The tricky lie of the state

During the past 10 years, countries have issued debt at outrageously low interests. This has made states lazy, overconfident on debt to finance conventional payments. Now, default risks are going up all over the board and financing is more expensive.

States, especially Western ones, who have become dependent on debt, now see how there is no other possible income source to finance the way out of the crisis, and expenses keep piling up. Once they relied on debt, they have taken care of a lot of redundant and questionable expenses that are now in the same bag as the functional and basic operational expenses that account for the services the state has to give its citizens. However, this bag is like a pudding, everything is mixed. Every budgetary expense is going to raise turmoil if cut, since there will always be a mouth fed by some dysfunctional social policy, somebody used to cheap subsidies, addicted to some outrageous political promise.

I attended an occupy meeting in an unknown European city attended by unlikely members. They were unemployed, and apparently had suffer from a poor education. A school teacher who was sacked claimed the government was on strike because it has stopped "feeding the citizens" with rights. Absolutely dumb! They even went into raising funds for something that apparently happened in Peru (???) !!! I was outraged. In which world did those people live? Of course, they had their iPhones.

People has lost the contact with reality, if they ever had any. People should learn to pay whatever services they want with their taxes, not by selling debt and promise to pay it in the future. To raise taxes one needs industry, and people should learn that they lost every bit of manufacturing to China, where their iPhone comes from, where they earn a slave salary, the salary that their will converge to. People should learn that the State cannot make up to the industry loss. A job made to fulfill a new law does not compensate a manufacturing job lost to cheaper hands. The state needs to pay for that and it can only be done with new debt issues.

So, next time you meet some gimme-right character, you tell him to
SHUT HIS MOUTH AND FUCKING READ SOMETHING IMPORTANT

Ohh by the way, screw the the clown game called olympic games (intentional lower-case).

The turning point and the next leg in Gold

We have been warned about further near-term weakness in gold and pretty much else by prominent investors such as Jim Rogers (link here)

That is not to say that gold is bulletproof. In fact, Rogers says a gold price correction could happen sooner rather than later, and the downside is USD1200 - USD1300 a troy ounce.

and Marc Faber (link here)

Gold may not perform very well in the near future. The gold market has performed so well, we could have some setback.

Which is part of a broader market weakness stressed again by Marc Faber (link here)

The market is vulnerable. Many stocks sell off on news that is not really bad, but not just as good as expected. So I am of the view that maybe we have something more serious here.

Bear in mind that no asset will inflate more without additional monetary stimulus. The inability to generate profits at the same pace than overall interest payments due to sustained high energy prices is burning the money that solvent businesses have. A credit implosion burns money and removes liquidity, creating a monetary deflation whose effects are similar to the Great Depression. This is what Bernanke knows, but I don't know whether he has factored in the true importance of oil in the equation.

In any case, without monetary easing, equities will crash, draining liquidity out of the system and making several institutions insolvent, which will spur fear into the already weakened markets and will drive them further down. That is the signal Bernanke is waiting. I've been hearing talk about further QE since April 2011, but Bernanke is an elegant guy and will not let politicians, economists and the broad public criticize him over QE. They will have them begging him for more QE. And that moment will come once equities crash.

This scenario is a market-wide collapse in which only one asset would survive: oil in case of a conflict with Iran, an option that has become increasingly likely. Short everything, long oil.

Concerning gold and silver, bloggers Dan D. from The Fundamental View, Mr. Hui from Humble Student of the Markets, and of course the previously mentioned investors Jim Rogers and Marc Faber, and myself, are expecting further short-term weakness that will make the metal plunge (for the last time in my opinion) until reaching the max pain point of many investors, only to recover after institutional investors (not the small investor) counts on immediate easing. Look for a massive drop in both the price and open interest in the COT (Commitment of Traders). I am no chartist (and I could use one), but I believe that USD18 to USD20 could be a bottom for silver in the worst-case scenario, that would revert all gains from QE2. That would put gold in USD1260 to USD1400 using a crashed-BDI ratio of 70. I chose this ratio because it would coincide with low industrial demand for silver, and would correlate very well with another plunge in the Baltic Dry Index.

I believe the 1260 number is appealing to technical chartists, since it is the bottom gold made back in 2010. This figure is also in the range Jim Rogers is saying in the media.

So, wait for those beautiful Chinese 2012 silver pandas to fall into your hand at incredibly cheap prices. Be patient, buying silver will again be profitable and a very good investment because it will react with the same strength as it did in 2011.

And if you plan to trade these markets, trade safe and good luck.

DISCLAIMER: I have no position in commodities at this time, nor I plan to open any position in the near future.

Monetary contraction, deflation and gold

Societies and their economies are complex systems that are not easily explained and whose dynamics are too complicated to be captured by statistical and econometric linear models. These linear models come from the linear nature of human thinking.

I hear people that favor the theory of an imminent sudden inflation as credit and the monetary base expand, and others that believe the only thing we will see is a job-destroying deflation that will only be stopped by a centrally-planed monetary policy.

What I think is that both maybe right. The only question is timing, just the same as the markets. Markets can stay irrational longer than you can stay solvent, says a market saying. The general economy may refuse to follow the path designed by planners because there is more to the economy than just the monetary base plus credit. The economy needs energy to move, and energy can't just be printed. The less energy you have, the more restrictive credit and money become if unstable economic processes are to be avoided. Therefore, the use of credit and money has the effect of a drug for the economy. They can boost it during some period, but the sustained use of those must be matched by an equal sustained use of energy. If no new energy is added to the system, inflation will appear but, at the same time, asymmetric access to credit and money can lead to deflation in those sectors affected by a late access to them. However, this is nothing but transitory, and money will flood the markets like a tsunami as credit is suddenly liberated by banks, usually responding all at once to a fear stimulus.

That is brilliantly described by Mike Maloney at his conference in Puerto Rico. His thesis, which I support, describes a scenario in which first a deflation will occur, and then an inflationary or hyperinflationary process will start some years later.

I think that is what we are seeing now. As I reported, the M1 monetary base is contracting in the Mediterranean countries and credit is inflating the housing bubble in Germany and Austria.

For this reason, gold may go down in the following months and still be an excellent investment, maybe the investment of your life. Do not pay attention to the permabull gang of KWN, they sell bullion, they tell you it is a bargain at USD600 and at USD1900: if it goes down is on manipulation and is forming a bottom, if it goes up then we are days away from going to infinity.

Jim Rogers and Marc Faber, who I regard as two stand-up and achieved investment professionals and honest individuals, have been saying in numerous occasions that gold dynamics are very strange and they expect some kind of important correction. Pay attention to them, they tell you for the sake of telling you. Make a little room in your heart for deflation.

Two videos aus Deutschland

The first starts with Dirk "Mr.Dax" Müller, slamming the door pretty hard on those that only see an unlikely interest rate in a brilliant exposition about economic growth:

On the other hand, here is some common wisdom out of Berlin, by Prof. Bernrd Senf, in two series

Prices gone berserk in Germany

There are many news reporting high inflation in Europe in general: food, fuel, and so on. But, how bad are the money shots in real estate prices in Germany? this is very serious. This fresh credit and money printing via the ECB's balance sheet expansion is doing a very pernicious effect, i.e., raising prices, which reduces competitiveness. Merkel knows this well, and knows that this inflation and these money shots are not what Germany needs.

Furthermore, this creates the same housing bubble that was created in southern countries, especialy Spain. Here are some news signal an active inflating market:
Warum der deutsche Häusermarkt jetzt boomt 
Makler sehen jetzt die richtige Zeit zum Kauf 

What is happening, as I say, is that many banks in Germany and Austria are not funding commercial projects, but simply going into real estate. This produces a corrosive inflation: rising property prices hinders productive investment, as the growing costs of premises and the flow of money out of the industry makes it impossible to undertake a project, leading to an erosion of Germany's industrial economic edge. Do you really think that Merkel will let house prices to continue to rise by 10-15% annually? This is not sustainable and I expect the German government to take action in some way, most likely confronting ECB's president Draghi. On the other hand, housing prices in Austria are going crazy. An acquaintance reported a fifth-floor, 140 square meters penthouse selling for 1.2M €. This acquaintance, who has lived there for 25 years, has never seen anything like it: many food items have doubled in just one year, and certain not so basic, but necessary products have tripled in nine months. Inflation is also inflating commodity prices, it is not uncommon to find bread for 4 € in Billa or Merkur supermarkets, which would be unthinkable just a year ago. What this means is that money thought to reactivate Portugal or Spain is moving around and wreaking havoc in European creditor countries.

At this juncture, I believe that some action to move rates higher will be taken. They will, or maybe already have, abandoned Spain and Greece, Ireland and Italy, and the Euribor, the main housing rates index, will go to levels close to those of 2008 and 2009. This would be a death sentence for those countries industries.

We can therefore say that the era of low interest rates in Europe is over. For those having a mortgage, especially in the peripheral countries, brace yourselves.

Smoothing splines and interest rate curves

Yield curves are important in Economics and used by finance professionals to analyze bonds and look for trading opportunities and by economists, to try to understand economic conditions.

The yield is the amount in cash that returns to the owners of a security, for example, if a sovereign bond with maturity at time $T$ is bought at time $t$ for a price $P(t,T)$, the yield would be high if $P(t,T)$ is much less than the maturity price $P(T,T)$ (which would obviously be the risk-free amount received by the lender). A higher yield allows the owner to make more profit from the investment, but it may also mean that the security is being sold at a discount as a result of some risk related to the security. For a recent example of this, Greek bonds, which were sold at such discounts because the market anticipated a default, this made yields soar, with risk-averting investors unloading bonds at the lower prices that risk-taking investors were comfortable buying in. Ultimately everybody took a haircut.

For fixed income mathematics, a set of axioms must be assumed, namely:

1. The market trades continuously over its trading horizon: it extends from the current time to some distant future time such that the maturities of all the instruments to be valued fall between now and the trading horizon..
2. The market is efficient: information is available to all traders simultaneously, and every trader makes use of all the available information, also related to the axiom that
   
3. There are no arbitrage opportunities: the price of a portfolio is the sum of its constituent parts.
   
4. The market is complete: any desired cash flow can be obtained from a suitable self-financing strategy based on a portfolio of discount bonds.

It is assumed further that there are no legal barriers to trading and that the market is rational (traders try to maximize their profits).

Now, define the zero yield in terms of the bond price above. The zero yield, as seen at time $t$, of a bond that matures at time $T$, is denoted by $y(t,T)$ and is defined by
$$
P(t,T)=e^{-(T-t) y(t,T) }
$$
for every $t<T$, which means that the current price of the bond is equal to discounted price at maturity (using compound interest).

Suppose that at time $t$ we enter into a forward contract to deliver at time $T_1$ a bond that will mature at time $T_2$ (obviously $T_2>T_1$). Let the forward price of the bond be denoted by $P(t,T_1,T_2)$. At the same time, a bond that matures at time $T_1$ is purchased at a price of $P(t,T_1)$. Again at time $t$, a bond that matures at time $T_2$ is bought with a price of $P(t,T_2)$. Notice that the axiom specifying that there are no arbitrage opportunities implies that the price of the bond maturing at time $T_2$ must be equal to the product of the price of the bond maturing at time $T_1$ and the forward price $P(t,T_1) P(t,T_1,T_2)$. Let the implied forward rate $f(t,T_1,T_2)$, valued at time $t$, for the period $(T_1,T_2)$ as
$$
P(t,T_1,T_2)=e^{-(T_2-T_1) f(t,T_1,T_2) }
$$
Notice that $P(t,T_2) =P(t,T_1) P(t,T_1,T_2)=e^{-(T_1-t) y(t,T_1) } e^{-(T_2-T_1) f(t,T_1,T_2) }$ and, summing the exponents, we get
$$
f(t,T_1,T_2)= \frac{(T_2-t) y(t,T_2) - (T_1 - t) y(t,T_1)}{T_2 - T_1}
$$
which is the period forward rate. However, the instantaneous forward rate is of much greater importance in the theory of the term structure. The instantaneous forward rate for time $T$, as seen at time $t$, is denoted by $f(t,T)$ and is the continuously compounded rate defined by
$$
f(t,T)= \lim_{h \rightarrow 0} {f(t,T,T+h) } = y(t,T) + (T-t) y_T (t,T)
$$
where $y_T = \frac{\partial}{\partial T} y(t,T)$. We can interpret the previous equation as the current  yield value plus the instantaneous change of the yield with the maturity time.

To interpolate curves, and thus have values for all the points within the interval and not only the data points that are made available to us by the problem, we can use a number of different methods. One needs some complexity to be able to capture what the nature is saying, but at the same time this complexity might be cause by some "noise", or perturbations that we want to avoid (market panics, manipulations or poorly registered data). We can choose a parametric family, such as polynomials, fix the order and fit the coefficients. However, this appears as somehow arbitrary. One can choose to interpolate with a non-parametric method such as splines. When using some functional space, one must restrict himself to functions that meet some criteria, not only that approximate well (or maybe the best approximation in that space). This is to avoid overfitting the said noise.

Now we can choose to fit an approximating yield or the forward curve that approximates the true yield or forward curves, with the information given by actual bond prices as of time $t$, by minimizing the following functional (assuming we fit the yield curve $\varphi$):
$$
R(\varphi,t) =  \sum_{i=1}^n (P(t,T_i) - P(t,T_i,\varphi))^2 + \lambda \int \left( \frac{\partial^2}{\partial s^2} \varphi(s) \right)^2 ds.
$$
Where $\lambda$ is a regularization parameter, and $P(t,T_i,\varphi)$ is a functional that prices a bond of maturity $T_i$ at time $t$ with the yield curve $\varphi$. We change formulation, for practical derivation purposes (we now compute the observed yield $y(t,T_i)$ from the observed bond price)
$$
R(\varphi,t) = \sum_{i=1}^n (y(t,T_i) - \varphi(T_i))^2 + \lambda \int \left( \frac{\partial^2}{\partial s^2} \varphi(s) \right)^2 ds.
$$
And then we apply the standard smoothing splines theory to compute the solution, which is:
$$
\mathbf{w} = (I+\lambda K)^{-1} \mathbf{y}
$$
Where $\mathbf{y}$ is a vector with elements $y(t,T_i)$, $K$ is a matrix whose elements are of the form $\int \frac{\partial^2}{\partial s^2} \phi_i (s)  \frac{\partial^2}{\partial s^2} \phi_j (s) ds$, with $\phi$ is a choosen spline basis (notice the dot-product structure) and $\mathbf{w}$ is a vector with the coefficients on that basis, so that the estimated function is
$$
\varphi = \sum_i w_i \phi_i
$$