Bogus Bond Bust

It was another snoozer overnight in stock and commodity markets. A U.S. index of leading economic indicators was up for the second straight month. This emboldened the view that the recession is getting less bad. And in addition to “green shoots” you can add the words “bottomed out” to the list of phrases designed to reassure everyone that things are getting they better.

To some extent, things ARE getting better. For example, today is Friday. Yesterday was Thursday. Tomorrow is Saturday. Most people enjoy the weekend. We are that much closer to it now. Things ARE getting better.

Whether the real economy is any closer to working off the credit excesses of the last twenty years...well, that we doubt. But for every story on bad bets by banks and bad loans wandering around like zombies on the balance sheet, let’s not forget where all that money did not go: energy exploration and capacity expansion.

While the Western world was in a ten-year torrid love affair with residential real estate and mortgage securitisation (with a fling in credit default insurance trading on the side) it forgot to keep looking for oil and gas in sufficient quantity to meet growing demand from the developing world. It was a structural mistake, and, it turns out, an intriguing investment/speculative bonanza.

For example, earlier this week Malaysia oil giant Petronas signed a deal to take two million tonnes a year of LNG for the next twenty years from the LNG project in Queensland run by Santos. The deal begins in 2014. BG signed a similar deal last month to supply LNG to China National Offshore Oil Company.

What’s remarkable about so many foreign companies and big money getting into Queensland LNG plays is that no one has a commercial process yet to turn coal-seam-gas (CSG) into LNG. This is why we consider the CSG LNG plays to be unconventional energy plays and thus more speculative than the off-shore deepwater LNG production from companies like Woodside Petroleum (a Diggers and Drillers stalwart).

But the speculative nature of the smaller Aussie-listed players in the CSG and LNG industries is what makes them the perfect province for small-caps editor Kris Sayce. He’s been all over the story (having just taken profits of over 450% on one share). And just today Kris published his latest issue of the Australian Small Cap Investigator. It’s another exciting unconventional energy play. If you aren’t an ASI reader yet, you can become one by going here.

The LNG market is derivative of the oil price, by the way, but not in the toxic, weapons-of-mass-financial-destruction way. That is, LNG prices will probably track oil prices higher, as long as oil prices continue to rise (which we think they obviously will over time). Your main risk in these stocks (not excluding production failures, bad management, or funding bottlenecks) is that the oil price crashes again. But with markets tip-toeing the recovery line, oil seems to be firming up around US$70.

Bonds, however, are looking rather infirm. Prices fell and yields rose on U.S. Treasury bonds. This is easy enough to dismiss as a natural consequence of the recovery theme gaining traction. But might also have something to do with the fact that the U.S. Treasury will auction another $140 billion in bonds next week.

That amount tops the $104 billion amount auctioned last week. It’s a lot of borrowing, isn’t it? The auction on June 25th will include $40 billion in two-year notes, $37 billion in five-year notes, and $27 billion in seven-year notes. The U.S. government ran a $189 billion deficit...in the month of May.

Note the absence of 30-year bonds in this auction. Whether by design or by accident, this confirms that U.S. borrowing is become a lot more interest rate sensitive. Creditors, we think, are beginning to shy away from lending to the U.S. at fixed rates for longer than ten years. They want their money back before the value of their investments is inflated away by quantitative easing. This makes funding U.S. debt more expensive...and vulnerable to a spike in yields.

Speaking of counterfeiting, did you see the story of two “alleged Japanese businessmen” who were arrested with $134 billion in allegedly fake U.S. Treasury bonds while trying to cross the border from Italy to Switzerland? The story sent the Internet into a tizzy, speculating if Japan—which had expressed “unshakeable confidence” in the U.S. dollar earlier in the week—was secretly unloading a huge chunk of its U.S. debt. The U.S. Treasury Department has since said that the bonds were fake and that no one, repeat no one, was attempting to quietly dump U.S. bonds.

Ahem. Nothing to see here. Move along.

And finally, a quick follow up to our report yesterday about problems in Aussie bank land. The Reserve Bank of Australia published a report yesterday providing an interesting insight into how Australia’s banks fund their lending. If you are into these sorts of things, you can find the report here.

If you are not into these sorts of things, we will give you the brief version of what we think the report suggests about the future of Australia’s capital markets: the RBA has lost control of the price of money in Australia.

The main driver in the cost of capital for Australia’s banks is not the RBA’s cash rate but the global cost of capital. In other words, the credit depression is already leading to higher capital costs in Australia beyond the control of the government and the RBA. This could lead to lower bank lending down the track and less growth (lower business investment, fewer funds available for commercial property development and residential real estate). It could also lead to more government lending and money printing to fill the lending gap, which would lead to higher interest rates and an Aussie gold price.

We maintained earlier in the week that the property boom in Australia was paid for with money borrowed from foreigners. The RBA’s numbers show that the big four banks source 45% of their funding from domestic depositors. The rest of the bank funding comes from a combination of foreign borrowing, short-term bonds in the domestic capital market, long-term bonds in the domestic capital market, and securitisation of things like residential mortgages.

We’re not sure how this percentage break down compares to other countries’ bank funding. But you can still draw a few conclusions from the RBA study. First, Australian banks are putting up interest rates in part to attract more depositors because deposits are becoming a more important source of funding. This reflects the growing importance of deposits as a source of funding versus, say, securitisation, which has all but dried up with the credit crunch..

While politicians may whinge about the banks putting up rates, you can also argue that Aussie banks have to put up rates on savings and other accounts in order to attract more money used for domestic lending. If rates don’t go up, neither will lending. And without a lending recovery, you can’t have an economic recovery. Of course higher rates might attract savers and increase the supply of loanable funds, but they are generally matched with higher borrowing costs too.

If it sounds like a bit of a paradox, it is. But it also illustrates some of the internal contractions that result from having an economy addicted to credit. If we can get in touch with him, we’ll ask Shawn Cownah to comment next week.

In the meantime, Aussie banks are paying more to borrow in international capital markets. It also costs them more to hedge their currency risk. Both factors squeeze the banks. And the banks like to pass the squeeze on to customers.

We’ll have more on the subject next week. But for now, we think this shows that the contrary to received wisdom that Australia’s banks are immune and insulated from the GFC, the effects are already being felt. And in a credit depression, we suspect the effects will begin to multiply this year and next. Until next week...

Dan Denning
for The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• The Really, Really Long Bond
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• The Bond Market’s Search for the Bottom
• Why Retirements Are Going Bust, Again
• The Fight Between Greed and Fear, Boom and Bust, Expansion and Contraction