How exhausting is this market? Are you worn out yet? Good. We nearly are too. An oppressive sense of bear fatigue has settled over the Old Hat Factory this week. Perhaps it’s lifting though…
First, the objective facts. Stocks in New York rallied. Nearly all the major benchmarks were up by four percent. The Aussie market has again followed the New York lead. Stocks on the ASX shot up at the open.
Back in America, the Federal Reserve did what everyone expected and cut the Fed Funds rate (the rate at which banks lend to one another) by 75 basis points to 2.25%. Only 225 basis points to go before we hit zero.
For good measure, the Fed lopped another 75 basis points off the discount rate, which now stands at 2.5%. Remember the Fed had already cut the discount rate by 25 basis points on Sunday as part of its counter-attack on the mounting financial crisis.
But the crisis seems to have abated just a bit, at least for the day. You can almost hear the collective sigh of relief from investors all over the planet. This has been an exhausting week, and it’s not even half over.
Here’s an interesting point. The Fed’s decision was not unanimous. Richard Fisher of the Dallas branch of the Fed and Charles Plosser from the Philadelphia branch voted against the big rate cut. The Fed’s minutes said both men “preferred less aggressive action.” Both men—and quite rightly we reckon—fear that the Fed has sown the seeds for massive inflation later this year.
Here’s another thought: absolutely no one on Wall Street wants to be caught dead borrowing from the discount window. It’s not just that it’s embarrassing. Embarrassing is having spinach caught between your teeth during an important business meeting.
Broadcasting to your peers in the financial industry that you are so down on your luck that you have to borrow directly from the Fed…that is a financial death wish. You might as well hang out a sign in front of your offices that says, “short sellers welcome.”
The firm most anxious to avoid attracting negative attention—and losing clients and deposits—is Lehman Brothers (NYSE:LEH), though we reckon Citigroup can’t be far behind. Lehman was probably the biggest winner from Tuesday’s rate cut. Lehman’s shares were up 46% on the day.
Lehman is at the top of many “next domino to fall” lists (details below). But it did not fall yesterday. The company reported a 57% decline in first quarter net income. This was better than Wall Street expected. Lehman earned 81 cents a share, while analysts (for what they are worth) expected 71 cents.
So now we wait.
The banks (investment and retail) have been less than candid about both the quality of their assets and the adequacy of their capital. For example, Bear Stearns had US$46 billion in total holdings of mortgage and asset-backed securities and collateralised debt obligations at the end of last year, according to Brad Hintz at research firm Sanford Bernstein. Meanwhile, the value of the banks tangible equity (the value of its physical assets) was much lower. “Bear’s exposure equaled 424 per cent of its tangible equity,” says Hintz.
Lehman has US$91 billion in total holdings of the same stuff. “Lehman’s shares have plunged because of its large exposure to the mortgage market, which is the highest in the sector at 496 per cent of the bank’s tangible equity.”
Do you think it’s over? Was it over when the Germans bombed Pearl Harbor!? Hell no!
We jest (and quote from Bluto in Animal House). But perhaps it is unfair to scrutinize bank balance sheets for tangible assets. After all, banks are in the money business, not the stuff business. Lehman says it has US$30 billion in cash and US$64 billion in “near cash” assets—assets it can quickly convert to cash if it has to. There is no liquidity problem, Lehman tells us.
Let’s hope that’s the case. We are one more major bank failure away from a Depression style panic. And it’s not even Thursday.
Still, we remind you that the current crisis is both a liquidity AND a solvency crisis. The Fed’s rate cuts at the discount window haven’t dramatically improved inter-bank liquidity. Lending has dried up. The bond market is still shockingly abnormal . There is simply no market for some debt-based securities.
And that brings us to the solvency issue. Banks won’t lend to each other or buy securitised assets because they doubt the asset quality on other bank balance sheets. Whole swathes of mortgage-backed securities are still out there, and still carrying triple A credit ratings, which is so far from the truth that the market isn’t going anywhere higher until its sorted out.
The Fed’s willingness to make money available or to accept mortgage-backed collateral may loosen up credit markets. But it won’t and can’t improve asset quality. The solvency issue—the concern that banks may still be sitting on losses that could wipe out their capital and shareholder equity—won’t go away any time soon.
It won’t go away until losses on mortgage-backed securities are fully realised. We have no idea when that will be. But the Fed’s action merely drags out the day of reckoning.
Hey it’s almost April isn’t it? We are writing a short article about annual coal price negotiations for the next issue of Diggers and Drillers. But what about iron ore? The annual contract between Aussie producers and Chinese consumers is supposed to be concluded by April 1st. But the negotiations appear to be getting a little testy.
“In a move reminiscent of previous iron ore talks, when the Chinese Government sometimes used heavy-handed tactics to pressure the miners, traders in China said Beijing had delayed issuing import permits for March, stranding at least three unloaded cargoes at Xingang port in Tianjin,” reports Andrew Trounson in today’s Australian.
China is reacting to Rio Tinto’s decision to sell more ore into the spot iron ore market, where prices are nearly double last year’s contract price. As you know, Rio and BHP are pushing for a 65-70% increase in the contract price for this year. The Chinese mills, though they are already paying more than that in the spot market, are playing hard ball.
How much can China afford to pay for Australian coal and iron ore and still make money on steel? Profit margins for Chinese steel markers are obviously under pressure. We wonder if there’s a price at which the Chinese decide they can’t make money making steel. We’ve asked Diggers and Drillers editor Al Robinson to investigate. We’ll let you know his findings.
And yesterday we mentioned that the U.S. Dollar index was no longer a useful predictor of how much lower the dollar could go. This was not precisely true. If you to a long-term chart of the dollar index that includes the 1970s, you get a nice downward trend line for the dollar.
Our French currency trading colleague Gabriel reports, “As we saw yesterday, the US Dollar Index is plunging towards unprecedented low levels. It fell roughly 40% since July 2001. Its value on March 18 is 71.89. And you need more than US$1.56 to buy a Euro.
“The dollar index chart shows that a plunge below 70 is probably going to happen. But let’s have a look today at the USD in terms of gold to get a better idea of this impressive decrease in value.
“The U.S. government gave up its policy of convertibility dollar/gold in 1971, due to the fear that it wouldn’t be able to meet increased demand by foreign central banks to convert their growing dollar reserves into gold at $35 per ounce.
“The current price of an ounce (oz) of Gold is 1,005 USD. Let’s then calculate the discount of the Greenback since 1971. In 1971 the price of the ounce was $35, therefore the gold value of the USD was 1/35 oz. Today the current gold value of the USD is then 1/1,005 oz.
“Consequently, in terms of gold, the USD has lost 1/35-1/1,005=> 0.9651=96.51%
This loss of 96.51% is also called a discount, which is an interesting indicator of the depreciation of the USD. It affects not only cash holdings, but also the dollar-denominated assets including bonds, annuities, pensions, insurances etc…
Now on a roll, Gabriel adds this, “The instability and volatility of the Greenback generate a growing crisis of confidence in it. That’s why a few economists already claim it’s time to return to the gold standard, even if this system has its own problems. At least rampant inflation and runaway government spending are not among them.
“Nathan Lewis, author of “Gold: The Once and Future Money” would like to set up a system where the USD value would be fixed to a given quantity of gold. The target of the Fed would become therefore to adjust the money supply to keep a constant value of the dollar in terms of gold. The FED interest rate policy would then disappear as the market itself would set the interest rates, and the USD would no longer move up or down.”
It will probably never happen. The Fed is run by private bankers. The Fed is also a kind of business. Its business is running the money franchise of the American government. It’s a lucrative monopoly to have. And that is why the Fed is so keen to restore confidence in its product.
In the meantime, the dollar gained against gold as the yellow metal fell back below US$1,000 in the futures market. This is the correction in gold we wrote about earlier this week. And it would not surprise us at all to see higher stock prices and lower gold prices as the Fed wages its reflationary campaign.
Many investors are still suckers, and they will rotate out of metals and back into beaten-down financial shares. This is woefully stupid. But hope truly is audacious. Investors are people too. And one of our biggest flaws is that we put our money behind the scenarios we want to be true.
In retrospect, historians will probably say that the Depression began in 2001, with a strong four-year counter trend rally between 2002 and 2006. Then, shortly after the top of the American housing bubble, the credit markets began imploding in mid-2007. Investors routinely convinced themselves that each piece of good news was a turning point and that the worst was behind them. But a bear market in credit has us truly in its firm paws.
No real recovery in financial markets or the real economy can occur until the misallocated capital from the previous credit bubble is liquidated. The Fed is fighting that liquidation tooth and nail right now. Sadly, it has managed to lure some investors back into a market that is still extremely dangerous and likely to head much lower by the end of the year.
It’s going to be a war of attrition, in which paper currencies and financial assets steadily lose ground to real money and real assets. The Fed enjoyed a brief victory. But do not be fooled by rising stock prices, dear reader. In nominal terms, stocks will rise if the Fed’s effort to reflate is somewhat successful. But we’d expect oil and real asset prices to rise faster, relatively speaking.
In any event, this is the Fed’s final stand. It has formidable unconventional resources. It’s going to need them. Tomorrow, we’ll tell show you how we think it’s going to play out, including a key indicator of how weak the dollar can get before it’s abandoned by its international supporters in China and Japan. Until then…
Markets and Money