- The Concept Of Money And The Money Illusion
Submitted by Koos Jansen via BullionStar.com,
Awareness about the concept of money is making a comeback. Gone are the decades in which the global citizenry was fooled to leave this subject to economists, governments and banks – a setup that has proven to end in disaster. The crisis in 2008 has spawned debate about what money is, where it comes from and where it should come from. These developments inspired me to write a post on the concept of money and the money illusion. (All examples in this post are simplified.)
The Concept Of Money
Money is a collective human invention
First, let us have a look at the fundamentals of money. How did Money evolve? Thousand and thousands of years ago before any trade occurred homo sapiens use to be self-sufficient; families or small communities grew that their own crops, fished the seas, raised cattle and made their own tools.
When barter emerged the necessity to be self-sufficient ceased to exist. A farmer that grew tomatoes and carrots could exchange some of his production output for bananas or oranges if he wished to do so. There was no necessity for the farmer to grow all crops he wished to consume, when there was an option to trade.
Farmers participating in a barter economy were incentivized to specialize in production, because they could escalate their wealth (gain more goods) by producing fewer crops on a greater scale. Through trade increased productivity (efficiency of production) could be converted into wealth, as the more efficient commodities were produced, the higher the exchange value of the labor put in to produce them. Consequently, barter economized production among its participants.
By exchanging, human beings discovered ‘the division of labor’, the specialization of efforts and talents for mutual gain… Exchange is to cultural evolution as sex is to biological evolution.
From Matt Ridley.
Direct exchange (barter) was a severely limited form of trade because it relied on the mutual coincidence of demand. An orange farmer in demand for potatoes had to find a potato farmer in demand for oranges in order to trade. If he could find a potato farmer in demand for oranges and agree on the exchange rate (price) a transaction occurred. But, often there was no mutual coincidence of demand. When all potato farmers were not in demand for oranges the orange farmer could not exchange his product for potatoes. In this case there was no trade, no one could escalate his or her wealth.
This is how money came into existence: the orange farmer decided to exchange his product for a highly marketable commodity. A bag of salt, for example, could be preserved longer than oranges and was divisible in small parts. He could offer it to a potato farmer, who in turn could store the salt for future trade or consumption. If no potato farmer was in demand for oranges, surely one was to accept salt in exchange. Eventually, the orange farmer succeeded via salt to indirectly exchange his product for potatoes. The medium used for indirect exchange is referred to as money.
In the early stages of indirect exchange there were several forms of money. When economies developed the best marketable commodity surfaced as the sole medium of exchange. A single type of money has the advantage that the value of all goods and services in an economy can be measured in one unit, all prices are denominated in one currency – whereas in barter the exchange rate of every commodity is denominated in an array of other commodities. One set of prices makes trade more efficient, transparent and liquid. Often precious metals, like gold or silver, were used as money as precious metals are scarce (great amounts of value can be transported in small weights), indestructible (gold doesn’t tarnish or corrode) and divisible (gold can be split or merged).
Money is supposed to serve three main purposes:
1) a medium of exchange,
2) a store of value,
3) a unit of account.
Indirect exchange is not restricted by mutual coincidence of demand; every participant in the economy offers and accepts the same medium of exchange, which enormously eases trade. The boost money has given to global wealth is beyond comprehension, the concept of money has been an indispensable discovery of civilisation.
We must realize the subject of money is always a matter of trust, because money in itself has no use-value for us humans. An orange, car, shoebox, t-shirt or house does have use-value. Money does not have use-value as it’s not the end goal of a participant in the economy, the end goal is goods and services. Therefor, what we use as money is a social contract to be used in trade and to store value, always based on trust.
Commodity money (like precious metals) does have some use-value, which it derives from its industrial applications. The majority of commodity money’s exchange value is based on its monetary applications, the residual is based on its industrial applications (use-value). If a commodity is abandoned from being used as money, the monetary value leaves and what is left is the use-value. The exchange value of money equals the amount of goods and services it can be traded for at any given moment, popularly called its purchasing power.
After commodity money came fiat money. The nature of the latter is fundamentally different. From Wikipedia:
Fiat money is currency which derives its value from government regulation or law. The term derives from the Latin fiat (“let it be done”, “it shall be”).
Fiat money is what nowadays is used all around the globe. Instead of being picked by all participants in a free market as the best marketable commodity, it’s created by central banks and it can exist in paper, coin or digital form. Out of thin air and without limitation it can be brought into existence by printing paper bills or typing in digits into a computer. When fiat money is created it’s exchanged for assets a central bank puts on its balance sheet, after the first exchange the money can start circulating in the economy. A central bank can buy any asset, but usually it will be government bonds. Whereas commodity money has its value anchored in the free market economy, the value of fiat money is simply determined by the board of governors of a central bank. Throughout history central banks have been able to control the value of fiat money for relatively short periods, over longer periods the value of fiat money is wiped out inevitably.
The value of commodity money is anchored to the value of all goods and services in a free market, because it requires capital and labor to produce commodity money. This is how the anchor mechanism works (in our example gold is the sole medium of exchange: a simplified gold standard). Say, gold mines increase production output in order to literally make more money. The amount of gold circulating in the economy starts to grow faster than the amount of goods and services it can be traded for. The value of gold will decline relative to goods and services, as there is an oversupply of gold. In this price inflationary scenario it would be more profitable for economic agents to produce other goods than gold, as gold’s purchasing power is falling. When gold miners shift to alternate businesses and mines are closed the amount of gold in circulation starts to grow slower than the amount of goods and services it can be traded for, as a result the value of gold will increase relative to goods and services. In this price deflationary scenario gold’s purchasing power increases, which eventually incentivizes entrepreneurs to start mining gold again, until there is an oversupply of gold, etcetera. Gold used as money on a gold standard is not exclusively subjected to this mechanism. Simply put, in any economy entrepreneurs will grow potatoes when they are expensive and stop growing them when they are cheap. A free market economy in theory stabilizes the value of gold. In reality, for several reasons, gold’s exchange value is not exactly constant, but over longer periods gold’s purchasing power is impressive and more constant than any fiat currency.
Courtesy Sharelynx.
In the above chart we can see the green line resembling the index price of goods and services in the United Kingdom since the sixteenth century. The blue line resembles the index price of gold. Both are denominated in pounds sterling on a logarithmic scale. When the index price of gold overshoots the index price of goods and services gold’s purchasing power – the red line – will rise and vice versa. If your savings had been in fiat money since 1950, your purchasing power would have declined by 94 % as the index price of goods and services rose from 400 to 7,000. If your savings had been in gold since 1950, your purchasing power would have been fairly constant (actually would have increased). The green line takes off at the same time when the gold standard was abandoned from which point in time the currency was no longer tied to gold and became fiat.
Fractional Reserve Banking And The Money Illusion
Both commodity money and fiat money can be used for fractional reserve banking. The roots of banking go back many centuries to fraudulent practices by blacksmiths. When people used to own gold coins and bring it to a blacksmith for safekeeping they got a receipt that stated a claim on gold in the vault. These receipts began circulating as money substitutes, instead of having to carry gold coins or bars it was more convenient to make payment with lightweight receipts – this is how paper money was born. Blacksmiths noticed few receipts were redeemed for metal. The gold backing those receipts was just lying idle in their vaults or so they thought. Subsequently, they began issuing more receipts than they could back with gold. Covertly lending out money at an attractive interest rate appeared to be profitable. Naturally, the risk was that when customers found out and simultaneously redeemed their receipts, the blacksmiths went bankrupt. More importantly, not all customers holding a receipt got their gold.
Essentially, modern day banking works in a similar fashion although the scheme has been refined. In 1848 a Supreme Court in the United Kingdom ruled:
Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it. … The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted, having received that money, to repay to the principal, when demanded, a sum equivalent to that paid into his hands.
Guess what. Your money at the bank is not your money. A bank deposit is a loan to the bank, which should justify the fact banks only have a fraction of outstanding liabilities (receipts) in reserve. Let us examine this modern day practice of banking and the creation of what I call illusionary money. In our simplified example there is only book entry money, nowadays digital.
The process begins with the European Central Bank (ECB) that creates 10,000 euros, by the stroke of a keyboard, to buy bonds. The seller of these bonds is Paul who receives the 10,000 euros and deposits these funds at bank A. The ECB’s policy is that commercial banks are required to hold 10 % of all deposits in reserve. Meaning, bank A can lend 90 % of Paul’s money to John who needs money to buy a boat. When John borrows these 9,000 euros and receives the funds in his bank account, something remarkable has taken place. John now has 9,000 euros at his disposal, but Paul still owns 10,000 euros. Miraculously 9,000 euros has been created out of thin air! Before bank A had lend 9,000 euros to John there was only 10,000 euros in existence created by the ECB. After the loan there is 19,000 euros “in existence”, John’s 9,000 euros on top of Paul’s 10,000 euros. Bank A has created 9,000 euros through fractional reserve banking.
And it doesn’t end there. When John buys a 9,000 euro sailing yacht from Bob, Bob deposits these funds at bank B. For this bank the same rules apply, it’s only required to hold 10 % of the 9,000 euros in reserve, so it lends 8,100 euros to Michael. Another 8,100 euros is created out of thin air, now there is 27,100 euros in existence! Needless to say, Michael’s money will be deposited at a bank and multiplied by 90 % as well, and the new money will multiplied by 90 % as well – you get the picture. Eventually, out of the initial 10,000 euros created by the ECB a fresh 90,000 euros can be created by commercial banks at a required reserve ratio of 10 %.
The degree to which commercial banks can procreate money from central bank money is referred to as the money multiplier (MM), which is the inverse of the reserve requirement ratio (RRR). A smaller RRR will result in a higher MM, and vice versa, as the smaller a bank’s reserves, the more it can lend (create). Money created by a central bank is called base money and money created by commercial banks is called credit (note, on a gold standard, the gold was base money). If banks make loans they create credit and the total money supply in the economy expands, if these loans are repaid (or default) the money supply shrinks. In the next chart we can see how 10,000 units of base money procreate 90,000 units of credit through 50 stages of fractional reserve banking (RRR = 10 %).
Note, the total money supply in the economy nowadays is compounded of less than 10 % base money and more than 90 % credit! For the sake of simplicity I’ve used a reserve requirement ratio of 10 %.
The essence of fractional reserve banking is exactly the same as what the blacksmiths did. When all customers run to a bank to get their money out, the bank has to admit it doesn’t have all the money. Banking thrives on the presumption not all money will be withdrawn from a bank at once. That is, until that happens. Millions of banks have gone bust in the past and many will in the future. The question is not if a bank can go bust, but when, as banks are by definition insolvent in holding a fraction of deposits in reserve. After the bankruptcy of investment bank Lehman Brothers in 2008 an economic depression was triggered and governments globally bailed out banks whose insolvent nature was exposed.
The fact banks are by definition insolvent is “strangely” accepted throughout society. People know banks go belly up when everybody rushes to get their money out, though they’re less aware of alternatives to storing money at the bank. This situation can be explained by the fact people are fooled by how banks operate. In high school and university students are taught banks simply facilitate in lending out money from depositors, striking a profit on the difference in interest rates. While actually banks create money to lend out, whereby a fraction of the initial deposit is held in reserve and the insolvent state is conceived. Most people that work at banks are not even aware about the fine details of credit creation. Henry Ford once said:
It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
The bait for fractional reserve banking is of course interest. Why do you receive interest on a bank deposit? Basically, because you lend your money to the bank and receive interest for the risk of losing it – the golden rule is: no risk no return. Banks have to offer interest or no one would hand over their money. Then banks charge borrowers a higher interest rate than they pay on deposits and the wheel of credit starts turning round. Until the expansion of credit sends up asset bubbles that eventually pop and the house of cards comes tumbling down. The real problem starts to surface when the money supply shrinks prices and incomes decline. This makes it harder for everyone to repay debt to banks, pushing bank bankruptcies. Deflation is a huge threat for the fractional reserve system.
The most intriguing fact is that credit simply doesn’t exist. Credit is created through an accounting trick. If more than a fraction of all bank customers want to withdraw their “money”, it’s just not there. Credit only exists as book entries and in our minds. If customers have 1,000,000 euros deposited at a bank in total, they think they truly own that money, whereas in reality there is only a fraction of the 1,000,000 euros held by the bank in reserves. Yet every financial decision they make is based upon the amount of money they think they own. The lion share of their money only exists in their minds. This is what I call the money illusion, in which most of us on this planet are submerged. Will we ever awaken from this dream and will the real value of money and credit be exposed?
- The Petrostate Hex: Visualizing How Plunging Oil Prices Affect Currencies
Every day, the world consumes 93 million barrels of oil, which is worth $4.2 billion.
Oil is one of the world’s most basic necessities. At least for now, all modern countries rely on oil and its derivatives as the backbone of their economies. However, the price of oil can have significant swings. These changes in price can have profound implications depending on whether an economy is a net importer or net exporter of crude.
Net exporters, countries that sell more oil abroad than they bring in, feel the sting when prices plunge. Less revenue gets generated, and this can impact everything from balancing the budget to the value of their currency in the world market.
Net importers, on the other hand, benefit from lower prices as it decreases input costs for production. For example, a country like Japan only meets 15% of its energy needs domestically, and must import 3.5 million barrels of oil each day. A lower oil price significantly decreases these costs.
For many major net exporters of oil, changes in oil prices are highly correlated with their currencies. With oil prices crashing over the last year, currencies such as the Canadian dollar and Russian ruble have been highly impacted in terms of USD. But the impact of oil on currency depends on how central banks approach to policy.
Courtesy of: Visual Capitalist
- Why Hedge Fund Hot Shots Finally Got Hammered
Submitted by David Stockman via Contra Corner blog,
The destruction of honest financial markets by the Fed and other central banks has created a class of hedge fund hot shots that are truly hard to take. Many of them have been riding the bubble ever since Alan Greenspan got it going after the crash of 1987 and now not only claim to be investment geniuses, but also get downright huffy if the Fed or anyone else threatens to roil the casino.
Leon Cooperman, who is an ex-Goldman trader and now proprietor of a giant fund called Omega Advisors, is one of the more insufferable blowhards among these billionaire bubble riders. Earlier this week he proved that in spades.
It seems that his fund had a thundering loss of more than 10% in August during a downdraft in the stock market that the Fed for once took no action to counter. But rather than accept responsibility for the fact that his portfolio of momo stocks took a dive during a wobbly tape, Cooperman put out a screed blaming the purportedly unfair tactics of other casino gamblers:
Lee Cooperman, the founder of Omega Advisors, has joined the growing chorus of investors blaming last week’s stock market sell-off — and his own poor performance in August — on esoteric but increasingly influential trading strategies pioneered by hedge funds like Bridgewater.
Well now. Exactly how was Bridgewater counting the cards so as to cause such a ruction at the gaming tables?
In a word, Ray Dalio, the storied founder of the giant Bridgewater “All-Weather” risk parity fund, has been doing the same thing as Cooperman, and for nearly as many decades. Namely, counting the cards held-out in plain public view by the foolish monetary central planners domiciled in the Eccles Building.
To be sure, Dalio’s fund has had superlative returns and there is undoubtedly some serious algorithmic magic embedded in Bridgewater’s computers. But at the end of the day its all a function of broken capital markets that have been usurped and rigged by the Fed.
The only thing your need to know about the vaunted “risk parity” strategies that have served Bridgewater and their imitators so handsomely, and which have now aroused the ire of more primitive gamblers like Cooperman, is the graph below:
The above, of course, is the Fed’s “wealth effects” printing press at work. There have been about 30 identifiable “dips” since the March 2009 low and every one of them have been bought by the casino gamblers. And for good reason.
The Bernanke Fed’s egregious, desperate and utterly unwarranted bailout of Wall Street at the time of the post-Lehman crash taught the gamblers a profound lesson. That is, they could be exceedingly confident that the Fed would keep the free money flowing at all hazards, and that it would resort to any price rigging intervention as might be necessary to keep the stock averages rising.
Indeed, never in all of history have a few ten thousand punters made so many trillions in return for so little economic value added. But what Dalio did in this context was to invent an even more efficient machine to strip-mine the Fed’s monumental largesse.
To wit, Bridgewater’s computers buy more stocks on the “rips”, when equity volatility is falling and prices are rising; and then on the “dips” they rotate funds into more bonds when equity volatility is rising and the herd is retreating to the safe haven of treasuries and other fixed income securities, thereby causing the price of the latter to rise.
In short, there is a payday in every type of short-run financial weather because Bridgewater’s computers are monetary sump pumps; they constantly purge volatility from the portfolio.
But here’s the thing. The above chart could never exist in an honest free market.
You couldn’t create algorithms to safely pump out volatility and milk the market on alternating strokes because the regularity of the waves on which it is based are not natural; they are the handiwork a central bank that has been taken hostage by the casino gamblers.
Nor is “hostage” too strong a word. In the days of Paul Volcker and William McChesney Martin anybody who even speculated about 80 months of ZIRP would have been assigned to the William Jennings Bryan school of monetary crankery.
As it happened, however, in the last few weeks the long reign of the global money printers has begun to sprout fractures. Over on the other side of the earth in China what had become a 20-year long $4 trillion cumulative “bid” for US treasuries and other DM fixed income securities has gone serious “offers”.
This will prove to be one of the great financial pivots of history. During the course of their stupendous inflation of China’s $28 trillion Credit Ponzi, the red suzerains of Beijing bought treasuries hand over fist and thereby kept their price rising and the volatility of the world bond market falling.
To be sure, this wasn’t charity for America’s debt besotted shoppers and governments. It was done in order to peg the RMB exchange rate and thereby keep its mercantilist export machine humming and the people grateful to their beneficent communist party rulers.
But at length it became too much of a good thing because every time the Peoples Bank Of China (PBOC) bought Uncle Sam’s debt it similtaneously expanded the internal banking system and supply of RMB credit. Moreover, after Beijing launched its madcap infrastructure building campaign in response to the the 2008 financial crisis the phony construction and investment boom which ensued attracted increasing waves of hot money from abroad, thereby inflating the domestic Chinese economy to a fever pitch.
In fact, the PBOC was forced to let the RMB slowly rise against the dollar to keep its banking system from becoming a financial runaway. But the steadily rising RMB drastically accelerated the inflow of foreign capital and speculative funds into the Chinese economy, thereby filling the vaults of the PBOC to the brim at more than $4 trillion early this year compared to a few hundred billion at the turn of the century.
But these weren’t monetary reserves in any meaningful or historic sense of the term; they were the fruits of an utterly stupid mercantilist trade policy and the conversion of a naïve old man, and survivor of Mao’s depredations, to the view that communist party power could be better administered from the end of a printing press than from the barrel of a gun.
But Mr. Deng merely unleashed a Credit Monster that sucked in capital and resources from all over the globe into a domestic whirlpool of digging, building, borrowing, investing and speculation that was inherently unstable and incendiary. It was only a matter of time before this edifice of economic madness began to wobble and sway and to eventually buckle entirely.
That time came in 2015—-roughly 30 years after Mr. Deng proclaimed it is glorious to be rich. So saying, he did not have a clue that a credit swollen simulacrum of capitalism run by communist apparatchiks was a doomsday machine.
In any event, what is happening in China now is that the speculators—-both domestic and foreign—–see that the jig is up. That is especially the case after Beijing’s incredibly botched effort to alleviate its massive corporate debt problem by inciting a $5 trillion stock market bubble that is now being blown to smithereens.
This has happened notwithstanding the party bosses sending out truckloads of cash to arrest the stock market’s collapse and then doubling down by sending fleets of paddy wagons to arrest any one who might be tempted into overzealous offers to sell what the PBOC is trying to buy. It means that confidence in the Red Ponzi has at last been shattered.
Accordingly, money is leaking out of China thru a thousand rivulets, by-ways and financial back alleys. To prevent the RMB exchange rate from plunging and thereby inciting even more capital fright and flight, the PBOC has shifted into reverse gear in a large, sustained and strategic way—-as opposed to tactical FX management—– for the first time since the putative miracle of red capitalism incepted.
Ray Dalio wasn’t counting on this because despite Bridgewater’s proficiency in concocting trading algorithms, its vaunted macroeconomics staff consists of standard issue Keynesians—-with a dash of Minskyites thrown in for good measure. Alas, they were not prepared for the possibility that Austrians have said is inevitable all along.
To wit, that Beijing’s experiment with Red Capitalism would eventually end in a crackup boom, causing the seemingly endless Red Bid for US treasuries to become a disruptive and unwelcome Red Offer to sell hundreds of billions of said paper and like and similar dollar/euro/yen liabilities.
To make a long story short, during the gyrations of August bond prices didn’t rise like they were supposed to when the stock market plunged by 12% to its Bullard Rip low at 1867 on the S&P 500. Accordingly, Bridgewater’s risk party portfolio became swamped with too much volatility on both the bond and equity side of Dalio’s big boat. So the algorithmic sump pumps went into over-time dumping stocks in order to drain the ship.
Consequently, Bridgewater wiped out its entire profits for the year in a few days during August, pushing the momo chasers like Cooperman into the drink in the process. Needless to say, the capsizing Big Boats in the casino are now firing at each other, but also lining-up for a full court press at the Eccles Building.
Ray Dalio has already said its time for QE4. He apparently realizes that the Fed’s big fat bid is needed to replace the missing Red Bid in the treasury market, and thereby get his risk parity algorithms working again.
At the same time, Goldman today sent out its chief economist to pronounce that today’s Jobs Friday report tipped the case to no rate increase at the Fed’s upcoming September meeting. Why we need an 81st month of ZIRP when 80 months so far have not succeeded, he didn’t say.
No matter. You can be sure of this. If the market holds above next week’s retest of the 1967 Bullard Rip low, the Fed will likely announce a “one and done” move in September, causing the casino to stage a short-lived, half-heated rally.
By the same token, if the market drops through the Bullard Rip low, the Fed will plead market instability and defer its 25 bps pinprick yet again, thereby causing the same short-lived half-hearted rally.
What won’t happen, however, is another leg higher in the phony bull market engineered by the Fed and its fellow- traveling central banks. That’s because the global “dollar short” is finally coming home to roost.
For nearly two decades the central banks of EM mercantilists have been buying treasury paper, as have the commodity producers and the petro-states. So doing they have helped the Fed drive the benchmark rate to absurdly non-economic levels.
That’s what happens when the printing press is used to generate $12 trillion of so-called FX reserves and $22 trillion of total footings for the consolidated monetary roach motels of the world, otherwise known as central banks and sovereign wealth funds.
In turn, this massive stash became the collateral for the private issuance of friskier dollar denominated corporate and sovereign credits throughout the EM world, thereby slacking the thirst for yield among desperate money managers.
But now China’s house of cards is cratering, causing economies to plunge throughout the worldwide China supply chain. Witness Brazil where industrial production is down 8% from a year ago, and slipping rapidly from there; or South Korea where exports have plunged by double digits.
Metaphorically speaking, dollars are hightailing back to the Eccles building. China and the petro-states are selling and off-shore dollar lenders are effectively making a margin call.
At length, both the epic bond bubble and the monumental stock bubble so recklessly fueled by the Fed and the other central banks after September 2008 will burst in response to the deflationary tidal wave now cresting.
Needless to say, that eventuality will be the death knell for the risk parity trade. It will cause the volatility seeking algos to eat their own portfolios alive.
Can the masters of the universe hanging around in the Hedge Fund Hotels say “portfolio insurance”?
Leon Cooperman and his momo chasing compatriots will soon be praying for an event as mild as October 1987.
- Guest Post: China’s Worst Nightmare – The US’s Oil Weapon
Submitted by Tingbin Zhang, founder of the independent Chinese economic think tank “Zhonghua Yuan Institute“
China’s Worst Nightmare – The US’s Oil Weapon
China’s islanding building on the four-mile-long and two-mile-wide Subi Reef in the South China Sea has put The US in a tight spot. To protect its ally from China’s aggression, The US will be left with little choice but to constrain China by military means. However, the US won’t directly engage China in the war in the foreseeable future, because the US dominates China with its superior naval and air force and the only way for China to level the playing field is to apply nuclear weapons. The nuclear nature of Sino-American warfare will make both the world no.1 and no.2 economy the fallen giants.
So there is a possibility that The US might use its oil weapon instead to strike at the core of China’s weakness – it’s huge dependence on oil import. At the moment, China imports 55% of its oil, almost half of which sails from countries in the Persian Gulf?which accounts to 5.3 Million Barrels per Day and is around 75% of Saudi Arabia’s production. As a matter of fact, China’s reliance on Middle Eastern oil has gradually grown in line with its rapid-increasing demand for oil. Right now, China has achieved the equivalent of the peak of U.S. Oil import dependence and is not slowing down a bit. The single largest source of China’s crude oil imports is Saudi Arabia.China’s state oil reserves of 475,900,000 barrels (75,660,000 m3) plus the enterprise oil reserves of 209,440,000 barrels (33,298,000 m3) will only provide around 90 days of consumption or a total of 684,340,000 barrels (108,801,000 m3).
Meanwhile, This US is inching towards the energy independence. With the technological breakthroughs of shale gas and tight oil, the US has started an energy revolution: U.S. crude oil production has increased by 50% since 2008. With that increase, as well as more efficient cars, oil imports have come down from their high of 60% in 2005 to 35% today—as low as in 1973. With domestic production and gasoline mileage still increasing, imports will continue to decrease. It’s also impressive that U.S. natural gas production has increased by nearly 33% since 2005, and shale gas has gone from 2% of output in 2000 to 44% today.
As of 2013, the United States is the world’s second largest producer of crude oil, after Saudi Arabia, and second largest exporter of refined products, after Russia.According to BP Plc’s Statistical Review of World Energy, the U.S. has surpassed Russia as the biggest oil and natural-gas producer in 2014. While looking at total energy, the U.S. was over 70% self-sufficient in 2008. In May 2011, the US became a net exporter of refined petroleum products.
With the newly acquired oil might, the US can trick Iran to block the Strait of Hormuz without any economic damage onto the US itself, in order to strike a severe blow to China’s fragile economy. First, The US congress will reject the Iran nuclear deal; and second, The US will give the nod to Isreal’s air strike against Tehran’s nuclear facilities. And then, Iran will retaliate by blocking the Strait of Hormuz. The Strait is the only sea passage from the Persian Gulf to the open ocean. Once it’s blocked, China will scramble to meet its oil demands. In China, the inflation will jump up; the China yuan will plummet, and an economic meltdown will come to bear.
China will succumb to the US’s might of oil weapon to save itself from political, economic and social collapse. The oil weapon will achieve what the military can’t achieve at less cost. This scenario is something China should be really worried about.
- The Margin Debt Time-Bomb
Submitted by Brian Pretti via PeakProsperity.com,
What is perhaps the greatest risk to individual investors these days?
Is it the potential for a decline in corporate earnings based on a slowing global economy? Is it that current valuation levels in both equities and fixed income instruments are much nearer historic highs than not? Is the biggest risk a US Fed that will soon raise interest rates for the first time in close to a decade?
Although all of these are specific investment risks we face in the current cycle, my contention is that the single largest risk to investors is a risk that has been present since the beginning of what we have come to know as modern financial markets. The single largest risk to investors is themselves. By that, I mean the influence of human emotion and psychology in decision making.
We Are Our Own Worst Enemies
After many years of managing through market cycles, it seems pretty clear to me that humans are uniquely wired incorrectly for long-term investment success. When asset prices double, we want those assets twice as bad. When asset prices drop in half, we want nothing to do with them. Isn’t this exactly what we saw in US residential real estate markets a decade ago? Isn’t this what we experienced with the rise in dot-com stocks in 1999 and their demise over the three following years? Human decision making shapes the rhythmic bull and bear market character of asset prices. We know the two most prominent emotions that drive markets higher and lower are those of fear and greed.
If we turn the clock back far enough in early human history, we know that humans ran in packs. Strength and protection was found in a pack or herd. It was when humans ventured away from the protection of the herd (consensus thinking) that they were physically vulnerable. The fight or flight mechanism has been an integral part of human development over time. Several thousands of years later, these learned decision making responses are simply hard to “turn off.” We find comfort in decision making within the herd. When confronted with challenge, it’s either fight or flight. These ingrained human character traits are why we often see investors buy much nearer a top and sell close to market bottoms. Decision making driven by emotion, as opposed to logic, is the single greatest impediment to long term investment success. There is an old saying in the markets: “Human decision making never changes, only the wallets do.”
Human Emotions Meet Animal Spirits
Just what does this have to do with decision making in the current environment? Remember, as investors, controlling our emotions is probably the single greatest obstacle to sound decision making. As such, we need to anticipate potential emotional triggers so we can better confront and allay our own human responses to market outcomes. There is probably no greater human emotional trigger than actual price volatility itself. If we can anticipate and understand why price volatility may occur, we hope to dampen our own emotions and objectively steer through the vagaries of market cycles.
What we are seeing in the current market environment as a catalyst for potential heightened forward market price volatility is the current level of NYSE margin debt outstanding. You may be familiar with the financial market characterization of “animal spirits.” The concept of “animal spirits” is integrally intertwined with human emotion, in this case meaningfully heightened confidence. There probably is no greater show of human confidence in the investment markets than borrowing to fund an investment. Certainly, leveraged investors expect a return above their cost of capital, with expectations usually much higher than just this simple metric. The direction and level of margin debt outstanding at any time is a reflection of these so called “animal spirits,” it is a reflection of human confidence.
The Margin Debt Time-Bomb
Let’s have a look at where we now stand. As of July month end, NYSE margin debt outstanding stood just below a record level of $500 billion. It hit a new all-time high right alongside the equity market itself, exactly in line with what we would expect in terms of the emotional side of human decision making.
A few observations regarding the consistent patterns of human decision making seen in the historical rhythm of margin debt are important. First, it is clear that margin debt peaks very close to the final run to cycle highs in stocks with each bull market cycle. Remember, when asset prices double, we as humans want them more than ever, but when prices are cut in half, we avoid them like the plague. At the recent peak, margin debt was up just shy of $50 billion this year after being flat in all of last year. After these near vertical historical accelerations at cycle tops, margin debt has peaked and begun to decline while stocks temporarily go on to new highs – this divergence being the tell-tale indicator equities have peaked for the cycle. Because this data comes to us with a bit of a short-term lag, it’s seen in hindsight. At July month end, the S&P traded above 2100, while margin debt balances fell just shy of $18 billion. On a very short-term basis, this divergence was established in July.
Where we go ahead will now be important. Official NYSE August margin debt levels will not be available for a number of weeks, but it’s a very good bet margin debt levels contracted again in August, perhaps noticeably. As I watched the Dow open down over 1000 points a number of Monday’s back, it was clear margin liquidation drove the open. Price insensitive selling dominated early trading in many an asset price gap down.
As we step back and reflect on “rational” decision-making, it would be much more appropriate (and profitable) if margin debt outstanding peaked near the bottom of each market cycle (low prices) and shrank near the top. As long as human decision makers susceptible to emotion are involved, that is not to be.
The final important observation germane to our current circumstances is that when market prices turn down, margin debt levels drop like a rock. Think about leverage. It works so well when the price of assets purchased using leverage rise. Yet leveraged equity can be eaten alive in a declining price environment. Forced liquidations are simply price insensitive selling. Of course, this will only occur after prices have already dropped meaningfully enough to either force margin calls, or cause margined investors to liquidate simply in order to remain solvent or limit loss. We have certainly seen a bit of this in recent weeks.
Why is all of this talk about margin debt important?
In Part 2: The Criticality Of Monitoring Margin Debt Closely From Here we explore how ever higher levels of margin debt represent tomorrow’s heightened price volatility in some type of a stressed market environment, whether that be a meaningful correction or outright bear market.
Both are an eventuality, the only question is When?
Click here to read Part 2 of this report (free executive summary, enrollment required for full access)
- "We Do Not Think This Is Sustainable": Barclays Warns On Massive Cost Of China's FX Intervention
One of the most important things to understand about China’s doomed attempt to simultaneously manage the stock market, the economy, a deleveraging in some sectors, a re-leveraging in others, and the yuan is that it’s bound to produce all manner of conflicting directives and policies that trip over each other at nearly every turn. One rather poignant example of this is the attempt to rein in shadow lending without choking off credit growth. Another – and the one that will invariably receive the most attention going forward – is the push and pull on money markets by the PBoC’s FX intervention and offsetting liquidity injections.
Recall that Beijing’s open FX ops in support of the yuan necessitate the drawdown of the country’s vast store of USD reserves. In other words, they’re selling USTs. The effect this historic liquidation of US paper will have on global liquidity, core yields, and Fed policy has become the subject of fierce debate lately although, as we’ve been at pains to make clear, this is really just a continuation of the USD asset dumping that was foretold nearly a year ago when Saudi Arabia killed the petrodollar.
In any event, when China liquidates its reserves, it sucks liquidity out of the system. That works at cross purposes with the four RRR cuts the PBoC has implemented so far this year. In short, Beijing, in a desperate attempt to boost lending and invigorate the decelerating economy, has resorted to multiple policy rate cuts, but to whatever degree those cuts freed up banks to lend, the near daily FX interventions undertaken after the August 11 deval effectively offset the unlocked liquidity.
What this means is that each successive round of FX intervention must be accompanied by an offsetting RRR cut lest managing the yuan should end up completely negating the PBoC’s attempts to use policy rates to boost the economy – or worse, producing a net tightening. What should be obvious here is that this is a race to the bottom on two fronts. That is, the more you intervene in the FX market the more depleted your reserves and the more you must cut RRR until eventually, both your USD assets and your capacity to deploy policy rate cuts are exhausted. There are only two ways to head off this eventuality i) move to a true free float, or ii) implement a variety of short- and medium-term lending ops to offset the tightening effect of FX interventions in the hope of forestalling further RRR cuts. Clearly, this is a spinning plate if there ever was one, as attempting to figure out exactly what the right mix of RRR cuts and band-aid reverse repos is to offset FX interventions is well nigh impossible. It’s against this backdrop that Barclays is out with what looks like one of the more cogent attempts yet to outline and illustrate the above and explain why it simply isn’t sustainable. Below, find some notable excerpts.
First, here’s Barclays explaining what we’ve said for weeks and what BNP recently highlighted as well, namely that while the PBoC used to manipulate the fix to control the spot, it now simply manipulates the spot to control the fix, which in fact leads to less of a role for the market, not more:
Since China’s FX policy change on 11 August, spot CNY has traded close to the daily fixings. However, this apparent success may have come at a heavy cost. While the daily USDCNY fixings are more aligned to the previous day’s close, the close itself appears not to fully reflect market forces.
Of course less of a role for markets means more of a role for the PBoC, and that means FX reserve liquidation. There’s been no shortage of attempts to quantify the burn rate, but for what it’s worth, here’s Barclays estimate:
Our analysis suggests that the PBoC stepped up its FX intervention to USD122bn in August, from ~USD50bn in July, which underscores the significant pressure from capital outflows. Nonetheless, this suggests that the recent relative stability of spot USDCNY could be misleading. Based on the available data for FX intervention in July and our estimates for August, the PBoC has spent around USD172bn on intervention in both July and August. While the PBoC has huge FX reserves (USD3.65trn as of July 2015), if the current level of capital outflow pressures is sustained, we believe this currency defence could become costly. If the pace of FX intervention remains at USD86bn per month, we estimate that the PBoC could lose up to USD510bn of its reserves between June and December 2015, which would represent a nonnegligible decline of 14%.
As should be clear from everything said above, FX interventions and liquidity injections are, as Barclays puts it, simply two sides of the same coin, and to the extent the interventions continue, so too will the liquidity ops. Here’s an in-depth look:
So what’s the solution? Well, there isn’t one. As Barclays concludes, until expectations of further yuan weakness subside, the situation can’t stabilize: “We do not think the present policy is sustainable given the associated costs in terms of FX reserves depletion and liquidity imbalances [and] as such, we maintain our view that the CNY will need to depreciate further to stabilise capital outflows; we forecast a further 7% fall by year-end.”
So unless suddenly everything is fixed or, as SocGen puts it, “for the RMB to appreciate compared to its current value will require a very positive environment for EM coupled with a cessation of capital outflows and a vibrant cyclical growth and an export recovery,” the road ahead looks rather precarious, and not just for China, but for the Fed and by extension for the entire global economy. And on that note, we’ll close with what we said earlier this week:
As the Fed debates whether or not to hike, and how much, the acceleration in Chinese capital outflows starting on August 11 has set the path for the Fed, and at this point any incremental delay in hiking merely adds more to the already vast cross-capital and currency confusion around the globe. However, no longer is the Fed’s quandary open ended: with every passing day, China is suffering incremental tens of billions in capital flight and reserve liquidation, and thus, tighter global financial conditions, as can be expected from the unwind of the world’s largest depository of USD-denominated reserves.
Finally, what all of this really means, is that having pushed China to the point of dissociating itself from the USD peg officially, the more the Fed tightens, the more China will have to push back through devaluation or otherwise, and the more capital outflows it will be subject to, thereby amplifying the Fed’s tightening posture around the globe. In this very unstable arrangement, suddenly the smallest policy error will reverberate exponentially, and result in the only possible outcome: the Fed’s admission of policy failure by adopting a tightening bias, and ultimately launching another phase of monetary easing, be it QE4 or perhaps even the long-overdue and much anticipated Friedmanesque “helicopter money” episode.
- What QE Actually Impacted
The end of excess liquidity & the end of excess profits always spelt the end of excess returns, as BofAML notes, especially as the hand-off from psychotic monetary stimulus to economic recovery has been so lame in nominal terms.
But, as Gavekal Capital explains, the 'gains' from QE are even more tenuous than previously believed…
The Federal Reserve’s balance sheet has now been relatively unchanged for about 10 months. Total asset at the Fed are about $61 billion higher than they were one year ago. It sounds like a lot but considering total assets are currently $4.48 trillion, $61 billion is a drop in the bucket.
During the various QE programs in the US, a useful template to track different market and economic indicators was to plot them against the 3-month change in total Fed assets (see some of our older posts here, here, and here). Now that we have gone nearly a year since the taper ended, let’s check in on some relationships.
QE certainly affected asset prices. For government bonds, yields widened as the Fed’s balance sheet expanded and have narrowed as the Fed’s balance sheet has stopped growing. For corporate bonds, spreads over treasury narrowed as the Fed was expanding its balance sheet and have since widened substantially as the Fed’s balance sheet has stopped expanding. Breakeven inflation expectations have dropped significantly as the Fed’s balance sheet has stopped growing as well.
Stocks were positively affected as well. The 12-month change in the S&P 500 has fairly closely tracked the 3-month change in Fed assets. Momentum in the market has also tracked the change in Fed assets.
The effect on economic indicators is much more mixed. QE seems to have clearly impacted the manufacturing PMIs. However, the effect on manufacturing IP itself is tougher to discern.
It’s tough to see if QE had much effect on house prices. And it certainly didn’t matter to the consumer or small business owners. However, it seems to have negatively impacted economic surprises and increased perceived macro risks in the world as it was winding down.
Finally, QE didn’t seem to make much of a difference for nominal GDP or employment.
Unfortunately, overall it seems that QE had a much larger impact on bond and stock prices than on real economic activity. Government bond yields widened when the Fed was expanding its balance sheet while corporate spreads over bond yields narrowed. Stock prices were positively impacted by QE as well and have lost a lot of momentum since QE ended. Manufacturing surveys, in the US and globally, have been affected by QE but real economic indicators such as employment, small business intentions, and GDP have shown little relationship to changes in the Fed’s balance sheet level.
- Look For These Trades To Blow Up As The Rally Ends
What are the most crowded trades currently (and hence where the next round of carnage is coming from)? Long the US Dollar? Short US Treasuries? Long VIX? Think again…
And none of them ended well. Which is why this…
…might be the start of something very ugly.
Source: BofAML
- Europe's Biggest Bank Dares To Ask: Is The Fed Preparing For A "Controlled Demolition"
Why did we focus so much attention yesterday on a post in which the IMF confirmed what we had said since last October, namely that the BOJ’s days of ravenous debt monetization are coming to a tapering end as soon as 2017 (as willing sellers simply run out of product)? Simple: because in the global fiat regime, asset prices are nothing more than an indication of central bank generosity. Or, as Deutsche Bank puts it: “Ultimately in a fiat money system asset prices reflect “outside” i.e. central bank money and the extent to which it multiplied through the banking system.“
The problem is that the BOJ and the ECB are the only two remaining central banks in a world in which Reverse QE aka “Quantitative Tightening” in China, and the Fed’s tightening in the form of an upcoming rate hike (unless the Fed loses all credibility and reverts its pro-rate hike bias), are now actively involved in reducing global liquidity. It is only a matter of time before the market starts pricing in that the Bank of Japan’s open-ended QE has begun its tapering (followed by a QE-ending) countdown, which will lead to devastating risk-asset consequences. The ECB, which is also greatly supply constrained as Ewald Nowotny admitted yesterday, will follow closely.
But while we expanded on the Japanese problem to come in detail yesterday, here are some key observations on what is going on in both the US and China as of this moment – the two places which all now admit are the culprit for the recent equity selloff, and which the market has finally realized are actively soaking up global liquidity.
Here the problem, as we initially discussed last November in “How The Petrodollar Quietly Died, And Nobody Noticed“, is that as a result of the soaring US dollar and collapse in oil prices, Petrodollar recycling has crashed, leading to an outright liquidation of FX reserves, read US Treasurys by emerging market nations. This was reinforced on August 11th when China joined the global liquidation push as a result of its devaluation announcement, a topic which we also covered far ahead of everyone else with our May report “Revealing The Identity Of The Mystery “Belgian” Buyer Of US Treasurys”, exposing Chinese dumping of US Treasurys via Belgium.
We also hope to have made it quite clear that China’s reserve liquidation and that of the EM petro-exporters is really two sides of the same coin: in a world in which the USD is soaring as a result of Fed tightening concerns, other central banks have no choice but to liquidate FX reserve assets: this includes both EMs, and most recently, China.
Needless to say, these key trends covered here over the past year have finally become the biggest mainstream topic, and have led to the biggest equity drop in years, including the first correction in the S&P since 2011. Elsewhere, the risk devastation is much more profound, with emerging market equity markets and currencies crashing around the globe at a pace reminiscent of the Asian 1998 crisis, while in China both the housing and credit, not to mention the stock market, bubble have all long burst.
Before we continue, we present a brief detour from Deutsche Bank’s Dominic Konstam on precisely how it is that in the current fiat system, global central bank liquidity is fungible and until a few months ago, had led to record equity asset prices in most places around the globe. To wit:
Let’s start from some basics. Global liquidity can be thought of as the sum of all central banks’ balance sheets (liabilities side) expressed in dollar terms. We then have the case of completely flexible exchange rates versus one of fixed exchange rates. In the event that one central bank, say the Fed, is expanding its balance sheet, they will add to global liquidity directly. If exchange rates are flexible this will also mean the dollar tends to weaken so that the value of other central banks’ liabilities in the global system goes up in dollar terms. Dollar weakness thus might contribute to a higher dollar price for dollar denominated global commodities, as an example. If exchange rates are pegged then to achieve that peg other central banks will need to expand their own balance sheets and take on dollar FX reserves on the asset side. Global liquidity is therefore increased initially by the Fed but, secondly, by further liability expansion, by the other central banks. Depending on the sensitivity of exchange rates to relative balance sheet adjustments, it is not an a priori case that the same balance sheet expansion by the Fed leads to greater or less global liquidity expansion under either exchange rate regime. Hence the mere existence of a massive build up in FX reserves shouldn’t be viewed as a massive expansion of global liquidity per se – although as we shall show later, the empirical observation is that this is a more powerful force for the “impact” of changes in global liquidity on financial assets.
That, in broad strokes, explains how and why the Fed’s easing, or tightening, terms have such profound implications not only on every asset class, and currency pair, but on global economic output.
Liquidity in the broadest sense tends to support growth momentum, particularly when it is in excess of current nominal growth. Positive changes in liquidity should therefore be equity bullish and bond price negative. Central bank liquidity is a large part of broad liquidity and, subject to bank multipliers, the same holds true. Both Fed tightening and China’s FX adjustment imply a tightening of liquidity conditions that, all else equal, implies a loss in output momentum.
But while the impact on global economic growth is tangible, there is also a substantial delay before its full impact is observed. When it comes to asset prices, however, the market is far faster at discounting the disappearance of the “invisible hand”:
Ultimately in a fiat money system asset prices reflect “outside” i.e. central bank money and the extent to which it multiplied through the banking system. The loss of reserves represents not just a direct loss of outside money but also a reduction in the multiplier. There should be no expectation that the multiplier is quickly restored through offsetting central bank operations.
Here Deutsche Bank suggests your panic, because according to its estimates, while the US equity market may have corrected, it has a long ways to go just to catch up to the dramatic slowdown in global plus Fed reserves (that does not even take in account the reality that soon both the BOJ and the ECB will be forced by the market to taper and slow down their own liquidity injections):
Let’s start with risk assets, proxied by global equity prices. It would appear at first glance that the correlation is negative in that when central bank liquidity is expanding, equities are falling and vice versa. Of course this likely suggests a policy response in that central banks are typically “late” so that they react once equities are falling and then equities tend to recover. If we shift liquidity forward 6 quarters we can see that the market “leads” anticipated” additional liquidity by something similar. This is very worrying now in that it suggests that equity price appreciation could decelerate easily to -20 or even 40 percent based on near zero central bank liquidity, assuming similar multipliers to the post crisis period.
Some more dire predictions from Deutsche on what will happen next to equity prices:
If we only consider the FX and Fed components of liquidity there appears to be a tighter and more contemporaneous relationship with equity prices. The suggestion is at one level still the same, absent Fed and FX reserve expansion, equity prices look more likely to decelerate and quite sharply.
The Fed’s balance sheet for example could easily be negative 5 percent this time next year, depending on how they manage the SOMA portfolio and would be associated with further FX reserve loss unless countries, including China allowed for a much weaker currency. This would be a great concern for global (central bank liquidity).
Once again, all of this assumes a status quo for the QE out of Europe and Japan, which as we pounded the table yesterday, are both in the process of being “timed out”
The tie out, presumably with the “leading” indicator of other central bank action is that other central banks have been instrumental in supporting equities in the past. The largest of course being the ECB and BoJ. If the Fed isn’t going doing its job, it is good to know someone is willing to do the job for them, albeit there is a “lag” before they appreciate the extent of someone else’s policy “failure”.
Worse, as noted yesterday soon there will be nobody left to mask everyone one’s failure: the global liquidity circle jerk is coming to an end.
What does this mean for bond yields? Well, as we explained previously, clearly the selling of TSYs by China is a clear negative for bond prices. However, what Deutsche Bank accurately notes, is that should the world undergo a dramatic plunge in risk assets, the resulting tsunami of residual liquidity will most likely end up in the long-end, sending Treasury yields lower. To wit:
… if investors believe that liquidity is likely to continue to fall one should not sell real yields but buy them and be more worried about risk assets than anything else. This flies in the face of recent concerns that China’s potential liquidation of Treasuries for FX intervention is a Treasury negative and should drive real yields higher.… More generally the simple point is that falling reserves should be the least of worries for rates – as they have so far proven to be since late 2014 and instead, rates need to focus more on risk assets.
The relationship between central bank liquidity and the byproduct of FX reserve accumulation is clearly central to risk asset performance and therefore interest rates. The simplistic error is to assume that all assets are treated equally. They are not – or at least have not been especially since the crisis. If liquidity weakens and risk assets trade badly, rates are most likely to rally not sell off. It doesn’t matter how many Treasury bills are redeemed or USD cash is liquidated from foreign central bank assets, US rates are more likely to fall than rise especially further out the curve. In some ways this really shouldn’t be that hard to appreciate. After all central bank liquidity drives broader measures of liquidity that also drives, with a lag, economic activity.
Two points: we agree with DB that if the market were to price in collapsing “outside” money, i.e. central bank liquidity, that risk assets would crush (and far more than just the 20-40% hinted above). After all it was central bank intervention and only central bank intervention that pushed the S&P from 666 to its all time high of just above 2100.
However, we also disagree for one simple reason: as we explained in “What Would Happen If Everyone Joins China In Dumping Treasurys“, the real question is what would everyone else do. If the other EMs join China in liquidating the combined $7.5 trillion in FX reserves (i.e., mostly US Trasurys but also those of Europe and Japan) shown below…
… into an illiquid Treasury bond market where central banks already hold 30% or more of all 10 Year equivalents (the BOJ will own 60% by 2018), then it is debatable whether the mere outflow from stocks into bonds will offset the rate carnage.
And, as we showed before, all else equal, the unwinding of the past decade’s accumulation of EM reserves, some $8 trillion, could possibly lead to a surge in yields from the current 2% back to 6% or higher.
In other words, inductively reserve liquidation may not be a concern, but practically – when taking in account just how illiquid the global TSY market has become – said liquidation will without doubt lead to a surge in yields, if only occasionally due to illiquidity driven demand discontinuities.
* * *
So where does that leave us? Summarizing Deutsche Bank’s observations, they confirm everything we have said from day one, namely that the QE crusade undertaken first by the Fed in 2009 and then all central banks, has been the biggest can-kicking exercise in history, one which brought a few years of artificial calm to the market while making the wealth disparity between the poor and rich the widest it has ever been as it crushed the global middle class; now the end of QE is finally coming.
And this is where Deutsche Bank, which understands very well that the Fed’s tightening coupled with Quantiative Tightening, would lead to nothing short of a global equity collapse (especially once the market prices in the inevitable tightening resulting from the BOJ’s taper over the coming two years), is shocked. To wit:
This reinforces our view that the Fed is in danger of committing policy error. Not because one and done is a non issue but because the market will initially struggle to price “done” after “one”. And the Fed’s communication skills hardly lend themselves to over achievement. More likely in our view, is that one in September will lead to a December pricing and additional hikes in 2016, suggesting 2s could easily trade to 1 ¼ percent. This may well be an overshoot but it could imply another leg lower for risk assets and a sharp reflattening of the yield curve.
But it was the conclusion to Deutsche’s stream of consciousness that is the real shocker: in it DB’s Dominic Konstam implicitly ask out loud whether what comes next for global capital markets (most equity, but probably rates as well), is nothing short of a controlled demolition. A premeditated controlled demolition, and facilitated by the Fed’s actions or rather lack thereof:
The more sinister undercurrent is that as the relationship between negative rates has tightened with weaker liquidity since the crisis, there is a sense that policy is being priced to “fail” rather than succeed. Real rates fall when central banks back away from stimulus presumably because they “think” they have done enough and the (global) economy is on a healing trajectory. This could be viewed as a damning indictment of policy and is not unrelated to other structural factors that make policy less effective than it would be otherwise – including the self evident break in bank multipliers due to new regulations and capital requirements.
What would happen then? Well, DB casually tosses an S&P trading a “half its value”, but more importantly, also remarks that what we have also said from day one, namely that “helicopter money” in whatever fiscal stimulus form it takes (even if it is in the purest literal one) is the only remaining outcome after a 50% crash in the S&P:
Of course our definition of “failure” may also be a little zealous. After all why should equities always rise in value? Why should debt holders be expected to afford their debt burden? There are plenty of alternative viable equilibria with SPX half its value, longevity liabilities in default and debt deflation in abundance. In those equilibria traditional QE ceases to work and the only road back to what we think is the current desired equilibrium is via true helicopter money via fiscal stimulus where there are no independent central banks.
And there it is: Deutsche Bank saying, in not so many words, what Ray Dalio hinted at, namely that the Fed’s tightening would be the mechanistic precursor to a market crash and thus, QE4.
Only Deutsche takes the answer to its rhetorical question if the Fed is preparing for a “controlled demolition” of risk assets one step forward: realizing that at this point more QE will be self-defeating, the only remaining recourse to avoid what may be another systemic catastrophe would be the one both Friedman and Bernanke hinted at many years ago: the literal paradropping of money to preserve the fiat system for just a few more days (At this point we urge rereading footnote 18 in Ben Bernanke’s “Deflation: Making Sure “It” Doesn’t Happen Here” speech)
While we can only note that the gravity of the above admission by Europe’s largest bank can not be exaggerated – for “very serious banks” to say this, something epic must be just over the horizon – we should add: if Deutsche Bank (with its €55 trillion in derivatives) is right and if the Fed refuses to change its posture, exposure to any asset which has counterparty risk and/or whose value is a function of faith in central banks, should be effectively wound down.
* * *
While we have no way of knowing how this all plays out, especially if Deutsche is correct, we’ll leave readers with one of our favorite diagrams: Exter’s inverted pyramid.
- Whither The Economy?
Submitted by Paul Craig Roberts,
The great problem with corporate capitalism is that publicly owned companies have short time horizons. Unlike a privately owned business, the top executives of a publicly owned corporation generally come to their positions late in life. Consequently, they have a few years in which to make their fortune.
As a consequence of the short-sightedness of reformers and Congress, the annual salaries of top executives were capped at $1 million. Amounts in excess are not deductible for the company as an expense. The exception is “performance-related” pay, which has no limit. The result is that the major part of executive pay comes in the form of performance bonuses. Performance means a rise in the price of the company’s shares.
Performance bonuses can be honestly obtained by good management or mere luck that results in a rise in the company’s profits. However, there are a number of ways in which performance bonuses can be less legitimately obtained, almost all of which result in short-term gains to executives and shareholders and long-term damage to the corporation and economy.
Replacing American workers with foreign workers is one way. The collapse of communism in Russia and China and the collapse of socialism in India resulted in the under-utilized Indian and Chinese labor forces becoming available to American corporations. Pushed by “shareholder advocates,” Wall Street, and large retailers, US manufacturing corporations began closing their manufacturing plants in the US and producing offshore the goods, and later the services, that they market to Americans.
From the standpoint of the short-term interests of executives and shareholders, this decision made sense. But to transform manufacturing companies into marketing companies, as happened for example to Apple Computer, which apparently does not own a single factory, was a strategic mistake for the long-term. By offshoring the production of their products, US corporations transferred technology, physical plant, and business knowhow to China. American corporations are now dependent on China, a country that the idiots in Washington are endeavoring to turn into an enemy.
Further downside comes from the fact that research, development, and innovation are connected to the manufacturing process, because it is difficult for these important functions to be successful in a sterile atmosphere removed from the production process. As time goes by, US companies are transformed from manufacturing enterprises into sales organizations and lose connection to the work process, and these functions relocate abroad with the manufacturing jobs.
Offshoring manufacturing jobs left Americans with fewer high-value-added well-paid jobs, and the US middle class downsized. Ladders of upward mobility were taken down. Income and wealth distributions worsened. In effect, the One Percent got richer by giving away US incomes and GDP to China. Economists who shilled for the offshoring corporations promised new and better jobs to take the place of the lost manufacturing jobs, but as I have pointed out for years, there is no sign of these promised jobs in the payroll jobs releases or ten-year jobs projections.
Jobs offshoring began with manufacturing, but the rise of the high speed Internet made it possible to move offshore tradable professional skills, such as software engineering, Information Technology, various forms of engineering, architecture, accounting, and even the medical reading of MRIs and CT-Scans. The jobs and careers of university graduates were sent abroad and denied to Americans. Many of the jobs that remained in the US were given to foreign workers brought in on H1-B and L-1 work visas based on the obviously false claim that there was a shortage of talent in the US.
The gains in executive bonuses and shareholder capital gains were achieved by destroying the economic prospects of millions of Americans and by reducing the growth potential of the US economy. In the long-run this means the demise of the US as a world power. As I forecast in 2004, “the US will be a Third World country in 20 years.”
As jobs offshoring ran its course and had fewer remaining gains to offer the One Percent, short-term greed turned to new ways of wrecking both corporations and the US economy in behalf of executive and shareholder gains. Executives of utility companies, for example, forewent maintenance and upgrades and used the money instead to buy back their own shares. If you have ever wondered why you can’t get faster Internet in your area or why your electricity is constantly interrupted, this is probably the cause.
Executives also use the company’s profits to repurchase shares, and when they lack profits executives arrange bank loans to the companies in order to buy back shares. Executive “performance pay” goes up, but the corporations are left more heavily indebted and thus more vulnerable to recession and foreign competition. In recent years, buybacks and dividends have used up most of corporate profits, leaving the corporations bereft of updates and reserves.
Publicly owned capitalism’s short-term time horizon is also apparent with regard to nature’s resources and the environment. Ecological economists, such as Herman Daly, have established the fact that environmental destruction is the consequence of corporations moving many of the waste costs associated with their activities off their profit and loss statements and onto the environment. As other ways of artificially raising corporate profits and share prices become exhausted, expect corporations to push harder against pollution control measures. As the environment declines in its ability to produce new resources and to absorb wastes or pollution—for example the large growing dead areas in the Gulf of Mexico—the planet’s ability to sustain life withers.
President Richard Nixon established the Environmental Protection Agency in order to reduce the external or social costs that corporations impose on the environment. However, the polluting industries were not slow in taking over or capturing the agency, as University of Chicago economist George Stigler predicted.
A basis of economic theory is the absurd assumption that man-made capital is a perfect substitute for nature’s capital. This means that if the environment is used up and ruined, not to worry. Innovation and technology will substitute for nature. This absurd foundation of economic theory is why there are so few ecological economists. Economics teaches not to worry about the environment.
To sum up, the One Percent have enriched themselves at the expense of the economy’s potential and everyone else.
Where does the economy stand at the present time, a question on many of your minds? I am not a seer. Nevertheless, various things are obvious. In the US consumer demand is constrained by high debt and the absence of growth in real median family income. Evidence of the constrained US consumer shows up in lackluster real retail sales and in year-over-year declines in factory orders. On September 2, Zero Hedge reported that factory orders had fallen for 9 consecutive months.
As I point out, the monthly payroll jobs announcements are always overblown and consist largely of lowly-paid, part-time, domestic service employment. The 5.3% unemployment rate is phony, because it does not count any discouraged workers, and there are millions of them. Indeed, the absence of jobs is the reason the labor force participation rate has continually declined, a contradiction to the alleged recovery. On September 1, the Economic Cycle Research Institute reported that the US government’s data on employment/population ratios by education shows that the employment/population ratio for those with high school and college diplomas is lower now than when the alleged economic recovery began in June 2009. The only job gains have been for those without a high school diploma, the cheapest labor available in the US. Clearly, these are not jobs that will produce any rebound in consumer demand. And clearly education is not the answer.
The main economic releases from Washington—the ones that make the headline news: the unemployment rate, payroll jobs, GDP, and the consumer price index—are worthless. The unemployment rate does not include millions of unemployed, the CPI is rigged to undercount inflation, and as inflation is undercounted, real GDP is over-reported. Indeed, in my opinion and that of economic-statistician John Williams of shadowstats.com, nominal GDP deflated with a correct measure of inflation shows essentially no growth during the alleged recovery. What the government and financial media call economic growth is essentially price rises or inflation.
What is happening to America is that all of the surplus in the system accumulated over decades of success is being used up. Americans have had no interest income from their savings since the Federal Reserve decided to print trillions of dollars with which to purchase the troubled financial assets of a small handful of mega-banks. In other words, the Federal Reserve decided that, contrary to the propaganda about serving the public interest, the Fed exists to serve a few oversized banks, not the American people or their economy. As an institution, the Federal Reserve is so corrupt that it should be shut down.
The elderly avoid the stock market, because a decline can be long-lasting and eat up a large chunk of one’s savings. The same can happen from long-term bonds. Therefore, older people prefer shorter term interest instruments. The Federal Reserve’s zero interest rate policy means that older people are using up their savings, at the expense of their peace of mind and their heirs, in order to prevent a collapse in their standard of living. The elderly are also drawing down their savings in support of unemployed children and grandchildren. Unable to find jobs that will support the formation of a household or even an individual existence, many young college educated Americans are living with parents or grandparents, something I have not previously seen in my lifetime.
All the while the corrupt financial media pump us full of good economic news.
Many readers want to know if the stock market decline is over. It remains to be seen. In my opinion two opposite forces are at work. Based on earnings and the economy’s prospects, stocks are overvalued. However, the appearance of a successful economy is important to Washington’s power, and this brings in the Plunge Protection Team, a US Treasury/Federal Reserve team that intervenes to support the market. Wall Street managed to get the team created in 1988, and in the recent troubled days there are signs of it in operation. For example, suddenly during a time of market decline strong purchasing appeared, arresting the decline. Normally, optimistic purchasers who interpret declines as buying opportunities wait until the decline is over. They do not buy into the middle of a decline.
Today most stock purchases are made by money managers, such as mutual funds and pension funds. Individuals do not account for much of the market. Money managers are judged by their performance relative to their peers. As long as they move up or down with their peers, they are safe. Once the professionals see that government is supporting the market, they support it. This behavior is bolstered by greed. Participants want the market to go up, not down. Therefore, even if money managers understand that stocks are a bubble, they will support the bubble as long as they think the Plunge Protection Team is holding up the market.
The unanswered question in the minds of money managers is whether the Treasury and Fed are committed to maintaining an overvalued market or whether they are just holding it up long enough for their well-connected friends to get out. Only time will tell.
My book, The Failure of Laissez Faire Capitalism and Economic Dissolution of the West, will introduce you to the damage done by jobs offshoring and to the mistaken assumption of economists that the environment puts no constraints on economic growth.
The other part of the story comes from Michael Hudson, who explains the financialization of the economy and the transformation of the financial sector, which once financed the production of real goods and services, into a money-sucking leach that sucks all life out of the economy into its own profits. I recently posted a link to Pam Martens’ review of his book, Killing The Host.
If you can absorb my book, Michael Hudson’s book, and one of Herman Daly’s books, you will have a much firmer grasp on economics than economists have. Go to it.
- Putin Confirms Scope Of Russian Military Role In Syria
Over the past 48 hours or so, we’ve seen what certainly appears to be visual confirmation of a non-negligible Russian military presence in Syria. For anyone coming to the story late, overt Russian involvement would seem to suggest that the geopolitical “main event” (so to speak), may be closer than anyone imagined.
Russia’s excuse for being in Syria is the same as everyone else’s: they’re there, ostensibly, to fight ISIS. As we mentioned yesterday, and as we’ve detailed exhaustively as it relates to Turkey, the fact that ISIS has become a kind of catch-all, go-to excuse for legitimizing whatever one feels like doing is a dangerous precedent and Turkey’s crackdown on the Kurds proves beyond a shadow of a doubt that Islamic State will serve as a smokescreen for more than just the preservation/ouster (depending on which side you’re on) of Bashar al-Assad.
Having said all of that, going into the weekend Russia had yet to confirm publicly that it had commenced military operations in Syria despite the fact that it’s the next closest thing to common knowledge that at the very least, the Kremlin has provided logistical support and technical assistance for a period that probably spans two or more years.
But on Friday, Vladimir Putin looks to have confirmed the scope of Russia’s military role, even if he stopped short of admitting that Russian troops are engaged in combat. Here’s The Telegraph:
Russia is providing “serious” training and logistical support to the Syrian army, Vladimir Putin has said, in the first public confirmation of the depth of Russia’s involvement in Syria’s civil war.
And while the highlighted passage there is actually impossible to prove given that the term “depth” is subjective, it certainly does appear that Putin is now willing to concede that support for Assad goes far beyond “political”. Here’s AFP as well:
Asked whether Russia could take part in operations against IS, Putin said: “We are looking at various options but so far what you are talking about is not on the agenda.”
“To say we’re ready to do this today — so far it’s premature to talk about this. But we are already giving Syria quite serious help with equipment and training soldiers, with our weapons,” RIA Novosti state news agency quoted Putin as saying.
And back to The Telegraph briefly:
Speculation is growing that Russia has significantly expanded its involvement in recent months, including with deliveries of advanced weaponry, a raft of spare parts for existing machines, and the deployment of increasing numbers of military advisers and instructors.
Last week Syrian state television released images showing an advanced Russian-built armoured personnel carrier, the BTR-82a, in combat. Videos have also appeared in which troops engaged in combat appear to shout instructions to one another in Russian.
Of course whether or not the troops Russia has on the ground were sent to Syria with explicit orders to join the fighting is largely irrelevant when the bullets start flying. As Pavel Felgenhaeur, an independent commentator on Russian military affairs told The Telegraph, “it was quite conceivable that members of the advisory mission occasionally found themselves in combat or had even suffered casualties.”
So in other words, they’re at war, and even as Putin is now willing to admit, with a two year (at least) lag, that Russian boots are indeed on the ground, it may be a while before he admits to their role in direct combat and if Ukraine is any guide, he might never acknowledge the extent of Russia’s involvement. But make no mistake, the Russian presence has nothing to do with the “threat” ISIS poses to the world and everything to do with ensuring that Assad’s forces can fight on – at least for now.
The absurd thing about the whole effort is that ISIS itself is now just cannon fodder both for Russia and for the US led coalition flying missions from Incirlik that Turkey has suggested may soon include Saudi Arabia, Qatar, and Jordan. Even more ridiculous is the fact that since none of this has anything to do with eradicating ISIS in the first place, the bombing of ISIS targets by the US, Turkey, and Russia doesn’t really serve much of a purpose at all.
That is, everyone’s just biding time to see how far the other side is willing to go in support of their vision for Syria’s political future – a political future which, as we noted yesterday, almost certainly will not be decided at the ballot box, that is unless it’s after US Marines have stormed Damascus at which point the US will benevolently allow whatever civilians are still alive in Syria to choose between two puppet leaders vetted and supported by Washington.
And lest anyone should forget what this is all about…
- So That's Why Obama Went To Alaska
So that’s why he went to Alaska…
Threats…
…And Priorities…
- Did COMEX Counterparty Risk Just Reach A Record High?
The last few months have seen a steady drip-drip-drip increase in US, European, and Chinese bank credit risks, even as stock prices rose (aside from the latter). The turning point appears to have been the downturn in oil prices as traders began to hedge their counterparty risk in massive levered derivative positions tied to commodities. But it is not just banks… COMEX counterparty risk mut sbe on the rise, as Jesse's Cafe Americain notes, the 'claims per ounce of gold' deliverable at current prices has spiked higher once again, to a record 126:1.
Bank credit risk is rising…
And, as Jesse's Cafe Americain details, we suspect so is COMEX's…The 'claims per ounce of gold' deliverable at current prices has spiked higher once again, to 126:1.
As soon as the 'active month' of August was over at The Bucket Shop, JPM took a chunk of gold back off the registered for delivery roster. In the silver market JPM is gaining the reputation for a large physical silver hoard, and the role of a 'fireman' to maintain the stability of leverage in supply and demand.
These spikes higher in the ratio of open interest to deliverable bullion at current prices is not something that has happened in the past fifteen years at least. And neither has the steady increase in the ratio which we have been seeing in the past couple of years.
The Financial Times has finally noticed that the price for 'borrowed' gold bullion that is taken to Switzerland for re-refining and then final shipment to Asia for purchase and withdrawal is rising.
These are signs that one might expect to see in a late stage gold pool in which the manipulation of a market has gone too far for too long. One thing you can say about the financial speculators is that they never know when to quit. Remember the London Whale? He never stopped until the rest of the professional participants raised a fuss that he was disrupting the entire market!
The clever quislings for the bullion banks will note that an actual default on the Comex is unlikely, and they are right. It is not really a 'physical delivery' exchange, but is now primarily a betting shop. There is plenty of gold in the warehouses, if you do not concern yourself with the niceties of property rights. And claims can be force settled in cash on a declaration of force majeure.
Heck, as we saw in the case of MFGlobal, when JPM shoved to the front of the assets allocation line, even receipts for actual physical gold owned outright can be forced settled in cash. If you hold gold in a registered warehouse or an unallocated account, then your ownership is philosophically 'conceptual.'
The physical delivery exchanges are in other places, like the LBMA in London and especially the markets of Asia such as the Shanghai Gold Exchange.
And this is where we will see the first signs of a breakdown in the gold price manipulation pool of the bullion banks, first as signs of 'tightness' in the delivery of metals, and then in the initial 'fails to deliver.'
Rising prices will provide relief. But the pool operators are not shy about pressing and doubling down, in a familiar pattern of overreach. Remember the eventual demise of 'the London Whale?'
And although it is hard to believe, perhaps rising prices may not be so easily allowed.
"We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake.
Therefore at any price, at any cost, the central banks had to quell the gold price, manage it."
Sir Eddie George, Bank of England, September 1999
And it might not surprise anyone if it turns out that the wiseguy bullion banks are operating under the 'cover' of some bureaucratic boobs and a policy exercise gone horribly wrong. It would be like giving a platinum credit card to a gambling addict. Except you do not think that you ever have to pay the bills when they come due, since you are playing with other people's money.
"I have one other issue I'd like to throw on the table. I hesitate to do it, but let me tell you some of the issues that are involved here. If we are dealing with psychology, then the thermometers one uses to measure it have an effect. I was raising the question on the side with Governor Mullins of what would happen if the Treasury sold a little gold in this market. (just a little)
There's an interesting question here because if the gold price broke [lower] in that context, the thermometer would not be just a measuring tool. It would basically affect the underlying psychology.
Now, we don't have the 'legal' right to sell gold but I'm just frankly curious about what people's views are on situations of this nature because something unusual is involved in policy here. We're not just going through the standard policy where the money supply is expanding, the economy is expanding, and the Fed tightens. This is a wholly different thing."
Alan Greenspan, Federal Reserve Minutes from May 18, 1993
Just a little 'perception management' gone horribly wrong, right? And no one could have seen it coming.
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Or put graphically…
- Don't Forget China's "Other" Spinning Plate: Trillions In Hidden Bad Debt
To be sure, there’s every reason to devote nearly incessant media coverage to China’s bursting stock market bubble and currency devaluation.
The collapse of the margin fueled equity mania is truly a sight to behold and it’s made all the more entertaining (and tragic) by the fact that it represents the inevitable consequence of allowing millions of poorly educated Chinese to deploy massive amounts of leverage on the way to driving a world-beating rally that, at its height, saw day traders doing things like bidding a recently-public umbrella manufacturer up 2,700%.
The entertainment value has been heightened by what at this point has to be some kind of inside baseball competition among media outlets to capture the most hilarious picture of befuddled Chinese traders with their hands on their faces and/or heads with a board full of crashing stock prices visible in the background. Meanwhile, the world has recoiled in horror at China’s crackdown on the media and anyone accused of “maliciously” attempting to exacerbate the sell-off by engaging in what Beijing claims are all manner of “subversive” activities such as using the “wrong” words to describe the debacle and, well, selling stocks. Finally, China’s plunge protection has been widely criticized for, as we put it, “straying outside the bounds of manipulated market decorum.”
And then there’s the yuan devaluation that, as recent commentary out of the G20 makes abundantly clear, is another example of a situation where China will inexplicably be held to a higher standard than everyone else. That is, when China moves to support its export-driven economy it’s “competitive devaluation”, but when the ECB prints €1.1 trillion, it’s “stimulus.”
Given the global implications of what’s going on in China’s stock market and the fact that the devaluation is set to accelerate the great EM FX reserve unwind while simultaneously driving a stake through the heart of beleaguered emerging economies from LatAm to AsiaPac on the way to triggering a repeat of the Asian Financial Crisis complete with the implementation of pro-cyclical policy maneuvers from a raft of hamstrung central banks, it’s wholly understandable that everyone should focus on equities and FX. That said, understanding the scope of the risk posed by China’s many spinning plates means not forgetting about the other problems Beijing faces, not the least of which is a massive collection of debt that, thanks to the complexity of local government financing and the (related) fact that as much as 40% of credit risk is carried off balance sheet via an eye-watering array of maturity mismatched wealth management products, is nearly impossible to quantify or even to get a grip on.
Over the years, we’ve endeavored to detail China’s massive (and largely hidden) debt problem by drilling down into i) the local government debt saga (see here for the latest), ii) China’s management of NPLs (see here for instance), and iii) the lurking wealth management product problem (see here to read more than you ever cared to on this issue).
With all of the above in mind, we present the following from RBS’ Alberto Gallo who has made a valiant effort at summarizing contagion risk in China’s labyrinthine banking system.
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From RBS
The investment-driven model and fiscal stimulus have helped China achieve fast growth, but also led to rapid debt built-up. Unlike the US and Europe, which have deleveraged since the crisis, debt overhangs have kept growing in China. In common with previous examples of rapid credit growth, China now also has to tackle the collateral effects like overcapacity in industrial sectors, deteriorating asset quality and loss of growth momentum.
Local governments have also become dangerously levered. Under the fiscal rules introduced in 1994, local governments in China in theory were not allowed to raise debt. Faced with revenue expenditure imbalances, they often had to circumvent the rules by creating separate entities (local government financing vehicles) to borrow, largely through shadow banking channels. An official audit released in 2014 showed that total local debt had reached RMB17.9tn ($3tn) by the middle of 2013, equivalent to 38% of GDP. This figure includes debt local governments are directly responsible for (RMB10.8tn) plus guarantees. The government has started to reform the system by allowing direct bond issuance by local governments since last year, introducing more transparency and reducing their borrowing costs. However, more radical fiscal reforms (for example, an overhaul of the payment transfer system or greater taxation power for local governments) are difficult given the complex layers of government. In China, there are five levels of governments, compared to three in most other countries. This makes it logistically difficult to closely match tax collection and spending, and sometimes can encourage regional protectionism.
Banks have been the major intermediary for lending over the past years, leaving them vulnerable to rising credit risks. As shown below, most of Chinese corporates’ credit needs are still met by bank loans rather than bonds. Loans from China’s top four banks have more than doubled over the past seven years to reach 26% of GDP by H1 2015 (Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China).
Cracks are starting to appear: NPLs still look low, but are rising rapidly. According to the banks’ H1 2015 results, NPL ratios are still low at around 1.4-1.8%. However, the nominal rises in NPL amount have been significant, leading to flat profit growth for all four banks. Moreover, it has been a common practice in China for banks to roll over loans to strategic corporates when directed by the government. Such loans, though doubtful, will not be recognised as NPLs.
The government’s ability to support banks has declined. Traditionally the Chinese government has always stepped in to help banks when needed. For example, it issued special bonds to recapitalise the big four in 1998. Given the rise in banks’ loan books, the government’s ability to shoulder losses has declined. For example, bank loans increased to 130% of China’s FX reserves by FY 2014, up from 80% in 2006.
In addition, China also faces rising financial risks in the shadow banking sector. As shown above, the share of shadow banking credit has increased rapidly over the past years. As we discussed earlier, default risks remain high in the shadow banking sector. In August, ten trust companies and a fund manager requested a bailout from the top Communist party official in Hebei province (FT), following several default episodes last year.
Conclusion: The Chinese government is aware of the build-up of financial risks in the economy, and is trying to smooth the way of debt restructuring by more monetary easing. However, it is never an easy task to engineer an orderly deleveraging process, especially as the country also faces other structural problems and is in urgent need to transform its economic model and step up financial liberalisation.
- Global Economic Fears Cast Long Dark Shadow On Oil Price Rebound
Submitted by Evan Kelly via OilPrice.com,
After bouncing around, oil prices finished off the week with just a bit less volatility than when it started the week. WTI stayed at around $46 per barrel as of midday on September 4, with Brent holding at $50 per barrel.
Aside from supply and demand fundamentals in the oil markets, central bank policymaking is another major factor determining the trajectory of oil prices. The European Central Bank hinted that it might consider more monetary stimulus to help the stagnant European economy. Oil prices rose on the news. The markets, however, are waiting on a much more significant announcement from the Federal Reserve this month on whether or not the central bank will raise interest rates. This summer’s market turmoil – the Greek debt crisis and the meltdown in the Chinese stock markets – has dimmed the prospect of a rate increase.
Moreover, the global economic unease may begin to reach American shores. On September 4, the U.S. government released data for the month of August, revealing that the U.S. economy added only 173,000 jobs, a mediocre performance that missed expectations. Although an economic slowdown is no doubt a negative for oil prices, the news could provide enough justification for the Fed to hold off on raising interest rates. A delay in a rate hike could push up WTI and Brent.
Although a slew of Canadian oil sands projects have been cancelled due to incredibly low oil prices, several large projects were already underway before the downturn. With the costs of cancellation too high, these projects continue to move forward. When they come online – several of which are expected by 2017 – they could add another 500,000 barrels per day in production, potentially exacerbating the glut of supplies not just in terms of global supply, but more specifically in terms of the flow of oil from Canada. Canadian oil already trades at a discount to WTI, now at around $15 per barrel.
That means that when WTI dropped below $40 per barrel last week, Western Canada Select was nearing $20 per barrel. With the latest rebound to the mid-$40s, WCS is only around $30 per barrel. But with breakeven prices for many Canadian oil sands projects at $80 per barrel for WTI, oil operators in Alberta are no doubt losing sleep over their current situation. One important caveat to remember is that unlike shale projects, Canada’s oil sands operate for decades, so the immediate downturn does not necessarily ruin project economics. However, with a strong rebound in prices no longer expected in the near-term, high-cost oil sands projects are probably not where an investor wants to be.
Low oil prices continue to take their toll. Bank of America downgraded BP to “underperform” and warned that its dividend policy faces risks.
The EIA released a report this week that showed that there would be little effect on gasoline prices if the U.S. government lifted the ban on crude oil exports. In fact, gasoline prices could even fall because refined product prices are linked to Brent much more than WTI, so more supplies on the international market would push down Brent prices. The report lends credence to the legislative campaign on Capitol Hill to scrap the ban, a movement that is picking up steam. On the other hand, although few noticed, the EIA report also said that the refining industry could lose $22 billion per year if the ban is removed.
So far, many members of Congress have been reluctant to weigh in on this issue for exactly that reason: it pits drillers against refiners, both of which are powerful political players. But with the potential blowback from a spike in gasoline prices no longer a huge worry, the oil industry is gaining a lot of allies in its attempt to lift the ban. However, there is an elephant in the room: the 2016 presidential election could blow up any chance of meaningful energy legislation next year. Although several Republican candidates have come out in support of lifting export restrictions, the fear of attack ads could scare away others. If the issue becomes bogged down in presidential politics, it could ultimately kill off the legislative push.
Saudi Arabia’s King Salman arrived in Washington on September 4 to meet with U.S. President Barack Obama. The two leaders will discuss the Iran nuclear deal, a deal that the Saudi King had strongly opposed from the start, but has since begrudgingly warmed up to following security promises from the United States. If they can manage to stay on the same page with the Iran deal, the two leaders will then discuss the ongoing conflicts in Syria and Yemen. There is obviously little to no prospect that such intensely complicated conflicts will get sorted out in the near future, so more modest goals for the trip include simply building trust between the two countries. Although long-term allies, Saudi Arabia has become more mistrustful of the U.S. President following the thaw in relations between the U.S. and Iran. The trip follows what the media has called a “snub” when King Salman declined to come to Washington this past spring for a summit of other Gulf state leaders.
An oil spill closed part of the Mississippi River after two tow boats collided on September 3. One of the boats was carrying slurry oil, which spilled into the river. One of the ruptured tanks holds 250,000 gallons, but the exact amount that spilled was unknown. The Coast Guard is working with the boat’s owner – Inland Marine Services – to determine the extent of the damage.
Russian President Vladimir Putin met Venezuelan President Nicolas Maduro in China this week, and the two sides apparently discussed ways to stabilize oil prices. Maduro says that they agreed on “initiatives” to address low oil prices, but did not elaborate with details. In all likelihood, Maduro is engaging in a degree of bluster and wishful thinking. Neither side has the capacity to cut oil production as both are facing varying degrees of economic and financial crisis. However, earlier this week oil prices briefly spiked on news that Russia might be willing to negotiate coordinated action. Prices subsequently retreated once expectations subsided.
In nuclear power news, France’s EDF announced yet more delays at its Flamanville reactor, France’s first nuclear reactor in more than 15 years. The reactor was supposed to be completed in 2012 at a cost of 3.3 billion euros. But multiple delays have now pushed the start date back to the end of 2018 at the earliest, with costs ballooning to at least 10.5 billion euros. The delays are a familiar problem with the new generation of nuclear reactors, just as they were with the previous models. To be sure, building nuclear power plants is highly complex, but delays and cost overruns have plagued the industry, and each setback damages the technology’s competitiveness. When France and other industrialized countries were building up their power sectors in the ‘60s, ‘70s, and ‘80s, there were few other alternatives. But, with cheap natural gas and increasingly cheap renewable energy, nuclear power developers can ill afford setbacks.
- China's Central Bank Chief Admits "The Bubble Has Burst"
In a stunningly honest admission from a member of the elite, Zhou Xiaochuan, governor of China’s central bank, exclaimed multiple times this week to his G-20 colleagues that a bubble in his country had "burst." While this will come as no surprise to any rational-minded onlooker, the fact that, as Bloomberg reports, Japanese officials also confirmed Zhou's admissions, noting that "many people [at the G-20] expressed concerns about the Chinese market," and added that "discussions [at the G-20 meeting] hadn't been constructive" suggests all is not well in the new normal uncooperative G-0 reality in which we live.
Surprise – The Bubble Has Burst!!
But, as Bloomberg reports, the admission that it was a bubble and it has now burst is a notablke narrative change for the world's central bankers…
Zhou Xiaochuan, governor of China’s central bank, couldn’t stop repeating to a G-20 gathering that a bubble in his country had “burst.”
It came up about three times in his explanation Friday of what is going on with China’s stock market, according to a Japanese finance ministry official. When asked by a reporter if Zhou was talking about a bubble, Japanese Finance Minister Taro Aso was unequivocal: “What else bursts?”
A dissection of the slowdown of the world’s second-largest economy and talk about the equity rout which erased $5 trillion of value was a focal point at the meeting of global policy makers in Ankara. That wasn’t enough for Aso, who said that the discussions hadn’t been constructive.
…
It was China, rather than the timing of an interest-rate increase by the Federal Reserve, that dominated the discussion, according to the Japanese official, with many people commenting that China’s sluggish economic performance is a risk to the global economy and especially to emerging-market nations.
“It’s clear there are problems in the Chinese market, and at today’s G-20 meeting, many people other than myself also expressed that opinion,” Aso said after a meeting of finance chiefs and central bank governors.
Did the G-20 just admit that their all-powerful omnipotence is fading?
Meanwhile, though Jack Lew is happy to ream China as a currency manipulator, G-20 will not…
The PBOC shocked global markets by allowing the biggest yuan depreciation in two decades on Aug. 11, when it changed the exchange-rate mechanism to give markets a bigger role in setting the currency’s level. That historic move would not get a mention in the communique, according to the Japanese official, who asked not to be named, citing ministry policy.
- *G-20 COMMITTED TO AVOIDING PERSISTENT FX MISALIGNMENTS: DRAFT
- *G-20 WILL `REFRAIN FROM COMPETITIVE DEVALUATIONS': DRAFT
And – implicit in this exclamation is the fact that if it was a bubble – that has now burst – then is the PBOC admitting it is stoking a 'bubble' as opposed to supporting growth (or whatever mandate they are supposed to be living by)?
- Anatomy Of A Market Top, Part 1: Internal Combustion
Over the past few months, we have detailed the systematic deterioration in the internals of the stock market. This trend recently reached depths historically seen only near major market tops.
This is Part 1 of a 1 or 2-Part series on factors that are characteristic of a cyclical top in the stock market. It should really be a 3-Part series but, like Star Wars, we skipped over the 1st part of the story. Part 1A would have covered what we term the “background” conditions of the market. These background conditions – including valuation, sentiment, stock allocation, long-term price vs. trend, etc. – convey the general market environment that exists. These conditions are not catalysts or actionable indicators. Rather they reflect the market’s backdrop, instructing us as to which cyclical trends are likely to develop, at some point. Now, the status of these background conditions can persist – and for a long time. Indeed, we have been discussing the overbought/extended/high-risk nature of various of these indicators for years already. So, in a way we have covered the true Part 1 of this “Market Top” series, just not in a formal sense (our October 2013 Newsletter may have been the closest to an actual “Part 1”).
This piece covers the “internals” of the stock market. Internals (or breadth) refer to the level of participation among stocks throughout the entire equity market. It includes metrics like the number of stocks that are advancing versus declining, the amount of volume in advancing stocks versus declining stocks, the number of stocks that are making new 52-week highs versus new lows, etc. In our view, strong internals, i.e., widespread participation among stocks, is an important ingredient of a healthy market.
As a bull market ages, it tends to “thin out”. That is, it advances despite an ever-decreasing level of participation among all stocks. This thinning can persist for a while, and is not necessarily an immediate threat to the existence of the bull. However, eventually this “divergence” comes to a head as the relatively few (usually mega-cap) stocks still carrying the market higher are unable to continue to do the heavy-lifting. And when those stocks roll over, the foundation among the broad market of stocks does not exist to prevent a significant decline. This end-game development among the internals is quite possibly in motion as we speak.
Does this mean the end of the bull market is near – or here? Not necessarily. No one can know that and we are not going out on a limb to make such a call. However, the deterioration in market internals has reached truly historic depths – the kind typically associated with cyclical stock market tops. Over the past few months, we have systematically journaled on our blog the veritable procession of breadth failures. Here is a sample of the profusion of evidence that we noted.
Disclaimer: While this study is a useful exercise, JLFMI’s actual investment decisions are based on our proprietary models. Therefore, the conclusions based on the study in this newsletter may or may not be consistent with JLFMI’s actual investment posture at any given time. Additionally, the commentary here should not be taken as a recommendation to invest in any specific securities or according to any specific methodologies.
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NYSE Advance-Decline Line: The Grand-Daddy of Breadth Indicators
In our view, the grand-daddy of all breadth indicators is the NYSE Advance-Decline Line (A-D Line). The A-D Line is a cumulative running total of the differential of advancing stocks minus declining stocks on the NYSE on a daily basis. If we could have just one breadth indicator for purposes of analyzing the cyclical state of the stock market, it would be the NYSE A-D Line. It provides as good a picture as anything of the health of the broad market. And recent developments here do not paint a picture of good health in the market.
For one, on May 27, we noted that the NYSE A-D Line suffered a breakdown below its UP trendline from the 2009 low.
While similar trendlines for most indices remain intact, it is not unusual for the A-D Line to suffer a breakdown first. It has often preceded breaks in the major averages, serving as a warning sign that all is perhaps not well. Note similar warnings prior to the past 2 cyclical tops.
Secondly, while the trendline break was a red flag, it wasn’t the first warning sign to appear in the A-D Line – nor was it the most significant. That distinction goes to the development we noted on May 21. Specifically, the NYSE A-D Line failed to confirm the new 52-week high in the S&P 500 earlier that week. That is, the index made a new high while the A-D Line failed to do so. This is what we call a negative divergence.
So why is this significant? As mentioned in that post, the NYSE A-D Line has negatively diverged before every single cyclical market top since 1966. Now most of the prior divergences had significantly more lead time than this one. However, there have been other close-range divergences so this would not be unprecedented. That said, it would not be out of the question to see the S&P 500 eventually make another higher high concurrent with a more prominent divergence in the A-D Line.
New Highs-New Lows: Cyclical Breakdown
Another of the most popular gauges of market internals relates to the number of stocks making New 52-Week Highs or 52-Week Lows. One way to track the data is to simply subtract the number of New Lows from New Highs on a daily basis. This series tends to trend over a cyclical cycle, thus providing us with signals of various significance based on the series’ behavior.
This New Highs-New Lows indicator has been in an uptrend, in terms of higher lows, since it bottomed in 2008. However, as we pointed out in an August 21 post, like the A-D Line, this metric has also suffered a noteworthy breakdown, falling below that post-2008 Up trendline.
It is possible that this breakdown is occurring within the context of an intermediate-term washout. After all, the August 21 low reading occurred partly as a result of ZERO New Highs on the NYSE. That is a development normally only associated with a capitulatory phase of a major decline (indeed, of the prior 50 Zero New High days, the S&P 500 has been a median 31% below its 52-week high, versus the current 7.5%). Therefore, the market may possibly see a mean-reversion bounce soon. However, the bigger-picture ramifications should not be missed. Similar trend breaks have ushered in an eventual acceleration in losses during the prior 2 cyclical declines.
The Junkie Market: Too Many New Highs AND Lows
NYSE
While we just witnessed an extreme low number of New Highs (e.g., 0), another recent ominous development pertained to the abundance of New Highs and New Lows. Whatever the reason for this dynamic, such conditions have occurred at less than auspicious times. On July 16, we noted the occurrence in recent days of more than 100 New 52-Week Highs AND 52-Week Lows on the NYSE.
Historically, this development in the market’s internals has not been kind to the market going forward.
This was especially true when coming off of a recent 3-month low.
Nasdaq
On July 27, we noted the same situation on the Nasdaq exchange.
These events were similarly unkind to the Nasdaq market, especially the past 5 such occurrences.
NYSE AND Nasdaq
On August 7, we highlighted those occasions in which the NYSE and the Nasdaq exchanges each saw an abundance of both New Highs and New Lows.
As expected, the forward returns in the S&P 500 were quite depressed following these occurrences, particularly in the longer-term.
The Summation Of All Fears
Another way of measuring the cumulative state of market internals is via the McClellan Summation Index. The Summation Index is actually an oscillator that expresses the longer-term status of advances-declines, new highs-lows, etc. as either positive (above a zero line) or negative (below the zero line). While it is an oscillator, the Summation Index can, and usually does, remain positive for an extended period during favorable markets and negative for an extended period during difficult markets. Thus, it is fairly atypical of the McClellan Summation Index on either the NYSE advances-declines or the NYSE New Highs-New Lows to go negative when the S&P 500 is close to its 52-week high. It is especially unusual to see both of them below the zero line with the S&P 500 near its highs.
Yet, as we noted on July 30, this was precisely the situation in recent weeks. This may be the single most instructive chart in illustrating the deteriorating breadth situation juxtaposed against the close proximity of the major averages to their all-time highs.
Again, this type of negative breadth divergence has been a bad harbinger of things to come, eventually, for the market. A look at the forward performance of the S&P 500 following these events gives you an idea why we say this may be the most instructive data point in describing the negative divergence between prices and internals – and its potential consequences.
Losing Weight: Even The Leaders Are Thinning
Despite this preponderance of evidence pointing to the deterioration of the market’s internals, the major averages, as well as a select few sectors, continued to hold near their highs. The reason is that a relatively few (mainly mega-cap) stocks kept those areas propped up with their substantial weighting in the indices. However, as the relatively few strong areas of the market began to weaken, there was precious little support left to prevent a significant correction. We recently detailed such signs of deterioration even among the stronger areas of the market.
Equal-Weight S&P 500
We pointed out the first example of this on May 28 with respect to the S&P 500. Though the cap-weighted index was coming off a recent 52-week high, the equal-weight index was beginning to lag. As the name implies, this index applies an equal weighting to each of its components. This provides a more accurate look at the health of the broad market segment than does a cap-weighted index which can mask internal weakness if the largest stocks are still performing well.
This has been precisely the situation beginning with the equal-weight S&P 500 index failing to confirm the cap-weighted index’s new high in May. Additionally, after attempting a relative breakout versus the cap-weighted index earlier in the year, the equal-weight S&P 500 broke down below its post-2012 uptrend, recently hitting a 2-year low.
Equal-Weight Nasdaq 100
The technology-heavy Nasdaq 100 (NDX) has been one of the stalwarts of this bull market, hitting a 52-week high as recently as a month ago. However, the equal-weight NDX has also noticeably thinned out, as we indicated on July 22. As with the equal-weight S&P 500, the equal-weight NDX failed to confirm the cap-weighted index’s new high in July and has broken down below its post-2012 uptrend to a 2-year low.
Equal-Weight Consumer Discretionary
Lastly, even the leading sectors of the market have been showing weakening internals. One example is the consumer discretionary sector, which was at an all-time high as recently as 2 weeks ago. However, looking at the sector on an equal-weight basis, one can see that the strength was due to some of the larger-cap names in the sector. On a broad, equal-weight basis, the sector has been losing steam over the past few months. Like the examples above, the equal-weight consumer discretionary index failed to confirm the cap-weighted index’s recent high and has now fallen to a 6-year low on a relative basis.
July 20: The Turning Point?
Internal deterioration can last for some time before it has an impact on the major averages. However, when the divergences become as pronounced as they have, there is a certain point where they come to a head. Every cycle is different, but, at times, this inflection, climax, turning point, etc. can be narrowed down to a specific day. Such days are characterized by the major averages rising to or near a new high, but accompanied by egregiously poor breadth, relatively speaking. It’s as though the market has run out of gas in its push to make one more high. Some examples of such days occurred in August 1987, July 1990. March 2000 and July/October 2007 as well as near various tops in the 1960’s-70’s.
Obviously, these days are only identifiable in hindsight. However, we did make reference to the possibility that July 20 was one such “turning point day” in a post we titled “The Thinnest New High In Stock Market History”. Here is some of the evidence we used to back up that claim.
NYSE
On July 20, the S&P 500 rose to within 0.12% of its 52-week high. Since 1965, there had been 1,564 days on which the index closed higher to within 0.5% of its 52-week high. Among those days:
July 20 had the lowest % of NYSE Advancing Issues (31.7%) of all near-highs on the S&P 500
July 20 had the lowest % of NYSE Advancing Volume (28%) of all near-highs on the S&P 500
July 20 had the 2nd fewest NYSE New Highs vs. New Lows (35%) of all near-highs on the S&P 500
Nasdaq
On July 20, the Nasdaq Composite closed at a 52-week high for the 749th time since 1988. Among those days:
July 20 had the lowest % of Nasdaq Advancing Issues (31.6%) of all Nasdaq new highs
July 20 had the lowest % of Nasdaq Advancing Volume (42%) of all Nasdaq new highs
July 20 was the 2nd time ever with more Nasdaq New Lows than Highs at a Nasdaq new high
To reiterate, based on the evidence above, we labeled July 20 the thinnest new high in stock market history (at least for as far back as we have data on market internals). Despite the new highs, or near highs, in the major averages, the level of participation among the broad market in attaining this new high was staggeringly and unprecedentedly low. Thus, the foundation underlying the new high was extremely weak, leaving the market exceedingly vulnerable once the relatively few advancers finally succumbed.
Indeed, neither the S&P 500 nor the Nasdaq Composite have exceeded their July 20 close since.
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Conclusion
The not-formally written first part (1A?) on the Anatomy Of A Market Top would pertain to “background” conditions in the stock market. These conditions, such as valuation, investor allocations, long-term price versus trend, etc. orient us as to the “big-picture” market environment. Identifying the environment enables us to anticipate the types of large-scale moves that arise out of the given climate – eventually. Currently, the background conditions are as risk-laden as they come. Together, they form a market environment that has historically given rise to cyclical tops in the stock market. However, these background conditions can last for an extended period, years even, before the expected large-scale move unfolds. The fact that we have written about these elevated background conditions for several years now attests to their potential persistency. Something needs to change within the market’s structure to effect a cyclical decline.
The first change often occurs below the surface. In Part 1 here, we explain how the deterioration of the market’s internals typically occurs in the lead-up and development of a cyclical market top. Weakening breadth, i.e., advancing versus declining issues, new highs vs. lows, etc., even as the major indices continue to make new highs, is the first sign of tangible trouble in the market. That said, this dynamic too can persist for an extended period. Indeed, such negative divergences have been occurring for as long as 12 months now.
However, eventually these divergences reach a head. And the most egregious cases have historically occurred within close proximity to major, cyclical market tops. The deterioration of the broader market is so great that the resultant foundation of support below the surface of the popular market cap-weighted averages is nearly non-existent. Once the relatively few leaders propping up the market begin to collapse under the weight, the inevitable cyclical decline can commence.
That is when Part 2 of the Anatomy Of A Market Top occurs: the breakdown of prices. This looks to be unfolding as we speak, so stay tuned…
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More from Dana Lyons, JLFMI and My401kPro.
- This Has Never Happened To VIX Before
Amid the carnage and chaos of the last two weeks, one thing has become crystal clear – the effect of massive one-way bets on 'everything', predicated on the omnipotence of central bankers, has left a market (stocks, bonds, FX, commodities) bereft of fundamental linkages and instead driven entirely by technicals (flows, forced unwinds, systematic gamma). While many 'records' were broken in terms of velocity of moves, it is the VIX complex that seems to have suffered most, and as the following chart shows, positioning is now at an extreme in both stocks, vol, and bonds once again.
Speculative traders have never – ever – been this net long VIX futures… and traders have not been this net short S&P futures since Summer 2012.
The VIX curve remains deeply inverted – the longest period of backwardation since 2011's plunge.
And the crowd has 'decided' to pile into bond shorts – with 5Y Futures net shorts the largest in 7 years…
As is clear, the last time the crowd was this short, bonds ripped 250bps tighter, forcing a massive short squeeze.
With such extreme positioning across the equity, vol, and bond complex, it would seem no matter what The Fed does in September, there will be blood.
Charts: Bloomberg
- Exorbitant Privilege: "The Dollar Is Our Currency But Your Problem"
Submitted by Dan Popesceau via GoldBroker.com,
There is no better way to describe the international monetary system today than through the statement made in 1971 by U.S. Treasury Secretary, John Connally. He said to his counterparts during a Rome G-10 meeting in November 1971, shortly after the Nixon administration ended the dollar’s convertibility into gold and shifted the international monetary system into a global floating exchange rate regime that, "The dollar is our currency, but your problem.” This remains the U.S. policy towards the international community even today. On several occasions both the past and present chairpersons of the Fed, Ben Bernanke and Janet Yellen, have indicated it still is the U.S. policy as it concerns the dollar.
Is China saying to the world, but more particularly to the U.S., “The yuan is our currency but your problem”? China’s move to weaken the Yuan against the US dollar is in fact a huge response to America’s resistance to reforming the international monetary framework. It’s telling American policy makers that the longer they delay acting on reforming the international monetary system, the harder and longer they are going to make it for the U.S. to climb out of their trade deficit and depreciate their currency to where they need it to be.
China has been preparing for this moment for several years by accumulating gold through its central bank but also by using banks/corporations and individuals. It has in recent years signed several international agreements to bypass the US dollar in international trade and use preferably the Yuan. It has created an alternative World Bank (Asian Infrastructure Investment Bank) and a gold fund to invest in gold mining for more than 60 countries. The project is being overseen by the Shanghai Gold Exchange (SGE) and it is likely that the newly mined gold will be either traded on the SGE or be sold directly to the PBoC and other central banks. It has also bought a large amount of gold and kept the exact amount as secret as possible.
The international monetary system is in crisis and ready to collapse. It has been since at least 1971 but it seems we are very close to the end (within five years). The International Monetary Fund (IMF) is working discreetly to have the Special Drawing Rights (SDR) replace the US dollar as the international standard. Since the delinking of the dollar from gold in 1971, the US dollar has been the de facto international standard. The IMF itself makes no bones about its ambition to establish the SDR as the global reserve currency.
In a 2009 essay, Governor Xiaochuan of the People’s Bank of China (the Chinese central bank) also called for a new worldwide reserve currency system. He explained that the interests of the U.S. and those of other countries should be “aligned”, which is not the case in the current dollar system. Xiaochuan suggested developing SDRs into a “super-sovereign reserve currency disconnected from individual nations and able to remain stable in the long run”. What does he mean by “disconnected from individual nations”? The present SDR is a mathematical formula of the price of its composing currencies of “individual countries” with no backing whatsoever. Does he imply some kind of link to gold? That would explain many other statements in favor of gold by China’s officials and their aggressive encouragement of Chinese institutions and individuals to buy gold.
Julian D. W. Phillips, of Gold Forecaster, says, “What has become clear in the actions of the Chinese government and the central bank is that they are determined to accelerate the Yuan’s passage to a reserve currency, hopefully with the cooperation of the IMF, but if not, they will walk their own road.” However, this is not the final objective of China. Its target is to eliminate the “exorbitant privilege” of the dollar, not just to join the “club”. China doesn’t want to destroy the dollar, only to eliminate its “exorbitant privilege”.
With a different approach, but also very aggressively and more so since the U.S.-EU sanctions that amplified the new cold war, Russia has also accelerated its gold buying. Russia and China have also started a new payment system to avoid the U.S. dominated and controlled international payment system. Elvira Nabiullina, Chairwoman of the Russian Central Bank, said, “Recent experiences forced us to reconsider some of our ideas about sufficient and comfortable levels of gold reserves.” Also in a recent CNBC interview, Ms. Nabiullina remarked on Russia’s increasing gold reserves, saying, “We base ourselves upon the principles of diversification of our international reserves and we bought gold not only last year but during the previous years. Our gold mining industry is very well developed and it is ready to supply gold.” Dmitry Tulin, who manages monetary policy at the Central Bank of Russia, said, "The price of gold swings, but on the other hand it is a 100% guarantee from legal and political risks." Russia is boosting gold holdings as defense against “political risks”.
In 1997 Robert Mundell, Nobel prize of economics, wrote in an article, “The problem with the pure dollar standard is that it works only if the reserve country can keep its monetary discipline.” Aristotle said something similar 2,500 years ago: “In effect, there is nothing inherently wrong with fiat money, provided we get perfect authority and god-like intelligence for kings.” It is evident that since at least the collapse of Bretton Woods the U.S. has not kept its monetary discipline and has no intention to do it.
Dr. Mundell, in the same article, said, “The United States would not talk about international monetary reform … because a superpower never pushes international monetary reform unless it sees reform as a chance to break up a threat to its own hegemony … The United States is never going to suggest an alternative to its present system because it is already a system where the United States maximizes its seigniorage … the United States would be the last country to ever agree to an international monetary reform that would eliminate this free lunch (exorbitant privilege of the dollar)”. He seems to have been right. The U.S. is dragging its feet. The U.S. has not yet ratified the IMF reforms agreed even by the U.S. government in 2010. I doubt it will pass before the U.S. election at the end of 2016. This has upset not only China and Russia, but also the European Union and most of the international community.
During the 2008 crisis that almost succeeded in bringing down the current international monetary system, gold made a stunning comeback into the system. During the crisis, gold became the only accepted guarantee in order to get liquidity. What was significant was that after having been ignored for decades, gold was coming back into the international monetary system via settlements of the Bank for International Settlements (BIS). These transactions themselves confirmed that gold was coming back into the system. They revealed the poor state of the financial system before the crisis and showed how gold has indirectly been mobilized to support the commercial banks. Gold’s old emergency usefulness has resurfaced, albeit behind closed doors at BIS in Basel, Switzerland. Since the 2008 crisis both China and Russia have accelerated their purchases and accumulation of gold by any means possible as it can be observed in the chart below.
Since 2010 we have been in a G-0 world (no dominating power), in currency and gold wars and a new cold war. The world desperately needs a new world order and a new international monetary system. Will it happen after a major collapse and possibly war or through collaboration and consensus avoiding a war? It is evident to me that, as Dr. Mundell said in 1997, “Gold is going to be a part of the structure of the international monetary system for the 21stcentury, but not in the way it has been in the past.” What form will it take? It’s hard to say now. In this adversarial environment of a cold war and currency/gold wars I can hardly see a fiat monetary system succeed (fiat SDR). That requires trust and consensus at the international level between countries. A détente, disarmament and collaboration environment was there between 1990 (end of cold war) and 2008 (start of new cold war and currency wars), but no more.
In the conflictual environment we are now in, it looks more and more to me that gold will impose itself as the de facto money. Jim Rickards, in Currencies after the Crash, edited by Sara Eisen, said, “When all else fails, possibly including a new SDR plan, gold is always waiting in the wings as a stable, widely accepted store of value and universal money. In the end, a global struggle between gold and SDRs for supremacy as “money” may be the next great shock added to the long list of historic shocks to the international monetary system.” Any fiat SDR international settlement currency will only be postponing the inevitable “big reset” to some form of gold standard.
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