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Get Ready for the Next Financial CrisisRonald R Cooke Economic forecasting is loaded with risk. There are too many variables that can derail the best of prognostic intentions. But just as I was confident 2007 would produce an economic meltdown, I am now confident we are again entering a period of economic chaos. It would appear 2014 will not be a good year for the world economy. There are far too many unanswered economic and cultural questions to assume the world economy will somehow escape a market crash – followed by a terrible recession. Cheap yens and dollars are being used to fund the appreciation of paper and real assets, including bonds, stocks, gold, and so on. Investment funds can borrow yens and dollars for virtually no cost and reinvest the borrowed funds in other assets. But the yen to dollar trade has become irrational (speculative). On October 1, 2012, the yen was valued at 78 per dollar. By May 23, 2013, it took 32% more yen to buy a dollar (103 yen). Then the value of the yen abruptly increased to ~94 per dollar by June 17, 2013, and just as abruptly decreased in value to 101 per dollar by July 8, 2013. These are massive speculative moves in the yen/dollar trade. Can investors rely on a continuing devaluation of the yen against the dollar? Will the dollar devalue against the yen? Or will both currencies devalue? Since July 8 when it traded at 101 per dollar, the Yen has actually strengthened reaching 96.7 yen per dollar on August 12, 2013. The Bank of Japan has announced it will not expand its monetary injections (which would deflate the value of the Yen). In the meantime, the U.S. Federal Reserve has begun to vacillate about its $85 billion per month Quantitative Easing program (which devalues the dollar). The Fed’s purchase of treasury paper which would otherwise be used as high quality collateral in the lending markets has also reduced the liquidity of paper assets like bonds and stocks. A shortage of high quality treasury paper may force the United States Federal Reserve to taper whether it wants to or not. Since global asset speculation has been chiefly financed by cheap dollars and Yen, these moves suggest a looming liquidity crisis. Margin debt is very high. If highly leveraged speculators are short the yen or dollar, a decline of global liquidity may force a sharp reduction of short positions. Scrambling to cover, speculators will be forced to liquidate their long positions in other dollar denominated assets (stocks, bonds, gold futures, and so on) in order to raise cash. This will bring down most, if not all, of the other financial indexes. Gold, for example, will be caught in a volatile struggle between those who buy it as a safe haven versus those who need sell it in order to cover margin calls. Those who fear a global financial meltdown will buy gold and silver. For speculators, nothing will matter except liquidity. Both Japan and the United States are caught between a rock and a hard place. Japan may have to raise tax rates in order to pay down its massive debt. But that would reduce consumer spending and have a negative effect on Japan’s GDP. On the other hand, if it fails to address its debt challenges, Japan risks a credit market downgrade which would increase its borrowing costs. The United States has already enacted a huge increase in taxes. It’s called Obamacare, and the real cost (drag on the economy) will be felt in 2014. It is likely global investors will force an increase in debt interest costs for both nations no matter what their respective monetary authorities do: i.e. both nations will lose control of their respective monetary policies. Higher interest rates in either Japan or the United States will force an increase in worldwide interest costs. Generally speaking, higher interest costs are not good for the world economy or the markets. But the cost of money is going up. Higher interest rates will decimate the budgets of both nations, forcing a curtailment of government spending. The effect on Japan, however, is likely to be far more devastating because of that nation’s debt load. Bonds will go down in value and interest rates will go higher. Both nations face a sovereign debt crisis. Investors are caught in the middle of a Greece like conundrum. Will Japan default? Will declining asset prices force leveraged speculators to liquidate their long positions? Institutional endowment funds (such as those of universities and colleges), along with pension plans, have been finding it extremely difficult to fund their financial promises. Many have resorted to using hedge funds, or hedge fund techniques, to manage their portfolios. This means they have been forced, like hedge funds, to make extensive use of leverage, shorting, and derivatives to generate higher returns. It also means the equity markets are now subject to the potential chaos of extreme volatility, and a sudden collapse. If a single event triggers a loss of confidence, these speculative positions would have to be unwound in a very short time. It will be a rush to the bottom. Pension and endowment funds will be decimated. According to Deutsche Bank, the existing change in month over month increase in margin debt exceeds 10%, a critical warning signal that the underlying basis of market prices has become fragile. Even a relatively minor sell-off is capable of triggering a collapse as money managers scramble to answer margin calls by liquidating assets. Does speculative margin debt grow exponentially before a market peak? Margin debt peaked shortly before the S&P top in 2000. The real crash happened the following September. Margin debt reached $381.4 billion in July of 2007. The S&P peaked 3 months later. The real crash took almost 11 months to materialize. The New York Stock Exchange reported a U. S. exchange margin of $376.6 billion in June, 2013, down from $384.4 billion in April. Has margin debt peaked for this cycle? Did the S&P top on August 2? Will our current market repeat the precipitous decline of previous corrections? Did late spring margin calls force some of the shorts to sell gold and silver paper in order to increase their liquidity? Are margin speculators over-leveraged? Are recent market moves mostly the result of leverage? Are pension funds and endowments just as vulnerable to margin calls as hedge funds? Are the markets fairly priced? Are Japanese and Chinese investors bailing out of the U. S. markets? Will the Fed lose control of interest rates? Given the very high volume of high frequency trading, will the equity markets become incredibly thin and illiquid in a nanosecond? Will higher interest rates chill the housing market? Which of these factors (or a combination of them) will trigger another financial crisis? Is the world financial system sitting on a house of cards? Many questions: troubled answers. But I could be wrong. You decide. Ron ### Ronald R. Cooke About The Cultural Economist - Ron graduated with an A.B. in Economics from Bates College. He has been an auditor, line manager, computer salesman, marketing manager, product planning manager, and V. P. of Marketing. A management consultant by inclination, Ron has a comprehensive background in business development, product planning, market research, and industry analysis. He has authored multiple market research reports, contracts, business plans and operations research studies for corporate clients in 12 countries. Prior experience includes technology assessment, the evaluation of corporate financial performance, and the negotiation of corporate acquisitions. Ron is a former instructor with UCSC, and developed the curriculum for a science based approach to decision analysis. He has pursued the study of Cultural Economics since 1969, and has authored "Oil, Jihad and Destiny," [Amazon,] a thought-provoking research report on oil depletion (Opportunity Analysis - 2004, and revised in 2007), and "Detensive Nation," a book that redefines the role of government in an Energy Detensive EcoSystem (The Cultural Economist - 2007). 321gold Ltd |
