Major US banks & Derivatives

When people talk about huge and worrying numbers in finance the one they focus on most is the US national debt. At $17 trillion that’s a number too big for most people to comprehend. The odds of it ever being paid back are remote, and eventually it’s going to reach a size where just trying to cover the interest will bankrupt the nation. Believe it or not, though, in the big scheme of things it’s pocket change.

We’ve all heard of banks that are too big to fail. There used to be four of them in the USA; now there are five. The expression isn’t exaggerated; every one of those five banks is exposed to the mood of the global financial market on a scale that dwarfs the national debt. Yes, it really does. The total size of that exposure is difficult to work out because it’s such a complicated web, but by picking out one strand of it we can get an idea of how big the problem really is. That strand is derivatives.

If you’re looking for secure investments you need to buy things that are real, that have actual inherent value and that somebody will want to buy. Gold is the classic one; it’s what used to back up the US dollar as well as the other major currencies. The value of the bills in your wallet was backed up by a stockpile of real gold in a vault. Oil is another. It’s valuable, there’s a limited supply and if you have some to sell, somebody’s going to buy it. You don’t even need to stash the barrels in your basement – the markets give you plenty ways to invest your money in oil. The key thing is that you’ve bought something real and you can sell it again, hopefully at a profit. Whatever price you get, though, your asset – gold, oil, palladium, whatever – is real. But derivatives are different.

Derivatives aren’t backed up by real assets. They might be deals about assets that will exist in the future, or contracts based on predictions about the way prices will go – bets, in other words. The futures market is basically just a huge casino, and as the 2008 financial crisis showed it’s such a complex one that when an asset turns out to be worthless nobody can really tell who owns it. Remember all those sub-prime mortgages? Worthless “assets” that had been chopped, mixed up, reformed and sliced like cheap hamburger, then sold all over the world. Nobody who’d bought a package of mortgage debt as an investment knew how much of it was good loans and how much was junk. The result was the whole lot became a toxic product.

Imagine another crisis, another supposed asset being revealed as worthless. Exactly the same will happen again. It’s so complicated that by the time the markets have figured out who owns the good investments and who owns the dreck, confidence in the whole system will have been shaken and fortunes will be lost across the board. And before you start thinking that only affects rich bankers who brought it on themselves, no it doesn’t. The value of every trust fund, every pension scheme, every saving plan for the kids’ college fund, is tied up in this mess of opaque deals.

How big is the problem? It’s huge. Enormous. Too big for words to do it justice. But every single one of those five big banks has at least $40 trillion tied up in derivatives. Between them, in total, the figure is $280 trillion. If those banks go down the economy goes with them. The national debt is bad enough, but this mess is unsustainable. Someone needs to bring some clarity and transparency back into the system before the next disaster strikes.

Financial Update 9-22

The US dollar has been having a good few weeks. After months of lackluster performance it now seems to have broken out and headed for the high ground, registering significant gains against all the major benchmark currencies. That’s attracting a lot of attention to the Forex market right now as opportunities appear there, but it also has effects in other areas and one commodity that’s been feeling the chill recently is gold.

dollar-vs-goldDecent second quarter figures for the US economy have given the dollar a nudge upwards but it really took off when the Japanese government moved towards a more generous quantitative easing strategy and the European Central Bank started making noises about going in the same direction. That raised the specter of inflation in both those economies, prompting investors to shift away from the risk of weakening currencies. At the same time the UK pound has been struck by worries about the possible consequences of Scottish independence, which were only resolved by the No vote at last Thursday’s referendum on the issue. With the dollar already looking healthy it was the logical place to go for anyone who wanted to keep their money in currency.

At the same time a recovery in the equities market was having an effect on the values of precious metals, a traditional safe haven any time stocks are looking weak. When stocks go down metals tend to rise, and vice versa. With the Dow and FTSE 100 showing some of the best growth since the financial crisis hit gold and silver were already heading south, so when money that had been tied up in Euros and Yen started looking for a place to go metals weren’t looking attractive. The dollar, already rising because of the economy’s apparent health, was. It made sense to get behind it, and that was enough to accelerate its climb. In fact its performance has been incredible recently – last week’s 1.2 percent jump in the Dow Jones FXCM dollar index was the largest in 10 months.

So how long will the resurgent dollar continue forcing gold down? It’s hard to say. In theory metals should stay depressed as long as the dollar remains strong; the basic circumstances that caused the swing won’t have changed. In practice it’s almost never as tidy as that. For US investors gold isn’t looking very attractive just now, but the same picture doesn’t necessarily hold globally. Anyone in Japan or the Eurozone faced with the prospect of a weakening currency could still profit on gold even if its dollar value remains low; as long as the gap between the Euro or Yen keeps widening faster than gold’s dollar price sinks they can invest in metals and make a profit in their own currency. If enough people start doing that then gold will inevitably start to rise again, making it even more attractive and pulling in more investments. Eventually it could reach a point where it’s bullish enough that people sell dollars to buy gold.

The interplay between stocks, currencies and commodities is always complex and sometimes just incomprehensible. The best we can do a lot of the time is look at what’s happened before. One clue to watch for is the Fed’s policy towards the money supply. Gold often tracks that closely, so stay tuned for any update on interest rate policy. In the meantime don’t ignore the potential of gold – it often generates unexpected profits.

Americas Failing Public School System

There’s even more bad news this week about America’s failing public school system. It’s bad enough that schools are increasingly controlled by aggressive secularists and that academic standards are falling behind competitors in Asia and Europe, but it seems the system can’t even manage the basics now. Basics like hygiene and cleanliness. Our children are being crammed into filthy schools while money is wasted on imposing the ideologically driven Common Core standards on frustrated teachers.

A survey of Chicago public school principals has just handed in its results, and they’re appalling. Almost half of the schools quizzed have serious problems with cleanliness. The list of faults includes broken furniture, overflowing trash cans, dirty floors, lack of basic supplies like soap and toilet paper and infestations of vermin. Staff, already under pressure, are having to put in extra hours trying to keep their schools in a fit state. It goes without saying that the notorious Chicago Democrat machine is trying to blame the situation on the private contractors who handle cleaning, but worries about standards in public schools aren’t exactly new. In fact many people have been concerned about this – and trying to find a solution – for a long time.

There are alternatives to public schools and for many families they work very well, but they’re not for everyone. Private schools are financially out of reach for a lot of parents, although voucher schemes can help with that. Vouchers also resolve the unfairness of the system where parents who opt for private education still have to subsidize the public schools they’re not using. Even with this assistance, however, not everyone can afford it – and in any case there’s a shortage of private school places in many parts of the country, including some of the areas with the worst public education. Homeschooling is another popular alternative but again a lot of parents can’t do it. With many Americans having to work two or three jobs just to keep their heads above water it can be impossible to give up work to educate children at home – that’s a full time job on its own if you’re going to do it properly.

For millions of people the public school system is the only realistic choice, and that means it needs to be as good as we can make it. No American child should be denied a good education just to meet some politically correct agenda imposed from above, but that’s what’s happening. How can remote officials know what’s best for local schools? They can’t; the country is just too big and too diverse. Forcing a one size fits all education policy on schools isn’t working and we have more than enough evidence of that by now.

The problem in America’s public schools isn’t that private companies are being given cleaning contracts; it’s that the entire system is being undermined by interference from the federal government. Communities are the best level to handle educational policy; local school boards know the staff, know the students and know what the area needs. To return this country’s education system to what it used to be – a world leader – we need to take the power away from the faceless bureaucrats who’ve appropriated it and give it back to the people who can use it best, and that’s the American people themselves.

Financial Update 9-10

The big news on the stock market right now is the upcoming Alibaba Group IPO. Seeming to come out of nowhere with its quirky business model – putting western businesses and consumers directly in touch with China’s thousands of small manufacturers – it’s now become an e-commerce sensation; the company is expecting to raise up to $21 billion when it floats later this month. It’s a huge and complex offering; Alibaba does more business than Amazon and ebay combined. Markets are definitely buzzing with anticipation.

Not every company is Alibaba Group though, and there are signs that when more normal numbers are involved IPO fatigue is starting to set in. This is becoming obvious in the European markets, which are picking up steam again after the summer. So far this year there’s been a flood of IPOs, raising more than $55 billion in nine months – nowhere near the $160 billion Alibaba could be valued at, but still a significant pile of money. In fact it’s four times the corresponding figure for last year. All this has happened on a wave of enthusiasm for new stocks, a sign of recovering confidence as Europe continues to emerge from the recession.

That enthusiasm looks like it’s wearing off though. A new IPO means a lot of work for investors who take due diligence seriously, and the sheer volume is starting to draw groans instead of excitement. With a big name or exciting business model to play on an IPO can still generate enthusiasm but for more marginal businesses it’s getting a lot harder to attract buyers. The market is basically suffering from indigestion – it’s swallowed too many IPOs this year and its appetite for more is shrinking.

From a company’s point of view there are still good reasons to push ahead with an IPO. Valuations remain strong, and especially for a firm backed by private equity that wants to start feeding some money back to its founders that makes a flotation look tempting. The bar for entry is getting higher though. A few months ago investors would be all over just about any IPO, but now they’re getting selective. Without a unique selling point to attract their interest they won’t do the legwork to investigate the company, and unless that’s done they won’t risk their funds there either.

Another deterrent to investors is the strategy that’s been pursued by a lot of advisers. US hedge funds have been prepared to pay very high prices over the last few months, and that’s forced up valuations. The problem is that a high valuation at flotation doesn’t always translate into continued high share prices later, and several recent high-profile IPOs are now trading well below what they were issued at. That’s making potential buyers increasingly wary, and many are skeptical about how realistic valuations really are.

It looks as if right now the market’s jumped too quickly between extremes – from a shortage of IPOs during the recession to a glut of them now. Market Darwinism should restore equilibrium soon enough, forcing valuations down until the volume of new offerings coming along is at a level the market can comfortably absorb. That should make everyone happier except the bargain hunters.

Financial Update 9-3

The US dollar, which had been looking weak for much of the last year, has picked up quite a bit over the last few weeks and it’s now looking much healthier. Right now it’s at a 14-month high against a basket of the other major currencies and looks set to climb even more in the short term. Last week’s figures put the .DXY dollar index at 83.039, better than it’s been since last July.

Some of the dollar’s resurgence can be put down to weakness in other currencies, especially the Japanese Yen, but that doesn’t account for all of it. The Euro is currently rising but is still hovering near a one-year low against the dollar – and even briefly hit that mark on Wednesday, dropping to $1.3110 before pulling back to $1.3135 as it gained more ground against the Yen. Japanese investors are hesitant right now as they wait for details of changes in the country’s huge public pension fund and that’s pushing many to sell Yen.

At the same time the dollar is showing its best value against sterling for five months, currently trading at around the £1=$1.645 mark. That follows a 0.8 percent fall in the British currency, its biggest one-day loss since the beginning of the year. The Australian and New Zealand currencies also slipped at the same time. Sterling is likely to stay relatively weak in the short term as UK growth slows.

Another poor week to add to the woes for gold for the year.  Gold Bullion sales have continued to slump in the midst of much uncertainty in the world.  Look for continued resistance for the yellow metal to finish out the year.

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It’s All About Interest Rates These Days

One of the big questions in the markets right now is what’s going to happen with interest rates. Investors have been speculating for weeks that the Federal Reserve will raise interest rates, which would drive a move from precious metals and other commodities back to the recovering equities sector. As the Dow has climbed speculation has been steadily increasing about when rates will go up, but it looks like there might be a while to wait yet.

The Federal reserve has just held its annual symposium in Jackson Hole, Wyoming, with guests including bankers and politicians from around the world, and one of the main topics of discussion as the economic recovery and how to keep it on track. Among the major economies the USA and UK are the ones most confident in the strength of their equities markets, so should also be the ones thinking most seriously about raising lending rates. However it looks as if this option is on the table, but not likely to be implemented just yet; policymakers in both countries, and certainly in the Fed, don’t think the time is right yet.

One area of concern in the US economy has been the employment rate. While better than 200,000 net new jobs have been created every month this year, the bad news is that a very large percentage of these have been part-time jobs; the total number of American workers in full-time employment is actually down, possibly by as much as half a million. That has implications for the recovery’s solidity, so the government and the Fed are keen to encourage employers to take on more permanent staff. That makes raising rates too risky to proceed with right now.

New Fed chief Janet Yellen believes that the US labor force still has a lot of slack in it and that even though hiring is improving, and the end of the unprecedented run of low rates has to be planned, the job market still hasn’t fully recovered from the recession. There are dissenting voices, even within the Fed itself – St. Louis president Bullard suggested a tightening of rates might even be brought forward – but Yellen’s vote is likely to carry the day and there probably won’t be any significant raise before early next year at least, and perhaps as late as early summer.

While the way ahead for the USA is up for debate Eurozone finance ministers are looking at cutting rates even further to stave off a deflationary spiral. Given the volume of trade between the USA and EU there are risks in having policies between the two markets diverge too much, so that’s likely to act as a further drag on any rise here. Japan is also planning to hold firm until prices are stabilized, again mainly because their economy is relying too much on part-time workers right now.

It’s always hard to predict rates far in advance and new developments could nudge the Fed into action at any time, but from the point of view of commodity investors it could be time to dial back talk of an increase in the near term. We could be nine months away from that becoming a reality.