Lebanon’s Proxy War may lead to $85 to $100 oil?

Last week, I mentioned that crude oil treaded at a critical juncture looking for either a correction or a breakout. With the market’s declarative stand, Oil finally resolved the impasse with a breakout to a FRESH record nominal High. Its sibling gold was equally buoyed as shown in Figure 1.

Figure 1 stockcharts.com: Record Oil, Gold Follows

While one may argue that seasonality could have also been a factor in oil’s latest upsurge in view of the summer driving season in the US, the breakout coincides with the escalating violence in Lebanon which could have further tipped the fragile scale of balance in the world oil markets.

The public appears to have seriously underestimated the ongoing military developments in the Lebanon, which could run the risks of further escalation. The warring protagonists, Israel and the Hezbollah, seems to acting as representatives for other parties involved in advancing their positions in the Middle East, particularly, the United States and Iran and possibly Syria. In short we could be witnessing an unraveling of a proxy war.

According to the astute guys at Stratfor,

``Hezbollah has two patrons: Syria and Iran. The Syrians have used Hezbollah to pursue their political and business interests in Lebanon. Iran has used Hezbollah for business and ideological reasons. Business interests were the overlapping element. In the interest of business, it became important to Hezbollah, Syria and Iran that an accommodation be reached with Israel. Israel wanted to withdraw from Lebanon in order to end the constant low-level combat and losses...”

``Hezbollah strategically was aligned with Iran. Tactically, it had to align itself with Syria, since the Syrians dominated Lebanon. That meant that when Syria wanted tension with Israel, Hezbollah provided it, and when Syria wanted things to quiet down, Hezbollah cooled it.”

Hezbollah’s possible motivations for the kidnapping and killing of Israelis soldiers which provoked the vindictive strike in Lebanon could be for Iran, 1) to expand its negotiating levers or bargaining chips on its present standoff against the United States on its nuclear program and 2) in lieu of the Al Qaeda, by realigning a global network against US interests, to possibly ‘reclaim its leadership in the Islamic radical resurgence’.

For Syria, a possibility to reassert control or possibly reabsorbing Lebanon and/or to expand its commercial exploits.

For the US, according to the Stratfor, ``an invasion of Hezbollah-held territory aligns Israel with the United States. U.S. intelligence has been extremely concerned about the growing activity of Hezbollah, and U.S. relations with Iran are not good. Lebanon is the center of gravity of Hezbollah, and the destruction of Hezbollah capabilities in Lebanon, particularly the command structure, would cripple Hezbollah operations globally in the near future. The United States would very much like to see that happen, but cannot do it itself. Moreover, an Israeli action would enrage the Islamic world, but it would also drive home the limits of Iranian power. Once again, Iran would have dropped Lebanon in the grease, and not been hurt itself. The lesson of Hezbollah would not be lost on the Iraqi Shia -- or so the Bush administration would hope...Therefore, this is one Israeli action that benefits the United States, and thus helps the immediate situation as well as long-term geopolitical alignments.”

Further, today’s warfare could be a prelude to a US/Israel led military strike on Iran utilizing the present hostilities as cover.

In short, the risks run high that the theaters of war may escalate to include major oil producers as Iran. This heightened anxiety is giving way to a premise for higher oil prices as the drumbeat of war persists. Israel is said to be calling up its reserves, while Syria and Egypt are said to be having on going talks on this matter according Stratfor. $100 per barrel soon?

Based on technical or chart data, using the most recent trough-to-peak move, Crude oil may attempt to go for $85 (!!!) before undergoing a retracement.

Politics, Flawed Policies and the Road to Hell

``But there are many others who are not bashful about using government power to do "good." They truly believe they can make the economy fair through a redistributive tax and spending system; make the people moral by regulating personal behavior and choices; and remake the world in our image using armies. They argue that the use of force to achieve good is legitimate and proper for government - always speaking of the noble goals while ignoring the inevitable failures and evils caused by coercion. Not only do they justify government force, they believe they have a moral obligation to do so.”-Congressman Ron Paul of Texas

Oil prices soared to fresh record nominal levels yet domestic media, as we have it, continues to downplay on its significance, relegating such developments to secondary headlines and opting to give prominence to domestic politics. Media, after all, is about entertainment; it is paid to get your attention rather than to inform.

Because of the penchant for drama, personified by top-grossing tele-drama series, the public’s appetite for partisan politics have been constantly whetted upon by the incessant stream of internecine information. While glossing over the ramifications of rising crude prices, in the coming days, you can expect consumer prices in general to rise alongside, and the typical response by some political groups would be to advance on protest rallies using this as cover. As if the toppling of the incumbent government would be able to resolve the imbalances in the heavily politically dictated global oil economics. It never ends.

And because the voting public’s interests are mostly fickle and short-term oriented, the classic response of any democratic governments or its underlying institutions would also be that of immediate-term gratification or appeasement, mostly in adopting policies tilted towards the “appearances” of having significant bearings on “social” dimensions.

Think minimum wage. Most economists are cognizant to the fact that pricing labor costs above what the market can afford to pay have been generally baneful or deleterious to the business climate and contribute more to the unemployment figures rather than solving them, yet because of short-term political demands, such as the Catholic Bishop’s Conference of the Philippines’ (CBCP) adaptation of the ‘Marxist’ view of “priority of labor over capital”, these policies have been commonly accommodated for by policy makers.

Flawed short term policies applied over and over again engenders arrant wedges of inequalities. In short, the glaring conflict of interests between short term political gains for the stark purpose of power preservation and meaningful long-term reforms has been a stirring vacuum in most instances as history have shown are unlikely to be filled. Political players, like anywhere else or for that matter in any form of government, are likely to be subordinate and beholden to the short-term interest of their subjects or interest groups that sustain their existence.

Just ponder, how can long-term structural economic disequilibrium be resolved when political expediencies dictate the appeasement, through the “band-aid” approach, of the public’s divergent immediate term interests?

Today, most governments, be it developed economies and/or developing third world states or taxonomically “emerging market economies” have instead relied on economic growth to resolve such deeply-rooted imbalances borne out of collective policy failures in almost all aspects of governance. They are all in the hope that the present asymmetries will be offset by continuing economic growth. Yet, evidences show that such imbalances get to be accentuated, not diminished.

As testament, money and credit growth, instruments by which collective governments have control over nationally (for US- internationally), has grown tremendously over the years far surpassing the growth in real economic activities. Naturally, such tidal wave of liquidity has percolated into the private sector too. Present inflationary manifestations have been an inevitable product of these. In other words, the offshoot to these state induced interventionists inefficiencies and incompetence are the macro imbalances present in the financial and economic system in the world today. What is unsustainable simply won’t last. But as to when this imbalances would unravel is something I can’t predict. As an example, think of the entitlement programs set to implode in the coming years even among industrialized nations (US, Europe, Japan et.al.), due to the colliding impacts from a myriad cocktail of rigid labor and immigration policies, asymmetric capital flows, evolving demographic trends and scientific and technological breakthroughs (converging trends of nanotechnology and biotechnology-which may expand the average lifespan of the population). Nonetheless, such strains would eventually be evinced or transmitted to the financial markets and the global economies.

Despite the cognizance of such variability, most politicians and bureaucrats have largely turned a blind eye on these. Why? Because it requires painful UNPOPULAR structural adjustments, such as hefty cuts in welfare benefits or massive increases in taxation or extended working age requirements or a combination of, something of which they hope would simply go away.

While the gullible public would naturally be enchanted by ‘motherhood’ rhetoric premised on a corporeal “utopia”, who would elect a political actor who would subscribe to worldly pain, e.g. work-saving-investing ethics, as to attain such lofty goals?

My point is simple; voters like the average market investors are after short-term gains and would mainly espouse panaceas in whatever form in pursuit of these. Being personally responsible and observing a regimented way to uplift one’s life is smirked and disdained upon, simply because governments are there and perceived upon as an ‘easier’ channel to provide the short-circuited goals by manner of coercive unproductive redistribution. For an individual, why work or save when government “should” provide? For companies, why be efficient, if they can use laws and regulations to subvert competition, keep costs down and enhance profit margins? Yet, the supreme irony is that despite belaboring governments to live up to expectations (whatever that may mean to you or me), we hate (elude) paying taxes and abhor the perpetual corruption arising from the tentacles of bureaucracy. Still, to quote Murphy’s Law, ``Anything that can go wrong will”. Woebegone, the perpetual vicious cycles of personality based politics!

Nonetheless, statist advocates still believe that Big Brother in government knows what’s best for us. However, even the “noblest” of laws generally meant for our supposed wellbeing have turned out to be a miserable, dismal and disastrous failure. Take for example in the US, the national prohibition of alcohol beverages or the Volstead act of 1919. In an attempt to make alcohol consumption as illegal, the law, according to former US Congressman Bob Baubman (emphasis mine), ``was touted by its backers as the solution to reduce crime and corruption, solve social problems, lower the tax burden created by prisons and poorhouses, and improve health and hygiene in America.”

The net result? According to Congressman Bauman (emphasis mine), ``This ambitiously wrongheaded experiment clearly failed miserably on all counts. Alcohol became more dangerous to consume; organized crime was born; the court and prison systems were overloaded; and corruption of police and public officials was rampant.” In addition, many other repercussions emerged, such as the loss of tax revenues, unbridled smuggling and racketeering, and excess violence according to wikepedia.org. The feckless “moralistic” (ha ha ha!) law which even then US President Harding hardly observed (as a proponent of the law as Senator, he kept bootleg liquor at the White House!) was finally repealed in 1933.

In the Philippine context, as in every government diktat, quoting Honesto General of the Inquirer (emphasis mine), ``The culture that it is okay for a government corporation to lose money--it's only taxpayers' money, anyway--prevails to this day. There are now over 300 government corporations losing a total of almost P50 billion a year.”

As a saying goes, ``The road to hell is paved with good intentions.”

Crude Oil hits Fresh Record at $78 per barrel amidst Media's stoicism

Domestic media's predilection to cover sensational political issues rather than focusing on what truly affects our lives is simply amazing. These simply reflects on the public's gullibility to trivialism and "personality-based" politics "statist" solutions to our daily lives.

Crude oil has passed the recent high mark as early as the afternoon (Philippine time) and surged way above its resistance level, as discussed previously ($80 here we come). The absence of such news accounts is truly deafening.

Anyway, what media papers over is what we deal with. According to Bloomberg (you may click on the link for the entire article),

July 14 (Bloomberg) -- Crude oil rose above $78 a barrel in New York for the first time as escalating violence in the Middle East and disruptions in Nigeria threatened global supplies.

Hezbollah militants fired rockets from Lebanon into Israel's third-biggest city after Israeli forces bombed Beirut international airport and other targets. A Nigerian newspaper yesterday reported that rebels had attacked pipelines, later denied by the owner of the facility, Italy's Eni SpA.

``There's real disruption to supplies in Nigeria, potential disruptions in Iran, and now you've got what's happening in Israel,'' said Tobin Gorey, commodity analyst at Commonwealth Bank of Australia Ltd. in Sydney. ``Who wants to sell in this environment?''

Crude oil for August delivery rose as much as $1.70, or 2.2 percent, to $78.40 a barrel in after-hours electronic trading on the New York Mercantile Exchange. It was at $77.95 at 7:45 a.m. in Singapore, 35 percent higher than a year ago.

Phisix, Peso Driven by Fedwatch Plays; The Gallery Experience

``Globalization is defined as integration of economic activities, via markets. The driving forces are technological and policy changes--falling cost of transport and communications and greater reliance on market forces.” Martin Wolf, columnist, Financial Times

Morgan Stanley’s Stephen Jen recently wrote ``the market’s fixation on the Fed is justified, because it is the Fed’s action and posture that will dictate the global liquidity cycle and investor risk-taking attitude.” If global markets are indeed following the US Fed as a gauge on the liquidity cycle, then reckoning on the probability side, it is likely that the US Federal Reserve is at the near end or the peak of its tightening phase (for the moment).

So far, the domestic financial markets appear to buttress my view, that a pause or a cut for that matter, would restore the US dollar diversification investing theme. As I mentioned too in the past editions too, the rally in the gold market, another barometer of the anti-US dollar trade, appears to correlate with the performances of emerging markets bourses. For the week, as gold jumped 3.05% to $634.8 per oz, the US dollar denominated sovereign ROPs rallied, the Peso firmed by a hefty 1.43% to Php 52.35, while the Phisix gained a considerable 3.64%.

Figure 4: Phisix (candlestick) and the USD/PESO (blue line)

As you can see in Figure 4, the Philippine Peso has shown quite a strong association with the performance of the Phisix, such that a rising Peso positively correlates with an advancing Phisix (red arrows) and vice versa. This suggests that portfolio flows into the domestic financial markets could have at the margins contributed to the rising Peso.

While the Phisix accounted for foreign money outflows during the last four weeks, this has reversed as of last week and would probably see continued inflows if global investors persist on the Fedwatch plays. Although Monday could probably start off weak following the lead of Wall Street’s conspicuous decline last Friday, which could possibly be a buying window.

While risks factors arising from the latest selloffs are still present, I remain cautiously bullish with the Phisix, on the account of the US dollar diversification theme and a bullish outlook in gold, and would closely watch the bond and gold markets for signals on the possibility of the re-emergence of the risk reduction trade.

Finally I was at the gallery of the PSE in Makati last week, the quintessential casino hall of the stockmarket, where the ambiance was filled with all sorts of rumors/gossip based activities and the proliferation of mental shortcuts which can be heard from most of the participants, and was delighted to hear that retail investors have now learned how to follow on the gold markets with respect to the mines. For a long period (2003-2005), if you recall, I have decried on the public’s indifference to a rising gold vis-à-vis the mining sector even when the Philippines sits on one of the largest reserves in the world. As said in the past, psychological evolutions take time to form or shape, and as the gold and commodities markets resume their ascent they will further diffuse into the public’s mindset until the great upside capitulation comes (time to get out!). As always, it has been an unfolding cycle.

Post script, I continue to shun the trading floor and the gallery or stock forums due to the adverse experience in my second venture into stockmarket investing in the mid 90s. As a gullible novice then, I heeded on tips from group chatters which got me badly burned figuratively or my portfolio mauled, aggravated by margin trading, that I almost literally leapt out of the 12^th floor of the Tektite building (formerly the trading floor) out of despair and swore off the touching the markets then…until of course, I met my mentor who taught me the prudent way. How times have changed.

Record High Oil Prices and Interventionist Policies

``Since Japan's boom ended in 1990, its regulators have been using every presumed macroeconomic "tool" to get the Land of the Sinking Sun rising again. The World Bank, the International Monetary Fund, local central banks and government officials were "wisely managing" Southeast Asia's boom until it collapsed spectacularly in 1997. Prevent the bust? They expressed profound dismay that it even happened. Argentina's economy crashed despite the machinations of its own presumed "potent directors." I say "despite," but the truth is that directors, whether they are Argentina's, Japan's or America's, cannot make things better and have always made things worse.”-Robert Prechter, Elliott Wave Theory

Well, news headlines had been surprisingly silent about recent spike of crude oil prices to new record nominal levels exacerbated by brewing geopolitical tensions. I say exacerbated because, oil prices have been advancing incrementally even prior to the controversial ‘tests’ which provoked a worldwide uproar as shown by the blue arrow in Figure 1.

Figure 1: stockcharts.com: benchmark WTIC Crude oil at a trading range?

While it maybe premature to discern as to where oil prices would be headed for over the interim, Friday’s activities as portrayed by the price movements in the chart appears to suggest that oil could have hit a peak following a “double top” (red arrows). However, since the second quarter, the oil benchmark appears to be in a trading range from about a low of $68 to a high of over $75. Again, it is too early to say where oil prices are headed for but if it does successfully breakout over and above from the said channel, we could possibly see oil prices test the $80 to $85 mark. Otherwise, it could fall to the lower segment of the trading range.

Conventional mainstream analysts argue that slowing economic growth would likely depress oil prices. I am, however, uncertain and unconvinced of that outcome. If history would be a guide, and by vetting at the factors buttressing the present cycle, it may even suggest the contrary, according to the maverick guru Jim Rogers in his book “Hot Commodities”, ``In the history of oil prices, supply demand imbalances trump even poor economies and technological revolutions.” He goes to mention that in the 1970s as major economies like the US, Europe and others went sour, the price of oil rose 15 times! Such that not even technological breakthroughs supported the increase in supplies then to dampen prices.

Figure 2: Chart of the day: Inflation adjusted Oil prices

A replay of history or even a semblance of would translate to over $150 bbl, based on the 1999 low of $11 bbl at 15 times. Despite the fresh nominal record high last week, current oil prices are still below the inflation adjusted highs of the late 70s as shown in Figure 2.

If one would discern from the present market activities, despite the consensus outlook of some $10 to $15 per barrel of “speculative” or “terror” premium, the recent liquidations on heightened risk aversion last May appears to validate the supposition of inelasticity of oil prices relative to economic growth. If oil prices continue to ascend despite economic doldrums this could be a possible affirmation of the Peak Oil theory, or the diminishing supply of cheap oil.

One should not forget that Oil economics has been one of the areas where government intervention has been a primary mover. In other words, the massive imbalances as a result of the contortions brought about by the collective governments attempt to control the industry, for the so-called ‘social benefits’, have been reflected in today’s market prices.

While news accounts and mainstream analysts incessantly talk about growing demand from China and other emerging countries and the geopolitical tinderboxes as key drivers of sky high oil prices, hardly anyone talks about the structural side, namely, the past and present “nationalizations” of the industry and government price subsidies (limits efficiency and restrains output and investments), the inadequate “transparency” of proven oil reserves by Oil producing states (overstated OPEC reserves that allowed for higher production rates during depressed oil prices), “windfall” taxes and the tomes of environmental regulations and other legal strictures imposed (NAMBY-Not in my backyard drilling, gasoline formulations that led to refinery shortages); all of which has contributed considerably to the shortages of investments or the underinvestment to the industry thereby restraining supplies.

Moreover, on the demand side, the inflationary policies, such as prolonged periods of easy money policies (boom in worldwide real estate industry), surging credit growth and expansionary money base (boom in global financial markets), currency pegs (e.g. China remimbi-US dollar-current account imbalances) adopted by major economies aside from the stockpiling of strategic reserves have contributed to its explosive growth.

If government’s directives have been efficient, why has there been a massive shortage of investments by both public institutions and the private companies? Why has the demand-supply imbalances remained unresolved, if not aggravated? Or simply, why have oil prices persists to remain at lofty levels? And again, who pays for such miscalculations or ineptitude? Obviously, the people/consumers/constituents who ironically had been the intended party to benefit from supposed control. Whereas in the free markets erroneous decisions lead to individual losses or bankruptcies, flawed government policies have been borne by the citizenry or constituents via increased taxations or loss of purchasing power which essentially leads to the deterioration of the standards of living.

In short, the colossal high oil prices have simply been a manifestation of failed aggregate interventionist policies, very much like the endemic structural inequalities present in the Philippine economy and not due to the inadequacies of laissez faire markets. It is not the inability of free markets to function, but rather the lack of it. We tend to see what we believe in rather than believe in what we see.

As an offshoot to these, major Oil companies have been restrained from expanding of their reserves and/or adding production outputs due to the regulatory constraints and most importantly due to the inability of the companies to ascertain on the viabilities of prospective projects as a result of the uncertainties from the actual data on existing demand and supply (remember fudged data on proven reserves).

Petro companies have instead embarked on buying up of reserves of existing companies rather than undertaking drilling or oil/gas exploration themselves; the account of Chevron-Unocal merger in August 2005, the recent $21 billion Anadarko acquisitions of Western Gas and Kerr-McGee, Devon’s Energy’s $2.2 billion purchase of Chief Holdings attest to these unfolding developments.

Figure 3: Energy Letter: Global Rig Count (April)

Yes, while there has been a surge in drilling activities worldwide mostly due to juniors explorers see Figure 3, another problem according to Elliott Gue of the Energy Letter is of declining well productivity-well flows are of lesser quantity and target wells are of smaller reserve/reservoirs.

So, government interventionist policies, diminishing reservoirs/declining well productivity and geopolitical anxieties have been significant fundamental contributors to rising oil/energy prices and continue to do so.

Investment implication: the obvious trend is to search for junior explorers who could build up sizeable reserves and become likely acquisition targets by Oil Majors.

Bullish Gold Backed by Gold/Oil Ratio

``I wish I had an answer to that because I'm tired of answering that question.” Yogi Berra, former catcher manager in Major league Baseball

One interesting if not amazing development in the marketplace during the recent markdown was crude oil’s resilience despite the attribution of some $10 to $15 of “speculative” or “terror” premium to the price of oil by conventional or mainstream analysts.

Figure 5 Stockcharts.com: Holding WTIC Crude (candle) amidst financial market turmoil.

As Figure 5 shows, the West Texas Intermediate Crude ($WTIC) benchmark meandered sideways (horizontal blue line) as rising “risk aversion” supposedly reduced or marginalized leveraged positions from the high performance markets as shown by the Dow Jones World Index (declining green arrow).

Could the present developments indicate that the resiliency in oil prices amidst the financial turmoil represents a validation of the Peak Oil theory???

Figure 6 Matthew Simmons: Rising Demand on Declining Spare Capacity

In the face of persistent robust rising demand and supply constraints, (such as dwindling rigs, aging workforces, rusting iron, aging refineries, evaporating cushion, accelerating decline curves, end of technology, low prices that dissipated the once robust industry~Matthew Simmons), as shown in Figure 6, are we then looking at higher oil prices in the immediate future considering a more hospitable inflationary landscape?

Figure 7 Dailywealth: Gold/Oil Ratio: Gold cheaper than Oil

Which brings us to the next premise: could rising oil prices inspire a more animated rally in gold considering that its historical median is about 14 barrels of oil for every once gold, when its present level trades at low of a 8? My probabilistic guess/answer: yes, it would.

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.