During the weekend of March 14th, Fed Chairman Bernanke was lured into an exceptional TV interview where he said on tape that he saw the first green seeds of recovery in the economy. The following Monday markets rallied euphorically further.
Later that week the FOMC surprised the market again with their aggressive decision on quantitative easing. The consensus in the market was they would still take a wait and see stance.The result of all this was that markets were torn apart between the believers of “we have seen the bottom” and those who are still sceptical about it. The Fed action immediately sparked extreme volatility in the equity, currency, commodities and bond markets. The Dow Jones went from -200 points before the announcement to +200 immediately thereafter to end the session at +90. The dollar was under pressure throughout the session, trading in a 1.3416-1.3530 range against the EUR and in an 95.27-96.62 range against the JPY. The USD had its biggest fall since the G7 intervention in 2000 against the EUR and not surprisingly US 10y Treasury yields plummeted 47 bps to yield 2.535 %, the biggest drop since 1962. Gold was testing a technical resistance at 880 to rally back to 935, a 6.25 % rise.
The big question is whether we have seen the bottom indeed. If so, why would the Fed take out the most aggressive tool in history to fight the deflation monster? If there were signs of recovery deflation would certainly not be an issue with all that liquidity that has been pumped into the market so far.
Chairman Bernanke was probably right in saying they narrowly avoided a scenario which unfolded during the Great Depression. Unemployment rose above the 20% globally. At the moment there are no signs it is going to be like that, but on the other hand we are not out of the woods yet.
As said on previous occasions the current crisis is the result of imbalances and excesses built up over a long sustained period, and it will take time before we have digested all this. Global economic growth was driven by a spending spree of the US consumer.
The dynamics are well known by now. The US consumer bought goods from Asia and energy from oil exporting countries. The value of those purchases were simply larger than the US consumers’ income. The difference was funded with home equity or mortgage refinancing. In turn, the rise in mortgage debt was repackaged by investment banks. And to end the cycle all this was sold of and distributed all over the world.
It was just a matter of time before this gigantic imbalance would create a major economic distortion and to return to a normal equilibrium will take much more time then 12 months.
The US consumer will have to start saving (credit is not available anymore to the same extent as it was before 2008) (current savings rate stands at 5%+, vs. negative in the recent past !) which will cause a long period of low economic growth. The spending spree of the US consumer is felt in all layers of society. A very striking article on Bloomberg earlier this week underlines this. Stores on Greenwich Avenue, the ‘Rodeo Drive’ of Connecticut, are closing one after another. As banks and hedge funds cut jobs and close down, the stores on this exclusive avenue shut their doors too. Even a less exclusive brand as Banana Republic closed their shop earlier this month.
Further the global deleveraging process of the banking industry is best case at around 65% with a couple of USD trillion still to go. Increased government regulation and protectionism are hampering further a strong recovery. And excess capacity remains a huge problem.
All this means we will see economic growth below average, with further pressure on employment and corporate results. These are certainly not the signs that the bottom has been reached already. Otherwise, why would we see defaults of corporates of one a week on average at the moment?
Then there is the question whether the euphoria triggered by the upbeat results from Citigroup and BoA is appropriate. The banks posted a much better than expected operating profit. But operating profit says nothing about the solvency state. To be quite honest in the current is extremely attractive for banks. If one does not make a profit now when will they?
An interesting paper came out last week from Dr. Martin Weiss who runs an economic think tank in Washington. He made a thorough analysis on the banking bailout programme that is going on and he gave further arguments to believe the worst is not over yet. (1)
The Federal Deposit Insurance Corporation (FDIC) whose task is to protect deposit holders up to $ 250,000 in case a bank would fail has made a list of 252 institutions that are at risk. The total assets of these banks represent $ 159 bln.
However there is reason to believe that the FDIC is underestimating the outstanding risk and the list will be far greater:
• E.g. one of the largest banks who failed last year, IndyMac Bank of Pasadena ($ 32 bln) was not on the list.
• A number of banks, with total assets much higher than $ 159 bln, and who already received TARP money are not on the list, but this does not mean they are not at risk anymore
• Statistical rating model, developed by banking regulators, made a list of banks at risk which is more accurate then the FDIC’s list
This statistical rating model, called CAMELS ratings, takes into account capital adequacy asset quality, earnings, liquidity and sensitivity to market risk. Based upon this model Weiss Research came up with 1,372 commercial and saving banks still at risk with a total asset portfolio of $ 1.79 tln. Furthermore there are 196 savings and loans associations with $ 528 bln also at risk. Compare this with the FDIC’s number of $ 159 bln and there is reason to believe this is not over yet…
Last year in December we already referred to the exponential growth of the derivatives market causing sever systemic risk. The market already got a serious warning when Lehman Brothers was allowed to go bankrupt what the fallout of all this could mean.
The systemic risk is not going away. On the contrary due to the failure of Lehman and bailout of Bear Stearns and Merrill Lynch the systemic risk is even rising. At this moment the total notional amount of outstanding OTC derivatives is at $ 175 TRILLION. 97 % of the total amount is controlled by 5 banks!!! 49.9 % or $ 87 TRILLION is in the hands of one single bank, JP MorganChase!!!
All these banks have a credit exposure that by far exceeds their risk based capital.
Bank of America : 177.6 % ( credit risk as percentage of risk based capital)
Citigroup : 259.5 %
JPMorgan Chase : 400.2 %
HSBC Bank USA : 664.2 %
The major problem with this situation is that the US Government might not even be capable to bailout one of these banks as their exposure exceeds by far the resources the US Government has.
And the risk is not marginal. Why would for instance JP Morgan have better risk management tools as Lehman or Bear Stearns?
But stock markets are rallying indeed. Although in the past we have seen a similar phenomenon. This is a bear market rally. Figure 1 shows that in Japan they had at least 4 very strong rallies within the bear market trend. The last one was even a rise of over 55 % only to see the market resume its downward spiral. A similar trend was experienced after the tech bubble and 9/11 turned the markets in turmoil. There we can detect at least three false recoveries of 20 % on average each time (Figure 2).
Figure 1: Nikkei Index 1990 - 1999
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
Figure 2: S&P 500 1999 - 2003
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
Figure 3: S&P 500 2007 - 2009
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
In the current bear market this is only the second rebound we are seeing. From November till the beginning of this year we already saw the markets rebound by roughly 25% only to revisit new lows.
Based upon the fundamentals we just outlined above we are very sceptical the rally we are seeing right now is sustainable. Comments like “We have seen the bottom” are misplaced and will cause more pain. That’s why we call this the Smugglers Bottom. A smuggler always has a fake bottom in his suitcase to hide something behind it. This market is the same. The only difference with the smuggler will be that it ain’t something valuable behind it.
Certainly now that central banks across the globe (with the ECB the only exception at the moment but soon they will follow) are starting to bring the long end of the curve also down, sitting on cash could be so depressing that Average Joe is pushed, in a desperate search for some yield, to the stock market. He is even tempted by portfolio managers who are driven by performance anxiety and linked to a benchmark and drive prices up at the moment as the end of Q1 is coming up. The same happened at the end of last year. Managers still wanted to show some performance before the end of the year and a suckers rally was set in for the end of the year.
Forcing money into risky assets is perhaps the most dangerous experiment ever done, and is so large in scale and so unprecedented that we have no idea how it will end. I expect it to end poorly and with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that has bottomed. But this is sleigh of hand, an illusion, a chimera.
The Fed has declared a war on savers, a war on prudence and provided the ultimate Moral Hazard Card-and with our money no less (Bernanke put anyone ?). They are also setting up the ULTIMATE BULL TRAP-a trap so large that when it is sprung, perhaps as early as the end of the first quarter/beginning of second quarter, there will only be sellers left. (2)
Following the aggressive QE of the FED we also expect extreme volatility in the currency markets in the next 24 months.
The USD will experience some further weakness in the next couple of weeks due to the fallout of the unexpected aggressive quantitative easing program from the Fed. Although it is remarkable that investors are not leaving the USD head over heels. As we said on several occasions, once there are signs of stabilisation in the US economy it will bear the fruits of the actions undertaken. In that respect the EUR might be the victim longer term given the fact that European political and monetary leaders remain clueless how to tackle the crisis. On the other hand the risk of double digit inflation due to the massive printing of money can cause a Wicksellian disequilibrium.
Just to give a brief introduction into this mechanism, economist Knut Wicksell came to the view that the effects of a disequilibrium between general demand and supply on monetary prices are not temporal but cumulative. In simple terms, any deviation from an equilibrium sets off a dynamic process that continually leads the system away from the equilibrium. If for any reason, the general demand is set and maintained above the general supply, no matter how small that gap is, the consequence will be that prices will start rising and keep on rising.
Wicksell came to his conclusion based upon the findings of his experiences in physics. “The analogous picture of money prices should rather be some easily movable object, such as a cylinder, which rests on a horizontal plane in so called neutral equilibrium. The plane is somewhat rough and a certain force is required to set the price cylinder in motion and to keep in motion. As long as this force remains in operation the cylinder continues to move in the same direction. After a while it will start rolling: the motion is accelerated one up to a certain point, and it continues for a time even when the force has ceased to operate. Once the cylinder has come to rest, there is no tendency for it to be restored to its original position. It simply remains where it is so long as no opposite forces come into operation to push it back again.” (Wicksell 1936) (3)
This also partially explains the danger of intervention by central banks and the overshooting of their targets. From now on it will be key for the FED to start preparing the markets in explaining they have an exit strategy ready. If not the problems down the road can be very worrisome.
Therefore saying that we have seen the bottom is dangerous. We even dare to say it is almost beyond belief to hear this on prime time television from the most powerful man in the world.
(1) Martin D. Weiss “Dangerous Unintended Consequences: How Banking Bailouts, Buyouts and Nationalization can only prolong America’s second Great Depression and weaken any subsequent recovery.” March 19th 2009, Weiss Research Inc
(2) John Mauldin “Setting the Bull Trap”, Investors Insight, Jan 2009
(3) Wicksell “Interest and Prices”, p. 101, 1936 Augustus M Kelley Pubs
No comments:
Post a Comment