Mish's Global Economic Trend Analysis

China's Insolvable Problems; Watched Pot Thesis; Roll the Dice
Bill Gross on China, Secular Stagnation, and the Highly Leveraged "Negative Carry" Environment
China's Use of Derivatives to Hide Capital Flight Comes Unglued; Reserves Fall by Record Amount; "Worthless" Certificates of Confiscation
Is the Oil Bottom In? Reflections on Value, Volume, Other Ideas
Four or Five Rate Hikes in 2016? Really?

China's Insolvable Problems; Watched Pot Thesis; Roll the Dice

Posted: 07 Jan 2016 10:41 PM PST

China has not one insolvable problem, but many of them.

Yuan and Capital Flight

China needs to prop up the yuan to slow capital flight.
China needs to let the yuan drop to support exports.
China needs to float the yuan and remove capital controls to prove it really deserves to be taken seriously as a reserve currency.
If the yuan sinks, capital flight will increase and China risks the ire of US congress and those play into protectionist sentiment, notably Donald Trump.
Artificial stabilization of the yuan will do nothing but create an oversized move down the road as we saw in Switzerland.

SOEs and Malinvestments

China needs to write off malinvestments in state owned enterprises (SOEs).
If China does write off malinvestments in SOEs it will harm those investing in them, generally individual investors who believed in ridiculous return guarantees.
If China doesn't write off malinvestments it will have to prop up the owners of those enterprises, mainly the ruling class, at the expense of everyone else, delaying much needed rebalancing.

Property Bubble

China needs to fill tens of millions of vacant properties, but no one can afford them.
If China makes the properties affordable it will have to cover the losses, or builders will suffer massive losses.
If China subsidizes losses for the builders, there are still no real jobs in in the vacant cities.
If China does not subsidize the losses, the builders and current investors will both suffer massive damage.

Jobs

China is losing exports to places like Vietnam that have lower wage points.
Property bubbles, the overvalued yuan, SOEs, and capital flight all pose conflicting problems for a government desperate for job growth.

Stock Market

China's stock market is insanely overvalued (as are global equity markets in general). Many investors are trapped. A sinking stock market and loss of paper profits will make overvalued properties even more unaffordable.
Propping up the market, as China has attempted (not very effectively at that), encourages more speculation.

Pollution

Curtailing pollution will cost tens of millions of jobs.
Not curtailing pollution will cost tens of millions of lives.

What Did I Miss?

I am quite certain I have missed many insolvable conundrums even though I suspect those are the key ones.

Various Fed officials tells us China is not a concern because the problems are known.

Are the problems known? As I outlined above? If so, then let's see a solution.

Decoupling Revisited

Many believe the US will decouple from the global economy.

I find that as believable as the ridiculous notion proposed by Peter Schiff and others in 2007 that China would decouple from the US economy.

Currency Crisis Coming Up

I keep repeating a currency crisis is coming up. Many others are on that bandwagon.

The key issues have always been where and where?

For a long time all eyes were on Japan. Then various (and ridiculous) hyperinflation theories on the US surfaced. Then Europe and Greece. Venezuela and Argentina are in the news but they are not big enough to matter.

China certainly is big enough. So are Italy and Spain. Of course, so is the US.

Watched Pot Thesis

It appears to me that smack in the midst of a huge set of problems, most seem to discount China for one reason or another.

China (or a yuan/dollar relationship) could easily trigger a currency crisis encompassing both Japan and the US.

Yet, if everyone embraces the China thesis, the trigger will likely be somewhere else. For now, complacency still seems to rule, at least at the Fed. Of course, that requires one to believe the Fed believes what they are saying.

For now, former Dallas Fed Richard Fisher does seem believable, and he ignores China.

For details, and an incredible interview, please see Former Dallas Fed President Richard Fisher Goes to Squawk Box Confessional: "We Frontloaded a Tremendous Market Rally"; Transcript of Video.

Roll the Dice

A new set of dice get rolled every day. Place your bets.

Unlike most who are completely oblivious to the problems, and some who are aware of the problems and pretend to know when this all matters, I don't pretend to know when or where the next global crisis hits.

My bet is this will matter, in a reasonable timeframe, and gold will benefit.

That time could be now, or not. If someone tells you they know, trust me, they don't. If someone tells you the Fed has everything under control, laugh out loud.

Mike "Mish" Shedlock

Bill Gross on China, Secular Stagnation, and the Highly Leveraged "Negative Carry" Environment

Posted: 07 Jan 2016 01:40 PM PST

In a Bloomberg TV Interview, Bill Gross of Janus Capital spoke with Bloomberg's Tom Keene about the state of the global economy.

The interview and transcript below are well worth the time. Gross' thoughts on negative carry are particularly interesting. I offer my comments beneath the transcript.

Partial Transcript

TOM KEENE: Bill, good morning to you, thrilled to speak to you tomorrow on the jobs report. Let's talk about the more urgent matters of this market. First of all, Bill, China is the topic. Is this about China and their stock market? Or is there more going on on this January afternoon?

BILL GROSS: Yes, it is about China specifically, Tom. But there's a lot more going on and we've talked about it in past months.

The global economy is still highly levered and central banks are artificially elevating prices and keeping interest rates low.

It's a highly levered world and when something gets out of whack like the Chinese currency or in terms of the oil price, then you see these movements everywhere.

KEENE: Within a highly levered world, do you see any sense of an immediate catharsis to clear markets? Or is the theme for early 2016 that we slog along with this rolling pain in search of an abrupt move to clear markets?

GROSS: Well, China announced this morning that they are going to let markets clear. They haven't.

KEENE: What will we see tomorrow morning? Bill, what will we see out of Australia and into China tomorrow? They're going to go longer than seven or 12 minutes. What would you predict we will observe?

GROSS: Well, based upon the ETF in the United States, China is predicted to be down 5 percent or 6 percent. It depends upon whether the Chinese are good to their word in terms of letting markets clear. They haven't. And to the extent that it goes down more than 5 percent or 6 percent, who knows?

But China is an artificial market. All global markets are artificially based. And to the extent that we have a catharsis, I think, depends upon central banks basically giving up in terms of what they do. I don't think they're -- that's going to happen.

Draghi is in it, whatever it takes. The U.S. Fed will stop raising interest rates if the see a problem. China will get back into the markets if they have a catharsis and the Japanese, of course, buy stocks and bonds like they are going out of style.

So it's up to the central banks basically to save the day or prevent a catharsis. And I think they will. But ultimately, to my way of thinking, that's not a good thing but it allows for zombie corporations and zombie production that we are now seeing in terms of the oil market.

KEENE: Just so you don't call it zombie surveillance. Bill Gross, with what you just stated, of the responsibility of central banks, given the market turmoil and if we see more tomorrow and after the jobs report, will there be a responsibility of Chair Yellen to say we're one and done, that's all we're going to do with our rate rises?

GROSS: Well, I don't think she'll say that. They've been on this track of raising interest rates for so long that she's not going to come out with one or done. She may come out there -- someone may come out -- Fischer perhaps -- will come out and acknowledge the fact that global markets and that global financial conditions are an important consideration in terms of future policy.

But I don't think they're going to divulge that they are not raising interest rates for times as Stan Fischer said a few days ago.

KEENE: You know, I look here at the bond market, Bill, and you got to convince our less sophisticated viewers and listeners, the idea that they can be protected by being diversified or buying unconstrained in that. There's a real sweat out there that this is like '98 or this is like -- frame this within the history that you worked in at your previous employer and now at Janus. Where are we in terms of level of crisis?

GROSS: Yes and that's a great question and if you got a minute. I will go through it as quickly as I can.

KEENE: Please.

GROSS: Basically ever since -- ever since I began my career in the early '70s and the Fed basically relaxed and was off the gold standard, it has been a function of a carried trade for investors, not just unlevered investors but levered investors and hedge funds.

In other words, they tried to capture carry, carry in the form of duration, meaning longer maturity bonds, carry in the form of credit spreads, meaning lower quality instruments, carry in the form of volatility, carry, carry, carry. And ultimately that produced substantial bull markets, not just in bond markets but equity markets as well.

They captured basically carry relative to overnight financing and to Treasury bills.

Now when interest rates are so low and, in some cases, negative, it sets up the situation in which carry is not positive but negative. And you see in terms of the inner correlations, you see a market -- and this happened with hedge funds last year -- where the returns for hedge funds and other levered investors are basically zero or negative because the carry has collapsed and there's no carry to capture.

And so what we see on days like today, when markets go down and oil prices go down and currencies fluctuate is a negative carry in which investors start to lose money and that ultimately is what the financial markets have taken us from the early '70s in terms of high carry to now lower or negative carry.

KEENE: Well, that was beautifully explained but it also suggests we have got to get to an idea where we get back to normal.

Do you suggest, as Lawrence Summers suggests, that we are not going to get back to the normal where carry works because we are within a new terminal value, and we're within some form of secular stagnation?

I mean, is something that what we've seen the last 24 hours, is it something we need to get used to?

GROSS: Well, I have been saying that for years, not to preempt Larry Summers, who's a smart guy and secular stagnation, as he's suggested, was not even his original idea. But the new normal from the old PIMCO days, basically said the same thing, that growth will be low, that interest rates will be even lower and that we have to get used to a world of low returns.

Now we didn't really see that, did we, because of quantitative easing and the dropping of interest rates over the past three or four years. It has taken a while for that to take place.

But yes, secular stagnation in terms of demography, secular stagnation in terms of low interest rates, secular stagnation in terms of technology, all of that is producing a situation in which growth is low, interest rates are low, stock prices are relatively high and returns suffer.

Negative Carry, Negative Interest Rates, Piles of Debt

Central banks have attempted to fight price deflation with low interest rates. When that failed, we saw negative interest rates.

Corporations leveraged up with more debt, even though the problem is debt. Now equities and bonds are in even bigger bubbles than ever before.

The Fed bailed out the banks, but home prices are more unaffordable than ever.

Former Dallas Fed president Richard Fisher admitted as such. He specifically stated in a Squawk Box interview, "We Frontloaded a Tremendous Market Rally".

He also admitted the Fed created bubbles on purpose for the "wealth effect".
Click on that link for a transcript of an amazing video confession.

Like Bill Gross, I expected low growth, low interest rates, and low returns. It was the forecast for low returns that led to Gross' ouster at PIMCO, and caused a huge amount of grief for value investors.

Now, in search of yield, in a decreasing yield environment, hedge funds, pension plans, and others are more leveraged than ever.

Pension plans need 8% returns in a 1% world. That no problem if they use 8-10 time leverage, until of course prices decline.

Please note the counter-productive actions of central banks. Negative interest rates and huge equity bubbles have all but guaranteed negative carry.

Unwind of China

China has stepped in to defend its markets three times recently, and three times to no avail. Capital flight from China is massive.

For discussion, please see China's Use of Derivatives to Hide Capital Flight Comes Unglued; Reserves Fall by Record Amount; "Worthless" Certificates of Confiscation.

Currency Wars

The currency wars and volatility we see today are a direct result of central bank attempts to force their will on the markets.

I have said this before, wrongly for the past few years, but gold will eventually be a big winner in this economic madness.

Mike "Mish" Shedlock

China's Use of Derivatives to Hide Capital Flight Comes Unglued; Reserves Fall by Record Amount; "Worthless" Certificates of Confiscation

Posted: 07 Jan 2016 11:39 AM PST

China's Forex Reserves Fall by Record $107.9 Billion

China's foreign-exchange reserves are close to a three-year low, following the largest yearly decline ever.

Capital flight is not only intense, it's accelerating so much that China has undertaken measures to hide the intensity. First, let's consider the flight.

The Wall Street Journal reports China's Forex Reserves Fall by Record $107.9 Billion on Yuan Fears.

China's hoard of foreign-exchange reserves continued to shrink in December, recording the biggest monthly drop ever and falling overall to its lowest level in nearly three years as worries intensify over the country's economic slowdown.

With the $107.9 billion drop in December, Beijing's foreign-exchange reserves have fallen every month but one since May. The data suggest the central bank is having to spend huge amounts of dollars to support an increasingly beleaguered yuan amid decelerating economic growth and the onset of higher U.S. interest rates.

"It certainly confirms the end of an era," said Oliver Barron, head of research at investment bank North Square Blue Oak. "What we've been seeing is China now becoming an exporter of capital."

December's decline brought overall reserves to $3.33 trillion, the People's Bank of China said Thursday. For the full year, reserves fell $512.7 billion, the largest yearly decline on record. In addition to the PBOC's spending to support the yuan, some of December's decrease may have stemmed from depreciating nondollar assets among the central bank's holdings as the U.S. raised rates last month, analysts said. Higher U.S. interest rates make dollar-denominated assets more attractive to investors.

Goodbye Reserves

China's Uses Derivatives to Hide Capital Flight

Chinese capital flight is undoubtedly higher than the Wall Street Journal chart shows. For an explanation, please consider China Finds More Discreet Ways to Support the Yuan.

Just because China is burning through its reported foreign-exchange reserves more slowly doesn't mean it's losing its commitment to support the yuan.

[Mish Note: I was puzzled by Bloomberg's "more slowly" comment before noting the article was from October 20. Clearly some of what China attempted to hide came unglued in December]

The People's Bank of China and local lenders increased their holdings in onshore forwards to $67.9 billion in August, positions that would boost China's currency against the dollar. The amount is five times more than the average in the first seven months, PBOC data show. The positions are part of a three-stage process to support the currency without immediately draining reserves, according to China Merchants Bank Co. and Goldman Sachs Group Inc.

Standard central-bank intervention to support a currency generally involves selling dollars and buying the home tender. In this case, China's large state banks borrowed dollars in the swap market, sold the U.S. currency in the cash spot market and used forward contracts with the central bank to hedge those positions.

"If you can intervene without actually diminishing your reserves, it's somehow viewed as better," said Steven Englander, global head of Group-of-10 foreign exchange-strategy in New York at Citigroup Inc.

Mirage of Looking Better

You can't realistically intervene without diminishing your reserve, but you can attempt to make it look that way, for a while, using swap derivatives.

Things looked better, until December and January, when suddenly they didn't.

About Those "Worthless" Certificates of Confiscation

Please recall numerous discussions between 2010-2012 in which various pundits proposed China should sell its US reserves for commodities.

The then going theory was China should sell its reserves for commodities because US Treasuries were "Certificates of Confiscation". Here are some examples.

May 30, 2012 Bloomberg: James Tisch, the chief executive officer of Loews Corp., said bonds should be called "certificates of confiscation".
October 28, 2010 Floyd Norris of The New York Times: Now the government really is selling bonds that deserve the label "certificates of confiscation."
May 22, 2008: 2008 Market Oracle: US Treasury Bonds Fast Becoming Certificates of Confiscation. "For bond market players the focus is now on accelerating inflation," said one senior analyst in Tokyo to Bloomberg this morning. Fixed-income investments destroy wealth when the cost of living rises. That's why US Treasuries became known as "certificates of confiscation" during the double-digit inflation of the late 1970s. "The inflation outlook is weighing more on the market as it implies the Fed could hike interest rates," says Linowsky.
January 21, 2011: Before Its News Wall Street Definition of Bonds: "Certificates of Confiscation" that are "Certifiably Safe" but you lose money on them. Oxymoron, anyone?

For years, decades actually, the consensus opinion was only fools hold treasury bonds.

On August 11, 2011, I too commented on Certificates of Confiscation but in a completely different way.

Citing my friend "BC" whose analysis I happened to agree with, this is what I had to say:

The self-similar secular pattern implies the 10-yr. yield well below 2%, and perhaps below 1.5% along the way, which would imply a trend nominal GDP in the 1% range and core CPI falling to around 0% or negative during a global deflationary contraction.

The flattening of the yield curve will squeeze further the net margins of banks and ROA and ROI of insurers and non-bank financial firms, discouraging lending and risk taking.

For the record, yield on the 10-year treasury did hit 1.43% in July of 2012. Yield on the 30-year long bond bottomed at an amazingly low 2.25% in February of 2015.

Yield Curve 1997-Present

Those buying US treasury bonds when others were screaming "certificates of confiscation" at the top of their lungs were duly rewarded.

Selling Reserves to Buy Hard Assets

Had China sold reserves to buy hard assets as many begged China to do, this is what would have happened.

Copper Monthly

Crude Monthly

Aluminum Monthly

Silver Monthly

Gold Monthly

Pro-Cyclical Buying

Depending on when and what China bought, it may have had gains or losses. But buying assets when asset prices are high is not a good idea.

Storing huge amounts of oil and some base metals would have been impractical. Moreover, buying items like copper and aluminum would have been very pro-cyclical and would have driven up the price, resulting in even bigger crashes than we have seen.

With rebalancing, China has less need for copper, aluminum, steel, etc.

Accumulating Gold

China could have and should have been slowly accumulating gold over the past decade. Gold is a genuine financial asset.

The price in 2000 was only $250 per ounce. It's still over $1,000 per ounce. Accumulating gold, especially on dips, would have been successful.

Storage costs are minimal. It does not take a lot of space to hold $1 trillion in gold.

Reserves Needed to Defend Against Capital Flight

There is another reason for China to hold huge amounts of reserves, and it's a reason that I have warned about numerous times: China needs reserves to defend itself from capital flight.

Had China used all its reserves or even most of its reserves on hard assets, it would be dumping them now, straight into weakness, to raise those needed reserves.

Another 2% Yuan Devaluation Coming Up?

In case you missed it, please see Another 2% Yuan Devaluation Coming Up? What Are the Risks? Explaining Chinese Capital Flight.

In that post I explain in easy to understand terms pressures on the yuan, capital controls, and how Chinese corporations get around those controls for risk-free profit.

Mike "Mish" Shedlock

Is the Oil Bottom In? Reflections on Value, Volume, Other Ideas

Posted: 07 Jan 2016 08:16 AM PST

Oil swooned again yesterday, from $35.97 to $34.15. It's down again today.

Were the month to close here (charts below captured yesterday), this would be the lowest monthly close dating all the way back to December 2003.

Crude Monthly Chart

click on any chart for sharper image

Crude Daily Chart

Volume of contracts traded is displayed at the bottom of the chart.

One Hell of a Collapse

That's one hell of an impressive collapse from a daily, weekly, or monthly chart perspective. But is the bottom in? Some think it is.

For example, EconMatters writes That's the Bottom in the Oil Market.

EconMatters concludes his article, posted yesterday, with "You may now go long the oil market in your preferred instrument. Just stay away from companies that are going to go bankrupt, but in buying something like the USO oil futures ETF, you will definitely have a positive expected return over the next six months to a year going forward."

I sympathize with that conclusion, but would not use the word "definitely". I am not even positive about saying "likely".

One thing I can guarantee is that oil is far closer to the bottom than the top. My statement is simply a mathematical truism.

The top was $147 in June of 2008. The bottom is zero, and that bottom would assume free energy is coming.

Realistically, the bottom has to be above zero.

Disturbing Analysis

In between his opening statement and his conclusion, EconMatters makes a couple of claims that are worthy of comment.

"It took over 500k in futures contracts just to push oil futures below $34 a barrel on Wednesday, and trust me it wasn't an easy task for those involved in the pushdown. They now are stuck with being far too short the market at a level they don`t even like being stuck short."

"This entire move in equities and oil was already preplanned at the beginning of the year."

Conspiracy Nonsense

The idea that there is some "preplanned" force attempting to suppress the price of oil is patently absurd. It's equally nonsensical "this entire move in equities" was preplanned.

Commitment of Traders (COT) data is notably lagging so I don't know who is long or short or why. It's possible a squeeze is coming due to a supply disruption, a pickup in demand from China or elsewhere, or a war between Iran and Iraq breaks out.

I would not be short here, but the notion someone is stuck at a "level they don`t even like being stuck short at" is also ridiculous.

No combined force has preplanned where oil will go. And even if they did, EconMatters would be the last (besides me) to know.

Oil is trading lower, not because of any conspiracy, but because supply has increased in the face of a slowing global economy.

Volume Nonsense

Let's now investigate EconMatter's claim regarding volume.

The second chart from the top shows a volume, not of 500,000 contracts but rather 690,700. On that chart, volume certainly looks impressive.

It's not impressive by a long shot as the following chart shows.

Crude Daily - Nearest Contract

Volume is on the left, open interest on the right.

This is essentially the same chart as one second from the top.

What's the difference? The first daily chart shows volume specifically for the February 2016 contract. The Daily Nearest chart shows volume for the nearest unexpired contract.

In August of 2015, there were not many people trading the February 2016 contract, but they were trading the then front-month contract.

The Daily Nearest chart shows 500,000 oil contracts is relatively low amount of trading. Yesterday's volume of 690,700 contracts is just about average. Let's doublecheck for an entire year.

Spotlight on Oil Trading Volume for One Year

Using 700,000 contracts (not 500,000) as volume capitulation, one might have declared a bottom at $49 in January of 2015, at $60 in June of 2015, at $54 in July of 2015, at $42 in December of 2015, at countless points in between, and of course now at $34 on mere average volume.

Reflections on Value

My point here is not to pan the idea of buying energy.

Rather, my point is to call into question nonsensical conspiracy ideas and other rationale that people use to justify their position.

The lower the price goes, the more I like the sector. And I do find energy increasingly attractive from a value standpoint.

Mike "Mish" Shedlock

Four or Five Rate Hikes in 2016? Really?

Posted: 07 Jan 2016 12:09 AM PST

I am quite amused by the parade of Fed governors and presidents still toting the Yellen line that the Fed will hike three to five times in 2016, most likely four.

On January 4, MarketWatch reported Fed's Williams Foresees Up to Five Rate Hikes This Year.

The Federal Reserve could raise interest rates as many as five times this year, according to San Francisco Fed President John Williams.

"I think something in that three-to-five-rate-hike range makes sense, at least at this time," Williams said Monday in an interview on the cable news channel CNBC.

Williams said the U.S. economy is "in very good shape" and remains stronger than other major global economies.

The economy is on pace for continued job gains in 2016 after adding an estimated 2.5 million jobs last year, he said.

Williams said he was not surprised or concerned by weak Chinese economic data, which many blame for Monday's stock-market selloff. China, he said, has been undergoing a pretty significant shift for some time away from manufacturing and toward consumer spending.

Williams said he doesn't have a stock-market terminal on his desk telling him when the market moves up and down. He said the Fed is focused on the medium term and understanding why the market is moving, "rather than responding to just ups and downs."

Fed Frontloaded Massive Market Rally

If Williams wants to know why the market is as high as it is, he would gather the Fed members together and instruct them to look in a mirror.

In an act of contrition, Former Dallas Fed president Richard Fisher went to the Squawk Box confessional admitting: "We Frontloaded a Tremendous Market Rally".

Fisher, no longer a Fed president, is now free to squawk.

If you have not yet done so, please click on that link for a transcript of the video. It's a real eye opener.

Fed Fund Futures Don't Even Believe in Four Hikes

On January 4th, the day Williams was parroting Yellen, I captured a snapshot of Fed Fund Futures and plotted them in Excel.

That chart reflects the single most likely interest rate following each Fed meeting. Here is the probability table.

Implied Rate Hike Probabilities on January 4

FOMC Decision Date	Single Most Likely Interest Rate	Weighted Interest Rate	Implied Probability	Odds Higher	Odds Lower	Odds of 0% Rate
1/27/2016	0.50%	0.50%	90.50%	9.50%	0.00%	0.00%
3/16/2016	0.75%	0.75%	50.30%	4.80%	44.90%	0.00%
4/27/2016	0.75%	0.75%	49.90%	13.00%	37.60%	0.00%
6/15/2016	0.75%	1.00%	45.00%	31.40%	23.50%	0.00%
7/27/2016	0.75%	1.00%	40.90%	40.10%	19.00%	0.00%
9/21/2016	1.00%	1.00%	34.40%	22.80%	42.70%	0.00%
11/2/2016	1.00%	1.25%	33.90%	29.90%	36.20%	0.00%
12/21/2016	1.00%	1.25%	32.50%	37.30%	30.30%	0.00%

The single most likely rate is not the best way to depict things. Note that in December, the single most likely rate is 1.00% but there was a 37.3% chance of something higher, but only a 30.3% chance of something lower.

Giving the rate-hikers the benefit of the doubt when close, I estimate traders expected something between two and three hikes coming.

I displayed three hikes in the following chart.

Weighted Probabilities

December 21 Meeting Probabilities on January 4

Note the skew towards an additional hike. Let's check again after the close on January 6.

December 21 Meeting Probabilities January 6

The market is now barely pricing in two hikes for the entire year. I will believe four when I see them.

None seems more likely to me. Economic risks are hugely to the downside, and I have not seen anything to change my mind about a pending recession. A strong jobs report on Friday won't do it. I expect massive layoffs in February.

Mike "Mish" Shedlock

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Mish's Global Economic Trend Analysis

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