Low gas prices are not good for consumers or the US economy. Remember back in late 2015 and early 2016 when oil prices fell which pushed down the price of gas?
We had headlines in the MSM that lower oil prices were a big boost to consumers and so consumer spending was going to rise. It didn’t happen that way.
Gas Prices and Jobs
Lower gas prices mean lower profits for the energy sector which provides good paying jobs for millions of Americans. It’s not just direct energy sector companies either. Real-estate in and around major oil fields saw a crushing drop and mortgage default rates surged when oil drilling rigs went idol back in 2015 and 2016.
Lower gas prices are a net loss for the US economy because of the loss of jobs that accompanies the price drop. While we fell for the MSM headlines back in 2015 and 2016, let’s not fall for it again. Lower prices at the pump do not result in a meaningful increase in consumer spending.
Gas Prices Pull Down The Stock Market
Lower fuel costs pull down the stock market and not just in the US either but around the world. If oil prices were to average $40 a barrel this year, oil-exporting countries would have to sell upwards of $100 billion in various investments to cover their balance of payments deficits. We know this because it’s exactly what happened in late 2015 and early 2016 when oil fell.
It’s not just oil-exporting countries that would be selling. Oil is the primary holding of the world’s largest sovereign wealth funds. Those oil positions extend margin credit to fund managers who use that margin to buy appreciating assets around the world. When oil goes down, it’s like a giant global margin call that goes out and forces fund managers to reduce positions or infuse new money into the fund to meet the margin call.
According to JPMorgan’s estimates, a $40 average Brent price this year would result in the sale of $67 billion in government bonds, $24 billion in equities and another $19 billion in corporate bonds, hedge funds and cash over the course of the year.
Charting margin debt (red line), West Texas Intermediate (brown line), and the S&P 500 (blue line), you can see the effect that oil prices have.
Notice how oil leads both margin debt and by extension the S&P 500.
Not only does the black gold pull down the stock market via the reduction of margin debt, it also results in lower earnings and hence the earnings recession we experienced in 2015. You can see this relationship by charting S&P 500 earnings (green line) over the price of oil and margin debt.
Oil began plunging in 2014 and that drop showed up in earnings about 6 months later. Notice that when oil turned up in February of 2016, earnings again turned up about 6 months later.
Low gas prices are not good for consumers or the US economy. Traders need to watch the price of oil. It’s all about the oil. So goes oil, so goes the US economy.
Fed’s Eric Rosengren was clear in his speech early Friday that rates need to be raised. Mr. Rosengren said that if we don’t raise rates soon, we could crash the economy. Mr. Rosengren said, “A failure to continue on the path of gradual removal of accommodation could shorten, rather than lengthen, the duration of this recovery.”
Fed’s Kaplan (Dallas Fed) spoke about the need to raise rates very slowly but said that the Fed “has put markets on notice.”
Atlanta Federal Reserve chief Dennis Lockhart said on Monday, September 12, 2016, that a “serious discussion” of a rate increase was needed. Lockhart said, “I believe the economy is sustaining sufficient momentum to substantially achieve monetary policy objectives in an acceptable medium-term time horizon.”
Not only do banks need rates to move up as they have suffered for years under low-interest rates, but inflation is also coming on strong.
Jeffrey Gundlach of DoubleLine said last week, “This is a big, big moment.” The bond investor warned his peers that interest rates are ready to rise from their historically low levels and asset managers need to be “defensive.” Quartz writes…
Gundlach said investors should reduce duration in their portfolios, move money into cash and buy protection against volatility before rates rise and inflation picks up.
Gundlach uses the recent jump in the ECRI (index of leading indicators) to suggest that we are about to see more inflation in the US.
The ECRI US leading index continues to rise so the market should be pricing in higher inflation and therefore higher interest rates.
Consumer credit confirms an overheating market and the likelihood that inflation will explode higher. Consumer credit as a percentage of GDP is exploding higher to levels never seen before.
Deutsche Bank may be on the verge of collapse. Last week Deutsche Bank reported Q2 2016 earnings of 20 million euros which is a 98% drop in earnings year-over-year.
In 2015, Deutsche Bank announced its first full year of loss since the 2008 recession.
Deutsche Bank’s stock is down -60% over the last year meaning that the bank is close to collapse.
Deutsche Bank’s shares now trade for two-thirds less than their tangible book value, a steeper discount than even during the depths of the financial crisis.
Beyond Germany, few stock traders care if Deutsche Bank collapses. The problem with Deutsche Bank collapsing is its enormous derivatives portfolio valued at 42 trillion euros! To put in perspective, the entire EU (all 28 member states) has an estimated GDP value of 14.3 trillion. Deutsche Bank’s 42 trillion euro derivatives portfolio is about three times the size of the entire EU!
One might think that with such a high exposure to the derivatives market, Deutsche Bank would have already collapsed. The reason Deutsche Bank has not collapsed is because of something called netting. For every derivative position Deutsche Bank holds, they hold another position in the opposite direction, so they roughly cancel each other out. At least that’s what Deutsche Bank is reporting that they are doing. Whether that is true or not remains to be seen. Why would anyone hedge their longs with shorts in a 1:1 ratio? You would never make any money from trading, and you would slowly lose on slippage. The OCC tracks netting on U.S. banks and does, in fact, show that even with netting, net current credit exposure (NCCE) has been rising rapidly since 2014.
When Deutsche Bank collapses, it is going to be the explosion heard around the world, and it will be a disaster many times greater than the collapse of Lehman Brothers in 2008.
US Derivatives Exposure
The big U.S. banks have higher exposures to derivatives than Deutsche Bank. As of June 30, 2016, below are U.S. banks with the largest derivative exposures.
Citigroup has amassed the largest stockpile of interest-rate swaps as they bet on central bank rate changes.
Five U.S. banks hold 93% of all derivatives: Citigroup, JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley. The total value of these derivatives is $247 trillion (notional).
Morgan Stanley has $31 trillion in derivatives with $1.6 trillion (notional) in credit derivatives. What is scary is that Morgan Stanley is back to speculating in the same credit derivatives market that took down AIG in 2008. I don’t think Morgan Stanley necessarily wants to speculate in credit derivatives but with revenue flat the last few years, they may be getting more desperate to prop up their stock price. Morgan Stanley’s stock is down more than -25% over the last year.
Most traders in the U.S. don’t care about Morgan Stanley’s risky credit derivatives portfolio, but they should. Morgan Stanley has more than 15,770 retail brokers managing $404 billion of other people’s money (mom and pop savings, retirees, pensions, retirement accounts, etc.cause). Morgan Stanley’s risky credit derivatives position poses a huge threat to the investing community in my opinion.
Banks and Financial Firms Will Not Disclose Information Until It’s Too Late
If you are waiting for banks and financial firms to disclose risks and even how much they were bailed out from the last time they made risky credit derivative bets, don’t.
To survive the 2007-2009 Wall Street crash, Morgan Stanley received an injection of $9 billion from the Japanese bank, Mitsubishi UFJ Financial Group; a $10 billion injection from the U.S. government and over $2 trillion in secret, cumulative, below-market-rate loans from the Federal Reserve. According to data obtained by Bloomberg News following a multi-year court battle to obtain the information from the Federal Reserve, Morgan Stanley’s one-day secret outstanding loans from the Fed peaked at $107.3 billion on September 29, 2008.
The public would have never known about these secret loans shoring up Wall Street’s reckless conduct and hubris and obscene bonuses except for the court battle of Bloomberg News and legislation secured by Senator Bernie Sanders of Vermont requiring a Fed accounting.
Credit Derivatives Exposure On the Rise In the US
The Office of the Comptroller of the Currency reports some scary facts in their most recent quarterly OCC report.
– Insured U.S. commercial banks and savings associations reported trading revenue of $5.8 billion in the first quarter of 2016… $1.9 billion lower (24.9 percent) than a year earlier. [In my opinion, when trading revenues are down, trading divisions take on more risks in a desperate attempt to meet quotas like buying riskier credit derivatives as the data points below confirm].
– Credit exposure from derivatives increased in the first quarter of 2016. Net current credit exposure (NCCE) increased $65.1 billion, or 16.5 percent, to $460.1 billion.
– Notional derivatives increased $12.0 trillion, or 6.6 percent, to $192.9 trillion.
– Derivative contracts remained concentrated in interest rate products, which represented 76.3 percent of total derivative notional amounts.
Measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted. The total of all contracts with positive value (i.e., derivative receivables) to the bank is the gross positive fair value (GPFV) and represents an initial measurement of credit exposure. The total of all contracts with negative value (i.e., derivative payables) to the bank is the gross negative fair value (GNFV) and represents a measurement of the exposure the bank poses to its counterparties.
GPFV increased by $0.8 trillion (26.6 percent) in the first quarter of 2016 to $3.8 trillion, driven by a 29.9 percent increase in receivables from interest rate and FX contracts. Because interest rate contracts make up 76.2 percent of total notional derivative contracts, changes in interest rates drive credit exposure in derivative portfolios. Declines in interest rates tend to increase exposure. This effect has increased in recent years, as the maturity profile of interest rate derivatives has increased, making credit exposure more sensitive to changes in longer-term rates.
Credit risk exposure increased a whopping 26.6% in Q1 2016. Much of that increased credit risk exposure is coming from bets on Federal Reserve rate hikes. If interest rates go up, credit risk exposure in derivative positions goes down. If interest rates go down, credit risk exposure goes up. In other words, most of the bets in the derivatives market are on interest rates rising. Better hope Janet Yellen doesn’t have to lower interest rates!
Credit Default Swaps Dwarf All Other Forms of Derivatives
Credit default swaps dwarf any other form of credit derivative trading.
The notional amount for the 54 insured U.S. commercial banks and savings associations that sold credit protection (i.e., assumed credit risk) was $3.6 trillion, up $206.4 billion (6.0 percent) from the fourth quarter of 2015. The notional amount for the 50 banks that purchased credit protection (i.e., hedged credit risk) was $3.8 trillion, $224.9 billion higher (6.3 percent) than in
the fourth quarter of 2015.
It is interesting that many people are reporting having received a letter from their credit card company informing them that their interest rate is going up from 19.9% to 25% in August 2016. Some people have even reported receiving credit limit increase letters too. How kind of these bankers to go long credit default swaps while raising your credit limit and interest rate to insane levels at the same time.
Folks derivatives are dark financial products that cause excessive risk taking that ultimately leads to disaster. I have little doubt that the next global financial crisis will, at its core, once again involve speculative derivatives betting.