Fed Dilemma: Too Much Pressure To Continue Hikes

Yes, I have raised such concern that the Fed may initiate a pause or even a succession of rate cuts on the premise of an adverse US slowdown (see June 5 to 9^th edition: US Recession Watch: A Fed CUT in June or August?) highlighted by a continued downdraft by US financial markets benchmarks.

I have also raised the contention that a Fed Pause is likely to occur due to:

One, the political season is back, with congressional elections due later this year, suffering electorates are unlikely to vote for incumbents.

Second, Bernanke’s ideological leanings have been that of the Milton Friedman “monetarist” school of thought, where the salient solution to economic or financial dislocations is to inundate the system with liquidity.

Three, an upcoming economic slowdown or “moderation” under the semantics of the Fed.

Market guru/savant and philanthropist billionaire George Soros foresees a US “hard landing” recession in 2007, AME info quotes Mr. Soros, ``Almost inevitably, they have got to overshoot because they can't stop (raising interest rates) until the economy shows signs of a slowdown. By the time it shows these signs it may be a little too late. I happen to be on the pessimistic side.” So do I.

Except for the 3-month Treasury bills at 4.98% (???), the yield curve has now fully inverted (shorter term yields higher than long term instruments) following the Fed’s 17^th rate increase and the decline of the long end of the curve. This marks a restrictive territory for the price of money raising the probabilities of the specter of a recession in the horizon. As for the anomalies in the 3-month Treasury bills, it is said that what keeps its yields from rising is the prevailing onrush to the “flight to quality” mentality.

Yet, a marked slowdown or even a recession is no guarantee of easing inflation as had been in the 70s, ``Economists are also mistaken in their belief that a weakening economy will counteract inflationary pressures. This overlooks the fact that a weakening U.S. dollar will stimulate demand abroad (emphasis mine) at the same time it restrains it here at home. So even as Americans consume less, prices will continue to rise as they are forced to compete with wealthier foreigners for scarce consumer goods.” commented Peter Schiff of Euro Pacific Capital.

In addition, there is a growing popular clamor against such succession of rate hikes. According to the Bloomberg, in a poll conducted by Bloomberg/Los Angeles Times, ``By a 65 percent to 22 percent margin, Americans oppose another rate increase by the central bank, which says such moves are necessary to counter inflation.”

Moreover, while everyone seemed to be focused on rising commodity prices, as the commonly perceived ‘causal’ factor contributing to the groundswell in consumer/producer prices, none has taken into account that rising cost of money (until it stifles demand) has inflationary tendencies too, the amusing Mogambo Guru elaborates, ``And if you think that gingerly raising interest rates will stop a rising inflation, you are wrong, wrong, wrong. Until the rates get so high that they cripple the economy, higher interest rates only produce higher prices, which is de facto inflation: As the producer of goods and services borrows money to finance the on-going business, the higher costs of that borrowing have to be figured into the higher prices of the final output of goods and services so that the business can make a profit. So in the short run, higher interest rates actually cause higher prices. And that's another compelling reason, as if you needed any more reasons, not to let inflation in prices get started by letting inflation in the money supply get started.”

Put differently, raising rates in a measured pace are not going get us anywhere, unless the governing authorities decides to reassert themselves to combat inflation in the truest sense, i.e. regardless of the consequences in the market or the economy, in the same path of the Former Fed Chief Paul Volker in the early 80s or if bond vigilantes compel the Fed to do so by preempting the Fed and sell down US treasuries. However, the magnitude of leverage present in the financial system has had far more consequential impacts relative to the previous regimes as to make it far more parlous.

Finally, immoderate liabilities accrued by the US government will be further burdened by continued rate increases, to quote Daily Reckoning’s Bill Bonner, ``The Fed may want to fight inflation, they say, but its hands are tied. The federal checkbook is overdrawn by some $500 billion this year. In addition, the U.S. Treasury has a trillion-dollar mountain of short-term debt it must refinance in the months ahead. And then, there are the voters themselves, faced with rising interest rates, falling house values and $2.7 trillion worth of adjustable rate mortgages that will be reset in the next 24 months.”

What I am simply saying is that the Fed may succumb to either political or economic or financial pressures or a combination thereof as to take a pause or even reduce its tightening stance. This should, in essence, fuel the anti-US dollar sentiment or dollar diversification theme which would lead to resurgences in the liquidity flows into high return markets as commodities and emerging markets bourses.

Figure 3 Stockcharts.com: Rebound in Phisix (candle) and CRB Index (line chart)

The recent reaction by the world financial markets practically averred of this phenomenon. Commodities as measured by the CRB index gained 3.4%, Emerging Market stocks rallied mightily, our Phisix climbed an eye-popping 4.5% on Friday to lead Asian bourses on the backdrop of a reversal of foreign outflows seen in most of the week. With Friday’s surge, the Phisix accrued a 3.11% advance over the week.

If the latest “benign Fed” elixir does continue to gain momentum, which I am inclined to think of, we would likely see an interim reversal in the decline of Philippine bonds yields and of the USD/Peso and a rally in the domestic equity market. This will reflect a regional motion, meaning a similar rally in Asian currencies, bond markets and equities.

This does not however write off my long term cyclical view that interest rates will continue to rise in the distant future, underpinned by the well entrenched inflationary variables.

Figure 4 Economagic: Looks like a 40-year trough-to-trough cycle for benchmark treasuries

Figure 4 appears to show of the benchmark US Treasury yields on a 40+ years full trough-to-trough cycle, interspersed into 20+ year trough-to-peak (red arrow), and about 20 years peak-to-trough (blue arrow). The fast shaping advance or trough-to-peak cycle seems to be at work today, despite the recent stimulatory Fed Speak and the stark recoveries across assets in the global financial market.

EZ Money Addicts and Pavlov’s Drooling Dogs

The global financial markets reacted impassionedly to the Fed’s recent statements following its 17^th interbank rate increase to 5.25%. The US dollar index cratered, the bond markets (sovereigns and corporate) rallied furiously as shown in Figure 2, global equity markets and commodity prices vigorously rebounded.

Figure 2 Stockcharts.com: US Dollar (left chart) and benchmark US Treasury Yields (right chart-candlestick) breaks down, while JP Morgan Emerging Debt (line chart) Rallies

Despite being noncommittal on its next moves, as reflected by their latest FOMC statement (emphasis mine) ``The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information'', the markets appeared to have discerned on the culmination or the near-peaking of the US ‘interest rate cycle’ following the perceived “dovish overtures” from the Fed.

``Everyone jumped on the statement's focus on moderating growth (emphasis mine). What about the shift in emphasis from the recent one-note chatter on inflation, inflation and inflation? Instead of accusing Bernanke of flip-flopping as they had in the past, analysts lapped it up, praised Bernanke for becoming his own man and congratulated him on gaining the necessary credibility to let the data take center stage” decried Bloomberg analyst Caroline Baum on the market’s U-turn.

Robert Folsom of Elliott Wave International adds his dissenting voice to the market’s seeming irrational exuberance saying that present movements signify ``defiant mockery of everything the media has said about stocks for nearly three months – namely that the Fed has been raising rates because of "inflation fears," and in turn "inflation fears" have made the stock market decline.”

True. Fundamentally speaking, as to how a “moderating” or softening economy would translate to growing/expanding earnings is something beyond me. In addition, current price valuations reflected on the financial markets have been that of “rose colored” glasses or of a “goldilocks” (not so hot or not so cold) environment, or to say at least have been priced at the high or optimistic side, a natural response to a slowdown should be a downwards re-pricing. Yet the critical question is, how rational has the markets been?

One thing I understand is that Global GDP estimates are at $54 trillion in 2005 according to theGlobalist.com, which quotes World Bank figures. Whereas the world’s aggregate capital markets have been at over $118 trillion, using Mckinsey Quarterly estimates in 2003. This suggests that the global financial markets have virtually LED the global economy (by a ratio of over 2:1) more than serving its traditional function which is to basically provide support.

Moreover, according to Bank of International Settlements (BIS) on its June quarterly review issued last June 12^th (emphasis mine), ``Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by one quarter to $429 trillion between January and March 2006.” This implies that derivatives (or instruments used as a hedge, such as options and futures contracts, which derives their value from an underlying security, group of securities or index) bets are about 4 times the “derivative value” or the worth of the world’s capital markets and about 8 times the size of the global GDP. That is how leveraged the world is!

As to how these phenomena extrapolates on the rationality of the markets...since the world’s GDP is highly interdependent on the advances of financial markets (including the housing industry), it would need accelerated injections of money and credit to retain its present growth clip, something patterned like a grand-scale PONZI or pyramiding scheme to keep the present system afloat.

It also means that the global financial markets have to always keep growing too, regardless of what “micro fundamentals” says. The “chase for yields” and the “Current account imbalances” have been symptomatic of these burgeoning asymmetries fostered by the current monetary system, the US dollar system, matched by an equally compelling interrelation borne out of the Fractional Reserve banking system (fraction of deposits kept in reserves). Today’s liquidity flows have been multidimensional (bank and non-bank) and too complex to measure.

Once the liquidity injections reverse or the least “stalls”, the world financial markets and economies shrivels, falls or collapses like a house of cards. To quote Gavekal Research, ``Bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger…Or serious withdrawal follows.”

I do not like to sound so macabre, or adopt the slogans of the inveterate goldbugs...yet empirical evidences point towards the escalation of these systemic risks.

For instance, recently, Emil W. Henry, Jr., Assistant Secretary for Financial Institutions of the U.S. Department of the Treasury, acknowledged about the risks posed by the mushrooming outsized Government Sponsored Enterprises (GSEs) combined mortgage investment portfolio amounting to US $1.5 trillion, where he cautions, ``While the U.S. financial markets are highly efficient and resilient, they are not infallible”.

Like all incumbent officials deliberately downplaying on its potential occurrence as “unlikely”, he admonishes that in the event that it does (emphasis mine), ``An obvious transmission mechanism is through direct losses to the commercial banking system, derivative counterparties, or other creditors. If these key financial intermediaries suffered losses related to their GSE exposures, this could lead to a broader contraction of credit availability – for example fewer loans being made or more restrictive loan terms - that could have adverse implications for overall credit availability and U.S. economic performance.”

In other words, while the endemic systemic risks have been mounting worldwide for quite sometime now, global financial markets have been inured if not hardwired into believing of the constancy of advancement, irrespective of the enormous leverage latched into the system. That’s how rational the markets are. Add leverage in order to advance the financial markets, which should translate to economic growth.

So, aside from the analogy of addicts alluded to by Gavekal Research, global investors behave like the ‘Pavlov’s drooling dogs’, (where Nobel prize awardee Russian priest turned scientist Ivan Petrovich Pavlov, 1849-1936, discovered that stimulated reflexes honed by the ringing of bells to associate for food caused dogs to drool), equally stimulated with the Bernanke-speak Fed induced monetary accommodation.

I have to confess, I am one of these investors and portfolio manager ‘addicted’ to the realm of easy money. And like Pavlov’s dogs, salivate at the stimulation provided for by loose liquidity spawned by policies authored or engineered by Bernanke & Co.

Investing on conviction has hardly been a profitable venture as experience taught me, similar to fate of goldbug zealots. While I maybe possibly a goldbug at heart, premised on the constant abuses adopted by collective governments, I have to be a pragmatic investor or trader, and by principle, a sovereign liberal individual. However, unlike the archetype ‘addicts’, adopting contingent plans over the possibility of a sigma-4 standard deviation, black swan or low probability, high impact event is a must.

Hans Sennholz: Price Controls on Labor

Economic laws tell us that whether in the US, Europe or the Philippines...Price controls on labor known as the "minimum wage" have been utilized as tools for political appeasement, which have failed to serve their purpose at best, and at worst, have been one of the major causes of economic miseries. The governing incumbents of the Philippines knows this yet, for political purposes opts to go for cosmetic reforms.

Mr. Sennholz enunciates from the theoretical standpoint why Price controls fails...

Price Controls on Labor
by Hans F. Sennholz

Good intentions, when guided by error and ignorance, may have undesirable consequences. There is no better example than minimum wage legislation. It means to raise the wages and improve the living conditions of poor workers but actually condemns many to chronic unemployment. It forcefully raises the costs of unskilled and inexperienced labor and thereby lifts it right out of the labor market.

Yet, many politicians who neither own nor manage a business and do not employ such labor never tire of lamenting and deploring low wages and promising to raise the wage minimum by law and regulation.

The official Federal minimum presently stands at $5.15 an hour; the actual minimum is much higher. No employer can overlook the mandated fringe benefits which he is forced to pay above the minimum. There are employer Social Security taxes, unemployment and workers' compensation levies, and paid holidays.

In some industries the workers' compensation levy alone may amount to more than one-half of the wages paid. And if the employer should carry his workers' health insurance costs, employment costs may be double the minimum rate. If eager members of Congress should be successful in raising the minimum by two or three dollars an hour, many young people may be condemned to permanent unemployment.

The rate of unemployment tends to be directly proportional to the excess of labor costs over productivity. In many European countries with official minimum wages of more than $10 an hour, the rate of unemployment is measured in double-digit rates although governments spend massive amounts on make-work projects.

Some victims readily submit to their fate and endure a life of idleness and bare subsistence. Many learn to labor in black markets where goods are produced and services are rendered in violation of minimum wage edicts and other regulations and controls. But most victims are young people with little training and know-how who tend to react angrily and violently. Their rate of unemployment actually amounts to multiples of the official rate.

And if society should be divided ethnically, youth training and productivity may be lower yet and its rate of unemployment may approach 100 percent. Such a labor situation is laden with anger and fury which not only breeds high crime rates but also, at any time, may turn to violence by mobs of unemployed youth. The recent riots of French youth clearly resembled the riots of unemployed Americans in Watts in 1965, in San Francisco in 1966, Detroit and Baltimore in 1967, Chicago and Cleveland in 1968, and in Los Angeles in 1992.

The situation is most dangerous and explosive in cities and states with state minimums even higher than those set by the Federal government. Minimum wage legislation had its beginning in states long before there was a New Deal that made the Federal government the primary labor legislator and regulator. State governments continue to lead the way in raising labor costs; state rates of unemployment tend to indicate the political strength of the minimum wage movement.

Few economists have the courage to point to labor legislation and regulation as the very cause of mass unemployment. A few who muster the courage may emphasize the infinite demand for labor but are ever mindful that its costs set limits to the demand.

Few employers, if any, knowingly buy labor that costs more than it produces, just as few workers are likely to purchase consumer goods which, in their judgment, cost more than they are worth. Yet, economists who dare to point to labor legislation and regulation as important causes of mass unemployment are criticized, denounced, condemned, and vilified as callous and ruthless agents and spokesmen of greedy employers.

Politicians may draw applause and win an election with numerous wage promises and other assurances no matter how unrealistic they may be. Some politicians undoubtedly are Machiavellians who are fully aware of the evil consequences of such policies but continue to promise them in the hope of garnering the votes. They may point to new employment programs such as public works, neighborhood youth corps, job corps, and other benefit corps.

Some politicians may be candid and sincere but cannot be reached with economic reasoning. They are utterly unaware of inexorable economic principles but very eloquent in all matters of politics and law. With their eyes glued on the wants and needs of workers and their families subsisting on minimum wages, they place their trust in political edicts and in the power of the police to enforce them.

To alleviate minimum-wage unemployment is to restore freedom in the labor market; it would permit the cost of labor to readjust to labor productivity and offer employment to every young man and woman willing and ready to work. A free labor market would welcome young people, which not only would exhort and restore the spirit of work but also improve labor skill and know-how. The labor productivity of American youth soon would rise and exceed the ominous minimum levels that presently condemn millions to idleness.

Freedom has a thousand charms even in the labor market.

---

Hans F. Sennholz, Professor Emeritus Grove City College is an Adjunct Scholar of the Mises Institute. See his articles. Comment on the blog.

See also Professor Sennholz's book The Underground Economy (1984), available in PDF. A tribute to Professor Sennholz, by Joseph Salerno, Quarterly Journal of Austrian Economics, Vol. 5, No. 4, dedicated to Hans Sennholz, Austrian Economics Newsletter interview with Hans Sennholz (PDF), and Lew Rockwell's essay on Sennholz.

Entertainment Value in Stockmarket reporting

``One area that does show some significance correlation with accuracy, meanwhile, is the frequency of an expert's contact with the media. Unfortunately, that correlation is negative. You read that right: experts that tend to appear regularly on TV tend to make forecasts that are even less accurate, on average, than their camera-shy peers.”-Matt Stichnoth, Bankstocks.com

A recent headline attempted to justify the excruciating developments in the domestic market on the premise of “in anticipation of a rise in United States interest rates.” Citing several ‘experts’, the following attributes were mentioned consequent to such “anticipations”; namely “make dollar investments attractive”, “perceived to be overvalued” and “everybody was poised to see interest rates lower...but this was reversed”.

As usual, such account can be construed as deliberate efforts to oversimplify explanations from a rather abstruse dimensional framework. The public hardly realizes that it is media’s job to get your attention or to ‘entertain’ rather than to provide for a thorough exposition on the thereabouts. Yet in most instances, people fall for these ‘entertainment values’ which are not only diversionary and insipid but most importantly toxic sources of information.

Why toxic? Just consider, except for the US dollar, as measured by the Trade weighted index, US major stockmarket benchmarks and bonds have been mainly DOWN, does this then qualify as “attractive dollar investments”? How could negative returns be reckoned as attractive? Could the synchronized liquidations in the broad asset class worldwide be equated to being “overvalued” across the diversified asset spectrum? Should one take present conditions to mean that it should perpetuate well into the future? And lastly, why has our ‘experts’ been reticent about what seems to be the apparent ‘subordination’ to, (or have been passive about) the relative all important ‘connect’ between the unraveling events in Wall Street to the local financial markets?

``Causality can be very complex. It is very difficult to isolate a single cause when there are plenty around. This is called multi-variate analysis” wrote mathematician trader Nicolas Taleb in his insightful book Fooled by Randomness (emphasis mine). Yet in the eyes of media causality looks so simple.

Has Gold Found its Bottom? Philippine Mining Index to Lead Phisix Anew?

``No government wants a hard currency which preserves purchasing power. They want a deceptively soft currency which inflates away debt and secures a competitive advantage for exports.”-David Fuller, Fullermoney.com

Leveraged positions entrenched in the global financial markets present themselves as heightened volatility risks considering the argument to resolve current imbalances. However, we should not forget that it is from taking on more risks where above average returns can be generated.

Question is, considering the current risk environment, to what investment theme/s should one consider as to generate positive returns relative to the risks?

Figure 3: Stockcharts...Breakouts the US Dollar Index (black line) and US 10 Year Yields (candlestick)

I noted that the US dollar have so far benefited from the increased volatility seen in the global markets. Some have taken this in the context of rushing into the proverbial “safehaven” following the recent market rout. However, the global market signals a different tune. While US equities appear to be holding, the bond markets have been steadily weakening, hardly a manifestation of an onrush to dollar based assets (see figure 3).

Instead, in my view, these could be more of a short covering undertaken by the heavily levered bearish US dollar camp prior to the spike in volatility.

As a matter of leverage, those who massively shorted the US dollar were similarly intensively long gold, commodities and emerging market assets, as well as junk bonds. When the liquidity squeeze came about, every of these assets got hit.

Question is, has this been the end of the run for these markets?

In the past, rising interest rates have not hampered the rise in gold prices as shown in Figure 4, when REAL interest rates remained negative.

Figure 4 Rising Metal Prices (blue line) and FED Fund Rate (red line)

The US economy is said to be behind the curve, meaning that despite the series of increases in interest rates, Fed data does not represent real or actual inflation. With present interest rates still hovering at negative or that unofficial inflation rates are still higher than nominal interest rates, such conditions are still said to be accommodative. According to Adam Hamilton of ZealLLc.com, ``When real rates of return fall to near zero or below, capital flees credit instruments that begin to actually destroy real wealth and some seeks refuge in the ultimate safe asset, gold.”

In the 70’s despite rising interest rates gold leapt from $35 to over $850 at the time interest rates had been accelerating due to high inflation, aggravated by closed economies, wage spiral and highly protected and regulated markets. US treasury yields then galloped to over 15%! Until real interest rates became starkly positive “approaching 8%” according to Mr. Hamilton, before gold stumbled to its decade long bear market.

Figure 5 Daily Wealth: Gold’s floor?

Recently gold like all other assets which climbed on speculative leverage fell like a stone on the recent markdown brought about by the liquidity squeeze or increased risk aversion. As shown in Figure 5, the psychological threshold for gold appears to be at the $550 level. Today, gold appears to be staging a rally from its recent lows.

What makes me bullish about gold is first, from a net long position it appears that the shorts have taken over (if there is any leverage today it is the shorts-making a short squeeze very likely).

Second, technically gold has been quite oversold bouncing off from $550. This means that the psychological threshold which served as a base prior to its take off remains a significant and strong support level (until of course broken). This also suggests that gold then is coming off from a low (if such base holds).

Third, the uptrend despite the recent correction has been unviolated. Fourth, given the currency markets long wait before delivering the verdict for the US dollar to a breakout, in my view, such reluctance suggests that the US dollar is less likely the safehaven sought in the present volatility.

US dollar bears point to US imbalances as possible catalysts for a selloff, while US dollar bulls allude to a potential political, financial and economic crisis in China for its strength (rush to safehaven). My view is that when paper money whose strength derives from faith comes into question, the likelihood is a shift to hard assets, which makes gold a likely candidate.

Those who argue that gold’s fate has been tied inversely to the US dollar seems to forget that last year or in 2005 despite the strength of the US dollar, as measured by the trade weighted index, was up 12.86%, while gold soared even by more 17.92%! A correlation is a correlation until it isn’t. Yet none of the world’s greatest investment guru’s I know predicted on such possible correlation to thrive, as gold was predominantly viewed as the nemesis to the US dollar (wrong- to fiat currencies in general). Last week, both the US dollar index (+.81%) and gold (+1.08%) rose in tandem. When it comes to fear and lingering uncertainty, both gold, considering the thin market, and US dollar may rise!

Fifth, no I won’t be arguing about central banks shifting to gold which is rather speculative, in fact I prefer gold into private hands. If gold does rally as I expect it to, then the likelihood that we could see a rally in emerging market stocks, barring any unforeseen shocks...despite possible weakness in the US stocks. The incipient divergence may start to unfold.

Figure 6: Stockcharts: rallying Gold (candle) MS Emerging Free Markets (line)

Figure 6 shows the tight correlation between emerging markets performance as signified by the Morgan Stanley Emerging Free Index and gold, (which could likewise translate into a rally in the Phisix!). I know, I know....data have shown of net outflows during the past weeks....but could a rallying gold inspire a reversal to inflows anew?

I have talked about the potentials of the local mining index at great length ad nauseam. Despite the recent selling pressure over the broadmarket as manifested in the Phisix, the mining index have mimicked the price movement of gold lagged by only TWO days.

Figure 7: Phil Mining Index (candle) Phisix (green) and CBOE GOX (Blue)

Since my metastock chart has no gold chart for us to be able to overlap, I have in place taken the CBOE “GOX” Gold Mining (blue line) index of the US as representative. As you can see in Figure 7, the Philippine Mining index alongside the GOX has surreptitiously scaled higher in spite of the recent selling pressures in the Phisix.

If the correlation between gold and emerging markets will continue to hold true, then I am to project that the Phisix to progress alongside its peers despite being the traditional laggard.

Some are asking as to what extent of their portfolio should they allocate for their mining plays. It actually depends on your risk appetite. In my case, considering the massive growth potentials of the industry relative to total market cap or to GNP, I give them a majority.

Bernanke is No Bubble Buster, Little Visible Signals of Unwinding Yen Carry Trade

``Cycles in markets do exist, but it's impossible to pinpoint how long they will last with any precision. Much depends on the actions of government officials and the intelligence of the public. Each time is different. I recall commentators calling for a six-year gold cycle, or a 10-year real estate cycle. They are all ephemeral, because, as Shakespeare says, our actions are "not in the stars, but in ourselves."”-Mark Skousen Invest U

Figure 1: Economagic: Fed Fund and the US S & P 500 benchmark

Much like the inflation bogey, the Federal Reserve raised by a “measured pace” on its interbank lending rate by 16 times from 1% to 5% since June 2004. Yet rising interest rates have not deterred the benchmark S & P 500 from climbing to multi-year highs until May 10^th, as shown in Figure 1. In short, market expectations on the Fed and its policies, aside from its actualization; have not essentially spoiled the fun...until recently. So what has changed?

There are those who pin the blame on the neophyte FED Chief Ben Bernanke for smudging the Fed’s ascendancy over his recent media fumbling (remember the L'affaire Bartiromo at CNBC). In an effort to redeem the Fed’s ‘tarnished’ credibility, officials have undertaken a concerted makeover to regain a semblance of ‘control’ over its “inflation fighting capabilities” hence the continued rhetorical “hawkish” stance.

There are also those who argue that the marginalization of leverage or arbitrage plays have been prompted by Japan’s declared intent to normalize its money policies. Having thought to have funded the prevailing ‘carry’ trades, which could be exemplified by borrowing in Yen and investing in assets with greater yield spreads relative to the Yen, such as emerging market assets and/or commodities, etc., these arbitrage trades is said to have fostered an inordinate degree of leveraged speculative positions at the global financial markets.

With Japan’s economic recovery gaining some important headway, the previous undertakings to combat deflation through accommodative monetary policies (QE, ZIRP, and currency manipulation) have been promulgated to be reversed thereby allegedly serving as the proverbial “pin” to have pricked the lathered assets bloated by the Yen funded liquidity arbitrage. (See May 22 to 26 edition Jim Jubak/Gavekal: Yen Carry Tumult)

I am less convinced of this argument since the market’s reaction appears to say otherwise.

Figure 2: ADB’s Asiabondsonline: JGB’s 2 and 10 Year yields climbing higher

Repatriation of residents and government funds stashed overseas should in effect be seen with a rising Japan’s Yen and/or expanding stockmarket bellwethers (Nikkei and Topix) and/or Japan Government Bonds as shown in Figure 2. Unfortunately, none of them appears to be responding positively to such stimulus, in fact all of them have been victims of the recent onslaught.

Maybe Morgan Stanley’s Stephen Jen could be right arguing that relative to cumulative financial markets, the Yen arbitrage while having some effects could not be the catalyst for the collective decline (emphasis mine), ``I am not arguing that the BoJ policy has no effect on global asset prices. Rather, I am refuting the view that there is something extra special about JPY carry trades. When interest rates rise in Japan, capital outflows from Japan would clearly be adversely affected, ceteris paribus, and some risky assets could be hurt. I do not challenge this point. But it is unreasonable, in my view, to think that BoJ tightening would trigger a collapse in global equities, most commodity prices, etc. Even massive money printing by the BoJ failed to support the Nikkei for years and so I don’t see how money from Japan could have such a big impact on the world. Monetary tightening by the BoJ will have no more and probably less of an effect on asset prices than if the Fed or the ECB tightens.” Hmmm.

There is also the case of heavily levered Hedge Funds absorbing significant or outsized losses which has led to a contagion (some of which are said to be 200-300 times levered more than invested capital, according to a Hedge Manager interviewed at Bloomberg), aside from suspicions about the state of “innovative products” in the form of derivatives, where 85% of the outstanding derivatives in the US have been interest rate based bets, and where 96% of US derivatives bets have been concentrated on ONLY 5 banks(!!!), according to the BIS in October 2005.

Forbes’ mainstay guru Gary Shilling argues that the credit induced mortgage boom in the housing sector is in the process of an implosion from its own weight (emphasis mine), ``The speculative housing craze is crashing from its own excesses, not Federal Reserve action.”

In addition, another possible angle is that the recent rate hikes which appears as “coordinated” across the globe could be construed as IN RESPONSE TO (note: not the cause!) the initial bout of outflows, where interest rates have been driven up to curb the massive outflows, which has, over a very short term period, destabilized and wreaked havoc on domestic currency values relative to the US Dollar.

As the only proponent of liquidity based market movements among my domestic contemporaries, the present developments have not been unexpected, considering that as early as November of last year, we discussed the incipient signs of risks arising from liquidity compression (see November 21 to 25, 2005 edition, Declining Global Liquidity: Believe It...or Not?).

I have argued that inflation, in the monetary definition, has long been imbedded into the global monetary system (see November 14 to 18, 2005, Inflation Cycle A Pivotal Element to Global Capital Flows), and responsible for the majority of the movements of the Philippine financial markets. Such that rising gold prices relative to most if not all currencies in the past have likewise reflected on this phenomenon (see March 27 to 31, Listen To Your Barber On Higher Rates and Commodity Prices!), and that the present concerns of higher inflation (as reflected in consumer prices) and attendant interest rates increases are natural consequences to the past policies adopted by government authorities worldwide. As in the past, central command, conventionally thought to be as messiahs to the world’s multi-dimensional problems, always miscalculates, if not abuses. Yet we never learn.

Now the draining of US dollar based liquidity has its belated effects percolating into the US economy today, compounded by the persistent high levels of energy prices, which appears to rein on the trailblazing surge in economic growth brought about by rampaging asset prices particularly in the real estate industry.

Consumer spending has basically driven the economy which has been essentially funded by surging home prices. Yet, underpinning both consumer spending and soaring property prices have been massive growth in credit. ``The problem is that after allowing a late 1990s stock market bubble and a 2003-2006 housing bubble, the Fed has basically lost control. It feels the necessity to fight inflation until further signs of economic softening show up, and by that time it is too late to avoid a likely recession” comments the comstockfunds.com.

In my June 5 to 9 edition, (see US Recession Watch: A Fed CUT in June or August?), I have laid my contrarian analysis anew where I contended that the activities global financial markets could be portentous of this deceleration or softening. Since the US has been the key growth engine on the consumption side with China as the major production platform for the world, an economic slowdown would translate to respective growth reductions on its trade partners mostly dependent on the US markets for revenues. And such is the reason why, I think, commodities, with the exclusion of gold) and emerging markets have adjusted downwards. So the lagged effect of diminished liquidity aggravated by high energy prices has, in tandem reduced growth prospects in the US, which again may spillover to the world and manifested in financial markets.

On the other hand, noted economist Henry Kaufman interviewed by Kathleen Hays says that (emphasis mine) ``These are not extraordinarily repressive interest rates. Today, anyone who really wants to borrow can borrow. Today, anyone who wants to borrow creates Credit. And the Federal Reserve is not yet at that point where there is some pain in the system.” Mr. Kaufman believes that rates would have to go further than 6% in the coming 12 months with possible 50 points increases in the near future due to the Fed’s prevailing policies, Mr Kaufman adds, ``The Federal Reserve is going to have to decide when to abandon this measured response of 25 basis points. That’s a very difficult chore for them, considering how long they have pursued this policy here in the past. Secondly, I think as financial market participants we will continue to create a lot of Credit until there is much more uncertainty in the interest-rate structure. I think there is going to be significant volatility in the financial markets over time. ”

Mr Kaufman believes that the US economy can still endure more of rate increases before any pain can be evinced. The markets are signaling inchoate dislocations, which could be interpreted as doing so otherwise. Except for the 10 year treasury bonds yields, the equity benchmarks have not broken down YET and may even surprise to the upside to uphold Mr Kaufman’s view.

However, given the developments in the bond markets, yield inversions plus rising yields on the intermediate end have not behaved favorable to equity benchmarks in the past. This downcast outlook is likely to foreshadow the economy’s diminishing tolerance level for tightening.

Moreover, given that it is political season again in the US, question is, can the incumbent party afford to inflict pain on its citizenry, which could represent a sure recipe for electoral defeat?

Furthermore, given the ideological leanings of the Fed Chief (Friedman “monetarist” adherent) would he risk overshooting and face his dreaded nightmare of DEFLATION? Bubble bustin’ ain’t Bernanke’s game, I think.

The inflationary backdrop may go into a reprieve in the interim as the softening of economic growth takes hold. But unless Bernanke does a Paul Volker, i.e. boldly raise rates until its chokes economy and inflation despite the uproar (unpopular), I think the seeds of a long term inflationary environment have been deeply rooted and would accelerate over the fullness of time.

Gold’s back....Phil Mining Index leads the Phisix?

The recent emergence of a global “risk aversion” led to convulsive liquidations in a majority of asset classes with commodities and emerging bourses suffering the most after delivering the best returns over the past 3 years.

However, following the dramatic selling scare over the past month, it appears that gold prices, a leading representative of the commodities class, appears to have settled down or may have manifested signs of a bottom.

As you can see above (courtesy of stockcharts.com), Gold bounced off its 200-day moving averages following its recent low at $542, while technical indicators MACD seems to be in the process of segueing into the bullish "golden cross" and Relative Strength Index appears to indicate a forward momentum.

The Phisix including its Mining Index component like its peers abroad endured the recent spate of shellacking. However, activities in the gold market appear to have driven the mining index higher despite the lackluster foreign driven selling performance of the Phisix (blue line chart below).

As you can see from the chart above, the Philippine Mining Index lagged the gold market for 2 days only (vertical red arrow) while recent recovery (red trend line arrow) shadows that of the rallying gold.

And with technical factors pointing towards a recovery in the gold market, the mining index is likely to lead the domestic market once again. Fundamental-wise, a rallying gold could foreshadow the Fed taking a breather SOON. Time to ante up.

Whiff of Stagflation? Gone in May...Risks Still Large

``When I was young, people called me a gambler. As the scale of my operations increased I became known as a speculator. Now I am called a banker. But I have been doing the same thing all the time.”- Sir Ernest Cassel (1852-1891), British Merchant Banker and Capitalist

What’s probably lingering in most of the investor’s mind today is whether the recent sell-off has been ‘overdone’ and if the selling pressures have ‘turned’ (meaning if the ‘correction’ is over), given the downpour of liquidations over a very short time frame.

Candidly speaking, I do not hold a crystal ball to know the exact or definite answer but can, at best, discern on the probabilistic outcomes based on the adverted factoids, e.g. ‘rising’ inflation and interest rates, and other multifarious variables which may have influenced the present activities, such as the Japanese Yen carry and arbitrage trade, protracted period of investor complacency or “low volatility”, decelerating US-led global economic growth, contraction of global liquidity, hedge fund or derivatives based losses, the Bernanke and US Fed “credibility” factor, etc..

Highly Correlated Markets

From what has been taken into account, today’s increasingly “globalized” and technology enabled financial market integration have set forth a “domino” effect as highlighted by the selling contagion across asset classes, from bonds, commodities, currencies to equities worldwide. In other words, since the advent of the new millennium, diverse asset classes have developed a rather “close interdependence” or have seen “increased correlation” among its activities in the financial markets. So unless we learn to accept the truisms of a ‘macro’ dictated framework for financial markets analysis we are likely to miss proverbial “the trees for the forest”.

For instance, analyst Gary Halbert of profutures.com (emphasis mine) expounds on such associations, ``Even commodity prices are starting to mimic the equity markets. Imagine commodities like oil and precious metals increasingly moving in tandem with stocks. For purposes of example, I will cite the Goldman Sachs Commodity Index (GSCI) which tracks the prices of 24 traditional commodities markets (energy, metals, grains, food, lumber, etc.). As recent as 2000, the GSCI had a negative correlation of 14% with the S&P 500 Index, meaning that commodities tended to move up when stocks moved down and vice versa. According to the Merrill Lynch study released in March, commodities have recently shown a positive correlation of 33% with the stock markets.”

A correlation is a correlation until it isn’t. What was once negatively correlated and had been used as portfolio diversification for the functional intent to “spread risks” has now evolved against fulfilling its purpose. This goes to illustrate that the attendant integration of financial markets abetted by a profusion of worldwide liquidity has led to investors (especially the highly sophisticated Hedge Funds) into tapping different asset classes using diverse methodologies, such as relative value arbitrage strategies, event-driven strategies, directional or tactical strategies, for the hunt of above average profits.

Mr Halbert adds (emphasis mine), ``Six years ago, emerging market stocks (as measured by the MSCI EAFE Index) had only a 32% correlation with the S&P 500 Index. According to the recent Merrill Lynch study, that correlation had vaulted to 96%! Emerging stocks are now trending in line with the US S&P 500 Index.” This basically explains the underlying rationale behind the cross asset feebleness of late.

Naturally, an empirical dissection of recent events depends on the frame of reference taken by the observer. For instance, the concurrent carnage seen in the emerging asset class as reflected by the Morgan Stanley Emerging Free Markets Index, which serves as bellwether to the equity performances of developing economies’ markets, shows that on a year-to-date basis the previous highfliers, as of Friday’s close down by 2.5% from a gain of over 24% in May 10^th, which feels like a bear market due to the relentless selling.

Figure 1: MSCI Index Uptrend Still Intact

However, taken into the context of its three year performance as shown in Figure 1, the emerging market benchmark, after gaining by over 160% in three years, has retraced by about 38% from its peak. Moreover, despite the present selloffs the above chart shows that its 3 year trend remains unviolated, which means that the bulls remain the dominant force relative to a longer time frame despite the present selloffs.

So if you ask me, what future lies ahead for the emerging market bourses, as well as for the Phisix, my reply would be ‘until proven otherwise, the longer term bullish momentum still presents as buying opportunities...albeit until signs of stability or a bottoming out from the frenetic selloff emerges’.

Let me quote Mr. Ivan D. Martchev of Global View Points with a similar view (emphasis mine), ``I do believe that emerging markets over the long term have a very bright future. But anyone involved in emerging markets will tell you that the best buying opportunities are when there’s blood on the streets. And in the emerging market universe, there tends to be more bloodshed than in developed markets; that’s simply how it’s always worked, and how it will always work, until they finally emerge. Simply put, it can get worse.”

US: Final Phase of Business Cycle

``A lower dollar will not resolve the structural challenge the US is facing. A lower dollar will not re-create the US manufacturing industry. A lower dollar will not turn America into a nation of savers. We believe the pressures on the dollar will persist as long as there are not fundamental changes that will truly promote savings and investments. And to make it perfectly clear, we do not have an “ownership society” as long as the banks are the ones owning our homes.” Axel Merk, Merk Hard Currency Fund

The prospects of possibly going worse before getting better could still be deemed to be large. And as indicated in my previous outlook, the largest contributing factor to the present anxiety, for me, is the tempestuous developments in the US financial markets perforating into the global economy, notwithstanding the imbalances caused by the US dollar standard system.

Like your analyst, Austrian economist Hans Sennholz believes that the concomitant by global central banks are an attempt to resolve a bigger issue, ``Fears of growing imbalance and potential crisis finally prompted central banks to raise their rates, at first the Fed, then ECB, and now also the Bank of Japan.”

Furthermore Mr. Sennholz thinks that the present business cycle in the US is nonetheless headed for stagnation and or recession let me quote Mr. Sennholz at length (emphasis mine),

``Most Americans probably never heard a frank and impartial explanation of the business cycle. They do not realize that economic stagnation and recession are the final phase of a business cycle, the readjustment phase. A cycle begins when the Federal Reserve System, in order to stimulate the economy or assist government deficit financing, lowers its discount rate below the actual market rate at which the supply of and demand for savings are evenly matched. Or it may decrease interest rates through open-market operations of buying government securities. Capital at bargain rates excites many businessmen and encourages them in their investment decisions. They may expand and launch many new projects which make business thrive and boom. But as soon as goods prices and wage rates begin to rise, businessmen need additional funds. As long as the Fed provides them, the boom can continue and even accelerate. It comes to an end when the Fed ceases to throw new funds on the loan market or the quantity launched no longer suffices to feed the boom. At that time, the readjustment, that is, the recession begins.”

``The present cycle undoubtedly began after the bursting of the stock market bubble in 2000 and the terror attacks on the United States in 2001 when central banks everywhere braced for deflation and recession. In fear and trepidation they lowered their interest rates, the Bank of Japan to zero, the Federal Reserve to one percent, and the European Central Bank (ECB) to two percent, the lowest levels since World War II. In most countries the policy seemed to work as housing construction, which always is interest-rate sensitive, came to life again. Even the doubling of oil prices and other energy costs could not dampen the excitement. Goods prices rose moderately due to low-cost imports and some relocation of production, but business profits improved visibly.

``Artificially low interest rates not only stimulate economic production but also excite capital markets. As corporate profits rise, stock prices tend to soar. Real estate prices increase as buyers can shoulder greater mortgage debt. Even the loan market may flourish as foreign banks, for various reasons, acquire large quantities of American I.O.U.s. Massive trade deficits always add their quandary and risk. Last year, the U.S. balance-of-payments deficit amounted to $805 billion or 6.4 percent of gross national product. This year, it is expected to be even larger.

Whiff of Stagflation? Gone in May...Risks Still Large

I have noted in last week’s outlook of the present dislocations in the financial markets could be symptomatic of this unraveling disorder. Where Hoisington Investment Management Company in their first quarter outlook observed that 11 leading economic indicators (LEI) have been pointing down with the exception of stock prices and industrial commodity prices as measured by the Journal of Commerce, these apparently, with the recent turn of events, have turned down too, increasing the likelihood of Mr. Sennholz view that the business cycle has gradated into its final phase.

While, of course, one may note of the extreme oversold conditions resulting to the huge end of the week snapback rally in major US equity benchmarks, underlying economic trends appears to have signaled a downturn.

Figure 2 courtesy of Northern Trust on M2 Money Supply % change compared to Real GDP

As shown in Figure 2, Real Money stock M2 supply has led real GDP since the 60’s where meaningful declines in the real money stock resulted to a similar retrenchment in economic growth. Northern Trust Chief Economist Paul Kasriel comments (emphasis mine), ``I know that real M2 growth is now considered passé as an indicator of monetary policy or as a leading indicator. The Fed never mentions it, not even St. Louis Fed President Poole, a former member of the monetarist Shadow Open Market Committee. But for some odd reason the Conference Board chooses to keep PCE-price-adjusted M2 money supply in its index of Leading Economic Indicators. I suppose the odd reason is because the correlation between the Conference Board’s real M2 growth and real GDP growth is a not-too-shabby 0.60% (see Chart 2). So, we’ve got real M2 growth and the flat yield curve both suggesting that monetary policy is restrictive and the Fed on June 29 will raise the funds rate again. I can hardly wait to see how fast and by how much the consensus lowers its second-half real GDP growth forecasts after the advance Q2 real GDP data are released.”

The largely moderate view of BCA Research turned glum stating that headwinds have now intensified for US consumption spending in the next few quarters on a squeeze from higher rates, high energy prices and most importantly a downturn in housing prices, notes BCA...

Figure 3 BCA Research: Consumer Spending at Peak

``Retail sales growth peaked in January and the deceleration should continue as consumer incomes are being badly squeezed by increases in “unavoidable costs”. The share of income that is dedicated to essential spending - food, energy, medical care, and financial obligations (interest payments) - is at a record high. Importantly, a key tailwind, namely housing wealth gains, is fading fast. The Fed wants to be viewed as tough on inflation, but an interest rate hike at month-end is likely to be the last for an extended period, because a sustained downshift in overall spending growth is underway. Bottom line: a period of below-trend economic growth looms.”

Figure 4: Core CPI courtesy of Barry Ritholz RR &A

With equities priced for an overdrive, recent actions in the market appear to appropriately re-rate on the toned down or much chastened outlook on the world’s main economic engine.

Notwithstanding, the recent surge in US inflation outlook led by the jump in Owner’s Equivalent Rent as shown in Figure 4, likewise discussed in our May 15 to 19 edition (see US led Global Market Correction) have effectively turned the corner for the inflation data. A growing whiff of stagflation???

In addition, recent moves by China to curtail its economic overheating by raising bank reserve requirements after an unexpectedly strong economic data.

Finally, one of Wall Street’s favorite axiom, “Sell in May and Walk away” seems to have lived off its daunted reputation.

Figure 5: Chart of the Day Sell in May

Most of the gains in the US have been from November to April, which means that present activities could also represent seasonal weakness aside from the previously stated fundamental reasons.

All in all, if US based jitters continue to lead the directions in the global financial markets over the interim, specifically, a tightening money environment, lower growth prospects, broadening inflation data and subsiding earnings prospects aside from continued trends by global economies to seal excess liquidity leakages from its past accommodations and emerging risks of financial mishaps from hedge funds or derivatives, the risks potentials remain higher than prospective returns suggesting that any intermittent rallies from oversold conditions should not be mistaken for anything else except as a technical bounce.

Trade the Phisix on Opportunities; Maintain Lean Exposure

Over at the domestic market, the Phisix continues to be plagued by bleak sentiment brought about by the worldwide selloff. In fact, based on the technical picture as shown in Figure 6, the havoc wreaked by the series of foreign money selldown has effectively damaged its three year trend line signaling a possible trend reversal. Ugh.

The rallies during the last two trading days of the week, which echoed the rally in Wall Street had been patently feeble, as manifested by strong opening and weak closing while rising on lean volumes, which in technical jargon is known as a “ Dead Cat’s Bounce”. As previously described, despite local optimism, the lack of firepower by local investors has been dampened by foreign selling.

Figure 6: Phisix 3-year trend line broken!

While the prospects of a downward action for the Phisix, which may reflect activities in the global markets, could continue, I am predisposed to think that the present stockmarket cycle will either lead the Phisix to test the 1,887 or equivalent to a 50% retracement at worst or consolidate from the present levels, given that it has shed a hefty 38% from its peak, given the present circumstances.

The odds for the Phisix to return to the 1,000 level remain remote, unless the world possibly enters into a depression or another explosive political turbulence fazes the market in the absence of foreign buying. Yet, if such a scenario, a low probability high impact one does comes to pass, then the Phisix would still be drifting on a bottoming phase (reckoning from its 2002 bottom) at worst, instead of an advancing phase from present dynamics. However, the prospect of a declining phase or a break of 1,000, I think, has an infinitesimal chance.

This implies that present exposures to the market should be adjusted mainly towards trading opportunities, meaning “buy on dips and sell on resistance”, as to benefit from countertrend rallies emanating from marked selloffs.

Of course, unless some signs of stabilization manifests in the global markets, if not stark divergences among the performances of distinct asset classes or among regional equity bourses, then it would be best or prudent to remain lightly invested or underweight equities.

Awaiting Asia’s Markets to Diverge from the US

``The next half century will see a massive exchange of goods for assets that will not only shift the center of the world economy eastward but also negate the destructive impact of the age wave on asset prices and retirement opportunities.” Jeremy Siegel, The Future for Investors

Because your analyst is a staunch adherent of cycles, over the long term my view is that Asia’s stock market cycles may reflect more of a resurgent Japan’s Nikkei than of the declining US Standard & Poor’s 500, as shown in Figure 7 on the basis growing intraregional trade, and deepening economic ties, as well as, the region’s attempt to further integrate its financial markets.

Figure 8: IMF growing share of Asia’s economy to the world

As shown in Figure 8, Asia’s rapid economic growth clip, according to the IMF, based on weighted purchasing power parity, has made the region’s GDP share contribution relative to the world greater than that of the US and the EU. Aside from the regionalization trends, Asia has been mostly underpinned by growing trade surpluses, rising foreign exchange reserves, dynamic demographic trends, liberalization of economies and swelling middle classes, such that it won’t be long when the present trends of correlation diverges.

All these do not, of course, discount the litany of risks involved.

For instance, China’s banking system is said to be in a precarious state due to its outsized debts almost equal to its foreign exchange reserve surplus. Moreover, growth of China’s excess foreign reserves have been more than the combined trade surplus and the accounted foreign direct investments inflows suggesting that speculative capital in anticipation of the Remimbi’s appreciation have padded into the system, principally into its real estate industry, such that any reversal of expectations could allegedly lead to a stampede out of remimbi and back into the “shorted” US dollar.

In addition, Asia’s mercantilist economic policies are likely to be affected by a slowdown in their major export market; the US. Notwithstanding, the declining demographical trend or the shrinking population of Japan, aside from its huge fiscal liabilities, the largest among the developed nations.

You also have the brewing political animosity between China and Japan, over the latter’s war atrocities, aside from the sovereignty squabble for oil and gas drilling at the Diaoyu islands – or Senkaku in Japanese. We must not forget the unusually quiescent North Korea of late.

Relative to risk and potential returns, coming from a low, Asia appears to have more upside potential than the US which is coming from lofty grounds.