Thursday, October 30, 2008

How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets

One of the reasons why emerging market governments appear to be “creating” alternative means of conducting exchange is because the credit crunch among banks, mainly centered on the US, has restricted their access to US dollars.

Consequently, this predicament has exposed some of the vulnerabilities of Emerging Markets, which can be identified as having too much foreign currency risk exposure, or too geared domestic balance sheets or excessive dependence on short term debts or too large current account deficits.

While the US has extended an almost unlimited swap arrangement with many G-7 countries, outside the G7 the dearth of access to the US dollar has precipitated a cavalcade of crisis among many Emerging Markets such as Pakistan, South Korea, Argentina, Hungary, Ukraine etc…

Our idea is that the recent swap arrangements with G7 nations have been aimed at mitigating the fallout from the ownership of hazardous junk instruments of G7 institutions by having an open access to US dollars by the provision of liquidity through this swap mechanism from the Federal Reserves with the other global central banks.

Aside from, of course, for political reasons, assistance have been extended to US allies.

This only highlights how the present monetary standard operates with the US as its foundation.

Now that the US has been feeling more of the ramifications from the implosion of the domestically originated credit crisis, it has opted to extend its currency swap arrangement to some emerging markets as Mexico, Brazil and Korea. Also to Singapore.

According to the Federal Reserve, ``Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.”

Despite the recent downturn, global trade has significantly supported the US economy, thus the extension of dollar access facility seems to be targeted at cushioning or even inflating emerging market economies for them to sustain economic growth levels enough to continue to buy goods and services from the US.

Aside, there is this hope that once the crisis subside, the EM economies would continue to provide financing to the US by continually buying US financial claims or assets.

But you might wonder how a swap line work?

Mike Hammill of the Atlanta Fed’s research department provides a lucid illustration. His example is based on the September 18th Fed measures.

From Mr. Hammill (all highlights mine),

``A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

``Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

Currency Swap:

``An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

``However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

``The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.

``In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.”

Aside from the IMF, the extension of liquidity of the Federal Reserve to other central banks may temporarily allay the problem of liquidity crunch.

And we could be seeing this knee jerk market response via the rally we are presently seeing in Asian equities aside from improvements in the credit spreads as this Bloomberg report,

``The cost of protecting Asia-Pacific bonds from default tumbled after the Federal Reserve increased cross-border funding and the U.S., China and Taiwan cut interest rates to boost economic growth.

``The benchmark index of credit risk for investment-grade borrowers in Asia outside Japan fell the most since it was created in September 2007. The Markit iTraxx Asia credit-default swap index of 50 borrowers, including Thailand and Hong Kong's Hutchison Whampoa Ltd., fell 90 basis points to 470, according to ICAP Plc data as of 9:50 a.m. in Hong Kong.”

Some Thoughts:

-The domino effect of EM economies had been largely exacerbated by a paucity of liquidity amidst global deleveraging and the high risk aversion landscape which amplified the weaknesses of some EM economies to the point of falling into a crisis. If the US extends more of this swap tools to more EM economies then we should likely see fewer financial pressure and perhaps reduce the risks for the IMF to exhaust their limited $200 billion funds. The important difference is that for many EM it has been a liquidity problem, on the other hand, for US banking and financial institutions it has been a solvency issue.

-The global financial crisis is a systemic risk which emanates from the implosion of US credit related financial claims. Any implication that EM economies are in worst condition than its US mortgage collateralized securitization/derivatives/shadow banking peers is unjustified.

-The recent surge of the US dollar can be seen in the light of its privilege as the world’s currency reserve status. In addition, we must not forget that the present crisis which centers on the shadow banking system, derivatives and structured finance are mostly denominated in US dollars, hence, settlement and payment must be made in US dollars. So the US dollar’s rise is unlikely coming from a safehaven standpoint.

-Swap lines are essentially the US Federal Reserve printing presses outsourced to central banks overseas.

-The US has been strenuously exhausting all means to prevent a deep recession which accentuates higher inflation risks down the road.

Jim Rogers: Massive Inflation Ahead, Buy Agriculture!

This great Bloomberg interview with Jim Rogers..

Some noteworthy end quotes...

On Government bailouts: ``It’s like an insanity if you ask me; the government is going to run the banking system now? They can’t even run the postal. What’s wrong with these people? Why don’t they just let them fail and start over? That's the way the system works out."

On market bottom: ``When people say it is over and when we you see more bad news and stocks stop going down. But when they go up on bad news, that’s when we are gonna hit bottom. We are not gonna scream I don't know." (Hat tip: goldofthemoon)

Wednesday, October 29, 2008

Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?

In our previous blog, The Origin of Money and Today's Mackarel and Animal Farm Currencies, we pointed out how people responded to government’s action of banning money (such as prison community) or for society to lose confidence on the government decreed money (Zimbabwe).

We observed that when people lose confidence on the money government decrees on them or when they are barred from having to use “standard” money, people find alternative ways to select a media of exchange (Mackarel Money for California’s Prison or Barter for Zimbabwe).

And when we see governments similarly begin to use unorthodox means of transaction, we construe such action as emerging signs of diminishing faith in the present monetary standard.

This from yesterday’s news (courtesy of the Financial Times),

``Thailand on Monday said it planned to barter rice for oil with Iran in the clearest example to date of how the triple financial, fuel and food crisis is reshaping global trade as countries struggle with high commodity prices and a lack of credit.

``The United Nations’ Food and Agriculture Organisation said such government-to-government bartering – a system of trade not used for decades – was likely to become more common as the private sector was finding it hard to access credit for food imports.

``“Government-to-government deals will increase in number,” said Concepción Calpe, a senior economist at the FAO in Rome. “The lack of credit for trade could lead also to a resurgence of barter deals between countries,” she added.

``Officials and traders noted, however, that Iran was not typical because the US-led sanctions against its banks meant the country was facing difficulties financing agricultural trade even before the financial crisis

``With some developing countries’ official currency reserves facing serious depletion, particularly in Africa and Asia, agricultural officials said countries could barter more to avoid exacerbating their current account difficulties."

Our observation:

True, while Iran’s conditions have been stymied by US sanctions, the fact that both governments CAN yet TRADE with each other with their homegrown resources can be construed as Paper money failing to deliver its role as medium of exchange.

The banking system as key conduit for the present framework seems being bypassed for barter (which accounts for hard currency trading outside the US dollar standard system).

So what we apparently have here is another instance where “full faith in credit” in the present global financial architecture seems being eroded.

Is this an isolated incident? We think not.

Just last September, Brazil and Argentina came across a system which aims to trade goods without using the US dollar.

According to the International Herald Tribune,

``Brazil and Argentina are ready to stop using U.S. dollars to trade goods between them.

``Brazil's president tells the Buenos Aires-based Clarin newspaper that exports and imports between the two nations will be bought and sold in local currency — reals and pesos.

``President Luiz Inacio Lula da Silva did not say when the measure would take effect.

``Silva says the move will boost bilateral trade, which reached $US17.6 billion so far this year through July.”

If you think this is a joke, you can check out this speech by Mr Henrique Meirelles, Governor of the Central Bank of Brazil on the Inauguration of the Brazil-Argentina Local Currency System last Oct 2nd published at the Bank of International Settlements, where I quote (highlight mine),

``With elimination of a third currency in direct transactions among companies, exporters will set their prices in the currency of their own countries. Thus, they will be better able to calculate their margins precisely, since they will no longer be exposed to exchange rate risk.

Does the concerns over exchange rate risk end here?

Nope, just today we got this news that China and Russia are contemplating a similar medium for payment or settlement.

From Russia Today (Hat Tip: Craig McCarty),

``The growing trade turnover offers both nations the chance to move trade away from dollars and utilising national currencies. In his address to the 3rd Russia-China forum in Moscow, Vladimir Putin stressed that the dollar based financial system was in a state of shock - and said the counterparties should consider using their own currencies.

``Aleksandr Razuvaev, Chief Analyst at Sobinbank says that the major product being traded - oil - can be denominated in Rubles from next year.

``“There is less trust in the dollar and there is an idea to build up regional currencies. It will be the Ruble in the CIS region, and the Yuan in the South Asian region. So there will be demand for Russian currency due to oil exports and for the Yuan due to imports from China. So there will be enough liquidity in both currencies.”

So from a “MICRO” level of Mackarel Prison economy to an “Animal Farm” national Zimbabwean economy, the unconventional means of transactions seems to be growing MACRO, involving more bilateral exchanges using national currencies or by barter.

It seems that we could be witnessing escalating signs of cracks from the present monetary order.

Tuesday, October 28, 2008

Spreading the Wealth? Market IS Doing It!

At almost every election period candidates almost always raise the issue of income inequality as one of their top drawing crowd agenda. And almost always the seeming all popular solution has been to find ways to redistribute wealth.

It is like donating part of what you earn (although through legal coercion) to the underprivileged person on the street hoping that he/she uses this to improve on his/her life or at least to his/her family and much more importantly contribute to the wellbeing of society. Noble intentions indeed.

But here is the problem, what if the person turns up to be a dreg who takes your donation only to buy a bottle of gin? What if most of what we redistribute ends up producing a culture of dependency or to the pockets of the so-called wealth distributors? What if societies’ most productive resources are mainly channeled to non productive activities?

The end result is likely a lowered standard of living for the said society.

Nevertheless, who has the widest income equality or tendency to “spread the wealth” among the rich nations?

The answer is the US, that’s according to the Economist, `` And there is a lot of spreading potential: income distribution in America is the widest of the 30 countries of the OECD. The top 10% (or decile) of earners have an average $87,257 of disposable income, while those in the bottom decile have $5,819, among the very lowest of any country. Britain, Canada and Luxembourg also see big differences between the richest and poorest.”

Courtesy of the Economist

So it wouldn’t take so much for US Presidential candidates, during this election season, and liberal media to raise what development author Robert Ringer call as GAVEC ("guiltism", "angerism", "villainism", "envyism", "covetism") to ride along the advocacy to snag political power by promulgating policies of “spreading the wealth”.

But it doesn’t really require politicians to do it.

The way financial markets have been behaving today seems like more than sufficient force for wealth equalization.

For this year an estimated $30 trillion have been wiped off from global equity markets, notwithstanding losses written off by banks (estimated $680 billion) and global real estate markets.

Courtesy of Wall Street Journal

And which social group have been taking THE beating? You guessed... it the wealthiest!

This from Robert Frank in Wall Street Journal,

``The share of income held by the richest 1% of Americans has declined during each of the past three downturns. Between 2000 and 2002, their share fell to 16.9% from 21.5%, according to Internal Revenue Service income data compiled by economists Emmanuel Saez and Thomas Piketty.

``Their share also fell during the 1990 recession, hitting 13.4% in 1992 compared with 15.5% in 1988. The steepest decline was during the Great Depression, when the richest 1% saw their share of income plunge to 15.5% in 1931 from 23.9% in 1928.

"The Depression may be the best analogy for today when it comes to what will happen with income shares," said Mr. Saez, an economics professor at the University of California, Berkeley. He predicts that the share of income held by the top 1% will probably fall to 18% or 19% in the next year or two -- down from an estimated 23% or 24% in 2007.

``During the Depression, the assets of the wealthy declined along with their incomes. In 1928 the richest 1% held 36.5% of the nation's wealth; by 1932 it shrank to 28%. Studies by other economists and researchers show similar declines.

``The main reason for the declines: falling stock values. The wealthiest Americans have a greater share of their wealth concentrated in stocks and financial assets. When stocks plunge, as they have lately, the rich are hit disproportionately.

``The wealthiest 1% of Americans held more than half the nation's direct holdings of publicly traded stocks in 2004, according to the Federal Reserve. Stocks accounted for 11% of their wealth, compared with less than 3% for Americans in the 50th to 90th percentiles. The rich also earn more of their incomes from stock options.

``Of course, the rest of America also is losing wealth and income -- from falling home prices, rising unemployment and declining 401(k) accounts. But rising inequality has largely been fueled by surges at the top, and without capital gains or soaring business profits, those gains will reverse.”

So liberals should now pop the champagne bottles to celebrate the narrowing wealth inequality even without policy actions!

At the end of the day we get ourselves to be reminded of George Orwell's cynical Animalism laws in his satirical novel the Animal Farm ``All animals are equal, but some animals are more equal than others."

Reflexivity Theory: Japan Banks Victims of Prevailing “FEAR” Bias

In George Soro’s theory of reflexivity, the concept basically deals with two way psychological interaction or a feedback loop between the participant’s perception and the situation in which they are engaged in.

According to George Soros, “Financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also the so-called fundamentals that market prices are supposed to reflect in.”

In other words, where the conventional thinking of establishing market prices has been premised on the anticipation of changes in the underlying fundamental conditions of a security or market, on the contrary markets can do the opposite- they can actually shape the fundamentals via the prevailing biases (market momentum).

For instance, the sharp selloffs today, which is the prevailing bias, have brought share prices down enough for some companies operating under regulatory capital ratios to raise capital even when corporate fundamental conditions are healthy.

We are referring to Japanese banks, according to the Economist (highlight mine),

``UNTIL recently Japanese banks had largely avoided the agonies of the credit crunch that had caused such difficulties in much of the rest of the world. Now the misery has well and truly come to Tokyo. The culprit is not toxic derivatives and swaps, but ordinary shares held by banks in Japanese companies. These cross-shareholdings, a peculiar feature of Japanese capitalism, are having pernicious effects. As share prices fall, banks are force to revalue their assets, which in turn reduces their capital ratios. The result is a need to raise capital quickly.

``In the past four trading days, the Nikkei 225-share index has tumbled by 23%. On Monday October 27th the index plunged by 6.4% to 7,162.90, the lowest level in 26 years. Mitsubishi UFJ Financial Group (MUFG), Japan’s biggest bank, plans to raise as much as ¥990 billion ($10.6 billion) by issuing new common shares of perhaps ¥600 billion and preferred securities of ¥390 billion. Mizuho Financial Group and Sumitomo Mitsui Financial Group are said to be planning their own capital increases.

``The government is scrambling to help out. It is poised to announce a set of new measures, including spending perhaps ¥10 trillion to buy shares in companies that the banks hold (in an off-market transaction, so their values do not fall further). This was a tactic used by the Banks’ Shareholdings Purchase Corporation to respond to a banking crisis in 2002. The government may also request that pension funds and life insurance firms buy equities to support the market, though whether they would respond remains to be seen.”

Courtesy of Topix Banking

So what has caused the miseries of the Japanese banks, again from the Economist, ``Share prices are tumbling fast largely because foreign hedge funds have been forced—by the need to meet margin calls and redemptions—to liquidate positions. Investors are also worried that a big global recession will hurt Japan’s exporters, just as a domestic slowdown hurts other firms. Exporters are battered, too, by the steep rise in the value of the yen. It has soared by 11% against the dollar and around 21% against the euro in October, as the yen carry trade unwinds and amid a general flight to safety.”

So global deleveraging has prompted fear which brought upon severe market price distortions enough to require compliance of capital ratios by raising capital of affected companies. And government would now step in to provide assistance. This essentially validates Soros’ reflexivity theory at work.

To consider Japanese banks were thought to be in very a good financial position, such that they were intending to regain international dominance just a few months ago with acquisitions of distressed US financials, to quote again the Economist,

``Just a month ago, fresh from MUFG’s offer of ¥950 billion for a 21% stake in Morgan Stanley, and Nomura’s purchase of operations of the bankrupt Lehman Brothers in Asia, Europe and the Middle East, Japanese bankers felt they were once again dominant on the international financial stage. They were rich with capital and willing to spend, at a time when other institutions were desperate. Now they are victims not of contagion, but of collateral damage.”

So a fear driven market has virtually thrown everything out with the bathwater.

Monday, October 27, 2008

OFW Domestic Helpers Beware: The Home Robots Are Coming

If Filipinos worried about a slowdown of remittances from a potential worldwide economic recession seems valid enough, household chores based OFWs should worry about this.

Toyota has developed home robots that can do household work, and is about to hit the market in seven years time.

courtesy of Japan Times

This from the Japanese Times,

``Toyota Motor Corp. and a research body of the University of Tokyo have jointly developed a prototype for what many busy career people have been dreaming of for a long time: A hardworking robot that handles household chores.

``In a demonstration for reporters last week, the robot cleaned up rooms, smoothly put away dishes from a dining table and picked up shirts and put them in a washing machine.

``The 155-cm, 130-kg humanoid robot excels in the capacity to distinguish and perceive objects such as furniture and cleaning equipment, its developers said.

``The robot also analyzes past failures and corrects its behavior patterns, they said.

``Toyota and Tokyo University's Information and Robot Technology Research Initiative said the robot has been designed to help cope with the predicted labor shortage stemming from Japan's aging society and low birthrate.

``The developers said they will keep improving the robot and hope to start marketing it in around seven years.

``The robot is equipped with two arms, five recognition cameras and laser sensors. It gets around on wheels."

Some observations:

One, the present technology of robots are limited yet. They can’t drop or fetch school children, nor can they clothe, bath or apply first aid to them. Nor can they cook for the family or do marketing chores. But constant innovation will probably add more of these features in the future.

Two, if the cost of buying and maintaining a robot would prove to be more affordable or beneficial than one dispensed by the present household maids then our OFWs are likely in jeopardy of losing work. Yes, seven years is still seven years but preparation should prepare us from any shocks.

Three, Japan still has an inherently closed culture such that it would prefer to invent robots to do household work than to allow other nationalities to assume such a role.

With a rapidly declining population its a curiosity that they're afraid or averse to "intermarriages" or opening their society to other nationalities.

Has The Global Financial Meltdown Forced A Truce In US-Russia Political Tift?

Recently Russia indirectly confronted the US by partly invading Georgia, a staunch US ally.

Not contended with its recent political-military victory, Russia appears to have been flexing its military muscles by parading its warships in the Mediterranean aside from its recent military exercise with Venezuela a formidable political foe of the US.

Courtesy of Timesonline

It has also been capitalizing at US social-economic-financial pressures at home by expanding its influence outside its region. In short, the Putin led Russia have been rebuilding up on the scale of its old “Soviet Union” networks. A possible revival of the former US-Soviet “Cold war” looks likely at work. Or so it seems.

Now we read that the US and Russia are having unannounced highly confidential top level military meeting at Finland (Hat tip: Charleston Voice).

According to Turkish Daily News, ``A U.S. Embassy official says American and Russian military leaders are meeting for unannounced talks in Finland, the highest-level military meeting between the two countries since Russia's war with U.S. ally Georgia in August.

``U.S. Embassy spokesman Kim Hargan says the participants include Adm. Michael G. Mullen, the chairman of Joint Chiefs of Staff, and Gen. Nikolai Makarov, who was appointed the Russian Armed Forces' Chief of General Staff in June.

``Hargan declined to give any details on Tuesday's talks, which had not been previously announced in Finland.

``The Finnish Defense Ministry said the head of the Finnish defense forces, Admiral Juhani Kaskeala organized the meeting at an isolated manor house outside Helsinki. It gave no other details.”

Of course, such a meeting could mean anything and is subject to anyone’s interpretation or speculation. But considering how Russia has felt the brunt of the financial meltdown, to see its stocks collapse, its currency slammed and its bonds toast, while its main source of export revenues-oil and energy-getting walloped, maybe such a meeting puts on hold the political showboating of both camps.

Perhaps misery loves company.

Sunday, October 26, 2008

Phisix: Approaching Typical Bear Market Traits

``The biggest bull are usually too optimistic and the biggest bears are usually too pessimistic.” David Fuller of

For the Phisix we believe that the downside momentum will continue as global markets attempt to find a bottom, as we noted in Phisix: Learning From the Lessons of Financial History, our four bear markets had the following characteristics…

1. August 1987 to October 1988- the Phisix lost about 45% and consolidated for 13 months before recovering and resuming another attempt to the upside. The trigger for the bear market in 1987 – ex-Col. Honasan’s August 28th Black Friday’s botched coup d'état against erstwhile President Cory Aquino.

2. November 1989 to October 1990- the Phisix lost about 62% in about 11 months before convalescing. The trigger for the bear market of 1989 -November 30th Makati coup again by ex-Col. Honasan…

3. February 1997 to October 1998-the Phisix lost 66% in about 20 months. But following the election of President Joseph Estrada, the cyclical Presidential honeymoon period led to the Phisix rebound of 120%. This could be interpreted as the cyclical bullmarket within the secular bear market.

4. July 1999 to November 2001- the Phisix lost 62% in about 28 months for the culmination of the secular bear market cycle. Oddly, the Phisix appear to trace the developments in the US markets or when the Nasdaq bubble imploded in 2000, for a huge chunk of this cycle.

Since we have reached nearly the 50% level we could be headed for the typical bear market losses of 60% from the market peak, which means the Phisix could further fall to 1550.

We are presently 15 months into the present bear market which begun in July of 2007. The last time the Phisix shadowed the US markets it took 28 months for the market to hit a bottom. I am not suggesting the same dynamics although, seen in terms of the US markets, the recent crash seems different from the slomo decline in 2000.

Besides everyone seems fixated on the October 10 levels, from which determines if the lows of the US markets will hold and finally form a bottom, everything is so fluid right now that we can only guess.

Phisix/S&P 500: Oversold

But technicals as shown in Figure 7 reveals of the S&P 500 and the Phisix at oversold levels.

And given the panic in the markets we ought to see some technical bounce soon.

A Fear Driven Meltdown

``A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.”-Warren Buffett, Buy American. I Am.

As we pointed out in Another Grizzly Bear Transforms To A “Cautious Bull”: Jeremy Grantham of GMO former super bear Jeremy Grantham turned bull has been precise about the market’s mean reversions and market overshooting.

This implies that yes, even if the market is already “cheap”, there is that prospect or risk for markets to always overshoot to the downside in as much as markets can overextend upwards. It is plainly called momentum. Since markets over the short term are mostly about emotions, investing today should translate to having a time horizon expectations of at least 12 months.

Take a look at the inflation adjusted chart of the US Dow Jones courtesy of

Figure 2: Dow Jones inflation adjusted

The above chart indicates that support levels have broken down from the 2002 levels and could likely see more downside action. This chart squares with the reaction in the Nikkei chart above suggesting for a little more downside action. But from our perspective any ensuing fall could likely signify as a “selling climax”.

Besides, considering the magnitude of the selloffs, it cannot be discounted that markets can always make sharp countercyclical reactions, which means we can’t discount dramatic rebound anytime from now. Yet short term rebounds do not suggest the end of the bear market until the technical picture materially improves.

As Societe Generale’s Albert Edwards recently wrote, ``But cheap(er) markets will not alone generate a rally. The technicals need to be aligned for that to happen. Notwithstanding the forced liquidations now taking place amidst the wreckage of catastrophic Q3 hedge fund performance link, we see the conditions as ripening for a decent bear market rally.” (emphasis mine)

The reality is that markets or even economies always operate in cycles. And the present bear market developments suggest that this has yet to reach its full maturity before a bottom can be found.

So we are delighted to see a growing band of former contrarian bears converting into contrarian bulls. Aside from Jeremy Grantham, known perma bears like Warren Buffet, Dr. John Hussman, Pimco’s Mohamed El-Erian, Societe Generale’s Albert Edwards and James Montier are some of the prominent names that have began to see “value” in markets today.

Figure 3: Pimco: Massive Risk Aversion and Cash Levels

The point is that while none of them is calling for a market bottom, as none of them are known market timers, although they see the present the market activities as opportunities to steadily accumulate in anticipation of future recovery.

They understand that the present fear levels are indicative of near market bottoms as shown in Figure 3 courtesy of Pimco’s Mark Kiesel. Where market psychology has reached panic levels (left) and equally reflected in massive cash hoards (right).

Vanishing Hedge Funds

So what appears to be the source of the present worries?

With many credit spreads seen improving except for corporate bonds, the present concerns have been directed to mainly three areas, namely, hedge funds, emerging markets and fears of global economic recession.

As we noted in It’s a Banking Meltdown More Than A Stock Market Collapse! ``So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.”

The unraveling motions of investor redemptions appear to be in full gear where the $1.8 trillion industry is at risk of substantial contraction. According to a report from Bloomberg, ``U.S. hedge-fund managers may lose 15 percent of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 trillion, a 32 percent drop from the peak in June.” That’s $500 million of asset liquidation if such projections turn to reality.

Some experts have opined that the sheer force from the stampede out of hedge funds may compel governments to even suspend markets. According to another report from Bloomberg, ``Nouriel Roubini, the New York University Professor who spoke at the same conference, said hundreds of hedge funds will fail as the crisis forces investors to dump assets. ``We've reached a situation of sheer panic,'' said Roubini, who predicted the financial crisis in 2006. ``Don't be surprised if policy makers need to close down markets for a week or two in coming days.''

Emerging Market Shoes Drop

Next we have emerging markets.

Countries which had large current account deficits as % to the GDP, those that relied heavily on foreign and or short term borrowing or have been internally leveraged have endured a beating.

Figure 4: Danske Bank: Emerging Market Credit Default Swaps

For instance, Credit Default Swaps which indicates the cost of insuring sovereign debts against a default have spiked for several countries such as Argentina, Pakistan, Ukraine, Iceland, Ecuador, Venezuela and Indonesia as shown in Figure 4 (see right-1 month change of 5 year CDS). This means that the jittery environment has led investors to see higher risks of prospective government default on their debts. Argentina’s proposed nationalization of pension funds seems to underscore such distress.

And the spate of heavy market selling in the currency and debts markets has likewise caused a spike in inflation levels of some EM economies. So while some countries have been suffering from “deflation” symptoms (mostly advanced nations), others are seeing higher inflation rates due to the lack of access to funding and falling currency values. Hence the unfolding crisis has produced divergent impacts and is unlikely deflationary as some contend.

Korea which suffered from a spectacular market collapse last week (Kospi down 20%!) is said to bear the typical emerging market infirmities, according to Matthews Asian Fund ``For many, the collapse of the won is a sore reminder of the Asian financial crisis of about a decade ago. It highlights some of the weaknesses of regional capital markets—bond markets are underdeveloped and there is consequently little long-term funding for corporations as well as an over-reliance on short-term debt. In addition, Korean bank loans are about 30% greater than their deposit base, which means that the banking system has been more reliant on U.S. dollar-denominated funding.”

Although foreign currency rich neighbors of Japan and China have been reported as in a standby mode to provide assistance. In fact, the region is reportedly in a rush to put up a contingency fund ($80b) aimed at assisting neighbors in distress. So it isn’t just a function of IMF doing rescue efforts, foreign currency rich neighbors appear to be doing the same today.

Aside, the South Korean government extended a $130 billion rescue package-guaranteeing $100 billion of external debt and provision of $30 billion loans to banks. Nonetheless, these measures have not prevented foreign investors from rushing into the exit doors.

Figure 5: Danske Bank: Last Shoe to Drop

So not only has the recent credit crunch shrunk the available capital base among international banks, it also compressed investors’ appetite for emerging market investments. The recent outperformance of emerging markets finally phased into contagion side effects (see figure 5). What used to function as a “safehaven” has now caught up with the EM asset class as seen by the huge spike.

Meltdown in Commodity Markets More Fear Related

Given that many emerging markets have been enduring financial and economic turmoil, many see this as telling signs of deterioration in the global economic front enough to justify an across the board selling of commodities as oil, copper and others.

Figure 6: Commodity selloffs signs of FEAR!

But the recent behavior in the commodity markets appears to be pricing in a steep global recession if not a depression.

The meltdown has been focused on the assumption of a dramatic decline of global demand. They seem to forget that with the current credit crisis, many of the planned projects will be put on hold or shelved or cancelled, giving way to constriction of supply. If supply falls far larger than the rate of decline in demand then you end up having lack of supply thus higher prices.

Besides, commodities are not the equivalent of opaque and complex financial papers that have triggered this crisis. Commodities essentially don’t go bankrupt.

So even the commodity markets are pricing in more fear than rationality, hence you have an across the board selling of practically all asset classes except for US treasuries and the US dollar.

Albeit we are inclined to think that US treasuries could be the next shoe to drop considering the vast scale of debt issuance needed to bailout the US financial sector and the US economy.

On our part we think that the magnitude of market deterioration demonstrates exaggeration of such concerns, especially seen from our ground levels in the Philippines.

We certainly agree with Mr. Buffett that the deleveraging process has reinforced the fear psychology to the point of excessiveness. And this level of fear means opportunities for him and those with cash.

Moreover, we think that the market, functioning as a forward discounting mechanism, has already factored in the worst outcome and is pricing in fear more than fundamentals.

And when mainstream becomes afraid, this usually denotes of a bottom.

Japan’s Nikkei As Indicator

Japan is on the verge of breaking down from its major support levels. The Nikkei closed at 7,649 last Friday, compared to its previous low at 7,607 in April 2003.
Northern Trust: Nikkei 225 Long term chart

Here are some of our observations.

One, in the last major attempt to move forward during the late 1998-99, the Nikkei lost about 61%. Today the Nikkei is down about 58%. From the summit, the Nikkei has lost about 80% since 1989. Thus the tag of the “lost decade”.

Two, a Nikkei breakdown could mean a bottom phase yet to be ascertained since 1989 which also means structural bear markets could last for years.

Three, a breakdown of the Nikkei could signify as a leading indicator to the fate of the US markets over the interim.

Lastly this is not to suggest that the US markets will do a Nikkei’s “lost decade”. While there have been some significant parallels, conditions are greatly different. As an example the lost decade of Japan was “insulated” compared to the more global dependent US whose recent bubble bust has triggered a worldwide contagion. Thus, any comparison of the Nikkei’s travails to the US is an apple to orange comparison.

The point is that a breakdown of the Japan’s Nikkei could likely mean more downside actions for world markets.

Saturday, October 25, 2008

Federal Reserve: The Coming Zero Interest Rate Economy

The US Federal Reserve seems to be having a hard time trying to manage its short term rates even as they have now began paying depository institutions higher interest rates on its excess balances held at the central bank.

Casey Research: Fed Funds Rate vis-à-vis Fed Funds Actual Effective

The chart courtesy of Casey Research shows that the Fed Fund rates are at 1.5% but Fed Funds Actual Effective rate have been trading below 1%.

Nonetheless, given the slump across global markets last week, it does seem that the Fed could probably be following the market’s action as it has mostly done and cut rates in the next meeting.

The US is right on track to a zero interest rate policy economy.

Bretton Woods II: Asia Weighing In Too?

Earlier we suggested that today’s financial crisis seems to reveal of the emerging cracks in the present monetary and financial framework in as earlier discussed in Bretton Woods II: Bringing Back Gold To Our Financial Architecture?

Now the calls for such reform of the financial and monetary architecture appear to have reached the shores of China.

A leading broadsheet unofficially articulated on the abuses of the US by utilizing its “dollar hegemony” or its reserve currency status.

According to the Reuters (highlights mine), ``The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday.

``The front-page commentary in the overseas edition of the People's Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies…

``The People's Daily is the official newspaper of China's ruling Communist Party. The Chinese-language overseas edition is a small circulation offshoot of the main paper.

``Its pronouncements do not necessarily directly voice leadership views. But the commentary, as well as recent comments, amount to a growing chorus of Chinese disdain for Washington's economic policies and global financial dominance in the wake of the credit crisis.

"The grim reality has led people, amidst the panic, to realize that the United States has used the U.S. dollar's hegemony to plunder the world's wealth," said the commentator, Shi Jianxun, a professor at Shanghai's Tongji University.

And it’s not just about the strident unofficial op-ed commentary, and the growing recognition of the imbalances consequent to the US dollar standard, Asian and European leaders have jointly called for massive reforms in our global financial system.

According to this report from Bloomberg (emphasis mine), ``Asian and European Union leaders called for an overhaul of the global financial system, lending support to French President Nicolas Sarkozy as he presses the U.S. to join the initiative amid the credit crisis.

``The heads of more than 40 Asian and European governments ``pledged to undertake effective and comprehensive reform of the international monetary and financial systems,'' according to a statement released at a two-day meeting in Beijing. Chinese President Hu Jintao, Japanese Prime Minister Taro Aso, German Chancellor Angela Merkel and Sarkozy are among the participants….

``Sarkozy is leading the 27-nation EU's push to respond by revamping a financial system established after World War II. Leaders from around the globe will meet Nov. 15 in Washington to assess the turmoil at the urging of the EU, which has floated ideas including more bank supervision, stricter regulation of hedge funds, new rules for credit-rating companies and changes at the International Monetary Fund.”

Growing clamors to reform the global monetary architecture seem to signify emerging power struggles over the hegemonic nature of the US, which essentially has been backstopped by its political and military power and most importantly its economic might, in the spectrum of today’s monetary standard.

While of course, we don’t see this as a direct challenge to the geopolitical or military might of the US, this could also be probably seen in the light of other nations desiring to increase their share of influence in the conduct of world monetary policy affairs.

Where we previously noted that today’s global banking shakedown could be a possible manifestation of signs of diminishing confidence with the present US dollar standard system, ``We don’t know if this is signifies as 1) a mere jolt to the system or 2) the start of the end of the Paper money system or 3) the critical mass that would spur a major shift in the present form of monetary standard.”

It seems that the third option as the likely course of action.

Thursday, October 23, 2008

PIMCO’s Mohamed El-Erian on Emerging Markets: Focus On Fundamentals, Aggressive Policies Will Help In Time

Vetting on the wisdom of PIMCO’s Mohamed El-Erian who recently wrote about the current crisis (all highlights mine)…

Mr. El-Erian: ``Many developing countries were fortunate to enter this crisis in relatively strong shape. They had large holdings of international reserves, limited leverage and relatively low indebtedness. Policy flexibility was also considerable, as reflected in the ability to prudently use monetary and fiscal policy in a countercyclical manner. And internal consumption was picking up momentum.

``The robust initial conditions have served to partially insulate the developing world from the effects of the global financial crisis that most observers rightly classify as the worst since the 1930s. Contrary to what would be expected on the basis of the experience of the past 30 years, there has been no dramatic collapse in growth and consumption; widespread defaults have not materialized; and many governments retain their core policy credibility.”

My interpretation:

Emerging markets are stronger and more equipped today to cope with the present crisis.

There have been little signs of the prospects of a global depression.

Mr. El-Erian: ``What's more, the favorable initial conditions will provide little comfort for emerging-market equity investors. The long-term story in these markets may still look good, but investors are sitting on large losses now. Why? In major global dislocations like the one we are experiencing, fundamental drivers of value get totally overwhelmed by "technicals." Foreign investors, facing large losses at home, all scramble to repatriate their funds at the same time. The emerging-market equity door is simply not big enough to accommodate them all without a large and disorderly decline in prices.

``Provided they are sufficiently liquid and that their portfolios are not overly concentrated, investors should think twice before joining this stampede. As a rule, long-term value investors should not become distressed sellers on account of technical factors alone. They should be guided primarily by their views on fundamentals, which will once again assert themselves over time. Moreover, help is on the way. Emerging markets will be aided, albeit neither immediately nor smoothly, by the aggressive policy decisions now being taken in industrial countries.”

My interpretation:

Deleveraging, Fear and Momentum trades have basically driven EM equities to the cellar.

Investors should avoid the bandwagon or herd mentality effect and ruminate on fundamental issues instead. Those who focus on fundamentals will be promptly rewarded.

Like us, Mr. Mohamed El-Erian thinks that aggressive policy decisions by Industrial nations will help EM markets overtime. In Global Market Crash: Accelerating The Mises Moment!, we also noted ``So while today’s market has almost gutted most of the global financial markets (equities, commodities, bonds and currencies-yes newspapers focus on stocks but contagion has been across the board) as a result of massive deleveraging and stress in the global banking system, once such policies sink in or diffuse, we are likely to see divergent economic performances that should be reflected on the markets once the panic subsides.”

So we have a growing chorus of bullish contrarian gurus in a world driven by fear. The very same clique who successfully foretold of this crisis.

Federal Reserve Bank of Minneapolis: What Credit Crisis?

This financial crisis has painted a popular view that our economic and financial world seems careened towards perdition; largely underpinned by the blowup in the securitization markets and a freeze in the credit markets. And such is the reason why global governments have united to supposedly provide the intensive care treatment needed to avert a systemic meltdown.

Ironically, what the US Federal Reserve and the US Treasury have been saying runs counter to the insights of the Federal Reserve Bank of Minneapolis. The US government says the system is in danger which requires massive intervention while the Minneapolis implies that there is no systemic threat.

V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe in a recent working paper “Myths about the Financial Crisis of 2008” (HT: Mike Moffatt disputes much of the woes aired by the experts and the financial press.

From Chari, Christiano and Kehoe,

``Clearly, the United States and the world economy are undergoing a major financial crisis. Interbank borrowing and lending rates have risen to unprecedented levels relative to U.S. Treasury Bills. Several major financial institutions have failed. These real problems have also been associated with four widely-held myths about the nature of the financial crisis and the associated spillovers to the rest of the economy. The financial press and policymakers have made four claims about the nature of the crisis.

1. Bank lending to non financial corporations and individuals has declined sharply.

2. Interbank lending is essentially nonexistent.

3. Commercial paper issuance by non.nancial corporations has declined sharply and rates have risen to unprecedented levels.

4. Banks play a large role in channeling funds from savers to borrowers.”

The Federal Reserve Bank of Minneapolis presents the following charts…

While volume transactions of commercial paper fell dramatically, the non financial market seems to remain buoyant.

Meanwhile 90 day commercial paper rates have zoomed.
Our comment:

On the surface it would appear there hasn’t been much of the dislocation in the credit markets. But if one takes into account the spikes of Interbank 5A, commercial and Industrial loans 3A, Bank Credit 1A and Loans and Leases 2A, they seem coincidental with the US Federal Actions. Perhaps much of the recent gains in these credit activities could have been influenced by Fed policies.

Another possible factor for a spike in the loans is that the compressed activities in the commercial paper market could have prompted corporations to tap their revolving credit lines instead. Or perhaps consumers have used more of the credit card to sustain consumption patterns.

Nonetheless, if the present crisis is viewed from the angle of the US Federal Reserve’s Balance Sheet, the change of its composition and its rapid expansion implies that the crisis isn’t a myth. Chart courtesy of by Federal Bank of Atlanta.

Such dissonance could imply of the concentration of risks in the US banking system to a few but large heavily affected institutions.

As Christopher Whalen (HT: Craig McCarty) of the Institutional Risk Analytics observes, ``Despite grim macro outlook for US economy, most smaller banks in the US are in good shape. While losses will rise for the banking industry as a whole, smaller banks up through large regional institutions have the capital to absorb losses and continue during business. Top five institutions are where the assets are concentrated and the loss rates will be higher as the credit cycle peaks in Q1-2 of 2009.”

Lastly if it is true that today's crisis is a myth then why the need for all these coordinated and intensive intervention? Perhaps to save Wall Street?