So many credit crises are brewing, it’s hard to keep track without a scorecard.
The mother of all credit crises is coming to China with over a quarter-trillion dollars owed by insolvent banks and state-owned enterprises, not to mention off-the-books liabilities of provincial governments, wealth management products and developers of white elephant infrastructure projects.
Then there’s the emerging-markets credit crisis, with Turkey and Argentina leading a parade of potentially bankrupt borrowers vulnerable to hot money capital outflows and a slowdown of growth in developing economies.
Close on their heels is the U.S. student loan debacle, with over $1.5 trillion in outstanding debts and default rates approaching 20%.
Now we’re facing a devastating wave of junk bond defaults. The next financial collapse, already on our radar screen, will quite possibly come from junk bonds.
Let’s unpack this…
Since the great financial crisis, extremely low interest rates allowed the total number of highly speculative corporate bonds, or “junk bonds,” to rise 58% — a record high.
Many businesses became highly leveraged as a result. There’s currently a total of about $3.7 trillion of junk bonds outstanding.
And when the next downturn comes, many corporations will be unable to service their debt. Defaults will spread throughout the system like a deadly contagion, and the damage will be enormous.
This is from a report by Mariarosa Verde, Moody’s senior credit officer:
This extended period of benign credit conditions has helped many weak, highly leveraged companies to avoid default… A number of very weak issuers are living on borrowed time while benign conditions last… These companies are poised to default when credit conditions eventually become more difficult… The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives.
Many investors will be caught completely unprepared.
Each credit and liquidity crisis starts out differently and ends up the same. Each crisis begins with distress in a particular overborrowed sector and then spreads from sector to sector until the whole world is screaming, “I want my money back!”
When gold crashed on Monday, dragging market prices down to a low of $1321.50 an ounce from levels around $1560 only days before, holders of physical gold saw the value of their holdings decline as well.
However, we've seen a lot of claims that somehow there's a difference between the market for physical gold (people buying gold bars or gold coins) and that for "paper" gold (which refers to gold futures traded on the COMEX or shares of GLD, the gold ETF).
Jim Rickards, a prominent gold bull and author of the book Currency Wars, told Business Insider that the disconnect between the two markets evidenced by the crash on Monday is not one of price, but "in terms of behavior, in terms of people's responses to market developments."
So, what does that mean exactly?
Rickards uses a classic "weak hands, strong hands" analogy to compare physical gold buyers and paper gold buyers.
According to Rickards, the "weak hands" in the gold market were the over-leveraged buyers of gold futures and ETFs that caused prices to plummet in the recent sell-off.
"If you're an un-levered buyer of bullion - say, 10% of your investable assets - you kind of watched the headlines and watched the ticker [as gold crashed] on Thursday, Friday, and Monday, but it didn't affect you," says Rickards.
Below, Rickards expands on the analogy and explains where the hedge funds fit in:
Gold ownership is now divided between strong hands and weak hands. The strong hands are Russia, China, some of the other central banks, and anybody else who is buying gold for cash in physical form, without leverage.
The weak hands are retail jumping into GLD, at a top, using margin, futures players, and people who don't really understand gold. There are a lot of trend followers out there who started following gold on a trend basis, but didn't really understand anything about gold, or how it works, etc.
The hedge funds turn out to be weak hands, not strong hands. The reason is they've got redemptions. Hedge funds don't have permanent capital. They may have monthly redemptions, or quarterly redemptions, or one-year lockups, or whatever it is, but it's not permanent capital.
"Ukraine, South Africa and Chile are also highly vulnerable to a run on their reserves and a default on their external dollar-denominated debt.
The only issue now is whether the new crisis will be contained to Argentina and Venezuela or whether contagion will take over and ignite a global financial crisis worse than 2008.
It has been 20 years since the last EM debt crisis and 10 years since the last global financial crisis.
This new crisis could take a year to spread, so it’s not too late for investors to take precautions, but the time to start is now.
The Fed’s path of rate hikes and balance sheet reductions since December 2015 has reinvigorated the U.S. dollar, as I explained above. A stronger dollar means weaker EM currencies in general. Again, that’s exactly what we’ve seen lately. Right now, EM currencies are in free fall against the dollar.
But here’s a curveball question for you:
Now that the Federal Reserve raised rates again last month, is the bottom in for emerging-market currencies? And is the top in for the dollar?"
The dollar constitutes about 60% of global reserves, 80% of global payments and almost 100% of global oil transactions.
So the dollar’s strength or weakness can have an enormous impact on global markets.
Using the Fed’s broad real trade-weighted dollar index (my favorite foreign exchange metric, much better than DXY), the dollar hit an all-time high in March 1985 (128.4) and hit an all-time low in July 2011 (80.3).
Right now, the index is 95.2, below the middle of the 35-year range. But what matters most to trading partners and international debtors is not the level but the trend.
The dollar is up 12.5% in the past four years on the Fed’s index, and that’s bad news for emerging-markets (EM) debtors who borrowed in dollars and now have to dig into dwindling foreign exchange reserves to pay back debts that are much more onerous because of the dollar’s strength.
And EM lending has been proceeding at a record pace.
Actually, the Fed’s broad index understates the problem because it includes the Chinese yuan, where the dollar has been stable, and the euro, where the dollar has weakened until very recently.
When the focus is put on specific EM currencies, the dollar’s appreciation in some cases is 100% or more.
Much of this dollar appreciation has been driven by the U.S. Federal Reserve’s policy of raising interest rates and tightening monetary conditions with balance sheet reductions. Meanwhile, Europe and Japan have continued easy-money policies while the U.K., Australia and others have remained neutral.
The U.S. looks like the most desirable destination for hot money right now because of interest rate differentials. And that is having far-reaching consequences on EM economies.
A new EM debt crisis has already started. Venezuela has defaulted on some of its external debt, and litigation with creditors and seizure of certain assets are underway. Argentina’s reserves have been severely depleted defending its currency, and it has turned to the IMF for emergency funding...
Jim Rickards joined Kitco News and Daniela Cambone to discuss the latest news and analysis from gold markets, geopolitics and even bitcoin. The Wall Street veteran took on the bigger picture facing metals investors and what could be just around the corner in a bubbling market.
When asked why certain geopolitical tensions have greater impacts on gold and hard assets than others Rickards remarked, “There are two things going on, first is that the North Korean missile threat goes from high tension to back down again. This is a very serious threat and we are headed for war with North Korea. While I don’t know what it will take to not just get gold to go up but stocks and other sectors, ultimately markets are going to be impacted.”
"So, I would say two things about the monetary collapse. No. 1, it could happen very suddenly — and likely it will — and we won’t see it coming, so investors need to prepare now.
Investors almost say to me, ‘You know, Jim, call me up at 3:30 the day before it happens and I’ll sell my stocks and buy some gold.’
First of all, it doesn’t work that way for the reasons I just explained, but secondly, you might not be able to get the gold and that’s very important to understand. When a buying panic breaks out, you know, and the price starts gapping up, not $10.00, $20.00 an ounce per day, but $100.00 an ounce then $200.00 an ounce and then all of sudden, it’s like up $1,000.00 an ounce and people say oh, I got to get some gold. You won’t be able to get it. The big guys will get it, you know, the sovereign wealth funds, the central banks, the billionaires, the multibillion-dollar hedge funds, they’ll be able to get it, but everyday investors won’t be able to get it.
You’ll find that the mint stops shipping it. That your local dealer has run out so there’ll still be a price somewhere. You’ll be able to watch the price on television, but you won’t actually be able to get the gold. It’ll be too late."
The two questions I’m asked most frequently about the monetary collapse are: what’s the event that’s going to take down the system and when is it going to happen?
Those are logical questions, but the event that triggers the collapse doesn’t matter — and here’s what I mean by that.
Imagine you’re on a mountainside and there’s snow building up and it’s still snowing and you’ve got some avalanche danger… it’s windswept, it’s unstable. You’re watching the snowpack, and if you’re an expert, you know it’s going to collapse and it could kill some skiers or wipe out the village.
Well, here comes a snowflake, it disturbs a few other snowflakes, that spreads, it starts to shoot, it starts to slide, it gets momentum, it comes loose and the whole mountain comes down and buries the village.
Who do you blame? Do you blame the snowflake or do you blame the unstable pack of snow?
I say the snowflake’s irrelevant. If it wasn’t that one, it could have been the one before or the one after or the one tomorrow.
The same goes for the collapse of the monetary system. It’s the instability of the financial system as a whole. So, when I think about the risks, I don’t focus so much on the snowflake, it could be a lot of things that trigger the event. It could be a failure to deliver physical gold because gold’s getting scarce. It could be a Lehman type of collapse of a financial firm or another MF Global. It could be a prominent suicide. It could be a natural disaster.
It could be a lot of things, but my point is, it doesn’t matter. It will be something that causes the system to collapse. What matters is that the monetary system is so unstable. The blunders have already been made. It’s not as if we’re going to do some bad things that’s going to create risks. The risk is already there. It’s embedded. We’re just waiting for that catalyst.
So as to what will cause the global monetary system collapse, my answer is it could be a lot of things, but it doesn’t matter. What matters — and what investors need to be concerned about — is the instability is already baked in the pie.
Now, as to when this will happen, it will be sooner than later. By that I mean three, four years. This is not necessarily something that’s going to happen tomorrow, (although it could) but that’s not a ten-year forecast either, because we’re not going to make it that far and we never do.
These things do happen every four or five years. The dynamics, what we call the scaling metrics, and the size of the financial system and risk. One definition of risk is: What’s the worst thing that can happen?
It’s not a linear function. It’s an exponential function. What that means is that when you triple the system, you don’t triple the risk. You increase risk by ten or a hundred times.
That’s what we’re doing. We’re out there making the San Andreas Fault bigger so we can have even bigger earthquakes in the future. That’s exactly what’s going on.
