Monday, June 21, 2004

Financial Alchemy Underlying Risk and Uncertainty

Jim Puplava on the market from his crimson-stained tower.

Storm Watch Update

The markets don't look right to me. They appear to be out of order. Uncertainty is everywhere. Geopolitical risks abound from Central Asia and the Middle East to the American ballot box. Financial risks have never been greater with asset bubbles consistently inflating, fed by an avalanche of debt. Speculation is rampant with banks and hedge funds borrowing short and investing and lending long as well as households borrowing short and investing long in real estate. Despite record amounts of consumer, business, and government debt, financial markets remain complacent to the threat of higher interest rates.

An economy and stock market that is this levered is far more vulnerable to small movements in interest rates—even if they are measured. On the economic front, America's twin deficits keep expanding as our nation goes deeper in debt. Yet, the dollar has been in a rally mode since the beginning of the year. Inflation is also on the rise and is visible everywhere you look, but gold and silver prices have been falling.

What we have here is financial alchemy and I can't help but believe this is going to end badly. There is simply too much risk and uncertainty. What astounds me is the fact that investors seem oblivious to it all.
On Monday of this week the Commerce Department reported that the April trade deficit was the worst on record coming in at $48.3 billion, an annual rate of $575 billion or nearly 5% of GDP. The decline in the dollar over the last two years has done very little to stem the U.S. trade imbalance.

According to recent figures, America is importing and paying more for its oil. The average cost of oil in April was $31 a barrel. The trade deficit figures should be even worse next month as energy prices continued to resie to record levels in May.

But the growing trade deficit wasn’t entirely due to oil prices. Imports of everything from autos and electronics to furniture were also up. Automobile and auto parts imports rose to a record $19 billion, while Americans shelled out $31.7 billion for consumer goods. How is job growth in this country supposed to improve when more of our consumption goes towards the purchase of foreign made goods?

Economists argue that our rising trade deficit is due to our extraordinary economic growth in comparison with the rest of the world. Our GDP is expected to grow by over 4% this year. In contrast to our robust economic growth, French economic growth was revised downward to 0.50% for this year. Yet, America’s trade deficit has darker side. It reflects a lack of national saving that needs to be supplemented by importing foreign capital.

The U.S. Is Not Alone With Deficits

Other nations that are running large budget and trade deficits are seeing the price of their bonds drop in value along with their currencies. For example, Brazil and Turkey are two countries that have run into difficulty recently. Both countries have suffered the sharpest increases in interest rates among emerging countries this year.

Brazil, which is running a $21 billion budget deficit, needs to come up with $33 billion to cover maturing bonds in 1004 in addition to financing this year’s deficit. Turkey’s budget deficit this year will approach $31 billion. It will also need to pay the equivalent of $110 billion to domestic bondholders in 2004. Turkey will also need to pay $2.1 billion in U.S.-denominated bonds and $500 million in yen-denominated bonds by the end of the year. Both countries are experiencing rising interest rates and a falling currency.

With a Little Help From Our Friends

By contrast, the U.S. has experienced a rising currency even as our budget and trade deficits worsen. This is due to currency intervention by Japan and China and other central banks. On Monday, June 13th, the day the April trade deficit numbers were released, the dollar rose against the Japanese yen. The Fed reports that foreign central bank holdings of Treasuries at the Fed have risen by $293 billion in the last twelve months. They are up only $7.4 billion in the latest week ending on June 9th.

Why has the dollar risen instead of falling as would be the case if the markets weren’t altered?

Plain and simple: the value of the dollar has been held up by Asian currency policy. Asian central banks, in particular Japan and China, have been willing to endlessly buy dollars. So in effect, interest rates and the value of the greenback rest on the whims of Asian central bankers.

What will happen to interest rates here in the U.S.? What will happen to mortgage rates, to the value of real estate and to our stock market, which now rest in the hands of Japan and China more than it does the U.S. Fed? If foreign central banks stop buying or—even worse—start selling, our currency falls and interest rates rise. It is now a question of not “if” but “when” the dollar nexus unravels. No nation—not even the U.S.—can run $500-$600 billion twin budget and trade deficits into perpetuity. At some point foreigners will say “No more!”

The Carry Trade - The Search for Yield

What will precipitate this unraveling is yet unknown. It could be another rogue wave in the financial markets or a geopolitical event. I suspect this time it will be financial in nature.

According to a recent BIS (Bank for International Settlements) report, derivatives traded on global exchanges rose at the fastest pace in three years during the first quarter of this year. The value of derivative contracts on stocks, interest rates, commodities, and currencies increased by 31% during Q1 of this year, rising to a record $272 trillion.[2] Not since the first quarter of 2001 when derivative contracts surged 55% have we seen this much of an increase.

According to the BIS report, a robust appetite for risk underpinned equity and credit markets. Additional revelations of corporate malfeasance failed to put a dent in investors' appetites for risk. Equity and debt prices in emerging markets outperformed most markets. Implied volatility of options on U.S. equity indexes fell to record lows, while credit spreads narrowed on emerging and high yield debt.

During this speculative quarter not only did yields fall on risky debt, but in addition troubled economies of Brazil, Turkey, Venezuela and other emerging market borrowers continued to amass large amounts of new debt—more than any other quarter since 1996. Incredibly, despite increased risks, yields fell. To a large degree, this reflected the effects of the carry trade with institutions and hedge funds moving out of cash in search for yield.

Round One

That was March. Since then, things have changed. The first round of the unraveling of the carry trade took place in April and May. As it appeared that the Fed was going to tighten, the carry trade began to unwind. Shown below are charts of emerging market debt, junk bond spreads, the treasury market and the gold market. All four markets got hit hard. Emerging market debt fell by 15%, junk bonds fell by almost 10%, 10-year Treasury yields rose more than 119 basis points, and the gold stocks (HUI) fell by 29%. The major equity indices went from gains to losses. This was only round one.

As the markets began to unravel during this first stage of the tightening process, Federal Open Market Committee (FOMC) officials—or more appropriately the Federal Open Mouth Committee—went into high gear, feeding the markets soothing words such as “measured” and “slow.”

The damage above was all done without the Fed firing a single shot. Imagine what would happen if they were to get real serious about inflation. Fed officials were able to rescue the markets by reassuring market players that they would take their time in raising interest rates. This was supposed to assuage the market participants—and especially the carry trade—that they would have plenty of time to unwind their positions. The last thing the Fed wanted was another repeat of 1994, 1997, or 1998.

The markets have become even more geared since those turbulent days. In addition the Fed had plenty of bullets to fight a crisis with the federal funds rate at much higher levels than where it stands today. At the end of 1994, the federal funds rate stood at 5.50%. It was 5.50% at the end of 1997 and 4.75% at the end of 1998. All three years were crisis years. When the Fed raised interest rates in 1994, it nearly collapsed the financial markets creating the peso crisis and a crisis in derivatives with Orange County, Gibson Greeting Cards and other derivative players. Institutions simply didn’t understand the risks they were taking. I am not sure they understand those risks today.

The point that needs to be understood is that the U.S. economy and the financial system is far more leveraged than where it was nearly a decade ago. Globally, derivatives have grown to a mammoth $272 trillion. In the U.S. the notional value of derivatives in insured commercial bank portfolios grew to $71.1 trillion. Of this amount, $61.9 trillion was interest rate related. Bank derivative portfolios have grown exponentially since 1994. We've seen derivatives grow from less than $17 trillion in 1994 to today’s $71.1 trillion. Incredibly, bank derivatives have grown at a compound rate of over 17% over the last 9 years.

Unlike previous years, today’s players are more interconnected. Most trades are placed with a handful of banks and brokerage firms. Everyone believes that they have hedged their risks. In actuality, the risk has just been passed around from bank to bank and brokerage firm to brokerage firm. Everything works out as long as no major player goes under. If that happens, the whole system implodes like dominoes stacked up one against the other. You may think that you are hedged, but your hedge is only as good as the financial solvency of your counterparty.

So far during the first phase of the unraveling, there have been no real casualties. Markets have adjusted to future rate expectations with the bond market doing most of the Fed’s job. As shown in the 10-Year T-Note and 30-Year Bond charts, interest rates have risen significantly.

Massaging The Numbers Won't Make It Better

However, as much as rates have risen, they have much further to go. Inflation indexes indicate that the true rate of inflation is probably approaching 8-10%. The CPI and PPI numbers are statistically massaged to remove the major impact of inflationary increases. Instead of measuring the cost of housing, the CPI Index uses a rent equivalent number which is much lower than the true inflationary costs of housing. Other statistical measures, such as quality adjustments, temper or remove price increases so that inflation rates seem reasonable. Even with these adjustments, there is no hiding the fact that inflation is on the rise. May import prices for the United States were up 1.6% in May. While a good majority of this increase was due to a spike in oil prices, other commodity prices rose as well. Wage costs are rising, health care benefits are moving up at high single-digit rates and food costs have nearly doubled.

The May CPI index jumped 0.6%, which was the largest increase since January 2001. Higher food and energy costs accounted for the bulk of the increase. Year-over-year core CPI is up 1.7% and rising quickly this year. Including food and energy, which everyone needs, the CPI index is now rising at an annual rate between 7 to 8% a year. In the meantime, for the second time this year, the Bureau of Labor Statistics has delayed the release of the PPI, the second measure of inflation. The Bureau is having "technical difficulties" coming up with a number. One can only guess by the jump in raw material prices that the PPI number has risen considerably. The new improvement measures the Bureau is considering can suspiciously be seen as an attempt to suppress a sudden surge in the index. Given the fact that commodity prices are up this year, one would expect the PPI numbers to also be up. There is tremendous pressure to keep the numbers suppressed. Higher inflation numbers mean higher interest rates, higher COLA adjustments on pensions, and a major adjustment of market multiples. Higher inflation rates and higher interest rates pose a major risk not only to the financial markets, but also to the economy. It is important to maintain the illusion that inflation rates are low, especially for the bond markets, which are the traditional vigilantes of inflation. Regardless of what is said by Wall Street and Washington officials, inflation is on the rise and has worked its way down Wall Street to Main Street.

Remember When...?

During the 80’s inflation was transferred from the economy to the financial sector. Inflation accelerated during the 90’s as the money supply ballooned. Debt levels went through the roof. However, the bulk of this money and credit went into our financial markets giving us double-digit growth in the major indexes year after year. Inflation never showed up on Main Street because excess demand was made up by cheap Asian imports.

The burgeoning trade deficit, a Nasdaq at 5048, and P/E multiples of 100 to 1,000 on tech and Internet stocks was a reflection of this inflation. Consider the fact that since January 1995 M3 money supply has grown by $4.8 trillion, a growth rate of over 8 percent per annum.

What has changed in this new millennium is that money growth has accelerated as a result of the bursting of a stock market bubble, a recession, and the attacks of 9-11.

In addition to the growth of money and credit, U.S. companies and consumers now compete with Asian companies and consumers for raw materials and consumer goods. Asian economic growth now competes with U.S. economic growth. The result is that inflation has made its way over on to Main Street.

Stagflation Rears Its Ugly Head

We are now in a new environment somewhat similar to the 1970s when the money supply soared as central banks expanded money and credit to accommodate the impact of higher energy prices. The result was stagflation. Isn’t that where we are today? Rising energy prices, higher rates of inflation, anemic job growth, and stagnating wages all point to a stagflation environment.

Given the current budget and trade deficits of the U.S., inflation is likely to accelerate in the months and years ahead. The reason is simple: money and credit growth.

Watch What I Say... Not What I do

Forget what the Fed says and watch what it does. As shown below, the money supply is growing rapidly again. In addition the Fed has begun to monetize U.S. Treasury debt as shown in the table below.

With Asian central banks pulling back on their purchases, the Fed may have no choice but to start monetizing our debt. The government deficit will be over $500 billion this year and the trade deficit is tracking at an annual rate of $575 billion. Where will all of this money come from? If the government tries to get it from taxes, there will be a tax revolt in this country the likes we have not seen since the founding of this country. Taxes are going to go up no matter who is elected president. Kerry will raise tax rates the most, which will be the final death knell on the economy. Regardless of what tax rates our leaders impose, they won’t be high enough to cover the government’s voracious appetite for spending. (Each candidate is proposing massive new spending programs.) Taxes will not be able to cover the government’s bill. Government simply spends more than it takes in. So what they don’t take in taxes will be made up by printing more money. This will further accelerate inflation.

Some question whether the money supply numbers are real, since the Fed seasonally adjusts these figures. Recently the Fed adjusted the money supply data all the way back to 1998. As with all U.S. economic statistics, one never knows what one is getting. All of our economic numbers are seasonally adjusted. The GDP numbers are artificially inflated through hedonic indexing and adjusted inflation numbers. The unemployment and jobs report is inflated by the “net birth/death model" and the inflation indexes are manipulated through quality adjustments and exclusions of items that are rising in cost. If there are any doubters as to the degree of money growth, all one has to do is view the debt graphs below of total debt outstanding, bank credit, corporate debt, and mortgage debt.

If the money supply hasn’t been growing as fast as the figures indicate, then where did all of this credit come from? Or consider these facts: financial sector debt more than doubled since 1997 from $5,532 billion to $11,402 billion, total indebtedness grew by $15 trillion to $35 trillion from 1997 to 2003, and it is now $37 trillion. As for that pillar of the global economy—the American consumer—he is up to his eyeballs in debt having borrowed $775.7 billion in 2002 and $879.9 billion in 2003 by way of mortgages, home equity loans and credit cards. Consumer debt is now estimated at over $2 trillion dollars.

Unraveling: Then and Now

What you have today is an economy that is entirely run on credit. Even a small rise in interest rates can do irreparable harm. Think back to 1999-2000. The Fed began raising interest rates at its June 30th meeting in 1999. It raised the federal funds rate from 4.75% to 5%. Thereafter, it continued to raise rates in quarter point increments, taking the federal funds rate up to 6.5% by May 16, 2001. It raised rates gradually and in small increments. But it was able to raise interest rates by only 1.75%. The rise in interest rates gave us a 75% decline in the Nasdaq, a recession, the worst job growth and the largest pullback in business investment in nearly half a century.

Companies, consumers, the government at all levels, the financial markets, and our entire economy are far more leveraged today than we were in 1991 or even 2000. A rise in interest rates of as much as 1, 2, 3 or 4% (as many analysts and economists are indicating) would collapse our economy and financial markets. What is sustaining the U.S. economy, our financial markets, and the American consumer is ever increasing amounts of debt and the asset bubbles that underpin that debt. Homeowner equity has fallen steadily from 85% in 1945 to 55% in 2003. Even that figure is distorted by the amount of homes that are free and clear held by an older generation. Corporate debt remains high at close to 75% of GDP and the government's own debt is now over $7 trillion.

The Consequence of Rising Interest Rates

If the Fed raises interest rates as high as many in the financial community suggest, they will lead us into the next Great Depression. I doubt whether the next president—whoever that turns out to be—or an American Congress would look favorably at collapsing real estate prices, a collapsing stock market, another banking crisis, a sinking economy, and unemployment rates of over 10%. There would be a voter backlash of biblical proportions. The economy is simply too weak and dependent on easy and cheap credit. Deprive that economy of credit and the whole financial edifice collapses. Unlike 2000, the financial system—in particular the banking system—is dependent on inflated real estate prices as collateral for all of those mortgage loans made to consumers. (Mortgage assets represent almost 60% of banks' earning assets.) The financial sector appears healthy only as long as real estate prices hold up. Household balance sheets are stretched to the limit with less disposal income and debt levels at record highs.

Hedge Funds & The Risk of Derivatives

Besides a crisis in the economy that will come about through rising interest rates, there is also the looming crisis in the financial markets. The meltdown in emerging debt is now spreading to the junk bond market. Interest rates on high-yield bonds are rising as the hot money bails out. There are now more than 7,000 hedge funds that play a major role in terms of global capital flows. These funds tend to follow the leader as they move into the same sectors. There is very little diversity in hedge fund strategies. Most funds follow the same strategy in the same way that mutual fund managers do. Everyone is doing the same thing. These funds manage about $860 billion in investor capital. That figure is considerably larger when you consider that many funds are leveraged 20:1. When rates are low, hedge funds can make a lot of money by borrowing short-term and investing long. However when rates rise, regulators start saying their prayers. No one wants to see another LTCM. And yet just as most funds employ the same investment strategies, they also use the same risk models. These models are supposded to minimize the risk according to Nassim Taleb, author of Fooled by Randomness. Taleb points out that the trouble with these models is that they are all backward looking. Since most funds use the same models, they move money in and out of sectors at the same time. They may be hedged, but who are they hedged with? Banks used to hedge their loan books with derivatives. Now they sell that insurance to hedge funds and other market players. The fallacy of banks selling insurance to others as Taleb points out is akin to “… buying insurance on the Titanic from someone on the Titanic.”[4]

The growing use of derivatives is one major factor that hovers over the financial markets. It is capable of accelerating any downward move in asset prices. When everyone is on the same side of the boat and they bought their life insurance from a group sitting on the other side of the boat, I’m not sure who survives when the boat capsizes...

See the Complete Article, Charts, and Graphical Analysis at Financial Sense Online

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