Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.
Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money. And it was also clear that the authorities still have no idea of what is going wrong.
This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.
For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:
- First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
- Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.“
Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.
As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”
Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“. We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.
Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds? Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%? And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?
Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?
Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.
We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.
I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.
And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).
My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”. Current developments in the repo market may be a sign that this is more likely than many people realise. I hope I am wrong.
What we “assume” can make an “ass of u and me“, as the proverb says. And that is certainly true of the way central banks have manipulated the major currencies since the financial crisis began in 2008, as the chart shows of the US$’s movements versus the Japanese yen and the euro:
- It shows the change relative to December 2007 values, before the central banks realised the crisis was underway
- All 3 currencies were relatively stable in early 2008, but then performed quite differently
- The dollar began a 30% fall against the yen, and became quite volatile against the euro
- But Premier Abe’s election in December 2012 then led to the dollar soaring against the yen
- 2014 saw the European Central Bank making a similar decision to devalue versus the dollar
These moves were all created by central bank policy. At first, Japan and the European Central Bank were happy to let the US Federal Reserve weaken the value of the US$. They believed that this would help the US economy to recover, and so rebuild momentum in the global economy. But then they had second thoughts.
They had slowly realised that the Fed’s policy hadn’t worked, and that their economies were not recovering back to pre-2008 levels. Instead they hoped that devaluation would enable them to boost exports at the expense of the US. But they failed to recognise that China’s policies were also changing:
- China began its New Normal policies in 2013, reducing its massive stimulus programmes
- Global growth, measured in current dollars, fell to just 2%/year between 2012 – 2014 and declined 4.9% in 2015
In due course, the Fed then realised the US economy was suffering. And so in Q1 this year, it decided to devalue again. The dollar has therefore weakened against both the yen and the euro since the start of the year.
The problem all comes back to false assumptions.
One core central bank assumption is that their computer models can forecast the economy. A second is that they can create demand by printing money. A third is that demographics change doesn’t matter – they really do believe that a world full of 80-year olds would grow as fast as a world full of 30-year olds.
Common sense, of course, tells us that all these assumptions are wrong. Inevitably, therefore, their policies of devaluation and money printing do not create the growth they expect. Instead, they make life even more complex and difficult for companies and investors – and end up helping to destroy growth rather than create it.
Ordinary people like ourselves then end up taking the pain from their mistakes – making an “ass of u and me“.
The mention of deflation in the above front page headline of Friday’s Financial Times will not have surprised blog readers. But it appears that not enough people in the European Central Bank read the blog, as the FT went on to report the ECB’s sense of ”shock” at the thought that deflation could now be just around the corner.
This highlights the enormous gap between policymakers and those of us living in the real world. The Eurozone’s ageing population means deflation is much more likely than inflation, for the reasons last discussed back in July. It really should be no surprise to anyone in the ECB that October’s inflation was 0.7%, less than half the 2% target, as we remain firmly in the Cycle of Deflation pictured above:
- Competitive Devaluation is already underway, with the Japanese yen down 13% versus the US$ since January
- Commodity market weakness in oil, aluminium and cotton suggests actual deflation may not be far away
- Once deflation starts to take hold, people will start to delay purchases, as prices will be lower in the future
- This will be a complete change from the inflation of the SuperCycle
- Then rising prices made it sensible to bring forward purchases, particularly as credit was easy to obtain
As the BBC’s Robert Peston points out, the endgame of this Scenario is not difficult to imagine:
“If businesses and consumers began to believe that deflation was a serious prospect, they would defer purchases and investments to take advantage of falling prices – and the members of the currency union would be right back in the soup, with their economies shrinking sharply. Worse still, there would be an even greater incentive for businesses, households and banks to reduce their debts – to save as if there’s no tomorrow – because of the threat of deflation increasing the real burden of those debts. And that would be a double whammy to spending or investing today, and thus to the recovery”.
Hopefully your company has already begun to plan its response, should this Scenario occur. It is clearly becoming a far more likely Scenario than the consensus view that a return to SuperCycle growth, with oil at $100/bbl, is more or less inevitable.
The weekly comments from ICIS pricing and price changes since January on the benchmark products in the blog’s Downturn Monitor portfolio are below:
Benzene Europe, green, down 21%. ”Market continues to lack any clear sense of direction”
PTA China, down 16%. “Market extended losses because of weak demand and traders’ active selling activities amid a bearish market outlook
Brent crude oil, down 6%
Naphtha Europe, down 3%. “Glencore kept up its heavy activity in the window, switching roles from main buyer last week to main seller this week”
HDPE USA export, up 13%. “Prices were beginning to move lower, but prices have not yet moved low enough to attract significant interest”
US$: yen, up 13%
S&P 500 stock market index, up 21%
Friday provided a good test of the blog’s analysis that Japan’s aggressive policy of devaluing the yen could result in major downward pressure on crude oil prices:
• The yen crashed through the $1: ¥100 level, ending at a 4-year low of $1: ¥101.6
• Brent sold off by $2.80/bbl, only recovering after Asian markets closed for the weekend
Hedge funds have already woken up to the new profit potential that is developing. Thus Bloomberg reported the head of one large New York fund commenting “the inverse correlation between the dollar and the commodities is alive and well“.
The chart shows the 180 degree change that has taken place since March:
• Until then, all the main financial markets had continued to move together, in the ‘correlation trade‘ financed by western central bank liquidity
• But then the potential impact of Japan’s devaluation policy became obvious to major players
• A lower yen means a stronger US$ – hence no need to buy commodities as a ‘store of value‘
• Today Brent (blue line) and naphtha (black) are both down over 5%, whilst the dollar/yen (orange) and S&P 500 (purple) have risen over 10%
As Mizuho Securities noted, “commodities are taking a hit because the dollar is rising”.
Of course, it is still too early to be sure that crude will indeed crash out of its current trading range and revert to historical price levels below $30/bbl. Equally, markets never move in straight lines, downwards or upwards. But if one waits for proof, it could well be too late to do anything about it, as the blog warns in its new Research Note.
Critically, however, in terms of the fundamentals, US oil inventories remain at 82-year highs and supply is at 21-year highs: whilst forecast global demand growth this year is just 800kbpd.
Two other highly relevant points have also surfaced in recent days:
• Prof Martin Feldstein, President Reagan’s economics head, has called the Federal Reserve’s liquidity programme “a dead end“. He calculates its $2tn of new debt has raised consumer spending by less than 0.3% of GDP per year, adding that “the evidence suggests that the QE programme hasn’t worked”
• At the same time, the IMF has warned that US pension funds have piled into commodities and other risky assets in a desperate “gamble for resurrection“. It estimates their current shortfall at 28% – meaning they do not have enough reserves to pay current pension obligations. And it adds their issue is “solvency not liquidity”
Naïve pension fund trustees have thought ‘investments’ in crude oil and other commodities would enable them to avoid raising contribution rates or restructuring benefits. If prices now start to fall, they will have no alternative but to sell quickly, at whatever price is available in the market, in order to salvage what they can.
Meanwhile in Europe, further evidence of the impact of today’s failed policies in the real world emerged with the announcement of a proposed merger by INEOS and Solvay, Europe’s two largest PVC producers. This follows a 30% fall in PVC demand, and Kem One’s entry into administration in March. When first-class management teams like these are struggling, markets are clearly in very bad shape.
Benchmark price movements since the IeC Downturn Monitor’s April 2011 launch, and latest ICIS pricing comments are below:
Naphtha Europe, down 25%. “The prompt naphtha market has become balanced as a result of the 1 million tonne movement to Asia”
PTA China, down 21%. “Market outlook remains uncertain because of the volatility in crude futures and uncertainties over China’s manufacturing sector”
Brent crude oil, down 18%
HDPE USA export, down 17%. “Global export demand remained somewhat soft”
Benzene NWE, up 6%. “Prices ebbed and flowed alongside crude and benzene values in Asia and the US”
S&P 500 stock market index, up 20%