Ben’s helicopter, grounded by Fitch
Today demonstrated that the bond insurance agencies hold more near-term economic power than does the Federal Reserve. Implied volatility plunged from 28 to below 25 after the Fed’s 50 basis point rate cut (the higher end of the expected range), and then rose to nearly 28 again after Fitch downgraded bond insurer FGIC from AA to A. Moody’s and S&P downgrades of FGIC are coming, to say nothing of MBIA and Ambac. A single downgrade of one bond insurer by one ratings agency turned a “Fed rally” into a “Fitch rout.”
Spot gold reached $935 an ounce; the dollar’s weak January rally has been cut off at the knees, and one euro once again buys almost $1.50 ($1.4850 to be precise). Note that the value of the dollar is very close to its November trough, when gold was at about $810 per ounce, yet gold is now over $920 per ounce. Gold has appreciated nearly 15 percent in real terms in the past two months, and foreigners have been doing most of the buying this time around.
Overblown bond insurance fears
MBIA, Ambac, and FGIC collectively insure nearly $2 trillion in bonds. Basically, a bond insurer offers to guarantee significant repayments to creditors in the event of the creditors’ bond defaulting (hence “bond insurance”), in return for a fee. The bond insurance companies are somewhere between “technical insolvency” and “long past bankruptcy.” Ratings agencies Moody’s, S&P, and Fitch are not interested in playing Arthur Andersen for the bond insurance industry, and bond insurance downgrades are imminent.
Back in November, I switched from bearish to bullish after I had examined all the levers the US government has used to pump money into the economy – the Federal Home Loan Banks, the Federal Reserve’s cash-for-trash “Term Auction Facility,” the massive interest rate cuts by the Federal Reserve (which have not been followed by any other central bank anywhere), and the looming fiscal diarrhea from Congress and the White House – all that has added up to over $550 billion (conservatively) in the past six months, as well as an interest-rate differential 200 basis points less favorable to the United States (which means a lot less future investment here, and a lot more Americans exporting their savings to less inflationistic countries, a la Japan). That’s not good for the US dollar or US equities, but in nominal terms, it would reflate the dollar value of US assets.
The stock market’s reaction to Fitch’s long-anticipated downgrade shows you how jittery today’s markets are. There is little reason such a move could not have been priced in, and I am still vaguely baffled that such an expected piece of information would knock 1.5 percent off US equities markets.
But at any rate, so the market is making a major fuss out of potential bond insurance downgrades. If the ratings agencies were not under political pressure, they would downgrade MBIA and Ambac to somewhere between BB- and BBB+. Politics will probably keep it from getting that bad, but even if MBIA and Ambac are downgraded to A, that will entail approximately $150 billion more in writedowns by Western investment banks., according to two recent studies on the subject.
The banks will get hammered again. There will be more fears of Citigroup or Bear Stearns going bankrupt, because they will have to swallow another gigantic load of debt. Additionally, Merrill, Citi and Bear were all known to have sold large chunks of their bad debts to hedge funds with the guarantee of buying that bad debt back at a markup within one year, in the hope that financing would be easier after “the credit crunch” had passed. Monoline downgrades are going to hammer the investment banks, and come next October, a copious amount of bad debt will come back onto their balance sheets. In addition, by then the Beijing Olympics will be long gone, and China will have to confront its mounting inflation epidemic once and for all – which means that they will no longer be exporting liquidity to the rest of the world. No more Chinese stakes in US banks.
That said, while financials have some grim months ahead, there is much more to the economy than financials and housing. The rest of the economy will benefit in the short term – and lose big in the long term – from the Fed’s glut of credit.
As I never tire of repeating, commodities have been and will continue to be the big winner from all this, at least into the early summer of 2008. After June, the market will begin to wonder how much China will raise the value of the yuan to counter domestic inflation. China is vastly overcapitalized, overheated, overinflated, overliquid and overhyped. China will either blow up in a less-messy fashion or a 1989-style “tanks in Tiananmen” fashion. 20 percent of Chinese 2007 college graduates could not find a job, and in China, college education is even more expensive relative to income than it is in the United States. Educated people who cannot afford food under one regime will change the regime if necessary.
Whether China deals with its domestic inflation crisis by finally allowing market mechanisms to work, or by gunning down a lot of the unemployed, a flood of capital will leave China at that point for Vietnam potentially, India possibly, the Koreas probably, and the United States overwhelmingly.
SocGen drama and European weaknesses
The UK Telegraph leaked that the European Central Bank has quietly pumped money to Spanish banks, which are by far the most overextended in Europe. Once again, the European Central Bank is trying to have it both ways: quietly pumping paper to ailing underachievers, while at the same time maintaining a hawkish stance to the public markets.
Supposedly, the leak was from the Fed, which was furious with the ECB for not informing the Fed that last week’s market meltdown was solely due to a mass liquidation of Societe Generale positions (and possibly positions at BNP Paribas and other French banks). (The ECB had been informed several days before SG dumped its positions.) The Fed exposed itself as being provoked by the keystrokes of a single French equities trader, albeit a very unusual one, and the ECB chose . That at any rate is the word on the Street.
As we have often noted here, the European economic system is highly trifurcated between low-end exporters, e..g, the PIGS, high-end, Germanic manufacturing/ service exporters (the Nordics/ Germany/ Netherlands/ Austria), and the post-Warsaw Pact entrants from Eastern Europe. During a boom, those divisions seem to fade away. Then some kind of bust always hits, and European economic harmony collapses as overleveraged countries (Italy) renege on their commitments.
To “paper over” the weakness of southern Europe’s medium-end export economies, the ECB is basically printing money for southern European banks on the sly. This can’t go on forever. Fundamentally, the euro has very little strength left.
It’s an odd position to be in for me to be bearish on both the euro and the dollar at the same time. This is nominally a forex newsletter, which means I’m supposed to prognosticate currency fluctuations relative to each other. However, the euro and the USD, in the near term, are both headed down. The winners are the Chinese yuan and the Gulf currencies, all of which are largely state-controlled, and which will appreciate at some dramatic future event, but which will not appreciate in lockstep with the dollar and the euro.
Whenever you are bearish on the dollar, bearish on the euro, and bullish on currencies that don’t circulate widely outside the country of issue (can’t be traded on international forex markets), you are long precious metals.
All markets will exhibit predominantly downward volatility until the bond insurance issue is resolved. The market will not trust a government bailout as a long-term solution to the problem. Only an LBO by a massive, cash-flush private equity player, or the rapid rise of Berkshire Assurance, will solve the problem in the long run. When that event appears imminent, stocks will become very attractive again — particularly financials. Until then, think of precious metals as bonds/cash insured against competitive currency devaluation, and stick with them.