Saturday, July 30, 2011

U.S. Debt Woes Mount

It seems as if the United States' debt problems are coming home to roost.

The current conflict in Congress about raising the debt ceiling while putting a plan into place to cut the country's long-term debt shows how dysfunctional America's political system has become.

What will come out of all of this political rancor?

Most likely, a muddle through compromise will be brokered over the next several days. This compromise no doubt will raise the debt ceiling while making token, 'smoke and mirrors' cuts in the nation's debt.

Any token cuts made will be offset by the downgrade to the United States' triple-A credit rating by the credit rating agencies. Surprisingly to me, the rating agencies actually seem to be serious about the downgrade and giving the US a more realistic credit rating.

It is almost laughable seeing all the Wall Street talking heads on the financial news networks saying that the downgrade would be “meaningless”.

The downgrading of US debt would have very meaningful effects.

For example, there are many financial institutions around the globe such as pension funds which are only permitted to own triple-A bonds. This means if US government debt is downgraded to say AA, these institutions would be forced to sell all of their US Treasuries.

Needless to say, this would cause a steep sell-off in US Treasuries and other government-backed bonds.

The recent Wall Street reaction to this debacle shows once again the stupidity that runs rampant in the US financial industry today and passes for “street smarts”.

With a few notable exceptions like Pimco's Bill Gross, what do you think the geniuses on Wall Street are doing in reaction to the pending problems in the Treasury market? Why, of course, they are liquidating other assets and putting the proceeds into the “safe haven” of US Treasuries.

Huh? Did I miss something? Isn't the problem with US government debt?

There is a problem with US Treasuries, so you naturally go and buy more of them. Think of it this way – a nuclear blast has gone off and the geniuses on Wall Street, instead of fleeing, are running full speed towards ground zero. With the money you've invested I might add.

If you're an individual investor who invests on your own, what should you do?

Many of you may recall that I have been telling anyone who would listen to get out of US Treasuries for many months now. It is a bubble waiting to burst.

There are many other government bonds and currencies around the world which are much safer than US Treasuries and the US dollar.

The list of safer countries includes: Germany, Switzerland, Sweden, Norway and Australia. Even France, Canada and New Zealand aren't bad.

There are ETFs traded on the stock exchange which allow you to buy German or Australian government bonds, for instance. And Australian bonds pay about 5% too!

Saturday, July 23, 2011

China's Rising Currency

As the mid-year passes, investors need to look for trends that will influence global financial markets.

One of these trends which has been largely ignored by Wall Street is the emergence of the Chinese currency – the yuan or renminbi. China is slowly but surely internationalizing its currency. This will have a tremendous impact on trade and global financial markets.

Perhaps the real surprise is how little the yuan is used outside China's borders. China is now the second largest economy in the world, the largest exporter of manufactured goods and the largest holder of foreign exchange reserves. Yet the amount of its currency held overseas is negligible. This is a result of China's strict capital controls and restrictions on currency trading.

But that is about to change. The financial crisis has changed attitudes in Beijing. There is now growing support for a greater international role for its currency. China's long-term goal is to have the renminbi become the main currency for doing business in Asia and other emerging regions of the globe.

China's Baby Steps

China is already taking some small baby steps toward making their currency a global currency.

Over the past two years, it has tried to boost the availability of the yuan. China signed currency swap agreements, worth $800 billion renminbi, with central banks in eight countries. These countries are: Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore and South Korea.

Beijing is now strongly encouraging that international trade settlement to be conducted in renminbi. That process accelerated in last June when China expanded its plan to every country in the world and to 20 Chinese provinces and municipalities.

Then last July, the government allowed yuan-denominated financial markets to spring to life in Hong Kong. A month later certain investors, including some central banks were given limited access to China's onshore bond market. Malaysia's central bank is believed to be the first to hold mainland renminbi bonds in its reserves.

The purchase by Malaysia underlines the potential demand for renminbi assets among governments, banks and companies in Asia. A demand that will swamp the current limited investment opportunities.

And just last fall, China and Russia agreed to allow their currencies to trade against each other in spot inter-bank markets. This move will eventually allow the two countries settle their $40 billion in bilateral trade in their own currencies.

The effect of even these small measures has been dramatic. Two years ago, there was zero trade settlement in renminbi. Last year saw about $77.5 billion in trade settlement.

In addition, trading in the offshore renbinbi has gone zero two years ago to about $2 billion a day currently.

For Chinese companies, the attractions of settling cross-border trade in their own currency are clear. Avoiding the US dollar allows them to cut transaction costs and minimize foreign exchange risk. A huge benefit in a world at risk of a global currency war.

Trade Finance Growth

And an increasing number of multinationals are also experimenting with using the yuan in trade deals. This include American multinationals like McDonald's. Additionally, it and Caterpillar are the first two multinationals to issue bonds which are denominated in the renminbi.

This is very likely the beginning of a major trend. Shivkumar Seerapu, the Asia head of trade finance at Deutsche Bank, said “For our corporate clients, US dollars and euros are no longer the de facto currencies of trade.”

Deutsche Bank, Citigroup and JPMorgan are among global banks rapidly building the infrastructure needed to process renminbi transactions across the world.

However, two banks are already well-placed because of their strong positions in Hong Kong, the designated offshore center for the Chinese currency. These banks are HSBC Holdings and Standard Chartered.

The head of transaction banking for North Asia at Standard Chartered, Neil Daswani, says demand for the yuan has been strongest from Hong Kong. But he has also seen strong demand coming from Singapore, Malaysia, South Korea, Japan, the Middle East and the UK.

Trade finance experts believe the use of the renminbi in trade is likely to take off first in Asia. And then between China and other developing countries.

HSBC estimates that within three to five years at least half of China's trade flows with other emerging economies will be conducted in renminbi. This trade flow is valued at about $2 trillion! If this does occur, it will make the yuan one of the top three global trading currencies.

Chinese Currency Investments

It is no wonder then that some people in China have begun calling their currency the hongbi or “redback”. They believe the redback will become a true global rival to America's greenback.

Qu Hongbin, China economist at HSBC, believes the redback-greenback rivalry is for real. He said, “We may be on the verge of a financial revolution of truly epic proportions. The world economy is, slowly but surely, moving from greenbacks to redbacks.”

There are still many hurdles remaining before the renminbi becomes a true global currency. Such as the dense wall of capital controls that limit foreign inflows and outflows of funds.

However, as the yuan starts to play a bigger role in Asian trade settlement, it will lead to a buildup of the currency outside China. Asia's banks and companies will become a powerful lobby of investors wanting increased access to renminbi investments.

Eventually this will lead to China's currency becoming fully convertible. And as Adam Gilmour, co-head of foreign exchange sales for Asia at Citigroup, said “When that happens, I expect a significant amount of the world's reserves to go into renminbi.”

So it is a legitimate investment theme worth putting money into. The problem is that unless you're a major corporation which trades with China, no American can directly get a hold of any redbacks.

The only direct currency options investors have are an exchange traded fund and exchange traded note. They are the Market Vectors Chinese Renminbi/USD ETN and the WisdomTree Dreyfus Chinese Yuan Fund.

Neither offers direct exposure to the Chinese currency. Both are intended to match the currency's movements through the use of various derivatives.

With China gradually widening use of its currency, hopefully better alternatives appear for American investors in the near future.

Sunday, July 17, 2011

Europe's Debt Woes Hit Home

Surely, many American investors are bewildered by what is going on in Europe.

They must think to themselves – 'Greece, and even Ireland and Portugal are such small parts of the European economy, what's the big deal'.

True enough...but the problem is not the Greek economy or the Irish economy. The worries all center around their sovereign debt and whether that debt can ever be paid back to their creditors.

And who are Greece's creditors? Mainly European banks. Banks all across Europe are stuffed to the gills with this paper, which in Greece's case, is trading at about 50-55 cents on the dollar.

If European banks are forced to realize these losses, they will have insufficient capital to function. They then would need to conduct capital raising operations from reluctant investors. Or need huge bailouts from European governments which cannot afford it... in a kind of a vicious circle.

If the contagion spreads to the sovereign debt of large countries, such as Spain and Italy, the very real fear is that the entire European banking system becomes insolvent.

A quick look at the bond markets shows that the contagion has spread from Greece. Irish and Portuguese 10-year bonds are yielding over 11 percent.

Italian and Spanish yields had been treading water for most this year. But now there are signs that their yields are breaking out to the upside. In fact, the 10-year Spanish and Italian bond yields have recently risen to multi-year highs.

Moody's Cuts French Banks

These moves in interest rates may have prompted credit ratings agency Moody's to try to get ahead of the curve a few weeks ago.

It said it may downgrade the credit ratings of France's three biggest banks. These banks are: BNP Paribas, Credit Agricole and Societe Generale.

The reason cited by Moody's is the large exposure of these banks to Greek debt. French banks are major creditors to Greece with $53 billion in overall net exposure to Greek public and private debt according to the latest figures from the Bank for International Settlement.

For example, BNP Paribas had 5 billion euros in exposure to Greek debt at the end of 2010. SocGen had 2.5 billion euros in net exposure to Greek government bonds.

In addition to sovereign debt exposure, Credit Agricole and Societe Generale hold majority stakes in local Greek banks. SocGen's 54 percent stake in Geniki Bank gives it 3.4 billion euros worth of loan exposure in Greece. Credit Agricole's Emporiki Bank had $30.1 billion in outstanding net loans at the end of March.

What was surprising is that Moody's did not go further and threaten to downgrade Germany's smaller state-owned banks – the landesbanken – which are also highly exposed to Greek and other such debt. German banks have direct exposure of $34 billion to Greece.

What Investors Should Look For

There are legitimate concerns that any sort of restructuring of Greek debt will adversely affect European banks and the entire European financial system. The entire system may be at risk as was the US financial system when Lehman Brothers collapsed in 2008.

Greece, and for that matter Ireland and Portugal, will most likely not bring down the European financial system. A default or restructuring of their debt will be unpleasant for European banks.

But it is not catastrophic. They should be able to be successfully re-capitalized and continue to be solvent.

What investors need to look out for is Spain and Italy. These are much larger economies and the exposure to their debt is also much larger. Problems in these two countries will make the current difficulties look like a walk in the park.

That is where American investors concerned about the turmoil in Europe need to focus. Keep an eye on the 10-year bond yields in Spain and Italy. If they break out sharply to the up side, look out...rough seas ahead.

Saturday, July 9, 2011

Oil Market Surprise

There was a real shocker in the oil markets recently, sending prices tumbling.....

Western nations, through the International Energy Agency, announced the impending release of the largest amount of oil from their emergency strategic reserves since 1991.

Over the next few weeks, the IEA will release 60 million barrels of light, sweet crude oil. The release is to be led by the United States which will provide 30 million barrels of oil to the market.

The stated reason behind the release of oil from inventories is to replace the loss of production from Libya.

But the real reason behind the move is a rather different one and shifted the landscape in the oil market permanently.

Weak Global Economy and Politics

In the past, the IEA released oil from its reserves only when a major supply disruption occurred such as the Iraq War and Hurricane Katrina.

But now this release is happening when the only disruption to oil supplies is the minor one in Libya where production has fallen from 1.6 million barrels a day to just 200,000 barrels.

This is where it gets tricky for investors. The IEA decision was one based not on supply/demand or economics, but on politics.

It was a move aimed directly at putting a ceiling on oil prices. It is also intended to, in conjunction with increased Saudi production, bring down the price of oil quickly and sharply.

The reason is obvious. Western economies, particularly the United States, are slowing down rapidly. These economies are struggling with stubbornly high unemployment and consumers hurting from high prices for commodities like fuel. It is a very real effect. Goldman Sachs estimated that the rise in oil prices took $118 billion out of the US economy in the first quarter alone.

A sharp drop in the price of oil will serve as a stimulus to the global economy. This includes the United States where the effects of previous fiscal and monetary stimulus have worn off. The Federal Reserve two weeks ago issued a downbeat outlook for the US economy, emphasizing that growth would be lower than previously expected in 2012.

The US economy looks to be desperately in need of a stimulus heading into 2012 – an election year. Especially since it seems the Federal Reserve will hold off launching QE3 for at least a few months.

And so what do we get? Voila – we get stimulus – a release from the emergency oil reserves when there is no emergency, only an upcoming election.

The stimulus should work too, at least for now. Estimates are that for every $10 rise or fall in crude oil prices, there is a move of about 0.5 percent in the nation's gross domestic product.

Politics entering the equation may have permanently changed the way the IEA works. The IEA, largely controlled by Washington, will apparently intervene much more often now and enter the market with sales from its reserves any time the price of oil is deemed to be “too high”.

Who Benefits

For certain, the change in how the IEA works will put a ceiling on oil prices over the short and medium term.

Who stands to benefit from lower oil prices? Obviously, every consumer of oil on the planet including the United States.

But the ones benefiting the most will be the emerging markets. Consumers in these countries pay a much larger portion of their incomes than Americans do for basic commodities such as food and fuel.

Even the IEA stated that demand for oil is strongest in the emerging world and that countries including China, India and Saudi Arabia are the ones where demand for oil is growing the quickest.

Emerging markets are currently suffering because their central banks are raising interest rates due to rising inflation. Much of that inflation stems directly from soaring prices for commodities like oil.

So a drop in oil prices will likely begin a process where interest rates in the emerging world begin falling again, adding stimulus to already fast-growing economies.

Therefore, the current weakness in emerging market stocks presents a buying opportunity for investors.

But keep in mind that this form of stimulus cannot last for long. If the IEA keeps releasing reserves to lower oil prices, its inventories will eventually become depleted.

And as the IEA tries to restock its oil supplies, adding more demand, that will lead to much higher oil prices in the long term than otherwise would have been expected.

Saturday, July 2, 2011

The US Debt Problem

The old saying “be careful what you wish for” holds true in the investment world at times...such as now.

In the past several days, the stock market enjoyed its best rally in months. This occurred on the back of relief from investors that the Greek debt crisis is resolved, at least temporarily.

But now that the crisis is past, what happens next?

Most likely, the major global players in the bond and currency markets will shift their attention away from Europe and towards the elephant in the room.

That elephant in the room is the United States, its humongous debt, and whether that debt will be downgraded from its current AAA rating.

Treasury Market

During the European crisis, the Treasury market once again served as a “safe haven” for many investors. But now with politicians in Washington bickering about raising the debt ceiling, some investors have left that “safe haven” and Treasury yields are on the rise.

The question is whether the trickle of investors dumping Treasuries turns into a flood.

There are certainly reasons to worry about the nation's debt. The size of the US Treasury market – the amount of debt issued – has more than doubled since 2007. And the Congressional Budget Office (CBO) stated that the country faces a “daunting” budget outlook.

The ratio of US debt to the size of the US economy will approach 100 percent this year. The CBO projects that, without significant policy changes, the federal debt will reach nearly 200 percent of gross domestic product by 2035...a very Greek-like number.

These projections of the long-term position of US debt are what prompted Standard & Poor's in April to revise its outlook on the US credit rating from “stable” to “negative”.

Overseas Rating Agencies

US rating agencies are, however, behind their peers overseas on the outlook for US debt. Several overseas debt rating agencies have already downgraded US debt.

The German credit rating agency Feri downgraded US debt in June from AAA to AA. The reasons it cited were high public debt, inadequate fiscal measures and weaker growth prospects.

The Chinese credit rating agency Dagong downgraded US debt to AA last summer. But now they have taken it a step further.

Dagong now says that the United States has already defaulted on its debt. A Dagong press release said, “In our opinion, the United States has already been defaulting...Washington had already defaulted on its loans by allowing the dollar to weaken against other currencies – eroding the wealth of creditors, including China.”

The default comment is an exaggeration, but they certainly see clearly the Federal Reserve's policy of debasing the US dollar over time.

Will a Downgrade Happen?

The question of a downgrade on US debt by US rating agencies is not simply a theoretical one. If it happens, it will cost investors a bundle.

According to a study from S & P's Valuation and Risk Strategies, a research arm of Standard & Poor's, if US debt is downgraded it will cost investors owning Treasuries a total of up to $100 billion.

Will a downgrade happen? Bill Gross of Pimco – perhaps the most famous bond investor ever – must think so. He has been very vocal over recent months about the United States' long-term fiscal position and has turned negative on US government debt.

However, most investors appear to be very comfortable about US debt and are not worried at all about a downgrade. That is why Treasury yields are so low.

They are probably right. It is doubtful that US rating agencies will bite the hand that feeds them.