Crash Warning -- Three Storm Fronts Converge

By Justice Litle, Editorial Director, Taipan Publishing Group

Quote of the Week

The past six weeks have brought enough market-moving news to fill a reasonably exciting year, or, for that matter, a dull decade... as we go to press, after a catastrophic earthquake and tsunami, Japan is now faced with a meltdown -- not in the figurative, but in a very literal sense; the Middle East is once again proving flammable in the extreme, as the decades of neglect of festering political sores play out in the only way they could have... Europe is back in crisis mode (the only mode in which the European Union actually gets anything done)...

-- Hedge fund manager Eric Kraus, "Trading Strategies for the Apocalypse"

Market Commentary

The phrase "perfect storm" is much overused in the financial press, and should be restricted to the most severe of circumstances if not retired outright.

But if ever there were a time to highlight "perfect storm" conditions, this would be it...

Right now we have three fronts converging on the equity markets, coupled with a fourth "portfolio contagion" factor that threatens to act like kerosene on a fire. Those three converging fronts come from Japan, Europe and the Middle East.

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"Effectively Out of Control"

The phrase "effectively out of control" is not what you want to hear in respect to nuclear reactors. But those are the words Günther Oettinger, the European Union commissioner for energy, used to describe the situation in Japan.

"In the coming hours there could be further catastrophic events which could pose a threat to the lives of people on the island," he added.

Japan has asked the U.S. military for help in containing the reactor situation. Various rescue missions and helicopter operations have had to be called off because of potential radiation threats to rescue personnel. The situation is fluid and may have changed substantially even by the time you read this.

It is sadly ironic that Japan would suffer a nuclear crisis, because the Japanese financial situation has long been described in "nuclear" or "time bomb" terms. Noted hedge fund manager Hugh Hendry is on record as calling Japan "a nuclear bomb strapped to the chest of the world economy." It should be noted he made that metaphor a long time before the present turn of events.

Japan's fiscal situation is deadly serious because the country is sitting on a huge and unsustainable debt load in the form of Japanese government bonds, or JGBs. The Japanese government is leveraged to the hilt after 20 years of failed stimulus policies and zero or near zero interest rates. Japan watchers have long predicted that, at some point, the JGB "time bomb" would go off -- probably when Japanese retirees stopped putting their savings into bonds -- and a major currency meltdown would follow.

The irony of the situation is that Japan's currency has risen sharply in response to the crisis. The expectation is that large capital flows of yen will return home, pushing up the value of the currency. Meanwhile the BOJ (Bank of Japan) is scared to intervene in a large way because they fear accidentally setting off the JGB "time bomb."

But when that debt time bomb does go off, as eventually it must, we could see the Japanese yen transform from one of the strongest currencies in the world to a new version of the Thai baht or the Chilean peso.

Right now the unknowns of Japan center around human catastrophe and global supply chains. Japan is a major hub for many important electronics and high-end manufacturing parts, and so the nuclear power plant catastrophe threatens disruption and shutdown to significant portions of global trade. But the bigger unknown is how the JGB question and the inherent leverage in Japan's economy plays out...

Bahrain Burning, Rebels on the Brink

Meanwhile, even as the world fixates on Japan, the situation in the Middle East is going from bad to worse. Libya's rebels are begging the West to flat-out assassinate Gadhafi, or otherwise establish no-fly zones, as Gadhafi pounds them with money and military firepower.

As the WSJ reports,

Col. Moammar Gadhafi's forces seized the last town standing between them and the rebel capital, raising the specter that, even if the U.S. and Europe decide to intervene on the rebels' behalf, their help may come too late.

In a devastating development for the rebel cause, Col. Gadhafi's fighter jets bombed the center of the town of Ajdabiya, and his troops outmaneuvered rebel forces there, clearing a path to the rebel capital of Benghazi, in eastern Libya.

"The city is in ruins," said Ali Faraj Hammada, leader of Ajdabiya's revolutionary committee, as he fled toward Benghazi in a blood-soaked car...

Meanwhile the situation is going from bad to worse in Bahrain, where Saudi troops have intervened aggressively and even opened fire on protesters. As the Financial Times reports,

The crisis escalated this week after protesters over-ran the police on Sunday and took effective control of large swaths of the capital, spurring the arrival of more than 1,000 Saudi Arabian troops and light armour on Monday.

The arrival of Saudi soldiers and some police from the United Arab Emirates has escalated tensions in the already volatile Middle East region.

While the opposition denies there are any ties between Iran and the protesters, Saudi Arabia's military intervention has sparked concerns that Tehran could try to take advantage of the unrest in Bahrain.

As we have written of previously, Saudi Arabia is "Sunni" Muslim... Iran is "Shia" Muslim... and there is no love lost between the two. At the same time, Saudi Arabia has a disgruntled Shia minority situated in very oil-sensitive areas of the country. And so Iran has not been able to miss this golden opportunity to stir up trouble...

The net result is that the little country of Bahrain may wind up becoming a proxy battleground for a massive Sunni/Shia fight between Saudi Arabia and Iran.

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Europe Still in Crisis

And last but not least we have Portugal contributing to the mix again today... as long-time Macro Traderreaders know, we consider the fiscal situation in Europe to fall somewhere between a disaster and a farce, with the high likelihood of ending in tears.

It simply does not make sense for the powerhouse export machine that is Germany to be linked together with the much more fragile and debt-laden periphery countries (Portugal, Spain, Italy, etc.). This linkage is political in nature, an "experiment" that never gave true weight to crisis considerations.

And so now we are seeing monetary union with a lack of true cultural or political union cause Europe to lurch from crisis to crisis, with the endgame (in our opinion) being a massive devaluation of the euro as the European Central Bank (ECB) is forced to run the printing presses full tilt. As Reuters reports,

Portugal's government blamed higher rates paid at a debt auction on Wednesday on the opposition's refusal to back its latest austerity plans, warning a political standoff could force it to seek a bailout.

Pressure on Lisbon mounted after Moody's rating agency downgraded Portugal by two notches late on Tuesday, highlighting the challenges it faces in riding out its debt crisis.

The worsening financing situation for Portugal -- which many economists say is the next likely eurozone country to need a bailout after Greece and Ireland -- suggests the deal to boost the eurozone rescue fund may have come too late for it...

The Fourth Vector: Portfolio Contagion

Another major issue the markets face is that of "portfolio contagion" -- the risk that overleveraged long investors, hedge funds, mutual funds and the like, are forced to sell positions in healthy parts of their portfolios simply to "stop the bleeding."

The portfolio contagion issue is intensified by the fact that hedge funds became more leveraged in January (according to Bloomberg) than at any point since 2007 in their willingness to make leveraged long equity bets. This "leveraging up" was a function of the "can't lose" mentality associated with the Bid 'Em Up Bernanke stock market.

But now all that leverage threatens to have a powerful reverse effect in the form of contagion. The more exposure that leveraged long investors have to sharp declines, the more aggressively they will have to cut losses and get out.

And when too many of them attempt to do this all at once, the result is a cascading avalanche of selling that feeds on itself... i.e. a full-blown crash.