Gijsbert Groenewegen | Groenewegen Report
Posted Jul 1, 2011

Increasing credit risk will cause much higher interest rates across the borders

The Belgian/French bank Dexia, with a ¤4.3bn or $6bn+ exposure (according to S&P’s Corp) to government debts in Greece, has back stopped (guaranteed) $17bn in municipal bonds in the US according to an article in the WSJ. As a result of the problems in Greece interest rates of municipality bonds in small towns in the United States used to finance municipal facilities like schools, bridges, ice rinks etc are being pushed up. S&P warned last month of a possible downgrade of Dexia’s investment- grade credit ratings. It looks indeed like Lehman revisited when one of the victims of the CDO crisis in the US was a small town in Norway which had bought “triple A” CDO s. And don’t forget the exposure of AIG to the housing market through the Credit Default Swaps (CDSs) that were never going to be called because of the triple A status of the CDOs, and how it almost bankrupted Goldman and others.

While other investors are stepping in to buy those bonds, they are demanding sharply higher yields as compensation for the increased risk following a possible downgrade of Dexia’s credit rating. As a result, borrowing costs for some municipalities are now the steepest since the financial crisis. Some cost of borrowing are tripling and quadrupling in a matter of weeks.

Dexia is obliged to buy as much as $17 billion in municipal bonds if investors withdraw during the remarketing or rollover process. Some $400 million has already been taken back though in those cases, allowing Dexia to increase the interest rate paid by the municipalities whilst at the same time it can demand an accelerated pay back schedule. Some municipalities are trying to replace Dexia with other banks though the refinancing is likely to lead to much higher interest rates in some cases from 3% to 12% which increase borrowing costs by tenth of thousands of dollars which in turn leads to very high fees for the related facilities.

With the QE2 ending on June 30 (the Fed has bought 85% of all treasury issuances this year!!) and higher credit risks higher interest rates could bring down the markets. If we break above the 4.80% level on the 30-y Treasury bond we will break out of the downtrend since 1981 and could see much higher interest rates with all its obvious consequences for the financial markets and economies.

The interest rates are saying that Greece is already in default

Greece 10-y sovereign debt is trading at 17% currently whilst the 2-y debt is trading at 27%. Basically the market is already saying that Greece is in default. In fact Greece currently has interest payment obligations that are $5bn higher than its tax revenues. In other words Greece is loaning money in order to fulfill its ever higher interest commitments. Politicians though want to prevent a technical default at any costs since it would have major ripple effects as indicated here above. Interest rates for munis will go up, Greek debt can’t be used as collateral with the ECB any longer and banks will have to take losses on their Greek sovereign debt (BNP Paribas and Dexia have $57bn, Deutsche Bank and Hypo Bank have $34bn to name a few). According to some estimates the European banks own a huge chunk of Greece $467bn state debt whilst virtually none of this debt has been marked down. A default would weaken the European banks and put upward pressure on interest rates on Portuguese and Irish sovereign debt of which the European banks also own a large portion. US banks are avoiding euro zone government bonds.

The system is exhausted, which tools are left?

As we have mentioned in our previous blogs in our point of view all the problems in the world are connected to each other through the banks whilst all economies are connected through the currencies. In other words we can expect a huge chain reaction/ripple effect that won’t stop at the borders. This will be inevitable. The difference with 2008 will be that almost all possible tools to rescue the system will have been exhausted. And in tandem with that the credibility of the monetary authorities and the respective currencies which have been severely undermined following the non-successful stimulus programs. The competitive currency devaluations will accelerate hence the only currency with intrinsic value; gold and silver will probably go bid only after a brief sell off. A brief sell off could happen in our view because when everything sells off funds will have to sell all their liquid investments because investors will withdraw their investments in order to preserve the value that is still left. The US dollar is likely to benefit from the sell off because as happened in 2008 investors will park their money in US dollars, still the reserve currency. Though after this process has taken place and investors realize that the US might actually be in a worse situation than Europe the US dollar could be abandoned massively in order to try to exchange the paper currency for the intrinsic/real currencies. We want to emphasize that we will know that the US dollar will have lost it value when the US dollar will no longer be accepted in exchange for gold or silver.

Why is the US dollar weaker than the Euro?

As a note we wonder why at present the US dollar is still much weaker than the Euro despite the problems in Greece, Portugal and Ireland. Next to that Spain also doesn’t look too healthy, unemployment in Spain for 25 year olds and younger runs at a staggering 40-45% whilst overall unemployment is in excess of 21%. One of the puzzling questions is why the US dollar is so weak vis a vis the Euro. One answer could be the interest differential though we wonder if that would compensate for the possible risk of default. The Fed’s QE1 and QE2 stimulus programs to the amount of respectively $1.7trn and $600bn respectively didn’t have the desired effect, except for keeping the bond markets and thus equity markets up, hence the lackluster growth. In fact it was the weakest recovery of any recovery in the past nine decades if unadjusted for inflation. According to some estimates the Fed has bought this year about 85% of all treasury issuance. Next to that the US budget deficit is forecast to be $1.6trn and $1.3trn next year. All these factors in combination with the virtually zero interest rates have undermined the once all mighty US dollar.

Strongest commodity performance ever

In fact what we have been seeing is a huge shift from intangible/paper assets to tangible/real assets hence the strong commodity prices which were also boosted following strong demand from China and other BRIC countries. Commodities enjoyed their strongest ever performance in a recovery. As a result we are experiencing strong commodity inflation whilst recently also food inflation has started to roar its head. The increasingly volatile and extreme weather changes have pushed up food prices to 30-y highs.

On top of that the arable land in the world is declining rapidly following strong urbanization (China, India) and desertification. Next to that the world population is expected to reach the 7bn mark in October of this year. And in our calculation the 8bn level will be reached not in 20 years but in 7-10 years.

Middle class being wiped out removing an important buffer in the economy

Household wealth in the U.S. climbed by $943 billion in the first quarter of 2011 as rising share prices outstripped declines in home values. Though it should be noted that the top 10-20% own 80-90% of the stock and bond market wealth. What we are basically witnessing in the US is that the middle class is being wiped out. Its main asset, housing, which represents 38% of household wealth of $58trn for the first quarter of 2011, is declining steadily and further eroding what is left of household capital. On top of that the middle class is also slapped in the face with much higher food and gasoline prices. When the middle class gets wiped out the economy won’t have any buffer any longer to absorb the downturn in the economy. And as a result we could have a severe depression. We probably already have passed the tipping point in the West with declining productivity, increasing government debts, a destruction of household wealth, an aging population with in excess of $100trn in unfunded obligations in the US, a failing education system etc, etc. In fact if we look around the world we see a lot potential causes for unrest. In Europe and the US the debt and budget problems, in Northern Africa and the Middle East food and geopolitical problems and in China strong food and housing inflation and corruption. It looks as if a lot of problems are converging and coming to a head.

Precious metals, agricultural land and water

Not a pretty picture, anyway we are living in challenging times. Protect yourself with physical (no counter party risk) gold and silver, agricultural land in water rich countries, fertilizer companies and water. With a rapidly increasing world population the (relative) scarcity or all tangible assets is continuously increasing. On top of that we are exhausting our resources and we would like to make the point that with an ever declining replacement ratio it could be argued that the resources in the ground are becoming worth more every day. And last but not least, going forward be aware of counter party risk when the markets take a turn for the worse.

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