The centre cannot hold

It’s quaint you know. Analysts faith in the system, I mean. There are a couple of really smart articles out this morning from really smart people about really smart things. And they’re making reassuring noises that there is no recession coming and that you should stay in your trades, that yesterday’s money making strategy is the same as tomorrow’s.

Take Tim Duy, for instance. He’s my favourite Fed blogger. A really bright economist and flexible enough to bend with the data. Today he argues the following:

For what it’s worth, auto sales where up in July, setting the stage for stronger growth in the second half.  Thin rope to hold onto, I know.  But one inconsistent with recession, arguing instead for a “growth recession,” ongoing tepid growth rates.

This is where the first question bleeds into the second.  What kind of recession would we expect?  Mild or severe?  I think that fears of a deep recession should be highest when the economy is operating at high capacity and/or when significant imbalances have developed.  Obviously, in the current environment, the economy is operating at low capacity, with only limited recovery since the recession ended.  Difficult to see, for instance, a drop in new housing starts of the magnitude seen in recent years.  Impossible, really, given the downside limit.  One has to imagine something similar holds true for auto sales.  And bank lending.  And households are already in the process of deleveraging.

You get the idea.  I think combining my thoughts on the first and second questions yields a high probability of slow growth, but a lower (20-30%) probability of mild recession, and a very low probability of severe recession.  I was concerned that government spending would come to a standstill, which would certainly plunge the economy into recession, but luckily that fear was not realized.

And then we have the following from J.P.Morgan via Bloomberg:

Investors should retain holdings in commodities even as the global economy expands at a slower pace as raw-material demand is strong enough to support further gains, JPMorgan Chase & Co. (JPM) said, forecasting gold and copper rallies.

Gold may jump to a record $1,800 an ounce by yearend, while copper revisits $10,000 per metric ton, Colin P. Fenton and Matthew Lehmann wrote in a report yesterday. The bank had raised forecasts for both metals, they said, without giving the earlier estimates. The bank can’t release a separate report of full calls, said spokeswoman Polly Leung, citing compliance policy.

Commodities as measured by the Standard & Poor’s GSCI Spot Index fell for a seventh session today, the longest slump since May 2010, on concern that the global economy is slowing. JPMorgan cut its forecast for third-quarter U.S. growth by a percentage point to 1.5 percent, Chief U.S. Economist Michael Feroli said yesterday. The U.S. is the world’s largest user of oil, and is second to China in terms of copper and aluminum.

“Baring a material contraction in global growth, which we do not currently expect, commodities should continue to move higher,” said New York-based Fenton, global head of commodities research and strategy, and London-based Lehmann, a strategist. “Even at a now slower pace, global growth in the second half should be enough to outpace still-constrained supply in the major commodity markets.”

Ah yes, the old supply and demand argument. It’s a beauty and even works sometimes in the real economy. At times like these, however, it’s completely irrelevant.

What makes both of these arguments wrong is the same thing. Markets are far more simple beasts than this. They run on sentiment. Especially so our supersonic, highly sensitive and utterly interconnected modern market. The sophistication of contemporary capital markets – the floating connections between equity, government debt, currencies, private debt, derivatives, assets and liabilities  – has no backstop. The intricacies of connection are so finely tuned, so efficient, that there is no buffer in the system.

That only leaves sentiment as the glue that holds it together.

And so, when things are perceived to be good enough, the system inflates. When things are perceived to be poor, such as now, the system deflates.

This system is global and, bizarrely, it is the funding mechanism for the underlying global economy. That is what both of the above articles miss. The interplay of this global market mechanism with the underlying economy guarantees a recession. It does so because things are poor, and so, everyone sells, in case everyone else does, or, can’t pay their bills. Consumers, who own pieces of the market system, see their assets devalue. They retrench. Funding for the real economy becomes scarce. Business retrenches. A recession ensues. The great and global gossamer market leads, it does not follow.

Of course, this ingenious and truly insane system is not completely without supports. As we saw in 2008, when the panic comes, ‘officials’ step in and save the system. There are two types of ‘official’ – fiscal and monetary.

The last two years has seen fiscal ‘officials’ drawn into the madness. Having saved the system with their own Budgets, it has turned upon them. In saving the broken system, they, ironically, broke the rules that make the system tick. Fiscal debt is now the problem not the solution and must be expunged (I’m not going to get into a debate with MMT’s over this. It is an observable fact that these are the rules that the system sets itself).

And after ‘officials’ did so well in 2008, grasping the fleeing fume that is this market, they have been behind ever since. In the US we’ve recently experienced perhaps the most calamitously stupid fiscal policy process of my lifetime, which has resulted in a terrible outcome of fiscal contraction in an economy already sliding towards recession. Along the way, we were offered a debauched glimpse of the end of the world we have known all of our lives, a US default. For no reason whatsoever.

But, as bad as that is, it is in Europe where the collapse of sentiment around fiscal ‘officials’ is greatest. The past two years has been one slow motion effort after another to catch up with failing market sentiment. But ‘officials’ have always been behind and are now falling prey to the same panic. From the President of the European Commission, Jose Manuel Barosso, comes this public letter to his colleagues:

Developments in the sovereign bond markets of Italy, Spain and other euro area Member States are a cause of deep concern. Though these developments are clearly unwarranted on the basis of economic and budgetary fundamentals and the recent efforts of these Member States, they reflect a growing scepticism among investors about the systemic capacity of the euro area to respond to the evolving crisis. Markets remain to be convinced that we are taking the appropriate steps to resolve the crisis.

The 21st of July bold decisions on the Greek package and the increased flexibility of the EFSF (precautionary use, recapitalisation of banks and intervention in secondary bond markets), are not having their intended effect on the markets. Markets highlight, among other reasons, the global economic uncertainties due to both economic growth and the protracted decision on budgetary adjustments in the US but, first and foremost, the undisciplined communication and the complexity and incompleteness of the 21st July package.

Whatever the factors behind the lack of success, it is clear that we are no longer managing a crisis just in the euro-area periphery. Euro-area financial stability must be safeguarded, with all EU institutions playing their part with the full backing of euro area Member States. We need also to consider how to further improve the effectiveness of both the EFSF and the ESM in order to address the current contagion.

Concretely, I would like to call on you to accelerate the approval procedures for the implementation of these decisions so as to make the EFSF enhancements operational very soon. These changes should also avoid introducing excessive constraints in terms of either additional conditionality or collateralisation of EFSF lending. I trust that governments and national Parliaments will rapidly approve these decisions necessary to improve the EFSF flexibility.

I also take the opportunity to urge a rapid re-assessment of all elements related to the EFSF, and concomitantly the ESM, in order to ensure that they are equipped with the means for dealing with contagious risk.

Finally the Commission stands ready to contribute to the improvement of working methods and crisis management in the euro area.

Add to this the total denial, disorder and sheer decadence apparent in Italian leadership and is it any wonder global markets are in a growing disorder?

So, that only leaves us one ‘official’ support: monetary. The ECB has been buying Italian bonds. But as Alphaville pointed out recently, the ECB has neither the brief nor the firepower to quantitatively ease for the eurozone. A major crisis is slouching toward the European Central Bank. And with it a grave danger that we repeat 2008’s loss of faith in the system.

Across the Atlantic, the news is better. There is now no doubt that QE3 is coming. The market rout has at last broken the back of the oil price, blasting it through the $90 support and dropping it almost 6% to $86. I very much doubt it is finished. It’s going lower, along with everything else, and soon.

QE2 was launched with oil around $70. We may not get that low again this time, given everyone knows it’s coming. But I expect to see the price fall at least into the seventies. And when it comes, I have every faith that the great and gossamer global market will reverse and shower us with money once more, for a little while.

The black swan, however, is Europe. If monetary and fiscal ‘officials’ can’t restore faith there soon, then calling bottoms becomes a fool’s game.

Houses and Holes
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  1. There is now no doubt that QE3 is coming.

    Yeah, after last night, I was gonna say.

    So … who’s buying, and when? Prince?

  2. Guess we’re going to find out soon if the world economy can survive a stall.
    Hopefully it’s a truck, not a plane!

    • The scenario is eerily similar to the events on board the doomed Air France AF447. The plane suffered a high altititude stall due to instrument failure causing the autopilot to disengage. Everytime the pilot tries to ‘do the right thing’ by pointing the nose down, the onboard computer will say ‘STALL STALL STALL’ until the nose is pulled back up. In the end, the plane stalled and crashed into the ocean. Nobody survived.

      It’s a lot like what is happening to the budget hysteria in Europe and the US at the moment.

  3. QE3 will come if deflation starts to set in again. I could be wrong but with inflation spiking up I dont think the Feds can print anymore but guess we will wait and see.

    • Precious Bodily Fluids

      Couldn’t agree more. Was just looking at Treasuries TIPS spreads that indicate inflation expectations are pretty strong. Plus we’ve has this sudden jump in M2 money in the last couple of weeks. On the face of it that indicates more money chasing goods than would otherwise have been the case.

      The Fed guys are probably not pure bullhawks but inflation is a pretty big factor in their decision making. It will be a tussle between needing to be seen to do something and being ideologically opposed to do something based on inflation fears.

      I can’t see QE3.

  4. Jon Stewart on market sentiment:
    “Here’s something you always like to see,” Stewart says, scanning the front page of the Washington Post. “ ‘U.S. Trade Deficit Startles Markets.’ Now, we’ve understood the U.S. trade deficit for a while. Are the markets small children that are easily startled? The next day, they’ll get an unemployment number and go, ‘Oh, I don’t know why we were startled and lost 200 points yesterday; today, we realized the shirt on the chair wasn’t a monster, so we’re going to put 300 points back on the Dow because we’re fucking 5 years old.’ ”

  5. “Markets are far more simple beasts than this. They run on sentiment.”

    I would say on computer sentiment. Robots (algorithms) took over stock market so it really doesn’t matter anymore what we, people, think and feel.

    • Precious Bodily Fluids

      great example of sentiment is the flight to treasuries recently. The media and pundits go on about US sovereign risk but the sentiment is overwhelmingly “lets buy US debt”

  6. Precious Bodily Fluids

    While you said you don’t want to get into a debate, fair enough it is your blog, can you at least explain what the “rules that make the system tick” are?

      • Precious Bodily Fluids

        the broken rules are monetarist rules? You mean dropping rates to (near) zero? I don’t want to badger you, this just isn’t clear.

    • Precious Bodily Fluids

      Also in one paragraph you have said “Fiscal debt is now the problem not the solution

      and in the next paragraph you have said

      In the US we’ve recently experienced perhaps the most calamitously stupid fiscal policy process of my lifetime, which has resulted in a terrible outcome of fiscal contraction…

      this seems to be contradictory (fiscal debt is a problem, but contracting it is also a problem?). Can you please qualify/clarify what you mean in those two paragraphs?


      • That’s why I included my parenthesis. Anyway:

        I’m basically saying that markets hate sovereign debt.

        In the PIGS its made worse because they can’t issue debt in their own currency.

        The US can, especially with the reserve currency stretching the market’s hatred out some more, but stuffed itself with politics instead.

        • Precious Bodily Fluids

          Ok thanks.

          Leaving aside any philosophical or ideological considerations cause you don’t want to go there, I don’t think in the USAs case that the shakey market is due to debt. Treasuries are booming — people are stampeding to buy US debt. I think what we are seeing in the US is the culmination of a run of very poor data which has led to punters finally realizing the world is not rosy. Up until recently we had ridiculously (IMO) optimistic growth forecasts, and so on. The penny has finally dropped.

          BTW the ECRI has been calling a slowdown now for quite some time, although as recent as 2 days ago the boss was still not calling a recession.

  7. The sitaution is Europe is not a ‘black swan’ (unforseen and rare), but a ‘black turkey’ event (you should have seen it coming). Ever since they adopted the Euro, it’s been on the cards for a long time.

    After stock and oil, commodity prices should be the next to fall. It’ll be very ugly today on the ASX.

  8. Good read. But why should QE lower the oil price? All else equal QE should raise the oil price I would have thought?

    • Precious Bodily Fluids

      he means that if the oil price drops inflation will drop and that — a drop in inflation — is pretty much a lock before they can embark on more QE.

  9. Could any of the MB bloggers comment on whether they think QE3 could already be priced in?


    • That is a good question.

      I would say, yes, it is to a degree. The commodity complex has been levitating for months on the back of assumed QE3.

      But that is what we are seeing unwind now.

      The other risk is this gets out of control on Europe and QE3 won’t matter much at all.

  10. Funny the point about sentiment. I’ve been arguing the same thing with Fanboy who makes idiotic statements like “The trouble is sentiment, many think it is worse than it is”

    Sentiment is the market and the market is sentiment. If many think it is worse than it is, then it is worse than it is, justified or not.

    Mad Adam has been banging on about how the “problem is sentiment” as well, which says it all.

    • Classic Soros Reflexivity – perception of the fundamentals creates sentiment that drives markets which then change the underlying fundamentals.

      e.g the US does not have a debt crisis, it has an employment crisis, but the perception is the debt needs to be solved, which drives the markets to create more unemployment (by reducing government spending).

      This is the lunacy of market sentiment. But its the world we live in and empirically observable.

      Why economists don’t get that is not important, what is important is that we all understand the reality of the situation.

    • You may be missing my most important point. Sentiment is ALL there is because of the way we have structured modern markets.

      What I mean is, there is no structural counterweight – no position limits, reserve requirements or leverage ratios – it means than when things crack, the system itself comes into question, exacerbating all underlying movements…

      Hence the word ‘gossamer’, by which I mean an ephemeral market, that is nothing more than a bet between two people passing in the street…

      • You may be missing my most important point. Sentiment is ALL there is because of the way we have structured modern markets

        No, I got that bit. Perception is everything. Sovereign debt may or may not be a problem, but as soon as ‘the market’ perceives it as being a problem, then its a problem.

        If the confidence fairy could suddenly convince us all that the PIIGS are just fine, then they would be just fine.

        Note: Gittins! has a piece today about how Australia is talking itself into a recession. Like Mad Adam, he just doesn’t get it. The fatal flaw in the bullhawks view of Australia, is even though we are doing well in aggregate terms, the majority of Australians are struggling, and that kills confidence which eventually overwhelms the strength in the mining sector.