As I write this, it looks like the market will open about 200 points down, entirely due to the news that Dubai’s biggest company has asked for a “standstill” on almost $60 billion in debt for six months. Will this trigger the systemic heart attack that worries me? Probably not! Even if the lenders had to write-off their entire loan as worthless, which is silly to contemplate, it is only a small sliver of the total $1.5 trillion that is expected to be written off over the next two years. A more legitimate concern is that Dubai will fire-sale their other assets, driving down market prices, in order to raise cash. Most of those assets are in the UK, including a large ownership interest in the London Stock Exchange itself. However, this “chest pain” will undoubtedly reduce investors’ appetite for risk, slowing or stopping the markets rise. But, that’s OK, because the market has gotten too far ahead of the economy and needs a rest. It is even well ahead of its own 50-day-moving-average. It needs to slow down now to avoid a more disruptive drop later.
For the economic cardiologists among us, the thing to watch is not stock market closing prices, but the cost of credit default swaps. These derivatives played a large part in triggering the crash in September of last year. Unfortunately, information is hard to obtain on them. Nobody even knows how many there are. There is no central exchange to keep track of them. A mere $60 billion related to Dubai would mean nothing. But, that can be leveraged a great deal, thru derivatives called “CDOs squared”. A trillion dollars worth could easily produce the heart attack I fear. We need a central exchange NOW!
One thing is certain: The market will over-react. It has a long history of that, and it is especially true following a recession. The next few days could be ugly, but you don’t need to go the emergency room. I’ll let you know when you do!
Friday, November 27, 2009
Saturday, November 21, 2009
Dr. Bernanke: STAT
While data about our economic health has been improving rather consistently since the Crash of 2008, I’ve become very concerned that the patient might suffer an unexpected heart attack. The problem now is the same as the problem then. We still have not figured out how to intelligently regulate derivatives, which Warren Buffett described as “financial weapons of mass destruction”. But, heart attacks are often triggered by something exogenous, e.g., sudden exertion, surprises, etc. So, what would trigger our economic heart attack?
A few years ago, many economists fretted about the Yen-carry trade. At that time, investors were borrowing Yen in Japan at essentially zero interest rates and buying dollars in Australia or New Zealand, for example, which paid as much as 7%. They kept the difference in interest earned in Australia and interest paid in Japan as their profit. Their risk was that Japan might raise interest rates, which would cause the Yen to appreciate, which would then make it more expensive for the investors to buy enough Yen to repay their loans. This is the greatest risk to the investment strategy of “currency carry trades”. When the reversal happened, Japan paid a heavy price as the value of the Yen suddenly spiked, which made their exports un-competitive worldwide overnight.
Recently, famed pessimist Nouriel Roubini, who accurately predicted both the timing and the intensity of The Great Recession, claimed the Yen-carry trade was nothing compared to the new Dollar-carry trade, calling it “the mother of all carry trades”. I suspect he is right. The world is awash in dollars right now, borrowed at no cost and invested in more risky assets elsewhere, which has been a major factor driving up stock markets worldwide this year. However, when the market feels the Fed is ready to raise rates, we can expect a vast amount of more risky assets, such as international stocks, to be sold quickly, driving down their values. It will happen suddenly.
Will that trigger the heart attack I fear? Probably!
Will the patient be better prepared for a reversal of the Dollar-carry trade if we better regulate derivatives before then? Absolutely!
I wish it wasn’t so boring that Congress cannot pay attention . . . paging Dr. Bernanke!
A few years ago, many economists fretted about the Yen-carry trade. At that time, investors were borrowing Yen in Japan at essentially zero interest rates and buying dollars in Australia or New Zealand, for example, which paid as much as 7%. They kept the difference in interest earned in Australia and interest paid in Japan as their profit. Their risk was that Japan might raise interest rates, which would cause the Yen to appreciate, which would then make it more expensive for the investors to buy enough Yen to repay their loans. This is the greatest risk to the investment strategy of “currency carry trades”. When the reversal happened, Japan paid a heavy price as the value of the Yen suddenly spiked, which made their exports un-competitive worldwide overnight.
Recently, famed pessimist Nouriel Roubini, who accurately predicted both the timing and the intensity of The Great Recession, claimed the Yen-carry trade was nothing compared to the new Dollar-carry trade, calling it “the mother of all carry trades”. I suspect he is right. The world is awash in dollars right now, borrowed at no cost and invested in more risky assets elsewhere, which has been a major factor driving up stock markets worldwide this year. However, when the market feels the Fed is ready to raise rates, we can expect a vast amount of more risky assets, such as international stocks, to be sold quickly, driving down their values. It will happen suddenly.
Will that trigger the heart attack I fear? Probably!
Will the patient be better prepared for a reversal of the Dollar-carry trade if we better regulate derivatives before then? Absolutely!
I wish it wasn’t so boring that Congress cannot pay attention . . . paging Dr. Bernanke!
Friday, November 13, 2009
Why did we send in the clowns?
Late last year, a client wisely predicted that China would emerge from the crisis before the U.S. His reasoning was interesting. He thought that great problems require great decisions, but that the U.S cannot make great decisions like China, which is governed by engineers, while the U.S. is governed by lawyers. I've thought about this alot!
Yesterday, I heard from David Gergen, advisor to five different U.S presidents, of both parties. He pointed out that our founding fathers intentionally created a difficult legislative process. However, they had no expectation that the process would later be made ever more difficult with (1) the problem of filibusters, requiring 60 votes instead of 51, (2) the complexity of requiring CBO analysis of all spending bills, (3) the pointless "food fights" created by the media to sell advertising and (4) the "quiet conspiracy" between Republicans and Democrats to protect safe seats during re-districting every ten years, which pushes candidates to the extremes instead of the center.
If the founding fathers could have seen what would happen, would thay have made the legislating process so difficult? But is it too late to send in the engineers?
Yesterday, I heard from David Gergen, advisor to five different U.S presidents, of both parties. He pointed out that our founding fathers intentionally created a difficult legislative process. However, they had no expectation that the process would later be made ever more difficult with (1) the problem of filibusters, requiring 60 votes instead of 51, (2) the complexity of requiring CBO analysis of all spending bills, (3) the pointless "food fights" created by the media to sell advertising and (4) the "quiet conspiracy" between Republicans and Democrats to protect safe seats during re-districting every ten years, which pushes candidates to the extremes instead of the center.
If the founding fathers could have seen what would happen, would thay have made the legislating process so difficult? But is it too late to send in the engineers?
Thursday, November 12, 2009
But, what is the recipe?
Today, I listened to one of my favorite thought leaders, John Mauldin of Dallas, author of Bull's Eye Investing. He spoke of the difficult state of the U.S. economy and the few but painful choices we have:
1. The Argentine Solution - induce hyper-inflation to "inflate away"
the huge indebtedness of our country. He gave this a 1% probability.
2. The Austrian Solution - induce a collapse to eliminate the weak,
effectively flushing away the problems but creating 30%
unemployment now,while insuring the good times will return sooner.
He also gave this a 1% probability.
3. The Eastern Europe Solution - following the Soviet collapse,
that part of Europe had no choice but to make huge re-structuring
changes. However, given our inability to re-structure the health
care system, which "everybody agrees needs to be re-structured",
how can the U.S. effectively make the necessary decisions within
our current political system.
4. The Glide-Path Solution – announce an exit strategy for the huge
government deficit to expect an eventual return to the good times
at some point in the future, without trashing the dollar in the
meantime. This, he said, is our best hope!
My judgment is that he is correct, but we will have to experience all of the above before the good times return. We will experience significant inflation, as soon as deflation is eliminated. We will allow some companies to fail, as we did with Lehman. (We should have allowed GM to fail.) We will make some re-structuring decisions, e.g., health care, energy, or whatever. (The real restructuring we need is to improve our decision-making system, which was devised in the 18th century.) And, of course, the Fed has already made numerous comments about devising an exit strategy but cannot put a timeline on it, for obvious reasons.
It is not a simple trade-off between raising taxes or cutting spending. There are real strategies to be implemented.
Q: Which one is best?
A: All of the above!
1. The Argentine Solution - induce hyper-inflation to "inflate away"
the huge indebtedness of our country. He gave this a 1% probability.
2. The Austrian Solution - induce a collapse to eliminate the weak,
effectively flushing away the problems but creating 30%
unemployment now,while insuring the good times will return sooner.
He also gave this a 1% probability.
3. The Eastern Europe Solution - following the Soviet collapse,
that part of Europe had no choice but to make huge re-structuring
changes. However, given our inability to re-structure the health
care system, which "everybody agrees needs to be re-structured",
how can the U.S. effectively make the necessary decisions within
our current political system.
4. The Glide-Path Solution – announce an exit strategy for the huge
government deficit to expect an eventual return to the good times
at some point in the future, without trashing the dollar in the
meantime. This, he said, is our best hope!
My judgment is that he is correct, but we will have to experience all of the above before the good times return. We will experience significant inflation, as soon as deflation is eliminated. We will allow some companies to fail, as we did with Lehman. (We should have allowed GM to fail.) We will make some re-structuring decisions, e.g., health care, energy, or whatever. (The real restructuring we need is to improve our decision-making system, which was devised in the 18th century.) And, of course, the Fed has already made numerous comments about devising an exit strategy but cannot put a timeline on it, for obvious reasons.
It is not a simple trade-off between raising taxes or cutting spending. There are real strategies to be implemented.
Q: Which one is best?
A: All of the above!
Subscribe to:
Posts (Atom)