US dollar crisis

End of Fed printing and Derivative Ponzi scheme.

Recently I have become increasingly concerned about the stability of the markets,
because US Federal reserve ended their temporary liquidity measures (the “soup”
of emergency lending facilities that emerged during the financial crisis of 2008) in
late January, while the Quantitative Easing policy (lately mostly Fed purchases of
tainted MBS securities from banks using money created out of thin air, or “digitally
printed”) ended in late March 2010.

I believe the derivative Ponzi scheme grew so large, it is now entirely dependent
on newly printed money to feed it, otherwise it will collapse under it’s own huge
weight like all Ponzi schemes do. I think this is exactly what happened 2 weeks
ago, when the DOW plunged more than 1000 points intraday. News sources claimed
it was “fat finger” effect, or someone made a few orders of magnitude mistake while
placing a sell order.

Rather, I think computers that now dominate the trading volume, engaged in
indiscriminate selling and there were no bids under the market simply because
the new Fed liquidity, or printing, evaporated as of mid-April, when the last contracts
settled. Thus, the derivative bubble, which has already popped in 2008, ran completely
out of oxygen.

If this hypothesis is right and while the SEC and others try to figure out the reason
behind Thursday stock market meltdown, we may see more crashes shortly unless
Quantitative easing (money printing) resumes. Sovereign issues in Southern
Europe were blamed for the mess, and the market bounced on Monday following
the a huge European bailout. However, the bailout is a loan, not a printing effort.
Moreover, the loan money will not be injected overnight. Therefore, the danger of
more market mini-crashes or a big one due to derivatives and computers
malfunctioning from the lack of oxygen was not removed.

Stay tuned for May options expiration week, we may see a market meltdown!

See this earlier post for an explanation.

The Coming Sovereign Debt Crisis

Deterioration of sovereign debt in Southern Europe has recently become
the key concern of financial markets.

Dr. Doom Nouriel Roubini predicted that this will become a concern in 2010.
He explains the problem in this Forbes article:

The Coming Sovereign Debt Crisis

Nouriel Roubini and Arpitha Bykere

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were a stark reminder that
unless advanced economies begin to put their fiscal houses in order, investors and rating agencies will likely turn from friends to
foes. The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed
countries due to stimulus spending, lower tax revenues and support to the financial sector. The impact was greater in countries
that had a history of structural fiscal problems, maintained loose fiscal policies and ignored fiscal reforms during the boom
years. Going forward, a weak economic recovery and an aging population is likely to increase the debt burden of many
advanced economies, including the U.S., Britain, Japan and several eurozone countries.

In 2008 and 2009, the decisions by these governments to do “whatever it takes” to backstop their financial systems and keep
their economies afloat soothed investor concerns. But if countries remain biased toward continuing with loose fiscal and
monetary policies to support growth, rather than focusing on fiscal consolidation, investors will become increasingly concerned
about fiscal sustainability and gradually move out of debt markets they have long considered “safe havens.”

Most central banks will withdraw liquidity starting in 2010, but government financing needs will remain high thereafter.
Monetization and increased debt issuances by governments in the developed world will raise inflation expectations. These
governments will have to offer higher real yields or investors will move to more attractive emerging markets. Some countries will
continue to witness increased credit default swaps. Higher yields and interest cost on debt will also hurt economic growth—by
crowding out private consumption and investment, and reducing government’s productive spending. Several factors will likely
influence investors’ perception about sovereign risk—a country’s debt financing ability, its status as a “safe haven” relative to
other developed economies, politicians’ commitment to undertake fiscal reforms, exchange rate movements, and the debt
maturity structure.

The UK, Spain, Greece and Ireland will face sovereign risk pressures, especially if their fiscal imbalances are not addressed
immediately. Some eurozone members are quickly approaching their debt sustainability limits as deleveraging through
devaluation is not an option for these countries. Countries like Germany—whose fiscal imbalances have deteriorated largely due
to the economic and financial downturn—might have a greater capacity to stabilize their debt ratio. The U.S. and Japan might
be among the last to face investor aversion—the dollar is the global reserve currency and the U.S. has the deepest and most
liquid debt markets, while Japan is a net creditor and largely finances its debt domestically. But investors will turn increasingly
cautious even about these countries if the necessary fiscal reforms are delayed. The U.S. is a net debtor with an aging
population, weaker economic growth and risks of continued monetization of the fiscal deficit. Japan’s aging population and
economic stagnation will reduce domestic savings.

Developed economies will therefore need to begin fiscal consolidation as soon as 2011-12 by generating primary surpluses,
which can be accomplished through a combination of gradual tax hikes and spending cuts. However, an aging population, a
sluggish economic recovery and higher unemployment will keep governments’ entitlement spending high and revenues subdued.
These factors might also make tax hikes politically challenging. Fiscal consolidation efforts might not be strong until the bond
vigilantes signal shifting to safer assets. To achieve credibility, governments will need to pass binding legislation enforcing
tighter fiscal belts when their economies begin to recover on a sustained basis.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics

(RGE), is a weekly columnist for Forbes. (Read all of his columns here.) Arpitha Bykere is a Senior Research Analyst at RGE.

Global stock market and sovereign default.

Sovereign defaults present serious risk for the stock market. Overall, stocks in
affected countries decline considerably, and the desease infects the rest of the
Globe. Here is a recent example, the currency crash in Iceland. While US is
much bigger, the problems in the US, the UK, and Southern Europe are all similar.
2008 proved that TBTF (too big to fail) do fail!

Be careful and prepared

Sovereign risk and derivative domino effect.

While this web site was originally devoted to unhealthy imbalances
in the United States, these are currently present all over the globe.

As we have seen lately, as sovereign debt issues surfaced in Greece,
CDS market rapidly started pricing sovereign risk higher in other PIIGS
(Portugal, Italy, Ireland, Greece, Spain), the UK, Germany, and the US.

These imbalances in an isolated country normally occur after a financial
crisis, when the government attempts a Keynesian approach to fight
the crisis. If the fight is unsuccessful, the government assumes too
much debt, while the economy does not recover, a currency crisis
will follow (Argentina 2002, East Asia 1997, Russia 1998, Iceland 2008,
etc.,etc.).

The financial crisis of 2008 was global in nature, and the Economist
has a wonderful discussion of what might follow if the global economy
does not recover due to too much debt. I believe this is coming -
perhaps, later in 2010 or in 2011, as a consequence of the global
financial crisis of 2008.

Sovereign-debt worries – the Economist.
Domino theory
Assessing the risk that Greece’s woes herald something far worse

HOW far is it from Athens to America and which
countries lie on the way? That may sound like an esoteric geography
question, but it is being asked by investors as Greece’s debt crisis
creates global jitters about the safety of sovereign debt. So far
Portugal, Ireland and Spain, the other high-deficit countries on the
periphery of the euro zone, are thought to be next in line. In most big
rich economies, yields have been stable and well below their long-term
average (see chart).

But nerves are fraying elsewhere. The cost of insuring against
sovereign default (see article) has risen in 47 of the 50 countries for
which these instruments exist. Dubai’s sovereign credit-default-swap
spreads soared to their highest level in a year this week, amid concern
about the terms of a debt restructuring by a state-owned
conglomerate. There is increasingly shrill commentary arguing that
Greece is the start of a far bigger problem. “A Greek crisis is coming to
America”, blared the headline on a recent Financial Times article by
Niall Ferguson, a financial historian.

The stakes are high. A sudden loss of confidence in all sovereign debt,
and especially in American Treasuries, the world’s benchmark “risk-free”
asset, would have calamitous consequences in a still-fragile recovery.
Equally, an exaggerated fear of sovereign risk could prompt
governments into premature fiscal austerity, which might itself push
the world economy back into recession…..

A Shift in Sovereign Sentiment

In his excellent recent piece, Todd Harrison describes the sovereign debt problems
the globe now faces as a result of the financial crisis and compares the situation in
Greece with that at Bear Stearns in early 2008. US is far from being immune to the
problems in Europe. In fact, many states are much larger than European countries and
are in the same boat. Or, actually, they are much worse off.

A Shift in Sovereign Sentiment

By Todd Harrison

A message to CFTC – gaming the system will work no more.

CFTC recently engaged in a massive regulatory overhaul of the
commodity markets, targeting limited positions and increasing margins in commodities, in particular, in energy.
This affects exchange traded funds such as UNG (Natural Gas) and USO (oil). In their view, commodity speculators drove
oil and gas to unreasonable levels in the Summer of 2008, in part, triggering the current crisis.

While limited trading in any derivatives is a welcome step, this is, of course, ridiculous.
The run in commodities was triggered by the Fed drastically lowering interest rates and printing money to
save the literally huge derivative Ponzi scheme that our global financial system has become.

“Gaming” free markets is not the way to go. We did that for quite some time now, and that’s why
the financial crisis happened. The Free market broke free from all this derivative model manipulation
and this resulted in a Black Swan. As long as OTC derivative bubble is inflating further,
chances of another, deeper systemic crisis are increasing. If the current
policy of bailing out too big to fail counterparties continues, there is a chance the derivative
Ponzi scheme will eventually blow up and take down entire countries – including, possibly, USA.

Regulate what matters – OTC interest rate derivatives and credit derivatives!

Deutsche Bank 2010 investment outlook – sovereign debt.

Here’s what the Deutsche team, led by Jim Reid, say:

Although we’re positive in the near-term, looking at the world today it’s clear that the current macro environment will be
difficult to sustain. The markets will need evidence in 2010 that there is an observable path back to fiscal discipline for those
countries that have been most aggressive in responding to the fall-out from this crisis. If not we continue to run the risk of
Sovereign land mines disturbing the benign corporate landscape.

Indeed if 2010 is a difficult year it’s highly unlikely that the catalyst comes from within the equity or corporate credit markets.
This means the macro environment will decide 2010, and in reality investors in Sovereign debt around the world will probably
decide the fate of risk assets. In late 08/09 the authorities had little to lose in aggressively attempting to stave off a
Depressionary cycle. So far they deserve extremely high marks. However 2010 could be a transitional year between heavy
intervention and the paying of the bills. A return to positive global growth should help but we would expect more volatility in
2010 than in H2 2009.

Back to Sovereign risk, history is littered with examples of inflation, devaluations and Sovereign defaults after financial crisis.
One might wonder why this time should be any different. Sustainability is the key word. As soon as markets doubt the
sustainability of a country’s deficit then we have a problem. This is why it’s important that in 2010 the authorities provide a
credible path for future fiscal discipline, even this path involves many years of adjustments. One of the largest challenges will
be funding the still large global government issuance in a world with less QE. QE limited the discussion on the impact of
crowding out in 2009. Will we be as fortunate in 2010?

Deutsche Bank has the following scenarios:

Scenario 1 — This scenario is the most optimistic and is one where the authorities have as good a year as they did in 2009.
They likely keep stimulus extremely high in the system without there being any noticeable consequences of their actions (e.g.
rates at the short and long-end stay low). Under this scenario we would expect equities to be significantly higher, credit
spreads be much tighter but with bond yields only edging slightly higher as the authorities are seen to have firm control of
inflation expectations and may even be continuing to buy bonds.

Scenario 2 – This scenario is the most likely and suggests that we start to see gradual easing off the gas from the authorities
but only as it’s proved that there is some momentum in the underlying economy. Under this scenario risk assets have a good
year but returns are checked to some degree by rising bond yields and less stimulus being injected into markets. A satisfactory
year for risk, especially equities, but a mildly negative one for fixed income. Credit investors will likely have to rely on spreads
(and higher beta credit) to get positive total returns.

Scenario 3 – This is the second most likely scenario overall in 2010 but one that potentially becomes more likely as the year
progresses. Here we are likely to see sharply higher bond yields start to disrupt the positive momentum in markets. These
higher yields could be either due to Government supply starting to overwhelm demand (especially as the impact of QE, and
similar schemes, wane), or because of inflation fears. It seems unlikely that actual inflation will be a concern in 2010 but it’s
quite possible for expectations to become unanchored. We would also have to include the potential for a Sovereign crisis
somewhere in the Developed world within this scenario. We would note that the higher yields in this scenario are not based on
positive growth momentum but by inflation/Sovereign risk. Such a scenario is incorporated in Scenario 2.

Scenario 4 — This is the nightmare scenario of Deflation or in less extreme terms perhaps a double-dip. Given that much of the
world is currently still in negative YoY inflation territory it is difficult to completely rule out even if we do live in a fiat currency
system and even if inflation is expected to return to positive territory in early 2010. For deflation to be sustained we would
probably need an exogenous event to hamper the authorities ability to continue to successfully fight this credit crisis. Such
events could be a fresh banking crisis arising, a political backlash encouraging immediate increases in 2 December 2009 Macro
Credit and Equity Page 4 Deutsche Bank AG/London economic regulation or withdrawal of stimulus, or possibly a Government
bond/currency sell-off that forces the authorities to aggressively reign in stimulus for fear of a sovereign crisis. A Sovereign
crisis outside the Developed world could also encourage this scenario as there would be a flight to quality into Developed
market bond market in spite of the fact that these markets have their own large fiscal issues. Bond yields would eventually rally
strongly but risk assets would experience a very poor year. As time progresses this scenario becomes less likely as the system
gradually repairs itself and the authorities are allowed more time to inflate the global economy. As we discuss in scenario 3, the
more likely risk scenario is inflation, especially as time progresses.

We have tried to simplify and narrow down the scenarios as much as possible to allow for easy explanation but the reality is
that there are many other permutations for the year ahead. For example and as discussed above, within the worst case
scenario we would have to include a slightly less severe outcome where growth fails to show any momentum after the stimulus
starts to fade (a double dip perhaps?). If the authorities are unwilling or unable to stimulate further then we could have a weak
economy even if we don’t see outright deflation. This would likely be negative for equities/credit but the outcome would be
unlikely to be as negative as the -30% outcome.

The other big problem in differentiating between the two negative scenarios is with regards to Sovereign risk. If we have
Sovereign risk within the EM complex (e.g. Dubai) then Western bond yields could rally strongly on a flight to quality basis. So
an element of this risk is priced into Scenario 4. However we are in a fairly unusual point in history where there is also an
increasing risk of a Sovereign crisis occurring in the Developed world at some point. The fiscal deficits arising from this crisis
have to be addressed at some point. If the market eventually sees no credible medium-term way of certain Western countries
balancing their budgets and repaying their debts then we may see a large rise in Government yields. This in itself could be
enough to raise funding costs to levels that encourage a vicious circle.

Figure 1 and Figure 2 help us understand why we are entering into unknown territory in terms of Developed market debt. These
charts simply show the Debt to GDP ratio of the US and the UK. The Government part of the deficit is starting to rise sharply in
both regions and although it looks within the range of historic observations we have to remember that Governments have
implicitly and explicitly backed the debt of other parts of the economy. This makes Government liabilities potentially much
larger. The hope is that growth rebounds strongly enough for the Debt/GDP ratio to fall naturally over time. Such a scenario
would also require yields to stay low to facilitate such an adjustment. All we can say is that there are risks that the deficits of
such indebted countries at some point appear unsustainable to the market. This is when far more difficult decisions than those
made in 2009 would have to be made.

US and UK debt to GDP ratio

Derivatives – a disaster we avoided or a disaster in the making?

I have quite a few quant friends (and family) who are occupied in derivatives.
They know very well how to run stochastics and
Monte Carlo codes to price these complex instruments, but are unaware of
more pressing issues, such as why this huge Ponzi scheme caused a market
crash in 2008, why such enormous bailouts around the globe were required
to save it. Unfortunately, the repeated bailouts and saves by the global
central banks only provided liquidity to this Ponzi scheme and fostered further
expansion, pretty much ensuring another financial crisis in the future. The first time
derivatives caused a crash was 1987, when portfolio insurance (or put options, in
modern equivalent) caused a meltdown due to hedging as the market fell through
put strikes. Of course, quants say they were not perfect, since implied volatility was
then flat.

Here is what Myron Scholes has to say on the subject, and I totally agree. I would add,
blow up not just OTC CDS market, but all of it. Scholes knows. Not only he is the Nobel
Laureate and the father of Black-Scholes, he also ran LTCM that blew up for the very
same reason in 1998. Cancelling contracts while things are good seems to be an
excellent option. The reason for a complete seizure of the libor market was the
market pricing of couterparty risk. It happened before, and it can happen again.
The notional size of derivatives market is 10 times the size of the global GDP,
and the usual Central bank liquidity fix will only make it bigger.

Myron Scholes, intellectual godfather of the credit default swap, says blow ‘em all up

Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.

Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. “My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps,” Scholes said this morning. What that means, he elaborated, is that regulators should “try to close all contracts at mid-market prices” and then start up the market anew with clearer rules and shorter-duration contracts.

This was at a conference at New York University occasioned by a new collection of papers on how to fix the financial system, authored by a bunch of NYU Stern School faculty. Scholes kept saying Fred Adair. Sometimes he’d notice and correct himself, sometimes he wouldn’t. The FT’s John Gapper, who was on a panel with Scholes, finally speculated that this was because the government response to the financial crisis has been such an unwieldy mix of Fred Astaire (dancing around the problems) and Red Adair (doing something to fix them). Scholes did not disagree.

The blow-up-the-CDSes option is intriguing, and I’m going to check in with Scholes later to see if he wishes to elaborate. But for now, a few more notes from the panel, which was moderated by Paul Volcker and also featured NYU finance professor Matt Richardson:

Some would say Scholes is partly to blame for this whole mess, and Volcker dropped a couple of hints in that direction. Scholes didn’t exactly accept responsibility, but neither did he give a blindered, Chicago-style defense. For one thing, he cited John Maynard Keynes—still a nonperson to many of Scholes’s fellow Chicago Ph.Ds—arguing that we’re currently stuck in a situation where the financial system needs to deleverage, but its current deleveraging is causing asset values to plummet, meaning that it’s not succeeding in deleveraging at all (that is, debt is down, but so is the value of everybody’s capital, so leverage ratios aren’t declining). For another, he seemed to agree with one of the main criticisms of the Wall Street risk models that evolved in part from Black-Scholes—that they have some ability to capture the risks faced by one investor operating in a financial market that the investor is too small to influence, but aren’t much good at capturing the risks faced by the entire market. “Risk aggregation is not linear,” he said. “It’s nonlinear.” (This is what Chapter 13 of The Myth of the Rational Market is about. Doesn’t that sound exciting?)

As the moderator, Volcker didn’t say all that much. He did talk for a bit, though, about how “maybe we ought to have a two-tier financial system,” with a heavily regulated “core part that I will for purposes of simplicity call commercial banking” and a less-regulated outer realm of hedge funds, proprietary trading desks, and such. Hmmm, said Gapper, that “reminds me of something I once heard of called the Glass-Steagall Act.” This Glass-Steagall revivalism is happening all over. I’m even beginning to feel the spirit. But Gapper had an interesting question: “If you wanted to set up a new Glass-Steagall, where would you draw the line?”

Scholes finally got his free-market Chicago dander up over the possibility of synchronized global financial regulation—something that Volcker has been advocating as chairman of the Group of Thirty project on financial reform—sparking this entertaining exchange:

Scholes: If we internationalize everything, we end up with rules that stifle freedom and innovation. Mr. Sarkozy and others say our system has failed and we should adopt theirs. Do we want to become French?

Volcker: I’m not an acolyte of Mr. Sarkozy.

Gapper: Actually, the French banks are big derivatives users.

Volcker: The U.S. is no longer in a position to dictate to the rest of the world.

US standard of living is dropping

The crisis didn’t start last year, it was building up for some time.
The real reason was not the housing bubble. Yes, housing prices soared due to
Greenspan’s ultra easy monetary policy in the early 2000-s,
but, in fact, in gold terms they are quite average historically, as of late 2009/early 2010.
The real problem was falling US standard of living, and that has been happening for some time,
as seen on these charts below. The falling standard of living is a direct consequence of
the falling currency.

Stocks and dollar

Thanks to the Fed promising to keep interest rates at zero for some time, the US dollar has
already partially replaced Yen as #1 carry trade funding currency. As a result, the anticorrelation
that developed between stocks and the dollar is worth noting. The chart below illustrates
SP 500 index vs inverse US dollar index. While both could rally sharply on positive news like
better than expected jobs number, eventually the currency trade should prevail. Don’t be surprised 
if stocks correct sharply early next week.

SP500 vs inverse USD, 3 months

SP500 index vs inverse dollar, 6 months