Why the “Bond King” Is Having Flashbacks of the 2008 Financial Crisis

By Justin Spittler

As you probably know, Great Britain stunned the world by voting to leave the European Union on June 23. The “Brexit,” as folks are calling it, triggered a selloff that wiped $3 trillion from global stocks in two days. The announcement also shook the currency market. The pound sterling plunged 8% the day after the news broke. It was one of the British currency’s worst days ever. The U.S. dollar, euro, and Japanese yen experienced huge moves too.

It’s now been two weeks since the historic event and panic is still in the air. Investors around the world have piled into government bonds, which are widely considered safe assets. Yesterday, the yield on the 10 year U.S. Treasury hit a fresh all time low. Yields on British, Irish, German, and Japanese 10 year bonds also hit record lows. A bond’s yield falls when its price rises. Investors have loaded up on gold too. The price of gold has shot up 8% since June 23.
 
This shouldn’t surprise you if you’ve been reading the Dispatch. Regular readers know gold is the ultimate safe haven asset. It’s preserved wealth through every sort of financial crisis because it’s unlike any other asset. It’s durable, easily divisible, and easy to carry. Its value doesn’t depend on “confidence” in any government. In other words, it’s real money. After its Brexit fueled rally, gold is up 29% on the year. It’s at its highest price since March 2014. Yet, this rally is showing no signs of slowing down.

The SPDR Gold Shares ETF (GLD) just had one of its best days ever..…
On Tuesday, investors put $1.3 billion into the fund, which tracks the price of gold. According to Investor's Business Daily, it was the fund’s third best day ever. It was also the fund’s best day since stocks crashed on August 8, 2011. Investors have now plowed $15.26 billion into GLD this year. That’s the most of any of the 1,931 ETFs tracked by global analytics and research firm XTF.

In London, the panic has gotten so bad that several fund managers stopped their funds from trading..…
The Wall Street Journal reported yesterday:

Henderson Global Investors, Columbia Threadneedle and Canada Life are the latest fund managers to stop investors pulling their money out against a backdrop of political and economic uncertainty following Britain’s vote to leave the European Union. The fresh moves by fund companies to suspend redemptions Wednesday came after Standard Life Investments, Aviva Investors and M&G Investments suspended trading on U.K. property funds earlier this week. This means that half of the 10 largest U.K. property fund managers have suspended trading temporarily.

In other words, these managers have trapped their investors’ money to keep their funds from collapsing.

"Bond King" Bill Gross says something very similar happened just before the 2008 financial crisis..…
Gross is one of the world’s most well-known investors. He founded Pacific Investment Management Company (PIMCO) in 1971. Under his watch, PIMCO grew into the world’s biggest bond fund. Today, he runs his own bond fund at Janus Capital. Like us, Gross is worried about what’s happening in London right now. Bloomberg Business reported yesterday:

“It’s reminiscent of Bear Stearns’ subprime funds before the Lehman debacle,” Bill Gross, a fund manager at Janus Capital Group, said on Bloomberg TV. “The system doesn’t allow liquidity to flow into the proper places. If these property funds are just one indication, perhaps there will be others to follow. I think it’s something to worry about.”

The collapse of Lehman Brothers in 2008 helped set the global financial crisis in motion. The S&P 500 went on to plunge 57% in two years. And the U.S. economy entered its worst downturn since the Great Depression.

Government officials are scrambling to contain the crisis..…
Last week, the Bank of England (BoE) pumped £3.1 billion into Britain’s banking system. It pledged to inject as much as £250 billion to stabilize its financial system. And on Tuesday this week, the BoE announced more “stimulus” measures. It eased special capital requirements for Britain’s banks. Specifically, the BoE lowered how much money banks need to hold as a “buffer.” The move increases the lending capacity of U.K. banks by as much as £150 billion. Economists at the BoE believe more borrowing and spending will stimulate the economy. As we’ve shown you many times, this won’t work. Casey Research founder Doug Casey explains:

It’s part of the Keynesian view, in which spending and consumption drive the economy. This isn’t just wrong, it’s the exact opposite of what’s true. It’s production and saving that drive an economy. You have to save to build capital, and capital is necessary for…everything. What these people are doing is destructive of civilization itself.

Still, this won’t be the last stimulus measure that the BoE rolls out..…
Last Tuesday, we said the BoE would likely cut interest rates. Two days later, Mark Carney, who heads the BoE, said the central bank needs to cut rates soon. The Wall Street Journal reported:

Mr. Carney said it was his personal view that the central bank would need to cut its key interest rate, currently 0.5%, “over the summer,” adding that an initial assessment of the economic damage caused by the vote to leave the EU would be made at the Monetary Policy Committee’s July meeting, and a “full assessment,” alongside new forecasts for growth and inflation, would take place in August. That suggests he favors an August move, while leaving the door open to an earlier decision.

According to The Telegraph, the BoE could cut rates much sooner than August. That’s because the financial markets have “priced in” a 78% chance that the BoE will cut rates next week. But there’s a problem. The BoE’s key rate is currently 0.50%. In other words, it doesn’t have much room to cut rates. To stimulate the economy, the BoE will likely have to launch quantitative easing (QE), which is just another term for “money printing.”

The BoE won’t fix Britain’s economy by cutting rates or printing money..…
According to MarketWatch, central banks have cut rates more than 650 times since Lehman Brothers collapsed in September 2008. They have also “printed” more than $12 trillion over the same period. And yet, the global economy is barely growing. The U.S., Europe, Japan, and China—the world’s four biggest economies—are all growing at their slowest rates in decades. There’s no reason to think these easy money policies will work this time. It’s much more likely that central bankers will destroy the currencies they’re supposed to defend. Doug Casey explains:

In a desperate attempt to stave off a day of financial reckoning during the 2008 financial crisis, global central banks began printing trillions of new currency units. The printing continues to this day. And it’s not just the Federal Reserve that’s doing it: it’s just the leader of the pack. The U.S., Japan, Europe, China…all major central banks are participating in the biggest increase in global monetary units in history. These reckless policies have produced not just billions, but trillions in malinvestment that will inevitably be liquidated. This will lead us to an economic disaster that will in many ways dwarf the Great Depression of 1929–1946. Paper currencies will fall apart, as they have many times throughout history.

If you do one thing to protect yourself from reckless governments, own gold. As we mentioned above, gold is real money—it’s the only currency that doesn’t depend on a government or central bank doing the right thing. For other ways to safeguard your wealth, watch this free presentation. We encourage you watch this video even if you don’t have a dime in the stock market. That’s because the coming crisis will hit you no matter where you keep your money. The good news is that you can protect your money if you make the right moves soon. You could even turn this threat into an opportunity to make a lot of money. Watch this short video to learn how.

REMINDER: Doug Casey will be in Las Vegas next week..…
Doug will be at FreedomFest 2016: Freedom Rising, an annual festival where free minds meet to talk, strategize, socialize, and celebrate liberty. Doug will be giving several speeches, and he’ll also receive an award for his new novel, Speculator. He’ll join a star-studded lineup of speakers that includes Libertarian presidential candidate Gary Johnson, Senator Rand Paul, and Agora founder Bill Bonner. FreedomFest takes place July 13–16 at Planet Hollywood in Las Vegas. To learn more, visit www.freedomfest.com. Enter the code SALEM to get $100 off the ticket price.

Chart of the Day

Silver just set a new two year high. As you can see from today's chart, silver has soared 45% this year. On Monday, it topped $20 for the first time since August 2014. Longtime readers know that silver is gold’s more volatile cousin. Like gold, silver is real money. But unlike gold, it’s an industrial metal. It goes into everything from solar panels to batteries. Because of this, it's more volatile, and more sensitive to an economic slowdown than gold is.

So, if you’re nervous about the economy or financial system, the first thing you should do is own gold. We encourage most folks to hold 10% to 15% of their wealth in gold. Once you own enough gold, consider adding silver to your portfolio. It could see even bigger gains than gold in the years to come.

The article Why the “Bond King” Is Having Flashbacks of the 2008 Financial Crisis was originally published at caseyresearch.com.

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How The Best of Intentions Destroyed Liquidity

By Jared Dillian

I just got done grading the final exams for my class (took me 12 hours). It’s 100 short answer questions and two essays. One of the essay questions is about the Volcker Rule. “Paul Volcker, former Federal Reserve chairman, as part of the rulemaking process for Dodd-Frank, included a provision prohibiting proprietary trading by banks, known as the Volcker Rule. Do you agree or not agree with the Volcker Rule? Explain.”

The funny thing about asking someone what they think of a law is, if you leave the question open ended and you don’t really describe what the law does, the response is generally favorable. Out of a class of 20 students, only two or three opposed the Volcker Rule. Most of them were in favor of it, as they were in favor of Glass-Steagall when I asked them to write a paper on that.

Seems pretty straightforward. If you have these banks that you call “systemically important,” such that they could go out of business and get rescued by taxpayers, then you don’t really want them taking risks with their own capital, right?

I mean, look how this worked out in the past.

Milton Friedman once said that laws should be judged by their results rather than their intentions. Liquidity has disappeared, and it is directly attributable to the Volcker Rule. If you hear someone try to make an argument that it’s not, that person is probably a journalist or a professor with no first hand knowledge of the situation.

I remember when the Volcker Rule first passed, years ago, someone senior in the equity derivatives market asked me, “Do you really think they will have regulators going through your trades, one by one, line by line, asking you if it was your intent to make money?”

“That seems very unlikely,” I told him.....But that is what we got.

In addition to confiscating cell phones and monitoring phone conversations, chats, and emails, the vast army of compliance officers at investment banks really will go through a trader’s blotter line by line and determine if each trade was a bona fide hedging transaction or if he was trading for his own account. In single stocks, this is pretty straightforward—either you were buying GE for a client or you were buying it for yourself. But in derivatives, it’s not. If you get hit on the GE Jan 30 calls, you’re not going to be able to turn around and sell them—you have to sell something else.

For example, if you’re long too much vega, you may want to sell some short-dated stuff against it, putting on a term structure trade. Is that a hedge, or prop trading? It’s impossible to make that distinction. But the compliance guys try. The interpretation varies. In equity derivatives, traders generally get the benefit of the doubt. In credit, they don’t. You can’t sell bond B to hedge bond A. You literally have to sit there and try to sell bond A. This is why the bond market is such a mess, which we have talked about in this space before.

Of course, none of this gets us any closer to preventing an investment bank from blowing up, because the guy trading 500 call options on GE was never going to blow up the bank in the first place. On the other hand, the Volcker Rule never would have prevented Jon Corzine from blowing up MF Global with European sovereign bonds. If a CEO really wants to do something like that, is some compliance dork really going to stop him? To say that this regulation is a catastrophic failure would be an understatement. Liquidity has disappeared, with no discernible benefit. I’m a middlebrow market commentator, and I’m not supposed to say things like “This is dumb,” but this is really dumb. It doesn’t take an Austrian economist to figure out the unintended consequences.

In the old days (10 years ago), banks were the big liquidity providers. Let’s look at this a different way: do we want banks to continue to be liquidity providers, yes/no? Banks were not always liquidity providers. In the ‘90s, in equity options, it was the physical trading floors where all the risk was handled. Stocks, too. But the bond market has always been an upstairs phenomenon.

If banks aren’t going to be liquidity providers, then we need non bank entities to provide liquidity, and we need to encourage it. Some large hedge funds and some second tier (i.e., not systemically important) broker dealers are starting to do this. But it’s not enough.

The goal was to take a bank and turn it from a risk taking institution to a toll taking institution, where everything is traded on an agency basis, with a commission applied. The FX markets, which were once all risk, are starting to look like this. In equities, traders don’t do much aside from maintain relationships and plunk orders into auto trader, where they are preyed upon by the algorithms.

This is unsustainable, because how can you hire all these smart people from fancy schools and pay them all this money just to push a button—while all their communications are monitored? Nobody is happy with the current state of affairs. 10 years ago, you could sell 250,000 shares on the wire. Or $25 million of bonds.

I have two radical solutions. Here they are:

1. Repeal the Volcker Rule
2. End decimalization

When I came into the business, stocks still traded in fractions. On the options floor, I had to learn to add and subtract fractions in my head. Seriously—I ran drills on this, testing myself for speed. When I got to Lehman, to the program trading desk, I noticed something remarkable—we could send our orders to “wholesalers” like Spear, Leeds & Kellogg or Knight Trading. They would auto execute the orders up to 2,000 shares on the bid or the offer—for free.

Then decimalization happened. The preferential treatment lasted about another month, then they started charging us a penny a share. Market making went from being a profitable business to an unprofitable one.
Guess what—if market making is profitable, a lot of people will want to do it, and you will have a lot of liquidity. If market making sucks, nobody will want to do it, and you will have no liquidity.

Did the retail investor benefit? Maybe. Now he could go into his E-Trade account and execute something for a penny instead of 1/16. But if he was a shareholder in a mutual fund, the mutual fund portfolio manager now had to drop 250,000 shares into auto trader, getting preyed upon by the aforementioned algorithms, instead of getting it done for 1/8.

Then SEC Chairman Arthur Levitt led the charge for decimalization. More unintended consequences.
It’s not likely we’ll go back. Levitt was having conniptions about the length of time it was taking for the options market to decimalize, even though the computing power didn’t even exist.

Ask any portfolio manager today: Liquidity is the number one concern. That’s bullcrap. It’s like buying a house and having plumbing be your number one concern. It should just take care of itself.

Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. 

The article The 10th Man: How The Best of Intentions Destroyed Liquidity was originally published at mauldineconomics.com.

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