STEALTH QE III

This time QE III cannot be announced .... It must be (is being) quietly rolled out!
It is now highly likely that the Fed has no intention of introducing QE3 in any recognizable form we are anticipating, given that: 1. 2. 3. The expansion of narrow money so far has led only to a degree of price inflation, without much benefit to asset prices. With the ECB still reluctant to print Euros, QE3 would probably collapse the dollar/euro rate and propel gold considerably higher, placing unwelcome strains on the financial system. The Fed also finds itself having dramatically expanded the monetary base for little economic benefit: against all its expectations, the economy is sliding into recession again. Perhaps it is a case of all the people being no longer fooled all of the time with respect to what QE actually is.

No, another approach is called for. To the Keynesian mind, the obvious alternative must be to expand bank credit, particularly when there is an accumulation of $1.76T of non-borrowed reserves sitting on the Feds balance sheet.

Gordon T Long 9/5/2011

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STEALTH QE III
This time QE III cannot be announced... It must be (is being) quietly rolled out!

SECTION I - SEPTEMBER MONTHLY MARKET COMMENTARY

SHORT TERM MARKET HIGHLIGHTS - WHAT THE TECHNICALS ARE TELLING US. .............................................. 4 CURRENT MACRO EXPECTATIONS ............................................................................................................ 5 JACKSON HOLE BOMBS - AND THEY WEREN'T FROM BERNANKE!.................................................................. 6 STEPHEN CECCHETTI'S BOMB ............................................................................................................................................................ 6 CHRISTINE LAGARDE'S BOMB ............................................................................................................................................................. 8 BEN BERNANKE'S SILENCE................................................................................................................................................................. 10 STEALTH QE III AHEAD .......................................................................................................................... 12 NBRs (NON-BORROWED RESERVES)............................................................................................................................................... 13 REVERSE REPO MARKET .................................................................................................................................................................... 14 CONTINGENT LIABILITIES .................................................................................................................................................................... 16 US GOVERNMENT DEBT DURATION - "THE TWIST" ..................................................................................................................... 16 OPERATIONAL READINESS ................................................................................................................................................................. 17 GLOBAL GROWTH DEACCELERATES RAPIDLY - PRESSURES FOR COORDINATED CENTRAL BANK ACTION ........ 18 GLOBAL RECESSION WORRIES - SUPPORTING DATA-POINTS ................................................................................................ 18 EUROPE .................................................................................................................................................................................................... 19 USA ............................................................................................................................................................................................................ 19 NERVOUSNESS IN US BANKS & CREDIT MARKETS ..................................................................................... 20 BANK OF AMERICA ................................................................................................................................................................................ 20 STATE, CITY & LOCAL PROBLEMS: AVOIDING MUNI BOMBS ........................................................................ 22 GAME CHANGERS.................................................................................................................................................................................. 22 SWAP ACCOUNTING CHANGES ......................................................................................................................................................... 23 CONCLUSIONS ..................................................................................................................................... 24 GETTING WORSE, FAST! ...................................................................................................................................................................... 24 THE GLOBAL MACRO IS THE DRIVING FORCE .............................................................................................................................. 25 ELEVATED RISK ...................................................................................................................................................................................... 26 MARKET CORRELATION RISK ............................................................................................................................................................ 28

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MONTHLY PROCESS OF ABSTRACTION

The Monthly Market Commentary Service is an integral part of our monthly Process of Abstraction research methodology. The process begins monthly from the Tipping Points and completes with a final Synthesis. The sequence is optimized to align with the established Macro Economic Data releases.
Plan
III.

Release Date
3rd Saturday of the Month

Service
Global Macro Tipping Points (GMTP)

Focus

Coverage

Tipping Points Abstraction Abstraction IV. 1st Day of the Month Market Analytics & Technical Analysis (MTA) Technical Analysis Market Analytics Market Analytics II. Day Following Monthly Labor Report (~ 1st Saturday) Monthly Market Commentary (MMC) Synthesis Thesis Synthesis

Tipping Points Global Macro US Economy

Technical Analysis Fundamental Analysis Risk Analysis Commentary

Commentary Conclusions

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SEPTEMBER MARKET COMMENTARY

SHORT TERM MARKET HIGHLIGHTS - What The Technicals Are Telling Us.

The market action since March 2009 is a bear market counter rally that has completed the classic ending 5 Wave 3-3-3-3-3 diagonal pattern we have been predicting since March 2009. The Bear Market, which started in 2000, will resume in full force once a broad 'rounded top' formation is completed with cascading weakness across multiple markets presently being clearly evident. The rounded top formation is not yet completed. We are now in the midst of the 'rolling top'. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen near major reversals. It is all part of a final topping formation and a long term right shoulder technical construction pattern. I expect the rounded top to be shown to have been centered on the markets June 17th Quadruple Witch. It will take a further 2-3 months to complete. Rounded Top patterns are extremely difficult to trade as trading reversals are significant and frequent with high volatility. This adds to the confusion about market direction. The market behavior should be viewed as the market forces being in the process of systemically changing balance. It is very typical of major reversals. They are protracted affairs. Highlighted examples of continuing weakening analytics and warning signals are as follows: CONSUMERS -Consumer and small business sentiment remains at levels associated with other recent recessions. The trend in sentiment since the Financial Crisis lows has been one of slow improvement. The August final numbers from the Michigan survey are consistent with deep recessions. - The University of Michigan Consumer Sentiment Index has plunged from 77.5 in February to 55.7 in August. There was a similar large drop in August 1990, another in September 2001, and a third one in

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October 2008. All three were associated with recessions and turned out to be big sell signals for the stock market. - The plummet in August clearly signals, that a recession is on the way. That's the reading of the environment reflected in the Conference Board's August Index of Consumer Confidence. It fell by 25% m/m to 44.5. The latest figure was the lowest since April 2009 and it was well short of Consensus expectations for a reading of 53.3. - It was a decline in the expectations' subgroup of confidence which led the downturn with a 30.7% m/m drop. - What continues to stand out to me is that against comparable prints taken at financial crises and tragedies of the past, such as the October 1987 market crash, Desert Storm, LTCM, the dot com collapse, September 11, Katrina, and Lehman, they are substantially WORSE and getting worse fast! INVESTORS -The NFIB Small Business Optimism Index stands at 89.9, well below 100 and continues to deteriorate. - The National Association of Active Investment Managers (NAAIM) shows that on average they are extremely bearish at 22.19%, having plummeted from last quarter's average of 66.99%. - We have had a protracted period of Divergence with the Smart Money Index. This suggests the Smart Money does not believe this bull market is real, but believe it is an unhealthy and artificial market. Since the August sell-off, we see the Smart Money trying to buy the lows as the Dumb Money exits. The Smart Money sees a trading opportunity, not an investment opportunity; or the volumes and smart money would have been buying the rally since the March 2009 lows. - The Surprise Index measures the divergence between actual data and economists' forecasts, and is therefore another form of sentiment or expectations index. Economists are at a near record divergence against the reality of the data, and net bullish market sentiment is also at a near record divergence to how the data is coming out versus expectations. This is highly unusual and should be considered a market warning. CURRENT MACRO EXPECTATIONS OUR CURRENT MACRO EXPECTATIONS FOR FINANCIAL EQUITY MARKETS

The following schematic best represents the US S&P 500 Stock Index

We still consider ourselves to be WITHIN the Rounded "M" Top.

We will need to put in the right side 'external strength' of the "M" pattern later this fall.

HOWEVER, the bottom of the "V" is not yet in - Early fall will be scary!

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JACKSON HOLE BOMBS - AND THEY WEREN'T FROM BERNANKE! Three major developments occurred at the recent Monetary conference in Jackson Hole, Wyoming, when the global luminaries on Monetary Policy convened on August 25-27th, 2011. The much anticipated speech by Federal Reserve Chairman Ben Bernanke is at best the third, and that is only because the news was he said nothing substantive! I strongly recommend you read (in the following order) the three most significant speeches of the conference in this humble scribe's assessment, because the media failed to pick up on them but frame what lies ahead. 1. 2. 3. Stephen Cecchetti Christine Lagarde Ben Bernanke Bank of International Settlements Director, IMF Chairman, US Federal Reserve The real effects of debt Global Risks are Rising. Prospects for the U.S. Economy

STEPHEN CECCHETTI'S BOMB The Bank of International Settlements is the central bank to the Central Banks. So when someone of Stephen Cecchett's stature speaks, even Bernanke, Trichet and King, listen attentively. Renowned academics and authors, Carmen Reinhart and Kenneth Rogoff in their landmark book "This Time Its Different; Eight Centuries of Financial Folly", spelled out in over 443 pages of research that when sovereign debt exceeds 90% of sovereign GDP, growth is impacted. As a direct result, historically GDP falls by minimally 1%. It would appear until Cecchetti's speech Reinhart and Rogoff's work was ignored by this distinguished audience. Cecchetti not only validated the work, but in a 33-page significantly expanded upon it. In case you have already linked to Cecchetti's article above, you found that it has been pulled from the BIS site. What is so explosive that the BIS didn't want the media and researchers to get hold of the detail? Luckily I saved it immediately after reading the full study and it can be found at my site at: Cecchetti-BIS What Cecchetti lays out with charts and historical proof is the following: At moderate levels, debt improves welfare and can enhance growth. But high levels can be damaging. When does the level of debt go from good to bad? Cecchetti addressed this question using a new dataset that included the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. His results support the view that, beyond a certain level, debt is bad for growth. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. o For government debt, the threshold is in the range of 80 to 100% of GDP.

Up to a point, corporate and household debt can be good for growth. o But when corporate debt goes beyond 90% of GDP, our results suggest that it becomes a drag on growth. For household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

So where do we stand against these critical levels?

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According to Cecchetti:

The debt problems facing advanced economies are even worse than we thought!
The basic facts are that combined debt in the rich club has risen from 165% of GDP thirty years ago to 310% today, led by Japan at 456% and Portugal at 363%.

Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.
Demographic atrophy and aging costs will make this even nastier.

Rising dependency ratios put further downward pressure on trend growth, over and above the negative effects of debt.
Why has it happened? 1) Restrictions on credit have been systematically removed since the 1970s (i.e. Gordon Browns 120pc mortgages and other such idiocies).

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2) Greenspans Great Moderation fooled us all into thinking the world was free of risk. 3) The Asian Savings Glut pulled down real bond yields. (The BIS is being too kind to its masters central banks who also pulled down short rates for fifteen years, catastrophically so in my view). 4) Tax policies favor debt; i.e. corporate debt in Europe, or mortgages in the US, as well as a host implicit debt subsidies and guarantees (Fannie Mae and Freddie Mac?) So get rid of all these bad policies, gradually of course. Now that the facts are in, it means only one thing regarding public policy formulation - dramatic reduction in debt via debt write-offs (what the world told Japan to do, which they avoided), and policies that significantly incent savings. Both are considered unsellable policy directions. I am sure the political apparatus demanded that the BIS takedown the document and nothing has been seen in the press regarding it. CHRISTINE LAGARDE'S BOMB The second bomb that was dropped at the conference was from the newly appointed Director of the International Monetary Fund (IMF), Christine Lagarde. First she makes it clear that Growth and Savings are the problems, though savings needs to be held off in the short term and be a secondary priority: Put simply, while fiscal consolidation remains an imperative, macroeconomic policies must support growth. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery. The precise path is different for each country. But to meet the credibility test, each country needs a dual focus. A primary emphasis is on durable measures that will deliver savings tomorrow which, in turn, will help to create as much space as possible for supporting growth todayat least by permitting a slower pace of consolidation where possible. For instancemeasures that change the rate of growth of entitlements, health or retirement. She disregards Inflation, without any indication of a full appreciation of the impact of food inflation in developing countries and emerging economies. She seriously underestimates this growing problem. Monetary policy also should remain highly accommodative, as the risk of recession outweighs the risk of inflation. This is particularly true as: (i) In most advanced economies, inflation expectations are well anchored, and (ii) Pressures from energy and food prices are abating. So policymakers should stand ready, as needed, to dive back into unconventional waters. Micro-level policy actions to relieve balance sheet pressuresfelt by households, banks, and governmentsare equally important. We must get to the root of the problem. Without this, we will endure a painful and drawn-out adjustment process. Structural reforms will surely help boost productivity and growth over time, but we should take care not to weaken demand in the short term. While we can all agree on the broad brushstrokes of what needs to be done, the devil is always in the details. I would like to delve deeper into the different problems of Europe and the United States. Then Madame Lagarde gets to the meat and has the nerve, after the EU just releasing the second set of bank stress tests, to suggest the banks need to be urgently recapitalized! Hasn't she been listening? The banks are supposed to be solid.

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Europe Ill start with Europe. Here, we need urgent and decisive action to remove the cloud of uncertainty hanging over banks and sovereigns. Financial exposures across the continent are transmitting weakness and spreading fear from market to market, country to country, periphery to core. There are three key steps that Europe should take. First, sovereign finances need to be sustainable. Such a strategy means more fiscal action and more financing. It does not necessarily mean drastic upfront belt-tighteningif countries address long-term fiscal risks like rising pension costs or healthcare spending, they will have more space in the short run to support growth and jobs. But without a credible financing path, fiscal adjustment will be doomed to fail. After all, deciding on a deficit path is one thing, getting the money to finance it is another. Sufficient financing can come from the private or official sectorincluding continued support from the ECB, with full backup of the euro area members. Second, banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalizationseeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns. Third, Europe needs a common vision for its future. The current economic turmoil has exposed some serious flaws in the architecture of the eurozone, flaws that threaten the sustainability of the entire project. In such an atmosphere, there is no room for ambivalence about its future direction. An unclear or confused message will add to market uncertainty and magnify the eurozones economic tensions. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundationsincluding, for example, fiscal rules that actually work. Christine Lagarde lays serious blame at the footsteps of the US: The United States In the United States, policymakers must strike the right balance between reducing public debt and sustaining the recoveryespecially by making a serious dent in long-term unemployment. A fair amount has been done to restore financial sector health, but house price declines continue to weaken household balance sheets. With falling house prices still holding down consumption and creating economic uncertainty, there is simply no room for half-measures or delay. So the United States needs to move on two specific fronts. Firstthe nexus of fiscal consolidation and growth. At first blush, these challenges seem contradictory. But they are actually mutually reinforcing. Credible decisions on future consolidationinvolving both revenue and expenditurecreate space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility. After all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction? Secondhalting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment. The global dimension Stepping back to a global perspective, as I said at the outset, rebalancing has not advanced sufficiently, despite the slow growth in deficit countries. In some key emerging economies, policies keep domestic demand growth too slow and currency appreciation too modest, if not blocked outrighteven if this is not in their own or the global interest. Some other emerging marketsincluding those that have allowed their exchange rates to appreciateare dealing with threats to economic and financial stability from capital inflows.

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So the lack of rebalancing hurts everyone, while at the same time, everyone should recognize that decoupling is a myth. If the advanced countries succumb to recession, the emerging markets will not escape. As we take a global perspective, we should notand cannotforget the low-income countries, where populations are especially vulnerable to economic dislocation in the rest of the world. These countries need to focus on protecting themselves from future stormsincluding by rebuilding policy buffers and investing in social safety nets. The international community, of course, must stand ready to help. She had the audacity to suggest risks to the global economy are rising: ConclusionRisks rising, but path to recovery In sum, risks to the global economy are rising, but there remains a path to recovery. The policy options are narrower than before but there is a way through. There are lingering uncertainties, but resolute action will help to dispel doubts. I am confident that with the right actions, strong, sustainable, and balanced growth can and will be restored. As in the first phase of the crisis, we have reached a point where actions by all countries, doing what they can, will add up to much more than actions by a few. There is a clear implication: we must act now, act boldly and act together. I can assure you that for its part, the IMF will continue to do everything in its power to advocate for this outcome, and to lend its material support wherever it is requested and relevant. BEN BERNANKE'S SILENCE Bernanke's address was titled: The Near- and Longer-Term Prospects for the U.S. Economy. The net of his non message was: Don't blame the banks, blame small business: Credit availability from banks has improved, though it remains tight in categories--such as small business lending--in which the balance sheets of potential borrowers remain impaired.

Don't blame big export business, they are doing wonderful: Manufacturing production in the United States has risen nearly 15 percent since its trough, driven substantially by growth in exports. Indeed, the U.S. trade deficit has been notably lower recently than it was before the crisis, reflecting in part the improved competitiveness of U.S. goods and services. Business investment in equipment and software has continued to expand, and productivity gains in some industries have been impressive.

The best excuse Bernanke can come up with for the worst recovery in history is that most of the blame lies with: Temporary factors: including the effects of the run-up in commodity prices on consumer (most argue QE II caused this) and business budgets, and the effect of the Japanese disaster on global supply chains and production. They were part of the reason for the weak performance of the economy in the first half of 2011. Timing: the recession, besides being extraordinarily severe as well as global in scope, was also unusual in being associated with both a very deep slump in the housing market and a historic financial crisis. These two features of the downturn, individually and in combination, have acted to slow the natural recovery process. Old standbys aren't working: Notably, the housing sector has been a significant driver of recovery from most recessions in the United States since World War II, but this time--with an overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and ongoing concerns by both potential borrowers and lenders about continued house price declines--the rate of new home construction has remained at less than one-third of its pre-crisis level. The low level of construction has

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implications not only for builders but for providers of a wide range of goods and services related to housing and homebuilding. Though Bernanke fully admits the recovery is much weaker than he anticipated and has been forced to once again reduce his outlook, he tells people he still has more magic 'stimulus' options. Someone should tell Bernanke that LSD and Marijuana are stimulus drugs, but neither work when the body is either overdosed (on debt stimulus) or dead (insufficiently competitive and productive). The recession was even deeper and the recovery even weaker than we had thought; indeed, aggregate output in the United States still has not returned to the level that it attained before the crisis. Importantly, economic growth has for the most part been at rates insufficient to achieve sustained reductions in unemployment In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.

Bernanke makes sure he has an "out" and places the blame at the foot of Congress and the politicos. As Bill Gross of PIMCO described, who listened to the speech: "Bernanke basically pleaded for the administration and congress to do something!" Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if--and I stress if--our country takes the necessary steps to secure that outcome. The quality of economic policymaking in the United States will heavily influence the nation's longerterm prospects. To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies. Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank. To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage. The increasing fiscal burden that will be associated with the aging of the population and the ongoing rise in the costs of health care make prompt and decisive action in this area all the more critical. The country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses. Although details would have to be negotiated, fiscal policymakers could consider developing a more effective process that sets clear and transparent budget goals, together with budget mechanisms to establish the credibility of those goals. Of course, formal budget goals and mechanisms do not replace the need for fiscal policymakers to make the difficult choices that are needed to put the country's fiscal house in order, which means that public understanding of and support for the goals of fiscal policy are crucial.

The chances of Washington achieving any of this, as Bernanke is well aware is slim to none. In summary, I heard no answers from the Monetary side of the public policy house, other than more and increasing levels of stimulus. The general feeling was that the blame should be laid at the feet of the Fiscal Policy side of public policy. The Politicos were not present to argue against such views.

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