Showing posts with label Financial speculators. Show all posts
Showing posts with label Financial speculators. Show all posts
Saturday, August 25, 2018
The Cryptocurrency Bust
Cryptocurrencies are down about 75% from the beginning of the year. See https://www.cnbc.com/2018/08/20/after-the-bitcoin-boom-hard-lessons-for-cryptocurrency-investors.html. Many investors have taken losses in the range of 70% to 90%. Those who borrowed to buy cryptocurrencies learned the hard way that investments may or may not work out, but debts have to be repaid either way. There may be some winners, but clearly there are plenty of losers.
The problem with cryptocurrencies is that they basically have no intrinsic value. They're only worth what someone else will pay for them. If buyer interest falls, people holding cryptocurrencies end up holding the bag. If you want to buy cryptocurrencies, that's your choice. But understand it's a speculative choice and lots of speculations end badly.
The reason why stocks, bonds, real estate and a few other things have stood the test of time as good investments is they generally have underlying value. If you want to build wealth, invest in value. If you want to speculate, hope to win but don't be surprised if you lose. If you want a decent retirement, avoid wishful thinking and focus on the higher percentage plays. See http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.
Tuesday, November 14, 2017
Is Inflation Hitting Bitcoin?
Bitcoin is supposed to be insulated from inflation. Because there is a predetermined limit to the number of Bitcoins that can be created (21 million), Bitcoin supposedly should not be subject to anything like the monetary actions of governments, which can inflate fiat currencies by printing more money. There was an operational problem in August 2010, when someone created 184 million Bitcoins in a single transaction. But this transaction was voided and the operational problem dealt with. Thus, the 21 million coin limit was preserved.
Nevertheless, Bitcoin is subject to inflation risk. Inflation results from increasing the amount of a currency. Although the number of Bitcoins is limited, the number of digital alternatives to Bitcoin is not. Other cryptocurrencies, such as Ethereum, can be created with relative ease. There are few barriers to entry. Some 1100 cryptocurrencies now exist. Among them is Bitcoin cash, created by the Bitcoin community with features that make it easier than Bitcoin to use for transactions. The Bitcoin community also created Bitcoin gold, a cryptocurrency created to facilitate decentralized mining (Bitcoin itself is now dominated by a small number of large miners). As these alternatives proliferate, the value of Bitcoin can fluctuate wildly.
So far, Bitcoin has recovered from its sharp drops, and continued an overall upward trend in value. But volatility attracts fast money, and cash seems to be flowing into the Bitcoin market for speculative purposes. This may not end well. Hot money never stays in one place for long. With all the alternatives to Bitcoin, and the low barriers to entry for more, numerous other venues for volatility and speculation are or will become available. Speculators will stampede to whatever market appears to offer larger and quicker profits. The effect on Bitcoin could be similar to inflation. As cash flows away from Bitcoin, its value will diminish. Pause and think before you buy Bitcoins.
Nevertheless, Bitcoin is subject to inflation risk. Inflation results from increasing the amount of a currency. Although the number of Bitcoins is limited, the number of digital alternatives to Bitcoin is not. Other cryptocurrencies, such as Ethereum, can be created with relative ease. There are few barriers to entry. Some 1100 cryptocurrencies now exist. Among them is Bitcoin cash, created by the Bitcoin community with features that make it easier than Bitcoin to use for transactions. The Bitcoin community also created Bitcoin gold, a cryptocurrency created to facilitate decentralized mining (Bitcoin itself is now dominated by a small number of large miners). As these alternatives proliferate, the value of Bitcoin can fluctuate wildly.
So far, Bitcoin has recovered from its sharp drops, and continued an overall upward trend in value. But volatility attracts fast money, and cash seems to be flowing into the Bitcoin market for speculative purposes. This may not end well. Hot money never stays in one place for long. With all the alternatives to Bitcoin, and the low barriers to entry for more, numerous other venues for volatility and speculation are or will become available. Speculators will stampede to whatever market appears to offer larger and quicker profits. The effect on Bitcoin could be similar to inflation. As cash flows away from Bitcoin, its value will diminish. Pause and think before you buy Bitcoins.
Wednesday, July 10, 2013
Regulatory Challenges of the Bond Market
The Great 2013 Bond Market Chain Saw Massacre has probably caused trillions of dollars of losses. On May 1, 2013, the yield on the U.S. Treasury 10-year note went as low as 1.61%. Since then, it has vaulted as high as 2.72% and most recently closed at 2.63%. Such a jump in yields is, as kindergartners would put it, ginormous.
The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred. While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars. And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.
The game of musical losses is now in progress. Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up. The challenge for regulators is to find out, and quickly, where that end will be. What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss. Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)). Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch. Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.
Regulators should be proactively trying to pin down where the bond market losses will fall. Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates. Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet. That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions. It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch). Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight. But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.
There's more. The yield curve has been steepening during the last two months. The short end remains squashed by the Fed's scorched earth policy on short term interest rates. But the long end, as we noted above, has been rising meteorically. This steepening makes attractive a type of carry trade. It's possible to make a lot of money by borrowing short term and investing long term.
Fed policy makes this carry trade all the more enticing. The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%. Although employment has been rising, the unemployment rate has been static for several months. While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived. If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher.
To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor). But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank.
Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade. It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side. But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel. Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.
The inverse math of the bond market would dictate that when yields jump this much this fast, the principal value of bonds will fall painfully and nasty losses will be incurred. While precise numbers aren't readily available, losses in Treasuries may reach a trillion dollars. And when you add in corporates, munis, junk bonds, and mortgage-backed securities, the losses could be multiple trillions.
The game of musical losses is now in progress. Through short positions, derivatives contracts and other hedges, the losses are flowing through to wherever they will end up. The challenge for regulators is to find out, and quickly, where that end will be. What must be ascertained is whether the losses are spread out and landing in places where they can be absorbed without too much fuss. Or whether the losses are concentrated somewhere and could have secondary and tertiary rippling effects (i.e., cause a run on one or a few major financial institution(s)). Well within living memory (2008, to be exact), sharp losses in the mortgage markets triggered tsunamis in the financial markets that washed over Bear Stearns and Lehman Brothers, and threatened to wipe out AIG, Fannie Mae, Freddie Mac and Merrill Lynch. Bailouts and regulator-encouraged acquisitions barely prevented an abrupt, loud, low-flow flush of the entire financial system.
Regulators should be proactively trying to pin down where the bond market losses will fall. Complicating their task is the likelihood of speculators who used leverage to make derivatives bets on a fall in interest rates. Since there is no prohibition on speculating with derivatives, as opposed to hedging, it is possible (and probable) that some players in the financial markets made such a bet. That wouldn't be intrinsically different from the bet that John Paulson made in mortgages shortly before the mortgage crisis that sweetened his net worth by billions. It's also not intrinsically different from the gold bets that John Paulson's gold fund has likely made, which reportedly has sustained losses in excess of 60% (ouch). Any such speculative bets in the bond markets could exacerbate the game of musical losses, and make the regulators' tasks all the more difficult, since many of the speculators might be trading through entities chartered in off-shore locations that might frustrate U.S. government oversight. But the Feds will have to do their best, because the alternative would be what happened in 2008, when they waited until things blew up and bailouts were just about the only option.
There's more. The yield curve has been steepening during the last two months. The short end remains squashed by the Fed's scorched earth policy on short term interest rates. But the long end, as we noted above, has been rising meteorically. This steepening makes attractive a type of carry trade. It's possible to make a lot of money by borrowing short term and investing long term.
Fed policy makes this carry trade all the more enticing. The Fed's intent, as far as it can be discerned from the entrails currently visible, is to begin cutting down on bond purchases (i.e., QE) within months, but to keep short term rates at zero until unemployment reaches 6.5%. Although employment has been rising, the unemployment rate has been static for several months. While no one really knows when unemployment will reach 6.5%, it's not uncommon to read predictions of mid-2014 or so for that level to be acheived. If so, the carry trade could be profitable for a while, especially if the Fed's reduction of bond purchases push long term yields even higher.
To paraphrase P.T. Barnum, or Mark Twain, or somebody, there's a smarty pants who shows up in the financial markets every minute. Some--and perhaps many-- will surely indulge in this carry trade, most likely on a leveraged basis (because leverage boosts profits, assuming the trade works in your favor). But if the unemployment rate unexpectedly drops quickly to 6.5%, the partakers of this carry trade might wonder if they aren't living in a septic tank.
Either way, the regulators have to keep an eye out for the possibility of mounting risks from this sort of carry trade. It could look like easy money to banks, hedge funds, insurance companies and other important players in the financial markets--after all, with the Federal Reserve at least momentarily anchoring their borrowing costs while pushing up their profits, the government is on their side. But borrowing short to invest long is the E. coli that has poisoned many a would-be financial marvel. Regulators need to be watchful not only for bond market losses from risks that have already materialized, but also for the growth of more risk from the changing landscape of the market.
Wednesday, December 12, 2012
How Will the Fed Deal With Speculation on the Fed?
The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat. Or maybe it wasn't a shrug, but puzzlement. This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next.
One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go. For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market. Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to.
Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large. Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately. Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck.
With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world. After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right). The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited. Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on. The specter of systemic risk could lurk.
If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways. If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark). In such an instance, the very policy that the Fed is attempting to implement could be undermined.
But there is no practical way for the Fed to prevent benchmark betting. Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take. If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem.
The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable. That's nice theory. But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works.
One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go. For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market. Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to.
Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large. Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately. Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck.
With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world. After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right). The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited. Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on. The specter of systemic risk could lurk.
If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways. If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark). In such an instance, the very policy that the Fed is attempting to implement could be undermined.
But there is no practical way for the Fed to prevent benchmark betting. Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take. If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem.
The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable. That's nice theory. But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works.
Friday, September 23, 2011
Why Gold Isn't A Safe Haven
In the past couple of days, gold has dropped close to 10%, and is now trading around $1650 per ounce. That's 15% down from its recent peak price of around $1920. Why the belly flop? The answer is that, contrary to pronouncements of bug-eyed gold fanatics who drool from the sides of their mouths, gold is not a safe haven from fiat currencies or the financial system. Instead, it is joined at the hip with the financial system.
Among the most active traders in gold are hedge funds and other financial firms. These market players mainline leverage. And when they can't find a vein, they smoke the stuff. Consider the nature of leverage. It's a loan denominated in fiat currencies like the dollar and the euro. Leverage must be repaid in fiat currencies. Banks extending margin loans don't want to speculate in gold themselves, so they require repayment in dollars, euros or some other fiat currency.
Leverage financed the great gold rush of 2008-2011. This time, prospectors didn't search for yellow metal in stream beds or under the ground. They sought riches in the trading platforms of exchanges. The ones that got into the market two or three years ago hit the motherlode. But as gold bubbled up, smart players began to wonder when the party would run out of punch. The financial crisis of 2008 taught us that bubbles will burst at some point. Stocks and real estate both bubbled up and burst, and gold isn't different. Part of today's selling is to lock in profits while the getting is good. Locking in profits involves converting gold holdings to a fiat currency. That's the only way to take your gold profits and use them to repay margin loans, and buy cars, food, housing, and so on. So when money managers think the gold bubble, as valued by fiat currencies, has peaked, they will sell gold in order to obtain fiat currencies.
Other hedge fund managers may be selling gold because their investors, seeing the world go hinky in recent months, are making redemption requests to cash out. Investors may be worried about stocks, oil, or other assets besides gold that the hedge funds invested in and are now falling in value. But gold is easier to sell than some assets because it has a highly liquid market. So investor redemption requests, in effect, hit the gold market. Investors want payments in fiat currencies, not distributions of gold. That means the gold has to be sold to convert it into fiat currencies.
The players who dove into gold also traded on a leveraged basis in stocks, other commodities and maybe derivatives that no one can easily learn about because the derivatives market, three years after the financial debacle of 2008, remains opaque. Part of the selling of gold is due to speculators having to raise cash to meet margin calls resulting from falling prices for stocks, commodities other than gold (such as oil, which has lost some of its sheen) and, perhaps, derivatives contracts. In this way, leverage used to invest broadly on a diversified basis can have an interlinked downward impact when some markets go wobbly.
The recent woes of the euro add to the problem. A fall by the euro has pushed up the comparative value of the dollar. Since gold tends to trade inversely to the dollar, a good day for the dollar means a bad day for gold. That's another reason for gold investors to bail before they sustain more losses. The inverse correlation between the dollar and gold reveals a vulnerability of gold to a fiat currency.
With the financial markets and world getting hinkier by the trading minute, the selling has accelerated in the past two days. The ship seems to be sinking, and you know who is scrambling to get off first. Leverage dramatically pushed up the price of gold, and now deleveraging and other financial factors are driving it down.
Today's gold market is a creature of the financial system, and is subject to the same pressures and constraints as other assets. Gold isn't a safe haven. What is? That's the question people have been asking since they sharpened long sticks for protection and sought shelter in caves. When you have the answer, please clue in the rest of us.
Among the most active traders in gold are hedge funds and other financial firms. These market players mainline leverage. And when they can't find a vein, they smoke the stuff. Consider the nature of leverage. It's a loan denominated in fiat currencies like the dollar and the euro. Leverage must be repaid in fiat currencies. Banks extending margin loans don't want to speculate in gold themselves, so they require repayment in dollars, euros or some other fiat currency.
Leverage financed the great gold rush of 2008-2011. This time, prospectors didn't search for yellow metal in stream beds or under the ground. They sought riches in the trading platforms of exchanges. The ones that got into the market two or three years ago hit the motherlode. But as gold bubbled up, smart players began to wonder when the party would run out of punch. The financial crisis of 2008 taught us that bubbles will burst at some point. Stocks and real estate both bubbled up and burst, and gold isn't different. Part of today's selling is to lock in profits while the getting is good. Locking in profits involves converting gold holdings to a fiat currency. That's the only way to take your gold profits and use them to repay margin loans, and buy cars, food, housing, and so on. So when money managers think the gold bubble, as valued by fiat currencies, has peaked, they will sell gold in order to obtain fiat currencies.
Other hedge fund managers may be selling gold because their investors, seeing the world go hinky in recent months, are making redemption requests to cash out. Investors may be worried about stocks, oil, or other assets besides gold that the hedge funds invested in and are now falling in value. But gold is easier to sell than some assets because it has a highly liquid market. So investor redemption requests, in effect, hit the gold market. Investors want payments in fiat currencies, not distributions of gold. That means the gold has to be sold to convert it into fiat currencies.
The players who dove into gold also traded on a leveraged basis in stocks, other commodities and maybe derivatives that no one can easily learn about because the derivatives market, three years after the financial debacle of 2008, remains opaque. Part of the selling of gold is due to speculators having to raise cash to meet margin calls resulting from falling prices for stocks, commodities other than gold (such as oil, which has lost some of its sheen) and, perhaps, derivatives contracts. In this way, leverage used to invest broadly on a diversified basis can have an interlinked downward impact when some markets go wobbly.
The recent woes of the euro add to the problem. A fall by the euro has pushed up the comparative value of the dollar. Since gold tends to trade inversely to the dollar, a good day for the dollar means a bad day for gold. That's another reason for gold investors to bail before they sustain more losses. The inverse correlation between the dollar and gold reveals a vulnerability of gold to a fiat currency.
With the financial markets and world getting hinkier by the trading minute, the selling has accelerated in the past two days. The ship seems to be sinking, and you know who is scrambling to get off first. Leverage dramatically pushed up the price of gold, and now deleveraging and other financial factors are driving it down.
Today's gold market is a creature of the financial system, and is subject to the same pressures and constraints as other assets. Gold isn't a safe haven. What is? That's the question people have been asking since they sharpened long sticks for protection and sought shelter in caves. When you have the answer, please clue in the rest of us.
Sunday, December 6, 2009
Is the Federal Reserve's Free Ride Ending?
The announcement on Friday, Dec.4, that the unemployment rate had fallen slightly from 10.2 % to 10 % surprised many, and perhaps dismayed some at the Fed. At its Nov. 3-4, 2009 meeting, the Fed announced that it expected to keep the fed funds rate at "exceptionally low" levels for an "extended period" of time. That announcement helped to fuel stock and commodities prices for the month of November. But after Friday's announced unemployment drop, stocks closed with only a modest gain, gold fell 4%, oil fell a little over 1% and the 10-year Treasury note fell about 0.75% in value (with an increase in yield of about 10 basis points). The dollar rallied.
These market reactions were spurred by the implication that the Fed will have to raise interest rates sooner than it expected. An interest rate hike would strengthen the dollar, reduce the value of gold, and push bond yields higher (and bond prices lower). The price drop in oil--seemingly odd because a recovering economy would be expected to consume more oil--is a reflection of the asset bubbling spurred by the Fed's cheap money policies. The huge amounts of cash pumped by the Fed into the financial system pushed down the dollar, thereby making oil more valuable in dollar terms. If the Fed begins to pull back on its accommodation, thereby strengthening the dollar, oil prices in dollar terms would naturally abate.
The Fed's predictive powers have been demonstrably lacking. It failed to see the implications of the growth in the mid-2000s of looney mortgages (the kind given to people who couldn't repay), the misplaced risks and rewards of the securitization process (where Wall Street made monstrous amounts of money from doing deals--including excessively risky deals, recklessly stupid deals and irredeemably bad deals), the increasing opacity of the financial system's true condition caused by derivatives and then derivatives of derivatives, and finally the monumental blockheadedness of concentrating at AIG credit default swaps insuring hundreds of billions of dollars worth of mostly mortgage-related investments. One wonders whether the Fed has underestimated the pace of the economy's recovery.
On one level, we hope it has. Continuation of the Great Recession much longer could inflict lasting damage to consumers, workers, businesses and investors that might lead to the stagnation that has bedeviled Japan since its massive asset bubble burst in 1989-90. There, people seem to have lost faith in just about everything except the government. This was most recently demonstrated by the Japanese government's cancellation of plans to privatize its postal system (which is not only a mail carrier, but an enormous bank and insurance company). The U.S. government's greatly expanded role in the economy could easily become permanent if the private sector doesn't revive soon.
But a Christmas present in the form of improved economic performance could lead to volatility in the financial markets. A lot of players (they used to be called investors, but today long term investing is about as trendy as a large SUV) have borrowed dollars at cheap, short term rates, converted them into other currencies and invested in longer term plays denominated in other currencies. Or else they invested in oil or oil futures, betting that continued bottom of the barrel interest rates would push oil prices ever higher in dollar terms. Or they took heart from the Treasury securities market's improbable rally this year and the Fed's ongoing trillion dollar program to buy Treasuries and mortgage-backed securities, and used cheap borrowed money to purchase higher yielding long term securities they thought would be propped up by the Fed's massive money print. Or they jumped into the stock market with the hope that the Fed's gusher of liquidity would continue to push stocks higher, even after a 60% rally this year.
All this activity was premised on the Fed correctly foreseeing economic stagnation and keeping short term interest rates virtually at zero, as it publicly proclaimed. If the Fed again turns out to be wrong, and has to hike rates sooner than expected, a lot of free rides will end. The players who have borrowed short and invested long may well have to unwind their positions, learning the hard way that not matching the duration of your borrowings with the duration of your investments entails risk. That could lead to volatility in the financial markets. If the volatility begins to create systemic problems, the credit crunch could again rear its hideous head and banks may again become catatonic. Then we'd probably have the much feared double-dip recession.
The Fed meets again on Dec. 15 and 16, 2009. Don't expect any rate hikes then. But the Fed may be compelled by continuing good news to modify its promise (that's how financial markets players have been viewing it) of ultra low interest rates. If it does, the speculators in the financial markets might have to make painful adjustments (as they probably already are).
Even as the Fed for the past year has given banks and other financial market participants a virtually free ride on borrowed money, it's gotten a free ride in terms of monetary easing. With banks making almost no new loans and pulling back existing credit, no amount of Fed accommodation seemed to have any impact on consumer prices. The Fed could keeping shoving printed money off its loading dock and not pay the price of monetary policy gone wild.
But the law of unintended consequences always lies in wait to ambush federal economic policy. The Fed didn't intend for its monetary easing to stimulate asset speculation here and abroad, even though it should have been sensitized to that risk by its role in the pumping up the real estate bubble. Chairman Bernanke's pledge of greater transparency of the Fed's thinking is a good idea. But when the Fed starts to play that most dangerous game--publicly predicting the future course of the economy and interest rates--it had damn well better be right. Or the rest of us will pay the price.
These market reactions were spurred by the implication that the Fed will have to raise interest rates sooner than it expected. An interest rate hike would strengthen the dollar, reduce the value of gold, and push bond yields higher (and bond prices lower). The price drop in oil--seemingly odd because a recovering economy would be expected to consume more oil--is a reflection of the asset bubbling spurred by the Fed's cheap money policies. The huge amounts of cash pumped by the Fed into the financial system pushed down the dollar, thereby making oil more valuable in dollar terms. If the Fed begins to pull back on its accommodation, thereby strengthening the dollar, oil prices in dollar terms would naturally abate.
The Fed's predictive powers have been demonstrably lacking. It failed to see the implications of the growth in the mid-2000s of looney mortgages (the kind given to people who couldn't repay), the misplaced risks and rewards of the securitization process (where Wall Street made monstrous amounts of money from doing deals--including excessively risky deals, recklessly stupid deals and irredeemably bad deals), the increasing opacity of the financial system's true condition caused by derivatives and then derivatives of derivatives, and finally the monumental blockheadedness of concentrating at AIG credit default swaps insuring hundreds of billions of dollars worth of mostly mortgage-related investments. One wonders whether the Fed has underestimated the pace of the economy's recovery.
On one level, we hope it has. Continuation of the Great Recession much longer could inflict lasting damage to consumers, workers, businesses and investors that might lead to the stagnation that has bedeviled Japan since its massive asset bubble burst in 1989-90. There, people seem to have lost faith in just about everything except the government. This was most recently demonstrated by the Japanese government's cancellation of plans to privatize its postal system (which is not only a mail carrier, but an enormous bank and insurance company). The U.S. government's greatly expanded role in the economy could easily become permanent if the private sector doesn't revive soon.
But a Christmas present in the form of improved economic performance could lead to volatility in the financial markets. A lot of players (they used to be called investors, but today long term investing is about as trendy as a large SUV) have borrowed dollars at cheap, short term rates, converted them into other currencies and invested in longer term plays denominated in other currencies. Or else they invested in oil or oil futures, betting that continued bottom of the barrel interest rates would push oil prices ever higher in dollar terms. Or they took heart from the Treasury securities market's improbable rally this year and the Fed's ongoing trillion dollar program to buy Treasuries and mortgage-backed securities, and used cheap borrowed money to purchase higher yielding long term securities they thought would be propped up by the Fed's massive money print. Or they jumped into the stock market with the hope that the Fed's gusher of liquidity would continue to push stocks higher, even after a 60% rally this year.
All this activity was premised on the Fed correctly foreseeing economic stagnation and keeping short term interest rates virtually at zero, as it publicly proclaimed. If the Fed again turns out to be wrong, and has to hike rates sooner than expected, a lot of free rides will end. The players who have borrowed short and invested long may well have to unwind their positions, learning the hard way that not matching the duration of your borrowings with the duration of your investments entails risk. That could lead to volatility in the financial markets. If the volatility begins to create systemic problems, the credit crunch could again rear its hideous head and banks may again become catatonic. Then we'd probably have the much feared double-dip recession.
The Fed meets again on Dec. 15 and 16, 2009. Don't expect any rate hikes then. But the Fed may be compelled by continuing good news to modify its promise (that's how financial markets players have been viewing it) of ultra low interest rates. If it does, the speculators in the financial markets might have to make painful adjustments (as they probably already are).
Even as the Fed for the past year has given banks and other financial market participants a virtually free ride on borrowed money, it's gotten a free ride in terms of monetary easing. With banks making almost no new loans and pulling back existing credit, no amount of Fed accommodation seemed to have any impact on consumer prices. The Fed could keeping shoving printed money off its loading dock and not pay the price of monetary policy gone wild.
But the law of unintended consequences always lies in wait to ambush federal economic policy. The Fed didn't intend for its monetary easing to stimulate asset speculation here and abroad, even though it should have been sensitized to that risk by its role in the pumping up the real estate bubble. Chairman Bernanke's pledge of greater transparency of the Fed's thinking is a good idea. But when the Fed starts to play that most dangerous game--publicly predicting the future course of the economy and interest rates--it had damn well better be right. Or the rest of us will pay the price.
Sunday, September 23, 2007
Financial Market Speculators Jump Back on the Merry-Go-Round
Scarcely a moment had passed after the Fed announced its interest rate cuts before speculators jumped back into the financial markets. As reported in the Wall Street Journal (9/20/07, p. C1) and the Washington Post (9/22/07, p. D1), the Fed's interest rate cuts prompted increased speculative interest in emerging markets and the petroleum markets. These markets are expected to benefit from the rate cuts, but aren't tainted by the subprime mortgage and other other asset-backed securities messes. Thus, investors haven't lost confidence in them and they are ripe for bubbles. As reported by the Journal, one gambit is to jump in now, at an early stage, and pray for irrational exuberance. Speculators aren't gun shy about bubbles; they hope for them.
It goes without saying that the Fed would not have wanted to encourage more speculation,. Speculative excess has already brought us the 2007 credit crunch. The emerging markets were the bubbly source of the 1997-98 financial crisis. That, as you may recall, culminated in the near-collapse of Long Term Capital Management, hailed by some as an unsinkable battleship among hedge funds. And it was in the energy markets last year that Amaranth Advisers, another large hedge fund, foundered on the shoals of high leverage and high risk.
Profiting from government subsidies, however, is a time honored way of making easy money. Is it a surprise that agriculture has shifted away from the family farm to big-time enterprise? The availability of the government subsidies attracts capital and makes large-scale, subsidized operations the sensible thing to do.
There is a lot of speculation in agriculture. Farmers are gamblers by the nature of their occupation. But the amount of cropland available, and a variety of other factors, limit the extent to which farmers can speculate. Yields can increase by 10%, 20% or even somewhat more for any given crop from year to year. But they can't increase by several hundred fold.
Financial derivatives, on the other hand, allow investors to transact in equivalents of the underlying assets, and can multiply the amount of money invested with respect to those assets many times over. There is only so much crude oil being recovered at any given moment in time. But there are few effective limits on the amounts of derivative contracts based on crude oil that can be traded or held. And derivative contracts based on emerging markets are similarly without effective limits. Thus, the amounts of speculative risk derived from these markets can balloon upwards quickly, constrained only by the instincts of market participants for caution. The latter, as we now know from the subprime mess, may be scant.
Also scant is the Fed's ability to monitor ongoing and future speculation. The near complete absence of regulation of hedge funds and other entities of their ilk leaves the Fed with no comprehensive information about the extent of the risks building up in the financial system. Instead, it must rely on anedoctal information, making monetary policy perhaps in response to hearsay.
Could speculation in the emerging markets and the petroleum markets create levels of risk comparable to the problems of the mortgage markets? There's no way to know. There's no way to prevent it. And there's no reason to believe that it won't eventually endanger the stability of the financial system.
Past opposition to the regulation of hedge funds and the derivatives markets has been ideological in its fervor. But what ideological purpose is served by the government indemnifying the financial system from unmonitored, unregulated and unlimited risk? We have what is government insurance of financial assets on the one hand, without any controls over the risks to which those assets are placed. No commercial property insurer would provide coverage without assessing the risks involved and insisting on some controls over them. Moreover, it would charge premiums.
The Fed's interest rate cuts may bolster the economy. Or they may not, depending on how things go. With a falling dollar, rising oil prices, rising food prices and continued Brobdingnagian federal deficits, the prospects for inflation are hardly rosy. Now that the asset speculators have resumed their merry romp, perhaps we should ask the question that should have been asked with respect to another government policy: how does all this end?
Animal News: Cat returns from Oz. http://www.wtop.com/?nid=456&sid=1254575.
It goes without saying that the Fed would not have wanted to encourage more speculation,. Speculative excess has already brought us the 2007 credit crunch. The emerging markets were the bubbly source of the 1997-98 financial crisis. That, as you may recall, culminated in the near-collapse of Long Term Capital Management, hailed by some as an unsinkable battleship among hedge funds. And it was in the energy markets last year that Amaranth Advisers, another large hedge fund, foundered on the shoals of high leverage and high risk.
Profiting from government subsidies, however, is a time honored way of making easy money. Is it a surprise that agriculture has shifted away from the family farm to big-time enterprise? The availability of the government subsidies attracts capital and makes large-scale, subsidized operations the sensible thing to do.
There is a lot of speculation in agriculture. Farmers are gamblers by the nature of their occupation. But the amount of cropland available, and a variety of other factors, limit the extent to which farmers can speculate. Yields can increase by 10%, 20% or even somewhat more for any given crop from year to year. But they can't increase by several hundred fold.
Financial derivatives, on the other hand, allow investors to transact in equivalents of the underlying assets, and can multiply the amount of money invested with respect to those assets many times over. There is only so much crude oil being recovered at any given moment in time. But there are few effective limits on the amounts of derivative contracts based on crude oil that can be traded or held. And derivative contracts based on emerging markets are similarly without effective limits. Thus, the amounts of speculative risk derived from these markets can balloon upwards quickly, constrained only by the instincts of market participants for caution. The latter, as we now know from the subprime mess, may be scant.
Also scant is the Fed's ability to monitor ongoing and future speculation. The near complete absence of regulation of hedge funds and other entities of their ilk leaves the Fed with no comprehensive information about the extent of the risks building up in the financial system. Instead, it must rely on anedoctal information, making monetary policy perhaps in response to hearsay.
Could speculation in the emerging markets and the petroleum markets create levels of risk comparable to the problems of the mortgage markets? There's no way to know. There's no way to prevent it. And there's no reason to believe that it won't eventually endanger the stability of the financial system.
Past opposition to the regulation of hedge funds and the derivatives markets has been ideological in its fervor. But what ideological purpose is served by the government indemnifying the financial system from unmonitored, unregulated and unlimited risk? We have what is government insurance of financial assets on the one hand, without any controls over the risks to which those assets are placed. No commercial property insurer would provide coverage without assessing the risks involved and insisting on some controls over them. Moreover, it would charge premiums.
The Fed's interest rate cuts may bolster the economy. Or they may not, depending on how things go. With a falling dollar, rising oil prices, rising food prices and continued Brobdingnagian federal deficits, the prospects for inflation are hardly rosy. Now that the asset speculators have resumed their merry romp, perhaps we should ask the question that should have been asked with respect to another government policy: how does all this end?
Animal News: Cat returns from Oz. http://www.wtop.com/?nid=456&sid=1254575.
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