System Failure

If you’ve been here before, you will see I have changed the header pic of this blog.  If we’re not AT System Failure now….  I’ll eat my hat.  It’s all going pear shaped rather fast now.  And it’s hard to know where to start.

Peak Oil.

The last OPEC meeting ended in shambles.  Everyone agreed more oil should be pumped to reduce the price, but none of the members either could or would.  Historically, Saudi Arabia was one of them, and I am now utterly convinced SA has peaked, unable to make up for the substantial (1.7 Mbls/day) loss of the Lybian production caused by the conflict there.  As poor old Matt Simmons used to say, once the Saudis peak, it’s all over.

So what is the rest of the world doing about this?  Releasing oil from the Strategic Reserves….  I mean how stupid can they get?  Are they so scared the rising oil price will tank their precious economies that they will resort to this?  SPR’s are supposed to be “strategic”, used in a crisis, like a Katrina, or……  maybe the collapse of the world economy?

The real irony though, is that when that oil released from the SPR went to auction, it fetched an average $107/bbl, or more than $10 above the WTI price at the time. We have absolutely reached the scraping of the bottom of the barrel, it’s only a matter of time before reality deals with this energy situation, a crisis cannot be too far away.

Economics.

Let’s face it, unless you follow MSM for your economics info, you must be aware that things are not looking good.  The USA has hit its debt limit, and the politicians are fighting over what to do while the ship sinks. To pay the bills, the authorities are raiding pension funds, and firing all and sundry.  QE2 runs out in four days, as I write this.

QE2 started 4 November 2010 and was a decision by the Federal Reserve to spend US$B600 to support the issue of US Treasury bonds.  In the small print it also stated it would roll over existing bonds when fell due.  Analyst Greg Weldon has estimated that this would be worth an extra $250-300 billion.  For a grand total of almost one trillion buckeroos…

The US Treasury cannot collect enough money from taxes to pay its bills, (there’s a non recession on, remember?) so it auctions bonds – promises to pay $1,000 at a certain date in the future, plus some interim payments along the way.  It’s a complex, but investors work backwards from the date T Bills mature to arrive at a price now that will give them a yield they are happy with over the duration.  This yield has to be good enough to take inflation into account and still profit.  Once they’ve worked out the price to pay, they bid their valuation at the auction.

If investors’ estimates of inflation are high, they will require a high yield, and therefore will only offer a low price for the bond.  To ensure the price doesn’t fall too low, (ie yields go too high) the Fed under QE2 prints some money into existence (out of thin air as usual!) and uses it to buy bonds and underpin the price.  Furthermore, as these holdings mature, instead of taking the profits from the Treasury in cash, they immediately re-invest it in buying more bonds (a roll over).

The effect of keeping yields down is to keep the interest rates that everyone pays for money down as well.  Without this, interest rates would go up and the economy wouldn’t be able to afford to borrow as much and wouldn’t grow as much either.  Obviously, this is what the GFC did.

The downside of all this is that the Government takets the money and spends it into the economy, increasing the money supply and causing inflation (too much money chasing too few goods pushes prices up).  It also distorts the bond market, because nobody knows what the “free market” auction price would be without the Fed’s support.

The Fed publishes its asset book every week at http://www.federalreserve.gov/releases/h41/Current/ and its latest report (with 2 weeks of QE2 to go) shows it holds $1,568,863 million in Treasuries, up by $791,919 million from a year ago, so the market is well and truly distorted.

So what happens when QE2 ends and there is no QE3 to keep the game going?  Presumably the price will fall, the yields go up, and banks will have to offer better rates to get the money they need to lend to borrowers, and they will charge higher rates for their loans.  This will cause a slow-down in the economy as people borrow less, which means less paid in taxes, which means bigger Government deficits, which means more bond sales.

This is aggravated by all the talk of defaulting, which forces bond holders to insure against default by US Treasury (Credit Default Swaps) at increasingly expensive rates due to the rising risk. The counter-party to the CDS is usually a big bank, but if the default happens and they have to pay out the CDSs, they will go broke, so you also have to insure against that with another CDS on the bank, and the cost of all this insurance has to be built into the bond price.

So without QE3 to keep the Ponzi scheme going, the US bond market is likely to collapse and Treasury will have to default, at which point the entire world financial system will probably implode.

Of course QE3 won’t fix anything – it just postpones the inevitable default, but Bernanke has said over and over that he will not let the economy slip into deflation no matter how much money-printing it takes.

So it is a mystery as to why QE3 hasn’t been announced, unless it has to do with the impasse over raising the Government’s debt ceiling.  Anyway, come 1st July we will probably see the bond market collapse and then Congress will be forced to agree to the Fed stepping in with QE3, the raising of the debt limit, and the passing of Obama’s budget.

Even so, at some point, investors are going to start rushing for the exits by selling their US bonds on the Over The Counter market to other investors – if they can find any buyers.

China, with its massive holdings, could crash the US system any time it likes, and contagion from the Eurozone could do it even if nobody wants it.

Europe is in a mess, bolstering Greece when it should simply let it go and write off the debts.  Lending Greece more money to fix its debt crisis is…..  words fail me, apart from the four letter variety!  Let’s face it, using your credit card when you can’t meet the payments on your mortgage is not a good idea….