According to the BIS, the global total for exchange traded derivatives is now $US 279 TRILLION while the total for over the counter derivatives is $US 220 TRILLION. Combined, that's $US 499 TRILLION. But that's no problem, according to the world's major banks, because "only" about $US 25-35 TRILLION of these derivatives are currently "at risk".
Heck, that's only 161 to 265 percent more than the US broad money supply (M3), currently $US 9.59 TRILLION.
For seven weeks, between March 23 and May 10, the $US index was trading in a fairly tight range, with highs just below 85.00 and lows around 83.50. For most of that time, the range was even tighter, between 84.00 and about 84.60. On March 23, the spot future $US index closed at 84.61. On May 9, it closed at 84.60. Ho hum.
As you know, that tight range has been broken with a vengeance over the last three days of this past week. Here are the spot future closes for the $US since May 10:
Gold hung on until May 11. Then, on May 12 the spot future price dropped $US 5.70 to $US 422.20 and on May 13 it dropped another $US 1.50 to $US 420.70 - its lowest close since February 10. As one would expect, given the surge of the US Dollar, the Gold price hardly moved at all over the week in terms of most other major world currencies.
So, what's going on here? Well, to answer that question, we must turn our attention to the "hedge funds". If you have been following the financial news, you know that the investment positions of the hedge funds have suddenly become the subject of much concern in recent days. As one indication, here is a quote from Mr Ralph Axel, a US government debt "strategist" at HSBC Holdings, regarding hedge fund speculation: "Everybody's waiting for somebody to blow up. Whether it happens or not, it almost doesn't matter. The market's front-running that. When there's rumors there's fear."
In more and more trading rooms and investment centres across the world, the dreaded and unforgotten spectre of the demise of LTCM, the monstrous margin trader cum hedge fund which collapsed in mid 1998, is being raised. It is a well known fact in those same trading rooms and investment centres that the hedge funds have had a very tough time of it so far this year. But it is only very recently that this knowledge has morphed into genuine concern and, behind the scenes, a growing fear - as exemplified in the quote from Mr Axel.
To trace the development of the present state of affairs, consider the long-telegraphed troubles in the private pension funds of many of the biggest US corporations, notably the big airlines and especially the auto makers. The hedge funds have been dining out on these troubles for months, shorting the stock and going long the debt of these companies. The reasoning behind the buying of the debt paper was simply that the ever increasing yields on this paper guaranteed a healthy rate of return even if the nominal value of the paper receded.
The rationale for shorting the stocks was blown out of the water on May 4 when Mr Kirk Kerkorian announced that he was going to buy 8.8% of GM's outstanding stock. GM rose 18.8% on this announcement, and the hedge funds had to scramble to buy back their shorts.
The very next day, on May 5, Standard and Poors downgraded the debt of General Motors and Ford, removing the investment grade rating from the debt instruments of these two companies. Over this past week (May 9-13), the ratings ageny has started to downgrade its ratings of the DERIVATIVES backed by Ford and GM debt paper. The "sure bet" on the debt paper turned sour too.
On May 10, the problem for the hedge funds was GREATLY increased by two developments. First, a US bankruptcy judge approved a plan by United Airlines, which has lost $US 10 Billion since late 2001, to "dump" its $US 6.6 Billion underfunded pension plans on an agency of the US federal government, the Pension Benefit Guaranty Corp (PBGC). The PBGC itself was carrying a deficit of $US 23 Billion as of September 30 last year. This ruling has opened a gigantic potential "escape hatch" for the MANY other large US corporations (prominent amongst which are GM and Ford) which are being bled dry by huge and grossly underfunded pension plans. More to the point, by approving the plan to shift the pension plans to the government, the judge has illustrated the risks being taken by the hedge funds which have been investing in the paper of the companies which have been driven to such extreme measures.
This was directly reflected by the second big development. The Bank of America reported that the cost of insuring investment-grade debt against default had leaped on May 10 from $US 64,000 per $US 10 million to $US 72,000 per $US 10 million. Two months ago, the equivalent cost was $US 37,000. By May 10 it had almost doubled and the rise on May 10 itself was 23% or almost one-quarter of the total increase.
Please note that this is the cost for insuring against the default of INVESTMENT GRADE debt. There isn't much of that left. Consider the cost of insuring against the default of NON investment-grade debt. According to GT Group Inc. of New York, the cost of insuring $US 10 million worth of the paper issued by General Motors Acceptance Corp was, as of May 10, $US 717,000. Back in February, it had been $US 229,000. "Hedging" is getting much more expensive with breathtaking speed.
So is the concern about the increased costs now facing the hedge funds, combined with the losing trades which have been affecting more and more hedge funds this year. Hedge funds have been on the wrong side of the market moves in the US Dollar, on US Treasury debt, on global stock markets, and on corporate debt issuances. The situation has reached the point where the viability of more and more of the funds is being called into question - see the quote above. The situation has also reached the point where more and more of the hedge funds are having to increase their "liquidity" to cater for a growing expectation of redemption calls by disgruntled and increasingly nervous investors.
The US Dollar is now in the throes of its second upside surge of 2005. The first one came in the first six weeks of the year, fuelled by changes to US corporate taxes which made it VERY advantageous for companies to repatriate their foreign earnings back into the US and save HUGE amounts on their tax bill. This surge is being fed by the repatriation, not of foreign earnings, but of foreign investments back to the US in order to shore up "liquidity" to cope with an anticipated surge in risk aversion.
Clearly, one of the major components of this sudden surge of the US Dollar is the factor which leads to a sudden surge of any investment snared in a long-standing bear market - short covering - from the many hedge funds which have shorted the currency this year. But the main impetus has come from the sudden and shocking realisation of the extent of the deterioration of the credit quality of US corporations. Hedge funds have made GIGANTIC bets on US corporate credit, leveraging so called "collateralised debt obligations" and using the income derived to keep the money flowing to their investors. On only one item, the double losing bet on GM outlined above - short the stock and long the debt paper - the Bank of America estimates that the hedge funds face losses of 14% or more since April 1.
This situation is forcing the hedge funds to scale back their leverage on more and more of what are called "credit default swaps". This is in turn drying up hedge fund income at the same time as it is fuelling concern about the viability of the underlying paper and thereby inducing more and more hedge fund clients to cash in their chips. The entire paper pyramid reported on by the BIS is being slowly eaten out from below, as fears grow about the viability of the "assets" upon which the hedge funds and the entire derivative community has built such a grotesquely huge and complex paper structure.
The biggest "excitement" about the rise in the US Dollar over the period since May 10 has been that the major "victim" of the rise has been the Euro. Many of the biggest hedge fund bets in recent weeks have been based on US corporate debt and corporate pension obligations issued in Europe. It is these which are being liquidated and the resultant capital traded out of Euros and back into US Dollars which has been a MAJOR factor in the sudden Dollar rise of recent days.
Gold has almost perfectly reflected the increase in the US Dollar index this week. For public consumption, this surge in the US Dollar is being "credited" to all the US government statistics which have been released in recent weeks - lower trade deficit, higher employment, increased retail sales, etc., etc.. As has been exhaustively reported by us and by many others across the internet, ALL these statistics have been massaged to an extent far surpassing that which has gone before.
In FACT, this surge in the Dollar is a frantic attempt to shore up defenses in advance of what EVERYONE expects to be an earthquake in the hedge funds. The state of the hedge funds is a window into the state of the fantastic leverage which has built the derivatives reported by the BIS to its appalling present dimensions.
If there has ever been a wakeup call for the ownership of GOLD as the ultimate insurance against financial upheaval, this sudden surge of the US Dollar has provided it. We don't know how far the Dollar can rise and how long the surge can last. We DO know that the rise is NOT based on any kind of "health" in the global financial system and the US financial system in particular. The exact opposite is the case. The tide is not rising. The ship is sinking.