Monday, August 13, 2007

Signs of the Economic Apocalypse, 8-13-07

From Signs of the Times:

Gold closed at 681.60 dollars an ounce Friday, down 0.4% from $684.40 at the close of the previous Friday. The dollar closed at 0.7301 euros Friday, up 0.6% from 0.7260 at the previous week’s close. That put the euro at 1.3696 dollars compared to 1.3774 the Friday before. Gold in euros would be 497.66 euros an ounce, up less than 0.2% from 496.88 for the week. Oil closed at 71.47, down 5.6% from $75.48 at the close of the week before. Oil in euros would be 52.18 euros a barrel, down 5.0% from 54.80 for the week. The gold/oil ratio closed at 9.54, up 5.2% from 9.07 at the end of the previous week. In U.S. stocks the Dow Jones Industrial Average closed at 13,239.54 Friday, up 0.4% from 13,181.91 for the week. The NASDAQ closed at 2,544.89 Friday, up 1.3% from 2,511.25 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.80%, up 11 basis points from 4.69 for the week.

Despite a small rise in the stock market last week, the volatility, including a sharp drop on Thursday, still has everyone on edge. There were several reasons for this. First, the maintenance of stock prices at anything resembling their recent levels required a staggering infusion of “liquidity” (in other words, newly created money) by the world’s central banks, $213.6 billion on Thursday and Friday by the European Central Bank, $62 billion by the U.S. Fed). Second, that infusion of liquidity included an unprecedented departure by the U.S. Federal Reserve. This time they actually bought CDO’s (collateralized debt obligations). Usually they buy short term Federal Reserve obligations. This implies that no one else would accept these CDO’s. Finally, there was talk both in the media and at the highest levels of both government of what would happen if China pulled the plug on the United States.

All in all a very interesting week. Let’s look more closely at each aspect. First, the plunge protection team going all out:
Treasuries Decline as Fed Acts to Ease Credit Crunch Concerns

Daniel Kruger and Elizabeth Stanton

Aug. 11 (Bloomberg) -- Treasuries posted their first weekly decline since early July after the Federal Reserve added $62 billion to the banking system to help avert a crisis of confidence in global credit markets.

Yields of two-year Treasury notes, more sensitive than longer-maturity debt to changes in the federal funds target, rebounded from an 18-month low touched yesterday as the Fed, the European Central Bank, and central banks in Japan and Australia provided relief to banks facing elevated money-market rates.

``They'll probably continue to pump in liquidity,'' said Thomas Girard who helps manage $110 billion in fixed income with New York Life Asset Management in New York. ``Overnight and short-dated rates are still firmer than they should be.''

Two-year note yields rose 6 basis points, or 0.06 percentage point, 4.47 percent, according to bond trader Cantor Fitzgerald LP. They touched 4.34 percent yesterday, the lowest since January 2006. The price of 4 5/8 percent notes maturing in July 2009 fell 3/32, or 94 cents, to 100 9/32. Prices and yields move inversely.

The Fed's $38 billion in temporary funds yesterday was the most since September 2001.

``The central banks of the U.S. and Europe are saying they're not going to have a liquidity crunch,'' said Theodore Ake, head of U.S. government bond trading in New York at Mizuho Securities USA Inc. ``They will let the chips fall where they may in terms of bad loans, but they will provide liquidity.''

`Another Shoe'

Trading on fed funds futures indicated traders are certain of a cut in the target rate for overnight lending between banks to 5 percent at the Fed's Sept. 18 meeting and see a 34 percent chance of a reduction to 4.75 percent by the Oct. 31 meeting. Fed policy makers met Aug. 7 and left the rate unchanged at 5.25 percent, where it's been since June 2006.

``The concern is we don't know where or when another shoe is going to drop,'' said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading in New York at Deutsche Bank AG's Private Wealth Management unit.

The yield advantage of 10- over two-year notes rose yesterday to 34 basis points, the biggest since July 2005. For most of December 2005 through May 2007, two-year yields were higher than 10-year yields, reflecting expectations for steady monetary policy that would contain economic growth and inflation.

The Fed's additions yesterday lowered the overnight lending rate between banks to as low as 0.75 percent, below the Fed's 5.25 percent target, according to ICAP Plc. It began the day trading at 6 percent, the highest opening rate since 2001.

`Provide Liquidity'

``The Fed and central banks generally are doing what they're supposed to do, which is provide liquidity in times of stress,'' said Woody Jay, a former head of Treasury trading at Lehman Brothers Inc. who now runs Rock Ridge Advisors LLC, a $255 million hedge fund in Greenwich, Connecticut.

The rise in money-market rates reflects investors' reluctance to provide financing to banks for securities backed by loans after losses in subprime mortgages called into question the value of other types of collateral.

The U.S. central bank conducted its so-called open market operations earlier than usual yesterday, shortly after 8 a.m. in New York, lending $19 billion to dealers and accepting all forms of collateral. It later lent $16 billion and $3 billion. The central bank added $24 billion on Aug. 9.

The central bank normally conducts so-called separate repurchase agreements in which it specifies Treasury, federal agency or mortgage-backed debt as the lowest-quality collateral acceptable, said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.

Treasuries in Demand

Yesterday's agreements accepted all forms, meaning that dealers probably delivered only mortgage-backed securities, enabling them to retain their Treasuries at a time when those securities are in high demand.

The European Central Bank loaned the equivalent of $83.6 billion to banks yesterday after a record injection of $130 billion Aug. 9. The Bank of Japan added 1 trillion yen ($8.5 billion) to the financial system yesterday, the most since June 29, while the Reserve Bank of Australia lent A$4.95 billion ($4.2 billion).

Economists at JPMorgan Chase & Co., the third-biggest U.S. bank, said yesterday in a research note that an August rate cut is ``a genuine possibility.'' The firm last week changed its forecast for monetary policy from a fourth-quarter increase to 5.5 percent to an increase in June 2008.

U.S. Stocks Recover

The Standard & Poor's 500 Index closed little changed yesterday, recovering from a global sell-off, after falling almost 3 percent on Aug. 9. European shares fell yesterday the most in four years, and Asian stocks dropped the most in five months.

The U.S. government's auction of $13 billion of 10-year notes on Aug. 8 drew fewer indirect bidders than average. Indirect bidders, a class that includes foreign central banks, bought 32.1 percent of the auction. In the last eight new 10- year note auctions of the same amount, they bought 39.1 percent on average.

And, no surprise, stocks recovered:
U.S. Stocks Recover as Fed Assuages Lending Concern

Eric Martin and Lynn Thomasson

Aug. 11 (Bloomberg) -- U.S. stocks gained for the first time in four weeks on speculation the government will take steps to avert a lending crisis, helping the market overcome increasing home-loan and hedge fund losses.

The Standard & Poor's 500 Index began the week with the steepest two-day advance in four years, buoyed by a bullish economic outlook from the Federal Reserve. The benchmark was little changed yesterday after the Fed pumped the most money into the banking system since the September 2001 terror attacks and pledged more ``as necessary'' to bolster investor confidence.

``Someone needs to step in and create some stability, and we're seeing the Fed do that,'' said Jason Graybill, who helps manage $750 million at Abner Herrman & Brock Inc. in Jersey City, New Jersey.

The S&P 500 advanced 1.4 percent to 1453.64, recovering from the biggest three-week loss since February 2003. The Dow Jones Industrial Average rose 0.4 percent to 13,239.54. The Nasdaq Composite Index climbed 1.3 percent to 2544.89.

The yield on the benchmark 10-year U.S. Treasury note rose 0.11 percentage point to 4.80 percent this week as the Fed joined central banks in Europe, Japan, Australia and Canada in attempting to prevent a credit crunch.

Stocks tumbled on Aug. 9, with the S&P 500 slumping the most since February, as subprime mortgage contagion and hedge fund losses halted a three-day rally.

Manic, Depressive, Manic

Citigroup Inc., JPMorgan Chase & Co. and Goldman Sachs Group Inc. gained for the week, even after brokerage shares suffered the biggest one-day decline of the almost five-year bull market. Citigroup rose 2.8 percent to $47, JPMorgan climbed 1.4 percent to $44.25 and Goldman advanced 0.5 percent to $180.50.

After the close of trading yesterday, people familiar with Goldman's $8 billion Global Alpha hedge fund said it has lost 26 percent so far this year.

Quantitative hedge funds, including those run by Goldman, Highbridge Capital Management LLC and Tykhe Capital LLC, have lost money as credit spreads widen and volatility jumps, rendering useless their statistical investment models.

``Our market is rapidly swinging from manic to depressive and back to manic in nanosecond moves with each headline acting as a trigger,'' said Frederic Dickson, who manages $17 billion as chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon…

Investors will get clues next week on the health of the U.S. economy. Retail sales rose last month, signaling that a deepening real-estate slump and elevated food and fuel costs are slowing rather than stopping consumers, economists said before a government report.

Purchases rose 0.2 percent after dropping 0.9 percent in May, according to the median estimate in a Bloomberg News survey before a Commerce Department report on Aug. 13. Other reports may show prices increased in July, according to the survey.

The following piece by Floyd Norris of the New York Times offers some historical perspective on the current situation. The global financial system, how money is borrowed and how the risk is calculated, has changed into something new over the last decade or two:
A New Kind of Bank Run Tests Old Safeguards

Floyd Norris

August 10, 2007

A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough.

For a long time, that all seemed to be safely relegated to the past. But now the runs are back — and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.

“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”

This problem has plagued the United States at regular intervals. The Panic of 1907 was halted only when the banker J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.

Then the Depression, with a wave of bank failures, led to the establishment of deposit insurance. With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.

But a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.

Left to deal with the run are the institutions that were created to deal with the old system’s problems — notably the central banks like the Federal Reserve and the European Central Bank. But, in contrast to their close involvement with the banking system, these banks have little regulatory oversight of the securities that are in trouble and may not even know who is holding them.

At the heart of the new system was a decision to have loans financed directly by investors, rather than indirectly by bank depositors. Investors, ranging from hedge funds to wealthy individuals, had confidence in the arrangement because most of the securities were blessed as very safe by the bond rating agencies, like Moody’s and Standard & Poor’s.

The highly rated securities pay relatively low interest rates, but until now there were many willing to own them or to lend money to those who did own them. But there is no reason to hold them if there is any question about their safety — just as there was no reason to keep deposits in a bank that was facing a run amid rumors about its safety.

A result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit. The problem first gained widespread attention when two hedge funds run by the brokerage firm Bear Stearns collapsed and a third Bear Stearns fund had to suspend redemptions as investors sought to get out even though there was no evidence that the fund was in trouble.

“The third Bear Stearns fund announcement was the key,” said Robert Barbera, the chief economist of ITG. “You have to believe that in the hedge fund and mutual fund complexes, there is a decision that is building that says, ‘I want to hold some Treasuries to have a cushion if I see redemptions.’ ”

The basis of the system was a belief that securities backed by bad credit could be very safe — so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages or of loans to highly leveraged companies.

So far, none of those highly rated securities have failed to make their interest payments on time, but that fact is not enough to make anyone want to buy them. The rating agencies have downgraded some securities, and they are tightening their standards for new ratings.

Early this week, stock market investors around the world tried to reassure themselves that nothing was really wrong, and financial stocks bounced back after suffering sharp declines last week. Analysts argued that profits remained strong, as does world economic growth.

On Tuesday, the Fed declined to lower the federal funds rate, saying that despite financial market volatility and a decline in the housing market, “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

But that comforting outlook did not help the credit markets recover, or persuade anyone to buy the newly questioned securities — at least at anything like the prices people had assumed. No one wants to sell the securities at very low prices — and in many cases they have borrowed heavily against them. So the markets have dried up.

Yesterday, BNP Paribas, a major French bank, said it could no longer value three investment funds that it managed, whose assets had been invested in highly rated securities that were backed by dubious mortgages.

“The complete evaporation of liquidity in certain market segments of the U.S. securitization market,” the French bank said, “has made it impossible to value certain assets fairly, regardless of their quality or credit rating.”

Adding to the problem is that the questionable securities are widely owned and sometimes have been repackaged to form the basis of other securities. European banks and funds own paper tied to subprime mortgages, and it is not clear who else does, or how investors will react.

Banks that are worried about their own liquidity decided this week to increase their reserves, which they can do by borrowing from other banks. Loans on such rates rose as a result of the added demand. Both the federal funds rate — the rate on loans of reserves between American banks — and the London Interbank Offered Rate leaped sharply yesterday.

The Fed — which conducts monetary policy by focusing on the fed funds rate — was forced to inject money into the system to bring the rate back down to its targeted level. And the E.C.B. lent almost 100 billion euros ($130 billion), to European banks.

If the current panic is just that — unreasoning fear — then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.

On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.

Yesterday, stock prices fell in Europe and kept declining in the United States, amid speculation over what other owners of the securities might surface as having problems. But American stock prices remain well above the levels they fell to in February, after a sudden drop in the Chinese stock market, and many stock investors still think all will work out acceptably.

The central banks, while clearly crucial to dealing with the loss of faith in the new financial system, lost influence under that system. Loans could be arranged by nonbanks, not subject to bank regulators, and the regulators were hesitant to impose rules that would not apply to all lenders. The lenders sold securities to finance mortgages that let people borrow at rates that — temporarily — were far lower than the Fed envisioned. That delayed the impact of the Fed’s attempts to raise interest rates in 2005 and 2006.

“That is important because it means the decline in the housing market is likely to continue,” Mr. Barbera said. If the American economy does continue to weaken, the Fed may feel forced to reduce interest rates sooner than it had expected, even if that move threatens to hurt the value of the dollar.

Prices in the futures market for federal funds show that just a few weeks ago investors thought there would be no Fed easing this year. Now they seem to think such a move is highly likely, and some expect it as early as next month.

But the Fed’s influence is limited when lenders are suddenly risk-averse. “The impetus of lowering interest rates may not help, if they don’t let you borrow in the first place,” said Kingman Penniman, the president of KDP Investment Advisors.

The new financial system is not the one the Fed was created to deal with, but it is the one it must try to handle.

The following comment (on that video of Jim Cramer on MSNBC) adds some more perspective:

Subprime is an issue, but it's not the issue. Of itself it's nowhere near enough to break the market. What is enough is a spread from subprime into a contagion of other credit / credit derivative markets, and that is what's proved so interesting / alarming about the past few months. Will it or won't it?

There have been multiple distress signals from credit markets, hedge funds and mortgage providers in recent times. All par for the course. However, this morning we saw the london interbank market effectively cease to function. This is the marketplace where banks source their daily funding requirements for ongoing operations.

Interbank liquidity is, absent a black swan every five years or so, a given. The sun rises and sets, the banks lend and borrow. But not today. What these banks were saying was, in effect, "I don't trust any of these other banks enough to give them any cash at 4%pa overnight, because I'm not sure I'll get it back".

Think about that for a minute. I'm pretty sure most of you have your cash sitting at those same banks earning a paltry rate of interest, and I'm pretty sure most of you think it's safe. Well, this morning, following bnp paribas' revelations, the banks weren't so sure. The ECB then had to step in and guarantee any and all funding requirements for the day. About US$120bn all up. They've never had to make this guarantee before.

As a contrast, on 9/11 (the last time a similar operation was engaged) they injected around US$95bn. Without Government intervention, the European banking system may have shut down this morning - or at least operated in a half-arsed illiquid take-it-or-leave-it fashion. In other words, the market 'failed' (to free-market capitalists, the market was doing what it should do, simply re-pricing credit to make it more expensive given all the prevailing uncertainty / risk).

Does all this mean the world's gonna end? Not necessarily. The US Fed, in contrast, added $24bn, net $10bn this morning. Maybe double normal. On 9/11 they added roughly $200bn. So today was no big deal Stateside. Of course the S&P500 may not have agreed, and tomorrow is another day ...

So: Right now there's a lot of apprehensive traders and prudent risk managers and an inappropriately large number of Rumsfeld's unknown unknowns out there. The central banks played failsafe / backstop exactly as the system intended. All we've got for sure is a market that's spooked and running on fear. The danger is that, absent a circuit-breaker - say the Fed lowering interest rates 50bp by end October - is that the fear will lead to a vapourlock and total absence of liquidity in the marketplace. What did Enron in - and LTCM - was not just their leverage, and not just their wrongheaded underwater positions. It was the refusal of their counterparties to allow them any further credit - in effect, asking them to pony up and cover their outstanding debts before they would do any further business with them. Given they were leveraged to the gills, this was of course impossible, and under they went. So what, you ask? Well, unfortunately for all of us the banks operate under a fractional reserve banking system. Just because Cramer's on the excitable side doesn't make him wrong. For the record, though, the central banks' actions to date have been commendable.

Most commentators are spot on in noting the IB's self-interest. The pressure that's being bought to bear on the Fed - and in particular Bernancke - is enormous. There's a concerted PR campaign being waged out there to ensure Bernancke understands that if this goes wrong, he will be hung out to dry by Wall Street. They're after reassurance that the 'Greenspan put' is still alive and kicking ... it's understandable that there's some anger at the 'too big to fail' notion for the financial system, but a word of caution to those above wanting to pull the financial system down around their ears: be careful what you wish for. You may just get ten-fifteen years of tough times in which to work through your schadenfreude.

I won't continue to bore you with detail, but for now all you need to know is:

(1) IB's and hedge funds are holding a pile of toxic / junk credit that no-one can sensibly value;

(2) No-one wants to have this credit sensibly valued, because doing so would lead to massive writedowns / losses across the board. If you don't value it, there are no losses. The wonders of mark-to-market, a la Enron;

(3) No-one, at present, aside from the occasional side deal (Citadel/Sowood) is willing to buy this credit at any price (meaning in effect its value is zero in the current marketplace). The holders of this credit are refusing to accept this as reasonable and believe that eventually 'normality' will return. This concerns me, because it may not.

(4) There is an extensive OTC market in credit derivatives (CDO's, CLO's etc etc) that are priced and traded based on the underlying debt. As the underlying debt cannot be valued, neither can the derivatives. Just how big the losses are in these instruments, and who bears the bulk of these losses, is the big guessing game for now. Its a tangled web that the IB's don't really want to unravel - mainly because they're not sure what they'll find. Sometimes pulling on a single thread can unravel the whole jumper ...

(5) The market could, in its current frame of mind, run to a place where the Fed is forced to bail them out (beyond supplying repo / discount window liquidity, they may have to cut the overnight rate. FYI, the Fed Funds and Eurodollar futures have already priced in the assumption that this will happen. As is typical with markets, they've priced in the endgame well before the whistle is blown.

How this ends up, no-one knows. I'm not a big fan of making sweeping public predictions about market direction, as there's little upside in doing so. We could be back in happyland in three months, or we could spiral into something far more sinister. But there's enough historical synchronies with the current environment to make me wanna pull out my beat-up ol' copy of The Grapes of Wrath and get to reading ...

Now we see why the Fed was buying CDO’s last week. No one else would.

The Fed Is Buying Mortgage-Backed Securities?

PSP: Hoisted from Comments

Fri morning's N.Y. Times online edition:

The E.C.B. injected another 61 billion euros ($84 billion) into the banking system, after providing 95 billion euros the day before. The Federal Reserve today added $19 billion to the system through the purchase of mortgage-backed securities, then $16 billion in three-day repurchase agreements. The Fed also added money on Thursday.

I thought the Fed only bought and sold Federal debt. This says it is intervening directly in the mortgage-backed securities market. Is this as unusual as I think it is?


And, as if all this wasn’t enough, last week China and the United States openly discussed in the media the question of if and when China will pull the plug on the whole Anglo-American empire and financial system.

China threatens 'nuclear option' of dollar sales

Ambrose Evans-Pritchard

August 8, 2007

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.

Xia Bin, finance chief at the Development Research Centre (which has cabinet rank), kicked off what now appears to be government policy with a comment last week that Beijing's foreign reserves should be used as a "bargaining chip" in talks with the US.

"Of course, China doesn't want any undesirable phenomenon in the global financial order," he added.

He Fan, an official at the Chinese Academy of Social Sciences, went even further today, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so.

"China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.

"China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar," he told China Daily.

The threats play into the presidential electoral campaign of Hillary Clinton, who has called for restrictive legislation to prevent America being "held hostage to economic decicions being made in Beijing, Shanghai, or Tokyo".

She said foreign control over 44pc of the US national debt had left America acutely vulnerable.

Simon Derrick, a currency strategist at the Bank of New York Mellon, said the comments were a message to the US Senate as Capitol Hill prepares legislation for the Autumn session.

"The words are alarming and unambiguous. This carries a clear political threat and could have very serious consequences at a time when the credit markets are already afraid of contagion from the subprime troubles," he said.

A bill drafted by a group of US senators, and backed by the Senate Finance Committee, calls for trade tariffs against Chinese goods as retaliation for alleged currency manipulation.

The yuan has appreciated 9pc against the dollar over the last two years under a crawling peg but it has failed to halt the rise of China's trade surplus, which reached $26.9bn in June.

Henry Paulson, the US Tresury Secretary, said any such sanctions would undermine American authority and "could trigger a global cycle of protectionist legislation".

Mr Paulson is a China expert from his days as head of Goldman Sachs. He has opted for a softer form of diplomacy, but appeared to win few concession from Beijing on a unscheduled trip to China last week aimed at calming the waters.

Bush answered with this:

China dollar attack would be 'foolhardy' : Bush

August 8, 2007

AFP - President George W. Bush on Wednesday said China would be "foolhardy" to attempt to push down the dollar in retaliation for US pressure over Beijing's alleged currency manipulation.

Bush said he had not seen the report that Beijing was hinting at such a move, in Britain's Daily Telegraph newspaper, but warned against any attempt by China to hit back at Washington using vast foreign currency reserves.

"That would be foolhardy of them to do that," Bush said in an interview with Fox News, adding he doubted the report was based on sources from the office of Chinese President Hu Jintao.

"If that's the ... position of the government, it would be foolhardy for them to do this."

US Treasury Secretary Henry Paulson meanwhile said on CNBC that suggestions that China was considering selling off dollar denominated assets to hammer the already weakened US dollar were "absurd."

"We have tensions and we have to deal with tensions on both sides ... but overall, both of our countries are committed to a constructive economic relationships," said Paulson, who returned from talks with top leaders in China last week.
China said on Friday it would not be pressured into currency reform as Washington and the US Congress renewed calls for it to speed up changes to make the yuan more market-oriented.

The Telegraph reported that two officials at leading Communist Party bodies had given interviews in recent days warning that Beijing might use more than a trillion dollars in foreign reserves as a political weapon in the event of US sanctions designed to punish Beijing for yuan manipulation.

Described as China's "nuclear option" in the state media, such a move could trigger a crash of the already-falling greenback and a spike in the US bond yields, which could then dampen the beleaguered housing market and put the world's richest economy into a recession.

When asked whether such an option would hurt China more than the United States, Bush said, "Absolutely. I think so."

China reportedly holds some 900 billion dollars in a mix of US bonds.

Bush said the United States and China could resolve their differences "in a cordial way" as opposed to the reported option by Beijing of liquidating its vast holdings of US dollars or through legislation by the US Congress imposing sanctions on China.
He cited a high level "strategic economic dialogue" chaired by Paulson and Chinese Vice-Premier Wu Yi as an effective channel to discuss differences between the two powers.

Bush said the two powers had "a very complex trading relationship" and that it was "very important" for the US economy to have access to the vast Chinese market…

Or, as Paul Craig Roberts put it,

Uncle Sam, Your Banker Will See You Now

Paul Craig Roberts

08/08/07 "ICH" --- - Early this morning China let the idiots in Washington, and on Wall Street, know that it has them by the short hairs. Two senior spokesmen for the Chinese government observed that China’s considerable holdings of US dollars and Treasury bonds “contributes a great deal to maintaining the position of the dollar as a reserve currency.”

Should the US proceed with sanctions intended to cause the Chinese currency to appreciate, “the Chinese central bank will be forced to sell dollars, which might lead to a mass depreciation of the dollar.”

If Western financial markets are sufficiently intelligent to comprehend the message, US interest rates will rise regardless of any further action by China. At this point, China does not need to sell a single bond. In an instant, China has made it clear that US interest rates depend on China, not on the Federal Reserve.

The precarious position of the US dollar as reserve currency has been thoroughly ignored and denied. The delusion that the US is “the world’s sole superpower,” whose currency is desirable regardless of its excess supply, reflects American hubris, not reality. This hubris is so extreme that only 6 weeks ago McKinsey Global Institute published a study that concluded that even a doubling of the US current account deficit to $1.6 trillion would pose no problem.

Strategic thinkers, if any remain who have not been purged by neocons, will quickly conclude that China’s power over the value of the dollar and US interest rates also gives China power over US foreign policy. The US was able to attack Afghanistan and Iraq only because China provided the largest part of the financing for Bush’s wars.

If China ceased to buy US Treasuries, Bush’s wars would end. The savings rate of US consumers is essentially zero, and several million are afflicted with mortgages that they cannot afford. With Bush’s budget in deficit and with no room in the US consumer’s budget for a tax increase, Bush’s wars can only be financed by foreigners.

No country on earth, except for Israel, supports the Bush regimes’ desire to attack Iran. It is China’s decision whether it calls in the US ambassador, and delivers the message that there will be no attack on Iran or further war unless the US is prepared to buy back $900 billion in US Treasury bonds and other dollar assets.

The US, of course, has no foreign reserves with which to make the purchase. The impact of such a large sale on US interest rates would wreck the US economy and effectively end Bush’s war-making capability. Moreover, other governments would likely follow the Chinese lead, as the main support for the US dollar has been China’s willingness to accumulate them. If the largest holder dumped the dollar, other countries would dump dollars, too.

The value and purchasing power of the US dollar would fall. When hard-pressed Americans went to Wal-Mart to make their purchases, the new prices would make them think they had wandered into Nieman Marcus. Americans would not be able to maintain their current living standard.

Simultaneously, Americans would be hit either with tax increases in order to close a budget deficit that foreigners will no longer finance or with large cuts in income security programs. The only other source of budgetary finance would be for the government to print money to pay its bills. In this event, Americans would experience inflation in addition to higher prices from dollar devaluation.

This is a grim outlook. We got in this position because our leaders are ignorant fools. So are our economists, many of whom are paid shills for some interest group. So are our corporate leaders whose greed gave China power over the US by offshoring the US production of goods and services to China. It was the corporate fat cats who turned US Gross Domestic Product into Chinese imports, and it was the “free trade, free market economists” who egged it on.

How did a people as stupid as Americans get so full of hubris?

Roberts calls this a “grim outlook.” It is from a U.S. nationalist perspective. But is it really so grim if China’s economic power over the United States prevents the U.S. from attacking Iran? The following news was most likely not a coincidence:
‘Rival to Nato’ begins first military exercise

Tony Halpin in Moscow

August 6, 2007

Russian and Chinese troops are joining forces this week in the first military exercises by an international organisation that is regarded in some quarters as a potential rival to Nato.

Thousands of soldiers and 500 combat vehicles will take part in “Peace Mission 2007”, organised by the Shanghai Cooperation Organisation (SCO) in the Chelyabinsk region of Russia. Russian officials have also proposed an alliance between the SCO and a body representing most of the former Soviet republics.

Scores of Russian and Chinese aircraft begin joint exercises tomorrow before a week of military manoeuvres from Thursday that will include Tajikistan, Kyrgyzstan and Kazakhstan. At least 6,500 troops are involved in what is described as an antiterror exercise.

Colonel-General Vladimir Moltenskoi, the deputy commander of Russian ground forces, said: “The exercise will involve practically all SCO members for the first time in its history.”

Staff officers from Uzbekistan, the sixth SCO member, will also attend in what is being regarded as a major extension of the organisation’s capabilities. The SCO was founded as a nonmilitary alliance in 2001 to combat drugs and weapons smuggling as well as terrorism and separatism in the region. It has since developed a role in regional trade and is increasingly regarded by Moscow and Beijing as a counterweight to US global influence.

The secretary-general of the Collective Security Treaty Organisation (CSTO) called last week for joint military exercises with the SCO. Nikolai Bordyuzha said that the body representing Armenia, Belarus, Kazakhstan, Kyrgyzstan, Russia, Tajikistan and Uzbekistan should work with the SCO to guarantee security across the region. Mr Bordyuzha has already announced a CSTO plan to create a large military force capable of assisting a member state in the event of an attack. A rapid-reaction force is already based in Central Asia and there are plans for a common air defence system covering most of the former Soviet Union.

Leaders of SCO member states will meet in Bishkek, the Kyrgyz capital, next week for their annual summit. Turkmenistan will also attend for the first time, while Mongolia, Iran, India and Pakistan have observer status.

Igor Ivanov, the head of Russian security, played down concerns in May that the SCO was evolving into a military alliance to counter the expansion of Nato into Asia as part of the War on Terror. But MPs on the Foreign Affairs Select Committee expressed fears last year that the West could be on a collision course in the struggle for energy resources with “an authoritarian bloc opposed to democracy” that was based on an alliance between China and Russia.

A newly assertive Russia, flush with oil and gas revenues, is moving rapidly to increase its military capability amid tensions with the West over missile defence and Nato expansion. Almost £100 billion has been set aside for rearmament over the next eight years.


Blogger The Fundamental analyst said...


I have seen it asserted elsewhere that the Fed is accepting CDO's. However on the Fed website it says it will accept MBS. Is there an assumption that MBS includes CDO's?

Also this is not out of the ordinary as stated again clearly on the Fed website.

Also if you look at the amount of MBS they have actually accepted for repos it is just a fraction of what has been submitted.

Since most of these repos are of 1 - 3 day duration where-upon the owners have to buy them back the assertion that this liquidity was used for the maintenance of stock prices is drawing a long bow indeed.

6:21 AM  
Blogger Blinde Kuh said...

I hope you also read Elaines comments about China and Japans economics. It's really good as long as she keep talking about economy. She predicted the crash some weeks ago, when you couldn't read anything yet in the news.

9:48 AM  
Blogger Donald Hunt said...

Hi Fundamental Analyst,

I did assume that Mortgage Backed Securities include Collateralized Debt Obligations. Is that not true?

In any case, I think central banks' behavior in the last couple of weeks makes clear that they are very concerned, not just about maintaining stock market values, but all financial market values.

You could say, and it has been said (see that these are just normal moves by central banks to maintain targeted interest rates and keep adequate liquidity for normal functioning of financial markets.

But do you REALLY think these last two weeks are at all normal? Do you not think that there has been fear and panic at high levels (whatever you might think about the Plunge Protection Team)? Especially when everyone says that there is no way to adequately judge risk right now with all the levels of derivatives, etc.

9:32 AM  

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