Carlo's Think Pieces

Reflections of a Filipino in the Netherlands

Posts Tagged ‘Debt Ceiling’

2012: The Other Prediction

Posted by butalidnl on 18 October 2011

On 21 December 2012, the “world as we know it will end.” The Maya seem to have made a similar prediction, but they were referring to physical things happening e.g. a polar reversal, or a rapid change in sea level, or something like that. (Remember the movie ‘2012’?). My prediction, on the other hand, refers to the world financial system. More specifically, I predict that on 21 December 2012, the postwar Bretton Woods financial system – which has the US dollar as the world’s reserve currency – will collapse.

The dollar-based world financial system is set to collapse. This we saw during the 2008 world financial crisis.  The main reason that it didn’t collapse then was that the whole world’s economy would have crashed, as in deep depression worldwide. Thus, all countries chipped in to prevent the system from collapsing.  In the years since then, many countries have de-coupled from the US economy to the extent that if the US economy were to collapse, they will get ‘only’ a recession, instead of a depression. Other countries will be less willing, the next time around, to go into deep into debt to save the US; and causing them to suffer from secondary crises e.g. Eurozone sovereign debt crisis.

The US dollar is the cornerstone of the world’s economy, and it is under pressure. This is because of the dire state of the US economy, with its very high sovereign debt, negative trade and exchange balances, high unemployment, falling housing prices, etc. The US economy has been kept running mainly because of extremely low interest rates for US Treasuries, which have to go up sooner or later.

Why 21 December 2012? Well, why not?, why not on that date? But I have more going for this date than any other, as I will now explain. There are enough reasons to think that A CRASH WOULD HAPPEN on or around this date.

Triple Witching
21 December will be the ‘triple witching’ date for world markets in 2012. Every third friday of a month, option contracts (as well as warrants and futures) for stocks, bonds, currencies, and commodities expire. That is the month’s ‘witching’ date. Every three months (March, June, September and December), quarter options also expire. And on the 3rd friday of December (which is 21 December in 2012), the year options, quarter options and month options all expire at the same time.

Trading on a witching day is a lot more volatile than in ordinary days, since holders of contracts need to settle their accounts at the end of the trading day. Depending on how widely options had been bought and sold for a category, the fluctuations in the price of the underlying asset can vary by several percentage points. With triple witching, it could vary enormously.

Lame Duck, Debt Ceiling
The US will be having elections in early November 2012, but the winners will be installed only in late January 2013.  There will be almost 3 months when the outgoing congressmen and senators (and perhaps even president) will still be in office. This is known as the ‘lame duck’ period.

If, for example, the tea party congressmen and senators lose big in November, they will try to maximize the 3 month lame duck period to pass all kinds of laws they like. They will also block everything they don’t want with even more energy. It so happens that there is an important piece of legislation that is practically scheduled to be passed during the lame duck period, and this is a law that would (again) increase the debt ceiling for the US government. The recently approved higher debt ceiling is expected to be reached around December 2012, meaning that the debt ceiling would need to be raised at that time. The Democrats had demanded this, so that the decision won’t be influenced by the election’s dynamics.

Thus, the US debt ceiling legislation will have to be passed by the lame duck congress in December 2012. The fight over this promises to be even more intense than the last time, which was then quite destructive (as a result, the US Treasuries’ credit rating was downgraded).

Window Dressing
During the course of the year, traders buy shares of small-cap companies, emerging market stocks and bonds, etc, and before the year ends they sell most  of these and buy prime stocks, mostly from the Dow Jones Index. This is called ‘window dressing’. Traders everywhere do something similar, because they want to report holding ‘stable’ stocks at the end of the year. The only difference is that in each country, they would have some local stocks which are a ‘must hold’.

Now, imagine what traders will do when presented with the prospect of buying Dow Jones stocks, which are almost sure to lose value come 1 January. What will they do in terms of ‘window dressing’? Well, the prudent trader would buy up Euro, Yen and Swiss Franc denominated stocks (e.g. Nestle, Toyota, Shell, or Siemens)  and bonds; in the process selling a corresponding amount of US stocks and bonds. This may be prudent for the individual trader seeking to protect the capital of their investor-clients, but if they all do this at the same time it will mean a massive sell-off of dollars.

Christmas and New Year
21 December 2012 will be the last full trading day before Christmas. On Monday, 24 December, markets will only be open for a half day, at most.

But Christmas 2012 will be a bit different from most others. For one thing, it will be end of a year of depressing economic performance, particularly with regards to employment.  By mid-December, there will be initial figures for Christmas sales and Christmas hiring; and both are sure to be disappointing (i.e. significantly lower than 2011).

To make matter worse, foreign Central Banks usually decide to reduce the percentage of dollars in their currency reserves at the beginning of the year (i.e. on 1 January). They’ve been doing this for the last few years already, reducing the percentage of dollars held in reserve by one or two percent every time. It usually leads to a slight deterioration in the value of the dollar in January, and then the effect usually dwindles. But at the end of 2012, with so many things going on, the prospect of yet another factor causing the dollar value to dip could really worry traders. They may take from the experience of 2006, when the dollar lost value starting early December in anticipation of the January dip.

External Factors
So far, I have mentioned America-specific (and date specific) reasons for the US economic collapse on 21 December 2012. Now, let’s look at the external factors.

The Euro will be stable. It may be hard to imagine now, but by the middle of 2012, the so-called Euro crisis will be over.  The Eurozone countries would have settled the Greek problem with a programmed partial default, and have saved the banks from bankruptcy. They would have strengthened the EFSF, and made sufficient funding arrangements to help countries in trouble.  They would have even amended the relevant treaties to strengthen the Eurozone’s financial health. Financial market speculators will avoid betting against the Euro, knowing that it has enough ammunition to defend itself.

With the Euro stable, it will only take a few months before US investors would realize that they stand to earn more if they invested in Euro-denominated assets. The dollar is sure to lose value as a result. A stable Euro will make the dollar a lot less attractive as a place to put money. Why invest in dollar denominated assets when the dollar will devalue 10% to 15% per year? Dollar devaluation will be a self-perpetuating process.

High Oil Price. When winter comes, the price of oil usually goes up, as demand for heating oil rises. During the whole of 2012, the oil price would have inched itself higher and higher, reaching from $130 to $150/barrel (if not even higher) by December 2012. The price of oil has an inverse correlation with the value of the dollar.

Political Events. Foreign countries know that America’s political ‘wiggle room’ during the lame duck period is limited. If a country wanted to declare war with its neighbor, or if people plan to rise in revolution against a state that is supported by the US, the lame duck period would also be a great time to do it.

China Sanctions? I expect that the Democrats will seize control of both Houses of Congress in the November 2012 elections. With this, the Democrats would push for legislation accusing China of currency manipulation, and compelling the government to impose extra taxes on chinese imports. The Chinese would be extremely worried about this, and may start reacting as early as December 2012.

All in all, there is every reason to expect a very significant fall in the value of the US dollar and a huge stock market decline on 21 December 2012.  The US financial system is so shaky that it won’t be limited to a mere ‘dip’, but will become a crash that will signal the end of the US dollar’s financial dominance.

All this is assuming that nothing apocalyptic of the type the Maya predict will happen.

You have been warned.

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Beyond the Debt Ceiling

Posted by butalidnl on 16 July 2011

The US is in the grip of the political drama around the raising of the debt ceiling. Economists are worried that if politicians fail to come up with a satisfactory solution, the US will go back into recession even if they finally agree on raising the debt ceiling.

Most Americans do not realize that solving the debt ceiling problem isn’t really the main issue. The main issue that they have to face is that the US economy is designed for the wrong century, and that it is long due for a transition to a more ‘modern’  design. Officials try to avoid the inevitable by artificially propping up the economy, but it won’t work. The transition will come. And it will be much more painful than a mere ‘double dip recession’ – it will make the recession of 2008 look like ‘foreplay’.

Transitions are alright in economics – the market will be able to recover and adjust the distribution of goods and services to adapt to any changes in the patterns of use. However, some transitions take long, and this means that the economy will suffer till the transition is over and the market has made the necessary adjustments.

The US is in the midst of three transitions: that of its housing patterns, the use of resources, and the US dollar. And since the nature of all these transitions is that they take a long time, I believe the US “crisis” will last for some time.

The government will naturally act as if it is only a matter of pushing through certain programs, and then the economy will recover. Perhaps certain programs may result in short term growth or increased employment. But this will ultimately be quite futile, and the longer term trends will overpower these gains.

The economic crisis was caused by the housing bubble – specifically, the market for ‘sub-prime’ mortgages was oversold.  And this problem continues to this day, with homeowners continuing to default on mortgages. However, this is only part of the problem.  There is a creeping re-concentration of housing patterns in the US. People are not as willing as before to commute two hours or longer to work every day. This is partly due to the economic crisis – if you’re looking for a job, it is better to do so close to home. And, if your house is foreclosed, you would most likely move closer to the city for new and cheaper housing.

But the crisis only aggravates the problem, it did not cause it. Things like demographics (people getting older – and thus wanting to be nearer health care facilities) and the rising price of gasoline/diesel have a longer term effect on housing choices.

The movement of people from sprawling suburbs to smaller urban hubs means that many houses built in the suburbs will go unsold (or not rented) for a long time, and sometimes will only get sold at a very big discount. And the bad effect of this is that people won’t be that eager to buy houses in an area where house prices continue to go down. So, home building companies will lose money or even go bankrupt, until they completely shift their activities nearer urban hubs.

Expensive Resources
With the development of countries such as China and India (and of course, the rest of the world), there will be a squeeze to divide up all the resources needed. The days when Europe and America  could get away with using 80% of the world’s resources are over; and this means that the resources of the world should be shared more equally. And, this means that the price of most resources will go up significantly.

The resource that Americans  will really FEEL going up in price will be that of oil. From the crisis-level price of around $95/barrel, oil will surely go to $150/barrel by 2012. This is on the logic that if the world’s GDP returns to the pre-crisis level, so will the scarcity of oil, and this means that prices will return to pre-crisis levels. And that is only the beginning: beyond 2012, prices will rise even higher. Oil supply volatility may cause temporary peaks or dips in the price, but the overall trend is still for the price to rise.

For the American automobilist, this means that oil will return to highs of $5/gallon, or higher. This will need a permanent adjustment of living patterns. People will need to either commute less, ride trains or buses to work, or use smaller cars or hybrids.  And since oil is used for making things like plastics and fertilizers, the prices for these will also rise, forcing people to change their consumption patterns.

The rise in the price of grain, particularly that of corn, will eventually spell the end of feeding grain to cows.  At a certain point, the number of cows will be limited by the grass that they can eat. See High Corn Price Will Lead to Lower Beef Production Cheap meat will become a thing of the past.

Increased commodity prices will cause a move away from the throw-away economy. There will be a new emphasis on goods that last longer, and use less energy and other inputs.

The “Fall” of the US Dollar
The days of the US dollar as the international reserve currency are soon over. I would say that it would “fall” from this position sometime in this decade. And that the US economy will feel this change quite deeply. (see Two Years After the Fall )

The fall of the dollar finds its roots in the massive debts that the US has – almost 14.3 trillion dollars, to date. The Fed is even tried to stir up US inflation by ‘printing money’, or Quantitative Easing. And to make the problem worse, total US currency abroad totals $75 trillion.  The resulting inflation and the high amount of debt will be the dollar’s undoing; at a certain point, countries will decide NOT to keep dollars as reserve anymore, and NOT to buy up US treasuries, and this will drive up the interest rates on these treasuries.

Already, the rating agencies are threatening to downgrade the rating for US Treasuries from AAA to AA. While this seems like a small step, it will be the first push down the hill for the dollar.

The strength of the US Dollar rests on the willingness of other countries to keep dollars in their foreign currency reserves. Dollars make up to 80% of Central Bank reserves of many countries. Historically, this has meant that the US could buy more from other countries than it sells to them. If Central Banks’ change their mind regarding the desirability of the US dollar as a reserve currency (especially as a result of a change in Treasuries’ ratings), this will result in a sharp drop in the value of the US dollar. And  this point will happen sometime very soon.

After the Transition
After the decade of transition, the US will face a new period of sustained economic growth. The American people’s  flexibility and the country’s huge resources are sure bases for it to build a new prosperity.  Politicians should hurry the transition instead of trying to deny that it will happen.  They should not be distracted by the call to ‘preserve jobs’ or to ‘preserve our way of life’.

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Is US Dollar About to Fall?

Posted by butalidnl on 19 May 2011

The US Congress will have to raise the Debt Ceiling from the present $14.3 trillion by August 2, or else the country would face technical default. But the Republicans are demanding budget cuts be done first; and Democrats are demanding that measures should include increased taxes for corporations and the rich. Both sides are standing their ground, and there is a real danger that the country will indeed default by August 2.

Most probably, a deal will be made at the last minute, and the US can go on merrily increasing its national debt for a few more years. But the question remains: can the US dollar’s credibility withstand such a strain? Will the US dollar fall while Congress debates over raising the Debt Ceiling?

I think that sooner or later, within the next 5 years or so, the US dollar is going to “fall”.  The national debt limit is only part of the problem; the main problem is that the US has a triple deficit – of the budget, trade balance, and payments. And that it has accumulated a huge amount of “unbacked liabilities” in the world – to the staggering amount of $75 trillion.

All proposals on the table will help to reduce the budget deficit, but it will even not be enough to get a balanced budget.  Since there will continue to be a deficit in the coming years, the national debt will continue to grow. And then, there is the trade deficit which also grows from year to year. Thus, all plans now being considered will not improve the US’ capacity to repay its debt.

The world is getting impatient with the dollar, and it seems that US politicians are taking their time at solving it, not realizing that the problem is really urgent.

Signs of Trouble
The problems in the Middle East are all in the news. But the biggest problem with it lies not in Libya or even Yemen – but in the fact that the US dollar has not strengthened in the face of all these problems. Almost always before, when there is political turmoil somewhere, the US dollar gains in value, as money exits that country and goes to the safety of the US dollar. Now, the whole Middle East is ablaze, and the dollar, instead of strengthening, has weakened considerably.

Another sign of impending trouble is that the US, even with “QE2” (the program of the Fed for creating $ 600 B by buying government treasuries) and the extremely low Fed interest rate, faces rising commercial interest rates. QE2 was instituted in the first place to REDUCE interest rates. What will happen after June, when the QE2 program is over? Will interest rates rise substantially, resulting in a rise in unemployment? Will there be a double dip recession? If the Fed makes a “QE3” program instead, will this be enough to hold interest rates down? or will foreign fund managers dump US treasuries instead?

A third sign of trouble is the news that PIMCO, the world’s biggest holder of bonds, has entirely stepped out of US Treasuries. Even worse, PIMCO has resorted to selling US Treasuries short – which means that it even has negative ownership of Treasuries. This shows that US Treasuries are no longer attractive to the wiser international investors. I doubt that many hedge funds keep Treasuries in their portfolios either.

A fourth sign is that when Osama bin Laden was killed, he had with him 500 Euros. He had Euros, not US Dollars, which means that he considered Euros more useful in case he had to escape capture in Pakistan – Euros seem to be more useful in bribes etc. in Pakistan. This shows that even in the underworld, the US dollar is not considered a good currency anymore.

Roots of Crisis
The present crisis has its roots way back in the Bretton Woods agreement, made after the Second World War, to have the US dollar as the world’s reserve currency. Until 1971 the dollar’s value was pegged to the US supply of gold, keeping the US currency in “control”. In 1971 President Nixon let loose the gold peg, making the dollar itself as the only thing in reserve.

The US dollar as reserve currency meant that countries were willing to run a trade and exchange imbalance with the US, since this would mean that they would accumulate US dollars in their reserves. This meant that the US tended to have a structural trade and payments deficit with the rest of the world. This  effectively overvalued the dollar, making its imports cheaper than they otherwise should be. And this contributed to the very high standard of living in the US.

Over the decades, the US steadily accumulated a big debt burden. It is now at $14 trillion, or more than 90% of the US’ annual GDP. Among developed countries, it is only Greece and Japan which have higher debt/GDP ratios. Greece has had its debt crisis, and is now forced to undergo a strict program to get rid of its deficit. As for Japan, most of its debt is to Japanese citizens – and thus the impact of the debt is less than if it was held by foreigners.

The US debt is only part of the “US dollar overhang” in the world economic system; because the bigger part (approximately $60 trillion)  is simply the dollar reserves that countries have accumulated, due to the US trade deficit.  The national debt, in the form of US Treasury Bills, is the smaller part of the problem; but it is the more worrisome part of it, since the US has to pay interest on this.

Stumbling into Dollar Fall
The danger is always present that a country would decide to dump their US treasuries, leading to a chain reaction that sees other countries dumping treasuries, a spectacular rise in interest rates, and the dumping of US dollars from national reserves, and the fall of the dollar. This has not happened so far, since no country will do that consciously and devalue their own reserves. But we cannot depend on this not happening in the future. In fact, I think that the chance of this happening is getting bigger with time.

As more and more dollars are sent abroad, in the form of  US Treasury bills or simply “cash”, the danger that they will no longer be accepted by other countries increases. Already, many countries are calling for an overhaul of the international currency system. Countries have to continuously weigh the advantages of holding dollars against the cost due to the continued watering down of the dollar’s value.

Even if no country would willingly cause the dollar to fall by dumping it, a series of smaller events could push things so that even  minor players could accidentally cause such a fall.  The recent intervention against the Japanese Yen had the inadvertent effect of increasing Central Banks’ reserves of dollars. Central Banks all over the world had to subsequently find ways of restoring their dollar reserves to normal levels. The BRICS agreement to use their own currencies when trading with each other means that less dollars need to be kept as reserves. Eurozone countries intervention to support weaker Euro countries’ finances is another measure that strengthens the euro against a potential fall of the dollar. All these make the dollar weaker. A disruption of the scale of the 2007 sub-prime crisis happening now would surely topple the dollar.

Perhaps it won’t even be a single country or investor which would precipitate the dollar’s fall. It could be simply an accumulation of small steps that would push it over the edge. The US high unemployment rate has “forced” the Fed to keep the Fed Funds rate low, but this at the same time increases consumption and imports, and to further trade deficits.

The US dollar is undergoing something like a game of international “musical chairs”. US-based investors buy securities in other countries, effectively moving dollars abroad; Central Banks sell dollars to prevent their currencies from appreciating; the continuing US budget deficit means that the government has to issue more Treasuries;  foreigners buying US equities or Treasuries effectively returns dollars to the US;  too much incoming dollars could cause inflation, and increase unemployment. The cycle continues, and dollars are passed back and forth from the US and abroad.  A growing number of Central Banks are wary of keeping too much dollars, and this cycle would eventually break down at some point.

Tipping Points
There are a number of occasions or events which could push the dollar over the edge. The Debt Ceiling of the US has been reached, and by August 2 the US Congress has to agree to raise the limit. Not to do so will surely bring about a loss of trust in the dollar, and its subsequent fall.

And then will come the budget discussions later in the year. This is another occasion when confidence in the dollar may be critically damaged.  This will be followed by the Presidential election campaign and possibly a new administration.

At any time, Congress may pass a law imposing a tax on Chinese imports. This will cause Chinese countermeasures, including a stop to buying US Treasuries. And this will be enough to precipitate a chain reaction that will cause the fall of the US dollar.

The US dollar will fall within the next 5 years. While it will cause a deep crisis, it won’t be that bad, in the long run. I wrote a blog post about how it will be Two Years After the Dollar Fall

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