The Consequences Are Profound


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Very defintely market is now reversing to a worrisome yield curve..

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The Consequences Are Profound

  1. 1. Shamik Bhose ; shamikbhose@yahoo.comThe consequences are profound and if it is not your foremost concern as an investor then it probably should be.This morning news came down the wires that the rating agency S&P had downgraded Japans sovereign debt from AA to AA-. Thisis no small development. The reality is that Japans finances are in even worse shape than those of the US when its overall indebtedness is compared as apercentage of GDP. Japan is approaching a debt to GDP ratio of nearly 200%! Yes, you read that correctly. The only nation in theentire world that is higher is Zimbabwe. In effect, the Japanese government spends 2 yen for even one yen of overall economicactivity.What this means is that the rating agencies, who are watching these sovereign debt woes which have struck various countries in theEU, are concerned about the same problem beginning to surface in other quarters around the globe. Quite simply they are looking atthe huge deficits being run by many nations in the West (and Japan). In other words - TOO MUCH DEBT!That led to selling in the long end of the US yield curve this morning as bond traders are starting to be more than a bit fearful that thesame thing is going to happen to the USs AAA rating at some point in the future if the US does not get its financial house in order.They are watching massive amounts of QE2 and another ballooning of the federal budget deficit and are selling even as the Fedattempts to jam the market higher with its purchases. AT this point, the only thing holding the long end of the curve is the Fed. Howlong can that last especially without affecting the Dollar?More and more we see the integrity of sovereign debt being brought into doubt which leads to the question among many investors;"what is a safe haven that is actually safe?" Who wants to take the chance of holding a nations bonds if overnight they face the realrisk of being downgraded?The real world impact of this is that nations whose debt gets downgraded will have to offer potential investors a higher rate of returnto compensate them for the increased risk of holding their debt. For nations already hopelessly in debt, that means borrowing costsbegin to rise forcing them to borrow even more money just to keep their heads above water. The whole thing becomes a vicious cyclewith rising interest rates compounding the problem.The US has been able to sneak by and thus far avoid a rating agencys downgrade partly because its borrowing costs are so low.Should these agencies begin to train their sights on the US and give closer scrutiny to its miserable financial condition, there is achance that a downgrade could follow. Such a development, were it to indeed occur, would force the US to offer higher rates of returnon its debt. That of course would raise its borrowing costs at a time when it can least afford it not to mention short circuiting the QEpolicy which is deliberately designed to lower borrowing costs.This is why the take down in gold, after yesterdays nice performance, is so remarkable for its perverseness and why long termoriented holders of the metal should not be the least bit concerned as to the antics taking place in the paper market. Sovereign debtwoes are not behind us - the problem lies squarely ahead of us and no amount of wishful thinking is going to change that hard reality.This being said, one of the things we now want to monitor will be the performance of gold when priced in terms of the ;
  2. 2. Talking about cheap money- the Indian RBI is now falling behing the curve and showing nerves..........We are already battling an inflation of 8.5%+ in the country despite the Reserve Bank of India (RBI) already having raised theovernight repo rate to 6.25% to counter the upward movement in prices but so far with little success.The RBI, for its part, has alreadyindicated its desire to raise rates even further. However, a 25-basis point (bps) rise is mostly discounted by the market and the pricemovement of the rate sensitive stocks yesterday showed that the market would take a 25-bps rate hike as more of a fait-accompli thanas any surprise. The moot point is why would the RBI just raise 25-bps ? Let us look at the context.As of now, India’s one-year T-bill rate rose 50-bps last week to 7.70% perhaps to fully discount the possibility of 100-bps rate hikefrom the current rate in a year’s time from now. However, our 1-year T-bill rate is rising at a faster clip than the 10-year GovernmentBond yield, which seems to be stalling out close to 8.20%. The result of which the spread between their yield curve has narrowedconsiderably to just around 48-bps by the end of last week. This is a worrisome signal.Typically, stock markets do not perform wellwhen the yield spread is narrowing, especially as an outcome of tighter monetary policy. But that is not central bankers brief ?If the yield curve becomes flat with short term rates becoming equal to long-term bond yields, it generally results in a substantialcorrection in the equity market. It is said, if the short-term rates move above long-term yields for a significant time period it caninduce an economic recession and a bear market for equities.If the RBI continues to lift its repo rate by another 100-bps (including what it did this week) in this year it can at some point in timelead to a situation where the 10-year G-Sec yield would be lower than the 1-year T-bill rate resulting in a situation where we get an“inverted yield curve.” While this may sound a bit alarming but if the inflation genie refuses to get back into the bottle this could wellbe one of the possibilities whose probability of becoming a reality would not be that small to give us any degree of comfort except, ofcourse, if we decide to delude ourselves in wishful thinking that unbearable things simply don’t happen.The calibrated rate hikeexercise has become all the more difficult with the US FED becoming totally oblivious of inflation becoming a problem and continuesits dollar printing exercise currently with QE-2 and may be after June with another QE-3.The intransigent behavior of the FED is getting all the more blatant when you hear such things like the FED Governor Daniel Tarullosaid recently in an interview on a business television channel that he is not worried about inflation. He said, “The increases in longer-term interest rates in spite of the central bank’s efforts to bring them down are a sign (that) FED policies are working. At the moment,and looking forward, one does not see at this juncture any signs of upward significant pressure on inflation.” He added, “Rising foodand energy costs have boosted total inflation, but price increases excluding those items don’t show any signs of significant upwardpressure on inflation.” However, the impact of the FED’s highly inflationary QE-2 scheme is being felt very heavily in emergingcountries like India .Traders and bond market participants are worried that sharply higher oil prices that is already higher by 30% from its last Septemberlevels could fuel inflation (or, already fuelling) worldwide and tax the disposable income of households and businesses leading tocracks in equity market performances in most places.The problem is that commodity prices have gone up across the world. With suchhigh levels of commodity prices sooner than later corporate profitability would be dented severely in a rising interest rate scenario.What is even more worrying is the fact that the grand fiscal stimulus that was given here in our country from late 2008 would have tobe phased out if fiscal corrections have to be done. Would the high growth then be able to find its legs to stand on?Meanwhile, The Dragon ...prowls. Diversification of investments from normal debt market instruments that carry an inherentcurrency risk also.Thus the diversification of investment plus aquisition of resources or technology.................recent convergence of moves asdollar index weakened against the euro alongside gold/silver/crude oil / metals correcting.Although, each commodity group corrected for different reasons; ;
  3. 3. Metal’s were overbought, WTI crude found it hard to go beyond 93$ despite trying and gold - silver made double tops andwere technically weak...The consequences are profound and if it is not your foremost concern as an investor then it probably should be.Correlations have continued to increase despite falls in individual asset volatility.The most obvious manifestation is the lack of diversification which is now available to you, fat tail risk!! .Equities, interest rates, energy, commodities and currencies now move in tandem.And why has the euro gone from 1.29 per US$ to 1.36 in a matter of days ?Shamik ; shamikbhose@yahoo.comTo see our various commodity, currency and related world financial market articles visit our commodity dept. websiteof and click on the reports icon on the top left corner of the screen and you can also and type Microsec And Or and type Shamik Bhose in the search column toaccess our latest review and outlook articles ;