Bernanke's Race to the Bottom

With two rounds of Quantitative Easing complete, the US economy appears to be looking for firmer footing. Ahead of Helicopter Ben's speach tomorrow, expectations are low for QE3.  Inflation expectations are bound to take hold, eventually. I advocate going against the recent grain, buying stocks on any dips.

Money supply is extremely high (http://en.wikipedia.org/wiki/Money_supply).  Banks will eventually move the cash off their balance sheets in search for higher yields, as soon as they find an asset class they can believe in.  My first guess would be apartment REITs as renters in high cost areas such as Washington DC pay extremely high rents.  I like Avalon Bay of Arlington, VA (http://www.google.com/finance?q=avb).

The debasement of the dollar through Quantitative Easing is Bernanke's race.  How quickly can the Fed chief single-handedly cause asset price inflation? Devaluing the dollar will have the following effects on the economy:
- asset price inflation
- cheaper exports, increased manufactured goods
- wipe away household debt (i.e. mortgage, credit card, stud loan)
- increased purchase of T-bills by China as they seek to retain the fixed rate of money exchange
- larger spread between actual and theoretical value of yuan, opens door to currency speculators
- less incentive to hold cash

At what point does M2 move through the system? My guess is the money moves to emerging markets and domestically into mixed-use commercial buildings.  After all, real estate is currently very cheap in many areas, making commercial and multifamily development more enticing.

Gold will eventually shatter. I was wrong buying puts at 1,000/ounce. Two thousand an ounce is very tempting.  The big picture is people don't trust governments to do what is in their economic best interests.  However, by the time the bus falls off the cliff, it will be too late. Does anyone remember oil in the summer of 2007? The only reason to buy gold is fear. If a country is forced into pulling out of the Europen Union, this may be your final chance to get out.  After all, a couple of hedge funds could easily have access to more capital than the Italian government. There is a giant game of chicken, and usually, whoever puts the most money on the table wins. Think Soros shorting the British Pound.

In June 1879, William Tecumseh Sherman gave a speech to the cadets of Michigan Military Academy.  There before a crowd of 10,000 people he had this to say,“…I’ve been where you are now and I know just how you feel. It’s entirely natural that there should beat in the breast of every one of you a hope and desire that someday you can use the skill you have acquired here.  Suppress it! You don’t know the horrible aspects of war. I’ve been through two wars and I know. I’ve seen cities and homes in ashes. I’ve seen thousands of men lying on the ground, their dead faces looking up at the skies. I tell you, war is Hell!”

            Hell is what we as a nation have been in for the better part of a decade.  But this hell had an upside.  During this last decade the United States has had to re-grow its’ military from the drawdown of the 1980’s - 1990’s to the state we are in today.  Prior to 9/11 the Defense budget was around $370 billion, today the Defense budget is $550 billion dollars.  This buildup in personnel and equipment led to many things; jobs and an industrial military complex that has benefitted greatly from America’s decade of confict. 

            The military has around 1.4 million men and women serving on active duty.  This is a far cry from the previous decades when there were over 2 million people serving on active duty (Defense Budget for FY2003: Data Summary", CRS Report for Congress). It is easy to do the math, since the end of the Cold War the U.S. has cut over 600,000 from its active duty force.  From this downturn the military has had to rely more heavily on defense contractors.  The last fiscal year alone the “Department of Defense has spent $316 billion dollars on contracts… and at the start of Desert Storm there were 50 people serving in the military for every 1 contractor over seas.  In Afghanistan now, there are approximately 100,000 contractors, a ratio of 1:1  (Singer, Peter W. "The Regulation of New Warfare", The Brookings Institution, February 2010.).  Cuts to the Defense Department are being felt on Military bases all across the United States.  Security officers on posts are getting laid off, soldiers with a spotty past that the military turned a blind eye to, as little as 3 years ago, are now being chaptered from the because they never could shake their criminal behavior.  It won’t stop there, soon it will be PT failures, or soldiers that can’t progress in ranks and if the Defense Department can’t meet it’s numbers from chapters then the cuts will come.

            Cuts too are already being felt in the defense industry.  “Honeywell, which sells aircraft engines and other kits to the military, expects the base budget to decline about 1 to 2 per cent a year over the next decade, resulting in a 2 per cent to 4 per cent annual decline in revenues for its defense unit for three years...expect these budget cuts to affect the large prime contractors and to ripple across the supply chain to smaller, specialized providers,” (Industry feels the sting of US Defense Cuts, By: Jeremy Lemer, Financial Times).  The talk now isn’t about when change is coming, because it has already.    

People today are tired of war and look at the military as the biggest offender of an overspent federal government.  They are tired of the nation building in countries that many of them will never set foot in. So politicians will go after the defense budget, because most of their constituents will clamor for that happen then to see cuts in their medicare or social security.  But the Defense budget has an unforeseen effect on these two programs.  The Defense Budget is what has made the American economy the powerhouse it is today.  We have freedom of the seas because of the power of the US Navy.

  The United States needs to be strategic in allocating future resources.  Human rights in developing and land-locked countries depend heavily on foreign assistance.  Better appropriations procedures and auditing can go a long way to ensure that mouths are truly being fed. Budget constraints will be felt on domestic and international economies.  It will be as Sherman said, "hell".    

Outlook for S&P/Moody's: 'Negative'

On August 8, 2011
Congratulations Standard and Poor's. You have created an enormous buying opportunity for anyone who cares to take notice.  As a matter of fact, the yield on US T-Bills declined today as investors flocked to US securities in search of a safe haven investment, whether it be AA+ or AAA or AAAAAAAAAAA, doesnt really mean anything as far as this blog is concerned. I would buy more deep in the money leaps (jan13 or later) on WFT, POT, PM, MO, XOM, CVX. I own call options on WFT and POT.

In light of Standard and Poor's recent rise to fiscal responsibility, I would like to formally request a copy of all bonds and securities rated since the year 2005. In this report, I am specifically interested in cash flows for mortgage backed securities originated between 2005 and 2007, the payoff date of the security, the interest payments expected to be received by the investor,  the actual interest received by the investor and of course the correspond 'official' rating.
http://www.washingtonpost.com/wp-dyn/content/article/2010/08/31/AR2010083106192.html


On August 2, 2011

Moody's has posted an 'Outlook Negative' on the US credit rating (<http://finance.yahoo.com/news/Moodys-backs-US-tripleA-apf-2668047537.html?x=0&sec=topStories&pos=main&asset=&ccode=>).  I must think that too much austerity as the US is coming out of a recession is certainly not a good thing for the economy. At the same time, we need tax increases to close the deficit. The lawmakers did the right thing and got the debt deal done. Wasn't too good. Wasn't too bad. Good enough.  Let us move on.

I like how Moody's/Standard and Poor's are all of a sudden the steward of fiscal responsibility.  In Michael Lewis' book The Big Short,  he notes that anybody who doesn't get a job at a big investment shop has to settle for a job at Standard and Poor's, Moody's or Fitch.  He also points out that those betting against the housing market found plenty of ammunition in the pay to play scheme concocted in so called AAA ratings.  We should not forget that in the not too distant past a AAA rating was assigned to every subprime security in the TBA market.

The purpose of ratings agencies is to provide an opinion on the collateral that backs the debt of a corporate or government entity.  Typically, ratings agencies (and analyst opinions) are simply following the lead of bond investors in the market. They provide a reactionary opinion based on what has already happened based on bond yield spreads.  Since the subprime debacle, the agencies attempt to get out in front of credit problems of the US or European governments. They are simply translating what the bond markets are saying into plain English.

We should acknowledge the agencies in their plight to make themselves whole to the stewards of credit and simply ignore them when it comes to economic policy.  As they say, let the money do the talking; Bond yields will speak for themselves.    Even better, perhaps the ratings agencies should make statistics available on opaque securities that earn their stamp of approval, reference expected cash flows, debt percentages, and verify collateral to weed out fraudulent entities.