Month: January 2016

From June 26th 2012)

Rob Kirkby’s June 2012 blog article, ‘The Greatest Hoax Ever Perpetrated on Mankind’, recently caught my eye:

http://news.goldseek.com/GoldSeek/1339766400.php

It is one of those arcane areas of Finance that really ought to have a little more light shed on it, and probably should be written about much more than it has been. It may be a complex subject and prone to ‘buzzword bingo’ but we ought to persevere. Most people will be out of their comfort zone when exploring the ramifications of derivative trading and I am no exception. However, we should never be afraid to learn or ask questions.

So here goes.

The BIS (Bank of International Settlements) produces a half yearly report of the total number of global derivatives believed to be in existence at the end of a reporting period. The report dated 9^th May 2012 had the following comments on ‘key developments in the second half of 2011’:

‘Notwithstanding the increase in the reporting population, total notional amounts outstanding of OTC derivatives declined between end-June and end-December 2011, to $648 trillion. At the same time, gross market values, which measure the cost of replacing existing contracts, increased to $27 trillion, driven mainly by an increase in the market value of interest rate contracts.’

http://www.bis.org/publ/otc_hy1205.htm

So it would appear that we had $648 trillion of derivatives in place at the end of 2011.

Drilling further into the detail we find that of this $648 trillion, the largest element is that of interest rate derivatives, and of those nearly $403 trillion are ‘Interest rate swaps’:

http://www.bis.org/statistics/otcder/dt07.pdf

My feeble and amateur understanding of a credit interest swap is basically that of an exchange of cash flows between two parties. It might be to change a flow based on a fixed rate of interest to a variable rate, perhaps to exploit arbitrage opportunities, or maybe hedge risk in currency based transactions. The purpose and variety of these instruments appears to be almost limitless; each derivative being created pretty much on a bespoke basis to address a specific financial objective.

It stands to reason that as they are ‘binary’ on an individual basis then one of the two parties will be ‘in the money’; one wins, the other loses. Somebody has to take the other side of the trade.

Now this is where I start to have a bit of a problem. Either I need to better understand these things, or something about the whole derivative construct does not add up.

Let’s move on to the banking system, the ‘Big 5’ U.S. banks. I am not comparing ‘like with like’ from a definition perspective in switching from BIS tracking to OCC tracking but that is not really germane to the point I want to make. Limitations and inconsistencies acknowledged, let’s move on.

At the end of March 2012 the total notional amount of derivative contracts for the top five U.S. banks stood at $292.4 trillion:

http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq112.pdf

This is an aggregate amount and includes those defined as ‘interest rate swaps’ by the BIS. ‘Swaps’ remain the largest category within the OCC data definition at $168 trillion.

Now this is where my brain starts to seize. The total capital base of these same banks amounts to $8.2 trillion, and this plays an aggregate $292.4 trillion derivative book. Irrespective of whether we are looking at an element of this total or the total itself I cannot believe that the total net exposure between all the banks within the global derivatives market is zero, even less the case for the five largest banks. Are we to believe that the collective banking mind is coincidentally split 50/50 on its global perspective on future interest rates and future FX trading conditions?

The question for me is really one of how much the net exposure of these banks exceeds their aggregate capital base. Is this now the real role of the Exchange Stabilisation Fund, to act as an amelioration element within the global derivatives market?

As implied by Rob Kirby you either believe:

a)    That everything eventually nets out to zero.

b)    There is an unseen force acting to maintain long term stability.

His ESF argument is starting look plausible.

Far smaller in size but perhaps of more interest to those of us interested in gold and silver is the value of the notional amounts of gold and precious metal contracts at the end of March 2012. According to ‘Graph 8’ this totalled around $153bn for gold and $33bn for other precious metals. However, care is needed in recognising the note: ‘Figures above exclude foreign exchange contracts with an original maturity of 14 days or less, futures contracts, written options, basis swaps, and any other contracts not subject to risk-based capital requirements.’ Refer also to ‘Table 9’ which provides a breakdown by the ‘Big 4’ banks. With $117.4bn in gold and $18.5bn in ‘precious metals’ it will not be a surprise to find that JPM is by far the largest derivatives player in the PM space.

I don’t draw any new conclusions from this other than that it is a confirmation of what we already know: JPM’s PM derivative positions are extraordinarily large and they don’t seem to have any obvious counterparties. Are they supposed to be hedging against themselves, other market derivatives, or is someone else pulling the strings for purposes we can only speculate upon?

The more I learn, the less I seem to understand.

From June 8th 2012

I recently tripped over the almost-forgotten story of the September 1931 Invergordon Mutiny. As part of a government austerity drive, to deal with the effects of the Great Depression, the British Government instructed the Navy to impose a pay cut of 10% across the board, and 25% on certain junior ratings. It was poorly communicated and naturally provoked a reaction, which itself wasn’t particularly well handled.

Mutinies had always been very rare events within British naval history, and so it came as something as a shock to the wider community when news finally filtered through. Indeed, by the time it hit an already unsettled Stock Exchange it caused a panic, which of course rapidly rippled through into the currency markets. Despite an ultimately successful imposition of a flat 10% cut, confidence in Great Britain, its government and currency had been irreparably damaged; it caused a run on the Pound. On September 20^th 1931, less than ten days after sailors had read about their pay cut in newspapers, Great Britain was forced off the gold standard.

An apparently minor event geographically remote from our centre of finance acted as a catalyst for a tectonic shift in global power. Fast forward to 2012 and we have a level of interconnectedness exponentially greater than that of 1931. News, action and reactions are almost instantaneous; perceptions are reality and markets can be moved with a carefully worded phrase.

We are overwhelmed with an almost infinite universe of choices for what might be the actual catalyst for systemic collapse, some more obvious than others. It is as likely to be the less obvious as the obvious. After all the obvious are being managed, those ‘known knowns and known unknowns’ are almost certainly being choreographed towards what they hope will be a least-worst outcome. The lack of action from the ECB, MPC and FED this week is more likely to be part of an ongoing crisis management strategy, than an attempt to telegraph an air of confidence in global recovery. ‘Not now, maybe later’; ‘it’s too early to tell’. All focused on economic recovery elements, rather than the real issue; a debt laden and failing Europe, the herald of global failure. The trigger may not have been pressed but the bullet is in its chamber.

Spain the state may be bailed out, and the associated austerity imposed may well guarantee negative growth for a number of years, perhaps a decade. As with Greece, Ireland and Portugal, the credit markets will effectively close to them, rendering an indeterminate reliance on the Eurostate. It will be managed; it’s a known unknown, unknown only at the quantum level. ‘Experts’ may guess at €400bn but the Eurostate propaganda will ensure that the amount will be significantly less. Perception is reality.

It’s the stuff not being talked and reported about that we should be worrying about. It suits many in the City and on the other side of the pond to maintain focus on Spain, Greece, Ireland, Portugal and next on the block, Italy.

Meanwhile, other financial cancers eat away at the integrity of the system. The masses are not aware of the problem, and those that are think they are in remission. The collapse of credit within the shadow banking system never made it beyond the secondary media, out of sight but continuing to shrink. A lack of transparency in the $600 trillion global derivative market remains unreported. Four years after Lehman CDS’s remain un-backed by capital and continue to be traded opaquely, off any recognisable exchange on the planet. Commercial bullion banks, having negotiated extension after extension see the ever-closing threat of Eastern demand for physical bullion heading straight for their overexposed short positions. The widely presaged volatility is already starting to occur. We were warned to expect $100 moves in gold in a single day as the systemic spinning top gyrated in ever wider movements towards its inevitable fall; we saw $66 last week. A failure in any one of these areas could unexpectedly cascade through into the global arena.

Then there is Iran, away from the headlines at the moment.

Would it suit Israel to attempt a strike coincidental with the Euro break-up dominating the media? Few nations in the Middle East want nuclear armed Iran and the patience of the Israelis in the EU brokered negotiations is not infinite. It is a known unknown that could surprise at any time with a predictable impact on oil prices and gold.

And of course we have the unknown unknowns, the ‘black swans’ ready to take flight.

What will be the Invergordon Mutiny of 2012?

From June 5th 2012)

There is a significant divergence between the way the mainstream present the UK’s Debt to GDP ratio and the approach taken by ‘alternative media’ economists and writers in the blogosphere.

It very much depends on what you include and what you don’t.

Back in early 2011 the Office for National Statistics (ONS) included this under-reported gem as a header for its 25^th January public finances news release:

‘For the first time data for Royal Bank of Scotland and Lloyds Banking Group have been fully incorporated into the public sector finances. This has impacted considerably on the measure of public sector net debt that includes the effects of the financial interventions. It has not materially affected the measures excluding temporary effects of the financial interventions, that are used by HM Treasury for the purpose of fiscal policy and are the measures that are forecast by the Office for Budget Responsibility.’

Further into the release we find out that at the end of December 2010:

Net debt excluding the temporary effects of financial interventions was £889.1 billion,equivalent to 59.3 per cent of gross domestic product (£2322.7 billion, equivalent to 154.9% including interventions)

The measures excluding the temporary effects of the financial interventions are used by the Office for Budget Responsibility to forecast the public finances and by HM Treasury for the purposes of fiscal policy.

For the record let’s bring the numbers through to the end of 2011. They are slightly less obvious in this January 2012 release but are still there to be seen:

Public sector net debt at the end of December 2011 was £1003.9 billion (64.2 per cent of GDP). This compares to £883.0 billion (59.4 per cent of GDP) at the end of December 2010;

Public sector net debt at the end of December 2011 was £2329.9 billion (149.1 per cent of GDP). This compares to £2257.0 billion (151.8 per cent of GDP) as at the end of December 2010.

And a link to the ONS media release:

http://www.ons.gov.uk/ons/dcp171778_253584.pdf

So the ’64.2%’ ratio is our officially recognised year end rate, not the ‘149.1%’ which happens to include the liabilities of our semi-nationalised banking system.

It is ‘temporary’ of course, however long that may be.

My concern lies in what happens if we have a system-wide crisis with Europe acting as a catalyst. Will those banking liabilities crystallise? After all, although not included in the headline debt ratio by bringing them on to the national balance sheet the UK is effectively announcing to the world that it is standing behind them. How could the UK not be held to account in the panic of a crisis?

And of course what other ‘off balance sheet’ derivatives are also lurking in the banking undergrowth? Are there additional unknown contingent liabilities?

But our nationalised banks have assets. The £1.3 trillion is not reported because the assets of these banks exceed their debt. Indeed, there is a net book gain so there is nothing to worry about.

Enter IAS39, ‘mark to market’ and our global property problem.

Over on the asset side of our balance sheet we have lots and lots of loans and complex derivative securities predominantly secured by some form of property or financial asset. Alas, in many cases the underlying value of that security has tanked since the bursting of the property bubble.

But for the support of the regulatory authorities on both sides of the Atlantic in 2008 and 2009 we would already be in something of a pickle. Without labouring the point the U.S. authorities relaxed the ‘mark to market’ rules at the height of the credit crisis. In other words if the systemic drop in value threatened the system, get rid of the rule that required assets to be based at market value. I’ll leave Wiki to explain the background on this little wheeze:

http://en.wikipedia.org/wiki/Mark-to-market_accounting#Effect_on_subprime_crisis_and_Emergency_Economic_Stabilization_Act_of_2008

I mention this because within the profile of our local banks U.S. investments are not exactly under-represented.

IAS 39 is an international accounting standard that sets the basic framework for the recognition and measurement of financial instruments:

http://www.ifrs.org/NR/rdonlyres/BCE30C2D-F85E-42B7-ADB6-E91B50F13B39/0/IAS39.pdf

It is a technical document so I will get to what I find the most interesting element, the paragraph on the measurement of financial assets. On the face of it the document seems to make a lot of sense but the problem of course has been current market conditions. During 2008 and 2009 the banks carried too many assets as ‘available for sale’ which would have involved making them down to a ‘fair value’. The quantities involved were so great that they would have threatened the integrity of the entire system.

So, as in the U.S., a way was found to take these assets out of that category. They would be ‘held to maturity’. Some elaborate and very creative balance sheet manipulation took place, SPV’s, ‘Special Purpose Vehicles’, were created to hold ‘bad’ assets which could be held to term. Tainted and overvalued assets could be shifted and legitimately held at book value without impacting future profitability. No significant write-downs were necessary; the banking system survived and bonuses continued to be paid.

Our £1.3 trillion or so of banking assets are ‘backed’ by an asset portfolio which on the face of it should not cause concern. But what proportion of these assets are held at book value and how much of it truly represents underlying market values?

What happens when the sovereign debt problem does become a systemic issue?

Which number should we be looking at?

From June 3rd 2012

I once made the unfortunate mistake of suggesting that the revenue interest cover (not EBIT!) on my employer’s debt pile looked like it was heading for 25%. In other words revenues covered annual interest payments by a factor of four. It was obvious to me that the situation was unsustainable and that at some point in the not-too-distant future cash flow would bring the situation to a head. The comment was made to an exec board director of a large PLC, whose brand you would have recognised then, but which has now been consigned to corporate memory. It wasn’t what he wanted to hear.

Eighteen months later its U.S. holding company filed for Chapter 11 bankruptcy protection in what at the time was regarded as the largest failure in UK corporate history.

My analysis had been spot-on but my timing was off.

During 2009 and 2010 I came to the conclusion that the structural issues within the global economy would manifest themselves in some way through some sort of crisis. A few years earlier a move out of employee status into that of an independent had forced me into thinking about how to improve management of my investment portfolio – you need to carefully plan for those ‘downtime’ periods. It wasn’t long before I discovered gold and silver. Perhaps surprisingly, I had never really considered them as monetary alternatives. As with most people my education had conditioned me to think of that paper stuff as ‘money’. Keynes had come into favour by the time I had started to study my economics ‘A level’; it certainly did seem to make some sense, especially some of the basic formulae which seemed to suggest that you could manage an economy by pulling certain levers from time to time. In retrospect I feel pleased that I did not pursue the subject to degree level. While I had picked up an elementary understanding of the subject it was not enough to condition my thinking for the ensuing decades. I could still exercise an open mind about ‘alternative’ economic paradigms, unencumbered by an economics higher education. So I bought-in to the gold and silver story, literally, in 2006.

2006 and 2007 were still boom years. But the seeds of collapse had been planted many years earlier and artificially nurtured by nutrient accelerants. Those nutrients of course later manifested themselves as poison. Growth had certainly been substantial and endemic. Unfortunately our economic roots were not strong enough to hold the overwhelming foliage of debt that had appeared. Ugly, improbable and aberrant derivative growths appeared, exacerbating an already distorted and misshapen construct. Our economic tree looked like it was about to topple, slowly being crushed by the effects of its own weight, and being eaten away by elements clearly violating natural law. There had simply not been enough time to build strength into the eco-system, nor had it been effectively nurtured.

Our economic tree started to topple.

The Neo-Keynesian rulebook was consulted. Or eco-system needed more nutrients and better accelerants. Interest rates were forced down and money printed. A rapid injection of both provided some respite. Ugly, distorted and a fundamental violation of natural law it might be, but it still stood. We had a cure. When the system looked uncertain all that was needed was another injection of medicine.

But we don’t have a cure. Those economic steroids may have kept the system afloat for a time but our eco-system is still fundamentally flawed. Those genetically engineered derivative ‘growths’ are still there and the weight of debt shows no sign of decreasing.

The threat of entire branches falling away suggest an early autumn. Leaves, people and small businesses, are already falling; unemployment is on an upward trajectory. But it’s the threat of entire branches cascading down that will catch the headlines. Greece, Spain, Cyprus, Portugal may be followed by Japan, the U.K. and ‘eventually’ the U.S.

Only a few months ago it looked like we had a cure. The U.S. and the U.K. appeared to be in recovery, and the talk was of a ‘soft landing’ in China.

How things change.

The world is now polarised into two separate thinking paradigms. The U.S. conditioned by the awful effects of the Great Depression is fearful of an even greater depression. Concern is not with inflation but deflation. On the other side of the Atlantic Germany sits as marionette-master. It has a genetic memory of the Great Inflation, the wheel barrow Weimer Republic experience of the early 1920’s. And within Europe we have a tussle between an intractable Germany and an equally incorrigible European periphery, desperately seeking a world where someone else continues to pay.

We have an impasse. We don’t even have outcomes that could be seen as binary, none look positive.

As I write we also seem to have the worst of all worlds: decision paralysis. Twenty summits with no decisions have finally led to the Eurocracy being ‘found-out’ by the markets; and Europe’s people are starting to vote with their feet.

The politicians have effectively terrorised the Irish into voting ‘For’ austerity. In Greece, Cyprus, Spain and Italy the situation is different. Unemployment is already off the scale in some areas, thousands are homeless and the prospect of power cuts and food shortages threaten Greece. And Spain cannot afford to bail out Bankia, not to mention the queue of IAS 39 protected banks behind it. IAS 39, the one that facilitates ‘innovative’ presentation of property related assets on bank balance sheets. The unemployed in Spain and Greece have little more to lose; many have already lost a roof over their head, resorting to bins for the next meal. What possible hope can ‘austerity’ offer these people?

So the world teeters on the brink. What looked like years away only a few weeks or months ago may already be upon us.

My timing is not always exact.

But the analysis is usually close.

And the analysis suggests that all roads lead to gold. The move in gold on Friday June 1^st should act as a beacon to the world. The forty year experiment in a purely fiat based system is coming to an end. The rhyme and rhythm of history is repeating and natural economics law will reassert through creative destruction.

Fear has taken hold.

Whatever happens over the next few days, weeks or months does not look encouraging for the old fiat based system. Either we get a nuclear level of money-printing into the world’s system, or we don’t. Tinkering at the edges simply threatens to fuel the panic. Confidence evaporated on Friday and money is looking for a new home. Printing threatens high, possibly hyper-inflation in time; not printing will totally eviscerate confidence and almost certainly lead to a global deflation based ‘super-depression’. There are no good choices.

Nobody wants to be in a currency backed by a nation whose sovereign debt is supported by negative growth. And don’t forget that GDP does not matter. Borrowing and spending to create income would put you in jail in the private sector. It’s tax-take that matters. Taxes support payments, not GDP.

All roads lead to gold. If precedent is anything to go by, gold and gold-backed equities are amongst the few havens of safety in the new world, at least for the period of transition – however long that may be.

Meanwhile I feel uneasy on the timing.

While billions across the planet distract themselves with myriad tasks and entertainment, small groups of financial power-brokers are making decisions about what to do next. But they don’t think and act at internet speed. They work within a political paradigm where seconds of time in the markets equate to months of dialogue and dialectic.

They think they have time.

I’m not so sure.

The wheel of history looks ready to turn.

From June 2nd 2012

The increase in the price of silver on Friday was not as dramatic as that of gold. I’ve already seen some comments in the media about the fact that it is the ‘industrial metal’ aspect that is weaker because the global economy is showing signs of turning down.

But we need to remember that for the past year the U.S. was supposed to be in recovery mode, and that China has ostensibly been growing in the upper single digits.

And yet the price of silver declined during this ‘recovery’ period.

Now that the economic indicators are looking very weak gold has helped to pull silver up again, within striking distance of $29.

It’s the paper spot game that has been driving the silver price up and down – ‘short and cover’ – in a mechanical and cynical weekly trading routine.

One thing is for sure, once the economic downturn takes hold base metal mining volumes will tail off and the 70% of silver output associated with those metals will likewise fall.

On the other hand I can’t see silver investor demand dropping off. If anything the fear factor will act as an accelerant.

From June 2nd 2012

Around lunchtime on Friday gold recovered its safe haven status in the U.S. During the afternoon it moved up by $66, an almost unprecedented jump, from $1550 to $1626 smashing through old resistance points like a knife through butter. Hedge funds panicked into covering exposed positions, accelerating the leap:

http://www.kitco.com/charts/livegold.html

The HUI, the gold bugs equity index, had an equally stellar day on the North American markets, up by 6.74% to 444.50:

http://finance.yahoo.com/q?s=^HUI

Similar moves were seen on the XAU:

http://finance.yahoo.com/q?s=^XAU&reco=1

Meanwhile, the DXY, that beacon of fiat safety dropped below 83 showing some distinct signs of breaking an upward pattern established for the last three months:

http://www.marketwatch.com/investing/index/DXY

So what has driven this dramatic turn?

1) The U.S. NFP came in at 69,000 less than half the 150,000 expected by the markets.

2) The U.S. Chicago PMI released on Thursday is turning down, along with other U.S. LEI’s.

3) China LEI’s are now falling; there is fear of a hard landing.

4) Europe remains a basket case, paralysed by indecision and weak leadership more prone to eternal debating society level summits.

5) Bond yields in the U.S. and U.K. are now the lowest in history. German bunds are also at similar levels and you have to pay the Swiss to hold your money.

It’s just dawned on the markets, of which the U.S. is still the biggest player, that there is nowhere else to go. If sovereign debt looks safe, you had better watch out for QE3 and a similar policy in Europe. Expect that tiny return on bonds to evaporate with inflation when the big print starts.

And don’t think that retaining funds in USD is any safer. U.S. debt is already at $15.8 trillion and will crash through the $16.2 trillion limit before the U.S. election; Obama is already sending out signals about a $20 trillion limit.

With a U.S. economy turning down, the inflationary spectre of QE3 on the horizon and an uncontrollable debt burdon, already over 100% of GDP, how long will the USD retain its status a safe haven? How many years has it got left as the globe’s primary reserve currency?

So what’s all this got to do with us?

Well gold is obviously off the starting block. The North American PM sector has already made some initial moves but the full implications of what is happening has not been completely understood within the AIM PM sector. Some of the larger players inched ahead on Friday, but nowhere near the moves seen in post-Europe-close trading on the North American markets.

Our first moves have yet to be seen.

It’s time to make a move.

Anything Condor, Ortac or Red Rock specific will be accentuated once we see a firm sector trend move up. Gold will help arrest the old decline pattern, not Greenland.

From May 30th 2012

Looks like we have a 2008 situation on our hands albeit in slow motion at this point:

DXY up as Euro plummets:

http://www.marketwatch.com/investing/index/DXY

Gold falls on paper liquidation and reversion to risk-off USD/Treasuries:

http://www.marketwatch.com/investing/index/DXY

Even Brent has dropped to 103 although supply threats probably mean that it won’t go anywhere near the $40 we saw in 2008:

http://www.livecharts.co.uk/MarketCharts/brent.php

EUR/USD ping pongs around 1.24, a long way down from the 1.30 only a couple of weeks ago:

http://www.livecharts.co.uk/ForexCharts/eurusd.php

So we are back to considering the the context and implications:

– Germany still won’t agree to a big CTL+P
– The ECB can still only provide liquidity not solvency related bailouts.
– Spain can’t afford to bail out its banking system.
– Greece runs out of money on June 20th a few days after its election.
– Greece has already run out of bank collateral which means the ECB may legally have to cut liquidity flows before the June 17th election.
– U.S. LEI’s are faltering but have not all turned down yet.

At the moment it still looks like it will be down to FED to make the CTL+P decision on June 20th. It’s looking more and more like if they don’t do something on the 20th global markets could actually implode.

Why would the FED CTL+P?

1) U.S. equity indexes are starting to decline.
2) U.S. LEI’s are faltering.
3) U.S. U3 is still at 8.2%, months before the election.
4) It’s the last chance they can do something before actions become ‘political’.
5) The DXY is already too strong as is the EUR/USD. A strong USD threatens a U.S. export led recovery and thus unemployment.
6) Additional credit swaps may be necessary to provide additional liquidity in the EZ – buying time until after the elections.
7) Black Swans a) Israel/Iran; Israel may just press the button add inflame already nervous markets. b) An Ireland surprise c) Bond vigilantes take a pop at Portugal or Italy d) Greece tax receipts plummet even further bringing forward the day the Greece current account moves into the red.

With the news that: ‘Euler Hermes, the world’s biggest trade insurer, has suspended cover for exporters shipping to Greece amid fears the debt-laden nation could be forced out of the euro, hindering Greek importers’ ability to pay their bills.’ Greece could have some real trading issues in June.

From May 27th 2012

Correct me if I’m wrong but on a combined basis (import/export) wouldn’t that be about $342bn heading straight back into the U.S.?

Where else is it going to go? Russia? Brazil? I think not.

Now $342bn doesn’t sound a lot against annualised U.S. deficits of $1.2trillion but how much of that $342bn will be in M2? In other words over the next 12 months is the U.S. about to face an inbound avalanche of inflation producing cash (and credit)?

Will the FED need to go QE3 with all this cash about to return home?

http://www.gata.org/node/11416

I don’t think the media economists have thought through the implications of this yet, given the emphasis on the Euro and the (looming) Iran issue.

Note:

one trillion Japanese yen = 12.55600 billion U.S. dollars
12.48ty + 14.78ty = 27.26ty x $12.556bn = $342.27bn gross transaction value.