The Baltic Dry Index is a daily average of prices to ship raw materials. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for brokering shipping contracts. The index is quoted every working day at 1300 London time. The Baltic Exchange is similar to the New York Merc in that it is a medium for buyers and sellers of contracts and forward agreements (futures) for delivery of dry bulk cargo. The Baltic is owned and operated by the member buyers and sellers. The exchange maintains prices on several routes for different cargoes and then publishes its own index, the BDI, as a summary of the entire dry bulk shipping market. This index can be used as an overall economic indicator as it shows where end prices are heading for items that use the raw materials that are shipped in dry bulk.
The BDI is one of the purest leading indicators of economic activity. It measures the demand to move raw materials and precursors to production, as well as the supply of ships available to move this cargo. Consumer spending and other economic indicators are backward looking, meaning they examine what has already occurred. The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it.
Economic Implications
This index is one of the purest leading indicators of economic activity. It measures the demand to move raw materials and precursors to production. Consumer spending and other economic indicators are backward looking, meaning they examine what has already occurred. The BDI offers a real time glimpse at global raw material and infrastructure demand. This could also be gleaned from looking at commodity prices, but there are substitution effects and futures contracts that make it difficult to interpret the impact of commodity price fluctuations. Additionally, nearly all commodities are seeing severe increases in prices in 2008 regardless of supply situations as investors seek to hedge their inflation exposure with hard assets.
Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it. [5] The BDI will show how much a company or country is willing to pay to import raw materials immediately. For example, if a Chinese company has contracted out coal prices for the next year from Rio Tinto (RTP), then the spot price of coal increasing after a mine accident will not impact that established contract. However, when this company is willing to pay more per ton to ship the coal than to actually purchase it, an investor can see that price growth is accelerating.
Price Increases Passed To Businesses/Consumers
As the BDI increases, so effectively does the cost of raw materials. This cost associated with procuring the materials must be passed along the value chain by producers and refiners. In the end, consumers will see higher dry bulk rates in the higher prices they pay for goods derived from these raw materials. For example, when Folgers pays an extra $10/ton to import coffee beans, they will pass along this increased procurement cost to consumers to maintain margins.
Additionally, imported goods may often carry a BDI factor in the prices. An example of this would be the average Chinese imported good. As China transformed from coal exporter to importer, they began buying coal from nations such as Russia, Brazil, and Australia. The coal from the latter two must be shipped using dry bulk carriers. As the rates for the BDI went up in 07, so did the cost of coal to China. Since coal is used for 70-80% of China's energy generation, [6] overhead costs for factories increased with the price of coal. As the overhead costs increase, so must the price of the end good to maintain the margin of profit. As this end price increased, an American paid more for a t-shirt or toy at Wal-Mart.
Key Trends and Forces
* Commodity Demand - This is determined mainly by industrial production and energy demand. If commodity demand is strong, BDI rates will increase regardless of spot rates for those commodities. Companies that have contracted out spot rates will show increased demand through paying more for shipping of the materials. As more coal and steel are being demanded by China, so will the rates for dry bulk shipping increase.
* Fleet Supply - This is determined by the number of available ships, their capacity, and the utilization rates. Additionally, the average age of the fleets will determine where they are in the life cycle. The average ship lasts 25 years. If the average is closer to that number, supply will be decreasing in the short term. Also, supply is greatly determined by delivery of new vessels. Currently, there is significant back logged demand for new vessels. No new orders are being taken for delivery before late 2009. With this backed up supply, BDI prices soared in 2007. With rates for the largest dry bulkers fetching nearly 10x that of a comparable VLCC Oil Tanker, many companies converted tankers into dry bulk carriers.[7] As conversions and ships contracted to be built at the beginning of the price run up in 2006 come on line, the upward pricing pressure of a fleet in which 41% of its ships are over 20 years old will be held at bay.[8]
* Seasonal Pressures - Weather has a major impact on both demand and logistics. For demand, cold weather may increase the demand for coal and other energy creating raw materials. For logistics, cold weather may cause ice to block ports and low rivers to prevent travel. Both of these cause increases in the BDI. Conversely, a mild winter or early ice breakup in cold water parts will cause decreases in the BDI.
* Bunker Prices - Bunker fuel is a type of fuel oil a ship uses for propulsion. Bunker fuel accounts for between a quarter and a third of vessel operating costs. Higher crude oil prices also mean higher bunker fuel prices which will be reflected in higher BDI prices. So, just as higher oil prices will put a damper on Airline company margins, they will squeeze margins for dry bulk operators. High bunker fuel prices in 2008 caused many companies to instruct their crews to decrease ship speeds to conserve fuel, thereby increasing shipping times- which causes the BDI to rise. A new (2008) trend in the shipping industry is the recent development of a "skysail," a ship propulsion augmentation system consisting of a paraglider-type airfoil and an electronic deployment and control mechanism that uses wind to help propel ships and thereby save bunker fuel costs[9].
* Choke Points Nearly half of the world's oil passes through a few narrow shipping lanes. This includes the straights of Hormuz and Malacca, the Bosporus and the Suez and Panama canals. These geographic choke points cause natural caps in the number of ships that can pass through each day, month or year and therefore also limits the bulk tonnage capacity of certain shipping routes. If anything disrupts the flow of ships through the choke points, the BDI will increase. The narrow (52 mile wide) Bering Strait (also called the "Bering Gate" in the shipping industry) may soon become the world's newest strategic "choke point" for shipping [10].
* Market Sentiment - Because of the time lag in forecasting demand for raw materials, market opinion can greatly affect the freight exchange. [11] The recent halving of the index's value can be attributed to many companies forecasting lower global growth and cutting their production/demand targets.
* Port Congestion -This acts as another great buffer against supply increases lowering index prices. The actual infrastructure of these ports prevents more ships entering the market. The ports simply cannot handle more traffic. Until major changes occur at these vital terminals, there will be upward pressure on dry bulk prices. Shipping industry analysts [2] are actually developing an index to standardize and make available this incredibly vital data.
* Labor Relations - Nothing is loaded or unloaded from ships without labor. Labor relations at various ports around the world directly affects the BDI. For example, in the U.S. both the ILA (International Longshoreman's Association) and the ILWU (International Longshoreman's and Warehouse Union) exert enormous control over the labor at ports. Labor relations issues include: intentional work slowdowns, company lockouts, strikes and political boycotts. Labor unions have expressed their political power and influence in the past by boycotting products from apartheid South Africa, protesting the war in Iraq and even the Soviet Invasion of Afghanistan[13]. Labor relations impacts on the Baltic Dry Index should not be underestimated by the sophisticated investor.
* Piracy - Although piracy has been a constant factor affecting shipping for thousands of years, 2008 saw some significant piracy events including the capture and ransom of the MV Sirius Star, a Saudi owned oil supertanker seized by pirates off the coast of Somalia. Pirates are also holding crews hostage for significant ransoms as in the case of the MV Faina, a Ukrainian arms shipping vessel. Interpol and other global law enforcement agencies are investigating the connections of various organized crime groups that may be bankrolling and organizing pirate groups including those based in Somalia. Various nations including the U.S., Canada, France, U.K., Russia, Ukraine and China are now deploying warships to patrol the coast of Somalia. These factors put additional upward pressure on the BDI[14].
* New Arctic Shipping Routes - Shipping from Europe to China by means of the arctic offers a route distance savings of approximately 4000 miles, which is a large percentage of the non-arctic total route distance. Of course, the historical search for the Europe-China route was the reason for the discovery of the "New World" (America). With oil prices (Bunker Fuel) at 1st Q 2009 lows, arctic shipping may or may not be economical. But during mid-2008 oil prices, a 4000 mile route saving offered significant fuel and time savings. Discussion among scientists attending the March 2009 "Copenhagen Conference" suggests that the predictions by the 2007 UN- IPCC Report on Climate Change regarding the likely clearing of arctic sea ice has underestimated the rate of clearing and by 2013 arctic shipping may become feasible. Although the shipping industry remains highly secretive, the potentially significant economic advantages have caused many international shipping companies to begin analyzing and planning for potential new arctic routes. Shipping industry intelligence indicates that China is interested in potential deep-water ports in Iceland. Arctic routes do not currently affect the BDI but may in the near future[15].
Wednesday, November 18, 2009
Baltic Dry Index at 2009 high and what it means
LONDON (Commodity Online): The Baltic Dry Idex (BDI), the global benchmark for freight costs for dry bulk commodities has a hit a 2009 high of 4381 points as bids rose for the Capesize vessels that transport iron ore and coal to China. Analysts have described BDI as the purest leading indicators of economic activity as it measures the demand to move raw materials and precursurs to production, as well as the supply of ships available to move this cargo.
The Financial Times quoting Peter Norfolk of SSY Consultancy and Research said that at the start of 2009, 170 Capesize vessels were on order for delivery this year but new ship availability amounts to only 35 vessels at present due to congestion and scrappages and the fact that some greenfiled shipyards have either not been built or have not delivered on schedule.
The Baltic Dry Index is a daily average of prices to ship raw materials. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for brokering shipping contracts. The index is quoted every working day at 1300 London time. The Baltic Exchange is similar to the New York Merc in that it is a medium for buyers and sellers of contracts and forward agreements (futures) for delivery of dry bulk cargo. The Baltic is owned and operated by the member buyers and sellers. The exchange maintains prices on several routes for different cargoes and then publishes its own index, the BDI, as a summary of the entire dry bulk shipping market. This index can be used as an overall economic indicator as it shows where end prices are heading for items that use the raw materials that are shipped in dry bulk.
BDI measures the demand to move raw materials and precursors to production, as well as the supply of ships available to move this cargo. Consumer spending and other economic indicators are backward looking, meaning they examine what has already occurred. The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it. [1]
The index is maintained by the Baltic Exchange. The cargoes being moved are raw material commodities such as coal, steel, cement, and iron ore. The prices of underlying contracts are determined by the buyers and sellers, and then the exchange takes 20 different routes throughout the world for various materials and averages them into one index. The index does not concern itself with finished goods or container ships, only raw materials and dry bulk specific ships are factored into the calculation.[2] It also factors in all four sizes of oceangoing dry bulk transport vessels.
The Baltic Dry Index, had its ups and downs this year as in August first week it fell 17.2% from 3,350 to 2772 on falling coal and iron ore imports by China. At that time China's steel mills were locked in negotiations with foreign miners over import of iron ore and there fore, BDI fell to one of the lowest levels.
The Financial Times quoting Peter Norfolk of SSY Consultancy and Research said that at the start of 2009, 170 Capesize vessels were on order for delivery this year but new ship availability amounts to only 35 vessels at present due to congestion and scrappages and the fact that some greenfiled shipyards have either not been built or have not delivered on schedule.
The Baltic Dry Index is a daily average of prices to ship raw materials. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for brokering shipping contracts. The index is quoted every working day at 1300 London time. The Baltic Exchange is similar to the New York Merc in that it is a medium for buyers and sellers of contracts and forward agreements (futures) for delivery of dry bulk cargo. The Baltic is owned and operated by the member buyers and sellers. The exchange maintains prices on several routes for different cargoes and then publishes its own index, the BDI, as a summary of the entire dry bulk shipping market. This index can be used as an overall economic indicator as it shows where end prices are heading for items that use the raw materials that are shipped in dry bulk.
BDI measures the demand to move raw materials and precursors to production, as well as the supply of ships available to move this cargo. Consumer spending and other economic indicators are backward looking, meaning they examine what has already occurred. The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it. [1]
The index is maintained by the Baltic Exchange. The cargoes being moved are raw material commodities such as coal, steel, cement, and iron ore. The prices of underlying contracts are determined by the buyers and sellers, and then the exchange takes 20 different routes throughout the world for various materials and averages them into one index. The index does not concern itself with finished goods or container ships, only raw materials and dry bulk specific ships are factored into the calculation.[2] It also factors in all four sizes of oceangoing dry bulk transport vessels.
The Baltic Dry Index, had its ups and downs this year as in August first week it fell 17.2% from 3,350 to 2772 on falling coal and iron ore imports by China. At that time China's steel mills were locked in negotiations with foreign miners over import of iron ore and there fore, BDI fell to one of the lowest levels.
US urges China to strengthen renminbi
President Barack Obama on Tuesday urged China to strengthen its currency as tensions over exchange rates and trade broke through a carefully orchestrated show of co-operation between Washington and Beijing.
Mr Obama made his comments after a three-hour meeting on Tuesday in Beijing with President Hu Jintao, during which both leaders pledged to work together on a long list of pressing international issues.
However, the US president also joined in the growing chorus of international voices calling on China to allow the renminbi to appreciate.
“I was pleased to note the Chinese commitment made in past statements to move toward a more market-oriented exchange rate over time,” he said at a joint appearance with Mr Hu in the Great Hall of the People. Such a move would “make an essential contribution to the global rebalancing effort”.
The reference to “past” statements could imply that China did not make any new commitments on Tuesday. Mr Hu did not mention the currency issue in his own statement, although he did call on both governments to refrain from protectionism, a veiled criticism of recent US trade measures on Chinese steel pipes and tyres.
“I stressed to President Obama that under the current circumstances our two countries need to oppose all kinds of trade protectionism even more strongly,” he said.
Coming at a time when Chinese prestige is growing and the US is facing enormous difficulties, Mr Obama’s trip has symbolised the advent of a more multi-polar world where US leadership has to co-exist with several rising powers, most notably China.
Although the public appearance on Tuesday had been billed as a press conference, the two leaders did not take any questions from the media and made only prepared statements, adding to the impression that Mr Obama’s visit has been one of the most tightly scripted in recent years and frustrating his hopes to speak more directly to the Chinese people.
In their comments and in a nine-page joint statement, the two governments spelled out a programme for ever-growing co-operation including stronger ties between their militaries, joint research initiatives on climate change and clean energy and even “a dialogue on human space flight”.
On Iran, where the US has been pushing China to take a harder line against Tehran, Mr Obama spoke with stronger language.
“We agreed that the Islamic Republic of Iran must provide assurances to the international community that its nuclear programme is peaceful and transparent,” he said. “Iran has an opportunity to present and demonstrate its peaceful intentions but if it fails to take this opportunity, there will be consequences.” Mr Hu said it was important to try to resolve the issue through negotiations.
China’s currency has been effectively pegged to the US dollar since the middle of last year and in recent weeks a number of international officials and governments have complained at the advantage this gives Chinese exporters, given the current weakness of the dollar.
Dominique Strauss-Kahn, managing director of the International Monetary Fund, called again on Monday at a conference in Beijing for a stronger renminbi “the sooner the better”.
He Yafei, one of China’s vice foreign ministers, defended China’s exchange rate policy. “In the process of tackling the financial crisis, keeping the RMB stable not only was a contribution to fighting the crisis but also helped stabilise global financial markets,” he said.
In recent days, several senior Chinese officials have criticised the US Federal Reserve, arguing that loose monetary policy in the US was creating bubbles in asset prices and endangering the global recovery. Yu Yongding, a researcher at one of China’s leading government think-tanks and a former member of the central bank monetary committee, said on Tuesday that Europe and China “should play together and put pressure on the US to change its monetary policy”. China and much of the world was being held “hostage” by US monetary policy, he said.
Mr Obama made his comments after a three-hour meeting on Tuesday in Beijing with President Hu Jintao, during which both leaders pledged to work together on a long list of pressing international issues.
However, the US president also joined in the growing chorus of international voices calling on China to allow the renminbi to appreciate.
“I was pleased to note the Chinese commitment made in past statements to move toward a more market-oriented exchange rate over time,” he said at a joint appearance with Mr Hu in the Great Hall of the People. Such a move would “make an essential contribution to the global rebalancing effort”.
The reference to “past” statements could imply that China did not make any new commitments on Tuesday. Mr Hu did not mention the currency issue in his own statement, although he did call on both governments to refrain from protectionism, a veiled criticism of recent US trade measures on Chinese steel pipes and tyres.
“I stressed to President Obama that under the current circumstances our two countries need to oppose all kinds of trade protectionism even more strongly,” he said.
Coming at a time when Chinese prestige is growing and the US is facing enormous difficulties, Mr Obama’s trip has symbolised the advent of a more multi-polar world where US leadership has to co-exist with several rising powers, most notably China.
Although the public appearance on Tuesday had been billed as a press conference, the two leaders did not take any questions from the media and made only prepared statements, adding to the impression that Mr Obama’s visit has been one of the most tightly scripted in recent years and frustrating his hopes to speak more directly to the Chinese people.
In their comments and in a nine-page joint statement, the two governments spelled out a programme for ever-growing co-operation including stronger ties between their militaries, joint research initiatives on climate change and clean energy and even “a dialogue on human space flight”.
On Iran, where the US has been pushing China to take a harder line against Tehran, Mr Obama spoke with stronger language.
“We agreed that the Islamic Republic of Iran must provide assurances to the international community that its nuclear programme is peaceful and transparent,” he said. “Iran has an opportunity to present and demonstrate its peaceful intentions but if it fails to take this opportunity, there will be consequences.” Mr Hu said it was important to try to resolve the issue through negotiations.
China’s currency has been effectively pegged to the US dollar since the middle of last year and in recent weeks a number of international officials and governments have complained at the advantage this gives Chinese exporters, given the current weakness of the dollar.
Dominique Strauss-Kahn, managing director of the International Monetary Fund, called again on Monday at a conference in Beijing for a stronger renminbi “the sooner the better”.
He Yafei, one of China’s vice foreign ministers, defended China’s exchange rate policy. “In the process of tackling the financial crisis, keeping the RMB stable not only was a contribution to fighting the crisis but also helped stabilise global financial markets,” he said.
In recent days, several senior Chinese officials have criticised the US Federal Reserve, arguing that loose monetary policy in the US was creating bubbles in asset prices and endangering the global recovery. Yu Yongding, a researcher at one of China’s leading government think-tanks and a former member of the central bank monetary committee, said on Tuesday that Europe and China “should play together and put pressure on the US to change its monetary policy”. China and much of the world was being held “hostage” by US monetary policy, he said.
Short View: Dollar carry trade
Just hours before US president Barack Obama arrived in China, the country’s chief banking regulator said the US was fuelling “speculative investments” and endangering global recovery through loose monetary policy.
Hours after the president landed, Ben Bernanke, US Federal Reserve chairman, said he did not think new asset price bubbles were forming in the US. Who is right? Near-zero interest rates in dollars are one reason for the rush for higher-yielding assets, from US and European stocks to emerging market equities to corporate bonds and commodities. Indeed, creating demand for risky assets is part of the point.
What is not clear is how dangerous it is. A so-called “carry trade” of borrowing in dollars in low rates to invest in higher-yielding assets could be reversed as soon as US interest rates rise or the currency shifts. If there is a rush for the exits, some investors fear a knock-on collapse in prices of assets.
Though some investors are likely to be borrowing in dollars, it may not be that widespread. “Money and credit have been quite weak, suggesting that asset price movements have not been fuelled by increased leverage that would leave financial intermediaries vulnerable to a reversal of recent gains,” said Donald Kohn, Fed vice-chairman, this week. In the US, as well as in Europe, bank lending continues to fall. The amount lent against securities in the repurchase, or repo, markets is also well below the peaks of 2008.
The problem with measures of leverage in the financial system is they ignore market psychology. If nothing else was reinforced by last year’s market gyrations, it is panic travels fast. Aggregate positions also may not reveal build-ups in particular trades, which present particular exit dangers. Leverage is down, but a lack of leverage in markets does not mean there will be a lack of volatility.
Hours after the president landed, Ben Bernanke, US Federal Reserve chairman, said he did not think new asset price bubbles were forming in the US. Who is right? Near-zero interest rates in dollars are one reason for the rush for higher-yielding assets, from US and European stocks to emerging market equities to corporate bonds and commodities. Indeed, creating demand for risky assets is part of the point.
What is not clear is how dangerous it is. A so-called “carry trade” of borrowing in dollars in low rates to invest in higher-yielding assets could be reversed as soon as US interest rates rise or the currency shifts. If there is a rush for the exits, some investors fear a knock-on collapse in prices of assets.
Though some investors are likely to be borrowing in dollars, it may not be that widespread. “Money and credit have been quite weak, suggesting that asset price movements have not been fuelled by increased leverage that would leave financial intermediaries vulnerable to a reversal of recent gains,” said Donald Kohn, Fed vice-chairman, this week. In the US, as well as in Europe, bank lending continues to fall. The amount lent against securities in the repurchase, or repo, markets is also well below the peaks of 2008.
The problem with measures of leverage in the financial system is they ignore market psychology. If nothing else was reinforced by last year’s market gyrations, it is panic travels fast. Aggregate positions also may not reveal build-ups in particular trades, which present particular exit dangers. Leverage is down, but a lack of leverage in markets does not mean there will be a lack of volatility.
Mother of all carry trades faces an inevitable bust
Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.
This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.
So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.
People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.
So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.
The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.
But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.
This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.
So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.
People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.
So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.
The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.
But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.
Be Prepared for the Worst
The large-scale government intervention in the economy is going to end badly.
Any number of pundits claim that we have now passed the worst of the recession. Green shoots of recovery are supposedly popping up all around the country, and the economy is expected to resume growing soon at an annual rate of 3% to 4%. Many of these are the same people who insisted that the economy would continue growing last year, even while it was clear that we were already in the beginning stages of a recession.
A false recovery is under way. I am reminded of the outlook in 1930, when the experts were certain that the worst of the Depression was over and that recovery was just around the corner. The economy and stock market seemed to be recovering, and there was optimism that the recession, like many of those before it, would be over in a year or less. Instead, the interventionist policies of Hoover and Roosevelt caused the Depression to worsen, and the Dow Jones industrial average did not recover to 1929 levels until 1954. I fear that our stimulus and bailout programs have already done too much to prevent the economy from recovering in a natural manner and will result in yet another asset bubble.
Anytime the central bank intervenes to pump trillions of dollars into the financial system, a bubble is created that must eventually deflate. We have seen the results of Alan Greenspan's excessively low interest rates: the housing bubble, the explosion of subprime loans and the subsequent collapse of the bubble, which took down numerous financial institutions. Rather than allow the market to correct itself and clear away the worst excesses of the boom period, the Federal Reserve and the U.S. Treasury colluded to put taxpayers on the hook for trillions of dollars. Those banks and financial institutions that took on the largest risks and performed worst were rewarded with billions in taxpayer dollars, allowing them to survive and compete with their better-managed peers.
This is nothing less than the creation of another bubble. By attempting to cushion the economy from the worst shocks of the housing bubble's collapse, the Federal Reserve has ensured that the ultimate correction of its flawed economic policies will be more severe than it otherwise would have been. Even with the massive interventions, unemployment is near 10% and likely to increase, foreigners are cutting back on purchases of Treasury debt and the Federal Reserve's balance sheet remains bloated at an unprecedented $2 trillion. Can anyone realistically argue that a few small upticks in a handful of economic indicators are a sign that the recession is over?
What is more likely happening is a repeat of the Great Depression. We might have up to a year or so of an economy growing just slightly above stagnation, followed by a drop in growth worse than anything we have seen in the past two years. As the housing market fails to return to any sense of normalcy, commercial real estate begins to collapse and manufacturers produce goods that cannot be purchased by debt-strapped consumers, the economy will falter. That will go on until we come to our senses and end this wasteful government spending.
Government intervention cannot lead to economic growth. Where does the money come from for Tarp (Treasury's program to buy bad bank paper), the stimulus handouts and the cash for clunkers? It can come only from taxpayers, from sales of Treasury debt or through the printing of new money. Paying for these programs out of tax revenues is pure redistribution; it takes money out of one person's pocket and gives it to someone else without creating any new wealth. Besides, tax revenues have fallen drastically as unemployment has risen, yet government spending continues to increase. As for Treasury debt, the Chinese and other foreign investors are more and more reluctant to buy it, denominated as it is in depreciating dollars.
The only remaining option is to have the Fed create new money out of thin air. This is inflation. Higher prices lead to a devalued dollar and a lower standard of living for Americans. The Fed has already overseen a 95% loss in the dollar's purchasing power since 1913. If we do not stop this profligate spending soon, we risk hyperinflation and seeing a 95% devaluation every year.
Any number of pundits claim that we have now passed the worst of the recession. Green shoots of recovery are supposedly popping up all around the country, and the economy is expected to resume growing soon at an annual rate of 3% to 4%. Many of these are the same people who insisted that the economy would continue growing last year, even while it was clear that we were already in the beginning stages of a recession.
A false recovery is under way. I am reminded of the outlook in 1930, when the experts were certain that the worst of the Depression was over and that recovery was just around the corner. The economy and stock market seemed to be recovering, and there was optimism that the recession, like many of those before it, would be over in a year or less. Instead, the interventionist policies of Hoover and Roosevelt caused the Depression to worsen, and the Dow Jones industrial average did not recover to 1929 levels until 1954. I fear that our stimulus and bailout programs have already done too much to prevent the economy from recovering in a natural manner and will result in yet another asset bubble.
Anytime the central bank intervenes to pump trillions of dollars into the financial system, a bubble is created that must eventually deflate. We have seen the results of Alan Greenspan's excessively low interest rates: the housing bubble, the explosion of subprime loans and the subsequent collapse of the bubble, which took down numerous financial institutions. Rather than allow the market to correct itself and clear away the worst excesses of the boom period, the Federal Reserve and the U.S. Treasury colluded to put taxpayers on the hook for trillions of dollars. Those banks and financial institutions that took on the largest risks and performed worst were rewarded with billions in taxpayer dollars, allowing them to survive and compete with their better-managed peers.
This is nothing less than the creation of another bubble. By attempting to cushion the economy from the worst shocks of the housing bubble's collapse, the Federal Reserve has ensured that the ultimate correction of its flawed economic policies will be more severe than it otherwise would have been. Even with the massive interventions, unemployment is near 10% and likely to increase, foreigners are cutting back on purchases of Treasury debt and the Federal Reserve's balance sheet remains bloated at an unprecedented $2 trillion. Can anyone realistically argue that a few small upticks in a handful of economic indicators are a sign that the recession is over?
What is more likely happening is a repeat of the Great Depression. We might have up to a year or so of an economy growing just slightly above stagnation, followed by a drop in growth worse than anything we have seen in the past two years. As the housing market fails to return to any sense of normalcy, commercial real estate begins to collapse and manufacturers produce goods that cannot be purchased by debt-strapped consumers, the economy will falter. That will go on until we come to our senses and end this wasteful government spending.
Government intervention cannot lead to economic growth. Where does the money come from for Tarp (Treasury's program to buy bad bank paper), the stimulus handouts and the cash for clunkers? It can come only from taxpayers, from sales of Treasury debt or through the printing of new money. Paying for these programs out of tax revenues is pure redistribution; it takes money out of one person's pocket and gives it to someone else without creating any new wealth. Besides, tax revenues have fallen drastically as unemployment has risen, yet government spending continues to increase. As for Treasury debt, the Chinese and other foreign investors are more and more reluctant to buy it, denominated as it is in depreciating dollars.
The only remaining option is to have the Fed create new money out of thin air. This is inflation. Higher prices lead to a devalued dollar and a lower standard of living for Americans. The Fed has already overseen a 95% loss in the dollar's purchasing power since 1913. If we do not stop this profligate spending soon, we risk hyperinflation and seeing a 95% devaluation every year.
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