December 19, 2014

Junk Bonds Are Going To Tell Us Where The Stock Market Is Heading In 2015

Do you want to know if the stock market is going to crash next year?  Just keep an eye on junk bonds.  Prior to the horrific collapse of stocks in 2008, high yield debt collapsed first.  And as you will see below, high yield debt is starting to crash again.  The primary reason for this is the price of oil.  The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market, and those energy bonds are taking a tremendous beating right now.  This panic in energy bonds is infecting the broader high yield debt market, and investors have been pulling money out at a frightening pace.  And as I have written about previously, almost every single time junk bonds decline substantially, stocks end up following suit.  So don’t be fooled by the fact that some comforting words from Janet Yellen caused stock prices to jump over the past couple of days.  If you really want to know where the stock market is heading in 2015, keep a close eye on the market for high yield debt.

If you are not familiar with junk bonds, the concept is actually very simple.  Corporations that do not have high credit ratings typically have to pay higher interest rates to borrow money.  The following is how USA Today describes these bonds…
High-yield bonds are long-term IOUs issued by companies with shaky credit ratings. Just like credit card users, companies with poor credit must pay higher interest rates on loans than those with gold-plated credit histories.
But in recent years, interest rates on junk bonds have gone down to ridiculously low levels.  This is another bubble that was created by Federal Reserve policies, and it is a colossal disaster waiting to happen.  And unfortunately, there are already signs that this bubble is now beginning to burst
Back in June, the average junk bond yield was 3.90 percentage points higher than Treasury securities. The average energy junk bond yielded 3.91 percentage points higher than Treasuries, Lonski says. 
That spread has widened to 5.08 percentage points for junk bonds vs. 7.86 percentage points for energy bonds — an indication of how worried investors are about default, particularly for small, highly indebted companies in the fracking business.
The reason why so many analysts are becoming extremely concerned about this shift in junk bonds is because we also saw this happen just before the great stock market crash of 2008.  In the chart below, you can see how yields on junk bonds started to absolutely skyrocket in September of that year…

High Yield Debt 2008

Of course we have not seen a move of that magnitude quite yet this year, but without a doubt yields have been spiking.  The next chart that I want to share is of this year.  As you can see, the movement over the past month or so has been quite substantial…

High Yield Debt 2014

And of course I am far from the only one that is watching this.  In fact, there are some sharks on Wall Street that plan to make an absolute boatload of cash as high yield bonds crash.

One of them is Josh Birnbaum.  He correctly made a giant bet against subprime mortgages in 2007, and now he is making a giant bet against junk bonds
When Josh Birnbaum was at Goldman Sachs in 2007, he made a huge bet against subprime mortgages. 
Now he’s betting against something else: high-yield bonds. 
From The Wall Street Journal
Joshua Birnbaum, the ex-Goldman Sachs Group Inc. trader who made bets against subprime mortgages during the financial crisis, now has more than $2 billion in wagers against high-yield bonds at his Tilden Park Capital Management LP hedge-fund firm, according to investor documents.
Could you imagine betting 2 billion dollars on anything?

If he is right, he is going to make an incredible amount of money.

And I have a feeling that he will be.  As a recent New American article detailed, there is already panic in the air…
It’s a mania, said Tim Gramatovich of Peritus Asset Management who oversees a bond portfolio of $800 million: “Anything that becomes a mania — ends badly. And this is a mania.” 
Bill Gross, who used to run PIMCO’s gigantic bond portfolio and now advises the Janus Capital Group, explained that “there’s very little liquidity” in junk bonds. This is the language a bond fund manager uses to tell people that no one is buying, everyone is selling. Gross added: “Everyone is trying to squeeze through a very small door.” 
Bonds issued by individual energy developers have gotten hammered. For instance, Energy XXI, an oil and gas producer, issued more than $2 billion in bonds just in the last four years and, up until a couple of weeks ago, they were selling at 100 cents on the dollar. On Friday buyers were offering just 64 cents. Midstates Petroleum’s $700 million in bonds — rated “junk” by both Moody’s and Standard and Poor’s — are selling at 54 cents on the dollar, if buyers can be found.
So is there anything that could stop junk bonds from crashing?

Yes, if the price of oil goes back up to 80 dollars or more a barrel that would go a long way to settling things back down.

Unfortunately, many analysts are convinced that the price of oil is going to head even lower instead…
“We’re continuing to search for a bottom, and might even see another significant drop before the year-end,” said Gene McGillian, an analyst at Tradition Energy in Stamford, Connecticut.
As I write this, the price of U.S. oil has fallen $1.69 today to $54.78.

If the price of oil stays this low, junk bonds are going to keep crashing.

If junk bonds keep crashing, the stock market is almost certainly going to follow.

For additional reading on this, please see my previous article entitled “‘Near Perfect’ Indicator That Precedes Almost Every Stock Market Correction Is Flashing A Warning Signal“.

But just like in the years leading up to the crash of 2008, there are all kinds of naysayers proclaiming that a collapse will never happen.

Even though our financial problems and our underlying economic fundamentals have gotten much worse since the last crisis, they are absolutely convinced that things are somehow going to be different this time.

In the end, a lot of those skeptics are going to lose an enormous amount of money when the dominoes start falling.

Source

December 18, 2014

China Prepares To Bailout Russia

Earlier this evening China's State Administration of Foreign Exchange's (SAFE) Wang Yungui noted "the impact of the Russian Ruble depreciation was unclear yet, and, as Bloomberg reported, "SAFE is closely watching Ruble's depreciation and encouraging companies to hedge Ruble risks." His comments also echoed the ongoing FX reform agenda aimed at increasing Yuan flexibility which The South China Morning Post then hinted in a story entitled "Russia may seek China help to deal with crisis," which which noted that Russia could fall back on its 150 billion yuan ($24 billion) currency swap agreement with China if the ruble continues to plunge, that was signed in October. Furthermore, two bankers close to the PBOC reportedly said the swap-line was meant to reduce the role of the US dollar if China and Russia need to help each other overcome a liquidity squeeze.

As Bloomberg reported, earlier in the evening, China's Wang Yungui noted
  • *CHINA IS CLOSELY WATCHING RUBLE'S DEPRECIATION: SAFE'S WANG
  • *CHINA ENCOURAGES COS. TO HEDGE RUBLE RISKS, SAFE'S WANG SAYS
  • *REAL IMPACT OF RUBLE DEPRECIATION UNCLEAR YET, SAFE'S WANG SAYS
Adding that China plans sweeping reforms to promote FX flexibility.
And then The South China Morning Post hints,
Russia could fall back on its 150 billion yuan (HK$189.8 billion) currency swap agreement with China if the rouble continues to plunge.

If the swap deal is activated for this purpose, it would mark the first time China is called upon to use its currency to bail out another currency in crisis. The deal was signed by the two central banks in October, when Premier Li Keqiang visited Russia.

"Russia badly needs liquidity support and the swap line could be an ideal tool," said Bank of Communications chief economist Lian Ping.

The swap allows the central banks to directly buy yuan and rouble in the two currencies, rather than via the US dollar.

Two bankers close to the People's Bank of China said it was meant to reduce the role of the US dollar if China and Russia need to help each other overcome a liquidity squeeze.

China has currency swap deals with more than 20 monetary authorities around the world. Swaps are generally used to settle trade.

"The yuan-rouble swap deal was not just a financial matter," said Wang Feng, chairman of Shanghai-based private equity group Yinshu Capital. "It has political implications as it is a sign of mutual trust."

The rouble has lost more than 50 per cent against the US dollar this year, pushing Russia to the brink of a currency crisis, though measures announced by the central bank helped it recover some ground yesterday.

Li Lifan, a researcher at the Shanghai Academy of Social Sciences, said the swap would not be enough for Russia even if it is used in its entirety. "The PBOC might agree to extend something like 15 billion yuan initially as a way of showing China's commitment to Russia."
Source 

December 17, 2014

Western Banks Cut Off Liquidity To Russian Entities

As Zero Hedge first reported today, shortly before noon one (and subsequently more) FX brokers advised clients that any existing Ruble positions would be forcibly closed out because "western banks have stopped pricing USDRUB", over concerns of Russian capital controls. Ironically, it was this forced liquidation of mostly short RUB positions that pushed the RUB higher, which in turn had a briefly favorably impact on energy commodities and risk assets, as the market had by then perceived the Ruble selloff as excessive. Of course, since nothing had actually changed aside from a temporary market technical, the selloff promptly resumed into the close of trading once the market finally understood what we had explained hours previously.

And unfortunately for the bulls, various falling knife-catchers, and those who hope the Russian situation will stabilize imminently with or without capital controls, it appears things in Russia are about to get a whole lot worse because as the WSJ reports, the next driver of the Russian crisis is likely to come from within the banking system itself because "global banks are curtailing the flow of cash to Russian entities, a response to the ruble’s sharpest selloff since the 1998 financial crisis."

Presenting Russia's banks: now cut off from the outside world as the second cold war goes nuclear, at least when it comes to the financial system: 

Such banks as Goldman Sachs Group Inc. this week started rejecting requests from institutional clients to engage in certain ruble-denominated repurchase agreements and other transactions designed to raise cash, according to people familiar with the matter.

Bankers and traders say the moves to restrict some ruble transactions have become increasingly widespread among major Western financial institutions this week, even as the same institutions continue to try to profit from the ruble’s wild swings. The moves, which the banks are deploying to protect themselves against further swings in the currency, have the potential to add to the strain on Russia’s financial system.

Goldman in recent days largely stopped doing longer-term ruble-denominated repurchase agreements, or repos, in which securities or other assets are swapped in exchange for cash, said a person familiar with the matter. The Wall Street bank is still doing short-duration ruble repos, those that mature in less than a year, this person said.
And where Goldman goes, everyone else follows, even though according to the WSJ this has not happened, yet:
Other banks, including Bank of America Corp. and Citigroup Inc., haven’t changed their trading with Russia or in rubles, according to people familiar with those banks.
They will, it is only a matter of time. Meanwhile, the entire Russian capital market, and not just its currency, is becoming isolated from the rest of the Western world:
In one sign of the banking industry’s hasty retreat, the London-based manager of an emerging-markets hedge fund said Tuesday that he couldn’t get any banks to trade Russian government bonds with him.
Of course, anyone who read our article in early November explaining "How The Petrodollar Quietly Died, And Nobody Noticed", predicting the crunch in global intermarket liquidity as a result of the collapse in crude, would know this is coming. As for the death of the Petrodollar we warned about, a death which has resulted in the disintegration of market volume just as warned, suddenly everyone is noticing.

Regardless, what all of the above means is that Russia now has at best a few weeks in which to find an alternative source of short-term funding. One coming from the East.

The question is will Putin swallow his pride and proceed with the next logical step as the Eurasian axis realizes the time to abandon the dollar has long past, that now only actions matter and not words, and joins forces with China in a new monetary union, one which combines the Ruble and the Yuan, and is backed by China's gold and Russia's natural resources, as cheap as they may be for the time being... until one or more of the largest middle-east oil exporters experiences a major and "unexpected" geopoolitical incident, one which sends the price of oil soaring right back up.

Source

December 16, 2014

Inflation ... Deflation ... When a Central Bank Produces It, It's Wrong!

Ambrose Evans-Pritchard: Why Paul Krugman is wrong ... Central banks can always create inflation if they try hard enough ... He is wrong that you cannot create inflation when interest rates are at the zero bound, says Ambrose Evans-Pritchard ... Professor Paul Krugman is the world's most influential commentator on economic issues by a wide margin. – UK Telegraph 

Dominant Social Theme: Deflation is coming and it's going to be terrible. 

Free-Market Analysis: A recent article of ours made the point that deflation and disinflation are unstable monetary states in an era of central banking. 

While we didn't draw precise definitional lines between various kinds of deflation, our point was clear enough: Deflation and disinflation in a monetarist world are a product of asset expansion. 

We explained that Eurocrat cries of alarm over EU price deflation were insincere and merely meant to provide justifications for central bank actions that Brussels was not allowed to take. We explained that there were both monetary and price inflation in Europe and that Europe was more likely affected by "stagflation" than disinflation or deflation. 

 EU Deflation: Real Problem or Eurocrat Exaggeration? 

The recent argument between Ambrose Evans-Pritchard and Paul Krugman gives us an opportunity to revisit the issue and expand on why, in a central banking world, disinflation and outright deflation from a monetary and price standpoint are fairly rare events that take place mostly as asset bubbles collapse. 

Krugman first. The New York Times columnist recently argued once again that monetary inflation is vastly overrated in terms of its impact. Why is this important? Because Krugman, as a good socialist, wants government to be as proactive as possible. 

Money printing as a central economic cure is not enough for him. He wants FDR's New Deal programs re-initiated on an even more expansive basis. 

But there is another reason that Krugman downplays money printing and that has to do with the impact of central banks generally. You see ... if it doesn't matter how much money a central bank prints, then central banking itself is a fairly unimportant matter. And those who stand behind central banking, control central banking and reap its impossible rewards would like to encourage this concept of Krugman's. 

We don't believe this, of course. Those who coordinate central banks around the world and run the Bank for International Settlements are surely among the most powerful people in the world. About 100 years ago there were perhaps five central banks. Now there are around 150, many directly involved in a BIS pan-global structure. 

The hundreds and hundreds of trillions printed via BIS-operated central banks have created a situation unheard of in the world. This money has apparently been used to buy control of universities, think tanks, media properties, politicians, governments and military men and armies. The same money is likely to control – secretly – most of the major corporations in the world. 

The control is staggering and it's been used to further centralize and internationalize the West's sociopolitical and economic system. So Krugman is arguing a very important point when he says that printing money is at least somewhat irrelevant some of the time. By proxy, he is saying that central banking is not nearly so important as it's made out to be. 

And since there doesn't seem either monetary inflation or price inflation after seven years of crisis-response money printing, Krugman is beginning to write columns emphasizing his point of view. 

It is one of these comments that Evans-Pritchard is responding to. Here's more from Evans-Pritchard: 

He is brilliant, wide-ranging, readable, and the point of his rapier is very sharp. He correctly predicted and described the Long Slump; though whether he did so entirely for the right reasons is an interesting question. 

[Krugman] demolished claims by hard-money totemists that zero rates and quantitative easing would lead to spiraling inflation in a global liquidity trap, as he calls it – or in a China-led world of excess supply and deficient demand, as others would put it. 

He correctly scolded those who claimed that rich developed countries with their own sovereign currencies are at risk of a bond market crisis unless they retrench into the downturn, or might go the way of Greece.

 ... The dispute is over whether central banks can generate inflation even when interest rates are zero. He says they cannot do so, and that it is jejune to float such an outlandish idea. Monetary policies are to all intents and purposes impotent at that point. He goes on to suggest that the historical and global evidence has demonstrated this beyond any possible doubt, and here he ventures into flinty terrain.

... He rebukes me for quoting Tim Congdon from International Monetary Research, specifically for invoking traditional monetary theory to suggest that QE can work even when bond yields are hyper-compressed. The precise quote: "The interest rate is totally irrelevant. What matters is the quantity of money. Large scale money creation is a very powerful weapon and can always create inflation." 

Mr Congdon's claim is a self-evident truism. Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.

... It is becoming ever clearer that the US and UK recoveries are a serious challenge to the Krugman opus and what I would loosely call (though I have much sympathy for New Keynesian arguments) the doctrine of fiscal primacy. These recoveries should not really be as strong as they are, especially in a depressed world of flat global trade. America has carried out the most drastic fiscal squeeze since demobilization after the Korean War without falling into recession. The economy is growing briskly. The jobless rate is plummeting. 

The last paragraph illustrates the sterility of this debate. Despite denials, Evans-Pritchard more and more has adopted a neo-Keynesian point of view in his columns, arguing that monetary stimulation is necessary to keep the world afloat until such time as the "recovery" takes hold more fully. 

But there is no "recovery" in the classical sense of the word, nor can there be in a world filled with central banks. If the money were private, if the volume of money were not produced via force, if interest rates were not set metaphorically at the point of a gun, then perhaps one could speak of a recovery. But instead, in this modern world, we can have nothing but varying degrees of asset bubbles. 

At the beginning of the business cycle the asset bubbles have been deflated or at least are subject to disinflation, monetarily and even pricewise. But as more money is force-fed into the economy, these bubbles begin to swell again. 

The faster they swell, the more commentators and professors begin to speak of a recovery. It is not a recovery. The bubbles are simply advancing. 

First bank coffers swell and then the money leaks into multinational pockets and into stock markets, mostly. Marts travel up, and the wealthy and upper middle classes begin to leverage the wealth effect. High-end homes, yachts, expensive cars and the like begin to sell more quickly. The "recovery" is underway. 

Eventually the recovery reaches the middle classes. Factories gear up, wages rise, the "recovery" is proclaimed a success. But actually, such a recovery is merely a way-station to a further disaster because the asset bubbles will continue to swell until they burst. At which point we will once again, as before, have a conversation about deflation and disinflation. 

We should try to be fair, of course. Evans-Pritchard is in a sense correct about deflation. As we wrote before it is very hard to have real, long-lasting deflation in a modern, central bank economy where the printing presses are always churning out currency. 

What SEEMS like deflation or disinflation is mostly the collapse of bubbles that were stuffed by previously printed currency. 

Krugman is wrong. When you have central banks you almost always have unrestrained money printing. Central banks cannot know how much money is enough because there are no forward looking indices, as Alan Greenspan himself admitted during his tenure. 

And so central bankers print too much. If economies subside catastrophically, it is not because of deflation or disinflation but because of monetary INFLATION to begin with. 

Deflation is NOT the main problem by any means. Central banks are the problem. People like Krugman want to draw our attention away from the real issue. In this case, Evans-Pritchard has done us a favor by drawing our attention back to it. 

The trouble with Evans-Pritchard is that he then goes on to make the argument that central bank inflating is a kind of Keynesian good. But monopoly money printing is not good, either. And there you have it – a modern debate in which both sides are wrong because they are arguing effectively a false premise. 

Krugman wants to focus on the lack of monetary policy. Evans-Pritchard argues for continued inflation. 

We'll take the side of the argument that is NOT represented – which is that money ought to be privatized and that central banks ought to lose their monopoly money printing privileges. 

Conclusion When we begin to see that argument made in the mainstream press, we'll call it what it is ... Progress.

Source

December 15, 2014

We Just Witnessed The Worst Week For Global Financial Markets In 3 Years

Is this the start of the next major financial crisis?  The nightmarish collapse of the price of oil is creating panic in financial markets all over the planet.  On June 16th, U.S. oil was trading at a price of $107.52.  Since then, it has fallen by almost 50 dollars in less than 6 months.  This has only happened one other time in our history.  In the summer of 2008, the price of oil utterly collapsed and we all remember what happened after that.  Well, the same patterns that we witnessed back in 2008 are happening again.  As the price of oil crashed in 2008, so did prices for a whole host of other commodities.  That is happening again.  Once commodities started crashing, the market for junk bonds started to implode.  That is also happening again.  Finally, toward the end of 2008, we witnessed a horrifying stock market crash.  Could we be on the verge of another major one?  Last week was the worst week for the Dow in more than three years, and stock markets all over the world are crashing right now.  Bad financial news continues to roll in from the four corners of the globe on an almost hourly basis.  Have we finally reached the “tipping point” that so many have been warning about?

What we witnessed last week is being described as “a bloodbath” that was truly global in scope.  The following is how Zero Hedge summarized the carnage…
  • WTI’s 2nd worst week in over 3 years (down 10 of last 11 weeks)
  • Dow’s worst worst week in 3 years
  • Financials worst week in 2 months
  • Materials worst week since Sept 2011
  • VIX’s Biggest week since Sept 2011
  • Gold’s best week in 6 months
  • Silver’s last 2 weeks are best in 6 months
  • HY Credit’s worst 2 weeks since May 2012
  • IG Credit’s worst week in 2 months
  • 10Y Yield’s best week since June 2012
  • US Oil Rig Count worst week in 2 years
  • The USDollar’s worst week since July 2013
  • USDJPY’s worst week since June 2013
  • Portugal Bonds worst week since July 2011
  • Greek stocks worst week since 1987
The stock market meltdown in Greece is particularly noteworthy.  After peaking in March, the Greek stock market is down 40 percent since then.  That includes a 20 percent implosion in just the past three trading days.

And it isn’t just Greece.  Financial markets all over Europe are in turmoil right now.  In addition to crashing oil prices, there is also renewed concern about the fundamental stability of the eurozone.  Many believe that it is inevitable that it is headed for a break up.  As a result of all of this fear, European stocks also had their worst week in over three years
European stock markets closed sharply lower on Friday, posting their biggest weekly loss since August 2011, as commodity prices continued to fall and and shares in oil-related firms came under renewed pressure from the weak price for crude. 
The pan-European FTSEurofirst 300 unofficially ended 2.6 percent lower, down 5.9 percent on the week as the energy sector once again weighed heavily on wider benchmarks, falling over 3 percent.
But despite all of the carnage that we witnessed in the U.S. and in Europe last week, things are actually far worse for financial markets in the Middle East.

Just check out what happened on the other side of the planet on Sunday
Stock markets in the Persian Gulf got drilled Sunday as worries about further price declines grew. The Dubai stock index fell 7.6% Sunday, the equivalent of a 1,313-point plunge in the Dow Jones industrial average. The Saudi Arabian market fell 3.3%.
Overall, Dubai stocks are down a whopping 23 percent over the last two weeks, and full-blown stock market crashes are happening in Qatar and Kuwait too.

Like I said, this is turning out to be a truly global financial panic.

Another region to keep an eye on is South America.  Argentina is a financial basket case, the Brazilian stock market is tanking big time, and the implied probability of default on Venezuelan debt is now up to 93 percent
Swaps traders are almost certain that Venezuela will default as the rout in oil prices pressures government finances and sends bond prices to a 16-year low. 
Benchmark notes due 2027 dropped to 43.75 cents on the dollar as of 11:35 a.m. in New York, the lowest since September 1998, as crude extended a bear market decline. The upfront cost of contracts to insure Venezuelan debt against non-payment for five years is at 59 percent, bringing the implied probability of default to 93 percent, the highest in the world.
So what does all of this mean for the future?

Are we experiencing a repeat of 2008?

Could what is ahead be even worse than that?

Or could this just be a temporary setback?

Recently, Howard Hill shared a few things that he looks for to determine whether a major financial crisis is upon us or not…
The first condition is a serious market sector correction.
According to some participants in the market for energy company bonds and loans, such a correction is already underway and heading toward a meltdown (the second condition). Others are more sanguine, and expect a recovery soon. 
That smaller energy companies have issued more junk-rated debt than their relative size in the economy isn’t under debate. Of a total junk bond market estimated around $1.2 trillion, about 18% ($216 billion, according to a Bloomberg estimate) has been issued by energy-related companies. Yet those companies represent a far smaller share of the economy or stock market capitalization among the universe of junk-rated companies. 
If the beaten-down prices for junk energy bonds don’t stabilize or recover a bit, we might see the second condition: a spiral of distressed sales of bonds and loans. This could happen if junk bond mutual funds or other large holders sell into an unfriendly market at low prices, and then other holders of those bonds succumb to the pressure of fund redemptions or margin calls and sell at even lower prices. 
The third condition, which we can’t determine directly, would be pressure on Credit Default Swap dealers or hedge funds to make deposits as the prices of the CDS move against them. AIG was taken down when collateral demands were made to support existing CDS agreements, and nobody knew it until they were going under. There simply isn’t a way to know whether banks or dealers are struggling until the effect is already metastasizing.
I think that he makes some really good points.

In particular, I think that watching how junk bonds perform over the next few weeks will be extremely telling.

Last week was truly a bloodbath for high yield debt.

But perhaps things will stabilize this week.

Let’s hope so, because this is the closest that we have been to another major financial crisis since 2008.

Source

December 12, 2014

Will the Oil Collapse Kill Energy Junk Bonds?

Some ahead-of-the-curve analysts have warned of the magnitude of energy debt, mainly junk bonds issued to fund shale gas projects, that are now at risk thanks to plunging oil prices whacking the entire energy complex.

We’ve heard over the last few weeks sunny proclamations of how many shale players have lower cost structure than commonly thought and could ride out weak prices. The supposedly super bearish Bank of America report published earlier in the week called for oil prices to drop to a scary-sounding $50 a barrel. But the document sees that aa a short-term phenomenon. As supply and demand equilibrates (shorthand for “of course some people will drive more, and a lot of wells will get shut down”), it anticipates that oil prices will rebound to $80 to $90 a barrel in the second half of 2015.

The problem with conventional wisdom, even pessimistic-looking conventional wisdom, is that the noose of a lot of borrowings is likely to change the decision-making process of those producers. As the Financial Times’ John Dizard pointed out, companies with a lot of debt are likely to keep pumping, profits be damned, until the money guys choke them off. Banks are already signaling that they will be lenient, but that’s not the same as extending new loans. Nevertheless, the perverse incentive for producers with high debt levels is to keep pumping, even at a loss, in order to generate enough cash flow to keep servicing the debt. That means that wells won’t be shut off as soon as a P&L calculus would indicate, which in turn means the energy oversupply is likely to continue longer than many experts anticipate. Whether that is a mere couple of months or a more dislocating six months plus remains to be seen.

The reason that longer is worse is twofold. First, it means that more players that are seeing if they can hold in the face losses until prices rebound will hit the wall, so that in turn means more banks and junk bond investors will suffer. Second, a longer period of oversupply may lengthen the eventual adjustment period. Bank of America now sees it at six months. If we have an additional six months of not-factored-in overproduction, it could mean even higher inventories before the readjustment begins. That in turn means even lower prices before the turnaround.

And this chart (hat tip Ed Harrison) gives an idea how much a difference the drop from $70 a barrel to yesterday’s below $60 price means (click to enlarge):

shale breakeven energy junk bonds
And notice that the “half cycle return” is a dubious metric and greatly understates the requirements for meeting long-term profit targets.

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth. Originally published at Automatic Earth

Oil producer Russia hikes rates to 10.5% as the ruble continues to plunge, while fellow producer Norway does the opposite, and cuts its rates, but also sees its currency plummet. As Greek stocks lose another 7.35% after Tuesday’s 13% loss on rumors about what the left leaning Syriza party will or will not do if it wins upcoming elections, and virtually anonymous Dubai drops 7.42%. We all know the story of the chain and its weakest link, and beware, these really still ARE global markets.

Meanwhile someone somewhere saved WTO oil from falling through the big, BIG, $60 limit for most of the day Thursday, and then it went south anyway. And that brings to mind the warnings about what would, make that will, happen to high yield energy junk bonds. Of which there’s a lot out there, but not much is being added anymore, that market has been largely shut to companies, especially in the shale patch. So how are they going to finance their fracking wagers? Hard to see.

And something tells me this Bloomberg piece is still lowballing the debt issue, though I commend them for making the link between shale and Fed ‘stimulus’ policies, something all too rare in what passes for press in the US these days.

>Fed Bubble Bursts in $550 Billion of Energy Debt

The danger of stimulus-induced bubbles is starting to play out in the market for energy-company debt. Since early 2010, energy producers have raised $550 billion of new bonds and loans as the Federal Reserve held borrowing costs near zero, according to Deutsche Bank. With oil prices plunging, investors are questioning the ability of some issuers to meet their debt obligations. Research firm CreditSights predicts the default rate for energy junk bonds will double to 8% next year. “Anything that becomes a mania – it ends badly,” said Tim Gramatovich, chief investment officer of Peritus Asset Management. “And this is a mania.”

I think it’s obvious that the default rate could be much higher than 8%.
The Fed’s decision to keep benchmark interest rates at record lows for six years has encouraged investors to funnel cash into speculative-grade securities to generate returns, raising concern that risks were being overlooked. A report from Moody’s this week found that investor protections in corporate debt are at an all-time low, while average yields on junk bonds were recently lower than what investment-grade companies were paying before the credit crisis. Borrowing costs for energy companies have skyrocketed in the past six months as West Texas Intermediate crude, the U.S. benchmark, has dropped 44% to $60.46 a barrel since reaching this year’s peak of $107.26 in June. 
Yields on junk-rated energy bonds climbed to a more-than-five-year high of 9.5% this week from 5.7% in June, according to Bank of America Merrill Lynch index data. At least three energy-related borrowers, including C&J Energy Services, postponed financings this month as sentiment soured. “It’s been super cheap” for energy companies to obtain financing over the past five years, said Brian Gibbons, a senior analyst for oil and gas at CreditSights in New York. Now, companies with ratings of B or below are “virtually shut out of the market” and will have to “rely on a combination of asset sales” and their credit lines, he said.
When you’re as addicted to debt as the shale industry has been – and still would be if they could still get their fix -, then seeing prices for your products drop over 40% and the yields on your bonds just about double (just for starters), then you have not a problem, but a disaster. And one that’s going to reverberate through all asset markets. It’s already by no means just oil that’s plunging, – industrial – commodities (iron ore, nickel, copper etc.) as a whole are way down from just a few months ago. I read a nice expression somewhere: “the economy is topped with a copper roof”, which supposedly means to say that where copper goes, the economy will follow.

But this is by no means all of the news, it’s not even the worst. To get back to oil, there are some very revealing numbers in the following from CNBC, which call out to us that we haven’t seen nothing yet.

Oil Pressure Could Sock It To Stocks
With crude sliding through the key $60 level, oil pressure could stay on stocks Friday. West Texas Intermediate futures for January closed at $59.95 per barrel, the first sub-$60 settle since July 2009. The $60 level, however, opens the door to the much bigger, $50-per-barrel level. Besides oil, traders will be watching the producer price index Friday morning, and it’s expected to be off 0.1% with the fall in energy. Consumer sentiment is also expected at 10 a.m. EST. 
Consumers stepped up and spent in November, as evidenced in the 0.7% gain in that month’s retail sales Thursday. That better mood should show up in consumer sentiment. Stocks on Thursday gave up sizeable gains after oil reversed course and fell through $60. 
“Oil has pretty much spooked people,” said Daniel Greenhaus, chief global strategist at BTIG. “There just isn’t a bid. With everything in energy and the oil price collapsing as it is, who is going to step in and be a buyer now? The answer is nobody.” Oil continued to slide in after-hours trading. “The selling appears to have accelerated a little bit after the close with really no bullish news in sight,” said Andrew Lipow, president of Lipow Associates. WTI futures temporarily fell below $59 in late trading. 
“The big level is going to be $50 now in terms of psychological support. Much as $100 is on the upside,” said John Kilduff of Again Capital. Oil stands a good chance of getting there too. Tom Kloza, founder and analyst at Oil Price Information Service, said the market could bottom for the winter in about 30 days, but then it will be up to whatever OPEC does.
That was just the intro. Now, wait for it, check this out:
“It’s (oil) actually much weaker than the futures markets indicate. This is true for crude oil, and it’s true for gasoline. There’s a little bit of a desperation in the crude market,” said Kloza.”The Canadian crude, if you go into the oil sands, is in the $30s, and you talk about Western Canadian Select heavy crude upgrade that comes out of Canada, it’s at $41/$42 a barrel.” 
“Bakken is probably about $54.” Kloza said there’s some talk that Venezuelan heavy crude is seeing prices $20 to $22 less than Brent, the international benchmark. Brent futures were at $63.20 per barrel late Thursday. 
“In the actual physical market, it’s fallen by even more than the futures market. That’s a telling sign, and it’s telling me that this isn’t over yet. This isn’t the bottoming process. The physical market turns before the futures,” he said.
I see very little reason to doubt that what’s happening is that the media are way behind the curve in their reporting of what’s really going on. WTI and Brent are standards, and standards are one thing, but what oil actually sells for is quite another matter. Many companies – and many oil-producing countries too – must sell at whatever price they can get just to survive. And there is no stronger force in the world to drive prices down.

That is today’s reality. And while there are many different estimates around about breakeven prices for US shale plays, if we go with the ones from WoodMacKenzie, we get at least some idea of how bad the industry is hurting with prices below $60 (click to enlarge):

US Shale Breakeven Prices energy junk bonds

If prices fall any further (and what’s going to stop them?), it would seem that most of the entire shale edifice must of necessity crumble to the ground. And that will cause an absolute earthquake in the financial world, because someone supplied the loans the whole thing leans on. An enormous amount of investors have been chasing high yield, including many institutional investors, and they’re about to get burned something bad.

What it amounts to is that the falling oil price will chase a lot of zombie money out of the markets, the stuff created through a combination of QE-related ultra low interest rates and money printing, plus the demise of accounting standards that allowed companies to abandon mark-to-market practices. This has led to the record stock market valuation that we see today, and that could vanish in the wink of an eye once even just one asset, one commodity, starts being marked to market in defiance of the distortion official policies have imposed upon the global marketplace.

We might well be looking at the development of a story much bigger than just oil. I said earlier this week that it would be hard to find a way to bail out the US oil industry, but that’s merely one aspect here. Because if oil keeps going the way it has lately, the Fed may instead have to think about bailing out the big Wall Street banks once again.

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December 11, 2014

For Anyone That Still Believes Collapsing Oil Prices Are Good For The Economy

Are much lower oil prices good news for the U.S. economy?  Only if you like collapsing capital expenditures, rising unemployment and a potential financial implosion on Wall Street.  Yes, lower gasoline prices are good news for the middle class.  I certainly would rather pay two dollars for a gallon of gas than four dollars.  But in order to have money to fill up your vehicle you have got to have an income first.  And since the last recession, the energy sector has been the number one creator of good jobs in the U.S. economy by far.  Barack Obama loves to stand up and take credit for the fact that the employment picture in this country has been improving slightly, but without the energy industry boom, unemployment would be through the roof.  And now that the “energy boom” is rapidly becoming an “energy bust”, what will happen to the struggling U.S. economy as we head into 2015?

At the start of this article I mentioned that much lower oil prices would result in “collapsing capital expenditures”.

If you do not know what a “capital expenditure” is, the following is a definition that comes from Investopedia
“Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.”
Needless to say, this kind of spending is very good for an economy.  It builds infrastructure, it creates jobs and it is an investment in the future.

In recent years, energy companies have been pouring massive amounts of money into capital expenditures.  In fact, the energy sector currently accounts for about a third of all capital expenditures in the United States according to Deutsche Bank
US private investment spending is usually ~15% of US GDP or $2.8trn now. This investment consists of $1.6trn spent annually on equipment and software, $700bn on non-residential construction and a bit over $500bn on residential. Equipment and software is 35% technology and communications, 25-30% is industrial equipment for energy, utilities and agriculture, 15% is transportation equipment, with remaining 20-25% related to other industries or intangibles. Non-residential construction is 20% oil and gas producing structures and 30% is energy related in total. We estimate global investment spending is 20% of S&P EPS or 12% from US. The Energy sector is responsible for a third of S&P 500 capex.
These companies make these investments because they believe that there are big profits to be made.

Unfortunately, when the price of oil crashes those investments become unprofitable and capital expenditures start getting slashed almost immediately.

For example, the budget for 2015 at ConocoPhillips has already been reduced by 20 percent
ConocoPhillips is one of the bigger shale players. And its decision to slash its budget for next year by 20% is raising eyebrows. The company said the new target reflects lower spending on major projects as well as “unconventional plays.” Despite the expectation that others will follow, it doesn’t mean U.S. shale oil production is dead. Just don’t expect a surge in spending like in recent years.
And Reuters is reporting that the number of new well permits for the industry as a whole plunged by an astounding 40 percent during the month of November…
Plunging oil prices sparked a drop of almost 40 percent in new well permits issued across the United States in November, in a sudden pause in the growth of the U.S. shale oil and gas boom that started around 2007.

Data provided exclusively to Reuters on Tuesday by industry data firm Drilling Info Inc showed 4,520 new well permits were approved last month, down from 7,227 in October.
If the price of oil stays this low or continues dropping, this is just the beginning.

Meanwhile, the flow of good jobs that this industry has been producing is also likely to start drying up.

According to the Perryman Group, the energy sector currently supports 9.3 million permanent jobs in this country
According to a new study, investments in oil and gas exploration and production generate substantial economic gains, as well as other benefits such as increased energy independence. The Perryman Group estimates that the industry as a whole generates an economic stimulus of almost $1.2 trillion in gross product each year, as well as more than 9.3 million permanent jobs across the nation.

The ripple effects are everywhere. If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics, and many other items we come into contact with every day. The industry supports almost 1.3 million jobs in manufacturing alone and is responsible for almost $1.2 trillion in annual gross domestic product. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the industry.
And these are good paying jobs.  They aren’t eight dollar part-time jobs down at your local big box retailer.  These are jobs that comfortably support middle class families.  These are precisely the kinds of jobs that we cannot afford to lose.

In recent years, there has been a noticeable economic difference between areas of the country where energy is being produced and where energy is not being produced.

Since December 2007, a total of 1.36 million jobs have been gained in shale oil states.

Meanwhile, a total of 424,000 jobs have been lost in non-shale oil states.

So what happens now that the shale oil boom is turning into a bust?

That is a very good question.

Even more ominous is what an oil price collapse could mean for our financial system.

The last time the price of oil declined by more than 40 dollars in less than six months, there was a financial meltdown on Wall Street and we experienced the deepest recession that we have seen since the days of the Great Depression.

And now many fear that this collapse in the price of oil could trigger another financial panic.

According to Citigroup, the energy sector now accounts for 17 percent of the high yield bond market.

J.P. Morgan says that it is actually 18 percent.

In any event, the reality of the matter is that the health of these “junk bonds” is absolutely critical to our financial system.  And according to Deutsche Bank, if these bonds start defaulting it could “trigger a broader high-yield market default cycle”
Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.

A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialized,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.
If the price of oil stays at this level or continues to go down, it is inevitable that we will start to see some of these junk bonds go bad.

In fact, one Motley Fool article recently stated that one industry analyst believes that up to 40 percent of all energy junk bonds could eventually go into default…
The junk bonds, or noninvestment-rated bonds, of energy companies are also beginning to see heavy selling as investors start to worry that drillers could one day default on these bonds. Those defaults could get so bad, according to one analyst, that up to 40% of all energy junk bonds go into default over the next few years if oil prices don’t recover.
That would be a total nightmare for Wall Street.

And of course bond defaults would only be part of the equation.  As I wrote about the other day, a crash in junk bonds is almost always followed by a significant stock market correction.

In addition, plunging oil prices could end up absolutely destroying the banks that are holding enormous amounts of energy derivatives.  This is something that I recently covered in this article and this article.

As you read this, there are five “too big to fail” banks that each have more than 40 trillion dollars in exposure to derivatives.  Of course only a small fraction of that total exposure is made up of energy derivatives, but a small fraction of 40 trillion dollars is still a massive amount of money.

These derivatives trades are largely unregulated, and even Forbes admits that they are likely to be at the heart of the coming financial collapse…
No one understands the derivative risk positions of the Too Big To Fail Banks, JP Morgan Chase, Citigroup, Bank of America, Goldman Sachs or Morgan Stanley. There is presently no way to measure the risks involved in the leverage, quantity of collateral, or stability of counter-parties for these major institutions. 
To me personally they are big black holes capable of potential wrack and ruin. Without access to confidential internal data about these risky derivative positions the regulators cannot react in a timely and measured fashion to block the threat to financial stability, according to a National Bureau of Economic Research study.
So do we have any hope?

Yes, if oil prices start going back up, much of what you just read about can be averted.

Unfortunately, that does not seem likely any time soon.  Even though U.S. energy companies are cutting back on capital expenditures, most of them are still actually projecting an increase in production for 2015.  Here is one example from Bloomberg
Continental, the biggest holder of drilling rights in the Bakken, last month said 2015 output will grow between 23 percent and 29 percent even after shelving plans to allocate more money to exploration.
Higher levels of production will just drive the price of oil even lower.

At this point, Morgan Stanley is saying that the price of oil could plummet as low as $43 a barrel next year.

If that happens, it would be absolutely catastrophic to the most important industry in the United States.

In turn, that would be absolutely catastrophic for the economy as a whole.

So don’t let anyone tell you that much lower oil prices are “good” for the economy.
That is just a bunch of nonsense.

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December 10, 2014

Not Just Oil: Guess What Happened The Last Time Commodity Prices Crashed Like This?…

It isn’t just the price of oil that is collapsing.  The last time commodity prices were this low was during the immediate aftermath of the last financial crisis.  The Bloomberg Commodity Index fell to 110.4571 on Monday – the lowest that it has been since April 2009.  Just like junk bonds, industrial commodities are a very reliable leading indicator.  In other words, prices for industrial commodities usually start to move in a particular direction before the overall economy does.  We witnessed this in the summer of 2008 when a crash in commodity prices preceded the financial crisis in the fall by a couple of months.  And right now, we are witnessing what may be another major collapse in commodity prices.  In recent weeks, the price of copper has declined substantially.  So has the price of iron ore.  So has the price of nickel.  So has the price of aluminum.  You get the idea.  So this isn’t just about oil.  This is a broad-based commodity decline, and if it continues it is really bad news for the U.S. economy.

Of course most Americans would much rather read news stories about Kim Kardashian, but what is happening to the prices of these industrial metals at the moment is actually far more important to their daily lives.  For example, when the price of iron ore goes down that is a strong indication that economic activity is slowing down.  And that is why it is so troubling that the price of iron ore has almost sunk to a five year low.  The following comes from an Australian news source
The price of iron ore has held below $US70 a tonne in overnight trade, leaving its five-year low within reach. 
At the end of the latest offshore session, benchmark iron ore for immediate delivery to the port of Tianjin in China was trading at $US69.40 a tonne, down 0.4 per cent from its previous close of $US69.70 a tonne and only 2 per cent above the five-year low of $US68 reached a fortnight ago. 
This week’s dip back under $US70 a tonne has followed revised forecasts from JPMorgan that suggest the commodity will average just $US67 a tonne next year, about $US20 below the investment bank’s previous expectation.
Copper is probably an even better economic indicator than iron ore is.  Economists commonly refer to it as “Dr. Copper”, and there is a really good reason for that.  Looking back over history, the price of copper often makes a significant move in one direction or the other before the economy does.  And now that the price of copper just hit the lowest level that we have seen since the last financial crash, alarm bells are going off.  The following comes from an article by CNBC contributor Ron Insana
Copper prices are now below $3 a pound and there’s an expression that “the economy is topped with a copper roof.” More simply put, copper tends to top out in price, before it becomes obvious that, in this case, the global economy is about to weaken.
So is the global economy heading for rough waters?

Could 2015 be a very rough year economically?

According to Insana, the signs are all around us…
We already have evidence that the commodity crash has ominous portents for the rest of the world: 
* Japan’s recession is deeper than previously thought. 
* China’s demand for basic materials, amid a glut of uneconomic construction projects, appears to be plummeting.
* Russia’s ruble has collapsed and the country is on the brink, if not already in, a recession.
* India’s economic recovery is beginning to look shaky.
* Europe’s growth rate and inflation rate, for the next two years, were just revised downward by the European Central Bank, suggesting that Europe’s economic crisis is far from over. In fact, at least one former European leader with whom I recently spoke, believes the crisis in Europe may just be in its early stages.
* Brazil and other emerging market nations are struggling with a variety of issues, from recessions at home, to the rising value of the dollar, which is complicating how emerging markets conduct economic policies at home, given how closely their currencies are tied to the greenback.
In addition, the Baltic Dry Index is now at the lowest point that we have seen at this time of the year since 2008
Simply put, with collapsing commodity prices (iron ore for instance) and massive fleets of credit-driven mal-investment-based vessels, it should surprise no one that the shipping index just plunged back below 1000, now at its lowest for this time of year since 2008. Furthermore, the seasonal bounce always seen in Q3 was among the weakest ever.
What does all of this mean?

It is commonly said that those that do not learn from history are doomed to repeat it.

So many of the exact same patterns that we witnessed leading up to the financial crash of 2008 are happening again.

Unfortunately, very few people saw the last crash coming, and this next crash will take most Americans by surprise as well.

I have written more than 1,200 articles about the economy on my website since 2009, and right now our financial system is more primed for a crash than at any other time since I started The Economic Collapse Blog.

Hopefully we have at least a couple more months of relative stability, but without a doubt 2015 is shaping up to be the most “interesting” year that we have seen in the financial world in a very long time.

All of the signs are there.  But most people choose to believe that everything is going to be okay somehow.  When the next crash comes, those people are going to be absolutely blindsided by it.

When you see storm clouds on the horizon, the logical thing to do is to prepare.  And the number one thing that most people should be working on is an emergency fund.  So don’t be frittering your money away on frivolous things.  In the early stages of this next crisis, you are going to need money to pay the mortgage, to put food on the table and to take care of your family.

Just remember what happened back in 2008.  A lot of middle class families were living on the financial edge every month, and because they didn’t have any cushion to fall back on, millions of those families ended up losing their homes when their jobs disappeared.

You need to have an emergency fund that can cover at least six months of expenses.  You don’t want a job loss or a major emergency to put you into a situation where your family could be put out into the street.

And for those that still have lots of money invested in the stock market – I really hope that you know what you are doing.

The market giveth, and the market taketh away.

And when the market taketh away, the consequences can often be exceedingly cruel.

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