The U.S. equity markets, commodity markets, and fixed income markets (with the exception of U.S. Treasury Debt) continued their slide into the abyss this week.
How did this come about?
The short answer - "The sub-prime mortgage crisis" - is a great sound bite, and was likely the initial catalyst, but can hardly contain within it the sheer volume of the collapse in market value that the U.S. and world markets have experienced over the past 6 weeks.
No, extreme use of LEVERAGED debt, and a little understood, humongous market of Credit Default Swaps - really just life insurance policies on all of that leveraged debt, but without benefit of knowing whether or not the party issuing your policy could actually PAY off on a claim - set off a negative feedback loop that climaxed with the world's largest banks unwilling to lend to each other in the inter-bank markets (one of the most common terms, "LIBOR" for London Interbank Offered Rate, is one such measure), as the loans are unsecured. Accordingly, any bank experiencing a "run on the bank" such as Bear Stearns, Lehman, or Washington Mutual experienced recently, would leave their interbank debts unpaid. The interbank lending market moves cash to where it is needed on any given day - corporate payrolls for example - in the financial markets. (G.E. and GOldman Sachs both needed an emergency capital raise in order to make PAYROLL, and Warren Buffet was
only too willing to provide said capital at some very agreeable terms).
Once the mortgage default rate reached a certain point (many U.S. banks appeared insolvent using the current "mark to market" accounting rules of the SEC) they stopped lending to each other. This, by itself, and in conjunction with the way money is created in our fractional reserve banking system, led to an unprecedented shortage of available U.S. dollars in the world financial system.
This, in turn, set off another negative feedback loop with a massive sell off of leveraged bets against the U.S. $ in the form of Gold, Oil, Currencies (with the exception of the Yen, as the Yen was THE currency of choice in the international carry trade because of Japan's very low interest rates). Hedge Funds and Wall Street investment banks were forced to sell these leveraged positions, and as prices fell they were forced to sell more which only further pressured prices....
With the shortage of U.S. Dollars in the system, and with no bank willing or able to lend, the U.S. Federal Reserve was forced to take the U.S. banking system, the money markets, the commercial paper markets, bank deposits, etc... (commonly referred to in the industry as "The Nuclear Option") onto its balance sheet, and the U.S. Treasury has begun to raise (monetize) debt to fund this Fed balance sheet expansion. The U.S. pension system is likely the next beneficiary of a government bailout, along with the U.S. auto manufacturers.
The total of all of the various Fed & Treasury packages is likely to exceed $3 Trillion! This number does not include the stimulus package earlier this year, or any future stimulus/rebate or deficit fiscal policy designed to further "stimulate" the economy.
At the moment, the U.S. $ is still rising against every currency (except the Yen) and commodity. The Dollar Index has risen 20% in 6 months. That means that, for dollar investors, asset prices on the other side of the trade have fallen by a similar margin (all else being equal).
Can the U.S. $ continue to rise in the face of all of this money creation by the Federal Reserve? After all, the US$ rise was caused by a shortage of $'s in the system, not increased productivity, interest rate policy, or Federal or Trade surpluses. (None of these measures would argue well for a strengthening dollar). It then follows that as the Federal Reserve and the U.S. Treasury remove the artificial shortage of US$'s in the system that the "price" of US$'s would fall.
This is not to say that the Yen and the US$ cannot continue to rise fora period of time. They can. But when the carry trade has been unwound, and the excess leverage has been liquidated, the reversal will likely be swift, sure, and brutal.
Hindsight is always 20/20. While we fully saw the near collapse of banking system, we certainly wish we had seen the US$ squeeze in advance. We did not (nor did anybody else, or it would not have happened so abruptly). But that was then, and this is now. The time to have bought US$'s (or sold assets in exchange for US$'s) was 8 weeks ago. And maybe there are a couple weeks left for that trade. But it is "long in the tooth".
We believe that certain commodities are at bargain prices, prices we will look back on and say "that was sooooo obvious..." in terms of Fall 2008 US$'s. As they say in the commodity markets: "The cure for low prices are low prices". The price of Oil, Gold, and especially Silver have gotten below the costs of producing the marginal barrel or ounce. The incentive for the energy exploration and production industry to find and produce Tar Sands, Deep Water, Coal to Liquids, etc... has been destroyed. We believe this will lead to SIGNIFICANT oil shortages in 2010 - 2012. (Supply destruction will exceed demand destruction in our opinion.)
While Gold has fallen to the year's low for Americans, Gold is trading at a record or near record price for Australians, New Zealanders, South Africans, Brazilians, Russians, and is up over 20% for Europeans, as a result of the US$ squeeze... all in the last 30 days! This has been true, to a lesser extent for Oil as well. Commodities trade relative to the currency of the purchasing country. We believe the US$ "squeeze" is temporary, and possibly short lived. The endless creation of money via the printing press and very low interest rates has never been a successful strategy for maintaining the purchasing power of a currency (in order to buy Oil, bread, steel, milk, rubber, coffee, etc...) for any country at anytime in modern history. This will not be the first, in our opinion.
Mentatt (at) yahoo (d0t) com
6 comments:
I have to disagree on a couple of points. There is no U.S. dollar shortage. This is the mistake the Fed and Treasury don't seem to be able to get past. The U.S. is CHOKING on cash and credit. There was and is lots of it, but it is being hoarded. Did any of the banks seize up and make our deposits unavailable? Did prime borrowers such as myself have their HELOCs cut? Nope. The banks did indeed stop lending to each other, but that was because they didn't know which borrowing banks would pay the money back, as you indicated. It's not a cash problem; it's a trust problem. Second, up until recently, no new cash was being added to the system at all (see the St. Louis Fed's own M1 graph, which spiked upward recently for the first time). Only credit was added. It appears that Federal borrowing of trillions of dollars finally broke the back of the credit-only approach. Doesn't matter tho, as the credit loses FAR outweigh the cash being added. During the Great Depression, there was lots of intervention (super-low interest rates, civil works projects, the alphabet agencies to artificially employ people), and Japan in the 1990s also failed doing the same thing. Now our own govt. is going to try those same failed things all over again. Only thing that really helps is time. But for now, this all still points to a comprehensive collapse in demand -- deflation. Inflation would likely come next, and man, I hope so. Deflation is really, really bad overall.
I think you missed the point.
There certainly WAS a significant shortage of $'s available, overnight lending between the major banks fell by over 75% at one point.
THAT was the crisis.
The actions by the various central banks and national governments has begun to reverse THAT circumstance.
You mention hoarding. EXXXXACTLY! The banks were hourding their cash and refusing to lend it to other banks.
M1 was not the issue.
Nevertheless, please, by all means, take the other side of the trade we are about to enter into. Just email me. In our business there is ALWAYS someone on the other side. If you are correct, you will get to keep our investment. If you are incorrect...
This becomes something entirely different when you are putting real money on the line.
Let me go on with that line.
Some of the famous deflationists would have made a great deal more money by shorting the commodities and their equities rather than go long the Treasury. Sure, the long bond is up 5.6% this year, but a leveraged short bet would be up 1000%.
How many of the deflationists just made $100+ million scores. NONE. They are as surprised at the timing and steepness of the sell off as everybody else.
On the other hand, if I am correct, when the Euro/Yen cross reverses, the US$ rally will end, and a retracement of at least 50% will result. If I am wrong, the US$ will rally to 100 on the index (up from 86) and you can clean up.
Every trade has a buyer and a seller, and only one of them gets to be right.
Good luck!
:) The dollars are and always were there. The banks just didn't want to lend them. And no one wants to borrow, cause they can't be sure they will be able to pay the money back. The kept dollars also will cushion the banks' inevitable losses from the economic/mortgage fallout. This will reverse when the people want to borrow again. My contention is that it will be a loooog time before they will want to. The only way the banks will lend again is if the government buys 51% of their stock and orders them to. But there is no law saying people must borrow. Who is gonna borrow now?
I'm not trader of millions of $ like you, making bets with leveraged (= borrowed) money which is soooo 1990s :) I'm having to bet my personal wealth (not at a million yet) and my retirement from Uncle Sam. I have REAL money on the line. :) I just can read the handwriting on the wall, and I think you can also. The inflation you predict will come, but not before what will be a near-depression and deflation. The energy prices have already dropped and next will be food prices, as the commodities bought high 3 months ago arrive on the store shelves today. They will be throwing food at people for almost free. The next shoe after that to be explored is the ability of the Feds to borrow even more money to run this country. I'm not optimistic. I'm trying international govt. bonds now.
It's not fair to say no one saw the USD strength coming, Mish has seen it for two years or more!
This is what he wrote on Dec 27 2007,(http://globaleconomicanalysis.blogspot.com/2007/12/how-does-one-invest-for-inflation-and.html)
"One possible currency play is the Yen. Leverage will be unwound in deflation and right now there is a massive leveraged carry trade in the Yen. The unwinding of that carry trade is likely to be very good for the Yen vs. the US dollar. I like the Yen here very much as a long term play.
A second possible currency play is related to the unwinding of leveraged dollar short positions as well as extreme anti-dollar sentiment, that fueled a mad dash into the Euro. I like the dollar vs. the Euro here.
His thesis on deflation is playing out exactly as he conceived, just accelerated and worse than he saw, and that's scary!
I give Mish EXTREME credit for an excellent call. Sort of.
Mish did not believe enough to make the big leveraged bet. If one does not do that, one does not really know/believe/feel strongly about the call.
Still, my hat is off to the man.
Mish is indeed one of the few who can claim to have been nearly correct on everything for the last two years. Further, it is even more amazing that his wisdom is FREE! :) He is a big part of my current economic thinking, but I do read/watch others also: Jimmy Rogers, the peak oil websites, the Agora yahoos, as well as my friends and family who, while being empirical, are employed by just about every economic sector.
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