The Perfect Storm was one of those rare events that seldom occur or are seen in one's lifetime. Such a possibility now exists on our financial front. Instead of the Grand Banks, there is New York City – home to some of the worst financial storms of the century. A deflationary cold front is gathering force as the byproduct of a credit-induced, high-pressure system ready to burst. Coming off the power center located in Washington, a low-pressure inflationary hurricane has been slowly gathering force over the last eight years. It is the product of taxation, regulation, financial market manipulation, the suppression of gold and silver prices, under investment in key resources, trade deficits and a surfeit of dollars. As a result of the expanded money supply and its revenues, the tax system has been evaporating dollars out of the economy. The two storm fronts are about to collide.  Hovering above is the jet stream, which is the international monetary system, a huge interbank market that moves trillions of dollars of currencies around the world.

All that is needed is a trigger mechanism to shift the jet stream off its intended course and move the two storm fronts towards collision. Financial weather centers in New York, Washington, London, Frankfurt, Paris and Tokyo are monitoring the storm's progress. Financial meteorologists disagree as to the outcome and the direction of the storm, but they all know it’s out there. Some say it will be deflationary because of the credit-induced cold front. Others say it will be inflationary because of the energy force created by the expansion of dollars throughout the monetary system. Perhaps it will be both or something entirely different. Perhaps it will be The Perfect Financial Storm. The combination of a high-pressure system meeting up with a hurricane-fortified low could create something we have never seen before: a financial pressure gradient seldom seen by financial meteorologists, the simultaneous occurrence of two different storm fronts – one inflationary, the other deflationary.

At the risk of sounding repetitious, it is important to point out that these storm fronts are indeed gathering force. Wall Street expects a V-shaped recovery and a quick resumption of the bull market. In their view, the current problems have been assessed as nothing more than an inventory correction. However, as pointed out in previous installments, there is more at work here than a simple inventory correction. The problems are systemic. They are the result of a giant credit bubble fed by an expansionary monetary policy. This bubble has led to enormous imbalances within the economy and financial markets. These imbalances are creating the storms. It remains to be seen whether these storm fronts collide and form The Perfect Financial Storm.

The Deflationary Storm Front

Debt, Debt and More Debt Spells Trouble
Meanwhile the expansion of the money supply and concomitant expansion of credit go on unabated. As these graphs indicate, the money supply looks like an F-14 carrier launch. Everything from consumer credit, household mortgage debt, financial sector debt, and total credit debt outstanding are growing at near double-digit rates. Right now financial institutions are creating credit card-backed bonds. Selling the bonds enables financial institutions to sell more debt and turn more of their assets into cash.

These institutions remove the accounts from their books by repackaging them into bonds. Through this process they are able to collect more fees. Getting the loans off their balance sheet also allows the banks to free up additional cash required as reserves against possible loan losses. Large financial organizations such as Citibank and MBNA Corp. have grown their businesses at double-digit rates because of their ability to securitize their loans. Last year these two firms accounted for nearly 45% of the total of $459.3 billion in US credit-card accounts outstanding at the end of 2000. The result is that credit card debt grew by 17.7% since 1999. ¹

The consumer-spending binge cannot go on much longer. Consumer balance sheets continue to deteriorate by burdening debt and shrinking investment portfolios.  More than $4.5 trillion in wealth has been wiped out in the current bear market. This deflationary cold front could gather momentum as it hits the consumer with full force. Confidence is eroding with each 100-point drop in the financial markets and with each day’s announcement of more layoffs coming from corporate America. Debt levels are still expanding and the job sector is still strong, so we have not yet arrived at the point of panic.

A Possible Scenario
However, there comes a time when confidence is replaced by fear and fear is replaced by panic. That panic could induce further asset sales and bring the bear market into its second and most deadly phase where consumers jettison assets to pay down debt. Evaporating confidence causes consumers to retrench on current and future spending plans. Suddenly the economy begins to contract in a deflationary spiral. Injections of new credit are useless. The consumer is tapped out, businesses go under and nobody wants to lend.

Corporate America Showing Signs of Retrenchment
It is obvious that the credit bubble is beginning to burst. Five cuts in interest rates and an expansion of the supply of credit have failed to arrest a falling stock market. Job layoffs have become a daily news event. Corporations warn of profit shortfalls and analysts warn of deteriorating corporate balance sheets. Business stress can be seen everywhere. Air travel has been cutback, cheaper hotels are being used, and durable goods orders are down. Bankruptcy filings by major corporations such as Montgomery Ward, Sunbeam, TWA and Owens Corning are increasing. Junk bond defaults are escalating with a rise of 6.7% during the last twelve months. Recently Moody’s upped its default rate for this year to 9.7%. As more companies file for Chapter 11 bankruptcy, bondholders are getting paid back $.17 on the dollar. ⁴

Consumers Showing Signs of Retrenchment
Stress is also evident at the consumer level. Mortgage delinquencies increased by half a percent to 4.54% during the fourth quarter. Many consumers are carrying mortgages at 95-125% of their home’s value. While interest rates have headed lower, mortgage refinancing should hit $1.5 trillion this year. A consumer that is more willing to go deeper into debt has supported retail sales. But that may be coming to an end with collapsing stock prices. Our local paper in San Diego ran a headline story “Retailers in county wonder where their shoppers went.” Stores reported sales declines in March anywhere from 5.3% to 13.0%.

During a recent trip to my favorite clothier, I asked the manager of the store about business. He told me that week-by-week, over the last six months, that business has been steadily declining. Last year, sales of men’s suits were 48% of the store’s business. This year, suit sales were only 19% of store sales. Suits are high margin. Casual clothes, carrying a smaller margin, have replaced them. He attributed the decline and change in shopper preferences to worries about the job market. Customers are only buying the essentials.

As bank credit standards are tightened, debt-strapped consumers may find it more difficult to find new sources of credit. Bereft of skyrocketing stock appreciation, consumers are using more debt to fund their purchases. Consumers have increased their standard of living by credit spending. This has made banks very rich and families very vulnerable. The average annual percentage rate of credit cards is 15.52%. As more borrowers lose their jobs, they face debt loads they can’t handle. These debt loads threaten their mortgage payments and in many cases, lead to bankruptcy. Bankruptcy filings have increased by 22% during the first quarter of this year, and the delinquency rate on credit cards has risen to 5.3%. ⁵ The savings rate is now negative by over 1%.

Real Estate – The Last Bubble
Real estate is the last beneficiary of the credit bubble. Lower interest rates have allowed existing homeowners to trade up, new owners to buy in, and existing mortgages to be refinanced. However, as the economy slows down, job layoffs increase, and stock market wealth evaporates, housing will be the last bubble to burst. There are already signs that a retrenchment is taking place.

In April, new home sales posted their biggest decline in four years. The sale of single family homes tumbled 9.5%. Existing homes sales are already starting to slow and the rate of growth in new housing has come down. You can observe the subtleties of this slowdown by the increase in houses going on the market in your neighborhood. Where I live, which is Southern California, you have to be a near millionaire, have ample stock options or a six-figure income, or have a banker as a close friend to be able to afford a home. Housing prices can run as high as $250 a foot. Housing, property taxes and increased utility costs are mounting.

One of the untold stories last year was fact that the bubble shifted from the stock market into real estate. It continues today. Non-bank financial intermediaries like Freddie Mae and Freddie Mack are feeding it. Fannie Mae had mortgage volume of $105.6 billion in the first quarter of this year. This compares to $50.8 billion during the same period last year. The mortgage credit balloon is behind the current boom in real estate. However, as these entities continue to expand their balance sheets, they must continue to hedge their interest rate risk. Fannie and Freddie make money on the difference between their cost of borrowing and the yield they receive on mortgages. To maintain that margin, they expand their hedges through derivatives like options and interest rate swaps. The constant swings in the derivative markets have made their earnings less stable. They take a hit in earnings whenever long-term rates go down. This constant need to hedge an expanding balance sheet is forcing them to take on more risk to achieve their earnings objectives. Even Warren Buffett has been dumping his shares of Freddie and Fannie because he believes they have become risky. Aware of this risk, Congress is considering legislation that would transfer oversight of the two agencies to the Federal Reserve.

Deflationary Storm – A Matter of Phases
Once job layoffs begin to accelerate, we will see the price of real estate begin to soften, weaken, and then collapse. Lenders will then have to contend with a growing portfolio of delinquent loans. More real estate will come on the market, which will further soften prices as overburdened consumers unload expensive homes. Mortgage delinquencies will force banks to unload their loan portfolios further dumping supply onto the market and weakening prices. The downturn in real estate, following the collapse in stock prices will initiate the second phase of deflation. Once real estate prices cave in, consumer confidence will ebb to new lows, setting off phase three of deflation, which will be a full-blown recession. The recession will cause manufacturing to cut back, layoffs to accelerate, consumer spending to retrench, and retail sales to contract. This could lead to a shortage of real goods in the economy, which would cause an inflationary storm front to collide with a deflationary storm front in paper and real estate assets.

Inflationary Storm Front

Higher Waves in Raw Materials
While the deflationary storm front wrecks havoc with the economy, a simultaneous inflationary storm front will heat up in raw materials. Years of low prices have evaporated aboveground supplies and capacity in just about every raw material from silver, gold, platinum, palladium, to oil and natural gas. Years of low prices have led to under-investment in everything from new mines, offshore drilling rigs, pipelines, refineries, tankers, to sugar and cacao plantations.

The Energy Crisis Has Just Begun

Higher energy prices are hurting manufacturing by forcing production standstills. The Bonneville Power Administration, a government agency that sells hydroelectric power in Washington, Oregon and Idaho requested that the aluminum companies in the region stop using its power for up to two years. The ten smelters located in this region account for 40% of US aluminum-making capacity. Aluminum prices rose $32 on news of the possible shutdowns. Companies have agreed to shut down smelters to conserve energy. Alcoa and Kaiser have cut more than 1 million metric tons of production because of the energy shortage. The new shutdowns requested by Bonneville Power may result in 6,000 people losing their jobs. Elsewhere, Phelps Dodge is shutting down 11% of its annual production because of high energy costs. Many firms have found it more profitable to sell their electricity than produce raw materials.

Commodities Are On The Move

While we have under-invested in our energy infrastructure, low commodity prices have caused mines to be shut down and plantations to go fallow.  At the same time, with globalization during the 90’s, much of our manufacturing capacity has moved offshore. Mattel is now closing its last manufacturing plant in Kentucky and moving to Mexico. We import more of our basic goods from overseas which accounts for our record trade deficits. This further adds to the inflationary storm front that is building through the monetary system. Since we pay for these imports of consumer goods and energy with dollars, a collapse in the dollar would spell higher prices for basic goods, raw materials and energy. The rise in oil and natural gas prices, aluminum and palladium are signs of inflationary time bombs ready to detonate.

The Monetary Storm Front

International Currency & Confidence in the Dollar Eroding Meanwhile another storm front is brewing in the international currency markets. A falling U.S. stock market and a faltering economy could cause erosion in foreign confidence in the dollar. Throughout the financial turmoil of the 1990’s, the dollar has been a beneficiary of each global crisis: the peso crisis in 1994, Asia in 1997, and Russia in 1998. During each of these storms, foreigners could buy dollar assets as a safe haven and refuge. This served the U.S. well since it allowed us to fund a growing current account deficit. Today this huge current account deficit is unsustainable. A loss in confidence in the U.S. economy and financial markets could cause foreigners to cut back or even dump their dollar-based financial assets. A dumping of the dollar would force bond prices lower, thereby ratcheting up interest rates. Higher interest rates would play havoc with the economy and our financial markets. We Are Whom We Owe As these graphs of foreign holdings of U.S. Treasuries and financial assets indicate, a collapse of the dollar could trigger a simultaneous collision of inflationary and deflationary storm fronts. Whether a collision of these two storm fronts takes place will depend on the jet stream. In the realm of weather, the jet stream is the engine behind all weather fronts. It is a river of cold air circulating around the globe at elevations of thirty to forty thousand feet. In its path lie storms, cold fronts, hurricanes and short-wave troughs that get dragged eastward by this layer of cold upper-level air. The jet stream is unsteady and unpredictable. When, where and why storm fronts occur are beyond the ability of scientists to predict.

Financial Nor’easters Probable
In the financial world, the jet stream is the international monetary system. This market consists of a network of interbanks that move trillions of dollars of currency around the globe on a daily basis. Like the jet stream, it too is unpredictable. The global monetary system, which still runs on dollars and is no longer anchored to gold, is not only unstable but also capable of producing its own equivalent of nor’easters. These nor’easters are financial time bombs that can subject a nation and its financial markets to chronic turmoil. They have touched down in the U.S. in 1987, Mexico in 1994, Asia in 1997, and Russia and again in the U.S. in 1998. They are capable of producing immense destruction. These financial nor’easters can cause currencies to gyrate, interest rates to soar, send domestic economies reeling, and cause stock markets to crash. The jet stream moves money around the globe to various hot spots seeking the highest return. The more money governments create, the more money that is sucked up into the air of the international jet stream, and the more unstable it becomes.

Until recently, the U.S. has remained outside most of the storm paths brought about by this international system. This is because of the advantage the U.S. dollar holds as the world’s reserve currency. It has spared us from experiencing the harsher storms unleashed on Asia, Latin America, and Europe. In fact, in times of turmoil, we have been a refuge for currencies seeking shelter from other storms. Only once in recent memory did it impact the U.S. as seen in the dollar crisis of 1985-87 which led to the October stock market crash of 1987.

Over the last two decades, when a global storm front appeared, money flowed into the U.S.. Today we are now in danger of another dollar crisis. The US is running huge current account deficits with the rest of the world (now 4% of GDP). The massive credit bubble of the Clinton years has caused over-consumption and malinvestments in the U.S. It has also produced a negative savings rate, caused consumer debt loads to balloon, and imports to soar. Not only are we borrowing vast amounts of money domestically, but we are also absorbing much of the savings outside of the U.S. We have had the good fortune of having our trading partners invest our exported dollars back into our country. The danger is that we are consuming our capital assets. We have traded our inheritance for DVDs, stereos, TVs, consumer electronics, and automobiles.

These massive trade deficits have resulted in a transfer of our capital assets – from government debt, corporate bonds, to the ownership of US corporations – into the hands of foreigners. This process can’t go on indefinitely. In fact, if it unwinds, it could bring about The Perfect Financial Storm. In the past a financial crisis favored the U.S.. But unlike the past, we now have massive debt burdens at the consumer and corporate level. We no longer have a high savings rate that can cushion the country in an economic downturn. Our savings has been replaced by credit cards with average balances of $8,000. We don’t have large inventory imbalances. Instead, we have a large overhang of malinvestments in technology.

As mentioned in previous installments in this Storm Series, faith in the dollar is based on faith in our financial system and faith in the U.S. military. These are the intangibles that support the greenback. Should a situation undermine faith in either area, a serious dollar crisis would occur.

I have already identified our Achilles heel in Rogue Wave/Rogue Trader. An unexpected rogue wave hitting this market could lead to The Perfect Financial Storm.