Increasing credit risk will
push up interest rates
Gijsbert Groenewegen
Posted Jul 1, 2011
Increasing credit risk will cause much higher interest rates
across the borders
The Belgian/French bank Dexia, with a ¤4.3bn or $6bn+
exposure (according to S&P's Corp) to government debts in
Greece, has back stopped (guaranteed) $17bn in municipal bonds
in the US according to an article in the WSJ. As a result of
the problems in Greece interest rates of municipality bonds in
small towns in the United States used to finance municipal facilities
like schools, bridges, ice rinks etc are being pushed up. S&P
warned last month of a possible downgrade of Dexia's investment-
grade credit ratings. It looks indeed like Lehman revisited when
one of the victims of the CDO crisis in the US was a small town
in Norway which had bought "triple A" CDO s. And don't
forget the exposure of AIG to the housing market through the
Credit Default Swaps (CDSs) that were never going to be called
because of the triple A status of the CDOs, and how it almost
bankrupted Goldman and others.
While other investors are stepping in to buy those bonds, they
are demanding sharply higher yields as compensation for the increased
risk following a possible downgrade of Dexia's credit rating.
As a result, borrowing costs for some municipalities are now
the steepest since the financial crisis. Some cost of borrowing
are tripling and quadrupling in a matter of weeks.
Dexia is obliged to buy as much as $17 billion in municipal bonds
if investors withdraw during the remarketing or rollover process.
Some $400 million has already been taken back though in those
cases, allowing Dexia to increase the interest rate paid by the
municipalities whilst at the same time it can demand an accelerated
pay back schedule. Some municipalities are trying to replace
Dexia with other banks though the refinancing is likely to lead
to much higher interest rates in some cases from 3% to 12% which
increase borrowing costs by tenth of thousands of dollars which
in turn leads to very high fees for the related facilities.
With the QE2 ending on June 30 (the Fed has bought 85% of all
treasury issuances this year!!) and higher credit risks higher
interest rates could bring down the markets. If we break above
the 4.80% level on the 30-y Treasury bond we will break out of
the downtrend since 1981 and could see much higher interest rates
with all its obvious consequences for the financial markets and
economies.
The interest rates are saying that Greece is already in default
Greece 10-y sovereign debt is trading at 17% currently whilst
the 2-y debt is trading at 27%. Basically the market is already
saying that Greece is in default. In fact Greece currently has
interest payment obligations that are $5bn higher than its tax
revenues. In other words Greece is loaning money in order to
fulfill its ever higher interest commitments. Politicians though
want to prevent a technical default at any costs since it would
have major ripple effects as indicated here above. Interest rates
for munis will go up, Greek debt can't be used as collateral
with the ECB any longer and banks will have to take losses on
their Greek sovereign debt (BNP Paribas and Dexia have $57bn,
Deutsche Bank and Hypo Bank have $34bn to name a few). According
to some estimates the European banks own a huge chunk of Greece
$467bn state debt whilst virtually none of this debt has been
marked down. A default would weaken the European banks and put
upward pressure on interest rates on Portuguese and Irish sovereign
debt of which the European banks also own a large portion. US
banks are avoiding euro zone government bonds.
The system is exhausted, which tools are left?
As we have mentioned in our previous blogs in our point of view
all the problems in the world are connected to each other through
the banks whilst all economies are connected through the currencies.
In other words we can expect a huge chain reaction/ripple effect
that won't stop at the borders. This will be inevitable. The
difference with 2008 will be that almost all possible tools to
rescue the system will have been exhausted. And in tandem with
that the credibility of the monetary authorities and the respective
currencies which have been severely undermined following the
non-successful stimulus programs. The competitive currency devaluations
will accelerate hence the only currency with intrinsic value;
gold and silver will probably go bid only after a brief sell
off. A brief sell off could happen in our view because when everything
sells off funds will have to sell all their liquid investments
because investors will withdraw their investments in order to
preserve the value that is still left. The US dollar is likely
to benefit from the sell off because as happened in 2008 investors
will park their money in US dollars, still the reserve currency.
Though after this process has taken place and investors realize
that the US might actually be in a worse situation than Europe
the US dollar could be abandoned massively in order to try to
exchange the paper currency for the intrinsic/real currencies.
We want to emphasize that we will know that the US dollar will
have lost it value when the US dollar will no longer be accepted
in exchange for gold or silver.
Why is the US dollar weaker than the Euro?
As a note we wonder why at present the US dollar is still much
weaker than the Euro despite the problems in Greece, Portugal
and Ireland. Next to that Spain also doesn't look too healthy,
unemployment in Spain for 25 year olds and younger runs at a
staggering 40-45% whilst overall unemployment is in excess of
21%. One of the puzzling questions is why the US dollar is so
weak vis a vis the Euro. One answer could be the interest differential
though we wonder if that would compensate for the possible risk
of default. The Fed's QE1 and QE2 stimulus programs to the amount
of respectively $1.7trn and $600bn respectively didn't have the
desired effect, except for keeping the bond markets and thus
equity markets up, hence the lackluster growth. In fact it was
the weakest recovery of any recovery in the past nine decades
if unadjusted for inflation. According to some estimates the
Fed has bought this year about 85% of all treasury issuance.
Next to that the US budget deficit is forecast to be $1.6trn
and $1.3trn next year. All these factors in combination with
the virtually zero interest rates have undermined the once all
mighty US dollar.
Strongest commodity performance ever
In fact what we have been seeing is a huge shift from intangible/paper
assets to tangible/real assets hence the strong commodity prices
which were also boosted following strong demand from China and
other BRIC countries. Commodities enjoyed their strongest ever
performance in a recovery. As a result we are experiencing strong
commodity inflation whilst recently also food inflation has started
to roar its head. The increasingly volatile and extreme weather
changes have pushed up food prices to 30-y highs.
On top of that the arable land in the world is declining rapidly
following strong urbanization (China, India) and desertification.
Next to that the world population is expected to reach the 7bn
mark in October of this year. And in our calculation the 8bn
level will be reached not in 20 years but in 7-10 years.
Middle class being wiped out removing an important buffer
in the economy
Household wealth in the U.S. climbed by $943 billion in the first
quarter of 2011 as rising share prices outstripped declines in
home values. Though it should be noted that the top 10-20% own
80-90% of the stock and bond market wealth. What we are basically
witnessing in the US is that the middle class is being wiped
out. Its main asset, housing, which represents 38% of household
wealth of $58trn for the first quarter of 2011, is declining
steadily and further eroding what is left of household capital.
On top of that the middle class is also slapped in the face with
much higher food and gasoline prices. When the middle class gets
wiped out the economy won't have any buffer any longer to absorb
the downturn in the economy. And as a result we could have a
severe depression. We probably already have passed the tipping
point in the West with declining productivity, increasing government
debts, a destruction of household wealth, an aging population
with in excess of $100trn in unfunded obligations in the US,
a failing education system etc, etc. In fact if we look around
the world we see a lot potential causes for unrest. In Europe
and the US the debt and budget problems, in Northern Africa and
the Middle East food and geopolitical problems and in China strong
food and housing inflation and corruption. It looks as if a lot
of problems are converging and coming to a head.
Precious metals, agricultural land and water
Not a pretty picture, anyway we are living in challenging times.
Protect yourself with physical (no counter party risk) gold and
silver, agricultural land in water rich countries, fertilizer
companies and water. With a rapidly increasing world population
the (relative) scarcity or all tangible assets is continuously
increasing. On top of that we are exhausting our resources and
we would like to make the point that with an ever declining replacement
ratio it could be argued that the resources in the ground are
becoming worth more every day. And last but not least, going
forward be aware of counter party risk when the markets take
a turn for the worse.
###
Gijsbert Groenewegen
Groenewegen Report
email: g.groenewegen@silverarrowpartners.com
website: www.groenewegenreport.com/
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