Federal Reserve's Exit Strategy and What It Means for the Stock Market

"Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economy – an effort to preserve flexibility and manage highly unpredictable market expectations."

What does this mean? Why would the Federal Reserve reveal that they have "mapped a strategy" to stop their bond-buying binge?

First, the "what does it mean" question - nothing. It means nothing. No one expects the Fed to take any action in the immediate future.

The answer to the second question is more revealing; the Federal Reserve knows their policies have come to have a direct effect on the equity markets. This "leaked" bit of information was designed to gauge the reaction of the stock market to the inevitable end of the bond- buying program. The last thing they want is an overshoot to the downside in the market, so they are conducting research into possible actions to take. 

The great unknown is the effects of the ongoing currency war. The devaluation of the Yen makes the Fed's job infinitely more difficult by strengthening the dollar. It has also put immense pressure on the Eurogroup to act also.1

What to do?

I've been giving the warning that the current rise in the stock market is artificial and unsustainable. If you refuse to take my word for it, perhaps you would be interested in Bank of America's recently released strategy;

 1. Slow down of asset purchases

2. Slow down and then stop reinvestments

3. Raise short-term rates

4. Begin sell down of asset portfolios

1. I plan to do an article about the currency wars soon. The vast majority of people could care less about the price of money in Japan, but they should be very, very concerned, as it will have a profound effect on everyone.

Cyprus Crisis - Lessons for the U.S.

The Euro has essentially been split in two. There is the Cyprus Euro and the Everywhere Else Euro. Currency trapped in Cypriot banks is subject to capitol controls and export restrictions. While there are some aspects unique to Cyprus, there are important lessons to be learned and warnings to be heeded.

The latest estimates of the amount of “haircut” depositors will be subject to now range from 60 to 100%. Money held in-hand is still worth approximately the same as before the crisis unfolded. Money trapped in Cyprus banks is now worth 40 to 0% of what it was before the crisis. It is important to realize there isn’t really paper money in the banks. Deposits are simply accounting entries, because the Euro is a fractional reserve currency. 

- Just like the U.S. dollar.

 U.S. Bank Deposits vs. Currency

This chart plots total U.S. deposits and circulating currency[1]. At current levels, if the U.S. were to go through a similar crisis as Cyprus, non-cash dollars would lose 88%. In plain English, for every $1000 you had in the bank you would receive $120.Of course the U.S. government could take the non-Cyprus route and devalue the dollar instead, in which case you would get back the entire $1000 but it would only be worth $120. You lose either way. 

This is difficult for many people to grasp, but keep in mind, the 9.2 trillion dollars in deposits doesn't really exist! 

In both cases, capital controls would certainly include a restriction on the transfer of precious metals and possibly forced confiscation. Don’t believe for a second that it couldn’t happen because it already has; in 1933[2].

Comment;

This is one of the fundamental problems I have with main-stream economists and financial advisers. They invariable advise keeping assets in non-cash, non-good forms. The value of the dollar only has value because people think it has. It isn’t backed by gold or any other real asset, and it no longer is even backed by the classic ability of the government to tax. The world knows there will never be tax rates in the U.S. high enough to cover spending, and the world also has seen the U.S. government’s adamant refusal to balance the budget. There are also concerted efforts worldwide to destroy the dollar by removing its status as the worlds reserve currency. Most recently Australia agreed with China to trade directly in each others currencies, thereby bypassing the dollar. Russia, Brazil, India, Iran and others have also moved away from trading in dollars.

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[1] Federal Reserve Statistical Release, H.6, March 28, 2013

[2] Executive Order 6102 Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government April 5, 1933

Cyprus Central Bank Deposits

Above is data from the Central Bank of Cyprus's Monetary Financial Statement for March 2013 showing total deposits by country of origin. While deposits from locals actually went up, there was a slight decrease of foreign, non-eurozone deposits. The surprise is the drastic 18% decrease in deposits from other Eurozone countries. It will be interesting to see the data from March when it becomes available, to support or deny the rumors that certain non-eurozone countries are getting preferential treatment under the capital controls in place.

The Euro At A Glance

Use of the Euro is quite a bit more widespread than a lot of people realize. To help understand the potential impact of the ongoing crisis, I have put together the following document listing countries according to nine criteria;

 The Euro At A Glance

• Members of the European Union
• Members of the Eurozone (Eurogroup)
• Current European Union candidate countries
• Potential European Union candidate countries
• Countries using the Euro under agreement 
• Countries that have unilaterally adopted the Euro
• Countries using the Euro only for international trade
• Countries whose currency is pegged to the Euro

 

The Euro At A Glance

Crisis In Cyprus Update

In a previous post, Crisis In Cyprus, I mentioned that the Euroroup would take action to try to prevent a run on banks in other troubled Euro countries.
This is a statement from the Eurogroup dated 25 March 13;

"Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday.
Macro-economic adjustment programmes are tailor-made to the situation of the country concerned and no models or templates are used."

The statement is carefully worded to characterize the Cypriot plan as "specific". No mention is made that the newly adopted "Bank Resolution Framework." specifies that all future assistance will be under the exact same conditions as the Cypriot plan. For all practical purposes, it isn't a unique case at all.

Cyptus Bailout Plan In Plain English

1. Laiki bondholders and equity owners will likely lose everything. Uninsured deposits will incur loses of around 40%

2. Laiki bank will be shut down.

3. Good parts of Laiki Bank will be turned over to Bank of Cyprus. Uninsured deposits in BoC will remain frozen until recapitalisation has been effected, and may be subject to liquidation.

4. The Governing Council of the European Central Bank will provide liquidity to the BoC in line with applicable rules.

5. BoC will be recapitalised by exchanging deposits for bank equity.

6. The conversion will be such that a capital ratio of  9 % is secured by the end of the programme.

7. All insured depositors in all banks will be fully protected in accordance with the relevant EU legislation.

8. The programme money (up to 10bn Euros) will not be used to recapitalise Laiki and Bank of Cyprus.

Crisis In Cyprus - Part 3

Agreement between the Eurogroup and Cyprus in regards to the bail-out/in has been achieved. The terms were much more sensible than first discussed, and represents a seemingly responsible position for the Eurogroup. Seemingly, because while they have taken a correct position towards Cyprus, fundemental problems with the Euro have (still) not been addressed.

Cyprus, on the other hand, is doomed to disaster. They are encountering the perfect storm of both supply-side and demand-side crises. Their banking industry is decimated and it is estimated will be cut in half, resulting in massive layoffs. They are of course, unable to devalue their currency to stimulate the other majority sector, tourism.

Cyprus, like Greece before it, will slip into severe recession, possible depression. Over the next year or two, it will become more obvious that their best option would have been to exit the Eurogroup, take the severe devaluation, adjust the Cypriot pound, and immediately begin the process of recovery.

But having accepted the Eurogroup's bail-out, and still being saddled with the Euro, there will be a long, long period of austerity. The capital controls put in place were initially supposed to last a week. Now it has been announced they will be in place a month. In reality. the controls will be in place until there is political change. Being a democratic country, the people will grow weary of the austerity, and vote themselves into power a government that promises to reject the EU's demands. Then they will end up in the same place they find themselves today. The only viable choice it to dump the Euro.

Soros and the Bank of England Revisited

George Soros is much maligned for "breaking the Bank of England". But most ignore the more important fact, that he forced the UK to exit the European Exchange Rate Mechanism and keep the British Pound, rather than adopting the Euro. The UK has enjoyed relative prosperity since then. It was the artificial manipulation by the Bank of England to conform to the EERM that gave Soros the opportunity to short the Pound in the first place.

The same thing has been happening in recent months with the Japanese Yen, allowing Soros to walk away with another 1 billion dollars.

Soros has been a voice in the wilderness attempting to point out the Central Banks misdeeds that decimate the middle classes, but he has been successfully vilified by right-wing pundits and politicians whose main interest is protecting the Central Banks and their Corporate accomplices.

However you feel or have been taught about the man, it would be wise to listen to his financial advise. He has been right in a big way, time after time after time.

Crisis In Cyprus - The Options

After Cypriot lawmakers rejected the ECB bailout, there is much speculation as to what will happen next. The official response from the Eurozone (Eurogroup) is that they have “noted” the rejection. The bank reopening that was to occur on Tuesday, but then delayed until Thursday has now been extended indefinitely. With the closing of banks, the Cyprus Stock Exchange has announced they will close as well.

What are the options for Cyprus?

Get a loan from Russia and stay in the Euro -

Russia has much more vested interest in Cyprus than the EU does. Around 30% of Cyprus bank deposits belong to Russians. This is a sore spot with Euro leaders because they feel that much of any bailout would go directly to Russia. It is also a possible motivation for the deposit tax they demanded.

Russia has no compelling reason to agree to a loan without monumental concessions from Cyprus such as access to their undeveloped offshore gas deposits. Russia has been trying to gain access to these deposits for years, but have been repeatedly thwarted by the EU.

A Cyprus banking collapse would actually be good for Russia as it would shut down a huge tax haven for Russian taxpayers and bring some deposits back to Russia.

Convince the Eurozone leaders to lighten bailout terms -

There are two key elements that might prove to make this option very difficult or impossible. Number one is the feeling among Eurozone finance ministers that the Cyprus banking sector is simply too big, (8 times as big as GDP) and acts as a money laundering enterprise. The ECB is characterizing the Cyprus bailout as a unique, one-time situation that will have no affect on other troubled Euro countries. Cyprus is also a tiny part of the total Eurozone economy, accounting for far less than 1%.

The second reason is more complex; northern Euro countries whose economies are doing well are resistant to further bailouts. The Euro representatives have kept interest rates very low for the benefit of countries like Germany, causing countries like Cyprus and Greece to become more uncompetitive and making economic recovery much more difficult for them.

Exit the Euro and return to the Cyprus Pound

This option would require a deflation of approximately 20-30% along with the significant cost of actually converting the currency and financial instruments. While it would be very difficult in the short term, it would yield several important benefits in the longer term. The country would regain the ability to independently adjust the value of their currency to suit domestic financial conditions instead of being at the mercy of stronger northern EU member states. It would allow them to keep access to the potentially lucrative offshore gas fields. It would give them an opportunity to restructure and further legitimize their banking system

Cyprus exiting the Euro would be bad of course for the Euro’s reputation and might further acerbate the problems in the other weak Euro economies. But behind closed doors, the northern countries may be secretly wishing for a Cypriot exit.