Global Debt Crisis: Rotation from Global Equities ($7.8 trillion losses) to Bonds ($132 billion gains)

The global debt crisis experienced another rotation: Global equity markets posted whopping losses estimated at $7.8 trillion as bonds gained $132 billion.

From Bloomberg, (bold emphasis mine)

The worldwide retreat from stocks and commodities following Standard & Poor’s unprecedented cut of the U.S. AAA credit rating has driven the value of the global bond market to a record high.

The market value of Bank of America Merrill Lynch’s Global Broad Market Index has increased $132.4 billion since the end of July to $42.1 trillion, the most in data going back to 1996. The index, containing more than 19,000 bonds sold by governments, banks and the world’s biggest companies, returned 1.09 percent this month as yesterday’s stock rout wiped out about $2.5 trillion in global equity values, extending total losses since July 26 to $7.8 trillion.

While S&P said the credit worthiness of the U.S. was diminished when it cut the rating to AA+ on Aug. 5, Treasuries have surged. The yield on the benchmark 10-year note dropped today to as low as 2.27 percent, the least since January 2009. Investors are seeking the safest assets amid growing concern that debt crises in the U.S. and Europe and a manufacturing growth slowdown in the world’s two biggest economies may cause the global recovery to falter.

Point is: there always will be a bullmarket somewhere. This functional rotation should also take into the context the actions of gold, the Japanese Yen and the Swiss franc whom have, like bonds, has served as ‘flight to safety’ assets.

Nevertheless, this puts into perspective the negative correlation of bonds and stocks.

Minyanville’s Howard Simons observed of this widening bond-equity correlation in June and wrote,

Interestingly enough a rolling three-month correlation of returns between the two indices shows we are at a level normally visited only during a bear market. As the bonds’ returns are rising and stocks’ have been falling, we must conclude the debt claim on corporate cash has become quite expensive while the equity claim has become cheaper. Who is the starry-eyed cheerleader now?

The present state of affairs can be restated as bond investors over-paying for the perception of safety and stock investors underpaying for a dollar of dividend income. Viewed on this basis, stock investors remain chastened while bond investors are eager participants in a bubble driven by excess financial liquidity.

I add my two cents

Asset correlations changes over time. Negative correlations between bond and equities become pronounced during sharply volatile markets (today-the equity markets).

I guess this correlation should apply with other assets such as gold too. This should give us windows to trade developing correlations or correlation trade.

Next, Mr. Simons’ observations resonates more today than in June where stocks have been heavily oversold while bonds have been sharply overbought.

Finally, if this has truly been about a debt crisis, then both bonds and equities should have been equally in a downturn. Bond vigilantes would have haunted debts of nations whose paying capability has been put to question.

Such dissonant actions tell me that financial markets are either confused (distorted by heavy interventions) or has not been telling us the entire story.

Commodity Currencies as Refuge from Crisis?

“This time is different is a phrase” which I usually loathe. But applied to safehaven or refuge assets during a crisis, “this time has indeed been different” as Gold, the Swiss Franc and the Japanese Yen has replaced the US dollar, as discussed here.

Now a report from Bloomberg says that today’s market rout has seen gains in commodity currencies which may become alternative havens.

The currency havens are disappearing as Switzerland and Japan intervene in foreign-exchange markets, while U.S. and European debt loads undermine credit ratings.

The biggest beneficiaries in the $4 trillion-a-day currency market may be Norway’s krone and the Australia and New Zealand dollars, according to Frankfurt Trust, which oversees about $23 billion. All have debt that is less than 48 percent of gross domestic product, compared with about 60 percent in the U.S., 77 percent in the U.K. and 79 percent in Germany, according to data compiled by Bloomberg.

The Swiss franc and Japanese yen, which had become favorites of traders skittish about holding dollars and euros, became perilous after the Swiss National Bank unexpectedly cut interest rates and Japan sold its currency. The yen weakened as much as 3.2 percent on Aug. 4, according to Bloomberg Correlation-Weighted Indexes. The U.S. came within days of defaulting and Italian and Spanish bond yields approached levels that spurred bailouts of Greece and Ireland.

“You want to stay away from the euro and dollar because this is really an ugly pair and there are alternatives,” Christoph Kind, the head of asset allocation in Frankfurt at Frankfurt Trust, said in a telephone interview last week. “I like currencies like the Australian and New Zealand dollars, the Swedish krona and the Norwegian krone. They are AAA-rated countries with a currency they can manage and handle, and they have pretty liquid markets.”

Charts below from Yahoo Finance

One day does not a trend make.

While Norway krone (NOKUSD) and Sweden’s krona (SEKUSD) are headed up and above yesterday’s close (red horizontal line), this isn’t true with Australia (AUDUSD) and New Zealand’s (NZDUSD) dollar both of whom appear to be rebounding but are significantly below their respective previous closes. Before I forget, the charts above represent a one day window.

Is the Swiss Franc Better than Gold?

For the Economist the answer seems to be a yes

WHEN the going gets tough, investors buy two assets: gold and the Swiss franc. Gold's all-time peak in real terms was in 1980 when inflationary fears were particularly intense. That followed a long period of Swiss-franc strength in the 1970s, which forced the government to impose negative interest rates in a bid to dissuade foreigners from opening bank accounts in the currency. With investors now worried about European sovereign debt and the crisis over the American debt ceiling, it is not surprising that both assets are popular again. Gold has been hitting nominal highs, while the Swiss franc has reached a record in real trade-weighted terms (ie, against the country’s trading partners). The Swiss have both a fiscal and a current-account surplus, a low inflation rate and a relatively low debt-to-GDP ratio.

The Swiss Franc-gold correlation seems to be playing out a cycle.

In the two decades of the gold bear market during the early 80s until the late 90s, the Franc (CHF) has substantially outperformed gold. The middle green circle highlights this phenomenon by exhibiting the widest variance.

However, the recent rally in gold prices has been closing this gap, as shown by the gold ellipse on the right.

In the early 70s we saw a similar gap-closing dynamic by gold. This eventually culminated with gold topping out in the early 80s (red oblong-left).

It can be argued that based on the above chart, where in the stretch of 4 decades the Franc (CHF) has predominated gold, the Swiss currency has indeed been a ‘better’ safehaven option.

And a major additional reason, which the Economist above didn’t cite, is that Switzerland has the largest gold reserves per person (shown below)

Chart from the Economist

In short, the strength of the Franc can partly be attributed to its gold reserves.

Nonetheless, it is unclear if history would repeat or rhyme.

Given that the Swiss Central Bank has shown to be equally susceptible to inflating their currency, as recently prompted for by the Greece crisis, and like any nation operating on the central bank system, I am doubtful of the Franc-gold correlation “returning to the mean”.

This would depend entirely on monetary politics or how the Swiss Central Bank -government would respond to the unfolding events

The gap-closing trend by gold relative to the Franc, as indicated above, can be seen more clearly in this 3 year chart from stockcharts.com.

Bottom line: Since I am leery of central banking whom are prone or inclined to use their vaunted weapon (of money printing), I’d stick to gold.

Post Script:

The Philippine Peso seems no match to the Franc. (chart from Yahoo finance)

This just exhibits how relatively more inflationary the Peso (undergirded by obnoxious Philippine politics) has been.

Sovereign Debt The New Ponzi Finance?

``I have no sympathy for Madoff. But the fact is his alleged Ponzi scheme was only slightly more outrageous than the 'legal' scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds, which Moody's or Standard & Poor's rate AAA, and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn't a pyramid scheme, what is?" Thomas Friedman, The Great Unraveling

As we have earlier exhorted, navigating the rough waters of 2009 markets will be challenging. It is because conventional analysis would have to be sidelined in exchange for the reading of political actions into the pricing system of the marketplace. The traditional scrutiny of earnings and GDP growth will have to pave way for the fundamentally altering risk reward environment motions of political preferences and the unforeseen reactions that such directives may engender.

As PIMCO’s Mohamed El-Erian recently wrote, ``Where does this leave investors? As my colleague Paul McCulley likes to say, only a thin line separates courage from stupidity. Investors should position their portfolios predominantly under the umbrella of government support rather than outside it; they should follow government actions rather than pre-empt them; and they should focus primarily on the senior parts of the capital structure.”

For starters, we understand that governments around the world will jointly be conducting monetary and fiscal programs to arrest the destructive impact of debt deflation and its aftermath. For instance in terms of fiscal measures, some of the reported expenditures earmarked for stimulus programs are (IIF.com): Japan $105 billion or 2% of GDP, European Union $254 billion (1.5% of GDP), Australia $7.4 billion (1% of GDP), China $586 billion (8.9% of GDP), India $4 billion (1.5% of GDP), South Korea $11.3 billion (1.1% of GDP), Chile $2 billion or (1.5% of GDP) and Mexico $5.8 bullion (.8% of GDP). Overall an estimated $3 trillion could be sourced from the markets this year three times that of 2008 (Financial Times).

Yet despite these immense allocations from the fiscal side, yield spreads in benchmark sovereigns of most OECD economies have been dramatically falling to reflect a “flight to safety” (see figure 1).

Figure 1: IIF.com: 10 Year Bonds

And this is not just reflected in nominal yields but likewise in real yields (or inflation adjusted). This means that based on market price signals from today’s bond market, interest rates of major economies are expected to remain low despite the proposed surge of issuance of government bank debt instruments.

To consider, bond yields play a very significant role in the economy as they signify ``an important transmission mechanism through which an easing in monetary policy affects the broader economy” to quote the Institute of International Finance (IIF), the world’s only global association of international financial institutions with some 375 members in 70 countries. Big segments of consumer credit are being benchmarked to these instruments. As the IIF further points out, `As low rates permeate down the yield curve, so they help support activity affected by longer-term rates”. For example, the US mortgage market used to be highly correlated or had been benchmarked from the 10 year bond yields until the emergence of this crisis.

While it is true that today’s bond market “flight to safety” boom favors government’s activities of providing cheaply funded fiscal programs, it is unlikely that the prevailing conditions could be sustained over the long term. As a caveat since we are not in the business of market timing, booms can last until it can’t.

Why? As we have previously stated, the fundamental problem is one of debt overload. Most of the major economies have absorbed far too much debt more than it can afford to sustain. And the subsequent debt deflation preceding the inflationary boom comes with the feedback loop dynamics of regressing and shriveling collateral values, funding or liquidity constraints and a paucity of capital.

With over $30 trillion of stock market capitalization vaporized in 2008, additional enormous losses in other markets (see 2008 Trivia: Lobby, Bailouts and Losses) and most importantly, losses in the financial institutions have now tallied over $1 trillion see figure 2.

Figure 2: IIF: Losses and Capital Raised

According to IIF (bold highlight mine), ``Reported and potential losses have put pressure on bank capital, despite the fact that banks and other financial institutions have raised $930 billion of capital, more than a third of which represents government’s stakes. As a defensive response, banks have conserved their capital and liquidity to be in a position to absorb potential losses, thus reinforcing counterparty risk aversion in drying up interbank transactions. Investors have also pushed banks to raise their capital, not only as measured by their Tier 1 ratio but also the equity/asset ratio. Essentially, until asset markets settle down so that investors can form a clear assessment of potential losses, more capital injection including by governments will not be sufficient to stabilize the banking system.”

As noted by IIF, the mounting losses in asset values as reflected in the financial system losses will likely impel the industry to remain on the defensive by trying to remediate balance sheet impairments than to provide “normalized” business activities or rekindling risk activities. This essentially relegates the burden of providing support of collateral asset values, liquidity constraints and capital provision to the government which ironically depends on taxpayers, or borrowing capacity or the printing press. As clearly manifested in figure 2, the US government have substantially been replacing the private sector as purveyors of such capital.

Yet, in a recessionary environment, which technically means decreasing economic output but factually translates to the market clearing of malinvestments caused by previous inflationary policies, surviving private businesses will likely be safeguarding assets and also be conservative or scrimp on expansion plans while households will likely exercise austerity. Thus, the ability to save should essentially reflect the ability to refinance or reinvest.

But governments aren’t interested about savings. In fact governments are afraid of savings or the so-called misguided popular Keynesian concept of the “paradox of savings” or “paradox of thrift”. What is good for the individual is extrapolated to be bad for the economy, as we discussed in Consumer Deflation: The New Fashion. A weakening economy is always projected on the prism of the slackening of demand which necessitates government’s role to assimilate on such shortcomings. Thus, governments everywhere expect to takeover the role of “inflating” their national economy billed to the taxpayers of the next generation. It is a concept which relies on the principle of SOMETHING for NOTHING based on the virtue of consumption over production. (Why do you think central banks are adopting Zero Interest Rate-ZIRP regimes?)

Proof? From the incoming President Obama [CNNMoney], ``What's required for the economy right now [is] to put more money into the pockets of ordinary Americans who are more insecure about their jobs, who are continuing to see rising costs in an area like health care, who are struggling to make ends meet." Where does one source funding “to put money into the pockets of the masses”?

But if history should serve as guide, the performance of a command driven economy almost always underperforms and produces more dependence on inflationary actions which exacerbates the entire vicious process of inflation-deflation (boom-bust), market-socialism cycles.

As Ludwig von Mises presciently wrote (bold emphasis mine), ``“The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

This is unfortunately true today. As for our politicians and their lackeys, this addiction to spend using taxpayer’s resources, which is construed as an inexhaustible pool, is unsustainable. But like the recent real estate boom bust conditions, unsustainable [boom] trends can’t last, as the popular Herb Stein quote goes, ``If something cannot go on forever it will stop.”

Predicated on the surge of government rescue programs, the IIF views the onrush of government issuance and today’s market pricing as brewing pressure of destabilizing imbalances (bold highlight mine), `` It is hard to reconcile this bond market pricing with economic policies (both monetary and fiscal) designed to stimulate recovery. The inference, of course, is that G10 bond markets have become distorted by extreme conditions under which end investors and financial institutions are desperate for the apparent security offered by government bonds. As a result something of a bubble has developed in these debt markets. The problem with this flight to “quality”, however, is that G10 government bond yields are thus liable to upward correction at some point, either because of credit or inflation concerns (or a bit of both). This implies considerable downside price risk, which could be a new source of financial sector volatility at some point in the future.”

Nonetheless, the basic problem lies squarely with the patent building up of the mismatches between the supply side-availability and accessibility of capital-with the government’s demand for it.

Hence, if global economies recover and risk appetite regains ample groundswell then the safehaven pricing for treasuries will severely be reversed, as money flows will be redirected towards risk assets.

On the other hand, if the leverage absorbed and produced by the governments can’t be sustained or paid for by the revenues generated by the economy or its lack of ability to pay gets reinforced, then the sovereign risks of a credit default could become a reality.

This reminds us of Mr. William Gross’ outlook who recently discoursed about some of the intrinsic Ponzi structures in the US economy, `` Municipalities with begging bowls now extended for over a trillion of Federal taxpayer dollars, based their budgets and their own handouts on the perpetual rise in home prices, the inevitable upward slope of sales taxes, and the never-ending increase in employment and personal income taxes. To add injury to insult, they conveniently “balanced” their books with a host of accounting tricks that Bernie Madoff could never have come up with in his wildest imagination. Now, with cash flow insufficient to meet current outflows, they are proving my point that we have met Mr. Ponzi and he is us – all of us: auto companies that siphoned sales dollars to make labor peace instead of research and design expenditures; hedge funds that preposterously billed investors for 2% and 20% of nothing; a President and politicians who thought they could fight a phony war for free and distract the nation’s attention from $40 trillion of future social security and health care liabilities. Ponzi, Ponzi, Ponzi.”

Yes, sovereign debt has now assumed the new role of Hyman Minsky’s Ponzi financing.

Fundamentals of Credit Default Risks

So the credit default risks from sovereign debt emanates primarily from the debt issuance far outnumbering the pool of available capital, especially in a world where external trade has been shrinking and collateral has been losing value.

Another, any signs of the reemergence of inflation or of a global economic recovery may result to a stampede out of a one sided trade.

Furthermore, government debt will be competing with the private sector debt on a global scale for funding or capital raising, which is likely to lead to a “crowding out” effect. The crowding out effect as defined by wikipedia.org is ``when the government expands its borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit spending), crowding out private sector investment by way of higher interest rates.”

Of course, the “crowding out” phenomenon will only happen once the mechanism of the present global flow of funds diminishes. (We don’t believe that it will reverse because under a US dollar standard system, deficits are the inherent characteristic of the currency reserve economy.) Yet such phenomenon will likely occur as a result of governments working to strengthen their domestic economies, by utilizing their savings and or forex surpluses at home than by undertaking the previous global “vendor financing scheme”.

The crowding out effect, which gives priority to domestic government consumption than to private investment, therefore stifles economic growth. Therefore a world which engages in “nationalist” oriented policies would likely see repressed economic growth.

In addition, if the US Federal Reserve makes good of its threats to close the arbitrage gaps along the yield curve of US treasuries, by manipulating (buying) the long end, which is meant to reduce the incentives for the US banks to hold reserves and compel them to normalize operations (as we discussed in 2009: The Year of Surprises?), then such actions could possibly function as a window for the forex surplus rich major trading partners to “gracefully” exit US treasuries, while at the same time massively expand the balance sheet of the US Federal Reserve (possibly beyond the capacity for its citizenry to finance) and or serve as the bubble “blow-off” which could reintroduce substantial volatility back into the financial markets.

Remember, any drastic upsurge in the interest rates, as indicated by the activities in the US treasuries, will only serve to undo any incremental gains accrued from the recent activities.

Moreover, given the ginormous leverage built into the financial system, a sudden increase in US interest rates will mean higher cost of financing for the US government or for those institutions and virtually the economy on a lifeline which could further undermine its economic recovery path.

As we have earlier said, 2009 could likely be an exciting year, simply because government policy actions risks creating an environment where financial and economic conditions could swing from one extreme end to the other.