- Doug Casey: Why Do We Need Government?
Submitted by Doug Casey via CaseyResearch.com,
Rousseau was perhaps the first to popularize the fiction now taught in civics classes about how government was created. It holds that men sat down together and rationally thought out the concept of government as a solution to problems that confronted them. The government of the United States was, however, the first to be formed in any way remotely like Rousseau's ideal. Even then, it had far from universal support from the three million colonials whom it claimed to represent. The U.S. government, after all, grew out of an illegal conspiracy to overthrow and replace the existing government.
There's no question that the result was, by an order of magnitude, the best blueprint for a government that had yet been conceived. Most of America's Founding Fathers believed the main purpose of government was to protect its subjects from the initiation of violence from any source; government itself prominently included. That made the U.S. government almost unique in history. And it was that concept – not natural resources, the ethnic composition of American immigrants, or luck – that turned America into the paragon it became.
The origin of government itself, however, was nothing like Rousseau's fable or the origin of the United States Constitution. The most realistic scenario for the origin of government is a roving group of bandits deciding that life would be easier if they settled down in a particular locale, and simply taxing the residents for a fixed percentage (rather like "protection money") instead of periodically sweeping through and carrying off all they could get away with. It's no accident that the ruling classes everywhere have martial backgrounds. Royalty are really nothing more than successful marauders who have buried the origins of their wealth in romance.
Romanticizing government, making it seem like Camelot, populated by brave knights and benevolent kings, painting it as noble and ennobling, helps people to accept its jurisdiction. But, like most things, government is shaped by its origins. Author Rick Maybury may have said it best in Whatever Happened to Justice?,
"A castle was not so much a plush palace as the headquarters for a concentration camp. These camps, called feudal kingdoms, were established by conquering barbarians who'd enslaved the local people. When you see one, ask to see not just the stately halls and bedrooms, but the dungeons and torture chambers.
"A castle was a hangout for silk-clad gangsters who were stealing from helpless workers. The king was the 'lord' who had control of the blackjack; he claimed a special 'divine right' to use force on the innocent.
"Fantasies about handsome princes and beautiful princesses are dangerous; they whitewash the truth. They give children the impression political power is wonderful stuff."
IS THE STATE NECESSARY?
The violent and corrupt nature of government is widely acknowledged by almost everyone. That's been true since time immemorial, as have political satire and grousing about politicians. Yet almost everyone turns a blind eye; most not only put up with it, but actively support the charade. That's because, although many may believe government to be an evil, they believe it is a necessary evil (the larger question of whether anything that is evil is necessary, or whether anything that is necessary can be evil, is worth discussing, but this isn’t the forum).
What (arguably) makes government necessary is the need for protection from other, even more dangerous, governments. I believe a case can be made that modern technology obviates this function.
One of the most perversely misleading myths about government is that it promotes order within its own bailiwick, keeps groups from constantly warring with each other, and somehow creates togetherness and harmony. In fact, that's the exact opposite of the truth. There's no cosmic imperative for different people to rise up against one another… unless they're organized into political groups. The Middle East, now the world's most fertile breeding ground for hatred, provides an excellent example.
Muslims, Christians, and Jews lived together peaceably in Palestine, Lebanon, and North Africa for centuries until the situation became politicized after World War I. Until then, an individual's background and beliefs were just personal attributes, not a casus belli. Government was at its most benign, an ineffectual nuisance that concerned itself mostly with extorting taxes. People were busy with that most harmless of activities: making money.
But politics do not deal with people as individuals. It scoops them up into parties and nations. And some group inevitably winds up using the power of the state (however "innocently" or "justly" at first) to impose its values and wishes on others with predictably destructive results. What would otherwise be an interesting kaleidoscope of humanity then sorts itself out according to the lowest common denominator peculiar to the time and place.
Sometimes that means along religious lines, as with the Muslims and Hindus in India or the Catholics and Protestants in Ireland; or ethnic lines, like the Kurds and Iraqis in the Middle East or Tamils and Sinhalese in Sri Lanka; sometimes it's mostly racial, as whites and East Indians found throughout Africa in the 1970s or Asians in California in the 1870s. Sometimes it's purely a matter of politics, as Argentines, Guatemalans, Salvadorans, and other Latins discovered more recently. Sometimes it amounts to no more than personal beliefs, as the McCarthy era in the 1950s and the Salem trials in the 1690s proved.
Throughout history government has served as a vehicle for the organization of hatred and oppression, benefitting no one except those who are ambitious and ruthless enough to gain control of it. That's not to say government hasn't, then and now, performed useful functions. But the useful things it does could and would be done far better by the market.
- What Crisis Is The Gold/Oil Ratio Predicting This Time?
The number of barrels of oil that a single ounce of gold can buy has never, ever been higher.
For the last 30 years, when the ratio of gold-to-oil spikes, something systemically serious occurs globally (as opposed to the usual bullshit “this is transitory” statements).
So what happens next?
- Caught With Our Pants Down In The Gulf
Submitted by Justin Raimondo via AntiWar.com,
Your bullshit-ometer should be making an awful racket in response to the shifting explanations given for the twenty-four-hour Iranian hostage scare involving two US Navy boats intercepted in the Gulf.
First they told us “at least one of the boats” had experienced a “mechanical failure.” Then they said the boats had run out of fuel, although it wasn’t clear if they meant both boats. Then they said “there was no mechanical problem.” Then they claimed that the two crews had somehow not communicated with the military command, although “they could not explain how the military had lost contact with not one but both of the boats.” As the New York Times reported:
“Even as Mr. Kerry was describing the release on Wednesday morning, American military officials were offering new explanations about how the two 49-foot patrol boats, formally called riverine command boats, had ended up in Iranian territorial waters while cruising from Kuwait to Bahrain.”
And they still haven’t explained it – or any of the other distinctly odd circumstances surrounding this incident.
The best they could do was have an anonymous Navy officer aver “When you’re navigating in those waters, the space around it gets pretty tight.” However, as the Times put it:
“But that is hardly a new problem, and the boats’ crews would almost surely have mapped out their course in advance, paying close attention to the Iranian boundary waters. And each boat has radio equipment on board, so it was unclear how the crews suddenly lost communication with their base unless they were surrounded by Iranian vessels before they could alert their superiors.”
We are told they were on a “training mission” – but what kind of mission? The Washington Post adds a helpful detail by telling us that “The vessels, known as riverine command boats, are agile and often carry Special Operations forces into smaller bodies of water.”
Ah, now we’re getting somewhere.
Amid all the faux outrage coming from the neocons and their enablers in the media over the alleged “humiliation” of the US – Iran “paraded” the sailors in their media! They made one of the sailors apologize! The Geneva Conventions were violated! – hardly anyone in this country is asking the hard questions, first and foremost: what in heck were those two boats doing in Iranian waters?
And if you believe they somehow “drifted” within a few miles of Farsi Island, where a highly sensitive Iranian military base is located, then you probably think there’s a lot of money just waiting for you in a Nigerian bank account.
Anyone who thinks the adversarial relationship between Washington and Tehran has turned into “détente” due to the nuclear deal is living in Never-Never Land. Our close ally, Saudi Arabia, has all but declared war on the Iranians and that means we are being dragged into the rapidly escalating conflict. In this context, two US military boats coming a mile and a half away from a major Iranian base in the Gulf isn’t an accident. This ‘training mission” was a military incursion, and although we have no way of knowing what mission the US hoped to accomplish, suffice to say that it wasn’t meant to be a kumbaya moment.
Rachel Maddow is also raising questions about this: after a load of nonsense about how showing the sailors on Iranian media violated the Geneva Conventions – they didn’t: we aren’t at war with Iran yet – she pointed out the suspicious nature of the Pentagon’s shifting story during her January 13 broadcast.
To add another layer to the mystery, the Iranian government released the sailors after holding them for less than twenty-four hours – which isn’t the sort of behavior one might expect if those sailors were on a spy mission. And the Iranians issued an Emily Litella-ish statement, as reported by the Los Angeles Times:
“’After explanations the U.S. gave and the assurances they made, we determined that [the] violation of Iranian territorial waters was not deliberate, so we guided the boats out of Iranian waters,’ said Foreign Ministry spokesman Hossein Jaberi Ansari, according to the official Islamic Republic News Agency.”
So if those two boats were “snooping,” as the Fars News Agency originally claimed, why would Tehran come out with this all-is-forgiven statement?
None of it makes any sense, at least not until one realizes that the Iranian government is hardly a monolith: power is divided up between various agencies and factions, with only the loosest sort of unity being enforced by the Supreme Leader. Farsi Island is controlled by the hard-line Iranian Revolutionary Guard Corps (IRGC), the hard-line faction of the ruling elite, which wields enormous political and economic power within the multi-polar Iranian state apparatus. It was the hard-liners who released the video and photos of the American sailors with their hands in the air, and their spokesmen demanded an apology from the US. It was the diplomats, however – the moderates, who negotiated the Iran deal – whose contacts with the US facilitated the sailors’ quick release.
But it isn’t just the Iranians who are riven with factions and conflicting lines of authority: the American empire is overseen by a vast national security bureaucracy involving both military and civilians, and it isn’t monolithic, either. Although, in theory, civilians are in the drivers’ seat and the military just follows orders, in reality the Pentagon is an independent power that can obstruct or even effectively veto whatever diplomatic or military plans the White House has in mind. And while opposition to the nuke deal was centered in Congress, the Pentagon insisted at the last moment that sanctions on conventional arms and particularly those related to ballistic missiles remain in place. Iran’s recent testing of medium range ballistic missiles must have the generals in an uproar, and it could well be that this “training mission” in the Gulf was related – as either a spying mission, or an outright provocation designed to imperil relations. Or perhaps both.
We’ll probably never know for sure: but what we certainly can know is that the official explanation for this latest incident stinks to high heaven. There’s no denying we were caught by the Iranians with our pants down. The only question is – how were we trying to f—k them over?
I warned after the signing of the Iran deal that we are in for a long series of provocations in the Gulf, and this is only the beginning. In order to keep all this in perspective, just remember that the long dance between Washington and Tehran involves at least four partners, including their hard-liners and ours.
- China Stocks, Credit Risk Worsen Despite "Short-Squeezed" Yuan Strength
On the heels of new reserve ratio regulations and the biggest strengthening in the Yuan fix in 4 weeks, offshore Yuan has strengthened notably (despite Chinese default/devaluation risk surging in the CDS markets). Chinese stocks are weaker in the early going but corporate bond yields continue to slide to new record lows as the “last bubble standing” stands ignorant of the risks around it.
PBOC rixed the Yuan 0.07% stronger – the biggest gain in 4 weeks…
- *PBOC STRENGTHENS YUAN FIXING BY 0.07%, MOST SINCE DEC. 21
Offshore Yuan is rallying in early trading, because as Bloomberg notes,
*PBOC TO IMPOSE RESERVE RATIO ON OFFSHORE BANK YUAN ACCOUNTS
*PBOC SAYS RULE DOESN’T APPLY TO FOREIGN CENTRAL BANKS
*PBOC SAYS RULE WON’T AFFECT DOMESTIC YUAN LIQUIDITY
*PBOC SAYS WILL USE MONETARY TOOLS TO MAINTAIN LIQUIDITY
PBOC will impose a required reserve ratio on offshore participant banks with yuan deposits in the mainland, according to people familiar with the matter.
Raising reserve requirement is meant to increase cost of funding and discourage speculative short yuan trades, says Fiona Lim, Singapore-based senior FX analyst at Maybank
This marks the PBOC’s latest attempt to make shorting the CNH prohibitively costly by forcing banks to purchase CNH in the open markets. As Reuters adds, by forcing banks offshore to hold more yuan in reserve, it would reduce the amount of the currency available in the market, squeezing supply further and making it more difficult and expensive for speculators.
The costs of borrowing yuan “are set to rise” as a large volume of offshore yuan is actually being deposited back into China, explained an international investment banker who declined to be identified.
“The expectation of yuan devaluation has led to massive remittance of yuan,” said China Industrial Bank’s chief economist Lu Zhengwei.
“Raising the RRR will increase the cost of arbitrage,” Lu said.”Domestic banks conducting exchanges offshore and remitting yuan to China will be further controlled, pushing up the cost of offshore yuan funding.”
As a result of this latest intervention, the Onshore-offshore Yuan spread once converged again:
Although it does pose the question how desperate China must be, and how massive the capital outflow, if the PBOC is engaging in new FX manipulations virtually on a daily basis to prevent the ongoing uncontrolled devaluation of its currency.
Perhaps related to that, Chinese sovereign default/devaluation risk surges.
And stocks weaken:
- *CHINA’S CSI 300 INDEX SET TO OPEN DOWN 1.6% TO 3,068.23
- *CHINA SHANGHAI COMPOSITE SET TO OPEN DOWN 1.8% TO 2,847.54
But the money continues to flow aimlessly into the “last bubble standing” as we detailed previously with record low corporate bond yields in China (despite a collapse in creditworthiness fundamentals and huge supply).
But analysts are starting to worry:
“2016 is a year when we will see systemic risks emerge in China’s credit market,” said Ji Weijie, credit analyst in Beijing at China Securities Co., the top arranger of bond offerings from state-owned and listed firms.
“There may be a chain reaction as more companies are likely to fail in a slowing economy and related firms could go down too.”
Charts: Bloomberg
- Saudi Arabia Is Buying Up American Farmland To Export Agricultural Products Back Home
Submitted by Mike Krieger via Liberty Blitzkrieg blog,
Just what we need, cornfield crucifixions.
Seriously though, this is very troubling. The Saudis are explicitly conserving their own resources at home, while exploiting land and water supplies here in America.
CNBC reports:
Saudi Arabia and other Persian Gulf countries are scooping up farmland in drought-afflicted regions of the U.S. Southwest, and that has some people in California and Arizona seeing red.
Saudi Arabia grows alfalfa hay in both states for shipment back to its domestic dairy herds. In another real-life example of the world’s interconnected economy, the Saudis increasingly look to produce animal feed overseas in order to save water in their own territory, most of which is desert.
Privately held Fondomonte California on Sunday announced that it bought 1,790 acres of farmland in Blythe, California — an agricultural town along the Colorado River — for nearly $32 million. Two years ago, Fondomont’s parent company, Saudi food giant Almarai, purchased another 10,000 acres of farmland about 50 miles away in Vicksburg, Arizona, for around $48 million.
But not everyone likes the trend. The alfalfa exports are tantamount to “exporting water,” because in Saudi Arabia, “they have decided that it’s better to bring feed in rather than to empty their water reserves,” said Keith Murfield, CEO of United Dairymen of Arizona, a Tempe-based dairy cooperative whose members also buy alfalfa. “This will continue unless there’s regulations put on it.”
Recall, this is precisely the type of investment Michael Burry of “Big Short” fame recently said he was involved in.
In a statement announcing the California farmland purchase, the Saudi company said the deal “forms part of Almarai’s continuous efforts to improve and secure its supply of the highest quality alfalfa hay from outside the (Kingdom of Saudi Arabia) to support its dairy business. It is also in line with the Saudi government direction toward conserving local resources.”
Crucially, the issue of land rights comes into play.
The area of the Arizona desert where the Saudis bought land is a region with little or no regulation on groundwater use. That's in contrast to most of the state, 85 percent of which has strict groundwater rules. Local development and groundwater pumping have contributed to the groundwater table falling since 2010 by more than 50 feet in parts of La Paz County.
Sure, conserve local, exploit American. Just brilliant.
"We're not getting oil for free, so why are we giving our water away for free?" asked La Paz County Board of Supervisors Chairman Holly Irwin.
…
Added Irwin, “We’re letting them come over here and use up our resources. It’s very frustrating for me, especially when I have residents telling me that their wells are going dry and they have to dig a lot deeper for water. It’s costly for them to drill new wells.”
Local development and groundwater pumping have contributed to the groundwater table falling since 2010 by more than 50 feet in parts of La Paz County, 130 miles west of Phoenix. State documents show there are at least 23 water wells on the lands controlled by Alamarai’s subsidiary, Fondomonte Arizona. Each of the wells is capable of pumping more than 100,000 gallons daily.
“You can use as much water as you’d like, as long as it’s put to a beneficial use, and you’re not required to report your water use,” said Michelle Moreno, a spokesperson for the Arizona Department of Water Resources, which has scheduled a public meeting for Jan. 30 in La Paz County to hear concerns from residents.
More competition for land and fodder is likely to make things more expensive for dairy farmers in California and elsewhere.
“It will ultimately drive the price up for the West Coast dairy operations,” said Robert Chesler, vice president of the dairy group at FCStone, a Chicago-based commodity-risk management company. “This is where they are buying that hay. This is where they are buying the farmland for dairy farms as well as and where they are buying the dairy goods, because we are obviously exporting more out of the West Coast.”
Just another example of the Saudis giving it good and hard to American public.
- Wells Fargo Is Bad, But Citi Is Worse
Earlier we reported that Wells Fargo may have an energy problem because as CFO John Shrewsbury revealed, of the $17 billion in energy exposure, “most of it” was junk rated.
But, while one can speculate what the terminal cumulative losses, cumulative defaults and loss severities on this loan book will be, at least Wells was honest enough to reveal its energy-related loan loss estimate: it was $1.2 billion, or 7% of total – as Mike Mayo pointed out, one of the highest on the street. Whether it is high, or low, is anyone’s guess, but at least Wells disclosed it.
Citi did not.
Yes, the bank did disclose its holdings to the oil and gas sector at $21 billion funded and $58 billion which included unfunded (watch that unfunded exposure collapsing and shrinking the available pool of shale company liquidity in the coming weeks), and it did announce that it “built roughly $300 million of energy-related loan loss reserves this quarter”, but paradoxically one thing it did not disclose was its total reserves to energy.
Note the following perplexing exchange between analyst Mike Mayo and Citi CFO John Gerspach:
<Q – Mike Mayo>: Can we move to energy, though? I don’t want you being the only bank not disclosing reserves to energy – oil and gas loans. I mean, I think most others have disclosed that who have reported so far. And I mean, your stock’s down 7%. The whole market is down a whole lot, but I don’t – even if it’s a low number, it can’t hurt too much more from here. And so can you – how much in oil and gas loans do you have, and what are the reserves taken against that? I know you were asked this already, but I’m going back for a second try.
<A – John C. Gerspach>: When you take a look at the overall portfolio, Mike, we’ve reduced the amount of exposure. Our funded exposure to energy-related companies this quarter is down 4%. It’s about $20.5 billion. The overall exposure also came down about 4%. The overall exposure now is about $58 billion, that includes unfunded. When you take a look at the composition of the funded portfolio, about 68% of that portfolio would be investment grade. That’s up from the 65% that we would have had at the end of the third quarter. And the unfunded book is about 87% investment grade. So while we are taking what we believe to be the appropriate reserves for that, I’m just not prepared to give you a specific number right now as far as the amount of reserves that we have on that particular book of business. That’s just not something that we’ve traditionally done in the past.
And yet all other reporting banks have done it not only in the past, but this quarter as well.
One wonders just how much of Gerspach’s decision was dictated by the Fed’s under the table suggestion to avoid mark to market in energy entirely, and thus to stop marking its loan book. To be sure, without knowing the total amount of reserves to oil are, one simply can’t do any calculations on Citi’s total energy book, even if the once already bailed out bank so eagerly provided the incremental addition to this reserve. As if that number is in any way helpful.
Finally, we eagerly await for someone from the Dallas Fed to contact us and to comment on our article from yesterday that the “Dallas Fed Quietly Suspends Energy Mark-To-Market On Default Contagion Fears.” Because with megabanks such as Citi refusing to disclose energy losses, the longer the Fed remains mute on just what it knows that nobody else does, the more concerned the market will be that the subprime crisis is quietly playing out under its nose all over again.
But one thing is certain: the panic can begin in earnest when Janet Yellen says, at the next Fed press conference, that “energy is contained.“
- Japanese Stocks Enter Bear Market, Credit Risk Surges To 20-Month Highs
“It’s difficult to see the fall stopping today,” warned one Japanese equity strategist and rightly so as Japan’s broad TOPIX idnex just entered a bear markets (down 20% from the August 2015 highs). With the Nikkei well below 17,000, Kuroda is due to speak at the Diet today as Japanese corporate bond risk surges to 20-month highs.
TOPIX enters Bear Market
And now the Nikkei:
- *JAPAN’S NIKKEI 225 EXTENDS DECLINE FROM JUNE HIGH TO 20%
And Japanese corporate bond risk is surging – up 3.5bps to 87bps – the highest in 20 months…
Get back to work Mr. Kuroda!!
- *JAPAN’S PARLIAMENT CONFIRMED KURODA’S APPEARANCE
We just have one quick question – how does the government explain to its citizenry that foircing GPIF to go all-in Japanese stocks and corporate credit was a terrible idea and their retirement funds are FUBAR?
- Foreign Central Banks Furiously Dump US Treasuries: Record $47 Billion Sold In First Two Weeks Of 2016
It’s not just stocks have a terrible start to the year, in fact the worst start in history: so is the amount of US Treasuries held in custody at the Fed, a direct proxy for the holdings of foreign central banks, reserve managers and sovereign wealth funds who park owned TSYs at the NY Fed for convenience.
According to the latest Fed data, after a drop of $12 billion in the first week of the year, another $34.5 billion in Treasuries held in custody was sold in the week ended January 13, bringing the total to just $2.962 trillion, below the previous recent low recorded in early November, and at levels not seen since April 2015.
Indicatively since April, total US Treasury holdings have increased by $570 billion, meanwhile not a single incremental dollar has ended up in the Fed’s custody account.
As shown in the chart below, the drop recorded in the latest period is the single largest weekly drop recorded since China commenced liquidating its Treasury holdings in mid 2014.
Adding up the flows from the first two weeks of the year reveals the worst and most custody holdings “outflowing” start to the year in history.
The size of the liquidation promptly got the rate community’s attention.
On Friday afternoon, MarketNews cited Louis Crandall, chief economist at Wrightson ICAP, who said “we have seen declines of more than $20 billion (in such Treasury custody holdings) on each of the first two weeks of this year. While accounts are volatile from week to week, that is certainly consistent with increasing intervention activity” from foreign central banks needing money to intervene either in the foreign exchange market or in the stock market, he said.
“There is no way of knowing” exactly what such central banks sold, he added. “But it could just as easily have been liquidation of coupon securities.”
As MNI further writes, most observers saw China selling as behind the drop in Treasuries holdings at the Fed. “Circumstantially, that’s the conclusion that people would jump to,” said Crandall.
Some said it is not just China: Aaron Kohli, analyst at BMO Capital Markets, was less inclined to point to China. “It’s definitely a drop, but keep in mind, every foreign central bank is in there,” he said.
One other observer said that the decline “should be foreign central bank selling” as opposed to routine rolling of maturing securities. “Those are very chunky numbers. We did not even get such large sales back in August 2015 when we knew there was such selling” in Treasuries to get money to fund buying of China stocks, he said.
Others, however, disagree: “That kind of size could only be China,” said the observer. But he added that at the margin, other Asian central banks could have been selling Treasuries to raise dollars for foreign exchange or stock market intervention.
One trader said China “must be selling, along with others. Look at the Hong Kong dollar, also down big. It is a game of musical chairs, and everyone is devaluing at once. The U.S. dollar strength is apparent.”
* * *
One trader who has put all this together, and has linked it to the abnormal moves in the Treasury swap market is Ice Farm Capital’s Michael Green.
As he puts it, “those who chose to seek protection in rates are only experiencing middling success due to the continued inversion of swap spreads which have traded to record highs.”
Now this has been repeatedly noted in the press as irrational – why would US government bonds be trading at a risk premium to swap spreads which carry bank counterparty risk? I would suggest there is one very simple reason:
His conclusion is that “swap spreads appear to be blowing out because foreign holders of treasuries, namely China, are selling them at a record pace to defend their currencies. Currency levels are under attack in China, Saudi Arabia and now Hong Kong. The specter of 1997-1998 is again haunting the markets.”
As Green frames it, “the key question is “How long can this go on for?” Consensus is clearly that China, in particular, has a deep pool of reserves with which to defend their currency; I am less convinced. Having seen some contrarian work on the subject, my belief is that China is a paper tiger – with very little reserves left to defend their currency. Perhaps as little as three months given their current burn rate.“
If accurate (and Green’s calculation excludes the hundreds of billions China may need to leave on its books if its NPL credit cycle finally hits as Kyle Bass is currently anticipating) then the coming months could see an unprecedented shock out of China which having spent hundreds of billions to slow a record capital outflow, has no choice but to let its currency finally float freely, leading to the biggest capital exodus in recorded history.
- Here Is The Stealthy Way Some Are Betting On A Market Crash
Credit markets have been warning of a looming crisis for months…
And as the cost of protecting against credit collapse has soared so the cost of protecting against equity downside (VIX) has started to awaken:
However, as we detailed previously, more than a few market participants have turned to deep out-of-the-money options to protect themselves against drastic downside (pushing the skew – the relative cost of crisis protection over 'normal' protection – to record highs).
And so, with the cost of protection so high, traders are looking for cheaper alternatives.
Since the Fed folded in September (under the same conditions that are playing out now), basically admitting it is terrified to raise rates and willing to backtrack due to market fragility, IceFarm Capital's Michael Green explains, it appears many market participants are piling into par Eurodollar calls:
[the chart shows the cumulative open interest in par calls on eurodollar futures contracts that expire in 2016 and 2017 – basically options on short-term interest rates with a strike price of zero, such that they pay out if the Fed takes rates negative]
When queried whether this is indeed a trade to bet on a market drop, Michael Green responded as follows:
[A reader] thought this might be an attempt by hedge funds to hedge out their exposure to rising interest rates very cheaply.
My initial idea was that it actually could be a bet on negative rates (if for some reason the Fed had to come back into the picture with QE4).
The bottom line: "Deep OTM puts on the S&P are very expensive while par ED calls are relatively cheap. In my view, we are that inflection point where the Fed is going to start to waffle…the bear market beckons and they will not be able to stick with their interest rate guidance. Of course, markets tend to frown on Central Bankers revealed as less than omniscient…"
And the market is already shifting to that opinion – as CME shows, no one trusts The Fed's dot-plots anymore:
Thus, the ED Par Calls are a direct proxy for The Fed's "Dow-Data-Dependent" policy (and given the surge in Open Interest, it seems more than a few agree).
h/t IceFarm Capital's Michael Green
- Wells Fargo's Problem Emerges: $17 Billion In Junk Energy Exposure
When Wells Fargo reported its Q4 earnings last week, the one topic analysts and investors wanted much more clarity on, was the bank’s exposure to oil and gas loans, and much more color on its energy book over concerns that Wells, like most of its peers, was underestimating the severity of the upcoming shale default wave.
And while the company’s earnings call indeed reveals that things are deteriorating rapidly in Wells energy book, perhaps an even bigger concern for Wells investors, which just happens to be the largest US mortgage lender, should be what is going on with its mortgage book. The answer: nothing. In fact, at $64 billion in mortgage applications in the quarter, this was not only a major drop from Q3, but also the lowest since the first quarter of 2014.
Needless to say, without significant growth in Wells’ mortgage pipeline and originations, there can be no upside to Wells Fargo stock, meanwhile one can kiss the so-called housing recovery goodbye for the final time, because now that the US Treasury is cracking down on criminal and money laundering “all cash” buyers, we fully expect the housing industry to grind to a near halt in the coming 2-3 quarters.
That covers the lack of upside. As for the substantial downside, here are the key parts from Wells Fargo’s conference call discussing the bank’s energy exposure.
First: how big is Wells’ loan loss allowance for energy:
We’ve considered the challenges within the energy sector and our allowance process throughout 2015 and approximately $1.2 billion of the allowance was allocated to our oil and gas portfolio. It’s important to note that the entire allowance is available to absorb credit losses inherent in the total loan portfolio.
Then, from the Q&A, how much is Wells’ total loan exposure, its fixed income and equity exposure toward energy:
I would use $17 billion as outstandings for energy loans. And for securities, I would use, call it, $2.5 billion which is the sum of AFS securities and non-marketable securities.
In other words, a 7% loan loss reserve toward energy, perhaps the highest on all of Wall Street.
Then, here is the breakdown by services:
We’re focused on the whole thing. Half of those customers – half of those balances represent E&P companies, upstream companies. A quarter of them represent oilfield services companies, and a quarter of them represent pipelines and storage and other midstream activity. And it excludes what I would describe as investment grade sort of diversified larger cap companies where we don’t view the credit exposure as quite the same.
But the “downside risk” punchline was the following exchange with Mike Mayo:
<Q – Mike L. Mayo>: What percent of the $17 billion is not investment grade?
<A – John R. Shrewsberry>: I would say most of it. Most of it.
<Q – Mike L. Mayo>: So most of the $17 billion is non-investment grade.
<A – John R. Shrewsberry>: Correct.
To summarize: $17 billion in oil and energy exposure, which has a modest $1.2 billion, or 7%, loss reserve assigned to it (the highest on the street mind you), and which is made up “mostly” of junk bonds.
Why could the be concerning? Well, one reason is that junk yields just surpassed the all time highs set just after the Lehman bankruptcy.
In retrospect we can see why the Dallas Fed told banks to stop marking assets to market.
As for Wells, Warren Buffett may want to take another bath in the coming days.
Source: Wells Fargo Q4, 2015 Conference Call
- The "Putin Is Isolated" Meme Officially Dies As Japan Calls For Closer Ties With Russia
One of the great ironies of the Obama administration’s foreign policy record is the extent to which Washington started 2009 with designs on normalizing frosty relations with Russia and started 2015 with the worst US-Russo dynamic since the Cold War.
To be sure, not all of that was Washington’s fault – but most of it was.
Of course the international community probably should have curbed its enthusiasm early on, given that the entire effort got off to a rather inauspicious start when then-Secretary of State Hillary Clinton presented Sergei Lavrov with a big red button that was supposed to say “reset” (a nod to the “resetting” of relations between Washington and Moscow) but which actually said “overcharged” in Russian.
(“overcharged“)
Six years, one annexed Crimea, a raft of economic sanctions, and one Ukrainian civil war later, and we’re back to Soviet-era politics.
Part and parcel of Washington’s PR and foreign policy strategy over the last three or so years has been to perpetuate the idea that Vladimir Putin is “isolated” on the world stage. This, along with subtle reminders in the media and on the silver screen that America needs to preserve a healthy bit of Russophobia if it is to be safe, has worked domestically, but not internationally.
Russia has strengthened ties with China, kicked off the BRICs bank, cemented an alliance with Iran (another “isolated” state), and worked to de-dollarize everything from oil markets to cross-border financial transactions.
Moscow’s dramatic entry into the Syrian conflict and Russia’s common sense approach to ending the years-long affair has resonated with the likes of France and everyone else who understands that the way to fight terror is to kill the terrorists, not arm them.
Indeed, The Kremlin’s successful attempt to wake the world up to the fact that Washington and its regional allies are actually exacerbating the war in Syria by arming rebel groups with questionable motives has gone a long way towards forcing the international community to rethink who the “good” superpower really is.
Now, in what may be the best evidence yet that the “Putin is isolated” meme is officially dead, none other than US ally Japan is ready to “bring Putin in from the cold.”
“Japanese prime minister Shinzo Abe is pressing for President Vladimir Putin to be brought in from the cold, saying Russian help is crucial to tackling multiple crises in the Middle East,” FT writes, adding that “Mr Abe said he was willing to go to Moscow as this year’s chair of the Group of Seven advanced economies, or to invite the Russian president to Tokyo.” Here’s more:
Pointing to tension between Saudi Arabia and Iran, the war in Syria, and the threat of radical Islamism, Mr Abe said: “We need the constructive engagement of Russia.”
The former G8 excluded Russia following its annexation of Crimea and military support for separatist rebels in eastern Ukraine. But while Japan has joined in sweeping economic sanctions, Mr Abe made clear he wants to work with Mr Putin.
“As chair of the G7, I need to seek solutions regarding the stability of the region as well as the whole world,” he said, noting Japan’s ongoing territorial dispute with Russia over the Kuril Islands. “I believe appropriate dialogue with Russia, appropriate dialogue with president Putin is very important.”
As the only Asian nation in the club of rich democracies, Japan prizes its G7 membership, and Mr Abe is determined to make the most of the Ise-Shima summit he will host in May.
This is the kind of talk that will get you blacklisted in Washington and we wonder how long it will be before Abe gets a courtesy call from the Obama to remind Tokyo of the grave “threat” Putin poses to global peace and security.
Or maybe The White House will take a step back and ponder whether decades of foreign policy blunders combined with a misplaced (and highly off-putting) sense of exceptionalism have now left America as the “isolated” superpower.
- Oil Plunges To $28 Cycle Lows As Iran Supply Looms, Stocks Slide
February WTI Crude futures have plunged to new cycle lows at $28.60 (down 2.7%) as Iran supply looms over an already over-glutted global crude market. Brent is down even more (-3.7%). Dow futures are down 60 points at the open.
- *WTI OIL FALLS AS MUCH AS 2.7%, BRENT CRUDE DROPS 3.7%
Feb futures (which have just rolled) are under $29…
And the new on the run March contract is trading $29.60, down 2.6%…
It seems Nomura may be right:
“Iran’s additional crude shipments have the potential to further depress prices, perhaps to as low as $25 a barrel,” Gordon Kwan, Hong Kong-based analyst at Nomura Holdings Inc., says by e-mail Sunday.
And crude weakness (and fears over US banks) are weighing on US equities… Dow futures down 65 points
- "China Banks Seem To Be Doing Whatever They Can To Avoid Paying Anyone In Dollars"
By Dan Harris of China Law Blog
Getting Money Out of China: What The Heck is Happening?
Regular readers of our blog probably know that our basic mantra about getting money out of China is that if you have consistently follow all of China’s laws, it ought to be no problem. Not true lately.
In the last week or so, our China lawyers have probably received more “money problem” calls than in the year before that. And unlike most of these sorts of calls, the problems are brand new to us. It has reached the point that yesterday I told an American company (waiting for a large sum in investment funds to arrive from China) that two weeks ago I would have quickly told him that the Chinese company’s excuse for being unable to send the money was a ruse, but with all that has been going on lately, I have no idea whether that is the case or not.
So what has been going on lately?
Well if there is a common theme, it is that China banks seem to be doing whatever they can to avoid paying anyone in dollars. We are hearing the following:
1. Chinese investors that have secured all necessary approvals to invest in American companies are not being allowed to actually make that investment. I mentioned this to a China attorney friend who says he has been hearing the same thing. Never heard this one until this month.
2. Chinese citizens who are supposed to be allowed to send up to $50,000 a year out of China, pretty much no questions asked, are not getting that money sent. I feel like every realtor in the United States has called us on this one. The Wall Street Journal wrote on this yesterday. Never heard this one until this month.
3. Money will not be sent to certain countries deemed at high risk for fake transactions unless there is conclusive proof that the transaction is real — in other words a lot more proof than required months ago. We heard this one last week regarding transactions with Indonesia, from a client with a subsidiary there. Never heard this one until this month.
4. Money will not be sent for certain types of transactions, especially services, which are often used to disguise moving money out of China illegally. This is not exactly new, but it appears China is cracking down on this. For what is ordinarily necessary to get money out of China for a services transaction, check out Want to Get Paid by a Chinese Company? Do These Three Things.
5. Get this one: Money will not be sent to any company on a services transaction unless that company can show that it does not have any Chinese owners. The alleged purpose behind this “rule” is again to prevent the sort of transactions ordinarily used to illegally move money out of China. Never heard this one until this month.
What are you seeing out there? No really, what are you seeing out there?
- The State Of Our Denial Is Strong
- What Just Happened With OIL?
Yesterday, we reported exclusively how the Dallas Fed is pulling strings behind the scenes to conceal the fallout from the oil market crash. As Dark-Bid.com's Daniel Drew notes, by suspending mark-to-market on energy loans and distorting the accounting, they are postponing the inevitable as long as possible. The current situation is eerily reminiscent to the heyday of the mortgage market in 2007, when mortgage defaults started to pick up, and yet the credit default swaps that tracked them continued to decline, bringing losses to those brave enough to trade against the crowd.
Amidst the market chaos on Friday, a trader brought something strange to my attention. He asked me exactly what the hell was going on with this ETN he was watching. I took a closer look and was baffled. It took me awhile to put the pieces together. Then when I saw the story about mark-to-market being suspended, it all made sense.
Here is the daily premium for the last 6 months on the Barclays iPath ETN that tracks oil:
Initially, Dark-Bid.com's Daniel Drew thought this was merely a sign of retail desperation. As they faced devastating losses on their oil stocks, small investors turned to products like oil ETNs as they tried to grasp the elusive oil profits their financial adviser promised them a year ago. Oblivious to the cruel mechanics of ETNs, they piled in head first, in spite of the soaring premium to fair value. After all, Larry Fink is making the rounds to convince the small investor that ETFs are indeed safer than mutual funds. Because nothing says "safe" like buying an ETN that is 36% above its fair value.
Sure, there are differences between ETFs and ETNs, particularly regarding their solvency in the event of an issuer default, but the premium/discount problem plagues ETFs and ETNs alike. Nonetheless, widely trusted retail sources of investment information perpetuate the myth that ETNs do not have tracking errors.
But was it just retail ignorance?
Something remarkable happened in the last hour of trading on Friday which sparked the massive decoupling in OIL from its NAV…
Making us wonder, was an 'invisible hand' at play? Or was this just more evidence of OPEX-inspired broken markets?
As Dark-Bid.com's Daniel Drew so eloquently concludes,
With the oil fallout quickly spreading, the Fed is resorting to behind-the-scenes manipulation of energy debt, and now, that apparently includes oil ETNs as well.
Is anything too much (too off limits, too conspiracy wonk) for them? Do they really think the ETF tail can wag the oil complex dog and rescue the disastrous MtM values of the US banking system's energy loans?
- Syria 4 Years On: Shocking Images Of A Post-US-Intervention Nation
While US intervention in its various forms has likely been ongoing for decades, March 2011 is often cited as the start of foreign involvement in the Syrian Civil War (refering to political, military and operational support to parties involved in the ongoing conflict in Syria, as well as active foreign involvement).
Since then the nation has collapsed into chaos with an endless array of superlatives possible to describe the economic and civilian carnage that has ensued.
However, while a picture can paint a thousand words, these four shocking images describe a canvas of US foreign policy “success” that few in the mainstream media would be willing to expose…
Mission un-accomplished?
- Cracks At The Core Of The Core
Exceprted from Doug Noland's Credit Bubble Bulletin,
January 15 – Bloomberg (Matthew Boesler): “The U.S. economy should continue to grow faster than its potential this year, supporting further interest-rate increases by the Federal Reserve, New York Fed President William C. Dudley said. ‘In terms of the economic outlook, the situation does not appear to have changed much” since the Fed’s Dec. 15-16 meeting, Dudley said, in remarks prepared for a speech Friday… He added that he continues ‘to expect that the economy will expand at a pace slightly above its long-term trend in 2016,’ and said future rate increases would depend on incoming economic data.”
January 15 – Reuters (Ann Saphir): “The stock market's swoon does not change the economic outlook and is merely market participants trying to make sense of global developments, San Francisco Federal Reserve Bank President John Williams told reporters… ‘As the Fed is moving gradually through a process of normalization it's not surprising that we are not going to be at the peak stock prices’ of last year, Williams said. So far swings in stock market prices have not fundamentally changed his expectation for moderate economic growth, he said.”
The world has changed significantly – perhaps profoundly – over recent weeks. The Shanghai Composite has dropped 17.4% over the past month (Shenzhen down 21%). Hong Kong’s Hang Seng Index was down 8.2% over the past month, with Hang Seng Financials sinking 11.9%. WTI crude is down 26% since December 15th. Over this period, the GSCI Commodities Index sank 12.2%. The Mexican peso has declined almost 7% in a month, the Russian ruble 10% and the South African rand 12%. A Friday headline from the Financial Times: “Emerging market stocks retreat to lowest since 09.”
Trouble at the “Periphery” has definitely taken a troubling turn for the worse. Hope that things were on an uptrend has confronted the reality that things are rapidly getting much worse. This week saw the Shanghai Composite sink 9.0%. Major equities indexes were hit 8.0% in Russia and 5.0% in Brazil (Petrobras down 9%). Financial stocks and levered corporations have been under pressure round the globe. The Russian ruble sank 4.0% this week, increasing y-t-d losses versus the dollar to 7.1%. The Mexican peso declined another 1.8% this week. The Polish zloty slid 2.8% on an S&P downgrade (“Tumbles Most Since 2011”). The South African rand declined 3.0% (down 7.9% y-t-d). The yen added 0.2% this week, increasing 2016 gains to 3.0%. With the yen up almost 4% versus the dollar over the past month, so-called yen “carry trades” are turning increasingly problematic.
Importantly, the past month has seen contagion effects from the collapsing Bubble at the Periphery penetrate the Fragile Core. Japan’s Nikkei 225 index was down 7.6% over the past month. While bubbling securities markets have worked to underpin European economic recovery, now prepare for the downside. The German DAX is off 11% in the first two weeks of 2016, with stocks in Spain and Italy also sporting double-digit declines. France’s CAC 40 has fallen 9.2% y-t-d. And highlighting a key Issue 2016, European bonds have provided little offsetting protection against major equities market losses. So far in 2016, German bund yields are down only eight bps. Yields are little changed in Spain and Italy. Sovereign yields are up 20 bps in Portugal and 130 bps in Greece. European corporate debt has posted small negative returns so far in 2016.
Recent weeks point to decisive cracks at the “Core” of the U.S. financial Bubble. The S&P500 has been hit with an 8.0% two-week decline. Notably, favored stocks and sectors have performed poorly. Indicative of rapidly deteriorating economic prospects, the Dow Transports were down 10.9% to begin 2016. The banks (KBW) sank 12.9%, with the broker/dealers (XBD) down 14.1% y-t-d. The Nasdaq100 (NDX) fell 10%. The Biotechs were down 16.0% in two weeks. The small cap Russell 2000 was hit 11.3%.
Bubbles tend to be varied and complex. In their most basic form, I define a Bubble as a self-reinforcing but inevitably unsustainable inflation. This inflation can be in a wide range of price levels – securities and asset prices, incomes, spending, corporate profits, investment and speculation. Such inflations are always fueled by some type of underlying monetary expansion – typically monetary disorder. Bubbles are always and everywhere a Credit phenomenon, although the underlying source of monetary fuel often goes largely unrecognized.
I’ll posit another key Bubble Dynamic: De-risking/de-leveraging at the Periphery is problematic, with a propensity for risk aversion and associated liquidity constraints to spur contagion effects. At the Core, de-risking/de-leveraging becomes highly destabilizing. Indeed, I would strongly argue that de-leveraging at the “Core of the Core” is tantamount to financial crisis.
It is the “Core of the Core” that now concerns me the most. That is where Federal Reserve (and global central bank) policies have left their greatest mark. It is at the “Core of the Core” where momentous misperceptions and market mispricing have become deeply entrenched. It’s the “Core of the Core” that has attracted enormous amounts of “money” over recent years. It’s also here where I believe leverage has quietly been used most aggressively. Over recent years it became one massive Crowded Trade. Now the sophisticated players must contemplate beating the unsuspecting public to the exits.
I’ll return to “Core of the Core” analysis after a brief diversion to the “Core of the Periphery.”
At $275 billion, Chinese Credit growth surged in December to the strongest pace since June. While growth in new bank loans slowed (15% below estimates), equity and bond issuance jumped. China’s total social financing expanded an enormous $2.2 TN in 2015, down slightly from booming 2014. Such rampant Credit growth was (barely) sufficient to sustain China’s economic expansion. At the same time, I would argue that Chinese stocks, global commodities and developing securities markets in particular have been under intense pressure due to rapidly waning confidence in the sustainability of China’s Credit Bubble.
A similar dynamic is now unfolding in U.S. and other “Core” equities markets: Sustainability in the (U.S. and global) Credit Bubble – the monetary fuel underpinning the boom – is suddenly in doubt. The bulls, Fed officials and most others see the economy as basically sound, similar to how most conventional analysts argued about the Chinese economy over the past year. Inherent fragility and unsustainability are the key issues now driving securities markets – in China, in the U.S, and globally. And, importantly, sentiment has shifted to the view that policy tools have been largely depleted.
January 15 – Reuters (Trevor Hunnicutt): “Fund investors continued to sour on U.S. stocks and corporate debt during the weekly period that ended Jan 13, Lipper data showed…, as risk appetite waned in the wake of global market turmoil. U.S.-based stock mutual funds and exchange-traded funds lost $9.0 billion to withdrawals during a week that saw U.S. stocks continue one of their worst starts to a new year… The outflows also included $5 billion pulled from one ETF alone: SPDR S&P 500 ETF… Before last week, ETF investors had been bullish on U.S. stocks, pumping money in for twelve weeks straight… Corporate bond funds suffered too. Investment-grade bond funds, widely held by retail investors, extended to eight straight weeks their streak of outflows after posting $740 million in outflows during the week. The two-month run of outflows now totals $15.4 billion, about 1.8% of the assets those funds held when the trend started…”
January 15 – Barron’s (Chris Dieterich): “Money hemorrhaged from of mutual and exchange-traded funds for the second week in a row, EPFR Global data show… Global investors pulled $12 billion out of U.S equity funds and a combined $4.5 billion from high-yield bond, bank loan and total return funds in the week ended Jan. 23. Emerging-market funds shed cash for the 11th week in a row. Over the past two weeks, some $21 billion has come out of equity funds, still shy of the $36 billion during the August 2015 selloff.”
January 15 – Bloomberg (Aleksandra Gjorgievska and Fion Li): “Exchange-traded funds that hold U.S. junk bonds dropped to their lowest levels since 2009 as the global growth fears that clobbered stock markets also raised doubts about whether companies’ would continue to generate as much cash to pay their debt obligations.”
This week saw the Bank of America Merrill Lynch High Yield Energy Bond Index trade to a record17.43% yield, surpassing the December 2008 high (from Barron’s Amey Stone). “Triple C” bond yields jumped to 18.8%, the high since 2009 (FT’s Joe Rennison). The yield on the Markit iBoxx Liquid High Yield index jumped this week to the highest level since 2012.
Returning to “Core of the Core” analysis, investment-grade corporate debt has rather abruptly joined the market turmoil. After a rocky first week of 2016, investment-grade debt spreads widened again this week to a three-year high, as investment-grade funds suffered their eighth straight week of outflows.
“Triple A” MBS occupied the mortgage finance Bubble’s “Core of the Core”. GSE securities were perceived as “money”-like (“Moneyness of Credit”), with implied backings from the Treasury and Fed seemingly guaranteeing safety and liquidity. Throughout the global government finance Bubble period, I have often invoked the concept “Moneyness of Risk Assets.” With the Federal Reserve and global central banks determined to do just about anything to uphold booming securities markets, the marketplace perceived that safety and liquidity were virtually ensured. Trillions flowed into global stock and bond mutual funds, the majority into perceived low-risk U.S. equities indexes and investment-grade corporate debt products.
It is worth recalling that my tally of Total U.S. Securities (Treasuries, Agencies, Corp Bonds, Munis and Equities) ended Q2 2015 at a record $76.924 TN, or 429% of GDP. This was up $30.90 TN (77%) from 2008’s $46.034 TN (313% of GDP) – and greatly exceeded 2007’s $53.279 TN (368% of GDP).
As securities market inflation inflated Household Net Worth, spending increases bolstered corporate profits and income growth. Booming markets, especially ultra-easy financial conditions throughout the corporate Credit market, spurred stock buybacks and incited record M&A activity. As noted above, Bubbles are self-reinforcing but inevitably unsustainable. Especially with faltering Bubbles at the “Core of the Core,” wealth effects will now operate in reverse. Spending (household and corporate) will slow, with domestic issues joining international to pummel corporate profits. Significant tightening in corporate Credit will weigh heavily on both stock repurchases and M&A. And as economic prospects darken at home and abroad, there will be reinforcing downward pressure on U.S. equities and investment-grade corporate debt.
Back in 2000, Dallas Fed president Robert McTeer suggested that our economy’s ills would be rectified “if everyone would hold hands and buy an SUV.” And for the next 15 years Fed policies did the unimaginable in the name of (indiscriminately) stimulating growth of any kind possible. And if epic mortgage finance Bubble financial and economic maladjustment was not enough, the past seven years have seen the type of financial folly and egregious wealth redistribution that tear societies apart.
The bottom line is that Bubbles destroy and redistribute wealth, though the true effects are masked for a while by inflated securities and asset markets – along with resulting unsustainable spending patterns and economic activity. Regrettably, years of policy mismanagement, gross financial excess, deep structural maladjustment and the most imbalanced economy in our nation’s history will now come home to roost. At this point, I cannot confidently forecast how quickly the bust will unfold. I do, however, believe this process has begun as Bubbles falter at the “Core of the Core.”
- US Bank Counterparty Risk Soars After Energy MTM Debacle
A few dots are starting to be connected now that we have exposed the debacle of The Fed's decision to allow banks to mark-to-unicorn their energy loans. "Something" was wrong in recent weeks as the TED-Spread surged (implying rising counterparty uncertainty among banks) and then the last week – since The Fed's alleged meeting with banks – has seen financial credit and stocks crash.
Coincidence? We don't think so. In the week since The Fed gave the nod to banks to hide losses on energy loans, credit risk has spiked and stocks tumbled…
It is clear banks are hedging against one another's systemic risk.
Simply put, it's 2008 all-over-again as "when in doubt, sell 'em all" is back for the US financial system. When you know/question one bank (or some banks) is not transparent in their loan losses (and implicitly their capital ratios) then contagion (and collateral chains) tells any good fiduciary to sell them all – and the banks themselves will enable a vicious circle as they hedge.
And of course, the unintended consequence of The Fed's decision to enable cheating in the banks' energy loans is a surge in financial system instability as banks and the price of oil now become systemically more coupled.
- JPM Explains How Crude Carnage Creates $75 Billion SWF "Contagion" For Equities
Back in August, we explained why the great petrodollar unwind could be $2.5 trillion larger than anyone thinks.
China’s effort to “control” the glidepath for the yuan devaluation led to a dramatic decline of Beijing’s FX reserves and pushed reserve liquidation to the front of the market’s collective consciousness.
But “the great accumulation” (as Deutsche Bank calls it) of USTs ended long before the RMB deval forced the market to start talking about FX reserves. In short, the inexorable decline in crude prices (and commodities in general) forced producers to sell USD assets in an effort to offset pressure on their currencies and plug yawning budget gaps.
And while the world is now fully awake to the fact that these asset sales amount to QE in reverse (global central banks are selling the same assets the Fed once bought), what isn’t as well understood is that looking strictly at official FX reserves paints an incomplete picture. “Crucially, for oil exporting nations, central bank official reserves likely underestimate the full scale of the reversal of oil exporters’ ‘petrodollar’ accumulation,” Credit Suisse wrote last year. “This is because a substantial part of their oil proceeds has previously been placed in sovereign wealth funds (SWFs), which are not reported as FX reserves (with the notable exception of Russia, where they are counted as FX reserves).”
The difference between total SWF assets and official reserves for oil exporting nations is vast. “Currently, oil exporting countries hold about $1.7trn of official reserves but as much as $4.3trn in SWF assets,” Credit Suisse went on to point out, adding that. “In the 2009-2014 period, oil exporters accumulated about $0.5trn in official reserves but as much as $1.8trn of SWF assets.” Or, visually:
As you can see from the above, oil exporters’ accumulation of SWF assets comes to a dramatic halt when crude prices fall. Critically, it’s exceedingly possible that the accumulation of SWF assets turns negative now that the return of Iranian supply means oil prices are set to stay lower for longer. Or, as Credit Suisse put it, “now that the tide has turned, it is likely that not only official reserves drop but that SWF asset accumulation slows to nil or even reverses.”
Perhaps the best example of this is Norway’s SWF which, at $830 billion, is the largest in the world.
Falling crude has put enormous pressure on Norway’s economy, and with oil revenue plunging along with prices, the country is now set to drawdown its SWF rainy day fund for the first time in history in order to plug budget holes and pay for fiscal stimulus designed to offset some of the jobs lost to the industry downturn. The fund will still grow as long as return assumptions hold up, but as we saw in the first two weeks of this year, any “assumptions” about returns are dubious in an increasingly uncertain environment. Here, for reference, it a handy table lists SWFs by country and AUM:
It’s important to understand that SWFs hold more than just bonds. That means that if SWFs become sellers, there are implications for other asset classes.
Like stocks.
Here are some findings on SWF equity investments from “Sovereign Wealth Fund Investments: From Firm-level Preferences to Natural Endowments,” by Paris School of Economics’ Rolando Avendano:
There is significant variance in the allocation of SWF equity investments, depending on underlying factors associated with the fund (source of proceeds, OECD “effect”, home/foreign bias). Whereas most SWFs are attracted to large firms, with proven profitability and international activities, differences among groups remain:
-
Non-commodity funds favour firms with more foreign activity and higher turnover, in contrast to commodity-funds.
-
OECD-based funds prefer firms with lower leverage levels, whereas non-OECD funds have a preference for profitable and international firms.
-
SWF foreign investments are oriented towards large and highly leveraged firms, in contrast with their domestic (small and low leveraged) investments. Foreign investments are attracted to R&D sectors.
- In line with the previous literature, I find that SWF ownership has a positive effect on firm value. However, this effect is only significant for commodity and OECD-based funds.
The study was from 2006-2009 and one imagines some of these preferences might have changed in the post-crisis world, but the paper (found here) is still worth a read.
All of the above begs the following question: will the SWFs of oil producing countries be net sellers of stocks if crude prices remain subdued and if so, how much will they sell?
JP Morgan’s Nikolaos Panigirtzoglou and team have ventured a guess. “In our mind financial contagion from lower oil prices to equity markets is created via sovereign wealth funds,” JPM begins. Here’s more:
The lower the oil price the higher the potential depletion of SWF assets as oil producing countries struggle to prevent their spending from declining too much. And the equities owned by oil producing countries SWFs encompass all regions and all sectors.
To assess SWF flows and their potential impact on equity market flows, we update our analysis on FX reserves and Sovereign Wealth Fund (SWF) assets for 2016 in light of the recent steep decline in oil prices. Using our average Brent oil forecast of $31 for 2016, how would oil-related financial flows look like in 2016?
In 2015, oil exporters (Middle East, Norway, Russia, Africa and Latam countries) received $740tr from their oil exports and will see their oil revenue decline further to $440bn should Brent oil price average at $31 this year. Oil exporters’ revenues are recycled via two channels: via imports of goods and services from the rest of the world and via accumulation of financial assets, mostly through SWFs. In 2015, oil exporters consumed $70bn more than their oil revenues to prevent their spending from declining too much. On our estimates, this excessive spending was met via around $50bn of FX reserve depletion and $20bn of SWF depletion.
Assuming a $22 decline in the average oil price in 2016 relative to 2015 (i.e. from $53 to $31), the oil exporters’ aggregate current account balance will likely decline to around -$260bn vs. -$70bn in 2015 (based on last year’s sensitivities of current account balance change to oil price change). This year’s dis-saving of $260bn should be mostly met via depletion of official assets, i.e. FX reserve and SWF assets ($240bn) rather than issuance of government debt ($20bn). For 2016 we look for FX reserve depletion of $100bn and a decline in SWF assets of $140bn.
Assuming selling in accordance to the average allocation of FX Reserve Managers and SWF across asset classes, we estimate that the sales of bonds by oil producing countries will increase from -$45bn in 2015 to -$110bn in 2016 and that the sales of public equities will increase from -$10bn in 2015 to -$75bn in 2016. There is little offset to this -$75bn of equity sales from accumulation of SWF assets by oil consuming countries, as we expect these countries to spend most of this year’s oil income windfall.
In short, SWF’s will liquidate some $75 billion in equities this year assuming oil at $31 per barrel. Needless to say, the lower oil goes, the more selling they’ll be.
“This prospective $75bn of equity selling by SWFs in 2016 is not huge but becomes significant after taking into account the potential swing in equity fund flows,” JPM continues, in an attempt to discuss the impact this will have on markets. “Last year retail investors bought $375bn of equity funds globally. This year we expect an amount between 0 and $200bn. Subtracting $75bn of selling from SWFs would leave the overall equity flow from Retail+SWF investors barely positive for 2016.“
Well, not really. It’s “barely positive” if retail buys $76 billion or more. But if retail investors buy anywhere from zero to $74 billion, SWF + retail goes negative.
Needless to say, the first two weeks of the year haven’t done anything to either shore up the SWFs of oil producers or put retail in a bullish mood. That being the case, the market better home the “smart” money is buying or you can forget about equities catching a bid this year.
* * *
An infographic look
-
Digest powered by RSS Digest
Saving...