|W.I.L. Home Page||Finance Digest Home|
|Sign Up||Offshore News Digest Home|
A TRIBUTE: DR. KURT RICHEBACHER
“Anti-bubble” patriarch does not live to see his long-running warnings vindicated.
It does not seem just: The patriarch of the current “anti-bubble” camp, Dr. Kurt Richebächer, has died at age 88. He did not live to see his long-running warnings come to be vindicated. Just as he fell ill, events began to cascade into the vicious credit crash that erupted this past August.
Kurt Richebächer was well known around the world as an authoritative financial economist and author subscribing to the Austrian School. He had an illustrious career, his public profile spanning six decades, leaving few contemporaries. After earning his Doctorate in Economics from the University of Berlin, he quickly established himself as one of the most influential voices on economic policy in West Germany while a financial journalist. He was appointed a Director of the Dresdner Bank in 1964, serving as its “lightning rod” Chief Economist.
His outspoken and incisive “no holds barred” approach often raised the hackles of government leaders. At one point, then Chancellor Helmut Schmidt reputedly asked the head of Dresdner Bank, Jürgen Ponto, to quell Kurt’s incendiary criticism of his government. Ponto then set up Richebächer with his own independent newsletter as Kurt’s analysis and insights were widely respected.
Dr. Richebächer was quoted around the world, frequently contributing guest articles in prominent publications. His commentary was so influential – and provocative at times – central bankers on both sides of the Atlantic paid attention to him. At his retirement party from Dresdner Bank in 1982, Otto Pohl (then head of the West German Bundesbank), Paul Volcker, and other well-known economic luminaries attended. Speaking at this occasion, Volcker said, “Sometimes I think it’s the job of each Fed chairman to try to prove Richebächer wrong.”
Thankfully for another generation of investors, Kurt did not take down his shingle after he retired. He carried on his weighty newsletter, Currencies & Credit Markets, producing it faithfully for another 25 years. It continued to enjoy a solid distribution around the globe in various forms, most recently under the name The Richebächer Letter. Readers may sometimes have sensed an authoritative and prophetic aura in his writing ... as rumbling admonitions rolling down the slopes of Mount Sinai. The Doctor produced his last letter (see excerpts here) in February of this year.
It is a sure observation that many analysts around the world secretly relied upon Kurt for his cogent analysis and the sharply articulated causality supporting his views. He was the man that could validate theoretically what for many were just “gut feelings”. At heart, Richebächer was an economic theorist, capable of producing a clarity of logic that could be devastatingly crushing to his opponents. He was widely read, his prodigious library including many original editions of the classic economic authors.
Certainly no market timer and not at all disposed to the frenzied short-term trading fraternity and its cheerleading cadre of Wall Street economists, in latter years he was seen more as a bane to the broader financial community. Yet, due to Kurt’s brilliant and insightful analysis, there are today thousands of investors around the world who have been alerted to the unsustainable foundations to present-day monetary and financial follies.
Urbane and warmly affable in private, it sometimes seemed that his existence was lived entirely inside economic theorems and monetary mechanisms. His idea of prompting dinner conversation on occasion was to ask the question, “What do you think of the economy?” My wife, a photographer and homemaker for many years, faced that question numerous times. He was always ready for a debate, and seemingly never doubtful about the correctness of his opinions.
In recent years, Dr. Richebächer became ever more despondent about the runaway financial inflation he was seeing in America ... and nascently, also around the globe. He was sometimes apoplectic, disbelieving that such recklessness were possible. He would often mention how few financial economists were left on Wall Street and its sister centers around the globe who knew anything about theory and causality. Without such understanding, he regarded the quantitatively-driven research of Wall Street as so much voodoo.
He found less and less contacts in financial circles that he could converse with. On one phone call a few years ago, he said something to me that I will no doubt continue to cherish, though surely undeservedly: “You are the last one in North America that I can talk to.” But now this thudding thought: What great eminence now remains for us to talk with?
The Doctor – a bright beacon, an anchor of sensibility, a purist in theory – is gone. He now leaves us “shadow Austrian economists” to make our own way. One wonders if there are any that could assume his mantle. Most contenders seem too enslaved to the readership survey or the sensationalist media sound bite.
No, Kurt Richebächer was an original. There can be no copies.Link here.
THE LIQUIDITY CRUNCH IS NOT YET OVER: THE INSOLVENCY CRUNCH HAS HARDLY BEGUN
Yes, investors are jumping back into the stock markets, hoping this is just another routine shake-out – much like February 2007, or May 2006 – before the rally resumes. The “buy-on-dips” orthodoxy dies hard. And yes, speculators have renewed their leveraged bets on the yen and Swiss franc carry trades, borrowing cheap in Tokyo and Zurich to play global assets. The core belief is that nothing has really changed, that the world economy is still in rude good health.
Be very careful. Interest rates in Europe and Asia are that much higher now, with delayed effects starting to bite hard. Japan’s economy has stalled to 0.1% growth in Q2. The euro-zone has slowed to 0.3%. And China’s refusal to import (by currency manipulation) makes it a drain on world demand. Above all, the credit bubble that perpetuated the rally of the last 18 months beyond its natural life has definitively burst.
Credit spreads on the iTraxx Crossover (a good barometer of corporate bonds) have ballooned 180 basis points since February. The cost of borrowing for most firms in Europe and North America has jumped from circa 6.5% to 8.3%, if they can get it. Many cannot. Germany’s Chamber of Industry told me that it had been flooded with distress calls from family Mittlestand firms unable to roll over credit lines. In Canada and Australia, junior mining finance has dried up almost entirely. Global junk bond issuance has been frozen for two months. Fresh sales of CDOs – a $1 trillion sold last year – have all but stopped. Banks have yet to off-load $300 billion of debt from LBO deals, forcing them to keep the liabilities on their books. They are all snake-bitten now.
The private equity buy-out premium – which pushed up the price/earnings ratio on the MSCI-600 of “median” stocks to a record high of 20 in May – has vanished. The P/E ratios on the Dow Jones Industrials are much lower – because they are too big even for the big cat predators – but they are not low, given the late stage of the cycle. In reality, an earnings bubble and ultra-cheap credit have unnaturally fattened profits.
So no, the world has changed, dramatically. Whether this means a protracted global downturn and a “profits recession” depends on how quickly the central banks choose to respond, and how far they are willing to go.
Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month U.S. Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before. Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies. This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (it hit in August 1931). If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.
“There will be large bankruptcies, and liquidity is not going to help because too many people bet the farm at the top of the cycle, and they’re now insolvent,” said Albert Edwards, global strategist at Dresdner Kleinwort. “A lot more bodies are going to be floating to the surface before this is over.”
The belief that Europe would somehow be insulated has been tested over the last two weeks. Two German banks have required bail-outs on subprime bets. Alexander Stuhlmann, boss of WestLB, confessed that the German banking system was in a “not uncritical situation”. Jochen Sanio, head of the German regulator BaFin, said a few days earlier that the country faced the worst banking crisis since 1931. Hence the continued liquidity injections of the ECB.
“Banks are still thirsty for credit, and the spreads have been amazing. This is not business as usual at all,” said Julian Callow, chief Eurozone economist for Barclays Capital and an expert in the arcane field of central bank operations. Just like the dot-com bust, when the U.S. sneezes, Europe catches ... you know the rest.
In a warped sense, one has to admire the cool way that Americans – who save nothing, in aggregate – tapped into the vast savings pool of thrifty Germans to finance their speculative excesses, and then left the creditors holding a chunk of the subprime losses. I am endebted to Randall W.Forsyth from Barron’s for this delicious quote from a hedge-fund operator, recounting with disgust what happened this time in a letter to clients: “‘Real money’ (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to ‘mark up’ these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! ... These CDOs were the only way to get rid of the riskiest tranches of subprime debt.”
Markets, as readers know, are shaken by the problem of subprime mortgage debt and are getting nervous about other potentially dangerous investments: collateralized-debt obligations (packages of often funky bonds), lower-grade mortgage-backed securities (collections of home loans, which may well default) and market-neutral hedge funds (these supposedly do well in downturns – just not these days). Add in the massive junk bond financings for private equity buyouts and the dubious stock offerings the buyout firms hawk as they take their targets public again.
If and when these investments go south, so will the returns of institutions from hedge funds to pension plans. The commercial and investment banks that finance the private equity gang’s schemes will suffer significant damage.
Announced acquisitions have shot up to $3.1 trillion globally through July, which is 56% above 2006’s record amount, according to Richard Bernstein, Merrill Lynch’s chief investment strategist. With $1 trillion-plus in investors’ money flowing into private equity in the past few years, the leveraged buyout guys are scrambling to foist their debt-laden portfolio companies on the greater fools buzzing around the stock market.
Understand what is happening here. The path to wealth for the LBO outfits has two steps. In the first, they persuade the public to surrender shares of stock of a company in return for debt obligations. The second step reverses the transaction, with bonds or bank debt called in and shares again released to the public. The dealmakers look on the difference in prices at which these two transactions take place as evidence of their business savvy. At any rate, it pays for their yachts. All of these deals hang on the willingness of public investors to swallow the securities dished out to them – the junk bonds of the companies being taken private and the equity of highly leveraged companies being brought public again.
With the credit markets seizing up, a batch of buyouts have been delayed of late, ranging from Chrysler ($12 billion) to Oxygen Media ($350 million). Caught in the middle are the big underwriters on the order of Bank of America, JPMorgan Chase, Citigroup, Morgan Stanley, Goldman Sachs, Merrill Lynch and Bear Stearns. They may be stuck either holding junk debt they cannot unload or paying cancelation fees.
How about the other half of the round-trip – the sale of equity in companies LBO’d a while ago? Peddled by the likes of KKR, the Blackstone Group and Cerberus, the newly public companies often look much scarier than they did in their earlier public incarnations. Cinemark, taken public in a share offering in April, has debt equal to 208% of equity – and that is after the new injection of equity).
So let us sum up the situation. Poor-quality bond issues are in huge supply. Investors are backing away from them. Underwriters are facing the prospect of writing off billions on the debt they are stuck with – a backlog of leveraged companies they are committed to finance in a shaky stock market. Sounds like the recipe for a classic financial shakeout. What can you do to protect yourself?
First, stay away from the new issues private equity firms are dishing up. That means both the portfolio companies they are taking public and the shares in their own money management businesses (like Fortress and Blackstone). Second, although their price/earnings multiples look cheap, do not buy stock linked to the ratings agencies, i.e., that of Moody’s or McGraw-Hill, parent of Standard & Poor’s. If there is an uproar on bad credit ratings, these companies will suffer. Third, stay away from Ambac and MBIA. They cover large chunks of CDOs and MBS’s. This stuff is toxic waste. Stick with solid blue chips that do not have a lot of debt on their balance sheets and are not trading on the prospect of being bought out in an LBO.Link here.
Glasses with half-drunk cocktails, sticky tables, piles of dirty dishes. Cleaning up the morning after is a gloomy affair. That is where we are today. The end of the great credit rally that began in October 2002 is upon us. The party is over.
Let us not be in denial: This is not an environment in which you should stretch for returns. This is the time to pull back. If you own stocks or bonds in highly leveraged entities, sell them. Now.
A lot of people, though, do not want to believe the party is over. After all, they have made good money for the past five years by taking risks. Leverage has been the electric Kool-Aid acid of choice, making ordinary business successes look dazzling. Structured finance, which employs such vehicles as CDOs (securities backed by a pool of bonds) and collateralized loan obligations (banks’ commercial loans), has allocated risk very efficiently and rewarded risk-takers such as partnerships doing LBOs.
Still, the best thing that can be said about structured finance is that the pain has been distributed. That allows the optimists to say that we are just in a short-term correction and the party will resume soon. They point to continued economic growth overseas and say it will offset any problems here.
Well, maybe not. The halo effect of foreign growth is less than it is cracked up to be. That party across the ocean may be winding down as well. China continues to raise reserve requirements for its lenders, which could throttle capital spending there. India’s central bank has unexpectedly tightened. How many signs do we need to flash yellow? Samuel Zell, whose nickname is Grave Dancer, in February divested his real estate business, Equity Office Properties. This guy knows when to sell. Blackstone, the giant LBO firm, took itself public in June at a valuation more appropriate to a marquee growth company than to a cyclical financial – and the stock has tumbled since.
The U.S. subprime mortgage market has imploded, and the problem has harmed the entire home lending realm. American Home Mortgage, which has little to do with subprime lending, closed up shop in early August. Junk bond underwriting and bank loans to high-debt companies are choked off. Bear Stearns suffered the ignominy of seeing two of its affiliated hedge funds go bust on account of subprime exposure.
Equity performance, stoked by corporate takeovers, will suffer as well. The days of jumbo buyouts are over. A respected investment banker told me recently that his firm will not even make a due diligence call on a transaction larger than $2 billion. Stocks trading on the expectation that they will be taken out in an LBO will come down in price to the point where they again sell on fundamentals. There will be much pain en route.
Every cycle has an eerie feeling of déjà vu. As banks discuss walking away from their commitments to lend to TXU and pay the deal’s breakup fee instead, I am reminded of the failure of the UAL buyout just prior to the 1989 minicrash.
Before you leap out the window, however, let me point out that the U.S. market is not doomed. Foreign investors will maintain a floor for it – perhaps lower than the current level – because America is still the world’s largest economy and a haven of stability and enterprise. Plus our assets are way cheap. The euro, at $1.36, is close to its historic high against the greenback. Someone using euros to buy dollar assets today will get an enhanced return when the euro retreats to a more rational valuation.
My read on Bernanke is that he will not prime the pump by pulling down rates, as predecessor Alan Greenspan would have. The markets should work their will, without the government artificially propping them up. Amity Shlaes’s brilliant new book, The Forgotten Man, shows how Franklin D. Roosevelt’s meddling prolonged the Great Depression. Rather than let the private sector reduce wages to keep workers employed, his experiments in wage and price controls prolonged the agony. One telling image from the book: Roosevelt would sit up in bed every morning in 1933, stick a finger in the air and make up a gold price for the day.
Aside from dumping stock in highly leveraged companies, what is a lady to do? Pay off margin debt, so you will not be vexed by margin calls, the rotten fruit of a falling market. Then take profits in U.K. and European investments (the exchange rates have magnified your returns) and plow them into smart investments at home. My favorite: 6-month T-bills, yielding just under 5%, free of state taxes. They provide a great place to hide.Link here.
MONEY MARKET ISSUES
With confidence in Wall Street finance suddenly gone, keeping all the balls in the air is still harder.
Some still refer inaptly to the “subprime crisis”. It should by now be evident that subprime was merely the point of initial risk market dislocation, in a crisis of debt contagion that has now engulfed the epicenter of the credit system – the Money Market. Global central bank interventions to the tune of $400 billion or so have been instrumental in controlling what otherwise would have been a devastating “seizing up” of global financial markets. And it certainly did not hurt that Federal Reserve chairman Bernanke was quoted last week as saying he “intends to use all available tools.” The markets delighted in the timely reminder of two of Dr. Bernanke’s most famous speeches – his October 2002, “Asset-Price ‘Bubbles’ and Monetary Policy”, and his November 2002, “Deflation: Making sure ‘it’ doesn’t happen here”.
With the past couple days of strong stock market gains and the perception that abundant liquidity has returned, scant attention will be paid to Bill Gross’s comment that the asset-backed commercial paper market was likely “history”. Wow! At the time, I thought to myself that in more normal market environments such a revelation would have been good for a 500 point drop in the Dow. But stock market complacency remains palpable – faith in the Fed and global central bankers resolute. According to the bullish consensus, economic fundamentals remain sound and, with assurances of ongoing Fed patronage, growth and corporate profits will hardly miss a beat.
Before I dive into the Money Market issue, I am compelled to refute the notion that the Fed today enjoys great flexibility to lower rates to whatever level whenever necessary to sustain the economy and stock prices. In fact, a strong case can be made for quite the opposite. For one, I believe inflationary risks are greater than generally perceived by the bulls. In stark contrast to the “disinflationary” period of the 1990s through the initial years of this decade, the global backdrop is inflationary and, perhaps, stubbornly so. Booms in China, India, Russia, Brazil, and elsewhere have respective heads of steam and, importantly, so far domestic credit systems appear to possess atypical immunity to U.S. credit tumult.
In spite of troubling illiquidity issues in cross-sections of the financial markets, the massive dollar reserves held in overabundance around the world will likely for some time buttress global energy and commodities prices. I further believe that the vulnerable dollar will prove the proverbial Achilles heel for the upcoming easing cycle. The days of aggressive – and market-pleasing – Greenspan-style rate collapses could prove a luxury of the past.
The Bank of China Ltd dropped 5.4% last Friday on the Hong Kong stock exchange after disclosing that it had $9.7 billion of U.S. subprime exposure. The European banking system is under considerable stress as it struggles to deal with U.S. credit woes. The market focus today may be on the apparent success huge interventions by the ECB and Fed are having in restoring liquidity. Yet the critical issues of private sector risk intermediation and U.S. current account deficit “recycling” become murkier by the day.
Wall Street and Washington have been all too happy to perpetuate the myth that the world simply cannot get its fill of U.S. “investment”. As the fable is told (and repeated), we consumers must gorge on imports to satisfy the requirements of a massive “global savings glut” that foreigners are almost desperate to bestow upon our (miracle) economy. Yet it is now emerging that the international banking community (especially European) has been a major participant in a massive speculative arbitrage in U.S. debt instruments – a financial scheme that is now unraveling. To what extent the dollar owes its resilience over the past few years of massive current account deficits to speculation-based “conduits” and “carry trades” is today a legitimate question.
The interrelated markets of money market funds, commercial paper, and CDOs comprise a dominant position in today’s money market. They were absolutely crucial in sustaining the aged credit bubble in the face of mounting financial and economic strain. In reality, they have amounted to the heart and soul of contemporary “Wall Street Finance” as it succumbed to perilous “blow-off” excess. After years of financial innovation begetting soaring remuneration begetting ever greater risk-taking and innovation, Wall Street had fully mastered the “alchemy” of transforming endless risky loans into securities that could be pooled to create highly-rated yet relatively higher-yielding CDOs (and other derivative instuments). Structured Investment Vehicles (“SIVs”) and various types of “conduits” used their top ratings to issue cheap short-term commercial paper to the money market funds and various (perceived safe and liquid) “money-like” investment vehicles. This Credit “arbitrage” had been enormously profitable. The securities firms accomplished similar excess returns through various special purpose vehicles, along with the newfound strategy of using CDOs and other risky securities as collateral for “repos”. This powerful monetary process was at the heart of the seduction of seemingly insatiable credit supply AND demand.
The subprime implosion and the resulting forced liquidation of various securities and structures set in motion the revelation that top ratings masked what were in many cases significant underlying credit and liquidity risks. Newfound risk aversion and the resulting reversal of the flow of speculative finance immediately and dramatically altered credit availability and marketplace liquidity, with the upshot being (“Ponzi Finance”) fragility and rapidly escalating credit and liquidity risks issues. Suddenly, the marketplace lost trust in the securities, CDOs and structures used as collateral for their commercial paper borrowings. There was a “run”, and many “conduits” were unable to roll their commercial paper and other short-term borrowings.
It is my best guess that a large chunk of the $400 billion or so central bank intervention has been provided in large part to the European banks as liquidity to accommodate the repayment of “conduit” short-term borrowings. While the scope of the problem is alarming, central banks are well-placed for providing such liquidity directly to the banking community. But I fear the market is overly complacent with respect to the ramifications and repercussions of the dislocation in this critical marketplace.
If the asset-backed commercial paper market is indeed “history” then I would expect this development to prove a seminal event for Wall Street “structured finance”. All the SIVs and conduits worked marvelously to camouflage, distort, conceal and, in the end, perilously mis-price risk – and did all of the above in grand, historic excess. Central banks maintain the capacity to create the liquidity necessary to accommodate the unwinding of this specific credit “arb”. I question, however, the viability of this critical Wall Street mechanism for risk intermediation going forward.
The “money market” has traditionally been at the nerve center of financial crises. It will often be the case that an abrupt change in perceptions (i.e., what qualifies as “money”) and a bout of risk intolerance in the “money market” will spark a panic and liquidity crisis that quickly engulfs the riskier markets. But I will be the first to admit this is no typical financial crisis. It escalated at breakneck speed, with global equities, commodities, and general asset prices at or near record highs. Additionally, the global economy is in the midst of an unusual boom. Ironically, acute fragility in the relatively safe Money Market has so far proved a boon to global stock markets. Extraordinary central bank intervention (agree or disagree, the central banks played their accepted role) has equity market participants assuming they are protected.
And while an impending financial crash was fortunately circumvented for the time being, bubbling U.S. and global equities markets cannot for long avoid vulnerability to altered risk intermediation dynamics. And this issue gets back to the flawed view of the Fed’s role in the Great Depression: If only the Fed had created $5 billion and recapitalized the banking system, so they believe, that would have provided a (“mopping up”) remedy for disastrous boom-time excesses. It would not have worked.
The issue then, as it is today, is not some finite amount of liquidity to keep the banks solvent and markets liquid. It was/is the enormous ongoing credit creation and intermediation required to sustain levitated asset prices, incomes, corporate earnings, government receipts and maladjusted economic systems. I personally believe it is at this point likely impossible to maintain these extremely inflated credit and economic bubbles, especially if trust in Wall Street finance is waning. I expect that central bankers will have to either accommodate an insatiable appetite for liquidity injections or, at some point in the not too distant future, make an attempt to draw a line in the sand and hope for the best.Link here.
STOCK MARKET GYRATIONS, PLUNGE PROTECTION, AND THE “YEN CARRY” TRADE
Crash averted, for now. A behind-the-scenes analyis of recent volatility.
For long-term buy and hold investors in the U.S. stock market, who simply sit through wild market gyrations, it is good to know that you have “Plunge Protection Insurance”. The dynamic duo of U.S. Treasury chief Henry Paulson and Federal Reserve chief Ben “B-52” Bernanke are working overtime these days, and using all the weapons in their arsenal to prevent a bear market from materializing, while Wall Street faces its worst financial crisis in many decades.
In today’s world of extreme market volatility and information overload, the memory span of the average hedge fund trader has been reduced to about 24-hours. Just two weeks ago, the global stock markets went into a mini-meltdown, after BNP Paribas, France’s biggest bank, froze €2 billion in three hedge funds it manages, because they contained toxic U.S. subprime mortgage debt that could not be sold. It was the second time that the American subprime debt bomb exploded in Europe. Earlier, Germany’s IKB Bank, said it expected to lose 20% of its €17.5 billion stake in U.S. subprime mortgages. To stop IKB from unraveling, the Bundesbank cobbled together several banks to provide €3.5 billion euros to cover the bank’s losses, and prevented Germany’s biggest banking crisis in 75 years. In July, Bear Stearns declared that two of its hedge funds that owned U.S. subprime slime were headed for bankruptcy. Now traders are wondering if other banks and investment firms that are exposed to billions of dollars of the toxic sub-prime mortgages, will come clean and show the full extent of their losses.
Looking at the big picture, the Dow Jones Industrials Average is a key instrument of national economic policy, and that by “actively managing” its direction, the PPT aims to impact the wealth of tens of millions of U.S. households, and by extension, influence consumer confidence and spending. Its strategy is to offset weakness in the U.S. housing market with increased household wealth in the stock market, to avoid a recession.
The PPT has several weapons in its arsenal to “influence the direction” of (rig) the stock market. The first is “jawboning” or propaganda spewed to the media, designed to influence market psychology and trader behavior. But when verbal intervention begins to wear thin, or is seen as not credible, the PPT can turn to its next weapon, active intervention in the stock index futures markets. In July, the PPT tried to draw a line in the sand for the DJIA at 13,250, by purchasing stock index futures contracts after big market plunges, and squeezing short sellers. But the shocking revelations at BNP Paribas and IKB, and reports that Citibank might own $35 billion of subprime home loans, overwhelmed the PPT’s defense line at 13,250.
Once 13,250 was broken, the DJIA fell sharply, and went into a panic free-fall on August 16th, when Countrywide Financial tapped an emergency $11.5 billion line of credit from its bankers to stave off bankruptcy. It was looking very bleak for the S&P 500 that day, which was teetering on its first 10% correction in 53-months, but then suddenly the PPT began its most impressive rescue operation this year. First, the Fed injected $12 billion into the hands of Wall Street dealers in the last hour of trading, who in turn, pumped DJIA futures from a 330-point loss to break-even by the closing bell. The next morning, the PPT unleashed its second most powerful weapon, by lowering the discount rate on loans to major banks by 0.50% to 5.75% just minutes before the expiration of put option contracts on U.S. stock indexes. The DJIA futures market rebounded from a 120-point loss in European dealings to a stunning 257-point gain, within a 5 minute span, after the Fed pledged to drive interest rates as low as necessary to drive the stock market higher.
The PPT’s inter-meeting move to lower the discount rate by 0.5%, coupled with a pledge to take further action to inflate the stock market, created a powerful short squeeze. It was reminiscent of the “shock therapy” applied by former Fed chief “Easy” Al Greenspan in April 2001. Greenspan slashed the fed funds rate by 0.5% to 4.50%, as part of his crazed effort to reinflate the U.S. stock market bubble, and avoid the Japanese deflation experience. The surprise rate cut boosted the DJIA by 400 points, and was followed up by another 0.5% cut to 4.00% a month later, juicing the DJIA up 375 points to 11,200. In hindsight however, the DJI-30 was simply building a “rounding-top” pattern, and ultimately rolled over into an erratic bear market over the next 22-months.
The Tokyo Connection
In today’s brave new world of global investing, the PPT leans heavily on Tokyo’s financial warlords, to help manage the “yen carry” trade. The sharp unwinding of yen carry trades from July 19th thru August 16th, highlighted by the U.S. dollar’s slide from 123.50 yen to as low as 112.10 yen, contributed significantly to the DJIA’s slide from the 14,000 level to as low as 12,500. Between the Fed’s $12 billion repo injection on the afternoon of 8/16, and the discount rate cut on the next morning, Japan’s new FX chief, Naoyuki Shinohara, made his first public comment since taking up the job, “As always we are watching currency markers carefully.” Currency traders understand the code words “watching carefully” as a threat of intervention in the market.
Just minutes before the opening of the NYSE on the morning of 8/17, Japan’s Kyodo news agency reported, without quoting sources, that the Bank of Japan would likely to hold off from raising interest rates at its policy board meeting on August 23rd. The report lifted the USD to 114.30 yen. Two days later, Japanese Finance Minister Koji Omi told the media, “I am watching developments closely,” lifting the USD further to 115.20 yen. Omi said he agreed with Henry Paulson in a phone conversation on August 21st that the two sides would closely watch market developments for a while.
Anytime the yen rises sharply, Japanese warlords begin talking about “unnatural moves in markets,” and warn, “We are watching the yen closely.” Having elevated “jawboning” to an art form, outright intervention usually is not necessary. Few traders are willing to challenge Tokyo warlords, after Japan sold a massive ¥35 trillion ($330 billion) in 2003 and Q1 2004, to stop the dollar from falling under 100-yen.
Nobody knows the exact size of the yen carry trade, but estimates run anywhere from $500 billion up to $1.2 trillion. But as long as Tokyo continues to actively manage the dollar’s value against the yen, and the Bank of Japan keeps its interest rates pegged below 1%, the trade will continue to mushroom to dangerously high levels. The only way to put this high leveraged trading activity out of business, is for the impossible to happen, the BoJ must lift its interest rates above 1 percent! “Global financial markets need Japan’s interest rate to be returned to normal,” said Bank of Australia chief Glenn Stevens on August 17th. But the U.S. Treasury and Wall Street are hooked on cheap capital from Tokyo, and love the yen carry trade.
What surprised yen carry traders during in the U.S. dollar’s recent slide to as low as 112-yen, was the lack of Japanese intervention at the 116-yen area, where Tokyo warlords had placed a floor under the dollar in December 2006 and again in March 2007. Tokyo might have bowed to heavy pressure from its trading partners in Asia, Canada, and Europe for a stronger yen, to level the playing field for exporters. When the dollar fell below 116 yen, the unwinding of the yen carry trade hit the stock markets like a hurricane. Global traders, who leverage about 10 times their own cash to trade stock index futures contracts, were unwinding losing positions with the trigger of automatic stop-loss limits. The dollar quickly plummeted to as low as 112.10 yen.
Tokyo warlords paid a very heavy price for allowing the dollar to fall below 116 yen. It triggered a second wave of selling in the Nikkei-225 Index to the 15,400-level, or 15% below the 6-year high of 18,250 reached in mid-July. Banking shares led losers on uncertainties over their exposure to the U.S. credit market turmoil. If the Nikkei-225 Index remains weak and underperforms other global markets, a BoJ rate hike to 0.75% could be on ice for a long time. The BoJ will take another look at the dollar/yen exchange rate and the Nikkei-225 at its September 18th meeting.
Currency traders are already jumping back into the yen carry trade, betting that the Plunge Protection Team will pressure the BoJ to keep its rates steady for the remainder of the year, especially with the Fed expected to lower the U.S. fed funds rate in the months ahead. The BoJ’s leak to the Kyodo news agency, telegraphing a steady Japanese monetary policy had already energized the Dow Jones Industrials’ with its 800-point rally above the August 16th low.
PPT expected to unleash its most powerful weapon.
Now, the PPT is working hard to jig the DJIA back into its former trading range between 13,250 and 13,700, with its magic bag of tricks. A lower fed funds rate is probably required to keep the artificially inflated stock market afloat. The question in the Chicago interest rate futures market is whether Bernanke will lower the fed funds rate by a quarter or a half-point, perhaps at an inter-meeting rate cut before September 18, for extra shock treatment.
Yet how far could the Fed cut rates, given the perilous state of the U.S. dollar? And what impact would Fed rate cuts have on the yen carry trade? It is a very dramatic turn of events since the Fed’s statement on August 8th, when it held the fed funds rate steady at 5.25%, and said its top concern was elevated inflation. But over the past decade, every time there has been a crisis the Fed has opened the spigots and poured liquidity into the stock market to mute the impact on the real economy. The “Greenspan put” was a bet that “Easy Al” would respond predictably to financial crises. His response to the bursting of the dot-com bubble in 2000-01 was to slash real interest rates to less than 0% for more than a year.
Greenspan was a serial bubble blower, and today’s problems with record home foreclosures, a deflating housing bubble, incipient inflation, a crippled U.S. dollar, and the subprime debt bomb are all part of Greenspan’s legacy. Now that “B-52” Ben is signaling a lower fed funds rate ahead, some traders are wondering if an easier Fed policy could signal the death knell for the DJIA’s bull run since March 2003, similar to the experience of 2001-02. On the other hand, the PPT has demonstrated its ability to rig the stock market in the past week. The PPT is “watching the markets closely”, and Paulson and Bernanke aim to prevent a 10% correction at all costs.
PPT rigging under fire from Swiss National Bank.
Swiss National Bank chief Jean Pierre Roth sharply criticized the PPT for trying to rig the stock market in a interview with the Neue Zuercher Zeitung on August 19th. “We hope that volatility stays higher. What we had was not normal, namely, practically no volatility. Markets cannot be a one-way street, or you will get excess. The aim of central banks should not be to eliminate volatility again,” he said.
Roth said explosions from the U.S. subprime mortgage debt bomb have some way to fully detonate. “What happened is unbelievable,” said Roth. The exposure of French and German banks to the U.S. subprime slime did lead to a flight to safety into the Swiss franc from the euro in recent weeks, tightening monetary conditions in Switzerland. SNB deputy Philipp Hildebrand said banking giants UBS and Credit Suisse were in a “comfortable position” to deal with potential shocks through their profitability and surplus capital. “They are capable of absorbing larger shocks through their balance sheet.”
So it will be very interesting to see if the SNB goes forward with a 0.25% rate hike to 2.75% at its upcoming September 13th meeting, especially with the Fed under heavy pressure to lower rates to prop up the U.S. stock market. The SNB often coordinates its rate moves with the European Central Bank, which will decide whether to lift its repo rate by 0.25% at the very last minute, at its upcoming September meeting. Higher interest rates in Europe, coupled with an easier Fed policy, could knock the U.S. dollar lower. Swiss franc Libor futures for September are yielding 2.75%, suggesting that traders are betting that the SNB will lift its Libor target next month, despite the turmoil in the global credit markets. Much will depend upon gyrations in the euro/Swiss franc exchange rate.
Ancient Chinese Secret
If U.S. Treasury chief Paulson wants to know the magic elixir for elevating the Dow Jones Industrials to 20,000, perhaps he can ask his hosts in Beijing for the secret, the next time he goes on a mission, asking for a stronger yuan. Shanghai red-chips climbed above the 5,000 point, passing another milestone in a spectacular bull run that has more than quadrupled the index since the start of last year.
The bull-run has added a staggering $2.5 trillion to the value of the Shanghai and Shenzhen markets since the start of 2006. Three months ago, Greenspan warned that the Shanghai red chip rally was a bubble about to burst. And who knows more about bubbles than Greenspan himself? At that time, the Shanghai index was at 4,173 points, before a brief correction to 3,600 unfolded.Link here.
WORLD ECONOMY CONFRONTED BY PARADOX OVER LIQUIDITY
There is a paradox of liquidity in the world economy today. In large parts of the financial system market liquidity is in scarce supply. The supply of credit is tightening and the price of risk is going up. But at the macroeconomic level, liquidity remains abundant.
To some extent the liquidity paradox is an illusion, deriving from the fact that we use the word liquidity to describe several distinct ideas. As investors have discovered in recent days, macro-liquidity (plenty of savings) does not guarantee cheap and available credit, or micro-liquidity (ease of buying and selling in markets).
Kevin Warsh, a Federal Reserve governor, argued in a speech in March that micro-liquidity was largely a product of confidence – a commodity that is in short supply now. But Ken Rogoff, a professor at Harvard and former chief economist of the IMF, says: “There is clearly a link between macro-liquidity and micro-liquidity.”
“Global liquidity is strong,” says Raghu Rajan, a professor at Chicago and, a former chief economist of the IMF. “There is still in some sense an excess of desired saving over investment.” He says the problem is not supply of savings, but the fact that market dysfunction is making it hard to reallocate these savings. “This certainly is one of the differences from 1998” – when there appeared to be a global shortage of savings – says Mr. Rajan.
Some sketch out a scenario in which the sovereign wealth funds that invest some of the world’s excess savings could ride to the rescue of troubled markets. This is unlikely, as these funds are risk-averse. Still, the savings have not gone away, and once markets stabilize this should help to moderate any long-term increase in the price of risk and decline in market liquidity. Throw in a strong global economy and cash-rich corporate balance sheets as well, says Mr. Rogoff, and it is “an extremely soft cushion on which to land.”Link here.
HEDGE FUND’S SHORT BETS FAIL TO OFFER PROTECTION AGAINST LOSSES ON LONG SIDE
James Pallotta’s $8.5 billion Raptor fund has fallen 8% this year through August 15 as a common hedging strategy he uses – betting against some stocks – failed to protect him amid a global equities selloff. “Some of our core longs were simply crushed,” Pallotta, who manages Raptor from Boston for Tudor Investment Corp., wrote in an August 21 letter to investors. “Compounding matters, our short book failed us, which was enormously frustrating because historically it has been more volatile than our long book.”
The list of hedge funds reporting losses this month has been dominated by quantitative managers such as AQR Capital Management LLC and Goldman Sachs, which use computer programs to pick trades. Pallotta is a long-short manager who buys shares he expects to rise and hedges those bets with short sales of stocks he expects to fall. “For the first time in the history of our equity strategy, we received virtually no performance contribution from our short book against the backdrop of a precipitous market decline,” Pallotta wrote. “While we believe conditions will revert to ‘normal,’ it will take time.” Pallotta, 49, also called deeper economic troubles “likely” in coming months.
Pallotta has posted an annual return of 19.2% since Raptor opened in October 1993, almost double the S&P 500. Tudor, founded by billionaire trader Paul Tudor Jones, 52, manages a total of $20 billion. “Currently, we believe that having more cash is prudent in the short run,” Pallotta said in his letter. “Our response to the drawdown is exactly that expected by our investors and demanded by the Tudor ‘playbook.’ Gross and net exposures have been reduced dramatically and may shrink further.” Raptor’s managers are “cash flow-obsessed stock pickers,” he wrote. “Hence, we will be more discriminating until there is, for better or worse, greater clarity about both the functioning of the capital markets and the path of economic growth.”Link here.
COUNTRYWIDE DEAL A BARGAIN, NOT A BAILOUT
For real bailouts, just wait ...
Sentiment is growing that Bank of America’s Kenneth Lewis may have won a place in the pantheon of great Wall Street titans by using his financial clout to help the country avoid economic ruin. In some circles, Bank of America is being seen as critical to the end of the Panic of 2007.
The Wall Street Journal crowed that “the deal at once helped stabilize the credit markets and gave Bank of America a foothold in the nation’s biggest mortgage lender.” The move also was a tonic for a company that was driving “depositors into branches to withdraw funds and [sending its] stock tumbling,” Merrill Lynch wrote in a negative credit report that mentioned the possibility of bankruptcy. “The infusion also may help to reassure investors that the mortgage market is safe after rising default rates sparked a global credit crunch,” Bloomberg said. In Europe, Agence France-Presse observed that Lewis “boosted confidence about an easing of the credit squeeze,” and that this was “a sign of confidence that the storm in the mortgage sector may be ending.”
The B of A move comes exactly a century after J.P. Morgan – back then, the man and the bank were the same – helped stem the Panic of 1907. That year, depositors made a run on two U.S. banks. Morgan responded by convincing U.S. Treasury Secretary George Cotelyou to inject $25 million into the banking system. Sound familiar? Morgan also created a $3 million pool to save Trust Company of America. Responding to pleas from the New York Stock Exchange, Morgan, leading a consortium of bankers, pledged another $25 million to back the exchange. He also bailed out New York City by backing a $30 million bond issue.
In today’s terms, that would be about $600 million for the banking system, $71 million to Trust Co. and a $631 million bond issue. Morgan did not put up all the funds, but he organized the relief. His reward? Morgan helped the economy, and in turn his own assets. A thankful Washington allowed him to buy a railroad worth about $16.7 billion today for $1.1 billion.
Morgan is not alone in coming to the rescue during a financial crisis. Warren Buffett rescued Salomon Brothers in 1991, and a consortium of banks rallied by the New York Federal Reserve bailed out Long-Term Capital Management by putting up $3.6 billion in 1998. U.S. banks also stepped in to buy flailing savings and loan thrifts in the late 1980s and ‘90s. They usually scooped up assets as discount prices.
This idea of bailing out by bargain-shopping is really what is at work here with Lewis. “Bank of America was just looking for a bargain, and essentially got one,” said Charles Geisst, a history professor at Manhattan College and author of several finance books. Geisst believes that the Countrywide acquisition did not even really stabilize the mortgage markets, as some have suggested. The market for mortgage-backed securities is still impaired, he noted.
This leaves Lewis as more of a shrewd opportunist than patriotic investor. He and B of A, after all, have been pining for a piece of Countrywide for more than five years. Not only did the executive get the stock at a deep discount of nearly 50%, but also the shares pay a 7.25% dividend. What is more, the investment immediately returned a paper profit of more than $400 million after the deal was announced and Countrywide’s stock soared.
For those longing for a Wall Street baron to save the markets like the great J.P. Morgan, there may be opportunity yet. “We will get some rescues,” Geisst said, pointing to the decision by B of A, Citigroup, J.P. Morgan Chase, and Wachovia to borrow $500 million each from the Fed’s discount window. “Those four going to the discount window is like someone from the Upper East Side going to Wal-Mart,” Geisst added. “They were probably fronting in the marketplace for an institution that was really in trouble.” Maybe there is a modern-day Morgan out there. We can all pitch in and buy him a railroad.Link here.
BE A SMART INVESTOR, OWN WATER
It is no surprise to you that we have been seeing one of the most volatile markets of this century. It should also be no surprise to you that it takes sound investments to actually make money in times like these. I would like to share with you one way to navigate around the falling share prices of late.
In the rising tide of market volatility, the sinking level of worldwide water supply provides us with a fundamentally sound investment theme. Simply put, water is precious, especially when you do not have it. The New York City pipe explosion last month gave us a sneak preview of what the problems here in the U.S. are. Pipes that stretch across the entire U.S. like are ready to burst like the one on 41st and Lexington did. And, to my surprise, people still have not put it together. Water companies are still trading for unbelievably low prices.
The water theme has many facets. There are water pipemakers and filtration companies, irrigation equipment, water pumps and more. The facet I want to focus on here is just the basic resource itself – owning actual water – because the investment backdrop for a rising water price looks pretty good from here. The Financial Times recently highlighted the salient population-based facts. Take a look at this chart. The chart shows how water use has grown faster than population growth. In fact, annual world water use rose 6-fold – more than double the rate of population growth. What does it mean? The FT opines, “One unavoidable consequence will be that the price of water will rise substantially.” I would agree.
When you study where population growth is greatest, you come to find out that it is in areas where water is most scarce. Look at the U.S., for example. The two fastest-growing populations in the country are those of Nevada and Arizona. The American West is already a dry and arid place. This past spring was the 6th driest on record. In some states in the U.S. south, it was the driest spring in 113 years. Drought conditions persist into summer in many parts of the country. Wildfires have devoured hundreds of thousands of acres of valuable timberland. Crop losses start to add up. And now drought threatens the Midwest, the heart of the ethanol boom and home to record levels of corn acreage. It should only get drier as the years roll by. No matter what you believe about what is causing this pretty little blue and green planet of ours to warm, it is nonetheless warming. And everyone seems to agree that certain places will get drier and hotter. These trends provide a powerful backdrop for rising water prices.
Right now, there are some absurd anomalies in water markets around the world, because governments provide or heavily regulate most of the water consumers use. You have absurdities such as those that occur in California. Farmers consume 80% of California’s water. California’s infamous alfalfa growers drink up 25% of the state’s water. However, because of government subsidies, they pay only $2-20 per acre-foot for water – about 10% of the water’s full economic cost. There is little incentive to cut water use when rates are this low. In Europe, the government still provides 2/3 of the water supply. In America, it is 85%. In Asia, 95%. Water has been too cheap for too long. And years of government ownership have, not surprisingly, led to neglect of these systems.
In the U.K., “where the water sector is mainly privately owned,” the FT informs us, “and prices probably reflect costs more accurately, prices are the third highest in the world – 66% above those in the U.S.” We will pay more for our water one way or another, or we will no have it. In certain Western states, you can see how much people pay for water by looking at contracts between the owner of water rights and utilities (and other end-users). The price per acre-foot is tens of thousands of dollars in some places.
The price of water has nowhere to go but up.Link here.
THE INDIAN INTERNET INDUSTRY
Asia’s online population is growing by leaps and bounds, but it still has a long way to go. With more than 3.6 billion people, the Asian continent is home to approximately 54% of the world’s population. But only about 10% of them are online, according to Internet World Stats.
But the Internet fever is spreading. The number of Chinese online increased by about 1/3 during 2006, to 132 million people. Overall, China’s online population has increased 486% since 2000. But that is nothing compared with India. The country’s Internet population has grown 700% since 2000. And there is still plenty of room for it to expand.
More than 1.1 billion people live in India. Only 40 million are online – a mere 3.5% of the total population. In mature Asian Internet markets, such as Hong Kong, Japan and South Korea, there is a saturation rate of about 68%. If India reaches 50% saturation over the next several years, this will mean more than 500 million new Internet customers. Compare this with the 210 million Internet users in the U.S.
Until recently, the Indian telecom industry was controlled by the government. This led to the services being generally inferior to those in other countries. And it is now in the infancy of expanding and updating these communications. The government is helping things along by reducing barriers for telecom providers. Cheaper computers are also on their way.
Internet access in India is surprisingly affordable, as well. A monthly broadband subscription can cost as little as 199 rupees ($4.50). Also, we are seeing lots of new local content being created, specifically Web site registrations under the “.in” domain. These factors will lead to millions of new Internet connections over the next several years. And more Indians will be searching the Web for locally relevant content.
The potential here is enormous. Japan’s market penetration is around 67%, but during its growth period huge money was being made. Take a look at this chart. This shows the revenue growth of Japan’s largest ISP, Nifty Corp, during its breakout growth period in the 1990s. This pattern could soon be duplicated by one or more Indian ISP(s).
And now, we have found the perfect company that is ready to profit from the information age’s advance on the Indian subcontinent. This company has been the pioneer of computer network and ISP companies in India. It was the first independent company to offer dial-up connections when the market was deregulated in 1998. And it was the first Indian Internet company to be listed on the NASDAQ National Market in the U.S.
The company believe’s the growth of the Internet in India has been held back by high costs and poor user experiences caused by inadequate infrastructure and slow network connections. They intend to change that. The company has invaded the Indian market in four main sectors: Dial-up and broadband Internet services, local content on numerous Web portals, corporate networking services, and the largest franchised network of computer cafes on the subcontinent. Once the ball gets rolling, this revolution stands to show investors serious gains.
[Ed: The company described appears to be Sify Ltd. (symbol: SIFY, home page: sifycorp.com). It does not look cheap based on assets, earnings or cash flow (none of either), sales, etc. On the other hand, the balance sheet shows minimal debt, and price-to-sales is around 2.5. So if the concept works out, at least the upside is not already priced in.]Link here.
SCIENTISTS ARE FINALLY UNDERSTANDING HOT FUSION
Some scientists at the esteemed Max Planck Institute have just cracked one of the thorniest unsolved questions about electricity. It may have powerful applications. New Scientist reports that ball lightning – the mysterious form of energy sometimes seen during thunderstorms – has been created in the lab. The Max Planck Institute’s scientists have figured out how to use underwater electrical bursts to generate ball lightning. (Technically, they call it “luminous plasma clouds”.) The creations last for about half a second and are 8” in diameter. This makes their size comparable to the size of naturally occurring ball lightning, which has been reported by many observers, including scientists, for centuries.
The laboratory-created version does not last nearly as long as has often been reported. However, when people are startled or frightened, time often seems to pass more slowly, so it is possible the observers were wrong about duration. It is also possible that the scientists have yet to understand the properties of these balls fully, and that optimization is possible.
The scientists are hopeful that these plasma fields will deepen understanding of “hot” fusion reactions such as those inside stars. The intent is to develop an inexhaustible power source based on the fusion of deuterium – a special form of hydrogen found in seawater – atoms. Interestingly, more than one approach to creating ball lightning has proven successful in recent months. Earlier this year, Israeli scientists succeeded.
The practical significance of all this is, as yet, unclear. “Hot” fusion has been “the next great energy source” for decades, and always seems to be 20 years away. I am not holding my breath for that one, especially when alternatives (including so-called cold fusion) are stirring up so many interesting results.
Having said that, it may have more down-to-Earth significance. One of the challenges in generating a true “hydrogen” economy is the efficiency of converting water to hydrogen and oxygen. Specifically, it currently takes more energy input to split them than is recoverable by burning them (although I am watching a California startup that may just have cracked the problem using an ingenious approach). A better understanding of these unique plasmas that dance around like living beings may hold the clues to a better approach to generating hydrogen.
That would be huge.Link here.
THE 21ST CENTURY DUST BOWL
The next Great Black Blizzard is on its way.
A darkness blacker than night is how it was often described. It was only midmorning. People had never seen anything like it. If you ventured outside into the cold and biting wind, sand would get in your nose and mouth and ears. You would hurry back inside and cough up black. While inside, people soaked sheets and towels. They would try to stuff them around windowsills and doorframes. Choking dust still filtered in.
It was November 11, 1933 – Armistice Day – in South Dakota. When it was finally over, families would stumble out of their farmhouses and peer out at a new surrealist landscape. The fields were gone. The trees were no more. Just mounds of sand and eddies of dust swirling in the light autumn breeze. There were no roads. No tractors or machinery, no fences. All of it laid buried in sand.
The great Black Blizzard of 1933 destroyed farmland stretching from the Texas Panhandle all through the Great Plains and clear to the Canadian border. The following day, the skies darkened over Chicago. A steady stream of filth fell on the city like snow. Even people as far east as Albany, New York could see the menacing dark clouds roll their way across the horizon. That winter, red snow fell softly on New England.
Yet 1933 was “only a prelude to disaster,” as Frederick Lewis Allen wrote in his panorama of the 1930s, Since Yesterday. In 1934 and 1935, the dust storms destroyed thousands and thousands of acres of farmland. The lives of more than half a million Americans changed forever. Many hit the road, forced to wander like refugees in their own land. Most headed west, looking for a new start.
The Dust Bowl was a seminal event in American history. Unlike a natural disaster such as a hurricane, “There was a long story of human error behind it,” as Allen wrote. After World War I, there was a great demand for wheat. Mechanized farming also became common. Farmers tore up the sod that covered the plains and farms expanded. The Great Plains was a region of high winds and light rainfall. Yet the 1920s were pretty forgiving in terms of drought. There were warnings, though, such as stories of topsoil blowing in Kansas after a stretch of dry, hot weather. But in the 1930s, we had some real droughts in these places. The combination of drought and desiccated farmland would create the epic Dust Bowl.
I recently spent some time looking over pictures of the aftermath of these blizzards. They are incredible and simply hard to believe. Yet I see how something like this could happen again. Except this time, it will be bigger. And it will happen in China. Plumes of dust emanating from northern China have already hit the U.S. mainland. As Lester Brown, author of Outgrowing the Earth explains, “With little vegetation remaining in parts of northern and western China, the strong winds of late winter and early spring can remove literally millions of tons of topsoil in a single day – soil that can take centuries to replace.” These dust storms often force the closure of schools, airports and stores – even in places as far away as South Korea and Japan.
As with the Great Plains, northern China is dry and farmed intensely. Already, China’s farmland is turning to desert at an alarming rate. Estimates peg the loss at more than 900 square miles per year. And Chinese farmers already struggle to meet the demands of the Chinese people. There is limited arable land in northern China. So the Chinese rely more on fertilizers to boost yield. Currently, fertilizer use in China is more than three times the global average. This is one of the reasons companies like UAP Holding Corp. (NASDAQ: UAPH) thrive today.
So you have chunks of Chinese farmland turning into desert every year. You have got limited water resources in a dry region. Already you have got dust storms that kick up plumes of dust that travel thousands of miles. If China relied on the rest of the world for even 20% of its grain needs, there would be an incredible strain on the world’s grain producers.
Many of the challenges China faces exist in the world at large already. Grain production per person is falling worldwide. So is cropland acreage per person. We are also approaching the limits of what fertilizers can do in terms of boosting crop yields. Plus, strong demand for biofuels like ethanol now competes with food demand. By some estimates, we will need to produce about 136 million tons of grain in 2007 to prevent grain stocks from falling again. Yet annual increases in grain production have averaged only about 20 million tons since 2000.
The investment conclusion from all this seems to be that we are in a long bull market for grains. Expect the prices of corn and wheat to keep rising. Expect the price of meat to rise. It also seems that fertilizer producers should continue to do well. Other ancillary ideas also come to mind – shippers of dry goods (i.e., grains) and manufacturers of farm equipment. The potential for another 1930s-style Dust Bowl only adds to the power and durability of these trends.Link here.
WHEN FOOLS RUSH IN, THE JOKE IS ON THEM
Dissecting the Henny Youngman Economy.
An idea for a morality play: Capture the madness of an era when investors, entranced by new technology, a novel set of economic assumptions, and an all-powerful Federal Reserve, lost their heads, blew an exuberant bubble, and suffered a painful bust. Sure, it may be late for a chronicle of the zany dot-com 1990s. But this template can be adapted easily to the financial trend that has defined this decade – and that may have now come to a close. It is, in a way, the Henny Youngman Economy. Lenders pleaded: “Take my money ... please!”
In recent months, harbingers of the end of the credit bubble have been popping up like shoots of forsythia in the spring. The spring brought rising subprime delinquency rates and the ensuing failures of subprime lenders. In July, leveraged hedge funds tanked, and several massive corporate-debt offerings were shelved. This month, mortgage rates for borrowers with good credit have spiked, and credit-card giant Capital One Financial jacked up interest rates, citing “business and economic factors.”
In the past six years, since Alan Greenspan’s Fed slashed short-term interest rates after 9-11, and U.S. auto companies rolled out 0% financing, cheap money evolved from a privilege extended only to the ultrarich into a near-constitutional right. Credit derives from the Latin root credo, meaning “I believe.” (Subprime comes from the Latin root sub primo, meaning “Foreclosures in southern California.”) And this credit boom rested on the staunch belief in three pillars of faith, all of which, coincidentally, underlay the 1990s boom:
Cue Mr. Youngman. As low rates proliferated, lenders fell over themselves to stuff cash in customers’ pockets. And, ultimately, the lenders jumped the shark. 95% loans gave way to no-money-down mortgages to buy preconstruction condos in Miami. Subprime loans morphed into low-doc loans, no-doc loans and, the ne plus ultra, NINJA loans: no income, no job, no assets. In this age of promiscuous credit, the overriding sentiment was “trust, but don’t verify.”
Bankers proved similarly accommodating to corporations, especially to private-equity firms. Historically, most bank loans came loaded with covenants – early-warning systems that stipulate that the borrower has to keep spending to a certain level. But starting in 2005, Wall Street banks, eager to supply credit to hungry private-equity firms, began extending “covenant-lite” loans – debt blissfully free of such requirements. In May 2007, according to Goldman Sachs, such loans accounted for 15% of bank debt.
It all worked fantastically well – borrowers got their money, bankers collected their fees, investors harvested interest payments. But this year, one by one, the pillars underlying the Henny Youngman Economy crumbled. The securitization of subprime mortgages had the perverse effect of tethering more investors around the globe to the same crumbling assets. Home prices fell nationwide for the first time in a generation. And Alan Greenspan’s replacement, Bernanke, revealed himself to be more concerned with the prospects of inflation than with the prospect of unemployment among hedge-fund managers.
Chagrined lenders have been gripped by the sudden realization that debt can, and does, go bad. So, just as rapidly as they rushed to lower standards, mortgage companies – the ones that remain solvent – and lenders of all types are rushing to tighten them. Credit, the fuel that powers the economy, is becoming more scarce and expensive. Somewhere, in the great borscht belt in the sky, Henny Youngman is hoisting his violin.Link here.
THE PUNCH BOWL CAUCUS
The motley collection of gazillionaires, conservatives, and industrialists begging the Fed to cut interest rates.
In the past week, a strange group has been pleading for the Federal Reserve to return the punch bowl to the toga party – to slash interest rates to restart the Wall Street party. The Punch Bowl Caucus, whose members hail from all over and hold different ideological views, share a common belief: that the Fed, by reducing either or both of the interest rates it controls, can turn the clock back to the halcyon days of 2005 and 2006, when home values moved in only one direction, when defaults were nonexistent, and when credit to homebuyers, consumers, and, above all, to hedge fund operators, ran downhill like a mighty stream.
CNBC commentator James Cramer founded the caucus with his now-famous capitalist manifesto on Aug. 3. (He serves as honorary chairman of the Wall Street chapter.) Cramer urged the Fed to act on behalf of the greatest among us – “My people [that is, hedge fund operators, private equiteers, and assorted tycoons] have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business” – as well as the least among us. “Fourteen million people took a mortgage in the last three years. Seven million of them took teaser rates or took piggyback rates. They will lose their homes.”
While Cramer’s tirade was lighting up YouTube, desperate manufacturers banded together to form a Midwestern chapter. Ford CEO Alan Mulally and Chrysler CEO Robert Nardelli may be new to Detroit, but they have quickly adopted the local custom of looking to Washington when sales begin to slump. A week after signing on to Chrysler, Nardelli, the former CEO of Home Depot, realized he had jumped from one position where he got nailed by the declining housing market to another where he is likely to get nailed by the declining housing market. So on August 16, Nardelli suggested it would be a good idea if the Fed were to cut rates. The following week, Ford CEO Mulally obliquely echoed Nardelli’s call.
Meanwhile, supply-siders were organizing their own punch bowl chapter, which has a unique bylaw: The government should never intervene in the economy, unless it is to bail out hedge funds and investment banks. Trusting the suddenly volatile, forward-looking markets more than backward-looking government data, supply-siders have concluded that inflation is under control, and hence that it is safe for banks to start giving money away again. Wayne Angell, a former Fed governor, convened this chapter in its clubhouse – the Wall Street Journal op-ed page – with a call for the Fed to cut the Federal funds target rate by 75 basis points. Angell’s motion was heartily seconded by CNBC’s Larry Kudlow, writing in the National Review group blog the Corner.
The caucus has had its biggest recruiting successes in the housing sector. In announcing the formation of this chapter, Angelo Mozilo, CEO of Countrywide Financial, the nation’s largest mortgage lender, succumbed to the common sin of extrapolating to the general from one’s particular circumstances. In his interview with CNBC’s Maria Bartiromo, Mozilo said that the punk housing market would undoubtedly lead the nation into recession—an event that should inspire cuts in the Fed funds rate.
But it is not just struggling rich guys who are begging for cuts. Martin Wolf, chief economics commentator of the Financial Times, formed an international auxiliary. Wolf appealed to Americans’ vanity and missionary zeal. He pleaded with Bernanke to forget about the sufferings of gazillionaires like Angelo Mozilo, and think about poor Chinese peasants. In today’s global economy, he argued, Americans excel at borrowing and spending while the rest of the world excels at saving. Americans must spend to keep the world’s factories humming. And to do so, they need cheap credit.
The Punch Bowl Caucus has already proved to be an effective lobbyist. The Federal Open Market Committee meets next on September 18, and the futures markets indicate that investors believe a rate cut is highly likely. But while the caucus looks like it will chalk up an early tactical victory, I wonder whether it has a winning strategy. The Punch Bowl Caucus holds as an organizing principle that the Fed can provide a real and psychological boost to markets, and hence minimize or obviate entirely the fallout of natural economic occurrences such as asset bubbles and the business cycle. College students do not alleviate the after-effects of an evening spent at the punch bowl by returning to lap up the dregs. Just so, finance types should know that cheap money, credit on demand, and endless leverage are not the cure for a hangover caused by too much cheap money, leverage, and credit on demand.Link here.
THE FED’S NEXT MOVES
Let us not forget the Fed’s main job: The save the big banks.
Bernanke and the Fed Open Market Committee are now paying the price of their tight-money policies that began the month that Bernanke became Fed chairman, February, 2006. He inherited the boom and bubbles that Alan Greenspan’s expansionist monetary policy had created. This expansion began in mid-August 1982 under Paul Volcker, and accelerated in the month Greenspan took over, October 1987. With stop-and-go policies to restrain price inflation, Greenspan concealed the irreversible direction of an 18-year era of loose monetary policy.
After June, 2000, the Fed began lowering the target rate for federal funds, the rate at which banks lend money to each other overnight. It fell from 6.5% to 1% in 2003. Then, slowly, it was raised back up. When Greenspan left office, on January 31, 2006, it stood at 4.5%. The target rate is the rate that, when breached by the actual free market Fed Funds rate, the Fed will intervene and buy a financial asset with newly created money, thereby lowering the Fed Funds rate. This intervention reassures bankers that the Fed will honor its target rate.
This happened on August 3, when the high for the day hit 6.5%. It hit 7% twice in June and twice in July. In each case, the Fed intervened, and the rate dropped to 5.25% or slightly above. The Fed intervened immediately on August 3, as before, and by the end of the day, the market rate was 5.24%. It hit 6% again on August 7. The Fed knocked it down to 5.27%. The next day, it went to 6.05%, and the FED knocked it down to 4.68%. And so on, every day, ever since. The free market Fed Funds rate has been above the target rate every day, interday, and the FED has knocked it back down before the end of the day. You can monitor this here.
So, what we see in recent months is that the market rate has been pushing through the target rate, then the FED knocks it down. This has led to an increase in the adjusted monetary base since the first week of July. The chart is here (PDF). This is not proof of a great reversal of the FED back to inflation, but it is consistent with such a move.
The Fed Funds rate under normal times remains under the target rate all day long. The market does not normally get a full percentage point above the target rate, interday. Yet it did twice in June and twice in July. That should have tipped off stock market investors that a problem was brewing. Money was getting tight. Banks were not meeting their reserve requirements, and were forced to borrow. I told my website subscribers on June 23 that I thought the stock market was close to a peak, but it took until July 19 for this peak to occur. There was a euphoria that blinded investors’ eyes to problems brewing regarding bank liquidity.
Stock market investors respond to symbolic announcements. When the stock market is toppy, the symbols that investors respond to most are changes in the Fed’s announced rates. In most situations, this is the Fed Funds rate. In rare instances, it is the discount rate, the rate at which the Fed loans money directly to banks. Usually, this is kept a percentage point above the target Fed Funds rate. On August 17, the Fed announced a cut in the discount rate from 6.25% to 5.75%. This is very rare: a half-point spread between the FedFunds target rate and the discount rate.
Five days later, on August 22, four major money center banks borrowed $500 million each: Citigroup, J. P. Morgan Chase, Bank of America, and Wachovia. These are the four largest banks in the U.S. This was very peculiar. First, this market is usually under $100 million. Second, the Fed has a policy of not revealing which banks have borrowed. Third, the announcement came independently from the four banks. Fourth, all of them borrowed exactly $500 million. Deutsche Bank AG also borrowed, but it did not say how much.
Let’s review: The four largest U.S. banks on the same day borrow the same amount of money and go public with this information when they are not required to. This was not collusion. Not at all. Nobody who does not want a lawsuit would say it was. It was just one of those things, just one of those crazy things.
The Wall Street Journal offered this interpretation: The move is widely viewed as symbolic, since all of the banks borrowing from the central bank can obtain less-expensive funds elsewhere. But one Fed goal is to remove the traditional stigma attached to borrowing from the discount window so that more banks may feel comfortable borrowing. Historically, the discount window has been where banks borrow when they are unable to borrow anywhere else. But, so far, these large banks appear to be the only ones that have tapped the discount window, with its above-market rate of 5.75%, when money can be obtained at 5.25% through the Fed Funds market.
On August 24, Fortune reported that on August 20, the Fed temporarily exempted Citigroup and Bank of America from restrictions on these banks’ lending money to their brokerage divisions. The article also said that this exemption had been granted by letter on August 20. Then they both borrowed $500 million on August 22. Just one of those crazy things.
But what does this exemption mean? The article’s author thinks it means there is a liquidity crisis. The regulations in question effectively limit a bank’s funding exposure to an affiliate to 10% of the bank’s capital. But the Fed has allowed Citibank and Bank of America to blow through that level. Citigroup and Bank of America are able to lend up to $25 billion apiece under this exemption, according to the Fed. If Citibank used the full amount, “That represents about 30% of Citibank’s total regulatory capital, which is no small exemption,” says Charlie Peabody, banks analyst at Portales Partners.
The Fed says that it made the exemption in the public interest, because it allows Citibank to get liquidity to the brokerage in “the most rapid and cost-effective manner possible.” On the day this information appeared, the Dow rose 145 points. Investors thought this was all great news. I think it reveals panic at the Fed, which in turn is based on panic at the money center banks.
What will the Fed do next?
Forecasting what the Fed will do is like reading tea leaves, but let me give it a try. The Fed does not want to send a message of panic, so it will not lower the Fed Funds target rate until its next scheduled meeting, which is September 18. At that meeting, it will announce a rate cut. The Fed will cut it by at least 0.25 percentage point. But to be sure that bankers know the Fed means business, I think it will be 0.50 percentage point, matching the cut in the discount window’s rate. This will be heralded by the financial media as a sign that it is time to buy stocks. The increase from 1% in 2003 to 5.25% in 2006 was also seen as a signal to buy stocks. Everything is the media’s signal to buy stocks.
The Fed has another problem to deal with – the lack of information on the condition of the banks’ business loans. Are borrowers in good shape to repay? This is the issue of looming corporate insolvency, which is the result of the liquidity problem in this, the early stage of a contraction in the economy. So, I think the announcement of a half point cut in the Fed Funds target rate will be accompanied by new requirements on reporting to the Fed – a quid pro quo for providing new banking reserves.
Here are the Fed’s two problems. First, the Fed for three months has been battling to keep the Fed Funds market rate at 5.25%. To do this, it has had to increase its holdings of debt. This is inflationary. If it pushes the target down to 4.75%, then it will have to add reserves even faster than it is adding them today. Second, the Fed cannot examine every business account in every bank. It must sample a few big-name banks’ largest clients, whose faltering would present a problem for the money center banks. The Fed cannot examine every small bank’s client base.
As Franklin Sanders says, the Fed has only two tools: inflation and blarney. They will use both on September 18. This assumes the Fed can wait until September 18. If things get really dicey between now and then, the Fed will have to cut the rate early. This will create uncertainty about the extent of the crisis. The Fed’s fiat money is always welcome, but the Fed must not be perceived as running around like a chicken with its head cut off.
The yield curve is the drawn shape of interest rates for Treasury debt from one month to 30 years. I think the 90-day/30-year rates are most significant. Others prefer 90-day/10-year. Under normal times, the 90-day rate is below the longer rates.
On August 20, the rate for 90-day T-bills fell from 3.76% on day before to 3.12%. This indicated investors’ near-panic move to safety. It was on this day that the Fed sent out the letter authorizing Citigroup and Bank of America to lend money to support their equity funds. The next day, August 21, the rate went up sharply to 3.59%, indicating that the panic had subsided. The 30-year T-bond rate was at 4.98% on August 20. The next day, it fell to 4.95%. On August 24, it was at 4.88%. This indicates a move into long-term debt. Why would an investor do this? In order to lock in a rate for 30 years. This is a move toward recession-protection and away from inflation-protection.
Yet the money supply is increasing. Won’t long rates go up? Yes, but not in a straight line if investors at the margin see recession as the major threat. Long rates will fall, then rise. I remain bearish on the economy, but I also recognize that stock market investors respond to symbolic moves by the Fed. They see fiat money as good for the economy. They think the Fed can overcome a looming recession. The war between bulls and bears will continue. I think the bears will win it over the next six months.
While the Fed is now pumping in new reserves at a little under 6% per annum, and I expect it to continue this policy for the foreseeable future, I do not think this will be enough to reverse the sagging economy in the next six months. If I am wrong, then we can expect a return of accelerating price inflation.
I think the Fed has reversed course. The comparatively tight-money policy it followed from February 2006 to late June 2007, is a thing of the past. Preliminary signs of the recession predicted by Austrian economic theory became visible in the capital markets: first, with respect to new home builders, then with respect to the inverted yield curve, then with daily upward breaches in the Federal Funds rate, then with a falling stock market.
I do not believe the Fed can withstand pressures from money center banks to inflate or die. It has not resisted since about 1938. I see no reason to believe that it will again reverse course and allow a major credit crisis. “Too big to fail” is still the Fed’s mantra. It is also Congress’s mantra.
Its relatively tight-money policy was nice while it lasted, but it looks as though the economy’s days without the punchbowl have ended. Of course, I hope I am wrong. The economy needs stable money. But the price is a move into recession and the bursting of the housing bubble. Politically, this is a price the Fed is unwilling to pay. It would generate too much pressure from incumbent politicians in Washington. The Fed’s #1 function is to save the money center banks. It has surely taken visible steps to meet this obligation in recent weeks.Link here.
TOO MUCH CONFIDENCE
The rapid rebound in the world’s stock markets following the Fed’s cut in its discount rate demonstrated again the central feature of the current market: investors have far too much confidence that all will turn out well, without major economic calamities or even market downturns. For their own wealth and that of the U.S. and world economies, the quicker we can inject some healthy worry into their outlooks, the better.
The problem is that confidence sells. Indeed we need a fair amount of confidence in order to get through our day successfully. Psychologists have demonstrated that our natural state is to imagine ourselves more capable than we really are, imminently about to make the big breakthrough in our careers, able to forecast with more than usual accuracy which investments will do best for us. While it is notoriously the case that most institutional investors fail to beat the averages over the very long term, it is inescapably the fact that most private investors do even worse, buying high, selling low, being absurdly prone to following fashion and missing the performance of the stock averages by a substantial margin. The only thing that prevents us falling into terminal depression is that most of us are too lazy or poor at record-keeping to benchmark our performance properly against the indices.
The investment management and brokerage industries flourish through our optimism. That is why most market commentary is relentlessly bullish. Of course, over the last 25 years relentlessly bullish market commentary has been right most of the time, with only the occasional regrettable setback in 1989-91 or 2000-02. Brokers, whose worst nightmare is the investor who sticks his money into an index fund and forgets about it, have made large fortunes over that period by convincing us that their bright new strategy is the one that will infallibly lead us to riches. Institutions themselves are not immune, otherwise the hedge fund and private equity fund industries – distinguished more for the size of their fees than for the superiority of their returns – would have no customers.
At the top of the cycle, of course, the perpetual optimists have credibility – and money. Ken Fisher, the broker whose perpetually bullish commentary infests the Internet, is a billionaire according to Forbes. In his new book, annoyingly advertised to me by e-mail, he claims investors believe three falsehoods: high price-earnings ratios make stocks risky, rising oil prices drive stocks down and big budget deficits are bad for the economy. I would argue that two out of three of those “incorrect” beliefs are bedrock principles of economic understanding and the third is true in most cases. However he is a billionaire and I am not, so let us pass on. As I said, optimism sells.
Confidence and salesmanship are particularly lucrative in the more high-tech portions of the financial market, where disclosure is limited and understanding even more so. Products such as securitization and derivatives have enabled deals to be done that would have been impossible in days when lenders knew their borrower the old-fashioned way. The entire subprime mortgage market rested on this.
This is also the case in the leveraged buyout market ... and in the hedge fund arena. Confidence and salesmanship allow the hedge funds to accumulate huge amounts of capital, then leverage themselves further from the banking community, pledging supposedly risk-free assets as “collateral”. Their quantitative investment techniques work well provided there is enough money behind them – they can force the market in the direction they need it to go. Borrowing yen at 2% and lending Australian or New Zealand dollars at maybe 6% or 7% is easy money while you can force the yen down and the Aussie dollar up, preventing any unpleasant losses on your currency mismatch. Derivatives trades allow the reality to be obscured and sometimes bring additional returns.
Once confidence ends, the markets move in the wrong direction on their own and even the weight of hedge fund money becomes insufficient to force them into submission. Complex derivative contracts, particularly those involving options, become illiquid and the models driving the investment strategy cease to work. Thus hedge funds using these strategies can suddenly report losses of 30%, 40% or even 100%.
Market action in the last 10 days suggests there is still ample confidence in the system. Most participants are after all young and well paid (which itself tends to make them over-confident) and barely, if at all, remember the last significant credit market downturn, in 1989-90, let alone the last big one in 1973-75. The U.S. stock market is off only about 5% from its peak, and is well up for the year. The yen carry trade appears to have resumed, with the yen showing weakness against the dollar. Countrywide, one of the biggest mortgage lenders, has been bailed out with an equity injection from Bank of America. BNP has figured out a way to price its subprime mortgage bond funds again.
This is not a good thing. The spread of securitization and derivatives has enabled more bad deals to be done, confidence to be raised to a higher and more irrational level and the asset bubble to be prolonged. By increasing the opacity of the market, these new techniques have weakened its ability to price risk appropriately.
Needless to say, when confidence finally disappears, the market outcome will be very bloody indeed. We have already seen this, in a blip in the inter-bank market similar to the darkest days of 1974, in which banks have been forced to pay more for simple overnight funding because counterparties did not trust what hideous losses might be hidden in their dealing rooms. This first time around, injections of cash from the Fed and the ECB prevented the panic from worsening. However panic will return, and at some point the world’s central banks will be unable to dampen it down. In the end, when all becomes opaque, all becomes uncertain and market confidence dies. Roll on that day, for ending the wave of overconfidence is a necessary corrective. The longer it is delayed, the more expensive the denouement will be.
At that point, market participants will doubtless wish that a healthy suspicion of new apparently painless ways of making money had been maintained throughout.Link here.
WHAT YOU PROBABLY DID NOT KNOW ABOUT THE U.S. DOLLAR AND GOLD
I turned bullish on gold in the late ‘90s, in my former post as a stockbroker. The collapse of the “strong dollar policy” of that period formed one of the major premises of my case for gold at the time. However, by early 2005, as the currency reached my original target and began bouncing off its long-term lows, I recommended that clients no longer bet against the dollar, because I felt that the dollar would level off. Still, I wrote, gold prices were going to make their biggest move yet. As subsequent events proved, I had that one right.
Now, the gold story is this: The value of money is in danger of dropping precipitously again, and it is increasingly likely that the world monetary system will have another brush with hyperinflation akin to what occurred in the 1970s, except this time, worse.
The evidence supporting this thesis is devastating, yet this story is scarcely factored into gold values, let alone financial markets. That is, we have seen a rush to gold when the foreign exchange value of the U.S. dollar has crumbled, when other commodities have left the station, because the Chinese and Indian economies were heating up, and so on. But there has yet to be a significant enough deterioration of confidence in central banking institutions, or the quasi-fiat money they produce, to produce a true hard goods buying panic. The evidence suggests we are headed there, but it also suggests that the most spectacular part of the bull market in gold must still lie ahead of us. But the most interesting part about these “spectacular” moves in gold, where the market’s spotlight focuses entirely on the gold story (the greatest story never told), is the behavior of the currency markets.
The biggest moves in the gold price occur when the foreign exchange value of the U.S. dollar is stable.
It may initially sound counterintuitive. Consider first the fact that the largest moves in gold’s free-trading history occurred in four brief periods each lasting 2-3 years: 1973-1975, 1978-1980, 1985-1987, and 2005-? We know that the first two of these occurred during bull markets in gold, the third one in a bear market rally, and the last one we believe to be a bull market move, which can hardly be considered arguable at this point. The two former periods and the last (current) one have something important in common – they saw the lowest (inverse) correlations with the currency. They occurred when the U.S. dollar had reached some level of relative stability following a 2-3 year collapse in its foreign exchange rate.
Since its 1971 fix, the price of gold is up about 18.5-fold. Everyone will notice the general inverse relationship between the dollar and the gold price that can be seen in the chart, but it is not a well-known fact that the gains in the price of gold that occurred in the top three bull market moves alone (shaded regions in the previous table), where exchange rates were most stable, explain nearly 2/3 of this whole move in gold prices – more than $400 of the gain from $35 to $650 – while the U.S. dollar’s foreign exchange rate fell less than 5% net.
If we apply the 1970s model to the current move that started in 2005, we would suggest that it could end in late 2007 with a run in gold prices to somewhere between $900-1,200, and the dollar might well be only a few points from where it is today when it all blows over. Both of the instances of dollar stability in the ‘70s saw the most spectacular gains in the gold price, and by all counts, the same factors are at play today. Investors were surely just as surprised by it then as they will be today.
There are a lot of strong arguments for why the dollar should continue to new lows. But these arguments may already be factored in the medium-term (3-18 months) currency outlook, and attention should perhaps be drawn to the overlooked bullish arguments favoring the U.S. dollar, e.g., money supply inflation by international central banks has exceeded the Fed’s for four years.
The main point is to illustrate the historical precedent behind a potentially bullish gold price explosion, regardless of whether the U.S. dollar makes new lows or not. The historical fact is that gold’s biggest moves occur when the U.S. dollar is relatively stable. Now you know what few people do.Link here.
|Previous||Finance Digest Home||Next|
|Back to top|