Where Are The Adults?

Peruse some headlines from this weekend:

The Pin To Pop This Mother Of All Bubbles?

“Metastability” Will Lead To “Cataclysmic Events”

Can We See A Bubble If We’re Inside The Bubble?

Undercurrents Of Worry

The Glaring Resemblance Between 2017 And 1999

Illinois In Massive Crisis

Tax Overhaul In Trouble

Fear Of Contagion In Italy

I can go on and on and on – but you get the idea.

In a nutshell – here is what is occurring:

What has been called the ‘Trump Trade’ is in doubt. The ‘Trump Trade’ was premised on political promises of tax reform, Obamacare repeal, massive deregulation, Dodd-Frank repeal, and so forth. These items appear to be in serious jeopardy due to the political climate in DC. Many markets inflated based on the assumption that these promised legislative changes would become reality. The more that doubt grows that these changes will become reality the more corresponding doubt appears that market investments predicated on those legislative items were a sound investment.

Despite what partisan motivated headlines may declare the economy is weakening – not just in the United States but also globally. Yield curves in various countries are inverting and this is a highly reliable indicator of pending recession. What is more – the demand for credit is weakening significantly. These are not signs of a happy healthy economy. These are reliable signs that the economy is likely to shrink rather than grow in the near future.

Over the last eight plus years the Federal Reserve and central banks around the world re-inflated the real estate and equities bubbles that burst in 2008 and 2009. This was primarily accomplished by adopting negative interest rate policies or zero interest rate policies. These policies by and large remain in place around the globe. The other tool the central banks have used the last eight plus years are liquidity injections. These continue even now at the rate of $200 billion a month being injected in order to keep the system solvent.

In other words – we have fixed nothing since the great meltdown almost nine years ago.

If we enter into a recession in the near future – what will be the policies? Interest rates going even deeper into negative territory? More asset purchases and liquidity injections by central banks? Undoubtedly that is what they plan. The problem with that plan is that every dollar of liquidity injected is marginally less effective than the previous dollar injected. For example, if you are my age and you had an Econ 101 class in college many decades ago you had a textbook that said something to the effect that “Due to the multiplier every dollar of credit introduced produces $4 dollars of economic growth.”

Many people still assume and believe that is true – but it is not. It currently requires about $4 of credit to be introduced in order to generate $1 of economic growth. That ratio has completely reversed – and it is only getting worse. Four years ago, every dollar of liquidity the Federal Reserve introduced produced 73 cents of economic growth – a terrible decline from decades ago – but not nearly as terrible as the first quarter of this year where every dollar of liquidity injected produced only 25 cents of economic growth.

It does not take a PhD to grasp the problem here – and to extrapolate out that in the case of a recession and massive amounts of additional liquidity being introduced that the return on credit will only decline further. The people in charge study Keynes and do not study von Mises and Hayek – if they did study von Mises and Hayek they would have realized long ago that the marginal decline in the effectivity of credit would have been the inevitable outcome.

These are real problems. These problems at some future point will overwhelm the petty melodramas that our politicians allow to engulf their lives and attempt to ensure engulf our lives.

In conclusion, reality is a bitch. All of the play-acting that constitutes American politics will not change the glide path we are on.

Where are the adults in the room when you need them?

Morning Reading

A few articles and posts from this week that are worth your time to read:

Charles Hugh Smith ask “Can We See a Bubble If We’re Inside the Bubble?”– “We want this time to be different so badly, we can almost taste it.”

James Kunstler posted “Things To Come” – “Quite a bit of that wealth was extracted from asset-stripping the rest of America where financialization was absent, kind of a national distress sale of the fly-over places and the people in them. That dynamic, of course, produced the phenomenon of President Donald Trump, the distilled essence of all the economic distress “out there” and the rage it entailed. The people of Ohio, Indiana, and Wisconsin were left holding a big bag of nothing and they certainly noticed what had been done to them, though they had no idea what to do about it, except maybe try to escape the moment-by-moment pain of their ruined lives with powerful drugs.”
Ray Keating wrote “All Uncertainty from Washington Is Not Created Equal” – “As Knight wrote, “The fact is that while a single situation involving a known risk may be regarded as ‘uncertain,’ this uncertainty is easily converted into effective certainty; for in a considerable number of such cases the results become predictable in accordance with the laws of chance, and the error in such prediction approaches zero as the number of cases is increased.” Meanwhile, a “true uncertainty” is a “form of uncertainty not susceptible to measurement.””
Lance Roberts posted “US Jobs Market: Much Worse Than Official Data Suggests” – “President Trump ran on a campaign that repeatedly touted “jobs, jobs, jobs.” His emphasis on jobs creation and bringing employment back to America struck a chord with voters. Trump’s election in itself contradicts the popular narrative that the US jobs market is tight and robust.”
Pedro Nicolaci da Costa “The Fed’s plan to shrink its giant balance sheet dodges the market’s most pressing question” – “The Federal Reserve’s detailed plan for reducing its balance sheet likely starting later this year, presented alongside this week’s interest rate hike, was a bit of obfuscation via transparency.

There was a ton of information, but none of it answered the central question on the minds of investors and bond traders: What will be the balance sheet’s ultimate size?”

Jonathan Garber observed “A predictor with a perfect track record on the American economy is moving closer to signaling a recession” – “An inversion would most likely be a signal that a recession is imminent. An inverted yield curve has a perfect track record of predicting recessions.”
Danielle DiMartino Booth eloquently produced “Housing in America: Movin’ on Up” – “This should be welcome news for renters. (Do you sense a however coming your way?) However, the vast majority of new construction in recent years has been in luxury units. That helps explain why half of would-be renters cannot afford to set out on their own – that $1,300-plus monthly pill is too big to swallow based on the affordability standard of 30 percent of income.

That’s assuming, mind you, you draw a decent salary. According to a recent report detailed in the Washington Post, no city in America has low enough rents on two-bedroom apartments for someone earning minimum wage to call home. All of 12 counties nationwide boast rents low enough for minimum-wage earners to let, that is if they can confine their belongings into a one-bedroom unit.”


Systemic Threat

Let us make a few connections on China, Greece, Europe and Puerto Rico: the common thread on all of these is defaulting on debt. Each debt is a credit to another party. Each of those credits has, in all likelihood, been used as collateral on a derivative of some sort. Due to hypothecation and re-hypothecation it is probable that each of these credits presented as collateral has been used for multiple derivatives.

Grasp that chain. That is the key to understanding what happens from this point forward. This is key to understanding why these different events in far off places matter to your life.

The Chinese markets are highly leveraged, that is that many people and institutions borrowed money to invest in these markets. If these markets dive in value then paying back the borrowed money becomes even more difficult. China in the recent past has prevented people from selling. Each share may have a number associated with it on a board somewhere but if you are not allowed to sell that share then the effective value becomes zero. The inability to pay back these loans will daisy chain into other markets, both in and out of China. Go back to the model, each of those debts taken on to buy stocks is a credit to someone else and that credit has probably been used as collateral.

As I have mentioned before, banks are no longer a bank as we traditionally know them to be. They are now effectively hedge funds and they monetize this credit, not by having you pay back the loan, but by collateralizing that credit. This is the systemic threat. The same model goes for Puerto Rican and Greek bonds.

No single person or entity in the world knows where the trail of counter parties, collateralizing, hypothecation, and re-hypothecation leads. This is a problem that central banks and governments have in trying to react to this problem.

Another problem is that, due to our electronic trading and communication ability, this can theoretically melt down worldwide in milliseconds. It is on cruise control.

Yet another problem is that, due to the ability to hypothecate and re-hypothecate, the same credit collateral has been used over and over again to secure more debt. For example there are nearly $700 trillion in the notional value of derivatives the world over. This is secured by about $70trillion in collateral. To make it worse, due to be able to use the same collateral over and over, the actual base value of the collateral securing all of that $700trillion is estimated at $7-10trillion.

As debts are defaulted on there is a scramble for the ‘quality’ collateral. As you can see from the numbers above, there is not a seat for everyone when the music stops. In fact there will be a seat for hardly anyone.

To summarize: each debt represents a credit that has been collateralized many times over. In a default situation, if that credit has been collateralized ten times, nine of those counter parties will not be made whole. Because those nine would of used that derivative which is now in failure as collateral for even more derivatives you end up with a cascading failure.

This is the systemic threat to the world that China, Europe and Puerto Rico represent today.

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