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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The TED spread measures the dailyand on occasion, minute by minutechange in the interest rate spread between U.S. Treasury bills and eurodollar depositsTHE TED SPREAD: GLOBAL FINANCES THERMOMETER With domestically generated dollars becoming scarce, at a time when banks balance sheets were seriously impaired by bad Third World loans, eurodollars moved from a backup source of liquidity to the primary source of global financial liquidity. Volckers defense of the dollar had the unforeseen effect of raising the value of the trillions of eurodollars and dollardenominated eurobonds sloshing around the world. The 1980s were the decade of the Reagan Recovery, a robust but disinflationary boom that put a sickly banking and Savings & Loan system under sometimes intolerable strains. Hundreds of financial institutions would fail, the stock market would crash in 1987, and the whole process of debt-unwinding would end with the real estate bust of 1990. From the time investors and regulators began worrying about the banks exposure to Third World loans, a new stress indicatorthe TED spreadbecame indispensable for market watchers. The TED spread measures the dailyand on occasion, minute by minutechange in the interest rate spread between U.S. Treasury bills and eurodollar deposits. As the worlds premier short-term investment medium, Treasury bills are the basic financial rate, responsive to Fed policy. As the rate on uninsured dollar deposits in banks around the world, eurodollars always traded at higher yields than T-bills. When problems developed anywhere in the global banking system, eurodollar rates would rise as bankers and investors moved out of euros into T-bills. That change in rates would also occur if investors became worried about the value of the dollar and moved their deposits into other currencies. The TED spread has been the thermometer for the international financial system now for a quarter century. Investors have been able to chart it by checking spot rates through their banks or by watching the yield spread between the two key short-term financial futures contracts traded in ChicagoTreasury bills and eurodollars. That yield spread was (and still is) low double digits in confident times (of which there were few in the 1970s and 1980s), and leaped above 100 basis points (1 percent) each time the system was at bay. In every financial crisis from 1978 through 1998, the TED spread climbed sharply. In every case that the TED shot up, stocks fell sharply. The TED had a 100 percent accurate forecasting record. The worst TED spread crisis came in May 1984 when the Continental Illinois National Bank and Trust Co. collapsed. As the Fed official who helped manage what they considered the worst global financial crisis since 1930 told me, when the TED leaped from the 100 range to 415, alarm bells went off. What Paul Volcker did that day was brilliant, audacious, and gutsy. The Continental was a mismanaged Illinois bank with pretensions to being a major global bank despite being hobbled by an archaic Illinois law that prevented local banks from operating branches. So, from one location on LaSalle Street (across the road from where this is written), the Continental tried to become one of the global biggies by bidding aggressively for extra-large (wholesale) eurodollar deposits. Japanese and German banks were among the major participants in these funding operations. Through them, Continental managed to become the seventh largest commercial bank in the United States. When word leaked out that the bank faced collapse because of bad (even by the loose standards of the time) lending practices, major foreign holders of Continentals eurodollar deposits declined to roll them over. Continental desperately bid up to try to replace the matured loans, but the euroflow worldwide seized up. As rumors of the collapse of a major U.S. bank spread through the system, other banks declined to roll over their eurodollar deposits, switching to Treasury bills or other eurocurrency assets. In a matter of hours this became a worldwide flight to quality within the banking system. At one point during the morning, it looked as if the world faced the worst financial crisis since the Depression. Then Chairman Volcker averted catastrophe by announcing that the Fed would cover Continentals eurodollar liabilities and that the Continen tal would be restructured and recapitalized. (The only deposit insurance existing at that time was Federal Deposit Insurance, which insured domestic depositsnot eurodollarsup to a limit of $100,000; what Volcker did was doubtless illegal under U.S. regulations, but it was unquestionably the right response to a crisis. The TED spread plunged to normalcy. The ultimate cost to the taxpayers was trivial, and the financial world resumed functioning until October 1987.) EURODOLLARS AND THE CRASH OF 1987 The Crash of 1987 came barely six months after I moved to Wall Street as portfolio strategist for Wertheim Inc., a respected research firm. One reason they recruited me was because my eurodollar-based stock market forecasting record had been good. The reason I kept my job after that debacle was because I had alerted so many major institutional clients to the risk in the financial system, as demonstrated in the rising TED spread. (Some clients would for years afterward call me Mr. Ted Spread.) The 1987 crash was born in a eurodollar squeeze at a time of rapidly dwindling foreign faith in the dollar. The stock market was vulnerable to correction because of relatively high valuation, but what occurred was a crash caused by the financial equivalent of severe heart attack. The leap in the TED was a signal that the blood flow in the system was experiencing blockage. I was in Dallas to see institutional investment clients of Wertheim on Monday, October 19. I was deeply worried because the TED had leaped from the 120 range to 145 on Friday. The problem was a falling U.S. dollar, which was being defended by newly minted Fed chairman Alan Greenspan. He had succeeded Volcker on August 11 and quickly arranged two tightenings of monetary policy. They were designed to stop inflation in its tracks and also to put a safety net under the falling dollar. On Monday, I phoned my assistant in New York from my hotel room at 7:20, when the eurodollar futures started trading at the Chicago Mercantile Exchange. When she heard my voice on the line, she giggled nervously. Don, she said, the TED is at 215. I told her Id see the clients booked for that day, but would fly back to New York that night. I told her to expect the most exciting day of her career. I then awakened my son Stuart, who was with me because wed planned to attend the Dallas Cowboys Monday night game. Stuart, I said, Youre going to have to go to the game by yourself. Ive got to fly back to New York, because theres going to be a stock market crash today. Oh, Dad, you always exaggerate, he grunted, and went back to sleep. I went to the client meetings in their offices. I explained what a TED spread crisis was, but the meetings were difficult. People would exit to check the market, return and announce the latest number, and we would gasp. The big lesson from that terrifying bear raid was that one ignores a leap in the TED at ones cost. That lesson served me and my clients well in the years to follow. There has not been a TED spread crisis since October 1998. The TED signaled All Clear during the major sell-off of 2001-2002, which meant that this was the first full-blown bear market since the eurodollar market began in which the viability of the financial system was never in question. THE DOLLAR AND THE EURO When eurodollar holders switch out of dollar deposits, they have a wide choice of eurocurrency deposit vehicles for their money. A Swiss holder of eurodollars might decide to switch into Swiss francs or euros or into other currencies such as British, Canadian, or Japanese deposits, based on two considerations: the relative interest rates available and the outlook for the currencies. (Just as eurodollars are dollars on deposit in banks outside the United States, eurocurrencies are any other currencies on deposit with banks outside of the currencys issuing country.) Eurodollars were fine investments for Continental Europeans from 1995 until 2002 because those investors earned competitive rates of interest and, more important, they profited from the rise in the value of the dollar. Yet the dollar had entered a bear market against the euro on January 31, 2002 (see Chart 7-1). A German holder of eurodollars from January 31, 2002, to June 30, 2002, would have had little reason to be happy with his investment. The interest rate paid on his deposits was significantly lower than was available in euro or British deposits, and he lost 14 percent on the sudden fall in the dollar. At then-prevailing eurodollar rates, it would have taken him more than six years of interest income to offset his currency lossassuming he was paying no income tax. That also assumed that the dollar fell no further. Why did the dollar and the euro suddenly switch roles from winner to loser? Why did a dollar bull market suddenly become a dollar bear market at the end of January? To answer that question, we have to go back to the dreams and delusions of Jacques Delors and his fellow eurocrats. They planned ahead for the day when all holders of deutschemarks, lire, francs, guilders, pesetas, drachmas, and escudos would be trading in their paper money for the new euro paper money. When they announced agreement on creating this new supercurrency, they exulted in the thought that the faces on the bank notes would be the great Europeansthose whose achievements transcended the narrow nationalism of most of the visages on the existing money. Naturally, a committee was struck. Its job originally was to select the great people of the past who would make holders of those notes proud to be Europeans. This was to be a big part of the process in which Europeanness subsumed the parochialism and nationalism that had been such curses for Europe over the centuries. What did the committee choose? Structures. Yes, structures. They were apparently unable to agree on any great European people for the back of the bank notes, but they were able to agree on great European architecture. They couldnt agree on a bridgebecause everybody had a bridge in his or her country that was truly special. They compromised with generic bridges; they look a lot like bridges youve seen, but you cant quite identify them. One engineering expert wrote that one design wasnt the design of any bridge in Europe he knew, but it did look like a famous span in India. So much for the new European consensus! I took this eurocommittee paralysis to be confirmation of my view that most of the hype about the new Europe and about the inevitable attractiveness of the new currency would be proved wrong. The bureaucracies, committees, red tape, eurosclerosis, and excessive taxation that had bedeviled the European Union would continue. I told clients to sell the new currency short, or to borrow in it because they would be repaying the loan in depreciated currency. Europes heavy taxes and the insatiable demands of Europes farmers for costly handouts were at the root of a eurocratic decision that would help sink the euro in the months leading up to the issuance of the new paper money. (That issuance, let it be noted, was a splendid organizational accomplishment, and was a sign of a turning point from ugly duckling to swan for the euro.) As the date for issuance of the currency neared, Brussels announced that, as of the date of distribution, all previously issued banknotes would become nonnegotiable. This was a shock to millions of people who assumed they could hang on to their cherished deutschemarks and guilders and francs, which would be accepted at any time at the official exchange rate. Even more shocking was the ukase that said that when people exchanged their existing currency for euros at their banks, the banks would be required to report all sizable transactions to the government. Jacques Delors and his friends had all along assumed that this unpublicized aspect of the conversion would expose massive tax dodging. All that paper money under floorboards and mattresses would have to come out, and then the gleeful tax men would have grounds for some very interesting inquiries. And just how did you manage to accumulate 275,000 deutschemarks when your tax returns showed no income and you have been collecting welfare for six years? The Italian authorities were awaiting the appearance in Sicilian bank branches of mafiosi who would have huge fortunes to explain. Well, of course it didnt work out that way. There was one big remaining loophole. All a holder of these currencies needed to do was to swap them for foreign currencies at the ubiquitous exchange wickets and the tax man wouldnt be any the wiser. Result: a frenzy of sales of European currencies, mostly into dollars, in the waning months before the financial portcullis clanged shut. In January 2002, the dollars exchange rate against the euro peaked as the last tax-sensitive holders of big supplies of paper money completed their cleanouts of mattresses, floorboards, and safety deposit boxes. Then the dollars bear marketparticularly against the eurobegan. |
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