Posted on 13 July 2011.
A Look at This Weeks Show:
-The middle class: “When they feel the heat, they’ll see the light.”
-Replace the flawed U.S. tax code with a national sales tax.
-Work toward a gold standard.
The best currency forecasters say the dollar’s 12 percent slide over the past year is coming to an end as Europe’s deepening debt crisis discourages bets against the world’s reserve currency.
Led by Schneider Foreign Exchange Ltd., the five most- accurate firms during the six quarters through June 30 as measured by Bloomberg see the dollar trading at $1.42 per euro on average by year-end, compared with $1.43 on July 8. Against the yen, they predict the greenback will rise to 83 from 80.64.
While Moody’s Investors Service added to Europe’s woes last week by lowering Portugal’s credit ranking to junk, the dollar is regaining its status as a haven after the worst performance over the past year among 10 developed-market currencies based on Bloomberg Correlation-Weighted Indexes. The dollar is up 5.9 percent from a 17-month low on May 4 against the euro.
“There’s not a lot of room left for it to weaken beyond $1.50 to the euro, and we still see it recovering to about $1.40 by year-end,” said Stephen Gallo, head of market analysis at Schneider in London, who had an average margin of error of 5.05 percent across all currency pairs. “The risk of a disorderly default is, for now, much higher in Europe than in the U.S.”
Hedge funds and other large speculators are no longer betting the dollar is going to collapse.
Wagers on a decline against peers including the euro, yen and pound were 203,230 on July 5, data from the Commodity Futures Trading Commission in Washington showed last week. That’s down from 405,267 in March, the most since at least November 2003.
“It’s difficult for the dollar to fall out of bed,” said Paul Mackel, director of currency strategy in London at HSBC Holdings Plc, the eighth most-accurate forecaster. “The euro- zone crisis has definitely slowed the pace of dollar weakness. The dollar is still the reserve currency of the world and will be for some time to come.”
HSBC sees it ending the year at $1.44 per euro, compared with $1.4037 as of 10:23 a.m. in New York. It earlier strengthened to $1.4026, the highest since May 25. The greenback accounted for 60.7 percent of the world’s currency reserves in the first quarter, compared with 61.8 percent a year earlier, the International Monetary Fund in Washington said June 30.
The U.S. currency rallied 1.8 percent last week against the 17-member euro and has dropped 5.4 percent this year. It fell 0.3 percent today to 80.42 yen.
The dollar has stabilized as the euro-region debt crisis worsened, forcing Greece to seek a second bailout in little more than a year from the European Union and the IMF, stirring speculation Portugal and Ireland will follow.
The Dollar Index, which IntercontinentalExchange Inc. uses to track the currency against those of six trading partners, rose in four of the past five weeks as the German government and the European Central Bank debated how best to ward off a Greek default and investors fled riskier assets.
EU leaders are pushing banks and insurance companies who hold Greek bonds to contribute to a new aid package after last year’s 110 billion-euro ($156 billion) rescue failed to stop the region’s debt crisis from spreading.
The threat of contagion has sparked a surge in the cost of insuring against Spanish and Italian defaults, with the yields on the 10-year securities rising to euro-era record spreads with equivalent German debt today.
“Everyone is aware inside and outside of the euro area that these countries cannot bail themselves out of these debt burdens,” said Schneider’s Gallo in a Bloomberg Television interview with Betty Liu on “In the Loop.” “The bottom line is there is no way to ring fence this entirely the losses are going to have be swallowed.”
Earnings growth is rebounding in the U.S., albeit at a slower pace. Companies in the Standard & Poor’s 500 Index are poised to boost income by 19 percent in 2011, including a 13 percent advance in the second quarter, according to analyst estimates compiled by Bloomberg.
The gain will push profits back in line with their average increase of 6.9 percent over the last 51 years, data compiled by Brockhouse & Cooper Inc. and Bloomberg show.
“Our central scenario is that the U.S. dollar is bouncing along the bottom,” said Richard Grace, chief currency strategist and head of international economics in Sydney at Commonwealth Bank of Australia, the ninth-best forecaster.
Concern the U.S. economy will falter and a growing debt load may hurt the dollar.
Data from the Labor Department in Washington on July 8 showed employers added jobs in June at the slowest pace in nine months. Payrolls rose by 18,000, less than the 105,000 positions forecast in a Bloomberg survey of economists.
The U.S. economy may grow 1.1 percent in the 12 months ending June 2012, according to research by the Federal Reserve Bank of Clevelandusing Treasury yields and growth data for the past five years to project output for the coming 12 months. That’s less than half the 2.7 percent to 2.9 percent range projected by the Fed in its official estimates.
The U.S. risks missing debt payments should Republicans and Democrats fail to agree on raising the $14.3 trillion federal borrowing limit before an Aug. 2 deadline. S&P said June 30 it would cut the U.S.’s credit rating to D, the lowest level on its scale of creditworthiness, should a failure to raise the debt limit lead to a default.
“It’s really hard to build a near-term to six-month story where the U.S. dollar rallies when they have no credible fiscal plan in place,” saidCamilla Sutton, chief currency strategist in Toronto at Bank of Nova Scotia. The firm is the seventh- ranked forecaster in the survey.
The dollar will slide to $1.52 per euro by year-end, following a decline to $1.50 by the end of the third quarter, according to Societe Generale SA, the second-most accurate forecaster, whose average margin of error was 5.21 percent.
“I’m negative on the dollar,” said Kit Juckes, London- based head of foreign-exchange research at the company. “The U.S. favors a weaker currency as part of its economic solution and with employment well below where they want it to be, the Fed will keep rates lower for longer.”
The Fed won’t raise its target interest rate for overnight loans between banks, currently a range of zero to 0.25 percent, until the second quarter of 2012, according to the median forecast of 33 analysts surveyed by Bloomberg.
Schneider’s Gallo estimates the dollar will end the year at $1.40, about 1.9 percent stronger from last week, and number three Wells Fargo & Co. predicts a recovery to $1.39.
Fourth-ranked JPMorgan Chase & Co. sees the dollar weakening to $1.48 by year-end. Credit Agricole SA, the most bullish dollar forecaster and ranked fifth in the survey, estimates $1.30.
“The safest bet is to stay long the dollar against the yen,” said Nick Bennenbroek, head of currency strategy at Wells Fargo in New York, the third-most accurate forecaster. “As soon as the market starts to see a shift in interest-rate futures, that would be enough for the dollar to move higher. We expect this to happen by the end of the fourth quarter.”
While the Fed repeated after last month’s meeting it will keep its key rate at a record low for an “extended period,” the U.S. currency may find support from the June end of the central bank’s asset-purchase program, or quantitative easing, known as QE2, which helped depress bond yields this year.
“We don’t have a scenario where the U.S. economy weakens a lot further or in a prolonged sense such that the Fed then undertakes another round of quantitative easing,” said John Kyriakopoulos, head of currency strategy at National Australia Bank Ltd. in Sydney, the number six forecaster. “We don’t see a further large fall in the U.S. dollar.”
The dollar appreciated on June 22 after Fed Chairman Ben S. Bernanke ruled out a third round of asset purchases.
“As U.S. bond yields begin to gradually drift upwards in anticipation of policy normalization from the Fed, a lot of the liquidity that has drained out of the U.S. is going to flow back again,” said Daragh Maher, deputy head of global foreign- exchange strategy at Credit Agricole Corporate & Investment Bank in London, which had a margin of error of 5.65 percent. “That’s going to have some positive dollar impact.”
Currency forecasters were ranked according to the accuracy of their estimates for the six quarters beginning with the first three months of 2010. Long-term accuracy was judged by a forecast for the twelve-months to end-June 2011.
Only firms with at least four forecasts for a particular currency pair were ranked, and only those that qualified in at least five of eight pairs were included in the ranking of best overall predictors. In all, 50 firms submitted enough forecasts to be ranked in at least one currency.
On Tuesday, I went for lunch with Frédéric Blondeau and Benoit Caron of Gestion de Placements Eterna, a Quebec trust company founded by Alphonse Tardif in 1928 and successfully managed by three generations of the Tardif family. The company is now run by his grandson, Paul Tardif.
Frédéric contacted me, telling me he and Benoit are fans of my blog. I was more than happy to meet them and talk about markets, pensions, the Quebec SARA Fund, Quebec's financial community, global REITS and commercial and residential real estate.
Let me first say these are two standup individuals, the type of people who renew my faith in real estate investment professionals. I say this because apart from a handful of people I've met in the past in institutional real estate, most of the investment professionals in this asset class are slimy, sleazy, unethical, arrogant, ruthless sharks who only care about their pockets (true of most individuals in finance but particularly true of real estate guys and gals). And I mentioned this to them because most of the "shady characters" I know are now working together in Montreal for a well known private equity fund (that's another scandal!).
Frédéric and Benoit struck me as highly professional, highly ethical and extremely sharp individuals. The fact that they chose to work at Eterna tells me a lot too because this firm has a stellar reputation in Quebec. They both have extensive experience on the buy and sell side. Frédéric was a founding member of Presima, the Caisse's real estate division that was sold to the National Australia Bank. Interestingly, the Caisse never disclosed the terms of the deal and how much they received for the sale of this division, but I will closely examine Presima and Otéra Capital, the Caisse's real estate debt subsidiary, in a future comment. Too many individuals have asked me to look into these operations and I promised them that I will look at all public records.
Benoit Caron worked as an analyst at Montrusco Bolton, Canaccord Genuity where he ranked high on the Brendan Woods survey, and then moved to the National Bank Financial as a VP, Fundamental Research on Infrastructure and Engineering. We spoke about the sell-side and the "constant pressure of being bullish on markets." I worked as an economist at the National Bank Financial back in 2000-2002 and remember the bear market following the tech meltdown. I was the assistant to Clément Gignac, the Chief Economist then who is now Quebec's Minister of Economic Development, Innovation and Export Trade. Never forgot what Clément told me: "In a bear market, investors rediscover the value of economists." So true, which is why along with Stéfane Marion, Vincent Lépine and Martin Roberge who was the Chief Strategist at the time, we garnered most of the soft dollars during that recession.
Frédéric and Benoit told me that they've been reading my comments on seeding Quebec hedge funds and they're in full agreement with many of my opinions. As I told them: "Look , the Caisse screwed up and they invited me into their offices to 'set me straight'. I may have been too harsh in my criticism of the SARA Fund, but the truth is there is hardly any seeding going on. All I see is René Perreault and his rich buddies getting richer. It's a big club, the Quebec club."
I added: "I got nothing personal against Jean-Guy Desjardins. The man in an entrepreneur, made more than a few people multi-millionaires, including a former boss of mine. I give him credit, unlike many powerful Quebecers who just talk the talk, Jean-Guy Desjardins walks the walk and he delivered on his promises. But what really frustrates me is how political this file has become. It's simple, if done properly, everyone wins by seeding Quebec hedge funds, including depositors, Quebec's financial community and the thousands of university students studying finance who end up leaving for Toronto or New York because there are no jobs for them here. And what really makes me angry is that we've wasted billions in failed venture capital programs and call 'seeding hedge funds' too risky when the opposite is actually true."
I really hit my point when I said: "There is a petty, jealous behavior in Quebec. Quebecers say they're proud but they don't support their own talent, forcing many of its brightest to leave. It's disgusting and really not necessary. We have amazing talent in this province which Quebec's institutions don't want to promote and see succeed. That's what Ontario Teachers' did in Ontario and that's exactly what we should be doing here."
Frédéric and Benoit agreed it's difficult to raise money in the current context but they added "no doors are closed, it's just that people want to see us perform a bit before trusting us with their savings." They got an important mandate from SSQ which is public and a few others that are not public. They specialize in global REITS, an extremely liquid market. They're looking to start a hedge fund on global REITS but are proceeding cautiously, taking their time to set up the back and mid office properly, wanting to show institutions that they are ready for the institutional setup. I commended them on this approach and think it speaks volumes on their professionalism and integrity. They're not willing to cut corners and in a rush to raise assets until they are ready to properly handle the inflow on the operational and risk management side. Others do not have the luxury of having Eterna's support staff backing them and are scrounging to get by.
We ended with a frank discussion on the real estate market. Benoit told me that he sees the slump in US residential real estate continuing because too many mortgages are still under water. He told me that the spread between existing home prices and new home prices is at a historic low where it's more attractive to buy an existing home. Moreover, "with youth unemployment at historic highs" many new home entrants can't afford to buy houses. All this bodes well for rental units, especially apartment buildings.
We both agreed that fiscal tightening pretty much ensures more quantitative easing by the Fed, which will be a boon for Wall Street but not for Main Street. As I told him: "There is simply no choice for the Fed but to counteract any fiscal tightening that comes from the debt deal." He told me he sees the ECRI indicator "rolling over," which doesn't bode well for global growth.
Finally, and most interesting, Frédéric and Benoit agreed with me that the Canada bubble will burst and that Canada's mortgage monster stands to lose billions and is in a very tenable position. According to Benoit: "Too many people are way over-leveraged, are mortgaged to the hilt buying houses they can't afford, and they risk getting killed when they lose their job or if rates rise. If we suffer a slowdown that is just 20% of the US slump, we're in big trouble. It's simply not true that real estate prices won't get hit in Canada; this isn't the 1970s, and people are in for a shock in the coming decade."
I found the whole conversation fascinating. I told them when I wrote my comment on post-deleveraging blues in March 2009, I totally (and erroneously) ignored REITs because I didn't know enough about the market and honestly thought REITs were cooked. They turned out to be among the best performers since. I leave you with a Yahoo Daily Ticker interview with Gary Shilling, the deflation king, who sees another 20% Drop in Housing to Cause Recession in 2012.
Technically the title of this post is wrong: the truth is that nobody could possibly know or predict what a bank run would looks like in details suffice to say that it would have terminal and devastating results on the global economy. One needs only remember what happened when the Reserve Fund broke the buck and the $3 billion money market industry was at risk of unwinding (for those who do not, Paul Kanjorski does a good summary here). What we do, however, wish to demonstrate is the tenuous balance between physical money - yes, just like precious metals, there is actual "physical money", better known as currency in circulation - and more abstract, confidence-based, "electronic money." Now when it comes to talking about systemic instability, pundits often enjoy bringing up the case of the $600+ trillion (recently discussed here in a different capacity) in synthetic derivatives, whose implosion would "wipe out the world." While that may indeed be the case (the memory of the CDS-precipitated AIG implosion is still all too fresh), since nobody really can comprehend the side effects of the collapse of global derivative system, which by some estimates is over $1 quadrillion when combining exchange and OTC based derivatives, it is largely based on pure conjecture. And, as we demonstrate below, one doesn't even need to do get that high up in the pyramid of credit money. The truth is that should there be an American bank run, what would happen is the conversion of all electronic dollars into physical dollars, as retail Americans rush to empty their checking and savings accounts, exit their money markets, while institutional America converts all "shadow" liabilities into hard dollar assets (Zero Hedge has a specific methodology of defining what liabilities make up the shadow banking system). The truth is that should there be a D-Day in the American banking system and there is a global scramble for physical paper (ignore gold) the conversion ratio for binary dollars into hard ones could be as high as 30 to 1. Which begs the question: should one apply a 90% discount when evaluating their electronic dollar exposure? That, and many other questions too...
Physical dollars
When looking at actual "hard" dollars, there is just one place: the Fed's weekly H.6 statementwhich shows what the total amount of currency in circulation at any given moment is. The H.6 is the statement that breaks down the two forms of monetary stock tracked by the Fed: M1 and M2. Currency is at the very top. As a reminder, currency, together with Fed bank reserves are the only two actual forms of money "printed" into circulation. Yes, there is much polemic over the nature of bank reserves, but they, together with currency in circulation are the only two actual liabilities on the Fed's balance sheet, backed by such assets as Treasurys, Mortgage Backed Securities and, questionably, gold (questionably, because as Ron Paul has been crusading, the existence of gold on the Fed's asset side is taken on faith, and is based on promises by the Fed that it in fact exists, but nobody is allowed to actually see it).
So how many actual physical dollars are there? Well according to the H.6, as of June 27, there was $967.3 billion in currency currently circulating within the US economy, while the H.4.1 tells us that as of July 6 there was $1.66 trillion in bank reserves with the Fed, which if need be can be promptly released as currency to the wider public on demand (granted the dynamics of this release are completely unclear).This adds up to just over $2.6 trillion in "physical currency" (which also happens to be the "record" asset side of the Fed's balance sheet).
So that's what the the 'supply' side of money looks like in a dollar bank run. What about the demand. In other words, who will have the non-contractual "right" to pursue these $2.6 trillion in cold, hard cash?
Let's start with the M1, which is where the first tranche of electronic dollars is situated.
M1, in addition to currency in circulation, also contains demand and checkable deposits. The most recent number for these two is $982.9 billion. So far so good: if only demand and checkable deposits were pulled, the currency in circulation would be sufficient, although there would be a small impairment of just about 1.5%.
Next up, we go to the M2, which in addition to the M1 components, also contains such abstract concept as Savings Deposits, Small-Denomination Time Deposits and Retail Money Funds. The dollar values associated with these assorted claims on cash are $5,662.8 billion, $827.9 billion, and $698.7 billion respectively, or a total of just under $7.2 trillion. Add to this the roughly $1 trillion in non-cash M1 and you get $8.2 trillion. And this is where things start getting interesting. Because should every retail saver who has documented paper claims in America's checking, savings, time-deposits and money market pull their money, they would find that there is just $2.6 trillion in cash available to actually satisfy said claims.
But wait, there's more.
While the M2 conveniently ignores it, another major component of monetary aggregates is institutional money funds, which adds another $1.833.2 trillion in claims to physical fiat. Added across and we get just over $10 trillion.
But wait, there's more.
Remember how on March 23, 2006 the Fed discontinued the M3 because it was "too expensive" to keep track of all this "money." Well, courtesy of various replication loophole Zero Hedge has been able to track a far more comprehensive indicator of the broadest money stock in the US economy: the shadow banking system, which for all intents and purposes is the same as above: namely claims on actual money however more by institutional accounts than retail.
The breakdown, based on the most recent Z.1 (through March 31, 2011) is as follows:
Whipping out the calculator, and we get... $13.1 trillion in shadow banking system claims. Adding across with the M1 and M2 stock noted above and one gets $23.1 trillion. As a quick reminder, the physical money, in a best case scenario, is $2.6 trillion when adding reserves, and in a worst case, $967 billion. In other words, the paper to physical dilution is anywhere between 8.8 times and 24 times.
But wait, there's more.
Observant readers will recall that in our 2009 piece which before anyone else had even considered it, explained how the Fed bailed out the world with FX liquidity swaps, one of the key take home messages was that there was a synthetic short on the USD to the tune of about $6.5 trillion courtesy of the USD carry trade and other considerations. In other words, this is how many dollars would have to be conjured up into existence to satisfy existing electronic claims (and why the Fed had to scramble to implement the FX swaps when it did). One thing that is certain is that in an American (and thus global) bank run, all of the dollar shorts would cover in milliseconds as the carry trade would collapse instantaneously.
The take home is that courtesy of this latest and greatest demand on cash, there is up to another $6.5 trillion in potential claims on underlying hard dollars (and likely much greater as this BIS study was conducted at a time before ZIRP, and before the USD was the new, step aside JPY, carry currency of the world).
Summing it all up
Putting together all of the above, there are anywhere between $967.3 billion and $2.6 trillion in physical claim satisfying pieces of paper which everyone would scramble to grab if the sky was falling, and against these there are just under $30 trillion in paper claims on said hard paper. This can be seen visually on the indicative chart below:
Do readers see now why it is irrelevant to add X trillions or even quadrillions in derivatives?Because when just taking the plain vanilla electronic claims on circulating dollars there would have to be between a 11x and 31x haircut when everyone rushes to procure the suddenly all too precious pieces of paper with the picture of a dead president on the face.
For all intents and purposes this has been more of a thought experiment than any indicative scientific evaluation as there are many other nuances when analyzing all of the above. However, for the sake of esthetic purity, the truth is that no matter how one slices and dices it, there will be an unimaginable scramble to get out of electronic dollars and into physical ones. The amusing thing is that there are many who are worried that physical silver claims may be diluted by outstanding paper. This is true, however, ironically, it is very true when dealing with the heart of the fiat system. And recall that we refused to look at the $1 quadrillion in credit money at the derivative level. We believe that for illustration purposes, knowing that at best 10% of electronic money is covered in a worst case scenario should be sufficiently enlightening. As for those who say that all the Fed would need to do is merely hit the print button and not stop, remember: this money would simply flow to bank reserves. How it gets from there to outright currency in circulation is something the Fed has been bashing its head over the past 3 years, so far, unsuccessfully. And any money paradropped into circulation directly, would not do anything to alleviate the dilution factor as it would add to both sides of the "claim" and "deliverable" ledger (not to mention that it would also leads to instantaneous hyperinflation).
So, in the loosely paraphrased immortal words of Troy Mclure, now that you know, roughly, what a bank run would look like, don't do it.
