The ActiveRain Addiction

I'm a couple weeks behind this one, as all the media focus lately has been on the health care bill.  I've had several interesting discussions around cap and trade lately that inspired me to put my thoughts down into a blog post.

Disclaimer

I consider myself a fairly environmentally conscious person, I do believe based on data and observations human activity is creating a huge and very negative impact on the global climate.  I'm extremely worried about the this planet over the next several decades.  To me the health of this planet overrides any economic impacts of decisions, but at the same time I believe doing what is right for the planet can be done in ways that is also very economically beneficial in the long run.  I'm not writing this post to debate these points...

Cap and Trade is a Wolf in Sheeps Clothing

The idea behind the bill sounds fine based on the highest level talking points, incentivize investment in alternative energy and at the same time disincentivize the polluters.  Once you look under the hood though, the best phrase I can use to describe it, is "financial scam".

What got me looking at, and thinking about the impacts of the cap and trade bill was when I noticed the biggest supporters throwing the most lobbyists and money behind it was not the alternative energy industry but the Wall Street investment banks.  Why?

It comes down to the whole "trade" part of the bill where carbon credits received can be traded/sold to carbon producers.  It's been estimated that this could create the largest derivatives market, larger than the CDS's (credit default swaps).  These credits would trade on an exchange (partially owned by Goldman Sachs) and would be a multi-billion dollar windfall for the investment banks. 

Since the number of carbon credits available is fixed, and is reduced each year this creates a made in heaven market for large traders and speculators (hedge funds, investment banks).  The carbon bubble will become the new credit bubble, as speculators suck productive money from the system.

Destructive Impacts on the Alternative Energy Industry

I've got a lot of friends involved in the alternative energy industry who believe this bill is a windfall for the industry and will spark the next big revolution in alternative industry.  Be careful what you wish for, the long term impact on the industry may in fact be very destructive.

It's analogous to what happened with the housing market and credit bubble in 02-06 with all these new fangled mortgage products, CDO's, CDS'.   Everybody touted these products as being great for the housing industry as they made housing more "affordable" and accessible to the masses.  We now realize the truly destructive nature of these products, which incidentally were created by the same Wall Street banks behind the cap and trade bill.

Particularly as the price of carbon credits in driven up by speculators, it will become extremely profitable for companies producing them.  The catch is the total number of credits is limited and there really isn't a direct tie between a technology being beneficial long-term, and producing carbon credits.  You will see hundreds of companies pop up, simply built to capture huge profits from carbon credits, with technologies that otherwise would not make any sense. 

In much the same way as imprudent lenders pitching alternative mortgage products forced prudent lenders out of the mortgage business, viable alternative energy technologies will be squeezed.  Investment will be redirected from the productive to the speculative, with very negative consequences.  Of course this bill is practically designed to create a "carbon bubble", who's popping in a few years, will sow yet another round of economic destruction laying waste to a whole industry while the pig men walk away with their sacks of money.

My in my last blog post a mid-year update to my 2009 market and economic predictions I got multiple comments about the economic threat of inflation or even hyper-inflation rearing it's ugly head.

"It will be interesting to see how those TARP funds play out and what the aftermath will be.  My guess will be massive inflation.... think about it this way."

"One thing is for certain. If inflation rears its ugly head, interest rates will increase to combat that."

"Still have you noticed how no one is talking about the inflation rate?   We know that in order to spend the "trillions" that more money will have to be printed."

This also seems to be the common thread in the media and much of the financial world, everybody is expecting or thinks we are currently experiencing a huge, hidden inflation.  I'm going to lay out the case, why I not only don't any evidence of it, I expect the opposite, a very deflationary outcome, over the next several years.

Truth be told the central banks around the world, including our FED, are desparately trying to return to an inflationary environment.  There is nothing they fear more than deflation, but their efforts to reignite the inflationary engine can only be described as an epic failure.

We already had the massive inflation through credit expansion

For about a 5 year period between 2002-2007 and maybe a little bit before the US went through a massively inflationary period, not represented by the standard government inflation or money supply numbers. It was caused by what many sometimes refer to as the "shadow banking" system (because it doesn't show up in the numbers) that drove massive credit expansion.

Not that it was exactly very hidden.  It drove speculative bubbles all around us, both residential and commercial real estate, commodities, corporate debt fueling leveraged buy outs and equities.  If you believed the CPI numbers published you saw inflation rates of around 2-3% during this period.  Several economists have calculated the real inflation rate was actually somewhere between 10-15% annually during this period.  This lead to both real interest rates that were very negative, and also a very negative real wage growth. 

The last year and a half we've seen the exact opposite, a massive credit contraction, driving deflation across almost all asset classes.  Just as the government numbers as an artifact of what they measure severelly understated the inflationary period they are massively understating the amount of deflation that is ocurring.  Look around at real estate, stocks, bonds, commodities.  Do you see rising or falling prices over the last two years?

Credit destruction is MANY times larger than credit creation

The most common inflationary argument is the FED and other central banks are printing trllions, upon trillions of dollars that are being pumping into the system.  While there has been a couple trillion in money put into the system, the actual amount used to monitize debt through quantitative easying is only around a trillion or less.  Now counter balance a trillion vs. over $50 trillion in global wealth destruction in 2008 alone.  What's the bigger number?  To put in bluntly the FED and other central banks are merely pissing into the wind with their efforts.

The money isn't moving

Now here is the real crux of the problem for central banks why money supply creation and stimulus are not having their intended inflationary effect.  While the technical definition of inflation is size of the money supply, all the inflationary effects people worry about are instead driven by the velocity of money.  A small amount of money moving very fast through an economy creates more inflationary effects than a large amount of money sitting on a balance sheet plugging holes.

In fact the velocity of money has completely collapsed as it's being used to pay down and service debts or cover losses.  The last time the velocity of money was this slow, was heading into the Great Depression.  Below is a chart of MZM the broadest measure of monetary velocity.

The hyperinflationary setup

For those people worried about imminent hyper-inflation, it might be worth looking historically at characteristics of hyper-inflationary collapses.  There have been dozens of well documented ones throughout history, some of the ones that come of most peoples minds first are the Weimer Republic in 1920's Germany and recently in Zimbabwe.

Hyperinflation almost always occurs following a severe deflationary collapse.  While I've made my case we are experiencing deflation right now, we are no where near what would be considered a collapse, yet.  It also ocurrs in a countries that base purchasing power on a stable foreign currency.  In other words if you have the world reserve currency like the US dollar, it is near impossible to get hyperinflation.  It's much more likely you see hyperinflation in foreign countries that attempt to peg their currencies to the US dollar, which would result in a relative strengthening of the dollar. 

I could see us, creating a setup for hyperinflation if the dollar looses reserve currency status, and we experience a deflationary collapse, but it would take us several years to get there.

Interest rates rising without inflation

Ok, so I've gone on record saying I expect rising interest rates and possibly a crash in the US Treasury market within the next year.  If rates are rising doesn't that imply inflation?  Well not exactly...

Inflationary expectations are only one component of what sets interest rates, the other major one is risk of default.  The higher the risk of default the higher rates must go.  It's this rising risk of default that I expect to significantly push up rates not inflation.  In fact the rising rates may have a highly deflationary impact as it will further choke off credit, stalling economic recovery.

More charts, "Dude, where's my inflation?"

We are now officially half way through the year so it's time for me to do an update to my 2009 market and economic predictions, also known as, Matt is being a buzz-kill again.  The quick scorecard is, four have already occured, four I'm still predicting will happen, one I still think will occur but probably not this year and one is DOA.

The media has become fairly delirious from smoking few too many of those "green shoots" as of late along with 90% of economists calling for the recession to end shortly.  It should be noted that a similar number of economists were confident we'd avoid a recession in the first place. They are latching onto month to month fluctuations in data claiming the economic recovery is upon us, while almost all trending and forward looking data is continuing to paint a fairly pessimistic outlook. 

Another main factor in my continued pessimistic outlook is the attempt by those in charge to play confidence games instead of solving problems.  If we believe things are getting better, they will, right?  Confidence without the foundation to support it, is not a very good economic base to build from.

1. The "Credit Crisis" morphs into much wider economic crisis

Ok, I think this one is playing out as we've moved from people claiming we're just having financial system and housing issues to seeing dramatic drops in employment and even more dramatic drops in tax revenues (corporate, income, sales).  While the official government reported unemployment rate is now up to 9.6% the broader unemployment measure like U6 has now skyrocketed to 16.4% the highest since the 70's. 

The data shows job losses are actually accelerating, not decelerating.  With the unbelievably dramatic drops across the board in tax revenues, we are just beginning very extensive layoffs from the nations largest employer, the local, state and federal governments.  We also have not seen the layoffs happening in the automotive industry show up in the official numbers yet.

2. The recession gets an upgrade

While I didn't expect an official pronouncement this year my prediction is that we'd meet the criteria for a depression not just a recession, which is defined by more than a 10% total loss in GDP.  I still think this is going to happen, and in fact I think the forward looking data makes this almost a lock to happen.  Though, this quarters GDP coming in flat or even just slightly positive wouldn't surprise me.

For some great visuals on how bad the economic trends really are check out this post on Nate's Economic Blog.

http://economicedge.blogspot.com/2009/04/economic-cliff-diving-by-charts.html

3. Pension funds, the biggest non-story of 2008 becomes THE STORY of 2009

Ok, I'll give myself about 1/3 of a point for this one.  The story is huge, it's just getting almost no play in the main stream media.  Many of the largest pension funds in the country are in deep trouble shifting into riskier and riskier investment strategies to make up shortfalls.  For example CALPERS the largest pension fund in the country shifting large portions of their assets to real estate right at the top of the bubble and then stocks right at the top.  They are in a massive hole, and have stated they are relying on being able to borrow from the state of California to fill the massive hole.  Yes, the state who tomorrow will start issuing IOU's in lieu of checks to pay bills.

Not to be outdone by California, PBGC (Pension Benefit Guaranty Corporation) which insures pension funds including those at GM and Chrysler followed suit.  Why are the pension funds pursuing such a risky strategy that would once have been looked upon as insanity? 

He said the previous strategy of relying mostly on bonds would never garner enough money to eliminate the agency's deficit. "The prior policy virtually guaranteed that some day a multibillion-dollar bailout would be required from Congress,"  Boston Globe article on PBGC

As they say, when in a hole, keep digging, or something like that...

4. House prices continue to fall, but in most regions not as fast

Not much to add here, the Case-Schiller data showed a 19% year over year price drop first quarter, with declines in all 20 major markets they track.  Anecdotal the declines in many markets appear to be slowing but historically in housing downturns the steepest declines occur in the first 2 years, where the average overall length of price declines in 5-7 years.  There's also still a huge backlog of foreclosures sitting on bank balance sheets which have been held back from the market.  This will keep inventories in most markets elevated for some time and keep the downward pressure on prices.

Update: Just saw the updated Case Schiller data released today, basically shows what I expected.  Still declining across the board but at a much slower pace.

5. The stock market is far from seeing a long term bottom

My prediction was that we'd see the November lows of 738 on the S&P500 broken this year, and we saw that happen in the first quarter of this year ominously putting in a low at 666 on the S&P 500.  Despite a several month, 35% straight up rally since then I don't believe we've seen the lows for this bear market, and see a high probability of the S&P500 going under 500 later this year.  Simply put we are still in a deleveraging phase and we've seen a massive drop in corporate profits making the stock market extremely overvalued at it's current level by almost all metrics.  These profits by and large were driven by the credit bubble, particularly in financials and unless we are able to blow another massive bubble they are not returning, like some are placing bets on.

6. Where does the bailout money come from when it's time to pay up?

We'll have to see, they just started issuing the debt a couple weeks ago, and we're now issuing as much treasury debt per week as we were per year less than a decade ago.  This is at the same time the major foreign buyers are slowly inching their way to the door, buying shorter and shorter duration debt, as the FED tries to hold back the flames through quantitative easing.

7. A crash in the US Treasury market?

This was the prediction I said I was the most hazy on last year, and now I think it's inevitable due to the insane government spending we've seen coupled with the gigantic collapse in tax revenue.  The FED has been pulling every trick in the book trying to surpress rates and support the treasury market through quantative easing.  History shows these types of efforts are simply fingers in the proverbial dike that inevitably bursts.  If the treasury market does crash you'll see double digit interest rates on mortgages within a few months.

On a related note, the consensus of late seems to be for rising interest rates but due to (hyper)inflation.  I simply don't see the case, all of the data points to massive deflation.  Oh, the FED's monetizing debt and printing.  The problem is the deflationary pressures and wealth destruction is dozens of times larger.  Also, the FED pumping money is only inflationary if the money moves, as inflation really is the velocity of money not the size of the money supply.  A small amount of money moving very fast through an economy is more inflationary than a large amount of money that sits on a banks balance sheet plugging holes.  The fact it's being used to plug holes that are not magically going away, is exactly why I don't see it suddenly becoming inflationary.

8. GM files for bankruptcy despite the automaker bailout

My prediction was that both GM and Chrysler would file for Chapter 11 bankruptcy this year despite their bailout at the end of 2008 with the goverment providing massive DIP (debtor in possession financing).  Check...

9. Regional bank failures and consolidation accelerate

We're up about 50 regional bank failures this year compared to 25 all of last year.  Technically I guess this counts as acceleration but it's still well below the hundreds I was expecting.  It has nothing to do the increased stability in the banking system and more to do with the FDIC and OTS not doing their job to protect depositors and tax payers. 

A good example of this is Bank United a large regional bank in Florida that collapsed about two months ago, at an estimated cost of about $10 Billion.  This bank was on my list of dead men walking back in April of 2007, due to the how badly their loan portfolio had already depreciated.  Two years ago it was clear from their balance sheet without pulling accounting tricks they were insolvent.  Every Friday for nearly two years I was shocked when I didn't see an announcement his bank had been seized due to how far gone it was.  Had it been seized two years ago it's likely there would have been very little, if any cost to the FDIC and US taxpayers, instead it cost us $10 billion. 

Then two weeks ago the head of the OTS resigned after it turned out he had ordered the Bank United to falsify financial statements to cover up their insolvency.  Yes, the top banking regulator was ordering banks to fudge their financials so they would appear solvent and would not be seized.  Bank United is not an isolated case, not by a long shot.  In fact, 2 other high ups at the OTS resigned or were fired in the last year for pulling similar stunts with other banks.  There is a organized effort to avoid failures at all costs by covering up the problems and hoping they go away.  This just makes the ultimate failure many times worse.  

The government banking "stress tests" meant to prove to the public and investors how sound are banking system was a similar sham.  We're already well past the loan default rates used in their most stressful scenarios, banks were asked to provide the valuations for complex securities like CDO's, and provided values many times above current market prices.  Commercial real estate, who's impact on bank balance sheets is likely to be worse than residential mortgages, showed almost no losses in the stress test numbers.  

Suffice to say, I expect the next "unexpected" banking crisis to rear it's head this fall at the latest and this time I'm not sure if there's the will political will to throw a few hundred billion more at it.

10. A revolt against corruption

Grrrrrrrr...  Where's that change Mr. Obama...  Must stop writing here or I'll launch into a rant and this post will be 20 pages before I know it...