After a mid-day decline on Thursday that topped 350 points, the Dow rebounded in late afternoon trading to close down 254.56 points at 15,660.18, off 1.60 percent.
The news of the day came from Federal Reserve Chairman Janet Yellen’s testimony before the Senate Banking Committee. Yellen admitted the Fed would not “take off the table” the possibility of joining the European Central Bank and the Bank of Japan in implementing negative interest rates in an attempt to reverse global selloff in global equity markets.
“We had previously considered them and decided that they would not work well to foster accommodation back in 2010,” Yellen told the Senate committee. “In light of the experience of European countries and others that have gone to negative rates, we’re taking a look at them again because we would want to be prepared in the event that we needed to add accommodation.”
As the selloff intensifies, the concern is that, unlike in 2008, central banks worldwide have “run out of ammunition.”
The solution in 2008 was to increase debt, as the Obama administration entered on a course that appears certain to double the amount of U.S. national debt from approximately $10 trillion when President George W. Bush left office on Jan. 20, 2009, to $20 trillion when President Barack Obama is scheduled to leave in January.
The Guardian in London on Wednesday reported the decision by central banks in the E.U. and Japan to resort to negative interest rates is seen by many financial analysts as the start of the “final capitulation.”
Cheap money policies, aimed at lowering the cost of borrowing, largely for corporate clients, have been implemented through policies known as “Quantitative Easing,” in which central banks print money used in turn to buy government debt, with the goal of keeping interest rates at or near zero.
“The artificial support from central banks is at a crossroads,” Evan Lucas of IG Australia in Melbourne told the Guardian. “Central bank intervention will no longer create the holding pattern of the past year; markets now believe banks are out of ammunition.”
What are negative interest rates?
Negative interest rates essentially mean the customer must pay to keep money on deposit at a bank.
The same principle applies to banks. If rates were a negative 10 percent, for example, a bank keeping $1 million on deposit with a central bank would have to pay $100,000 for the privilege.
The same principle applies to bond holders investing in the debt of corporations, governmental units and governmental agencies. A negative 10 percent interest rates would mean an investor buying a bond and holding it to maturity would get only 90 percent of his money back.
Negative interest rates are intended to stimulate borrowing by reducing the cost of loans. If the rate for loans were minus 10 percent, the customer would have to pay back only $900 to retire a $1,000 loan.
“One does not require a Ph.D. in economics to recognize [negative interest rates] as an unnatural distortion that will create more problems than it solves,” said John Browne, a senior economic consultant to Euro Pacific Capital.
Central banks deciding to implement a Negative Interest Rate Policy, known in the financial industries as NIRP, are considered desperate. Negative interest rates have been an extremely rare phenomenon that have never been tried in a region as large as the Eurozone. Even during the Great Depression of the 1930s, U.S. interest rates were never negative. And during the height of the global financial crisis in 2008 some U.S. Treasury bill yields only briefly fell below zero.
Oil rather that housing this time
The 2008 financial crisis was caused by the collapse of the subprime real-estate market triggering a collapse in complex Wall Street-created bonds known as “Collateralized Mortgage Obligations,” or CMOs, which, in turn, caused a collapse in the mortgage derivatives market.
Derivatives are complex financial instruments that boil down to bets that banks, institutional money managers and other large players in the financial services industries, including insurance companies, make with one another over the future price of a particular underlying asset – usually stocks, bonds, currencies, commodities, interest rates and market indexes.
A derivatives contract typically involves a put or a call, betting on the price, for example, of interest rates, mortgages, a particular currency or a commodity.
As monitored by the International Bank of Settlements in Geneva, the total amount of Over-the-Counter, OTC, derivatives outstanding worldwide was $552.9 trillion at the end of June 2015.
Derivative contracts far exceed in amount the value of the underlying assets being bet upon. In 2008, losses in the subprime mortgage market in the millions grew to losses in the billions in the CMO market and in the trillions in the global mortgage derivative market.
The bankruptcies in financial giants such as Lehman Brothers and Bear Stearns in 2008 was caused by the huge losses taken in the mortgage derivatives market, not specifically by losses taken directly in the mortgage market or the CMO market.
Louis-Vincent Gave, chief investment officer and chief risk officer at Hong Kong-based Gavekal Capital, notes that in 2008 about $500 billion worth of losses on U.S. mortgages were magnified through the derivatives market, resulting in $28 trillion being wiped from global equity markets and $7 trillion from global gross domestic product.
WND reported on Thursday that the meltdown in global equity markets occurring in 2016 is being caused by the collapse in the price of oil worldwide.
The dynamics are similar to the 2008 collapse in the subprime mortgage market in the U.S. The collapse in oil could cause a domino-like reaction, first causing banks to fail because of billions of dollars in bad loans in the oil industry, spreading to commodity derivatives losses, with the ultimate impact of trillions of dollars in oil-futures derivatives losses.
The Australian Financial Review reported on Feb. 3 that JP Morgan Chase warned that if oil stayed at about $42.50 a barrel, it would be forced to add as much as $750 million to its loan-loss reserves. Citigroup said its problem corporate loans were almost a third higher in October-December than the year-earlier period, mainly reflecting its North American energy book.
Crude oil on Thursday was trading on world markets at just under $27 a barrel, meaning that the loan-loss reserves large U.S. commercial banks are holding must be even larger today.
Commodities today account for approximately $3 trillion of the global $552.9 trillion global derivatives market.
“This unfortunate precedent raises the question of whether we could see a 2008-like crisis, with the catalyst this time around being the bankruptcy of commodity companies which cannot fulfill their derivatives promises, instead of the default of mortgage bonds,” Louis-Vincent Gave has warned, providing a likely explanation of why so many bank stocks worldwide are currently underperforming.
“Looking at market behavior, it is hard to escape the conclusion that someone is getting one heck of a margin call,” Gave continued. “Back in 2008, the ‘margin call’ was on everything housing-related – this time around, the margin call is likely to be on everything related to commodities.”
The difference in 2016, compared to 2008, is that today – after nearly eight years of worldwide debt accumulating to unprecedented heights – central banks are “out of ammunition.” Resuming a policy of Quantitative Easing printing of money to lower interest rates to zero would only result in further depressing commercial bank profits worldwide.
The alternative central banks appear to be using in desperation is the NIRP strategy that is taking the EU and Japan into uncharted waters, with the Fed very likely to following along.
WND reported last month an epic wave of debt defaults – including defaults on large commercial loans, as well as on sovereign debt owed by nation-states at risk of default, a condition Greece seems unable to escape – could well cause in 2016 a collapse of the global economy that could dwarf the economic financial crisis of 2008.