Introduction and summary
It is now possible to pencil in how the next credit crisis is likely to develop. At its centre is an overvalued dollar over-owned by foreigners, puffed up on speculative flows driven by interest rate differentials. These must be urgently corrected by the European Central Bank and the Bank of Japan if the distortion is to be prevented from becoming much worse.
The problem is compounded because the next crisis is likely to be triggered by this normalisation. It can be expected to commence in the coming months, even by the year-end. When flows into the dollar subside and reverse, bond yields can be expected to rise sharply in all the major currencies. There will also be a number of other unhelpful factors, particularly rising commodity prices, the timing of the Trump stimulus and trade tariffs pushing up price inflation. Coupled with a declining dollar, price inflation and therefore interest rates are bound to rise significantly.
Then there is another problem: when it comes to rescuing the global financial system from the systemic fall-out, not only will the challenge be greater than at the time of the Lehman crisis, but legislative changes, such as confusing bail-in provisions, have made it more difficult to execute.
There is also evidence that during the last credit crisis in 2008, the Russians were tempted to interfere with the Fed’s rescue attempts, potentially crashing the whole US financial system. At that time, they failed to get the support of the Chinese. Now that Russia has disposed of most of its dollar investments in return for gold, and following an escalation of geopolitical conflicts, a new financial crisis may be regarded as an opportunity by America’s enemies to emasculate America’s financial and geopolitical power.
The outlook for the dollar and all dollar-dependent assets is not good. The only protection will be the possession of physical gold and silver, beyond the reach of systemically-threatened banks.
The chattering classes in financial markets have droned on and on about how the Fed’s interest rate policies are creating crises in emerging markets. But emerging markets are likely to be just bit players in a new global tragedy. As Shakespeare put it in Macbeth, they are “but walking shadows, a poor player who struts and frets his hour upon the stage, and then is heard no more….”
In the process the real problem has been under-reported, and that is the strains between the mega-currencies: the dollar, the euro and the yen. Could they be the leading players in the next credit crisis, and if so how will the tragedy unfold?
You only have to note the disparity in bond yields, particularly at the short end of the yield curve, to see what is moving money. Two-year US Treasuries yield 2.74%, while the two-year German bund yields minus 0.55%. Two-year JGBs at minus 0.12% are also out of whack with USTs. You do not get disparities like this at the short end of the yield curve without moving massive quantities of short-term money.
Putting currency risk to one side for a moment, a Eurozone bank, insurance company or pension fund is taxed on short-term investments in bunds through negative yields, while being offered a tempting and potentially increasing yield on similar risk USTs.
Tempting, isn’t it?
Obviously, we can’t ignore currency risk. For simplicity, we will assume that fully matched risk insurance more or less eliminates the profit opportunity. It is possible to use out-of-the-money currency derivatives to cap the risk, and indeed, that’s one reason why OTC foreign currency derivatives stood at over $87 trillion in the second half of last year.
But we digress slightly. Maximum profits are obtained by taking a naked punt, and here, the trend is your best friend. If you feel sure the dollar is going up against the euro, not only will a euro-based financial institution gain more than three per cent by holding two-year USTs over equivalent sovereign risk two-year bunds, but there is the juicy prospect of a currency gain as well. We will also note that the Fed still plans to raise interest rates while the ECB does not. That should ensure currency risk is kept safely at bay.
Euro-based financial institutions must be sorely tempted. Furthermore, the dollar stopped falling in April and since then its trend has been up. Talk in the market is of dollar shortages as emerging-market governments may be forced to cover dollar liabilities, which coupled with Fed-induced interest rate rises makes further dollar gains against the euro, and even the yen, appear to be a racing certainty.
We can be sure that euro-based traders have been salivating over the prospect, particularly with Italian risk soaring and therefore a further reason to sell euros, which are by far the largest component in the dollar’s trade-weighted index. Hedge funds based in Europe and the US must also be keen on this trade, for the same reasons. The only question remaining is how to maximise the opportunity. Fortunately, banks and dealing intermediaries are queueing up to lend against high quality short maturity USTs, either directly or by way of reverse repurchase agreements. A bank loan for a credible customer will secure gearing of eight or ten times, and a reverse repo even more.
Let’s stick with ten times. Finance costs are based on euro or yen money-market rates, which for three-month euros is minus 0.3%, and for yen 0%. For ten times gearing, before fees we can therefore expect a gross return of 30% per annum in euros by buying two-year USTs, or 26% in yen before exchange rate gains and price changes. It is not much less investing in 13-week Treasury bills for cash players on the same geared basis.
Little wonder this is becoming the biggest game in Financetown. The attraction of these differentials between the major currencies is why the US Government has encountered no problem financing its budget deficits. And so long as the ECB and the BOJ insist on negative and zero rates, and the ECB continues printing money to buy Italian bonds, it can go on for ever.
That is the dollar bulls’ case. For balance we need to introduce a note of caution. Whenever we see a sure-fire way to make grillions of dollars, experience tells us it is time to do the opposite. Vide equities in 1999-2000. Vide residential mortgages in 2007-08. Vide the growth of shadow banking in 2007-08 to finance speculation. Today, we have something far larger: excessive speculation in favour of the dollar and against everything else. The most destabilising element for the dollar it is not the walking shadows in emerging markets, but the relationship between the dollar and the euro, and to a lesser extent the Japanese yen. This interest rate cum bond yield arbitrage is bound to prove particularly destabilising for Eurozone markets as well.
Draghi’s “whatever it takes” is no more
In recent years, the interest rate differential between the euro and the US dollar has been growing. The arbitrage opportunity has also been exploited for some time. An important element of it has been the financing through shadow banks, which is lending activity that is not reflected in bank balance sheet statistics.
According to the Financial Stability Board, which monitors shadow banking, in 2007 identified shadow banking totalled $29.2 trillion, which by 2015 had increased to $34.2 trillion. It should be noted that the FSB’s statistics only cover 27 reporting jurisdictions, some of them minor, excludes China, and is not much more than a stab in the dark. However, of that $34.2 trillion total, shadow banking taken up by collective investment vehicles in the fixed interest market (including hedge funds, fixed income, mixed investment funds and money-market funds) is recorded as having doubled to $22 trillioni.
The activities of this group now dominate shadow banking. It is an activity that has been building since the 2008 financial crisis. As long ago as May 2015 the ECB also warned us that the rapid growth of shadow banking was a risk to financial stability in the Eurozoneii. It will be noted that all figures published by both the FSB and the ECB, besides only being a guide, are horribly out of date and much will have changed by today. But we can surmise that what we are now seeing is simply the culmination of speculative trends that have been growing for some time.
If the ECB was worried over three years ago about the rapid growth of shadow banking, it should be terrified now. It must raise interest rates pretty damn quick, but it cannot do that without collateral damage in Portugal, Italy, Greece, Spain, (remember the PIGS?) and even France. These spendthrift governments have taken full advantage of a zero or near-zero cost of borrowing. And Italy is now rebelling even before any rise in interest rates, and before the ECB’s money-printing to buy Italian debt is due to cease in December.
It is no longer credible for the ECB to claim that the Eurozone is only in the early stages of recovery, when the US economy is clearly moving towards overheating. In fact, the Eurozone economy has been like the curate’s egg; good in parts. Countries such as Germany, the Netherlands and Finland, have been doing well, but others, such as France, less so. Unemployment in the PIGS has remained stubbornly high, particularly for the young. But these are fiscal and structural problems, not monetary ones.
The ECB will undoubtedly have to bite on this bullet, tell the PIGS to put their own houses in order, and increase rates to stop destabilising the global economy. This article has gone to press before today’s ECB monetary policy committee meeting, which should at least indicate the start of monetary tightening, bringing forward the timing of interest rate rises.
For the moment, dollar bulls are simply ignoring the reality that the ECB must act. Record long positions in the dollar had been building up for some time, long before the current stampede started. The dollar bulls of today are likely to be the last buyers, leaving only profit-takers and other sellers to dominate tomorrow’s markets.
Rescuing the banks is more complicated than last time.
We should take notice of a joint article by Ben Bernanke, Tim Geithner and Hank Paulson last week in the New York Times iii. It was effectively an admission that there will be another financial crisis, and as such, these three men who presided over the last one must be worried that we are now heading towards the next.
They point out that some of the tools they deployed ten years ago are no longer available. The critical paragraph is the following:
But in its post-crisis reforms, Congress also took away some of the most powerful tools used by the FDIC, the Fed and the Treasury. Among these changes, the FDIC can no longer issue blanket guarantees of bank debt as it did in the crisis, the Fed’s emergency lending powers have been constrained, and the Treasury would not be able to repeat its guarantee of the money market funds. These powers were critical in stopping the 2008 panic.
Their concern is that under current legislation and regulations, a similar crisis to Lehman would increase the risk of a total collapse of the financial system, because the financial authorities have their hands tied. While there is some truth in their concerns, they might be overcome by emergency executive orders from the president.
The authors are oddly silent on the larger problem that makes a globally coordinated financial and systemic rescue much more difficult, and that is the bail-in provisions adopted by all the G20 members and enshrined in their laws. Last time, bail-outs and nationalisation of the banks were the methods deployed, and they protected both depositors and bond holders. The cost was borne entirely by the state.
Without much thought, bail-in provisions were introduced specifically to prevent the cost of future bank failures being forced on the state, and instead the costs are to be shared by bond holders and uninsured depositors. Their application to individual failures of banks not deemed systemically important financial institutions is actually superfluous, because normal bankruptcy laws are sufficient for these instances. The difficulty occurs when a potential bank failure threatens to escalate into a systemic threat. But if you bail in such a bank, by forcing losses upon bond holders and uninsured depositors, you simply escalate a systemic problem.
The three men at the centre of the Lehman crisis appear to have learned little from their experience. The overriding lesson is of the futility of closing some stable doors while opening others.
Other governments are watching
Russia appears to have already made a strategic judgement against the dollar. It’s not for nothing she prefers gold, which has the potential to protect against a dollar crisis.
Russia’s strategic partner in Asia is the largest foreign holder of both dollars and USTs. China’s total non-gold reserves stand at $3.13 trillion, of which $1.12 trillion is invested in USTs. Much of the remaining $2 trillion is in dollar deposits and other liquid dollar securities. Some of this China has loaned to other countries. For example, total loans to African nations at the end of 2017 totalled $143bn. Earlier this year President Xi promised a further $23bn in loans to Arab states. The China Development Bank is lending $20bn to Latin America for infrastructure projects. These are small amounts for China, but substantial for the recipients. China appears likely to continue to loan out and spend her dollars as a way of getting rid of them.
The continuing trade surplus with America means that China is still accumulating dollars at a faster rate than she can use them for buying influence in emerging markets. Given her strategic objectives, this must be undesirable. She will be monitoring the situation carefully, but for the moment, American trade tariff tactics are her immediate concern.
However, there will come a time when China refocuses her attention to her own interests. Her appetite for industrial materials is enormous, and she is likely to be accumulating reserves of vital commodities, such as copper and other base metals, to deploy in her own infrastructure development plans as well as for development along the two silk roads. It is to secure these raw material and energy supplies that she has been investing dollars in the emerging economies that supply them.
Yet, speculators have been shorting these metals on Comex and elsewhere as a means of buying the dollar, while appearing ignorant of Chinese plans. Copper stocks on the London Metal Exchange (which, incidentally, Chinese interests also owns) have now become very low, with tradable tonnage falling from 319,525 tonnes at end-March to only 147,450 tonnes last week.
The strong dollar presents an excellent opportunity for China to accelerate spending on commodity stockpiles. So far, this has not led to price disruption, because China has proved to be a careful buyer. However, the shortages of deliverable stocks in key commodity markets such as copper are bound to end with a price shock. In the case of oil, WTI and Brent are now both in backwardation ahead of US sanctions against Iran, due to come in from 5th November. Venezuela continues to be a production disaster.
China has proved to be acutely aware of Western market dynamics and continually liaises with Russia over the implications for geopolitical and financial strategy. In this context, the following is an important quote by Hank Paulson (US Treasury Secretary during the Lehman Crisis) in an interview given to Robert Peston, when he was with the BBC, in connection with the handling of the Lehman crisis: "Here I'm not going to name the senior person, but I was meeting with someone… This person told me that the Chinese had received a message from the Russians which was, 'Hey let's join together and sell Fannie and Freddie securities on the market.' The Chinese weren't going to do that but again, it just, it just drove home to me how vulnerable I felt until we had put Fannie and Freddie into conservatorship."
It seems the Russians were ready to interfere with America’s rescue plans in the wake of the Lehman crisis ten years ago. Today they have reduced their exposure to US Treasuries to insignificant levels and would surely consider intervening again. With deep and personal US sanctions against them, they really have little to lose and much to gain.
We cannot be so sure the Chinese will refuse to go along with the Russians this time. Today, there is an unpredictable American president in Donald Trump and his tariff wars. America’s antagonism against China has deepened. An assumption that China will cooperate with Washington towards global stability through back-channels cannot be assumed to hold in a new financial and systemic crisis. So long as the Chinese financial system is ring-fenced, the negative impact of a collapse of the West’s financial system on China’s economy could be sold to the Chinese people as the fault of the West, and nothing to do with China. China’s “responsible” attitude in appearing to protect herself and her citizens could be politically beneficial to the regime.
They need do very little, other than to refuse to help. Therefore, China is able to use a future American financial crisis as an opportunity to let the dollar destroy its own hegemony and to enhance China’s own economic and geostrategic plans.
The next credit crisis is now shaping up
We can be certain of one thing, and that is central banks through their actions create the one crisis they cannot deal with. Individual countries in financial difficulty can be dealt with. As Mario Draghi said, “Whatever it takes”. Systemic risk is routinely covered up by Panglossian stress tests and the continual tightening of financial regulations. But when central banks expand the quantity of money early in the credit cycle, they always store up trouble for later.
The inevitable credit crisis eventually occurs. We can now make a guess how serious it will be, because it is in proportion to the earlier stimulation. Since 2008, globally that has been unprecedently large. To this we must add earlier credit distortions that were not expunged by the last credit crisis, and even the one before that.
It is shaping up to be the most serious financial event in our time, of that there can be little doubt. What we don’t know precisely is the form it will take and when it will happen. All we know is that rising interest rates will undermine business models, government finances, and consumer spending somewhere first, and it will rapidly spread from there. It may be rising interest rates and bond yields in the Eurozone, as the ECB acts to close the yield gap referred to above. It could be America herself; these are the most obvious candidates. Rising interest rates or an expectation of them are always a trigger for a reversal of speculative flows. And the next crisis is shaping up to be the most fundamental attack on the global financial system since the dollar lost all its gold convertibility. It will commence with an implosion of the dollar bubble.
Besides the flow of record quantities of speculative funds out of the dollar, there are a number of other factors that risk driving dollar interest rates higher. There is the timing of the Trump budget stimulus, which comes inappropriately late in the credit cycle, fuelling bond supply, while foreigners turn sellers. There are trade tariffs to the extent they are actually imposed, because they raise costs for the American consumer and therefore the CPI. There is the potential for commodity and energy prices to rise over the next year or two on the back of Chinese demand, as she dumps her dollars for the raw materials she needs to progress her thirteenth and fourteenth five-year plans. These factors can now be foreseen by those prepared to look for them. Taken together they have the potential to be a perfect storm.
As we have identified, the real tragedy is the ECB’s monetary policies are unbelievably out of kilter. It is a matter of utmost urgency that they be corrected. Therefore, we can expect this issue to be addressed soon, if not on the day of this article’s publication at the ECB’s monetary policy meeting (13 September), then on 25th October, which is the date of the meeting following.
This means the timing for the next credit crisis can now be tentatively suggested between now and the year end, at the latest early next year. Expect a shift of the ECB’s monetary policy, which will be designed to support the euro and drive it higher, so the dollar should begin to reverse its gains at that time. The shortages of warehouse stocks should see key commodity prices rising strongly and the impending sanctions against Iran will begin to push up energy prices. US price inflation, already recorded officially at 2.9%, will soon be over 3% and rising.
US bond yields will rise as dollar outflows increase their momentum, disrupting US Government finances. Despite the rise in bond yields, the gold price should rise sharply, reflecting a developing dollar crisis. In short, the change in sentiment for the dollar promises to be unexpectedly swift.
At the beginning of this article, the question was posed as to what form this crisis would take. This time, it is unlikely to be driven by collapsing equities or residential property prices; they will fall on the back of a dislocation in currency markets, leading to a collapse in bond prices. It is the outlook for bond prices and their effect on other financial assets where the next crisis promises to differ from the last. In 2008, the yields on US Treasuries declined as investors sought safety from private sector investments. This time, foreigners selling dollars and USTs are likely to overwhelm domestic safety-seekers and drive bond yields higher. We should also bear in mind that US Government financing has become heavily dependent on foreign investment inflows continuing.
Rising bond yields, reflecting foreign selling, will therefore be beyond the Fed’s control. Banks, as the intermediaries, have stronger balance sheets in the US, but Eurozone banks are both more highly leveraged and more exposed to bonds. Both banking systems are even more highly geared when you factor in the increase in shadow bank balances, about which the monetary authorities still remain broadly ignorant.
Last time, the crisis hit the US banking system first. The banks had become as greedy as hell, securitising debt to hide it from the regulators. Eurozone banks got caught out buying this debt mostly through Irish-based subsidiaries. But the real problem was in America, with others suffering the consequences. Next time, it will not be just America, but a global problem undermining the reserve currency, most probably created by a forced reduction in the divergence of monetary policies between the Fed and the other two major central banks. The upcoming crisis threatens to be on a greater and wider scale than the last one because it will stem from the gross overvaluation of the reserve currency.
Any attempt to rescue the finances of the US Government, banks and businesses by printing money will simply provide more fuel for the inflationary fire, but it is hard to see that there can be any other material response by the Fed. The only real tool it has is monetary expansion, and it is tasked with keeping the system afloat. The same applies to the Eurozone and the ECB.
The only parties that appear able to avoid the worst consequences are the Russians and the Chinese. China may have a different set of problems, depending on how it reacts to a dollar crisis, but that is beyond the scope of this article. I have written elsewhere about their monetary strategy, particularly with respect to gold, which most of the countries in their Asian domain have been accumulating. But if China and Russia survive the next credit crisis with fewer wounds than the rest of us, it can only add to a change in the geopolitical balance. One thing is as certain as certain can be: physical gold will be the safest of safe havens when the dollar begins to slide, taking everything with it.
What can America do to stop the dollar sliding towards obscurity? The only answer is to restore gold convertibility, and we better hope for a change in monetary policy to this end, and that America still has the gold reserves to do it. Even that assumes the banks can be rescued, which is by no means certain.
i See the FSB’s Assessment of shadow banking activities, risks and the adequacy of post-crisis policy tools to address financial stability concerns: http://www.fsb.org/wp-content/uploads/P300617-1.pdf
iv This part of the interview was not used by the BBC, but Peston’s account of it can be found here: https://www.bbc.co.uk/news/business-26609548
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