Before we launch in today’s instalment of the Markets and Money, let us quickly correct an error. Sunday is the free Gold Investment Day for the Gold Standard Institute’s conference this weekend in Canberra. You can see the program for it here. That’s the day your editor will be speaking about “Five monetary events to watch for in the next five years.”
If you want to attend the presentations and discussions over the next four days, you can still do so. But you should contact conference organiser Marcus Matthews today. You can reach him via email at email@example.com. And if you’re there on Sunday, be sure to say hello.
Yesterday we promised to show you how the funding model for the fiscal welfare state is blowing up. But this is going to have to wait at least another day. Don’t worry though. It’s not going anywhere.
Today, there is a banking story to cover. You recall that yesterday we were worried about the next banking crisis. But the lingering effects of the last one are still with us. National Australia Bank reported a 43% fall in net profit yesterday. Ouch.
Don’t feel too bad for NAB. Net profit fell from $4.54 billion to $2.56 billion. But the bad and doubtful debts charge for the year grew by 53% from $2.49 billion to $3.82 billion. With $654 billion in assets and $616 billion in liabilities, the bank is sitting on $37.8 in equity. A few billion in bad debts and loan losses won’t wipe out that amount of equity.
But it’s worth noting that NAB’s total assets are 17.3x times equity. This isn’t as high as some leverage ratios in the U.S. just prior to the banking crisis in 2008. But it’s not far off where NAB was at the time. And there are two further risks worth mentioning.
First, as the IMF paper on Aussie banks concluded earlier this year, Aussie banks are probably strong enough to withstand a normal shock to the balance sheet. That is, the IMF stress-tested Aussie banks for losses on their two largest loan portfolios – corporate loans and mortgages. The IMF concluded the banks were adequately capitalised to survive the shocks it tested for, but that, “The above shocks do not constitute a rigorous stress test and the results are only indicative of the health of the banking sector.”
If we’ve learned one thing in the last two years, it’s that bankers and analysts have consistently underestimated the frequency and magnitude of systemic shocks. That doesn’t mean the IMF conclusions aren’t to be trusted. But it means in the event of another more severe shock, the banks could face larger asset writedowns and losses than the IMF has modelled.
This brings us to the second risk worth mentioning. A bank facing bigger loan losses takes fewer risks. It reduces lending. This is how the credit crisis was transmitted from America’s housing market to Australia’s economy. The Aussie banks had to tighten up to prepare for losses on overseas assets.
Next time around, though, we reckon the losses – when they come – will be on domestic real estate assets. And with so much exposure to domestic real estate (mortgage loans), the assets could face a world of hurt. But even if bank asset quality doesn’t crash (housing prices don’t crash), an external shock affects Aussie bank liabilities.
The IMF report says that, “On the liabilities side, however, banks had sizable short-term external debt obligations, and access to offshore wholesale markets was disrupted by the Lehman Brothers collapse in September 2008.” Of course the government’s wholesale funding guarantee eased the pain of this shock, which is one reason why that guarantee may become permanent in all but name.
But the IMF wrote that, “A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks’ wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore. Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009.”
Maybe the short-term external debt levels have improved in the last six months. We haven’t checked yet. But in simple terms, it means a lot of domestic lending is funding from external funding, borrowing abroad to loan at home. If American banks again blow up on the destruction of their remaining collateral (mortgage loans and U.S. Treasury bonds) we’d predict another ice age in global credit markets.
Needless to say, as a capital importer, this would put Australia in an awfully uncomfortable spot. But hey! No one is worried about that at the moment. The Aussie dollar is being inflated by the U.S. dollar carry trade. It’s a shame that the strong Aussie is going to devastate local industry and manufacturing with higher costs, but at least it obscures for now the risk that Aussie banks are reliant on foreign borrowing.
In the bigger picture, this means the investment needs of the economy can’t be met by household savings alone. But that’s an even bigger problem than we can address today. So we won’t!
And what about our theory that a U.S. dollar rally will trigger a correction in gold, oil, and stock markets and lead to a mini-rally in U.S. Treasury bonds? Bond fund king Bill Gross agrees. Writing on Pimco’s website, Gross concedes, “Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets — while still continuously supported by Fed and Treasury policy makers — is likely at its pinnacle.”
Dr. Doom himself, analyst Nouriel Roubini, called the present market “The mother of all carry trades.” “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals,” Roubini said via satellite to a conference in Cape Town, South Africa. “The risk is that we are planting the seeds of the next financial crisis.”
With the S&P up nearly 65% since touching 666 in March (seriously), we’d say the seeds are already bearing fruit. But maybe it’s poisoned fruit. After all, the rally has been worldwide and extremely impressive by historical standards. But it’s fully consistent with previous bear market rallies. If anything, it’s happened faster.
What nobody yet knows is if it IS a bear market rally…or a garden variety stock market rally that precedes a recovery in the economy. You know what we think.
There IS one notable difference between 2008 and today, though. Yesterday we mentioned that U.S. banks have loaded up on a whole other kind of super-dodgy collateral; U.S. Treasury notes and bonds. Demand for those securities may go up with a U.S. dollar rally and a reversal of the dollar carry trade. But in the longer-term, we think the banks have invited another toxic house guest on to the balance sheet.
But where did the previous smelly houseguest go? You know, all those mortgage backed securities and subprime loans? Where does that risk now reside? And what happens if it comes home to roost?
According to this report by the San Francisco Federal Reserve, over 95% of all new residential mortgage lending in the U.S. is now being backed directly by the U.S. government. With the banks unable or unwilling to lend, Uncle Sam has become the sugar daddy of the U.S. mortgage market. See the chart below.
The Fed supports this market by purchasing the securitised mortgages issued by Fannie and Freddie. The Congress funds the agencies which make the loans available. But no matter how you slice it, the U.S. government is supporting the housing market. It will continue to do so as a political imperative.
But by taking on this massive liability – not that it doesn’t already have its hands full – the Fed is further consigning the dollar to the scrapheap of history. Do you think foreign creditors will not realise that the U.S. is borrowing money to keep house prices elevated? Will they not notice that the U.S. is printing money to do this? And what will happen to the dollar then? And gold?
The truth is that creditors already do know this. Today’s Australian Financial Review reports that overseas Chinese investment is “surging.” Chinese policy makers are trying to trade dollars for tangible assets or equity in resource shares as quickly as possible. “China reported a 190% jump in overseas investment by its companies for the third quarter.”
“Policymakers might be encouraging Chinese firms to invest abroad, in part to help counter pressure for the nation’s currency,” the article continued. “Investors are betting on the yuan to appreciate as China’s growth accelerates from its weakest pace in a year.”
Most currencies that are not the U.S. dollar could appreciate in the coming years. Australia’s currency has already done so. Brazil is considering a tax on capital flows into the country in order to prevent investors from speculating on a further rise in its currency by buying Brazilian assets. And of course speculators have tried for years to find a way to position themselves for an appreciation in China’s currency. China’s capital markets are not friendly in this regard, although Hong Kong stocks remain a popular option.
The fact that countries like Australia, China, and Brazil are trying to limit currency appreciation versus the greenback shows you how unbalanced the world economy still is, how unprepared it is for the reality that America’s deleveraging will take place for years. Households and businesses must save and repair balance sheets. Some other country is going to have to consume what the world produces.
In the interim, the U.S. government will increase deficit spending to make up the difference. It is the stupidity of Keynesianism to support aggregate demand when what everyone needs is a correction and a recovery. But all the Feds will succeed in doing is blowing up the balance sheet of the U.S. government in spectacular fashion. Go gold.
Mind you we still think the short-term move is a dollar rally and some profit-taking on the dollar carry trade. We asked Slipstream Trader Murray Dawes what he sees when looking at the U.S. dollar index. Murray spends most of his time finding trading opportunities in Aussie stocks. But he also knows that Aussie markets (and capital flows) are still massively affected by what’s going on in America.
Murray wrote that, “If we look at this chart of the US Dollar index going back to 1985, you can see quite clearly that the 10 week moving average crossing over the 35 week moving average has been a very good indicator of the trend. There are only a few instances over that whole time period where this indicator gave a false signal.”
“Therefore,” Murray continues, “we should be keeping an eye on this indicator going forward to tell us whether the US Dollar index has turned back up and is ready for a counter trend rally. The short US Dollar trade is getting pretty full, as I have mentioned in the past. And there is a high correlation between the direction of the dollar and the direction of gold, oil and stocks.
“The US Dollar has taken over the Yens role of funding the carry trade and this will be the situation for as long as the Fed remains too scared to raise rates, which seems to be for the foreseeable future. So we can probably expect the dollar to weaken further over the long term, but a counter trend rally (short squeeze) may be closer than people think and this would lead to weakness in commodities and stocks.
“When should we trade this move? Well have a look at the chart again. Notice the false breaks that keep occurring when the all time lows get breached (denoted by the numbers 1,2,3). With the trend still strongly down we can expect to see either a false break of the lows around 71 reached last year or if that doesn’t occur then a crossover of the 10 week/35 week moving average to confirm that the trend has changed. Trading the move before either of these are confirmed would be jumping the gun.”
Murray is tracking which Aussie stocks will move if and when we see the dollar index break out. We’ll keep you posted.
for Markets and Money