Some measures indicative of the financial turmoil « American Armageddon Judgement Day

Some measures indicative of the financial turmoil

Doom is Busting Out All Over

2008 will go down as one of the wildest years in financial history, having witnessed two huge earthquakes that have reordered the political and economic landscape, just as surely as the collapse of the twin towers did on 9/11/2001.

One shock in 2008 was the meteoric rise in energy prices, which crested just shy of $150 a barrel in the summer, followed by an equally bloodcurdling descent. Whole US industries–airlines, trucking, housing, autos–responded in the summer with a near death experience.

Following this oil shock was the cratering of various markets in September and October, which brought to a sudden new intensity the bear market in just about everything that began in the last part of 2007. Commodities, seemingly exempt, succumbed in August after oil prices peaked in July. Emerging markets crashed. Europe crashed. Latin America crashed. Asia crashed. And, of course, so did the good ole’ USA.

The dark specter–a return of another Great Depression–seemed suddenly to be decidedly more than a remote possibility. It would be a capital historical irony for that to happen, for US officials have for three generations taken the avoidance of that experience as their lodestar. At least, that is what they thought they were doing. Yet there it was again, big as life and twice as ugly, baying at the door.

Scary times.

The charts that follow in this chapter on financial stress provide a sketch of the havoc now ongoing. Then we’ll look to causes, consequences, and remedies.

Thursday

World Stock Market Capitalization Crumbles

Click this link for an updated version of the Dow Jones World Stock Index. Math whizzes, please tell me how much it would be worth if it hit the lows of 2003.

This page from stockcharts can be used to see charts on a wide variety of other financial indices.

10/26/08

Twin Peaks

This lovely mountain view from Jesse’s Café Américain gives the last twenty years of financial history at a glance. The chart was made on October 10, 2008. For more historical perspective, see the bear market interactive chart at the New York Times.

Stock Market Volatility

Stock market volatility in early October 2008 surged beyond any comparable level in the post 1945 era. Only the 1930s displays comparable mayhem. Bespoke Investment Group explains the above graph as follows: “Over the last month (23 trading days [since October 3, 2008]), the S&P 500 has seen 10 days where the index rose or fell (mostly fell) by more than 3%. You have to go all the way back to 1938 to find another one-month period where there were this many 3% days. As shown in the chart, there were many multi-year periods between 1950 and 2007 where the S&P 500 didn’t have even one 3% day. If you’re not a regular market participant and someone that is tells you we are experiencing something that hasn’t happened since the Great Depression, they’re not joking!”

Kim Zussman, in “Mother of All Swans,” has also put together a long term historical chart measuring volatility. Zussman used the daily returns of the Dow Jones Industrial Average from 1928 to early October 2008 and calculated the standard deviation for every non-overlapping 10 day period. The Crash of 1987 is still at the top of the charts on this one.

Both charts above were made in early October 2008. Here’s the latest snapshot of two widely used measures of volatility, the VIX and the VXO (click for updates). As you can see, both blew well past the post-1945 record as measured by Bespoke and are back to the wild levels of the 1930s.

Markets, despite being the results of millions of individual decisions, have personality. Sometimes they are the very picture of bourgeois respectability. At other times, like now, the alternating moods swings of euphoria and panic resemble the turbo-charged highs and suicidal lows of a crack addict. “Nothing better! I’m gonna die!” Such is the wonderful world of the American capital markets, circa 2008.

If you want to learn more about volatility, the go-to-guy is Bill Luby at Vix and More.

High Yield Bonds Over 20%

This New York Times graphic is updated daily for high-yield bonds as well as other measures of credit stress.

This is bad news for businesses dependent on access to the credit markets, some of which face impossible rates above 20 percent to borrow anything. It’s also bearish for stocks, because bondholders get paid off before stockholders in a liquidation.

High Yield Credit Spreads Top Levels of 2003

This chart from Bespoke Investment Group shows the “spread” or difference in yields between two classes of bonds: high yield or “junk” bonds and comparable Treasuries issued by the U.S. government. High yield bonds do well in times of economic expansion, as investors anticipate the great returns from the scenarios sketched in prospectuses. They do poorly in times of contraction, as the yields are driven higher (and the price lower) by fears of bankruptcy. The snapshot above was taken by Bespoke on October 2, 2008.

The chart below (click for updates) measures the same thing as the chart above, but does so by taking the ratio between two exchange traded funds (HYG & TLT) that are proxies for high yield bonds and comparable long-term Treasuries. The panic in the week of October 6-10 drove the ratio down more than 30 percent from mid-summer 2008. “The corporate bond market,” wrote one specialist on October 21, “is a broken shattered vessel and a shoddy reminder of its once mighty and powerful self.”

AAA Corporate Bonds: Compared To What?

While we’re on the subject, there’s two other relationships to monitor.

One is the ratio of investment grade corporate bonds, rated AAA, with US Treasury bonds. That ratio has been going down, in a “flight to safety.”

The other is the relationship between investment grade corporate bonds and high yield corporate bonds. That ratio has been going up, also in a “flight to safety.” (click for updates).

Remember: these are not just squiggles on a chart. They have profound implications for the health of businesses and for future levels of unemployment.

Tuesday

LIBOR and Financial Stress

(click to enlarge)

Adjustable rate mortgages, credit cards, and student loans are linked to LIBOR, as this graph from Bloomberg shows. By shooting up over 400 basis points during the October crisis (click for updates), it made all of those much more expensive. The price of credit is going up sharply. In conjunction with the “resets” in adjustable rate mortgages, it will force a large number to pack it in. So there’s tremendous hardship in those “400 basis points.”

The following chart from the St. Louis Fed looks at the LIBOR/OIS spread as a summary indicator of financial stress, and shows the significant worsening in September/October 2008.

Flame-Broiled Mortgage Spreads

The spread (or difference in yields) between five year Fannie Mae notes and similar Treasury notes has traditionally also been a sign of financial stress, and the spread passed historic levels on October 14, 2008.

This relationship is complicated. Fannie Mae was brought into government receivership in 2008 after its stock price collapsed in the summer. The US government has guaranteed the debt, with apparent conviction. Yet if the US government stands behind the “agency debt”—named after the “Government Sponsored Enterprises” or “G.S.E’s,” of which mortgage buyers Fannie Mae and Freddie Mac are the biggest and baddest—why shouldn’t treasuries and agencies trade at the same value? Why the premium? If Mr. Market distrusts the U.S. Treasury regarding the agency debt, why should he be super-confident about the Treasury debt? Here are a couple of factors–unintended consequences from the Treasury bailout, a sharp drop in foreign central bank buying–that are relevant in considering these questions.

It is possible to spend your existence pondering such matters, which thank God I have not done (until recently).

TED Spread from 1980s

This chart gives a long term view of the TED spread–that is, the difference in yield between Treasury bills issued by the U.S. government and the 90 day Eurodollar. At 2% when this chart was drawn, it subsequently shot up to 4.64% on October 10, 2008. There is an updated version available at the New York Times and Bloomberg. Further discussion at Macroblog, where this chart first appeared.

Commodities Tank

The Baltic Dry Index is a leading indicator of industrial production and trade (click for update). It charts the cost of freight movements in 26 of the world’s biggest shipping lanes of “dry” materials, such as coal, iron ore and grain which feed into the production of finished goods some weeks or months ahead. It rose above 11,600 in July 2008 and subsequently fell to 715 on November 28, 95% below the June high (click for updates).

This collapse in the BDI was the most dramatic exemplification of the sudden and brutal bear market in commodities, and shows the intimate relationship between the credit dysfunction and world trade. The “inability of shippers to get banks to accept letters of credit from other banks” notes Yves Smith, will lead, if not reversed, to “Smoot Hawley on steriods.”

You can see the powerful disinflationary forces across the commodity sector in the series of links gathered by Russ Winter at his perceptive Winter Watch:

“Coffee, higher costs to the economy? No, abating.
Drinks and beverages? Maybe Joe can afford his sixpack again.
Metals, higher costs to the economy? No, enormous relief.
Copper cathode for transmission lines? huge relief
Logs? Timberrrrrr!
Rubber? meets the road
Rice, panic buying? No, hoarding bubble has burst.
Oranges, prices killing consumers? Nao mais.
Beef? Rollar coaster but on the down slope.
Shrimp? cheapest in years
Olive oil? cheapest in years.
Soybean meal used to feed poultry? the hyperinflationary spike is gone, good riddance!
Cotton for clothes? Look for big sale items this Christmas on clothes, and hardly distressed selling.”

11/28/08

Consumer Credit Crashing

From Bloomberg, October 20, 2008: “Borrowing by U.S. consumers fell in August by $7.9 billion, the most since statistics began in 1943, to $2.58 trillion as lenders curbed access to loans.” Clicking the link above will take you to a snapshot of the latest data on consumer credit. This index excludes loans secured by real estate (also collapsing) but covers most short-term and intermediate-term credit extended to individuals. The September and October data will show it falling much further.

The now suddenly altered credit environment occurs against the background of the low levels of household savings. “From 1960 until 1990, households socked away an average of about 9 percent of their after-tax income.” Thereafter, savings steadily declined, with Americans putting away less than 1 percent of income in the last three years. As these charts show, household balance sheets badly deteriorated.

Savings declined as Americans leveraged their cash to investments in stocks and real estate. How has that worked out? “Household net worth, as measured by the Fed, fell $2 trillion in the second quarter from a year earlier — and that was before the stock market’s nosedive wiped about $3.9 trillion off investors’ portfolios in the past month and a half.”

This is some kind of double whammy for the middle and upper-middle class, but it also affects the poor and rich. With both credit and wealth evaporating, the American household’s “debt/equity ratio” has just done a moonshot.

Class assignment: Is this the “new normal”? Who does it affect the most? What are the implications?

One Big Happy Human Family

This is a worldwide crisis; the global capital markets and the world economy are a tightly linked system. That is one of the meanings, perhaps the primary meaning, of “globalization.” How far it will “uncouple” because of the financial crisis is a great unanswered question.

One of the ironies of the meltdown is that the countries previously deemed most immune (China, Brazil, India, Russia) have gotten hit harder than the US market, where the crisis undoubtedly originated. That is something to think about. Do not underestimate the power of money to foster resentment, ill will, dark malicious feelings. Remember your Machiavelli, who advised the prince that it is better to be feared than loved, but in no case should he be hated: “above all he must abstain from taking the property of others, for men forget more easily the death of their father than the loss of their patrimony.” The losses are rousing the American people to anger. The same causes will produce the same effects abroad.

Emerging stock markets have fallen by about fifty percent and were hit especially hard in the October 2008 crisis (click for updates). Emerging market bond spreads have also widened considerably, though they are far from decade-ago levels. On this website you can see spreads on twenty different countries and regions. The following snapshot, taken on October 19, 2008, gives the view from 1997.

Class assignment: pick a country, read its press, and summarize the role the United States is seen to have played in the financial crisis by public opinion in the country.

The Banking System: The Issue of Trust

Paul Kedrosky writes:

“People keep talking about the perils of nationalizing the banking system. Newsflash: There currently is no banking system, if by that you mean a network of organizations lending to one another and to quality companies in a predictable way. (Look at the spread on today’s IBM issue for an example.) Instead, there are a bunch of paralyzed deposit-hoarding institutions stuck in a game theory experiment that no-one understands or can exit.

The solution to a systemic breakdown in tightly-coupled systems is to uncouple the systems, build in slack, and break the feedback mechanisms — and not necessarily in that order. In this context you can do that most directly by either recapitalizing a select set of banks immediately, or by letting banks fail and consolidate. Either way, you end up with uncoupling and the eventually reappearance of trust, whether through a government backstop or through defaults and collapse. I tend toward the former approach, but I fully understand its risks and the attractiveness of the latter to some people.

Either way, trying to fix things on the fly, without breaking the feedback mechanisms, and without introducing slack to protect a fragile and badly damaged system from the next inevitable lurch, is stupid, destructive and childish.”

The Banking System, Nationalization and Slack

This summarizes a crucial issue, but I strongly favor the less costly and more equitable proposal set forth by Luigi Zingales.

Carry Trades Unwinding

In a “carry trade,” speculators borrow money from a currency whose interest rates are low and invest in currencies where yields and opportunities are higher. When their investments crater, as now, they must buy back the currency whence they borrowed the funds. The Japanese Yen was the favored currency for carry trades in the recent past, and in the fall 2008 financial crisis the trade unwound savagely, as this chart of the Aussie dollar against the yen shows (click for updates).

The Euro/Yen cross has also taken a nosedive, though the longer term chart does not suggest unreasonable valuations at 1.19 (its price on October 24, 2008–click for updates)

The dollar has fallen sharply against the yen but risen dramatically against the Euro and most “emerging” currencies. In late November 2008 it touched 89 and had retraced nearly 38% of its decline from 2002. (click for updates)

This development confounded many expectations. Most political economists had imagined that a crisis, if it came, would be bound hand and glove with a dollar crisis, but the demand for liquidity has perversely created a tremendous demand for dollars, as liabilities must be settled in the “reserve currency.” The dollar itself was a “carry currency”: investors or speculators in commodities, notes Ronald Solberg, funded their positions “with US dollar-denominated credit, in effect, creating a US dollar short position. Now that these commodity carry trades are being unwound, it exacerbates commodity weakness and contributes to US dollar strength.”

In the panic, European banks required to settle their liabilities in dollars expressed fury with Washington and New York for having been sold a bill of goods.

11/28/08

Measuring Inflation

Measures of financial stress in the real economy are obfuscated by the unreliable nature of government statistics. The guy who has delved most deeply into this is John Williams of Shadow Government Statistics, whose perspective is summarized in this February 2006 interview. In this chart, the red line shows the “headline” inflation figures given out in official government releases. The SGS Alternate CPI is calculated according to the methodologies in place in 1980.

Monday

Unemployment Mythologies and the “Misery Index”

This chart, also from John Williams’ Shadow Government Stats, shows the unemployment rate according to three different methodologies. The official rate in red is especially misleading because it is dominated by assumptions about job creation in a normal economic expansion (the so-called birth/death model). In 2008, it kept showing expansion in financial services and construction, when anybody who could read a business page knew that wasn’t so.

The Bureau of Labor Statistics calculates a broad measure of unemployment (U6), also given in the chart; Williams has adjusted for that in his SGS Alternate Unemployment Rate to reflect discouraged workers “defined away” when the methodologies were recalculated during the Clinton Administration.

Adding the inflation rate and the unemployment rate together gets you a “misery index.” Coined by the economist Arthur Okun, the phrase entered the political arena in the 1970s, with Jimmy Carter declaiming against a misery index of 13.57 in the summer of 1976. Then Ronald Reagan made it a centerpiece of his campaign in 1980, when the misery index reached a high of 21.98.

According to official government statistics today, the misery index is at 13.5, a lot lower than it was in 1980, and you could go lower than 10 and be feeling awfully chipper if you used the “pce/deflator” to calculate inflation. But if you measure inflation and unemployment according to the methodologies in place in 1980, as Williams has done, it’s at about 26.

Update: The Peterson Institute is out with a “new and improved” misery index (see the chart below) that pegs it at 24.2 in the first half of 2008, in contrast with an “official” rate at 13.5, a difference of 10.7 points. Gary Hufbauer and colleagues are using pretty conventional figures for inflation and unemployment–that is, a CPI of 8.4% for the first half of 2008, in contrast with Williams’ estimate of some 12%, and an unemployment rate of 5.1% for the same period, in contrast with Williams’ whopping 14%.

The Peterson innovation is to add some weightings for equity and real estate prices in its “augmented misery index,” which boosts it to 24.2.

However, using Williams’ inflation and unemployment numbers, and adding 10.7, gets you a misery index of 36.7.

Anybody for a drink?

The authors of the Peterson Institute study seem most interested in getting their misery index to talk to presidential approval ratings, whereas my main interest is in misery as such. In 2004, there was a guy with a website who showed the close inverse relation between gasoline prices and presidential approval ratings, and I admit to having studied this closely in that presidential race, thinking that it would matter. Then the Bushies engineered lower gas prices into the fall, indicating that they were studying this master political indicator with the same rapt attention.

11/02/08

If You Want More,

The chart above shows the rate at which municipalities can borrow in the short term money markets. It is calculated every Wednesday by the Securities Industry And Financial Markets Association.

Here are a few other credit indicators highlighted by the blogger Accrued Interest.

Calculated Risk also promises a daily update on credit conditions. See here and here.

The St. Louis Federal Reserve has a good section on interest rates, plus much more.

Markit.com contains a wealth of vital information on credit derivatives. Unfortunately, the charts usually go back only about three months, so it is difficult to get historical perspective. Someone at markit needs to take this website in hand and give it a good scrubbing, especially in synthesizing the data and providing the historical material.

10/26/08

Minsky Moments

In summation of these various indicators of financial stress, we have arrived at “The Minsky Moment.” Named after Hyman Minsky, an iconoclastic economist ignored by the mainstream, it refers to the time when market crashes create a severe demand for cash. Minsky foresaw that long periods of stability could subtly lay the ground for seismic periods of instability, and he propounded a sort of natural history of that process, one that well describes the current period of cardiac arrest.

At its core, as Justin Lahart explains the matter, “the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. ‘This is likely to lead to a collapse of asset values,’ Mr. Minsky wrote.”

So here we are at the Minsky moment with its mad scramble for cash and its collapsing asset values. Lahart wrote that on August 18, 2007, in The Wall Street Journal, and insisted that the Minsky moment had arrived. We have subsequently learned that the Minsky moment can span a yet longer period of time. We seem to be having a lot of these Minsky moments lately. Thou shalt not be a Minsky era, let us pray.

This entry was posted on December 8, 2008 at 9:59 am and is filed under Blogroll . You can follow any responses to this entry through the RSS 2.0 feed Responses are currently closed, but you can trackback from your own site.