Mr. Bernanke's Fed. Bravo!!!

The FOMC statement issued Tuesday August 9, 2011 at around 14:15PM was dissented by three committee members. It initially stirred confusion in all markets. Equity markets were taken by surprise as they focused on the bleak economic outlook the Fed suggested.  The Dow was down 200 points, shedding almost 450 points in 30 minutes before recouping after watching the Treasuries' plummets and appreciating the insight that maybe equity yields were favorable investments after all.  At the end of the day, the Dow had rallied back over 600 points. It was a session marked with enormous market volatility. Dow closed the day 430 points higher in the most dramatic session in decades.

The same announcement shook short date (2 years and less) Treasury markets dramatically,  generating yields that camouflage Short date Notes as fed funds- zero coupon- for all intents and purposes, and sent the US dollar into a tailspin against the meek Swiss Franc and roaring Gold,  after market players correctly interpreted that the Fed was capping rates at near-zero for the next 30 months until the end of Mr. Bernanke's term.

Most observers also correctly felt that the Fed intentionally avoided sabotaging already nervous equity markets that were showing promise with substantive earnings and a sufficient capital base. The Fed action was seen as creating favorable portfolio opportunities  for money managers to retain good yielding equity that confirm good earning and dividend profiles. The Fed idea was not to undermine potential economic benefactors and job creators. Quantitative Easing 1 (QE1) and QE2 had already successfully channeled funds through the system and filled corporate treasuries with low cost capital which is supporting the already fragile recovery. 

Others perceived the Fed move as a preparatory scenario for an another QE3-fielding the necessary signals to the market, keeping available liquidity for timely Bond releases.

Notwithstanding the above probable explanations, I think Mr. Bernanke and this Fed were engaged in a more extraordinary exercise and endorsing a more subtle stance that blindsided a myopic market, naturally  focused on its malaise. Mr. Geithner had already voiced his concerns that exogenous factors existed which also influenced US markets. Mr. Geithner minced few words when he warned the markets that European contagion was a real threat to a global recovery,  much greater than the immediate slowdown in the US economy. It was confirmed by all Central Banks that if Italy failed to refinance it might mark the collapse of the eurozone and generate a systemic collapse. The Fed was aware, as was the Treasury, that ECB and the EFSF resources would not suffice to cover the Italian and Spanish risk, if and when (within 2 years) they surfaced. There is only one player in the world that can assume the role of backstop required by the situation: enable the Eurozone to stay afloat in case of overwhelming risk, and  keep Germany, France and Italy from following into political and economic disarray, and from sending the euro through Hades, and many to Dollars and Gold,  SFr and maybe yen-but how much liquidity can they carry. The same can be said of gold: how much demand can it support.  European contagion would also dramatically undercut the engines that drive emerging market momentum which, at present, supports some of the global economic growth. Intrusion of the Fed in the short dates would have unnecessarily squeezed  Italian and Spanish offerings. It may just be that the US has saved the Italian offering.

The Fed's move was larger in scope and more daring in nature than meets the market eye. Perhaps, Frau Merkel can be more accommodating in tone when she reacts to the 'problems' in US markets and the challenges of the US Government.

US Sovereign Downgrade by S&P: Buffo!

On the evening of Friday, August 5, 2011, Standard and Poor’s, in an act of Bravura, downgraded United States Sovereign Debt rating to a AA+ from a AAA while reaffirming its A-1+ rating on US short term, notwithstanding their $2-trillion math-error! Bravura?  More Buffonata! than Bravura! This move had to some extent been discounted by global markets. Suffice to note the past week’s session drops in all major bourses. Those drops may also pre-empt the impending confusion and instability that will characterize the upcoming weeks' sessions on most security markets, especially from Asian and European markets which, opening after watching the announcement, should experience a tumble, but not a crumble.  

Todate, Moody’s and Fitch Rating have shown caution in this regard reserving their assessments for later.

The analysis by Mark Zandi of Moody's on fiscal sustainability,  tax reform and responsible compromise demonstrates the type of level headedness that is required by Credit Rating Agencies when they approach new paradigmatic scenarios, because de facto, the current US Debt situation invites paradigmatic shifts in methodology and optics.

Sovereign Balance Sheet is not a Corporate Balance Sheet. There are overwhelming incidences of political discretion that can neither be reduced to a quantitative measure nor can they be appreciated as stand-alone components for a measurement standard. The deficit cannot be isolated from the trade-off matrices that configure the US relationship to its broader sphere of influence within the domestic and  global political and economic network.   

Apart from a global audience whose appetite was partially satisfied by the Washington deal, the winners of the Washington tug-of-war will be investors. The basic premise that some investors will be precluded from future purchases is unrealistic. Most institutional players have portfolio criteria that permits purchases on any security rated a AAA to peers by at least one or two of the Big Three. Flight from US Treasuries is also very unlikely because there is no other safer investment haven in the world than the United States.

On the downgrade, markets will bid up the AA+ US Treasuries; many investors will pull out of equity markets leading to their decline resulting from the failure of corporate equities to compete with rising sovereign debt.  The US Dollar could appreciate for a time, as timely capital inflows into the US on purchases of US sovereigns dominate foreign exchange markets. At one point, given all things equal, markets will reach a state of equilibrium: the USD should subsequently  fall into a lethargy . How far down must the Dollar fall before the J-curve comes into play is anyone’s guess. US manufacturers are no longer very competitive on global markets. Marshall-Lerner conditions may no longer prevail in an orthodox manner- what previously worked and set precedents may no longer apply to current conditions.  Ultimately, a drop in the currency increases the existing deficits and dissembles interest for the de-facto guarantor of most of the world’s assets. Moreover,  core expenditures cuts may dramatically affect a large number of sectorial players in energy, financials, defense, health and transportation as well as state, municipalities and para-government agencies.

By 2012, unless deemed progress is made on the deficit front, markets may be confronted by another adverse assessment of the US Debt situation that could trigger another downward spiral and so on.

So returning to rational predicaments.
When is the Big Sell-Off.
How much has already been Shorted.
What is the option to a Big Sell-Off.

As with any rational and conceivable counterfactual scenario, the market must review the effects of the day-after.

Firstly, if a AA+ still attracts investors, then the S & P  Grid is substantively superfluous, because it does not deter investors, it merely panders a price peg.

Secondly, if it really considers US Sovereign Debt as relatively compromised in relation to other options (what similar options are there?), then S&P should be integrally considering a reassessment, if not a downgrade, of every major holder of US securities: reassessing the actuarial liability of every pension fund, the unit value of every mutual and the stability of every Bank in the world carrying US Treasuries especially the those of the UK, Canada and the Caribbeans, as well as the holdings of the Governments of China, Japan and Taiwan, since the integrity and liquidity of their respective financials are now compromised.

Thirdly, trading partners' current accounts may find themselves as compromised by the US deficit reduction plan as US domestic players. They, and their own nationals, may indeed have to envisage a weaker investment profile than anticipated in face of such a contagion as their own economic growth falters and begins staggering.   

Finally, the effect of contagion within the American political and administrative system is even more immediate. Municipal, state and other domestic secured borrowers will not only find their investments more expensive to finance, they may actually find themselves excluded from markets. The impact of the above is extremely onerous on regions and communities attempting to recover. It is even more onerous on the American people as households will be forced to pay more for their debt. What appeared as an enterprising improvement in household wealth in the last quarters may quite rapidly deteriorate into ephemera.

There appears to be no end to the downward spiral. The downgrade weakens the Dollar, and eventually adversely skews expectations on Dollar Assets, further defeating the Dollar Stability Paradigm. Why would anyone hold Dollar assets under such conditions.  It is somewhat irrational to advance a rational argument that impels an irrational decision. Theoretically, the world should dump dollars; but no coordinated action has been exercised yet. Is the premise false or are the components of the dilemma flawed. Probably a combination of both. As to the premise that the downgrade weakens the Dollar and the Stability Paradigm is weakened, there is some truth, but there is no  real dilemma since there is no credible option to the dollar, except for the esoteric: Gold, and that should experience an early surge next week, or short date moves to the Swiss Franc or Yen. If one buys into the Gold Niche, then the predicament is: should we not revert back to the Gold Standard.

Perhaps, the real issue is that no one cares about the one S & P evaluation in the case of US Debt because 'safe haven' should be given more value than the nature or size of the deficit. Or perhaps, as reality sets in, investors will realize that the US will continue refinancing its interest payments at a higher cost indefinitely, and the principal is far enough out that it will not affect their immediate results, and in turn will be itself refinanced. So enough for intergenerational considerations!Circuit theory  and modern monetary theory can certainly clarify the situation at hand and suggest reasonable solutions. We are de jure dealing with a perpetual money printing process.

As bond yields rise, equity markets sell-off,  and since interested liquidity is not abundant these days, the market promotes its own volatility, prefers the selloff to being hostage to an uncertain future 12 months down the line-the US debt-limit problem will resurface in 2012. One hears the snickers of a community of free-loaders and free-riders. In the end, one witnesses a run to les paradis artificiels of gold and similar glitters. Metals follow course and a manufacturing sector that had tolerated an adverse and unexplainable peak in prices, experiences once again a surge in commodity prices, a drop in demand -the combination of which dampens their recovery. Layoffs follow. Companies close and household wealth plummets. We are in the third phase of the Great Recession, or Phase One of the Great Collapse. For workers and their families, it is inconceivable that this happen in and to the United States.  

Did S&P cynically engage in a Marketing bravado of 'I was First' or 'We blew it last time, and we got hammered by the US Government-it's our turn now!!! '

If so, then it's ironic that Nemesis should be invoked in this farcical manner. Showmanship is not publicly responsible. To be sure, what the Rating Agency contends is that it is simply acting in accordance with its professional responsibility, intending Hayek and claiming unintended consequences  with respect to the outcomes in performing its mission.But markets have short memory spans; they were ready to crucify S&P a few years ago for negligence; now they'll take the free ride they offer.

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