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Futures Markets; Financial, Agricultural & Metals the Coming Liquidity Tsunami into Something Real

May 14, 2011

Futures contracts are a market solution designed to hedge tomorrow's uncertainties; the risk of unforeseen future events ruining the best laid plans of today. But decades ago futures markets were hedging risks that were primarily agricultural in nature, such as floods, droughts, and diseases destroying crops and livestock. Commodity futures allowed farmers and food processors to bet against their future success, as all insurance products do, by including leveraged speculators in the price bidding process in America's commodities exchanges.

Farmers are astute small businessmen. They know how much money they'll need in March to produce a crop for sale in September, and how many cents per bushel of the sale, months from now, will be their profit. The Chicago Board of Trade provides farmers with the means to lock in a profitable price months before their crops are even in the fields. If the coming summer is rainless, or for those farmers who in mid-May 2011, still find their fields flooded by the American Midwest's swollen rivers, "hedging these risks" allows them to still make money in a bad year, thanks to the leveraged speculators who took the other side of their futures contracts, whose losses are the farmers' insurance payment.

Futures contracts on agricultural production go back to the 19th century. These contracts form the bedrock in a system of food production, processing and distribution that has ensured that no major famines have occurred in nations wise enough to adopt them. Show me a major famine in an industrialized country during the 20th century, and I'll show you a market risk that couldn't be hedged: socialist intellectuals dictating "policy" in the market place.

"Communism is not the victory of socialist law, but the victory of socialism over any law."

- Peter Stuchka, Soviet Legal Theorist of the 1920s, "The Dictators," by Richard Overy, Page 290

Laws like the US Constitution and the Bretton Wood's Monetary Accords.

In August 1971, when the perpetually expanding Federal Government of the United States unilaterally removed the link the Bretton Woods Agreement had put in place 27 years earlier by pegging the world's reserve currency at a fixed ratio of $35 to an ounce of gold, the business of hedging risks left the barnyard, and took the financial districts of Chicago and New York by storm. The post 1971 dollar became a risky medium in which to do business, a political football, destabilizing:

  • Currency exchange rates
  • Interest rates
  • Asset Values

in every market where it was the unit of trade. Global industrial concerns, whose long term planning spanned both years and national borders, suddenly needed a solution to their new US dollar problems.

By 1971, consumer prices had been rising steadily since the early 1940s, as noted in Barron's:

"[the US dollar]---which on November 15, 1951 reached a new low of 53 cents in terms of 1935-1939 dollar value.--- From the standpoint of the creditor, the buyer of Savings bonds, the pensioner, the insurance beneficiary, the school teacher with lagging pay, the experience during and since World War II has been disheartening. Inflation is a concealed type of tax and these are the people who took the brunt of it." -- Barron's Editorial, 31 Dec 1951

Twenty years later, with the delinking of the US dollar from gold in 1971, interest rates and the consumer price index soon soared to double digits. Fixed currency exchange rates became unhinged.

Looking at my copy of the Chicago Board of Trade's, Commodity Trading Manual, the first financial future's market was created for hedging volatility in foreign currencies. Beginning in May 1972, industry could hedge their new risks in the UK Pound, German Mark, French & Swiss Franc, and Japanese Yen. It only took nine months after the Nixon Shock of August 1971, for international corporations to begin paying insurance premiums in the futures markets as a routine cost of business, to protect themselves from Washington's monetary malfeasance.

Government guaranteed mortgages: Government National Mortgage Association (GNMA) contracts first began trading in October 1975, and for good reason. With the soaring consumer prices in the 1970s, it became obvious that interest rates would soon increase. What better way to compensate the secondary mortgage market for their inflationary losses than a futures market in mortgages!

The increase in mortgage rates from 1975-82 was quite predictable. But what never could have been predicted 36 years ago was the decrease in mortgage rates from 2007-11, during a continuing credit crisis in the mortgage market, while consumer prices once again began to increase.

In the 19 August 1985 issue of Barron's magazine ($1.50 an issue at the time, today $5.00), the headline article was on the latest new development in futures: interest rate swaps. At the time, the market for interest rate swaps had a notional value of $150 billion dollars, a huge number for any market in 1985! Twenty six years later, the Bank of International Settlements reports the notional value of interest rate swaps for June 2010 (the latest data available at the time of writing this article) was $347,508 billion dollars ($347.5 Trillion dollars). The interest rate swap market has grown 2,315% in the past 26 years, and this is only one type of dollar related contract traded at the OTC derivative market; credit default swaps, currency swaps, and other synthetic derivatives all trade in the tens to hundreds-of-trillions of dollars.

What are these "swaps?" They are non-standard financial contracts, used to bundle interest and payment streams from various bonds of different credit quality, into a "financial product" that is sold to money managers. It's called "structured finance." For instance, Wall Street (with Washington's blessing) takes 1000 high quality bonds everyone wants, and 1000 bonds no wants anything to do with, and swap the interest streams between the 2000 bonds. Include a credit-default swap to provide "insurance" against the "risk" of default, then apply this financing model on the entire US mortgage market, and you'll understand why everyone's pension fund and money market account in 2008 was contaminated with sub-prime mortgages, as they still are. With the Federal Reserve having purchased over a trillion dollars of these "mortgage products" for "monetary reserves" since the 2008 credit crisis, even the kid who cuts my grass has a sub-prime problem when I pay him his $20!

Currently, there are $347,508 billion dollars ($347 trillion) in notional value of these contracts still in existence. This suggests that the credit crisis is not yet resolved, though many "experts" on CNBC would disagree. But one fact I suspect the "experts" on CNBC would prefer not to discuss, is how exactly, during the worst credit crisis since the Great Depression did the interest rates on US mortgages, actually decline? After all, mortgages were at ground zero in the 2008 credit crisis. Look at the chart above to see the truth of what I'm saying! As a staunch believer that one should never ask questions in a public forum, to which one does not already have an answer, my answer to the above question is that there are currently $347,508 billion dollars ($347 trillion) (in notional value) of these interest rate swaps in existence!"

It's like I was once told, by someone who's name I've long since forgotten, the ancient Greeks once pondered death from a scientific perspective. One day Pericles was manning the walls of Athens against the Spartans. The next day a plague came and Pericles was gone, though his now room-temperature body was still in Athens. Question: what changed? Maybe warming his now cold body would cause Pericles to return; and then again, maybe not! But who can say until we try?

If I were to write a script for a play, using the Peloponnesian War as a motif of the current financial situation, the US financial system would certainly be Pericles: glorious and powerful one day, and somewhat else the next. If asked, I'm sure the academics from our Ivy-League schools of social sciences would demand to play the part of the old Greek philosophers. But I see them more as the vectors of "policy" that has pulled our poor hero down to his lamentable state. That leaves us with what to do with the politicians? Well no one would ever mistake these corrupt, baby-kissing sycophants for Greek philosophers! So, I guess the politicians will have to play the part of the vectors of "policy" and I'll let Doctor Bernanke dress up like Socrates.

In the opening scene, Pericles lays still on a marble slab, at room temperature, when Doctor Bernanke orders members of the AMA (Athenian Medical Association) to warm poor Pericles' human remains to that of the living. He steps back into the gloom of the Parthenon, as a Greek choir (played by the financial media) then lets loose a mournful chant, 3 times:

"Woe unto Athens! Though the philosophers have warmed worthy Pericles until his toes smoke, still neither does he move nor speak!"

A brilliant spot light cuts through the gloom of the scene, highlighting the noble presence of Socrates (played by Doctor Bernanke) as he brings the Greek Choir to silence with a sweep of his arm, and proclaims to the audience (played by everyone who still believes their pension fund and social security will be worth something ten years from now): "Pericles needs not move nor speak to serve Athens well. A pulse he needs not. As long as the wise men of "policy" can maintain his body temperature above that of the marble slab on which he rests, all will be well!"

The spot light fades to black, the curtain closes, and all educated and respectable people are happy with the performance, and will continue to be until dear Pericles begins to reek more than "policy" predicted. This is as good a way of understanding the current state of the debt markets as any you'll see on TV or in the papers. Think of structured finance, using derivatives in the hundreds-of-trillions, as "policy's" method of giving trillions of dollars in dead assets the appearance of being alive, though a closer inspection shows they are merely warm and motionless. The secondary market in American mortgages stopped trading several years ago, so for what purpose are these dubious derivatives still serving? I suspect someday we will discover that this is the "policy makers" chosen method to enable trillions of dollars of worthless mortgage assets held by large banks, to continue generating income for the financial system.

With gold eliminated from playing a role in the world's monetary system, the best and the brightest in high finance, and government regulation now have nothing to restrain their fiendish creativity. For the past few decades, creating dollars by the tens-of-billions for the big banks to "earn" has never been a problem for the Fed. But since the beginning of the mortgage crisis in 2007, I suspect the major concerns for central bankers have been finding a mechanism to "inject" their inflationary cash into illiquid banks; a mechanism that has the appearance of legitimacy. The unregulated, unmonitored, and little understood multi-hundred-trillion-dollar derivative market may be THE indispensible "policy tool" used today to keep Wall Street's elite financial institutions' doors open for business.

This would also explain why mortgage rates actually declined during the credit crisis of 2008. Historically, during financial panics, questionable assets have been rushed to the market to get what cash they will bring, while they still can be traded for cash. Since this did not happen in the 2008 credit crisis, we should ask ourselves why the world's largest financial institutions chose to hold onto trillions in bad debt? The obvious answer to that question is that these favored financial institutions were allowed to write options and derivatives contracts on their worthless assets, collecting underwriting fees, from the Federal Reserve and other central banks. The central bankers, so my theory goes, were not only willing to pay the underwriting fees, but knowingly took the losing side of these trades as a means of "injecting" inflationary income into their banking systems.

The TARP program, in which Washington just gifted $700 billion dollars in bogus loans to Wall Street, was a public-relations disaster! Using the OTC Derivative market would have been just as effective, and a much quieter mechanism to entice large holders of US mortgage "products" to keep their paper off the market, removing any motive to write off their illiquid mortgages, thus keeping US mortgage rates low, and Washington's political class happy.

Of course, this is all just pure speculation on my part. But to say this isn't happening would also just be speculation, as no one outside the inner-circle of high finance really knows what is going on in the multi-hundred-trillion-dollar derivative market - and something definitely is going on in this multi-hundred-trillion dollar market. In 2011, the largest financial market on Earth has somehow gone off the radar screens of the media, and the public. It seems no one cares what might be happening, especially our Congress. This is very strange!

Okay, so you and I care. But let's stop speculating on the 800 pound gorilla sitting quietly in the corner of the room, and examine the regulated futures markets, where standardized contracts trade, whose prices are published daily, and are regulated by the Commodities & Futures Trading Commission (CFTC).

As noted above, financial contracts currently trading in Chicago and New York, did not even exist until after the dollar was decoupled from the Bretton Wood's $35/1oz of gold link. Forty years later, managing the risks inherent in the current flawed US dollar, comprise the biggest futures markets supervised by the CFTC.

The list of futures contracts in my table is not intended to be all-inclusive. For instance, I chose the Chicago, CBOT's wheat contract. But wheat is also traded in Minneapolis and Kansas City. This is true for most of the commodities listed above. Be-that-as-it-may, the notional value of all contracts in the list above, that are not financial in nature (agriculture, energy & metals), was only $608 billion on 09 May, just 4.5% of the combined $13.5 trillion notional value of the Euro-Dollar and Fed Funds (interest rate) contracts.

What should we make of this? Well we should first note that the BIS derivative link's (table 19) lists the notional value of ALL-OTC derivative interest-rate contracts at a fantastic $451.83 trillion dollars. Remember, this BIS figure is for June 2010. Still, using the data at hand, the unregulated, unsupervised OTC derivative market for interest rate contracts is 34.7 times the notional value of the Euro-dollar and Fed Funds interest-rate contracts, which trade under the supervision of the CFTC. Also, seeing that Wall Street and Washington need to hedge their financial system with $743 in OTC derivative contracts for every $1 hedged by the real-economy for tangible stuff selected in my table above, like energy, grain and metal in Chicago and New York, should make you wonder why Mark Lundeen has to be the guy to make you aware of such an important point, and not the talking heads on CNBC.

It's time to wake up and smell the coffee; since August 1971 when the US severed the final ties between the dollar and gold, Washington and Wall Street have been "playing chicken" with reality in the global financial markets. How much more "risk" will the global financial system be able to take on? We will all soon find out as a global tsunami of fiat money attempts to flee to any non-financial safe haven from the collapsing house of cards, built of the riskiest assets ever known to mankind: illiquid structured financial products, denominated in US dollars. Exactly when this will play out, I don't know, or care to guess, but when the end comes, it will be more sudden that anyone can predict, and only those holding liquid, tangible assets will come out of it standing.

Gold and silver were chosen by man to function in this role thousands of years ago, before governments started tampering with the people's medium of exchange and store of wealth. In the coming currency collapse, no one will trust banks, brokers, commodity and exchanges. That will go double and triple for the governments, and their regulators who allowed this historic fraud to continue for decades. Paper money, backed by the "full faith and confidence of the United States Government" is going to be discounted in the goods and labor markets. People will by necessity demand something real in exchange for good and services, a form of wealth they can hold in their hand. Gold at $1500, silver at $50: cheap! Get what you can, while you still can.

Publishing note: These articles are hard work! I need a week or two off. So unless something interesting happens between now and 03 June, I'll most likely only write a short update on the stock market. I should also thank two people whose assistance greatly increases the readability of my articles: The Bunny, whose beauty, and kind nature graces my world, as her red pencil improves your reading enjoyment. I also need to thank the mysterious MR. H, from way out West. Mr. H has considerable knowledge of the financial world. When he's not climbing the naked rock face of Yosemite's Half Dome, Mr. H edits my articles for content, and adds a nice polish to the final product.


Mark J. Lundeen

[email protected]

14 May 2011

One cubic foot of gold weighs more than half a ton (1,306 pounds).
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