Credit Markets

 

The Madness of Negative Bond Yields

As we have frequently discussed in these pages, time preference must always be positive on a society-wide basis – it is a praxeological law that future goods and/or satisfactions are valued at a discount to identical present goods. We emphasize “identical” here because sometimes people are asserting that there are exceptions, such as in the famous example that men would prefer having ice in the summer over having it in the winter (thus, in wintertime, ice available in the future would be valued more highly). However, “summer ice” is not identical to “winter ice”, even though it has the same physical properties. The reason is that the satisfaction if provides is not the same.

 

bank

 

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An Accelerating Trend

While the euro itself has recovered a bit from its worst levels in recent sessions, euro basis swaps have fallen deeper into negative territory. In order to bring the current move into perspective, we show a long term chart below that includes the epic nosedive of 2011. We are not quite sure what the move means this time around, since there is no obvious crisis situation – not yet, anyway.

A negative FX basis usually indicates some sort of concern over the banking system’s creditworthiness and has historically been associated with euro area banks experiencing problems in obtaining dollar funding. This time, the move in basis swaps is happening “quietly”, as there are no reports in the media indicating that anything might be amiss. Still, something is apparently amiss:

 

1-euro basis swapsParty like it’s 2011: Three month, one year, three year and five year euro basis swaps – click to enlarge.

 

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The Final Chapter in the Credit Bubble Story

Before we get to that, we note that the Dow fell 60 points, or 0.3%, on Friday. Gold was more or less unchanged. An ounce of the yellow metal traded at $1,242 at last check.

Not to leave our dear Diary readers in doubt, we expect a crack… or even a crash… in stocks sometime this year. But that won’t be the end of the story. We suspect it will mark the end of one chapter and the beginning of another – the final chapter in the credit bubble story that began in the early 1970s.

It’s a long story. And it’s a big story. Too bad it has been so overshadowed. Watergate … Vietnam … massacres from Hanoi to Bombay … Boy George and J-Lo. The plain people have time for the Super Bowl, but certainly not for the Super Bubble … even though it is more important to them.

 

Nafea-Faa-Ipoipo-1892

A famous – and horrendously expensive – painting by Paul Gauguin (Nafea faa ipoipo?). In fact, it just became the most expensive art work in all of history.

 

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Soaring Prices of Government Debt

As the WSJ reports on government debt yields in Europe:

 

“As much as €1.5 trillion ($1.7 trillion) of euro area debt maturing in more than a year now pays a negative yield, according to J.P. Morgan. That compares to none whatsoever a year ago.

German government bonds offer negative yields on maturities up to six years, according to Tradeweb, along with those in Denmark. For five years, the Netherlands, Austria, Sweden and Finland are in the club. For four years, add France and Belgium. In Switzerland, bonds out to a whopping 13 years in length have negative yields.”

 

Approximately €220 billion in bank reserves are subject to negative deposit rates as well (this is actually less than it once used to be, as banks have moved excess reserves from the deposit facility to the current account facility at the ECB, which at least yields zero instead of the 20 basis point penalty rate applied to the deposit facility).

 

15-2-2-Gold-coin-634Photo via moneyweek.com

 

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A Disturbance in the Farce?

We usually like to keep an eye on indicators that are not getting a lot of attention, in an attempt to circumvent the “what everybody knows isn’t worth knowing” problem. Recently, several noteworthy things have happened with the $VIX, or rather, the derivatives traded on the VIX. The VIX is a measure of implied volatility, referring to front month options on the S&P 500 Index (it used to be the S&P 100 back when OEX options were still the most liquid index options – the OEX version is these days called VXO). While the first OEX version used only at-the-money options expiring 30 days hence, the calculation has been expanded over time. Now it is a blend of front and second-month at-the-money and out-of-the-money options. Those interested in the precise calculation procedure can take a look at it here: CBOE VIX White Paper (PDF). The aim is to calculate the expected 30-day volatility of the SPX at a 68% probability (one std. deviation) as expressed by the options market.

 

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Image credit: James Steidl / Thinkstock)

 

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Governments in Dire Straits

A number of governments find themselves in severe financial trouble – these represent the fringe of the fiat money bubble, the fraying edge of it, if you will. They will provide us with a preview of what is eventually going to happen on a global scale. It would actually be better to say: what is going to happen on a global scale unless significant monetary and economic reform is undertaken in time. Obviously, we cannot be certain what the future holds in store – however, we can certainly extrapolate the path we are currently on.

Looking at efforts that have been undertaken in this respect thus far, they are partly insufficient and partly extremely wrong-headed. For instance, the euro zone received a rather clear wake-up call in the sovereign debt crisis of 2009-2012. The effort to create a “fiscal compact” that forces governments to limit their deficits and public debt to specific percentages of economic output is a laudable attempt to bring the problem under control. However, the effort is lacking in many respects. For one thing, the accord will likely prove unenforceable when push really comes to shove. It is already meeting with considerable resistance, and one suspects that enforcement against core countries like France will continue to be lax.

Secondly, there are many ways in which such fiscal targets can be achieved, and we can be certain that in many cases European politicians will opt for the worst methods. Simply hiking taxes and bleeding the private sector dry is not a workable or sustainable policy. What is required are massive cuts in government spending, combined with economic liberalization on a vast scale. In other words, the kind of reforms that the ruling classes of the European socialist super-state project are most unlikely to consider. Even if they were considering them, they would have to overcome a plethora of vested interests to implement them.

Thirdly, one of the methods chosen to get a grip on government finances is financial repression, aided and abetted by the central bank’s ultra-loose monetary policies. This is certain to lead to capital consumption and impoverishment, thus making the long term success of the fiscal compact strategy even less likely.

 

Venezuela supermarket

Empty shelves in a supermarket in Caracas. The government has tried to counter spiraling inflation with price controls – this is the inevitable result.

Photo credit: Getty Images

 

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Vale of Tears

Vale is the world’s largest producer of iron ore. The price of iron ore has recently hit a 5 year low, as China’s mad-cap building of ghost cities and the associated infrastructure has slowed down considerably. Iron ore prices are highly volatile – they rose far more than those of most other commodities during the bull market and are liable to fall more as well. In fact, the long term history of the iron ore price suggests that there is still a lot of potential downside – current prices are only low compared to the prices seen at the height of the bubble.

 

Iron Ore62% iron ore, January futures contract – click to enlarge.

 

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A Brief Update on Yields, CDS Spreads and Implied Default Probabilities

Currently there are a number of weak spots in the global financial edifice, in addition to the perennial problem children Argentina and Venezuela (we will take a closer look at these two next week in a separate post).

There is on the one hand Greece, where an election victory of Syriza seems highly likely. We recently reported on the “Mexican standoff” between the EU and Alexis Tsipras. We want to point readers to some additional background information presented in an article assessing the political risk posed by Syriza that has recently appeared at the Brookings Institute. The article was written by Theodore Pelagidis, an observer who is close to the action in Greece.

As Mr. Pelagidis notes, one should not make the mistake of underestimating the probability that Syriza will end up opting for default and a unilateral exit from the euro zone – since Mr. Tsipras may well prefer that option over political suicide.

Note by the way that the ECB has just begun to put pressure on Greek politicians by warning it will cut off funding to Greek banks unless the final bailout review in February is successfully concluded (i.e., to the troika’s satisfaction). The stakes for Greece are obviously quite high. There are two ways of looking at this: either the ECB provides an excuse for Syriza, which can now claim that it is essentially blackmailed into agreeing to the bailout conditions “for the time being”, or Mr. Tsipras and his colleagues may be enraged by what they will likely see as a blatant attempt at usurping what is left of Greek sovereignty, and by implication, their power.

 

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Image via Arabia Monitor

 

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Non-Confirmations Still Persist

The S&P 500 has recently made a new high, in short the rebound from the mid October low has not failed at a lower high. Therefore, the clock has so to speak been reset. However, as our updated comparison chart between SPX and the major euro-land indexes shows, there is now a third divergence in place between them, and this one is even more glaring than the first two. Keep in mind that there such divergences have not always been meaningful in the past. However, when global markets are drifting apart, it is a sign that the global economy is no longer well-synchronized. Given that the Fed’s “QE inf.” is in relative pause mode (we hesitate to say it has ended), the situation is certainly worth keeping an eye on.

 

1-Euroland vs. SPXA third divergence between the SPX and the major continental European stock markets is now in place – click to enlarge.

 

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The Bad News First – Greece is Crashing Again

We only recently reported on the ludicrous idea of Greek prime minister Antonis Samaras to pretend that the Greek government is suddenly not bankrupt anymore (see: “Greece Tries to Escape Bail-Out” for details). Note that non-performing bank loans in Greece stand at an estimated €90 billion, so it should also be kept in mind that the banking system remains de facto insolvent as well – in spite of having been bailed out once already.

It is probably getting more so in recent days – Greek stocks and bonds have essentially crashed, with government bond yields back at levels that normally indicate severe crisis conditions (in other words, they are way above the level that would allow for what is generally considered “sustainable” refinancing of the government’s debt). The Greek stock market meanwhile is very close to getting cut in half once again:

 

AGTThe Athens General Index has been in free-fall lately – click to enlarge.

 

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A Test of Broken Trendlines from Below?

The divergence between US and European stock markets which we discussed in late August continues to persist. This happens in spite of the fact that major European markets have been somewhat stronger than US markets in recent weeks, no doubt due to further easing by the ECB – which was first anticipated, and then became reality. In fact, the measures announced by the ECB “exceeded expectations”.

Below is an updated version of the chart we showed previously. Germany’s DAX and France’s CAC-40 have rallied back to their previously broken trendlines and appear to be turning down from there. If they fail to exceed the recent interim peaks, their divergence with the SPX will so to speak have been “perfected”. Note though that we have seen similar short term divergences between these markets before (it happened e.g. in the summer of 2013), so it remains to be seen if they are meaningful this time.

Even though one cannot be certain yet whether it is an important signal, it is something we are keeping an eye on, especially as all these markets are far more stretched to the upside than they were previously. We have picked the DAX and CAC-40 on purpose, because they are the stock markets of the euro zone’s “core” countries. Moreover, the DAX has been Europe’s strongest market, the only one that has managed to reach new all time highs since the 2008 crisis. To be sure, the divergence is relatively small at this juncture, due to the recent strength in European stocks. Obviously though, no-one is going to ring a bell and shout “this time it means something”, even if it later turns out that it did. So it probably pays to be aware of these things in good time. If the divergences are going to be invalidated, it is in any case likely to happen soon, as it would require only very little by way of an additional advance.

Another reason why these divergences may actually be more meaningful this time around is that a very similar divergence between SPX and HYG (an ETF serving as a proxy for high yield debt) has recently formed.

 

1-european-DivergenceDAX, CAC-40 and SPX – the former are still diverging from the latter and may just have put in a lower high right at their previous trendline support – click to enlarge.

 

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Update on Global High Yield Debt Issuance Volumes

Here is a small addendum to our recent articles on the corporate debt bubble (“A Dangerous Boom in Unsound Corporate Debt”) and the associated derivatives-berg, which is intended to hedge both the credit and interest rate risk this credit boom has given rise to (“A Perilous Derivatives-Berg”).

We recently combed through John Hussman's weekly commentaries, one of which contained an up-to-date chart of global high yield debt issuance per quarter from Q1 2006 to Q2 2014. Both global issuance volume and the number of deals are depicted on the chart. As you can see, we have long left all previous records in the dust.

 

hi-yieldGlobal high yield debt issuance in USD billion per quarter, plus the number of offerings, via John Hussman.

 

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Derivatives and the Credit Bubble

In principle, there is absolutely nothing wrong with derivatives. They serve a valuable function, by transferring risk from those who don't want to be exposed to it to those who are willing to take risk on in their stead for a fee. However, since the adoption of the pure fiat money system, credit growth has literally gone “parabolic” all over the world. This growth in outstanding credit has been spurred on by interest rates that have been declining for more than three decades.

Larger and larger borrowings have become feasible as the cost of credit has fallen, and this has in turn spawned an unprecedented boom in financial engineering.

When critics mentioned in the past that this had created systemic dangers, their  objections were always waved away with two main arguments: firstly, the amount of net derivatives exposure is only a fraction of the outstanding gross amounts, as so many contracts are netted out (i.e., things are not as bad as they look). Secondly, the system had proven resilient whenever financial system stresses occurred. Perhaps not as resilient as it seemed, considering that these crises as a rule required heavy central bank interventions and/or bailouts in various shapes and forms. Would the system have been as resilient if those had not occurred? We have some doubts with regard to that.

 

total_derivativesSince the crisis, derivatives growth has stalled, but the notional amount has returned to its record highs as of the end of 2013 – click to enlarge.

 

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John Hussman's Latest Comments on the Bubble

In his newest weekly column, John Hussman talks about a feature of the current echo bubble era that we believe will turn out to be an extremely important one. Readers of this site know of course that we have frequently sung from the same hymn sheet, but it is a topic the significance of which cannot be stressed enough.  After briefly recapping the history of the housing bubble and the ensuing credit crisis, Hussman writes:

 

“Now, as we observed in periods like 1973-74, 1987, and 2000-2002, severe equity market losses do not necessarily produce credit crises in themselves. The holder of the security takes the loss, and that’s about it. There may be some economic effects from reduced spending and investment, but there is no need for systemic consequences. In contrast, the 2007-2009 episode turned into a profound credit crisis because the owners of the vulnerable securities – banks and Wall Street institutions – had highly leveraged exposure to them, so losing even a moderate percentage of their total assets was enough to wipe out their capital and make those institutions insolvent or nearly-so.

At present, the major risk to economic stability is not that the stock market is strenuously overvalued, but that so much low-quality debt has been issued, and so many of the assets that support that debt are based on either equities, or corporate profits that rely on record profit margins to be sustained permanently. In short, equity losses are just losses, even if prices fall in half. But credit strains can produce a chain of bankruptcies when the holders are each highly leveraged. That risk has not been removed from the economy by recent Fed policies. If anything, it is being amplified by the day as the volume of low quality credit issuance has again spun out of control.

 

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The Dear Departed

Not much action in the markets on Wednesday. So, let us return to the economy. That’s where the excitement is. According to leading economists – notably those paid by the US government to forecast the future – interest rates are going to stay low for a long time.

Perhaps we should pause and say an Ave Maria… or whatever you say when you put a market cycle into the grave. Maybe we should proclaim a day of mourning. Or at least raise a glass or two.

Yes, the feds have pronounced our old friend dead. Dead… dead… stiff dead… cold dead. Immobile. They denied responsibility for the death of the credit cycle, but admit that it was in their custody when it expired.

 

memento-moriHic iacet cyclus fenebris semimortuus

(Photo © Sekitar)

 

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