I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Tuesday, August 31, 2010


Crazy idea (sort of). Charts in a sec.

Okay, you know what I think? I think that was it. I think Minute 1 ended today for most of the indices.

... Whaaa???

Hear me out. I think we had a lot of sound and fury signifying nothing. Despite a sharp move yesterday and this morning, we had no down volume (again). The down breadth was pathetic. We got NO follow through. And the positive divergence that I mentioned last night not only got worse, but the MACD on many timeframes is now positive. This has the earmarks of a trend change, not just divergence for a Wave 4, or a wave 2 of 5.

Now, when I say trend change, I am referring to a Minute degree 2 up. I do not anticipate a major rally. Just something to burn off the bearish sentiment and set up for a nice and "pleasant" Labor Day rally.

This is what my preferred count shows. But moreover, this is what my gut is saying

.... but my gut is also hungry ....

Monday, August 30, 2010


Okay, my big beef with the counts thus far is that I have been unable to reconcile the SPX, Nasdaq and the Russell. This led me to this option: Spice Weasel. But I don't love the count. And per my last post: Spongebob, I am not favoring the 1-2, 1-2 count down. We had a selloff today that could be developing impulsively, but it happened on NO VOLUME!. .... No sir, I don't like it.

What makes sense to me, based on the divergences we are seeing on the 15, 30 and now 60 minute charts, is that we will see a bottom soon. The McClellan is showing divergence as well: Span.

But the damned Russell keeps throwing in a monkey wrench!

... Unless its Minor 2 top is out of phase with the other indices. Blankfiend put together and excellent Russell examination (Russell 2000) and it got me to thinking about this wave.

I now have a count that:

1) Jives with the divergences noted above
2) Allows for a pre and post Labor Day rally (I think this is *extremely* likely)
3) That I like / find believable


The count options are all bordering on ridiculous at this point (both bearish and bullish). If you looked only at the price action, the count looks quite bearish. The 1-2, 1-2 down count looks not only plausible but even likely.

However, if you look at volume and breadth, it does not jive with the story at all. So something tells me it is still a trap.

But even if it is a trap, I am walking into it. By that I mean I am short. And even though I think we will get a bounce here, I will not change my position. The long term trend is down, and these squiggles (while annoying) are not convincing me that the trend is back up.

So if I have to endure some more sideways and up action, so be it. I am a patient guy. I will wait for the larger trend to unfold. I am still not interested in playing short term volatile and largely unreadable bounces.


Trying to make sense of the short term micro. See the last few posts to put this micro into context.

Sunday, August 29, 2010


My friend MOe is still saying don't bet on a breakdown here, that this is likely a spot for a turn higher. Is it a major turn? I think not.

See my counts: Splinter and Spice Weasel

Friday, August 27, 2010


I think BVN's Weekly chart is very bullish. This series of patterns (a cup and handle forming the handle of a much larger cup and handle) is suggesting a large move up. BVN is a major gold and silver producer. And I (of course) am very bullish on gold and silver.

This would also tie into gold's very positive seasonality which I talked about a few weeks ago here: My hat is old. My teeth are gold. And now my story is all told.

Disclosure: I have a long position in BVN

Spice Weasel

See yesterday's post for the explanation: Splinter

I don't think we are in the middle of a 1-2, 1-2 yet. Nor do I think we are on a major leg to go above the August highs.

If you look at the RUT and COMPQ, you can see where the old count is invalid.

Thursday, August 26, 2010


Okay, time for another one of binve's crazy idea counts :)

First idea is this one, from Spine. It is the fact that the move down this past week can be counted as a wedge. I was thinking it was an LD... but I am revisiting that.

Second idea is this one, from BS. It is the observation that a pattern that has occurred many times over the past 3 months is happening again. And is suggestive of a bounce.

Going with this observation is that volume and breadth is still pretty crappy. I was thinking this was because we were still working on Minute 1, but if you look at this post Hmmmm......, there are too many overlaps to be a believable count (that we are in a Minuette 4). I just don't buy it.

So then if that count is out (which I think it is), then are we in a 1-2, 1-2 down? The count can certainly be supported that way. But I hate this count if you consider that all the down moves have occurred on gaps, the down volume stinks, the down breadth is anemic. This is hardly a compelling 1-2, 1-2 windup at the point in time. This is not the same behavior, or even remotely similar behavior, leading up to the flash crash. My counts, indicators, and charts were predicting something big then before it happened. See: 1-2 Heaven? and There is a word for days like today

So, what do I think?

If you use your imagination, the move down the last 2 weeks looks like a pretty good fractal of Minor 1.

Given all these observations, that's what I am going with right now.

Adding my H&S chart to show how the current count fits in. This was prompted by Scraoppy's comment on my last post:

[Addition 10:30]

And just for kicks, the McClellan Oscillator is beginning to sport some positive divergence.


Read the notes on my chart below. Today definitely has a "BS" feel about it.


Here is an idea that I have for this wave. I am drawing heavily off of Blankfiend's excellent work in European Bounce Haus

So this is likely not a 4 (due to overlaps)... but it could be a 2.


The Nasdaq and Russell are not playing nicely with the current wave count. See below with the green circles. I think we might be getting our Wave 2 bounce here. I am playing around with a few counts to find which one I like best.

Wednesday, August 25, 2010

Speling Eror

I am the greetest!!

See Spümco for more details

Hey, Do you Remember the 80s?

The NIKKEI sure does. It is reliving its 80s glory years: Miami Vice, Member's Only jackets, The Breakfast Club, Walkman's, etc. But at this rate, they will be revisiting the 1970s.

Because critical support has been broken. The NIKKEI is now trading below the levels seen in May ... of 2009

If you recall my last post on the NIKKEI: Back at Support, I was showing the critical support line just above 9000.

It is now gone. This does not bode well at all.


The Danes call it Quality.

I have been vacillating whether we are in Minute 1 or Minute 3, and I really believe we are in Minute 1. (See the second chart for some reasoning). This means I am turning my microcount from all blue (which is what I do when I show relative waves but don't know their degree yet) to something more useable.

I also have a few targets based on some relationships. I am also very happy to see a lot of the potential positive divergences getting wiped away by the last 2 days. I am much more happy with this count. Which I suppose didn't really matter (because I am short and was going to stay short either way) but it at least makes me feel better :)

Tuesday, August 24, 2010

Moving Average Examination

Just a quick look at the First Derivative (rate of change of price) of the 200 day MA. We can all see that it is flattening out. The actual rate of change is now zero (at least very close to it) and looks quite likely that it will turn negative. A down trending 200 day MA will be another confirmation that a top is most likely in.*

* Note: Simply because the 200 day MA turns negative, doesn't guarantee anything. It could be essentially flat for years if it wanted to (e.g. a trading range). But given all the macro developments, possibilities of a double-dip (or even just a single scoop, per Rosenberg), institutional investors will likely look at a down turn in the 200 day MA as a very ominous sign.


Nice follow through. Still unhappy with the lack of volume. But if every wave and indicator was perfect, we would all be in agreement and there would be no ambiguity, right? :)

Is It Time to be Bullish on Cattle?, (part III)

Here is an update on my cattle-call (yuk, yuk)

First post from April 5: Is It Time to be Bullish on Cattle?
-- http://marketthoughtsandanalysis.blogspot.com/2010/04/is-it-time-to-be-bullish-on-cattle.html
-- http://caps.fool.com/Blogs/is-it-time-to-be-bullish-on/366753

I said this:

binve says "Moo" [translation: If it makes a higher low at support ~64-65, then there is an inverted H&S setup that targets ~80, which is also the 38% retrace from the top]..... cows have a very concise language, leaves more time for grazing.

Second post from June 16: Is It Time to be Bullish on Cattle?, (part II)

-- http://marketthoughtsandanalysis.blogspot.com/2010/06/is-it-time-to-be-bullish-on-cattle-part.html
-- http://caps.fool.com/Blogs/is-it-time-to-be-bullish-on/407875

The ETN COW is showing a similar pattern. It somewhat tracks this underlying index (i.e. it is supposed to but doesn't do a very good job all the time).

So, is it now time to be bullish on cattle? binve says "Mrraaa Mrrooooo mo moo Moooo" [translation: yes]

And here is what it looks like today.

So, is it now time to be bullish on cattle? binve says "munch munch chew chew" [translation: Uhhhh, yeah. Where have you been.]

Monday, August 23, 2010


1-2 Minor
1-2 Minute
1-2 Minuette
1-2 Subminuette

... it could be.

But, with all this positive divergence, something still doesn't feel right. However, this is still what I am going with for now.

Sunday, August 22, 2010

Space Madness

I have been thinking about this wave a lot this weekend.

I hate the action on Friday. It just doesn't fit. If this really is 3 of 3 of Minor 3 about to bust this market wide open to the downside, then why the crappy volume? Why the crappy breadth? Why the hell are we making a slightly lower low with positive divergence on a 60 minute chart? Why are all the moves down happening as overnight gaps without much breadth and activity intraday?

This is not the same behavior, or even remotely similar behavior, leading up to the flash crash. My counts, indicators, and charts were predicting something big then before it happened. See: 1-2 Heaven? and There is a word for days like today

This time around it seems like it is consolidating and building a temporary bottom, IMO.

Now don't get me wrong, I am more bearish than probably most of you reading this. We had a number of hugely negative macro developments this week. I think the shit is going to hit the fan soon (between the next few days and maybe as long as a month). So even if we do get a bounce here there is NO WAY I am covering my shorts. I held short through the Feb/March madness because it felt like a fake wave and so this one won't shake me out in the slightest.

I am just saying that something doesn't jive here and that next week might not go as us bears expect and are currently planning for. I just don't want anybody to get "thrown" by a bullish hiccup.

This is when it helps to step back, take a bigger picture view, and to realize that even 100 point moves on the SPX are small potatoes compared with whats to come. Bear markets always have high volatility and huge moves both ways: What type of markets do 4% up days happen in?.

I just want everybody to keep their heads screwed on tight and to expect volatility both up and down before the market shows its hand.

So what I show above is a possibility, just one of my alternate counts. I don't know if it fits the technicals the best, but it fits my uneasiness the best. Below, however, continues to be my preferred wave count:

Friday, August 20, 2010


Current thoughts. Read the notes on the chart. I do not agree where a lot of people are labeling 2 based on the move in the NDX, COMPQ and RUT. I think there is a very tricky wave at work here and requires a tricky count.

Do Deficits Matter, Debt and Deleveraging, Resource Constraints, In/De/Hyper/Stag/etc./flation, Part I

This post is a follow-up to my last post The Matter of Deficits, Sovereign Default, and Modern Monetary Theory found at MTaA or on my Caps blog. Also in the process of writing this post, the length kept increasing that I decided to break it up into a series. This will be Part I.

The purpose of my last post was very specific: To get an answer to the question 'What is the default risk on US Sovereign Debt?'. To be very specific, I was referring to technical / nominal default only.

Another way to pose the question would be this way: 'What should the Credit Default Swap (CDS) rate be on US Sovereign Debt?'

You have to understand exactly what I was asking. In my last post, I was *not* asking 'What is the credit worthiness of United States Government (USG) debt?'. That is a separate issue to whether a sovereign currency issuer can default on their own debt.

The answer I come up with to the question: 'Is there a monetary reason for the USG to ever technically default on its debt?' is NO

Even though this is not the most important question (credit-worthiness and the 'value' of USG debt and the Federal Reserve Note [FRN, a.k.a. the US Dollar] are the far more important questions), it is still a very important question and a very important point to make. Because there is the perception today that the USG can technically be forced to into a position to default on it's debt. And per my last post, the conclusion that I came to and painstakingly demonstrated is that this is an incorrect operating assumption.

But now that we have settled that point (which is important because we can now adequately separate credit risk from default risk) we can get to the more important questions.

From my last post I wrote this definition:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.

This last sentence is not technically clear enough and will be the entire crux of this series of posts. Here is the way I should have written it:

From the standpoint of servicing it debt (not considering the value of the currency), the US Government is never revenue constrained

As I will discuss in-depth in this series of posts, there is a very big difference between technical default (which as I argued in the last post has no monetary basis for occurrence for a sovereign currency issuer) and effective default.

The point of this series will be to answer (or at least explore) the ideas of deficits, credit worthiness, and scenarios where the USG can effectively default.

In my last post, in order to properly answer the question 'What is the default risk on US Sovereign Debt?' we had to first understand more fully the fiat monetary system we currently have. We needed to understand the role of the US Treasury and the Federal Reserve in the current system, and it helped to understand the historical reason for them coming into existence. Please, if you have not done so already, read my last post (MTaA or on my Caps blog) since I will be drawing heavily upon and continuing this line of thought.


Okay, let the fun begin :). In order to explore these ideas I will start out with two examples which will be necessarily basic and contrived, in order to get across key ideas clearly. But I will add more realistic complexity later on, so please bear with me and (hopefully) enjoy the ride :)


Lets say in the entire world there are only two countries: Joeyland and Bobtenstein. They are sovereign entities. Moreover Joe is the leader/ruler/owner/dictator/what-have-you of Joeyland and Bob is the same for Bobtenstein. This makes Joe and Bob the only two sovereign entities in the world. And lets further say that the population of each country is identical with, I don't know, 1 million people each.

As sovereign rulers both Joe and Bob are responsible with coming up with and administering monetary systems. Bob comes up with a gold standard and calls his currency the 'shiner' and Joe comes up with a fiat money system and calls his currency the 'joeybuck'.

Further: Bobtenstein does not sit on any gold deposits. Everything was mined out of the ground and is in Bob's possession. As such there is a fixed amount of gold in Bobtenstein which the population is already aware of. Also Joeyland starts out with a fiat money system. This is different than the United States which started out on gold standard and transitioned to a fiat money standard. This was a scenario that I explored in-depth in my last post. So as such, Joey does not have a Central Bank or a Treasury (which as I demonstrated previously have no real use in a completely fiat system). Bob on the other hand only has a Treasury. There is no Central Bank of Bobtenstein (we will address this one in a bit).

So here we go. We have two countries, two rulers, two currencies. How do things work? Or more importantly, how do things get 'started'?

Lets start with Bobtenstein

Bobtenstein is a beautiful, but large country. There are isolated villages each living near various natural resources: lakes, grasslands, forests, mineral deposits, etc. They are happy, keep mostly to themselves, and are just living off the land. Bob, who is a nice guy and wants to do right by his people (we will call him a benevolent dictator), thinks that natural resources near one village could benefit the inhabitants of another village, and so he wants encourage the sharing of natural resources. Essentially he wants to Bobtenstein engage in commerce. Now, like I said, he is a nice guy and wants people to be happy. And he thinks the best way for this to occur is for people to determine for themselves what things are worth. Not to divvy up all of the natural resources (some of which are significantly more labor intensive to extract than others) and spread them out equally.

So Bob calls up his Treasury (after all he needs a building to warehouse the gold), tells them the plan, and takes half the gold (the 'shiners') in the Treasury and goes to every villager and gives them an equal share of the shiners. He explains his idea, says that every shiner is exactly the same. In order to get things started, he sets the price of a good based on the amount of labor it took to produce. But he then further explains that these prices are not set permanently, because he knows that eventually supply and demand will determine the actual prices and that they will change over time based on harvests, good fishing years, lumber quality, etc.

Bob is a happy guy, his people are happy. Bob has no army. He just wants things to be pleasant. But Bob is a busy guy checking up on the villages, and doesn't have time plant, fish, chop wood, etc. But he has the other half of his country's gold in his treasury. So what Bob does is spend just enough out of the Treasury that it takes himself to live on and what it costs to employ the keepers at the Treasury. But realizing that this action would create an imbalance, Bob implements a tax. The tax is shared among everybody, so that each person pays a small percentage of the amount of gold they hold and when totaled equals that which Bob spends in a year. This way his budget is balanced. His Treasury takes in what goes out so that it always contains half of the gold in existence. And the gold in circulation is always constant.

Commerce develops. People become more connected. Villages become more connected. People start to specialize in their crafts/labors. Bob likes what his country is becoming. Everybody is happy.

Now lets go to Joeyland.

Joe and Bob, despite being separate sovereign rulers, are good friends. Joeyland is very similar to Bobtenstein in that it has isolated villages and diverse natural resources. Bob tells Joe what he has been doing in Bobtenstein, says that it is great! He is happy, his people are happy, life just seems richer with everybody interacting.

Joe likes what he is hearing. But he thinks Bob's gold as a currency idea is dumb. First Joe doesn't have any gold anyways (that is the only real difference between Bobtenstein and Joeyland) and second he thinks gold is dumb. It is shiny and it is heavy. He finds it unwieldy. Third, he hates the name 'shiner', he thinks it is idiotic. But Joe does want Joeyland to benefit from the same style of commerce that Bobtenstein does. Joe is also a very nice guy and he wants his people to be happy. So in lieu of gold, Joey implements his 'joeybuck' idea.

Joe goes around to all the villages explaining his idea, just like Bob did. But instead of handing out gold, Joe hands out pieces of paper with his face on it. He says that this is legal tender for trading purposes. He gives everybody an equal share of the joeybucks. And basically does the same thing as Bob. He prints up a bunch of them, gives half to the population and keeps the rest for himself (and he doesn't need a Treasury, they are just stacks of paper).

He also implements a tax, just like Bob did and for the same reasons. Joe is very happy to see that commerce does ensue in Joeyland just like it did in Bobtenstein. People are happy, they like the joeybucks (Joe is a handsome guy so it is a nice picture which the ladies definitely appreciate), they like the trade, they like the interconnectedness. Joe is happy.


So I apologize for the cartoon-ish story, but I wanted to set up something simple first to illustrate some ideas to come.

If you recall from this post (The Gold Blog and scroll down to just before comment #1) I put together criteria for defining money and the characteristics it should exhibit, which are: 1) Money must be valued equivalently by all parties in the exchange, 2) have enduring value, 3) be regulated, 4) be liquid and 5) be fungible. I went through a similarly cartoonish (but ultimately useful) example of the failure of trying to use Snickers bars as money. If you haven't read that post before, I would encourage you to do so now. I wrote it over a year ago but I think many of the concepts are still useful. You will also notice, if you read the entire post, that I talk about debt servicing burdens and default risks of the US Government. I make some observations in this gold post that I have proven incorrect in my last post. My own view and understanding of this topic is constantly evolving. I have no problem admitting when I am incorrect in an assumption and I am willing to put my thoughts down as an object lesson so that you can see where I either make good points or learn from my own past mistakes. My hope is that my reasoning is useful, even if it takes me awhile to come to the right conclusions :)

The first observation to be made is that both systems behaved effectively identically. In this case the gold standard was operationally equivalent to the fiat money standard. Why? Precisely because the money supply was fixed in both cases. This being the case, because Bobtenstein and Joeyland have materially similar natural resources and the same population, the pricing structures of those natural resources will also be materially similar. The gold standard was neither better nor worse than fiat money in this case.

But here is another subtle point. The populace of Bobtenstein knew already that there was no more gold. That the amount of gold that Bob had was all there is. Therefore they knew a priori that Bob couldn't make more and that each shiner was always going to be worth the same. The populace of Joeyland did not have that luxury. They were being handed a piece of paper which might or might not be fixed in scarcity and told to exchange it for goods, as opposed to the Bobstensteinians who did know that their shiny yellow rocks were fixed in scarcity. But since Joe personally vouched for the fixed supply of Joeybucks, and everybody trusts Joe, and Joe has never given them a reason to think otherwise, they do trust the joeybucks. And everybody is happy.

What I am trying to (hopefully successfully) get at is the idea of trust in a currency. Trust is *not* just applicable to fiat money, but the gold standard as well. I mean why didn't the Bobstensteinians trade yellow rocks before? What was the reason to trust it? It is because Bob set up the framework within which gold could act as a currency. And once it became accepted as such, the idea is self-perpetuating, because the Bobstensteinians knew that the gold in circulation was a fixed quantity. Once the trust in the shiner was started, there was never any reason to 'untrust' it. This is not quite true for the Joeylanders. There is an initial ramp up in trust required for the joeybuck, just like there was for the shiner. But there must be renewed trust with each transaction since the only reason for the fixed quantity of joeybucks is based on Joe's word. As long as the trust between the currency holder and the sovereign currency issuer remains intact, the currency will always be viable. Trust is the key.

There is another salient point to make here. Recall this statement from my last post:

The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!! Is this true, does this even make any sense? The answer is yes.

Lets apply this statement to the example of Joeyland and Bobtenstein.

Neither the Joeylanders nor the Bobstensteinians had a currency before Joe and Bob introduced it. So, by definition, when Joe and Bob invented their currencies, and they are the sovereign entities, they had all the money and the population had no money.

But we need to think a little more philosophically here. Let's say I am the only person in the world, the last man on Earth so to speak, and I have a billion dollars, just stacks of $1 dollar bills sitting around, do I actually have money? It is true that it looks like money and has George Washington's face on it. But is it 'money'? .... The answer is no. Because for money have have any meaning, for it to exist there must be two or more parties that a) have goods to exchange for it (otherwise they are just passing the same papers back and forth) and b) all parties must be willing to accept that the money as a store of value (otherwise why trade real goods for it). So as the last man on Earth, even with a billion pieces of green paper, I don't have money. Or said another way, money is the potential of a currency to enact commerce. If there are no other parties, or the other parties don't have money and goods, then commerce is not possible (I am referring to the trade of goods for legal tender, not bartering which can obviously happen without money).

So in exactly the same manner, since the populations of Joeyland and Bobtenstein has no money, and Joe and Bob were the only ones that did have money (and for the purposes of this example Joe and Bob cannot trade with eachother, e.g. the SHN/JBK is not a recognized symbol :) ) money for all practical purposes doesn't exist.

It comes into existence the moment that both Joe and Bob spend it into existence. In the example above, they simply give half to the populace. They simply spent without getting anything in return (like a donation is a charitable action, but it is still technically spending). But the point is that the money was effectively 'spent into existence'

Further, now that the money is in existence, then the second observation from the previous post can be made: This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity. The population has (is saving) half of both Joe's and Bob's original amount. It is savings for the private sector and identically debt for the public sector (in this case Joe and Bob).


...Okay! This is very good!

We now have operational concepts for money, savings, currency trust, as well as a set of (albeit simple) examples against which we can exercise and verify some of the concepts from my last post.

Now, let's make things more interesting .... :)


This post is already long enough, so I will save the more realistic additions for the next post in the series. Unfortunately both Bobtenstein and Joeyland will be subject to 'monetary innovation' and 'creative accounting', and our happy land will not be so happy soon :(

Using the example countries defined in this post, the next post will cover these topics: revenue constraints, deficit spending, structural debt, private/private debt, public/private debt, bonds, taxation, etc.

I think this will end up proving a rather useful exercise. Stay tuned!

Thursday, August 19, 2010


Current thoughts. This could be the "big one", but I have some nagging doubts about it. I am highly short, so I would be quite happy for a breakdown. But this still has the feel of an OPEX game to me.

Wednesday, August 18, 2010

The Matter of Deficits, Sovereign Default, and Modern Monetary Theory

Okay, fair warning. This is going to be one of my "thinking (and probably unfortunately rambling) out loud" posts. But I really do hope you read it because I am looking for feedback in this post. Because some of the conclusions I come to are ..... disturbing.

Let me also preempt the reading of this post and any subsequent discussions that I am not advocating for *anything* in this post. I am simply exploring what the world would look like if I were looking through Modern Monetary Theory's eyes.

The reason for this post:

I am very concerned about sovereign debt risks and the possibility of sovereign defaults. From a traditionalist standpoint, the US is running massive budget deficits, and issuing bonds at an alarming rate to try to keep the stimulus going but also just to simply keep the government running. Tax revenues are falling. This also seems incredibly unhealthy and unsustainable.

So from this point of view, the default risk of United States sovereign debt is certainly not zero. There are arguments regarding the size of the risk (based 90% debt-to-GDP, 100% debt-to-GDP, etc.). There are a whole host of ways to look at sovereign risk in historical terms.

Now there is another point of view, the Modern Monetary Theory view, regarding the sovereign default risk of the US

.... and it is 0. Not 0.0001%, not 0.00000000000000001%, but precisely and identically zero.


I have been doing a lot of reading, thinking and pondering on this topic. I want to take you all along for my thought experiment ride. And I want to solicit feedback regarding the validity of my analysis. Again, I am not looking for ideas on whether the current framework is 'good or bad' (even though inevitably some of my own thoughts on the matter are likely to show through). I am trying to simply understand it. Understanding is, after all, the key to risk evaluation.


So the idea goes like this

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.


Because notice in our definition of the FRN the Fed does not have to look at tax receipts or the size of the national deficit or the success of bond auctions with China and Japan as buyers. It quite literally says 'I have a million/billion/trillion/etc. FRNs in my account today' and can subsequently fund the government with whatever it needs instantaneously.

Now I expect a lot of people are yelling at me right now and saying "it's not that simple!". Which is technically true. But the reason, which I will show in a second, is because of a hold-over from earlier monetary times. There is literally nothing that would stop funding of the USG in this manner in practical terms. But even the the term 'funding' requires clarification in the MMT framework which I will get to in a minute.

First, let me address the "it's not that simple!" criticism with a simple question:

What is a US Government Bond?

From here: A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company. A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France. It was in the form of a tontine.

This definition makes sense. It is what we are all used to. And let me illustrate why: The British Pound Sterling, or the US Dollar (not FRN, remember the Federal Reserve is a recent invention historically speaking) used to be convertible currencies. That is you could 'convert' the currency for a specified amount of gold or silver. In the past, governments were most definitely revenue constrained. There was a fixed amount of gold and silver in the world (new mining supply adds to the above ground supply historically by 0.25-1.5%, very small and largely insignificant).

So in this case, how does a government run a deficit?

You bet, it issued debt in the form of bonds. Creditor nations (ones that ran budget surpluses, based on collecting more taxes than they spent) could loan gold and silver, or their own currency (and since it was convertible was equivalent to loaning gold and silver), to debtor nations to fund projects. In the quote above, it was to fund a war.

The government bond market was basically invented as a way to get around the gold standard. Now, I am not trying to cast judgement, I am simply reviewing history to see what makes sense. Quite often a government felt an activity was so important that it felt like it needed more money than they had immediately (which generally boils down to two categories: wars or stimulus). Since the gold standard is by definition fixed, it requires all budgets to be balanced. You cannot spend more money than you have. Unless you have a alchemist in the back room turning lead into gold (which coincidently, alchemy was a *government* funded endeavor in the Middle Ages). The reason is simple. Again, I am not casting judgement, just making an observation. Politicians and Bureaucrats are not accountants and economists. They don't want constraints. Balancing a budget is hard. Fiscal planning is hard. Large expenses in the short term mean cutting elsewhere to balance. Politicians like to promise, and they are quite bad (historically speaking) at taking away.

So this is where the very rich history of sovereign defaults originates. When a government takes out debt and spends it on unproductive endeavors (war being most egregious form of an unproductive endeavor) or even endeavors that are simply less productive than the rate of borrowing (i.e. the debt incurred does not increase GDP and/or tax revenues to cover the servicing cost), then the deficit becomes structural. Historically the accumulation of too much structural debt is the primary reason for sovereign defaults under previous monetary systems.

... okay, so the point of that was to show why Government Bonds came into existence in the first place. Again. I am not labeling them as 'good' or 'bad'. I am simply trying to recognize where they came from and how they fit into today's world.

Now lets fast forward to 1971. (I am skipping over a lot of important details, such as The Federal Reserve Act of 1913, the Bretton Woods Agreement, etc. Because I am focusing on sovereign debt in this post and trying to answer questions regarding default risk)

Nixon closes the gold convertibility window. This means that the FRN (not the US Dollar anymore) is 100% fiat for the first time. The reason? To pay for the Vietnam War. Now I am sure a lot of economic historians will argue with me regarding its usefulness in removing the world from the shackles of gold or other ideological statements. My point in making this statement is that the conversion in 1971 was based almost completely on practicality. The US Treasury could not honor gold and silver commitments, we were engaged in an escalating war, the traditional route of USG bond offerings were getting progressively worse (interest rates), so it was time to change the rules of the game.

And the point of this post is to realize just how much they changed. And I have been thinking about this for a long time. I have written many posts regarding macroeconomics and the US Dollar, making many of these same observations that I have made in this post. But this point is, until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So, as a testament to the haphazardness of the implementation of the 100% fiat currency experiment, I will pose simply one question:

What happened to all the USG bonds?

Recall what I said at the beginning of this post:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are way that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve Note (FRN from now on), which is of course the US Dollar, is monopoly issuer of the currency and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs. What this means is that the US Government is never revenue constrained.

In 1971, we got rid of the gold standard and made our currency 100% fiat. In a 100% fiat system, the currency issuer is never revenue constrained. So in this system, government bonds are irrelevant.

Practically speaking it was something that the government did not want to deal with in war time. I mean countries all around the world held USG bonds. So what would have happened? Do we covert bonds to currency at prevailing rates (like I said, there is no limit to the amount of FRNs the Fed can produce, so it could have converted all the obligations with one stroke of the pen, this was before proliferation of computers :))? What happens to unpaid but implied future interest? Do we negotiate for foreign currency holdings? How should it have been handled? As you can see, it would have been an accounting nightmare. So what did they do instead? They punted.

They left a pre-fiat concept (from above: the government bond was invented as a way to get around the gold standard) in place in a newly 'minted' (sarcasm intended) fiat world, because it was too complicated to figure out how to sort it out, and go to this new currency regime, and fight a war all at the same time. Again, I am simply trying to look at this historically, not ideologically. Because what we have now is a mess, and it doesn't make sense. And I am trying to understand why it doesn't make sense.

So now I am going to fast forward to today. Again, I am going to skip over concepts like The Great Moderation (which is a huge debate, but I am not going there at the moment), and The Credit Bubble. Because I am trying to get at Sovereign Default Risk and the place of Treasury Bonds in our current monetary system.

What happens with a USG Treasury Bond today? What is it's function? purpose?

Remember again what I said at the beginning: In a 100% fiat currency system, the sovereign issuer is *never* revenue constrained. So in our new monetary system, we don't actually need to sell bonds to raise revenue. Japan nor China is our banker in this case. In China's case, they buy US Treasuries to manage the yuan exchange rate: Steve Saville: Getting Some Things Straight Regarding China

So what gives? The Fed-Treasury "dynamic duo" is one of the keys to how our modern financial system "works"... right? Let's see what's going on under the hood (from http://pragcap.com/when-will-the-bond-auctions-begin-to-fail):

So what happens when we auction bonds? Well, the NY Fed has accounts all over the country. The Treasury keeps very close tabs on excess reserves so as to avoid overdraft at the Fed. So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves. Why do they do this? Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves. Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit – TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

So now I need to back up for just a minute and address the The Federal Reserve Act. The idea of founding the Federal Reserve back in 1913 was to address the "booms and busts" that occurred under the gold standard. The idea being that the Federal Reserve could manage the money supply, expand and contract it somewhat around the gold standard to even out the boom/bust cycle [rant alert! I need to interject in my own thought because even though this whole idea sounds nice, neat and smart in theory, the fact of the matter is that booms and bust did *NOT* happen because of the gold standard, but because of deficit spending / bond issuance by not adhering to a gold standard. The boom/bust cycle is primarily driven by excess government indebtedness, which eventually migrates to the private sector leverage, which begets speculation. The formation of the Federal Reserve is simply the 'fix' to a misdiagnosed problem. end rant]. So they had a very specific function and mandate under a gold standard (and we can argue endlessly whether this is good or not), but they have no true mandate under a 100% fiat standard. I will finish this train of thought up in a minute.

I now have to return to the statement in bold near the top of the post: until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So what is this alien idea? It is expressed here which I will sum up (http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation)

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).

When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.

Basically it means this: The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!!

Is this true, does this even make any sense?

The answer is yes. Like I said, in 1971, the implementation of this system was ad hoc, basic questions about about the treatment of USG bonds were left unanswered, the role of the Fed (which is irrelevant in this system) was left in place to keep the hold-over "funding" mechanisms intact (even though as I have demonstrated above, they are not necessary. The Fed buys Treasuries to manage rates, not fund the government).

Again, I have touched on this idea in the past in my large gold and dollar posts, but never has it been so clearly and simply stated. I mean, it sounds so ridiculous when stated that way. But the government spent 100% fiat money into existence which is why we have money. This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity.

.... okay.

So let's answer this question first, before I go on:

Can the US Government default on its debt? The answer I come up with is: No.

There is no monetary reason at all for this to ever occur. Congress may do so out of spite, everybody at the Fed may get food poisoning and not be there to buy US Treasuries during an auction. But there is no monetary reason for the US to default on its debt.

.... I have thought long and hard about this, and this is my conclusion. So before I go on, the question I have of the group is: Does this make sense?

Moreover, any country that is the sovereign issuer of their own currency has no monetary reason to ever default. This would be notably Great Britain and Japan (more on this at a later time).

However, any of the Eurozone countries could default, since they cannot issue their own currencies. The ECB controls the currency and Eurozone members cannot create as much money as they wanted to service their debt. This means Greece, Italy, Germany, etc. all non-zero sovereign default risks.

DO NOT MISINTERPRET WHAT I AM WRITING! I am *NOT* saying that this situation is 'good' or 'bad'. I am first just trying to recognize 'what is' so that I can confirm my analysis and move on from there

..... If this is leaving you a little queasy feeling, you are not alone.

Because then it really further fractures the concept of money.

Fair warning, I will probably digress a little here, but I think it will be useful.

If the USG is not revenue constrained then there are three items in existence that had reason to exist in a gold standard but have no reason to exist in a 100% fiat money system: Federal Taxes, The US Treasury and the Federal Reserve.

Federal Taxes: If the USG is not revenue constrained, then taxes serve no true economic purpose. The tax code is complicated, antiquated, and wastes so much time and energy. So if the Federal government does not need tax revenues to operate, which by my observations above then it doesn't, then it is simply an unnecessary and costly (in terms of wasted productivity) hold-over from our earlier monetary system.

The US Treasury: It's main job was to hold the nations gold and silver, and to issue and manage debt offerings. None of these are applicable in the current system.

The Federal Reserve: It was invented to add flexibility that the gold standard didn't offer. Now it has a made up / ad hoc mandate of "targeting a stable inflation rate". The market can and should determine what the price of money is (which is what interest rates are) based on supply and demand.

.... These may sound extreme. But my point is stating these observations is that WE ARE LYING TO OURSELVES!. At the government level, we keep talking about funding, taxing, spending as if we were on an earlier monetary system. But as I observe, these are ad hoc holdovers based on a quick transition to a 100% fiat monetary system. The are confusing holdovers that should be eliminated.

But here is the crux of the matter: Governments always want a free lunch.

Look at the history I laid out. The bond market was invented as a way to get around the gold standard (free lunch with the risk of sovereign default), the Federal Reserve was invented as a way to get around the gold standard and the bond market (free lunch with the risk of sovereign default and bigger speculative bubbles), and the 100% fiat currency system is just the next evolution of the free lunch mentality.

At least I posit that it was when it was implemented.

The problem is that any government has never been a good steward of the peoples money. Yes, yes, I know this is a loaded statement, but I am sure good debates will ensue. But my point is that in a 100% fiat money system, the monetary supply is so much more susceptible to manipulation and politicization. We need to think very carefully if this makes sense for us or for the world.

The gold standard or the 100% fiat money standard is neither good nor bad in and of themselves. They are simply systems. How easily those systems are 'gamed' / subverted is the more pressing question here.

There is a whole other line of though regarding 'do deficits matter', 'deflation', 'hyperinflation', the current recession, stimulus spending, etc which speaks to 'good' or 'bad' and I will not address them here (however you can be sure I will in another post :) )

However.... I can foresee a 'good' outcome out of all of this (the ideological side of binve is shining through :). And that is if a government does spend money into existence, and the citizens either spend or save depending on where we are in the business cycle, and if there is no Federal Reserve then interest rates will reflect the actual demand for money. This would be a remarkably self-regulating system. Then when the government decides it wants to go to war, etc. interest rates will eventually reflect the citizens reaction to this. And interest rates are not important for bond auctions, but rather the cost of borrowing for the citizens (while the USG is not revenue constrained the citizens definitely are). And so while governments can spend like crazy, the health of balance sheets in the private sector is always the measure of a nations economic health (which is why we call this current recession a household balance sheet recession). Productivity doesn't come from the government, it always comes from the private sector. This is precisely the problem with centrally planned economies. But I am veering off topic and that is a discussion for another post.

I think this *could* be a step in the right direction towards more transparent Free Market Capitalism (assuming the Fed is abolished). Now I am not 100% no-government. They serve some very useful purposes such as the maintenance of environmental laws (at least the laws that are not written by corporate lobbyists. But we have crony-capitalism now, not free markets) and the funding of pure science endeavors that may not have immediate practical value but have far reaching beneficial human impacts. However, governments are very bad at economics and monetary policy and they should stop messing with both.

In a 100% fiat system, everything regarding the confidence of your system is reflected in your currency. And without the gamesmanship of 'selling bonds' when it no longer necessary, then a global economy could be more fruitful, productive, balanced and fair based on honest market driven exchange rates.


So.... what do you think? Am I full of BS? Am I fundamentally not understanding the monetary system at play here? Do you agree / disagree?

Please discuss!!

Tuesday, August 17, 2010


A few thoughts on this wave. See Spud for more details.

Monday, August 16, 2010

I will assume

I will assume that everyone has read "some investor guy"'s ongoing series regarding Sovereign Debt Risks on Calculated Risk

... if you haven't .... then you should.

This is an excellent and very accessible series that talks specifically about Sovereign Debt and Sovereign Default risks. If you want to know why I harp on this subject so much, especially in this weekends post: Where we are: The Long Count and some thoughts, this is one of your answers. Seriously if you haven't read it, then you owe it to yourself to do so.

For your convenience, here are links to the current series


Here is what I think 2 (either Minute or Minuette) will do.

So I decided to check out the max pain from here: http://www.optionpain.com/MaxPain/Max-Pain.php, and that story seems to jive.


Current count

Sunday, August 15, 2010

Where we are: The Long Count and some thoughts

Just thinking and reading this weekend, and decided to update some of my charts on the long counts and to revisit / reiterate why I continue to be bearish on equities as a general asset class.

First the macroeconomic and fundamental pictures.

I have written so many posts on this, so there is no need to regurgitate them again. I am bearish, and I believe there is a well-founded reason to be so. For my posts pertaining to this, see:

-- Long Term View
-- Bond Market and Yield Spread Update
-- What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations
-- US Dollar Count Updates
-- Bigger Fish to Fry, and update to Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR
-- Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR
-- Of Modeling, Risk, Financial Innovation, and Liquidity Crises
-- Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally
-- Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave
-- Connect the Dots Before Financial Depressurization
-- Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?
-- Debt Saturation
-- Global Macro Investor August Report - This is a Must Read
-- The Big Interview with David Rosenberg
-- What is the Consumer Metrics Institute Growth Index saying?
-- Rear View Looks Fine, But The Macro Forward Outlook Is Deteriorating
-- John Hussman: Recession Warning (Unthinkability is Not Evidence)
-- Buying dimes with dollars is bad business, government-funded or not

to name a few.

I think we are in a secular bear market. I think we are not at the end. I think we are not near the end. I think March 2009 was not the bottom (Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?), neither fundamentally nor macroeconomically.

So where are we? Here are the 3 options that I think are the most likely

1. We are in cycle wave C

We have a large impulse down to complete before this bear market is over. The implication that we are in an impulse means that things are going to deteriorate precipitously over the next couple of years. The most obvious and likely catalyst for this to happen is a massive sovereign debt crisis in the world's advanced economies. I have talked about this view, ad naseum, especially if you are a reader of my Caps blog.

2. We are in Cycle Wave Y

We have a corrective move down from these levels. This would be equivalent to a Great Depression (I) type move. After the crash in 1929, there was a 50% rally in 1930. Then from 1930-1933, there was a crushing, overlapping bear market. If you go back and look at the daily and weekly charts, while sharply down, the move is not really an impulse. There was a lot of overlapping moves. I am sure every down move and subsequent sharp rally made everyone think "the bottom is in!" only to be crushed over and over again.

.... This move would suck. Precisely because of the fakeout effect described above. At least with the impulse count, there will be a P3 which will tell everybody "this is *not* the bottom!" and to serve as a more readable technical setup.

The macro picture here would be not a wildfire of sovereign defaults (such as Option 1) but maybe a few interspersed with some massive intervention by central banks. This would serve to "bounce" each crisis for a few months (B and X waves) but then go to new lows after the market decides all of the new debt to stop these crises is *not* a good thing (A and C waves)

3. We are in Cycle Wave X

This is the crushing deflationary Japanese style multi-decade bear market nightmare. See this post for a preview if option 3 were to play out: Back at Support

More thoughts:

Notice that I have a specific range of outcomes, between 400 and 100 on the SPX (roughly 4000 to 1000 on the Dow) for the next 5-10 years. And my preferred count is at the higher end of that range.

I am not a 100% "deflation-scenario" believer. I do not believe cash will be king. Please see my logic in this post: US Dollar Count Updates. There are those that believe in a triple digit Dow endpoint, and I am not one of them. In fact, I am quite bullish over the long term, and I do not consider myself a permabear. I simply recognize the macroeconomic problems we face, and the current fundamentals of the market and what is priced in, and the lack of political will to sustainably fix these problems (much less even admit the magnitude of the problem to begin with). This is fundamentally a debt crisis. But at the end of the day, the debt will have to be dealt with one way or another. And when it does, the world can get back to solving problems and increasing the quality of life. This is why I am a long term optimist: Why I hold Gold: Why I am a Long Term Optimist and consider holding gold and Optimistic Endeavor, and Why I think the Stagflationary Scenario is more likely Macroeconomically in the Intermediate term (next several years)

... Just recognizing the problems we face, I am adamantly not bullish on equities for the next 5-10 years.

So if you want a bullish option from here, go read another blog. I am not bullish. Even if we somehow eek out positive GDP growth from here on out, I doubt it is much over 1%. And as Gary Schilling correctly points out, we need 3.3% GDP growth just to keep the unemployment rate stable. So if you want to be a bull here and count the waves up as a 1-2, 1-2, then power to you. I will simply not indulge in that fantasy on this blog.

Detail on Option 1:

Because I think a Sovereign Debt Crisis is the biggest impact event on the macro horizon and one that has a (IMO) higher than commonly acknowledged probability of occurring, here is my preferred count in more detail.

Just some macro and technical thoughts from the fringes of the blogosphere.