How Rising US Treasury Yields May Impact the Phisix

Now experience is not a matter of having actually swum the Hellespont, or danced with the dervishes, or slept in a doss-house. It is a matter of sensibility and intuition, of seeing and hearing the significant things, of paying attention at the right moments, of understanding and co-ordinating. Experience is not what happens to a man; it is what a man does with what happens to him. It is a gift for dealing with the accidents of existence, not the accidents themselves. By a happy dispensation of nature, the poet generally possesses the gift of experience in conjunction with that of expression.—Aldous Huxley, Texts and Pretexts (1932), p. 5

You shall know the truth and the truth shall make you mad. ― Aldous Huxley

Last week I wrote[1]: (bold original)

Ultimately it will be the global bond markets (or an expression of future interest rates) that will determine whether this week’s bear market will morph into a full bear market cycle or will get falsified by more central bank accommodation.

US Treasury Yields Surges!

The surge of yields of US treasury will have interesting implications on global markets. 

According to the mainstream[2], Friday’s “robust” jobs data in the US supposedly would extrapolate to a so-called “tapering” or an eventual reduction of monetary policy accommodation by the US Federal Reserve. Such has been imputed as having “caused” the monumental spike US treasury yields from the 5, 10 and 30 year maturity spectrum.

But this narrative represents only half the picture.

Previously there has been a broad based boom in US financial assets (real estate, stocks and bonds). This has been changing.

Given the Fed’s accommodative policies, a financial asset boom represents symptom an inflationary boom. Such boom appears to have percolated into the real economy which has been reflected via the ongoing recovery in commercial and industrial loans which approaches the 2008 highs (upper window)[3]. Consumer credit has also zoomed beyond 2008 highs[4]. This means that the pressure for higher has been partly a product of greater demand for credit.

But treasury yields have been rising since July 2012. Treasury yields have been rising despite the monetary policies designed to suppress interest rates such as the US Federal Reserve’s unlimited QE in September 2012, Kuroda’s Abenomics in April 2013 and the ECB’s interest rate cut last May.

Rising treasury yields accelerated during the second quarter of this year, which has now been reflected on yields of major economies, not limited to G-4. And rising global yields as pointed out last week, coincides with recent convulsions in global stock and bond markets, ex-US currencies, and increasing premiums in Credit Default Swaps.

What Rising UST Yields Mean

The spike in US Treasury yields has broad based implications.

Treasury yields, particularly the 10 year note[5], functions as important benchmark which underpins the interest rates of US credit markets such as fixed mortgages and many longer term bonds.

Rising treasury yields means higher interest rates for US credit markets.

Treasury yields also serves as the fundamental financial market guidepost, via yield spreads[6], towards measuring “potential investment opportunities” such as international interest rate “carry trade” arbitrages. 

The McKinsey Global Institute estimates that the stock of global equity, bond and loan markets as of 2^nd Quarter of 2012 has been at US$225 trillion[7]

Market capitalization of global equities at $50 trillion signifies a 22% share of the total. The $100 trillion bond markets, particularly government ($47 trillion), Financial sector bonds ($42 trillion) and Corporate bonds ($11 trilllion) constitute 44%, while securitized ($13 trillion) and non-securitized loans ($ 62 trillion) account for 33% of the global capital markets.

Said differently, interest rate sensitive bond and loans markets represent 78% share of the global capital markets as of the 2^nd quarter of 2012.

And as interest rates headed for zero-bound, the global bond and loan markets grew by 5.6% CAGR since 2000, this compared with equities at 2.2% CAGR.

Higher interest rates translate to higher costs of servicing debt for interest rate sensitive global bond and loan markets. Theoretically, 1% increase in the $175 trillion bond and loan markets may mean $1.75 trillion worth of additional interest rate payments. The higher the interest rate, the bigger the debt burden.

Moreover, sharply higher UST yields will likely reconfigure ‘yield spreads’ drastically on a global scale to correspondingly reflect on the actions of the bond markets of the US and the other major developed economies.

Such adjustments may exert amplified volatilities on many global financial markets including the Philippines.

For instance, soaring US bond yields have already been exerting selling strains on the Philippine bond markets as I have been predicting[8]. 

Philippine 10 year bond yields[9] jumped 35 bps on Friday or 13 bps from a week ago.

And no matter how local officials earnestly proclaim of their intent or goal to preserve the low interest rate environment[10], a sustained rise in local bond yields will eventually compel policymakers to either fight bond vigilantes with a domestic version of bond buying program which amplifies risks of price inflation (which also implies of eventual higher interest rates), or allow policies to reflect on bond market actions.

Worst, a sustained rise in international bond yields, which reduces interest rate arbitrages or carry trades, may exacerbate foreign fund outflows. Such would prompt domestic central banks of emerging market economies, such as the Philippines, to use foreign currency reserves or Gross International Reserves (GIR) to defend their respective currencies; in the case of Philippines, the Peso.

‘Record’ surpluses may be headed for zero bound or even become a deficit depending on the speed, degree and intensity of the unfolding volatilities in the global bond markets.

Yet any delusion that the yield spreads between US and Philippine bonds should narrow towards parity, which would imply of the equivalence of creditworthiness of the largest economy of the world with that of an emerging market, will be met with harsh reality which a tight money environment will handily reveal.

The new reality from higher bond yields in developed economies are most likely to get reflected on “yield spreads” relative to emerging markets via a similar rise in yields.

Yet many banks and financial institutions around the world are proportionally vulnerable to losses based on variability of interest rate risk exposures particularly via fixed-rate lending funded that are funded by variable-rate deposits.

Importantly, the balance sheets of public and private financial institutions are highly vulnerable to heavy losses as bond yields rise.

As the Economist observed[11], (bold mine)

The immediate threat to banks is a fall in the market value of assets that banks hold. As yields of government bonds and other fixed-income securities rise, their prices fall. Because the amounts of outstanding debt are so large, the effects can be big. In its latest annual report the Bank for International Settlements, the Basel-based bank for central banks, reckons that a hypothetical three-percentage-point increase in yields across all bond maturities could result in losses to all holders of government bonds equivalent to 15-35% of GDP in countries such as France, Italy, Japan and Britain

What has been categorized as “risk free” now metastasizes into a potential epicenter of a global crisis.

It would be foolish or naïve to shrug at or dismiss the prospects of losses to the tune of 15-35% of GDP. These are not miniscule figures, and my guess is that they are likely to be conservative as these figures seem focused only on bond market losses.

While a sustained increase in the price of credit should translate to eventually lesser demand for credit, as the cost of capital rises that serves to restrict or limit marginal capital or the viability or profitability of projects, what is more worrisome is that “because the amounts of outstanding debt are so large” or where formerly unprofitable projects became seemingly feasible due high debts acquired from the collective credit easing policies by global central banks, the greater risks would be the torrent of margin calls, redemptions, liquidations, defaults, foreclosures, bankruptcies and debt deflation.

Government Debt and Derivatives as Vulnerable Spots

And such losses will apply not only to the private sector but to governments as well.

I pointed out last week of a report indicating that many central banks has been hurriedly offloading “record amount of US debt”. As of April 2013, according to US treasury data[12], total foreign official holders of US Treasury papers, led by China and Japan was $5.671 trillion.

This means that the $5.671 trillion foreign official holders (mostly central banks and sovereign funds) of USTs have already been enduring stiff losses. This is likely to encourage or prompt for more selling in order to stem the hemorrhage. I would suspect that the same forces have played a big role in this week’s UST yield surge.

Additionally, the propensity to defend domestic currencies from the re-pricing of risk assets via dramatic adjustments in yield spreads means that the gargantuan pile up of international reserves are likely to get drained for as long as the rout in the global bond markets continues.

As of April, the stock of US treasury holdings of the Philippine government (most of these are likely BSP reserves) has likewise been trending lower. That’s a month before the bloodbath. It would be interesting to see how developments abroad will impact what mainstream sees as “positive fundamentals”—or statistical data compiled based on a period of easy money.

I also previously pointed out[13] that of the $633 trillion global OTC derivatives markets as of December 2012, interest rate derivatives account for $490 trillion or 77.4%

The asymmetric risks from interest rate swap transactions as defined by Investopedia.com[14]

A plain vanilla interest-rate swap is the most basic type of interest-rate derivative. Under such an arrangement, there are two parties. Party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments. Both streams of interest payments are based on the same amount of notional principal.

Sharply volatile bond markets, in the backdrop of higher rates, increases the rate of interest payments and equally increases the risk potential of financial losses particularly on the second party who “receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments”. And the corollary from the ensuing amplified losses may imply of magnified credit and counterparty risks. And we are talking of a $490 trillion market.

Yet it is not clear how much leverage has been accumulated in the US and global fixed income markets, fixed income based mutual fund markets as well as ETFs via risk exposures on Corporate bonds, Municipal bonds, Mortgage Backed Securities, Agencies, Asset Backed Securities and Collateral Debt Obligations[15], as well as, emerging market securities.

Will a sharp decline in fixed income collateral values prompt for higher requirements for collateral margins? Or will it incite a tidal wave of margin calls? How long will it last until one or more major US or global institutions “cry wolf”?

Rising interest rates in and of itself should be a good thing since this should rebalance people’s preferences towards savings and capital accumulation, the difference is that prolonged period of easy money policies has entrenched systematic misallocation of resources which has engendered highly distorted and maladjusted economies, artificially ballooned corporate profits and valuations, and has severely mispriced markets by underpricing risks.

The bottom line: If the tantrum in the bond market persists or even escalates, higher bond yields in developed economies will not only reflect on a process of potential disorderly adjustments for “yield spreads” of emerging markets such as the Philippines—under a newfangled renascent regime of the bond vigilantes—but they are likely to negatively impact the growth of the intensely leveraged, low interest rate dependent $225 trillion capital markets, as well as, the $490 trillion derivative markets.

It is imperative to see bond markets stabilize before ploughing into any type of investments.

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[1] See Phisix: Don’t Ignore the Bear Market Warnings June 30, 2013

[2] Bloomberg.com Treasury Yields Reach 2-Year High as Job Gains Boost Taper Bets July 6, 2013

[3] St. Louis Federal Reserve, Commercial and Industrial Loans at All Commercial Banks (BUSLOANS)

[4] St. Louis Federal Reserve Graph: Total Consumer Credit Owned and Securitized, Outstanding (TOTALSL)

[5] About.com 10-Year Treasury Note and Rate

[6] Investopedia.com Yield Spread

[7] McKinsey Global Institute Financial globalization: Retreat or reset? March 2013

[8] See How Volatile Bond Markets May Affect the Phisix June 3 2013

[9] Investing.com Philippines 10-Year Bond Yield

[10] Inquirer.net BSP seen to maintain easy monetary policy July 5, 2013

[11] The Economist Administer with care June 29, 2013

[12] US Department of Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[13] See Phisix: Will Abenomics trigger a “Sell in May”? May 27, 2013

[14] Investopedia.com Interest-Rate Derivative

[15] Investopedia.com How Bond Market Pricing Works

The Symmetry Between Ponzi Scams and Ponzi Financed Global Financial Markets

Lessons from the Aman Ponzi Scam

A few months back I warned that the current negative real rates regime will foster and bring about accounts of fraudulent financial operations such as Ponzi and pyramiding schemes 

I wrote last March[1],

Since fixed incomes will also suffer from interest rate manipulations, many will fall victim or get seduced to dabble with Ponzi schemes marketed by scoundrels who would use the current policy induced environment as an opportunity to exploit a gullible public.

I even followed this up last week[2],

instead of locking money through interest rate dividends from savings account in the financial institutions, zero bound regime or negative real rates which are part of financial repression have been forcing people to chase on yields and gamble in order to generate returns. So the public have become more of a “risk taker” and take on “greedy” activities in response to such policies. Some would even fall or become victims to Ponzi schemes which I expect to mushroom.

Enormous losses from Ponzi operations of the Aman Futures Group[3] to a whopping tune of Php 12 billion (US 289 million at 41.5 to a USD) from over 15,000 victims coming from various sectors, largely from Southern Philippines, particularly in Visayas and Mindanao, has been a recent revelation.

The streak of large scale financial hoaxes continues to surface.

Today, another financial scam in Lanao, also in Mindanao, by an alleged Jachob “Coco” Rasuman group[4], whom preyed on a smaller number, specifically 29 Muslims investors by defrauding them of Php 300 million (USD 7.22 m) was reported by media. Ironically, these scumbags got gypped or suffered a dose of their own medicine, when they invested in Aman Futures. Talk about karma. 

Negative real rates, which in reality punishes savers and creditors, have been forcing many people to chase on yields in order to preserve on their savings. Such environment has encouraged the vulnerable public to take unnecessary risks and gamble which unscrupulous agents take advantage of.

While negative real rates necessarily do provide the incentives for many in the public to get financially duped or hoodwinked, this has not been a sufficient reason.

A big part has been a mélange the lack of financial alternatives, which has been tied or linked to the dearth of financial education, as well as, the paucity of critical thinking and self-discipline which has been associated with the welfare mentality.

All Ponzi operations have been anchored on “something for nothing” dynamic.

Typically astronomical returns on placements by early investors are paid for by the infusion of new money from new investors. Of course, sky high returns are dangled as compelling motivation for financial patsies to ensnare the bait. Yet, once the critical mass or where insufficient money from new investors to pay for existing ones has been reached, the whole bubble operations collapses like a house of cards.

It is quite obvious that a yield offer of something like 50% a month would translate to a nominal 600% returns a year. Yet nobody seems to have the common sense to ask “what kind of businesses or investments would return at least 600% a year”?

The apparent insufficiency of financial common sense can be traced to the underdeveloped conditions of the country’s financial markets. 

The development of financial markets has been associated with greater degree of economic development. According McKinsey Global Institute[5], most of the emerging markets’ financial depth has been between 50 and 250 percent of GDP compared to 300 to 600 percent of GDP for developed countries. In other words, increasing standards of living from the accretion of individual savings, which became the cornerstone of financial intermediation that led to the development of financial markets, has played a significant role in capital formation and the subsequent growth in the economy.

Financial depth has been conventionally measured[6] through:

-the traditional banking system,

-the non-banking financial institutions[7] which comprises risk pooling institutions (Insurance), contractual Savings Institutions (Pensions and Mutual funds), Market Makers (broker dealer), Specialized Sectoral Financiers (real estate, leasing companies, payday lending) and Financial Service Providers (security and mortgage brokers) and finally

-financial markets[8], particularly capital markets (stock and bonds), commodity markets, derivatives, money markets, futures markets, insurance markets and foreign exchange markets.

One would note of the severe deficiencies of the state of non-banking financial institutions as well as the financial markets. Example the Philippines remains as a laggard in the ASEAN regions commodity markets having no existing commodity markets. Another example is that specialized investment vehicles have been inaccessible to the public such as short sales (short sales exist but operating rules render them useless), derivatives (which have been limited to banks), and select futures (e.g. currency forwards also restricted to banks) among many others.

Thus the immature state of financial markets essentially restricts the transmission mechanism of savings to investments that has functioned as one key hurdle to economic growth and development.

Again, no less than the heavily politicization, taxation and overregulation of the industry or the political unwillingness to openly promote alternative savings and investment vehicles, as well as incentivize industry competition, has been responsible for the backward state of affairs.

Because many lack the access to such legitimate financial alternative options, there has been similarly less desire or motivation to imbue the necessary knowledge to protect oneself from financial knavery.

And while education may help, in reality, contextual education to establish the virtues of self-discipline or emotional intelligence is paramount.

Education per se (or education as a function of social signaling) has not deterred the infamous Bernard Madoff from having to cream, bamboozle and embezzle $50 billion off from a legion of supposedly professional finance managers representing top banks, insurers, hedge funds[9] with his Ponzi version which got busted in 2008.

Also, the public’s increased reliance on politicians to exercise the paternalist ethical plane of behavioral guidance for financial operators and for market participants has prompted for the substitution of self-responsibility and mutual respect for dependency: the welfare mentality. Plainly put, such victims outsourced self-responsibility to equally gullible local politicians, who in a bizarre twist of events, “openly endorsed” and likewise became victims of the grand Philippine Ponzi scam. This simply serves as another lucid example of the knowledge problem at work.

So while national political authorities swiftly use such crisis as opportunity to pontificate on the supposed paternalist virtues in seeking redress and the rightful justice deserving for the aggrieved parties, these politicians skirt the blame of the adverse effects from their policies. Out of ignorance or in collusion with the political establishment or both, mainstream media has been equally culpable for concealing the social effects of bubble policies.

Nonetheless, bubble policies promote bubble psychology, bubble attitudes and bubble actions.

As the late economic historian Charles P. Kindleberger wrote in Mania’s, Panics and Crashes (p.66 John Wiley)[10]

Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud

The Addiction to Legalized Ponzi Financing

Think of it, if Ponzi schemes are considered illegitimate because they arise from financing investment operations by enticing new money[11] from new investors by offering surrealistic returns, how would one call today’s financial markets which operate on the deepening dependency on central banks to provide ever increasing “new” money to bolster or at least maintain elevated asset prices? 

Everyday we see signs of these.

A parallel universe represents an alternative reality. If doctrinal finance teaches that economic growth serves as indicator to corporate earnings which should get reflected on stock prices then Japan’s financial markets and her economy appear to operate on a parallel universe. That’s because economic growth and stock market pricing seems to move in diametrical directions which jettisons the conventional wisdom.

Ever since the 2011 triple whammy Earthquake-Tsunami-Fukushima Nuclear disaster, Japan’s economy continues to weaken. Japan has reportedly entered a mild recession in the 3^rd Quarter[12]. Yet since April’s bottom, the Japan’s major equity bellwether the Nikkei 225 continues to gain grounds.

Yet much of these pronounced gains had been made last week, ironically when the Prime Minister Yoshihiko Noda dissolved the parliament and simultaneously called for a snap election on December 16^th[13].

His expected replacement, Shinzo Abe, leader of the once dominant Liberal Democratic Party (LDP) has been widely expected to pressure the Bank of Japan (BoJ) to aggressively stimulate the economy.

Thus like the Pavlovian conditioned stimulus, the smell of freshly minted or digitally created money sends the financial markets into a rapturous bliss

So amidst the announcement of a recession, the Nikkei 225 jumped 3.4% for this week. That’s effectively half of the modest year to date return of 6.73%. The reversal of the Nikkei’s year to date performance from loss to gains come at the heels of further weakening of major global equity bellwethers.

In other words, Japan’s politicians, media and the marketplace continue to carry unwavering faith and undying hope over the BoJ’s action, despite the series of QEs launched since. In short, all the money printing did has been to boost asset prices even as the economy tumbled. Such Pollyannaish belief is tantamount to “doing the same thing over and over again and expecting different results”. Someone once defined this as insanity.

Just last month, the BoJ announced a back to back QE 8^th[14] and QE 9^th[15] in a span of one week.

Yet despite all the easing polices by other major economies, previous gains continue to dissipate from the current string of losses.

Since the latest peak of the S&P 500 in mid-September 2012, the major US bellwether has lost in 6 out of 9 weeks, which as of Friday’s close, has been off about 7% from the zenith and has pared down year to date gains to just 6.42%. 

President Obama’s class warfare policies which will raise capital gains and dividend tax substantially, contradicts the US Federal Reserve’s easing policies, thus US equity markets remain plagued by political uncertainties[16]. US markets remain hostaged to politics. 

Yet what has been apparent is the volatile environment from the addiction to central bank Ponzi financing.

Financial analyst and fund manager Doug Noland of the Credit Bubble Bulletin[17] at the Prudent Bear neatly captures the soul of today’s policy based Ponzi-bubble dynamics

a Credit Bubble is sustained only through ever-increasing quantities of “money” and Credit.  The greater the Bubble, the greater the required policy response to sustain the inflation.  But, importantly, the greater the policy measures imposed the greater the market reaction – and the greater the market reaction the greater the necessity for even bigger policy interventions in the future.  

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[1] See After 5,000: What’s Next for the Phisix? March 5, 2012

[2] See The Phisix in the Shadow of the US Fiscal Cliff November 11, 2012

[3] Inquirer.net Thousands duped in P12-billion scam November 14, 2012

[4] Inquirer.net Bigger scam in Lanao Sur November 18, 2012

[5] McKinsey Global Institute Mapping global capital markets 2011 August 2011

[6] Financial Depth (Size) Rethinking the Role of the State in Finance WorldBank.org

[7] Wikipedia.org Non Bank Financial Institutions

[8] Wikipedia.org Financial market

[9] See Madoff Ponzi Scam and Boom-Bust cycles December 21, 2008

[10] Charles Kindleberger, Mania’s, Panics and Crashes A History of Financial Crisis, p.66 John Wiley

[11] Wikipedia.org Ponzi scheme

[12] Editorial Japan Times Nip the recession in the bud, November 17, 2012

[13] The Globe and Mail Election call puts spotlight on Bank of Japan, November 14, 2012

[14] See Bank of Japan Adds More Stimulus October 27, 2012

[15] See Bank of Japan’s Back to Back Stimulus November 1, 2012

[16] See Obama’s Fiscal Cliff: The Effects of Taxing Wealth November 13, 2012

[17] Doug Noland, When Money Dies, Prudent Bear November 16,2012

Many Americans Opt Out of the Banking System

Perhaps mostly as a result of bad credit ratings from lingering economic woes, many Americans have turned into alternative means to access credit financing.

The following report from the Washington Post,

In the aftermath of one of the worst recessions in history, more Americans have limited or no interaction with banks, instead relying on check cashers and payday lenders to manage their finances, according to a new federal report.

Not only are these Americans more vulnerable to high fees and interest rates, but they are also cut off from credit to buy a car or a home or pay for college, the report from the Federal Deposit Insurance Corp. said.

Released Wednesday, the study found that 821,000 households opted out of the banking system from 2009 to 2011 and that the so-called unbanked population grew to 8.2 percent of U.S. households.

That means that roughly 17 million adults are without a checking or savings account. Another 51 million adults have a bank account, but use pawnshops, payday lenders or rent-to-own services, the FDIC said. This underbanked population has grown from 18.2 percent to 20.1 percent of households nationwide.

The study also found that one in four households, or 28.3 percent, either had one or no bank account. A third of these households said they do not have enough money to open and fund an account. Minorities, the unemployed, young people and lower-income households are least likely to have accounts.

This serves as proof that despite the lack of access through the conventional banking system, substitutes will arise to replace them. Demand for credit has always been there. Such dynamic resonates with the post bubble bust era known as the Japan’s lost decade.

I may add that people opting out of the banking system may not at all be about bad credit ratings, they could also represent manifestations of an expanding informal economy in the US. Chart below from Bloomberg-Businessweek includes undocumented immigrant labor, home businesses, and freelancing that escape the attention of tax authorities.

Over the past decade, the informal economy has been gradually ascendant even for developed nations. Advancement in technology may have partly contributed to this.

Although the recession of 2001 (dot.com bust) and the attendant growth in regulations, welfare and ballooning bureaucracies may have been the other principal factors.

My guess is that the post-Lehman era, which highlights governments desperate to shore up their unsustainable fiscal conditions, may only intensify the expansion of the informal economies even in the developed world.

Add to this the growing concerns over the economic viability of the banking system and continued innovation in technology (e.g. P2P Lending, Crowd Sourcing and etc…), the traditional banking system will be faced with competition from non-traditional sources.

David Stockman: The US Federal Reserve is Destroying the Capital Markets

David Stockman, former Republican U.S. Congressman and director of the Office of Management and Budget, founding partner of Heartland Industrial Partners and the author of The Triumph of Politics: Why Reagan's Revolution Failed and the soon-to-be released The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy in an interview at the Gold Report has this biting message. [bold emphasis mine]

The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. The yield curve signals nothing anymore because it is totally manipulated by the Fed. The very idea of "Operation Twist" is an abomination.

Capital markets are at the heart of capitalism and they are not working. Savers are being crushed when we desperately need savings. The federal government is borrowing when it is broke. Wall Street is arbitraging the Fed's monetary policy by borrowing overnight money at 10 basis points and investing it in 10-year treasuries at a yield of 200 basis points, capturing the profit and laughing all the way to the bank. The Fed has become a captive of the traders and robots on Wall Street…

I think the likely catalyst is a breakdown of the U.S. government bond market. It is the heart of the fixed income market and, therefore, the world's financial market.

Because of Fed management and interest-rate pegging, the market is artificially medicated. All of the rates and spreads are unreal. The yield curve is not market driven. Supply and demand for savings and investment, future inflation risk discounts by investors – none of these free market forces matter. The price of money is dictated by the Fed, and Wall Street merely attempts to front-run its next move.

As long as the hedge fund traders and fast-money boys believe the Fed can keep everything pegged, we may limp along. The minute they lose confidence, they will unwind their trades.

On the margin, nobody owns the Treasury bond; you rent it. Trillions of treasury paper is funded on repo: You buy $100 million (M) in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out.

If that happens, the massive repo structures – that is, debt owned by still more debt – will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked.

Read the rest here.

Many people believe that the numerous incidences of irregularities seen in financial markets emanate from unscrupulous behavior by some market agents, little has been understood that central bank policies, together policies that cater to crony capitalism, have been incentivizing or fostering such behavioral anomalies.

And importantly, the nature of capital markets have been intensely distorted to the point where conventional wisdom of its mechanics has nearly been rendered obsolete.

Either we face up to such evolving realities or suffer from our recalcitrance to adjust when the day of reckoning arrives.

Capital Markets in the Information Age: More Financial Innovations

The world does not operate in a vacuum. Given the trend of rapid increases in the imposition of strangulating bank and financial regulations, entrepreneurs have been exploring ways to sidestep or bypass the system, by harnessing advances in technology, where they can profit from serving the consumers.

I have earlier pointed out that the internet has spawned innovative ways of borrowing and lending, of payment systems, and of the financing of commercial projects via P2P Lending and Crowd Funding.

Jeffrey Tucker at the Laissez Faire Books shows us more

Squareup. This is an innovation by Jack Dorsey (Twitter fame) and his friends, and came about only in 2010. The first problem they were trying to overcome was there has to be an easier way for merchants to accept credit cards. They decided to give the hardware away for use on simple mobile phones, and then charge per transaction. Win!

In the course of developing the business, which is valued already at $1 billion, they solved an even stranger problem that all of us have but never really noticed that we have: If we don’t have our wallets with us, we can’t buy anything.

Now this is genius: Square allows you to pay by saying your name. The merchant matches a picture of your on the square system with your physical face. You look each other in the eye and the deal is done. Anyone can sign up. Yes, it is incredible. Simple and wonderful.

The Lending Club. Again, this is mind-blowing. The Lending Club matches up lenders and borrowers while bypassing the banking system altogether. The idea emerged in October 2008, just as the existing credit system seemed to be blowing up. Today, the company originates $1 million in loans per day.

Anyone can become a lender with a minimum investment of $25 per note. Lenders can choose specific borrowers or choose among many baskets and combinations of borrowers to reduce risk.

Any potential borrower can apply, but of course the company wants to keep default rates at the lowest possible level, and these are published daily (right now, they are running 3%). As a result, most applications to borrow are declined (this is good!).

The average rate of interest on the loans is 11%, cheaper than credit cards but more realistic than the Fed’s crazy push for zero. As a result, the average net annualized return is 9.6%.

The focus if of course on small loans for weddings, moving expenses, business startups, debt consolidation and the like. If you are an indebted country with large unfunded liabilities, you probably can’t get a loan. But if you are student with a job who needs upfront money to put down on an apartment, you might qualify.

Dwolla. This is a super-easy, super-slick online payment system that specializes in linking payments through social networks like Facebook and Twitter. Like most of these companies, the idea was hatched in 2008 in response to the crisis. The system was breaking down and needed new services that worked. Dwolla got off the ground in 2009, and today, it processes more than $1 million per week.

An easy way to understand Dwolla is to view it as the next generation of PayPal, but with a special focus on reducing the problem that vexed PayPal in its early years: getting rid of credit card fraud. Dwolla is focussing its product development on ways to pay that do not require sending credit card information over networks.

Dwolla has also taken a strong interest in the Internet payment system called Bitcoin, a digital unit of account that hopes to become an alternative to national monetary systems. It is a long way from becoming that, but it is hardly surprising that a young and innovative company would be interested in competition to failed paper money.

These are a few of the services, but there are hundreds more. None were created by the money masters in Washington. They are results of private innovation, individual entrepreneurs thinking their way through social and economic problems and coming up with solutions. They accept the risk of failure and enjoy the profit from success.

Indeed, as forces of decentralization deepens, we should expect more innovative technology based solutions to emerge and flourish in every industry; finance and money notwithstanding.

China Deepens Liberalization of Capital Markets

I have pointed out that the ongoing tensions in the political spectrum in China may have been ideologically based.

Entrepreneurs in China may have grown enough political clout enough to challenge to the degenerative command and control political structure of the old China order.

And it seems as if the forces of decentralization seem to be getting the upper hand, as China undertakes further liberalization of their capital markets.

From the Bloomberg,

China accelerated the opening of its capital markets by more than doubling the amount foreigners can invest in stocks, bonds and bank deposits as the government shifts its growth model to domestic consumption from exports.

The China Securities Regulatory Commission increased the quotas for qualified foreign institutional investors to $80 billion from $30 billion, according to a statement on its website yesterday. Offshore investors will also be allowed to pump an extra 50 billion yuan ($7.95 billion) of local currency into the country, up from 20 billion yuan

China, the world’s second-biggest economy, has pledged this year to free up control of the yuan and liberalize interest rates as the government deepens reforms to revive growth and offset slowing exports and a cooling housing market. China needs to rely more on markets and the private sector as its export- oriented model isn’t sustainable, World Bank President Robert Zoellick said in February.

Here’s more

The regulator had granted a total of $24.6 billion in quotas to 129 overseas companies since the program first started in 2003 through the end of March. About 75 percent of assets were invested in Chinese stocks, with the rest in bonds and deposits, according to the statement.

The CSRC accelerated the program last month, granting a record $2.1 billion of quotas to 15 companies. It was more than the $1.9 billion in 2011 as a whole.

“The QFII program enhances our experience of monitoring and regulating cross-board investment and capital flows,” the CSRC said in the statement. “It is a positive experiment to further open up the market and achieve the yuan convertibility under the capital account.”

Premier Wen Jiabao is seeking to attract international investment as economic growth cools, prompting the benchmark Shanghai Composite Index to slump 24 percent in the past year. The country posted its largest trade deficit since at least 1989 in February as Europe’s sovereign-debt turmoil damped exports.

China needs to break a banking “monopoly” of a few big lenders that makes easy profits, Wen told private company executives in Fujian province yesterday, as cited by China National Radio.

Breaking up a privileged banking monopoly essentially transfers resources to the productive sector which should serve China well, as well as, serves as welcome and enriching news for Asia and the rest of the world.

And by liberalization of their capital markets, China will become more integrated with the world, and thus diffusing risks of brinkmanship geopolitics, or the risks of military confrontations.

Again such development adds evidence to my theory that the Spratlys tensions may have just been about political leverage or about helping promote indirectly the US arms sales.

Nevertheless, China has yet to face the harmful unintended consequences of her past and present Keynesian bubble policies.

However the long term is key, or far more important. The kind of reforms matters most.

And reforms that deepen economic freedom or laissez faire capitalism (away from state capitalism) in China and the attendant development of capital markets could likely mean that the rest of Asia may follow suit. The implication is that regional and domestic capital will less likely be recycled to the West, and instead would find more productive use at home or a ‘home bias’ for Asian investors.

Moreover, the crumbling welfare states of the west would mean more capital flows into the Asia as savings seek refuge from sustained policies of inflationism.

All these should accentuate my wealth convergence theory.

Of course, China’s strategy to liberalize her capital markets may also represent a move to challenge the US dollar standard.

Recently BRICs officials slammed US and Euro’s monetary “tsunami” policies and in the process has been contemplating to put up their version of a World Bank—joint development bank.

While these gripes have been valid, the latter’s action has little substance. What the other ex-China BRICs should to do is to mimic China’s path to rapidly liberalize their economy and their capital markets.

That’s because societal integration functions as a natural force when commercial activities or economic freedom intensifies.

As the great Ludwig von Mises wrote about the social effects of the division of labor,

Social cooperation means the division of labor.

The various members, the various individuals, in a society do not live their own lives without any reference or connection with other individuals. Thanks to the division of labor, we are connected with others by working for them and by receiving and consuming what others have produced for us. As a result, we have an exchange economy which consists in the cooperation of many individuals. Everybody produces, not only for himself alone, but for other people in the expectation that these other people will produce for him. This system requires acts of exchange.

The peaceful cooperation, the peaceful achievements of men, are effected on the market. Cooperation necessarily means that people are exchanging services and goods, the products of services. These exchanges bring about the market. The market is precisely the freedom of people to produce, to consume, to determine what has to be produced, in whatever quantity, in whatever quality, and to whomever these products are to go. Such a free system without a market is impossible; such a free system is the market.

Capital Markets in the Information Age: P2P Lending

The information age has been bring about changes in the capital markets, I earlier showed crowd funding, now comes a variant, P2P lending

Writes Alex Daley at the Casey Research

It's a new idea but is based on the familiar technologies of the Internet; it's known as peer-to-peer (P2P) lending. The premise is simple: cut the bankers out of the loan market and keep the difference for yourself by making loans directly to other consumers.

I know, that sounds rather risky. When I see my neighbor pull up in his driveway with a shiny new car that I can guarantee costs more than his annual salary, the idea of loaning money directly to other consumers seems a little crazy. However, that's where the real innovation lies. With peer-to-peer lending, an individual investor doesn't make a single $10,000 loan. Instead, he can buy 400 different loans, taking only $25 of risk per loan, for example. Services that offer this option pull together large numbers of investors, who each take a small slice of large numbers of loans, thereby distributing risk much like an index fund. The result is usually a steady and expected rate of return after fees and defaults.

And there are plenty of defaults. Consumer credit is a risky space, after all. With peer-to-peer lending one can choose among unsecured loans only. However, despite what you may have gathered from your last attempts to find a parking space at Home Depot on a Saturday, the majority of people are good. And those good people have a tendency to pay back their loans. As an investor, these P2P services allow you to pick loans by risk category. Credit scores, debt-to-income ratios, income verification, and all the familiar tools of the professional lender are there, allowing you to make decisions about what kind of loans to buy and which to avoid.

This allows individual investors to tailor a portfolio to their own risk tolerance. Whether selecting all the individual loans by hand, or using the bulk investing tools each of the suppliers provide, a portfolio can be built in a variety of ways: from only investing in "A" grade loans with single-digit interest rates and predictably low defaults, to debt-consolidation loans for consumers with much lower credit scores, paying much higher interest but coming with significantly higher defaults as well, and everything in between.

Read more here

The above represents changes in the investment sphere (perhaps some of these companies will be publicly listed someday), as well as, changes in the social dimensions which should impact the political economy: The growth of P2P lending and Crowd Funding will eventually reach a tipping point where it will be seen or becomes a threat to the establishment. And that threat will be met with a feedback mechanism: response-counter response feedback by political authorities and the markets.

Nonetheless the internet has been providing the platform to expedite dramatic and rapid innovation based transformations.