not to play

The Derivative Market Will Take Out And Bring Down The Financial System

Egon V. G. says a $1,400,000/oz gold price wound't even be enough to cover a derivatives failure. here's just how big the problem has become…

Gambling is according to Wikipedia the wagering of money (or something of value) on an event with an uncertain outcome.

Three elements are required for gambling, Consideration, chance, and prize. Thus, you make a bet and if you are lucky you win a prize but you can also lose it all. Gambling has been around for thousands of years and maybe longer. The first 6-sided dice dates back 3000 years. Eventually gambling became more organised as casinos were established. The first well known casino was set up in Venice in the early 1600s.

Casino means a small house and the house was the banker. The odds were naturally always in favour of the house and that has not changed for centuries. In the last 100 years, the bankers or the House have made fortunes and especially in the last 25 years as market manipulation has taken massive proportions.

Over the last 100 years, governments and central bankers have made the investment markets into a casino with only winners which primarily have been the bankers themselves.

DERIVATIVES – THE HOUSE ALWAYS WINS

Central and commercial bankers have created the most perfect Casino model, a model where the banker is the winner every time. Firstly, the banker issues the money with the help of infinite leverage. Then he sets the conditions – interest rates, fees, terms etc. To further improve his odds, the banker also manipulates markets so that they are always in his favour.

The most perfect market from the bankers' point of view is the derivative market. This is the biggest financial market in the world. It consists primarily of unregulated Over the Counter (OTC) instruments. A derivative is an instrument which derives its value from underlying assets such as stocks, stock indices, bonds, foreign exchange, gold, silver etc.

Derivatives is the biggest money spinner of the financial system and has made many bankers very wealthy. The system is totally skewed against the buyers of the derivatives. Prices are set so that the issuer of the derivative cashes in virtually every time. Prices are always set for the bank to collect 100% of the premium and never pay out. As maturity of a derivative in the money approaches, the bank will do its utmost to manipulate the price to make the derivative worthless.

GOLD AT $1.4 MILLION PER OZ TO COVER DERIVATIVE FAILURE

Total derivatives outstanding is around $1.5 trillion. The Bank for International Settlements (BIS) reports a figure of $500 trillion. But that figure is not credible since it was adjusted some years ago after netting off a major part of the gross exposure. The gross derivative exposure is 1070x central bank gold. So if central banks needed to cover an implosion of the derivative market with gold, the gold price would increase over 1,000 fold from here to $1.4 million. This might not seem a plausible price but we must remember that gold reached 100 trillion Marks during the Weimar Republic and is now in Venezuela 53 million Bolivars. (The black market price is 370 million bolivars). As global credit markets implode and money printing starts in earnest, a $1.4 million gold price might be much too low.

DEUTSCHE BANK – 650X LEVERAGE IN DERIVATIVES

If we look at the derivative exposure of some of the major banks, it also shows a very dire picture:

With equity of 0.15% to 0.5% of total exposure, these banks are unlikely to survive the next crisis.

The exposure shown is most probably well below the real exposure since it is based on the BIS calculation. The real figure is probably twice as high. Still, it shows the massive risk that these banks are exposed to. They will of course argue that this is the gross exposure and that the net position is a fraction of the gross. That argument is valid in an orderly market when counterparty pays. In 2007-9 we saw what can happen when counterparty fails like with Lehman. The global financial system was then saved in the last minute. But with global debt having doubled since then and risk up manifold, next time we have a global crisis, counterparty is very likely to fail.

DERIVATIVES – TOO BIG TO SAVE

The risk in the derivative market is not recognised by the banks, central banks or the market. In the 2007-9 financial crisis, it was mortgage linked derivatives that brought the world to the brink. Next time around it will also be the derivative market that will bring the financial system down. But that time, the system is unlikely to be saved. Interest rates are already low and money printing will have no real effect.

As the cube shows above, there is too little gold in the world to save the system when fiat money becomes worthless. Or to look at gold in a different way, gold and silver will need to appreciate at least 1,000 fold and probably a lot more, to reflect the losses in the system and the debasement of money.

GOLD AND SILVER – INCREDIBLE VALUE

Gold at $1,320 and silver at $16.50 represents incredible value in a financial system that is unlikely to survive in its present form. Precious metals is the only asset class which will maintain its purchasing power in the coming financial crisis. But more likely is that gold and silver will do a lot better than just maintaining value. Commodities are now finishing a major bear cycle and will outperform all asset classes in coming years. Gold and Silver will be the winners amongst all the commodities and will reach levels which are hard to imagine today.

What is guaranteed is that paper money will become worthless in the coming crisis and that most bubble asset classes will decline 75-95% in real terms. Gold is nature's money and as such will be the only money that will survive the coming crisis just as it has for over 5,000 years.

Warning: The Stock Bubble is Getting Dangerously Close to Its Needle

Rates are rising once again.

Over 90% of investors focus almost exclusively on stocks. This is a mistake. The reality is that everything happening in stocks since 2008 has been the direct result of Central Banks creating a bubble in bonds.

Because our current financial system is debt-based in nature (meaning sovereign debt, not gold or some other asset is the bedrock of the financial system) when Central Banks did this, they effectively created a bubble in everything (including in stocks).

Put simply, it is BONDS, not stocks, that concern Central Banks the most. If stocks collapse, it's a big deal for investors. If bonds collapse, it's a big deal for entire countries/ the financial system.

With that in mind, consider that bonds have begun to collapse, with US Treasury bond yields rising sharply above their downtrends.

THIS is what triggered the February meltdown.

And by the look of things, we're not done yet. Instead of falling hard, rates have found support and are preparing to breakout to the upside again.

Daniel Nevins: Economics for Independent Thinkers

Economists are supposed to monitor and analyze the economy, warn us if risks are getting out of hand, and advise us on how to make things runs more effectively -- right? Well, even though that's what most people expect from economists, it's not at all how they see their role, warns CFA and and behavioral economist Daniel Nevins. Economists, he cautions, are modelers. They pursue academic lines of thought in order to make their models more perfect. They live in a universe of equations and presumptions about equilibrium states and other chimerical mathematical perfections that don't exist in real life. In short, they are the wrong people to advise us, Nevins claims, as they have no clue how the imperfect world we live in actually works. In his book Economics For Independent Thinkers, he argues that we need a new, more accurate and useful way of studying the economy: However far you go back, you can find economists who had a more realistic approach to how humans actually behave, than the way that mainstreamers assume they behave in the models that the Fed uses to pick winners and losers. You mentioned credit cycles, business environment, and behavioral economics. What I've done is to say, "Okay. We know that the modeling approach, the systems of equations approach doesn't work. But instead of starting completely from scratch, what can we find in the economics literature that is maybe more realistic?" And the interesting thing is that if you look at the work that was done, the state of the profession before the 1930s, before Keynesianism took hold, you can find a lot of work that was quite sensible. I think where that points is towards this notion that when we think about economic volatility, there are really three things that we need to bring together: 

- One is the behavioral side. And we have to be realistic about the way that people really process information, the way that they truly make decisions.              - The second has to do with the way businesses operate and all the challenges that businesses face to gain and retain profitability. That's something that economists were intently focused on before Keynesianism and then it became kind of sidelined afterwards because all of these models assumed that businesses didn't have any challenges. If you pick apart the standard models that the Fed uses that are taught in PhD programs, they assume that business are always profitable, they always sell all of their output instantaneously, and they know exactly what their customers want, and businesses don't struggle. So, that's another thing we need to correct that you can find a lot of useful research if you know where to look (before Keynesianism and at the nontraditional schools that have continued in the older approaches).                                                                                                                                                                                        - And then the third thing is the credit side where mainstream economics is just so off-target, especially in their models that exclude any role for banks. Effectively, mainstream economists have made assumptions about the way money works and the way banks work that just flat do not match how they actually work in real life. That's something that's hugely critical to understanding economic volatility and understanding financial crises. But even regular business cycles have a lot to do with the ebbs and flows of bank lending. And banks just aren't included in standard macroeconomic models(...) Until you understand that the economic profession is really not doing anything like what I would say they should be doing—studying these things that go wrong, the recessions and depressions and crises—you might not realize that we shouldn't really be relying on mainstream economists to tell us how policies should be crafted, to tell us what risks might be out there. We need a different approach. 

Two Days To Trade Wars: Can Stupidity Be Avoided?

US steel and aluminum tariffs start Friday.

Germany's economy minister is in D.C. But Trump has stringent demands.

No one wins trade wars. The notion is ludicrous.

I have more on the "meaning of win" in a moment. But first let's consider the Eurointelligenceview.

This is not a trade war the EU can ever win, as Wolfgang Munchau points out in his FT column. If the EU were to put up a big fight over this, with a long list of sanctions on Friday, the US would immediately respond with a tariff on car imports. It would be the equivalent of the Fool's Mate in chess, Munchau argues. Donald Trump is right in his assertion that trade wars are easy to win - if your opponent is sufficiently desperate and addicted to the export of manufactured goods, like Germany is. When we said that a current account surplus of 8% (or probably higher) is not sustainable, it was not meant as a statement of right or wrong. Unsustainable means that it will end at some point - through either adjustment or force.

Spiegel magazine had a story over the weekend that there is a glimmer of hope. It was one of those short Spiegel news stories, something they picked up from a single source, but not quite worthy of a full-length article. The story says the US will make three specific demands as a pre-condition for exempting the EU from the steel and aluminium tariffs. The first is that the EU caps steel output at 2017 levels. The story did not reveal the metric, whether in volume or value. The second is that the EU take anti-dumping measures against China, and agrees to cooperate with the US in questions of international trade policy. And, to top it all, the Europeans will have to deliver proof that they are on the way to meeting their Nato commitments on defence spending. The latter is an impossible demand to meet since no such proof can exist. The German grand coalition, for example, is making no efforts to increase defence spending. The priority of the new finance minister, Olaf Scholz, is to maintain the fiscal surplus.

OK, Where's the Win?

Eurointelligence never explained how this magical "win" occurs.

Instead, Eurointelligence linked to a report by Brad Setser: Forming an Alliance With U.S. Allies Against Bad Chinese Trade Practices Won't Be Enough to Bring the Trade Deficit Down.

There are growing calls for a global coalition of U.S. allies to pressure China to change some of its most egregious commercial practices.

That makes some sense [Mish - actually it makes zero sense - explained later], even if it is much easier said than done. It is relatively simply to get agreement that China should change many of its policies. But China doesn't typically respond to peer pressure alone. It is relatively hard to get agreement on what to do if China doesn't change voluntarily.

After a useless diversion into complaints about China, Setser admits this interesting tidbit:

China's current account surplus is well below that of the Eurozone. Or that of Japan. [Mish - It's simply high with the US].

Even at 2.5 percent of China's GDP, it is smaller, relative to China's GDP than the current account surpluses of the United States' security allies. ​

U.S. allies generally have much tighter fiscal policies than China. That's a big reason why they run larger current account surpluses than China. [Mish - Not really - the reason is that Nixon closed the gold window and this is the logical result.]

Korea and Taiwan (and neutral Switzerland) also put their finger on the foreign exchange market when needed to keep their currencies weak (Korea rather egregiously in January).

As a result, the combined current account surplus of U.S. allies in Europe and Asia is close to $800 billion—well over China's roughly $200 billion. That sum would be a bit bigger if you added in the surplus of democratic but formally non-aligned European countries like Sweden and Switzerland.

A China that behaved better commercially would no doubt help many companies. And if China lowered barriers to actual imports, overall trade with China might expand. But better commercial practices on their own aren't enough to assure a smaller Chinese trade surplus. [Mish - On that I strongly agree with Setser]

So long as Asia and Europe's aggregate surplus remains high, someone in the world will still need to run a large external deficit, and odds are that will still be the United States. [Mish - Once again this is a mathematical necessity!]

In Dollar Terms

See the Problem?

The US has its biggest trade deficit with China, but globally the imbalance is with Germany and Japan.

Placing tariffs in Chinese steel will so nothing but make the US more uncompetitive on exports.

Averting a Trade War

To stave off the trade war, assuming Trump sticks to his guns, the EU needs to do these three things.

• EU caps steel output at 2017 levels.

• EU takes anti-dumping measures against China, and agrees to cooperate with the US in questions of international trade policy.

• EU must deliver proof that they are on the way to meeting their Nato commitments on defence spending.

If not, we have a trade war.

Easy to Win

Wolfgang Munchau say In a Trade War Germany is the Weakest Link and "If your target is Germany, then yes, a trade war is easy to win."

Munchau bases his opinion on the idea that the EU, Germany in particular, is very dependent on exporting cars at a time when Germany's diesel technology is on the verge of being worthless.

Brexit poses an additional threat as Germany is a huge net exporter to the UK.

Here's Munchau' conclusion: "This trade war is indeed easy to win. It is going to be the equivalent of the fool's mate in chess: the game could all be over in two moves."

Meaning of Win

What does it mean to "win" a trade war?

Donald Boudreaux at the Cafe Hayek explains in his post: An Oxymoron to Beat All Oxymorons.

No two human activities are as opposite one another as are trade and war. Trade is voluntary; war is coercive. Trade is peaceful; war is violent. Trade enriches; war impoverishes.

Trade is a mutually advantageous exchange of property rights; war is a bilateral destruction and confiscation of property rights – destruction and confiscation that never are mutually advantageous and that too often, in the end, are advantageous to no one.

When trading, each party improves his welfare only by attending to, and enhancing, the welfare of others; when warring, each party improves his welfare only by attacking, and diminishing, the welfare of others. Those who trade with each other have an interest in each other's well-being; those who war against each other have an interest in each other's annihilation. Trade enhances life; war ends life.

What are called "trade wars" are indeed wars, but they involve only war and no trade. Every so-called "trade war" is each government making war on its own citizens, coercing them not to trade as they would otherwise peacefully trade.

The term "trade war" makes no more sense than do the terms "good evil" or "peaceful violence." We should stop using it. We must find a better term to describe governments' waging war upon those of their own citizens who dare to trade with others.

Curious Way to Win

As Munchau, Trump, and Peter Navarro (Trump's trade guru) see things, it is remarkably easy for Trump to win.

In reality, the only way to win is to not play the game at all.

Please reflect on this: Shall we play a game?

The Markets Are Now Globally in “Risk Off” Mode (the US is Next)

Sentiment is now completely disconnected from reality.

Currently, sentiment suggests that stocks are in a raging bull market and will never fall. This sentiment is based on the fact that much of last year (2017) the US stock markets rose virtually non-stop.

However, that era is now OVER. And globally the markets are moving into "risk-off" mode.

Don't believe me?

Consider that most global markets are in fact now DOWN for 2018.

That is not a typo.

Japan's Nikkei, Germany's DAX, Australia's stock market, Canada's stock market… ALL of them are in the red thus far in 2018.

The reason?

Globally the bond market is forcing ALL risk assets to be repriced.

As noted in the recent past and again, following 2008, Central Banks created a bubble in sovereign bonds. And because these bonds are the bedrock for the current financial system, when they did this they created a bubble in everything (the "Everything Bubble").

However, this bubble, is now beginning to burst. Bond yields are rising around the globe.