Storm Watch Update
PEDAL TO THE METAL
by Jim Puplava
www.financialsense.com
October 5, 2001

The government came out blazing this week with both monetary and fiscal stimulus. The Fed started the week out with a half a point rate cut in the fed funds rate and the discount rate. The fed funds rate now stands at 2.5 percent and the discount rate is at 2 percent. You would have to go back to the first year of the Kennedy Administration to find rates this low. As this graph shows the nation's money supply is heading into the stratosphere. The supply of money has risen now by close to $1 trillion in the last twelve months. That just goes to show you how serious things have become. The Fed has lowered interest rates nine times this year and Tuesday’s rate cut won’t be the last in 2001. This is unprecedented. Greenspan and company have now lowered the federal funds rate by 400 basis points.

This is the most aggressive action I’ve seen from Mr. Greenspan since he assumed the office of chairman of the Fed in 1987. That was the year Greenspan had to tackle the stock market crash that could have led to a global meltdown of the financial system. Back then, the economy was in better shape. There was less debt, less speculation, and stock prices were more reasonably priced. The Fed Chairman now faces an economy that is heavily leveraged and whose stock market, though it has fallen, still remains greatly overvalued.

Source: CBS Marketwatch 10/2         

Some Will Benefit ... But Not All
The nine rate cuts will give banks something that they have not had for close to a decade -- free money. Lowering rates and liquidity injections will certainly help bank balance sheets, but it will do little for consumers. Savers will soon be getting next to nothing for their savings. Interest rates on savings accounts and T-bills are close to 2% and they could be heading lower. Investors sitting in money market funds and hoping to ride out a bear market aren't seeing a real return on their money. After adjusting for inflation, real interest rates are at zero.

Lower rates will have very little impact on most Americans other than to reduce the returns on their savings. While borrowing costs for banks have dropped to the lowest level in 39 years, long-term mortgage rates have hardly budged in comparison. This is because most home mortgages are bundled and sold as bonds in the securities market. It may surprise you, but when it comes to long-term interest rates, bond investors set the interest rate -- NOT the Fed. Right now those bond investors are worried about the above Money Supply graph. An expansion of the money supply of this magnitude is ultimately inflationary. It is one reason why long-term rates haven’t come down in a similar fashion as short-term rates. Short-term rates are more controlled by the Fed. Mortgage rates on thirty-year mortgages average close to 6.7%. But they are nowhere close to the 5.8% during the Kennedy Administration. As a result of this week's Fed rate cut of half a point, the 30-year fixed rate mortgage dropped 12 basis points to 6.58 percent. Rate moves in the longer end of the bond market, which includes mortgages, tend to precede Federal Reserve rate cuts. Because mortgages are long-term loans they move independently of Fed rate moves rather than react to them as short rates do. This is one reason why the reductions in interest rates have done very little for the economy. They have mainly benefited the banking system.

President Bush Proposes Stimulus Package
Recognizing the problem within the economy is much more serious is one reason the President has moved aggressively this week on the fiscal front. President Bush is proposing a stimulus package of $75 billion on top of the $55 billion for the airlines and emergency spending for the military and rebuilding New York. Unemployment benefits will be extended by another 13 weeks for those people who lost their jobs after the September 11 terrorist attacks. The new stimulus package would be a compromise package of new or accelerated tax cuts, fiscal spending, a minimum wage hike and other fiscal measures designed to pump money back into the pockets of a shell-shocked consumer. The Fed is pumping money into the pockets of bankers. The President wants more of the money to go into the hands of consumers who account for two-third’s of the nation's economy.

There are many economists who are calling for much more drastic fiscal spending. Economist James K. Galbraith, a devoted Keynesian, believes the government should devalue the dollar by as much as 25% and increase fiscal spending by as much as $600 billion. In a piece titled “The War Economy” Galbraith argues that the U.S. economy is facing a major crisis. “We are facing what is not only a terror attack, but also an economic calamity…as these events cascade through the economy, they will shatter fragile household balance sheets and precipitate steep cuts in consumer spending. The ensuing recession could be very deep and very long.”

Even legendary investor Warren Buffett weighed in on the economy this week. Speaking to reporters, Buffett said that we are now in a recession that will be relatively deep and extended.

Lower Quality, Bigger Hit
Getting back to interest rates again one obvious casualty from the attacks that has accelerated has been the spread between Treasuries and low quality issues known as junk bonds. Corporate bonds rated Ba1 by Moody’s now yield on average 8.1 percentage points more interest than Treasuries. You would have to go back to the last recession to find spreads this wide. In the last recession in 1991 the spread got as high as 8.94 percentage points. Before the September attacks the spread had widened by 6.5 percentage points based on recessionary fears. The return on junk bonds plunged 7.7 percent last month making September the worst month for junk bonds in 15 years.

Confidence Sags
Another significant indicator signaling stress in the financial system is the decline in the Barron’s Confidence Index. This index takes the high-grade bond index and divides it by the intermediate-grade bond index. The index measures what the smart money does when investing in the bond market. It signals what lies ahead. When the ratio moves up it indicates that bond buyers are willing to accept more risk by investing in high yield bonds. Conversely, when the ratio falls, it indicates that bond buyers have become more cautious and are investing in safer, high quality bonds. In the latest week, that ratio dropped from 88.3 to 84.6 from the previous week. This is big.

* In billions of dollars: notional amount of futures, total exchange traded options, total over the counter options, total forwards, and total swaps.
 Note that data after 1994 do not include spot fx in the notional amount of derivatives.  Note: numbers may not add due to rounding.
Data Source: Call Reports from OCC, 2 Qtr 2001

Pumping Money Supply Has A Purpose
This raises the question, "Why is the Fed pumping this much money into the banking system?" During the second quarter of this year, the notional value of interest rate derivatives held by commercial banks increased by $3.9 trillion to $39.6 trillion. Interest rate derivatives make up 83% of all commercial bank derivative portfolios. As the table below indicates, the notional value of derivative contracts has increased exponentially since 1998. While the number of banks holding derivatives decreased by 28 to 365 banks during the quarter, the derivative book is still is concentrated in 7 banks who  hold 96% of all derivatives. (See 7 Banks chart.) One bank in particular bears watching -- J.P. Morgan Chase. They hold 61% of the total notional value of all of the derivatives held by the 367 banks and trust companies.

Somebody... Somewhere...

I doubt whether any of the large bank derivative models had 9-11 built into them. Somebody, somewhere, is on the wrong side of a trade. What happened on September 11 was a very big, unexpected event. The last time anything of this magnitude happened was in the third quarter of 1998 during the Russian debt crisis. The main casualty was LTCM, which had bet that the widening spreads between junk and quality bonds would revert back to the norm. They didn’t. They widened instead causing LTCM’s portfolio to hemorrhage. The result was a major financial crisis, which bankrupted LTCM and nearly brought the world’s financial system to an end.

Back then the derivative holdings of our largest banks were half of what they are today. They were less concentrated. As this graph illustrates, the last time banks suffered major losses in their derivative books was during the third quarter of 1998. I wonder what this graph will look like when it is released for the third quarter?

I wrote something in Rogue Wave/Rogue Trader that bears repeating. “There will come a day without warning, at a time when nobody expects, when that rogue wave will appear. It will be a day when events overwhelm the financial markets… when the house of paper will fall…when our financial institutions will be put to the supreme test, when the mettle of a man is tested… when faith in our institutions will be called into question. It will only be on that day and in that hour that we will know if the Holy Grail of Finance truly exists.”

This is a test... only a test
This is a time of testing for the Holy Grail of Finance. It will be a time to find out if the professors' theory of risk defined as volatility holds true. This period is just a test. There will be more to follow. When you are in a storm, rogue waves can become more frequent. As the strength of the wind picks up, so does the chance and frequency for rogue waves to increase. Somewhere on Wall Street, the character of a man is being tested. Models are being reworked and contracts are being called. Some will hold. Some will fold. All the resources of the captains of our economy are being brought to bear in an effort to right this ship. The ship has survived the first rogue wave, but bulkheads are fragile and the ship has been damaged. Let us hope there will be no other rogue waves.

Increased Unemployment Claims Cause Concern
The other important news of this week is the jump in unemployment claims. They soared by 71,000 in the latest week to 528,000. They had jumped by 64,000 in the previous week. This indicates a major deterioration of the labor markets which has accelerated in wake of the terrorist attacks. Continuing claims for workers who have received at least a week of benefits rose to 3.41 million for the week ending September 22, the latest data available. This makes September the highest job-cut month so far this year. Total announced job cuts totaled 248,332 in September, up 77% from the previous month. Job layoffs numbered 140,019 in August according to outplacement firm Challenger, Gray & Christmas. Over 81% of those job cut announcements took place after the attacks on the Trade Center and the Pentagon on September 11.

The transportation sector has been the hardest hit. Other sectors hurt in the wake of the terrorist attacks have been the technology and telecommunications sectors. Geographically, because of the concentration of high tech, California is the largest job cutting state.

This morning’s report of a flat unemployment rate seems suspect to me. If employers cut 199,000 jobs, how can you match that number with a flat unemployment rate? In the final analysis, I'd wager the trend towards higher unemployment has accelerated as a result of the terrorist attacks. As business sales have suffered in the transportation and travel industry, businesses and consumers have cut back sharply on their spending plans. This has prompted corporations and small businesses to cut back on employment in an effort to stem lower sales trends.

So What's The Government To Do?
The President and Congress will have their hands full. The storm is quickly gathering force. The Fed’s interest rate cuts have done little to keep the storm offshore. Fiscal spending may help temporarily, but then what? The problem is simply that all of the excesses of the past decade are now coming home to roost. It may be impossible to avoid them but tax cuts will help. The best idea put forward is a reduction of the payroll tax. This impacts Americans the most. The surplus generated by those taxes is now being spent. Nobody is talking about putting a lockbox around Social Security trust funds. Those talks ended right after September 11. So why not put those dollars back into the wallets of the people who pay the tax? This might give liberals heartburn, but it would help those who need it, most which are low-income Americans. A reduction in the capital gains tax would do very little right now. First of all, there are very few with capital gains left after the bear market of the last eighteen months. Acceleration of the lower income tax passed in this year's tax reduction package would be a better idea to follow a reduction in the payroll tax. Let us all hope our leaders are listening to the burdens of most Americans and take wise action.

How Now Dow?
On a final note, I’ve been fascinated by all of the blather from the bubbleheads on bubblevision. They called this last week's rally a sign that we’ve hit bottom and now its onward and upward. Look at this chart of the Dow's Moving Average. It depicts the Dow against its 50 and 200-day moving average. The Dow touched below the 200-day average in March and April. It then rallied before flirting with falling below the 200-day trend line for most of the summer. It then fell steadily below the 50 and 200-day average in the middle of August. In September, following the Trade Center attack, the trend accelerated where it has remained since.

It may come as a surprise to many in the media, but stocks can rally within a bear market. With P/E multiples at 22 for the Dow and 37 for the S&P 500, we have hardly approached bargain levels that would generate strong fundamental buying. This is nothing more than a trading rally. Another shibboleth [a commonplace idea or saying; language that is a criterion for distinguishing members of a group.] of the bottom theory has been a rise in the advance/decline ratio on the NYSE. It turns out that close to 48% of stocks listed on the exchange are closed-end stock and bond funds and preferred stocks. They have risen as a result of investors seeking a refuge from stocks and a higher return than what is offered on money market funds. The AD line for the S&P 500, which only includes stocks, is still falling. The smart money must love bubblevision. They give people hope when caution is warranted. This allows those who want to get out another chance to bail out at the expense of the uninformed, which includes the bubbleheads.

Smart Money Moving Quietly
The smart money is heading into gold and silver. They have been buying and continue to buy. This is reflected in the rise in gold and silver shares this year as well as a rise in the price of the physical metal. Another crisis is waiting for those who have gone short. Imagine what they thought after September 11 when our markets were closed and they were short gold and silver bullion or short mining shares. Dealers across the country are reporting robust buying. There are even delays reported in getting physical possession of hard metals. Some may be surprised to learn that a good portion of it remains buried underneath the Trade Center.

Silver is on the verge of exploding. Unlike the rise in the price of gold after the Sept. 11 attacks, silver prices have barely budged. Demand for silver continues to outstrip supply. Unlike gold, where central banks still hold vast quantities that can be lent to the markets to suppress prices, there are no vast hoards of silver. The stockpiles from the 80’s have been greatly reduced. According to the CPM Group, silver stockpiles fell to 500 million ounces last year. We are currently running silver deficits of 10 million ounces a month. Just last month someone tried to buy 10 million ounces and it pushed the price up 25 cents an ounce. When the hive wakes up to this fact the price is headed for a moon shot.

The gold market has awakened as a result of the Trade Center attack. Even gold pessimist such as Andy Smith of Mitsui Securities in London has done an about-face. According to Smith, “The price of gold could go to $340 an ounce within the next three months - and continue to soar after that.” As I have stated, "There will come a day unlike any other day..." that day is coming for gold and silver.  ~ JP