The currency conundrum – is it another leg up for gold?

The logic in the currency markets usually has been: sell lower interest rate currency and buy higher/stronger rates. The strategy seems to have reversed now – low/zero yield seems to positive. Sample this:

“… when in Prague the Czech central bank slashed its interest rates to an all-time low, the Czech Koruna actually bounced vs. the Euro...

… 100-basis point cut to South African rates worked to stem the slide in the Rand - now trading one-third below its US-Dollar value of last February despite paying fully 1,050 basis points more...

… in London, the Bank of England took its base rate further into record-low territory at 1.0%...yet currency traders pushed the Pound Sterling to a two-week high above $1.4650...

… when the Reserve Bank of Australia cut its interest rate to a 45-year low, the Aussie Dollar bounced from near-6 year lows in response...

… after the central bank of Norway cut its target interest rate by 50 basis points to 2.50%, the Norwegian Krone turned higher after losing one-third of its value vs. the Dollar since July last year...

… when the world's No.2 behind the Fed, the European Central Bank (ECB), opted to keep its rates flat - the Euro lost 2¢ from this week's high…...despite paying returns to cash fully 200 basis points above the Dollar.”

The phenomenon was first witnessed with USD and JPY as the respective central banks raced to cut the rates to near zero. This clearly is a deflation biased view which it appears is looking to punish debtors.

Euro is likely to suffer in this sense till it announces a rate cut in March. If it also joins the zero interest band-wagon then one may wonder what’s left for the currency markets to play with? Is this is a precursor to a crisis brewing here? Does gold get a further leg up – it’s anyway a zero yield currency!

Look forward to readers views.

Disclosure: No Positions

Copyright © 2008 - 2009 Tradesense

‘Good Bank -Bad Bank’ – Is there any other way out?

The proposal to take the toxic/lousy assets of the US banking system into a ‘bad bank’ and leaving the performing/good assets with the existing banks had initially received a positive response from the street wise it appears has run into a block – how to value these assets?

As one expert explains:

“Say a bank has a security it wants to sell to the bad bank. The face value is $100. The bank holds it at a value of $85. The market thinks it’s worth $65.

Banks will want the government to purchase assets for as high a price as possible, or at least to find some middle ground above depressed market values.

Buying the security at, or close to, $100 means the government would recapitalize the bank while transferring losses from shareholders to taxpayers.

Well, future taxpayers. They will be the ones who pay down the debt the government hopes to sell to fund this transfer, and make good on any losses. That debt, meanwhile, could prove stifling to the economy, and the losses pushed onto taxpayers could further undermine government finances.

‘Postpone the Pain’

“Creative pricing of toxic assets will only postpone the pain, extend the duration of the crisis, and present a bigger bill,”...

If the government purchases the security at $85, the future losses and bill to the public purse would be less. The problem is that this price could cause banks to recognize as permanent their losses on other securities. Right now, they claim those losses are temporary.

Such a move would cripple banks’ regulatory capital ratios. Plenty of banks could still fail. In that case, banks and taxpayers both get hit.

Buying the security at the market price of $65 means banks and the financial system immediately face a day of reckoning. While bank balance sheets would get unclogged, many wouldn’t be able to, or willing to, face the losses.

Nationalizing Banks

“If the government elects to pay fair market value, the bank will likely not elect to participate as capital hits would be too dear,” …

That could force the government to nationalize banks or seize them as part of the process of buying up assets. Either way, shareholders would get wiped out.”

So what we have is a ‘Damn if you! Damn if you don’t!’ situation.

According to various reports:

• It is estimated that the falling US and British financial institutions have received $1trn. from the government (taxpayers), sovereign wealth funds and other investors.
• Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles -- leveraged lending vehicles used by big banks to fatten their profits in boom times -- are being forced back to banks' balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
• Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.
• When you add the $500 billion from sovereign wealth funds to the $500 billion from the first tranche of the Troubled Assets Relief Program, it's only $1 trillion. That's already been provided. So that leaves a gap of $500 billion to $1.5 trillion.

And the feeling one gets is that nobody still has an idea on the depth of toxic assets in the system as a whole while individual institutions may have an idea about their position but may not want to disclose it fully.

The complication that has been brought in to the bailout approach is truly mind-boggling and it is becoming very clear that everyone is clueless.

Is there a simpler approach?

Now that it is very apparent that the taxpayers and public (present and future) at large are the suckers in this game and are going to foot the bill (which anyway is going to run into a few trillions of dollars), why not take a simpler approach.

The primary cause has been mortgages – and at the root are the ‘sub – prime’ mortgages. If the bad loans have been identified as they should have been by now, the government can take over these loans into its books and tell the banks that it will pay the monthly installments as per the original agreement with the borrower. If the average tenure/maturity is about 15 years say the government gets reasonable time to raise these trillions over a much longer period. As regards the banks these become performing assets and as the government instead of doling out only to the banks can also dole out to the mortgagees by giving them the actual ownership of their homes. While this would be akin to a grant and some may raise moral hazard issues, but what morality is left in the present plans? Further taxpayers and citizens will feel better knowing that they have helped fellow citizens than the unscrupulous financial institutions. Politically too it might find favor as relevant constituencies are addressed.

Given that the mortgage repayments are now to come from the government the derivatives based on the mortgages will also stabilize and the banks can reckon these mortgages in their books at face value thereby avoiding any major need for recapitalization because of loan loss provisions. The derivative products, given the government backing may turn liquid and find its value too.

Am I missing something? Look forward to your comments and response.

Disclosure: No Positions

Copyright © 2008 - 09 Tradesense

OIL – What’s Cooking?

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contago or forward premium is the order. Further the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

“Since the Eighties, WTI has ruled the global crude oil market. As it is produced and refined in the US, the world s largest consumer and importer of crude oil, it has been widely accepted as the best indicator of global demand-supply. Nymex WTI contract is the largest market for this crude oil.

Brent oil is pumped out from the North Sea and shipped to Europe, Russia and parts of Asia. Oil from Europe, Africa and the Middle East flowing to the West tends to be priced relative to this oil, i.e. it forms a benchmark. However, large parts of Europe now receive their oil from the former Soviet Union, especially through Russia.

Traditionally, Brent traded at a discount to WTI because it is less light and less sweet.”

From the charts below it can be seen that the differential between the near/front month contract between WTI and Brent started appearing toward the end of 2008. Also note the Dec09 contracts have shown very little differential.

So what’s cooking?

One explanation that I have come across is:

“…it is becoming more expensive because the North Sea oil fields are getting depleted. But that doesn’t explain its premium over WTI. On the other hand, WTI was clearly over-supplied. The problem was created by the very nature of the WTI market. The WTI market has a large number of independent producers who sell their crude based on posted price. The oil is then brought into Midland and sent to either towards the Gulf Coast refining areas or towards Cushing, Oklahoma. Cushing is an oil-trading hub and the delivery point for NYMEX light sweet crude oil futures contracts. Due to pipeline logistics, once the oil flows outwards from Midland towards Cushing, WTI can only go in one direction: towards Chicago.

So if refineries in Chicago want less oil, you can’t divert the oil towards other places where there might be more demand. In the last three months, several factors led to large supplies of oil flowing into Cushing.”

However, demand for crude has come down as it is reported that the refineries off take has fallen given that the refining margins are wafer thin or negative. This has reflected in the pump prices going up.

Now what’s happening in Cushing? NYT explains:

“A year ago, oil producers and refiners could not move their products fast enough to meet growing world demand and chase rising prices. Now, with demand and prices slumping, they are sitting on 327 million barrels at tank farms around the country, particularly at Cushing, Okla., a major storage hub and a crossroads for pipelines. That is more than 40 million barrels more in storage than this time last year, and more than 30 million barrels higher than the five-year average. The mounting buildup has come during the last 100 days or so, as consumption of oil fell behind imports and domestic production”

In this context note that:

“The International Energy Agency predicted that the worsening global economy will leave demand at 85.3 million barrels a day _ 0.6 percent lower than 2008. Demand last year is estimated to have slid 0.3 percent.

The IEA says it lowered its forecast because it has nearly halved its estimate for global economic growth to 1.2 percent.

U.S. petroleum deliveries _ a measure of demand _ fell 6 percent to 19.4 million barrels a day last year, with declines for all major products made from crude, according to the American Petroleum Institute.

The Organization of Petroleum Exporting Countries has also lowered its energy demand forecast for 2009, saying in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009 from the previous year.”

The demand destruction is further evidenced by the fact that:

“From the Indian Ocean to the South Atlantic to the Gulf of Mexico, giant supertankers brimming with oil are resting at anchor or slowly tracing racetrack patterns through the sea, heading nowhere.

The ships are marking time, serving as floating oil-storage tanks. The companies and countries leasing them for that purpose have made a simple calculation: the price of oil has fallen so far that it is due for a rise.

Some producing countries are trying to force that rise by using the tankers to withhold oil from the market, while traders are trying to profit by buying cheap oil now to store and sell at a higher price later. Oil storage has become so popular that onshore tank capacity is becoming scarce.

…noted that a trading company could buy oil at the spot price of nearly $40 a barrel, store it and sell a contract to deliver it in a year for about $60. “You pay between $6 and $10 a barrel to store it, and you can make $10 a barrel,”... “That’s why Cushing is filling up rapidly and people are leasing tankers...

… With storage tanks filling up onshore, private and national oil companies, refiners and trading companies are storing another 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years, according to Frontline Ltd., the world’s largest owner of supertankers.

The different players have different reasons for storing oil, whether onshore or offshore.”

As to why the futures are trading at such premiums the reasoning is that:

“…OPEC has announced 4.2 million barrels a day of production cuts since September, moves that investors have so far ignored. But markets may be anticipating those output cuts will start to tighten oil supplies later in the year,…

“The OPEC production cuts are going to take time to widdle away the build up in inventories," ... "But if compliance is high, that could support prices looking further out..."

Coming back to the question of WTI and Brent the question that arises is: “How can oil around the globe be priced by a small US location, which doesn’t have a safety valve to deal with a few million extra barrels of oil?” or should Brent become the benchmark as I understand it has no such logistics related bottlenecks. And therefore is Brent now reflecting a truer picture?

The jury is still out on this.

Disclosure: No Positions

Copyright © 2008 Tradesense

Will Asia Provide Diversification?

Having looked at the possible developments in China, the latest news out of rest of Asia is also not good. Factory output in Japan fell more than 8% in November the biggest drop in 55 years. It is also expected that Toyota may report the first ever loss since WWII. According to a Bloomberg report:

“Japan's economy will probably shrink at an annual 12.1 percent pace this quarter (ended Dec 08), the sharpest drop since 1974, as exports collapse,…

… “We expect negative growth will continue for a fifth straight quarter to the April-June period of 2009.

Companies surveyed said they planned to reduce output a further 8 percent this month and 2.1 percent in January. Exports slid an unprecedented 26.7 percent last month from a year earlier.

The data prompted other economists to revise their GDP projections. Bank of America Corp. now predicts an annualized 6.5 percent contraction from a 2.7 percent drop previously estimated.”

Yen at around 90 to a dollar is on a 13 year high and has accentuated Japan’s export woes.

As US and European consumers cut back on spending it is hitting countries like Taiwan and Thailand apart from China & Japan. Excess capacities have been built and unless the situation in US stabilizes the capacities in these countries are going to find it extremely difficult. If the US stimulus does not work for some reason then these countries are going to find it extremely difficult. As US moves from a leveraged and credit based society to a cash flow based, the absorption of the excess capacities may also take time.

Competitive devaluation may also start. Japan has already indicated that it plans to take steps to counter the rising Yen. It said

“…Japan was ready to intervene in the foreign-exchange market for the first time in four years. With the nation’s economy already in recession along with the U.S. and Europe, the surging yen is adding to pressure on exporters…”

Most Asian countries except Japan are expected to see a disinflation or a low inflation and not a deflation. According to a Morgan Stanley report:

“...we highlight that Singapore and Indonesia lie at the two extreme ends of the inflation spectrum. The open nature of Singapore’s economy makes it most vulnerable to build-up of slack, and hence lower pricing power. Moreover, the correction in the real estate cycle is likely to show up in CPI as rental contracts reset with a lag. In the 1998 and 2001 recessions, when GDP growth was -1.4% and -2.4%, respectively, there were three to four quarters of deflation. We expect negative inflation toward 2H09.”

Countries that have economies driven by deficits are the one that will be most affected as global liquidity shrinks and flow of foreign capital reduces compared to the leveraged era gone by.

It appears that diversification strategies will not be easy to implement even in 2009.

Disclosure: No Positions

Copyright © 2008 Tradesense

China’s Possible Hard Landing

We continue with our watch list.

China showing any signs of bottoming out is a function of how its exports perform. Reports say

“…China’s growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, as recessions in the U.S., Europe and Japan cut demand for exports, according to Shanghai- based Industrial Bank Co.

The Purchasing Managers’ Index rose to a seasonally adjusted 41.2 in December from 38.8 in November… A reading below 50 indicates output contracted.

A measure of export orders rose to 30.7 from 29 in November. The output index jumped to 39.4 from 35.5. The new-order index rose to 37.3 from 32.3. November’s levels were the lowest for each of those indexes since the survey began in 2005. …

The economic slide may intensify pressure on the central bank to keep cutting interest rates after five reductions in three months and as the government rolls out infrastructure spending...

…forecasts the key one-year lending rate will fall by at least 81 basis points from 5.31 percent in the first half of this year.”

Earlier it was reported that Chinese exports were down over the past year, the first year-over-year decline since 2001.

The $584bn.China stimulus is expected to start having some impact from the second quarter. But the main factor would be the expected revival of the western markets after the second quarter which would then give a fillip back to Chinese exports. If this for some reason does not happen or is delayed than we may see some serious dumping by China causing prices worldwide to fall and adding to the deflationary trend. This could lead to protectionist tendencies to increase leading to a global slowdown in trade with attendant political and economic consequences.

The politics of trade is likely to increase as it is reported that:

“Obama’s advisers are considering including a “buy American” provision in the economic-stimulus legislation that the incoming administration has made its first priority.

“We are reviewing the buy American proposal and we are committed to a plan that will save or create 3 million jobs, including jobs in manufacturing,” said Jen Psaki, a spokeswoman for Obama’s transition team.”

Experts also opine that one needs to watch the effect of this downturn on China’s labor intensive industries than the capital intensive ones as the unemployment numbers will be largely a function of this. Current urban unemployment is reported to be at 9.4%. Export sector employs about 50mn. of which 4mn. or so have been laid off. It is estimated that any fall of GDP growth rate below 5% can bring in a social unrest. According to a Time report:

“At a December speech, Premier Wen Jiabao confessed to being particularly worried about unemployed workers and university graduates. Even the head of the country's Supreme Court warned judges to take social stability into mind when passing rulings. Overseas, too, worry swelled about just how deeply China's fragile social compact might be shaken by the experience of economic hard times for the first time in 30 years. The Obama administration should have a contingency plan for "what we would do if there's a major collapse of the political order," Roderick McFarquar of Harvard, one of the world's most respected China scholars, recently told a reporter. (See photos here of China on the wild side.).”

China’s downturn can affect certain other neighboring countries too. It is in a way the assembly plant of component and part imports from Japan, South Korea etc.

Hard landing of China could therefore have far reaching effects.

Disclosure: No Positions

Copyright © 2008 Tradesense