Crowd behavior is crowd behavior

Outlook

Sentiment is a function of rational thought and emotion. On the rational side, the equity market-sell-off is not really warranted on the basis of one lousy data point from Germany or the oil sell-off from one scary data point on US gasoline consumption. US equity index futures point to an unhappy open, which must be at least in part due to the earnings season starting next week and disappointments looming left and right. There might also be some small worry that central bank-fueled buying (free money forever) is getting long in the tooth.

Today we get US trade and two service sector reports, but once the tone is set for gloominess, it’s not likely even the best of all possible US data can overcome it. It doesn’t help one bit that we have two Fed presidents saying opposite things about the next rate hike. Boston Fed Rosengren will deliver a speech saying he expects the “very slow removal of accommodation reflected in futures-market pricing could prove too pessimistic.” Assuming data continues good, and he does, “it will likely be appropriate to resume the path of gradual tightening sooner than is implied by financial-market futures.”

Then we have Chicago Fed Pres Evans repeating the economy is beset by downside risks and the path toward normalization over the next three years is “very shallow.” We can easily be wrong, but we don’t recall hearing the path to normalization is thought to take three years.

We have more Fed speakers this week, plus the minutes of the last FOMC on Wednesday, including the St. Louis Fed Research Conference. If you are not getting a long nap at this event, you are having your socks blown off.

Then there is an extraordinary conference at International House, one of those do-gooder organizations that thinks it’s cool to called itself “iHouse” these days. In what decade would that be cool? Anyway, the speakers are all the living Fed chiefs—Volcker, Greenspan, Bernanke and Yellen. At a guess, nothing new will come of it—too much tiptoeing around the egos. The moderator is the always excellent Fareed Zakaria so there’s some hope of a controversy, or at least some hurt feelings.

The real event of the week is new Minneapolis Fed Pres Kashkari and his conference on “Too Big to Fail.” Kashkari looks eerily like Ben Kingsley. His background includes Pimco, Goldman, running TARP and a run at the California governorship. Kashkari has already announced he will prod some member of Congress to initiate legislation to cut down the big banks because they really are still too big. Wall Street in Advance guru Lynne notes that the timing is interesting because the banks are set to submit their stress test data and capital plans—today. Kashkari admits new legislation is not likely to go anywhere (and even Barney Franks derides the idea), but at least Congress will be properly informed.

We side with Kashkari on this one. Mervyn King, former BoE chief, in his book The End of Alchemy, asserts that what went wrong in the 2008 financial crisis was down mainly to over lever-aging by banks. King notes that as the crisis began, some banks had leverage ratios as high as 40 and 50.

But even with a leverage ratio of 25, it takes a drop of only 4% in average asset value to wipe out a bank’s capital. We had to read that sentence three times. And at the same time, total US bank assets were about 100% of GDP. This metric got as high as 500% of GDP in the UK and 800% in Ireland.

But even with a leverage ratio of 25, it takes a drop of only 4% in average asset value to wipe out a bank’s capital. We had to read that sentence three times. And at the same time, total US bank assets were about 100% of GDP. This metric got as high as 500% of GDP in the UK and 800% in Ireland.

So we went shopping for data on bank leverage today and the ratio of bank assets to GDP. Leverage is hard to get. The Basel agreements go back and forth, the Fed allows delay, and the whole thing is in-comprehensible because the narrative is couched in terms of capital requirements even when leverage is the true target. Bloomberg does a heroic job of trying to simplify the issues but the best it can do in the end is the table below—capital has doubled, but it’s still under 5%. The Fed is giving the banks extra time to get it up to the new standard of 5%. A 5% leverage requirement means a bank’s assets can’t exceed 20 times its equity, implying of course that it’s still over 20. It may be worse. Banks get to define the riskiness of assets and also get to spin off new entities to hold them, escaping at least some oversight. Some Congressmen, wise to these tricks, want the leverage standard at 15%.

Quick, what are the total assets of US banks? The St. Louis Fed database, our pal FRED, says total assets of all US commercial banks is $15.720 trillion. Five banks control 45% of that sum and the top 8 banks, over half. Compare to US GDP at $18.7 trillion in 2015 or US sovereign debt, $19.2 trillion as of Feb 2016. This would mean bank balance sheets are still inflated compared to GDP, although not everyone thinks assets are in the same ballpark as GDP—see below. Since balance sheets must balance, let’s look at the deposit side that funds these assets. Of total liabilities as of the latest March week at $14,011.8 billion, $11,153.8 billion are deposits. The rest is borrowed (and inability to borrow was at the heart of the Lehman crisis). That puts bank liabilities at 75% of GDP and non-borrowed deposits at 60% of GDP. Better than 100% but still not great.

Wait, it gets worse. We couldn’t get an updated number on derivatives. The latest number we can get is from 2013, and it’s $1.2 quadrillion. Now compare to world GDP at $71.8 trillion. Derivatives are a multiple of GDP. This is why Warren Buffett says derivatives are toxic. Some of them may be a good idea but this is ridiculous and dangerous. Clearly those derivatives are not all on bank balance sheets. After all, banks invent them to sell to yield-seekers.

We admit to not being able to decipher the data in Fred to arrive at an accurate leverage number. But just a quick run-through like this suffices to send our bias in favor of whatever argument Kashkari is going to make. We can’t wait to hear the data he puts forward. King’s point, and no doubt Kashkari’s, too, is that a crisis blows up far faster than we can cope with.

We admit that what should be big worries about the banking sector doesn’t really pass the “so-what?” test. After all, UK and European banks, Japanese banks, and Chinese banks are all in the same soup. Banks complain that trading activities in various asset classes, including commodities and FX, are being curtailed because of the pressure of new capital requirements. Maybe FX will lose a little more liquidity, something that has been going on for several years now. At a guess, this is not a game-changer. What is a game-changer would be breaking up the big banks. These are the FX market-makers. It’s too soon to fret, of course, but if a Kashkari movement gets going, start worrying.

Critics of this line of reasoning wonder if Yellen might not bring down a hammer on the Kashkari’s head—the Fed does not initiate legislation! Besides, bank assets shouldn’t be compared to GDP—it’s not apples to apples. Better would be the ratio of bank assets to total wealth. GDP is production of goods and services, not wealth. “Economists are suckers for xyz/GDP ratios,” according to one savvy Reader responding to the advance version of the Kashkari story last night.

And bank assets are far better categorized into riskiness tiers these days. And finally, the capital ratio is used because it’s something the green eyeshade boys can measure, whereas the real issue is liquidity, and that’s a tough nut. Our Reader writes “Even non-Treasury securities values will fluctuate by large amounts in times of stress. That's why we need a lender of last resort to banks. And that lender, the Fed, should not cheat in the banks favor by generously valuing the collateral supplied.”

Here’s the kicker from our critic—no one knows the value of assets in a crisis. Whatever it is, it has nothing to do with GDP. Who is to say small banks would behave any better?—crowd behavior is crowd behavior. “It's not well recognized but hundreds of smaller banks also got government financial assistance in the recent ‘Great Recession.’ … if the too-big- to-fail banks approach failure, nationalize them or put them into conservatorship, clean them up, dice them up, fire the bozos without mercy and then sell the parts hopefully at a profit.”

To return to the immediate task in hand—whither the dollar? Up, except against the yen, for a couple of days. We have studied the various cycle and day-counting theories for many years now and can’t make any of them work on a consistent basis. But the old stand-by for a counter-trend move, three days, is probably about right this time.

Fun Political Tidbit: The preposterous Trump asserts unemployment is at 20% (when U6 is 9.9%) and the US economy is about to go into a massive recession. No mainstream economist agrees, not that the public gives a hoot what economists say. But now the economists are joining the international political gang, responding to stupid statements about NATO and outright encouragement of nuclear proliferation.

Trump already lost the non-bimbo female vote, not to mention the Latino and black vote. What’s left is a crowd of uneducated white men. Here’s a good quote from Gustav LeBon, who studied crowd behavior: “….those who join a crowd descend several rungs in of the order of civilization.” Even the GOP is starting to get worried that it’s a short step from crowd to mob. The only change we detect in the Trump rhetoric so far is an end to encouraging mob behavior. Maybe somebody took him to the woodshed.

		Current	Signal	Signal	Signal
Currency	Spot	Position	Strength	Date	Rate	Gain/Loss
USD/JPY	110.36	SHORT USD	WEAK	02/04/16	117.57	6.13%
GBP/USD	1.4207	LONG GBP	WEAK	03/31/16	1.4371	-1.14%
EUR/USD	1.1358	LONG EURO	STRONG	03/11/16	1.1094	2.38%
EUR/JPY	125.35	LONG EURO	STRONG	03/29/16	127.24	-1.49%
EUR/GBP	0.7995	LONG EURO	WEAK	03/11/16	0.7759	3.04%
USD/CHF	0.9592	SHORT USD	STRONG	03/11/16	0.9877	2.89%
USD/CAD	1.3150	SHORT USD	STRONG	02/01/16	1.4031	6.28%
NZD/USD	0.6764	LONG NZD	STRONG	02/01/16	0.6478	4.41%
AUD/USD	0.7528	LONG AUD	STRONG	01/25/16	0.6980	7.85%
AUD/JPY	83.07	LONG AUD	STRONG	03/03/16	83.57	-0.60%
USD/MXN	17.6138	SHORT USD	STRONG	02/23/16	18.1208	2.80%