Charts: Has the Hiatus of US Dollar Ended? Return of Risk OFF?

The February-March Risk ON landscape has partly been a function of oversold conditions from the January 2016 meltdown. However, the fall of the US dollar has signified as the primary driver for 'fast and furious' rebound (helped by the global central banks' recent Shanghai Accord).

Yet has the US dollar's hiatus (via short covering) ended?

The Bloomberg USD (BDXY) index

The original USD (DXY) Index

The Asian dollar (JP Morgan Bloomberg ADXY) Index

The rise in the USD translates to lower commodities in particular oil. 

US WTIC

Europe's Brent

And higher US dollar will mean lower the overall commodity prices: the topping of the S&P GSCI commodity index?

And the correlation of oil with risk assets have only tightened which means if the correlations hold then lower oil equal lower stocks.

 

Moreover, since the rise of the USD implies tightening of systemic liquidity then it should also mean lower prices for risk assets

The FTSE World

The MSCI ACWI World iShares

And finally the PSEi's twin, Brazil's Bovespa

Has Risk OFF arrived?

Interesting

Charts: Saudi Riyal, Dow Jones Industrials, OPEC Basket, Baltic Dry and Commodity Returns

The Zero Hedge posted some terrific charts today.

Has this week's market turmoil been a "China only problem"?

Not so says the Saudi Arabian currency, the riyal.

The Zero Hedge notes

Saudi riyal forwards hit their highest level in almost two decades as oil plummeted: twelve-month forward contracts for the riyal climbed 260 points, and set for the steepest close since December 1996 on growing speculation the world’s biggest oil exporter may allow its currency to slide against the dollar for the first time since 1986 (incidentally, Bank of America's "Number One Black Swan Event For The Global Oil Market In 2016").

Should the current pressure be sustained, the USD-SAR peg may break. What happens next? [clue: mayhem]

US stocks were a toast last night. And it's been a bad start so far.

Well, it has not just been a bad start, but for the Dow Jones Industrials the worst since 1900!

As for oil, WTIC closed past $33 last night. But WTIC hit an intraday low of $32.1 which virtually breached the 2008 low of $32.4. Well, as for the OPEC oil equivalent, prices of the OPEC basket plunged to 2004 lows. 

Notes the ZH: Amid Saudi price cuts to Europe, the basket price was set at $29.71 today - the first print below $30 since April 2004.

And on commodity shipments, the Baltic index likewise hit fresh lows.

Again from the ZH: Another day, another fresh all-time record low in The Baltic Dry Index as Deutsche Bank's "perfect storm" appears ever closer on the horizon. Plunging 4.7% overnight to 445 points, this is 20% lower than the previous record low in 1986 and as one strategist warns, "It’s a brutal start of the year, there’s just nowhere to hide on the market."

Finally with oil and commodity trade on milestone lows, how about return on commodity investments?

Rate of returns on commodities have hit the Great Depression levels! Incredible!

The ZH: While the "sell in 1973, and go away" plan had worked out for some in the commodity space, the destruction of the last decade has only one historical comparison... the middle of The Great Depression. The 10-year rolling annualized return for commodities is -5.1% - the lowest since 1938...

For commodities, a buying opportunity should arise someday...

So a critical test on the SAR peg, the worst DJIA performance since 1900, OPEC Basket at 2004 lows, fresh lows for the Baltic index and annualized commodity returns at Great Depression levels, PLUS CHINA--do all these suggest bullishness for risk assets or of growing probability of a global financial economic crisis?

Infographic: The Silver Squeeze

The following infographic courtesy of the Austrian Insider (hat tip Zero Hedge)
 
The Silver Squeeze – An infographic by the team at The Silver Squeeze Free Infographic

Commodities And The Good Life

In a book review, the ever brilliant Matt Ridley narrates how commodities has contributed to economic progress and our good life.

An excerpt…

The discovery of the elements shadows and to some extent explains this evolving history of specialisation. The ancients knew of just seven metals: gold, silver, copper, tin, iron, lead and mercury. By giving each specialised roles, they improved their living standards—tin for hardening bronze, lead for moulding, silver for coinage and so on. By the modern era only one more metal—zinc—had joined them (although platinum was known to natives of the Americas). But then came a steady flow of new metals, each of which finds its particular role in technology and society: tungsten for hardness, aluminium for lightness, chrome for polish, neodymium for magnets, barium for medicine. Each finds its niche as surely as each profession and vocation does in human society. Just as our story is one of specialisation, so the story of chemistry is one of purification.

Each metal marches into our lives along a path from novel to banal, says Aldersey-Williams. Aluminium was once so difficult to make that Napoleon III used aluminium cutlery for only his most favoured guests and gave his son, the Prince Imperial, an aluminium rattle. Then it became so cheap that it was considered, well, cheap. Titanium, once rare and exotic, is becoming ubiquitous. For niobium and tantalum, Aldersey-Williams writes, “the journey is just beginning.” This is a tantalising thought. There are so many elements whose talents we have barely begun to use.

Financialization of Commodities: Boon Or Bane?

A Wall Street report recently highlighted on the "financialization of commodities" or the increasing role of commodities being used as investment assets.

They cite a study from Ke Tang at Renmin University in China and Wei Xiong at Princeton University which showed of the growing correlation between prices of commodities with stocks and the US dollar. Mr. Tang and Mr. Xiong writes,

``We find that concurrent with the growth of index investment, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with oil. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the GSCI 25 and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed to a substantial part of the large increase of commodity price volatility in 2008."

In addition, this has been used by some to cast a bearish light on commodities price trends.

Analyst Simon Hunt is bearish on copper, ``This economic scenario is not conducive to a strong trend growth in world copper consumption let alone to its declining intensity of use, a result of high and volatile copper prices. Moreover, copper’s end users, together with their fabricators, are fully aware that prices have not been driven by real fundamentals, but by the growing intrusion of the financial sector into treating copper, as for other base metals, as an alternative investment." (bold highlight mine)

Well in my view, financialization of commodities isn't a reason to be bearish.

This reflects on the deepening of capital markets in search of higher yield from relative returns, it also signifies the market process of discovering alternative havens or 'store of value' from inflationism and even possibly 'commodity as assets' could also function as sanctuary from numerous regulations.


Besides, commodities plays a minor role (.47%) in the $615 trillion derivatives [from the Bank of International Settlements] market largely dominated by interest rates (73.17%) and followed by foreign exchange (8%) and credit default swaps (5.32%). To consider that even weather plays a role in the derivatives market today as part of the growing sophistication of financial risk management.

Importantly, one mustn't forget that commodities once played the role of money, as Murray Rothbard wrote in Man, Economy and the State,

``Money is a commodity that serves as a general medium of exchange; its exchanges therefore permeate the economic system. Like all commodities, it has a market demand and a market sup­ply, although its special situation lends it many unique features. We saw in chapter 4 that its “price” has no unique expression on the market. Other commodities are all expressible in terms of units of money and therefore have uniquely identifiable prices. The money commodity, however, can be expressed only by an array of all the other commodities, i.e., all the goods and services that money can buy on the market. This array has no uniquely expressible unit, and, as we shall see, changes in the array cannot be measured."

Therefore, in today's environment where inflationism is the dominant path of policymaking, commodities can partly play the role of alternative store of value.

This means that the demand for money which consist of exchange demand (by sellers of all other goods that wish to purchase money) and reservation demand (the demand for money to hold by those who already hold it), would translate to what the mainstream sees as "speculation" or "hoarding".

In short, commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.

Moreover, when developments reveal heightened concerns over the accelerating loss of purchasing power in a currency, the role of commodities as money could be reinforced.

As Mr. Ludwig von Mises wrote,

``He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people [p. 427] believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does this inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.

``But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the 'twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call "velocity of circulation."

So in my opinion, where commodities serve as insurance against a crack-up boom, financialization of commodities is just one additional way to obtain access to such insurance. Not bad for as long as the counterparty in these contracts produces the 'real goods', when claims are presented.

Lastly, in competition with other asset classes, the financialization of commodities should likewise add to the pricing efficiency of the marketplace.

The Euro Bailout And Market Pressures

``The problem is that the fundamentals of these economies are not right. People in those countries cannot maintain a decent standard of living because they are not producing enough in the private economy to keep the public-sector unions afloat. Unfortunately, these unions are so powerful that they can extort pay and work agreements that plunder the taxpayers, and now that the bailouts have arrived, look for the unions to be even more militant and violent. These countries don’t need more inflation, contra Keynesians. They need to stop feeding the monster of public-employee unions and permit business to operate without being smothered by rules and regulations. But after being bailed out, these governments will go back to doing things as they always have, and the malinvestment will continue.” William L. Anderson, Will the New Bailout Save Europe?

The ultimate question at present is whether the Greece crisis would escalate into a full-blown international sovereign debt crisis, in spite of the recent monster $1 trillion bailout[1] announced by an EU-IMF syndicate last Sunday or if the market stresses emanating from the Greece episode would lead to a cascading impact on the real economy. And for that matter the sequential question should be, what would be the attendant policy response if the markets continue to react negatively?

Bailouts Are Politically Motivated And Ballooning

It’s a silly notion to limit ourselves to only the economic aspects, when throughout the decade the policy response, when confronted with a crisis, has been mostly politically designed which eventually had political results, particularly boom bust cycles. And this is why political reactions[2] by global leaders have been like clockwork, which has seemingly validated us anew.

For instance, the nearly 10% plunge[3] in the US the other Friday, which was mostly pinned on computer error, has prompted authorities to conduct an investigation. Here is a very telling commentary, as quoted by the Financial Post[4], from a US lawmaker,

"We cannot allow a technological error to spook the markets and cause panic," Rep. Paul Kanjorski said late on Thursday. "This is unacceptable."

This only implies that US markets have been very much incorporated into the policy setting modules of US authorities, where falling stockmarkets for valid reasons or not, e.g. due to technological glitches, is like a taboo.

And there is little nuance when compared to the EU’s bailout of the Euro, where EU Commissioner Olli Rehn announced, ``We shall defend the euro whatever it takes”[5]

These are more than enough proofs that the guiding principle for global authorities is to shore up their markets as means to convey “confidence”. As we have been saying, the intuitive response by global governments has been to unceasingly throw money at the problem. And confidence in the market is likely to translate to financing for politicians running for elections, aside from a favourable image to the public.

And one would note that the cost of bailouts have been growing,

This from Bloomberg[6],

``The cost of saving the world from financial meltdown has been bloated by ‘hyperinflation’ since Long Term Capital Management LP’s rescue in 1998… rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia’s default, and the almost $1 trillion committed to halt the European Union’s sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. ‘We haven’t had any kind of normal inflation in the last decade, but we’ve had hyperinflation in writedowns and the magnitude of bailouts,’ said Jim Reid, head of fundamental strategy at Deutsche Bank… ‘You have to do more to get a similar effect every time.’”

As we earlier wrote[7], To paraphrase Senator Everett Dirksen ``A trillion here and a trillion there, and pretty soon you're talking real money; (gold as money)"

There seems to be no apparent end to the spate of bailouts.

QE In 4 Largest Economies And A Different Kind Of Carry Trade

Will global governments wake up to face reality recognizing the attendant risks by adapting policies that require stringent sacrifices to clear their respective markets of excesses or malinvestments? Or will they continue to flush the economic system by the massive use of their printing press as a short term fix or a nostrum?

For us, until they are faced with a crisis that forces their hands, the path dependency for authorities is for the latter.

Yet a genuine manifestation of an international sovereign crisis would be a surge in interest rates among nations afflicted by growing risks of debt default.

However this seems unlikely to occur yet, as governments would still be able to manipulate the bond markets for political expediency, particularly to finance existing deficit as incidences of inflation appear muted.

And part of such policies to suppress interest rates would be to buy government bonds from the financial markets or the banking system. And this apparently has been part of the measures that was packaged with the bailout of the Euro.

In essence, we have 4 of the world’s largest economies that have now engaged in “quantitative easing” (even if the ECB denies these, for the reasons that she would “sterilize” her purchases or offset bond purchases from banks/financial institutions with sale of EU bonds).

And these 4 economies constitute nearly 85% of the $83 trillion global bond markets as of 2009[8].

In short, world markets and the global economy would likely suffer from an unprecedented meltdown in a horrific scale, which would make 2008 a walk in the park, if any of the developed nation’s sovereign crisis transform into a full contagion.

However, I don’t believe that we have reached that point yet.

Figure 2: US Treasuries Index, EM Index, Yield Curve, US Dollar

The highly volatility in the markets have led a misimpression of a repeat scenario of carry trade circa 2008.

As we have pointed on last February, there is little evidence that a carry trade from the US dollar has been building among the global banking system[9].

Instead what the Euro crisis has been showing us is that the carry trade has been within the Eurozone system as seen by the interlocking[10] activities or the vastly intertwined network among private and national banks, EU member governments and the ECB. In short, it isn’t a foreign currency arbitrage, but a carry trade of government debts distributed among EU banks.

As we earlier quoted[11] Philipp Bagus[12],

(bold emphasis mine)

``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

And the existing regulations which mandate the banking system to hold government debt as a risk-free reserve has equally contributed to the current mess by introducing the moral hazard problem effectively channelled into subsidies to the subprime EU member states as Greece.

So the pressure seen in the Euro markets of late isn’t due to the unwinding of US dollar carry trades but a perceived rise in the default risks and possibly the consequent impact to the real economy from a perceived slowdown due to compliance to fiscal adjustments, or of the question of the European Union ability to survive the crisis without getting dismembered.

As shown above, US interest rates markets and the US dollar have been chief beneficiaries from the troubled Euro. The Morgan Stanley US Government Morgan Stanley Fund (USGAX), a fund where 80% of its assets are invested in Treasury bills, notes and bonds, has surged. Moreover, the US dollar Index where the Euro has the largest share of the basket, has continually spiked.

This, in essence, looks more of a rotation away from EU assets into US assets than a looming full blown international sovereign crisis.

In addition, we are seeing parts of that rotation away from the EU into Emerging Market Bonds as shown by rise in the Salomon Bros. Emerging Market Debt Funds (XESDX).

Likewise, the spread between the 3 month Bills and 30-year Bonds remains steep in spite of a relatively higher 3 month rates since the start of the year.

In a full scale sovereign crisis we are likely to see a faster surge of short term bills rather than bonds. And this will likely be triggered by a spike in inflation which sets about a self feeding mechanism that would force up rates. At this point, governments will have to choose to bring down interest rest rates by printing more money or by totally renouncing inflationism.

This Isn’t Lehman Of 2008; China’s Role And Slumping Commodities

Well obviously this isn’t 2008, where the disruptions in the interbank funding markets forced a seizure or a rapid system-wide contagion in the banking system.

Yes, we are seeing some volatility but this has been nowhere near the post Lehman episode as shown in the credit markets or in the interest spreads (see figure 3).

Figure 3 Danske Bank: Credit Markets Isn’t Manifesting Signs Anywhere Near 2008

The yields in US cash indices for different corporate bonds (left window) have largely been unscathed in spite of the current selling pressures.

And the 3 month Libor-OIS spread considered as a measure of the health of the banking system (in the US and Europe), hasn’t been suffering from the same degree of stress during the zenith of the Lehman days (right window).

And that’s also why EU officials have been quick to institute “buying of government bonds” or “quantitative easing” in response to signs of growing stress in Europe’s banking system.

By making sure of the ample liquidity of markets, these actions which work to suppress interest rates are meant to allow markets and the banking system continually finance EU’s bailout. In other words, the bailout is not only meant to politically uphold the Euro as the region’s currency, but to also keep intact the carry trade, unless overhauled by reforms-which appears to be nowhere in sight.

Morgan Stanley’s Joachim Fels sees the same view,

(bold highlights mine)

``More generally, with the establishment of a potentially large stabilisation fund, fiscal policy in the euro area is being effectively socialised. No country will be allowed to fail, and it seems that no country will be too big to bail. Ultimately, this creates an incentive for governments to run a looser policy than otherwise. If markets then refuse to fund a profligate government, it could turn to the fund, borrow at below-market interest rates and domestically blame the required fiscal tightening on the ‘diktat' from the euro area partners and the IMF. So, our bottom line on the implications of the European fiscal emergency plan is that, while it addresses the near-term liquidity problems, it does little to solve the underlying problem of fiscal sustainability and may even make things worse on this front over the medium term.”

Moreover, I’d like to add that while some have argued that the EU’s actions will not violate the principle of Maastricht treaty, which disallows for direct bailouts, the Special Purpose Vehicle (SPV) created to extend loans to troubled nations, for me, signifies as EU’s act to go around their self-imposed rule, or regulatory arbitrage, but this time by the EU government.

If governments would work to circumvent their rules in order to accommodate political expediency and likewise save particular interest groups in the context of the meme of saving the economy or the Union, then how else would this politically privileged group react when they knowingly feel protected? They are likely to engage in more reckless behaviour.

This reminds us of Hyman Minsky[13] who warned that bubbles emanate from government intervention, ``It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.”

So its more than just inflating, it’s also a burgeoning moral hazards problem.

In addition, considering that the US is directly and indirectly involved, through the Federal Reserve via the currency swap lines and the IMF respectively, this can’t be seen as “beggar thy neighbour” approach considering that the US Federal Reserve sees the spillover risks from a banking contagion as possibly harmful to the sensitive state of her counterparts. In other words, the Fed isn’t causing a higher a US dollar for trade purposes but to ring fence the US banking system from a Euro based contagion.

Instead, such policy is more of a “beggar thy economy” genre where resources are being marshalled to save the banking system in the US and in Europe, at the expense of the real economy.

It’s not clear that the recent spate of falling oil or commodity prices are materially connected to the events in Greece or Europe, as they seem more correlated to the developments in China (figure 8).

Figure 4: China and commodities

As you can see the sharp drop in China’s Shanghai index (SSEC), which has been under constant assault from her government in an attempt to quash formative bubbles, has nearly been concurrent with the drop in oil (WTIC) and general commodities (CRB). Albeit the SSEC’s recent steep decline has also coincided with the fall of global markets from the Greece crisis the other week.

However, one bizarre development which seems moving in contrast to the current tide has been the Baltic Dry Index (BDI). The BDI appears headed towards the opposite direction almost as markets have been falling.

And with reports that consumer price inflation has been accelerating, it is quite likely that the Chinese yuan, could be expected to appreciate soon. And possibly, the rising BDI could possibly mean two things: one, a rising renmimbi means cheaper imports, which could reflect on the possibility of China’s positioning, and second, the falling prices could also be another factor for increased demand.

Unlikely Slump For Global Markets

So what does this tell us of the global markets?

First I am doubtful if this is the “inflection point” as expected by the permabears.

I see this more of a reprieve than a reversal. As said earlier, for as long as consumer price inflation rates are low, governments can continue to flood the economic system with newly printed money that may artificially contain interest rates levels.

Since money isn’t neutral, the impact from bailouts will have uneven effects to countries or specific sectors in particular economies. Even those expecting a deflation in Greece seem gravely mistaken[14].

Second, aside from the liquidity enhancement programs, policy rates by developed economy central banks are likely to stay at present levels for a longer period of time.

We even think that EM economies are likely to maintain rates at current levels, given the current conditions. In addition, rate increases enhances the risks of attracting more foreign capital in search of higher yields. Policymakers in EM nations will be in a fix.

Three, given the still steep yield curve, I have been expecting a pick-up in credit activities even in nations afflicted by over indebtedness. So far there have little signs of these (see figure 5)

Figure 5: St. Louis Federal Reserve: Consumer Loans at All Commercial Banks

Our basic premise has been that incentives provided for by the government to punish savers and reward debtors by suppressing rates will eventually force people to spend or speculate at the risk of blowing another bubble.

Besides, debt has been culturally ingrained in Western societies. It is an addiction problem[15] that will be hard to resist considering that the government itself is the main advocate of the use of addictive credit.

Fourth, economies of emerging markets have been performing strongly and are likely to maintain this momentum given the ultra loose liquidity backdrop.

Fifth, any slowdown or economic problems in any countries is likely to produce more bailouts from governments.

The trend has been set, therefore the chain of events are likely to follow. For instance, US participation in the bailout of Greece is likely to set a moral hazard precedent for financially troubled domestic states.

As Ganesh Rathnam argues[16], (bold highlights mine)

``The Federal Reserve's and IMF's participation in the eurozone bailout will not be lost on union members and politicians of heavily indebted US states such as California and Illinois. When the day of reckoning arrives for the US states who are unable to close their budget gaps and whose pension plans have huge funding gaps, they will be up in arms for their bailout as well. How could the US government politically defend its bailing out Greece via the IMF and the Federal Reserve and refusing the same for its own citizens? The idea that California would be allowed to default on its obligations when Greece wasn't is unthinkable. Therefore, the bailout of the PIIGS sets the stage for similar bailouts of bankrupt US states and cities.”

So governments worldwide will continuously pour freshly minted or digital money into the system. And yes this is going to be an ongoing battle between the markets and government armed with the printing presses.

Finally, Nassim Taleb in a recent interview[17] said, “No government wants solution to apply on themselves”.

And this only means that there will be even more government spending, bigger deficits and debts, higher inflation and missed fiscal targets or slippages from proposed austerity programs.

In the Eurozone, the EU circumvented existing rules to accommodate a bailout. These are signs that rules can flouted for political goals.

For the interim, this will all help. But at a heavy price in the future.

---

[1] see $1 Trillion Monster Bailout For The Euro!

[2] Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?

[3] See A Black Monday 1987 Redux?

[4] Financial Post, Obama says authorities probe cause of stock swoon

[5] see $1 Trillion Monster Bailout For The Euro!

[6] InvestorVillage/Bloomberg, Cost of Bailouts Keep on Rising

[7] See Are Record Gold Prices Signalling A Crack-Up Boom?

[8] The Asset Allocation Advisor, World Stock and Bond Markets and Portfolio Diversity; distribution share as follows US 37.9%, Euro 28.7%, Japan 13%, UK 4.9%

[9] See Does This Look Like A US Dollar Carry Bubble?

[10] See Was The Greece Bailout, A Bailout of The Euro System?

[11] See Why The Greece Episode Means More Inflationism

[12] Bagus, Philipp, The Bailout of Greece and the End of the Euro Mises.org

[13] Minsky, Hyman "Inflation, Recession and Economic Policy", 1982 (page 67) quoted earlier here More On Goldman Sachs: Moral Hazard And Regulatory Capture

[14] See Is Greece Suffering From Deflation?

[15] See Influences Of The Yield Curve On The Equity And Commodity Markets

[16] Rantham, Ganesh A Greek Tragedy in the Making

[17] See Nassim Taleb: Waking Up One Day To Perceptional Hyperinflation

Commodities And Bonds Point To A Return Of Inflation

I am on a hiatus this weekend, so I'd just be posting some charts of vital interests along with my pithy comments.


The above charts from stockcharts.com reveals of near simultaneous breakouts of key commodities, in particular, Oil (WTI), Gasoline (GASO) and copper, while the industrial metal group (DJUSIM) is at the resistance levels.

Given the mainstream definition, where growth is associated with "inflation" [relative to the output gap], this perspective interprets the rise of commodity prices sensitive to the economy's growth as alluding to "recovery". As earlier commented, instead we think these are signs of a transitional formative bubble.

We'd have to admit that not every commodities has been on the run; and this has been evident in agriculture (DBA-Powershares DB Multi-sector commodity trust agriculture fund), particularly among grains, and in natural gas (NATGAS). The latter saw a recent spike, but remains on a medium term downtrend.

Albeit the performance of the Agriculture sector remains mixed to lower, with only the Livestock index (DJALI) seemingly at the outperform phase.

Meanwhile, the CRB index (CRB) remains at a trading range, despite the run in the metals and energy, to reflect on this balance.

Nevertheless, commodities do not usually move in concert. The only exception is during the 2008-2009.

As Howard Simons points out in Minyanville, (bold highlights mine)

``Note the large jump in late 2008 and early 2009; that wasn't convergence during a bull market in commodities, that was the period when all commodities along with all stocks, all real estate, all corporate bonds, and a handful of markets none of us knew could roll over and die all rolled over and died together in the financial market musical tribute to mass cyanide poisoning, Jonestown Is Your Town.

``Prior to that episode, the one-year rolling correlation of returns for these indices had never exceeded 0.51 and had, in fact, been negative. We're in the process now of moving back toward randomness."

My inference is that the difference then was that global equity markets were headed lower and much of the residual money from previous looseness found its way to commodities, which made a belated peak, even as the world economy had been contracting and money had been tightening. Perhaps this led to the anomaly of intra commodity convergence.

Meanwhile the Lehman episode, which resulted to a global banking gridlock, was the proverbial nail to coffin that brought almost all assets to its knees (except for bonds and the US dollar).

With the Bernanke Put clearly in place, which assures a continued flow of liquidity underpinned by the implied gargantuan support for her banking system, the reversion to randomness only suggest that inflation has yet to turn widespread.

This only supports our view that we are in the benign stage or in the "sweetspot" of inflation [see previous explanations in Philippine Markets And Elections: What People Do Against What People Say and Does Falling Gold Prices Put An End To The Global Liquidity Story?]

Finally, the actions in the equity, commodity and bond markets seem to be reinforcing the same story, a return of inflation.

Long term bonds as seen in the 30 year (TYX) and the 10 year yields (UST10Y) are seen inching higher.

Though the short term vis-a-vis the long term yields (UST10Y:$UST1 year-10 year versus 1 year and TNX:UST1Y 30 year versus 1 year) remain steep, they appear to have reached its zenith.

And competition to acquire materials for long term projects seem to be forcing up short term yields relative to long term yields [see Is The Recovery In Global Manufacturing A Symptom Of The Next Boom Bust Cycle?]

Yet the long end is looking at higher rates most possibly from inflation. As Morgan Stanley's Richard Berner and David Greenlaw recently wrote,

``In our view, heavy Treasury coupon issuance will combine with a revival in private credit demands to lift real yields. Moreover, uncertainty about inflation and the fiscal outlook will boost bond risk premiums."

Deflation, where?

Influences Of The Yield Curve On The Equity And Commodity Markets

``The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.-Gary North

The first structural factor, the record steep yield curve, should be a familiar theme to those who regularly read my outlook.

This accounts for as the “profit spread” from which various institutions take advantage of the “borrow short term and lend or invest in long term assets”[1].

The Yield Curve (YC) is a very dependable tool for measuring boom bust cycles (see figure 2).

That’s because artificially lowered interest rates, a form of price control applied to time preferences of the individuals relative to the use of money, creates extraordinary demand for credit and fosters systematic malinvestments or broad based misdirection of resources within markets and the economies.

Figure 2: Economagic.com: Yield Curve and the Boom Bust Cycle in the S&P 500

Sins Of Omission: The Influences of Habit or Addiction

It’s fundamentally misplaced to also conclude that just because balance sheet problems exist for many consumers, particularly for developed economies in the West, as they’ve been hocked up to their eyeballs on debt, that they would inhibit themselves from taking up further credit to spend. This also applies to some corporations.

Such presumption fatally ignores individual human action, particularly, for people to develop and sustain irrational habits. Some of these habits grow to the extent of addiction, which could have a beneficial (reading) or negative or neutral effect (mowing lawns). Albeit, addiction has a predominantly negative connotation.

While addiction[2] has many alleged modal causes, e.g. disease, genetic, experimental, and etc., some models have been argued on the basis of purely psychology, specifically:

-choice [The free-will model or "life-process model" proposed by Thomas Szasz],

-pleasure [an emotional fixation (sentiment) acquired through learning, which intermittently or continually expresses itself in purposeful, stereotyped behavior with the character and force of a natural drive, aiming at a specific pleasure or the avoidance of a specific discomfort."- Nils Bejerot]

-culture [“recognizes that the influence of culture is a strong determinant of whether or not individuals fall prey to certain addictions”]

-moral [result of human weakness, and are defects of character]

-rational addiction [as specific kinds of rational, forward-looking, optimal consumption plans. In other words, addiction is perceived as a rational response to individual and/or environmental factors. There wouldn’t be an addict or substance abuse problem, if those affected are disciplined enough to correct habit abuses.]

If affected persons, in recognition of such problems, simply applied self-medication or took preventive measures to avoid the worsening development of negative addiction, then obviously we wouldn’t have addiction problems at all! But certainly this hasn’t been true.

From a psychological standpoint, it would seem quite apparent that addiction is largely a stimulus response feedback mechanism or very much a behavioural predicament.

In other words, negative addiction is fundamentally a choice between temporal happiness over future consequences (frequently adversarial outcomes) or where habit interplays with choices, rational alternatives, environment, moral frailty, cultural influences or seductiveness of pleasure vis-a-vis normal behaviour.

Simply put, there is an incentive for people to develop different forms of addictions.

Applied to the markets or the economy, what if the source of profligacy [or Oniomania[3] or compulsive shopping or compulsive buying], a form of addiction, stems from government initiatives, by virtue of artificially suppressed interest rates?

And what if government induces people to spend on things they can’t afford with money they don’t have, out of the desire to fulfil economic ideology or to promote certain industries?

Will the teetotaller refuse government’s offer of free drinks?

How much of government induced behaviour from reckless policies will force individuals and businesses to take the low interest rate bait?

And this seems to be the story behind the yield curve.

The Stock Market And The Yield Curve Over The Long Term

Notice that every time the long term yield (30 year treasury constant maturity-red) materially diverges from the short term yield (1 year treasury constant maturity-blue) to form a steepened yield curve (black arrow pointed upwards), the S&P 500 (green) blossomed.

On the other hand, inverted yield curves, where short term yields had been higher than the long term yields (green arrow pointed downwards), had preceded recessions and severe market corrections.

Like normal yield curves, the yield curve’s impact on the economy has a time lag, a 2-3 year period.

Even the October 1987 Black Monday crash appear to have been foreshadowed by an account of relatively short inversion in 1986.

And the inflation spiral of the late 70s saw short term rates race ahead of short term rates for an extended period.

So why does an inverted yield curve occur?

Because the debt markets reveal the amount or degree of misallocations in the market ahead of the economy.

According to Professor Gary North

``This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

``This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.”[4]

This means that when consumers and businesses compete for short term funds, demand for short term money raises interest rates. Nevertheless, as the fear of inflation recedes, “an ever-lower inflation premium”[5] forces down long term yields.

As a caveat, since corporations operate on the principle of a profit and loss outcome, they’re supposedly more cautious. But this hasn’t always been the case. And it should be a reminder that a fallout from an imploding bubble does not spare so-called blue-chips, as in the case of the US investment banking industry, which virtually evaporated from the face of earth in 2008.

Industries that have been functioned as ground zero for bubbles are usually the best and worst performers, depending on the state of the bubble.

Figure 2: Business Insider: Falling Net Debt To Cap

Figure 2 is an interesting chart.

Interesting because the chart shows of the long term trend of the S & P 500 Net debt to Market cap-which has been on a downtrend, for both the overall index (red spotted line) and the ex-financials (blue solid line).

Since it is a ratio, it could mean two things: debt take up has been has been falling or market cap has been growing more than debt. My suspicion is that this has been more of the growth in market cap than of debt (since this is a hunch more than premised on data, due to time constraints, I maybe wrong).

In addition, since the tech bubble, corporate debt hasn’t grown to the former levels in spite of the antecedent boom phase prior to the crash of 2008.

Nevertheless, the substantially reduced leverage from corporations, particularly the net debt (red spotted line) which has reached the 2005 low, suggest of a recovery. This could signify a belated play on the yield curve.

Prior to the recent crisis, the S&P net debt began to recover at the culminating phase of the steep yield curve cycle.

Could we be seeing the same pattern playout?

Commodities And The Yield Curve

Finally, the link of the yield curve relative to US dollar priced commodities has not been entirely convincing. (see figure 3)

Figure 3: Economagic: Yield Curve and the Precious Metals

Over the span of 3 decades, we hardly see an impeccable or at least consistent correlation.

Precious metals in the new millennium soared during the steep yield curve. But it also ascended but at much subdued pace during the inversion.

In the late 70s precious metals exploded even during inverted yield curve. While it may be arguable this has been out of fear, it does not fully explain why gold and the S & P moved in tandem see figure 4.

Figure 4: Economagic: Precious metals and the S&P 500

Moreover, between the 80s and the new millennium, correlations have been amorphous.

And perhaps as we earlier averred this could have been due to the formative phase of globalization where much of liquidity provided by the US Federal Reserve had been “soaked up” by the inclusion of China and India and other emerging markets in global trade as a result of policies from Reaganism and Thatcherism and the collapse of the Soviet Union.[6]

The various bubbles around the globe, during the said period, serve as circumstantial evidence of the core-to-the-periphery dynamics.

Overall, as the yield curve remains steep, we believe that the upward thrust of markets should continue to hold sway as the public will be induced to take advantage of the “profit spread” as well as with central banks continued provision of stimulus conditions that would revive the compulsive manic behaviour seen in persons afflicted by varied forms of addiction.

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[1] See Does Falling Gold Prices Put An End To The Global Liquidity Story? and Why The Presidential Elections Will Have Little Impact On Philippine Markets

[2] Wikipedia.org, Addiction

[3] Wikipedia.org Oniomania

[4] North, Gary; The Yield Curve: The Best Recession Forecasting Tool

[5] North, Gary; When the Yield Curve Flips. . . .

[6] See Gold: An Unreliable Inflation Hedge?