FINANCIAL REVIEW

Something is Rotten

Sinclair Noe — December 12, 2014

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DOW – 315 = 17,280
SPX – 33 = 2002
NAS – 54 = 4653
10 YR YLD – .08 = 2.10%
OIL – 2.52 = 57.43
GOLD – 5.60 = 1222.80
SILV – .06 = 17.14

The fall in oil prices has been dramatic, now down almost 47% since June. Nobody was expecting it would fall that far that fast. Goldman was forecasting $85 oil for 2015 as recently as October 29. Crude-oil futures fell to their lowest since May 2009 on Friday, briefly dropping below $57 a barrel, after the International Energy Agency delivered the latest reduction in forecasts for global oil demand. On the week, oil futures have lost slightly more than 12%. So, oil is a bit oversold right here but it is never a good idea to try to catch a falling knife.

And the whole drop just tells us that something is rotten in the markets. The fundamentals of oil have not changed in concert with the price. We don’t have double the oil we had in June. So why is the price cut in half? I know that’s overly simplistic, but either the market is too negative on energy, or it is not diligent enough in thinking about broader implications. Low prices lead to oil being left in the ground. Low oil prices lead to debt defaults. Low oil prices can lead to collapses of exporters. Benefits to consumers likely smaller than expected. Hoped for renewables lose luster with low oil prices. The sharp decline in the price of oil has disoriented markets and changed the perception of the creditworthiness of companies and countries. And don’t forget, deflationary pressures, which is great when you go to the gas station to fill up but not so great in a number of other ways.

Bill Gross, who used to run the world’s largest bond fund before joining Janus Capital in September, said the Federal Reserve may become more “dovish” after oil prices plunged in recent weeks. Gross says the Federal Reserve would have to take lower oil prices “into consideration.” Why would they start to eliminate language that talked about an extensive period of time when the US itself is, not deflating but disinflating, and certainly not moving in the direction of its 2 percent inflation target?

The drop in oil prices likely reflective of world reaching debt expansion limit. The worry, as always, has nothing to do with the central banks’ concern for you, your job, your children, wealth equality, or the future, and everything to do with the simple fact that the stability of the banking system absolutely depends on a steady stream of new loans being created. The core of the problem is that we have a monetary system that is either expanding or collapsing. It has no steady state. Oil has been an engine of growth, resulting in global spending of nearly $3 trillion over the past decade, and that means a bunch of financing. We have never spent more money developing new oil supplies than we did last year, nearly $700 billion; and for all that spending, we did not double the current production. Something is very wrong with that equation, and that means something has to give. New oil drill programs are being scrapped left and right. New drill permits in the U.S. shale plays were down 40% in November compared to October and for good reason: most of the plays are uneconomical at current prices.

The shale miracle could easily turn into the shale collapse. This calls into question the sky-high valuations we currently see for stocks and bonds. Central banks have tried to prop up financial assets and financial markets, and one way was to finance the energy sector; after all, they already blew up the housing market. A decline in oil prices is not only due to supply issues but demand issues.

So, right now, the market players are having a hard time figuring out what all this means, and when they are clueless, they sell. The S&P 500 ended the week with the biggest loss in two-and-a-half years, while the Dow Jones Industrial Average recorded its biggest weekly decline since Sep 2011. The S&P 500 lost 3.5% for the week. Maybe it is just that we were due for a down week. The Dow was down 3.8% for the week, and the Nasdaq Comp lost 2.9% for the week.

A couple of economic reports today. Producer prices, or prices at the wholesale level, fell a seasonally adjusted 0.2% in November, the second decline in the last three months. The rate of wholesale inflation over the year fell to a nine-month low of 1.4%. The Federal Reserve policy committee will meet next week and this is another bit of data showing inflation should not be a concern.

The University of Michigan and Thomson Reuters consumer sentiment gauge rose to a preliminary reading of 93.8 from 88.8 in November; it’s the highest reading since January 2007. The global economy may be going to hell in a hand basket but if we can fill up the SUV and still have money to go to a movie, life is pretty sweet.

Sometime tonight or maybe Monday, the Senate will vote on whether to fund the government. Late last night, the House passed a spending bill and a two day extension to give the Senate time to vote. The idea of funding the government isn’t really controversial. We all know that the government will be funded, but the politicians use it as leverage to tack on poison pills, or provisions that probably would not pass on their own merit but they are accepted to avoid a shutdown. Perhaps the most controversial of these add-ons is a Wall Street-friendly provision which made its way into the bill at the last minute, the weakening of the so-called “swaps push-out rule” from the 2010 Dodd Frank financial reform law.

The push-out rule bans big banks from using taxpayer-insured depositor funds to back certain risky derivatives trading. It also requires financial institutions to move parts of their business involved in those trades to separate groups or affiliates, without FDIC insurance. The new provision would allow banks to gamble in the derivatives markets with FDIC insured depositor money. If their bets turn out to be losers, the taxpayers would bail them out, again. Imagine going to Las Vegas and gambling; if you win you get to keep all the money but if you lose the taxpayer has to pay for your losses.

If this sounds like a sweetheart deal for the big banks, well it is. The language in the bill appeared to come directly from the pens of lobbyists at Citigroup. Yes, this is the same Citigroup that was bailed out in 2008 because they were ready to implode under the weight of bad bets in derivatives. The Citi-drafted legislation will benefit five of the largest banks in the country: Citigroup, JPMorgan Chase, Goldman Sachs, Bank of America, and Wells Fargo. These financial institutions control more than 90 percent of the $700 trillion derivatives market.

The Washington Post is reporting that the provision was so important to the profits at the big banks that JPMorgan’s chief executive Jamie Dimon himself telephoned individual lawmakers to urge them to vote for it. You should try that, call your Senator; you’ll either get a recorded message or an aide who will write down your message and then throw it in the wastebasket. Jamie Dimon has a direct line. Why? Because money is more important than a vote.

Yes, this is the same JPMorgan that is the subject of an open criminal investigation by the Department of Justice for manipulating foreign exchange rates. Yes, this is the same JPMorgan that has paid billions of dollars in fines for a variety of transgressions and signed deferred prosecution agreements that if they ever broke the law again they would be criminally liable. Yes this is the same JPMorgan that gambled in the derivatives markets in the London Whale deal, and then lied about it.

And what they are likely to win is the repeal of the Dodd-Frank Act provision that requires them to separate their gambling from their banking; they fought against inclusion in the Act in 2010, and they’ve been fighting it ever since. So JPMorgan and Citigroup wrote new legislation and there is a good chance it will pass, without debate or amendment because they slapped it on the spending bill. But in finally getting what they wanted, big banks also thrust themselves back into the limelight in the worst possible way, simultaneously reminding the public of their role in causing the financial crisis and in their continuing influence over the various levers of the government. In one fell swoop, they undid whatever recovery to their battered reputation they’d made in the past four years and once again cast themselves as the sleazy casino gamblers and the bribers of politicians who offer a one-finger salute to taxpayers who bailed them out.

Sheila Bair, the former chairman of the Federal Deposit Insurance Corporation said in an interview yesterday that the bankers are trying to blackmail us by making sure government is not funded unless they get their way. Now consider that repealing the swaps provision, which was Section 716 of Dodd-Frank, is likely to only help banks on the margins, since they are allowed to continue engaging in the activity through affiliates. So, why are they fighting so hard to repeal it? Wall Street’s business model depends on the ability of large financial conglomerates to keep exploiting the cheap funding provided by their “too big to fail” subsidies.

Last year Bloomberg calculated that the top 10 US banks received a taxpayer subsidy worth $83 billion because the largest banks can borrow money at a lower rate because creditors assume the government, on behalf of taxpayers, will rescue them in an emergency. And so if this banker written legislation passes, we the taxpayers will be on the hook for the next bailout of the banksters, because the bankers’ money is more important than anything. And it will only be a matter of time.