Will the real reason rates weren't raised please stand up...

September 22, 2015 12:33 PM

Not raising rates took many by surprise. After all, our economy is plugging along and rates have never been held this low for so long, etc., etc. I am sure there is some sound concern regarding what is going on in China and elsewhere, as there should be, as a justification for not raising them. But is there more here than meets the eye?

To get some grasp of the situation today we need to know what has evolved since the recession of 2008. That recession was triggered by the financial/real estate bubble mess we had managed to get ourselves into. There were rumblings about Europe but nothing really came of it. It was the U.S. that took the big hit. At that time our national debt was $9.7 trillion. And the Fed balance sheet was $935 billion.

So what did the Fed do to “save the economy”? Rack up even more debt with QE. As of 2012 our national debt had increased to $17.5 trillion. Our Fed balance sheet has increased to $4.2 trillion. Global debt has increased from approximately $2.5 trillion at that time to $158 trillion. That was as of 2012. It is now over three years later and only a fool would expect those numbers to have dropped.

Most of that $4.2 trillion balance sheet increase is in bonds (mostly acquired by Wall Street banks). And that is where the trouble starts. These sovereign bonds are allowed to be reported on the bank’s balance sheets as an asset and gives the banks a license to steal through the leverage allowed. A $1 million investment in your typical U.S. Treasury can backstop $15 million worth of derivatives trades for the banks that buy the bonds.  Derivatives are a security whose price is dependent upon or derived from one or more underlying assets. 

Anyway, the banks trade these derivatives and they are a primary source of revenue for the banks. The leverage is huge and also very dangerous but potentially lucrative if you make smart trades. (The situation with the Whale and J.P. Morgan was a good example of when a trade went bad). So all the banks are deep into derivatives trading because of the potential. 

Since 2000 the global bond market has tripled in size pretty much to pay old debt off with new. The banks gobble the bonds up because of the leverage it gives them with their derivatives business. The global bond market is over $100 trillion in size.  And it is backstopping over $600 trillion in derivatives trades. U.S. banks hold over $236 trillion in derivatives with only about $9.4 trillion dollars in assets combined. I’m sure there isn’t a reader out there that doesn’t see the problem with this.

So no wonder you keep hearing about a “bond bubble.” Governments keep issuing more bonds to finance old debt that is coming due. We did that in the 4th quarter of 2014, issuing over $1 trillion in new debt simply to pay back old debt coming due. That is how a bond market becomes a bubble. Since 2000 the global bond market has nearly tripled in size. We all know by simply balancing our own checking accounts, you can’t do that forever. But that hasn’t stopped the world’s central banks from issuing debt since the large banks willingly play along by buying their bonds because of what they get out of the deal.  Since 2007 central banks have pumped over $10 trillion into the financial system to prop up the financial institutions derivative trades because it is those sovereign bonds that back up that business. And all the time the central banks claim it is for the sake of the economy and nothing more that they rack up more debt. 

And during this same time they have held interest rates at near zero. Why? They have to keep them near zero to try to prop up the bank’s derivate trades because of the exposure. In other words, if the underlying asset goes (sovereign bonds via a bubble and rates increase) so goes the derivatives business. And so goes a few of our top banks in the process. There wouldn’t even be a funeral. So this issue has to have some influence on what the Fed does. Believe me they are aware of it.

But it doesn’t stop there. Because of this exposure, with due credit to the Fed, they have instructed banks to de-risk their balance sheets. It is a little known fact that most of a bank’s derivatives are held by its Holding Co. with a small portion held by the FDIC division (the same division that guarantees our funds in any bank). 

Late last year one bank took over top spot in terms of derivative holdings and increased them against the request of the Fed.  And they shifted a large share of the responsibility from their Holding Co. to the FDIC side, which they were not supposed to do. The FDIC fund has approximately $46 billion to cover $4.5 trillion worth of deposits. There is also $280 trillion worth of derivatives that our five largest banks are exposed to but under the bankruptcy reform act of 2005, derivatives have first access to the FDIC, you and me second. Do the math. If these banks went down we would be out in the cold with our deposits at these banks. So back to this one bank that increased its derivative exposure and increased that liability to the FDIC. They lobbied and petitioned our Congress (you know, those guys we elected who are supposed to have our interests at heart) and succeeded in being allowed to continue to do what they were doing???

There is only one way to interpret this. This bank got itself into trouble with their derivatives trading and need time to hopefully trade out of the mess and our government is going along with it. The same thing happened with the Whale and JP Morgan in 2013. All of a sudden there was an escalation in the derivatives trading to try to average a bad trade. When it got to several billion, it all came crashing down. With this current bank it is in the trillions. So this should give one some idea of the potential exposure out there. Since nothing has happened with this bank to date, no one knows what really is going on there and if the situation has been defused. Hopefully it has. But it shows what a “powder keg” this derivatives business really is.

And it shows what position the Fed is really in. It’s a balancing act that makes Wallenda on the high wire look like a piece of cake. Knowing what is going on behind the scenes with these banks, you have to suspect that the situation with China, etc. is only part of the reason for no rate increase. Could it be they didn’t raise rates and really can’t because of this financial house of cards that is teetering on the brink of collapse as it is? If so, needless to say the Fed’s decision to hold back with rates makes a lot of sense. And the increase in debt to answer debt and keep the derivatives market afloat is what is overhanging the global economies and the root cause of the deflation we are seeing. This sovereign debt is caving in under its own weight. It is almost like a dog chasing its own tail. It goes nowhere.

So you have to wonder what the real reason is that China has recently been dumping our sovereign bonds at a rate unseen in the past. They were our largest individual buyer. Is it possible they see the handwriting on the wall? Could be.

So our Fed is between a rock and a hard place. I don’t envy them. Stimulus has a shelf life that has already been proven. Even a Fed survey recently stated that QE doesn’t work. They are figuring that out now?  Bottom line the Fed has run out of rabbits to pull out of the hat.

But that could be a blessing in disguise. In the end, the market will win out over the “tinkering” of our Fed and every other central bank in the world. It may have already started. It is pretty obvious an economic realignment will occur to flush out a lot of the debt, one way or another. After all, how can all that debt be repaid? It can’t.  Possibly this time some of the banks “too big to fail” will, as they should have the first time around.  Possibly this time we will return to a healthy economy where if a company is poorly managed, the company goes, as it should be. At least that is the way it used to be in the real world. It was much healthier economically for all. 

In the meantime the visual result of this massive debt worldwide is deflation big time. Where it will end no one knows because it can’t be stopped. It is part of the realignment process. But the good thing about it is that it is showing that the real fundamentals are starting to take over irrespective of our Fed and other central banks. And that is a good thing. Without knowing it, we could be already starting the real road to recovery that should have started in 2008.  And we have deflation to thank for it.


About the Author

Judy Crawford is a senior broker at Zaner Group. Raised in rural Minnesota, Judy went to the University of Minnesota and received a BA Degree in language. She specializes in technical analysis of the markets and write a market commentary entitled “Market Update” that is available to readers via e-mail. Sign up at her website: www.tradingfuturesmarkets.com.