Special Report: A Global Economy Pushed To Its Limits

Sep 26, 2011

A Global Economy Pushed To Its Limits

By: Douglas Ashburn, Contributing Editor

Back in 2005, as Alan Greenspan neared the end of his tenure as chairman of the Federal Reserve, he was faced with a situation where the actions of the Fed did not lead to the desired outcome. At the time, Greenspan was in the process of systematically raising the Fed funds rate to slow asset prices rises in an overheating economy. The back end of the yield curve, however, would not cooperate. In fact, long bond yields actually fell 100 basis points. He famously referred to this phenomenon as a “conundrum.”

Of course, we all know how the story unfolded. Greenspan (and then Fed Chairman Ben Bernanke) could not stop the asset bubble from forming, nor could they engineer a “soft landing.” Eventually, the yield curve inverted, portending a recessionCredit markets seized up as the bubble burst. Hundreds of financial institutions failed and/or required bailouts, including “too big to fail” institutions such as AIGCitigroupBear StearnsWashington Mutual, Countrywide and Lehman Brothers. A “Great Recession” ensued, which featured unprecedented actions by the world’s regulators, central banks and fiscal authorities. While early reactions were positively received, by mid-2011 the global economy has slowed to a crawl and another recession may be imminent.

As the crisis unfolds, we are faced with a new conundrum, one that touches all nations and all asset classes. Policy actions have been largely unsuccessful and fraught with unintended consequences. The Fed has exhausted its “conventional’ options and is now delving into “unconventional” territory. In this John Lothian News special report, we take a broad look across our family of newsletters to offer a complete picture of the new global economic conundrum.

The debt market conundrum centers around the fact that zero interest rates have a limited effect during a deleveraging cycle. Banks will not loan money if the underlying collateral is eroding in value, or if the borrower’s ability to maintain a payment schedule is in doubt. Quantitative easing and fiscal stimulus did little to stoke aggregate demand and have left the U.S. on shaky ground.

The Fed’s newest tactic of swapping short-term debt for log-term debt, dubbed Operation Twist, is embedded with potential pitfalls. For example, a flattening of the yield curve, even if intentional, has been a reliable precursor to recession. Additionally, lower long-term yields would cause further strain on public and private pension plans, already at record levels of underfunding. Lower yields also punish retirees and other savers, who must either cut back on consumption or invest in riskier assets in an attempt to maintain current levels of income. Since cheap debt and risky investment were the causes of the crisis, they are not likely to be the solution.

The foreign exchange conundrum involves a nation’s tendency to depress its currency in hopes of stoking or protecting its export sector. The problem arises when all nations simultaneously engage in this tactic. Every country cannot be a net exporter; someone must be a net importer. Until the last crisis, this task of conspicuous consumption fell to the U.S. This time, however, the U.S. found itself fiscally incapable of maintaining its level of consumption, especially as the dollar eroded in value. Last week’s panic, however, was accompanied by a rapid appreciation of the dollar, similar in fashion to the 2008 crisis. The dollar is rallying amid a freefall in general asset prices, though, so is unlikely to usher in a new era of U.S. consumerism.

An additional FX conundrum involves emerging market currencies. Until recently, many developing nations had been practicing currency debasement, in hopes of exporting their way out of their problems. India, Brazil and Southeast Asia central banks now find themselves propping up their currencies to prevent a rout. A depressed currency may encourage exports, but a worthless currency will lead to capital flight; a far worse problem.

The conundrum has extended to the metals market as well. Over the past two years, low yields and fiscal profligacy have encouraged a rapid rise in commodities and metals in what many call a bubble. The rationale for the bubble was inflation protection and non-correlation with traditional assets. As the European sovereign debt crisis reached the panic stage, the dollar re-emerged as the prime safe haven. This led to a massive selloff in the metals market. Gold was down $100 per ounce on Friday. Silver lost 25 percent of its value in two trading sessions. In general, metals have followed the stock market too closely to be considered a hedge. Following suit, the CBOE Volatility Index (VIX) hit 29-month highs as well, forcing the Chicago Board Options Exchange to raise margins there as well.

There is a regulatory conundrum afoot as well. The 2008 financial crisis caused many to lose faith in capital markets. Regulators across the globe responded to the crisis by promising greater transparency and an end to “too big to fail” financial institutions. Global “systemically important” institutions have argued that enhanced reserve, margin and loss absorbency requirements will further constrain capital formation at a time when it is needed most. Just this past week, JP Morgan CEO Jamie Dimon called for the U.S. to pull out of the Basel III agreement. As the previously unregulated $400 trillion swaps market comes under CFTC and SEC jurisdiction in the U.S., market participants have systematically called for a watering-down of Dodd-Frank regulations. Essentially, the world’s financiers are arguing that the global economy is too fragile to be regulated.

The same argument is being used to counter environmental regulations. Any impediment to growth in consumption must be removed. Since the dawn of the Industrial Revolution, the formula for economic growth has been the conversion of fossil fuels to economic output. Negative externalities such as environmental degradation are “necessary evils” that can be mitigated but not eliminated. Too much mitigation, however, will truncate growth, which may cause some entities to cut corners on environmental protection. A changing climate brings its own set of costs, however. Without clean air and water, quality of life and productivity decrease; medical costs increase.

This set of challenges and policy moves are likely to shape the global economy for years, if not decades. And for those charged with finding solutions, this is a conundrum, indeed.

Interest Rates

Economic Signals Heighten Worries of a Double-Dip
Wall Street Journal
Is the world heading for another recession?
Fresh data Thursday pointed to a decline in manufacturing activity in both China—a critical engine of the global recovery—and Europe, a sign businesses are bracing for
slower growth. Compounding the concern is the political paralysis in Europe and the U.S., where rival parties are divided on how to respond to the crisis.
**Also from this piece: “The IMF this week cut its forecast for 2011 global growth by a third of a percentage point, to 4%, from its estimate three months ago. It predicted the U.S. would grow at 1.5% this year—or half the pace of growth needed to keep up with the expanding labor force. The IMF estimated euro-zone growth of 1.6%, and expects Japan’s economy to contract.”

IMF’s Blanchard Says World Economy Has ‘Enormous Risks’ Now
By Bob Willis and Tom Keene, Bloomberg
European officials need to convince investors that European Union countries aren’t at risk of becoming another Greece as they forge ahead with their own deficit-cutting measures, said Olivier Blanchard, chief economist at the International Monetary Fund.
**Also from this piece: “Clearly the danger is in Europe. First, you have to make clear that the other countries are not like Greece. On this, the news is actually quite good.” – Olivier Blanchard, chief economist at the International Monetary Fund.

Fed Will Shift Treasury Holdings to Longer-Term Securities
By Scott Lanman, Bloomberg
Federal Reserve policy makers will replace much of the short-term debt in their portfolio with longer-term Treasuries in an effort to further reduce borrowing costs and keep the economy from relapsing into a recession.
**Find the FOMC September 21 statement here.
**CN: What is Operation Twist, and why the name? Read more about the effort on the Operation Twist page in MarketsWiki.

G20 promises collaboration to boost world economy
USA Today
The Group of 20 leading advanced and emerging economies are vowing to work together to boost the struggling global economy and financial system. The G-20 voiced the resolve in a statement, saying its finance ministers and central bank governors are “committed to a strong and coordinated international response to address the renewed challenges facing the global economy.”


Currency Wars Shift Toward Intervention
So much for the global battle to hold currencies down to keep a competitive edge. Now authorities around the world are intervening to prop them up in the wake of a mad scramble for dollars, especially in export-orientated Asia.
**Besides Brazil jumping in to strengthen the real, Asian central banks “are suspected of intervening this week to defend their currencies, including those in South Korea, Indonesia, Thailand, India, the Philippines, Singapore and Taiwan.”

Greek default talk gathers pace
Talk of a possible Greek default gained pace on Friday while a pledge by the world’s major economies to prevent Europe’s debt crisis from undermining banks and the global economy failed to lift financial markets for long.

Asian currencies end week with steep losses
Financial Times
Steep declines in Asian currencies this week have delivered a stark reminder to investors that the region remains as vulnerable as ever to financial shocks from the west.


Gold loses lustre as haven asset
Jack Farchy – Financial Times
It wasn’t supposed to be like this. Gold, touted as the ultimate haven, was supposed to rise in a crisis. And yet in the past four days, its behaviour has been in line with the riskiest of assets.

Gold tumbles as investors scramble for cash
Gold fell on Monday, buckling under the weight of the strength of the dollar as investors scrambled for cash in the face of mounting fear over the impact of a potential Greek debt default on the euro zone economy.

Copper: Red bull
The Economist
The locked doors of a public library in West Norwood, a drab part of south London, are an unlikely economic indicator. But a plaintive note explaining the closure—thieves have stripped the roof of its copper cladding, letting in rain on the books below—hints at profound changes to the global economy. And copper is the metal most intimately affected.
**The price movements in ‘Dr Copper’ are “widely believed to prefigure shifts in the world economy”; as copper prices continue to fall, even as supply issues begin to emerge, many are worried about what it says for the global economy


VIX Discount Erodes on European Concern
Options show traders expect Europe’s debt crisis to engulf the U.S. as contracts to protect against losses in the Standard & Poor’s 500 Index erase the gap with the euro region’s benchmark gauge.
The Chicago Board Options Exchange Volatility Index increased 33 percent last week to 41.25, bringing it within seven points of the 29-month high reached Aug. 8. The VIX, as the gauge is known, has eliminated more than half the discount to Europe’s VStoxx Index in the past week, cutting it to 7.3 points from 15 on Sept. 12, data compiled by Bloomberg show.

VIX Futures Margins Raised for 4th Time Since August 
Traders in the market’s most popular volatility futures faced higher margin requirements Friday for the fourth time since early August.
The Chicago Board Options Exchange said late Thursday it would raise minimum margin requirements for contracts tied to the CBOE Volatility Index, also called the VIX or “fear index.” VIX futures are used to construct often-complex bets on swings in the stock market, or to hedge against those swings.

CFE Extends VIX Futures Opening Time to 7 AM (CT) Starting September 26
CBOE Futures Exchange, LLC (CFE) today announced that beginning on Monday, September 26, the CBOE Volatility Index (VIX) futures contract opening time moves to 7:00 a.m. from 7:20 a.m., pending regulatory approval. The 3:15 p.m. closing time for VIX futures remains unchanged.
The earlier opening offers market participants more time to establish or offset VIX futures positions surrounding potential market-moving events — overnight news, banking actions or key economic reports — before the general market opens.

Energy & Environment

Carbon Market Loses ‘Mojo,’ Tracks EU Economic Health, IdeaCarbon Says
The European carbon market is increasingly becoming an indicator of European Union economic output, rather than being fixed by supply and demand for the permits, IdeaCarbon said.

Oil Era’s Twilight Drives Depression, Debt Crisis, Rifkin Says: Interview
The world economy will face shocks and depressions, punctuated by ever-shorter and weaker recoveries, as long as it relies on outdated fossil fuels, says Jeremy Rifkin, author of “The Third Industrial Revolution.”

Regulatory Issues

JPMorgan’s Dimon Calls Basel Capital Rules ‘Anti-American’
In an era when the public’s view of bankers is less-than-positive, JPMorgan Chase Chief Executive Jamie Dimon has been one of the few who have not had their reputations blown apart and now he’s going to bat for U.S. banks. A story from the Financial Times quotes Dimon calling Basel III capital rules “blatantly anti-American.” He was referring to new capital requirements that call for banks to hold core tier one capital that equals 7% of risk-weighted assets. That number climbs to 9.5% for systemically important financial institutions like JPMorgan Chase, Citigroup and Bank of America.

Don’t be fooled, too big to fail is alive and well
CNN Money
Is “too big to fail” just a distant memory? That’s what Moody’s seems to be telegraphing to the market after it slashed the credit ratings of Citigroup, Wells Fargo (WFC) and Bank of America on Wednesday. But while the government says it is no longer in the bailout business, it is hard to believe that moral hazard is dead. After all, the banks are bigger and more interconnected than ever before, making a potential failure far more devastating than when the government allowed Lehman Brothers to collapse in the fall of 2008.

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