Prepare for asset "repricing"
By Bill Bonner
Jan 30, 2007
Rerun the tape!
No, we’re not talking about the War in Iraq. We’re talking about the financial show. Each new twist is just a bit more absurd than the one that went before.
The plot in the US, as we recall it, runs like this: Tech bubble blows up, the economy and the stock market tank, 9/11 comes along, the feds panic. The Bush Administration takes a modest, fraudulent surplus and turns it into a massive budget deficit. Taxes are cut; spending increases. In the space of 18 months, we seem to remember, a total of about $1.5 trillion is added to the economy.
Desperately worried that it had a Japan-like deflationary slump coming up - a fear to which we happily contributed, albeit in a small way, in our first book "Financial Reckoning Day," - the Federal Reserve swings into action too. It is the Ides of March every day at the Fed. Slash, cut; rates go down to a nominal 1% - or about 2% below the rate of consumer price inflation.
Then, 3 years later, while rates are being ‘normalized’, the Fed continues to worry...this time about a slump in US residential housing. Even though rates are increased, the Fed boosts liquidity by allowing the money supply to expand at a 10% rate – about 3 times faster than GDP growth. And Adrian Van Eck estimates that another $1 trillion of new money will be added to M3 in 2007.
This tide of liquidity, by the way, doesn’t stop at the US border. Instead, it washes all over the world. Other countries need to keep their own currencies from rising against the dollar; they, too, find they have to turn on the taps just to stay even. In Europe, for example, M3 is now rising at 9.7% per year – about the same as the US – its fastest rate in 17 years.
Where is all this new money going? Into consumer prices? Nope...not yet.
Banks, investment companies and large speculators control the flow of this new loot. It never reaches the working man, except in the form of additional debt. So, it does not seem to lift prices of huggies and cola. Instead, it floats up the prices of financial assets. Art...derivatives...swaps...you name it...
As things rise in price, the intermediaries are able to get even more leverage out of them. Trade ‘em, refinance ‘em, repackage ‘em, sell ‘em on, restructure ‘em, hedge ‘em; the whole economy has become a dervish – with each whirling, swirling, twirling financial instrument throwing off fees, commissions, and spreads for the shrewd operators who manipulate ‘em.
It’s almost too much for us to keep up with.
The head of the European Central Bank elaborates...
"There is now such creativity of new and very sophisticated financial instruments...that we don't know fully where the risks are located," said Jean Claude Trichet. "We are trying to understand what is going on - but it is a big, big challenge."
Mr Trichet was speaking to the illustrious group gathered in Davos, Switzerland. The Financial Times describes the debate in which he played a role:
"Many investment bankers - and some regulators and economists - argued in some sessions at last week's meeting in Davos that the growth of the $350,000 billion plus derivative sector has been beneficial, since it has helped reduce market volatility this decade and made the system more resilient to shocks by spreading credit risk.
"However, other officials fear that these instruments may now be raising leverage and risk-taking in the system to dangerous levels, and keeping the cost of borrowing at artificially low levels - thus increasing the chance of future financial crises."
Here at the Daily Reckoning we have our opinion; the more a financial innovation proves successful, the more successful investors will find ways to make it fatal. Norman Angell’s book, published at the beginning of the 20th century, argued persuasively that new innovations in politics and markets of the period made war unthinkable. People stopped thinking about it. They stopped worrying. They stopped taking precautions. Never had people been more optimistic and more complacent than they were – right up until WWI began in August, 1914.
Then, all the innovations that so delighted Angell – industrialization, technological improvements, nationalization - became the exact same innovations that made it the bloodiest and most expensive war in history.
Coincidentally, that was also when US property prices reached their last epic high. In real terms, they went down in WWI and kept going down for 70 years or more. Only in the last 10 years have they gone back up – returning to their 1914 high only in 2005.
And now, a whole new round of innovations are supposed to make market crashes and depressions obsolete. Perhaps it is true. But we wouldn’t bet on it.
The credit bubble has now been expanding at an extraordinary rate for so long that people have begun to take it for granted. But residential property in the US is taking a breather, maybe even going down a little. US stocks are taking it easy – flat since the beginning of the year. Oil seems stable around $55. Gold is marking time at $640. Bond yields have been rising for the last 2 months. Where’s all the money going? Or is this great liquidity bubble finally beginning to lose air?
If not yet...when? We wish we knew. Mr Trichet warns that investors should prepare for a ‘repricing’ of financial assets. We doubt he knows any more than we do...but we don’t doubt he is right.
Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.
* Read more by Bill Bonner at Swissamerica.com HERE
* Request a free copy of "The Future of Gold" magazine with Bill's explaination of the "Derivatives Debacle: Little Big Bubbles" HERE
The derivatives market, in which hedge funds tend to speculate, has reached a face value of $480 trillion...30 times the size of the U.S. economy...and 12 times the size of the entire world economy. Trading in derivatives has become not merely a huge boom or even a large bubble - but the mother of a whole tribe of bubbles... dripping little big bubbles throughout the entire financial sector.
In this late, degenerate imperial age, no one gets richer faster than hedge fund managers. Last year, Edward Lampert, of ESL Investments (a hedge fund business), set the pace with $1.02 billion in compensation. Compared to him, James Simons of Renaissance Technologies Corp. must have felt like a charity case, with only a bit more than $600 million in take-home. But he still did better than Bruce Kovner, at Caxton Associates, who earned $550 million.
We do not report those figures out of jealousy, but simply puzzlement and amusement. Every penny had to come from somewhere. And every penny had to come from clients' money. Investors in leading hedge funds must be among the richest, smartest people in the world. Still, with no gun to their heads, they turned over billions of dollars' worth of earnings to slick hedge fund promoters.
Read the full story in "The Future of Gold" ... request a free copy HERE
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