December 4, 2014

Fall of Bond King.

Fall of the Bond King: How Bill Gross Lost an Empire as Pimco Cracked
Bloomberg By Mary Childs 22 hours ago
Bill Gross, the 70-year-old king of bonds, rushed through the offices of his $2 trillion empire on a Friday morning distributing hand-written notes. He knew his reign was over.

The billionaire co-founder of Pacific Investment Management Co. and its undisputed ruler for four decades was about to be overthrown. So just before 5 a.m. that day, on Sept. 26, he walked into Pimco's headquarters in Newport Beach, California, and quietly placed notes on the desks of more than a dozen colleagues.

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"Keep doing a great job," Gross wrote on trade tickets used to buy and sell bonds. Of Pimco, he wrote: "Look after her."

Gross's exit -- an event that, not long ago, would have seemed unthinkable -- unleashed a crisis that Pimco is still trying to contain. His departure was followed by record withdrawals from the mutual fund he once ran, and which he built into the world's biggest. Competitors swooped in, poaching clients from a firm that oversaw more assets in bonds than any competitor ever did. The government reached out to financial firms to ensure Gross's departure didn't destabilize the $100 trillion bond market.

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Balls, Thimons
Interviews with 25 current and former Pimco employees, who asked for anonymity to discuss internal matters, paint a complex picture of the events that led to Gross's departure, including details that have never before been published. The resignation in January of Pimco Chief Executive Officer and Gross's heir apparent Mohamed El-Erian, 56, had prompted media reports of infighting at Pimco, and resulted in a management reshuffle that strengthened some of the firm's younger executives. At the same time, Gross's main fund was trailing competitors and clients had started to pull money.

Gross spent much of the past year hunting down employees who he believed were leaking information about the internal clashes to the press, according to the interviews. Among them were money managers Andrew Balls, one of Gross's newly appointed deputy investment chiefs, and Joshua Thimons. Gross tried to fire both but his effort was thwarted by Pimco's new CEO Douglas Hodge, 57, and President Jay Jacobs.

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On at least three occasions, Gross proposed to step back as tensions within Pimco worsened.

September Showdown
Behind closed doors, the billionaire also opposed the firm's expansion into stocks and real estate, areas seen by others as crucial to position the firm as the bond rally on which Pimco's growth had been built showed signs of waning. In pushing for a return to a simpler business model, he questioned why the firm needed some of the executives it had hired.

By September, as Gross revived plans to fire Balls, 41, Pimco's new senior managers turned against him. Several of the firm's key executives offered to resign. When Gross proposed again to take a smaller role, give up management responsibilities and hand over his main fund to a successor by the end of 2015, Pimco executives were considering his ouster.

Rather than suffer the humiliation of being fired, Gross decided to walk away from the firm that he had started in 1971. A few hours later on that Friday morning, he was on a plane bound for Denver to join Janus Capital Group Inc. (JNS), the money manager run by his former general counsel and operating chief Richard Weil, 51.

‘Enduring Legacy'
"Bill Gross left an enduring legacy at our firm and we are grateful for his contributions," Pimco's Hodge said in a statement. "At Pimco we are guided by a set of core values of putting our clients first, acting with integrity always, being respectful of each other and delivering excellence. This is the foundation upon which Pimco is built and these are the principles that will carry us forward into the future."

Steven Shapiro, a spokesman for Janus with Communications Strategy Group, declined to comment.

Gross built Pimco with some of the best long-term investing track records, and was the face of the bond market with television appearances almost every day. Assets at the firm doubled between 2010 and 2013, making Gross one of the best-compensated money managers, with a bonus of about $290 million in 2013, a fortune even by Wall Street standards.

An Ohio native who graduated from Duke University with a psychology degree in 1966, Gross built a reputation unparalleled among mutual fund managers, with his main fund, the $162.8 billion Pimco Total Return (PTTRX), beating 96 percent of peers over 15 years, according to research firm Morningstar Inc. The fund has become a staple in the 401(k) retirement accounts of millions of Americans.

Vietnam Vet
His departure triggered a combined $60.5 billion in withdrawals in the past three months from Pimco Total Return, which at its peak in April 2013 was the world's largest mutual fund, with $293 billion. Assets in the fund have since shrunk by 44 percent.

Gross, who spent three years in the Navy and served in Vietnam, was obsessed with performance. When his flagship fund trailed 77 percent of peers in 2011, he apologized to clients, calling it a "stinker" of a year and reassuring them he hadn't lost his touch. After a rebound the next year, he examined his legacy in an investment outlook that said the careers of great investors were fueled by a credit expansion that may be ending, and that the real test of his investing prowess was yet to come.

"Am I a great investor?" he wrote in an April 2013 investment outlook. "No, not yet."

Tensions Surface
A month later, the Federal Reserve indicated it would unwind its bond purchases. Gross miscalculated the impact of those actions, giving his fund its biggest loss in almost two decades. Pimco Total Return trailed 65 percent of peers in 2013, even as it beat its benchmark, according to data compiled by Bloomberg. Clients started to pull money that month, in May 2013, and have continued redeeming every month since.

Around this time, tensions within Pimco were boiling to the surface. In June 2013, Gross lashed out at then-CEO El-Erian in front of a dozen members of the firm's investment executives. He said he had an investing record of more than four decades, and asked El-Erian what he could point to.

El-Erian, who received a bonus of about $230 million in 2013, was seen by some within Pimco as a shock absorber between Gross and other employees, according to three people familiar with the matter. As their relationship deteriorated, Gross agreed in an executive committee meeting to hiring a mediator to try to mend it. After a search and a scheduled meeting with the mediator, Gross backtracked and said he had never agreed to a mediation.

El-Erian Resigns
As El-Erian informed the firm in December 2013 that he was going to leave, Gross offered to step back instead. El-Erian, a contributor to Bloomberg View, stuck with his decision and on Jan. 21 announced his resignation. Soon after, Marc Seidner, a high-profile generalist fund manager and member of Pimco's investment committee who had worked with El-Erian at Harvard University's endowment, quit. Seidner passed up an opportunity to serve as one of three deputies to Gross, along with Daniel Ivascyn, 45, and Balls, choosing instead to join Boston-based money manager Grantham Mayo Van Otterloo & Co.

Those departures strengthened others in the firm and weakened Gross. Pimco named six deputy chief investment officers -- Ivascyn, Balls, Mark Kiesel, Virginie Maisonneuve, Scott Mather, and Mihir Worah -- and Gross promised that each would have "some empowerment that probably was lacking to some extent in the past."

Standing Ovation
In the weeks that followed, Gross tried to close ranks. He spent more than 20 minutes before a firm-wide meeting to discuss the media scrutiny that had beset the company, a speech in which he disparaged El-Erian, according to two people. When he ended to a standing ovation from the audience, including Hodge and Ivascyn, at least one executive declined to rise. Thimons, a managing director outspoken in his objections to Gross's leadership, disagreed with his comments and refused to stand, according to a person who was present.

El-Erian's departure had prompted media scrutiny and reports of clashes between El-Erian and Gross. The Wall Street Journal cited one example where Gross complained that El-Erian wouldn't let him run the firm's entire $2 trillion in assets.

"I'm Secretariat," Gross said, referring to the famous racehorse, according to the Journal. "Why would you bet on anyone other than Secretariat?"

To stop the reports, Gross set up interrogations of members of the investment committee, managing directors, and lower-ranking money managers. He carried around a three-ring binder of printed-out e-mails and hand-written notes to find out who was talking to the press.

‘Mr. X'
Among his suspects were Balls, a former journalist, and Thimons, the executive who had remained seated during the standing ovation and who had organized a going-away party for El-Erian. Gross sought to fire Balls, a move opposed by Pimco's new executives. Gross gave in and agreed not to pursue the matter at that time.

"Andrew and Josh are senior and respected professionals at our firm, and we have complete confidence in their leadership and integrity," Daniel Tarman, a Pimco spokesman, said in a statement.

Balls and Thimons didn't return e-mails seeking comment.

Gross later told DoubleLine Capital LP's Jeffrey Gundlach that he had been chasing a "Mr. X," a person sympathetic to El-Erian who was trying to sabotage him by revealing internal conversations.

Angering Management
While clamping down on leaks inside the firm, Gross called Reuters in early March, telling the news organization that El-Erian had been trying to undermine him and that he was responsible for the Wall Street Journal article.

Gross apologized internally for speaking to Reuters. A month later, in an interview with Bloomberg Television, he angered his colleagues again by calling on El-Erian to explain the reason for his departure. That interview prompted Jacobs to call an emergency meeting of the executive committee without telling Gross. After the meeting, Jacobs told Gross that he'd been suspended from media appearances indefinitely, provoking an outburst by Gross, according to a person with direct knowledge of the situation.

Pimco managers worried that Gross was becoming increasingly uncontrollable in public appearances after he strolled on stage at Morningstar's investment conference wearing sunglasses and referring to himself as the bond market's Justin Bieber. He also made a lengthy allusion to the movie "The Manchurian Candidate," suggesting he wished he could hypnotize journalists into writing positive things about him.

Deep Divisions
At one point, weeks after El-Erian's departure, Gross was seen yelling at Hodge and Jacobs in a glass room just off the trading floor, in plain view of more than 60 people. Later, he told colleagues he'd staged the dressing-down publicly to intimidate others.

Amid the media scrutiny, Gross demanded public support from his colleagues for his role at Pimco. Hodge obliged in a "viewpoint" in August on the website extolling Gross's investing prowess.

"We are unaware of any person who has created more wealth for more people in the history of fixed income investing than Bill Gross," Hodge wrote.

The divisions within Pimco went beyond Gross's media appearances and his management style. Gross's view of Pimco's future was increasingly diverging from that of management. He was unhappy with the expansion into equities and wanted to return to a simpler model.

Criticizing Cupps
Four years after a Bloomberg Markets article in which Gross said that stock-market returns would beat bonds, the firm's equity business wasn't meeting expectations, having gathered less than $3 billion into its four main mutual funds.

Gross argued the push wasn't cost-efficient, that stocks and other assets were too expensive, that Pimco should retrench and didn't need the staff it had hired to diversify.

During a strategy meeting in August, he criticized Wendy Cupps, a managing director and head of product management who was paid a bonus of about $50 million the year before, saying she was taking too much of a lead developing products without his consent. He said her products group was "stealing the firm," according to a person who attended the meeting. The comments stunned other executives and prompted opposition.

Gross, who steered Pimco through the 2008 financial crisis unscathed, also criticized the acquisition of real estate assets, saying such assets would be difficult to sell.

Alaskan Cruise
The next day, on Aug. 20, Gross proposed to senior leaders he would step back if they agreed to his demand that Balls and Thimons, whom he referred to as "Mr. X" and "Mr.Y," be fired. He asked for management to work on a formal proposal while he was on a two-week vacation.

In his absence, Pimco composed a power-point presentation listing Gross's requests, among them fewer client-facing responsibilities and managing fewer accounts, according to two people familiar with the matter.

Gross had made efforts in the past to be a warmer boss. He chartered a cruise ship with his own money from San Francisco to Alaska and back in the summer of 2003, for more than a week of firm-wide bonding. The endeavor cost him about $10 million, according to one person who attended. Gross stayed up until dawn mingling with employees.

Even that team-building effort, remembered fondly by many of Pimco's long-term employees, was marred by his expectations. When some employees with children asked if they could arrive late or leave early, Gross expressed frustration in a meeting with the managing directors, saying the employees were spoiled.

‘People Management'
"I'm not especially known for people management," Gross said in an interview with Bloomberg News in June. "I am learning," he said, comparing managing employees to raising children.

By September, as Gross returned from his vacation, tensions within Pimco were finally coming to a head. In a meeting with Pimco's executive committee on Sept. 10, attended by executives including Hodge, Jacobs, Cupps, Worah and General Counsel David Flattum, Gross proposed that he would share his role with a co-chief investment officer and that they could start a search immediately.

Succession Plan
He would manage the Total Return fund with the co-CIO until Dec. 31, 2015 and then would transition his responsibilities to other managers before stepping down. He proposed that he would instead run Pimco's Unconstrained and a few other select strategies. Gross also offered to step down from Pimco's executive committee and the partner compensation committee that sets pay.

After Gross left the meeting, the executive committee continued talking and eventually discussed firing Gross, according to a person familiar with the contents of the meeting. The Pimco executives viewed the timeline offered by Gross as too long and lacking a clear succession plan for the remaining funds he managed.

That week, more than 100 investment professionals had gathered at Pimco for the quarterly Cyclical Forum, including Balls. Gross pulled Balls aside to urge him to resign for the good of Pimco. He also made his case to fire Balls at an executive meeting, and was told by Hodge that Gross wasn't authorized to fire a managing director.

Seating Arrangement
After the forum, Gross devised a seating plan for a meeting of portfolio managers, relegating Balls, Ivascyn and Mather to the rows of the conference room instead of at the main table. The arrangement was perceived as a snub, according to a person familiar with the matter.

By now, key employees including Ivascyn, Jacobs and Cupps individually had told Pimco they were ready to exit.

As management debated what to do about Gross, Ivascyn emerged as a favorite to succeed him as CIO. His main mutual fund, Pimco Income Fund (PIMIX), had beaten 99 percent of peers in 2013.

Private funds, those not sold to retail investors, run by Ivascyn's teams had raked in $3 billion in profit between 2010 and 2013, according to a former employee. Ivascyn got a bonus of about $70 million last year, a quarter of Gross's.

The week of Sept. 15, Michael Diekmann, CEO of Pimco parent Allianz SE (ALV), had flown in from Munich and had breakfast with Gross at the Marriott Hotel in Newport Beach. He proposed a "sidecar" that Gross would manage under Pimco's name in a separate structure, a proposal Gross agreed to, according to a person with knowledge of the matter. Diekmann, 59, said he would take the plan to Pimco's management.

Losing Control
Later that day, Gross met with Hodge and Jacobs, who presented a plan to announce his retirement at year-end, praising his accomplishments over his long career. Gross asked about the "sidecar" structure he had discussed with Diekmann. Jacobs declined and instead offered that Pimco would help him start a new company or fund.

"That's a bone even a dog wouldn't pick," Gross replied.

Allianz spokeswoman Petra Brandes declined to comment.

Gross knew he had lost control. He called DoubleLine co-founder Gundlach, a prominent bond investor who had been pushed out by TCW Group Inc. five years before. He also re-engaged in conversations with Janus's CEO Weil about partnering with him.

Gundlach Meeting
When he met with Gundlach, 55, the next day, Sept. 17, at Gundlach's house near Santa Monica, they discussed the possibility of employment. Gross said he'd be willing to work for $1, indicating they could work out details later, according to Gundlach. The two men parted without coming to a decision.

The following week, Gross's last at Pimco, he was told there would be a meeting scheduled to discuss his future on Friday, Sept. 26, at 2 p.m. and management had all but decided to oust him.

He called Janus's Weil, who said that the firm would have an office ready for Gross.

At 5:28 a.m. California time on Sept. 26, Janus announced that Gross was joining them to manage a start-UNp fund with about $13 million, surprising Pimco and Allianz and rattling markets.

Since then, some managers who had left under Gross have come back. Seidner rejoined Nov. 12. Jeremie Banet, who left in June to run a food-truck business, is back as an executive vice president. Nobel Laureate Michael Spence, who departed in February, is returning as a consultant.

Bonus Pool
Less than two weeks after Gross left, the firm announced it added five people to its equities team, reporting to Maisonneuve, CIO for equities. Hodge has said Pimco will announce more new hires in the near future.

The firm, which still has $1.87 trillion under management, has the money to pay for top talent. Gross and El-Erian together received about $520 million in bonuses last year, roughly a third of the entire payout pool.

Pimco has also introduced a 225 million-euro ($279 million) award program that applies to "all employees that are not participating in the Pimco profit pool," Munich-based Allianz's Chief Financial Officer Dieter Wemmer said on a Nov. 7 conference call.

As Pimco's leaders work to restore calm, the Total Return Fund has beaten 99 percent of peers in the past month, as bonds rallied. Redemptions from the fund slowed to $9.5 billion in November, Pimco said yesterday.

Gross has resumed some of his earlier routine. Since Sept. 29, he has driven from his cliffside mansion in Laguna Beach to an office in a not-yet-finished building that's almost identical to Pimco's new headquarters, a five-minute walk down the street.

Soros Backing
His new fund has attracted more than $1.2 billion of client deposits since he started, according to a person familiar with the matter -- a fraction of the billions that flowed out of Pimco since his exit.

George Soros, the former hedge-fund manager famed for successfully betting against the Bank of England in 1992, committed $500 million to a separate account with a strategy similar to his unconstrained fund. Scott Bessent, Soros's chief investment officer, visited Gross in Newport Beach the week after he joined Janus, according to a person familiar with the matter.

Soros's firm saw an opportunity to invest with a talented money manager while he was still running a small amount of money, according to the person.

To contact the reporter on this story: Mary Childs in New York at

To contact the editors responsible for this story: Christian Baumgaertel at Sree Vidya Bhaktavatsalam

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November 27, 2014

Is GOLD coming back big time?Swiss gold referendum could spark rush

Swiss voters will head to the polls to vote on a controversial measure that could lift global gold prices.






November 5, 2014

Why it may be time to cash in on this casino stock

Casino stocks are on a cold streak. And according to the latest data out of Macau, it may not get better anytime soon.
October gaming revenues in Macau sank 23 percent compared with 2013. That is the largest year-over-year drop in its recorded history. Being blamed for the decline are a slowdown in mainland China’s economy, a recent smoking ban and a crackdown on corruption that is keeping VIP players home.
Investors greeted the news by cashing in their chips on Wynn Enterprises, MGM and Las Vegas Sands. All three fell between 3 and 4 percent on Tuesday.
For names such as Las Vegas Sands, which gets more than 70 percent of its revenues from Macau, the news is particularly troubling.
But one market watcher isn’t too worried. According to Gina Sanchez, founder of Chantico Global, Las Vegas Sands investors shouldn’t be too worried, particularly about the recent drought of VIP gamblers. That’s because the company is looking to diversify its customer base in Macau.
“They’re going after the mass market, which is more of the middle-class gamers,” said Sanchez. “That actually could be its saving grace.”
But the charts are not as positive, according to Steven Pytlar, chief equity strategist at Prime Executions. He sees the stock as now testing a critical support level at $59.85 per share.
“On the chart, we see that this was a high on two tests previously in recent years,” said Pytlar, referring to Las Vegas Sands’ March 2012 and May 2013 highs. “When you have a stock that broke past two major highs and is now coming back to retest those highs, that tells you there is a lot of deterioration in the stock. It tells you there is a lot of sellers and not a lot of buyers.”
The technical implications are that Las Vegas Sands’ stock could potentially move lower, Pytlar explained. “We could see more selling pressure,” he added. “If it falls below those two prior highs, we could see it potentially fall significantly more. We would be staying away from this stock right now based on the charts.”

Oil below 60?

Oil prices could have a hard time finding a floor after Saudi Arabia trimmed prices in the face of growing North American oil production.
The market took the price cut this week as another sign the kingdom is willing to use pricing as a lever to preserve its market share, rather than cut production in what is now an oversupplied market. Even if it was not the intention, some traders took the Saudi move as a sign the kingdom would like falling prices to slow U.S. shale production.
U.S. West Texas Intermediate fell sharply on Tuesday, dipping close to the psychologically key $75-a-barrel level, before closing at a three-year low of $77.19, off $1.59 per barrel. Brent fell along with it to $82.82 a barrel, the lowest settle since October 2010, after Saudi Arabia set a new price in the U.S. 45 cents lower than November's level.
Workers at an oil facility near Riyadh, Saudi Arabia.
Hasan Jamali | AP
Workers at an oil facility near Riyadh, Saudi Arabia.
Tradition Energy analyst Gene McGillian said the next technical level he's watching for WTI is $74 a barrel, and it's not clear how much further it will fall.
"The managed money longs still outnumber shorts 3½-to-1. If this isn't a heavy exodus of the money manager longs, we could still have a significant drop, especially if all these factors that are driving us lower continue to weigh on the markets," he said. "The dollar strength and also fears of slowing economic conditions in Europe and China are still continuing to play a role."
There was initially a muted reaction to the Saudi announcement Tuesday as the market focused on dollar strength and other factors.
"I don't think the probability is we're looking at a meltdown or collapse. If there was a global price war, it could go between $30 and $50 a barrel but more realistically, we're within 10 percent of the bottom," said Tom Kloza, senior oil analyst at
"What the Saudis are doing is business as usual. They change the price formula each month. The problem is there's an implication that it's business as usual in terms of production. The problem is if they continue to produce what they've been producing in the last two months, the market is headed for trouble, and downward pressure will be more significant than upward pressure," said Kloza.
Some analysts said the Saudis were motivated by market fundamentals. "In our view, it's not a direct attempt by Saudi Arabia to grab market share," said Dominic Haywood, crude and products analyst at Energy Aspects. "We think it's more a move by them to stimulate some demand from Gulf Coast refineries that are coming back from maintenance in November and December. By cutting to the U.S., you allow more exports to the U.S."
Haywood also did not think the Saudis were attempting to curb shale production. "In any case, you need crude below $70 a barrel for much longer than a month to limit U.S. production," he said.
Saudi Arabia's price setting was a market mover for a second month. For November, Saudi cut prices to Asian customers, and for December, it raised them for Asian and European customers while cutting U.S. prices. What the market sees as bearish is the lack of discussion of production cuts, analysts said.
"It's really the first time we are in this kind of era," said Max Denery, commodities strategist at Bank of America Merrill Lynch. "I think the OPEC meeting will be very interesting Nov. 27, and there is no real consensus about if they're going to cut or how much they're going to cut. They have a total ceiling of 30 million barrels. My thinking is if they cut between 300,000 and 500,000 barrels a day, it would not have an impact and might be bearish for the market because it's not enough to reduce the oversupply. If they cut 700,000 to 1 million, that would make a difference."
Denery said he sees the West Texas price stabilizing around $75 per barrel though it's possible the price could fall through that level first. He said prolonged prices of $70 would ultimately trigger a slowdown of production by some U.S. producers, and there could be less investment in new wells.
But he expects $75 to ultimately be the floor. "As soon as you see headlines about producers saying we need to cut some production or even close some wells, I think the market would react," he said.
The nature of the U.S. shale industry makes it flexible, serving as an economically driven swing producer that can brake or speed up production based on prices. Wells are most productive when they are first drilled, and production can be cut in half after the first year, so Denery said it is easier to slow production but not drilling new wells.
"We think that we need to have even lower prices to get some reaction from the shale industry. It's true that the supply response is much higher in shale than in other areas. In order to have significant reduction in growth, we would need to have WTI in the $70 area," Denery said.
Because U.S. breakeven costs for drilling vary dramatically by region and within regions, Denery said it would be the smaller producers with the highest costs that will be the first to slow down. "Those will be the first companies that will be hurt. Those companies do not hedge, and they try to produce as much as they can because they are on the edge," he said.
In the Permian Basin, in Texas and Oklahoma, companies' breakeven averages $55 to $60, while at Eagle Ford, they average $45 to $50, he said. In the Bakken in North Dakota, there is an area with $40 breakevens, but another area averages about $55 per barrel.
Watch: Read MoreSaudi Arabia's oil fight
The levels can fluctuate within each area, and some of the higher-cost production could be as much as $70 or $75 a barrel.
Oppenheimer energy analyst Fadel Gheit said the type of oil companies most vulnerable to lower prices are those with the highest debt loads.
"Not one company so far admitted or denied that they are canceling projects, but the question is not how many producers will say they are canceling projects but the question is how many projects and which are the companies. Every company will slow down. The question is, is it 5 percent or 50 percent. It will depend on the financial flexibility and the nature of the investment," he said.
Denery has already projected growth in shale drilling will slow next year. "For this year, shale growth was about 1 million barrels. Next year, we believe a little less. From the combination of an efficiency gain and slightly lower prices, we think growth in shale will be about 700,000. If prices drop to $70 a barrel, then you might see a growth in shale of just 300,000 to 400,000 barrels a day," Denery said. "We're still going to get growth but there's going to be a reduction in growth."
Denery said demand has not yet responded to the lower prices, and he expects to see demand improve in 2015. "The demand reaction takes much longer than the U.S. shale supply elasticity. If we have a lower price in 2014 then you're going to see another maybe 300,000 barrels a day of growth," he said.
Weekly U.S. government data, due Wednesday, should show that the world is well supplied with crude and U.S. production continues to approach 9 million barrels a day, a million barrel a day more than last year. Oil inventory data is released Wednesday at 10:30 a.m. ET.
"We're looking for another big build in inventories, another 2 million plus barrels," said John Kilduff of Again Capital. "It's been massive in the last couple of weeks. It's really what flipped the term structure into contango." Contango is when futures for coming months show higher prices than the nearby prices, a bearish sign.
"I think these prices are going to remain under significant pressure into the OPEC meeting, and I think it's going to go very badly. It's going to set us up for another leg lower, possibly into the 50s in the first quarter," Kilduff said.

October 18, 2014

Why deflation is so scary

If the price of a car or an iPhone drops, that’s usually good news for consumers. So it might be puzzling that investors and economists suddenly seem freaked out about the possibility of deflation, or a sustained drop in the level of all prices, on average.
Deflation was a concern back in 2010 and it’s a fresh worry now as oil prices plunge, the stock market wavers and consumers put spending plans on hold.

The paradox of deflation is that falling prices on a few items can generally be good for consumers, leaving more money in their pockets for other things. But falling prices on too many things can have ruinous effects on the economy that are hard to reverse. Japan suffered nearly two decades of deflation starting in the early 1990s, and deflation helped prolong the Great Depression in the 1930s.
When all prices fall, consumers have a strong incentive to put off purchases -- after all, everything will probably be cheaper tomorrow. Some purchases are hard to delay—food, medical care, gasoline to get to work. But a lot of the things we buy can wait, which is why sales of cars, clothing, and appliances drop sharply when times get tough.
In an economy like ours — in which consumer spending accounts for about 70% of total GDP — a powerful incentive to postpone purchases can be disastrous. When spending drops, so does corporate revenue, raising pressure to cut costs, which leads to layoffs and other personnel cutbacks. Companies are likely to freeze salaries or even cut pay for those workers remaining. Dwindling income makes consumers even more leery about spending money, worsening the whole cycle.

More expensive debt
The other mechanism for deflationary ruin is debt. One big reason lending helps the economy grow is inflation—most loans become easier to pay back over time, because the principal doesn’t grow but income used to pay it down does. We typically think of inflation as a rise in prices, but it's usually accompanied by an increase in workers' wages as well, and as long as wage increases exceed price hikes, ordinary people get ahead. Home buyers, for instance, often “grow into” a mortgage that might seem onerous at first, because their income climbs as they progress through their careers. The mortgage payments on a fixed-rate loan, by contrast, remain constant. So in a typical economic environment, you gradually earn more income to make the same payment every month.
Deflation creates the opposite phenomenon: Debt gets more expensive over time, because consumer spending power declines. When prices and corporate revenue fall for a sustained period of time, wages inevitably go down, too. That makes fixed-rate debt more expensive, because you have less money instead of more to make the same regular payments. The mismatch affects companies and even governments the same way it does consumers, causing cash-flow shortages, liquidity problems and bankruptcy. Each of these ugly outcomes reinforces the others, making a deflationary spiral very hard to pull out of.
On top of that, deflation makes people wary of taking out debt in the first place. Too much debt is a problem in itself, but prudent lending is an essential element of capitalism. Without it, investment shrivels and wealth is more likely to disappear than accrue.
We don’t have deflation yet, but we may be in a period of "disinflation," in which prices rise but at a progressively lower rate. The U.S. inflation rate dropped from 2% in July to 1.7% in August and will probably come in lower during the rest of the year, if only because plunging oil prices will lower the cost of gasoline and other products affected by petroleum or energy costs. This chart tracks the monthly inflation rate during the last five years:
View photo
Source: Moody's Analytics.
Source: Moody's Analytics.

Will central banks respond?

The risk of deflation is greater in Europe—where inflation is just 0.3% (a five-year low) and the economy is weaker than in the United States. Disinflation (though not deflation) may also be taking hold in Japan and China.

Lower inflation abroad will reduce prices for U.S. imports, as will a strengthening dollar, which has occurred as investors have chosen to put more money into U.S. assets and less into foreign ones. All of those factors contribute to disinflation and could generate outright deflation if they become severe enough. As the chart above shows, however, disinflation doesn't always lead to deflation; the rate of inflation dropped in late 2011 and early 2012, but then leveled out around 1.5%.
The Federal Reserve has been determined to head off deflation, which is one of the rationales behind the super-easy monetary policy that began in 2009. Part of that policy—quantitative easing—ends this month, which may be one of the factors shaking up markets. It seems unlikely the Fed will restart QE, although one key Fed official, James Bullard, recently argued the Fed should keep QE going. His case would get stronger if deflation seemed imminent. Under QE, the Fed pumps money into the economy by buying bonds, which in theory ought to make borrowing cheaper, lubricate consumer spending and potentially cause inflation. But many predictions of runaway inflation have been way off the mark, with deflation concerns today undermining how weak the global economy really is.
A more likely source of quantitative easing may be the European Central Bank, which has long hinted at aggressive stimulus measures but acted more modestly, to appease inflation worrywarts in Germany and elsewhere. Near-zero inflation—or full-blown deflation, if it happens—may finally prompt the ECB to mimic the bolder moves of the Fed. Meanwhile, if you see a good deal on a phone or an SUV, consider whether you can get a better deal by waiting. If you think you can, we may all be in trouble.
Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman

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