Are Surging Oil Prices Symptoms of a Crack-up Boom?

Dr. Ed Yardeni thinks that there has been a mismatch between oil prices and oil demand

Dr. Yardeni writes

The price of Brent crude oil is up again this morning over $124 a barrel. It’s up from $107.65 at the end of last year as a result of increasing tensions with Iran following the imposition by the US and Europe of tough new sanctions on Iran. They are already reducing the ability of Iran to export crude oil. Last year, Iran exported about 2mbd. That is likely to get cut by half or more. That’s not enough to explain why oil prices are soaring given that global oil supply is around 88mbd. Of course, concerns are mounting that the diplomatic and economic confrontation with Iran could turn into a military conflict that would disrupt oil traffic coming out of the Persian Gulf. This certainly explains why oil prices are rising.

Global oil demand, on the other hand, is weakening and suggests that oil prices could fall sharply if the Iranian issue can be resolved without push coming to shove. As I’ve explained previously, I believe that the sanctions are rapidly crushing Iran’s economy and may force the Mullahs to give up their ambitions to build nuclear weapons. This may take some time, of course. Meanwhile, if oil and gasoline prices continue to rise, I expect that the Obama administration will coordinate a global release of supplies from the Strategic Petroleum Reserves, as occurred last summer in response to the drop in Libya’s exports.

While tensions over Iran partly contributes to the elevated state of oil prices, there are deeper factors involved as previously explained

Importantly when mainstream economists talk about demand they usually refer to consumption demand and ignore the second type of demand—reservation demand.

The distinguished dean of the Austrian school of Economics Murray N. Rothbard explained,

The amount that sellers will withhold on the market is termed their reservation demand. This is not, like the demand studied above, a demand for a good in exchange; this is a de­mand to hold stock. Thus, the concept of a “demand to hold a stock of goods” will always include both demand-factors; it will include the demand for the good in exchange by nonpossessors, plus the demand to hold the stock by the possessors. The demand for the good in exchange is also a demand to hold, since, regard­less of what the buyer intends to do with the good in the future, he must hold the good from the time it comes into his ownership and possession by means of exchange. We therefore arrive at the concept of a “total demand to hold” for a good, differing from the previous concept of exchange-demand, although including the latter in addition to the reservation demand by the sellers.

Yet what prompts for an increase in reservation demand?

Again Professor Rothbard

an in­crease in reservation demand for the stock may be due to either (a) an increase in the direct use-value of the good for the sellers; (b) greater opportunities for making exchanges for other purchase­-goods; or (c) a greater speculative anticipation of a higher price in the future

Speculative activities also drive the increased demand to hold a stock of goods. Or in the case of oil prices, increased speculation has also been responsible for the recent spike.

This means that monetary policies designed to ease credit via zero interest rates and quantitative easing have been responsible for encouraging, not only consumption but speculative activities too, by increasing people’s time preferences.

One would note that oil prices and stock market prices (S&P 500) have been ramping up. These are symptoms of an inflationary boom.

Of course, inflationary boom extrapolates to a boom bust cycle or to a crack-up boom.

As Professor Ludwig von Mises wrote

The boom could continue only as long as the banks were ready to grant freely all those credits which business needed for the execution of its excessive projects, utterly disagreeing with the real state of the supply of factors of production and the valuations of the consumers. These illusory plans, suggested by the falsification of business calculation as brought about by the cheap money policy, can be pushed forward only if new credits can be obtained at gross market rates which are artificially lowered below the height they would reach at an unhampered loan market. It is this margin that gives them the deceptive appearance of profitability. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.

Neither could the boom last endlessly if the banks were to cling stubbornly to their expansionist policies. Any attempt to substitute additional fiduciary media for nonexisting capital goods (namely, the quantities p3 and p4) is doomed to failure. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. However, as a rule, the banks in the past have not pushed things to extremes. They have become alarmed at a date when the final catastrophe was still far away.

While a crack-up boom is not imminent, current monetary policies have brought us into this direction. The more governments engage in reckless policymaking in our monetary affairs, the greater risks of spiraling commodity prices.

Rising oil price, thus can be seen as symptoms of a chronic disorder in the current state of money.

The Coming Global Debt Default Binge: Moody’s Downgrades Japan

The global debt default binge is in process with credit rating downgrades signifying as the initial symptoms.

US credit rating agency Moody’s today downgraded Japan.

From Bloomberg, (bold emphasis mine)

Japan’s debt rating was lowered by Moody’s Investors Service, which cited “weak” prospects for economic growth that will make it difficult for the government to rein in the world’s largest public debt burden.

Moody’s cut the grade one step to Aa3, with a stable outlook, it said in a statement today. Rebuilding costs from the March 11 earthquake and tsunami, along with continuing efforts to contain the Fukushima nuclear crisis, may make it hard for officials to meet their borrowing target this year, it said.

The first Japan downgrade by Moody’s since 2002 reflects deteriorating credit quality across developed nations from Italy to the U.S., which lost its AAA status at Standard & Poor’s this month. While the move adds to the challenges of the next Japanese prime minister, scheduled to be picked next week, the impact on bond yields may be limited by what Moody’s described as domestic investors’ preference for government debt.

The rerating has also been felt in the CDS markets…

The cost of insuring corporate and sovereign bonds in Japan against default increased, according to traders of credit- default swaps. The Markit iTraxx Japan index rose 7 basis points to 153 basis points as of 12:09 p.m. in Tokyo, on course for its highest level since June 10, 2010, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market…

Today’s rating move brings Japan to the same level as China, showing the diverging paths of Asia’s two biggest economies. China replaced Japan as the world’s No. 2 last year and Moody’s has a positive outlook on its ranking

But debt acquisition won’t be curtailed despite the downgrade…

Moody’s said today’s decision was “prompted by large budget deficits and the build-up in Japanese government debt since the 2009 global recession.”

Japan’s public debt is projected to reach 219 percent of gross domestic product next year even before accounting for borrowing to fund reconstruction after the March 11 earthquake, according to the Organization for Economic Cooperation and Development.

The government has amassed a debt of 943.8 trillion yen, according to the Finance Ministry, after two decades of fiscal spending to energize an economy hobbled by the collapse of an asset bubble in 1990 and lingering deflation that’s sapped private demand. The yen’s advance to a post World War II high this year also threatens exports, a main driver of the nation’s economic growth…

The government has pledged to raise the sales tax to 10 percent by the middle of the decade, a rate that would still be below the IMF’s recommendations. The additional revenue is intended to pay for social welfare for the aging population.

Japan’s government plans total spending of 19 trillion yen over five years to rebuild after the magnitude-9 temblor and tsunami that devastated the northeast coast of Japan and triggered the worst nuclear crisis since Chernobyl.

Politicians won’t learn until forced upon by economic realities.

So the initial preemptive response to the anticipated downgrade has been to inflate the system using the recent triple whammy calamity as pretext.

Finally, it certainly is not true that current developments recognized as “fiscal austerity” have been about getting off the welfare state-big government-deficit spending path.

What has been happening instead is the political process where massive amount of resources are being transferred from the welfare state to the banking sector.

Global political leaders are hopeful that by rescuing the politically privileged interconnected banks, they can bring 'normalcy' back to the 20th century designed politically entwined institutions of the welfare state-banking system-central banking system.

Proof?

Just look how the Japanese government (and other developed governments) addresses their dilemma—mostly by raising taxes!

As the illustrious Milton Friedman once said,

In the long run government will spend whatever the tax system will raise, plus as much more as it can get away with. That’s what history tells us. So my view has always been: cut taxes on any occasion, for any reason, in any way, that’s politically feasible. That’s the only way to keep down the size of government.

So tax increases equates to the preservation of the welfare state or big government.

Unfortunately, the system has already been foundering from under its own weight. And importantly, politicians apparently blase to these risks, continue to impose measures that would only increase the system's fragility. What is unsustainable won't last.

The Coming Global Government Debt Default Binge

From the Wall Street Journal blog:

The biggest risk, however, isn’t Greece per se. It is the prospect of other peripheral euro members — Ireland, Spain, and Portugal — following Greece down the default path. That cascade effect has to be avoided….

The global credit authorities and financial markets have been digesting this problem for more than a year. Some participants think a default is inevitable; Greece should just do it.

Then the world can move on to an even bigger worry: whether the U.S. government will soon default on its debt.

Yes, ballooning debt as a consequence of incessant government spending on the welfare state isn’t just an issue of Greece. It’s everywhere.

From the Bank of International Settlements

Sooner or later, something will occur to prevent debt from exploding: governments will adopt corrective measures on their own, or they will be forced to act as sovereign risk premia reach unbearable levels.

And this is only from the facet of government liabilities, which does not include the banking system

This bring us to the admonitions of the great Ludwig von Mises

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.

Governments will default, either by massive inflation or by the far better option-deflation.

And that’s why the events in Greece is a prelude to the next monumental chain of government-and-banking debt crisis.

We are approaching the Mises moment.

War on Commodities: UN Endorses Price Controls

UN endorses more price controls on commodities

Reports the Bloomberg,

Commodity markets need international oversight, more transparency and intervention to deflate bubbles because increasing speculation means prices are no longer driven by supply and demand, the United Nations said.

Increased investment in commodity markets has encouraged “herding behavior” and creates bubbles, the UN’s Conference on Trade and Development said in a report published today. Anticipation of the global economic recovery played a “disproportionate role” in higher commodity prices, it said.

“Prices can move far from levels justified by the fundamentals for extended periods, leading to an increasing risk of price bubbles,” the UN said in the report. “Due to these distortions, commodity prices do not always provide correct signals about the relative scarcity of commodities.”

By how exactly does the UN determine “prices are no longer driven by supply and demand”? Their math models?

It’s an irony because earlier they had been warning about a US dollar collapse

From the IBTimes FX

Rob Vos, a senior UN economist involved with the report, said if emerging markets "massively start selling off dollars, then you can have this risk of a slide in the dollar."

Are they assuming that “selling off dollars” and “prices are no longer driven by supply and demand” are not at all connected?

Put differently, that there is absolutely no connection between debasing one’s currency and rising prices?

Maybe Zimbabwe did not experience a socio-economic depression from hyperinflation (2004-2009).

Instead Zimbabwe could have suffered from the herding effects of speculators. Speculators cratered the Zimbabwe dollar and caused consumer prices to double every day

Such is UN's prism of economics.

In the real world, rising commodity prices in response to government’s continued debasing of a currency is a symptom known as the “Flight to Real Values”.

From Mises.org

The frantic rush to spend all monetary savings and other available cash, buying goods, whether needed or not, in order to avoid holding, even for a short time, any rapidly depreciating monetary units. This occurs at that point in the development of inflation when the public is convinced that prices will continue to rise endlessly and at an accelerated pace. The flight into goods or real values is also known as a "Crack-up boom" (q.v.) and marks the complete breakdown of a monetary system.

The UN can only pretend. But they will not succeed in controlling prices if they do not treat the root of the problem—government’s inflationism.

As Ludwig von Mises warned in Planning for Freedom

those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation-the rise in prices-are masquerading their endeavors as a fight against inflation. While fighting the symptoms, they pretend to fight the root causes of the evil. And because they do not comprehend the causal relation-between the increase in money in circulation and credit expansion on the one hand and the rise in prices on the other, they practically make things worse.

A Crack-up Boom in Belarus

Belarus appear on the verge of experiencing hyperinflation.

Reports the Bloomberg, [bold emphasis mine]

Belarus is headed for an economic “meltdown” and the ruble will need to depreciate another 51 percent, VTB Capital said, as locals lay siege to shops and protest price increases after the central bank devalued the currency.

The Belarusian central bank let the managed ruble weaken by 36 percent versus the dollar on May 24 as demand for dollars and euros from importers and households threatened to derail an economy already laboring under a current-account deficit equal to 16 percent of gross domestic product. Russia and other former Soviet partners last week agreed to give Belarus a $3 billion loan and urged President Aleksandr Lukashenko’s government to sell $7.5 billion of assets to replenish the state’s coffers.

“A ‘91-style meltdown is almost inevitable,’’ said Alexei Moiseev, chief economist at VTB Capital, the investment-banking arm of Russia’s second-largest lender, referring to the country’s economic slump after the collapse of the Soviet Union. ‘‘Rapid privatization is the only way that can help avert complete disaster.”

From Zero Hedge

As always political goals such such as the desire to maintain hold on power by incumbent political leaders abetted by inflationist and socialist policies have contributed to this.

Again from the same Bloomberg article, [bold highlights mine]

Lukashenko reintroduced controls on prices and the currency and re-nationalized some companies and infrastructure after coming to power in July, 1994, on a platform of “market socialism.” The nation’s economy returned to growth in 1996, according to World Bank data.

At the Minsk Refrigerator Plant Co. shop in the capital today, about 20 people queued in drizzling rain to use their rubles to buy fridges. While the shop didn’t open on the day of the devaluation, most of the models in the store already had ‘Sold Out’ stickers on their doors.

“I came on Saturday and it was a nightmare, the store was stormed by people who wanted to spend their rubles because of rumors about the devaluation,” said Nikolay, a 74-year-old pensioner who declined to provide his last name. His entire savings of 6 million rubles now buy one fridge compared with three before the devaluation, he said.

The ruble traded at 5,019.75 per dollar at banks and currency kiosks around the country today, according to the median mid-price of six banks compiled by Bloomberg from the lenders’ websites. That’s 1.8 percent weaker than the official rate.

The devaluation lifted the local price of automobile fuels as much as 24 percent, according to Belneftekhim, an industry group for the country’s oil sector. Last night, about 50 people protested the price increase in the car park of a Minsk hypermarket.

“I can’t describe how I feel without using obscenities, this is all our government’s fault,” said Sergey, a 32-year old attending the protest who works for a computer importer. “The whole world tells them, guys, you have economic problems, you should do something, and all they did was live off getting more and more loans.”

Both the IMF and the EBRD have blamed Lukashenko’s spending before last year’s presidential election for much of the economy’s woes. Lending was increased by 38 percent last year and public-sector salaries rose by about 50 percent, the Washington-based IMF said in a March 9 report.

Belarus got a $3.5 billion bailout loan from the IMF during the global credit crisis and the country has more than $2 billion of ruble and dollar debt outstanding. Foreign-currency reserves hit a 1 1/2-year low in March...

The price of children’s diapers has “gone completely insane” in Minsk, said Natalia, a 24-year-old mother also queuing outside the refrigerator store. “I used to buy a pack for 69,000 rubles, now they cost 140,000,” or almost half the 343,260-ruble monthly child benefit paid by the government, she said.

“We have become paupers,” said Tatiana, a 70-year-old woman in the line who also declined to give her last name. “We have been squeezed into a corner by this devaluation.”

Belarus’ skyrocketing inflation from Danske Bank

The previous bailout of the IMF has introduced the moral hazard factor which seems to have compounded this process.

Yet the unfolding episode in Belarus seems like a good example of the phase of the inflation process known to the Austrian school as the crack-up boom

From Ludwig von Mises,

But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them

Russia’s Putin Says US Federal Reserve Policies Represent ‘Hooliganism’

Even some governments recognize the implicit harm from US Fed policies.

This report from Wall Street Journal Blog (Bold highlights mine)

WSJ Blog AFP/Getty Images Prime Minister Vladimir Putin

Russian Prime Minister Vladimir Putin slammed expansionary U.S. monetary policy, calling it “hooliganism”, in remarks that followed more veiled criticism from China after Standard & Poor’s Corp. cut the outlook on its U.S. debt rating this week.

“We see that everything is not so good for our friends in the States,” Putin told lawmakers Wednesday.

“Look at their trade balance, their debt, and budget. They turn on the printing press and flood the entire dollar zone — in other words, the whole world — with government bonds. There is no way we will act this way anytime soon. We don’t have the luxury of such hooliganism,” he said.

Even as Putin blamed the U.S. for printing money — something for which Russia was criticized during periods of hyperinflation in the 1990s — other Russian officials said there is no alternative to the U.S. dollar and declined to discuss cutting the country’s dollar holdings.

Russia has the world’s third-largest international reserves after China and Japan, with the biggest part in U.S. government debt. However, Russia appears to have cut its direct Treasury holdings significantly in recent months, according to data from the U.S. Treasury.

Russia can be seen as benefiting from the recent policy of the U.S. Federal Reserve, linked to higher commodity prices. But an increase in dollar supply and low interest rates could also lead to a commodities bubble that could wreak havoc on Russia’s finances if oil prices later collapse.

Authorities of some nations earlier admonished the Fed’s actions as stoking a currency war.

The above report reveals that Russia’s Putin recognizes the consequences of the massive money printing operations as one of the bubble cycles and commodity inflation which eventually will sow chaos or devastate global economies again. (Could Putin be reading Austrian economics?)

It is not true that “there is no alternative to the U.S. dollar”. People will intuitively shift to either other foreign currencies or bring back hard currency once the ‘policies of hooliganism’ worsens.

With gold and commodities generally soaring, these represent symptoms of a worldwide “flight to real values” from the ongoing crackup boom.

Gold As Safehaven From Currency Devaluation: Belarus Edition

From Reuters.com (hat tip Bob Wenzel)

Belarus' central bank has stopped selling gold to local retail customers for Belarussian roubles BYR=, it said on Friday, after demand for precious metals soared due to expectations of a currency devaluation.

The bank did not explain its decision.

The explanation:

This represents an instinctive response by Belarussians against the expectation of their government’s debauchery of money.

Such action can be read as “flight to real values”.

US Dollar, Gold and Democracy

I find it odd or self-contradictory for a high profile investment expert[1] to claim that Eurozone bondholders should accept losses while declaring US muni bonds as a “buy”. In short, bearish Euro bullish USD. I view this more as an endowment bias where people place a higher value on objects they own than objects that they do not[2] (That’s because the expert is domiciled in the US).

It may true that state of the US muni bonds should be seen at the local level, but this should apply to the Eurozone too. In other words, prospective haircuts should apply to any nations/state where the cost to maintain debt levels can’t be economically sustained and where the policy of bailouts ceases to be part of the picture.

The cost to maintain debt levels can also be read as the willingness to pay, as Dr. Antony P. Mueller rightly commented[3],

``With debt it is as much the willingness to pay as it is the ability to pay. One could even say that the willingness to pay precedes de ability to pay.”

In addition, there is the tendency to ignore the role played by central banks. In as much as the US Federal Reserve can print money to conduct bailouts, so as with the Europeans through the ECB. So who prints more money will likewise impact on the relative economics of debt.

While it may be true that interest rates would impact the Eurozone more than the US (see figure 2), interest rate dynamics can swiftly change depending on either rate of change of inflation at the national level or on the public’s fluid perception of credit quality conditions.

Interest Payments as share of GDP[4]

Besides, both the US dollar and the Euro are fiat based money that are structurally flawed, as it is being shown today with a gamut of bailout policies left and right, targeted at rescuing the banking system and welfare nations/states in distress.

Thus, like all paper money subject to currency debasement and currency wars or competitive devaluation, that would make both like a race to the bottom.

So it’s a matter of which country (US or the Euro) would make more policy errors.

So even while I may be bullish the Euro over the US over the short-term, I wouldn’t recommend positioning on either one of them over the opportunity costs of holding other assets.

Why the USD or the Euro when there are others to choose from?

And many investors seem to share my view and vote with their money. According to analyst Doug Noland[5]

``The past year saw another $500 billion flee the U.S. money fund complex in search of higher yields. Tens of billions flooded into perceived low-risk bond and muni funds, while tens of billions more headed overseas. Meanwhile, money flowed into the hedge fund community, where assets and leverage are said to now approach pre-crisis levels. All of this amplifies systemic risk.”

So while it may hold the US dollar may rally, mostly as a result of a weakened Euro, I think this could be temporary.

Yet even as the USD should rally, we shouldn’t expect the same pattern of asset behaviour to occur as with the 2008 paradigm as some other experts seem to suggest.

It’s not true that a strong USD automatically translates to weakness in all other assets.

In 2005 the US dollar rallied alongside commodities and global equity markets. Thus, reference points can give divergent views and the view that a strong USD means automatic weakness in all others means anchoring to the 2008 post Lehman bankruptcy episode.

For me, it will always be a question of how authorities are likely to respond to any unfolding problems than simply projecting past or present conditions into the future.

For now, the auto response mechanism or path dependency by policymakers has been to engage in bailouts. Thus, in sustaining these policies means we should position for boom bust cycles, or at worst, insure ourselves from the prospects of a crack-up boom phenomenon (flight to commodities) since money is never neutral.

In a similar vein, it would seem to be impractical to be bearish on gold or precious metals for the same reasons.

And in growing recognition of these reckless monetary policies, in the US, lawmakers of some 10 states have reintroduced bills to recognize gold and silver as money[6].

Thus, it would misguided to suggest that democracy can’t be compatible with gold.

As Professor Tibor Machan points out[7]:

In a just society it is liberty that is primary – the entire point of law is to secure liberty for everyone, to make sure that the rights of individuals to their lives, liberty and pursuit of happiness is protected from any human agent bent on violating them. Democracy is but a byproduct of liberty

Thus if gold should represent liberty then democracy, as a byproduct of liberty, should blend well with gold as money.

And this may be zeitgeist of the current trend of gold prices

---

[1] Moneynews.com Pimco’s El-Erian: European Bond Investors Must Accept Losses, January 14, 2011

[2] Wikipedia.org, Endowment Effect

[3] Mueller, Antony P. Portuguese Bond Sale, cashandcurrencies.blogspot.com, January 12, 2011

[4] Mitchell J. Daniel Which Nation Will Be the Next European Debt Domino…or Will It Be the United States?, Cato.org, January 11, 2011

[5] Noland Doug Issues 2011 Credit Bubble Bulletin, PrudentBear.com, January 14, 2011

[6] TPMDC At Least 10 States Have Introduced Gold Coins-As-Currency Bills, January 5, 2011

[7] Machan Tibor R. Reexamining Democracy, January 4, 2011

Trick Or Treat: The Federal Reserve’s Expected QE Announcement

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.-Ludwig von Mises, Interventionism: An Economic Analysis, Inflation and Credit Expansion

What I think would be the most important driver for the global financial markets over the coming weeks would be the prospective announcement by the US Federal Reserve’s Quantitative Easing version 2.0 on Wednesday.

The Gist of QE 2.0

I do NOT share the view that QE has been FULLY factored IN on the financial markets for the simple reason that estimates of the scale and duration and or terms have been widely fragmented. And there hardly appears to be any consensus on this.

The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

And all talks about currency wars, global imbalances and others are most likely to be diversionary ‘squid’ tactics to avoid the public from scrutinizing on the Fed’s arbitrary actions.

I see the ongoing QE 2.0 as heavily correlated with the legal issues surrounding the ownership[1] of many mortgage securities that has plagued the industry over the past few weeks.

Of course, it is also possible that Federal Reserve Chairman Ben Bernanke and company maybe pre-empting the results of the midterm elections, which they might think, could upset the current policy directions directed at providing subsidies to the banking system. The possibility of Cong. Ron Paul taking over the banking committee in Congress, they might see as a potential risk that could disrupt the viability of the banking system.

More Evidence Of Inflation

Yet there is hardly any convincing evidence that the US will likely succumb to another recession even without QE 2.0.

Even the credit markets have been saying so as we earlier pointed out[2].

Figure 2: Improvement On US Credit Markets (charts from St. Louis Fed)

For an update (see figure 2): Bank Credit of All Commercial Loans seem to be picking up momentum anew (top window), even Individual loans at ALL commercial which have recently skyrocketed, seem to be in a short pause but still looking vibrant (bottom pane) while Commercial and Industrial Loans of ALL Commercial banks seem to be bottoming out (mid window).

Figure 3: US Monetary Aggregates Points To Inflation (St. Louis Fed)

And even US monetary aggregates[3] appear to be saying the same story: MZM (upper window) and M2 (mid window) have recently been exploding skywards, while the M1 multiplier, a former favourite tool of permabears which tries to measure velocity of money, appears to be emerging fast from a bottom. And this is even prior to the Fed’s supposed renewed engagement with QE.

What all these seem to be pointing out isn’t what the mainstream and the officialdom has been looking at: we seem to be seeing are convergent signs of emergent inflation!

You have seen the actions US credit markets and US monetary aggregates, now the actions of the financial markets.

Figure 3: EM Equities, US Bonds and Commodities In A Chorus

We have argued that the convergence between rallying US bonds and a bullmarket in gold and or commodity markets would seem incompatible, from which the incoherence the markets would eventually resolve.

We seem to be seeing clues of this happening now, of course, going into our direction.

And deflationistas, whom have adamantly argued that bonds will likely benefit from a so-called liquidity trap, and have used the deflation bogeyman as justification for more inflationism, appear to be on the wrong the trade anew.

As one would note in Figure 3, emerging market equities (MSEMF or the MSCI Emerging Market Free Index), the CRB or a major commodity benchmark, a bellwether of Treasury Inflation Protection Securities or TIPS (iShares Barclays TIPS Bond Fund) and 10 year US Treasury Yields appear to be in a chorus.

What all these (credit market, monetary aggregates, financial markets) seem to be indicating isn’t what the mainstream and the officialdom have been looking at. (They’ve been fixated with employment figures).

Instead, what we seem to be seeing is a convergence of surging inflation worldwide!

And this is even prior to the Fed’s coming actions.

Not only that.

Last week, the US government sold $10 billion of 5 year Treasury Inflated Securities (TIPS) at minus .55% or negative interest rates for the first time in US history[4]!

TIPS investors don’t just earn from coupon yields, they earn from the adjustment of the securities’ par value[5] along with that of the consumer price index (CPI) thus giving protection against inflation as measured by CPI (which I think is vastly underreported).

This only means that the aggressive bid up of TIPS, which has led to a milestone of negative interest rates, represents a monumental swing in investor sentiment towards a deepening recognition of our transition to an inflationary environment which over the recent past had only been a fringe idea!

And this, in essence, would validate our 2009 prediction that inflation will be a key theme for 2010[6]!

And this also means that the premises of deflationistas are being demolished or dismantled as inflation expectations emanating from central bank policies deepens.

What To Expect

So how does QE 2.0 translate to the actions in the Financial markets?

If the Fed announcement should fall substantially below market expectations (perhaps $ 1 trillion or less) then we are likely to see some downside volatility which should prove to be our much awaited correction.

Yet any substantial volatility in the financial markets would translate to the Fed likely upping the ante on the QE 2.0. Remember falling asset prices would pressure the balance sheets of the banking system, and thus, would prompt for the Fed to make additional injections.

However, given the penchant of the Fed to resort to shock and awe, I wouldn’t be surprised if the FED would equal or go over the previous $1.75 trillion[7] monetization of treasury and mortgage related securities in 2009.

Of course, the other important aspect would be how other central banks would react to the Fed’s actions. We cannot take the Fed’s action as isolated.

If Bank of Japan and Bank of England would augment the Fed’s QE 2.0 by increasing its exposure on its current programs, then we should expect money flows into emerging markets to expand significantly. And this should go along with commodity prices and commodity currencies.

From the current market actions, we seem to be witnessing the early stages of a crack-up boom.

I remain bullish on equity markets, which I see as protection or serving as insurance against the currency debasement programs being undertaken by central banks to promote covert political agendas.

For Emerging Markets and Philippine stocks, we should remain exposed to commodities, energy and property issues.

[1] See The Possible Implications Of The Next Phase Of US Monetary Easing October 17, 2010

[2] See The Road To Inflation, August 29, 2010

[3] M1: The sum of currency held outside the vaults of depository institutions, Federal Reserve Banks, and the U.S. Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions (except demand deposits due to the Treasury and depository institutions), minus cash items in process of collection and Federal Reserve float.

The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

MZM (money, zero maturity): M2 minus small-denomination time deposits, plus institutional money market mutual funds (that is, those included in M3 but excluded from M2). The label MZM was coined by William Poole (1991); the aggregate itself was proposed earlier by Motley (1988).

M2: M1 plus savings deposits (including money market deposit accounts) and small-denomination (under $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments under $50,000), net of retirement accounts.

St. Louis Federal Reserve, Notes on Monetary Trends

[4] Financial Times, US Treasury sells negative-rate bonds, October 26, 2010

[5] Investopedia.com Treasury Inflation Protected Securities - TIPS

[6] See Following The Money Trail: Inflation A Key Theme For 2010, November 15, 2009

[7] The Economist, A roadmap for more Fed easing, December 4, 2009

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.

Evidence Of Inflationism: Competitive Devaluation In The Eurozone

Here is an example why the paper money-central banking regime is in peril or can't be expected to last. And also why we should expect inflation, in spite of the recent market volatility.

This from Bloomberg, (bold highlights mine)

``Swiss central bank president Philipp Hildebrand is finding himself in a tug of war with currency markets and he may be on the losing side.

``Concern that the Greek fiscal crisis will spread through the euro area is pitching the Swiss National Bank against investors, forcing the Zurich-based central bank to sell francs at an unprecedented pace to fight the currency’s appreciation against the euro. With the SNB’s foreign-currency holdings now accounting for 68 percent of its balance sheet, economists say Hildebrand may have to spend even more to maintain the resistance.

“Greece is giving the SNB a major headache,” said David Kohl, deputy chief economist at Julius Baer Holding AG in Frankfurt. “We expect the SNB to continue to lean against the appreciation for as long as possible, but they won’t be able to keep up the pace of currency purchases much longer.”

``Hildebrand is already stepping up the fight as the franc strengthened to a record 1.4003 per euro on May 17, 14 months since the SNB began its intervention campaign to insulate Swiss exports and deflect deflation threats. The central bank added 28.5 billion francs ($24.6 billion) to its currency reserves in April, the biggest increase in at least 13 years, as Greece’s turmoil undermined the euro."

``The franc has strengthened 5 percent against the currency of the 16-nation region in the last six months."

Global central banks like the US Fed, the ECB and the SNB as shown above, are not only printing money in massive scale but absorbing assets of dubious quality...

Swiss Franc-Euro Trend

...with the aim of maintaining certain exchange rate levels for whatever goals (yes interventionism is always politically designed, but camouflaged by economic intent).

The problem is that market interventions almost always lead to unintended consequences.

A warning from Ludwig von Mises, (bold highlights mine)

``If one looks at devaluation not with the eyes of an apologist of government and union policies, but with the eyes of an economist, one must first of all stress the point that all its alleged blessings are temporary only. Moreover, they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations' monetary systems."

When the public awakens to the reality that central bank balance sheets represents as the "emperor with no clothes" and that the power to tax has reached its limit, then the crack-up boom is likely to emerge.

Are Record Gold Prices Signalling A Crack-Up Boom?

Gold prices zoomed to nominal record highs based on the US dollar during the past two days. See chart below


While much of the recent actions have been imputed to the events in the Eurozone, e.g. 'currency fears', gold's rise hasn't been a one-off affair, but a long term trend.

Likewise rising gold prices hasn't been limited to the US dollar but against global currencies.

Put differently, this means gold prices has risen across paper money over the long term and where the current pace of increases seem to be accelerating.

Below are charts of gold prices relative to different currencies, courtesy of gold.org.

As reminder, these charts were updated last May 10th and doesn't include the spike of the previous two days.

Gold Prices in US dollar since 2000

Gold Prices in Japanese Yen

Gold Prices in British Pound

Gold Prices in South African Rand

Gold prices in Australian Dollar

Gold prices in Canadian Dollar

Gold Prices in India Rupee

Gold prices in G5 currency basket

There are two possible themes which record gold prices appear to be telling us:

One, since the symptoms of the monetary disorder (or inflationism) has been intensive and applied on a global scale, gold prices are seemingly being incorporated gradually as part of the global currency system.

And as Ludwig von Mises reminds us,

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system."

This leads us to the second theme, the growing risks of global hyperinflation.

As global governments continue to inflate the system to delay the day of reckoning, the rate of financing bailouts through money printing and through suppressed interest rates appear to be swelling. And all these appear to be enhancing the case of a crack-up boom or our Mises moment.

The original bailout for Greece at $146 billion (110 billion euros) didn't calm the markets. And it took a "shock and awe" or a Hank Paulson's bazooka approach of nearly $1 trillion (750 billion euro) to achieve some semblance of stabilization.

To paraphrase Senator Everett Dirksen ``A trillion here and a trillion there, and pretty soon you're talking real money; (gold as money)"

For now, every leakage that could bring about a global bust, would be fiercely met by the policies revolving around the printing press as solution, until the critical point where policymakers would have to decide whether to embrace market reality (declare a default or restructure) or let the printing presses rip. The latter would put an end to the current paper money system.

And we hope the world will come to their senses enough to realize the lunacy of inflationism, before it is too late.