Bubbling Up...8/12/12

1) U.S. Trade Deficit Largely Due to "Intra-Firm" Trade by Dan Crawford @ Angry Bear

The vast majority of the U.S. $727 billion trade deficit in goods for 2011 is due to "intra-firm" or "related party" trade, that is, trade between two units of the same corporation, according to the U.S. Census Bureau. This is significant because such trade is the most open to companies manipulating the prices between subsidiaries to minimize tax liabilities, usually known as abusive transfer pricing. Moreover, as Stuart Holland argued in 1987, intra-firm trade is also less responsive to changes in exchange rates than is trade between independent businesses, since within an individual multinational corporation each subsidiary will have a specific role to play in its supply chain, which won't be quickly changed.

U.S. goods trade and related party trade (billions of dollars), world and selected countries, 2011:

Country        Exports from US Imports to US Balance

World            $1480.4     $2707.8          - $727.4

World (RP)     $ 365.0      $1056.2          - $691.2

Canada          $ 280.9      $ 315.3            -$  34.5

Canada (RP)   $ 98.1        $ 162.0           - $ 64.1

Ireland           $ 7.6          $ 39.4             - $ 31.7

Ireland (RP)    $ 1.5          $ 34.6             - $ 33.1

Mexico           $ 196.4      $ 262.9            - $ 64.5

Mexico (RP)    $ 60.5        $ 155.7            - $ 95.2

…

The bottom line is that we need to reverse the incentives in the tax code that encourage the offshoring of jobs. (Why does Apple have $64 billion in cash abroad?) However, to emphasize the point I made last time about what Americans want out of tax reform and the "reform" that has actually happened, it's worth pointing out that Robert Gilpin of Princeton University, author of the seminal U.S. Power and the Multinational Corporation (1975), made the same policy recommendation almost 40 years ago, and it hasn't happened yet. We've got our work cut out for us.

2) Zero rates have created a dangerous risk seeking return mentality by Edward Harrison @ Credit Writedowns

You saw the posts by Sober Look on the excess risk investors are taking on in the high yield market and the consequences of low yields on US households. Let’s make it a trilogy of posts then. There are plenty of other posts today that highlight this problem.  And it is a problem. One thing Austrians harp on is the misallocation of resources caused by heavy handed and persistent interest rate market intervention. They are right that the industrial organization and the structure of investment capital priorities is critical to longer-term growth. What we are seeing now is a skew into high risk activities. As I wrote 4 years ago

Woj’s Thoughts - Follow the last link for a marvelous step-by-step description of a credit bubble and bust. Harrison combines insights from the Austrian and Modern Money traditions, which is a prospect I hope to further in my own research.

3) The Jackson Hole "fix" is not coming by Walter Kurtz @ Sober Look

Market participants are looking for a fix, a repeat of the "high" Bernanke delivered at Jackson Hole in 2010 when QE2 was introduced. Markets however are in for a major disappointment because no outright asset purchases will be announced. There are multiple reasons for this, including the fact that real rates are now deep in the negative territory (as discussed here) and the policy as expressed in long-term real rates is far more accommodative than it was in 2010.

But what makes 2012 entirely different is that the key concern that pushed the Fed into asset purchases in 2010 no longer exists. The summer of 2010 was marked by renewed fears of deflation driven by credit contraction. The Fed was afraid of Japan-style deflationary pressures that are extremely difficult to arrest as bank lending shuts down. In the months preceding the 2010 Jackson Hole speech, credit was contracting sharply with banks steadily shrinking balance sheets. As discussed before, just the opposite is true in 2012 - credit is expanding at a decent pace. The chart below compares the trends now and in 2010.

Woj’s Thoughts - Kurtz goes on to suggest that markets may sell-off if disappointed by Bernanke, but I’m not convinced. Expectations of further “stimulus” have consistently proven resilient when faced with no new information. Markets may therefore simply shift expectations of further action to September, October, December and on, or until enough FOMC voting members explicitly state action is not coming.  

Permanent Zero Will Crush Treasury Shorts

Source: Fed: Crushing The "Smart" Money's Hopes Since 2009 at Zero Hedge

Apparently the natural instinct is to assume that the Fed will raise rates back towards “normal” levels in the near future. Rate hikes are not coming back for several more years and the Fed may very well signal an extension into 2015 or beyond in the coming months. Attempting to short Treasuries for any period over a couple months is likely to be a losing battle for the foreseeable future.

Related posts:
Permanent Zero: Record Low Treasury Yields and Banking Instability
Harrison: Why Permanent Zero is toxic and leads to depression

Permanent Zero: Record Low Treasury Yields and Banking Instability

The Fed is squeezing interest rates down to levels where you see private portfolio preference shifts, a euphemism for the risk seeking return mentality that arises from artificially low real fixed income returns and that forces up risk assets. But this can only go one for so long.

See, eventually there will be another recession and the question should be what happens to all those toxic assets on bank balance sheets. What happens if new loans go sour too? If you recall, US FDIC-insured institutions recorded $35 billion in Q1 2012 accounting gains. But the quality of those accounting gains was dubious. Here’s the key line to note:

Lower provisions for loan losses and higher noninterest income were responsible for most of the year-over-year improvement in earnings.

Read it at Credit Writedowns
What record low 10-year rates tell us about the toxic effects of permanent zero
By Edward Harrison

Yields on 10-year Treasuries reached a new record low of 1.617% today.
Regarding the continuing decline, Harrison explains that Long-term interest rates are a series of future short-term rates. The Fed has already “promised” to hold rates near zero through 2014 and I suspect that target date will be extended further by year end. Separately, when the Fed altered policy to begin paying interest-on-reserves (IOR) it also changed the direct measure by which monetary policy is adjusted. Given the enormous size of the Fed’s balance sheet (and outstanding Treasury debt), going forward it may be easier to effectively raise interest rates by hiking the IOR rate rather than actually altering the Fed’s target rate. With these concepts in mind, it should come as no surprise that 10-year (and 30-year) yields continue to move lower in similar fashion to Japan (although I currently don’t expect Treasury rates to reach the JGB lows).

Over the past couple years I have also remained suspect of US banking profits (and by extension S&P 500 operating profits) for the reason highlighted above from the FDIC. Much of the gains appear to be merely accounting profits. When the next recession/crisis hits, those accounting profits can (and probably will) easily flip to large accounting losses. In my view, the risk of serious shortfalls in capital during the next downturn remains extremely present today. As Minsky often pointed out, complacency about risk is often a warning of building risks in the background.  

The next crisis/recession will probably occur with short-term rates still at zero and without many aspects of the Dodd-Frank Act or Basel III provisions in place. Given the public response to previous bailouts, the Treasury/Fed response will be a wild card. Any bets on what their initial actions will be?

Related posts:

Fed Stands in Own Way on Monetary Policy
Treasury Yields Low for Good Reason