10 Reasons We Are in a Credit Crisis

 

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Yesterday's news was about a potential Greek default and it caused a global market selloff. Today,  hopes of preventing a Greek default are causing markets to rally. This alternating news flow is repeating over and over again. Investors should pay attention to the big picture however and not the noise of the day. The important thing to realize is that we are in a second global credit crisis.

Credit crises follow certain patterns, which include: recognition of overpriced financial assets, money flowing into safe havens, increased market volatility, rising costs for financial insurance, and various forms of government action to stop the problem. The specifics of the current credit crisis are below.

1. Government debt is being downgraded. This happened in Italy yesterday, the U.S. in early August and many times in Greece. This is the upfront recognition of the problem, which is almost always widespread public knowledge by the time it happens. In 2008, securitized debt containing subprime real estate loans was downgraded in mass, frequently from the triple A ratings that had previously been given.

2. Global money is flowing into safe haven U.S. treasuries. When yields hit lower levels than a previous credit crisis or all-time lows, this indicates this is happening on a mass scale. U.S. government two-year notes had a yield below 0.15% at one point this September 19th. During 2008, the two-year held above 0.60%. The ten-year yield has fallen below the 2.04% low in 2008 and below the all-time low of 1.95% in 1941.

3. Global money is flowing into safe haven currencies. In 2008, this was the U.S. dollar and the Japanese yen. In 2010, this is the Japanese yen, the Swiss franc, and gold (which needs to be thought of as a currency if it is to be analyzed correctly). The Swiss franc rallied so much that the Swiss stopped it from trading freely. The Japanese have also taken action to try to lower the value of the yen.

4. Stock market volatility has increased enormously. In 2008, there were a significant number of mini-crashes (a drop of 5% or more in one day). These were more common in the U.S. back then. Now they are more common in Germany, but they have been happening here as well. The flip side of mini-crashes is sudden sharp moves up in the market. These are also occurring.

5. Bank stocks are the focus of the big moves up and down in the stock market. U.S. banks and other financial stocks really got hit in 2008 -- a number of the companies themselves went under. This time it's European banks falling the hardest. One-day drops for some major EU and UK banks have been as high as 10%. Bank stocks aren't dropping that much in the U.S., but they are underperforming other sectors like technology.

6. Credit default swaps have hit record levels. Credit default swaps (CDSs) are bond insurance and they became a big news item in 2008 when they rose to unprecedented levels. While CDS rates for Greek sovereign debt have hit records and are rising for the other highly indebted EU countries, they have also hit records for some UK and EU banks in 2011 indicating a worse crisis than in 2008.

7. Major and ongoing bailouts are taking place. The EU had to bail out Greece in the spring of 2010 and then Ireland and Portugal. A second bailout for Greece had to be arranged this July, even though the first bailout was supposed to have taken care of Greece's debt problem. In 2008, the U.S. had TARP and arranged for failing banks to be taken over by stronger banks  (Bank America is now in trouble again because of the legacy loans from the banks it absorbed during this period). Fannie Mae and Freddie Mac had to be nationalized. 

8. Central banks are buying bonds in the open market. The EU has been buying up Italian, Spanish, Irish and Portuguese bonds in order to hold down interest rates in those countries. As long as it has an infinite access to funds, this strategy will work. The Fed began buying U.S. debt instruments in the fall of 2008 during the Credit Crisis. 

9. Global coordinated central bank intervention took place last week. The need for global action is a consequence of the interconnectedness of the world financial system. A major problem in one region (in 2011 this is Europe, in 2008 it was the U.S.) will invariably spread everywhere. Central banks coordinate their activity to try to control the contagion. 

10. The global economy is turning down.  Problems in the financial system impact the real economy and they can turn a shallow downturn into a major one as has happened in 2008. Economic figures throughout the world have flattened and there are some warnings of a bigger drop to come (extremely low consumer confidence numbers for instance). GDP contraction in a number of regions will be the final confirmation that another global credit crisis has occurred. 

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Is the Bond Market Setting Up for Another Credit Crisis?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Spreads on high yield bonds and U.S. treasuries are narrowing. Junk bond issuance is at an all-time high because excess liquidity is lowering risk aversion. Who is buying all the bonds is not particularly clear however. But don't worry, just as they did before the last Credit Crisis, the economic elite is telling us there is nothing to worry about this time either.

When there is too much money sloshing around the global financial system, the distortion shows up clearly in the bond market because it's an insider's game. The average investor isn't exactly trading credit default swaps in his or her 401K. According to a recent Wall Street Journal report, less than $29 billion has gone into high yield bond funds in the last 20 months. Yet Dealogic data indicates that $172 billion of junk bonds have been issued in just 2010 alone. Spreads over 10-year treasuries are now around 6%, but have been somewhat lower during the summer. In 2007, spreads fell to around 2% and this indicated all common sense had abandoned the bond market. The inevitable collapse followed and at the height of the Credit Crisis, junk/treasury spreads were over 20%.

One of the major determinants of yields on junk bonds is the danger of default. The economy is in much worse shape now than it was in 2007, even though we were just told yesterday by the NBER that the recession ended 15 months ago (boy, that sure is a timely announcement). So we should not get as low as a 2% spread between junk and U.S. treasuries like we did last time. Less risk of failure because of government bailouts should not be assumed either. Few issuers of junk bonds would be considered too-big-to-fail and the government blank check for bailouts is either over or it soon will be.

There is also the mystery of why as more and more bonds are being issued, less and less trading activity is taking place. Bloomberg economist Michael McDonough recently reported U.S. treasury trading is down and so is junk bond trading. Trading in stocks on the NYSE is also down as the market has risen. So how can prices be going up when there is a greater supply of bonds, but apparently less demand?  This is not really possible, so there has to be missing information. Now who would have access to vast sums of money and the ability to hide their activities in the market?

A narrow spread between junk and treasuries is something to keep an eye on and to worry about. It is a good indicator of whether or not central banks have injected so much liquidity into the financial system that they have risked another credit crisis. It is not possible to say where the exact point is where the spread is too low, although it is now definitely somewhere well above 2%. If we haven't reached it yet, we are getting close.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Markets Trading Like They Did During Credit Crisis

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Stocks are selling off globally. Commodities are down, but gold is holding up the best. Money is pouring into the perceived safe havens, the U.S. dollar and treasuries. Is it the late fall of 2008 or late spring of 2010?

Without further information, you can't answer that question. There is a global financial crisis occurring now because of the problems with the euro. There was a global financial crisis in 2008 because of the collapse of the prices of derivatives related to subprime mortgages. The problems with subprime debt had begun the year before and started impacting stocks in July 2007. Stocks were already in an advanced bear market sell off by the fall of 2008. The current euro crisis is only a few months old and U.S. stocks are only in a correction so far (loss of over 10% versus loss of over 20% for a bear market).

The current stock market sell off is worldwide as it was in 2008. It goes without saying the stocks in the eurozone are suffering, but technical damage can be found in major markets everywhere. The Dow Jones has broken key support at 10,000 twice already. The Nikkei gave up its significant 10,000 level a while ago, closing at 9521 last night. The Hang Seng has fallen below important support at 20,000, dropping to 19,378. In the UK, the FTSE is barely holding above 5,000 today.

The trade-weighted dollar (DXY) was as high as 88.71 in New York this morning (June 7th). This is higher than its peak in November 2008, but not as high as the top in March 2009. There was a major sell off in the middle, with the euro (FXE) having a sharp rally. Something similar is likely to happen early this summer. The dollar is very overbought and the euro is very oversold. The euro has traded as low as 1.1878 today. It may pop back up to the 120 support level and if not, there is stronger support around 115. The dollar is already hitting major resistance, so the set up for a short-term reversal looks like it is taking place.

As would be expected, U.S. treasuries have rallied strongly during the euro crisis. It is highly unlikely that they will get to the extremely low levels they did in 2008. As treasuries rally, interest rates go down of course. Interest rates on the 10-year fell to around 2.00% in December 2008. They were at 3.18% this morning. There is strong chart support at and just above the 3.00% level. So not much more of a treasury rally, interest rate sell off should be expected for now.

Currently gold has recaptured its safe haven status. It was selling off with the euro between last December and this February. Then it started rallying with the U.S. dollar, although it usually trades opposite to the dollar. Gold sold down in the fall of 2008. Central bank leasing was responsible for this. The big banks and large hedge funds leased gold at a small price and then sold it on the market to raise desperately needed cash. This is not happening at the moment to a significant enough degree that it can offset buying elsewhere. Ironically, a sharp relief rally in the euro could be short-term bearish for gold. Despite the selling in the fall of 2008, gold still closed the year up along with the U.S. dollar and U.S. treasuries. Almost every other asset closed down. It's still too early to tell if 2010 will end the same way.   

Disclosure: None

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Interest Rate Rally Portends Inflation in 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


U.S. treasuries closed out 2009 with their biggest loss since 1978. It was the first loss since 1999 and only the fourth loss in 31 years. Interest rates at the long end of the curve are now almost double what they were at the height of the Credit Crisis. It was quite a turnaround from the end of 2008, when bonds managed to rally and survive the market slaughter that took down almost every asset class. 2009 witnessed a complete turnaround when treasuries went down and almost every other asset class went up. The rally in bonds in 2008 and the severe drop in interest rates was used as a key piece of evidence for those who argued the deflation would be a problem. They ignored that inflation-sensitive gold and farmland were the other two assets that had gone up in price that year (gold was up again in 2009 with a 25% gain - it's ninth straight annual gain; final figures for farmland are not yet available).

Very short-term interest rates are still close to zero in the U.S. As long as Fed Funds stay at that level, 3-month T-bills will not be much higher. Long-term rates themselves were kept down by the Fed purchasing 10-year treasuries as part of its quantitative easing program. This ended on October 31st. Once the Fed was no longer propping up the government bond market, December became one of the worst months for treasuries in a long time.  The case for deflation, although  questionable from the start, collapsed right along with treasury prices. Deflationary environments are characterized by low short-term rates and low long-term rates, as was the case in Japan starting in late 1990s and the U.S. during the 1930s Depression. The yield on the 10-year Japanese government bond fell below 1% in 2003, not far above the near zero rates on shorter dated paper. Rising long-term rates indicate inflation and the bigger the spread between them and short-term rates, the higher future inflation is likely to be. That spread is now already wide and widening even further in the U.S.

The problem isn't isolated to one side of the Atlantic either. Rates for 10-year gilts in the UK are already over 4% and are higher than government bond rates with the same maturity in Italy. The UK is engaging in major money printing and its policies are perhaps even more inflationary than those of the U.S. The yield on the 10-year U.S. treasury at the end of 2009 was 3.84%. The 30-year yield was 4.64%. This was not the high for 2009 though. That took place in June when the 10-year yield was around  4.00% and the 30-year yield around 5.00%. It was already clear by then that deflation was not going to happen. Nevertheless, the Federal Reserve, the Treasury and a number of prominent economists continued to maintain otherwise. The same thing happened in Weimar Germany, with the equivalent cast of characters claiming deflation was a problem - not inflation - right up to the point where prices exploded. There is no reason the script should be different this time. It rarely is.

Inflation is devastating for long-term bonds. Their prices have to drop substantially, so yields can go up enough to induce potential purchasers to buy them. These were some of the worst investments during the 1970s (until the final peak in interest rates in 1980, when they became excellent investments). Back then, the average investor's only option to deal with a dropping bond market was to stay away from it. Now we have the ETFs TBT and TMV, which have portfolios that represent leveraged shorts on long-term U.S. treasuries. Long-term treasuries are approaching resistance on the charts, so a pull back should be expected in early 2010. This could prove to be an excellent buying opportunity.

DISCLOSURE: Long gold, farmland, TBT and TMV.

NEXT:

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.