The trouble with a sovereign debt crisis is that you just never know what the tipping point is going to be. Things can be travelling along nicely with apparent stability and suddenly you find yourself in the middle of a crisis. For the last month we’ve been warning about a sovereign debt crisis in the Western Welfare states. After all, they are the ones (the U.S., UK, Italy, Japan) with high government debt-to-GDP ratios.
But we completely forgot about Dubai. It came up yesterday in conversation briefly with our colleague here in New Zealand under the topic: greatest misallocations of credit in history. We were talking about the wisdom of turning oil money into indoor ski slopes in the desert.
Today, however, we’ll be talking about whether Dubai could default on its debt. German, French, and British stock markets were all down over three percent overnight. The worry in markets is that Dubai could delay its debt payments. It would, according to Bloomberg, be the biggest sovereign debt default since Argentina in 2001.
Dubai World – the group that built an island shaped like the world – has $59 billion in liabilities. It has sought a “standstill” agreement from creditors. That includes $3.52 billion in bonds due on December 14th, which according to our calendar is in a couple of weeks or so.
Dubai World has assets all over the world. It has casinos in Vegas and banks in London and luxury goods stores in New York. Presumably it has assets it could liquidate to pay some of the debt. But there’s a lot of debt.
Bloomberg reports that Dubai borrowed nearly $80 billion over a four-year period. That borrowing – made possible in a way by the income stream from energy exports and rising energy prices – went straight into one of the worlds more impressive and outrageous property booms. But the bust has wiped nearly 50% of property values in Dubai and now this, the risk of sovereign debt default.
And suddenly the move into short-term U.S. Treasuries looks understandable, if not sensible. Emerging markets sold off on the Dubai news. And in the scheme of things, if you’re going to own sovereign debt risk at the moment, perhaps 90-day U.S. paper will cause you the least anxiety. It’s not a major commitment either (thirty years, for example).
How all this plays in Australia today will be interesting. We notice that Australian Small Cap Investigator editor Kris Sayce has trailing stops triggered on three positions over the last two days. Kris is taking profits on energy stocks mostly. The virtue of the trailing stop – other than turning a paper gain into a real profit – is that it makes the decision to sell a lot less emotional. If the stock hits your stop, you hit the sell button and take your money off the table.
However we’re assuming the selling momentum in the market will pick up. Wall Street managed to buck Europe’s negative lead. The Dow managed to close up for the day. And in the currency market, the greenback rallied against a whole basket of currencies, from the Vietnamese Dong to the Brazilian Real to the South African Rand.
That’s the kind of move – paired with the flight to sovereign bonds on the Dubai news – that could produce the dollar short-covering rally we wrote about several weeks ago. When so many people are short (especially with leverage) a short-squeeze can see huge moves in markets as investors and traders are forced to sell leveraged positions (emerging market stocks and high yield currencies) and repay their dollar loans before the currency gets much stronger.
Mind you, as we believe Voltaire once said, all paper currencies eventually reach their intrinsic worth. But between now and then, you might want to buckle yourself up for a powerful U.S. dollar rally. It will defy the fiscal and monetary fundamentals in America. But this market is not trading on fundamentals at the moment.
This mean’s the Aussie dollar’s march to parity against the greenback may be on hold. Even oil dropped off the pace a bit. Another round of global deleveraging would not bode well for economic growth, which would not bode well for oil. For now, only gold seems to be holding the line – perhaps because the demand for gold is not economic but monetary. December gold futures traded up over five dollars to $1,193.80.
Meanwhile, ominous sounds are coming from the U.S. banking industry again. The Wall Street Journal reports that in the third quarter, loans by U.S. lenders fell by the largest amount since the government began tracking such things. Loan balances fell by $210.4 billion, or 3%, according to the Journal.
This confirms the suspicion that banks aren’t lending…at least not to businesses and consumers. Banks are, instead, lending to the U.S. government via purchases of short-term U.S. bills and notes. We dispute the idea that it’s “risk free.” But it probably beats new mortgage lending by a good margin. And some banks – already struggling to stay solvent – wouldn’t be keen to put any more money at risk.
The Journal reports that, “The FDIC’s quarterly banking profile, which analyzed data from 8,099 federally insured banks, reported that 552 financial institutions, with combined assets of $345.9 billion, were on the government’s problem list at the end of September, up from 416 with $299.8 billion of assets at the end of June. That means roughly 7% of all U.S. banks are on the list and face a higher probability of failure.”
That is not a misprint.
It is, however, a warning. The GFC isn’t over. The FDIC story is about a coming American banking crisis. But it will surely affect global liquidity, which makes it an Australian story too.
The Fed began inflating the bond market a year ago with its planned purchases of Treasury bonds and agency debt. By telegraphing its intention to support bond prices, it fed the bond bubble. This pushed U.S. interest rates even lower, which made borrowing dollars to buy other things all the rage.
And 2009 has been all about the rage. Borrowed dollars have bid up assets all over the planet yet again. The debt side of the balance sheet has not been appreciably shrunk, meanwhile. Asset quality at banks has not notably improved. And national governments have actually gone the other way, expanding their liabilities to try and plug the spending gap in the economy left by the departure of consumers from the field.
Here we are at the end of the November, with the whole leveraged financial economy seemingly at another Lehman – like moment. The cost of insuring sovereign debt against default is rising in the Middle East. Investors are tallying up the year’s profits and deciding enough is enough. It’s time to sell and buy some gold and government bonds.
Is this a case of post-Lehman jitters? Is it a minor aftershock to the major temblors of the last two years? Or is it a sign of the “big one” to come? It’s hard to imagine financial events can get any bigger or worse than during the last few years. In fact, we can think of only one, the Great Depression. It’s beginning to look awfully familiar.
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