Charting around Asia

Global Tango!

by John Needham, The Daniel Code Report | October 8, 2008

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S&P Revisited

Financial Sense readers have been well served by the Danielcode. Many will recall, and others will wish they had recalled this chart and comments from “Le Tour-Future Directions for the S&P” published exclusively by FSO on 8 July, exactly 3 months ago:

“The 2000-2002 correction (that’s all it really was) went to within 8 points of its Danielcode target at 760. That level is the 4th iteration of DC retracement levels. A similar degree of correction from the current top takes us to 1097, a level favoured by stock market pundits. The recent global crash warning by The Royal Bank of Scotland’s strategist Bob Janjuah,  identifies a target of 1050 for the S&P.

I think we can do a little better.

By completing this matrix we now have a new DC target at 971 which reinforces our existing targets at 965 and 976. Actually the average of our previous two levels is 970.50. Close enough. So look for 1097 on the S&Ps trip to 971. Despite the inevitable hysteria from the long only brigade, that is only one degree past a normal correction, not Armageddon.”

Today’s low in SPX has been 972.98  But that’s a story for another day.

Securitisation:

Global economies are hemorrhaging from the “American Disease”-securitisation. US success in inventing and marketing these extraordinary products once again shows US mastery of the financial universe as securitisation packagers and distributors not only planted the ticking time bomb in their own belly but managed to persuade other countries of many hues to digest them as well. UK and Europe seem to have been predominant gluttons together with China and in Australia the National Australia Bank has already written off its total exposure to $1 billion of failed CDOs which it purchased from Lehman Brothers in a joint deal with Merrill Lynch. Strangely those instruments will now be made good by selling them into the US TARP plan.

If you think that the correction in US housing markets is the sole cause of the global meltdown you are missing the point entirely. We now have a firmer estimate of  securitisation losses and attendant capital destruction with the IMF updating its current forecast to $1.4 trillion, but that’s only part of the problem. The next shoe to drop will be the realisation that markets will do sufficient damage to blunt the enthusiasm of punters to embrace risk by recapitalizing the financial sector. At that stage, someone is going to figure out that without access to securitisation and its attendant mechanism of constantly replenishing capital and shifting risk away from the originators, lenders and thereby consumers are going to be terribly constrained.

To make a reliable assessment of where we are and where we are going, we need to tie together some important evidentiary points. The evidence is there for all to see. The problem is that most lack the intellectual rigor and concept of time frames to put it together. I will endeavour to lead you through that process as simply as possible. Every analysis starts with a “where are we” and how did we get here précis. Doug Nolan of Prudent Bear lays out a masterful summary. As the consumer on which much of Asia relies, US is still the epicenter of the Asian financial picture. I urge you to read Doug’s summary carefully and reflect on what it means. Reading lists of numbers can be tiresome but there is simply no way for you to be informed investors without an understanding of the magnitude of the problem that the addiction to debt has wrought.

Where we are

Looking back, Total Non-Financial Debt (NFD) expanded $578bn during 1994.  By 1998, NFD growth for the year had surpassed $1.0 TN.  Non-Financial Credit increased $1.153 TN in 2001, $1.415 TN in 2002, and $1.676 TN in 2003, before reaching the $2.0 TN milestone in 2004.  Incredible as it was, debt expansion then surged over the next fateful three years.  Growth rose to $2.319 TN in 2005, $2.428 TN in 2006 and then to last year’s record $2.561 TN.

Importantly, this historic Credit Inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the U.S. and global economy.  It was a self-sustaining Bubble bolstered by ongoing Credit excesses, asset inflation and resulting purchasing power gains.  But NFD growth slowed sharply to an annualized $1.726 TN during this year’s first quarter and then sank to $1.127 TN annualized during the second quarter.  Credit growth is now in the process of collapsing. 

To be sure, there were momentous effects to both the Economic and Financial Structures during the Bubble period between 1994’s $578bn Non-Financial Debt Growth and 2007’s $2.561 TN.  It is also worth noting that Financial Sector Debt expanded $462bn in 1994 compared to $1.753 TN in 2007.  Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 TN, while Financial Sector borrowings rose 75% to $16.0 TN.  This Credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy.  It is today impossible both to generate sufficient Credit and to maintain previous patterns of spending. 

It is worth recalling today that Wall Street assets began year 2000 at about $1.0 TN and ended 2007 at $3.0 TN.  The ABS market surpassed $1.0 TN in 1998 and ended 2007 at $4.5 TN.  GSE assets surpassed $1.0 TN in 1997 and ended last year at almost $3.4 TN.  Agency MBS surpassed $2.0 TN in 1998 and closed 2007 at almost $4.5 TN.  “Fed Funds and Repos” reached $1.0 TN in 2000 and ended 2007 at $2.1 TN.  This Bubble in Wall Street Finance was one of history’s most spectacular Credit expansions.  It also comprised the greatest use of speculative leverage ever.

Despite last summer’s collapse in private-label MBS and related markets, the faltering Wall Street Bubble nonetheless persevered up until the Lehman collapse.  While it was problematic that overall system Credit growth had slowed markedly, there remained key sectors of Credit and risk intermediation that remained very much in expansionary mode.  In particular, GSE-related obligations, bank Credit, and money market fund assets had expanded rapidly in spite of the subprime collapse.  Importantly, the speculator community had maintained easy access to cheap finance.  As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in “money” and the core of the system had held steadfast.  This all ended abruptly three weeks ago with the Lehman filing.

Today, confidence has been shattered, and Wall Street finance is a complete and unsalvageable bust.  The spigot for Trillions of finance - that for years fueled the asset markets and U.S. Bubble economy – has been essentially shut off and dismantled.  In particular, Wall Street finance was a mechanism for intermediating higher-yielding riskier loans.  This finance provided rocket fuel for both residential and commercial real estate markets – and the attendant wealth effects.  Wall Street finance also grew into the key source of finance for auto purchases, student loans, Credit cards, municipal finance and various business enterprises.  Many of these loans were of a risk profile unappealing to traditional bank lending – and, hence, provided the type of higher yields quite appealing to the speculator community. 

And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep into the Economic Structure.  Or, stated differently, risky loans came to play a major role in determining spending and investment patterns throughout the “Bubble” economy.  Wall Street finance became a major direct and indirect generator of household incomes and corporate profits.  Moreover, Wall Street finance came to dominate the flow of finance both in and out of the securities markets.  Wall Street could create its own liquidity and funnel it into the U.S. and global markets – and earn unimaginable returns in the process.

The leveraged speculating community played such an integral role in the overall Credit Bubble and, more specifically, to the Bubble in Wall Street Finance.  They were instrumental in both spurring financial sector Credit creation/leveraging, while directing this Flood of Finance to the asset markets.  And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by this expanding pool of speculative finance.  And the greater the returns, the more robust the “investment” flows into the hedge fund community – spurring more leverage and more potent fuel for additional self-reinforcing asset inflation.  One of the greatest manias ever – surely The World's Greatest Episode of “Ponzi Finance” – is absolutely coming apart.  And the wreckage is accumulating in all markets – everywhere.

Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit.  It’s simply not going to happen.  The $700bn from Washington would seem like an enormous amount of support.  In reality, it’s nowhere even close to the amount necessary for systemic stabilization.  To the $2.0 TN or so of new Credit required this year (and next) add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging (liquidations forced by huge losses). 

How we got here

No solution to any predicament is possible without an examination of how we got here. Failure to recognise the causes and the key players instrumental in the serial bubble blowing we have seen since 1997 means a continuation of failed policies. Central banks led by US and Japan have failed to establish a proper credit regime. Greenspan’s insistence that he couldn’t recognise a bubble at the time it was happening and Bernanke’s subsequent acquiescence in setting rates below their real risk cost directly led to first the dot.com bubble and now a larger asset bubble, this time based around property assets. By fostering unsustainable levels of economic activity, secondary bubbles formed in other asset classes notably the stocks of players in the bubble game. Japan’s decade long obsession with near zero interest rates created the bubble in the carry trade which was directly responsible for the commodity bubble and the pain borne by consumers from $100 plus Oil. UK and Europe aped this behaviour by having their central banks too maintain rates at below real risk costs. As a general observation we know that over 60 central banks assisted with the marketing of  US securitized paper with Asia taking its share particularly of GSE paper.

Today we have direct evidence that US, UK, Europe and the lands Down Under, Australia and New Zealand are using their central banks and their sovereign wealth funds as repositories for not only tainted securities but new securities specifically parceled to take advantage of these facilities. We have a one line announcement that the Australian Futures Fund has made unspecified advances to all the major Australian trading banks and last week the Australian Treasury created a $4 billion facility specifically to assist non bank mortgage originators. As Australia is one of the nine central banks participating in the US TARP program we can assume that these actions mesh with the wider approach of many central banks. It’s the same old game. None have yet faced up to the alternate of drastically reduced credit. None have yet contemplated life without a 90% LTV mortgage. Last year in the face of an obvious topping of housing markets, 46% of mortgage originations Down Under were of the 100% LTV variety. I suspect that many more obtained 100% status by other means.

Indeed most central banks are engaged as partners in a fascinating dance. One of the endearing lessons from the 30’s is that whatever remedies are available must be delivered conjointly and not piece meal. One out attempts at solutions for global problems merely focuses the attack, so all of the 9 central banks involved in TARP and the other 50 who assisted in the great securitisation sales are taking urgent lessons in the Tango. They are dancing together whether they like it or not!

Yesterday the Australian Reserve Bank triggered a storm in currency markets and a one day recovery in its equity markets with a 1% or 100 point cut in official interest rates. Aussie Reserve had at least been active in moving its rates upwards in baby steps but as Paul Volker pointed out many years ago, the baby steps don’t have an affect on markets so the Aussie bubble too kept inflating together with the rest of the world.

On 29 January I wrote for you in Financial Sense about the Uridashi trade that has been financing Australia and New Zealand’s property bubbles. It was a strange word unfamiliar to all but the elite London traders who originate most of these bonds. The crux of those articles was that the borrowings were extreme and essentially backed into the AUD-USD hedge (although the capital raising is done in NZ the NZ banks are subsidiaries of Australian parents). Uridashi today has seen the light of day in UK Telegraph and NZ talk shows as commentators are belatedly coming to grips with what you knew nine months ago. As holders rush to exit the weakening commodity currency of Australia and retreat into the relative safety of the Yen, this is what the pincer movement on AUD has produced.

A 29% drop in 2.5 months. Does that look like fun?

Parenthetically we ask how willing Japanese investors are going to be in rolling over this issuance when it rolls to maturity. Conventional wisdom is that they always take the 15 year compounding view but these are not conventional times. For Aussie and Kiwi exporters particularly miners and primary producers who have long term contracts denominated in USD, this is cause for celebration but if they are not cash flow positive, restrictions on bank funding may soon impact although that is not happening yet.

Primary holders in AUD-JPY are having even more fun as this cross has lost 35% since October 2007.

While well capitalised and profitable, Australia's banks are exposed by their need to rollover large slabs of their short-term funding in global credit markets that have seized up. “Australia's banks are financially sound, but the global turmoil has highlighted their vulnerability to rollover risk associated with short-term wholesale funding," according to the International Monetary Fund report on Australia's financial system released last month. "This funding structure makes the banks dependent on a stable international and domestic funding environment, and leaves them vulnerable to increases in the cost of funds and to the protracted loss of access to international short-term debt markets." Of course none of these cautionary flags were raised in the past decade’s boom.

Markets

Major Asian markets are panicking with Japan’s important Nikkei index having its biggest down day since the 1987 crash losing 952 points or 9.38% in Wednesday’s trading:

In China, the Shanghai Composite broke and recovered the Danielcode black line, the last level of DC support for the penultimate swing. Showing great prescience this index anticipated the Feds action today, by many hours having an up day with its intra day low just 20 points above the DC number. Interesting to watch those Chinese Walls. They sure are porous at times!

Coordinating the Feds

The 100 point cut in Aussie Reserve Bank rates was obviously a shot heard around the world as in the past hour,

Oct. 8 (Bloomberg) -- The Federal Reserve, European Central Bank and four other central banks lowered interest rates in an emergency coordinated bid to ease the economic effects of the financial crisis. The Fed, ECB, Bank of England, Bank of Canada and Sweden's Riksbank each cut their benchmark rates by half a percentage point. The Bank of Japan, which didn't participate in the move, said it supported the action. Switzerland also took part. Separately, China's central bank lowered its key one-year lending rate by 0.27 percentage point.

``The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability,'' according to a joint statement by the central banks. ``Some easing of global monetary conditions is therefore warranted.'' The Fed's decision brought its benchmark rate to 1.5 percent. The ECB's main rate is now 3.75 percent; Canada's fell to 2.5 percent; the U.K.'s rate dropped to 4.5 percent; and Sweden's rate declined to 4.25 percent. China cut interest rates for the second time in three weeks, reducing the main rate to 6.93 percent.

IMF Outlook

In the IMF’s latest assessment, they argue that an orderly de-leveraging that supported some growth in the private sector would require something in the order of $US10 trillion of banks assets to be either sold or run off bank balance sheets between 2008 and 2013. That would require public sector support. The IMF’s best case scenario (zero or at best negligible credit growth in the US and Euro zone), is predicated on $US2 trillion of public sector purchases of bank assets.

Without any public sector participation in the salvaging of the system or any bank recapitalisations credit growth would be negative 7.3 per cent in the US, negative 6.3 per cent in the UK and negative 4.5 per cent in Europe. In an interesting but hardly rational circular argument, the report strongly recommends the use of  taxpayer funds on the basis that the likely outcome of this action will  protect taxpayers from the real economic consequences of not using taxpayer funds. The IMF says, the "extreme downward pressure" on the share prices of financial institutions is analogous to a "run" on bank capital, with investors rushing to withdraw their funds and creating a vicious downward spiral that cuts the institutions off from any prospect of an equity lifeline.

The deleveraging argument should catch your attention. Deleveraging cannot be a one sided affair. Reducing leverage or debt also means disposing of the supported asset and given that we have a pretty good idea what these assets are, losses on disposal also mean capital destruction. If the loss on asset disposal is just 10%, an optimistic outlook at present, then the IMF estimates imply another $1 trillion in bank capital losses. It’s going to take all of Wall Street’s fabled financial engineering and innovation to come up with the funding this scenario demands.

Fortunately many of Wall Street’s brightest are now working for US Treasury to assist with the disbursement of Paulson’s bailout goodies so all that talent is right there on tap.

Gold and Commodities

Gold came off its latest Danielcode T.03 buy signal issued for Monday 10/06 with a burst of European and Asian buying that for the first time since March missed its highly correlated turn in DX which had a Danielcode sell signal just one day later on Tuesday. Gold trading at 904 has made a nice $50 profit for those who knew the signal but the move is muted in comparison to the mid September bounce. Silver’s response to Gold’s current move is tepid whilst HUI has failed to show enthusiasm. Nonetheless the correlation of direction between Gold and Silver is being maintained if not the quantum.

Oil and grains have fallen dramatically from their blowoff highs with Oil now trading near $88, a precipitous 40% drop.

Asia’s most important crop Rice, topped at 2482 in April, ran down to its first DC target near 1606, elected the “I don’t know” trading option of a 50% bounce and is now hovering at 1770. Strangely whilst these are the levels that provoked food riots early in the year, Asian press is mute on this subject presumably as concerns closer to the heart and pockets of more affluent readers give bigger headlines to crowd this topic away. With the liquidity purge out of market traded commodities, Rice alone of the grains has not had a major correction.

Global Currencies

US Dollar index DX has restored some cachet with its relentless rise from its March lows. Hedge funds have been hit hard with the strength in both of the favoured carry trade currencies, the US dollar and the Yen. September quarter hedge fund reports were dire and showed some market leaders sporting large losses for the month. Hedge funds are going to be much reduced participants going forward as the ban on short selling plus currency losses and stock market blues combine into a witch’s brew for many.

Here is DX which went onto a T.03 sell signal for subscribers last Friday, repeated on Monday and again on Tuesday. On this weekly chart it is reversing just 14 ticks from the DC black line target for the minor swing. I expect the current sell signal to be just a tradeable turn as I believe that apart from the short squeeze on carry traders that this market was engineered to produce, there is an element of global acknowledgement that US is best placed to deal with the credit market carnage. Whether Treasury and US Fed’s actions are right or wrong at least the US system allows a co-ordinated response with legislative and executive branches working together. Consider Europe’s predicament with no central constitution and each member country having autonomy over its banking system. Chaos.

Financial Sense readers who follow the Danielcode Reports may recall our upside call for DX in the September 3 article “Anger and Angst” in Asian Markets (see FSO archives). Our forecast at the beginning of September was:

“DX has gapped into its DC retracement at 78.15. The purpose of this rally was to kill off the one way short trade espoused by all from gurus to fashion models. The low hanging fruit has now been comprehensively picked and we expect a retracement before this market continues its rise. Just past 81.89 is the intermediate target for DX.”

Is 81.75 close enough?

 

Whilst the following chart is headed DX it is actually a composite of the daily CME currency futures contracts for major currencies, all of which have USD as the other side of the contract. The yellow line is the Yen which has shown amazing strength against all currencies including USD since mid August. Commentators believe that the Yen does well in tough times. That may be so but what you are really seeing is the late believers in the Yen carry trade being torched. That squeal is Yen shorts being taken to the woodshed!

The support by China and Japan for the Fed’s 50 point rate cut today and the global coordination of cuts by other central banks shows how closely the fortunes particularly of China are intertwined with US. As US’s biggest creditors a high level of tolerance and understanding from these players will be required as international insolvencies, recognised or not, continue to unwind. But hey, that’s why US Treasury made good all those GSE deals that China was holding.

Interesting times indeed!

 

CAUTION-The Daniel numbers on these charts are from historic sequences that may not be current at the time of publication. They are appended for historic interest only. Do NOT use these numbers to trade markets. Current Daniel sequence numbers for most currency crosses are available to subscribers at the Danielcode website.

Copyright © 2008 John Needham
Asia Editorial Archive

John Needham is a Sydney Lawyer and Financial Consultant. He publishes The Danielcode Report and writes occasionally on other markets. He lives with his family in Australia and New Zealand.

“The fox knows many things, but the hedgehog knows one big thing. A Hedgehog Concept is not a goal, intention or strategy to be the best. It is an understanding of what you can be best at. The distinction is absolutely crucial”. ~ Isaiah Berlin, The Hedgehog and the Fox

contact information

John Needham | The Danielcode Report | Taupo, New Zealand | Email | Website

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