Last week was as depressing and alarming as any we’ve seen in the financial markets in the last ten years. Let’s hope this week isn’t an encore. But we’re not betting on it.
“The economy is headed for recession next year, with a 50 per cent plunge in share values and a double-digit drop in house prices,” reports David Uren in today’s Australian. He’s quoting from Morgan Stanley economist Gerard Minack. Minack says the Aussie economy is at the end of its fifth bull run of the last 100 years or so and that earnings will revert to the mean.
What does that mean? Going back to the 1970s, Minack reckons profits are 44% above their-long term trend. This roughly corresponds with a decline in Aussie savings rates. So you can do the maths at home. Households are running on a thin margin of cash flow error. Rising share prices and house prices make a low savings rate tolerable in a boom. You spend because you feel rich, and corporate earnings rise.
In a bust, though, it all begins to work in reverse. And it clearly seems like we are going backwards now. Minack reckons base metals prices could fall by 40% and soft commodities by another 15%. That is not what Australia needs to hear right now. But that is the elephant in the room in the Lucky Country, that our close relationship with China may not be enough to save us with the U.S. in recession and the world de-levering.
Meanwhile, Friday’s action in the U.S. market has set up another negative day here in Australia. The jobs data in the U.S. revealed that the American economy shed 65,000 jobs in February. This was bad enough. It’s hard to increase spending when your income evaporates.
But Friday’s action was marked by an acute sense of fear that a third powerful wave in the credit crisis may just now be crashing into the shores of the stock market. JP Morgan sent a note to clients that the U.S. banking sector faces a “systemic margin call.” The banks could lose as much as US$325 billion in capital as the deleveraging of the financial system continues.
You can hear the exasperation and desperation from the brokerages that make their living selling stock to the public. “The market is totally dysfunctional and it’s certainly a lack of understanding, particularly with the new investors in the last couple of years who have never seen anything like it,” Linda Chan of Macquarie Bank told the Australian.
Note to Miss Chan: none of us have seen anything like it. Markets go in cycles. But no previous cycle relied more on borrowed money than this cycle. Hedge funds borrowed from Wall Street banks to lever up returns on risky strategies. Now, faced with massive and on-going losses in the mortgage market, Wall Street banks are calling their loans into the hedge funds.
The margin calls force the hedgies and other leveraged borrowers to sell assets to repay the loans. But this is not a great market to sell assets in. London-based Peloton Partners faced a margin call it couldn’t meet last week. And it is not alone.
“Peloton joins Thornburg Mortgage Inc. and Sailfish Capital Partners LLC on the list of funds and companies that have had to sell securities or shut down after banks restricted how much they could borrow, or demanded more collateral as values of securities backed by mortgages slumped. The world’s biggest financial institutions are cutting off lines of credit to hedge funds after at least $163 billion of asset write downs and market losses,” reports Pierre Paulden at Bloomberg.
Markets always overshoot. But then you’d expect that when people behave emotionally. First love is always irrational. And your first broken heart is always the worst. For many investors, this is their first real, knee-buckling bear market. A sense of despair and hopelessness creeps in. Lenders who were once happy to lend to anyone cannot be persuaded to give up a penny.
Into this vortex of frayed nerves stepped the Fed on Friday. The Fed continued its “risk laundering” operation by increasing the amount of money it is willing to lend against dodgy collateral. “The Fed increased the size of its loan auctions to commercial banks from $60bn to $100bn and unveiled another $100bn in new one-month repurchase operations primarily for investment banks,” reports Krishna Guha at the Financial Times.
The Fed is offering to become a giant correctional facility of sorts for recalcitrant capital. Banks can send of their poor-performing assets to be baby-sat by the Fed’s custodians. Under the terms of the second repurchase agreement of US$100bn, the Fed offers to loan money for up to 28 days against any type of security-Treasury bonds, agency bonds, mortgage-backed bonds.
In practical terms, the Fed is offering to absorb all the impaired assets of the banks for as long as it takes. It hasn’t been put to the test yet, but you can imagine the Fed will be happy to roll over the lending period past the original 28 days if it has to. In effect, it’s offering to lend to hold dodgy collateral until the market stabilizes and banks begin lending again. It is, as some have suggested, a stealth nationalization of the American banking sector.
There’s a lot going on here. First, will the banks lend to leveraged borrowers? It doesn’t look like it. Prime brokers lend to hedge funds. Hedge funds use leverage to bet on the direction of asset prices. Why would the Fed want to enable this? And if the prime brokers won’t lend to the hedge funds, will the Fed?
Remember, the Fed is owned by the big banks. There is a chance that the banks are happy to have the Fed do their dirty work for them. That is, the banks can force the illiquid collateral and poorly-valued on to the Fed’s balance sheet and off their own. The loser in that deal is the American public. The winner, the banks that own the Fed. Would the public catch on to the swindle? What do you think?
Here’s another question, does the expansion of the term auction facility actually expand the money supply? Is it inflationary? There is great debate about this among monetary policy wonks (you know who you are). It depends on what measure of money supply you use. In fact, it depends on what you mean by money.
We will leave the subtleties of the argument for another day. But we’d also say that by expanding the asset side of its balance sheet by so much (accepting collateral is technically expanding the Fed’s assets…although they are not your garden variety assets), the Fed further undermines the credibility and viability of the U.S. dollar. We’ll have more on this later this week.
The action of the last few days makes you wonder how much room inflation has to go. On the one hand, consumer inflation in China is running at about eight percent. Food prices are soaring all over the world. Coal is tipped to rise 200% on supply shortages. Oil set an all- time high.
But then you have this massive de-leveraging in the financial system. We should not underestimate the damage this could do to shares. Forced selling by hedge funds of stocks and commodities threatens both resource stocks and underlying commodities. And yes it does so even in the face of bullish supply/demand scenarios for various commodities. Why?
Hedge funds manage some US$2 trillion in assets. But with leverage, that turns into much larger bets on the direction of asset prices. With asset prices falling, the funds de-leverage. That means they have to pay back all the borrowed money, and you can only do that by selling the assets.
A disturbing sign of how bad things are is that hedge funds are being forced to sell what they thought were quality assets. This is certainly the case at Thornburg, who thought is mortgages assets were safe and secure. But banks are having none of it. Thorburg had trouble finding buyers for US$4 billion of its supposedly high-quality mortgage debt. And the doubt about asset quality is creeping into other markets too.
Yields on the bonds of Fannie Mae and Freddie Mac rose to 22-year highs last week. These bonds-up until now-have been considered just a notch below U.S. Treasury bonds. Freddie and Fannie’s bonds are backed, implicitly, by the U.S. government. The trouble is that Fannie and Freddie guarantee some US$4.3 trillion of the U.S. mortgage market. There is a looming suspicion that the companies face much larger losses than they’ve admitted to…and that their capital levels might not be adequate to handle the losses.
Another name for this is insolvent.
“Everything is telling you the financial system is broken,” says Scott Simon at Pacific Investment Management. The Fed can’t save the mortgage market. Banks won’t lend. Hedge funds can’t borrow and have to de-lever. Stocks are sold.
That is where we are on a Monday. There is the small chance that markets, overshooting in both directions, have already overshot to the downside. And there is a larger chance that the downside is much larger, and getting closer day by day.
Frankly, it is impossible to forecast what to expect from here. But we’d expect lower lows on the major indices. We would also raise a red flag on resources and commodities. There is no telling how much leveraged money there is in the commodities market. We will find out shortly. But don’t be at all surprised to see big falls in commodity prices.
Ultimately, the Fed will have to expand the money supply much more directly than it appears to be doing through the term auction facility program. Either way, the Fed’s action is certain to be dollar bearish. And that is the most compelling argument for precious metals and tangible goods for the rest of the year.
The Daily Reckoning Australia