More stimulus and bailouts

It seems to be a done deal that the US Senate will approve an extension of the housing tax credit. Bad economics if most often trumped by good politics, and the S&P Case-Shiller index increasing for the fourth month in a row is a clear political capital that can be taken to the bank. Unfortunately, US consumer confidence remains unconvinced by housing prices and a stock market rally. And political capital is no substitute for the real thing. It also doesn't help when the architect of your political house of cards, starts to talk about housing in "bubble territory". This is exactly what Professor Robert Shiller said in comments made to Reuters Televisions, as reported in The Daily Telegraph

The tax credit has had a strange effect on existing home sales in the US. While new home sales have failed to get off the canvas, home prices in properties where buyers qualify for the tax credit (as first home buyers) have gone mad. The tax credit has been overwhelmingly derided by economists and the true cost per house has been estimated to be a higher by a factor of five or more due to the actual number of sales generated. Extending it will cost even more per household. Not exactly efficient stuff. Here's an article by Simon Johnson and James Kwak in the Washington Post:

The main argument for the tax credit is that it stimulates the economy and stabilizes the housing market. Seen purely as a stimulus, the tax credit is highly inefficient. The National Association of Realtors claims that the credit created 350,000 new sales; the Calculated Risk blog calculates that this means the government is paying $43,000 for every extra house sold (since most sales would have happened anyway). According to the Wall Street Journal, Goldman Sachs estimates 200,000 new sales, implying a cost of $80,000 per marginal sale.

Even at a price of $43,000, what are we getting? Given that these are first-time home buyers, and given the glut of homes on the market, most of these are financial transactions where a house changes hands in exchange for cash (and additional transaction costs). The $43,000 is not being invested; it isn't buying anything for the public, like a new road. It's just cash going into people's pockets.

Putting cash in pockets does have a stimulative effect because some of that cash will turn into consumption. But as far as stimulus measures go, it has a low multiplier (the ratio of new economic activity to stimulus spending). By contrast, we could take the same cash and hire more teachers, police officers or soldiers to fight in Afghanistan. We would get more economic activity, and the government would get something for its money.

But the tax credit stabilizes the housing market, people say. What does this mean? It means that the credit keeps housing prices artificially high. But housing is something that all people need. Why do we want it to be expensive? Would we want government policies that artificially push up the price of food?

The leaks about the extension of the housing tax credit have come in conjunction with the news that another company perennially looking for handouts, GMAC, is asking for another bailout:

In a stark reminder of how some battered financial firms remain dependent on government lifelines, GMAC Financial Services Inc. and the Treasury Department are in advanced talks to prop up the lender with its third helping of taxpayer money, people familiar with the matter said.

The U.S. government is likely to inject $2.8 billion to $5.6 billion of capital into the Detroit company, on top of the $12.5 billion that GMAC has received since December 2008, these people said. The latest infusion would come in the form of preferred stock. The government's 35.4% stake in the company could increase if existing shares eventually are converted into common equity.

The willingness by Treasury officials to deepen taxpayer exposure to GMAC reflects the troubled company's importance to the revival of the auto industry. Founded in 1919, GMAC has $181 billion in assets and is a major financier for 15 million borrowers and thousands of General Motors and Chrysler car dealerships in the U.S.

GMAC has obviously been declared to big, or more likely too politically connected and important to fail.

In other news, the equity price action of the last few days is clear proof to the now widely held thesis that markets have been driven by a weak dollar of late.

The trouble with business as normal

Today I will turn to imbalances of an economic kind, leaving off from yesterday's post that was perhaps a little more impassioned than usual. At its worst it spoke for a rather large group of people. I try to avoid generalisations, at least on these pages, because there is a danger that I am lumping myself in with the same people that I criticise. Men like Bob Herbert, and Thomas L. Friedman do better jobs than I do on that score, anyway. Let's rather let the facts speak for themselves.

I was at a lunch hosted by a major international bank a few days ago and had the chance to speak briefly to the head economist for Australasia. Tow points I brought up - yesterday's money velocity issue, and overcapacity in China that had potential trade wars ramifications. The economist flatly denied the overcapacity issues and we spoke at length about money velocity and then got stuck into pre-Depression history. As fun as it was, I couldn't help feeling a little alarmed later that an economist of his standing wasn't a little more concerned about overcapacity in surplus nations combined with weak demand and excess capacity (in the form of unemployment) in deficit countries.

The overcapacity in China - despite the doubts of the big bank economist - is real and has been confirmed by officials per this article (thanks to Michael Pettis):

The National Development and Reform Commission (NDRC) will mainly redress production overcapacity in six sectors, said Chen Bin, director of the Department of Industry of the NDRC, Thursday. The six sectors include steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

The NDRC also warns of obvious production overcapacity in sectors like electrolytic aluminum, ship manufacturing and soybean oil extraction, said Chen during an on-line interview on www.gov.cn., the website of China’s central government. He said China would fight serious overcapacity in sectors like steel industry and offer guidance for new-born industries like windpower equipment to avoid low level repetitive construction.

China has achieved preliminary progresses in fighting the global economic downturn, but the foundation for economic recovery is not stable yet and overcapacity might lead to bankruptcy, unemployment and bad bank loans if it was not checked in time, he said.

Michael Pettis has written extensively on Chinese loan growth and overcapacity in recent times and I am indebted to his research. I'll let an excerpt from the first draft of his upcoming report to the Carnegie Endowment:

Although China is still a very poor country, there is no question that Chinese household income has grown substantially over the past few decades, but it has not grown nearly as quickly as GDP. While China’s GDP grew at 11-12% over the 2002-2007 period, for example, MIT economist Yasheng Huang estimates that household income grew at a much lower 9%. If we were able to adjust Huang’s measure to take into account changes in other forms of household wealth – which are described below – growth in household income would have been even lower. This is why consumption has declined as a share of national income, and why China’s total production has exceeded its total consumption by a large and growing amount. This is at the root of China’s high savings rate.

Why haven’t Chinese households maintained their share of national income? Largely because the rise in household income was constrained, especially in the last decade, by industrial polices which were aimed at turbo-charging economic growth. These policies systematically forced households implicitly and explicitly to subsidize otherwise-unprofitable investment in infrastructure and manufacturing. Although these policies powered employment and manufacturing growth, they also led to wide and divergent growth rates between production and consumption. These policies included:

o An undervalued currency, which reduces real household wages by raising the cost of imports while subsidizing producers in the tradable goods sector.

o Excessively low interest rates, which force households, who are mostly depositors, to subsidize the borrowing costs of borrowers, who are mostly manufacturers and include very few households, service industry companies or other net consumers.

o A large spread between the deposit rate and the lending rate, which forces households to pay for the recapitalization of banks suffering from non-performing loans made to large manufacturers and state-owned enterprises.

o Sluggish wage growth, perhaps caused in part by restrictions on the ability of workers to organize, which directly subsidizes employers at the cost of households.

o Unraveling social safety nets and weak environmental restrictions, which effectively allow corporations to pass on the social cost to workers and households.

o Other direct manufacturing subsidies, including controlled land and energy prices, which are also indirectly paid for by households

By transferring wealth from households to boost the profitability of producers, China’s ability to grow consumption in line with growth in the nation’s GDP was severely hampered. Of course the gap between production and consumption is the savings rate, and as production surged relative to consumption, a necessary corollary was a rising Chinese savings rate.

Pettis goes on to comment on the trade tensions issue where, from my view, a weak currency and overcapacity will cause major friction.

...measures that can improve China’s export competitiveness are not good for the rebalancing effort if they exacerbate, rather than reverse, the process of transferring income from households to corporations. Lower wages, of course, do just that, and so they cannot be a solution to China’s underlying overcapacity problem except to the extent that they allow China to expel trade competitors. This is not a permanent solution by any means, especially in a world of rising trade tensions.

Bad loans in China are surely a growing problem, the rapid pace of loan growth due to stimulus measures doesn't engender for due-diligence. As I have mentioned in the past, the stimulus measures and lending explosion has merely created more capacity or inflated asset bubbles in equities and real estate. The productive effiency of the economy has not been improved and, as mentioned in the this Pivot Capital report, it now takes $7 of credit to produce $1 of growth whereas the rather was 1.5:1 in 2000. The burden of bad loans will again fall on households, just as they did in 2003 when the government created asset vehicles to rescue China's banking system through the issuance of bonds in return for their non-performing loans. The chainrman of China's sixth largest bank, China Merchant Bank, was quoted in the FT this week saying that the government needed to address asset bubbles. I urge anyone to read Michael Pettis' blog and the aforementioned (and linked) Pivot Capital report.

The world is out of balance despite the current earnings hype and USD weakness-fueled rally in equities. Demand slack in developed economies has to be taken up somewhere. Overcapacity and currency weakness in China can only lead lead to export of disinflation, which will inevitably cause trade tensions. The US, Europe and BRIC countries can't all export their way out of trouble at the same time and expect the same results. What does potential stag-deflation mean for the US, and can a jobless recovery work when deflationary pressures abound?

Imbalances

The trouble with being a populist President, funded and elected through one of the largest grass-roots campaigns of all time, is that you become beholden to the populist voice - your mandate is theirs. One would assume that President Obama, the proclaimed agent of change, is keen to prove that he can make overt moves to appease his base. Universal healthcare is the beginning, and I feel that a redress of wealth imbalances is next.

The USA has never embraced fairness in the same way as socialist democracies in Europe have. Fairness has seen no part in the great American movement that is the drive for personal wealth. It is openly despised by conservatives, bluntly ignored by the poor and hungry, as an absent and therefore unnecessary aid in the march towards success. Minimum wage is so low that it almost seems designed as an unholy means to urge people off the bottom. When there is no safety net you keep climbing and don't look down.

These elements of the American Dream, the natural energy that has propelled immigrants - illegal and otherwise - to take up the challenge, is sullied by corruption and political influence. America has the most obvious entrepreneurial promise but this can't survive in an age of deferred or even displaced responsibility. I am obviously pointing towards Wall Street, and this most recent financial crisis has the potential to ignite the ire of many millions of Americans. The "heads I win, tails you bail me out" culture has never seen greater scrutiny than now. Bank bonuses, leverage and risk taking are now more a part of the public consciousness than ever before, and perhaps this is logical for they have each grown exponentially in the last decade.

The US consumer is on his/her knees - they have gorged on and been force-fed credit that has been their undoing. This misery has been compounded by the burden they have had to assume in the form of bailouts for banks and industry - a mountain of public debt. If this is not bad enough, they now have to watch as bonuses break all records on the back of a rally born by excess liquidity that never touched Main Street. They have participated wholly in the losses and have now been wholly excluded from the profits.

If you would like something a little more real, lets consider money velocity for a second. Money velocity is the amount of economic activity of a given money supply. We will consider M2 - M1 is too narrow, and the Fed have stopped publishing M3 because it is a terrifying measure of recent wealth destruction. M2 has been growing at an extraordinary rate, but it is obvious to see that its affect on economic activity has been whittled away.




It is therefore clear that all this liquidity hasn't gotten much further than the narrow but deep world of financial markets. A crude measure of its velocity is the performance of equity, government and corporate bonds and commodity markets. We all know the story there. The outcome is that banks are not lending to the broader economy and instead earning fat profits on fixed income and other investments by putting free money to work. There is a moral issue over participation, and money velocity and the national debt are cold measures of its imbalances.

Showdown in Chicago is one of many grassroots movements currently underway in the US as a direct results of banking practises and failure of regulators.

Speaking of regulators, the SEC has hired a 29 year-old ex Goldman Sachs employee:

The U.S. Securities and Exchange Commission hired Adam Storch, a 29-year-old former employee in Goldman Sachs Group Inc.’s business intelligence unit, as the enforcement division’s first chief operating officer, according to people familiar with the decision.

The COO, who started Oct. 13, has “a great deal of background” in technology and managing processes and the pace of work, Robert Khuzami, head of enforcement, said yesterday in Washington. Storch, who worked since 2004 in a unit at Goldman Sachs that reviewed contracts and transactions for signs of fraud, will be charged with making the unit more efficient. Storch, reached by telephone at the SEC, declined to comment.

I have no further comment...

Recent news headlines confirm the belief that the financial world can't return to business as normal. Here's the latest column from Paul Krugman:

It was the best of times, it was the worst of times. O.K., maybe not literally the worst, but definitely bad. And the contrast between the immense good fortune of a few and the continuing suffering of all too many boded ill for the future.

I’m talking, of course, about the state of the banks.

The lucky few garnered most of the headlines, as many reacted with fury to the spectacle of Goldman Sachs making record profits and paying huge bonuses even as the rest of America, the victim of a slump made on Wall Street, continues to bleed jobs.

But it’s not a simple case of flourishing banks versus ailing workers: banks that are actually in the business of lending, as opposed to trading, are still in trouble. Most notably, Citigroup and Bank of America, which silenced talk of nationalization earlier this year by claiming that they had returned to profitability, are now — you guessed it — back to reporting losses.

Ask the people at Goldman, and they’ll tell you that it’s nobody’s business but their own how much they earn. But as one critic recently put it: “There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.” Indeed: Goldman has made a lot of money in its trading operations, but it was only able to stay in that game thanks to policies that put vast amounts of public money at risk, from the bailout of A.I.G. to the guarantees extended to many of Goldman’s bonds.

So who was this thundering bank critic? None other than Lawrence Summers, the Obama administration’s chief economist — and one of the architects of the administration’s bank policy, which up until now has been to go easy on financial institutions and hope that they mend themselves.

The problem with the consolidation in the banking sector, aside from a lack of competition, is that systemic risk is now higher. Banks that were too big to fail are now bigger. This from The Telegraph: Mervyn King: bank bail-outs created 'biggest moral hazard in history':

In comments which will be seen as a clarion call for a potential break-up of Britain's banks, the Bank of England Governor warned that the support handed out by the Government had "created possibly the biggest moral hazard in history". He said that it was insufficient to expect that in the future tighter regulations alone would be enough to prevent banks from generating financial crises.

The warning goes against the grain of efforts by Governments on both sides of the Atlantic, which have tacitly ruled out splitting up the biggest banks and opted instead to scrutinise them more actively. Mr King, who said earlier this year that if banks are "too big to fail, then...they are too big," said that there is a risk the financial crisis comes and goes but the current system, in which big banks enjoy an effective guarantee from the state, remains.

In a speech in Edinburgh, he said "It is in our collective interest to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities. The case for a serious review of how the banking industry is structured and regulated is strong."

He added: "The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion," adding: "It is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector."

More on Mervyn King's comments from the FT.

From Bloomberg: Goldman, JPMorgan Bonuses Need Some PR This Year: Matthew Lynn

Here’s a puzzle to test the brain- power of even the mightiest intellects in investment banking: How are you going to justify the massive bonuses you pay your staff this year?

The old lines won’t work anymore.

What you need is a grand, politically correct gesture designed to make your critics look small and to disguise the profits you have been making with taxpayers’ help. A huge charitable donation, say, or putting Nelson Mandela on the board may be a good start.

The issue is certainly pressing.

Goldman Sachs Group Inc. last week reported a tripling in third-quarter net income, and the firm has set aside $16.7 billion to pay employees so far this year. JPMorgan Chase & Co. said last week earnings rose to the highest level since the subprime-mortgage market collapsed in 2007. The investment bank raised the amount earmarked for compensation to $8.79 billion.

After the credit crunch, nothing has really changed. Bonuses this Christmas will be as big as ever. There is one big difference: The bankers will need to find a new way to justify those big payments.

Bankers used to say their wages were set by a free market, and that always produced the right result. It’s hard to stick to that line when you went bust a year ago. If market forces always get things right, how come you are still in business?

And this one: Goldman Sachs exec defends bonuses at ethics debate

Defending lavish bonuses expected at the U.S. investment bank, Brian Griffiths said he was not "ashamed" of his bank's compensation package, which has inflamed the bonuses debate.

The British public should "tolerate the inequality as a way to achieve greater prosperity for all" Griffiths said at the public meeting examining what role morality should play in the marketplace.

I apologise for avalanche of words and links in the this post, but I think it reflects the growing momentum against business as normal. It remains to be seen, however, if there is sufficient political will to exact lasting change on a system that is primed for spectacular success and failure yet faces no consequences on the downside of the cycle.

"Which lie did I tell?"

In William Goldman's Hollywood, as in Timothy Geithner's Wall Street, one could easily imagine an analyst on the phone to a newspaper emitting a stream of well-rehearsed sentences. The screenplay might read thusly:

INT. OFFICE OF WALL ST ANALYST

Jim is on the PHONE to a major national newspaper, he is spinning a story about stocks, China and lean US companies that are about to start growing really fast as the output gap closes. His associate, Bill, sits across from him - they are taking imaginary high fives as Jim hits on each of the rehearsed talking points. Jim is on fire, he barely stops for breath. Bill stands up to leave, giving Jim two big thumbs up - he reaches the door just as Jim puts the phone down with a big flourish.

JIM
(calling after Bill)
Bill, Bill! Which lie did I tell?

Bill turns, flashes a big smile

BILL
All of them, Jim.

CUT TO:

INT. New York Stock Exchange. A pretty young financial news anchor with big hair is commentating on the day's bullish market action. Her portly co-anchor - a man old enough to be her father - interjects with hokey, well-worn phrases as he talks the market up to new year-highs. Behind them traders scuttle about as the big number on the board ticks steadily upwards.

FEMALE ANCHOR
Is there any stopping this rally?

PORTLY MALE ANCHOR
Not with all this money on the sidelines.

FEMALE ANCHOR
Are we headed to 15,000?

PORTLY MALE ANCHOR
I think we are, the green shoots are everywhere. Remember, we're still climbing the wall of worry.

FEMALE ANCHOR
And don't fight the Fed, right?

PORTLY MALE ANCHOR
You got it!

FADE OUT:

Back to the real world:

The USD is a hair stronger against the EUR today. The AUD started out weaker against the USD, but then moved higher.


The USD will be facing competing forces today as EU finance ministers meet. Their likely complaints about euro strength will be up against comments from Pimco's Richard Clarida about further weakness and some tax-subsidy boosted housing numbers in the US tomorrow. Sentiment about monetary tightening in the US next year is also starting to wane as witnessed by the retreat of the euro-dollar strip reds. Dec 10 looks to lacking conviction:


Meanwhile, oil marches on and the contango is flattening out:


You can read this as a bullish sign - that those specualtors with oil in storage will hold it for longer given the low costs of storage at present. You can also read it is a bearish sign that a lot of physical oil is about to come onto the market or go through refineries as investors are no longer making easy money. Here is Steven Schork's October 16 CNBC column:

A headline from Platts summed up the NYMEX reaction beautifully…NYMEX crude jumps $2 on bullish EIA data. Refinery throughputs plummet on weak margins, seasonal maintenance.

We love it. That one simple headline succinctly sums the NYMEX paradox. Let’s dissect the diagram of this sentence, shall we?

Refinery throughputs plummet…

What does that mean to you? Let’s not overcomplicate this. To us here at The Schork Report , that means exactly what it says. Throughput, the amount of crude oil being put through the complex is plummeting.

…on weak margins…

The Carbon Challenge - A CNBC Special Report - See Complete Coverage
Okay, we get it. Refiners cannot make money on boiling oil. Therefore, they have stopped pushing oil into their tea pots… because they can’t make any money doing so.

…seasonal maintenance

Thus, even if refiners could pass on their exaggerated input costs to a vocationally challenged consumer, demand would be muted anyway.

Yet, somehow the EIA data is “bullish”. Why else would crude oil jump $2?

So who exactly was clamoring to own crude oil yesterday? The refiner, who cannot make any money with the crude oil already on hand, or Wall Street?; because, after all, crude oil is an inflation hedge and, oh yeah, those darn Chinese can’t get enough of 530 yuan oil? Right?

"There is no truth but ours"

"Tell me where is fancy bred,
Or in the heart or in the head?"

William Shakespeare, The Merchant of Venice, Act 3, Scene 2

...or perhaps:

"Where are all good bankers dead, in the heart or in the head?"

In financial markets, in an age where good and bad news gets shuttled around the world at the speed of light, we may become victim to opinions that are repeatedly pressed upon us. Modes of thought - when hammered home by financial journalists, analysts and brokers - turn quickly from ideas to truth. Dreamt-up ten-word Bloomberg headlines start as mild explanations but then give way to outcomes that have serious consequences. Willem Buiter, Professor of European Political Economy, London School of Economics and Political Science, has a few words to say on accepted truths:

I spent the past weekend in Istanbul at the seminar jamboree that precedes the IMF-World Bank Annual Meetings. Ministers of finance, central bankers, government officials and international civil servants all agreed on one thing: there would be no premature exit from quantitative easing, credit easing and other unconventional expansionary monetary policy measures such as the ECB’s enhanced credit support.

All those in a position of authority subscribed to the view that there was a major asymmetry between the risk of exiting too late and exiting too early: exiting too late would only cause minor overheating problems that could easily be corrected. Exiting too soon would cause irreversible damage, because after a too early exit, policy could not be re-activated again.

Nobody explained the analytics or empirics to support that view. It simply became an accepted truth. In the world of mathematics and formal logic, there are two modes of proof: deduction and induction. In economics, as in the other social sciences, we have three modes of proof: proof by induction, proof by deduction and proof by repeated assertion.

So while "green shoots" are watered by quantative easing and bank analysts upgrade eachother's stock and taxi drivers tell me to short the US dollar, it is important to keep a keen eye. Something is broken when you can trade indices blind based on FX moves and old bubles begin to reinflate.

The good cheer bubbled over 10,000 points on the Dow as JPM reported bumper profits on Wednesday. J.P. Morgan made $5 billion in fixed-income revenue, as well they should when they are borrowing at close to zero. However, anything retail related looked quiter bleak and $2 billion was added to reserves to cover consumer loans. Bad news was happily glossed over, and any questions over a dividend increase was greeted rather coolly, as was reported in the WSJ:

Still, Mr. Dimon expressed caution about continued signs that the pace of consumer delinquencies may be slowing, saying that the trends so far haven't yet convinced the bank to stop building loan-loss reserves. The latest addition brings total reserves to $31.5 billion, or 5.3% of total loans.

Although some analysts had predicted that J.P. Morgan might stop adding to reserves this quarter, bank officials made it clear that that they won't do so until they see more signs that delinquency levels are stabilizing.

"We're just not fully prepared to say that it stays that way," said Michael Cavanagh, chief financial officer, in a conference call with reporters.

The same holds true for the bank's annual dividend, which was slashed earlier this year to 20 cents a share from $1.52. The bank might consider raising the payout to 75 cents or $1 a share "when we are confident that the economy doesn't have another potential leg down," Mr. Cavanagh said.

JPM will happily reward employees with increased bonuses this year but shareholders can clearly take 20c and get stuffed. It seems a common theme from banks worldwide who are unable to raise dividends in line with their bullish claims for the health of the global economy.

Goldman Sachs also published some unsurpsingly good results last night, mostly due to their trading divisions. The biggest hedge fund in the world masquerading as a bank has a version of the world all of its own - best you know what you are doing when you get on the other side of a trade from GS. Compensation was the single biggest expense, with 43% of revenue dedicated to it. With GS looking like a farm team for the Treasury, it is hard not to believe that their opinions get closer to the those that matter than others.

Even Citigroup managed to make a profit, but again I can't get excited about a trading profits from fixed income. Boring.

The most annoying thing about proof created by repeated assertion is that it only holds until they doesn't. The US dollar will only be going down forever until it violently reverses and all those leveraged shorts will summarily be taken out to the barn and shot. Oil will be going back to $140 until it corrects with a bang rather than a whimper. It so happens that today looks like a bullish break-out over $78.

Group think has been proven to be a force known more for its ill effects rather than for the good. When market watchers start talking about psychological levels (that Dow at 10,000 is quite topical) one has to wonder. The "market" gives license for broad generalisations, often predicated on the mistaken assumption that markets behave rationally. If anything, talking about magic numbers like 10,000 undercuts this broadly-accepted nonsense that is the efficient market hypothesis. It exposes equity markets for what they really are - a collection of numbers that comprise fear, hubris, herd mentality, shonky accounting, storytelling and some small measure of mixed-in reality. To this blend of psychology and figures we apply rational tools like technical analysis, which mostly tell us where the price of an asset has been rather than where it is going. When technical analysis works, it rather hard to say whether or not this is a self-fulfilling prophecy. Again, mathematics is very useful for quantitative analytics, but a poor tool for explaining a 5% down day on the index.

Perhaps the most ludicrous debate currently doing the rounds is whether inflation or deflation is occurring, which is almost like arguing whether or not it is raining. With continued consumer deleveraging, the CPI still negative YoY and growing unemployment, the answer now is deflationary. Yes, the future is quite possibly mildly inflationary, but excess capacity by Chinese exporters and high developed world unemployment (excess capacity, too) will certainly be a drag.

If there is a point to this rather long-winded post it is that it doesn't always pay to be right when it comes to investing. If through repeated assertion, others more influential than you believe in robust global growth for 2010, or gold over $1000 means that according to Elliot Wave thumbsucking it will go $2000, then one has little choice but to follow the momentum. However, if you are not dead in the head, you will have plenty of downside protection for when you'll need it.

On crude and natural gas

The price for front month NYMEX Crude just crossed $75 in Asian trading. $76.75 looks to me to be the resistance, beyond which it will go higher. Just how much, though, is anyone's guess, but the best guess seems to be USD related. On the face of it, demand just doesn't seem up to the task, but talk like this has its equivalence in standing on your roof screaming for the wind to stop blowing.

In terms of flows and balances, the view is clouded:

The EIA reported last week that stockpiles of petrol in the US increased by 2.9 million barrels in the week ended Oct. 2. Distillate inventories rose by 700,000 barrels. Crude inventories (net imports), however, showed a drop in nearly 1,000,000 barrels as imports slowed. Yet refining of petrol rose 3.5% to 9.42 million barrels a day, whilst demand eased 0.9%

A picture does emerge of expensive crude imports due to a falling dollar resulting in a greater draw down on inventories. This mixed with a fall in demand for gasoline seems to be rather bearish. However, the decrease in inventories was more than enough to set the stage for a run up in prices as anti-dollar demand went into overdrive. Below is a chart of the dollar index (DXY) and front month crude:


Examining the movements of oil tankers is also a useful exercise, especially given the habit of long speculators in oil like Goldman Sachs to hire tankers so that they can take physical delivery on futures contracts. They have made great money on a pretty big contango, which offered great profits due to a large spread between front and subsequent months with low storage costs due to the crisis. Oil's contango has shrunk rapidly since January and this trade may catch a few people with their pants down. No coincidence, then, that Goldman Sachs raised their 2010 global oil demand forecast by 1.9%.

Very Large Crude Carriers (VLCC) in service:


VLCC anchored:


VLCC rates Arabian Gulf to the US:


VLCC rates Arabian Gulf to the Far East:


VLCC underway:


VLCC on order:


None of these charts create a particularly bullish picture for the global oil trade. Even rates to Asia have shown no meaningful increase. I shall now get down from the roof and go back to trading based solely on the DXY!

US Natural Gas inventories also seem to be at their season highs, add this to sharp fall off in open interest in futures and it would seem that the brief rally enjoyed by natural gas is about to end:




I hope that the picture is clear: these days commodity inflation is always and everywhere a US dollar phenomenon (with apologies to Milton Friedman).

A race to the bottom

The USD, funding currency of this bubble's carry trade, and the GBP are in a race to the bottom against the Euro. It seems that the pound has it by a head at this stage as Gordon Brown is likely to use the last days before the resounding Tory election victory to devalue the nation's currency.

There is a certain element of intrigue when analysing the dollar, a geopolitical matrix of funding, reserves, commodities and trade relations. Most importantly, the dollar is the world's reserve currency and will remain the same for the foreseeable future despite calls from Russia, Asia and Marc Faber. I don't doubt the rise to prominence of the euro as a reserve currency, but the dollar's hegemony is not going to end in a hurry.



Sadly, the pound is like a Morris Marina, it works but it is ultimately doomed to extinction.

Gordon Brown's announcement on Monday that the government will start selling assets doesn't do much to bolster support for sterling. Let's be honest, £16 billion is a drop in the ocean, but it points more to the idea that things are getting pretty desperate on Downing Street. Facing a surging budget deficit, Brown and then Cameron will be facing the juggling act of fiscal tightening, spending cuts, and tax increases. It makes for a hugely unpopular mix for the next PM, and to devalue the pound looks like the easiest route for the moment.

However, here is a very real danger that devaluation won't work this time as it has in the past. The United Kingdom is no longer a manufacturing nation, it is one built on financial services, government spending and television shows on property development. The GDP boost from cheaper exports might not be enough to counteract falling tax revenues and stagnant domestic demand caused by more expensive imports.

Horrendous British cars from the 70's aside, here's the real stuff:




The pound has it by a nose:

Once more with feeling

The burning-dollar theme was interrupted here on Friday morning when a little bit of Ben Bernanke humming a hawkish tune was released to Asian test audiences. The dollar was immediately picked up by the scruff of its mangy neck and popped a quarter of a percent in no time at all.

Equities went with it, and the ASX 200 - after looking robust all morning - took a nosedive.


You could trade the ASX 200 blind at the moment, only paying attention to EURUSD. The demand for anti-dollars is what is driving this show.

Crude oil continues to look overstretched on a fundamentals basis, but as one of the most-loved anti-dollar assets, it has continued to push towards $75. I don't wish to belabour the fundamentals theme, because it is quite obvious that markets stopped paying attention to them a while ago. Regardless, here's some sobering info on crude, gasoline and distillates from Bloomberg.

The Fed has the choice to intervene verbally in the US Dollar or allow commodity inflation to start forcing their hand. The first hawkish utterance from Benny and Feds notwithstanding, us non-believers in the dollar-down-forever gospel would like to hear something better. Once more with feeling, Ben.

Winter comes early for Latvia and Swedish banks

It is a well known side-bar to the most recent global financial crisis that Western European banks - buoyed by easy money and a cheery outlook - lent piles of money to Eastern Europe in the hope that a facsimile of the "Asian Tigers" story was appearing on their doorstep. Banks from Sweden and Austria took to this growing market for credit with great alacrity, betting on new and potential members of the EU that had emerged from the wastes of the former USSR ready to do business.

Where Austria focused on its Eastern neighbours like Hungary, Serbia, Bulgaria, Romania and the Ukraine, Swedish banks focused on Baltic states just over the brine - Estonia, Latvia, Lithuania. Loans were made in euro, making Sweden especially vulnerable to currency movements. According to RGE Monitor, Swedish banks’ outstanding lending to the three Baltic states is around 20% of their collective GDP (US$ 60 billion), mostly in foreign currency.

Having recently been to Tallinn, the capital of Estonia, I found the preponderance of expensive cars and tall buildings with Scandinavian banks' names on them rather unusual for a town that seems to exist only to serve Finnish drunks and English stag weekends.

My n=1 and highly subjective opinion at the time, seems to have been rewarded by some rather juicy gossip coming out of Sweden regarding Latvia, Europe's most likely country to default next. According to this translation of a Swedish newspaper article, there are more clandestine reasons for Swedbank's second rights issue.

Latvia pegs its currency, the Lat, to the Euro, and it is now under huge pressure to devalue or face the Icelandic alternative of default. Already facing stringent cost-cutting measures that accompanied the $11bn international resucue package, you would think that Latvia might be more accommodating to Sweden's concerns considering they kicked in 10% of the package. However, the Latvian Prime Minister, Valdis Dombrovskis, instead aimed the middle finger at Swedish banks and is now enacting legislation that forces banks to collect on the current value of the property rather than the value of the loan. Property prices happen to be down 70% and this would then give Dombrovskis the ability to devalue the Lat, allowing Latvia to export its way out of trouble, and not risk killing lenders (who borrowed in euros) with the sudden hike up in the value of their loan.

Good for Latvians, bad for Swedes. GDP in Latvia is expected to fall by 18% this year and this, combined with a looming Lat devaluation, could cause serious damage to Swedish banks' capital and their ability to lend for the foreseeable future. As for your rank and file Latvian, the proposed legislation is proof that even the man on the street can get a bailout.

The dollar can't catch a bid

You could almost imagine Ben Bernanke and Tim Geithner taking telephonic high-fives yesterday. The dollar-going-down theme received a fresh tailwind yesterday and Bernanke and Co. are starting to see the debt inflate away before their very eyes. There is now a glimmer of light at the end of what seemed and endless tunnel of policy problems. Glenn Stevens of the Reserve Bank of Australia also gave global equities and commodities another tenuous reason to rally. I assume a cheque is in the mail – my advice would be to bank it quickly with the USD seemingly offer-only at the moment.

Indeed, Tuesday administered a jolt of adrenalin for dollar bears:

Firstly, there was this rather ridiculous story in The Independent. Apparently there have been clandestine meetings between the BRICS and Japan about ending dollar-denominated dealings in oil. The article is full of extraordinary speculation on behalf of the Chinese, Russians and Brazilians, ending in this inane paragraph:

Iran announced late last month that its foreign currency reserves would henceforth be held in euros rather than dollars. Bankers remember, of course, what happened to the last Middle East oil producer to sell its oil in euros rather than dollars. A few months after Saddam Hussein trumpeted his decision, the Americans and British invaded Iraq.

The story was later denied by all implicated, but not before the greenback had been pummeled into the canvas. The story also fails to recognise that a country's reserves are a function of trade relationships and dollar dealings for oil will continue as long as people want to put petrol in their tanks in the USA.

Secondly, Glenn Stevens made another shot for central banker prominence as the RBA became the first central bank of consequence to raise rates. Why they did it is baffling: CPI holds no danger, and the currency was already well-bid. The RBA hardly gave their hawkish language assault on the Australian public time to work. My only conclusion is that they were concerned by recent rises in median property prices. The RBA and Australians mineral exporters seem very confident that demand for their commodities is inelastic to currency changes. I am reminded of this Intel commercial as I imagine the scene at the RBA lunch room on Martin Place yesterday.

Finally, the demand for anti-dollar/risk-on/inflation-themed assets ran rampant. Anti-dollar assets now imply anything vaguely tradable in this space – gold, silver, crude, commodities hard and soft etc. Sure this was accelerated by the two stories above, but the demand for anti-dollars has become a self-reinforcing monster in itself.