Markets Rally on Hopes of Huge EU Bailout

  

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.

In a replay of the 2008 Credit Crisis, global stock markets are now rallying strongly after a huge selloff last week. This pattern was common in late September and all during October three years ago. It seems to be replaying itself again in 2011. Huge moves down and up are common in severe bear markets.

As has happened many times so far, stocks are rallying on "hopes" of a resolution to the Greek debt problem and liquidity issues with EU banks. The Greek prime minister has stated confidently that Greece will definitely receive the next tranche of money from the first bailout and his comments got a lot of positive press attention. The mainstream press failed to inform the public that Greek officials have consistently made "misleading" statements during the debt crisis and their credibility might be considered questionable. The next payment from the first bailout has been delayed because Greece broke the promises it made for meeting fiscal objectives. Instead of listening to Greek officials, investors should consider that Greece has a CCC credit rating — the lowest sovereign debt rating in the world. If any country is going to default anywhere, it's Greece.

The numbers describing Greece's situation also speak for themselves and clearly indicate the inevitability of default.  Greece's debt to GDP ratio was 127% in 2009 in the early stages of the crisis. By the end of 2010, it was 143%. Reuters and a number of other sources report it as now around 160%. This rapid rise is taking place as Greece is getting €110 billion bailouts (the second one is in the works). Clearly the bailouts are not solving the problem, but merely slowing down an explosion of debt. Historically, once a country's debt to GDP goes over 150%, default seems to become inevitable.

The market keeps predicting default in Greece by setting astronomical interest rates. The one-year government bond had a yield of 138% on September 26th, down from its high of 142% on September 14th. Two-year debt was yielding 71% yesterday and the ten-year bond 24%. How can any entity pay these interest rates and avoid default?

All sorts of schemes are being discussed by EU leaders to handle the current crisis. There are rumors of a default plan that involves Greece paying back only half of its debt. EU officials described these rumors as just speculation, although in some cases the denials were less than firm. They also denied any enlargement of the EFSF (European Financial Stability Facility) — the EU's 440 billion euro bailout slush fund — was underway. The current global stock market rally got started when CNBC News reported that the EFSF would be leveraged up to eight-times and the European Investment Bank would issue bonds to buy up sovereign debt. The specific reaction to this report from one EU official was that it was "just bizarre". The big-money investing operations can make quite a bit of profits by planting "just bizarre" stories though because they can juice the markets up for a day or two. Then some bad news story appears and markets drop right back down. We've seen this pattern over and over again in the last two months.

At some point, the Greek debt crisis will be resolved. Until then, the EU will kick the can down the road as long as it can. At this point though, the can looks like it was run over by a freight train and then tossed around by a tornado. Greek debt holders will have to take a significant haircut on their debt and this means that banks in Germany and France will have to be recapitalized. Then something will have to be done to prevent the emerging defaults in Portugal and Ireland (both have already been bailed out once) and prevent the situation in Spain and Italy from getting bad enough to need a bail out. This will take a lot of money,  much more than the €440 billion in the EFSF.  Where will this money come from? It's quite simple — it will be printed.

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.

U.S Credit Rating Downgrade - A Humpty Dumpty Moment

 

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.

As everyone knows by now, S&P downgraded the U.S. sovereign debt rating from AAA to AA+ on Friday. While the extent of the downgrade is minor, the implications are major. As the recent debt ceiling negotiations revealed, the U.S. cannot run its day-to-day operations without borrowing money. It lives on credit (as do most countries in the world today) and anything that impacts its ability to borrow money has serious consequences.

It takes a lot for a credit rating agency to lower the credit rating of a top corporation or country. This is usually only done long after the actual credit worthiness has experienced a significant decline.  The last major Friday afternoon credit downgrade from the credit rating agencies was when they lowered Bear Stearns rating on March 14, 2008. The company didn't open its doors again the following Monday.  The rating agencies were also tardy with lowering the credit ratings of accounting fraud poster child Enron, although they all did finally lower its rating to junk status four days before it declared bankruptcy. Perhaps the best analogy to the current U.S. situation though is the AAA ratings given to a number of securitized bonds that held subprime mortgages. These turned out not to be worthy of a top credit rating after all.

The farcical nature of how the credit agencies determine the rating of U.S. government debt was made clear during the debt ceiling negotiations. Numerous articles in the press reported that failure to come to an agreement, which would allow the U.S. to continue to spend money it didn't have because it could borrow more, would be viewed as fiscally irresponsible! A more rational response would have been, it's quite obvious that the U.S. can't function without borrowing an increasing amount of money and it is therefore insolvent. Under such circumstances its credit rating should be at the junk level - a BB or less - not an AA+. Eventually, this might happen, but as was the case with Enron, this would mean the U.S. would likely be going under a few days later.

The difference between the AA+ credit rating and the BB or lower one is caused by the fantasy factor. The AA+ rating is based on the glorious financial past of the U.S. and ignores the current downward trajectory it is on. Before the debt ceiling problems temporarily curtailed spending for a while, the U.S. was on course for as much as a $1.65 trillion budget deficit. This represents 11% of the current GDP number of $15 trillion (there are many reasons to think GDP is substantially overstated). It is true, that the U.S. is not borrowing money to pay for most of this deficit however - it's printing it. Quantitative Easing 2, a form of money printing, conducted by the Fed covered 70% of the deficit in the first half of the year. A country doing this certainly does not deserve an AAA credit rating, nor does it deserve an AA+ credit rating unless you can make a case that a company engaged in the business of counterfeiting money also deserves a close to top credit rating.

The Obama administration complained that S&P overestimated future U.S. deficits by $2 trillion. What this means is that S&P refused to accept the pie-in-the sky budgets numbers that the government generates. If you look at these, you will see that they assume GDP growth of over 5% a year, each and every year, until 2016. One year of GDP growth over 5% would be good and continual annual GDP growth of over 5% for the U.S. economy just isn't possible. The budget scenario also assumes very low inflation, which would certainly not be the case if the high growth it assumes takes place.  A combined deficit of $20 trillion in the next decade instead of the administration's $7.7 trillion would be more plausible. S&P assuming $2 more is still ridiculously low.

The immediate impact of the U.S. credit downgrade will be to cap the credit rating of companies at AA+. The government of the country has to have the highest credit rating in that country because in theory it has no default risk. Economists say that governments can use their ability to tax to pay off their debts. Although as finances deteriorate it is much more likely governments will print money to pay off their debts. No fiscally solvent government ever engages in excess money printing however. The U.S. Fed had increased its balance sheet (a measure of money printing) by $2 trillion since 2007. It doesn't appear that the credit agencies are taking this into account.

The longer-term implications for the lowered credit rating are far more serious.  More downgrades are likely. Interest rates will go up. Money will leave the United States. The U.S. dollar will lose its reserve currency status and this will lower its value substantially. Higher interest rates and a falling currency will both be inflationary. 

The financial world operates very much on image and reputation. Once that's shattered, it can take years to repair it, if it can be done at all.  When Bear Stearns was downgraded in March 2008, the damage to its ability to operate in the financial markets was terminal. The company imploded like an overinflated balloon that had a pin stuck in it. Fortunately, this is not likely to happen to the U.S. - at least not yet.

Disclosure: None

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

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.

Fed Decision Today; Dollar, Bonds and Gold

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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The FOMC concludes its two-day meeting today and will issue a statement around 2:00PM New York time. There is no chance the Fed will be tightening its zero interest rate easy money policy, although it may announce some vague longer term liquidity reduction that will take place at some indeterminate future date (like the IMF gold sale that was announced over and over again for more than two years before it actually happened). The Fed knows that without its super low interest rates the economy would go into a tailspin and the stock market would tank. Don't expect the Feds quantitative easing (aka money printing) policy, which is slated to be terminated at the end of October, to be stopped either. Interest rates would skyrocket overnight (treasury bond prices would plummet) and the U.S. wouldn't be able to fund its massive budget deficits. It is not likely there will be an announcement about this today however.

While easy money leads to stock rallies (and higher precious metals prices), it undermines a nations currency. The trade-weighted dollar hit a new yearly low in pre-market trading this morning. The ETF DXY had an ugly gap down yesterday. It was as low as 76.00 on Tuesday (a key support level) and fell to 75.89 in pre-market trading today. Ironically, this was the low one year and one day ago. Perhaps less ironically, I constantly see headlines cross my computer screen about the dollar rallying, but every time I look at the price it has gone down. Can the dollar hold its support in here? There are rumblings from the central banks in a number of countries about supporting the dollar in order to lower the value of their currencies. Look for some possible hints of this from the G20 meeting tomorrow, but don't expect action.

The approximately zero short-term interest rates in the U.S. has led to a carry trade. Traders sell U.S. dollars to buy high yielding currencies like the Australian and New Zealand dollar. This is one reason that Australian and New Zealand dollars have been going up in value. Currencies from countries with upgraded credit also benefit. Brazil just had its sovereign debt rating raised to investment grade. Don't expect the credit rating agencies to ever lower the U.S. sovereign debt rating to junk status though. This should have already been done.

Gold has continued to perform admirably. It has closed above its breakout level of $1003.50 for eight days in a row as of yesterday. The close on Tuesday was $1015.50. Silver closed at $17.16. There can still be some overhang on the precious metals market until the G20 meeting is over. Gold still needs to trade intraday above $1033.90 to finish its breakout. Hopefully soon.

NEXT: Market Sells Off as Dollar Rallies ... As Usual

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.

Government Investment Pools Dry Up

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

While the downgrades of the bond insurers threatened U.S. municipalities with higher future interest costs, it became obvious in November 2007 that there were far more immediate risks to public finances when there was a run on Florida's Local Government Investment Pool . The run began when word got out that the Investment Pool had exposure to $1.5 billion in defaulted and downgraded SIVs. Florida had to freeze withdrawals to prevent the fund from collapsing. The municipalities that got out early were lucky, all others had to find emergency funding to meet their payrolls for police, firemen, hospital workers, teachers, and other employees.

Local, State and Government investment pools existed in at least 20 states and were essentially special money market funds that bought short-term debt and were set up to get higher yields that would otherwise have been available. Little did they know that these slightly higher yields were being produced by taking on massively higher risk through exposure to subprime toxic waste that the big brokers (Lehman in Florida's case) were more than willing to sell to them. Problems were by no means isolated to Florida either. In the last days of November, Montana school districts, cities and counties withdrew 10% of the total $2.4 billion in its investment fund after the rating on one of the pool's holdings was lowered to default. The state of Maine had invested 3% of it money, apparently on Merrill Lynch's advice, into a fund only two weeks before its credit rating was lowered to junk status. Financial difficulties with government investment pools were also reported in Orange County, California and Seattle, Washington.

While the losses of the Government Investment Pools were certainly serious, were they isolated of were they likely to spread? If these ultra-sophisticated money-market funds got into trouble, wouldn't it be reasonable to assume that the money market funds open to the individual investor might suffer similar problems in the future? By the late fall of 2007, it had already been reported that Bank of America, SunTrust, Wachovia and Legg Mason had taking steps to prop up money market funds that contained securities of possibly questionable worth. And it looked like the formerly safest of investments were in some cases becoming among the riskiest.

Next: Subprime Freezes Over

Daryl Montgomery
Organizer, New York Investing meetup

For more about the New York Investing meetup, please go to our web site: http://investing.meetup.com/21