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XMFSinchiruna (26.59)

A Tale of Two Recoveries: Our Unfortunate Macroeconomic Reality in One Bloated Nutshell



October 22, 2009 – Comments (15)

These are the best of times, and these are the worst of times. The distinction lies in your position on the globe.

You may have heard from any number of financial pundits that the late-2008 paralysis observed throughout the world's economies, and the depth of the commodities correction, had proven decoupling to be nothing more than an unrealized myth. They mistook panic's pause as a lasting linkage between the economies of the old and new guard, and they deemed China's economy in particular unable to sustain growth while shedding its dependence upon the Western export market. They were wrong.


China is on fire. That in itself increases the likelihood of a correction there as well, as a nation can only stockpile so nany natural resources. However, at the most fundamental level, China is not exposed to the same constraints to growth that America and Europe now face.

So much that was built upon leverage must still recede in the West, while the East scurries to convert its large coffers of Western currency into strategic assets of all kinds. Please don't gloss over the last point simply because I've said it many times before. That fact lies at the heart of understanding the economic world at this moment in time. Also key is comprehending the significance of China's announcement last month that Chinese state-controlled entities would be permitted to unilaterally walk away from failed derivative obligations. The moment that occurs, global credit markets freeze again, and we will see just how premature it was for economists to retire the term "systemic risk". Letus all hope that was merely some sort of diplomatic faceoff.

Those who mistook the admittedly horrendous commodities correction as the popping of a bubble ... the end of an era ... think again. The engines of industrial demand are revving up throughout the greater Australasian region, in at least three of the four BRICs, and in the emerging and frontier markets bolstered thereby. It's a tale of two response strategies and two stimulus programs. It's a tale of two positions within the broadest of economic cycles. It's a tale of two poles in the balance of economic power. It's a tale of two legendary empire-builders. Ultimately, it's a tale of two reserve currency regimes.

It's a Tale of Two Recoveries - Please read, rec, and return. :) [This piece was my original reason for posting.]


The outlook for Europe and the U.S., unfortunately, remains both painfully obvious and woefully contrary. This is an instance of terminal leverage. It is the end of an era, and requires a shift in economic paradigms.

This is not a global depression, but a Western Depression ... a deleveraging event that will continue to target assets in those nations whose financial institutions brought those derivative demons into existence until the demons turned on their masters. Derivatives, dear Fools, are denominated (in their enormous majority) in dollars and Euros ... the currencies of the "old guard" in the now-shifting balance of global power. They are still, many hundreds of trillions of dollars worth of them, effectively worthless because they have no liquid market in the absence of government guarantees and shady swapping mechanisms shrouded in the FED's unaudited books.

As noted by fellow blogger KDakota, Niall Ferguson understands that we are witnessing before our very eyes the decline of the American financial empire. I can't predict how it will play out, nor how long it will take, but the events of 2008 were the tipping point in a peaking phase that began some years earlier (perhaps when the dollar began losing its grip and derivatives flourished shortly after the millenium). Maybe decoupling is the wrong word ... does dethroning create a clearer image of what's happening?

Decoupling Confirmed

My evidence for declaring decoupling a defensible present reality, rather than a debunked theory, is all contained within the links embedded into my Peabody Energy article linked above (or here). I will post additional links to relevant articles below.

If you have eliminated the three 'd' s (decoupling, derivatives, and depression) from your personal economic lexicon, I urge you to reinsert them for fresh consideration. As much as I wish that I could bury those words in the past the way the financial media has ventured to do, the words are staring at us from the edge of their oblivion and wondering whether the world has simply gone illiterate. 

Is there anyone left out there who thinks the broader equity rally remains sustainable? Is anyone out there still lending an ear to poor mixed-up Mr. Krugman, and thinks more stimulus is the answer? Stimulus was never the answer.

If the rally is so clearly divorced from fundamental reality, then why does it not implode?

If you adjust the rally for the deterioration of the USD that occured simultaneously, you are left with a 35% rally. Now, ask yourself, how much of that 35% rally can be directly attributed from a fundamental viewpoint to the massive interventions and guarantees to thaw the frozen capital markets? Then ask yourself, what remaining portion of this rally has been constructed atop constructed and spun expectations of a recovery that is unfortunately not in the cards with any semblance of sustainability.

I believe that this is the cold, hard truth. I understand that many will retain differing interpretations of the evidence I cite, but I challenge anyone to construct a an alternate case on the merits of countering evidence alone. In fact, as I've repeatedly said, I would like nothing more than to be wrong. This is, after all, my beloved country. At stake is the very well being of my fellow countrymen and Fools. I concede that the conclusions I have drawn sadden me. I write because I hope some will really approach the topic with an open mind and consider the evidence on the merits. I welcome reasoned debate, again, on the merits. Please, debunk me so I'll feel better about our collective financial future. I want to be wrong ... I hope I am wrong ...... Time will tell.


POSCO's Furnaces Blaze Into Recovery

Derivatives Are Daggers to the Dollar

Profit From China's Exploding Resource Blitz

Time to Crank-Start the American Industrial Machine

Systemic Risk for European shipping-related financial interests (Hamburg, London, Piraeus, etc.)

Saddle Up for the Straight Talk Express

Don't be Tempted by Illusory Steel Demand 

Recovery Gets Harder to Haul

Coal Investors in a Quandry

Hidden Treasure in Leftover Clunkers

A Contrarian View on Housing

Round II of the Mortgage Meltdown is still waiting for us

Considering a New Investment Paradigm

The Untold Story Behind This Golden Breakout  [Even if you eschew gold, it's critical to understand.]

Fools please understand that the stagflation we face is a currency event, and not a demand-pull consumer pricing event. Jim Sinclair has been one of several voices of reason on this front. If you take one thing away from Jim Sinclair, let it be this:

"Financial TV’s new spin is that crude is the new gold. What they have missed is that crude is your first example of how a currency has the potential of delivering hyperinflation as cost push without any meaningful demand pull."

As I stated in the Peabody piece, the tenuous condition of the dollar underlines a key currency component of the decoupling phenomenon.

Gold's Next Monster Move

Gold Overload

By the way, for anyone interested ... Here is Jim Sinclair's formula, which he offered back in 2006 as his scenario for how continued currency devaluation (which he saw as baked into the cake) would play out. I don't know about you, but I think he's nailed 10 out of 10 so far, and the other two are looking pretty likely to me.

It's the guys who have been consistently right that I still want to be paying attention to.

Final thought: The impossible reflation/releveraging strategy at the heart of the collective response to this fiscal crisis is, still, at the heart of the matter when considering our broader economic outlook.


Someone, please ... debunk me!  :)

15 Comments – Post Your Own

#1) On October 22, 2009 at 8:51 PM, RVAspeculator (28.37) wrote:

I cannot debunk you because I agree on most of your points.   I think I have rec'ed every post that you linked in this post!  :)

I do not think these economies are completely decoupled but I do think that they hit a bottom in 2008 and even if we go lower they will not take out their lows because of decoupling.   Still a great deal of the runs they are seeing are based on the though that we are out of the recession here in the US.

I just wrote a blog tonight about the dollar and bond yields if you have a minute, give it a read and a rec.

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#2) On October 22, 2009 at 8:59 PM, XMFSinchiruna (26.59) wrote:


Very true, valid points. I agree that Asian markets will feel the impacts of renewed selling in the West, but ultimately the balance of power is a contest of relative strength. In terms of relative economic strength, China has no formidable rival, save for India.

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#3) On October 22, 2009 at 9:45 PM, ChrisGraley (28.67) wrote:

Sinch, you know I always agree with just about everything that you put out there and I still do, but although I think China is ready to decouple it's currency from the US, I think it will have long term negative effects later. I think that China knows it too, but is underestimating the effect.

China is making the right move by stockpiling commodities and concentrating their own stimulus to create domestic demand, but they are missing a few  key reactions if they decouple. First of all, the Euro will fall with the Dollar at a slightly greater pace. There will be a huge decline for global demand when this happens and the Chinese consumer is demanding a lot different items than the Western or European consumer. The companies in China will not be able to react quick enough. Second, they are the biggest co-conspirator. They hold the most dollars and the global market will not be able to unload their dollars at a quicker rate than the rest of the world when they start to sell. If they move too fast, a country holding fewer dollars will dump everything on the market and be sold out before China can dump the rest. Third, their people will revolt if they don't have continued growth at 9% and may revolt anyway. They are looking at a whole bunch of transition costs that could make them a debtor nation fairly quickly.

Given that there are a lot of countries waiting in the wings to be the next emerging nation, I don't think it's going to be as easy for China as everyone thinks.

I still believe, just like you do (I think) that the commodity producing nations are the best play in this game.They will win no matter how this plays out.

Canada and Austrailia are my 2 favorites right now.

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#4) On October 22, 2009 at 9:46 PM, XMFSinchiruna (26.59) wrote:

Australia will be interesting to watch, that's for sure. :)

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#5) On October 22, 2009 at 10:15 PM, ChrisGraley (28.67) wrote:

*They hold the most dollars and the global market will not be able to unload their dollars at a quicker rate than the rest of the world when they start to sell.*

Should have been...

They hold the most dollars and they will not be able to unload their dollars at a quicker rate than the rest of the world when they start to sell. Report this comment
#6) On October 23, 2009 at 6:44 AM, XMFSinchiruna (26.59) wrote:


I couldn't find updated data just now, but the USD contingent of China's $2.7 trillion in foreign reserves remained at less than $1 trillion when I last checked. In a rapid deterioration scenario for the dollar, China would still have a huge chunk of its reserve fund sitting in non-USD.

Also, consider that new additions to their reserve are likely heavily skewed away from the dollar, given that China has been the most vocal among nations attempting to diversify holdings away from the greenbackL:

Globally, central banks have been putting more reserves into Euros and Yen as the dollar slides. Nations reporting breakdowns put 63% of new cash into the European and Japanese currencies in April, May and June, according to Barclays Capital. China doesn’t give such details.

China, which held 800.5 billion USD of Treasuries at the end of July, up 45% from a year earlier, has expressed concern this year at the safety of the nation’s dollar assets, with central bank Governor Zhou Xiaochuan promoting the idea of a new world currency.


What will be interesting to see is whether China nationalizes its gold production to recoup USD losses. When gold lurches towards $2,000 per ounce, that will be a temptation for the world's largest producer.

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#7) On October 23, 2009 at 11:17 AM, kdakota630 (29.09) wrote:


Your blog was already rec'd by me as well as having decided to commend you on another great blog, when I noticed that I was even referenced in this, so I have to thank you for that as well.

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#8) On October 23, 2009 at 2:39 PM, GeneralDemon (26.33) wrote:

Chris, I am aligned with your thinking, but I have one question.

I have read that the total derivative notational value of the OTC market is 594 trillion, but the total value at risk is only 11 trillion.

If the total GDP of the world is 60 trillion, is this 11 trillion really that bad? And I am assuming that only a percentage of that 11 trillion is worthless.

Since the derivatives were set up for the offsetting of risk - shouldn't the total assumed loss be around 50% (5.5 trillion)? 

What I am getting at is wasn't the potential losses arbitraged?

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#9) On October 23, 2009 at 4:48 PM, XMFSinchiruna (26.59) wrote:


I'm struggling to understand how those two things can go together. :)

They are mutually exclusive.

If you believe that only $11 trillion of the derivatives mountain is at risk, then I implore you to realign your thinking to another paradigm than my own ... because basically everything that I spelled out above would be entirely different if the derivatives issue were merely an $11 trillion issue.

I would love a link if you remember where you read that ... in fact I would love to write an article debunking that implausible estimation.

We still have entire tranches of the global derivatives market that remain frozen. When "assets" remain frozen in time for a year or more, how long does one wait before declaring those assets worthless?  The final tally of losses in the deleveraging of derivatives could dwarf the global GDP, and therin lies the unthinkable scope of our financial crisis. Since the response strategy to date has been one of reflation and releveraging, the risk of systemic collapse where even presumed "healthy" tranches of the derivatives market become infected with the toxic frozen market syndrome has risen substantially. Many, including Jim Sinclair whose views I respect, believe that ultimately all OTC derivatives will revert to their intrinsic value: zero. I am not sure I ascribe to that particular view, but consider the likelihood of losses eclipsing the scale of global GDP quite high.

If the crisis were only $11 trillion in scale, I would be investing in blue chips and heralding the imminent recovery ... especially given that federal interventions have already exceeded that scale ... and so all losses would already be "covered". Of course, that is not the case, and there is not enough currency in the world to "cover" the real losses that we face from the menacing mountain of derivatives.


As to your question about risks being balanced by countering trades... if only they had been so rational in their approach. The unfortunate answer is "no" ... there has never been regulation in these markets, and so no one ever developed a system whereby an equal bet had to be placed in both directions of a bet. You could direct a derivatives origination broker to write contracts totalling $x based upon condition "x" being met, and so long as a counterparty could be found for the contract who was willing to pay out if that condition was met, you could originate it. Nowhere in the process was any sort of balancing mechanism inserted to ensure that cumulative bets were not skewed to one side of a trade or another. That's how it all broke down in the MBS market ... the long-held assumption that home values would appreciate ad infinitum led to derivative bets being massively skewed to the bullish side ... such that when the reality went contrary to that assumption the principle counterparties (in this case the monoline insurers like AMBAC and MBIA) found themselves undercapitalized to pay out on the contracts they signed. They were undercapitalized because they thought they'd never have to pay ... they were like insurance contracts for a risk that was perceived as so miniscule that it didn't warrant avoidance of terminal levels of leverage to maximize profits in an environment of low perceived risk. Does that help?

Furthermore, you must understand that when a derivatives market freezes, it's not a question of one side of the bet or another losing ... but rather both. The full notional value of the contract is lost to both parties when a market becomes irrevocably frozen. Because of the amount of leverage involved over the cumulative monetary assets of the planet as a whole, the risk of systemically and irrevocably frozen segments of the derivatives market spearding into other segments in a chain reaction of deleveraging persists in this Fool's view. The still-pending breakdown among commercial real estate loan securities, and even new phases of the residential MBS market meltdown could become destructive catalysts, while CDS (credit default swaps) and interest rate swaps bear watching. The commodity price derivatives are relatively small by comparison, by my reckoning, but China's announcement that it may walk away from those could certainly trigger further freezing in unrelated segments of the mess.



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#10) On October 23, 2009 at 6:01 PM, GeneralDemon (26.33) wrote:


My latest source for the $11T is from the PBS Frontline piece on 10.20.09.

And from Slate 10.15.09:

They list the "market value" of the $596T of derivatives as $14.5T

"An alternative way to measure the size of the derivatives market is to calculate the instruments' market value—which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. (That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.)"


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#11) On October 23, 2009 at 6:16 PM, IIcx (< 20) wrote:

"Greed is King" but I have never nor will I ever buy a product produced in China. So, bloat away, I'm not buying it.

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#12) On October 23, 2009 at 6:50 PM, XMFSinchiruna (26.59) wrote:


OK ... I understand the confusion. The market value has nothing to do with the amount of capital at risk. The DIFFERENCE between the market value and the total notional value is the closer to the maximum scale of of potential losses in a worst case scenario. The final tally of losses is anyone's guess, but notional values come into play when frozen markets leave both counterparties with meaningless paper.


Presumably you don't think China is so dependent upon its export economy that it can not effectively adapt to a more protectionist geopolitical climate and stagnant trade? The future is all about having access to resources, and China is actively placing itself in pole position while we drown in debt.

Greed may be king, but if so the derivative originators who drowned our nation in debt built greed's golden idol.

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#13) On October 23, 2009 at 7:01 PM, GeneralDemon (26.33) wrote:

Chris, what I got out of the Frontline piece - the most important part - is that the side bets are "black box" contracts between two parties and are totally private - no one knows the extent of the problem - no one.

So everyone posting about this including me and you are blind. 

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#14) On October 23, 2009 at 9:18 PM, XMFSinchiruna (26.59) wrote:


And even the part we know about, no one understands ... not even those who originated them.

They are the scariest pieces of paper ever filed.

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#15) On October 23, 2009 at 10:18 PM, SnapDave (48.21) wrote:



Great post and article. 


Being stuck with worthless dollars won’t be the end of the world for China.  My bigger concern about China is that they are hard at work preparing for resumption of the pre-2008 secular world economy.  Creation of consumer demand is not happening.  On the plus side they can probably endure wasting this effort as well as taking a huge hit on their dollar reserves.  The stockpiles of commodities will help here.  I could be wrong but I believe a large appreciation in the RMB is a very necessary, if painful, step in moving the world forward.  I’m also sure it will happen.  I guess I’m trying to say I agree with your substance but see some monster potholes in the road for China.  I don’t share much of your optimism about India though. 


The selling of other assets involved in covering even $11T in screw-ups is no small matter. 

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