Sunday, May 31, 2009

Bond Vigilantes Are Waiting At The Corner!

``Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession. The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.”- John Taylor Exploding debt threatens America

The Bonds Vigilantes are back! That’s according to the newswires and the opinion pages.

Bond vigilantes are supposedly a class of bond investors who serve as disciplinarians against government overspending. Sensing the perpetuation of profligacy, these market enforcers would sell sovereigns which would translate to rising interest rates and which effectively functions as a kibosh on the extravagancies of government.

The recent volatility in the long dated US treasuries markets (see figure 1) apparently breathed life on such market persona after more than two decades long of hibernation.

Figure 1: Bloomberg: UST 10 year yields (orange), Freddie Mac Mortgage Rates (green), Bankrate 30 year mortgages (yellow)

The recent surge in yields has prompted for concerns on the marketplace over the sustainability of stock market gains. Rising interest rates, as interpreted by the mainstream, may yet foil government measures to resuscitate the housing market and US consumers. As you will notice in the chart above, long dated treasuries often serve as benchmark to bank lending rates-so rising Treasury yields means higher mortgage rates.

But often doesn’t mean always. And with US government’s severe scale of marketplace interventions, mortgage rates and treasury yields departed earlier, as we noted in early May, see US Mortgage Rates versus Treasury Yields: Does Divergence Signal An Anomaly or A New Trend?

Yet the dynamics of the bond markets of the yesteryears haven’t been the same as today; foreigners have been pinpointed as the potential source of rising yields, through liquidations.

According to this report from Bloomberg, ``The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.”

Unfortunately, the classic definition of the bond vigilantes doesn’t hold true today, because rising long dated yields doesn’t automatically equate to investor selling YET see figure 2.

Figure 2: Foreign Buying of US Treasury Bills Have Surged!

As noted in last week’s $200 Per Barrel Oil, Here We Come!, the composition of the ownership of US treasuries held by foreigners, mostly by China, has dramatically shifted. In the face of declining foreign currency surpluses, foreigners have sold US agencies and reallocated their holdings mostly into short term bills.

This, we argued, has been primarily politically motivated. China doesn’t want to seen as ruffling the feathers of the US leadership and instead would like to be perceived as in “cooperation” and “collaboration” with them, despite expressing displeasure over the direction of present policies. This essentially places the responsibility of the repercussions from US policies entirely on US policymakers. So in contrast to bond vigilante actions of liquidations, foreigners have continued to buttress the US treasuries market, however yields continue to climb.

As example, Thursday’s US Treasury issuance of $26 billion in 7 year notes had been fully subscribed and this adds to the week’s total of $101 billion. While demand for the 7 year notes have been ample, ``the Treasury was forced to raise the yield by nearly 0.03 percentage points to entice buyers” reports the Associated Press.

In other words, rising yields hasn’t been due to foreign investor liquidations YET, but from oversupply or overissuance of US sovereigns relative to available capital, where the markets has been pricing a premium (through higher yields) for scarce capital to fund US government expenditures.

Nevertheless, events seem to be unfolding in an extremely fluid mode, such that we can’t count on the persistence of foreign support on US treasuries, especially if markets do turn disorderly.

Although the news report cited above, didn’t account for the category of buyers of the recently issued 7 year treasury notes, the US Federal Reserve can pose as the “buyer of last resort” as it can simply “monetize” debts through its digital or printing presses, since an “auction failure” can be highly disruptive to the financial markets, especially to the US dollar.

Bond Vigilantes Ahoy!

Nonetheless the bond vigilantes appear to have indeed surfaced in select US debt markets, concentrating on areas where governments have intervened to favor “political classes”. Here, comparable spreads have ostensibly widened between companies or industries affected by state intrusion relative to those without.

According to the Reuters (bold emphasis mine), ``To gauge whether those cases have made debtholders wary of other companies with so-called favored political classes, Garman compared spreads, or bonds' extra yields over U.S. Treasury yields, for companies with collective bargaining agreements with the high-yield bond market as a whole…

``Apart from automakers, sectors heavily influenced by collective bargaining agreements include supermarkets, construction, wired telecommunications, delivery and healthcare, Garman found. Gaming, select media and publishing companies and paper and textile companies also made his list.”

Uncertainty over the arbitrary selection of winners by the US government, the clash of objectives or priorities between management and government and the fickleness, changeability or instability of policies has translated to investor aversion or bond vigilantism.

Decoupling In Global Bond Markets?, Monetary Forces Gains Momentum

And as almost every government in the world have massively applied “stimulus” to their respective economies to provide for “cushion” from recession and to “jumpstart” economic growth, as discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, they will be competing with the private sector for access to funding in the capital markets which implies for “higher yields”.

Moreover, the capital markets will likely be the primary conduit for these fund raising activities as the banking system remains substantially dysfunctional, particularly in the bubble bust affected areas.

Evidences of such dynamics have begun to emerge, according to this Wall Street Journal report (all bold highlights mine),

``In the first quarter of the year, the value of corporate investment-grade bond issuance globally rocketed to $875.1 billion -- a 124% increase from the same period last year. That boom stands in sharp relief to a fall in the market for syndicated loans, in which a syndicate of banks makes a loan to a corporation, spreading the risk of the corporation's default between them.

``The value of banks' new corporate investment-grade lending fell 40% to $349.3 billion compared to the same period last year, according to financial data from Dealogic….

``There are two main reasons why loans from banks are stuttering: banks' available capital and banks' cost of funding. Both have made the interest terms that banks are offering corporations relatively high, making the bond market a preferable route to financing…

``Bank lending to the corporate sector has shrunk dramatically. In the nine months to December last year, global cross-border bank lending shrank almost $5 trillion -- the sharpest fall on record -- according to research out this month by the Bank for International Settlements.”

In other words, the current operating dynamics as seen in the US treasury markets will likely be applied elsewhere, but to a lesser degree on Emerging Markets and in Asia as the latter’s banking system have largely been unimpaired.


The US bond market volatility in conjunction with a falling US dollar have prompted for a divergence or “decoupling” in bond activities see Figure 3.

Figure 3: Emerging Market-US Sovereigns “decouple”

The Morgan Stanley’s fund of investment in US treasuries as represented by the USGAX (red-black line), which according to Google, “normally invests at least 80% of net assets in U.S. government securities, which may include U.S. treasury bills, notes and bonds as well as securities issued by agencies and instrumentalities of the U.S. government” has been diverging with the JP Morgan’s benchmark for Emerging Debt JEMDX (black line) which according to Google invests in ``a portfolio of fixed-income securities of emerging-markets issuers. The fund normally invests at least 80% of assets in emerging-market debt investments. These emerging-market securities may be denominated in foreign currencies or the U.S. dollar.”

Last week, emerging market bonds posted their best week since 2002 (Bloomberg) in spite of the turmoil in the US sovereign markets as US bond yields rose to nearly a 6 year high (Bloomberg). If this isn’t decoupling, I don’t know what is.

Yet the falling US dollar (USD- lower window in the chart) has easily been made as a scapegoat for the actions in the volatility in the US treasury markets. The simplified explanation is this- a weaker US dollar extrapolates to higher value of emerging market currencies, ergo high bond prices for Emerging Market Bonds.

But this dynamic hasn’t been in place when the US dollar index fell from its peak in 2002 until its trough in early 2008!

In other words, the languid performance of US dollar index and the divergences in emerging markets sovereign relative to the US sovereign hasn’t likely been the underlying cause and effect. Instead, we suggest that it has been monetary forces that has accounted for as the principal driver of this rapidly evolving phenomenon-globally.

In short, monetary inflation has been getting a far bigger pie of the activities in the financial markets as well as in the real economy.

All told, as capital markets takes on a bigger role in the distribution of limited capital over banking system, in the choice of either funding government expenditures or private investment, the resurgent function of bond vigilantism will likely be accentuated as time goes by.

Mainstream Denials And The Greenshoots of Inflation

``We're going to have a currency crisis, probably this fall or the fall of 2010. It's been building up for a long time. We've had a huge rally in the dollar, and artificial rally in the dollar, so it's time for a currency crisis.”-Jim Rogers Bloomberg

Nobel Laureate Dr. Paul Krugman recently wrote in his widely read column at the New York Times to dismiss of the risks of inflation. He suggested that what has been happening in the marketplace isn’t about inflation, but an attempt by the opposition to dislodge present policies,

``But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.” (bold emphasis mine)

Dr. Krugman’s basis for debunking inflation has been 1) most recent data on consumer index and importantly 2) banks haven’t been lending enough since bank reserves remain bloated. Apparently, the popular economist believes that what happens today should be construed as tomorrow’s events.

Yet, Dr. Krugman’s prescription is for the Obama administration to continue with its inflationary path. In other words, the mainstream’s ideology has been epitomized by Dr. Krugman.

And this is the same ideology, which for us has been heightening the risks of intractable inflation, despite the supposed “omniscience” of the Nobel awardee.

As we argued last week in $200 Per Barrel Oil, Here We Come!, inflationary policies will largely cause a spike in oil prices in combination with oil’s structural fundamental imbalances.

Unfortunately Dr. Krugman, who believes in the almighty power of governments as solution to everything, has a skewed understanding of inflation; inflation has been always a political process. Since government actions, such as spending, lending, guaranteeing, protecting, subsidizing etc…, are not determined by the marketplace or by fundamental economic laws of demand and supply, as they are arbitrarily decided upon by policymakers and regulators, then such actions are reckoned as political in nature. Hence, inflation fear mongering isn’t political, Dr. Krugman gets it the other way around, but the use of mandated coercive powers to implement redistributive process is.

Monetary Forces Strengthens Decoupling

Mainstream experts, like Dr. Krugman, have been lost with the sudden rise of stock markets and in the commodity markets as the actions marketplace appears to have been detached from the developments in the real economy. This is because Dr. Krugman has been predicting of a deflationary depression and even wrote a book about it. Lately, Dr. Krugman conceded that “We have averted utter catastrophe.”

As we mentioned in our mid week article, see Monetary Forces Appear To Be Gaining An Upper Hand, these experts have been “rationalizing” on market actions to either affirm or dispute market accounts depending on their inherent biases.

For the bulls, the recent market activities account for as some form of triumph by government policy efforts to resuscitate the global economy or the much ballyhooed “greenshoots”.

For the bears, the widening disconnect with the real economy seems like a surefire indicator of a maturing bear market rally which will ultimately end in tears.

For us, while some signs of economic recovery have indeed been taking place in response to the “shock” (or our Posttraumatic Stress Disorder-PTSD) arising from the near meltdown of the US banking system, due to an institutional bank run which took place late last year, recent developments or market outperformance have been symptomatic of monetary forces asserting dominance over both the marketplace and the economic sphere.

We also beg to differ from the mainstream opinion that the present rising markets is about expanding global risk appetite.

Instead, we see the risk profile as shifting substantially to weigh against US markets more than Emerging Markets or Asia.

Aside from the Bond markets or stock markets (see Figure 4), we note that from the economic growth perspective to policy trajectories (Asia has been adopting policies directed at integration amidst this crisis) to prospective business conditions signs have evinced of “decoupling”.

Figure 4: Bespoke Invest: BRIC outperforms S&P 500

And we are entirely agree with the observation that the ongoing dynamics has been a “shift from the Core to the Periphery”, as analyst Doug Noland in his Credit Bubble Bulletin predicts, ``A robust Core to Periphery Dynamic and the re-emergence of dollar vulnerability are a potent combination. U.S. markets to this point remain sanguine with the prospect of an expanding Federal Reserve balance sheet rectifying any spike in interest rates. But currency markets are no doubt increasingly fixated on our propensity to monetize our massive debt. At some point, increasingly unwieldy flows out of our currency may force the Fed’s hand. The scenario where the Fed is forced to choose between loose monetary policy and currency crisis could be a potential big negative surprise for U.S. markets.” (bold highlight mine)

In short, since the survival of the present paper money system is mainly a measure of confidence or trust in the system, policies that work to undermine these framework risks the extreme ends of either a hyperinflation or deflation.

Another, mainstream deflationists continue to struggle with the fallacies of lack of aggregate demand, US centric global growth model, global surplus capacity, imbalances of current accounts and ‘velocity of money’ all of which are based on the assumption of the neutrality of money.

Debunking Mainstream Fallacies

Inflation doesn’t need demand. This mistakenly assumes that normalization of the credit process depends on the private sector as the sole pathway for inflation.

In the recent Zimbabwe or the 1920s Weimar Germany experience, their governments simply increased liabilities on an exponential scale and simultaneously spent them on the economy and the result was a hyperinflationary depression! No consumer spending required, it had all been government spending!

Today, governments not only in the US but all around the world have been frontloading fiscal expenditures or inflating altogether. Hence the inflationary transmission scheme can’t be compared to Japan in the 90s since this has been a global effort more than a stand alone stint!!!

In addition, as noted above, financing today has apparently taken place outside of the banking system, particularly on the capital markets. Example, financing for junk bonds in Europe has reportedly been brought back to life (Wall Street Journal)!

Thus, global government ‘stimulus’ spending, growth of financing obtained from global capital markets and a semblance of normalization of the banking system risks unleashing outsized or “substantial” inflation, if not the extreme-hyperinflation!

Remember Asia and the emerging markets have the capacity to undertake massive credit expansion since they are both systemically underleveraged relative to OECD economies and have a functional banking system largely unscathed by the recent crisis [see Will Deglobalization Lead To Decoupling?]. Moreover present government policies have likewise been geared towards attaining such goals.

The next problem would be if governments would be able to withdraw or reverse present policies at the right time if benign inflation turns savage!

Moreover, the collapse in global trade late last year was mainly read by the mainstream as a structural loss of the US driven global growth engine. Thereby, without the US consumers it is held, the world was bereft of a buyer for their products. This has been proven to be incorrect.

Apparently, the emergence of barter trades (post October collapse) suggested to us that demand wasn’t impaired but that the problem was in the gridlock in the US banking system which hampered trade financing [see What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis].

And as the world has recovered from this shock, global trades have begun to show indications of significant improvements, and this partly includes the US.

So while it is true that we won’t see volume of trades in the magnitude of the peak of the bubble days and that it would take sometime for the world to adjust to new patterns, recent activities have only confirmed our suspicion that the world hasn’t been dependent solely on the US, as markets everywhere have depicted signs of “decoupling” or divergences.

And if the world isn’t US centric then the rest of the other fallacies which relies on the US as the center of power crumbles along with it, namely surplus capacity, velocity of money or current account imbalances.

Furthermore, since some public personalities such as Pimco’s Bill Gross or former US comptroller General David Walker have raised the likely prospects that the US could lose its AAA credit ratings based on present directions of government policies, some analysts have rushed into the defense stating that the US position is privileged since debt has been underwritten from its own currency and that the US has a larger taxing capacity.

We again beg to differ; if the US continues to debase its currency then it has effectively been implicitly repudiating its debt.

As Henry Hazlitt wrote in From Bretton Woods to Inflation, ``Devaluation is the modern euphemism for debasement of the coinage. It always means repudiation. It means that the promise to pay a certain definite weight of gold has been broken, and that the devaluing government, for its bonds or currency notes, will pay a smaller weight of gold.” Hence, the US risks jeopardizing on its hegemon as the world’s currency reserve standard as it breaks its promises to its creditors.

Money Is Not Neutral

We also agree when experts tell us that the US will endure from significantly higher taxes in order to finance government redistribution programs when nearly two-thirds of the population is close to being bankrupt and that the remaining one third would suffer from a stifling burden of new taxes.

All these imply that the US won’t see any vigorous recovery soon and probably could experience intermittent bouts of economic recessions or weaknesses.

Yet this is also exactly why we should continue to expect accelerated inflation. The mainstream represented by Dr. Krugman, whom has been influential to the present administration, encourages its government to adopt a Dr. Gono “Zimbabwe solution” of money printing away from its miseries. This is because mainstream ideology thinks of money as neutral.

According to Ludwig von Mises in The Non-Neutrality of Money, ``The reasoning of modern marginal utility economics begins from the assumption of a state of pure barter. The mechanism of exchanging commodities and of market transactions is considered on the supposition that direct exchange alone prevails. The economists depict a purely hypothetical entity, a market without indirect exchange, without a medium of exchange, without money. There is no doubt that this method is the only possible one, that the elimination of money is necessary and that we cannot do without this concept of a market with direct exchange only. But we have to realize that it is a hypothetical concept which has no counterpart in reality. The actual market is necessarily a market of indirect exchange and money transactions.”

``From this assumption of a market without money, the fallacious idea of neutral money is derived. The economists were so fond of the tool which this hypothetical concept provided that they overestimated the extent of its applicability. They began to believe that all problems of catallactics could be analyzed by means of this fictitious concept. In accordance with this view, they considered that the main work of economic analysis was the study of direct exchange. After that all that was left was to introduce the monetary terms into the formulas obtained. But this was, in their eyes, a work of only secondary importance, because, as they were convinced, the introduction of monetary terms did not affect the substantial operation of the mechanism they had described. The functioning of the market mechanism as demonstrated by the concept of pure barter was not affected by monetary factors.”

In other words, mainstream economics have analyzed mainly from the context of pure barter trades, or if money is taken into account, they consider its function as medium of exchange only.

This view disregards or dismisses the other function of money as a store of value. Hence, the proclivity by the mainstream, like Dr. Krugman, to suggest of money printing as certified way to juice up an economy.

However for us, money isn’t neutral. It impacts prices relatively, and importantly functions as a store of value (backed by real savings) that has psychological underpinning based on expectations which is being transmitted on real time to the marketplace by virtue of price signal dynamics.

As Henry Hazlitt wrote in What You Should Know About Inflation, ``the value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat, so the value of a dollar depends on a similar variety of considerations. The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors which may often be complicated.”

Surging Food Prices As The Proverbial “Nail In The Coffin”

Well as the mainstream remains firmly in denial, the unfolding price surges continue across stock markets and the commodities sphere.

We will just wait until these significantly percolate into food prices from which should serve as the final “nail in the coffin” see figure 5.

Figure 5: Economist: Food Prices Creeping Up!

In addition to the creeping food prices above, last week saw White Sugar rose to a 3 year high in London and soybeans notched its third weekly gain.

In other words, the broadening of gains seen in commodity prices has now filtered into food. This reinforces our view that monetary forces are becoming “sticky” and that the price inflation has been accelerating.

Since food prices are even more politically sensitive than oil or energy, rising prices will consequently mean a global public outcry that risks political destabilization in some parts of the world. Again this initially will be blamed on “speculators” than on governments, until inflation gets really out of whack.

We expect the 2007 episode to dwarf and function as a prologue to the forthcoming food crisis that could be expected to erupt in several parts of the world as discussed in Four Reasons Why ‘Fear’ In Gold Prices Is A Fallacy.

Finally, the growing incidence of public discontent on high food prices will eventually lead the mainstream ideologues and deflationists to capitulate.

But that would be a great time to talk about deflation.

Friday, May 29, 2009

Decoupling in Business Conditions?

Under the present financial crisis conditions, many parts of the world have tended to de-globalize or close interactive channels with the outside world which risks hampering trade, finance and investment flows.

In other words, the present environment could impair business conditions of some countries, but not all.

The Economist offers their estimate on the potential changes in business conditions, ``GLOBAL business conditions are set to worsen for the first time since 1996, according to a new report by the Economist Intelligence Unit, a sister company to The Economist. Its business-environment ranking for the next five years assesses 82 countries in categories including the economic and political environment, finance, and infrastructure. The outlook for half of the countries surveyed will deteriorate as the downturn takes its toll. While rich countries' scores will decline most, particularly those of Britain and America, they are still a better prospect for businesses than almost anywhere else. Countries with financial problems, such as Ukraine and Venezuela, will see conditions worsen considerably." (bold highlight mine)

The Economist gives a complete breakdown....
Countries impacted directly by the present financial crisis are likely to suffer most from deteriorating business conditions.

And these are the economies that experienced a national bubble bust (UK, US, Europe) and on economies that had their export markets directed to serving these bubble economy (Hong Kong, Singapore, Malaysia, etc.).

There are exceptions. Venezuela and Ecuador are economies that have been embracing socialism even prior to the bubble bust.

However some economies particularly the BRICs and other Emerging Markets have been expected to improve business conditions even as the others falters.

Clearly if these estimates hold true then it can be construed as decoupling in business conditions. And investments are likely to flow into nations with improving business than otherwise.

Hedge Funds Pile Into Commodities

According to Bloomberg, ``Hedge funds are making the biggest bet in nine months that commodity prices will rise as the global economy rebounds from its steepest slump since World War II.

Adds the Bloomberg article, ``The CHART OF THE DAY shows an index of the net long position in U.S. commodity futures, or bets prices will rise, held by hedge funds and other large speculators. The index, consisting of 20 raw materials monitored by the U.S. Commodity Futures Trading Commission, rose to its highest since August.

``The gain “indicates further willingness for investors to take on asset classes which they were earlier cautious of,” said Kevin Norrish, an analyst at Barclays Capital in London. The index plunged from a peak of 1.37 million in February last year to as little as 86,220 in December.

``Sugar and corn had the largest net-long positions by the week ended May 19, while investors held the largest net-short positions in natural gas and copper.

``“Agricultural products are not going to be as vulnerable to the current economic retrenchment as things like metals or oil,” Norrish said.

``The Reuters/Jefferies CRB index of 19 raw materials rose 6.3 percent this year, after a 36 percent decline in 2008.

My take: So it's not just China but also international Hedge Funds piling into commodities backed by so many rationalizations.

This is no less than a manifestation of shifting preference to hold "hard assets" over rapidly depreciating paper money.

Monetary forces are indeed gaining traction.

Wednesday, May 27, 2009

Free Market's Product: Evolution of Cell Phones

One of the wonders of market driven technological innovation is to have a rapidly progressing evolution of mobile phones or cell phones.

The article from shows in pictures how this has been transforming. We quote an excerpt,

``Cell phones have evolved immensely since 1983, both in design and function.

``From the Motorola DynaTAC, that power symbol that Michael Douglas wielded so forcefully in the movie “Wall Street”, to the iPhone 3G, which can take a picture, play a video, or run one of the thousands applications available from the Apple Store.

``There are thousands of models of cell phones that have hit the streets between 1983 and now.

``We’ve picked a few of the more popular and unusual ones to take you through the history of this device that most of us consider a part of our everyday lives.

See the pictures or read the rest of article here.

(Hat tip: Professor Mark Perry)

Evidences of Monetary Forces Gaining Upper Hand in Hong Kong

In our previous post, Monetary Forces Appear To Be Gaining An Upper Hand, we argued that the tsunami of monetary programs applied by global governments have been distorting financial markets relative to the real economy. This has prompted for glaring disconnections which has caused quite a confusion between the bears and the bulls looking for justification for their causes.

We find further proof of these phenomenon evolving in Hong Kong.

We excerpt an article from the Wall Street Journal, (bold emphasis mine)

``A wave of money flooding into Hong Kong from mainland China and the rest of the world has propelled property and stock prices even as the economy falters.

``Hong Kong's government predicts the economy will shrink up to 6.5% this year and unemployment is at a three-year high. Yet home prices are up about 13% this year, while the benchmark Hang Seng Index has gained 18% in the same period.

chart from

``The strong inflows of capital from abroad have kept Hong Kong's de facto central bank busy. Since January, it has pumped more than US$22 billion of Hong Kong dollars into the market to keep the pegged currency within its mandated trading band against the U.S. dollar. The result is a wave of liquidity washing into asset prices.

``Hong Kong's real-estate market may be one of the more pronounced beneficiaries of a global effort by governments to print money and stimulate lending. Quantitative easings by central banks in the U.S., Europe and Asia have created "booming capital flows" that are "swamping" some markets, Sean Darby, a Hong Kong-based strategist for Nomura International, wrote in a recent report.

From Wall Street Journal

``Hong Kong's situation, however, is unusual. In other places, a net inflow of foreign funds can lead to both a rise in asset prices and a rise in the value of the local currency. But thanks to Hong Kong's link to the dollar, only the asset prices can rise -- and because the currency can't, the gains are more pronounced.

``The peg also makes Hong Kong attractive to investors during a period of currency instability. And Hong Kong's stock market is one of the most accessible and liquid places for foreign money to bet on a recovery in mainland China, where currency controls make direct investment trickier.

``Andrew Fung, head of investment and insurance for Hang Seng Bank in Hong Kong, believes that, with Western markets still sputtering, Hong Kong investment dollars that have long flowed overseas may now be coming back home.

``Anecdotal evidence also suggests some of the money is coming from mainland China, where Beijing's efforts to hurriedly channel four trillion yuan ($586 billion) in stimulus measures into the domestic economy have energized bank lending and unleashed a flood of liquidity."

So there you have it; quantitative easing, China's stimulus program and repatriated capital driving the Hong Kong Financial Markets where inflationary programs have indeed been buoying the marketplace.

Welcome to the new bubble.

Monday, May 25, 2009

Mining Friendly Nations

Interesting charts from Fraser Institute depicting the pecking order of Mining Friendly nations.
Notice that the Philippines ranks near the bottom of the chart, despite the thrust to promote the industry.

Based on mineral potential relative to current regulations and land use restrictions, the Philippines was rated nearly 60%, which means we are far from harnessing our fullest potentials.

However, assuming no land use restrictions and assuming industry “best practices”, the Philippines leaps to the higher echelons. This implies regulatory obstacles have been a key deterrent to the industry's Growth.

The following are anonymous comments by local mining participants on the industry (bold emphasis mine).

``Philippines [has] unclear policies, extremely high level of official corruption, a banana-republic approach to governmental administration, the civil war in the south and fighting elsewhere between government forces and the NPA [New People’s Army] insurgency."—Exploration company, company vice-president

``In Philippines, the law is promoting the development of the mining industry but at the same time strict on environmental and social responsibilities."—Producer company with more than US$50M revenue, company president

All said, the Philippines needs to foster a mining friendly investment environment by easing up on regulations to encourage more growth in the industry.

Sunday, May 24, 2009

Monetary Forces Appear To Be Gaining An Upper Hand

Many have been puzzled by the widening disconnect between what's happening in the financial markets and what's going on in the real economy.

For instance the 30% surge in the US major bellwether S&P 500 since March 9th has prompted for a record PE ratio.

According to, This ``illustrates how this plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the current plunge in earnings and the recent 2.5 month stock market rally, the PE ratio has spiked to the low 120s – a record high."

Yet for some analysts earnings will continue to plummet....
The above chart from Barry Ritholtz's Big Picture

For the bulls, this phenomenon translates to reflexivity- markets are sending signals of economic recovery.

But for the bears, this translates to a false dawn-an unsustainable bear market rally.

However we offer a third opinion: markets have been reflecting monetary forces gaining an upper hand. The sustainability of which will depend on the persistence of the application of inflationary mechanism by governments, especially the US.

Yet can stocks depart from fundamentals?

Let us look at history but from an extreme end.

The following charts are all from

In 1920s the Weimar Republic in Germany experienced a hyperinflationary depression

As you can see above unemployment exploded!

Yet the stock market soared!However, the German currency the Mark fell of the cliff as the German government massively printed money!
Finally, hyperinflation-the cost of living skyrocketed!

So the answer is yes; stockmarkets or financial markets and the real economy can "disconnect" when monetary forces utterly overwhelms the economy. That's because when money losses its "store of value" functions due to excessive government policies to inflate, people look for a substitute. They accumulate or transact in foreign currencies, buy hard assets or conduct exchanges in barter. It's anything but the inflated local currency.

However, in the US, today's environment has been a raging battle between deflationary forces and government inflation, so the likelihood is sharp volatility until one of which will dominate.

Nonetheless since almost every governments had also been conducting their own variant of inflation, the surges in the commodity markets and world stock markets appear to be symptoms of monetary forces gaining an upper hand.

Hence we could be looking nascent inflation that risks developing into super-stagflation or at worst hyperinflation.

$200 Per Barrel Oil, Here We Come!

``This gets back to the disagreement I’ve had with the “inflationists” for years now: In the name of Keynesian economics, inflation proponents have repeatedly called for massive stimulus in response to the bursting of THE Bubble, while in reality this activist policymaking was instrumental in only extending and worsening a systemic Credit Bubble. This was especially the case after the bursting of the technology Bubble and is again true today following the bursting of the Wall Street finance/mortgage finance Bubble. Now, more than ever before, “Keynesian” inflationism is THE Bubble. When it eventually bursts Washington policymakers will have little left to offer.” Doug Noland Inflationism’s Seductive Battle Cry

For us, $200 oil is not an issue of IF, but rather an issue of WHEN. This will be highly dependent on the course of actions undertaken by global policymakers.

Here, we won’t deal with demand and supply imbalances of oil, as we had made our case late last year in Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?, instead we will deal with the rapidly evolving market signals and prospective political actions by policymakers

Growing Disconnect Between Markets And Real Economy

“World oil demand to hit 28-year low” screams the headline from the National.

So one must be wondering: Why has oil impetuously shot beyond $60? Has the oil market been pricing an abrupt global recovery?

The Economist instead finds justification on widening supply constraints, ``The explanation is simple. Oilmen are worried because they believe that many of the factors behind the record-breaking ascent last year remain in place. Much of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments that will not allow foreigners to exploit it…So when demand begins to revive, a sharp rise in prices is inevitable. That does not mean that a price spike is just around the corner, however. The speed with which it arrives will depend on the strength of the global recovery.”

While the article mainly underscores the geographical access limitations posed by governmental restrictions, falling demand and high inventories, as discussed in Seeds of Hyperinflation Have Been Sown have reflected on an egregious disconnect between fundamentals and the marketplace. The Economist article appears more like an attempt to explain away or to rationalize on the market activity than vet from the causality angle.

The highly reputed independent research outfit the BCA Research has a fabulous chart manifesting this phenomenon, see figure 1.

Figure 1: BCA Research: Oil Breaks Out: Is It Sustainable?

According to the BCA, ``The higher price of oil reflects in part the upturn in Chinese oil imports and car sales at a time when oil production is lagging. Russia continues to have difficulty boosting output and oil production has been flat for most OPEC countries. Saudi Arabia has cut production sharply. As with other commodities, oil should benefit from both a weaker U.S. dollar and a shift in investor portfolio preference toward real assets as a hedge against inflation. The upturn in our global leading economic indicators is another positive sign for the commodity complex.” (bold highlight mine)

True, China has been massively acquiring oil and other commodities.

And we won’t dismiss some veritable evidences of economic and financial “recovery” following the “banking meltdown” late last year, of which has functioned as a psychological “shock” (Posttraumatic Stress Disorder-PTSD) that has buffeted world financial markets and global economy.

But China has been buying way beyond its needs. It has been buying to shore up its strategic reserves.

Analysts at Sanford Bernstein reported that Google Images reveal on how China has been intensively constructing depots to hold oil. ``Bernstein says satellite images show a marked increase in oil-storage construction over the past few years and estimates that China’s number of days of forward demand–a gauge of oil storage–amount to just 28 days of imports and 14 days of total demand. China is targeting storage capacity that will hold demand cover of around 90 days,” wrote the Wall Street Journal,

Yet according to another researcher as excerpted by the Guardian, China plans to amass 3 million tonnes (about 22.5 million barrels) of oil, ``China wants to set up a 3 million tonne reserve of oil products this year, which is practically impossible, a researcher at a think-tank run by the country's top oil refiner, Sinopec Group, was quoted as saying on Saturday.”

Moreover, China’s huge appetite for commodities registered record imports for Copper and Aluminum this April. However many experts say that China’s buying activities for these commodities may have probably peaked since targets may have been met. According to Bloomberg, ``Refined copper imports by China will slow over the rest of this year as scrap supplies improve, said Ma Xiaoqin, deputy- general manager of the copper department at Minmetals Nonferrous Metals Co., the country’s largest trader, on May 8. The State Reserve Bureau has mostly completed its buying and stockpiling by manufacturers has ended, said Edward Fang, an analyst at China International Futures (Shanghai) Co.”

If such buying activities have indeed culminated then copper and aluminum prices should be expected to meaningfully correct, see figure 2. But we have our doubts.

Figure 2: Copper and Aluminum

So far only Aluminum has been showing signs of relative weakness. Although copper seems to be in a consolidation phase where a “pennant” pattern (blue converging lines) may suggest a continuation of the present uptrend.

China Attempts To Balance Political Rhetoric With Market Actions And Political Goals

This isn’t about China believing its own “bullish” tale of vigorous economic recovery, where the supposed “conventional” view equates China’s economic growth to commodity bullishness. Instead the above dynamics reflects the ongoing inflation phenomenon.

The fact that China’s officials have raised the furor over possible losses of its US asset portfolio holdings from the current US policies appears to dovetail with the activities in the commodities market.

China’s Premier Wen Jiabao, as quoted by the Financial Times recently said, ``We have lent a huge amount of money to the United States,” Mr Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.” (bold emphasis mine)

Of course one may argue that China’s acquisition of US assets hasn’t slowed.

In contrast to Premier Wen’s statement, China has even increased its acquisition of US treasuries see Figure 3. And this would seem like a conflict between China’s intentions and actions. But this view myopically glosses over the geopolitical implication. There’s more than meets the eye.

Figure 3: New York Times: China’s Changing Role

It would be tantamount to political suicide if China decides to naively “sell” US treasuries to support its concerns, especially under the present environment which has been a fertile ground for engendering protectionist policies. For instance, recently some US lawmakers have revived efforts to brand China as a currency manipulator. Hence mass liquidations of treasuries would only fuel bilateral antagonism. And a trade war isn’t in the interest of China.

Another, it isn’t also a certainty that the underlying motivation behind China’s purchases of US assets reflects on the same paradigm of “promoting exports” as it had been in the past. Past performance doesn’t guarantee future results-that’s because the incentives behind today’s conditions have radically changed. The US consumer model as the world’s growth engine has apparently been broken. And China appears to be well cognizant of this.

Moreover, since China holds massive amount of US dollar assets- estimated at an astounding 82% of foreign currency reserves (Standard Chartered/New York Times)-any mass liquidation will most likely impact the markets extensively and stoke disorder. Where such actions will likely be mutually destructive, such policy directions will likely be avoided.

Hence, China’s political actions should also be seen from a different prism- China may want to be seen in good light with the US, where she would continually support the US even at the risks of incurring substantial losses in its portfolio of US dollar assets.

As Luo Ping, a director-general at the China Banking Regulatory Commission recently justified, ``Except for U.S. Treasuries, what can you hold?”

Moreover, China may want to project that in case a possible mayhem emerges in the financial markets this isn’t going be due to her doing. In other words, China seems to be placing the onus of the consequences from policy choices squarely on US shoulders.

Nevertheless, actions demonstrate preferences. While China remains supportive of the US in terms of buying assets, the composition of its acquisitions has materially changed.

According to the Keith Bradsher of the New York Times, ``China has also changed which Treasuries it buys. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none.

``But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.” (bold emphasis mine)

So yes, China has been increasing its purchases of US treasuries to appease the US government, but has been concentrating these activities towards short term maturities. And by doing so she has been acting to reduce her risk exposure as well as balancing political rhetoric (bleating about US policies, announcement of past ‘covert’ gold purchases) with market actions (diversifying portfolio holdings into commodities) and political goals.

And aside from heavily buying into commodities, as previously discussed in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency, China has been utilizing its currency as an instrument to expand its political and economic influence across the globe by increasing swap agreements, by providing project financing and conducting trade in the remimbi or ex-US dollar currencies. Recently Brazil and China concluded an accord to conduct transactions using their national currencies instead of the US dollar.

In all, China could be working to insure herself from the risks of substantial US inflation, to expand its influence globally with its currency and possibly to challenge the US hegemony in terms of having the remimbi as a global currency reserve sometime in the future.

The Global Inflation Train Speeds Faster

And as we keep repeating, in the world of unprecedented scale of government intervention in the marketplace combined with unparalleled degree of applied inflationary measures, the repercussions intended or unintended will be vented on the currency markets.

And we agree with Professor Steve Hanke where he wrote in a Forbes article ``There are tectonic moves afoot in the currency markets these days.”

Tectonic moves afoot in the currency markets will also be parlayed in the Oil Market see Figure 4.

Figure 4: Inverse Correlation of Oil and the US Dollar

Visibly, oil in the past has moved in consonance with the US dollar, albeit in an inverse scale (see blue trend lines).

This dynamic seems to be a classic rerun as the recent weakness of the US dollar index (USD) has equally coincided with rising oil prices (WTIC-main window).

Alongside this development has been the rise of 10-year US Treasury yields (TNX) in spite of the recent activities from the US Federal Reserve where the ``Fed bought $18.277 billion of U.S. debt in three purchase operations this week and minutes of the central bank’s April 28-29.” (Bloomberg).

The US Federal Reserve in its March 18th press release has earmarked $300 billion to purchase long term Treasury securities.

But there seems to be one missing ingredient. In the past, the falling US dollar had been accompanied by falling treasury yields-perhaps reflecting what Former Fed Chair Alan Greenspan’s calls as a conundrum of low bond yields. And this phenomenon was suspected to have been influenced by foreign purchases of US treasuries that have kept yields low.

But since recent treasury issuance to fund US government deficits has surged far more than what foreigners or China has recently bought as shown in the chart earlier, where according to the same Bloomberg report, ``President Barack Obama has pushed the nation’s marketable debt to an unprecedented $6.36 trillion. [bold highlight--mine] His administration raised on May 11 its estimate for the deficit this year to a record $1.84 trillion, up 5 percent from the February estimate, and equal to about 13 percent of the nation’s GDP”, yields have materially risen!

And as we have previously discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, the colossal government spending by the US and elsewhere and the prospective surges of government treasury issuance are posing as risks towards hefty inflation or national bankruptcies.

Hence, today’s rapidly deteriorating US Dollar, rising treasury yields and rising oil prices seem to be solidifying the manifestations of inflation gaining traction globally.

Credit Rating Downgrades Amidst Exploding Deficits

Figure 5: Washington Post: Projected Deficits

The recent spate of massive waves of deficit spending in many crisis havocked economies has put pressure on their respective credit rating standings.

The S&P recently issued a downgrade from “stable” to “negative” on UK’s outlook which means the country is at risk of losing its coveted AAA status.

Concerns over the same predicament has apparently spilled over to the US considering the huge planned dosages of government spending aimed at jumpstarting the economy as shown in Figure 5.

Well the impact of concerns over these deficits, aside from rising treasury yields, has been deterioration in credit default swaps, which function as insurance against the risks of credit default.

According to Bloomberg, ``The cost to hedge against losses on U.S. government bonds for five years climbed to a three-week high, indicating perceptions the nation’s credit quality is deteriorating. Credit-default swaps on U.S. debt rose 3.5 basis points to 41, the highest since April 29, according to prices from CMA Datavision in New York. An investor would have to pay $41,000 a year to protect $10 million of debt from default.” (bold highlight mine)

Mainstream Calls For More Inflation Ensures Oil at $200!

These credit rating warnings should serve as call to action on governments to limit overspending. Remember there is no free lunch. Ultimately taxpayers will pay for government profligacy.

But will these warnings be heeded? Apparently not.

On the contrary the mainstream has vociferously been desiring for more inflation.

The Bond King, PIMCO’s William Gross, recently predicted that the US will eventually lose its AAA rating according to Bloomberg.

Yet his prescriptions to support the economy account for the same factors that would ensure the US will likely lose its prime credit rating.

It’s because Mr. Gross subscribes to the Keynesian methodology of printing money as a cure, where the same report quotes Mr. Gross, ``We need more than that,” Gross said at the time. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

And the policy prescriptions of Mr. Gross have been joined by the similar calls from well known Harvard experts-Kenneth Rogoff and Greg Mankiw.

``I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.” (Bloomberg)

Meanwhile, Mr. Mankiw former chairman of the Council of Economic Advisors under President George W. Bush said ``Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt” (Bloomberg)

So in the face of rising risks of default, these mainstream experts sporting a good clout over at the officialdom may be reflective of the policy directions of the present administration.

Of course inflation can be achieved through massive credit expansion (through public or private channels) or via the government spending route or both.

And if Mr. Bond King’s suggestion will be adhered to and if it’ll likewise be copied elsewhere the risk of a runaway inflation will be tremendous.Figure 6: BIS: Balance Sheets of the Central Banks of the US, UK and ECB

Since the advent of the crisis the balance sheets of the US Federal Reserve, the ECB and the Bank of England have surged see figure 6.

So policymakers have made sure that inflation will likely take hold; inflation is what they ask for hence inflation is what we will get.

As Dr. John Hussman admonished in his latest weekly outlook (bold highlight mine),

``The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.”

Even Yale’s David Swenson told Bloomberg that everyone must own inflation protected securities in the face of substantial inflation, ``We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation, or at least pretty substantial risk of inflation,” Swensen, Yale University’s investment chief, said in an interview on the “Consuelo Mack WealthTrack” television show that aired yesterday. Treasury Inflation- Protected Securities “should be in every investor’s portfolio," he said.”

Finally fund manager David Dreman has another unorthodox suggestion for the US government.

He posits that the US stimulus package be directed at the commodity markets.

According to Mr. Dreman, ``My idea is that we accumulate useful resources, such as crude for our strategic oil reserve. This would create new jobs, halt a deflationary spiral and give us some protection against the next international oil crisis. If the government allocated $500 billion at current prices, it would add 10 billion barrels of oil, which amounts to 17 months' consumption. The government could undertake similar purchase programs for copper, aluminum, lead and other essential industrial commodities now trading at very depressed prices.

``An oil-buying binge would be a win for taxpayers as well. Oil bought today below $60 a barrel can be released back into the market at $120 after economic activity has picked up and inflation has resumed.”

Mr. Dreman’s suggestion implies that the US government should engage with China and the rest of the world in a bidding war over oil and other commodities. The idea is to directly stoke inflation by means of direct intervention in the commodity markets.

However, high commodity prices reduce the purchasing power of consumers or the taxpayers, so it is a contradiction how taxpayers/consumers would benefit from high commodity prices. Put differently, the US government may earn from a spread alright, but the world in general will be poorer because of the lesser amount of goods the Americans and people around the world can acquire.

Moreover he seems to suggest that the US government should be transformed into a proprietary trading desk. Governments don’t work for profit but for social concerns.

Besides a policy directed at a race to own commodities could serve as a casus belli for a world war at war or a world resource war.

What have these “inflationists” have been smoking, anyway?

Overall, the inflationary policies of global governments are key drivers to oil prices at over $200 per barrel!