President-elect Barack Obama’s new spending initiative, which is reported to involve massive infrastructure investments in education, clean energy, and others, is not the remedy to the economic crisis, but it’s nonetheless the best course of action for the government. Unlimited and indiscriminate temporary liquidity provisioning, and even permanent cash grants to individual firms have both failed to produce a perceptible improvement in the financial markets, despite the persistence and extravagance of the government authorities. Nor should these measures be expected to produce any results, because this crisis broke out as a consequence of money saturation, i.e. the explosion of a bubble, where the efforts of  central banks to further inflate the money supply, and increase risk appetite receive ever decreasing responses from the markets until such a point is reached that the central banks and government authorities become all but irrelevant to the behaviour of the markets.


One can speak of a money saturation event as the mirror image of hyperinflation which is nowadays more often seen in emerging markets and developing nations, where the ability of the financial system to mask inflation through speculative activity and sustained asset price rises is far more limited. In an advanced economy such as the US, where the political mechanisms are so formed that the wage-setting power of the employee is much less limited, the increasing money supply is directed to channels that cause inflation in a more subtle and less obvious way: instead of the employee causing prices to rise through increased demand, the  employer causes asset values to rise through speculative activity, the windfall from which is shared with employee through the transmission channels of an advanced economy, such as mutual funds, REITs, and others.


In other words, inflation caused by higher wages is the fruit of a more socialistically-inclined system. Inflation caused by higher asset prices, leading to money saturation, is the creation of a more capitalistic system, where political power is willing to check the irrational desires of labour, but is far more complacent with the nonsensical activities of the rich and powerful. The terms “rich” and “labour” are only used in a general sense here, without implying that the agents that cause asset price inflation are always the “rich” in the direct sense of the word.


Once a more unified understanding of inflation is thus achieved, it is also easier to see why gold is not gaining against the dollar nowadays, and why, for instance, despite the extreme profligacy of the government, the dollar is not collapsing. The simple fact is that the collapse in the value of the dollar that many in the market have been anticipating in the past years has already occurred: gold has already appreciated from around 220 dollar per ounce to more than 1000 per ounce in the course of around eight years. In that sense, the US was already going through a period of hyperinflation, however, the event was masked by asset price appreciation, as CPI remained relatively tame. Thus, whereas in a developing nation, or an emerging market, extreme rises in money supply will result in hyperinflation, and will essentially lead to money being to worthless to be used as a transaction mechanism, a money saturation event will lead to money being too valuable to be used as a tranaction mechanism, with the result, however being the same. Both hyperinflation, and money saturation lead to recessions. The hallmark of hyperinflation is extremely high nominal rates, while that of money saturation is negative rates.  


The implication of all this, of course, is that an economy without the structures (such as securitisation, investment banking, pension insurance) that can channel money supply in effective ways to create asset bubbles, will be faced with hyperinflation in the classical sense, provided that there is enough growth in money supply to create it. However, the characteristic of a money saturation event is the rapid shrinkage of money supply which essentially precludes any wage inflation until the underlying pessimism is overcome.


This website declared a few days ago the Fed offers unlimited funding to institutions which it knows are bankrupt, but demands punitive interest in return, which it probably knows cannot be repaid.” Here are the latest developments on this matter:

American International Group Inc. got a $150 billion government rescue package, almost doubling the initial bailout of less than two months ago as the insurer burns through cash at a record rate. The Fed will reduce the $85 billion loan to $60 billion, buy $40 billion of preferred shares, and purchase $52.5 billion of mortgage securities owned or backed by the company. The interest rate on the $60 billion credit line will be reduced to the three-month London interbank offered rate plus 3 percentage points, from a previous spread of 8.5 percentage points in the original rescue plan.  The original $85 billion loan was disclosed on Sept. 16, a day after the collapse of  Lehman Brothers. AIG later received an additional $37.8 billion credit line on Oct. 8 to shore up its securities-lending program and then another $20.9 billion on Oct. 30 under the Fed commercial paper program designed to unlock short-term debt markets. AIG has about $5.6 billion left unused in the CPFF. The company renewed doubt about its prospects today by saying in a federal filing that it might not survive.

AIG has posted a $24.5 billion third- quarter loss today. The insurer has posted about $43 billion in quarterly losses tied to home mortgages. Edward Liddy’s plan to repay the original $85 billion loan by selling units stalled as plunging financial markets cut into their value and hobbled potential buyers.

“It was obvious to me from Day One that the terms of that arrangement were really quite punitive in terms of the interest rate and the commitment fee and the shortness of it,” Liddy said today in a Bloomberg Television interview. “I started really about a week after I got here trying to renegotiate.”.

AIG’s third-quarter loss equaled $9.05 a share and compared with profit of $3.09 billion, or $1.19, a year earlier, AIG said in a statement. Losses in the past year erased profit from 14 previous quarters dating back to 2004.

The revised rescue may fix two AIG operations that are draining cash because of the collapse of subprime mortgage markets. In the first, the U.S. will provide as much as $30 billion to help buy the underlying assets of credit-default swaps that AIG sold to investors, including banks. AIG will contribute $5 billion and bear the risk of the first $5 billion in losses, the Fed said.

Credit-Default Swaps

The insurer guaranteed about $372 billion of fixed-income investments in CDS as of Sept. 30, compared with $441 billion three months earlier. AIG booked more than $7 billion in writedowns during the quarter on the value of the swaps.

The New York Fed also will lend as much as $22.5 billion to a new limited-liability company to fund the purchase of residential mortgage-backed securities from AIG’s U.S. securities-lending collateral portfolio. AIG will make a $1 billion subordinated loan to the new entity and bear the risk for the first $1 billion of any losses, the Fed said. The securities lending operation and the previous $37.8 billion credit line from the Fed will be shut down, AIG said.

Securities lending accounted for $11.7 billion, or about two-thirds, of the $18.3 billion in impaired investments in the third quarter, AIG said.

The biggest insurers in North America posted more than $120 billion in writedowns and unrealized losses linked to the collapse of the mortgage market from the start of 2007, with AIG representing about half that total. The company has units that insure, originate and invest in home loans.

What’s the new one-year price target for GM? It’s zero, according to Deutsche Bank. GM is one of the best suited companies in the US for bankruptcy, as it hasn’t posted an annual profit since 2004 and its sales in the U.S. have declined every year since 1999. On what kind of capitalistic basis can the US government justify the saving of such a company? If it offers any great danger to the system, than it should be dismantled gradually. But to save it, and to allow it to exist as a living corpse is entirely against all the principles of a free market economy.

General Motors Corp. plummeted as much as 31 percent and moved toward its lowest level in 62 years after a Deutsche Bank AG analyst downgraded the shares, saying they may be worthless in a year.

“Even if GM succeeds in averting a bankruptcy, we believe that the company’s future path is likely to be bankruptcy-like,” Deutsche Bank’s Rod Lache wrote today in a note which recommended selling the shares and cut his 12-month price target to zero. He previously advised holding the stock.

Barclays Capital and Buckingham Research Group cut their price targets for GM to $1.

Government Support

This weekend, U.S. House Speaker Nancy Pelosi of California and Senate Majority Leader Harry Reid of Nevada wrote to Treasury Secretary Henry Paulson in order to urge that bank-bailout funds be opened up for loans to automakers. As Rahm Emanuel, chief of staff to President-elect Barack Obama, said the U.S. auto industry is “essential” to the economy, the White House signaled its opposition, saying aid to the industry wasn’t discussed during the debate on the banking bailout. Congress may take up automaker assistance when it returns next week.

GM, in a regulatory filing today said “Based on our estimated cash requirements through December 31, 2009, we do not expect our operations to generate sufficient cash flow to fund our obligations as they come due, and we do not currently have other traditional sources of liquidity available to fund these obligation.”

Implied volatility for GM options exceeded 300, a level Lehman Brothers Holdings Inc. topped before its bankruptcy filing and American International Group Inc. reached prior to the U.S. government’s bailout.

The particular case of GLG is related to Lehman, and thus its troubles are not that unexpected. However, we keep getting reports of more hedge funds freezing client withdrawals, as their debt-financed business model appears to have lost its credibility in the eyes of many investors:

GLG Partners Inc. limited client withdrawals from the $2.9 billion GLG European Long-Short Fund so it isn’t forced to sell selected investments that have tumbled in price, people familiar with the matter said. The fund, the London-based firm’s largest, segregated the securities in an account called a side-pocket, where it plans to hold them until values recover. Investors’ redemption requests will be reduced because the fund has fewer assets available for sale to raise cash.

GLG, which oversees $17 billion, took a similar step last month with its Emerging Markets Fund. GLG said last week it suspended redemptions from its Market Neutral Fund and GLG Credit Fund, also to prevent forced sales of investments.

“Hedge funds have seen and will likely see continued outflows given the market conditions,” Noam Gottesman, GLG’s chairman and co-chief executive officer, said in a call with analysts and investors today.

GLG, founded as a unit of Lehman Brothers Holdings Inc., said today that third-quarter profit excluding acquisition costs fell 25 percent to $21.8 million. Assets dropped 27 percent to $17.3 billion at the end of September from $23.7 billion on June 30.

Pre-IPO Securities

The European Long-Short fund saw the percentage of assets invested in companies preparing an IPO rise as the value of its publicly traded shares dropped. Those securities couldn’t be sold at the prices the fund paid for them.

Lagrange’s fund fell 14.6 percent this year through Sept. 30, according to data compiled by Bloomberg. That compares with the average 23 percent loss by long-short funds, according to data compiled by Hedge Fund Research Inc. in Chicago.

Meanwhile despite fears of waning demand, Treasuries gained after the government’s first sale of three-year notes in 18 months attracted stronger-than-forecast demand today. So far there is no evidence of any inflation panic among investors, and the continued massive borrowings of the government may hinder some inflation being realized, as the liquidity sucked out of the markets through government auctions is lost in the clogged channels of the US banking system, where the government throws it. But it’s especially important that, from Bloomberg “indirect bidders, a class of investors that includes foreign central banks, bought 36.1 percent of the notes sold today, the most since May 2005, when they purchased 40.3 percent. Investors bid for 3.07 times the amount offered, the most since May 1998.” This data in itself is enough to ensure continued strengthening of the dollar. Indeed, that is what I expect to occur throughout next year, and possibly beyong, based on the assumption that the economic slump will be long-lasting.

Yields on two-year notes fell to an almost eight-month low. The $25 billion auction drew a yield of 1.8 percent. Today’s sale was the first of three this week totaling $55 billion, the biggest quarterly refunding in more than four years.

“It was pretty obviously a very strong auction,” said, an interest-rate strategist in New York at Barclays Capital Inc., one of the 17 primary government securities dealers required to bid at Treasury sales. “It indicates that strong demand remains for short-end Treasuries and the Treasury’s not yet being penalized for increasing supply significantly.

Yields on the benchmark 10-year note fell 4 basis points to 3.75 percent, below their 200-day moving average of 3.79 percent.

AIG Rescue

The U.S. revived the three-year note to help pay for the Treasury’s $700 billion bank-rescue plan and fund a budget deficit projected to widen from last fiscal year’s $455 billion as the economy shrinks and tax receipts slow. The Federal Reserve and the Treasury today enhanced a rescue package for American International Group Inc., almost doubling to $150 billion an initial bailout in September, as the insurer burns through cash.

The government plans to sell $20 billion in 10-year notes Nov. 12 and $10 billion in 30-year bonds Nov. 13 as part of its quarterly refunding, the biggest since February 2004. The Securities Industry and Financial Markets Association recommended trading close at 2 p.m. in New York and stay shut worldwide tomorrow for the U.S. Veterans Day holiday.

`Find a Home’

“The fear was that this particular auction was going to fare poorly because the three-year was on a short day, the holiday was coming and we have more supply coming” this week, said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. “Money has got to find a home somewhere, and there are a lot of products that don’t exist anymore or institutions that just won’t buy those products anymore.”

Goldman Sachs Group Inc. forecast the deepest recession since 1982, with the economy contracting 3.5 percent in the fourth quarter and 2 percent in the first three months of 2009.

18-Month Turnaround

It will take at least 18 months to turn around the U.S., even if President-elect Barack Obama “does everything perfectly,” Columbia University Professor Joseph Stiglitz, a Nobel Prize-winning economist, wrote in the Washington Post yesterday.

The difference between two- and 10-year yields increased to 2.50 percentage points as the shorter-maturity notes outperformed. That’s the highest since October 2003, based on closing prices.

The yield gap reached a record of 2.74 percentage points in August 2003 after the Fed finished a series of 13 rate reductions. Typically, the spread is steepest as the central bank stops lowering borrowing costs and investors anticipate an economic recovery, according to Tony Crescenzi, chief bond strategist at Miller Tabak & Co. LLC in New York.

`Remain Depressed’

“I think yields will remain depressed and continue to decline here, particularly on the front end” of the Treasury market, said Martin Mitchell, head government bond trader at the Baltimore unit of Stifel Nicolaus & Co. “The Treasury needs to fund all these bailout programs they are announcing, and that could keep pressure on the curve and keep it relatively steep, and that could present a struggle for the long end.”

The Treasury today also auctioned $27 billion in three- month bills at a rate of 0.355 percent and $27 billion of six- month bills at a rate of 0.99 percent.

After Australia, China, Japan, India, the U.S., the euro region and the U.K. all reducing interest rates within the past three weeks, there’s some improvement in the unsecured lending market. However, with the Libor-OIS spread still at an enormous 170 points, compared with a normal of just  11 basis points in the five years before the crisis started, we’re very far from a recovery in lending, and we’ll probably see even worse numbers in the coming weeks.

The London interbank offered rate, or Libor, that banks say they charge each other for such loans declined 5 basis points to 2.24 percent today, the lowest level since November 2004, the British Bankers’ Association said. The overnight rate rose 2 basis points to 0.35 percent, still 65 basis points below the Federal Reserve’s target rate. The Libor-OIS spread, a measure of banks’ willingness to lend, narrowed.

In a sign that central bank attempts to loosen credit are starting to work, interest rates on U.S. commercial paper, or CP, fell to the lowest in at least 12 years today. Rates on the highest-ranked 30-year CP dropped 16 basis points to 0.88 percent, or 12 basis points less than the Fed’s target’s rate. Average rates soared to a record 278 basis points more than the target rate on Oct. 9, according to yields offered by companies and compiled by Bloomberg since January 1996.

On the other hand, financial institutions lodged 225.5 billion euros ($288 billion) in the European Central Bank’s overnight deposit facility Nov. 7, down from 297.4 billion euros the previous day, the ECB said, indicating many banks are still reluctant to lend to each other. The daily average in the first eight months of the year was 427 million euros.

In Asia, three-month Hibor, the benchmark for Hong Kong interbank loans, dropped 10 basis points to 2.14 percent as the city’s monetary authority added funds to the system. Australian banks lowered the rate they charge each other for three-month loans by 3.7 basis points to 4.95 percent as the Reserve Bank of Australia signaled more rate cuts. A basis point is 0.01 percentage point.


There’s now speculation of widespread devaluations in emerging market currencies, and I believe that defaults in the emerging market sphere will be inevitable during the next two years. Bloomberg is reporting on Russia, but I’m much more concerned about Turkey, with its very large and worrying external deficit position, and its seemingly complacent economic leadership.  


Goldman is added to list of those who are dissatisfied with their analysts:

Goldman Sachs Group Inc., the Wall Street bank that cut 3,200 jobs, about 10 percent of its work force, last week, identified six equity analysts who were fired by the firm, including William Tanona, who covered companies such as JPMorgan Chase & Co., and Deane Dray, who followed General Electric Co.

“Goldman has always been the best, and when the best of the breed starts to weaken, it’s not a good sign for any of them,” said Joseph Saluzzi, the co-head of equity trading at Themis Trading LLC in Chatham, New Jersey. “Research was kind of a loss leader. If you’re not making money on the trading side, you can’t support the research.”

Bank and brokerages worldwide have eliminated about 150,000 jobs since the subprime mortgage market collapsed last year.

But the analysts themselves keep fluttering in Cloudcuckooland: (kudos to Aristophanes for this term)

Even after cutting estimates at the fastest rate ever, Wall Street strategists still need the biggest year-end rally in the Standard & Poor’s 500 Index for their forecasts to come true.

David Kostin of Goldman Sachs Group Inc. predicts an advance because U.S. companies are cheap relative to earnings. Strategas Research Partners’ Jason Trennert is counting on a resumption in bank lending to lift equities. Thomas Lee at JPMorgan Chase & Co. says stocks are swinging so much that a 25 percent jump by Dec. 31 isn’t out of the question. Kostin, Trennert and Lee are among the most pessimistic of Wall Street strategists with year-end estimates tracked by Bloomberg.  The average Wall Street forecast calls for the S&P 500 to break out of a bear market and surge 20 percent to 1,118 by Dec. 31 — more than twice as much as the biggest-ever advance to close out a year. Strategists were even more bullish at the beginning of the year, predicting that the S&P 500 would end 2008 at a record 1,632.

Strategists were also calling for a record gain at this time last year, after the first quarterly decline in corporate profits dragged the S&P 500 down from its high of 1,565.15 on Oct. 9. It never materialized and stocks have dropped 41 percent since.

The S&P 500 is poised for its worst year since the 1930s after almost $700 billion in bank losses froze credit markets and spurred concern the economy will shrink. U.S. equities posted the steepest monthly loss in 21 years in October and $6 trillion was erased from U.S. markets in 2008.

The strategist who cut his projection the most since September was Deutsche Bank AG’s Binky Chadha. Chadha abandoned his year-end call for the S&P 500 to reach 1,350, decreasing it on Nov. 7 to as low as 800 and becoming the first strategist to acknowledge the possibility that stocks may fall for the rest of the year. Chadha, previously one of Wall Street’s biggest bulls, declined to comment through spokeswoman Renee Calabro.

Fair Value                                          

Merrill Lynch & Co.’s Richard Bernstein also reduced his forecast last week. “Severe overvaluation at the end of August is correcting,” wrote Bernstein, who doesn’t provide a year-end estimate, on Nov. 4. “Our models are still working their way back to fair value.”

The rate at which strategists are reducing their estimates is a sign equities are close to a nadir, some investors say.

“The U.S. is going to be the first market out of the bottom,” Barton Biggs, a former Morgan Stanley strategist who now runs Traxis Partners LLC, a New York-based hedge fund, said on Bloomberg Television. “We’re at a major buying opportunity.”

And this is also where my 500 target for the S&P 500 in 2009 comes from: The S&P 500 trades at 10.39 times next year’s estimated earnings from continuing operations, compared with the weekly average of 21.1 times historical operating profit over the past decade, says Bloomberg. The key phrase here, is, of course, “estimated”. With the “analysts” performing with the accuracy of a coin toss, or a dice roll, it’s only a matter of time before the estimates are reduced to much lower levels, and that is when even todays P/E ratios will appear expensive. There’s some time for all this, but at least I’m quite confident in what I expect from next year.

And finally:

The state agency that runs New York City’s buses and subways may raise fares next year by more than the 8 percent it had previously proposed and implement deeper service cuts amid a swelling deficit.

The Metropolitan Transportation Authority needs to find ways to fill a budget gap that may widen by a third from a July projection to as much as $1.2 billion in 2009. The agency is facing lower projected tax revenue, higher debt costs and less money from fares as ridership is forecast to drop because of the climbing unemployment rate in the New York metropolitan area.

All news clips are from Bloomberg.

Deflation or Inflation?

September 23, 2008

In general, there’re two opinions on where money supply and the dollar are headed:

1. The world and the US are headed for a “nasty” recession, quite possibly a depression. A universal contraction in demand will cause the services sector to shrink very strongly in the US, leading in turn to a halt to manufacturing expansion in Asian nations, and, eventually, to a large number of bankruptcies, as a large part of industrial capacity becomes idle. This will lead to higher unemployment across the globe, and cause deflation in commodities, goods and services, leading to higher dollar.

2. The world economy is headed for a one-two year long recession, as the US government continually bails out increasing segments of the economy, starting with banks. That the Treasury has moved so fast from rescuing the GSE’s to rescuing the entire banking industry of the US, and then some more in the rest of the world, shows that the Americans have no interest in paying the price of the excesses of the past decades, and will instead do whatever they can do save the day, regardless of what happens in the longer term. They will print more and more Treasury bonds to sustain the US consumer and to prevent the necessary adjustment in the consumer’s spending habits, which will prevent the rest of the world from suffering a severe slowdown, but will create inflation and crush the dollar in the process.

What does Washington want? I believe that the answer is very clear. At all costs, they want to prevent a demand contraction, and they have the means to achieve this, albeit only in the short term. “Live today, forget the rest” is more or less the modus vivendi of the American, and it now seems that this will also be how they manage this problem.

To be fair however, the administration is only willing to consider reflating the economy because it believes that the results would be more controllable and orderly than a depression and a collapse in demand. It’s not illogical to think that an artificially induced inflationary environment is easier to live with than a sudden, severe and unpredictable contraction of the economy. Those who oppose this argument suggest that it’s far from clear that the inflationary remedy can resolve the problem, that is, it’s not clear that by resorting to inflation we will not end up with both inflation and a depression. It must be mentioned that there’s no real example of an economy that has averted depression through easy monetary policy.

But I believe that the government at least has the power to devalue its currency: they can create such a great supply of dollars that even the most fearful investor sees little value in holding an asset which is likely to shrink at great speed as soon as the fear factor that is upholding it lessens.

That is why I support number two of the above options. I believe that the dollar is sentenced and damned. The US, as a nation, has chosen to sacrifice its tomorrow for saving the day, and the first to pay the price will be the dollar.

Why is the dollar rallying?

September 9, 2008

1. The US economy has been the first to enter into the recession, and it will be the first to exit it.


2. Financial markets are discounting the prudent and creative monetary policy of the Federal Reserve.


3. The dollar is simply undervalued on a broad basis.


4. The collapse of the commodity bubble has caused panicky delevering and margin calls across the board, and the dollar is the natural beneficiary.


5. Geopolitical tensions are strengthening the dollar.


6. The worst of the financial crisis is over.


7. The global economy is slowing, the unique situation of the US as a nation in recession is over.


I disagree with one, two, and six. The troubles of the US economy are likely to go on for a long while. The policies of the Fed depend on the creation of bubbles for success, but we’re out of bubbles. The worst of the financial and economic crisis is not over – banks have not raised their risk capital to a level in line even with delinquent loans. So there will be more writedowns and more losses.


The dollar is likely to rally for about a year only because there’s panic in the financial markets. This is obvious in libor spreads, contraction in credit, the gradual collapse in high yielding assets since August of last year, bursting of the commodity bubble, and, the rise of the dollar itself. One must understand that holding dollar-based assets in the current environment can only be justified on fear. Otherwise, the extreme financial indiscipline of both the private and public sectors, continued wars, long-running inflationary monetary policy, a housing depression, rising unemployment, bank failures, and bankruptcies, twin deficits of the nation, and a very large cloud of unknowns about almost every aspect of the US economy makes holding US dollars an extremely foolhardy enterprise.


But there’s panic now, and in a panicky environment people act irrationally. Even the best promise of returns is unlikely to convince them to risk their assets. And as most of the active financial assets of the world are dollar-denominated, the withdrawal of liquidity creates shortage and demand for dollars. 


In the medium term geopolitical issues and inflation will determine the dollar’s course. As I noted in a previous post, crises of confidence can create adverse feedback loops, and this will probably add to the strength of the dollar. On a longer term basis, say three-five years and longer, the dollar will probably resemble a third world currency.


The US government keeps adding to its debt burden: unless it raises taxes, how will it be able to service that burden with decreasing revenues? The easiest option would be to devalue the dollar, encourage people to save and export more. While this is unlikely in the immediate future, I do not see how the US can continue its past customs without risking very high interest rates.


I believe that the dollar’s status as the world’s reserve currency is in doubt. To be sure, the decision will not be made by the Americans themselves; rather, a confluence of factors may gradually cause the dollar to be abandoned by more and more nations and institutions across the world, and the process is naturally a long-running one. But more importantly, the days when holding dollars provided safety and confidence are permanently over. The structural problems of the US will take many years to be resolved and the international markets can hold on to a depreciating and shrinking asset class for only so long.  

So the inevitable has happened. The government has taken Fannie Mae and Freddie Mac into conservatorship. It’s in essence an acknowledgement that they’re bankrupt. They had no other option, and at least the uncertainty surrounding this particular matter has lessened.


The real issue here is that this has been caused by Bill Gross. If the US government doesn’t have as much as credibility as the head of PIMCO, it’s hard to predict where this crisis will end.


The bailout means less mortgage credit, and less housing activity. While in the short run the Treasury may get away with low interest as result of panicky financial markets, in the long run this will cause more taxes. Or of course, if the politicians decide so, it may mean less taxes, but lower dollar. And if they decide to do nothing, it may as well bring about bankruptcy of the US.


I believe that the dollar will be the victim.

The dollar is rising, and while reappraisal of the global economy may lead to further strength for the dollar in the coming 6-12 months, it’s important that we put the macro picture into perspective when analysing the direction in the forex markets.


When there is no excessive divergence in interest rates or central bank policies, one should expect currencies to perform according to the underlying fundamental strength of the respective economies.


Such is the case between Europe and the US, where the rate differential is too small to override macroeconomic concerns. Since the introduction of the Euro, and except for a brief period during the global stock market bubble, the behaviour of the euro-dollar pair has beem based on fundamentals. The overextended finances of both the public and private sectors in the US contrasts unfavorably with the balanced current account situation of Europe, the relatively less leverage of its citizens, and the much better fiscal discipline of the governments. Until recently even Spain’s government could boast of a singnificant fiscal surplus, and on the whole the stringent requirements of the euro area treaties, and continuous urging by the ECB for fiscal responsibility allowed Europe better fundamentals than those of the overextended, overleveraged US. There’s, in short, every reason to be negative on the dollar versus the euro, based on the fundamentals of the two economies: The dollar is just another word for leverage and indiscipline.


When the Fed began reducing rates in September 2007, in spite of external financing concerns, and fears of inflation, investors and speculators around the world reacted by buying commodities and selling dollars, partly in anticipation of decoupling, and partly to profit from the dollar-negative momentum. And they were justified in their pessimism for the US dollar, except for one difficulty:


The USD is the world’s currency for trade: it’s supply will be ample during times of increased economic activity, as the supply of USD from exporters to the US, and also from global players such as hedge funds and mutual funds widely exceed the USD demand for imports such as oil, copper, and finished goods. Thus, as greed, and the quest for yield cause ever greater amounts of US dollars to be exchanged for other currencies, the buoyancy of the global economy will also draw down the value of the dollar, especially when the medium term fundamentals of the US economy are as weak as detailed in the previous paragraph.


When however, the opposite happens, and global demand contracts, as the growth of demand for commodities, the volume of international trade is in danger of declining, there will be less circulation of the dollar, and the currency of international trade will also see increasing demand, just as the supply of dollars from international economic actors contracts as a result of the same reasons: the prospect of weaker economic activity will cause repatriation flows, extracting dollars from the global financial system, and in the worst cases, as we’re witnessing now, a shortage of the US currency.


This then explains why the discrepancy between the value of oil and the euro versus the dollar created an arbitrage opportunity, provided that the investor sees them as different faces of the same investment paradigm. Indeed until recently the fluctuations of euro-dollar parity, and the oil price showed a close correlation even of intraday movements. It was only natural that one would follow the other.


Now, if rising dollar means less global economic activity, at a time when internal demand in the US is likely to shrink as a consequence of deleveraging, and rising unemployment, then how do we explain the recent rise in stock prices? Rising dollar and rising yen are the hallmarks of pessimism and fear; if US and Japanese investors are withdrawing funds from overseas, putting it in bonds and cash, is it possible to interprete this phenomenon as being positive for financial markets?


While the disinflationary effect of the rising dollar is welcome, one must remember that even before the recent turmoil, there were significant inflationary pressures in the world economy. The era of cheap Chinese labour is already over – inflation is now a structural problem, not a temporary one.


We’re likely to see continued falls in the stock markets in the next few weeks, and months.

Ineffective Monetary Policy

August 26, 2008

Monetary policy in the modern age dictates that a central bank should provide liquidity and expand credit during a slowdown or financial crisis. But this time there’s every sign that isolated strong action by a single central bank is not only ineffective, but also counterproductive.

Of the major central banks of the world, only the Federal Reserve responded to the financial crisis with aggressive rate reductions. The ECB has chosen to interprete its legal mandate strictly, and has actually increased rates in response to inflation that has recently reached 4 percent. Rising inflation and rapidly deteriorating economic outlook has prevented Bank of England from acting decisively, while Bank of Japan has chosen to remain neutral but fearful, with rates already near zero. Brazil, Turkey, Thailand, China, Russia, India all face significant inflationary pressures, and some have been forced to raise rates in order to combat the risk of runaway inflation, which so far seems to have materialised only in Vietnam.

In the US and to a lesser extent in the EU, credit growth decelerated sharply, with banks and financial institutions tightening some forms of credit to unprecendented levels; in contrast, in most emerging markets money supply has continued to expand strongly, invigorated by flows of short term money from the industrialised world seeking better yield. Exacerbated by the parabolic rise in commodity prices, mostly a result of the falling dollar, the already heated economies of these developing nations have been grappling with increasing inflationary issues ever since the Federal Reserve began its rate cut cycle in September of last year.

The argument that rate reductions by the FED have prevented the situation from worsening in the US is devalued by the fact that in the Eurosystem the experience of financial institutions has not been any better or worse than those in the US. European banks have had massive exposure to problematic US paper, and some of the worst write-downs have been taken by a Swiss institution.

What is more, because of the lagged effect of constricted credit channels, the stimulative effect of reduced rates on the real sectors of the economy have been hardly felt so far. A shutdown of credit sources to non-financial institutions is far from being the case, both in Europe and the US, and central bank interventions have not prevented banks from shrinking balance sheets and squeezing credit where they believed it to be be necessary.

What then, has been the achievement of monetary policy thus far?

In the US, the result has been the falling dollar, and high inflation. Neither the fear premium on LIBOR, nor  mortgage rates have been ameliorated by lower rates. And the near failure of Bear Sterns occurred at a time when the Federal Reserve had already reduced rates by about 200 basis points from their August 2007 levels. Reduced rates, and even the new and innovative liquidity facilities announced by central banks, have not been successful in preventing financial participants from nervously speculating on who is to fall next.

In the rest of the world, where stimulus wasn’t needed, the Fed’s inflation gift, via the lower dollar, has forced central banks to increase rates, making sure that the only parts of the world where growth was relatively unhurt by the financial crisis would now be on the inevitable path to recession because of high interest rates necessitated by inflationary pressures.

The impact of the Fed cuts on the global economy has been mostly negative. The global recession that’s yet to be experienced in its full force is likely to be long lasting and painful.