My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
Last week we continued to examine markets and their tendency to be manipulated under our current systems. This article puts more meat on the bone for those wishing to understand how and why this is occurring now and also describes how the world is facing some extreme challenges on the ecological front:
https://www.peakprosperity.com/blog/114677/2019-beginning-end-free-premium-report
Here is the link to last week: Issue 37
We will now look at how some of the many different markets operate, the risks involved and hope to further convey an understanding of the basic operations of markets in general. Markets have evolved greatly since this book was written and we now find ourselves facing the unknown effects of central banks unwinding their previous QE with QT (Quantitative Tightening). The Fed is progressing cautiously for fear of creating a recession although there are many indicators that the global system is slowing down. It will prove to be an interesting 2019 as the months unfold.
CHAPTER 7
Markets
“Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods.”
Ludwig von Mises: “Planning for Freedom”
Everything is determined, the beginning as well as the end, by forces over which we have no control. It is determined for the insect as well as the star. human beings, vegetables, or cosmic dust, we all dance to a mysterious tune, intoned in the distance by an invisible piper.
Albert Einstein
Many variations on this thought experiment can be considered.
There is much more to this scenario than is seen at first sight because there are many options available than just exchanging contracts for a one-off sale. Now that you have more information about the market you could ‘double-up’ your trading by, say, buying many more apples on credit (this is known as (‘leverage’) than you could using your original, limited, £200 initial investment in the first purchase.
This is where trading markets gets interestingly complex, known generally as ‘derivatives’ and will be explored further in the next Chapter 8 on the subject of ‘Financial Engineering’. Also there are many different global markets to exploit and here are some of the main ones:
- Equities markets which trade stocks and shares
- Currency trading and foreign exchange markets are massive dealing in currencies, Money markets and re-purchase markets (repos) are also massive
- Treasury bonds for government securities
- Interest rates are highly complex, high in volume with massive derivative products
- Credit markets for Corporate bonds, Municipalities and other financial institutions
- Commodity markets for raw materials, finished products and precious metals and oil
- Utilities including power, water, waste processes and electricity markets
- Transport markets including air, rail, shipping and road haulage
- Pharmaceutical and Agricultural products
Markets for debt, interest rates and loans
We have already touched on a few of these market areas such as bonds which are a large proportion of global trading and are heavily influenced by interest rates which at present are so artificially low that the normal operation of these markets has been compromised to a large degree and where pricing is distorted beyond economic rationale.
The biggest bond market is that of US Treasuries which are many and varied and quoted on all the main exchanges like the NYSE in the same way the UK bonds (gilts) are quoted on the LSE. Because America is by far the largest global financial player the influence of US Treasury bonds leads the world and causes interest rates to be set according to the US government’s requirements.
Interest rates rose during June and July 2013 and it seems that recent years of falling interest rates have encouraged global economies to use debt financed by ‘variable rate interest’ rather than ‘fixed rates’. When interest rates increase the effect is quite shocking because it affects everybody by increasing their costs across the board from mortgage rates to credit card and student loan debt. For example, the interest on an Adjustable Rate Mortgage (known as an ARM in the USA) jumped from 3.5% to 4.5% in just one month, which means discretionary spending falls; the economy slows down and it becomes serious for an economy when approaching a recession.
Another victim of increases in interest rates is the long-term Treasury bond (20 -30 years). Retail investors have poured about $1Trillion into bond funds between 2009 and 2012, because the price of bonds have been rising for many years and have always been considered zero risk and a very safe place to invest savings.
Because these bonds offer a fixed rate of interest (coupon) over a fixed period, the effective interest rate varies inversely to the quoted bond price on the market at any one time – as bond prices increase, coupon rates fall and vice versa. Rising bond prices have helped individuals, institutions and pension funds rebuild their capital which was lost during the 2008 crisis.
However, in the first half of 2013, US bonds lost $60 billion from withdrawals and prices have fallen dramatically. In effect this means that the ‘safe’ part of a person’s savings in now more risky and worthy of higher interest payments in the future.
Sovereign debt is at risk of rising interest rates impacting government debt
Even more worrying is the systemic risk associated with ‘sovereign debt’ – the debt of governments. One way a government can hide the effects of their mounting debt is by arranging for their borrowing to be short-term, say, a few months to one year, when rates are close to zero and money is effectively free.
When long-term rates start rising governments have a choice on how to manage their portfolios. When a Treasury bond ‘matures’ it means that the government has to pay the investors back their original money so they will generally roll over their maturing long-term debt by issuing more debt as we have discussed in previous Chapters. If they chose to issue short-term ‘bonds’ (confusingly known as ‘Bills’), this would have the effect of keeping interest costs down but making it necessary to roll over even more debt each year. Otherwise they can keep the bond to the maturity (i.e. the date of redemption) of the new debt in the same period of 20-30 years but will experience an increase in their interest costs.
Another alternative is to have their central bank buy up even more debt (by printing more money) and then ‘write off’ the interest (known euphemistically as retiring the interest or debt) but at the risk of a tidal wave of newly-created money devaluing the currency even more.
There is another massive risk associated with rises in interest rates which cause banks, investors and financial institutions to lose money on their ‘derivative’ products which they have issued in the hundreds of trillions of dollars around the world. These are known as ‘interest rate swaps’, in which holders of a security which pays a fixed rate of interest exchange their income stream for a variable rate of interest based on a ‘base’ or ‘benchmark’ interest rate.
The players on the variable-rate side of the bet can lose big if interest rates keep rising and were part of the cause of the last financial debacle in 2008. This subject is discussed more fully in the next Chapter on the subject of Financial Engineering when we will continue with our thought experiment using the ‘apple’ analogy already described. Because all these markets are linked together a small increase in interest rates generally can cause a large disruption to all the interlinked markets at the same time and is what governments fear the most.
To be continued next Saturday
