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Trading Lessons

May The Interest Rate Rise With You

Interest-Rates / Financial Markets 2014 May 20, 2014 - 05:50 PM GMT

By: Raul_I_Meijer

Interest-Rates

If global financial markets cannot set interest rates, they are distorted and dysfunctional by definition. Of course one may argue that they have long been distorted regardless, and there’s plenty merit to that, but without being able to determine interest rates, it is impossible for markets to become functional again, other than through a collapse so severe nobody wants to be seen dead with any paper ‘assets’ anymore. That is the inevitable fork in the road: either you allow interest rates to be – freely – set by markets, or you run head first into a market crash. There are other requirements too, like getting rid of bad debt, restructuring, allowing defaults and throwing out bankrupt zombifies market participants, but none of that will do much good as long as central banks and governments can claim the right of granting themselves the authority to set rates at whim.


That this practice of rate setting by ‘the leaderboard’, which has gained such huge popularity all over the globe in the last 20 years that you can’t help wonder how stupid the leadership of earlier times must have been for not having done the same thing for centuries (they wouldn’t have had any troubles with debts, or gold standards …) . Maybe it has something to do with recognizing that manipulating interest rates doesn’t just do nothing to right any wrongs, it serves as a major tool to preserve the wrongs, and let them suck the lifeblood out of the real economy, in order for malignant tumors and vampirized undead to live to see another day. Interest rates in a functioning market, like stock prices and even derivatives contracts, show you where the weaknesses are in an economy, in the same way that predators target the sick and crippled and keep the herd healthy.

That rates manipulation by ‘the authorities’ would somehow be a positive thing for either markets or the larger economy, the reason central bankers claim is behind their policies, is humbug propagated by those who profit from the distortion. That is to say, politicians who threw their voters into the quicksand in an almost literally all-consuming quest for power, and finance professionals who all happened to be either downright bankrupt, on their way there, all-consumingly greedy, or any combination thereof. With the Fed funds rate hovering around the freezing point, major players can borrow for free and invest in anything bolted down or not. Which makes this announcement at Reuters today ironic to say the least:

EU Charges HSBC, JPMorgan, Crédit Agricole With Rate Rigging

European Union antitrust regulators charged Europe’s biggest bank HSBC, U.S. peer JPMorgan and France’s Credit Agricole on Tuesday with rigging financial benchmarks linked to the euro, exposing them to potential fines. The European Commission also said it would charge broker ICAP soon for suspected manipulation of the yen Libor financial benchmark. U.S. and European regulators have so far handed down some $6 billion in fines to 10 banks and brokerages for rigging the London interbank offered rate (Libor) and its euro cousin Euribor while prosecutors have also charged 16 men with fraud-related offences. “The Commission has concerns that the three banks may have taken part in a collusive scheme which aimed at distorting the normal course of pricing components for euro interest rate derivatives,” the EU competition authority said.

No, they never get enough. No matter how much rates are manipulated in their service, they still see a profit in manipulating then some more. And why not? Punishments for crimes in the financial world are exceedingly rare, and what there is is directed at banks, not bankers or traders. That, too, is part of the protect-the-zombies system that has been developed around us, at our peril. That zero interest rate policies (ZIRP) are bad for fixed income has long been recognized, but that it also pushes pension fund managers into ever lower quality assets which carry ever more risk is much easier overlooked. And that’s just the top of the iceberg when it comes to the perverting consequences of what is still to this day – hard as it should be to believe – advertized as beneficial for society.

If I go through my daily links today, and I didn’t really select them for the purpose, some of these consequences crystallize. First, Phoenix Capital via Tyler Durden:

The $12 (or $192) Trillion Fed Funds Rate Ticking Time Bomb (Phoenix)

Time and again, we’ve been told that the Great Crisis of 2008 has ended and that we’re in a recovery. Indeed, earlier this year, we were even told by Fed Chair Janet Yellen that the Fed may in fact raise interest rates as early as next year. If this is in fact true, how does one explain the following statement made by the Fed’s favorite Wall Street Journal reporter, Jon Hilsenrath?

One worry: As they move toward a new system, trading in the fed funds market could dry up and make the fed funds rate unstable. That could unsettle $12 trillion worth of derivatives contracts called interest rate swaps that are linked to the fed funds rate, posing problems for people and institutions using these instruments to hedge or trade.

So… the Fed may not be able to raise interest rates because Wall Street has $12 trillion in derivatives that could be affected? Weren’t derivatives the very items that caused the 2008 Crisis? And wasn’t the problem with derivatives that they were totally unregulated and out of control? And yet, here we find, that in point of fact, all of us must continue to earn next to nothing on our savings because if the Fed were to raise rates, it might blow up Wall Street again… Simply incredible and outrageous. What’s even more astounding is that Hilsenrath is in fact understating the issue here. It’s true that there are $12 trillion worth of derivatives contracts related to the fed funds rate… but total interest rate derivatives contracts are in fact closer to $192 TRILLION. And that’s just the derivatives sitting on US commercial bank balance sheets.

That leaves little to the imagination, I would say. The Too Big To Fail banks have contracts – bets – out on Fed interest rate policies that would sink them if Yellen would move an inch left or right without telling them first. And even of she did, the Treasury would be obliged to bail them out. That alone should be sufficient to make people say ‘hold it right there’. But nobody does. the next one is from Alhambra:

How Fed/ECB Interest Rate Repression Gifts Too Big To Fail Banks

Deutsche Bank over the weekend announced a significant dilution to existing shareholders, raising some €8 billion in equity capital in two distinct transactions. About 60 million shares are being sold in a single transaction to a new “anchor” investor, Paramount Holding Services, the investment fund of the (a?) Qatari Shiek. The second transaction is a fully underwritten offering, meaning DB has already obtained the commitment of investment banks to acquire any shares not sold into the “market.” [..] The most evident question to arise from this surprise announcement is “why now?” [..] … suspicions running toward balance sheet health can be understood. In that framing, DB’s capital might look dangerous, particularly with its primary position as the largest derivatives trader in the world. As we know from bank earnings across the industry, fixed income has been an extreme sore spot and one of rising concern (derivative trading falls in here).

Large corporations, especially banks, use artificially ultra-low interest rates to shore up their financial positions. Apple had a huge share issue recently, and Apple is fine but they do it too, simply because it’s so obvious. But it’s taking a seriously scary direction now. Because in a global economy that can only approach recovery in journalists’ and politicians’ fantasies, “There’s more capital out there than we can consume, a huge wall of money”, as Bloomberg Shell’s CEO saying:

Long-Bond Frenzy Gains Strength as Sales Surge

The cheapest long-term borrowing costs on record are enticing companies into the bond market and allowing them to lock in rates for up to 100 years. “My treasurer tells me always borrow when you can, not when you have to,” said Simon Henry, CEO at Royal Dutch Shell. Global borrowers from Shell in The Hague to Peoria, Illinois-based Caterpillar raised a record $368 billion this year from bonds maturing in 10 years or more, according to data compiled by Bloomberg. The average yield companies pay to raise long-dated debt worldwide fell 61 basis points this year to 4.4%, approaching the low of 4.1% reached in 2013 … [..]

“There are huge liquid pools at whatever tenor we need,” Shell’s Henry said [..]“There’s more capital out there than we can consume, a huge wall of money, a lot of it coming from emerging market sovereign wealth funds and pension funds that’s looking for a home.” Europe’s biggest oil company, which has $11.9 billion of cash on its balance sheet, priced 1 billion euros (1.37 billion) of 12-year notes to yield 2.5% in March, following a 30-year deal in August when it paid 4.59% to sell $1.25 billion of securities …

Caterpillar sold its first 50-year notes this month, when it paid 4.8% to raise $500 million. Toymaker Hasbro sold 30-year notes paying a 5.1% coupon, down from 6.35% when the company issued debt with the same maturity in 2010. [..] In the U.S., companies pay 4.7% on average to sell bonds of 10 years and more, approaching the all-time low 4.3% reached in November 2012. Average yields are at a record-low of 2.8% in Europe, down from a peak of 7.3% in 2008. The likelihood of borrowing costs climbing in Europe is diminishing, with policy makers considering monetary easing next month to spur slow growth in the 18-nation euro area where inflation is at less than half their goal.

If it would only be ZIRP, perhaps the damage could be contained, even if those tasked with the containing go the exact opposite direction. But there’s also the insane amount of worldwide QE programs. And it’s looking for yield. Obviously, sovereign bonds are an afterthought, though there’s so much QE sloshing around that there’s no problem getting the big players to buy them too just to please the QE providers. Still, if Shell can issue 30-year debt at 4.5%, you just know things are way out of whack, because Shell is already in big trouble with its oil and gas reserves today – they’re fast diminishing – and where the company will be by 2044 is anyone’s very very wild guess.

There’s far too much credit/money/cash running through the plumbing, and the pipes are about to burst. Where will the cracks show? How about this David Stockman take on China:

Thunderous Hard Landing Inevitable For China’s Ponzi Economy

What the People’s Printing Press of China has been doing is simply passing the hot potato by converting the vast inflow of dollars, euros and yen emitted by DM central banks into a fantastic flood of RMB. This massive expansion of the domestic monetary system, in turn, enabled the greatest credit bubble in world history. [..] China’s total credit market debt outstanding did not explode from $1 trillion to $25 trillion in just the last 14 years because the sons and daughters of rice farmers working in export factories went on a savings binge, thereby enabling a healthy expansion of debt-financed investment.

To the contrary, the central banks of the world went on a money printing binge and the comrades in Beijing took the bait. Namely, they chronically and massively scooped up excess foreign exchange from trade and capital inflows and stuffed it into the vaults at the central bank. This was supposed to keep the exchange rate battened down and the growth and export miracle ramping. [..] … the aging autocrats who ran the system, and who had learned their economics from Mao’s Little Red Book, were actually swapping the labor of their young people and resources of their land for debt emissions of the profligate West.

And in the process they were steadily inflating a fantastic credit bubble that financed the construction of anything that could be imagined by local party cadres and “businessmen” alike – airports, bridges, highways, high-rises, office towers, train stations, fast rail, shopping malls, new cities, endless factories. [..] … the party overlords got lured into a dangerous economic Ponzi. They sent more and more freshly minted credit – 20-35% more in some years – down the state controlled banking system where it was parceled out to state controlled enterprises, local party rulers and independent entrepreneurs.

And that, grasshoppers, is where, how and why Yellen and Draghi will lose their control, and their ability to shove the rates their paymasters desire down the throats of the entire planet. Too low interest rates will be, must of necessity be, utterly destroyed by too low rates of return on capital. Even if that capital is borrowed at too low interest rates.

Our leadership refuses to let free market systems do their thing, because doing so would mean curtains for the Wall Street bigwigs that got them their jobs. But the bigwigs lost behemothically big at the crap table. So what they came up with is screw fixed income, and screw the next generation of Americans and Europeans, let’s spend their money today and squeeze what wealth is left through interest rate manipulation. Which worked for years because China bought a lot of the debt that was the result, but which will also fail because China bought so much of it. China is getting hammered by the western debt in the PBOC’s vaults. It was fine to purchase it when the economy was growing at a double digit clip, but that’s long gone and will never be back.

And now the blow back is on. Which will lead to things like this:

2.3 Million UK Householders To Become ‘Mortgage Prisoners’ (Independent)

About 2.3 million householders could become “mortgage prisoners” who struggle to afford their repayments when interest rates rise, according to a report published today. [..] … the proportion of people struggling to pay their mortgage fell only slightly during this period and still stands at 1.1 million today, the foundation said. That figure could more than double to 2.3 million households – almost one in four of the 8.4 million with mortgages – by 2018 if interest rates rise to 3% as financial markets expect. The report said the total number at risk of becoming “mortgage prisoners” could be as high as 3.5 million …

If rates rise to just 3%, millions of people in the UK won’t be able to service their debts. How clear must the message become? Low interest rates can seem lovely, and there’s more than enough media propaganda to drag people even deeper into the swamp, buying homes with huge mortgages and all that. But even if you have a fixed rate locked in, you’ll still get a margin call when property prices plunge. Which they will do when rising interest rates make purchasing less attractive if not entirely impossible for you.

Forcibly and artificially low interest rates are not there for your benefit, so using them to get what you want, whether it’s a home, a car, or anything else, is a very dangerous thing to do. If only because those who have the power to lower rates have that power only for a limited period of time.

Free and properly restructured markets, having gone through needed defaults to clean the herd of disease, markets cleared of zombies, are the only thing that’s actually good for you. Unless you have a big mortgage. Well, that’s just too bad, you should have paid attention. What’s been going on for the past 20 years is packing an ever larger weight onto the backs of your children, a weight so forbidding they’ll never be able to walk upright.

Hey guys, you’re the ones letting it happen, no use blaming anyone else. Until and unless you say ‘hold it right there’, this is not going to stop, it’s just going to get worse. And when rates start rising, and they will, because there is no other way for them to go, there is no other option, you will be the ones paying the bill. But at the same time, rising interest rates are the very, and only, thing that can cleanse our economies.

By Raul Ilargi Meijer
Website: http://theautomaticearth.com (provides unique analysis of economics, finance, politics and social dynamics in the context of Complexity Theory)

© 2014 Copyright Raul I Meijer - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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