Global Equity Meltdown: Political Actions to Save Global Banks

“However, hanging onto money is highly risky in a time of monetary inflation. The security-seeker does not understand this. Keynesian economists do not understand this. Politicians do not understand this. The result of inflationary central bank policies is the production of uncertainty in excess of what the public wants to accept. But the public does not understand Mises' theory of the business cycle. Voters do not demand a halt to the increase in money. It would not matter if they did. Central bankers do not answer to voters. They also do not answer to politicians. "Monetary policy is too important to be left to politicians," the paid propagandists called economists assure us. The politicians believe this. Until the crisis of 2008, so did voters.” Professor Gary North

Local headlines blare “Global stocks gyrate wildly; sell-off resumes in markets”[1]

To chronicle this week’s action through the lens of the US Dow Jones Industrial Average (INDU), we see that on Monday August 8th, the major US bellwether fell 635 points or 5.5%. On Tuesday, the INDU rose 430 points or 4%. On Wednesday, it fell 520 points 4.6%. On Thursday, it rose 423 points or 3.9%. The week closed with the Dow Jones Industrials up by 126.71 points or 1.13% on Friday.

All these wild swings accrued to a weekly modest loss of 1.53% by the Dow Jones Industrials.

Some ideologically blinded commentators argue that these had been about aggregate demand. So logic tell us that aggregate demand collapsed on Monday, jumps higher on Tuesday, tanked again on Wednesday, then gets reinvigorated on Thursday and Friday? Makes sense no?

How about fear? Fear on Monday, greed on Tuesday, fear on Wednesday, and greed on Thursday and Friday? Do you find this train of logic convincing? I find this patently absurd.

Confidence doesn’t emerge out of random. Instead, people react to changes in the environment and the marketplace. Their actions are purposeful and seen in the context of incentives (beneficial for them).

And that’s why many who belong to the camp of econometrics based reality gets wildly confused about the current developments where they try in futility to fit only parts of reality into their rigid theories.

And part of the realities that go against their beliefs are jettisoned as unreal.

So by the close of the week, these people end up scratching their heads, to quip “weird markets”.

Weird for them, but definitely not for me.

Political Actions to Save the Global Banking System

Yet if there has been any one dynamic that has been proven to be the MAJOR driving force in the financial markets over the week, this has been about POLITICS, as I have been pointing out repeatedly since 2008[2].

I am sorry to say that this has not been about aggregate demand, fear premium, corporate profits, conventional economics or mechanical chart reading, but about human action in the context of global policymakers intending to save the cartelized system of the ‘too big to fail’ banks, central banks and the welfare state.

As I pointed out last week[3],

Important: The US has been downgraded by the major credit rating agency S&P after the market closed last Friday, so there could be an extended volatility on the global marketplace at the start of the week. This largely depends if such actions has already been discounted. The first thing on Monday is to watch Japan’s response.

The S&P’s downgrade tsunami reached the shores of global markets on Monday, where the US markets crashed by 5.5%.

It is very important to point out that the market backlash from the downgrade did NOT reflect on real downgrade fears, where US interest rates across the yield curve should have spiked, but to the contrary, interest rates fell to record lows[4]!

And as also correctly pointed out last week, the US Federal Reserve’s FOMC meeting, which was held last Tuesday, introduced new measures aimed at containing prevailing market distresses.

The FOMC pledged to:

-extend zero bound rates until mid-2013, amidst growing dissension among the governors,

-maintain balance sheets by reinvesting principal payments of maturing securities,

and importantly, keep an open option to reengage in asset purchases[5].

Some have argued that the Fed’s policies has essentially been a stealth QE, as the steep yield curve from these will incentivize mortgage holders to refinance. And this would spur the Fed to reinvest the proceeds.

According to David Schawel[6],

A surge of refinancing will reduce the size of the Fed’s MBS holdings and allow them to re-invest the proceeds further out the curve

The Fed’s announcement on Tuesday, basically coincided or may have been coordinated with the European Central Bank’s purchases of Italian and Spanish bonds or ECB’s version of Quantitative Easing. The combined actions resulted to an equally sharp 4% bounce by the Dow Jones Industrials.

Mr. Bernanke has essentially implemented the first, “explicit guidance” on Fed’s policy rates, among the 3 measures he indicated last July 12th[7].

The resumption of QE and a possible reduction of the quarter percentage of interest rates paid to bank reserves by the US Federal Reserve signify as the two options on the table.

My guess is that the gradualist pace of implementation has been highly dependent on the actions of the financial markets.

I would further suspect that given the huge ECB’s equivalent of Quantitative Easing or buying of distressed bonds of Italy and Spain, aside Ireland and Portugal, estimated at US $ 1.2 trillion[8], team Bernanke perhaps desires that financial markets digest on these before sinking in another set of QEs.

And to consider that US M2 money supply[9] has been exploding, which already represents a deluge of money circulating in the US economy, thus, the seeming tentativeness to proceed with more aggressive actions.

Wednesday saw market jitters rear its ugly head, as rumors circulated that France would follow the US as the next nation to be downgraded[10]. The US markets cratered by 4.6% anew.

On Thursday, following an earlier probe launched by the US Senate on the S&P for its downgrade on the US[11], the US SEC likewise opened an investigation to a possible insider trading charge against the S&P[12].

Obviously both actions had been meant to harass the politically embattled credit rating agency. The possible result of which was that the S&P joined Fitch and Moody’s to affirm France’s credit ratings[13].

To add, 4 Euro nations[14], namely Italy, Belgium, France and Spain has joined South Korea, Turkey and Greece[15] to ban short sales. A ban forces short sellers to cover their positions whose buying temporarily drives the markets higher.

These accrued interventions once again boosted global markets anew which saw the INDU or the Dow Industrials soar by 3.9%.

Friday’s gains in global markets may have been a continuation or the carryover effects of these measures.

Unless one has been totally blind to all these evidences, these amalgamated measures can be seen as putting a floor on global stock markets, which essentially upholds the Bernanke doctrine[16], which likewise underpins part of the assets held by the cartelized banking system and sector’s publicly listed equities exposed to the market’s jurisdiction.

Thus, like 2008, we are witnessing a second round of massive redistribution of resources from taxpayers to the politically endowed banking class.

Gold as the Main Refuge

AS financial markets experienced these temblors, gold prices skyrocketed to fresh record levels at over $1,800, but eventually fell back to close at $1,747 on Friday, for a gain of $83 over the week or nearly 5%.

From the astronomical highs, gold fell dramatically as implied interventions had been also extended to the gold futures markets. Similar to the recent wave of commodity interventions, the CME steeply raised the credit margins of gold futures[17].

We have to understand that gold (coins or bullions) have NOT been used for payments and settlements in everyday transactions. So gold cannot be seen as fungible to legal tender imposed fiat cash (for now), even if some banks now accept gold as collateral.[18]

In an environment of recession or deleveraging—where loans are called in and where there will be a surge of defaults and an onrush of asset liquidations to pay off liabilities or margin calls, fiduciary media (circulating credit) will contract, prices will adjust downwards to reflect on the new capital structure and people will seek to increase cash balances in the face of uncertainty—CASH and not gold is king. Such dynamic was highly evident in 2008 (before the preliminary QEs).

Thus, it would signify a ridiculous self-contradictory argument to suggest that record gold prices has been manifesting risks of ‘deflation’.

Instead, what has been happening, as shown by the recent spate of interventions, is that for every banking problem that surfaces, global central bankers apply bailouts by massive inflationism accompanied by sporadic price controls on specific markets.

Alternatively, this means that record gold prices do not suggest of a fear premium of a deflationary environment, but instead, a possible fear premium from the prospects of a highly inflationary, one given the current actions of central banks.

This panic-manic feedback loop or in the analogy of Dr. Jeckll and Mr. Hyde’s “split personality” which characterizes the global markets of last week has been materially different from the 2007-2008 US mortgage crises.

Not only has there been a divergence in market response across different financial markets geographically (e.g. like ASEAN-Phisix), the flight to safety mode has been starkly different.

The US dollar (USD) has failed to live up to its “safehaven” status, which apparently has shifted to not only gold but the Japanese Yen (XJY) and the gold backed Swiss Franc (XSF).

It’s important to point out that the franc’s most recent decline has been due to second wave of massive $55 billion of interventions by the SNB during the week. The SNB has exposed a total of SFr120 billion ($165 billion!) over the past two weeks[19]. The pivotal question is where will $165 billion dollars go to?

Bottom line:

This time is certainly different when compared to 2008 (but not to history where authorities had been predisposed to resort to inflation as a political solution). While there has been a significant revival of global market distress, market actions have varied in many aspects, as well as in the flight to safety assets.

This implies that in learning from the 2008 episode, global policymakers have assimilated a more activist stance which ultimately leads to different market outcomes. Past performance does not guarantee future results.

The current market environment can’t be explained by conventional thinking for the simple reason that markets are being weighed and propped up by the actions of political players for a political purpose, i.e. saving the Global Banks and the preservation of the status quo of the incumbent political system.

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[1] Inquirer.net Global stocks gyrate wildly; sell-off resumes in markets, August 12, 2011

[2] See Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?, November 30, 2008

[3] See Global Market Crash Points to QE 3.0, August 7, 2011

[4] See Has the S&P’s Downgrade been the cause of the US Stock Market’s Crash?, August 9, 2011

[5] See US Federal Reserve Goes For Subtle QE August 10,2011

[6] Schawel, David Stealth QE3 Is Upon Us, How Ben Did It, And What It Means Business Insider, August 9, 2011

[7] See Ben Bernanke Hints at QE 3.0, July 13, 2011

[8] Bloomberg, ECB Bond Buying May Reach $1.2 Trillion in Creeping Union Germany Opposes, August 8, 2011

[9] FRED, St. Louis Federal Reserve, M2 Money Stock (M2) M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs). Seasonally adjusted M2 is computed by summing savings deposits, small-denomination time deposits, and retail MMMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

[10] The Hindu, Fears of France downgrade trigger massive sell-off in Europe, August 11, 2011

[11] Bloomberg.com U.S. Senate Panel Collecting Information for Possible S&P Probe, August 9, 2011

[12] Wall Street Journal Blog SEC Asking About Insider Trading at S&P: Report, August 12, 2011

[13] Bloomberg.com French AAA Rating Affirmed by Standard & Poor’s, Moody’s Amid Market Rout, August 11, 2011

[14] USA Today 4 European nations ban short-selling of stocks, August 11, 2011, see War against Short Selling: France, Spain, Italy, Belgium Ban Short Sales, August 12, 2011

[15] Business insider 2008 REPLAY: Europe Moves To Ban Short Selling As Crisis Spreads, August 11, 2011, also see War Against Market Prices: South Korea Imposes Ban on Short Sales, August 12, 2011

[16] See US Stock Markets and Animal Spirits Targeted Policies, July 10, 2010

[17] See War on Gold: CME Raises Credit Margins on Gold Futures, August 11, 2011

[18] See Two Ways to Interpret Gold’s Acceptance as Collateral to the Global Financial Community, May 27, 2011

[19] Swissinfo.ch Last ditch defence of franc intensifies, August 10, 2011

War against Short Selling: France, Spain, Italy, Belgium Ban Short Sales

Regulators/Policymakers maintain a delusion of control.

From Bloomberg, (bold highlights mine)

France, Spain, Italy and Belgium will impose bans on short-selling from today to stabilize markets after European banks including Societe Generale SA hit their lowest level since the credit crisis.

“While short-selling can be a valid trading strategy, when used in combination with spreading false market rumors this is clearly abusive,” the European Securities and Markets Authority, which coordinates the work of national regulators in the 27- nation European Union, said in a statement after talks ended late yesterday. National regulators will impose the bans “to restrict the benefits that can be achieved from spreading false rumors or to achieve a regulatory level playing field.”

The watchdogs are trying to stem a rout that sent European bank stocks to their lowest in almost 2 1/2 years and quell concern that European lenders may be struggling to fund themselves. Banks’ overnight borrowings from the European Central Bank jumped to the highest in three months yesterday, a sign some lenders may have need for emergency cash. Regulators imposed similar limits on short sales in September 2008 following the collapse of Lehman Brothers Holdings Inc.

Politicians and regulators want you believe that prices can be fixed by edict or fiat.

They make you believe that a worthless or junk piece of security should have value because they say so.

The countries planning to impose the ban on short sales have all seen their stock prices crashing.

Essentially France (CAC; orange), Spain (MADX; green), Italy (FTSEMB; light orange) and Belguim (BEL20; red) have been in bear market territories. The performance or % yield from the above chart is seen from the year-to-date perspective. This means that the above does not reflect on the peak-trough returns, which should amplify the degree of losses.

As I pointed out in the same recent case as Korea:

1. Bans hardly have been effective. Instead they are mostly symbolical as the “need to be seen as doing something”

2. Regulators react almost always too late in the game (which means that their markets may be at the process of nearly bottoming out.)

3. I would further add current policies have clearly or overtly been in support of the banking system and the stock market.

4. This only validates the theory that the policy direction of governments and global central bankers has primarily been anchored upon the Bernanke ‘crash course for central bankers’ doctrine of saving the stock market.

5. Importantly, applied policies have been meant to preserve the tripartite cartelized system of the welfare state, central banks and the crony banking system.

Where are Germany’s Gold’s Reserves?

That’s essentially the question posed by James Turk of Gold Money below

Mr. Turk writes,

This gold has been entrusted to the Bundesbank and provides peace of mind knowing that it is there. But where is it really? And just as important, how much is there? Unfortunately, we do not know the answer to these questions.

The Bundesbank’s latest Annual Report states: “As of 31 December 2009, the Bundesbank’s holdings of fine gold (ozf) amounted to 3,406,789 kg or 110 million ounces. The gold was valued at market prices at the end of the year (1 kg = €24,638.63 or 1 ozf = €766.347).” The total value therefore reported by the Bundesbank on its balance sheet is €83,939 million. There have been, however, repeated claims suggesting that the Bundesbank's gold vault is empty. The reporting by the Bundesbank in its Annual Report does nothing to disprove these claims.

The Annual Report states that the Bundesbank owns €83,939 million of “Gold and Gold Receivables”. Surprisingly, it does not distinguish between these two fundamentally different assets, nor does it report how much of each it owns.

Clearly, gold stored safely and securely in the Bundesbank’s vault in Frankfurt has a different level of risk than gold that has been loaned out. Physical gold is a tangible asset, and therefore does not have counterparty risk. But a loan – regardless whether you are lending euros, dollars or gold – is only as good as the creditworthiness of the borrower. This lesson was learned the hard way, for example, by the central bank of Portugal. It had loaned gold to Drexel Burnham Lambert, and that gold receivable was still outstanding when this bank failed two decades ago.

By not reporting “gold in the vault” and “gold receivables” separately as two different assets, the Bundesbank is saying in effect that cash and accounts receivables are the same thing. Of course they are not, and their fundamental difference is made clear by Generally Accepted Accounting Principles, which highlights a deficiency in the Bundesbank’s Annual Report.

Are central banks being transparent? Or has central banks been using accounting entries to fudge their actual gold reserve holdings? Or to the point, has major central banks, as the Bundesbank (and Belgium), been short gold (via gold leasing)?

To me, these represent as more signs of the growing fissures of the paper money system. And fresh record prices of gold attest to such development.

War on Speculators: Restricting Short Sales on Sovereign Debt and Equities

How does government resolve the problem of their profligacy? Well, blame the speculators (a.k.a. markets)!

From the Wall Street Journal

European Union finance ministers Tuesday reached an agreement on rules limiting short-selling of shares and sovereign debt, overcoming concern from the U.K. that the legislation will give the EU's new securities regulator too much power.

The ministers must now negotiate a final version of the legislation with lawmakers at the European Parliament, which favors broader rules that would also cover short sales of credit default swaps linked to sovereign debt.

France and Germany in particular have blamed short-selling of sovereign debt for having exacerbated the euro-zone debt crisis, though regulators say there is little evidence that trading activity has caused the yields of Greek, Irish and Portuguese bonds to soar in the past year.

These has been a continuing motion to pass the blame on everyone else in what truly represents as the unintended adverse consequences of past policies.

Will The Proposed Ban of Short Sales Support Global Markets?

The US SEC is said to be contemplating to impose a temporary ban on short selling (CBS).

A ban on short selling is another form of price control. How? Because short selling to quote Gary Galles of Mises.org, “increases the number of people with an incentive to discover valuable information about firms' prospects, by providing an added mechanism to benefit from information that turns out to be negative. When someone's research or information leads them to negative conclusions about a firm, short selling allows them to communicate their less optimistic expectations to others and make a profit if they anticipate the direction the market will later come to agree with. That is, they profit only if they come to "correct" conclusions before others. In the process, they benefit others by revealing accurate information sooner than would otherwise be the case, reducing the mistakes people would have made from relying on the less accurate prices that would otherwise exist.” In short, a ban on short selling, attempts to inhibit price discovery.

It could be also seen as a form of “market manipulation” except that it is done by governments.

Of course, because curbing short selling means covering all existing short positions, the initial impact would be for the markets to soar. However, like in the recent example, where the US SEC banned short selling on 19 financial stocks last July 21^st,(but announced on July 16^th)…

Short term gain-long term woes

...the "soothing" effects proved to be temporary- for the Dow Jones Industrials, bank, financial and broker indices. Eventually market forces reasserted themselves by exposing the fallacies of camouflaging inherent weaknesses of why these stocks /market have been falling in the first place.

We never seem to learn.

The issue here is about financial system “insolvency” in the US and a ban on short sales will be a quick fix which is likely to only prolong the agony.

Will King Dollar Reign Amidst Global Deflation?

``Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.- John Stuart Mill (1806-1873) British philosopher, political economist, civil servant and Member of Parliament, was an influential liberal thinker of the 19th century.

Deflation proponents have been confidently increasing their pitch of a global depression or “severe and prolonged” recession cheering about the US dollar’s recent gains as signs of such manifestation.

Since the US credit system has turned disorderly and dysfunctional, it is true that an alternative major flux for global “liquidity” stems from the US current account deficit. And an improving US current account deficit suggests of a further drain of liquidity AWAY from the global financial system, thus amplifying risk towards the financial markets.

Deflation proponents emphatically argue that the strength of the US dollar stems from (factually) the US dollar’s role as the de facto world currency reserve and secondarily from its sophisticated, deep and advanced state of the markets that are likely to attract “limited” capital flows away from the hinges and back to the center or the origin. Hence a global meltdown extrapolates to KING dollar reasserting its hegemonic role in the international monetary sphere.

Global Liquidity Story Isn’t Exclusively A US Dollar Issue

The US dollar’s role as the nonpareil currency reserve of the world is yet incontrovertible, meaning the US still maintains its lead position among the other currencies as the elected currency benchmark (or reserves) for central banks.

BUT its leadership isn’t at all the monopoly it once used to be. And this is the important difference: the Euro has incrementally been expanding a material foothold in the share of the composition of the currency reserve market especially in the context of developing countries or emerging markets.

From the IMF’s September 2007 survey (emphasis mine),

``Data reported to the IMF by industrial and developing (nonindustrial) countries, compiled on an aggregate basis in the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) database, reveal that more developing countries than industrial countries have switched holdings into euros. Nonindustrial countries hold some 30 percent of their reserve assets in euros and 60 percent in dollars (as of December 2006), compared with 19 percent and 70 percent, respectively, six years earlier.

``Industrial countries' use of the euro has risen to 21 percent from 17 percent in December 2000, while their dollar holdings have remained fairly steady at 72 percent compared with nearly 73 percent six years earlier. Their remaining holdings are in such currencies as the Japanese yen and the pound sterling.”

Figure 1: Brad Setser: Central Banks Still Buying Dollars

Figure 1 from our favorite fund flow analyst Brad Setser of the Council of Foreign Relations shows how the composition of global currency reserves have been growing over the past decade.

So even as currency reserves of global central banks have steadily grown in absolute terms, which also translates to growth in other major currencies aside from the US dollar, the Euro seems to have outpaced the growth in the US dollar. Hence, the growing share of the Euro relative to the US dollar in the universe of currency reserves.

Why is this important? Because if the premise for a severe recession comes from financial links in terms of a liquidity crunch (aside from the trade linkage), then from the angle of asymmetries in the current account distribution-the Euro zone against the emerging markets-also matters.

If hypothetically 65% of global currency reserves are in the US dollars, and 25% comes from the Euro then the trade imbalances also project liquidity flows not only from the US (although it signifies the main channel) but also from the secondary reserve currency in the Euro and also (but insignificantly) in others. Hence the Euro is also a contributor to global liquidity!

In other words, global liquidity flows from the premise of the trade-current account is not solely a US perspective and can’t be the only basis to reckon for liquidity flows, see figure 2.

Figure 2:tradingeconomics.com: China Trade Balance

Figure 2 from tradingeconomics.com illustrates China’s growing surplus from its trade balance with the world despite the present economic growth slowdown, which implies a shift of the weight of its trade from the US to the Eurozone. Thus, these surpluses have “partially” contributed to the amazing $1.81 trillion surge in their forex reserves last July in spite of the sagging global economy.

And this shouldn’t be seen in the context of China alone as much as it should apply to other emerging countries such as the oil exporting nations most especially the Gulf Cooperation Council (GCC).

While it may be true that the Eurozone may now be feeling the pinch of a US led dramatic growth economic slowdown as we pointed out in our recent weekday post Global Recession watch: Japan and Euroland Economic Growth Turns Negative!, this will also translate to a second round leash effect on the US, which means it isn’t clear whether the US current account deficit would improve at all (since both exports and imports are likely to deteriorate in the face of a slowing global economy!).

One thing seems clear is that regardless of the state of the US current account, the case for the taxpayer funded government intervention to ameliorate the woes from the deleveraging plagued stricken Wall Street plus the spillover effects on the Main street are likely to more than offset any improvements in the current account, which means more financing needs by the US public-by either of the following options borrowing abroad, selling assets or printing money-and private sector.

The point is improving current account imbalances should reflect both sides of the ledger and doesn’t automatically translate to a complete or outright drain of liquidity as deflation proponents suggest.

Strength of US Dollar Depends On The Reliability Of US Markets?

Yet if the argument will directed to the premise that the inherent advantage of the US markets due to its depth, sophistication and advance conditions signify as main reasons why the perceived “trust” as a safehaven status, this quote from the Bank of the International Settlements over the fate of the Euro as an alternative foreign currency reserves should serve as an eye opener (highlight mine) `` The euro comes closest to challenging the dollar in its role as a store of value. As a unit of account and medium of exchange, the dollar’s role is not as secure as it once was, but the dollar is still preeminent.”

So what defines a store of value for the BIS?

Again the BIS ``In the strictest sense, this will be a currency whose value is reliable in terms of future purchasing power. This in turn is linked to the maintenance of sustainable macroeconomic policies. Moreover, the store of value function can also depend on the anchoring role of a currency to the extent that the central bank tries to align the currency composition of its country’s assets and liabilities. More generally, the store of value function of an international currency is linked to the breadth and depth of financial markets, in particular to the availability of investments which meet wealth holders’ risk-return objectives.”

So if the Euro’s best chance to compete with the US dollar is seen in the role of a store of value, it implies that the Euro’s “breadth and depth of the financial markets” appears to have nearly assimilated the US markets in order for the BIS to issue such qualifying statement.

Besides, in today’s functioning monetary platform in the fiat “paper” money standard whose system is backed by nothing but promises based on “Full Faith and Credit” of governments then the US dollar as the alleged beneficiary via the “safehaven” asset status from a global meltdown overlooks where the epicenter or source of today’s crisis emanates from.

This comment from Yu Yongding, a former adviser to China's central bank on the cataclysmic repercussions for the global financial system on a failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac as quoted by Bloomberg (HT: Craig McCarty)

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.''

If we go by Mr. Yongding’s statement; the end of the current international financial system is tantamount to the end of the US dollar as the global currency reserve!

So how does one consider the US dollar as today’s “safehaven” when it has been a major source (US housing bust, subprime, Fannie and Freddie Mac) for most of the troubles scourging the financial markets today?

True, global central banks continue to accumulate US dollars have been responsible for their policy decisions, but this is done to maintain the status quo or because of the Nash Equilibrium-(wikipedia.org - a game of two or more players wherein “each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy (i.e., by changing unilaterally). If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.”)

- or its military doctrine equivalent of the Mutually Assured Destruction (MAD) scenario where once such an event unfolds could prove to be devastating to all involved (once deeply exposed trading partners of the US suddenly decide to quit the game)! So for example, if China decides to quit from the US dollar accumulating game, hell would probably break lose (via a US dollar crisis or hyperinflation on a global scale)!

So it isn’t clear that global central banks will continue supporting the US economy or its financial markets, which will likely to be reflected in the state of the US dollar, if economic or political conditions degenerate further.

Besides, US officials seem very much aware of these conditions, hence quickly signed into a new law to provide for a temporary fix to the ailing GSEs; aside from previous bridge liquidity “alphabet soup” of Fed-US treasury programs, widening the scope of collateral acceptance and direct stimulus to the public.

Another, the seeming “resiliency” of the US economy in the face of a housing and financial sector meltdown has been predicated on mainly its “net” exports and global central bank financing. Thus we read into US Federal Reserve Chair Ben Bernanke’s current policy actions as an indirect stimulus meant for global economies especially for countries tied to the US dollar via currency pegs as previously discussed Global Financial Markets: US Sneezes, World Catches Cold!. The US seems banking on “inflating” on global growth to sustain its economy and keep it out from the clutches of recession.

Thus inflation as a US monetary policy is being transmitted globally and the world has been reciprocating.

Proof?

This from Joachim Fels of Morgan Stanley (emphasis mine),

``In most countries – even in many that have raised interest rates this year – the policy stance is fairly easy. Real short-term interest rates (nominal policy rates minus current CPI inflation) are currently negative in no less than 20 of the 36 countries in our coverage universe. Among others, these include the US, Japan, Canada, Switzerland, Russia, Ukraine, the Czech Republic, Korea, Taiwan, Singapore, Indonesia, the Philippines, Malaysia and Peru. With policy easy to start with, there is thus little scope to cut rates aggressively. By contrast, there are only a few countries that have relatively high real short rates and thus tight monetary polices. Apart from Australia and New Zealand (where real short rates stand at 2.75% and 4%, respectively), these include Brazil and Turkey, where real rates stand at 6.6% and 4.65%, respectively.

``Global real policy rate still negative. Aggregating across all countries in our coverage universe, the weighted global monetary policy rate currently stands at 4.5% in nominal terms. However, current global (weighted) inflation is running at 5.3%, so the global real rate is -0.8%, the lowest in this decade. Thus, global monetary conditions remain very expansionary, limiting the room for a major global monetary easing.

So if global monetary environment remains expansionary how can deflation proponents argue that the world will be engulfed with a meltdown from deflationary forces? The US and the UK, Spain, Ireland, Australia and those suffering a structural “housing bust” does not translate to the same predicament all over the world, especially not in the Philippines.

Besides what is to “deflate” in the Philippines or most of Asia?

Figure 3: BIS: Loan/deposit Ratio of banking systems in Asia and the Pacific

Except for Australia and Korea whose loans are above deposit reserves, loans in most of Asia have not been “leveraged” as shown by the BIS and are below reserves of deposits. In other words, the Asian banking system has more deposits than extended loans.

Yes, a global economic slowdown is in the cards-some will experience recession, some won’t-but definitely not from the garden variety type as seen in the deflation paragon.

Deleveraging Is Not A One Way Street; Short Sales And Market Efficiency

Then there’s the other argument where the whole world will be enveloped by the feedback loop of de-leveraging.

Against the common impression deleveraging isn’t a one way-street though, see figure 4, especially when we deal with advanced or sophisticated markets because of the available facilities to bet on EITHER DIRECTIONS.

Figure 4: stockcharts.com: US-dollar Index-commodity Pair trade

The chart in figure 4 shows how gold (candlestick main window) /oil (lower pane) and the US dollar index (black line behind main window) have had a strong inverse correlation, as demarcated by the blue vertical lines (as US dollar troughs when oil/gold peaks and vice versa). The Dow Jones AIG Grain (lowest pane) seems to have moved ahead of its major commodity bellwether.

The tight correlation suggests of the proliferation of “paired” trades, which means participants who shorted/longed the US dollar also bought/sold oil and gold. Such is why the violent action in one market could have reflected an equally volatile action in the another-but in an opposite direction!

It also means that since every transaction is accounted for by an entity, anyone (represented by an individual or by a company) who is “forced to liquidate or delever” on their market position has to closeout (by taking the opposite position-of either a buy or sell-on the original position taken!). If an entity took up a “short sell” position then one closes by “buying”, and in the same manner if the same entity takes up a “long” position then the consummation of the trade translates to a “sell”.

Thus deleveraging doesn’t automatically mean selling, it can also mean buying!

Proof?

Figure 5: US SEC’s Short Sale curb=Magnified Upside For US Financials!

The US SEC imposed a curb on “naked” (selling without actual possession of borrowed shares) short selling on 19 financial companies last July 16^th. And as we demonstrated above, the huge short position taken by the public was forced to unravel, see figure 5 (see blue arrows). This led to a strong simultaneous upside rebound for the beleaguered Dow US financials (main window), the Broker Dealers (pane below the main window) and Banking indices (lowest pane). Yet this doesn’t account for derivatives.

Maybe one factor why the US equity markets have not entirely collapsed in the face of a prospective or ongoing recession, prompted by the meltdown in the housing and financial domain, is because of the public’s liberal access to “short” the market. To quote Mises.org’s Robert Murphy ``But the basic principle is simple enough: just as a speculator who wants to go long can borrow money to buy stocks, so too a speculator who wants to go short can borrow stocks to "buy money." Short selling is no more mysterious than buying stocks on margin.” Hence, the short selling facilities could have minimized the volatility on the downside by allowing for greater pricing efficiency through expanded liquidity.

Well of course since this isn’t back by any evidence, this is just a guess on my part.

But for the world markets especially in dealing with the deleveraging issue, it could be a different story. Deleveraging means global investors have to sell equity holdings as “short facilities” have not been as deep and widely used as those in the US.

For instance, the Philippines now allows for “borrow and lending”, though I have not read the entire regulation, based on my principal’s opinion, the rules seem quite stringent and rigid as to discourage any actual application because of the costs of compliance. If costs exceeds the benefit who will avail of the trade?

Put differently what good is a facility if it is stifled by suffocating regulations or if it can’t be used?

Finally the penchant of deflation proponents is to compare present occurrence to that of the Great Depression,

This quote from Professor Barry Eichengreen of the University of California, Berkeley in the Financial Times should account for a good retort,

``And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation. As US demand weakened, other countries saw their currencies become over­valued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

``The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

``The Fed’s response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.”

In short, the gold standard of then and today’s paper currency standard aside from the transmission effects of the currency pegs supported by mercantilist policies have been important nuances.

One important thing which was not marked by this observation was that the Great Depression was significantly exacerbated by “Protectionism”.

Summary and Recommendations

A global recession may happen but it isn’t likely to be a depression or alternatively said “severe and prolonged”. Not for most of Asia, especially the Philippines. A global recession may occur because OECD or major developed economies seem to be undergoing recession but is not likely the case for most of the EM economies.

The argument for a US current account improvement as effectively draining the global liquidity picture seems incomplete. The Euro is also a secondary contributor. Although a slowing Eurozone could also mean further test on global liquidity conditions.

Likewise, the second round effect from a global economic slowdown is likely to put a stress on US exports clouding the certainty of the improving path of the US current account balance.

What is clear is that the taxpayer funding of the financial sector and of the main street will offset any improvement in the current account which means more financing requirements through external borrowing, selling of assets to foreigners or monetization.

The argument that the US dollar represents as “safehaven” under a global deflation is unclear if not questionable. First, global deflation seems unlikely; the world’s monetary climate seems still expansionary. Besides most of Asia has less to deflate compared to the overleveraged West. Asia’s “contagion” problems will likely fall on liquidity and not solvency issues.

Second, since the US dollar is the source of the present stress, the argument of its “safehaven” status has been in a test since 2002. Such tests isn’t likely to end soon and may get worst.

Third, the recent rebound by the US dollar and the accompanying fierce selloff in the commodities could be as a result of pair trade deleveraging, aside from a reflection of a global economic growth slowdown. Deleveraging does not equate to outright selling since it can also mean buying especially under markets that are advanced, sophisticated and deep.

Fourth, we don’t buy the argument that the US dollar or the Euro or of any paper currencies as representing any insurance from currency debasement policies by global governments. Inflationary policies assure the loss of purchasing power of paper currencies.

Although the US dollar may rally against the Euro, this may signify an interim or cyclical move instead of a complete turnaround similar to 2005. The US dollar has been in a bear market since 2002 and is likely to remain under pressure given the massive fundamental imbalances it is faced with.

Meanwhile, gold has been on a losing streak. Gold and precious metals represent as our insurance against government’s inflationary actions. The precious metal sector could depart from the performances of its industrial siblings based on the question of health of global economies.

We understand gold to be in a long term bullmarket especially from the fundamental perspective where global governments will work to use their inflationary powers to reduce the impact of any financial or economic dislocation for mostly political ends.

Figure 6: US Global Investors: Gold’s Seasonal Performance

We understand too that added to gold’s present infirmities from delevariging issues is that gold is in a seasonal weakness (see figure 6) and could most likely pick up over the next few months once the deleveraging issues fade.