of CPI, PPI and Import prices are 3.2%, 6.8% and 11.1%, respectively. As price increases hit middle class consumers, the Fed is facing intense pressure to push down inflation by draining the balance sheet and raising interest rates. It's a dangerous game.

In its simplest terms quantitative easing is nothing more than the government's attempt to boost consumption by borrowing trillions of dollars. Over the long haul this is no way to run an economy, and a sustainable recovery will be impossible as long as such borrowing continues. But in the short term, a cessation of government borrowing will lift the veil on our artificial economy, and reveal how dependent we have become. U.S. fiscal and monetary austerity will cause GDP to fall as the deleveraging process that was interrupted in 2009 returns with a vengeance. I do not believe the Fed or the Administration has the intestinal fortitude to let that happen.

A bona fide Fed exit from interest rate manipulation means that both nominal and real interest rates would rise significantly. The ten year note yield is less than half its average over the past 40 years. Normalization of rates would provide a serious headwind to markets and the economy.

The high leverage that brought on the Great Recession has not been addressed in the slightest. U.S. household, corporate and government debt as a percentage of GDP has never been greater. So, if interest rates were to rise, why should we expect a different result from what occurred in 2008?

Whether or not the Fed is bluffing has dramatic implications for investors and the country. Mr. Bernanke will eventually have to choose whether he wants another depression or more of the inflation the Fed is so adept at causing and then denying.



Tags:  fedGDPquantitative easingrecession
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Pentonomics - Monopoly Money and Manufacturing
Posted by Michael Pento on 05/18/2011 at 7:09 PM

For an investor to prosper, it is imperative to understand the mindset of those relatively few individuals in government who control the direction of the economy and the markets. One such person is C. Fred Bergsten. This gentleman has many titles; He is a Senior Fellow for the Council of Foreign Affairs, Director of the Peterson Institute for International Economics and, most importantly, a member of the President’s Advisory Committee on Trade Policy.

Mr. Bergsten declared on a CNBC interview last week that the decline of the U.S. dollar “is an unambiguously good thing for the United States.” The so called evidence presented for making that assertion was is his claim that the dollar lost 25% of its value during 2002-2007, which cut the trade deficit in half from 2006-2009. Watching C. Fred espouse the benefits of a falling dollar was a perfect lesson on how to data mine the facts in order to present a spurious conclusion for the sole purpose of supporting a political agenda.

He went on to state quite emphatically that; “every 1% decline of the dollar strengthens our trade balance $20-$25 billion per year, once the lags of two or three years play through”. He continued, “That means if the dollar goes down even a modest 10%, we get a quarter of a trillion dollars of greater economic growth. That translates into something like a quarter of a million to a half a million jobs. So, it’s unambiguously good for the U.S. economy and that’s what we need at this point in time to get a sustained and strong recovery.”

You can watch the whole train wreck here.

Of course, the CEO of Caterpillar Doug Oberhelman, who was part of the interview, was quick to agree. Since Caterpillar is a large multi-national corporation, it earns a good deal of its revenue from foreign sources. Therefore, it makes his company’s foreign earnings look much better once they are repatriated back into U.S. dollars.

But Mr. Bergsten’s facts are just as wrong as his conclusions. First off, the U.S. dollar lost about 35% of its value on the Dollar Index (DXY) from the start of 2002 thru the end of 2007; not the 25% he claims. During that six year time frame, the U.S. deficit in services and goods soared from $420.52 billion to $702.09 billion, according to the Census Bureau.

He then cleverly claims that the deficit was cut in half from 2006-2009. That much is true. However, he selectively chose 2006 as his starting point because it was the high water mark of $759.24 billion worth of red ink.  But he doesn’t offer any explanation as to why the trade deficit soared 80% during that five year period from 2002 thru 2006. Instead, he falsely credits the falling dollar, instead of The Great Recession, for lowering the trade deficit. In fact, his deception is so nefarious that he conveniently forgets to mention the tremendous U.S. dollar rally, which took the currency from the low 70’s in 2007, to 89 in 2009, during that time frame.

The real reason why the U.S. trade deficit fell was because of the greenback’s rebound. It was not due to a decline in its purchasing power. The rising dollar caused the price of imports to fall—especially oil, which fell from $147 a barrel in the summer of 2008 to the low 30’s in early 2009. So we bought less oil because of the recession--and at much lower price.

Another one of Mr. Bergsten’s contentions is that a falling dollar helps create manufacturing jobs. Remember, he claims that a 10% drop in the value of the dollar would create a quarter to a half million jobs. Since the dollar dropped 35% on the DXY between 2002-2007, we should have seen at least a million manufacturing jobs created during that time frame. After all, C. Fred acknowledges that 80% of all trade is manufacturing. So where are the jobs? From the start of 2002 thru the end of 2007, the U.S. actually lost 1.7 million manufacturing jobs! And during his so called “pay-off period” of a falling dollar between 2006-2009, the economy lost 2.7 million manufacturing jobs!

What Mr. Bergsten and the current administration fail to understand is that our inflationary policies have not kept the dollar price of our domestically produced goods static. The value of goods and services produced in the U.S. has increased in conjunction with the decreased purchasing power of the currency. The result is that those foreign importers who have allowed their currency to appreciate vis a vis the dollar have become immune from our inflation and can purchase roughly the same amount of goods using the same amount of their currency.

But if the rate of dollar destruction continues, the U.S. will discourage most investment while sending prices for both domestic and foreign purchases out of reach for the average American consumer. The resulting inflation will eventually destroy the domestic manufacturing base because the purchasing power of the middle class will be greatly diminished--rising prices cause the elimination of discretionary purchases, causing massive job losses and plummeting output.

Turning the U.S. dollar into Monopoly money doesn’t engender a manufacturing renaissance. But a dramatic decrease in the purchasing power of a currency ruins the economy as it creates inflation and destroys all incentives to save. Ironically, during the same interview Bergsten acknowledged the need for Americans to save more, yet by punishing savers with a weaker dollar, his policy prescription would produce the opposite effect. Therefore, C. Fed Bergsten and the administration need to understand that a falling dollar doesn’t balance trade, but rather is a job and economy killer.



Tags:  recession
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Pentonomics - Two Different Worlds
Posted by Michael Pento on 05/12/2011 at 8:18 AM

Yippee! Consumers continue to dig themselves deeper into debt. Consumer credit has now increased two quarters in a row after falling 1.7% during all of 2010. In the fourth quarter of 2010, Americans increased their borrowing at a 2.1% annual rate and in Q1 2011 that borrowing picked up the pace to 3.0%.

Maybe consumers need to borrow more because prices for the stuff they buy keep rising. Import prices jumped 2.2% from March to April and soared 11.1% YOY.

But not surprisingly, all of this inflation and borrowing isn’t helping the economy. The National Federation of Independent Businesses (NFIB) put out a survey of small business sentiment this morning. The Small-Business Optimism Index dropped for the second month in a row, down to 91.2 in April and the report also stated that small businesses posted a substantial increase in the number of owners who reported raising selling prices. Here are some more highlights from the report:

  • In April, a net 12% reported raising average selling prices, a 3 point gain from March and 23 points higher than last September. A net 24% planned hikes in average selling prices in April.
  • The net percent of owners expecting better business conditions in six months slipped another 3 points to negative 8%, 18 percentage points worse than in January. Uncertainty is the enemy, and there is plenty of it to convince owners to “keep their powder dry”.
  • Only 50% of all firms reported making capital outlays last month, down 1 point from the month prior. The percent of owners planning capital outlays in the next three to six months fell 3 points to 21%, a recession level reading.  Money is cheap, but most owners are not interested in a loan to finance equipment they don’t need.  Prospects are still uncertain enough to discourage any but the most profitable and promising investments.

The business condition of large multi-national corporations looks much better because of the falling dollar. But small businesses earn revenue in dollars and sell to the domestic economy. So there you have the two different worlds. If you are a big business or a wealthy individual things look ok. If you are in the middle class or own a business that sells to just Americans…the recession continues.



Tags:  consumercreditinflationrecession
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Pentonomics - A Double Dip Recession
Posted by Michael Pento on 05/09/2011 at 8:25 PM

The evidence of a double-dipping housing market and economy are becoming undeniable, even to those who still perilously cling to the notion that government intervention has been a salve instead of a poison.

The main evidence presented on the part of the perma-bulls of a healing economy is that corporate earnings have been good. However, S&P 500 earnings from multi-national corporations have been significantly boosted by a U.S. dollar that has lost nearly 15% of its value in the past 12 months. So earnings look great but they don’t buy you very much, while small-cap domestic businesses suffer under the scourges of inflation and slow growth.  

But markets have the final say as to where the economy is headed and investors would do well to listen. The 10 year note yield has traded down to 3.19% from 3.72% three months ago and the 1 year T-bill is now yielding just .17%. In confirmation of the slowing economy, oil prices have dropped $8 dollars a barrel in a week, while copper prices have plummeted from $4.47 to $4.01 a pound in one month!

Recent economic data confirm the move lower in industrial commodities. Yesterday, we saw the ISM-Service Sector Index drop to 52.8 from 57.3 in March. New orders plunged to 52.7, which was the lowest reading since December 2009, from 64.1 in the prior month. And the employment index dropped to 51.9 from 53.7 a month earlier. First-time jobless claims surged by 43k to 474k in the week ending April 30th , which was the highest reading since August. And the four-week moving average rose to 431,250 from 409,000.

But perhaps most importantly, more evidence of an official double-dip in home prices was found in a report from Clear Capital. The report stated that its monthly index is now 0.7% below the all-time low set in March 2009. Two highlights (or lowlights) from the report:

  • Year over year national home prices are down 5%
  • Home prices have dropped 11.5% in the last nine months, a rate of decline not seen since 2008

The saddest news of all is the fact that over 25% of all homes with a mortgage are underwater on the loan. Home prices that continue to fall will bring that number higher and create the vicious cycle of a greater percentage of mortgage holders with negative equity, which causes more inventories, which leads to falling prices.

What’s a Fed Head to Do

The truth is that a double-dip recession was temporarily held in abeyance through a massive government effort to boost consumption. But that intervention in free markets was destined to fail from the beginning. , Quantitative counterfeiting part 2 hasn’t even ended yet and this ersatz economy that is based on borrowing and printing is already starting to falter. What does all this mean for the Fed? A slowing economy with rising unemployment and falling home prices will, unfortunately, keep the Fed in the ship building business (think QEIII) for quite some time. That means when the Fed, Treasury and Administration finally acquiesce to allowing market forces to reconcile the imbalances, i.e., allow the deleveraging process and asset price declines to consummate, the pain will be much worse.



Tags:  quantitative easingrecession
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