Why a US debt default extrapolates to the END of the US dollar hegemony

I previously pointed out from the public choice perspective why a debt default today by the US government is unlikely and has mostly likely been part of the political theatrics in the contest of power.

Politicians will hardly fight for an unpopular cause or principle, particularly against a system deeply hooked on entitlement or dependency programs, which will only cost them their careers and their privileges as political leaders.

The two-day bacchanalia by US equity markets where the Dow Jones Industrial skyrocketed by 434 points or 2.9% is a testament to this chronic addiction to the entrenched debt based entitlement culture. 

There is another major reason why the US the default card serves as another political poker bluff: A debt default extrapolates to the END of the US dollar hegemony.

Writing at the Project Syndicate, economist and political science professor Barry Eichengreen spells out the likely consequences of a US debt default. (hat tip Zero Hedge) [bold mine, italics original]

But a default on US government debt precipitated by failure to raise the debt ceiling would be a very different kind of shock, with very different effects. In response to the subprime disruption and Lehman’s collapse, investors piled into US government bonds, because they offered safety and liquidity – prized attributes in a crisis. These are precisely the attributes that would be jeopardized by a default.

The presumption that US Treasury bonds are a safe source of income would be the first casualty of default. Even if the Treasury paid bondholders first – choosing to stiff, say, contractors or Social Security recipients – the idea that the US government always pays its bills would no longer be taken for granted. Holders of US Treasury bonds would begin to think twice.

The impact on market liquidity would also be severe. Fedwire, the electronic network operated by the US Federal Reserve to transfer funds between financial institutions, is not set up to settle transactions in defaulted securities. So Fedwire would immediately freeze. The repo market, in which loans are provided against Treasury bonds, would also seize up.

For their part, mutual funds that are prohibited by covenant from holding defaulted securities would have to dump their Treasuries in a self-destructive fire sale. Money-market mutual funds, virtually without exception, would “break the buck,” allowing their shares to go to a discount. The impact would be many times more severe than when one money-market player, the Reserve Primary Fund, broke the buck in 2008.

Indeed, the entire commercial banking sector, which owns nearly $2 trillion in government-backed securities – would be threatened.Confidence in the banks rests on confidence in the Federal Deposit Insurance Corporation, which insures deposits. But it is not inconceivable that the FDIC would go bust if the value of the banks’ Treasury bonds cratered.

The result would be a sharp drop in the dollar and catastrophic losses for US financial institutions. Beyond the immediate financial costs, the dollar’s global safe-haven status would be lost.

It is difficult to estimate the cost to the US of losing the dollar’s position as the leading international currency. But 2% of GDP, or one year’s worth of economic growth, is not an unreasonable guess. With foreign central banks and international investors shunning dollars, the US Treasury would have to pay more to borrow, even if the debt ceiling was eventually raised. The US would also lose the insurance value of a currency that automatically strengthens when something goes wrong (whether at home or abroad).

The impact on the rest of the world would be even more calamitous. Foreign investors, too, would suffer severe losses on their holdings of US treasuries. In addition, disaffected holders of dollars would rush into other currencies, like the euro, which would appreciate sharply as a result. A significantly stronger euro is, of course, the last thing a moribund Europe needs. Consider the adverse impact on Spain, an ailing economy that is struggling to increase its exports.

Likewise, small economies’ currencies – for example, the Canadian dollar and the Norwegian krone – would shoot through the roof. Even emerging-market countries like South Korea and Mexico would experience similar effects, jeopardizing their export sectors. They would have no choice but to apply strict capital controls to limit foreign purchases of their securities. It is not inconceivable that advanced countries would do the same, which would mean the end of financial globalization. Indeed, it could spell the end of all economic globalization.

Once the confidence on the US dollar as a global reserve currency collapses, the outcome will be massive protectionism,  a horrific devastation of the global economy, widespread social unrest and worst, this will likely trigger a world war.

But the above doesn’t go far enough. Aside from global central banks taking a hit from their US dollar reserve holdings, the banking system outside the US will also come under duress or face the risks of collapse as the value of US dollar portfolios (reserves, assets and loan exposure) plunge. 

The highly leveraged currency markets itself will likely fail or seize up. The US dollar constitutes 87% of the $5.3 trillion currency market trades a day under today’s circumstances or conditions.

Domestic defaults, considering the  vastly expanded debt levels are likely to explode as financial flows freeze.

This will be compounded by a standstill of trade and economic activities, which should severely affect the the banking system’s loan portfolios.

And the icing in the cake will likely be a crash of financial markets, where financial assets makes up a key part of the banking sector’s balance sheet.

And given the systemic defaults ex-US government bonds are unlikely to function as safehaven too.

As of the 2nd quarter of 2011, US bonds account for 32% of the $99 trillion global bond markets which about half are government bonds.

And there surely will be huge impact on the global derivative market at $633 trillion as of December 2012

In short ramifications from a contagion of a US dollar collapse seems incomprehensibly catastrophic.

Given this scenario, I am not persuaded that ex-US dollar currencies will rise in the face of a US dollar meltdown.

This assumption will hold true only if ex-US banks have been prepared for such a dire scenario which is a remote possibility. 

But the fact that the US dollar remains a major part of the global foreign currency reserve system demonstrates the continued dependency by the world on the US dollar.

The global banking system whose architectural foundations has been built on the US dollar system are likely to disintegrate too along with the US financial system.

In my view, a collapse of the US dollar standard will extrapolate to the destruction of the incumbent paper money standard. The world will be forced to adapt a new currency standard, whether gold will play or role or not is beside the point. 

Yet I would like to add that the US Federal Reserve holds $2.87 trillion of US treasuries according to the weekly updates on the Factors Affecting the Reserve Balances as of October 9th. The accounting entry by the USTs held by the FED are at “face value” which according to them is  “not necessarily at market value”

This also means that the Fed is susceptible huge losses even if the Fed can resort to changes in accounting treatment to evade insolvency.

The bottom line is that if all the FED’s credit easing programs has been meant to shore up the unsustainable debt financed political system anchored on privileges for vested interest groups operating under troika of the welfare-warfare state, crony banking system and the US Federal Reserve, a debt default would essentially negate the FED’s actions, annihilate such political economic arrangements and importantly leads to the loss of the US dollar standard hegemony.

These are factors which the political “power that be” will unlikely gamble with, lest lose their privileges.

Yet given the persistence of the current debt financed deficit spending and other political spending trends, a debt default and a market driven government shutdown signifies as an inevitable destiny.

Global Foreign Exchange Market Now at $4.71 Trillion

Average daily global foreign-exchange turnover has grown to $4.71 trillion according to a Dow Jones Newswires analysis, underscoring how currencies continue attracting liquidity and growing as an asset class despite the uncertain state of the economy.

The Dow Jones estimate, which is higher than the $3.98 trillion daily foreign-exchange number published in the Bank for International Settlements' 2010 report, takes into account official information compiled from Australia, Japan, Singapore, North America and the U.K.--all of which released updated figures Monday.

The Dow Jones numbers also include estimates for trading data from the rest of the world, based on previous BIS annual data. Taken together, the data illustrate how currency flows expanded across the globe over the last year.

That’s according to the Wall Street Journal.

The news didn’t specify the breakdown or the contribution share of the currencies traded.

Nonetheless to me these are:

-Signs of the deepening and growing sophistication of financial markets (growth led by high frequency and retail traders)

-Evidences of growing interconnectedness of financial markets or technology enabled financial globalization

-Symptoms the profusion of liquidity from inflationism (bailouts, QEs and circulation credit)

Market’s Addiction To Inflationism As Seen In The Currency Markets

Exchange-rate policies produce the usual spiral of interventionism: the de facto consequences tend to diverge from the original intentions, prompting further rounds of doomed interventions. This interventionist escalation is not only limited to an incessant repetition of the same failed policies, but the errors committed in one policy area also affect other parts of the economy. Thus, it is only a matter of time until errors of monetary policy lead to fiscal fiascos, and exchange-rate interventions lead to trade conflicts.- Dr. Antony P. Mueller

The markets loudly cheered on Japan’s aggressive engagement of her version of quantitative easing. Even more ecstatically to the joint intervention by the G-7 on the currency market to weaken the Japanese Yen.

As I earlier pointed out, there is little relevance between Japan’s money printing and the containment of the radiation risk[1], as well as, the weakening of the Yen which may, on the contrary, even harm the recovery process, as a weak currency would increase the prices of imports which Japan sorely needs for her public works[2].

Yet this is exactly what I have been driving about since time immemorial, the global financial markets addiction to inflationism.

It’s not clear how effective such interventions work. The last time Japan intervened massively in the currency markets in 2004 (£150 billion[3]) as shown in the above chart[4] the result was an apparent failure.

To add, this week’s market meltdown, despite manifesting some signs of 2008 or across the board selloff, lacked the traditional safehaven features: the US dollar (USD) hardly rallied (red circle below the YEN) while the rally in US treasuries (UST) had likewise been unimpressive!

Meanwhile the Euro (XEU) substantially firmed while the Yen (XJY) soared by 3.3% on Wednesday March 16^th! But the Yen gave up much of its gains on Friday following the G-7 announcement.

Reports say that the repatriation trade has been exaggerated.

According to the Finance Asia[5],

Japanese insurers are well-hedged at about 70% and have huge holdings in government bonds, which they could easily sell if they needed yen. And the industry is reinsured by the government anyway, so there is no shortage of yen in the insurance market.

The repatriation trade is, at best, premature, but the rumour of its existence was enough eventually to tip the market into a forced sell-off yesterday as dollar/yen sank below 80.

Mrs Watanabe, the archetypal Japanese housewife, typically holds a long position in US dollars. By Tuesday, those positions reached an all-time peak and, with dollar/yen parked close to 80, foreign speculators anticipating repatriation flows started to sell in the early hours of yesterday morning as trading moved from New York to Tokyo and liquidity was exceptionally low.

It is unclear if these reports are accurate and dependable, but it would seem that the steep overnight climb of the Yen has been unwarranted.

And thus, the markets natural response has been to sell down the Yen down which apparently has been exacerbated by the G-7 intervention.

Furthermore, critical credit markets hardly budged.

US Cash indices and 3M Libor OIS spread for both the US and the Euro, had seen little signs of anxiety in the face of the meltdown.

All these simply evince of a knee jerk fear premium.

In addition, the European Financial Stability Facility [EFSF] has been reinvigorated which may have given some legs to the Euro. According to the Danske Bank research team[6],

The negative events seem to have overshadowed the positive news that EU leaders agreed on new terms for the EFSF. The lending capacity of the existing facilities has been increased to EUR500bn and the EFSF has been allowed to purchase bonds in the primary market. This could prove a substantial help for Portugal. In addition, the interest rate has been lowered for Greece and the maturity extended after Greece agreed to sell state owned assets worth EUR50bn. The moves by the EU leaders were ahead of market expectations and are positive for peripheral spreads and therefore for the banking sector.

The actions of the Euro have basically been fulfilling what we have been saying throughout 2010[7].

Bottom line:

The current environment has clearly departed from the 2008 episode.

Moreover, like Pavlov’s dogs, financial markets have been elated by inflationism, which only means that current market trends can continue if governments continued to inflate.

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[1] See Japan’s Disaster Recovery Program: Wishing Away Real Problems With A Tsunami of Money, March 15, 2011

[2] See Currency Intervention: Japan And The G-7 Aims To Boost Stock Markets, March 18, 2011

[3] Businss TimesOnline.co.uk Japan ends its £150bn currency intervention as economy firms, March 24, 2004

[4] Shedlock Mish Currency Intervention Madness, Japan Intervenes to Weaken the Yen, September 15, 2010

[5] Finance Asia, Mrs Watanabe, not repatriation, driving yen volatility, March 18, 2011

[6] Danske Bank, Weekly Credit Update, March 18, 2011

[7] See Ireland’s Woes Won’t Stop The Global Inflation Shindig, November 22, 2010; See Buy The Peso And The Phisix On Prospects Of A Euro Rally, June 14, 2010

Deflating The Mythical Powers Of Central Bankers

For those who believe that government officials can do magic, this should be a reality check.

Here is a list of major recent failures of central bank interventionism which Fortune’s Colin Barr commented as having “caused a kerfuffle, much to their citizens' dismay.”

From Mr. Colin Barr:

The Bank of Switzerland. It spent around $200 billion between March 2009 and this past June in a bid to hold down the Swiss franc's appreciation against the euro. How did that work out? The swissie appreciated 10% during that span anyway. "Those are some serious paper losses," said Popplewell. "You'd have to say their big picture strategy hasn't worked out."

The Bank of Japan. It has spent almost $800 billion since 1977 on currency intervention that "seems to have had little lasting effect" on the value of the yen, a 2007 report to Congress concluded. But try try again. And so it is that this month Japan intervened for the first time in six years in a move that was almost universally derided as doomed to fail – particularly since any Fed announcement of QE2-related action would likely send the dollar lower against all currencies.

The Central Bank of Brazil. It has wasted large sums in a forlorn bid to hold down the value of the real over the past year. But setting an example all central bankers are surely taking note of, Finance Minister Guido Mantega said last week the government won't let that stop it from making the same mistake over and over again. "We won't just stand here and watch this game," he said. But the moral of this story might be: Don't just do something, stand there.

Bottom line: Governments recklessly gamble away with OUR money yet FAIL to accomplish the intended goals!

The Inflating Bubble In The Global Currency Markets

The mainstream says there has been NO inflation or inflation hardly poses as a risk.

Unfortunately this view ignores the relative and uneven effects of inflation on the markets and the economies.

Usually, the initial manifestations are seen in the asset markets.

And at present, the currency markets looks like a key absorber of inflationism (aside from US treasuries).

According to the Wall Street Journal,

``The $4 trillion mark represents a 20% gain from $3.3 trillion in 2007, the last time the global foreign-exchange markets were surveyed, according to the Bank for International Settlements. While the survey found continued growth in currency trading, it did reflect a slowdown in the market's growth from the prior survey, when trading volumes had soared 69% from $1.9 trillion in 2004.”

So money printing worldwide seems to be getting a new outlet as more and more people trade a wider dimension of currencies.

Again from the WSJ (bold emphasis mine)

The survey showed how investors are seeking out faster-growing economies and big commodity producers. Trading volume between the U.S. dollar and the Australian dollar rose 35% from 2007, and volume with the Canadian dollar was up 44%. Trading also jumped in the Indian rupee, Chinese yuan and Brazilian real. In contrast, trading in the U.S. dollar against the British pound, a mainstay of the currency markets, fell 6%. Trading in the euro against the dollar rose 23%.

It’s not just globalization of trade, but globalization of asset inflation.

Of course, the US dollar remains as the de facto currency pair of most currency trades.

Again the WSJ (bold highlights mine)

Overall, the U.S. dollar remained the dominant global currency. It accounted for 84.9% of transactions, down from 85.6% in 2007. The euro's share rose to 39.1% from 37%. The share count data add up to 200%, to reflect the fact that there are two currencies in each transaction.

One should note that the trading the currency market means exposing oneself to highly leveraged positions.

The WSJ,

Currently, investors can borrow $100 for every dollar they invest. The Commodity Futures Trading Commission, which regulates foreign-exchange trading in the U.S., tried to cut that amount to $10.

And that again they are mostly used by financial institutions, the WSJ... (bold emphasis added)

The foreign-exchange market is actually a network of bank dealers and electronic-trading systems. At its core are investors or corporations needing to convert one currency into another, either as they buy or sell a stock or bond from another country or bring home profits earned abroad. For example, any time a U.S. investor buys a Japanese stock or a German company buys parts from a Korean supplier, a foreign-exchange trade occurs.

Banks are also heavy users of the currency markets to convert cash they borrow from foreign investors. Mutual-fund managers overseeing portfolios of foreign stocks may use currency derivatives to offset the impact of exchange-rate swings on those investments. And finally, there are speculators, such as hedge funds and mutual funds, who place bets on whether individual currencies will rise or fall.

Derivatives, carry trade and all those sophisticated and complex arbitrages which played a major role in the last bubble bust seems to be a significant contributor to the explosion of the volume trades in the currency markets.

For a broader perspective, the WSJ provides us with a comparison of the currency markets with other financial markets...

The currency market is by far the world's largest financial market. It dwarfs U.S. stock trading, which in April averaged about $134 billion a day, down from a daily average of $148 billion in 2007, according to data compiled by the Securities Industry and Financial Markets Association. Even trading in U.S. Treasurys, among the biggest markets in the world, averaged $456 billion a day in April, down from an average of $570 billion for all of 2007.

Now small investors are increasing their foreign-currency exposure. They are piling into mutual funds which make bets on currencies as a core part of their strategy. More broadly, U.S. stock mutual funds that invest overseas have taken in $42 billion over the past year, according to Morningstar Inc.

So the ingredients of a bubble seem all in place: high leverage, massive interventions, complex instruments and irrational behavior.

External Developments Are Prime Movers of Philippine Markets

``The key to making money in stocks is not to get scared out of them."-Peter Lynch

If there are any lessons learned from the events of last week, it is what we have earlier observed: markets are mostly externally driven and alternatively local ‘political’ activities have less an impact.

And as previously noted[1], ``So I am not as confident of a decoupling until we see more elaborate evidences from this.”

As long as politics revolve around non-financial or market issues, they will likely have lesser influence than from developments in capital markets abroad.

So whether it is political tumult in Thailand where headlines scream “Bangkok Burns”[2] or from the recent electoral finis in the Philippines, it’s been little about local events.

Proof? (see figure 2)

Figure 2: Global Market Rout Spillover To The Phisix And The Peso

When local analysts and media babble about election failure jitters, and where the Peso continues to firm, that would seem like foisting one’s desired opinion as the aura of truth, even in the absence of evidences. This essentially begs the question. It is like observing in a horse race where horse X is ahead of horse Y even if in reality Y is way ahead of X with only a foot away from the tape.

Following the elections everyone seems optimistic about markets due to a change in leadership. In contrast, our upbeatness on the domestic markets emanate from different reasons.

Yet market reaction and political developments appear to be diverging.

Currency Markets Bears The Brunt As The Phisix Remains Resilient

The market rout in the Europe and Chinese markets appears as being transmitted into sundry market channels, most notably through the currency markets.

This week alone, the Philippine Peso fell by a whopping 3.8% (green line in the chart), which seems like a prayer answered to a local exporting group, whom has been calling for a 46 to a US dollar level!

Unfortunately for this myopic exporting group, if markets continue to stumble as reflected on the falling Peso, a lower peso won’t translate to ‘better business’ or added demand simply because markets appear to be suggesting exactly the opposite--a prospective fall in demand, hence reflected on the fall in the Peso.

In short, this may be called as the return of risk aversion—for the moment.

Mainstream must be wondering, with a newly elected “People Power” president why the sudden stampede away from the Peso? The answer is that elections have had little influence on the markets.

Yet this isn’t just a Peso phenomenon. Asian’s currencies were mostly in a swan dive; the Korean won crashed by 8.6%, the Malaysian ringgit 4%, New Zealand dollar and the Australian Dollar 4% and 6% respectively. And only the Thai baht seemed little changed this week in spite of the Bangkok burning event.

As you can see above, the S&P 500 (blue line) plummeted by 4.23% this week after the ugly plunge 3.8% last Thursday. From a peak to trough basis the S&P has lost some 10.7% based on Friday’s close.

Meanwhile, the Philippine Phisix lost 4.54% over the week. One peculiar behaviour has been that the Phisix fell by only 1% in reaction to the hefty over 3.5% decline in the US, last Thursday. Moreover, the Phisix is down 4.54%, following a newly established high or zenith the other week. This compared to the 10% decline, from the peak in the US markets, last end of April.

While one week doesn’t a trend make, the seeming resiliency seen in the local market relative to the Phisix can be traced to a shift in dominance in terms of transactions from foreign to the locals. This has been the case since 2009 (see figure 3)

Figure 3: PSE: % Share Of Foreign Trade

The red line marks the 50% threshold. In 2008, most transactions have been dominated by foreigners, this changed in 2009 where most transactions have been shown below the trend line.

So while we don’t believe that there will be a decoupling yet, continued marked improvements like this could function as a foundation.

Nevertheless, this implies that the state of international markets remain as key factors in ascertaining local trends or even individual local issues.

The idea that corporate fundamentals will defy general trends seems like a misconception. Even the deeper and more sophisticated US markets seem to be showing the same symptoms[3], where tidal fluxes shape psychology and affect individual issues which eventually determines the general state of the markets.

So unless we can establish that global markets are not headed for a free fall, only from then can we work on the significance of micro dynamics.

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[1] See Phisix: The Philippine Presidential Honeymoon Cycle Is On

[2] See Politics And Markets: Bangkok Burns Edition

[3] See More Evidence On Liquidity Driven Markets

Welcome To The Mises Moment

``We have seen that each new control, sometimes seemingly innocuous, has begotten new and further controls. We have seen that for governments are inherently inflationary, since inflation is a tempting means of acquiring revenue for the State and its favored groups. The slow but certain seizure of the monetary reins has thus been used to (a) inflate the economy at a pace decided by government; and (b) bring about socialistic direction of the entire economy. Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocs. In short, we find that coercion, in money as in other matters, brings, not order, but conflict and chaos.”-Murray Rothbard, What has Government Done To Our Money

No investor today can rely on traditional metrics to ascertain investment themes since the financial markets have been living on government steroids.

Government has fundamentally usurped the role of gods as they determine the winners or the losers or which industries or businesses deserve to live or perish.

Such evolving shift towards the consolidation and expansion of government’s power in the marketplace or ‘state capitalism’ will mold a new risk environment from which will determine risk capital’s rate of return and how capital resources would be deployed overtime.

Yet most of the current policies applied are designed to impact immediate concerns and appear to be shrouded with unintended consequences. Hence, any serious investor would need to read into government actions and project their repercussions to the investing sphere.

Government actions today appear to be in unison with the goal to combat threats of “deflationary” recession. The collective belief is that the slack in ‘demand’ prompted by falling asset prices will induce the public to hold onto cash instead of generating consumption via the restoration of the credit cycle.

Thus government policies led by the US appear to be directed at patching up the lapses from an imploding bubble.

The Bernanke Doctrine

The direction of policy actions or what I would call as the ‘Bernanke doctrine’ has been telegraphed to the public since 2001 and has been his deflation fighting manual. I guess most central bankers have adopted his strategy so the seeming “collaborative” and “concerted” efforts.

The US Federal Reserve recently cut interest rates from a fixed target to range between 0 and ¼% which it expects to hold “for sometime”. And now that the US central bank has moved rates to near zero level (Zero Interest Rate Policy-ZIRP), which leaves them limited room to use interest rate as ammunition, they are left with the terminal option of balance sheet management. The Fed recently announced that they would:

1) purchase assets directly from the market- “will purchase large quantities of agency debt and mortgage-backed securities” and “evaluating the potential benefits of purchasing longer-term Treasury securities”,

2) provide credit directly- “will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses” and

3) expand the use of the printing press “consider ways of using its balance sheet to further support credit markets and economic activity”.

Notice that these endgame tactics involve the short circuiting the banking system which basically has not been different from Zimbabwe’s Dr. Gideon Gono’s strategy of using the printing presses aided by the an expansive government.

The aforementioned FED monetary policies, combined with the present fiscal package and the purported $850 billion inaugural program for the incoming President Barack Obama, which are allegedly aimed at jumpstarting the economy, seems headed for such direction.

And the buck doesn’t seem to stop here.

``The biggest fear is that people will do too little…like a start-up that fails because it didn't do enough”, the Wall Street Journal quotes an anonymous Democratic leadership aide on President Obama’s inaugural stimulus program.

This captures what we’ve been saying all along…political motives will shape policy decisions more than economic concerns. Officials will use the cover of popular demand to continually spend taxpayer money organically meant to keep afloat its US dollar standard fractional banking system even to the point where Ben Bernanke could resort to the nuclear option of the printing press based currency devaluation to inflate away the unsustainable debt levels.

The desire to print money to solve economic ailments can only lead to further financial or economic disorders.

Bernanke’s Asymmetric Playing Field

Yet the shift from interest rate to balance sheet or money supply management policy comes with many unknown effects.

One, the directives of US monetary policy seems to revolve heavily towards Ben Bernanke. This makes him, unknowingly to the public, the most powerful man in the world, an unelected official. Remember, the world operates around the US dollar standard system from which Bernanke’s clout has been strengthening.

As we pointed out in Is Ben Bernanke Turning The US Federal Reserve Into A Dictatorship?, the concentration of powers towards the center, by bypassing legal requirements or procedures and circumventing organizational hierarchy in the decision making process, could signify as consequence to the ongoing policy directional shift from ZIRP to the money supply.

According to Economist Bob Eisenbeis of Cumberland Advisors, ``The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC”, and since balance sheet management involves day to day decisions ``it is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.” Thus, the FOMC would probably be “mothballed” until ``the return of normalcy to policy formulation.” This explains the rational behind the apparent arrogation of power by Ben Bernanke.

Thus, the fate of the US and the world’s financial system (markets and banks) and even the economies now resides in the palms of Mr. Bernanke, see figure 1; ironically the same person who wrongly predicted the containment of the subprime crisis.

Figure 1: Cato.org: US Credit Triangle

Two, informational changes in the size and composition of the balance sheet or Bernanke’s present actions will be critical to market participants. The assets which the Fed buys today or in the future will give undue advantage over the assets it won’t be buying. Thus the fate of the markets depends on Mr. Bernanke’s biases, values or priorities (marginal utility). As we always say, inflationary policies always favor those with closest ties to the government.

Three, since the Fed relies on 17 primary dealers (including some foreign affiliates) to implement its purchasing activities, the said institutions will have “real informational advantage” (since they have access to Fed activities) or an information asymmetric edge over most market participants. Essentially, such developments makes markets today tilted towards an insider’s game.

In all, Ben Bernanke has altered the global financial market’s landscape into a casino like environment by playing with a loaded the dice, constantly changing of rules in the middle of the game to suit his predispositions and fostering an uneven playing field-where he assumes the role of the house. His newly assimilated omnipotent powers will likely shape world markets, economies or even implicitly political developments which could be laden with a minefield of unforeseen consequences. Hence, the risks are that policy mistakes made by omission or by commission will exacerbate further suffering to the world.

Global Central Banks Adopt The Bernanke Doctrine

The switch from interest rates to balance sheet policy management isn’t a development restricted to the US as Japan and Switzerland has also joined the trend of consolidating central bank power to wrench open the spigot of money supply with the goal to “stimulate” their respective economies.

The Bank of Japan (BoJ) cut rates from .3% to .1% last week and declared that it would increase purchases of government bonds, including inflation-linked bonds, floating rate bonds and 30-year bonds, aside from commercial paper. It will likewise consider buying corporate debt products (forextv.com).

The Swiss National Bank (SNB) also slashed rates by half a percentage point, last week, from 3-month Swiss franc LIBOR rate of 0.50-1.50 percent to 0.00-1.00 percent, its fourth cut in two months.

With policy rates at zero levels, the SNB is said to consider “quantitative easing” (running printing press) through unsterilized currency intervention by possibly buying ``Swiss franc bonds to lower borrowing costs or try to weaken the franc either by verbal or physical intervention.” (IHT.com).

According to Morgan Stanley’s Joachim Fels (highlight mine), ``the may choose to implement QE partly through unsterilised currency intervention, i.e., buying foreign currency without offsetting the impact on their balance sheet through open-market sales of other assets. The reasoning behind this is that for small open economies like Switzerland, the exchange rate is a more important driver of the economy than mortgage rates or other interest rates, and in the case of Japan, currency intervention might help to stem the recent sharp appreciation of the yen.”

Both the SNB and BoJ basically will be utilizing the same Bernanke’s textbook approach!

So as global central banks become more desperate they are likely to resort to their home printing presses aimed at devaluing their currency against everyone else. This raises the risk of a currency war or a tumultuous upheaval in the present monetary system, especially when Mr. Bernanke opts for the nuclear option.

Again this reminds as again of Ludwing von Mises who presciently wrote in Human Action, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

The currency markets will be the natural release valve for all these accrued government actions in 2009.

Welcome to the Mises Moment.

Currency Markets 101: FX Swaps and Cross-currency basis swap

One of the objectives of this blog is to spread financial literacy.

And considering the growing sophistication of financial markets, market participants may have learn, understand and perhaps consider using some of the available diverse tools to hedge on risks aimed at enhancing corporate returns or at financing investments.

This week we feature basics of FX Swaps and Cross-currency basis swaps which we will excerpt from a working paper by the Bank of International Settlements entitled “Price discovery from cross-currency and FX swaps: a structural analysis”

Note this is different from the US Federal Reserve instituted Swap lines as we discussed in How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets.

All highlights mine…

1. Cross-currency basis swap

There are numerous types of cross-currency swap contracts, among which the most widely used in recent years is a type of contract named the cross-currency basis swap. A typical cross-currency basis swap (hereafter “currency swap”) agreement is a contract in which Japanese banks borrow U.S. dollars (USD) from, and lend yen (JPY) to, non-Japanese banks simultaneously. Figure 1(i) illustrates the flow of funds associated with this currency swap. At the start of the contract, bank A (a Japanese bank) borrows X USD from, and lends X× S JPY to, bank B (a non-Japanese bank), where S is the FX spot rate at the time of contract. During the contract term, bank A receives JPY 3M LIBOR+α from, and pays USD 3M LIBOR to, bank B every three months. When the contract expires, bank A returns X USD to bank B, and bank B returns X× S JPY to bank A. At the start of the contract, both banks decide α, which is the price of the basis swap. In other words, bank A (B) borrows foreign currency by putting up its home currency as collateral, and hence this swap is effectively a collateralised contract.

These currency swaps have been employed by both Japanese and non-Japanese banks to fund foreign currencies, for both their own and their customers’ account, including multinational corporations engaged in foreign direct investment. Currency swaps have been also used as a hedging tool, particularly for issuers of so-called Samurai bonds, which are JPY-denominated bonds issued in Japan by non-Japanese companies. By nature, most of these transactions are long-term, ranging from one year to 30 years.

Illustration by BIS

2. FX swap

A typical FX swap agreement is also a contract in which Japanese banks borrow USD from, and lend JPY to, non-Japanese banks simultaneously. The main differences from the currency swap are that: (i) during the contract term, there are no exchanges of floating interest between JPY and USD rates; and (ii) at the end of the contract, the different amount of funds is returned compared with the amount exchanged at the start.

Figure 1(ii) illustrates the flow of funds associated with the FX swap. At the start of the contract, bank A (Japanese bank) borrows X USD from, and lends X × S JPY, to bank B (non-Japanese bank), where S is the FX spot rate at the time of contract. When the contract expires, bank A returns X USD to bank B, and bank B returns X × F JPY to bank A, where F Is the FX forward rate as of the start of contract. As is the case with currency swaps, FX swaps are effectively collateralised contracts.

FX swaps have been employed by both Japanese and non-Japanese banks for funding foreign currencies, for both their own and their customers’ account, including exporters, importers, and Japanese institutional investors in hedged foreign bonds. FX swaps have also been used for speculative trading. The most liquid term is shorter than one year, but in recent years, transactions with longer maturities have been actively conducted for purposes such as foreign currency funding for corporate direct investments and arbitrage activities with crosscurrency swaps. In fact, many market participants point out that the liquidity of FX swaps with maturities longer than one year has improved during the past several years.