The World Has Passed Into The Age Of Deleveraging And Currency Deflation

Financial market report for December 27, 2010

I … A Historical Review Of Carry Trade Lending To Latvia And Estonia

It’s helpful to go back in time and take a look at how the neoliberal floating currency economic theory of the Free To Choose economist Milton Friedman spurred carry trade investing, and has brought much suffering to the people living in Eastern Europe.

Marshall Auerback wrote the article Fiscal Austerity Fever Goes Global on 5-17-2010; this was just as the European Leaders Announced the Seigniorage Aid package for Greece as the European Sovereign Debt Crisis came to a head with the Euro plummeting in value:

“As I have pointed out before, no euro zone government issues its own currency. Consequently, they have to “finance” every euro they spend. And, as Bill Mitchell notes, if tax revenues do not cover pre-existing spending desires, then all of these countries (including Germany) have to issue debt. The current crisis is manifested by the bond markets’ unwillingness to lend to the PIIGS governments any longer because they are beginning to query the PIIGS’ national solvency. (and I add to query the PIIGS’ fiscal sovereignty and fiscal seigniorage)  

In June 2009, the newly appointed Latvian Prime Minister, Valdis Dombrovskis, made a national public radio address and said that his country had to accept major cuts in the budget because they would allow the country to receive the next installment of its IMF/European Union bail-out loans. He said the country was faced with looming “national bankruptcy” and then proceeded to ensure the validity of that claim by implementing the economic equivalent of carpet bombing. In effect, he turned the Baltic republic into an industrial wasteland via the most virulent form of neo-liberal economics.

Having broken free from the chains of the former Soviet Empire, Latvia promptly surrendered its currency sovereignty by pegging its currency against the Euro. This means it has to use monetary policy to manage this peg. The domestic economy also has to shrink if there are downward pressures on the local currency emerging in the foreign exchange rates. So instead of allowing the currency to make the adjustments necessary, the Latvian government handled the “implied depreciation” by devastating the domestic economy. (Public sector pay has been cut by 40 percent over the last year, while the economy has contracted by almost a third.)

But now, cries the government, there is light at the end of the tunnel! In the first quarter, GDP declined by a mere 6%! Well, when a country experiences a cumulative decline greater than anything sustained by the US during the Great Depression, I suppose a mere 6 per cent contraction seems like positive boom times again. And sure enough, Prime Minister Dombrovski has proclaimed this as “confirmation of the economy’s flexibility” – what is left of it – and “yield from reforms and the fiscal consolidation program, the so-called internal devaluation,” according to The Baltic Course. “Infernal devaluation” is a more appropriate description.

The currency peg is nonsensical, even though devaluation would be severely disruptive given the current nominal contracts held by the Latvian private sector. Around 80 percent of all private borrowing in Latvia is in euros, with the Swedish banks being the most exposed in Latvia. And, of course, the devaluation would undermine Latvia’s ambitions to join the EMU (hardly an exclusive club worth joining these days, as any Greek, Spaniard or Italian would likely tell the Latvians). The debate in Latvia about the EMU is that it will provide financial stability for the country. The fact that membership destroys their fiscal sovereignty is never raised in the public debate, narrowing the range of policy options that the political classes are prepared to discuss, and thereby legitimizing nonsensical ideas that a contraction of a “mere” 6% is something worth celebrating.

All of this pain for an exclusive club — the euro zone – which today looks on the verge of imploding

And Latvia is not alone. By virtue of its low public debt, and low inflation rate, Estonia has become the new poster boy for the IMF. Its budget deficit was 1.7 percent of gross domestic product in 2009, well within the 3 percent Maastricht limit, while its government sector debt was the lowest in the EU at 7.2 percent, according to the Statistics Estonia. Estonia could pay off all its public debts and still have reserves left over, which is why the country has been provisionally admitted to join the European Monetary Union in 2011.

So, should Greece, with public deficit of 13% and public debt of 113% (both as percentage of GDP), follow Estonia, bite the bullet and get down to slashing budget and wages? Or Spain? Like all of the euro zone nations, Estonia has no exchange rate policy option because the Kroon is pegged to the euro, so its fiscal policy is similarly externally constrained. The euphoria around Estonia should die rather quickly when one looks at the GDP performance in 2009. It fell nearly 15%; Greece’s GDP contracted just 2%. More recently, according to the Baltic Post, the number of jobs in Estonia is the lowest in almost 25 years. The release of Estonia’s first quarter labor statistics show that the unemployment rate grew by nearly four percentage points in comparison to the end of 2009 and reached nearly 20%. God help the rest of the world if it manages to emulate this “success story.” While their governments seems to think that by joining the EMU they will be “shock-proofed,” they should just get rid of the “proofed” part and realize that they will shock their citizens into a new kind of indentured servitude.”

[And Mr. Auerback provides an insightful fact by commenting: Michael Hudson has done a lot of excellent work on Latvia and noted that taxes on income exceed 50% whereas taxes on real estate are less than 1%. He feels (and I agree) that this has skewed the economy toward real estate speculation with deleterious consequences for Latvia as a whole.]

Mr. Auerback has done well in documenting that the people of Eastern Europe have passed from living in an Age of Economic Freedom, to now living in an Age of Austerity And Debt Servitude, which I say has come out of their currencies being pegged to the Euro, and has come from the neoliberal floating currency economic policy of Free To Choose economist, Milton Friedman, which provided the foundation for carry trade loans. I find it striking that the Mr. Friedman’s economic philosophy, which sounded so promising, would end in tragedy for many. 

The European sovereign debt crisis and a European Financial Institution banking system debt crisis is ongoing, and is manifested by the bond markets’ unwillingness to lend to the PIIGS governments any longer, and by rising sovereign debt interest rates as well as credit default swaps on European sovereign debt and banking debt. It was reasonable in May, and is reasonable today to question the PIIGS’ national solvency; that is their fiscal sovereignty and fiscal seigniorage.

II … The world passed from The Age Of Leveraging and asset value appreciation  …  And into The Age Of Deleveraging and debt deflation, that is Currency Deflation, On November 4, 2010

This was when the bond traders seized control of both the Interest Rate on The US 30 Year Government Bond, $TYX, and the Interest rate on the 10 Year US Government Note, $TNX, as Ben Bernanke announced QE 2. The 10-20 Year US Government Bonds, TLT, fell sharply on November 5, 2010.

World Government Bonds, BWX, and the major currencies, DBV, and the emerging market currencies, CEW, fell lower into an Elliott Wave 3 Down on December 15, 2010, when the European Leaders, as John Mauldin said in article, were kicking the can down the road, in not providing a comprehensive solution to the European Sovereign and Bank Debt Crisis. 

China rate hikes and falling European Financials,  EUFN, will be taking World Stocks, VT,  European Stocks, VGK, China, FXI, Emerging Market Stocks, EEM, the US Small Caps, IWM,  the United Kingdom, EWU, the Australian  stocks, EWA,  India, INP, Brazil, EWZ, as well as Bonds, BND,  and most commodities, DBC, such as base metals, DBB, down, which may include Gasoline, UGA, as well. However agricultural commodities, RJA, and Food Commodities, FUD, are likely to continue to trade strongly. Timber, CUT, will lose a great deal of value in a debt deflationary and growth deflationary world environment.

The Shanghai Shares, traded by CAF, entered into an Elliott Wave 3 of 3 Down on December 14, 2010, as they fell from December 13, 2010 price of 28.55. On December 23, 2010, Economic Policy Journal reported that the POBC raised the benchmark one year lending rate 25 basis points to 5.81%, and raised the one year deposit rate 25 basis points to 2.75%. This is the second series of rate hikes in the last 30 days.   The shares traded 1.4 % lower today on credit tightening. The Elliott Wave 3 of 3 down is the most sweeping of all waves. It is the one that builds wealth on the way up and destroys wealth on the way down. This wave down will for all practical purposes destroy the accumulated wealth in the Shanghai Index.       

Elliott Wave Surfer in article Shanghai Composite – Wave 3 down? states: I still regard the decline since early August 2009 as wave [C]. If this count is the right one, then we have just started wave (iii) of 3 of 3, which should be the most powerful of the declines in the [C] leg down

Since November 4, 2010, the Royal Bank of Scotland, RBS, that has lost the most of the European Financial Institutions, EUFN, as is seen in the chart of RBS, UBS, ING, BNPQY, STD, CS, DB, HBC and BCS. It is likely that Royal Bank of Scotland, RBS, and Banco Santander, STD, will continue to be a loss leaders.

Entry into the age of deleveraging means de-risking, with investment coming out of the economic growth stocks such as Deere, DE, Freeport McMoRan Copper and Gold, FCX, International Paper, IP, and Alcoa Aluminum, AA. The Morgan Stanley Cyclicals Index, $CYC, will be falling from its December 22, 2010 high of 1041.

There will be dollar carry trade and yen carry trade disinvestment from the small cap shares which were a safe haven investment from European Sovereign Distress and from money coming out of the longer term US Government bonds, EDV, as the 30 10 US Sovereign Debt Yield Curve, $TYX:$TNX, was topping out, when QE 2 was announced. 

The commodity driven Small Cap Energy,  XLES, and the financial driven Small Cap Revenue, RWJ, will be falling lower. Energy stocks include ION Geophysical, IO, GeoResources, GEOI,  Brigham Exploration, BEXP, and Bronco Drilling, BRNC. And Financial Shares include World Acceptance, WRLD,  Options Express, OXPS, EZPW, and Capital Source, CSE.

Notable fallers today included: The Global Water Index, CGW; Thor Industries, THO; Lear Corp, LEA, Buckeye Technologies,  BKI, CGAL, and the European Financials, EUFN; Gary of Between The Hedges reports that the Euro Financial Sector CDS Index remains at the highest level since mid-June and the Western Europe Sovereign CDS Index remains very near its record high set last month

Notable risers today included: Wall Street Financial Services, IYG, Homebuilders, M/I Homes, MHO, Quantum Corp, QTM,

Unwinding yen carry trades, such as the Mexico Peso Yen Carry Trade, FXM:FXY, will stimulate money out of Mexico Stocks, EWW.

In addition to the Euro, FXE, and the British Pound Sterling, FXB, the New Zealand Dollar, BNZ, has been a major currency loser since November 4, 2010.  The Unconventional Economist reports that the Standard and Poor’s November downgrading of New Zealand’s sovereign credit rating from AA+ stable to AA+ negative, has prompted the New Zealand Government to warn that its budgetary situation has worsened amid deleveraging by New Zealand households. The downgrade can be seen in the New Zealand Dollar, BNZ, falling lower which has taken the New Zealand stocks, ENZL, lower; these entered an Elliott Wave 3 of 3 down on December 7, 2010.

Wealth can only be preserved by investing in and taking possession of physical gold, $GOLD.

Keywords: debt servitude, carry trade investing, Milton Friedman, carry trade investing, sovereign debt crisis, age of deleveraging, Morgan Stanley Cyclicals Index, BNZ, FXE, FXB, DBV, CEW, BWX, EUFN, FXI, CAF, RBS, UBS, ING, BNPQY, STD, CS, DB, HBC, BCS, XLES RWJ IO, GEOI BEXP, BRNC, WRLD, OXPS, CSE, CGW, THO, LEA, BKI, CGA, MHO, IYG, QTM.


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