Davos and Goliath

Let's start with the most recent data from the keepers of the global numbers - the BIS (the Bank for International Settlements). ... As you can see, the BIS data covers half-year periods. For the latest data ended 1H 06, the prior six month growth in worldwide OTC notional derivatives outstanding was a little in excess of $72 trillion, standing at $370 trillion as of 6/30/06, up from $298 trillion at 2005 year end.

For a bit of perspective, total planet Earth did not have $72 trillion in total derivatives outstanding eight years ago, and now we're growing by that total amount in six months. Incomprehensible.

The chief cause of growth in the most recent period was credit derivatives as well as the old standby, interest rate related derivatives vehicles. Again, hard to believe we're seeing this type of growth. Is the global credit cycle in its supernova stage at this point?

The one and only place I’ve found were we get some type of true dollar at risk cash estimates for derivatives, as opposed to notional values, is in the BIS report. As is clear above, these folks are estimating that real cash exposure at risk in this market is $10 trillion as of 2Q 2006 period end.

Today, we live in a world of MCGCF – mouse click global capital flows. This is no longer your father’s (or mother’s) global financial system anymore. Not by a long shot.

And so at Davos this year we have real world decision makers such as those mentioned above at least seeming to sound the need for some type of meaningful assessment and understanding of risk in terms of the recent explosive growth in global financial derivatives. Alternatively we have voices from Wall Street suggesting these worrywarts “just relax.”

We are all aware of the reasons for the long-term negative outlook for the U.S.D. There is the trade deficit mandating we entice foreigners to commit 2 billion dollars per day into our markets in order to maintain dollar stability. In addition, the total U.S. debt is now over $8.6 trillion. This debt has allowed China to hold $1 trillion in foreign reserves (70% of reserves in U.S. dollars).

The Commerce Department reported Tuesday that the gap between what America sells abroad and what it imports rose to a record $763.6 billion last year, a 6.5 percent increase from the previous record of $716.7 billion set in 2005. For December, the deficit rose a bigger-than-expected 5.3 percent to $61.2 billion.

Democrats are forcing the Bush administration to file a complaint against China at the World Trade Organization over tax subsidies for exports and are calling for increased pressure on China to revalue its currency, which they say gives it an unfair trade advantage.

It seems that three scenarios have about an equal chance of unfolding. Under the first, oil heads up toward $80 a barrel, and the pressure from that price shock pushes the economy to the brink of recession.
Under the second, the price of oil stays about where it is, and we continue to struggle along with 2 percent to 2.5 percent growth, all the while worrying endlessly about any bad news.
In the third scenario, we get another happy oil shock, and end up with a significantly stronger economy than investors now expect.

Which way are we headed? When it comes to asset prices, I have always been a "random walker." The best model going forward for oil prices is to imagine that the fates toss a coin each day, and give us higher prices if the coin shows heads, and lower prices if it shows tails.