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14 Facts About The Absolutely Crazy Internet Stock Bubble That Could Crash And Burn In 2014

TwitterShouldn’t Internet companies actually “make a profit” at some point before being considered worth billions of dollars?  A lot of investors laugh when they look back at the foolishness of the “Dotcom bubble” of the late 1990s, but the tech bubble that is inflating right in front of our eyes today is actually far worse.  For example, what would you say if I told you that a seven-year-old company that has a long history of not being profitable and that actually lost 64 million dollars last quarter is worth more than 13 billion dollars?  You would probably say that I was insane, but the company that I have just described is Twitter and Wall Street is going crazy for it right now.  Please don’t get me wrong – I actually love Twitter.  On my Twitter account I have sent out thousands of “tweets”.  Twitter is a lot of fun, and it has had a huge impact on the entire planet.  But is it worth 13 billion dollars?  Of course not.

When it comes to the Internet, what is hot today will probably not be hot tomorrow.

Do you remember MySpace?

At one time, MySpace was considered to be the undisputed king of social media.  But then something better came along (Facebook) and killed it.

It is important to keep in mind that Facebook did not even exist ten years ago.  Yes, almost everybody is using it today, but will everybody still be using it a decade from now?

Maybe.

But the way that the financial markets are valuing these firms can only be justified if they are going to make absolutely massive profits for many decades to come.

Will Twitter eventually make a little bit of money?

Probably, as long as they get their act together.

In fact, Twitter should be making significant amounts of money right now if it was being run correctly.

But will Twitter ever make 13 billion dollars?

No, that simply is not going to happen.  But that is what Wall Street says that Twitter is worth.

The utter foolishness that we are witnessing on Wall Street right now is so similar to what we saw back in the late 1990s.  It is almost as if we have learned nothing from our past mistakes.

These days I keep having flashbacks of the Pets.com sock puppet.  For those too young to remember, the following is a brief summary from Investopedia about what happened to Pets.com…

It’s impossible to think of the first Internet era without thinking of the Pets.com sock puppet. He was everywhere and was nearly as well-known as the Geico gecko is today.

That familiarity, in part, persuaded many investors to lay down money in the company’s February 2000 IPO (which was backed by Amazon.com). Pets.com raised $82.5 million – but nine months later it folded, due to major recurring losses. Part of the reason for that was aggressive advertising, but the company also lost money on virtually every item it sold. In the third quarter of 2000, Pets.com reported negative gross margins of $277,000. (The second quarter had seen a $1.7 million margin loss.) That same quarter (its last full quarter as an operating entity), the company lost $21.7 million on $9.4 million in revenue.

As for the puppet, he went on to shill for BarNone, which helps people with bad credit histories get car loans. He’s still there today, front and center on that website.

Everyone loves to laugh at the poor little sock puppet, but the truth is that the tech bubble that is inflating right now is far worse than the Dotcom bubble of the late 1990s.  The following are 14 facts about the current tech bubble that will blow your mind…

#1 In just a few days, the Twitter IPO is expected to raise close to 2 billion dollars even though Twitter actually lost 64.6 million dollars last quarter and has a long history of not being profitable.

#2 It is being projected that after the IPO Twitter could have a market valuation of more than 13 billion dollars.

#3 Twitter is not expected to make a profit until 2015 at the earliest.

#4 According to CNBC, Pinterest is currently valued at 3.8 billion dollars even though it has never earned a profit.

#5 Yahoo paid more than a billion dollars for Tumblr even though Tumblr’s revenues are so small that Yahoo is not even required to report them on financial statements.

#6 Snapchat, an Internet service that allows people to send out messages that “self-destruct”, is supposedly worth 4 billion dollars.  But it actually has zero revenue coming in, and many believe that it is essentially worthless as a money making enterprise.  For one extensive analysis by a tech blogger, please see this article.

#7 The stock of Rocket Fuel, an online advertising company, is trading at about 60 dollars a share and it has a market valuation of about 2 billion dollars even though it has never made a profit.

#8 The stock of local business review website Yelp is up 241 percent this year even though it has never earned a quarterly profit.

#9 Fab.com just raised 165 million dollars from investors even though it recently laid off 44o employees.

#10 LinkedIn stock has risen in price by 136 percent since the 2011 IPO, and it is now supposedly worth more than 18 billion dollars.

#11 The head of engineering at Twitter, Chris Fry, got a 10.3 million dollar pay package when he joined Twitter last year.

#12 Facebook’s VP of engineering, Mike Schroepfer, earned 24.4 million dollars in 2011.

#13 Office rents in San Francisco (where many of these tech companies are based) are now 23 percent higher than they were at the peak of the real estate market in 2008.

#14 Facebook stock is up close to 140 percent over the past 12 months and the company is now worth more than 120 billion dollars.

And I am certainly not the only one that is concerned that we are repeating the mistakes of the late 1990s…

“When you look at valuations and look at the lack of earnings and revenue, it seems to me much like the dot-com bubble,” said Matt McCormick, a money manager at Cincinnati-based Bahl & Gaynor Inc. who helps oversee $10.2 billion. “This market looks a little frothy and Twitter is the personification of a risky trade.”

In fact, as the Wall Street Journal recently noted, we have seen some of these tech stocks crash more than once during the Internet age…

“It’s fascinating to me that today’s mini-mania includes shares of Amazon, Netflix and Priceline that have previously peaked and crashed before—in some cases they’ve peaked and crashed twice before,” says Darren Pollock, portfolio manager at Cheviot Value Management. “Stocks like these have again captured the imagination of speculators. We’re skeptical that there is enough underlying intrinsic value to many of the highfliers to support today’s prices.”

So how long will it be until the current tech bubble implodes?

That is a very good question.  Please feel free to share what you think by posting a comment below…

18 Signs That Global Financial Markets Are Entering A Horrifying Death Spiral

The spiral staircase at the Lighthouse in Mitchell Lane, Glasgow - Photo by George GastinYou can see it coming, can’t you?  The yield on 10 year U.S. Treasuries is skyrocketing, the S&P 500 has been down for 9 of the last 11 trading days and troubling economic news is pouring in from all over the planet.  The much anticipated “financial correction” is rapidly approaching, and investors are starting to race for the exits.  We have not seen so many financial trouble signs all come together at one time like this since just prior to the last major financial crisis.  It is almost as if a “perfect storm” is brewing, and a lot of the “smart money” has already gotten out of stocks and bonds.  Could it be possible that we are heading toward another nightmarish financial crisis?  Could we see a repeat of 2008 or potentially even something worse?  Of course a lot of people believe that we will never see another major financial crisis like we experienced in 2008 ever again.  A lot of people think that this type of “doom and gloom” talk is foolish.  It is those kinds of people that did not see the last financial crash coming and that are choosing not to prepare for the next one even though the warning signs are exceedingly clear.  Let us hope for the best, but let us also prepare for the worst, and right now things do not look good at all.  The following are 18 signs that global financial markets are entering a horrifying death spiral…

#1 The yield on 10 year U.S. Treasuries has risen for 5 of the past 6 days, and it briefly touched the 2.90% level on Monday.

#2 Rapidly rising interest rates are spooking investors and causing them to pull money out of bonds at a very rapid pace

Investors have yanked nearly $20 billion from bond mutual funds and exchange traded funds so far in August. That’s the fourth highest pullback ever, according to TrimTabs data. In June, investors took out $69.1 billion — the highest on record.

#3 The sell-off of U.S. Treasuries is being led by foreigners.  In particular, China and Japan have been particularly aggressive in selling off bonds…

China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.

The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.

China, the largest foreign creditor, reduced its Treasury holdings to $1.2758 trillion, and Japan trimmed its holdings for a third straight month to $1.0834 trillion. Combined, they accounted for about $40 billion in net Treasury outflows.

#4 Thanks to rapidly rising bond yields, some of the largest exchange-traded bond funds are getting absolutely hammered right now

• The $18 billion iShares iBoxx $ Investment Grade Corporate Bond fund (ticker: LQD) has fallen 7.94% since May 2, according to S&P Capital IQ. That’s including reinvested interest from the fund’s bond holdings.

• The 3.7 billion iShares Barclays 20+ Year Treasury Bond (TLT) has plunged 15.9% the same period. Longer-term bonds typically get hit harder when rates rise than shorter-term bonds. For example, the iShares Barclays 3-7 Year Treasury Bond fund (IEI) has fallen 3.2% since May 2.

• PowerShares Emerging Markets Sovereign Debt (PCY), which invests in government bonds issued in developing countries, has fallen 12.7%. The fund has $1.8 billion in assets.

#5 In recent weeks we have witnessed the largest cluster of Hindenburg Omens that we have seen since prior to the last financial crisis.

#6 George Soros has bet a tremendous amount of money that the S&P 500 is going to be heading down.

#7 At this point, the S&P 500 has fallen for 9 out of the last 11 trading days.

#8 Margin debt has spiked to extremely dangerous levels.  This is a pattern that we also saw just before the last financial crash and just before the dotcom bubble burst…

The exuberant mood comes as margin debt on Wall Street hovers near $377bn, just below its all-time high and well above peaks before the dotcom crash and the Lehman crisis.

“Investors have rarely been more levered than today,” said Deutsche Bank, warning that the spike in margin debt is a “red flag” and should be watched closely.

#9 The growth rate of new commercial bank loans and leases is now the slowest that it has been since the end of the last financial crisis.

#10 According to a shocking new report, Fannie Mae and Freddie Mac are masking “billions of dollars” in losses.  Will they need to be bailed out again just like they were during the last financial crisis?

#11 Wal-Mart reported very disappointing sales numbers for the second quarter.  Sales at stores open at least a year were down 0.3%.  This is a continuation of a trend that has been building for years.

#12 U.S. consumer bankruptcies just experienced their largest quarterly increase in three years.

#13 The velocity of money in the United States has hit another stunning new low.

#14 The massive civil unrest in Egypt threatens to disrupt the steady flow of oil out of the Middle East…

After last week’s bloody crackdown by the Egyptian army, fears of a disruption of oil supplies to the West have boosted the oil price. Brent crude prices were propelled to a four-month high of $111.23 on Thursday. If the turmoil gets worse – or unrest spreads to other countries – the risk premium currently factored into the price of crude is likely to increase further.

#15 European stocks just experienced their biggest decline in six weeks.

#16 The Japanese national debt recently crossed the quadrillion yen mark, and many are expecting the Japanese financial system to start melting down at any time.

#17 In Indonesia, the stock market is “cratering“.

#18 In India, the yield on their 10 year government bonds has skyrocketed from 7.1 percent in May to 9.25 percent now.

As the coming months unfold, keep a close eye on the “too big to fail” banks both in Europe and in the United States.  When the next great financial crisis strikes, they will play a starring role once again.  They have been incredibly reckless, and as James Rickards told Greg Hunter during an interview the other day, we are in much worse shape to deal with a major banking crisis than we were back in 2008…

What’s going to cause the next crisis?  Rickards says, “The problem in 2008 was too-big-to-fail banks.  Well, those banks are now bigger.  Their derivative books are bigger.  In other words, everything that was wrong in 2008 is worse today.” Rickards goes on to warn, “The last time, in 2008 when the crisis started, the Fed’s balance sheet was $800 billion.  Today, the Fed’s balance sheet is $3.3 trillion and increasing at $1 trillion a year.”  Rickards contends, “You’re going to have a banking crisis worse than the last one because the banking system is bigger without the resources because the Fed is tapped out.”  As far as the Fed ending the money printing, Rickards predicts, “My view is they won’t.  The economy is fundamentally weak.  We have 50 million on food stamps, 24 million unemployed and 11 million on disability, and all these numbers are going up.”

We never even came close to recovering from the last financial crisis and the last recession.

Now the next major wave of the economic collapse is coming up quickly.

I hope that you are taking this time to prepare for the approaching storm, because it is going to be very painful.

What Is Going To Happen If Interest Rates Continue To Rise Rapidly?

Question MarkIf you want to track how close we are to the next financial collapse, there is one number that you need to be watching above all others.  The number that I am talking about is the yield on 10 year U.S. Treasuries, because it affects thousands of other interest rates in our financial system.  When the yield on 10 year U.S. Treasuries goes up, that is bad for the U.S. economy because it pushes long-term interest rates up.  When interest rates rise, it constricts the flow of credit, and a healthy flow of credit is absolutely essential to the debt-based system that we live in.  Just imagine someone squeezing a tube that has water flowing through it.  The higher interest rates go, the more economic activity will be squeezed.  If interest rates continue to rise rapidly, it will be more expensive for the U.S. government to borrow money, it will be more expensive for state and local governments to borrow money, the housing market may crash again, consumer debt will become more expensive, junk bond investors will be in for a world of hurt, the stock market will experience a tremendous amount of pain and there is a good chance that we could see the 441 trillion dollar interest rate derivatives bubble implode.  And that is just for starters.

So yes, we all need to be carefully watching the yield on 10 year U.S. Treasuries.  On Friday, it opened at 2.76% and hit a high of 2.86% before closing at 2.83%.  The yield on 10 year U.S. Treasuries is up nearly 120 basis points since the beginning of May, and almost everyone on Wall Street seems convinced that it is going to go much higher.

We are truly moving into unprecedented territory, because we have been in a bull market for U.S. Treasuries for the last 30 years.  Many investors don’t even know that it is possible to lose money on U.S. Treasuries.  They have been described as “risk-free” investments, but that is far from the truth.

In fact, we could see bond investors of all types end up losing trillions of dollars before it is all said and done.

And those in the stock market will lose lots of money too.  Low interest rates are good for economic activity which is good for the stock market.  The chart posted below shows that stock prices have generally risen as the yield on 10 year U.S. Treasuries has steadily declined over the past 30 years…

CFPGH-DJIA-20

When interest rates rise, that is bad for economic activity and bad for stocks.  That is why so many stock analysts are alarmed that interest rates are going up so rapidly right now.

And as I wrote about the other day, we have just witnessed the largest cluster of Hindenburg Omens that we have seen since before the last financial crisis.  The stock market already seems ripe for a huge “adjustment”, and rising interest rates could give it a huge extra push in a negative direction.

By the time it is all said and done, stock market investors could end up losing trillions of dollars in the next stock market crash.

In addition, rising interest rates could easily precipitate another housing crash.  As the Wall Street Journal discussed on Friday, as the yield on 10 year U.S. Treasuries goes up it will also cause mortgage rates to rise…

Higher yields will push up long-term borrowing cost for U.S. consumers and businesses. Mortgage rates will rise, and investors are keeping a close eye on whether this may derail the recovery of the housing market, which has shown signs of turning a corner this year.

In one of my previous articles, I included an example that shows just how powerful rising mortgage rates can be…

A year ago, the 30 year rate was sitting at 3.66 percent.  The monthly payment on a 30 year, $300,000 mortgage at that rate would be $1374.07.

If the 30 year rate rises to 8 percent, the monthly payment on a 30 year, $300,000 mortgage at that rate would be $2201.29.

Does 8 percent sound crazy to you?

It shouldn’t.  8 percent was considered to be normal back in the year 2000.

If you own a $300,000 house today, do you think it will be easier to sell it or harder to sell it if mortgage rates skyrocket?

Yes, of course it will be much harder.  In fact, there is a good chance that you will have to reduce your selling price significantly so that prospective buyers can afford the payments.

Let us hope that the yield on 10 year U.S. Treasuries levels off for a while.  If it says at this current level, the damage will probably not be too bad.

But if it crosses the 3 percent mark and keeps soaring, things could get messy pretty quickly.  In fact, according to a Bank of America Merrill Lynch investor survey, the 3.5 percent mark is when the collapse of the bond market is likely to become “disorderly”…

Our latest Credit Investor Survey, conducted July 8-11, showed that 3.5% on the 10-year is most commonly thought of as the trigger of a disorderly rotation – i.e. higher interest rates leading to outflows and wider credit spreads – among high grade investors.

Put differently, 3.0% on the 10-year will not lead to overall wider credit spreads if there is enough buying interest from institutional investors (though note that the 10s/30s spread curve would flatten further, as mutual fund/ETF holdings are concentrated in the belly of the curve, whereas institutional demand is disproportional in the long end of the curve). However, if the probability of a further move higher in interest rates to 3.5% is high – which will be the perception if interest rate volatility is high – certain institutional investors will choose to remain on the sidelines.

Thus there may not be enough institutional buying interest to mitigate retail fund outflows and contain overall high grade spread levels.

So what is causing this?

Well, there are a number of factors of course, but one very disturbing sign is that foreigners are selling off U.S. Treasuries at a pace that we have not seen since 2007…

One of the biggest fears in the financial markets is that foreign investors will stop buying U.S. Treasury securities, causing borrowing rates to surge.

Not that this is the beginning of a frightening trend, but new data from the Treasury Department shows that foreigners were net sellers in June. In fact, this is the largest net sale of U.S. securities since August 2007.

Do you remember all of the warnings that we have received over the years about what would take place when foreign countries started dumping U.S. debt?

Well, it looks like it may be starting to happen.

Unfortunately, there is no way that the party that the U.S. government has been throwing can continue without foreigners buying our debt.  We have added more than 11 trillion dollars to the national debt since the year 2000, and according to Boston University economist Laurence Kotlikoff we are facing unfunded liabilities in future years that are in excess of 200 trillion dollars.

Even with foreigners continuing to loan us gigantic mountains of super cheap money, it would still take a doubling of our taxes to put us on a fiscally sustainable course…

Writing in the September issue of Finance and Development, a journal of the International Monetary Fund, Prof. Kotlikoff says the IMF itself has quietly confirmed that the U.S. is in terrible fiscal trouble – far worse than the Washington-based lender of last resort has previously acknowledged. “The U.S. fiscal gap is huge,” the IMF asserted in a June report. “Closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 per cent of U.S. GDP.”

This sum is equal to all current U.S. federal taxes combined. The consequences of the IMF’s fiscal fix, a doubling of federal taxes in perpetuity, would be appalling – and possibly worse than appalling.

Prof. Kotlikoff says: “The IMF is saying that, to close this fiscal gap [by taxation] would require an immediate and permanent doubling of our personal income taxes, our corporate taxes and all other federal taxes.

“America’s fiscal gap is enormous – so massive that closing it appears impossible without immediate and radical reforms to its health care, tax and Social Security systems – as well as military and other discretionary spending cuts.”

Can you afford to pay twice as much in taxes to the federal government?

Very few Americans could.

But that is how serious the financial problems of the federal government are.

And all of the above assumes that interest payments on U.S. government debt will remain at current levels.  If the average rate of interest on U.S. government debt rises to just 6 percent, the U.S. government will be paying out a trillion dollars a year just in interest on the national debt.

Also, all of the above assumes that we will have a healthy financial system that does not need to be bailed out again.

But if rapidly rising interest rates cause the 441 trillion dollar interest rate derivatives bubble to implode, the bailout that the “too big to fail” banks will need will likely be far, far larger than last time.

In fact, once that bubble bursts there probably will not be enough money in the entire world to fix it.

If the picture that I have painted above sounds bleak, that is because it is bleak.

Sometimes I get frustrated with myself because I don’t feel I am communicating the tremendous danger that we are facing accurately enough.

We are heading for the worst financial crisis in modern human history, and the debt-fueled prosperity that we are enjoying today is going to go away and it is never going to come back.

You can dismiss that as “doom and gloom” and stick your head in the sand if you want, but that isn’t going to help anything.  Instead of ignoring reality you should be working hard to prepare your family for what is coming and warning others that they should be getting prepared too.

When a hurricane is approaching landfall, you don’t take your family out for a picnic at the beach.  That would be foolish.  Unfortunately, way too many Americans are acting as if nothing like the financial crisis of 2008 could ever possibly happen again.

If you deceive yourself into thinking that all of this is going to have a happy ending somehow, you are going to get blindsided by the coming storm.

But if you make preparations now, you might just be okay.

There is hope in understanding what is happening and there is hope in getting prepared.

So watch the yield on 10 year U.S. Treasuries.  The higher it goes, the later in the game we are.

The Most Important Number In The Entire U.S. Economy

WatchingThere is one vitally important number that everyone needs to be watching right now, and it doesn’t have anything to do with unemployment, inflation or housing.  If this number gets too high, it will collapse the entire U.S. financial system.  The number that I am talking about is the yield on 10 year U.S. Treasuries.  When that number goes up, long-term interest rates all across the financial system start increasing.  When long-term interest rates rise, it becomes more expensive for the federal government to borrow money, it becomes more expensive for state and local governments to borrow money, existing bonds lose value and bond investors lose a lot of money, mortgage rates go up and monthly payments on new mortgages rise, and interest rates throughout the entire economy go up and this causes economic activity to slow down.  On top of everything else, there are more than 440 trillion dollars worth of interest rate derivatives sitting out there, and rapidly rising interest rates could cause that gigantic time bomb to go off and implode our entire financial system.  We are living in the midst of the greatest debt bubble in the history of the world, and the only way that the game can continue is for interest rates to stay super low.  Unfortunately, the yield on 10 year U.S. Treasuries has started to rise, and many experts are projecting that it is going to continue to rise.

On August 2nd of last year, the yield on 10 year U.S. Treasuries was just 1.48%, and our entire debt-based economy was basking in the glow of ultra-low interest rates.  But now things are rapidly changing.  On Wednesday, the yield on 10 year U.S. Treasuries hit 2.70% before falling back to 2.58% on “good news” from the Federal Reserve.

Historically speaking, rates are still super low, but what is alarming is that it looks like we hit a “bottom” last year and that interest rates are only going to go up from here.  In fact, according to CNBC many experts believe that we will soon be pushing up toward the 3 percent mark…

Round numbers like 1,700 on the S&P 500 are well and good, but savvy traders have their minds on another integer: 2.75 percent

That was the high for the 10-year yield this year, and traders say yields are bound to go back to that level. The one overhanging question is how stocks will react when they see that number.

“If we start to push up to new highs on the 10-year yield so that’s the 2.75 level—I think you’d probably see a bit of anxiety creep back into the marketplace,” Bank of America Merrill Lynch’s head of global technical strategy, MacNeil Curry, told “Futures Now” on Tuesday.

And Curry sees yields getting back to that level in the short term, and then some. “In the next couple of weeks to two months or so I think we’ve got a push coming up to the 2.85, 2.95 zone,” he said.

This rise in interest rates has been expected for a very long time – it is just that nobody knew exactly when it would happen.  Now that it has begun, nobody is quite sure how high interest rates will eventually go.  For some very interesting technical analysis, I encourage everyone to check out an article by Peter Brandt that you can find right here.

And all of this is very bad news for stocks.  The chart below was created by Chartist Friend from Pittsburgh, and it shows that stock prices have generally risen as the yield on 10 year U.S. Treasuries has steadily declined over the past 30 years…

CFPGH-DJIA-20

When interest rates go down, that spurs economic activity, and that is good for stock prices.

So when interest rates start going up rapidly, that is not a good thing for the stock market at all.

The Federal Reserve has tried to keep long-term interest rates down by wildly printing money and buying bonds, and even the suggestion that the Fed may eventually “taper” quantitative easing caused the yield on 10 year U.S. Treasuries to absolutely soar a few weeks ago.

So the Fed has backed off on the “taper” talk for now, but what happens if the yield on 10 year U.S. Treasuries continues to rise even with the wild money printing that the Fed has been doing?

At that point, the Fed would begin to totally lose control over the situation.  And if that happens, Bill Fleckenstein told King World News the other day that he believes that we could see the stock market suddenly plunge by 25 percent…

Let’s say Ben (Bernanke) comes out tomorrow and says, ‘We are not going to taper.’ But let’s just say the bond market trades down anyway, and the next thing you know we go through the recent highs and a month from now the 10-Year is at 3%. And people start to realize they are not even tapering and the bond market is backed up….

They will say, ‘Why is this happening?’ Then they may realize the bond market is discounting the inflation we already have.

At some point the bond markets are going to say, ‘We are not comfortable with these policies.’ Obviously you can’t print money forever or no emerging country would ever have gone broke. So the bond market starts to back up and the economy gets worse than it is now because rates are rising. So the Fed says, ‘We can’t have this,’ and they decide to print more (money) and the bond market backs up (even more).

All of the sudden it becomes clear that money printing not only isn’t the solution, but it’s the problem. Well, with rates going from where they are to 3%+ on the 10-Year, one of these days the S&P futures are going to get destroyed. And if the computers ever get loose on the downside the market could break 25% in three days.

And as I have written about previously, we have seen a huge spike in margin debt in recent months, and this could make it even easier for a stock market collapse to happen.  A recent note from Deutsche Bank explained precisely why margin debt is so dangerous

Margin debt can be described as a tool used by stock speculators to borrow money from brokerages to buy more stock than they could otherwise afford on their own. These loans are collateralized by stock holdings, so when the market goes south, investors are either required to inject more cash/assets or become forced to sell immediately to pay off their loans – sometimes leading to mass pullouts or crashes.

But of much greater concern than a stock market crash is the 441 trillion dollar interest rate derivatives bubble that could implode if interest rates continue to rise rapidly.

Deutsche Bank is the largest bank in Europe, and at this point they have 55.6 trillion euros of total exposure to derivatives.

But the GDP of the entire nation of Germany is only about 2.7 trillion euros for a whole year.

We are facing a similar situation in the United States.  Our GDP for 2013 will be somewhere between 15 and 16 trillion dollars, but many of our big banks have exposure to derivatives that absolutely dwarfs our GDP.  The following numbers come from one of my previous articles entitled “The Coming Derivatives Panic That Will Destroy Global Financial Markets“…

JPMorgan Chase

Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

Citibank

Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)

Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)

Bank Of America

Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)

Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)

Goldman Sachs

Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)

Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.

And remember, the biggest chunk of those derivatives contracts is made up of interest rate derivatives.

Just imagine what would happen if a life insurance company wrote millions upon millions of life insurance contracts and then everyone suddenly died.

What would happen to that life insurance company?

It would go completely broke of course.

Well, that is what our major banks are facing today.

They have written trillions upon trillions of dollars worth of interest rate derivatives contracts, and they are betting that interest rates will not go up rapidly.

But what if they do?

And the truth is that interest rates have a whole lot of room to go up.  The chart below shows how the yield on 10 year U.S. Treasuries has moved over the past couple of decades…

10 Year Treasury Yield

As you can see, the yield on 10 year U.S. Treasuries was hovering around the 6 percent mark back in the year 2000.

Back in 1990, the yield on 10 year U.S. Treasuries hovered between 8 and 9 percent.

If we return to “normal” levels, our financial system will implode.  There is no way that our debt-addicted system would be able to handle it.

So watch the yield on 10 year U.S. Treasuries very carefully.  It is the most important number in the entire U.S. economy.

If that number gets too high, the game is over.

A Nightmare Scenario

NightmareMost people have no idea that the U.S. financial system is on the brink of utter disaster.  If interest rates continue to rise rapidly, the U.S. economy is going to be facing an economic crisis far greater than the one that erupted back in 2008.  At this point, the economic paradigm that the Federal Reserve has constructed only works if interest rates remain super low.  If they rise, everything falls apart.  Much higher interest rates would mean crippling interest payments on the national debt, much higher borrowing costs for state and local governments, trillions of dollars of losses for bond investors, another devastating real estate crash and the possibility of a multi-trillion dollar derivatives meltdown.  Everything depends on interest rates staying low.  Unfortunately for the Fed, it only has a certain amount of control over long-term interest rates, and that control appears to be slipping.  The yield on 10 year U.S. Treasuries has soared in recent weeks.  So have mortgage rates.  Fortunately, rates have leveled off for the moment, but if they resume their upward march we could be dealing with a nightmare scenario very, very quickly.

In particular, the yield on 10 year U.S. Treasuries is a very important number to watch.  So much else in our financial system depends on that number as CNN recently explained…

Indeed, since May, just before Bernanke announced a probable end to QE3, the yield on 10-year Treasuries has jumped around almost one percentage point, to 2.6%, wiping out more than two years of interest payments. The markets clearly fear that far higher long-term rates are lurking in the absence of exceptional policies to rein them in.

That’s a crucial issue, because those rates are highly influential in determining the future performance of stocks, bonds, and real estate. Investors grant equities higher multiples when long-term rates are lower; both longer-maturity Treasuries and corporate bonds jump when rates decline; and developers pocket more cash flow from their projects when they borrow cheaply, raising the values of office and apartment buildings. When rates reverse course, so do all of those prices the Fed has been endeavoring to swell as a tonic for the economy.

Even though the yield on 10 year U.S. Treasuries has risen substantially, it is still very low.  It has a lot more room to go up.  In fact, as the chart posted below demonstrates, the yield on 10 year U.S. Treasuries was above 6 percent back in the year 2000…

10 Year Treasury Yield

And the yield on 10 year U.S. Treasuries should rise substantially.  It simply is not rational to lend the U.S. government money at less than 3 percent when the real rate of inflation is about 8 percent, the Federal Reserve is rapidly debasing the currency by wildly printing money and the federal government has been piling up debt as if there is no tomorrow…

National Debt

Anyone that lends the U.S. government money at current rates is being very foolish.  You will end up getting back money that has much less purchasing power than you originally invested.

Why would anyone do that?

But if interest rates rise, the U.S. government could be looking at some very hairy interest payments very rapidly.  For example, if the average rate of interest on U.S. government debt just gets back to 6 percent (and it has been far higher than that in the past), the federal government will be shelling out a trillion dollars a year just in interest on the national debt.

State and local governments all over the nation could also very rapidly be facing a nightmare scenario.

Detroit is already on the verge of formally declaring the largest municipal bankruptcy in the history of the United States, and there are many other state and local governments from coast to coast that are rapidly heading toward financial disaster even though borrowing costs are super low right now.

If interest rates start rising dramatically, it would cause a huge wave of municipal financial disasters, and municipal bond investors would lose massive amounts of money

“Muni bond investors are in for the shock of their lives,” said financial advisor Ric Edelman. “For the past 30 years there hasn’t been interest rate risk.”

That risk can be extreme. A one-point rise in the interest rate could cut 10 percent of the value of a municipal bond with a longer duration, he said.

Many retail buyers, though, are not ready for the change and “when it starts, it will be too late for them to react,” he said, adding that he was encouraging investors to look at their portfolio allocation and make changes to protect themselves from interest rate risks now.

In fact, bond investors of all types could be facing monstrous losses if interest rates go up dramatically.

It is being projected that if U.S. Treasury yields rise by an average of 3 percentage points, it will cause bond investors to lose a trillion dollars.

And already we have started to see a race for the exits in the bond market.  A total of 80 billion dollars was pulled out of bond funds during the month of June alone.  If you want a visual of the flow of money out of the bond market, just check out the chart in this article.

We are witnessing things happen in the financial markets that have not happened in a very, very long time.

And junk bonds will be hit particularly hard.  About a decade ago, the average yield on junk bonds was about twice what it is right now.  When the junk bond crash comes, there is going to be mass carnage on Wall Street.

But of much greater importance to most Americans is what is happening to mortgage rates.  As mortgage rates rise, it becomes much more difficult to sell a house and much more expensive to buy a house.

According to CNBC, there is an increasing amount of concern that the rise in mortgage rates that we are witnessing could throw the real estate market into absolute turmoil…

The housing recovery is in for a major pause due to higher mortgage rates. It is not in the numbers now, and it won’t be for a few months, but it is coming, according to one noted analyst. The market has seen rising rates before, but never so far so fast; there is no precedent for a 45 percent spike in just six weeks. The spike is causing a sense of urgency now, a rush to buy before rates go higher, but that will be short term. Home sales and home prices will both come down if rates don’t return to their lows, and the expectation is that they will not.

We have seen the number of mortgage applications fall for four weeks in a row, and at this point mortgage applications have declined by 28 percent over the past month.

That is an absolutely stunning decline, but it just shows the power of interest rates.

Let’s try to put this into real world terms.

A year ago, the 30 year rate was sitting at 3.66 percent.  The monthly payment on a 30 year, $300,000 mortgage at that rate would be $1374.07.

If the 30 year rate rises to 8 percent, the monthly payment on a 30 year, $300,000 mortgage at that rate would be $2201.29.

Does 8 percent sound crazy to you?

It shouldn’t.  8 percent was considered to be normal back in the year 2000…

30 Year Mortgage Rate

This is what we are talking about when we talk about the “bubbles” that the Federal Reserve has created.  The housing market is now completely and totally dependent on these artificially low mortgage rates.  If rates go back to “normal”, the results would be absolutely devastating.

But of course the biggest problem with rapidly rising interest rates is the potential for a derivatives crisis.

There are several major U.S. banks that have tens of trillions of dollars of exposure to derivatives.  The following is from one of my previous articles entitled “The Coming Derivatives Panic That Will Destroy Global Financial Markets“…

JPMorgan Chase

Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

Citibank

Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)

Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)

Bank Of America

Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)

Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)

Goldman Sachs

Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)

Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.

The largest chunk of those derivatives contracts is made up of interest rate derivatives.

I have mentioned this so many times before, but it bears repeating that there are approximately 441 trillion dollars worth of interest rate derivatives sitting out there.

If rapidly rising interest rates suddenly cause trillions of dollars of those bets to start going bad, we could potentially see several of the “too big to fail” banks collapse at the same time.

So what would happen then?

Would the federal government and the Federal Reserve somehow come up with trillions of dollars (or potentially even tens of trillions of dollars) to bail them out?

The Federal Reserve has created a giant mess, and when this current low interest rate bubble ends our financial system is going to slam very violently into a very solid brick wall.

As Graham Summers recently pointed out, entrusting Federal Reserve Chairman Ben Bernanke with control of our financial system is like putting a madman behind the wheel of a speeding vehicle…

Imagine if you were in the car with a driver who was going 85 MPH down a road with a speed limit of 35 MPH (this isn’t a bad metaphor as there is absolutely no evidence that QE creates jobs or GDP growth so there is no reason for the Fed to be doing it in the first place).

The guy is obviously out of control. The dangers of driving this fast are myriad (crashing, running someone over, etc.) while the benefits (you might get where you want to go a little faster assuming you don’t crash) are minimal.

Now imagine that the driver turned to you and said, “I’m thinking about slowing down.” Seems like a great idea doesn’t it? But then a mere two minutes later he says “ we need to continue at 85 MPH for the foreseeable future.”

At this point any sane person would scream, “STOP.” The driver is clearly a madman and shouldn’t be let anywhere near the driver’s seat. Moreover, he’s totally lost all credibility and isn’t to be trusted.

That’s our Fed Chairman.

Sadly, most Americans do not understand any of this.

Most Americans have no idea about the immense economic pain that is going to hit us when interest rates go back to normal levels.

All of this could have been avoided, but instead the American people let the central planners over at the Federal Reserve run wild.

When the bubble finally bursts, the official unemployment rate is going to rocket well up into the double digits, millions of families will lose their homes and America will find itself in the middle of the worst economic crisis in modern U.S. history.

Please share this article with as many people as you can.  We need to help people understand what is coming so that they will not be blindsided by it.

Have Central Bankers Lost Control? Could The Bond Bubble Implode Even If There Is No Tapering?

Panic - Photo by Wes WashingtonAre the central banks of the world starting to lose control of the financial markets?  Could we be facing a situation where the bond bubble is going to inevitably implode no matter what the central bankers do?  For the past several years, the central bankers of the planet have been able to get markets to do exactly what they want them to do.  Stock markets have soared to record highs, bond yields have plunged to record lows and investors have literally hung on every word uttered by Federal Reserve Chairman Ben Bernanke and other prominent central bankers.  In the United States, it has been remarkable what Bernanke has been able to accomplish.  The U.S. government has been indulging in an unprecedented debt binge, the Fed has been wildly printing money, and the real rate of inflation has been hovering around 8 to 10 percent, and yet Bernanke has somehow convinced investors to lend gigantic piles of money to the U.S. government for next to nothing.  But this irrational state of affairs is not going to last indefinitely.  At some point, investors are going to wake up and start demanding higher returns.  And we are already starting to see this happen in Japan.  Wild money printing has actually caused bond yields to go up.  What a concept!  And that is what should happen – when central banks recklessly print money it should cause investors to demand a higher return.  But if bond investors all over the globe start acting rationally, that is going to cause the largest bond bubble in the history of the planet to burst, and that will create utter devastation in the financial markets.

Central banks can manipulate the financial system in the short-term, but there is usually a tremendous price to pay for the distortions that are caused in the long-term.

In Bernanke’s case, all of this quantitative easing seemed to work well for a while.  The first round gave the financial system a nice boost, and so the Fed decided to do another.  The second round had less effect, but it still boosted stocks and caused bond yields to go down.  The third round was supposed to be the biggest of all, but it had even less of an effect than the second round.  If you doubt this, just check out the charts in this article.

Our financial system has become addicted to this financial “smack”.  But like any addict, the amount needed to get the same “buzz” just keeps increasing.  Unfortunately, the more money that the Fed prints, the more distorted our financial system becomes.

The only way that this is going to end is with a tremendous amount of pain.  There is no free lunch, and there are already signs that investors are starting to wake up to this fact.

As investors wake up, they are going to realize that this bond bubble is irrational and entirely unsustainable.  Once the race to the exits begins, it is not going to be pretty.  In fact, the are indications that the race to the exits has already begun

During the month of June, fixed income allocations fell to a four-year low, according to the American Association of Individual Investors, as major bond fund managers like Pimco experienced record withdrawals for the second quarter. That pullback sent places like emerging markets and high-yield bonds reeling—just as the Federal Reserve signaled plans to taper its easy-money policies within the coming years. Benchmark bond yields ticked up on that news, and in an unexpected twist, the stock market nosedived as well.

A lot of people out there have been floating the theory that the Fed will decide not to taper at all and that quantitative easing will continue at the same pace and therefore the markets will settle back down.

But what if they don’t settle back down?

Could the bond bubble implode even if there is no tapering?

That is what some are now suggesting.  For example, Detlev Schlichter is pointing to what has been happening in Japan as an indication that the paradigm has changed…

My conclusion is this: if market weakness is the result of concerns over an end to policy accommodation, then I don’t think markets have that much to fear. However, the largest sell-offs occurred in Japan, and in Japan there is not only no risk of policy tightening, there policy-makers are just at the beginning of the largest, most loudly advertised money-printing operation in history. Japanese government bonds and Japanese stocks are hardly nose-diving because they fear an end to QE. Have those who deal in these assets finally realized that they are sitting on gigantic bubbles and are they trying to exit before everybody else does? Have central bankers there lost control over markets?

After all, money printing must lead to higher inflation at some point. The combination in Japan of a gigantic pile of accumulated debt, high running budget deficits, an old and aging population, near-zero interest rates and the prospect of rising inflation (indeed, that is the official goal of Abenomics!) are a toxic mix for the bond market. It is absurd to assume that you can destroy your currency and dispossess your bond investors and at the same time expect them to reward you with low market yields. Rising yields, however, will derail Abenomics and the whole economy, for that matter.

The financial situation in Japan is actually very similar to the financial situation in the United States.  We both have “a gigantic pile of accumulated debt, high running budget deficits, an old and aging population, near-zero interest rates and the prospect of rising inflation”.  In both cases, rational investors should demand higher returns when the central bank fires up the printing presses.

And if interest rates on U.S. Treasury bonds start to rise to rational levels, the U.S. government is going to have to pay more to borrow money, state and local governments are going to have to pay more to borrow money, junk bonds will crash, the market for home mortgages will shrivel up and economic activity in this country will slow down substantially.

Plus, as I am fond of reminding everyone, there is a 441 trillion dollar interest rate derivatives time bomb sitting out there that rapidly rising interest rates could set off.

So needless to say, the Federal Reserve is scared to death of what higher interest rates would mean.

But at this point, they may have lost control of the situation.

The Trigger Has Been Pulled And The Slaughter Of The Bonds Has Begun

The Bears Are Unleashed On Wall StreetWhat does it look like when a 30 year bull market ends abruptly?  What happens when bond yields start doing things that they haven’t done in 50 years?  If your answer to those questions involves the word “slaughter”, you are probably on the right track.  Right now, bonds are being absolutely slaughtered, and this is only just the beginning.  Over the last several years, reckless bond buying by the Federal Reserve has forced yields down to absolutely ridiculous levels.  For example, it simply is not rational to lend the U.S. government money at less than 3 percent when the real rate of inflation is somewhere up around 8 to 10 percent.  But when he originally announced the quantitative easing program, Federal Reserve Chairman Ben Bernanke said that he intended to force interest rates to go down, and lots of bond investors made a lot of money riding the bubble that Bernanke created.  But now that Bernanke has indicated that the bond buying will be coming to an end, investors are going into panic mode and the bond bubble is starting to burst.  One hedge fund executive told CNBC that the “feeling you are getting out there is that people are selling first and asking questions later”.  And the yield on 10 year U.S. Treasuries just keeps going up.  Today it closed at 2.59 percent, and many believe that it is going to go much higher unless the Fed intervenes.  If the Fed does not intervene and allows the bubble that it has created to burst, we are going to see unprecedented carnage.

Markets tend to fall faster than they rise.  And now that Bernanke has triggered a sell-off in bonds, things are moving much faster than just about anyone anticipated

Wall Street never thought it would be this bad.

Over the last two months, and particularly over the last two weeks, investors have been exiting their bond investments with unexpected ferocity, moves that continued through Monday.

A bond sell-off has been anticipated for years, given the long run of popularity that corporate and government bonds have enjoyed. But most strategists expected that investors would slowly transfer out of bonds, allowing interest rates to slowly drift up.

Instead, since the Federal Reserve chairman, Ben S. Bernanke, recently suggested that the strength of the economic recovery might allow the Fed to slow down its bond-buying program, waves of selling have convulsed the markets.

In particular, junk bonds are getting absolutely hammered.  Money is flowing out of high risk corporate debt at an astounding pace

The SPDR Barclays High Yield Bond exchange-traded fund has declined 5 percent over the past month, though it rose in Tuesday trading. The fund has seen $2.7 billion in outflows year to date, according to IndexUniverse.

Another popular junk ETF, the iShares iBoxx $ High Yield Corporate Bond, has seen nearly $2 billion in outflows this year and is off 3.4 percent over the past five days alone.

Investors pulled $333 million from high-yield funds last week, according to Lipper.

While correlating to the general trend in fixed income, the slowdown in the junk bond business bodes especially troubling signs for investment banks, which have relied on the debt markets for fully one-third of their business this year, the highest percentage in 10 years.

The chart posted below comes from the Federal Reserve, and it “represents the effective yield of the BofA Merrill Lynch US High Yield Master II Index, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market.”  In other words, it is a measure of the yield on junk bonds.  As you can see, the yield on junk bonds sank to ridiculous lows in May, but since then it has been absolutely skyrocketing…

Junk Bonds

So why should the average American care about this?

Well, if the era of “cheap money” is over and businesses have to pay more to borrow, that is going to cause economic activity to slow down.

There won’t be as many jobs, part-time workers will get less hours, and raises will become more infrequent.

Those are just some of the reasons why you should care about this stuff.

Municipal bonds are being absolutely crushed right now too.  You see, when yields on U.S. government debt rise, they also rise on state and local government debt.

In fact, things have been so bad that hundreds of millions of dollars of municipal bond sales have been postponed in recent days…

With yields on the U.S. municipal bond market rising, local issuers on Monday postponed another six bond sales, totaling $331 million, that were originally scheduled to price later this week.

Since mid-June, on the prospect that the Federal Reserve could change course on its easy monetary policy as the economy improves, the municipal bond market has seen a total of $2.6 billion in sales either canceled or delayed.

If borrowing costs for state and local governments rise, they won’t be able to spend as much money, they won’t be able to hire as many workers, they will need to find more revenue (tax increases), and more of them will go bankrupt.

And what we are witnessing right now is just the beginning.  Things are going to get MUCH worse.  The following is what Robert Wenzel recently had to say about the municipal bond market…

Thus, there is only one direction for rates: UP, with muni bonds leading the decline, given that the financial structures of many municipalities are teetering. There is absolutely no good reason to be in municipal bonds now. And muni ETFs will be a worse place to be, given this is relatively HOT money that will try to get out of the exit door all at once.

But, as I wrote about yesterday, the worst part of the slaughter is going to be when the 441 trillion dollar interest rate derivatives time bomb starts exploding.  If bond yields continue to soar, eventually it will take down some very large financial institutions.  The following is from a recent article by Bill Holter

Please understand how many of these interest rate derivatives work.  When the rates go against you, “margin” must be posted.  By “margin” I mean collateral.  Collateral must be shifted from the losing institution to the one on the winning side.  When the loser “runs out” of collateral…that is when you get a situation similar to MF Global or Lehman Bros., they are forced to shut down and the vultures then come in and pick the bones clean…normally.  Now it is no longer “normal,” now a Lehman Bros will take the whole tent down.

Most people have no idea how vulnerable our financial system is.  It is a house of cards of risk, debt and leverage.  Wall Street has become the largest casino in the history of the planet, and the wheels could come off literally at any time.

And it certainly does not help that a whole host of cyclical trends appear to be working against us.  Posted below is an extended excerpt from a recent article by Taki Tsaklanos and GE Christenson

**********

Charles Nenner Research (source)

Stocks should peak in mid-2013 and fall until about 2020.  Similarly, bonds should peak in the summer of 2013 and fall thereafter for 20 years.  He bases his conclusions entirely on cycle research.  He expects the Dow to fall to around 5,000 by 2018 – 2020.

Kress Cycles by Clif Droke (source)

The major 120 year cycle plus all minor cycles trend down into late 2014.  The stock market should decline hard into late 2014.

Elliott Wave Cycles by Robert Prechter (source)

He believes that the stock market has peaked and has entered a generational bear-market.  He anticipates a crash low in the market around 2016 – 2017.

Market Energy Wave (source)

He sees a 36 year cycle in stock markets that is peaking in mid-2013 and down 2013 – 2016.  “… the controlling energy wave is scheduled to flip back to negative on July 19 of this year.”  Equity markets should drop 25 – 50%.

Armstrong Economics (source)

His economic confidence model projects a peak in confidence in August 2013, a bottom in September 2014, and another peak in October 2015.  The decline into January 2020 should be severe.  He expects a world-wide crash and contraction in economies from 2015 – 2020.

Cycles per Charles Hugh Smith (source)

He discusses four long-term cycles that bottom roughly in the 2010 – 2020 period.  They are:  Credit expansion/contraction cycle;  Price inflation/wage cycle; Generational cycle;  and Peak oil extraction cycle.

Harry Dent – Demographics (source)

Stock prices should drop, on average for the balance of this decade.  Demographic cycles in the United States (and elsewhere) indicate a contraction in real terms for most of this decade.

**********

I was stunned when I originally read through that list.

Is it just a coincidence that so many researchers have come to such a similar conclusion?

The central banks of the world could attempt to “kick the can down the road” by buying up lots and lots of bonds, but it does not appear that is going to happen.

The Federal Reserve may not listen to the American people, but there is one institution that the Fed listens to very carefully – the Bank for International Settlements.  It is the central bank of central banks, and today 58 global central banks belong to the BIS.  Every two months, the central bankers of the world (including Bernanke) gather in Basel, Switzerland for a “Global Economy Meeting”.  At those meetings, decisions are made which affect every man, woman and child on the planet.

And the BIS has just come out with its annual report.  In that annual report, the BIS says that central banks “cannot do more without compounding the risks they have already created”, and that central banks should “encourage needed adjustments” in the financial markets.  In other words, the BIS is saying that it is time to end the bond buying

The Basel-based BIS – known as the central bank of central banks – said in its annual report that using current monetary policy employed in the euro zone, the U.K., Japan and the U.S. will not bring about much-needed labor and product market reforms and is a recipe for failure.

“Central banks cannot do more without compounding the risks they have already created,” it said in its latest annual report released on Sunday. “[They must] encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever-larger quantities of government securities.”

So expect central banks to start scaling back their intervention in the marketplace.

Yes, this is probably going to cause interest rates to rise dramatically and cause all sorts of chaos as the bubble that they created implodes.

It could even potentially cause a worse financial crisis than we saw back in 2008.

If that happens, the central banks of the world can swoop in and try to save us with their bond buying once again.

Isn’t our system wonderful?

The 441 TRILLION Dollar Interest Rate Derivatives Time Bomb

The Derivatives Time BombDo you want to know the primary reason why rapidly rising interest rates could take down the entire global financial system?  Most people might think that it would be because the U.S. government would have to pay much more interest on the national debt.  And yes, if the average rate of interest on U.S. government debt rose to just 6 percent (and it has actually been much higher in the past), the federal government would be paying out about a trillion dollars a year just in interest on the national debt.  But that isn’t it.  Nor does the primary reason have to do with the fact that rapidly rising interest rates would impose massive losses on bond investors.  At this point, it is being projected that if U.S. bond yields rise by an average of 3 percentage points, it will cause investors to lose a trillion dollars.  Yes, that is a 1 with 12 zeroes after it ($1,000,000,000,000).  But that is not the number one danger posed by rapidly rising interest rates either.  Rather, the number one reason why rapidly rising interest rates could cause the entire global financial system to crash is because there are more than 441 TRILLION dollars worth of interest rate derivatives sitting out there.  This number comes directly from the Bank for International Settlements – the central bank of central banks.  In other words, more than $441,000,000,000,000 has been bet on the movement of interest rates.  Normally these bets do not cause a major problem because rates tend to move very slowly and the system stays balanced.  But now rates are starting to skyrocket, and the sophisticated financial models used by derivatives traders do not account for this kind of movement.

So what does all of this mean?

It means that the global financial system is potentially heading for massive amounts of trouble if interest rates continue to soar.

Today, the yield on 10 year U.S. Treasury bonds rocketed up to 2.66% before settling back to 2.55%.  The chart posted below shows how dramatically the yield on 10 year U.S. Treasuries has moved in recent days…

10 Year Treasury Yield

Right now, the yield on 10 year U.S. Treasuries is about 30 percent above its 50 day moving average.  That is the most that it has been above its 50 day moving average in 50 years.

Like I mentioned above, we are moving into uncharted territory and this data doesn’t really fit into the models used by derivatives traders.

The yield on 5 year U.S. Treasuries has been moving even more dramatically…

5 Year Treasury Yield

Last week, the yield on 5 year U.S. Treasuries rose by an astounding 37 percent.  That was the largest increase in 50 years.

Once again, this is uncharted territory.

If rates continue to shoot up, there are going to be some financial institutions out there that are going to start losing absolutely massive amounts of money on interest rate derivative contracts.

So exactly what is an interest rate derivative?

The following is how Investopedia defines interest rate derivatives…

A financial instrument based on an underlying financial security whose value is affected by changes in interest rates. Interest-rate derivatives are hedges used by institutional investors such as banks to combat the changes in market interest rates. Individual investors are more likely to use interest-rate derivatives as a speculative tool – they hope to profit from their guesses about which direction market interest rates will move.

They can be very complicated, but I prefer to think of them in very simple terms.  Just imagine walking into a casino and placing a bet that the yield on 10 year U.S. Treasuries will hit 2.75% in July.  If it does reach that level, you win.  If it doesn’t, you lose.  That is a very simplistic example, but I think that it is a helpful one.  At the heart of it, the 441 TRILLION dollar derivatives market is just a bunch of people making bets about which way interest rates will go.

And normally the betting stays very balanced and our financial system is not threatened.  The people that run this betting use models that are far more sophisticated than anything that Las Vegas uses.  But all models are based on human assumptions, and wild swings in interest rates could break their models and potentially start causing financial losses on a scale that our financial system has never seen before.

We are potentially talking about a financial collapse far worse than anything that we saw back in 2008.

Remember, the U.S. national debt is just now approaching 17 trillion dollars.  So when you are talking about 441 trillion dollars you are talking about an amount of money that is almost unimaginable.

Meanwhile, China appears to be on the verge of another financial crisis as well.  The following is from a recent article by Graham Summers

China is on the verge of a “Lehman” moment as its shadow banking system implodes. China had pumped roughly $1.6 trillion in new credit (that’s 21% of GDP) into its economy in the last two quarters… and China GDP growth is in fact slowing.

This is what a credit bubble bursting looks like: the pumping becomes more and more frantic with less and less returns.

And Chinese stocks just experienced their largest decline since 2009.  The second largest economy on earth is starting to have significant financial problems at the same time that our markets are starting to crumble.

Not good.

And don’t forget about Europe.  European stocks have had a very, very rough month so far

The narrow EuroStoxx 50 index is now at its lowest in over seven months (-5.4% year-to-date and -12.5% from its highs in May) and the broader EuroStoxx 600 is also flailing lower. The European bank stocks pushed down to their lowest in almost 10 months and are now in bear market territory – down 22.5% from their highs. Spain and Italy are now testing their lowest level in 9 months.

So are the central banks of the world going to swoop in and rescue the financial markets from the brink of disaster?

At this point it does not appear likely.

As I have written about previously, the Bank for International Settlements is the central bank for central banks, and it has a tremendous amount of influence over central bank policy all over the planet.

The other day, the general manager of the Bank for International Settlements, Jaime Caruana, gave a speech entitled “Making the most of borrowed time“.  In that speech, he made it clear that the era of extraordinary central bank intervention was coming to an end.  The following is one short excerpt from that speech…

“Ours is a call for acting responsibly now to strengthen growth and avoid even costlier adjustment down the road. And it is a call for recognizing that returning to stability and prosperity is a shared responsibility. Monetary policy has done its part. Recovery now calls for a different policy mix – with more emphasis on strengthening economic flexibility and dynamism and stabilizing public finances.”

Monetary policy has done its part?

That sounds pretty firm.

And if you read the entire speech, you will see that Caruana makes it clear that he believes that it is time for the financial markets to stand on their own.

But will they be able to?

As I wrote about yesterday, the U.S. financial system is a massive Ponzi scheme that is on the verge of imploding.  Unprecedented intervention by the Federal Reserve has helped to prop it up for the last couple of years, and there is a lot of fear in the financial world about what is going to happen once that unprecedented intervention is gone.

So what happens next?

Well, nobody knows for sure, but one thing seems certain.  The last half of 2013 is shaping up to be very, very interesting.

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