US Mortgage Crisis Contagion: There is NEVER One Cockroach!

``This is the age of what I call Vehicular Finance. The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on. These vehicles can fit together like Russian dolls. By way of illustration – and, I fear, slipping for a moment into alphabet soup – SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans. (The diagram may, or may not, help!)”-Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England

Domestic mainstream analysts have correctly pointed out to the US subprime sector as one key catalyst to the recent selloffs, but obviously missed out is the carry trade linkages which have been an equally important contributor (Japanese Yen up .68% and Swiss Franc up 1.34% week-on-week). They have been simply echoing much of what mainstream international news have been saying instead of thinking independently.

In the meantime, experts in the local banking industry have been swift to dismiss the exposures or implied associations of the local financial institutions to the US subprime mess as much as with the Asian region.

While there may be some grain of truth to such assertion, the vast dispersion of risk assets has resulted to unforeseen losses surfacing in unexpected parts of the world. Following several blowups, which we have previously pointed out in some Australian hedge funds, German bank IBF (presently being bailed out by the government), German mutual fund German mutual fund Union Investment Asset Management Holding (halted redemptions) and France’s AXA (closed two subprime funds) have been the latest high profile ex-US casualties, according to Bloomberg.

We are not inclined to believe that this is the end of the episodes of the US housing subprime contagion, to borrow the quote of the illustrious Dennis Gartman of the Gartmanletters, ``There is never one cockroach”. Our primary concern is that this may just be the beginning or the proverbial “tip of the iceberg” and market behavior could be at present reflecting this.

In the following months or so, there is a big possibility that we are to countenance more institutional casualties emerging from the impact of the “one-two-three punch” of the US real estate industry to the subprime (structured finance-derivatives combo) jitters to the subsequent re-ratings in the global credit markets as well as in the equity markets. Of course, I could be wrong and truthfully, wish I would be wrong.

As we explained at our June 25 to 29 edition (see US Subprime Woes Spreading; Feedback Loop Dictated by Market Ticker), the problem is not much with the exposure of local banks to the US subprime imbroglio or related credit instruments, although this should NOT be discounted.

The basic problem lies with margin calls or the “common holder problem”. The Financial Times describes this as ``This is where investors from hedge funds to insurers are forced to sell more liquid assets, such as loans, to cover losses in assets that are difficult or impossible to sell, such as stricken mortgage-backed securities, or collateralised debt obligations built out of these.” (highlights mine).

We in fact used CALPERS, both with significant exposures to unrated CDOs (about $140 million) and to Philippine equity assets ($78.5 million as of 2005) as an example to our hypothetical scenario.

Since foreign money constitutes about half of the Peso trading volume in the PSE year to date, thus, our major question is; to what extent does foreign investors in Philippine assets have similar exposures to these imploding credit instruments?

Commodities Rise Amidst Market Turmoil; Gold Nears a Breakout

``Like dogs chasing their own tails”, it is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line". Seth Klarman The Margin of Safety (1991)

Figure 2: PSE Weekly declines in Percentages by sectors.

Well last week’s market action in the Philippine Stock Exchange certainly did not reflect on a limited scale of finance-based selling if such should embody subprime based apprehensions. But rather, what transpired was an across the board frenzied bloodbath, as shown in Figure 2.

The PSE had the worst week in terms of selling magnitude as depicted by its market internals since I started collating PSE data since mid 2002. There were 4 declining issues against every advancing ones during the five trading sessions.

While foreign flows registered marginal net inflows of Php 135 million, this was mainly due to the aggregate IPO related Special Block sales, which accounted for about 29% of the total peso volume turnover. Otherwise, market activities accounted for a net selling of P 1.22 billion!

Even as the Phisix dived by 4.73% over the week, reducing yearly gains to 12.4%, the Philippine Peso lost a paltry .07% from Php 45.72 to Php 45.84 relative to the US dollar.

Where we expected the mining sector to possibly provide for some semblance of divergence to a selloff, instead the reverse happened, the public indiscriminately disgorged speculative “bubbles” or Cult Stocks alongside mines with “fundamentals”.

Said differently, Cult Stocks, as defined by Investopedia.com ``A classification describing stocks that have a sizable investor following, despite the fact that the underlying company has somewhat insignificant fundamentals. Typically, investors are initially attracted to the company's potential and accumulate positions in speculation that its potential will be fulfilled, providing the investors with a substantial payout…While most of these cult stocks promise they will be the next big story after they make a new discovery or get the newest contract from the government, most do not provide investors with anything other than the story. (Does this ring a bell???-B. Te) Furthermore, these stocks typically generate very little, if any, revenue at all”, had been treated with a similar status with companies that has cash flow fundamentals!

As a result, the mining and oil sector bled the most by 13.69%. Such imperceptive selling binges speak loudly of how our markets function. Meanwhile the financial sector supposedly the parties affected by the credit woes lost only 5.34%.

Anyway, moving against the public’s consciousness, we see that amidst the global carnage, Gold is now making a renewed attempt to breach its zone of indecision marked by the continuation pattern of the symmetrical triangle shown in Figure 3.

Figure 3:stockcharts.com: Rising Commodities, Falling US dollar amidst Market turmoil

Of course gold has lately tracked the movements of the Euro, and the renewed decline in the US dollar index (topmost pane), where the latter’s rally appears to have lost steam and is once again headed towards the 35-year critical low (which increasingly adds to our global risk profile).

Meanwhile, commodities have largely remained upbeat as shown by the (above pane below the main window) the CRB-Reuters Index and the US WTIC sweet crude bellwether (lowest window), where the latter despite correcting 2% over the week to $75.48 a bbl also remains on a firm uptrend.

Oddly so, while we see the general mining indices abroad trail the overall market sentiment on the account of declining industrial metals, global gold mining indices have remained at the upper ranges of the resistance levels! Similar to the footsteps of gold prices.

Nonetheless, we are not to argue with the market. If mines are susceptible to emotionally charged bouts of panic, then they are unlikely to serve as insurance even if we are to see further strains of overseas-led market distraught. However, such conditions may change once gold makes a massive move to the upside, where foreign buying may spillover to the market and give a lift to these amidst the local punter’s myopia.

As I’ve said before, while mines and the commodities are arguably two distinct animals, since we lack a functioning commodity market (not the spurious type like the commodity market established in the 90s or the US centered defunct Manila International Futures Exchange) to buy the real thing, mining issues then serve as my proxy to ownership in gold. Obviously given the recent rout, the public does not appear to share this view.

ARM Resets: Clear and Present Danger to Global Financial Markets

``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." Ludwig von Mises Human Action

Now as we have earlier noted, we believe that the credit markets will continue to reflect pressures from the persisting angst over the losses of illiquid structured finance/derivatives products which includes packages of subprime instruments now spilling over to the rest of the global financial markets.

Even high quality AAA instruments have now been marked down! According to one of our favorite author, Mr. John Maudlin (emphasis mine), ``Some BBB tranches of subprime paper are down by 60%. That is not surprising, given the quality of the loans that were made. What is very disturbing to investors is to watch what they thought was AAA credit already marked down by 10% or more. Some AA credits are down by as much as 25%. If you bought recent A rated mortgage paper you could be down by over 50%! That is ugly.”

So what was initially thought to be an insulated or “contained” event seems to be spreading towards the credit markets in general. As a result, rates of junk bonds, commercial real estate loans, and leveraged buyout financing have all tightened up. And tightening up means fewer activities or diminishing access to funding.

According to Mark Larson of Moneyandmarkets.com (highlights mine), ``As a result, we've seen activity in these markets drop dramatically. Compared to June, the total amount of corporate debt issued in July plunged 66%. The amount of sold junk bonds plummeted by a shocking 89%. And those Collateralized Debt Obligations (CDOs) that used to be so popular? JPMorgan Chase recently said sales of CDOs sank to just $9.1 billion in July from $43 billion in June.” For this week junk bond issuances have totally evaporated!

If mergers and acquisitions, corporate share buybacks and private equity deals had been previously the key drivers for the US equity markets then the sudden contraction of liquidity or access to funding combined with rising risk aversion by investors could have possibly resulted to a credit squeeze for the global financial markets addicted to leverage.

Quoting at length Mr. Doug Noland of the Credit Bubble Bulletin who aptly describes the present conditions (highlights mine),

``While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such the mortgage insurers, MGIC’s and Radian’s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during the final “blow-off” – total mortgage Credit doubled subsequent to the Greenspan Fed’s reckless post-tech Bubble “reflation.” Mortgage exposure now permeates the (global) system and is highly susceptible to “Ponzi Finance” dynamics.

``The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation - with major systemic ramifications.”

If the impairment proves to be systemic as Mr. Noland avers, then the likelihood is that we could be witnessing more downside volatilities for the financial markets in general. A disadvantage which used to be a widely touted advantage is that as risk instruments got to be widely distributed (spread risks), however, attempts to identify areas of concern has now become opaque even to regulators.

At present the financial markets could be at a denial stage, where the bulls will fight with its fullest intensity to restore or recapture its lost ground. If fundamental problems remain unresolved, the bulls will then likely encounter repeated failed attempts. This essentially leads into fear and desperation and eventually to panic and capitulation.

How good the chances of a recovery?

For Mr. William Gross, the Warren Buffett of bonds, Managing Director for PIMCO, it looks like this would be a protracted attrition like engagement. He says which we quote (emphasis mine), ``The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes – the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond.”

Figure 4: Mortgage Resets.com: ARM Resets as of January 2007

Those who bought into the peak of the US real estate cycle using teaser rates will end up paying amortizations of about 30% or more as rates adjust to reflect on their contracts (reset for every six months for 28 years after two years of low introductory rates), where some homeowners may be unable to cope with the higher payments (whose original intent was to earn by flipping “short-term” trading houses!).

With the present tightening trends in the lending standards by the surviving institutions and insufficient home equity shares as an offshoot to the declining real estate values, refinancing becomes less of an option for some homeowners while the threat of foreclosure looms.

Remember these household mortgages have been securitized, packaged and repackaged into different forms of highly levered instruments alongside other classes of debts, received improvised ratings from credit agencies as a consequence to the financial alchemy and sold to investors worldwide.

Now as foreclosures mount, investors or institutions holding on to these papers have been feeling the heat of the losses. Many of them will be forced to hold houses which they cannot liquidate in a market short of buyers. Credit lines to institutions with significant exposures are then cut and/or portfolio holdings significantly re-rated. Such losses subsequently eat up on their capital, which leads to their insolvency. Some of them go bankrupt; the others sell on the remaining liquid assets to settle on their outstanding liabilities and keep the company afloat. The general decline in collateral values (real estate, credit instruments and equities) essentially diminishes the ability to intermediate financing which then becomes a systemic risk.

If the credit markets today are feeling the unintended effects of $300 billion worth of resets in 2006 then we should expect more jitters to hit the credit markets as a tidal wave of more than $2 trillion of these loans (see Figure 4) or about a quarter of all mortgage loans outstanding are undergoing or will come up for interest rate adjustment in 2007 to 2008, according to mortgageresets.com.

For some, this imploding credit bubble is seen to have a potential widespread impact. Bear Stearns Chief Financial Officer Sam Molinaro was quoted by Reuters on Friday saying that ``Bond market turmoil sending investors fleeing from risk may be a worse predicament (highlight mine) than the 1980s stock market fall and Internet bubble burst.”

``These times are pretty significant in the fixed income market," Molinaro said on a conference call with analysts. "It's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme."

A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Puteo

``In a previous speech I suggested that periods of great market instability arise when three conditions are met. First, something happens that has widespread significance—is large enough to matter to lots of people. Second, the triggering event is a surprise. Ordinarily, events long anticipated are not troublesome because corrective action occurs before problems arise. Third, substantial uncertainty clouds resolution of the problem. It is especially difficult for investors to know what to do when the government's response to an unfolding situation is highly uncertain.”- William Poole, President, Federal Reserve Bank of St. Louis, Housing in the Macroeconomy

There are those who argue that the FED will remain hawkish and unlikely apply the Bernanke “Put” in the face of the unfolding liquidity squeeze.

A put option gives a buyer the right to sell a security/contract at a fixed price within a given period. Puts are essentially a hedge from declining prices. The Greenspan Put assumes that investors will be rescued by then Chairman Greenspan in response to an unraveling crisis with a series of interest rate cuts and injections of liquidity.

Figure 5: Yardeni.com: FED Cuts in at almost every crisis!

Figure 5 courtesy of Yardeni.com tells us that each time the US economy or financial markets faced an ongoing crisis, the PUT option was activated.

I think that under worsening conditions, Mr. Bernanke will be compelled to apply the PUT given the following:

First, it has been the FED's "winning formula" since ex-Chairman Greenspan took over.

Second, this path reflects on Bernanke's ideological inclination as signified by his speech at Milton Friedman's 90th birthday and his Helicopter (November 21, 2002) speech.

Third, I think being hawkish is merely rhetorical. Considering the complexity of today's financial instruments, several FED personalities, including St. Louis Reserve President William Poole (who has been stridently hawkish) has in the past acknowledged the uncertainties emanating from GSEs and untested financial instruments and their potential impact to the markets and the economy under severe or "testing" conditions.

Lastly, given the magnitude of financial leverage in today’s economy, I don't think the hawks can afford to tolerate a squeeze in liquidity, which should bring about the risks of debt induced deflation, something which Mr. Bernanke fears most.

Former Fed Chief Paul Volker acted to quell inflation in the late 70s because it was visibly exploding then. However today, such scenario has yet to egregiously manifest itself. Think of Gold $2,000 or more. Nonetheless, the act of preemption could spur negative political repercussions in the light of upcoming elections.

As Nicolas Taleb wrote, "Everybody knows that you need more prevention than treatment, but few reward acts of prevention. We glorify those who left their names in history books at the expense of those contributors about whom our books are silent. We are not just a superficial race (this may be curable to some extent); we are a very unfair one."

Since an ounce of prevention will unlikely lead to manifest rewards, based on incentives as a driving factor to the Fed’s decision making process, then they would likely opt for a treatment based action instead similar to its actions in 2000, as shown in Figure 6.

Figure 6: Economagic: FED Cuts as Rate as S&P fell!

To be sure, a cut in FED rates poses no guarantee that it will instantaneously boost the equity markets. The FED initiated its monetary actions by paring interest rates (red line) in late 2000 when the S&P 500 (blue line) has declined by as much as 15%! Yet, the rate cut did not deter the S&P from losing about 45% (peak to trough) as Fed rates nearly reached the floor at 1% in late 2002.

In the same context, we believe that similar circumstances would prompt for the FED to its traditional action, i.e. if US markets gets creamed by the worsening of credit conditions. Losses of anywhere between 10-15% could likely be the trigger.

However, anywhere in between now and 10% decline is likely to be a normal corrective phase and would NOT prompt any FED action.

In the meantime, taking defensive measures to preserve capital would likely be the best recourse under the current deteriorating conditions.

This could be a bear trap though, but given the fundamental developments, it seems unlikely so. I hope again I am wrong with such bearish outlook.

Finally, the PSE has introduced a new trading mechanism called the shorting facilities. It allows investors to profit from declining prices by borrowing shares and selling short an issue then buying back at a profit once the target decline in prices are reached. Inversely, cutting loss by closing an open position once shares move up instead of down.

I am not sure if this has been activated, although it sure is one good time to give them a test, especially if the Phisix comes off from a dead cat’s bounce.

A Nightmare on Wall Street; Currency Markets Turmoil

``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand." Thomas Carlyle (1795-1881) Scottish Philosopher, Essayist

Early this week, I had been asked why despite the adaptation of a bullish stance I sounded quite tentative. Well, the answer from the hindsight is quite obvious. We have been saying all along that since developments in the US markets appear to have been directing the path of the its counterparts in the global arena, if the financial markets were to reflect on the developments in the real economy, then we are at a loss of pertinent explanations except that we find massive expansion in today’s credit cycle and excessive risk taking behavior, underpinned by the expansionary policies assumed by the world’s central banks as basically responsible for the recent activities in today’s global financial marketplace.

Yet, regardless of the intensifying risks, financial markets have had their extended shindig, which seemed to uphold the impression that any inflection point could only be found in the distant future. Meanwhile, bearish analysts had been seen fading in the limelight as markets conspicuously contravened their outlooks as indices scaled to new heights. On the other hand, momentum investing appears to have gathered more following.

But suddenly, we found some of our apprehensions may have turned into a reality.

Last week, we described the possibility that as the US dollar Index approached its 35-year low, assaults on any major support levels have usually been accompanied by violent reactions. While we pointed out several factors that may lead the US dollar to breakdown into uncharted waters, we also raised the possibility that the US dollar index could in all probability stage a massive rebound from its lows. MOST of what we projected last week materialized as shown in Figure 1.

Figure 1: stockcharts.com: Currencies illuminate Market Stresses

At the start of the week, the US dollar index (+1.07% w-o-w) breached slightly below the 80s to a record low but fiercely recoiled after its attempted breakdown faltered (see panel above center window).

This coincided with a huge spike in the Japanese Yen (+2.06% w-o-w; see main window), which behind the scenes could have conspired to aggravate the turbulent conditions of several institutions holding assets already suffering from the worsening subprime implosions in the US.

And while both the Yen and the US dollar index surged, global markets represented by the US S & P 500 (upper pane below main window) and our own Phisix (lower pane) were thrashed (red circles). The blue vertical line signifies the demarcation timeline of the recent volatility chronicles.

In a perspective, the decline seen in the US markets in the weekly context has almost been similar in magnitude to the one seen late February (recall the “Shanghai Surprise”?), albeit a Bloomberg report calls it the worst week since 2002 (in allusion to the S&P 500--see how selective referencing can make a powerful difference in a presentation?) with about US $2 trillion in global market value wiped out.

This week the Dow Jones Industrials fell 4.23%, the S & P dropped 4.9% and the Nasdaq was lower 4.66% compared to end February’s 4.22%, 4.41% and 5.85%, respectively. This means that YES, the S & P was in accordance to the description by Bloomberg report but NOT so with the Dow Jones Industrials or the Nasdaq.

Similarly, for this week the Philippine Phisix got shellacked by 5.78%, however compared to February’s shakeout where the Phisix dived by a nasty 7.35%, the mitigated circumstances could have been cushioned by the latest BSP’s motion to reflate.

Anyway, following the said bloodbath early this year, the Phisix followed through with two successive weeks of decline, down 1.29% and 1.21% for a cumulative loss of nearly 10% before recovering. This is not to impress upon you that the Phisix will do a February reprise simply because the factors contributing to the recent actions have been dissimilar. Although our message is that streaks whether to the upsides or downsides occur. And given that the recent selloff resulted to some minor technical wreck (Phisix broke 50-day moving averages), momentum suggests to us that the path of least resistance could either be down or sideways.

Pockets of Resistance: Belated Effect or Incipient Decoupling?

Nevertheless, during February’s volatility, much of the world markets apparently sympathized with the actions of the US markets. However today, we see some peculiar divergences or markets behaving independently from the general activities in the equities frontier. For instance, while most people attribute February’s volatility to China, which we vehemently argued against, China’s Shanghai Composite rocketed by 7.06% and Shenzhen flew 10.84% (!) over the week in defiance to the prevailing sentiment across the globe--this should equally dispel the much touted China’s correlation with that of the world’s equity markets.

In addition, most of South Asia’s (Pakistan +2.09%, Sri Lanka +3.25%, Bangladesh +2.66%) and East European markets have likewise seemed insouciant to the recent turmoil to even end the week significantly higher. Even neighboring Thailand managed to eke out a 1.53% gain over the week.

Either we will be seeing belated effects on these markets or these pockets of aberration could be representative of emergent signs of financial markets “decoupling” with that of the highly leveraged US and western markets.

Threat to Global Markets: Credit Contraction or Liquidity Shrinkage

``What deflation is, is falling prices precipitated by a credit contraction—by the inability or unwillingness of lenders to lend and borrowers to borrow…But, for now, a superabundance of money and credit is financing a leap in asset prices across markets and time zones.” Jim Grant, Grant’s Interest Rate Observer

Nonetheless, there are several differences between that of February’s volatility and today’s carnage.

One is that as a function of market internals, as we pointed out in our June 18 to 22 edition (see Introspection on the US Markets and the Phisix, Deterioration in US Market Internals), the deterioration in the US has gone broad based, as shown in Figure 2.

Figure 2: Barry Ritholtz: Weekly Performance of Dow Subcomponents

Courtesy of one of our favorite analyst Barry Ritholtz, Figure 2 shows that even the previously buoyant sectors of Basic Materials, Energy and the Industrials responsible for the elevation of the main indices in the past has now degenerated. So instead of an interim recovery, which proved to be ephemeral, almost all of the industry groups have presently joined in the selloff. In short, what we are seeing today is a broad market decline in investor sentiment and this does not bode well for the US markets.

Second, credit markets are manifesting signs of a contagion…

Figure 3: Paul Kasriel of Northern Trust: Recent Spike in Yields still Low compared to yesteryears

Since one of the main pillars ascribed to as having boosted US markets of late has been the de-equitization process or “equity supply shortages for investment” mainly as a consequence to a combination of corporate share buybacks plus leverage buyouts or private equity deals (which accounted for more than a third of all acquisitions in the US in the first half of the year-Economist), the sudden rise of risk aversion as shown by the rising yield spreads has effectively reduced the incentives for such activities.

To quote another favorite analyst of ours Mr. Paul Kasriel of Northern Trust (highlight mine), ``But now, credit to fund de-equitization is getting more expensive. Since June 12, the yield spread between high yield (aka junk) bonds and 10-year U.S. Treasury securities has increased by 150 basis points. Even with this recent widening, corporate credit-risk spreads still are relatively low. But should they continue to widen, this de-equitization factor that has been driving up stock prices will wane.”

With the ongoing housing recession spilling over to the subprime mortgages, which during its heyday have been then packaged and rated in different forms of structured finance instruments, and sold or distributed to a diverse class of investors, the present re-ratings or change in risk assessment has likewise affected institutional holders in far corners of the globe. For instance, two Australian hedge funds were reportedly affected; Absolute Capital Group (suspended withdrawals) and Basis Capital Fund Management (hired Blackstone to negotiate with bankers to limit losses).

Even credit default swaps or contracts used to speculate on a third party’s ability to pay on our domestic sovereign bonds were recently repriced, according to Oliver Biggadike of Bloomberg, ``The perceived risk of owning Philippine and Indonesian notes rose to the highest in a year. Contracts based on $10 million each of Philippine and Indonesian dollar-denominated debt increased $55,000 to $205,000, according to prices from JPMorgan Chase & Co. The difference in yield on the nations' 10-year dollar- denominated benchmark notes compared with similar-maturity U.S. Treasuries increased to 2.08 percentage points and 2 percentage points respectively. Both countries' credit ratings are below investment grade. High-yield, or junk bonds, are rated below Baa3 at Moody's Investors Service and BBB- by Standard & Poor's.” Subsequently, the sharp rise in yields has evidently boosted the US dollar relative to the Peso (the latter had a precipitous drop over the week down by 2.05% from 44.8 to 45.72 pesos against a US dollar).

While Japan’s banking system is said to have little exposure on US subprime mortgages, according to the International Herald Tribune (emphasis mine) ``Japan's nine biggest banking groups have more than ¥1 trillion of combined holdings in products backed by U.S. subprime mortgages, the Nikkei English News reported.” That’s still equivalent to about a hefty US $8.418 billion but nonetheless a short change compared to the $600 billion subprime mortgage loans (as of 2006) in the US.

So with tighter credit standards self-imposed by the US financial entities arising from the subprime mortgage crisis, rising yield spreads have led investors to shy away from present deals, where according to the Economist (highlights mine), ``The mortgage malaise has, in short, led to a broader reassessment of risk. Until recently, issuers of high-yield (junk) bonds and loans were able to borrow at wafer-thin spreads over blue-chip credits. That gap is now widening by the day. As a result, more than 40 companies—many the targets of leveraged buyouts—have had to cancel, postpone or sweeten bond or loan offerings this month. This week banks pulled the sale of $12 billion in loans to finance the leveraged takeover of Chrysler. This has left some wondering if the golden age of private equity may be over. Shares in Blackstone, a private-equity firm that went public last month, are languishing 17% below their offer price.”

Effectively all these translate to one thing: Credit Constriction. If in the past liquidity or the availability to create, access and intermediate funds came with no apparent limit, today’s subprime busts have spurred a change in risk appetite which has reversed the course of investor’s expectations: investors now demand higher yields for commensurate risks taken.

Figure 4: Dr. Ed Yardeni: Assets of US Households

Lastly, the recent realignment in investor’s expectation could also affect the spending patterns of the US households which constitute about 75% of GDP.

Where total financial assets of the US households totaled US $42.522 trillion for the first quarter according to the Federal Reserve’s Flow of Funds, direct and indirect exposures to equities or via mutual funds and the real estate industry constitutes about 50% of the said assets, as shown in Figure 4 courtesy of Dr. Ed Yardeni of Yardeni.com. A broad deterioration in both asset classes could further restrict the financing options for the highly levered US households in the face of a contracting credit environment.

Under the Threat of Recession, The FED Will Likely Cut Rates!

``For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.”-Ben Bernanke, Chairman US Federal Reserve, On Milton Friedman's Ninetieth Birthday

With a slowdown in earnings growth, stubbornly high energy prices and a potential slackening of US economic growth (recent 3.4% could simply be a bounce), it becomes doubtful for jobs creation to pick up and weightlift its economy out of its present junctures. In short, the recent adverse reactions in the financial markets increases the likelihood of risks for a serious potential headwind; a RECESSION in the US, a development which we have been concerned with since last year.

In essence, the risks prospects that the US financial markets will possibly live through extended periods of downside volatility in the light of the changes in investor’s expectations as reflected in the credit markets as well as the recent re-ratings in the equities market seems accelerating until proven otherwise.

Since the US markets has reasserted its leadership role for most of the global equity asset markets, then the possible persistence of market turmoil could likely be transmitted into the global markets including that of the Phisix, as recently countenanced. We should then extrapolate such development to our portfolio by keeping ourselves judiciously in a defensive mode rather than wishing away our optimism. Remember no trends go in a straight line.

In the meantime, while the US dollar’s bounce was said to be a “flight to quality”, the stark manifestations in the credit markets are unlikely to herald “quality” with respect to US fixed income assets being the catalyst for the recent market deterioration.

What could be construed instead is that the US dollar has simply “bounced off from its record lows” following a test on its critical 35-year support level or in short, a plain vanilla TECHNICAL REACTION. Yes, US treasuries prices sharply rallied or yields declined, but this implies economic weakness (main window), as shown in Figure 5.

Figure 5: stockcharts.com: 10 Year treasuries, Oil

US sovereign securities (upper pane above main window) as measured by the Morgan Stanley Dean Witter U.S. Government Securities Trust served as a recent shock absorber to the recent carnage. Yet, this brings us to the implied message.

As we have discussed in the past, if the US equity markets undergoes further selling pressures, or possibly the Dow Industrials infringe on 12,600 or a correction of MORE than 10%, then we submit to the position that the US FEDERAL RESERVE will respond in a typical fashion when faced with ALL previous crisis: the provision of liquidity stimulus by the LOWERING of interest rates. It is thus said that a US recession induced bear market could translate to a loss of over 40% of market value!

The US Federal Reserve will most probably risk the destruction of its currency than live up to the risks of a debt induced deflationary recession that which is politically unpalatable.

And importantly, should losses exacerbate in US dollar denominated assets, this could also prompt foreign investors to look for alternative avenues to park their investments. In short, given the present circumstances the US dollar is unlikely to function as a safehaven.

To take a little gloom away; on the other hand, if the US markets manages to hold off at the said levels and consolidate then we are likely to simply experience a normal healthy corrective phase. But present market signals do not appear to validate this view yet.

Meanwhile, deflation proponents argue that monetary responses by the US authorities will prove to be inadequate this time around to save the US economy. Maybe so. However, given the reaction of the oil markets amidst the current upheavals, which even surged by 1.6% to $ 77.02 per bbl (WTIC-see Figure 5), it would appear that if the US will undertake inflationary measures via more expansionary policies to stave off what it frets most, some assets are likely to benefit from it, which leads us to a conjecture that precious metals would most possibly surge.

If the recent market actions in our Phisix should be an indication, then the mining sector was the least affected down by 2.56%. This, in contrast to the Phisix, which was down 5.87%, led by the Property sector (-8.3%), Holdings sector (-8.22%), Industrials (-6.52%), All shares (-5.73%) and the Financial Sector (-5.04%). Another bizarre development was the unfazed FTSE Australasia gold index which was unchanged over the week, compared to its counterparts which took the selling brunt as gold prices recently were equally slammed by the US dollar/Japanese Yen rally.

Lastly, with Asia, oil producers and emerging markets holding MOST of the world’s foreign exchange reserves and could probably be the LEAST exposed to the highly leveraged financial dominion of structured finance and derivatives compared to most of its developed market counterparts, it is likely that “quality” could instead be found within its asset markets.

As such, it won’t be a far fetched idea for global investors to get a whiff of this, and migrate financial flows or the genuine “flight to quality” which should cushion these markets from external selling pressures and prompt for these markets to delink or decouple from the US.

Will the Fall in the US Dollar Affect the Carry Trade Currencies and the Global Markets?

``But when people discuss chance (which they rarely do), they usually only look at their own luck. The luck of others counts greatly. Another corporation may luck out thanks to a blockbuster product and displace the current winners. Capitalism is, among other things, the revitalization of the world thanks to the opportunity to be lucky. Luck is the grand equalizer, because almost anyone can benefit from it. The socialist governments protected their monsters, and by doing so, killed potential newcomers in the womb”- Nassim Nicolas Taleb, Black Swan, The Impact of the Highly Improbable

The US dollar trade weighted index tumbled anew to a multiyear low down .57% over the week to 80.12. This signifies a continuation of the US dollar’s softening against MOST global currencies, including our domestic currency, the Philippine Peso which appreciated considerably to its 7 year high or to its 2000 level at Php 44.8 against the US Dollar.

This comes even as the foreign entities reported a record buying binge of US assets ($126.1 billion) last May, which was more than enough to cover its twin (current account, budget) deficits. Said differently, when positive news is insufficient to buttress sentiment from its present lethargic trend, this could possibly denote of more turbulence ahead for the US dollar.

Figure 1: stockcharts.com: Gold and Carry Trade Currencies

As observed last week, even currencies that served to fund the du jour cross border asset arbitrages or the well known CARRY trades have seen a reversal as shown in Figure 1.

The Swiss franc at the lower panel has recoiled from its recent lows and appears to be testing its key resistance levels (red circle).

Meanwhile, the Japanese Yen at the upper panel; seems likewise to be in a rebound phase (blue circle). The Yen jumped .74% this week to 82.53.

Two issues to consider with the Japanese Yen. First technically, the Yen’s price action seems to be shaping out a looming trend reversal. The red channel lines above indicate of a falling wedge reversal pattern. A break above the upper trend line or nearly around 84.5 could possibly pave way for a massive rally in the Yen.

Second is that the Yen’s role in the “carry trade” has been an important feature in today’s levitated and highly leveraged markets.

The infirm yen had been partially prompted by Japanese retail investors seeking higher returns overseas by reducing their “home bias” and investing in Uridashi bonds or “foreign bond denominated in non-Yen currency issued in the Japanese market by a non-Japanese issuer” (Deutsche Bank Private Wealth Management).

Another is that the present “stable or low volatile conditions” have provided incentives for institutions to capture higher returns by taking on more leverage to arbitrage in the spreads of currency yield curves. In figure 2 courtesy of the IMF, institutions have been shown to take short positions on the Japanese Yen and the Swiss franc while profiting from the yield differentials of the Australian Dollar, Mexican Peso and the Brazilian Real.

Figure 2: IMF: Global Stability Report: Institutional Currency Positioning (percentile rank)

According to the latest Global Financial Stability Report issued by the IMF last April, ``One measure of the shift toward carry trade shows that institutional investors (so-called “real money”) have positioned themselves strongly in favor of carry trades over the past six months—funding in Japanese yen and Swiss francs and investing in high-yielding assets in other currencies—to an extreme percentile position (assessed over 1994–2007).

Mr. Bob Lenzner columnist for the Croesus Chronicles at Forbes.com cited Merrill Lynch estimates of about US$ 1 trillion worth of yen carry transactions.

To put in a wider perspective, given the global bond ($58 trillion 2005-McKinsey Quarterly) and equity markets ($50 trillion 2006-World Federation of Exchanges), such exposure would represent a rather small share to present itself as a major risk factor to the world capital markets.

However, drastic moves could spark a financial market turmoil in a particular market that could ripple across other asset classes as in the previous cases of May 2006 and the latest February 2007 “Shanghai Surprise”.

Back to Figure 1, the blue arrows in the upper chart depicts of the previous 2 instances of the Yen spikes. On the other hand, the EEM or the iShares Emerging Market Index in the lower pane above the center window, represented by the red arrows indicates of the coincidental downward volatility-possibly in response to the abrupt closing of several Yen carry positions.

Mr. David Kotok of Cumberland Advisors estimates the mark down as a result of a surging yen to world bond and equities market in 2006 at around $7 trillion and for this February, the losses were assessed at around $ 2 trillion.

Mr. Kotok qualifies the diminishing impact of the Yen’s upside spike as a “step function” where the financial markets gradually adopts with the expectations for its eventuality. In Mr. Kotok’s words, ``The step function is geometric and not arithmetic. The impact lessens each time an event occurs.”

Going against the tide in Asia, Japan’s yen has been the only currency experiencing losses amidst its massive trade surpluses. The Yen is down about 1.8% year-to-date. Yet, one must remember that Japan holds the second largest foreign exchange surplus, but paradoxically corollary to its monetary policy, again due to government intervention, depressed interest rates have spawned factors leading to resident based outflows and institutional yield arbitrages that has distorted its currency value levels, making it the world’s most “undervalued currency” according to the Economist.

In other words, while the global financial markets may be anticipating for an eventual rebound in the Japanese Yen to reflect on its fair market value, and thus a rise in yen may result to a much diminished impact, this does not eliminate the risks where an unheralded upside explosion by the Yen may trigger some upheavals in the marketplace.

And since the Yen carry has financed many of the present leveraged positions elsewhere, a Yen ‘shock’ could amplify adverse reactions in the other asset classes experiencing distress, such as the mortgage markets in the US and could become a contagion.

So as the US dollar presumably proceeds with its downside ordeal, it would be worthwhile to keep an eye on the movements of the Yen and consequently how the other markets react to it.

It’s always better to be safe than sorry.

US Dollar Index At 35 Year Support Level; Gold is Your Best Friend Now

``Nixon Administration officials were convinced that cutting the dollar's tie to gold and devaluing it against other currencies would increase our exports, slash imports and give us a fabulous round of prosperity. Instead, unhinging the dollar from gold gave us more than a decade of debilitating inflation, catastrophic increases in the price of oil and record-high interest rates.”-Steve Forbes

Going back to the US dollar Index, we noted last week that as the US dollar plumbs to its critical juncture, gold and the precious metal group are likely to benefit from the erosion of the US dollar’s value.

Figure 3 Chartrus.com: 35 year price action of the US dollar Index

In the past 35 years, figure 3 courtesy of sharelynx.com and chartrus.com, the 80 levels of the US dollar index (shown by the red horizontal arrow) has been the bailiwick of the US dollar bulls where thrice (1992, 1994, 2005) they were successfully able to repel the US dollar bears. Obviously this will be the fourth attempt.

Last Friday, with the US dollar at 80.12, we apparently stand at the crossroads.

With that in mind several questions pop up…. Will the bears muster enough force to BREACH for the FIRST time the ALL important 35 year threshold level? If the support gives, will the decline be orderly? Will the assault on the 35 year support levels be violent or are we going to see a nasty bounce off from the 35 year support levels? Will the global FIAT money based system face tension for the first time since the gold window was closed in August 15, 1971? Or could there be a US dollar crisis?

Most of the signals APPEAR to point towards a successful breakdown of the US dollar index, such as the continuing saga of US subprime, structured finance and housing jitters, rising interest rates across the globe, outperformance of Global economy relative to the US, and rampaging commodity prices.

Meanwhile in the context of Gold, which closed on Friday at the TOP of the resistance channel in figure 1, a successful upside breakout next week, could lead it to a test on its previous May 2006 high at $720, and potentially, lay siege on its all time high at $850 back in 1980 anytime soon. Perhaps, by first quarter 2008?

Echoing the activities of Gold is the world mining indices. Lately, when gold prices attempted to move higher, global mining indices stagnated or simply did not follow gold’s price actions. Some analysts pointed to rising operating costs, which depressed profits, as the main reason for its deviation.

However, as of Friday, almost in synchronicity, we see global mining indices surge such as the AMEX Gold bugs, FTSE AustralAsia, FTSE Africa, FTSE Gold Americas, Japan’s TSE Mining index and Canada’s S&P/TSX capped Gold Index.

We are unsure if the Philippines counterparts will follow suit. Given the historical perspective, their correlation with global mines appears to be low. However a knock on effect from the floundering US dollar and the recovering gold will likely continue to influence global mines. And with that being the case, given the growing exposure of Philippine mining industry to the international arena, the probability could be tilted towards a spillover from the international field to the local mining index.

Simply said, if the global mining indices will continue to validate the movements of the prices of the precious metals then one can expect foreign money to pour on into the local mines very soon.

In the absence of a domestic commodities market, then the best recommended alternative would be an adequate exposure to the mining industry as insurance to the possibility of a vehement reaction to the US dollar’s breakdown. Remember gold stands not as your ordinary commodity but your alternative currency.

Well, for as long as the market’s response is orderly this should actually not be limited to the mines.

We must also not forget that the Philippine stockmarket cycle has been moored to the fate of the US dollar. Since the Phisix’s cyclical troughs in 2002, a declining US dollar has greatly boosted foreign portfolio flows into the country, from which so far has driven our Phisix to record territories. And our Phisix has largely played out closely alongside with the activities of its emerging market peers, responsive to the actuations of the US dollar.

Our bullish premise is conditional to the orderly and smooth decline of the US dollar index plus an equally upbeat or low volatility in the US equity market, as similarly reflected in our peers or the emerging market class and in our neighbors, the Asian markets.

Surging Food Costs in US Belie Muted Inflation Indices

``Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.” –Murray N. Rothbard, America’s Great Depression

A declining US dollar is inflationary. And despite muted inflation indices in the US we can take note of some conspicuous divergence.

Figure 4: CRBTrader.com: CRB Foodstuffs on a Tear!

We have been bullish agriculture primarily because of the investment cycle (growing demand in the face of limited and underinvested supply) and the inflationary bias undertaken by the world’s monetary institutions. In addition, we have governments intervening to create hideous distortions to the marketplace such as biofuel subsidies.

In figure 4, courtesy of CRB Trader.com, the CRB Foodstuff sub-Index which comprises butter, cocoa, corn, hogs, lard, soybean oil, steers, sugar, Minneapolis wheat and Kansas City wheat is now at its highest level ever. This means that the prices that underpin the stuffs that Americans eat have been rising significantly too! Yet, inflation figures shown by the government remain compressed.

This also means that inflation figures had been largely understated or manipulated for self serving purposes. To quote Antony P. Mueller, in the Myth of Price Stability, published in 2004 at the Mises.org (highlights mine),

``Price indexes necessarily average out the extremes; they are unable to signal the more subtle price movements and they leave out relevant items such as asset prices. This way, it is not only the general public that is being deceived, the central banks themselves are falling victim to their calculations like the joke of the statistician who drowns while crossing the water that he had thought was easy to wade based on the arithmetic average of its depth.

``Currently, for example, the depreciating value of the dollar is already visible in oil, real estate, precious metals, domestic services, health care, tuition, or even when calculated against other fiat monies such as the Euro. In this perspective, there is inflation taking place and it has been taking place for quite some time at a remarkable pace. However, when counting in a considerable portion of computer storage capacity and imported gadgets, the picture changes and the perspective of a deflationary trend could be diagnosed by that yardstick.

``The great cheat of the stabilizers consists in spreading the illusion that a stable or a moderately increasing price index would imply economic stability and would have no effect on the capital structure. Neither do monetary policy measures publicized under the heading of stabilization imply a constancy of purchasing power. Such measures rather mean that old distortions are covered up while new ones are being created.”

Governments in all forms can hardly be trusted.

Record Baltic Index Reveal Signs of Vibrant Global Exports?

``Firmer currencies also would help Asia kick its addiction to exports. The best way for the region to raise living standards is to move upmarket -- away from the cheap export model of the past toward greater entrepreneurship. Weak exchange rates leave fewer incentives to make that transition.”- William Pesek Jr., Bloomberg Asian Analyst

Another indicator that allows us to be bullish is the continuous surge of the Baltic Dry index, an indicator which reflects on the trading activities of raw materials or of basic commodities.

The Baltic dry index is an index which covers dry bulk shipping rates. According to the Baltic Exchange, the index provides:

``an assessment of the price of moving the major raw materials by sea. Taking in 40 shipping routes measured on a timecharter and voyage basis, the index covers supramax, panamax and capesize dry bulk carriers carrying a range of commodities including coal, iron ore and grain.” (Wikipedia.org)

Figure 5: investmenttools.com: Baltic Dry Index and Crude Oil confirming robust global growth?

Figure 5 courtesy of investmenttools.com manifests of the vigorous activities in global arena, resulting to high freight “dry bulk” rates and oil prices, which lend credence to our belief that the global economy remains resilient in the face of the softening US economy.

Moreover, according to Dr. Ed Yardeni global exports story continue to remain vibrant. To quote at length Dr. Yardeni,

``Let’s review some of the latest developments in the global exports story:

(1) According to the IMF, world exports rose to a new record high of $13.5 trillion in the 12 months ending March. They doubled since the start of the decade.

(2) World exports were up 11.5% y/y through March. This growth rate is highly correlated with the y/y growth in non-gold international reserves held by central banks, which is a good measure of global liquidity. This measure was up 21.3% through April, suggesting there is plenty of liquidity available to finance the global export boom.

(3) The BRICs have among the fastest growing export sectors with y/y gains of 15.8% for Brazil, 11.6% for Russia, 18.2% for India, and 25.9% for China. (My comment: Brazil’s real and India’s rupee has far outpaced the Philippine Peso’s advance yet they have been sporting massive export gains!)

(4) The EU is also exporting at a rapid rate with a gain of 20.0% y/y with Germany up 18.0%.

(5) The US has clearly benefited from global trade as exports have risen to a record high of $1.08 trillion over the past 12 months through May. This has been one of the major offsets to the housing recession. More specifically, capital goods industries have enjoyed boom times with their exports totaling a record $425.6 billion over the past 12 months.

(6) Of course, the US has been a big market for foreign exporters with our imports totaling a record $1.89 trillion over the past 12 months, but that’s just 14% of the world exports.

(7) US capital goods industries with record or near-record exports over the past 12 months include aircraft ($42.1 billion), jet engines ($17.9b), excavating machinery ($11.1b), agricultural machinery ($5.5 b), oil & drilling equipment ($12.5b), and generators ($9.8b).”

A caveat is that all these are past data.

However, shipping remains as the key transport used for exports, and thus, the said freight index could help serve as a leading indicator for the health of global trade. According to Christopher Hancock of Penny Sleuth, ``Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship (highlight mine).”

This means that if we are to compare the enumerated activities with that of the Baltic Chart, the recent vivacious export performances by global economies appears to have been corroborated by the tight shipping activities which resulted to the high prices seen in the world’s shipping index.

In addition, the recent record close by the Baltic Index could further indicate of the salutary growth clip the world could be experiencing today.

Again for as long as there won’t be any ‘shocks’ that could perturb the financial markets, under the conditions stated above we are likely to see more upside gains based on the present reactions of the several leading market indicators, as well as with the current momentum.

Don’t forget your mental stops.