From Brian Rogers of Fator Securities
Macro Commentary: The endgame of TBTF banks and rising rates
Global markets are stabilizing a bit after authorities worldwide are pulling out all the stops to stem the bloody tide. Greece and South Korea have followed Italy’s recent lead and even banned the short-selling of equities. Brazilian Finance Minister Mantega said the G-20 was prepared to take action to calm the global crisis. The concerns over the debt levels of Italy, a country which is Too-Big-To-Bailout, are quickly spreading to the US as Citigroup and Bank of America both fell over 15% yesterday. Personally, I don’t think it’s necessary to bifurcate these two problems much, both the Italian crisis and the TBTF bank sell offs in the US represent the same thing, potential threats to the banks that make up the $700tr derivative market. The $60tr global economy can take a haircut on billions of dollars in Greek debt, but it simply cannot take a haircut on $700tr in global derivatives sitting on the balance sheet of every major government, hedge fund, financial services company, TBTF bank, insurance company and major corporation that engages in any hedging activity. Greece, Italy, Spain, Portugal and Ireland could all simply restructure their debt and life would go on were it not for the leverage of the banks that hold them. In the US, real estate could be allowed to fall to its market clearing price or be written off by the lender were it not for the leverage of the banks that own it. No matter which way you turn, all roads lead to the TBTF banks, their leverage and the $700tr derivatives market. Until these issues are resolved, we will continue to go through bouts of panic, instability and market routs. The entire global economic system is threatened by the continued status quo regarding our TBTF banks and the global derivatives market. Everything else is just noise. Governments can be upgraded or downgraded, currencies can rise and fall and equity markets can rally or sell-off. But if one of the TBTF banks collapses, the game will change immediately to one of fear and collapse as the size of the potential asset write-downs that will follow is simply overwhelming.
What about QE3?
As many know, I have been banging the drum that the Fed would eventually be forced to launch QE3 because they really have no choice. In my opinion, they have painted themselves into a liquidity trap with a prisoner’s dilemma. More QE3 means more manipulation of the rates curve and thus less clarity as to the true cost of money which causes markets to lose their informational value. It also potentially means more inflation which is absolutely the last thing the Fed wants right now. There is also the issue of political weakness. After the failures of QE1 and QE2, the PhDs at the Fed aren’t exactly looking like the Oracle’s of Delphi that they’d like you to think they are. So I think it’s an open question if the Fed will do anything. My heart tells me they will as Bernanke will resolve himself not to blink as his predecessors did in the 1930s. He will climb in his helicopter with buckets of money and begin pouring them down on an economy that he is sure will revive itself with more liquidity. If he chooses to do QE3, it seems logical to me that he will go big, probably into the trillions. As I’ve argued before, too little QE and the market will be underwhelmed, his only bet is to go really big. Which means the Fed will continue to spread their economically transmitted diseases (ETDs) all over the world with reckless abandon. Remember, the Fed can choose how much money to print, but they cannot control where that money goes. As QE2 showed, much of it went into hard commodities which is why food and energy prices have jumped so much in the last 12 months. Will they be willing to take the same risk on QE3? We should know later today.
It’s all about rates
Regardless of the action the Fed takes today, it’s important to note that thus far the pain has been mainly felt in the equities markets. This isn’t meant to be comforting, especially if you own equities, but so long as rates are staying low, the game will continue. Stock markets can rally and sell-off, and they will, perhaps sometimes too far in one direction or another, but the status quo will live another day because rates remain low. Treasuries aren’t rallying now due a flight-to-quality bid, they are rallying simply due to their size and liquidity. It is the highest rated, largest, most liquid market available so it rallies but it’s certainly not due to quality. As we go forward, it’s becoming more and more important to remember the latter part of the 70s into 1980. We had slow growth then, we have slow growth now. We had high inflation then, we have rising inflation now. Gold/silver was rising then, gold/silver is rising now. The USD as world reserve currency was called into question then, same thing today. But the big difference then was rates. Rates needed to rise, aggressively, to quell the growing inflation. Fed Chairman Paul Volker was up to the challenge and raised rates to 20% to kill the inflation dragon. It worked. He caused a recession that lasted well into 1983 but it worked. Today, Bernanke has no such option. He cannot raise rates, even a modest amount, without further calling into question the weak position of the US balance sheet and potentially causing more sovereign credit downgrades. So even though no one is happy with equity markets falling globally, just be glad it hasn’t hit the US Treasury market yet. Because when rates begin to rise materially in the US, there will be no flight to quality except precious metals. Many of us agree that the USD should not be the world’s reserve currency but make no mistake that when the day eventually comes where this transition is to begin in earnest, rates in the US will likely rise to levels that slow everyone’s growth and pressure the entire global economic framework. -Brian
* Fator Securities LLC, Member FINRA/SIPC, is a U.S. entity and a subsidiary of the Fator group of companies in Brazil. The comments below are from Brian Rogers, who is employed by Fator Securities (Brian’s opinions are his own and do not constitute the opinions of Fator Securities or the Fator group of companies).
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