Leverage: the use of credit to enhance one’s speculative capacity
Merriam-Webster
Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.
Archimedes
The Swiss National Bank – the Swiss equivalent of our Federal Reserve – didn’t exactly move the world last week but the fallout from their surprise change in monetary policy did reverberate around it. The SNB pegged the Swiss Franc to the Euro a few years back in an effort to stem capital inflows from the rest of Europe. Investors throughout Europe saw the Franc as a safe haven, a hedge in case this whole Euro experiment proved untenable. Those inflows pushed up the value of the Franc, reducing the competitiveness of the export oriented Swiss economy. So the SNB decided to peg to the Euro, essentially tying the fate of the Franc to the fate of the Euro. Doing so required them to buy large amounts of Euros to support its value against the Franc.
And as recently as a couple of weeks ago the SNB was assuring everyone that the peg was here to stay. That assurance was apparently sufficient for “investors” to borrow huge amounts in Swiss Francs at paltry interest rates in the belief that the Franc would continue to follow the Euro lower. They used those borrowed Francs in a variety of ways but based on reports last week most of it went toward funding other speculations. Some apparently just assumed the Swiss would let the Franc go down with the Euro ship and sold short the currency at leverage ratios up to 20 to 1. It all worked wonderfully until last week when the SNB finally said assez or genug or whatever it is Swiss bankers say when they’ve reached their limit. And so they announced that the Euro peg that they had just assured everyone was sacrosanct was kaput and let the Franc float. And float it did, up 40% against the Euro at one point before settling at up about 20%.
Well, as Merriam-Webster says, leverage is how one enhances one’s speculative capacity and we found out in rather hasty fashion whose capacity had been enhanced. A retail currency broker in New Zealand dropped first, ceasing operations immediately, their clients wiped out. Then another retail shop in the UK followed suit. Next up was a US based broker, FXCM, which didn’t fold but had to go hat in hand to Leucadia for a $300 million bailout. Then the bank trading desks weighed in; Citi lost at least $150 million, Deutsche Bank a similar amount while Barclay’s managed to keep their losses to under $100 million. Last, but certainly not least, a hedge fund right here in my hometown of Miami announced that their $800 million global fund had managed to wipe out all its equity overnight. The fund was called Everest which was apparently a reference to its mountain of Swiss Franc debts, the Alps apparently not tall enough to describe their ambitions.
And that’s just what came out of the woodwork in a couple of days. We’ll probably hear about more funds and banks that took hits on their short position in Swiss Francs in the coming days and weeks. The losses will surely total in the billions. So, I know what you’re thinking. Who cares? So a bunch of currency gamblers lost their shirts. What does that have to do with the US assets where I have most of my money invested? Well, there probably isn’t a direct link except for the trading desks at the major US banks and they’ve all been shrinking their trading activities anyway. No, I bring this up as a warning about the dangers of a world that is still living beyond its means, that has not deleveraged as so many want to believe but has instead piled debt on top of debt even after the debacle of 2008.
The amount of Swiss Francs sold short is minuscule compared to the global US Dollar short position. The dollar index is up almost 18% since last summer and there is, at last estimate, approximately $9 trillion in outstanding dollar denominated debt outside the US. A foreign company or government with outstanding dollar debt is short the dollar every bit as much as that Miami hedge fund was short Swiss Francs. Their position may – and I emphasize may – be hedged somewhat if they also have US dollar revenue but last I checked global trade is not exactly going gangbusters right now. And for any corporate dollar borrower in the business of extracting commodities from the ground and shipping them to China the dollars they receive for their product has been shrinking right along with the CRB index. The currency markets should be very interesting the next few weeks with European QE on the menu this week.
The point is that while the rise in the US dollar has been seen almost universally as a positive – I’ve said before and will reiterate that a stronger dollar is in our best interest – it does create problems too, most obviously for those with a mismatch between their dollar debts and their access to dollars to pay them off. We like to think that the rise in the dollar is due to our virtues but it could just as easily be other’s vices that are driving the dollar higher. Dollar liquidity is drying up as the Fed’s QE has ended and oil prices have dropped. So keep an eye on the dollar and if it starts to rise rapidly, brace yourself because the dollar lever is a lot longer than the Swiss Franc one.
In any case, there isn’t any crisis right now and one hopes the Fed is aware of the potential for the dollar to destabilize things so I’ll continue to concentrate on things here at home. Stocks were down on the week but we’re still within striking distance of the recent highs. The real action has been in the bond market where long term Treasuries have been on a tear for the last year and high yield bonds have been moving steadily, if slowly and orderly, down. The Treasury market has been marking down inflation and growth expectations for months and it has accelerated in the new year. High yield bonds are moving in the opposite direction with credit spreads moving wider since last summer. That is an indication of a rising risk aversion in the bond market that hasn’t really worked its way into the stock market – yet.
The economic data isn’t nearly as dire as the bond market seems to believe. The data last week continued the trend of the last year – at least – of being okay but not great. As it seems every week, we got some good data points, some bad ones and some that are okay but moving in the wrong direction. In the first category was the JOLTS report which showed plenty of job openings and mortgage applications which jumped an incredible 49% in one week. In fact it was so incredible I’m not sure I totally believe it. For now I’ll take it at face value but don’t be surprised if we hear a mistake was made. The bad category was led by retail sales which fell 0.9% although about half of that drop was due to lower gas station sales. Even taking that out though it wasn’t a good report and contrasts sharply with the consumer confidence reports we’ve been seeing. Also in the bad category were the three reports on prices, all of which showed declines on the month (which I don’t think is necessarily bad but everyone else does).
The last category, reports that weren’t really all that bad but are moving in the wrong direction, included jobless claims which jumped 19,000 and back over the 300k level. That’s either seasonal weirdness or noise or the beginning of layoffs in the oil patch but whatever it is the level isn’t of concern at the moment but the direction is. Also in that category was the Philly Fed survey which stayed in positive territory but showed a marked slowdown from last month. Industrial production was also a bit light but all the drop was from reduced utility output.
Of course, the economic data is lagging information and is subject to large revisions especially at turning points which is why we look at more real time market indicators. Of much more concern than the flow of data is that action I mentioned earlier in the bond market. The yield curve has been flattening for over a year and has recently accelerated. While a lot of commentators seem to want to pin that on the action in foreign bonds – US bonds are more attractive with higher yields than European bonds – I take it more at face value. The flattening curve and the drop in long term rates is an indication of falling inflation and growth expectations. The curve always flattens leading into recessions and while we haven’t gone completely flat yet – the curve usually inverts before a recession – there is considerable uncertainty about whether history is a good guide in this cycle after so much Fed intervention. One good bit of news is that TIPS yields have not followed nominal yields lower – yet – indicating that real growth expectations haven’t fallen much and this is more about inflation than real growth. And I would just point out that the bond market is not infallible; there’s an old Wall Street saying that the bond market has predicted 9 of the last 5 recessions.
Of more concern is the action in the junk bond market where yield spreads to Treasuries have been widening since last summer. Widening credit spreads are the other canary in the coal mine and actually are a better warning about a slowdown than the yield curve. Almost every correction, even minor ones, in stocks is preceded by a widening in spreads. In this case the concern is centered on energy related issues and I think part of the volatility in stocks recently has been the uncertainty over whether lower oil prices will end up being a net positive or negative for the economy. The layoff announcements and capex cuts have been coming fast and furious from the oil patch with Schlumberger announcing 9000 layoffs just last week. The Dallas Fed recently estimated job losses in Texas at 140,000 if oil prices stay down and that’s just Texas. It will take time for this to play out but if this is a big deal we’ll likely see it first in the jobless claims. For now, we have a flattening yield curve and widening credit spreads which is a warning if nothing else and plenty reason to be cautious.
Warren Buffet has said that “only when the tide goes out do you discover who’s been swimming naked” and the tide went out in Switzerland last week. You should expect to find some embarrassed swimmers in the coming days and weeks. And if the dollar keeps rising – or worse accelerates – its going to look like a nudist colony in some corners of the world. In fact, the rising dollar is already claiming victims right here at home. Falling oil prices are as much about the dollar as supply and demand. Shale producers are learning anew the definition of leverage. It does enhance ones speculative capacity – and it works in both directions.
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