US Commercial Paper Markets: A Run on The Shadow Banking System?

``Federal Reserve independence is not set in stone…The dysfunctional state of American politics does not give me great confidence in the short run…and there may be ``a return of populist, anti-Fed rhetoric,'' Alan Greenspan ``The Age of Turbulence: Adventures in a New World” quoted from Bloomberg

In the financial sphere, it has been one heck of an interesting week where some ironic developments persist to unfold…

One, global central banks debate on how to resolve the present juncture…

Two, global equity markets continue to crawl higher despite the barrage of negative developments (are these salutary signs of “climbing the wall of worry?”) amidst conflicting messages seen across different markets and…

Lastly the Phisix survived the week with some bruises from an onslaught of foreign selling worst than during the August lows (!).

The Bank of England seemed to have assumed the “principled” path of central banking by adamantly refusing to go along the way of its peers in rescuing the money markets. It even rebuked the US FEDERAL RESERVE and the EUROPEAN CENTRAL BANK for “moral hazard” or by acting to bail out some banks last Thursday, from which we quote UK Central Bank governor Mervyn King (highlight ours), ``The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior, that encourages excessive risk-taking and sows the seeds of a future crisis.” Mr. King’s view was supported by Canada’s Central Bank Governor David Dodge.

Well, such rhetoric was good until Northern Rock, UK’s fifth largest mortgage lender, came knocking on its doors for liquidity support. Of course, there always has to be some justification; here is Bank of England’s statement, ``the FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

Incidentally, the problems at Northern Rock has NOT been due to US subprime papers but rather from banks reluctant to lend to each other, this from the Economist (highlight mine),

``Yet Northern Rock appears to be less of a protagonist in the current credit crisis than a bad case of collateral damage. Its problems were caused not because it risked its shareholders’ money on poorly judged investments linked to American subprime mortgages, as many far bigger and more international banks have. Instead, it has been hit by a failure to borrow from other banks to fund its mortgage lending practices. The interbank market where such borrowing usually takes place has partially seized up in recent weeks because big banks are hoarding as much capital as they can to pay for the cost of their own bad investments.”

As you can see, the ongoing liquidity drought in the credit markets has begun to affect the peripherals, as banks load up on their reserves to prepare for portfolio adjustments (losses).

Yet, much of today’s liquidity seizure has been seen via the US $2 trillion commercial paper markets.

Commercial paper markets are short-term (unsecured) debt instruments or promissory notes issued by financial and non financial companies with maturities ranging up to 270 days and an average 30 days (capital-flow-analysis.com). Such instruments are usually used by companies to fund their day-to-day operations such as inventory purchases or manage working capital.

These papers are usually bought by money market funds or by mutual funds that invests in short term papers.

The problem lies with the asset-backed commercial paper market or short term vehicle issued by financial institutions backed by physical assets such as receivables (mortgages, bonds, credit cards, car loans or other trade receivables), some of which had been collateralized by subprime mortgages.

Where many of the pooled investment vehicles as the Structured Investment Vehicles (SIVs) used by banks and sold to the public had been borrowed in the form of asset-backed commercial papers, the losses in the US subprime sector has resulted to a freeze in financing due to the questionable valuations of these vehicles.

In effect, the liquidity freeze in the commercial paper space has crimped on the access to financing by corporations to manage their day-to-day operations. This has likewise raised the cost of borrowing, and increased the risks of corporations raising cash by selling other assets in order to raise cash.

PIMCO’s managing director Mr. Paul McCulley labels such developments equivalent to a bank run but in the form of “The Shadow Banking System”, where in his outlook, Mr. McCulley wrote (highlight mine),

``Technically, that’s called systemic risk. And in the current circumstance, it’s called a run on what I’ve dubbed the "shadow banking system" – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.

``Unlike regulated real banks, who fund themselves with insured deposits, backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with un-insured commercial paper, which may or may not be backstopped by liquidity lines from real banks. Thus, the shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks and/or to liquidate assets at fire sale prices.”

In Friday’s commentary, the cautiously bullish BCA Research (see figure 1), seeing the continued pressures in the credit markets, now joins the ranks of those calling for rate cuts…

Figure 1: BCA Research: Monitoring the Credit Crunch

Quoting BCA Research, ``The price of credit remains elevated in many areas. The asset-backed commercial paper market remains locked up, with investors seemingly unwilling to buy at any price. Term financing is difficult to get and this, along with nascent banking sector concerns, has contributed to the ongoing elevation in LIBOR rates and the fed funds-LIBOR basis swap. The 2-year swap spread also continues to widen towards the previous peak. Similarly, both corporate bond and CDS spreads are grinding higher. Perhaps most worrisome, the price of debt for some consumers has also surged, as indicated by the recent blowout in the 30-year fixed jumbo mortgage rate. It is when creditworthy customers cannot access credit that the Fed must step in and deliver relief.”

So how are rate cuts supposed to help?

The lowering of rates aims to reduce the impact of higher borrowing spreads and potential loan losses. Remember, in a highly levered financial system, marginal moves reverberate! Yet, rate cuts cannot be taken with certitude that confidence will be restored, especially if the damage has been widespread.

All told, despite the gradual progress seen in the equity markets, the credit markets tell us that ALL IS NOT NORMAL and that the present liquidity drought has been seen affecting a broader part of the global economy. This suggests to us that the downside risks are far greater than what the consensus expects.

On Bailouts: Left Hand Doesn't Know What The Right Hand Is Doing; Asymmetric Market Signals

``Monetary policy, at bottom, is not independent of fiscal policy. While reckless fiscal policy invariably ends in attempts to “monetize” the government's debt by printing money instead of issuing bonds, inflation is ultimately always and everywhere a fiscal phenomenon. Money and bonds are essentially portfolio substitutes, and interest rates fluctuate in order to ensure that the existing quantities of both assets are held in equilibrium.”-John Hussman Ph.D., Hussman Funds

Anent the Bank of England’s bailout of Northrock: As we always insist, Bailouts or government interventions have always been a manifestation of the ETHICAL PROBLEM—political authorities’ preference for a “treatment based solution” instead of a preventive cure, aside from its INFLATIONARY CONSEQUENCES in light of the quest to preserve the health of the prime conduits of today’s functioning FIAT MONEY Standard.

The risks of inflation and the MORAL Hazard problem has always been used as the perpetual POLITICAL SLOGAN of which these institutions proclaim as their nemesis, but behind the scenes surreptitiously work to uphold…or a case of a “left hand doesn't know what the right hand is doing.”

Allow me to quote PIMCO’s Paul McCulley anew (highlight mine), ``Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation. The question is not whether the Fed Put exists, but where is its strike price?”

For instance, some would readily believe the propaganda that the FED’s utilization of its REPO tool constitutes only of a substitution of liquidity or does not translate to monetary inflationary. While on the surface, such arguments look plausible, on a deeper context, particularly viewed within the TIME VALUE of Money frame, REPO activities are evidently inflationary.

Minyanville.com Professor Succo or Mr. Practical has a trenchant explanation (highlight mine),

``But the main point is that it is not the Fed that creates liquidity in an economy; it is the commercial banking system. What the Fed (mostly) provides is the temporary liquidity for these banks to do so.

``Large money center banks lever their assets. They take deposits and CDs and REPOs as liabilities and lend money and buy securities as assets with it. Every time they take in money via a liability they earn a spread (taking risk). So first, the writer is not understanding the time value of money: those REPOs, even though they have to be paid back, earns spreads over their life. This is liquidity for banks. And that spread, once earned, gets levered – voila – 10 to 1 or more.”

``Here is the problem. All those risky securities the banks have been carrying and earning spreads on have fallen slightly in value. Because of the immense leverage, just this small mark down of assets had seized up the banks from lending more money as they have to keep more cash to finance the lower mark on the assets. The temporary REPOs by the Fed act to finance those mark downs. The banks are “hoping” that their value goes up during the duration of the REPO. If they do not, the Fed will have to roll them and that liquidity becomes more permanent. Few people realize just how little the value of those assets held at banks have to fall before all the world's banks' capital is wiped out.”

In today’s world of the fractional banking system, whose degree of leverage has been equally reflected outside the banking sphere, a marginal fall in asset prices owned by banks or other financial institutions could pose as sufficient risk enough to destabilize the entire financial system. Hence, monetary authorities being aware of these conditions have been quick to respond to any incidences of heightened volatility.

So to suggest an answer to Mr. McCulley, the strike price could be the 10% threshold in the US equity market which has recently been touched and correspondingly has sparked an outcry for political subsidies.

And as we have pointed out repeatedly in the past, the markets have already priced in a FED “bailout” or a rate cut even prior to the FED’s action which is slated this September 18^th, as shown in Figure 2. The argument today is the depth or degree of the whole process.

Figure 2: ChartoftheDay.com: Effective FED FUNDs RATE

So whatever gains we have recently seen has been CONCRETIZED on the foundations of such expectations.

Of course, there is always the “BLACK SWAN” risk that the FED might do otherwise. But such actions could unleash violent reactions in the financial markets with unseen magnitude and repercussions, which we think the Mr. Bernanke and Company would be unwilling to gamble with.

Besides, given the inherent predilections of the authorities, even exhibited by those across the Atlantic, this paints Mr. Bernanke to the corner.

Anyway, evidences have been escalating where signs of the credit crisis, once confined to the jurisdictions of Wall Street, have now started to take its toll at MAIN Street, see Figure 3. This should help justify Mr. Bernanke’s prospective action.

Figure 3: New York Times: Double Warning On Recession

When mainstream media broaches of a trend, it usually signifies either an accelerating momentum or it could also mark a peak of a deeply entrenched trend.

In this case we believe that it is the former, since the Recession chatter has hardly hit the mainstream airwaves, until last week.

Mr. Floyd Norris in an article entitled “Double Warning That a Recession May Be on the Way”, opens with (emphasis mine), ``THE employment statistics and the bond market are combining to send out a warning that has been heard only rarely in the past two decades: A recession is coming in the United States.”

Mr. Norris points to the bond market’s negative yield curve as a precursor, punctuated by the recent job numbers as potential harbinger of a US recession. Of course, the August retail figures likewise points to a meaningful softening of the US economy.

In addition, even inveterate bull as Larry Kudlow has raised his recession probability forecasts to 50%!

What we are trying to point out is that there is a SNOWBALLING trend from the fringes to the mainstream forecasting of a hard landing for the US.

While we do not adhere to sentiments of the consensus (none I think correctly predicted the US payroll losses last September 7^th) especially during MAJOR inflection points, we think that a good number of these forecasters are riding on the RECESSION bandwagon to use the occasion to apply PRESSURE on the authorities to do SOMETHING to save the markets.

Yes, US equity markets have impressively climbed above its downtrend line as depicted in Figure 4.

Figure 4: Stockcharts.com: VIX Still on an Uptrend

US benchmarks registered substantial gains this week, the Dow Jones Industrials up 2.5% (upper window) while the S&P 500 was higher 2.11% while the Nasdaq rose 1.42%.

Meanwhile, the volatility indicator as shown by the VIX index at the main window, still hovers above the 20 levels and most importantly reveals of an uptrend which implies that there could be further bouts of selling in the offing.

Technically while the US benchmarks have popped beyond some critical thresholds such as resistance levels, moving day averages and downtrend lines, they were accompanied by LOW and DECLINING volume, which makes as us skeptical of the recent recovery.

Further, most of the recent gains came at the near end of each of the sessions, which has fueled speculations of U.S. government’s handprints.

One must remember that bond markets and credit conditions are not within the ken of the public since these are usually transacted within the confines of the specialized institutions, whereas stocks have more a permeating psychological bearing to the public. So based on incentives alone, it wouldn’t a far fetched notion for US authorities to meddle with the futures market to fillip these benchmark indices.

So what we have here is an asymmetry of market signals; bond markets still suggesting for a marked slowdown, credit conditions remain extremely tight (hence the wide spreads), US dollar broke below the 80 level coupled with and rising commodities as RECORD WHEAT, RECORD OIL, and a BREAKOUT in gold indicative future inflation, while stock markets have been climbing on expected bailouts.

Such incongruence will be sorted sooner rather than later and will prove some of these markets wrong.

As for Asia, we are seeing a conspicuous recovery in the GMF SPDR S&P/Citigroup Emerging Asia Pacific index exhibited by the lower pane. Since the index contains publicly listed companies from the Asia Pacific Region as China, India, Indonesia, Malaysia, Pakistan, the Philippines Taiwan and Thailand. Our observation is that perhaps the outperformance had been due to dazzling gains of China and the remarkable recovery in Indian stocks, while all the rest remain sluggish as that of the Phisix (pane below main window).

Next week has some potentials for added volatility in US stocks as the earnings period sets in with several important brokers submitting disclosures, such as Lehman Brothers, Morgan Stanley, Bear Sterns and Goldman Sachs aside from the much awaited Fed’s September 18^th FOMC meeting.

It would be interesting to see how…

1. the market responds to the FED cuts (we are inclined to expect a “sell-on-news” if the FED drops by 25 basis points) and…

2. the credit crisis has affected the balance sheets and bottom lines of such financial institutions; and if their recent declines have been already discounted by the markets or if the markets will be rocked by surprises.

Phisix: MINING and SERVICES Outperform; Buy Mines When Gold Crosses $726!

``The most important thing about money is to maintain its stability; You have to choose (as a voter) between trusting to the natural stability of gold and the natural stability and intelligence of the members of the Government. And, with due respect to these gentlemen, I advise you, as long as the Capitalistic system lasts, to vote for gold.”-George Bernard Shaw

As we have propounded last week, it is our belief that while a decoupling may not manifest itself strongly yet, we may be entering into stagflationary period like the 70s to 80s where inflationary momentum would accelerate as authorities try to stave off a wave of debt destruction. Such politically calibrated policies should set precious metals and other commodities on FIRE.

We do not agree with those downplaying the decoupling scenario since their arguments have all been tied with the “economic” dimensions omitting the potentials of monetary leakages. In a complex world driven by multifaceted variables, tunneling or vetting on single dimension could lead to severely flawed analysis.

We also are inclined to view that as the US FEDERAL Reserves acts to rescue on its principal constituents in order to “safeguard” today’s paper money standard system, Asian markets being the “strong” link could benefit immensely from the opening of the money spigot, which would be initiated by the US Federal Reserves.

However, given that the present system is structured heavily from leverage, the risks of a US hard landing spreading globally and debt deflation overwhelming the inflationary activities by Central Banks could pose as a TEMPORARY SHOCK.

A further potential shock could be a DISORDERLY DECLINE of the US dollar (measured by its trade weighted index) which has been bluntly dismissed by the mainstream or perhaps a bust or collapse in the China’s skyrocketing stock and property markets.

Hence, given the shock potentials with undefined ramifications (Knightian uncertainty or Mandelbrotian Gray Swan), we will try to limit our exposures to the markets until signs are lucid enough to determine the strength of the seminal trend.

We’d like to remind our readers that if the 2000 tech bust would be the precedent then, despite the Fed’s gamut of rate cuts from 6% to 1% then, global equity markets could likely to suffer from a similar decline as discussed in our August 6 to 10 edition [see A “Normal” Correction in the FACE of Massive Government Interventions? No Can Do!]. Today’s juxtapositions to the 1998 or 1987 scenario presumes that the US eludes a recession; such is likely to be an apples-to-oranges comparison.

Since the Phisix is part of the Asian equity asset rubric then the likelihood is that movements in open markets in Asia are likewise to REFLECT on the Philippine benchmark.

As an example we’d like to point out how ASEAN have been sold last week, in spite of the recent rebound in US equities. The Philippines and Malaysia took the brunt down 1.18% and 1.15%, respectively but we saw similar but moderate declines in Indonesia (-.64%) and South Korea (-.79%).

The peculiar part is that the intensity of the selloff (Php 2.48 billion) by foreign money topped the height of the August panic (Php 1.42 billion) in the Philippine Stock Exchange last week!

Of course, anyone can easily blame these blights on politics. But since the local investors had been net buyers relative to their foreign contemporaries then it is UNLIKELY that politics had been the driver to last week’s activities.

Where the local populace has treated the recent saga of the ex-President as a TELE-Drama series, it is evident that the locals are the parties obsessed with banal political controversies centered on “Personality based politics”. Given such predisposition, locals are likely to be swayed by political developments.

On the other hand, foreign money has been stoic to Philippine politics if the records from 2003 are to be examined closely. Of course, past performance may not be indicative of future activities.

Since the Phisix has rebounded from its August lows, it appears that the recent activities have shown some departure from broad market moves to sector specific actions.

Notably as shown in Figure 5, the mining index and the Services segment of the Phisix has continued to show relative strength compared with the rest of the field.

Figure 5: PSE Sectoral Issues: Divergences at Work

The Bank sector (Red), the Phi-All (Violet), Phisix (Green), Commercial Industrial (Light Orange), Holding (Blue) and Property (Blue Gray), appears to have hit a wall and has been losing steam.

In contrast the Mining and oil index (black candle) and the Services (Lime Green) Index seems to have generated sustained momentum. The services sector comprises of the Telecommunication, Information technology, Transportation Services, Hotel and Leisure, Education and Diversified Services. In our view, the buoyant performance of the Telecom heavyweights could have been responsible for the levitated Services index.

Meanwhile, it can also be construed that since gold has performed strongly in the face of a sagging US dollar index and on the account of heightened inflation expectations, aside from parallel movements in the global mining sector (best performance has been the Australasia, shown in figure 6, and African Gold stocks), local mines could have responded in the same measure relative to its foreign peers.

Figure 6 Bigcharts.com: FTSE Gold Australasia

We received several feedbacks imputing the rise of specific mines or oil stocks to certain activities as the reopening of new mines, outstanding earnings, speculations on drilling activities or prospective deals, all these tend to focus on company SPECIFIC attributes. Yet, such view reveals of the inherent cognitive biases by the average investor and glosses over the scrutiny that mining and oil stocks have been RISING IN GENERAL.

While the outperformance of the mines is a recent wonder to behold, it has yet to be proven that the local mines could withstand any potential shocks seen in the global markets. Foreign money support on local mines have been sporadic and on select issues. Hence, we should still proceed with utmost cautiousness, regardless of our bullish outlook.

As we have previously explained, a monumental development found in the domestic stock market today is the signs of significantly increased participation by local investors. Since the August lows, local investors have spearheaded the recovery over the broadmarket. Last week’s foreign selling also demonstrated how local investors managed to absorb big amounts of foreign selling with limited damage. We have no data whether local retail investors or institutions have been responsible for this.

We discussed this phenomenon as early as 2004 see July 05 to July 09 2004 [To Expand Philippine Capital Markets, Demand Is Key]; whereby we expect the secular [long term cycle] transformation to draw back local investors into the markets. Aside from the deepening trends of global financial integration and technology-enabled connectivity and access to data, we believe that the overall weakness in the US dollar will likewise influence local investors to repatriate overseas investments as the Phisix goes higher. So much for our long term outlook.

For the moment, we believe that the risk prospect is greater for the overall markets, but we see some selective opportunities with respect to the commodity sector, particularly gold and oil. And we gladly observe, local investors have now been partially receptive to such outlook.

Our treatment of gold is as alternative money and not your run-of-the-mill commodity. Should gold continue to be responsive to the activities of global monetary authorities, then we will be increasing our exposure to the mines gradually, in the condition that the latter shows the same sensitivity (here and abroad).

As a barometer, a gold breakout of $726 of levels requires meaningful exposure to the mining sector, as proxy to owning the metal itself, considering the lack of gold market here.

Slowly but surely our projections are becoming a reality.

Will the Driver of the World Financial Markets Please Stand?

``Since the 1970s, the US has experienced five outright recessions and two mid-cycle slowdowns (in 1986 and 1995). Most of the US recessions that led to sharp slowdowns in the RoW were caused by common shocks such as oil shocks and the bursting of the IT bubble in 2000. The 1991 recession, for example, did not have much of an impact on Europe; emerging markets actually accelerated. At the same time, the two mid-cycle slowdowns were associated with a very modest growth slowdown elsewhere. Countries’ business cycles are primarily driven by global shocks or idiosyncratic factors that affect the region or the countries in question, and tend not to originate from a single country.”-Stephen Jen, Morgan Stanley, Assessing the Collateral Damage from the Crisis

The gist of today’s debate on the financial markets can be narrowed into three fundamental variables: an economic growth slowdown, a US recession and a global depression.

On the surface, none of them looks positive for global equities, yet it is odd how many have turned some scenarios into a positive spin in support of their biases.

For most of the bulls, the core of their arguments amidst the slowdown scenario centers on the sustained strength of the global economies that may cushion the US economy from a hard landing or a “decoupling” (the premise of which we will not question but rather observe on how they would react under the unfolding events).

And most importantly, the expectations that global central banks led by the US Federal Reserves would effectively steer away the present crisis from a disaster with the much needed elixir.

For instance, a favorite bullish analyst of ours, while acknowledging the rising risks of a US recession, which he places at 30% (double from the past!), says the reason to be bullish is that ``it isn’t a good idea to fight the FED”, where the FED is expected to institute a “monetary bailout” and cut interest rates aggressively, which should prompt for an orderly turnaround.

As you can see, such bullish premise focuses entirely on the success of the authorities to execute bailout measures on market participants, one of the principal beneficiaries of the inflationary process (money and credit expansion) in today’s Paper Money Standard.

In short, FAITH if not HOPE determines his winning formula! This is dangerous stuff. Looking for justification to confirm one’s bias is known as CONFIRMATION Bias or (wikipedia.org) ``the tendency to search for or interpret information in a way that confirms one's preconceptions.”

As an aside, this clamor for rescue reminds me of the “socialization of the rich” to quote James Grant, an op-ed writer for the Forbes magazine.

If one were to argue about the yawning income gaps, then the Fed’s future action should bring into light how inflationary activities boost “special interest groups” or inequality.

Oh please, bailouts are bailouts in whatever form…

…since “money is created via thin air” in spite of some “sterilization” efforts

…still “who pays for the losses via wider collateral acceptance by Central Banks?”

…and “how does Central Banks know how to value illiquid assets held by institutions in trouble?”-ain’t these outright subsidies?

Eventually these will be paid by the citizenry via higher taxes or reduced value of the currency or through diminished purchasing power which translates to a lower standard of living.

Well, the financial markets priced in such scenario which led to the breakdown of the US dollar trade weighted index BELOW 80, a multiyear low! More below…

Nor can we argue with technicians who say that the US markets are playing out the same patterns seen during the past bottoms. One thing technicians tend to overlook is that the operative conditions before and conditions today are patently dissimilar.

US Fed Chair Bernanke’s Hands Are Tied!

``Mr. Bernanke is the epitome of US economic thinking. He is like a navigator in the 16th century who did not believe the earth to be round. There is no such a thing as an “inflation target” except the increase in the annual supply of money, which the Fed does control. The increase in the quantity of money is inflation and not the consumer price index, which in the case of the US is doctored anyway. So, how would the good Dr. Bernanke wish to target inflation? Are rising oil and commodity prices, which are conveniently excluded from the core CPI, not inflation??? Mr. Bernanke “targeting of inflation” centers in my opinion around a flawed theory and is one of economic theory’s greatest sophism.”- Dr. Marc Faber, Good Luck Mr. Bernanke, November 8, 2005

Yes, understandably the FED is in a tight bind.

As we have noted in the previous outlook, US market’s present level appears to be sustained by the MASSIVE expectations for a bailout. One can just look at Fed rate futures and bond markets to see how the financial markets have been SCREAMING for these! And failure to deliver is likely to result to a total rout!

For Mr. Bernanke and their ilk, delivering the therapeutic dosages seems difficult knowing that inflation (relative to consumer/producer goods) still abounds elsewhere as shown in Figure 1.

Figure 1: Economagic.com: CRB Grains Subindex Surges to RECORD HIGH!

Because when global central banks open the monetary taps, they cannot control where the money flows.

As we have previously predicted, a confluence of events…a spike in demand, climate change, demographic trends, water shortages, desertification, environmental hazards, lesser arable lands, market distorting policies (e.g. Biofuel subsidies) and lower dollar value…today conspired to bring CRB Grains Sub-index to a Record high, led by record Wheat prices followed by surging prices of soybean, oat, rice, corn and canola! Yes Anton, Beer prices are likely to go up!

In addition, we see oil prices in another attempt to break its previous high!

Nonetheless, following the bloodbath in the US markets last Friday, as US payroll data dropped to its lowest level in four years, the politicization of the markets appears to have gained momentum. This report from the New York Times (emphasis mine),

``For the first time in four years, economic concerns are rivaling the war in Iraq as a top issue on the political agenda.

``Sensing new political momentum, Democrats in Congress and on the presidential campaign trail are stepping up their criticism of President Bush’s handling of the economy and offering their own proposals.

``And now that the malaise in housing and credit markets appears to be infecting the wider economy, the Federal Reserve could feel more pressure from Democrats and Republicans alike than it has since Alan Greenspan, then the Fed chairman, incurred the wrath of President George H. W. Bush for not cutting rates faster in the early 1990s.”

Some have alluded to Ex-Chair Paul Volcker’s tight money policies as a possible precedent for Mr. Bernanke, to which respond quoting Dr. Marc Faber in his June 23, 2003 GBD report titled, Financial Implications of a Reflation (emphasis mine),

``I would therefore argue that even if Paul Volcker hadn’t pursued an active monetary policy that was designed to curb inflation by pushing up interest rates dramatically in 1980/81, the rate of inflation around the world would have slowed down very considerably in the course of the 1980s, as commodity markets became glutted and highly competitive imports from Asia and Mexico began to put pressure on consumer product prices in the US. So, with or without Paul Volcker’s tight monetary policies, disinflation in the 1980s would have followed the highly inflationary 1970s.

``In fact, one could argue that, without any tight monetary policies (just keeping money supply growth at a steady rate) in the early 1980s, disinflation would have been even more pronounced. Why? The energy investment boom and conservation efforts would probably have lasted somewhat longer and may have led to even more overcapacities and to further reduction in demand. This eventually would have driven energy prices even lower.”

As we have been saying ad nauseum…POLITICIANS and their factotums or affiliates mostly resolve to act on treatment based solutions based on political signification. It is short term issues which delivers the vote, that’s why!

In essence, the scenario of a FED supported economic “soft landing” appears largely premised on oversimplified explanations in support of bullish biases of the analysts.

A Global Depression or Platonicity?

``A novel, a story, a myth, a tale, all have the same function: they spare us from the complexity of the world and shield us from its randomness. Myths impart order to the disorder of human perception and the perceived “chaos of human experience.””- Nassim Nicolas Taleb- Black Swan, The Impact of the Highly Improbable

This leads us to the next topic: global depression.

Major deflationist advocates argue that since the US economy is the sole consumption engine of the world, the transmission of potential debt defaults or credit destruction through the finance and trade channels would lead to a global depression. The Japan’s LOST DECADE scenario is the most frequently cited example.

And global depression means significantly higher US sovereign bond prices or lower yields and a rising US dollar. All other asset classes are likely to struggle including gold (although some deflationist argues counter-intuitively that gold will prosper under such scenario).

Let me first say that in the financial markets anything can happen. Therefore, extremities as a FED prompted “magic” or global depression could also occur and we don’t discount these. But to my opinion, the weightings I would assign for such probabilities would be in proportion to the logic in support of such arguments.

First of all, while it is true that the US FEDERAL Reserves and the other global central banks may not be able to “stop” deflationary forces our question is the US the world or the world the US?

In his book, Black Swan (incidentally my textbook) Mr. Nassim Nicolas Taleb describes “Platonicity” as (highlight mine) ``our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”

Let us take for example some ingredients of the present crisis, such as Collateralized Debt Obligations or CDO or a type of asset backed security and structured credit product which pools several collateral including mortgage securities.

Figure 2: SIFMA: Global CDO Issuance Market Data

One of the attributions to the present seizure in the global financial system has been due to the opaque valuations of the said highly levered and illiquid instruments.

Figure 2 from SIFMA tell us that up to 76% of CDO issuances in 2006 and 75% of 1^st half of 2007 have been US dollar denominated.

Since the US mortgage market is about $6.5 trillion (about $1.3 trillion are subprime), many of these securitized mortgages make up the tranches pooled within these CDOs, and as we previously mentioned…sold and distributed worldwide.

The predominance of US CDO issuance is a testament to the degree of leverage faced by the US financial system relative to the world.

Figure 3: IMF: GFSR Global Hedge Funds by Geographic Source of Funds

Hedge funds are said to be one of the major investors of CDOs, according to the Bloomberg, ``About 25 percent of the trading in U.S. asset-backed securities was done by hedge funds. They were responsible for 20 percent of the volume in mortgage-backed securities trading.” (highlight mine)

In figure 3 courtesy of IMF, while the growth of the hedge funds industry have been worldwide leading to a reduction of the share of US based institutions, what we want to point out is that if there will be any destruction of credit, the bulk or meat of the damage would likely still be in the US, where 62% of hedge funds are located.

Of course, hedge funds and CDOs don’t make up the entire investing sphere, but what we would like to point out is that deflationist school of thought overestimates the universality of the global credit structure. Such view is ultimately too US centric.

The problem of “foreign currency reserve rich” Asian countries has been as BUYERS of these tainted instruments which could result to some balance sheet losses but should not affect its economic functions in the entirety.

FinanceAsia interviewed ANZ's Melbourne-based chief economist, Mr. Saul Eslake, from which we quote,

``Asian investors and financial institutions will have some of this toxic debt on their books. And will have to confess to how much they have lost. But I doubt there are many institutions in Asia – that matter – whose fundamental stability will be put at risk by those losses. In a sense, Asia has spent the last 10 years taking out insurance against the events that laid Asia low 10 years ago – and that will insulate Asia from some of those things. But people who write insurance, take a hit when claims are made, and that is effectively what is happening at the moment.

``But as far as the Asian economies are concerned they should be resilient. If there is a recession in the US – it is not more forecast, but it is a risk – then there will be adverse consequences for economic growth. But what we are talking about is maybe a percentage point off Asia’s growth rate, not a recession.

``As far as Asian equity markets are concerned: if the central banks succeed in restarting the credit mechanimsm, part of the means by which they will do that is by cutting interest rates. Lower interest rates, combined with what is fairly good growth, should be good for Asian equity markets, particularly since – China aside – they are not really overvalued.”

Figure4 BIS: Median debt equity ratios

We think ANZ’s Paul Eslake makes a good point to rebut against a global depression. Figure 4 from Bank of International Settlements tells us how deleveraged Asian economies are following the Asian Crisis.

Quoting the BIS on their latest quarterly outlook (highlight mine), ``The situation improved significantly after the crisis. Beginning in 1998, leverage began to fall significantly for Korea and Thailand, with book (market) leverage dropping to 77% (76%) in Korea and 99% (52%) in Thailand by 2005, well below pre-crisis levels. At the same time, interest coverage ratios improved markedly to above pre-crisis levels in all of the crisis countries except the Philippines (Graphs 1 and 2). By 2005, much smaller percentages of firms in East Asian countries had an interest coverage ratio below 1. Only in the Philippines was the percentage of firms unable to cover their debt service still relatively high, at 13.5%.”

Second, is that depression advocates argues in the context oblivious of the existence of today’s Fiat currency Standard.

What we mean is that the US Dollar being the world’s de facto currency standard would require the US Government to fight tooth and nail for the sustenance of present system, which underpins its quintessential pride and dignity.

It could, under present circumstances coordinate with global central banks to institute measures to mitigate the present junctures circumstances as what we have lately. What used to be national is today global, such is the marked nuance.

Yes while there is no guarantee that these efforts would work, synchronized moves could allow central banks more arsenal at their disposal. In other words, the inflationary system could last longer more than what the depression advocates may think of.

Further global central bankers appear to operate under the concept of the game theory called the NASH equilibrium, from which we quote the old article of one of my favorite analyst John Maudlin (highlight ours),

``The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.”

Put differently, in the eyes of central bankers, there is less of an incentive to upset today’s conditions, regardless of the imbalances built under the present setup. Hence, they would probably attempt to work for the status quo, while gradually attempt (or at least pay lip service) to deal with the imbalances —the NASH equilibrium!

Third, the financial markets are not limited to reflect on the economic domain but transmissions of monetary policies…

Figure 5: zse.co.zw: Soaring Zimbabwe stocks!

Zimbabwe is a functional example. The economy is undergoing recession if not depression, suffers from 7,000% of hyperinflation, have a chaotic political order…BUT a SOARING STOCK MARKET! See Figure 5 from the Zimbabwe Stock Exchange.

We discussed this in our April 9^th to 13^th edition [see Zimbabwe: An Example of Global Inflationary Bias?], our point is, regardless of the economic situation, inflationary activities by central banks could lead to leakages elsewhere (in any asset classes) in this globalized world.

Maybe under a PROTECTIONIST or “closed” world order, the depression scenario could possibly have more clout.

Lastly, the Japan LOST DECADE scenario has been the frequently cited case of the deflation disorder, where Keynesian infers this phenomenon as the “liquidity trap”-- ``that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes (Paul Krugman)”—allegedly responsible for over a decade of economic slump.

The peculiar thing is that Bank of Japan has followed to the hilt the prescriptions of its Keynesian and Monetarist mentors to no avail--from exhaustively heaving up of public spending (which today led to the largest public debt among developed nations 176% to GDP -CIA, 2006 est) to adopting monetary policies as Quantitive Easing.

Of course, there are some extreme and elaborate distinctions; culturally, Japanese is the world’s biggest saver against the US which is the world’s most spendthrift nation. So a comparison is definitely an apples-to-oranges one but since our discussion covers the globe, depressionists suggest of covering of the entire basket of fruits.

Second, the polemics boils down to the valid analysis of the present conditions.

We quoted self-development author Robert Ringer in his article “Beware of False Perceptions” in the past (highlight mine), ``Action is the starting point of all progress, but an accurate perception of reality is the foundation upon which a successful person bases his actions. A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

From which we question, “could the liquidity trap theory be erroneous if not fallacious?”

The Austrian School through Chris Mayer disputes such widely believed theory, we quote at length (emphasis mine)

``Many are those who believe Japan is or was in a "liquidity trap." The basic idea is that people's "liquidity preference," or their demand for cash, is so high that the interest rates cannot fall low enough to stimulate investment. The basic Austrian criticism of the liquidity trap concept is that it has the causation backwards. Interest rates do not drive investment.

``As Murray Rothbard points out in his book, America's Great Depression, "saving, investment and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with it." In other words, the consumers' choices drive the rate of interest—not vice versa.

``Other analysts obsess over the "deflation problem." The idea that deflation is the villain of the piece misses an obvious fact: money supply continues to grow. However you slice it, be it M-1, M-2 or "broadly-defined liquidity"—they have all been growing every year since 1984, the earliest date provided by the BOJ data bank on its website. M-1 grew 8.5% in 2001, 27.6% in 2002 and 8.2% in 2003. M-2, a broader index, grew 2.8%, 3.3% and 1.7% in each of these years.”

The St. Louis Fed has charts on Japan’s growth of monetary aggregates click on the link to prove Mr. Mayer’s point.

``Deflation proper—a decline in the supply of money—clearly has not happened. Prices, as measured by the current fashionable indices, have fallen, but that is not a deflation—no more so than our current mild CPI readings measure low inflation. But even so, the Japanese consumer price index decline has been quite mild. According to the Japanese Statistic Bureau, the Japanese CPI stood at 98.1 at the end of 2003, a decline of 0.3% from the prior year (the base year, 2000 = 100).”

Again click on this link from the St. Louis Fed on Japan’s Inflation (Consumer and Producer Prices).

``It seems to defy common sense to suggest that the problem with Japan is the small annual decreases in its CPI. Surely, if a mild 1–3% increase in prices is acceptable to mainstream economists, then a decrease of less than 2% ought to pose no dire problems. Mainstream economists insist on treating price deflation as if it were some unholy beast and inflation as some manna of prosperity.

``The central problem of Japan is not a liquidity trap and it is not deflation—the fundamental problem is a pattern of production ill-suited and ill-fitted to meet the realities of the marketplace.

``In general terms, the Japanese wanted to protect their exporters, despite the fact that the marketplace had changed and moved against them. They wanted to persist in the belief that the blue chip debtors of yesteryear were still creditworthy. The Japanese economy was like a shopkeeper in denial of what his customers were telling him. Pretending not to hear it, he goes about his daily business as before only driving himself further into losses.”

Yes, mainstream analysts today espouse the view that Japan is under deflation. This prevalent thinking represents an oversimplified “platonified” explanation of developments even when they even don’t MEET THE TECHNICAL DEFINITION.

As Robert Ringer suggests above, misdiagnosis leads to the wrong cures or even worst, possibly a cure worst than the disease. The anatomy: False perception leads to false assumptions, which then leads to false conclusions thereby rendering negative results on the actions applied.

Obviously Japan’s policymakers in refusal to lose power and privileges to free markets adopted the backward process of thinking or the “rear view mirror” syndrome to apply ineffectual policies that have prolonged the slump.

It goes the same with investment analysis…

A FED induced economic and financial markets turnaround and…

A global depression operates on a common thread…

They are based on Nassim Taleb’s “Platonicity”- makes us think that we understand more than we actually do- or…

OVERESTIMATING what we know and UNDERESTIMATING on what we don’t. We don’t give room enough for randomness but rather play up on our biases.

Which is why we give weight to the second probability, a potential recessionary risks coupled with open ended global outlook…

Loosening Correlations: A Possible Reprise Of The 1970-80s “Stagflationary Era”?

``The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."-Ernest Hemingway, September 1932

When we try to distinguish from what could be real and what could be an illusion, we do this by listening to the markets or heeding on the messages transmitted by the markets.

So what does the markets tell us today?

Figure 6 tell us that we are at a crossroads as seen with several breakouts.

First, the US dollar trade weighted index has officially closed BELOW the 80 level (see topmost pane), a multi-year low (!), following the weakest Jobs report since 2003 as discussed above. We previously discussed this last July 9 to 13 [see US Dollar Index Sits At Multi-Year Lows, Risks of Disorderly Unwind Heightens] and in July 16 to 20 edition [see US Dollar Index At 35 Year Support Level; Gold is Your Best Friend Now].

Second, aside from rampaging grains and rising oil, gold BOLTED out of its 6 month trading range [main window] and seems on path to test May 11, 2006 high at $726 dollars.

Third, US treasuries as we have said above BROKE DOWN OF ITS SUPPORT LEVEL signifying the market’s expectation of a steep deterioration of the US economy.

Let me borrow an incisive explanation of Professor John Succo or Mr. Practical in Minyanville.com (highlight mine),

``This is why the Fed has lowered interest rates at the discount window (emergency room): private money is no longer willing to lend to banks holding crumbling and risky mortgage debt and the Fed and other central banks have become their only source of liquidity. Banks have little treasuries in inventory to exchange for new credit from the Fed; this is why the Fed is now accepting more and more risky collateral like mortgages and consumer loans. Ironically this may allow banks to not write down those assets to market prices: they exchange in REPO those assets at some artificially high price and the Fed carries it at that price through the term in the REPO.

``If the REPOs are continually rolled, the banks may not have to take losses on those assets for some time. If this is so (I am investigating this), it is just another shell game to buy time. In trying to get normal longer term funding, I know of a sterling deal floated by a major European bank that failed; it pulled the deal and funded through Euro debt at egregious terms (imagine what that will do to its earnings). This tells us, by the way, that it is not just a dollar debt problem (although dollar debt is by far the largest), but a global debt problem.

``A force weakening the dollar will be (may be acting now to a small extent) the final destruction of that debt manifested by foreclosures and prices of assets like land and houses (and yes, eventually, stocks) that act as collateral, falling domestically until foreign savings buys them at lower clearing exchange rate (this is likely to be much lower given the meager amount of world savings relative to dollar debt). It is when a significant portion of the dollar debt (I don't know the number) is destroyed (defaulted upon) that the forces working to strengthen the dollar are overwhelmed by the forces weakening the dollar. Remember, the dollar is not backed by real money, but by debt. When that debt is destroyed, the dollar becomes worth much less.

``This is when gold will rise precipitously against the dollar and other currencies as well. Those currencies backed by real savings will do relatively better.”

Borrowing the kernel of Mr. Practical’s exposition; the ongoing “debt destruction” in the US implies for a WEAKER dollar, which could be what we are witnessing today. Yes, there are reports that the China has initiated to unload some of its US treasury holdings, but the impact to further undermine the US dollar’s position depends on it’s the continuity of its actions.

And a weaker dollar means inflationary forces gaining an upperhand, despite the debt destruction “deflationary” process. The rise of gold, oil and grains could be supportive of this view. This also suggests of higher interest rates which possibly mean that the US treasuries could reverse, fall (rising yields) and undergo an inflection, even as the US economy deteriorates. This outlook goes distinctly against the views of depressionists.

Figure 7: Chart of the Day.com: September’s Travails

Earlier we stated that we are at the crossroads of possible formative major trends. If gold continues to rise alongside a weakening US dollar supported by flanking increases in the price of oil or other commodities in the face of declining US stock market and a potential US recession, then important divergences could be unraveling: a possible reprise of the 1970-80s “stagflationary era”.

Of course, one week does not a trend make, albeit Figure 7 (chartoftheday.com) tells us that September has been a cruel month for US stocks, today’s inspirational leaders for global equities including the Phisix. And it appears that events are playing out the September theme well.

Friday’s softening of the US markets in the face of an unexpected deterioration in the US job numbers could be the start of the unwinding risks of a US recession.

Recently, even authorities such as Reserve bank of St. Louis President William Poole see “higher chances for an economic downturn in the US”. Likewise former Fed Chair Alan Greenspan was even glummer with his comments comparing the present scenarios with that of the 1998 LTCM and Oct 1987 crash:

``The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987"

Timesonline.co.uk quotes further Mr. Greenspan, `` The human race has never found a way to confront bubbles,” he said, suggesting that the manipulation of interest rates offers little control to central bankers.”

``Bubbles cannot be defused until the fever breaks.”

While we are not impressed by Mr. Greenspan’s forecasting capabilities, the fact that Mr. Poole and Mr. Greenspan raised the issue gives credence to the heightening risks concerns on the health of the US economy.

So what to do?

First, we need to spot for continued divergences. If the present weaknesses in the US markets persist on to spillover to global equity markets, then we remain on the sidelines.

Second, if, however, in the face of faltering US stocks, precious metals continue to rise (confirmed by rises in other commodities as oil and a weakening dollar) and likewise reflected in global mining issues, then a gradual reentry into the MINES should be considered.

Third, if, however, in the face of swooning US financials markets, global markets manifest of strong signs of decoupling then one should consider repositioning back to the general market.

Where we do not see any confirmations, we remain seated at the gallery.

Finally, I’d like to borrow Dr. Marc Faber’s conclusion from Tomorrow’s Gold (emphasis added),

``I am leaning toward the view that some sectors and regions will deflate-either absolute price falls or currency depreciation-while those already extremely deflated will rise in price. So inflation and deflation could coexist for quite some time. Moreover, it should not be forgotten that, even in a strong deflationary environment, some commodities and assets can appreciate rapidly as their respective prices are determined not by the overall macroeconomic price trends, but rather by demand and supply forces specific to their particular markets.”

A Correlation is a Correlation Until it isn’t…Time for that much awaited Break!