Things That Make You Go Hmmm...
by Johm Mauldin
ca·tas·tro·phe
n.
1. A great, often sudden calamity.
2. A complete failure; a fiasco.
3. The concluding action of a drama, especially a classical tragedy, following the climax and containing a resolution of the plot.
In 1710, philosopher George Berkeley formulated a proposition in his work "A Treatise Concerning the Principles of Human Knowledge," which would inspire a philosophical discussion that continues to this day — three centuries later.
Berkeley wrote:
But, say you, surely there is nothing easier than for me to imagine trees, for instance, in a park ... and nobody by to perceive them.... The objects of sense exist only when they are perceived; the trees therefore are in the garden ... no longer than while there is somebody by to perceive them.
Twenty years later, William Fossett took Berkeley's baton and ran with it:
Tease apart the threads [of the natural world] and the pattern vanishes. The design is in how the cloth-maker arranges the threads: this way and that, as fashion dictates.... To say something is meaningful is to say that that is how we arrange it so; how we comprehend it to be, and what is comprehended by you or I may not be by a cat, for example. If a tree falls in a park and there is no-one to hand, it is silent and invisible and nameless. And if we were to vanish, there would be no tree at all; any meaning would vanish along with us. Other than what the cats make of it all, of course.
But it wasn't until June 1883 that the magazine The Chautauquan posed the question more or less in the familiar form we know today:
If a tree were to fall on an island where there were no human beings would there be any sound?
The Chautauqaun answered — rather too emphatically, I thought — "No. Sound is the sensation excited in the ear when the air or other medium is set in motion." But that implies a more scientific perception of the question than the philosophical one which has intrigued thinkers through the centuries.
It was from that example that the modern-day form of the question was finally settled upon:
"If a tree falls in the forest and nobody is there to hear it, does it make a sound?"
Now, rather than take the path followed by a million tortured souls and try to answer the question, I am going to pose my own question of a similar nature and see if I can stimulate a philosophical debate that will endure through the centuries, as George Berkeley did way back in the 18th century.
If "through the centuries" is reaching a little, would you all mind doing me a favour and just pretending to discuss it until I've left the room?
Much obliged.
OK... so all that remains is for you to click here for some appropriate mood music, and off we jolly well go...
"If something bad happens but nobody reacts badly to it, did nothing bad happen?"
Deep, huh? Not what you come here for, I know, but bear with me for a moment.
I recently read an article that bemoaned the level of volatility that besets the modern world, and the piece got me thinking: how volatile is the investment world, really?
The logical first stop for someone in my line of work is, of course, the VIX Index — a chart I could draw in my sleep, frankly; but let's go the extra mile and take a look at it anyway:
Source: Bloomberg
There are several observations about this chart that leap out at me, so let's go through them one by one:
1) After the global financial crisis of 2008, when the US government had stepped in to ensure that no harm came to anybody (and thus when the Age of Moral Hazard officially began), the VIX fell steadily, with each subsequent spike in volatility less pronounced than the last.
2) The next major eruption was the European crisis that kicked-off in mid-2010. Despite the hand-wringing and acres of press coverage explaining that this, like 2008, was potentially an end-of-days scenario, the spike in the level of fear (as measured by the VIX) was around half that experienced two years earlier. Of course, this time it was Europe's turn to do "whatever it takes," and their own painless future was set in motion.
Every subsequent spike on this chart that has been driven by Europe-related concerns has peaked lower than the last.
3) The third meaningful jump in volatility, which occurred in August of 2011, is the spike I want to focus on today, because the lessons it offers are extremely instructive.
The third spike, precipitated during a disastrous series of fractious negotiations about the authority of the US government to borrow money, was, of course, caused by the possibility that the USA would default on its debt. We all breathed a sigh of relief when a resolution was reached and the US debt limit was raised, because we realized that the elected representatives of the American people would never make that mistake again.
Before we continue, a quick primer on the mechanics of the debt ceiling is in order as, with all the talk, it's easy to lose the entire wood amidst the trees:
(Wikipedia): In the United States, the federal government can pay for expenditures only if Congress has approved the expenditure in an appropriation bill. If the proposed expenditure exceeds the revenues that have been collected, there is a deficit or shortfall, which can only be financed by the government, through the Department of the Treasury, borrowing the shortfall amount by the issue of debt instruments. Under federal law, the amount that the government can borrow is limited by the debt ceiling, which can only be increased with a separate vote by Congress.
Prior to 1917, Congress directly authorized the amount of each borrowing. In 1917, in order to provide more flexibility to finance the US involvement in World War I, Congress instituted the concept of a "debt ceiling". Since then, the Treasury may borrow any amount needed as long as it keeps the total at or below the authorized ceiling. Some small special classes of debt are not included in this total. To change the debt ceiling, Congress must enact specific legislation, and the President must sign it into law.
Got it? Good. OK, so what happened allllll the way back in 2011?
Well, in May of that year, roughly 40% of total US expenditure was borrowed, and the country found itself bumping up against the ceiling (again). There ensued a fevered debate as to what concessions would be required before the ceiling could be raised. It rumbled on for a couple of months, ratcheting up in intensity as it went.
Now, at this point, I want to make one thing crystal clear: I am neither a Republican nor a Democrat. I think just about every single elected official I have seen (and not just in America) wasn't worthy of the office, so if you are tempted to read any bias into my comments, you are officially mistaken.
In May of 2011, when the US officially hit the debt ceiling, CNN explained what it meant:
Treasury Secretary Tim Geithner told Congress he would have to suspend investments in federal retirement funds until Aug. 2 in order to create room for the government to continue borrowing in the debt markets.
The funds will be made whole once the debt limit is increased, Geithner said in a letter.
Sound familiar?
Source: SadHill
Essentially, Geithner was rummaging down the back of his couch to find loose change to feed the electricity meter — scrounging tactics hardly befitting the greatest nation on earth.
On July 31st, a day before the deadline set by Geithner, Obama signed into law a bill that would raise the ceiling by between $2.1 trillion and $2.4 trillion (a nice wide range. Guess which end of it we are running up against now?), which seemed then like an awful lot of money.
In fact, it was enough to cover the country's borrowing needs until 2013 (which seemed such a long way away).
On the flip-side of the borrowing was a hard-fought agreement to cut $2.1 trillion in expenditures over a decade — beginning, of course, the following year. Cuts would average out at $210 billion each year for 10 years. Again, that's a lot of money.
Which was good, right?
Immediately after the bill was signed into law, on August 3rd, the US national debt rose $238 billion (which equated to roughly 60% of the new debt ceiling and slightly more than a year's worth of spending cuts) in a single day, the largest one-day increase in the history of the United States.
Perspective? OK, try this:
In a single day, the US national debt increased by more than the GDP of Pakistan... or Portugal... or the Czech Republic... or, for that matter, Uruguay, Bulgaria, Luxembourg, Croatia, and Serbia — COMBINED.
That's some pent-up spending spree.
We all know about the subsequent S&P downgrade etc., etc., so I won't go into all that because we have more important stuff to discuss; but it's the quantum of the crisis that is important, and we are coming to that shortly.
The latest debt-ceiling crisis, which ended unremarkably this past week, has crystallized my belief that the gradual erosion of any sense of collective fear on the part of the investing public is reaching incredibly dangerous levels — levels which will ultimately lead to catastrophe, though not a catastrophe in the sense that a gentleman by the name of Jack Lew used the term when he addressed Congress recently. (Apparently, Mr. Lew is the US Treasury Secretary, a position he has held since being sworn in on February 28, 2012. Lew who? Who knew? I Googled him).
In his prepared remarks, Lew said:
The Treasury Department recently released a report examining the potential macroeconomic effects of political brinksmanship in 2011 and the potential risks of waiting until the last possible moment to increase the debt limit in the current economic environment. It points to the potentially catastrophic impacts of default, including credit market disruptions, a significant loss in the value of the dollar, markedly elevated U.S. interest rates, negative spillover effects to the global economy, and real risk of a financial crisis and recession that could echo the events of 2008 or worse.
Lew was using the word catastrophic to mean either:
1) a great, often sudden calamity or
2) a complete failure; a fiasco.
I am using it in a third sense: (3) the concluding action of a drama, especially a classical tragedy, following the climax and containing a resolution of the plot.
But that catastrophe is not yet quite upon us.
In fact, what governments and central banks have done in each successive crisis (as the chart of the VIX demonstrates) is to pacify investors and remove any sense of fear over future recurrences of potentially disastrous situations. Nowhere has that been more evident than in the past few weeks of pathetic political grandstanding and red-faced wrangling over the debt ceiling.
Allow me to elaborate.
Below is a chart of the S&P 500 in the period surrounding the lastmanufactured political point-scoring exercise totally legitimate debate about America's addiction to borrowed money. As you can see, in the week leading up to the announcement of the last-minute deal, the S&P plunged a little over 4%. Immediately after the announcement of the deal, talk began swirling about a possible downgrade to the US credit rating, and the market dropped a further 11% on, first, the mere speculation that such an event would happen, and then upon the event itself. Catastrophe!! Shame.
Source: Bloomberg
In language that makes a mockery of their lack of foresight during the subprime crisis, S&P had this to say when lowering the credit rating of the United States to AA+:
More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.
Of course, subsequent to the downgrade, S&P was heavily criticized by the White House:
(Reuters): ... the Treasury Department issued a statement critical of the decision.
“We believe S&P’s negative outlook underestimates the ability of America’s leaders to come together to address the difficult fiscal challenges facing the nation,” said Mary Miller, assistant secretary for financial markets at the Treasury Department. And White House Council of Economic Advisers Chairman Austan Goolsbee said, “I don’t think that the S&P’s political judgment is right.”
Errr ... underestimate what now? The "ability to come together to address the difficult fiscal challenges facing the nation", you say?
My dear Mary, you COULDN'T underestimate that ability if you started at zero and went backwards.
Then, along with the other major ratings agencies, S&P was quite coincidentally hit with a major DoJ investigation — which DEFINITELY started before the downgrade.
Definitely:
(NY Times, August 17, 2011): The Justice Department is investigating whether the nation’s largest credit ratings agency, Standard & Poor’s, improperly rated dozens of mortgage securities in the years leading up to the financial crisis, according to two people interviewed by the government and another briefed on such interviews.
The investigation began before Standard & Poor’s cut the United States’ AAA credit rating this month, but it is likely to add fuel to the political firestorm that has surrounded that action. Lawmakers and some administration officials have since questioned the agency’s secretive process, its credibility and the competence of its analysts, claiming to have found an error in its debt calculations....
It is unclear if the Justice Department investigation involves the other two ratings agencies, Moody’s and Fitch, or only S.& P.
It didn't. But that was then. This past few weeks has been all about now.
Given the incessant din of commentary that has surrounded debt-ceiling wranglings in recent days, I'm not about to add to it. Instead I'm going to compare the market's reaction in 2013 to its reaction in 2011 — to the exact same situation. Only this time, relations between the opposing sides were far more febrile; so surely the fallout, should these knuckleheads make the same mistake AGAIN, would be absolutely certain to be of a magnitude far, far greater than it proved to be in 2011.
You'd think.
This time, as we came ever closer to Zero Hour and the rancorous divide between Republicans and Democrats steadily worsened, the VIX Index jumped once again. However, instead of the risk of default causing the barometer to hit the 48 level to which it spiked the first time around, it reached a mere 20.
Big Whoop.
Source: Bloomberg
Not only that, but it fell back straight afterwards, whereas in 2011 uncertainty lingered and the VIX remained elevated for several months.
The dollar? Well that hardly moved in 2013 either, as you can see from the chart below; only this time, in the months before the debt showdown, it just kept grinding relentlessly lower as the collective realization that QE is with us forever (or at least until the market tells the FOMC it's time to end it) dawned far and wide across the investment landscape.
Source: Bloomberg
Treasuries, too, were remarkably sanguine heading into an event which would put them in default. The very short end of the curve ticked up slightly a week before the supposed default, and we reached a point where one-month T-Bills paid more than three-month T-Bills did, though both still paid essentially zero.
The term "risk-free rate" used to represent the securities themselves — now it represents where they are priced.
Ridiculous.
Source: Bloomberg
"But what about the S&P 500?" I hear you cry.
I'm glad you asked, because the S&P's response was quite amazing and does perhaps more than anything thus far to answer my philosophical question this week.
Here is the S&P in the days leading up to, and immediately after, the dramatic conclusion of the bullsh*t negotiations in Washington:
Source: Bloomberg
Now as you can see, a mere 24 hours before the US (at least according to Jack Lew, who, as some of you may have known, is the Secretary of the Treasury of the United States of America) was going to run out of money and default on its obligations (the Lew-styled "catastrophe", which according to the great and the good would once again "bring the financial system to its knees" — how many MORE times are we going to have to listen to that, I wonder?), the S&P 500 was trading exactly 2.30% from its all-time high.
Sound like anybody was worried about financial Armageddon to you, dear reader?
Not to me, either, but here's the thing:
The danger WAS very real, as a default by the US on its debt obligations would have gone to the very heart of the "plumbing" that underlies financial markets and caused havoc in the repo market and all kinds of problems with collateral (or at least, what little collateral is allowed amongst market participants once central banks have hoovered up their ever-expanding allotments).
The key clue passed most people by a week ago; but it came from, of all places, Hong Kong:
(FT): Hong Kong’s stock exchange decided the possibility of a US default had made some types of short-term Treasury bonds more risky, prompting it to force traders using the securities as collateral to provide extra backstops....
It came as the Asia Securities Industry & Financial Markets Association (Asifma), which represents banks, brokers and asset managers in the region, warned that any announcement by the US Treasury in advance of a default must arrive before the opening of the day’s trading in Asia to avoid “chaos”.
Japan’s clearing house, the Japan Securities Clearing Corporation (JSCC), said it was in “intensive discussions” to prepare for “anything that might happen”.
Hong Kong Exchanges & Clearing (HKEx) said on Thursday it had taken two measures designed to reflect the increased difficulty of valuing certain short-term US Treasuries amid the debt impasse.
First, its clearing house would apply an increased “haircut" to its valuation of US Treasuries held as collateral against futures trades. For bonds held with maturity of less than one year, that would be raised from 1 per cent to 3 per cent, effective immediately, HKEx said in a circular to members.
“This new haircut shall be applied on a daily basis to determine the value of the US Treasuries allowed to be used as cover for the margin requirements of HKCC [Hong Kong Clearing Corporation] participants,” HKEx said.
“Participants should make necessary funding arrangements to cover any shortfall to their margin requirements resulting from the increase in the US Treasuries haircut.”
Anyone posting US Treasuries with less than a year to maturity as collateral, would need to come up with three times their current posted margin.
Not good. Not good at all. The amount of liquidity this would suck out of a fragile market would be catastrophic very bad indeed, and any forced selling on behalf of those unable to post the additional collateral would be a catastrophemajor problem, leading to falling prices and spiking rates — neither of which are allowed anymore.
Now, if HKEx's move had become fashionable around the world (and it's safe to say that exchanges are very much pack animals), it would have been quite bad a catastrophe.
After a very subdued reaction to the can being kicked down the road until February debt ceiling being agreed, something rather strange happened on Thursday. See if you can identify at what point in the day it occurred:
(I should point out that the yellow overlay of the gold price looks green where it sits on top of the blue DXY chart. There are only two variables in this chart, the yellow gold price and the blue US dollar price.)
Now, there was already a clue as to what this event was, hidden away in an earlier chart, but (cue drum roll) the catalyst for the dollar's sudden drop and the sharp spike in the price of gold waaaaaaaaaaaas... THIS:
(Reuters): Chinese rating agency Dagong has downgraded the United States to A- from A and maintained a negative outlook on the sovereign's credit.
The agency suggested that, while a default has been averted by a last minute agreement in Congress, the fundamental situation of debt growth outpacing fiscal income and GDP remains unchanged.
"Hence the government is still approaching the verge of default crisis, a situation that cannot be substantially alleviated in the foreseeable future," Dagong said in a press release.
Now those are the straight facts of the issue, but contained within the rest of what was a very short article are three fascinating sentences that speak to the very crux of the problem as things stand today. The first two constituted the very next paragraph:
(Reuters): Dagong's ratings are hardly followed outside of China. The agency also classifies most countries it follows very differently from major agencies such as Moody's, Standard & Poor's and Fitch.
Absolutely correct. Dagong's ratings are seen as something of a joke and very much inferior in nature to the Big Three — a poor man's Egan Jones, if you will.
BUT... a few days earlier, Fitch had put the USA on Rating Watch Negative (RWN), and nobody blinked.
Curiouser and curiouser.
Then, the final paragraph summed things up nicely as far as how the future is going to go:
(Reuters): Apart from the symbolic meaning of the downgrade, though, Dagong's move is expected to have no effect on markets.
Hmmm...
So here's where we get to the nub (finally!) of this week's philosophical wanderings.
The question I posed, all those charts ago, was this:
If something bad happens, but nobody reacts badly to it, did nothing bad happen?
Well, with each successfully navigated new crisis, the reaction of the market the next time a crisis flares up becomes more muted. We've seen the spectre of a Lehman-style collapse dealt with, and now the phrase "... could bring the global financial system to its knees..." is shrugged off with alacrity.
We've seen the spectre of a European fracture, a Grexit, a Spexit, and the end of the euro taken off the table by determined governments and central bankers; and now, each fresh outbreak of the European crisis is greeted with apathy and ennui. (I wonder if the French have a word for that.)
And now we've seen the extent of the reaction to the US debt-ceiling debacle the second time around. I would describe it as "quizzical interest" at best.
Why?
Because the Nannycrats are continually telling us that everything will be OK, that we shouldn't worry about things and ought instead to just Keep Calm and Carry On.
How bad has it gotten? Well, amidst the "hoo-ha on the Hill" recently, we saw one of the most bizarre things I've witnessed during the mayhem of recent years: Barack Obama's telling Wall Street that they SHOULD worry:
(Huffington Post): A self-described "exasperated" President Barack Obama told Wall Street CEOs on Wednesday that they should not take for granted that the Republican-led House of Representatives will raise the nation's debt ceiling by Oct. 17.
"I think this time is different," the president said, when asked by CNBC's John Harwood whether the financial markets were right to assume that the upcoming conflict would ultimately get resolved in time. "I think they should be concerned."
Barack, let me explain something to you.
The reason Wall Street WASN'T worrying is that you and Bernanke and Geithner and Paulson (not you, John — Hank) and Yellen and the rest of the Crazy Crew have gone out of your way for five years to make absolutely certainthat nothing bad ever happens again. Ever.
Why the hell WOULD they worry?
It's YOUR fault that they're not. You just can't have it both ways.
That's what moral hazard looks like, I'm afrai...
(Washington Examiner): Treasury Secretary Jack Lew thinks that markets aren't worried enough about the government running out of funds with which to pay its obligations.
Speaking at a Bloomberg event in New York City on Tuesday afternoon, Lew said that investors' confidence that Congress would strike a deal to lift the debt ceiling and avoid a default is “greater than it should be.”
Sheesh! Not now, Jack, OK? Your buddy's already on it.
So, it would appear that the answer to my philosophical question is "no". If something bad happens (which it unequivocally has these past few weeks) but nobody reacts badly to it (which they didn't, despite the urging of the Mollifier-in-Chief), did nothing bad happen?
Apparently not.
Except...
There's always a crack somewhere, even in the most iron-clad assumptions, and this time we catch a glimpse of it in that Dagong downgrade — and more importantly, in the reaction to it.
Somewhere, sometime, when it makes absolutely no sense to anybody, something is going to matter to everybody; and when it does, the instability which has been magnified by means of repeated assurances that nothing bad will be allowed to happen will bring the world to its knees, I'm afraid.
It's hard to deny that the world at large is a far more dangerous place now than it was 50 years ago. Yet, as a parent, I, like others in similar circumstances, go out of my way to make the world around my own children as safe and as sound as I possibly can.
Unfortunately, as they go about their days insulated from larger worries, my children's feeling of safety floats farther and farther from the reality of the dangers awaiting them in the "real world" every day.
The day that real world — the world in which mathematics and debts and credit ratings and unemployment levels and tax receipts and political stability and mathematics and free and fair markets and accountability and transparency and honesty and reality and — did I mention mathematics? — are alive and well — crashes through our gleaming soap-bubble world of reassuring illusions proffered by the likes of Obama, Merkel, Draghi, Bernanke et al, we are in for a world of hurt.
And when that something bad happens, it won't be greeted by the deafening silence of millions of trees falling in millions of deserted forests, but by the deafening noise of billions of people falling hard into reality, trying to understand why suddenly the safety their leaders had been promising them for years has vanished when they needed it most.
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