``This gets back to the disagreement I’ve had with the “inflationists” for years now: In the name of Keynesian economics, inflation proponents have repeatedly called for massive stimulus in response to the bursting of THE Bubble, while in reality this activist policymaking was instrumental in only extending and worsening a systemic Credit Bubble. This was especially the case after the bursting of the technology Bubble and is again true today following the bursting of the Wall Street finance/mortgage finance Bubble. Now, more than ever before, “Keynesian” inflationism is THE Bubble. When it eventually bursts Washington policymakers will have little left to offer.” Doug Noland Inflationism’s Seductive Battle Cry
For us, $200 oil is not an issue of IF, but rather an issue of WHEN. This will be highly dependent on the course of actions undertaken by global policymakers.
Here, we won’t deal with demand and supply imbalances of oil, as we had made our case late last year in Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?, instead we will deal with the rapidly evolving market signals and prospective political actions by policymakers
Growing Disconnect Between Markets And Real Economy
“World oil demand to hit 28-year low” screams the headline from the National.
So one must be wondering: Why has oil impetuously shot beyond $60? Has the oil market been pricing an abrupt global recovery?
The Economist instead finds justification on widening supply constraints, ``The explanation is simple. Oilmen are worried because they believe that many of the factors behind the record-breaking ascent last year remain in place. Much of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments that will not allow foreigners to exploit it…So when demand begins to revive, a sharp rise in prices is inevitable. That does not mean that a price spike is just around the corner, however. The speed with which it arrives will depend on the strength of the global recovery.”
While the article mainly underscores the geographical access limitations posed by governmental restrictions, falling demand and high inventories, as discussed in Seeds of Hyperinflation Have Been Sown have reflected on an egregious disconnect between fundamentals and the marketplace. The Economist article appears more like an attempt to explain away or to rationalize on the market activity than vet from the causality angle.
The highly reputed independent research outfit the BCA Research has a fabulous chart manifesting this phenomenon, see figure 1.
According to the BCA, ``The higher price of oil reflects in part the upturn in Chinese oil imports and car sales at a time when oil production is lagging. Russia continues to have difficulty boosting output and oil production has been flat for most OPEC countries. Saudi Arabia has cut production sharply. As with other commodities, oil should benefit from both a weaker U.S. dollar and a shift in investor portfolio preference toward real assets as a hedge against inflation. The upturn in our global leading economic indicators is another positive sign for the commodity complex.” (bold highlight mine)
True, China has been massively acquiring oil and other commodities.
And we won’t dismiss some veritable evidences of economic and financial “recovery” following the “banking meltdown” late last year, of which has functioned as a psychological “shock” (Posttraumatic Stress Disorder-PTSD) that has buffeted world financial markets and global economy.
But China has been buying way beyond its needs. It has been buying to shore up its strategic reserves.
Analysts at Sanford Bernstein reported that Google Images reveal on how China has been intensively constructing depots to hold oil. ``Bernstein says satellite images show a marked increase in oil-storage construction over the past few years and estimates that China’s number of days of forward demand–a gauge of oil storage–amount to just 28 days of imports and 14 days of total demand. China is targeting storage capacity that will hold demand cover of around 90 days,” wrote the Wall Street Journal,
Yet according to another researcher as excerpted by the Guardian, China plans to amass 3 million tonnes (about 22.5 million barrels) of oil, ``China wants to set up a 3 million tonne reserve of oil products this year, which is practically impossible, a researcher at a think-tank run by the country's top oil refiner, Sinopec Group, was quoted as saying on Saturday.”
Moreover, China’s huge appetite for commodities registered record imports for Copper and Aluminum this April. However many experts say that China’s buying activities for these commodities may have probably peaked since targets may have been met. According to Bloomberg, ``Refined copper imports by China will slow over the rest of this year as scrap supplies improve, said Ma Xiaoqin, deputy- general manager of the copper department at Minmetals Nonferrous Metals Co., the country’s largest trader, on May 8. The State Reserve Bureau has mostly completed its buying and stockpiling by manufacturers has ended, said Edward Fang, an analyst at China International Futures (Shanghai) Co.”
If such buying activities have indeed culminated then copper and aluminum prices should be expected to meaningfully correct, see figure 2. But we have our doubts.
Figure 2: stockcharts.com: Copper and Aluminum
So far only Aluminum has been showing signs of relative weakness. Although copper seems to be in a consolidation phase where a “pennant” pattern (blue converging lines) may suggest a continuation of the present uptrend.
China Attempts To Balance Political Rhetoric With Market Actions And Political Goals
This isn’t about China believing its own “bullish” tale of vigorous economic recovery, where the supposed “conventional” view equates China’s economic growth to commodity bullishness. Instead the above dynamics reflects the ongoing inflation phenomenon.
The fact that China’s officials have raised the furor over possible losses of its US asset portfolio holdings from the current US policies appears to dovetail with the activities in the commodities market.
China’s Premier Wen Jiabao, as quoted by the Financial Times recently said, ``We have lent a huge amount of money to the United States,” Mr Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.” (bold emphasis mine)
Of course one may argue that China’s acquisition of US assets hasn’t slowed.
In contrast to Premier Wen’s statement, China has even increased its acquisition of US treasuries see Figure 3. And this would seem like a conflict between China’s intentions and actions. But this view myopically glosses over the geopolitical implication. There’s more than meets the eye.
Figure 3: New York Times: China’s Changing Role
It would be tantamount to political suicide if China decides to naively “sell” US treasuries to support its concerns, especially under the present environment which has been a fertile ground for engendering protectionist policies. For instance, recently some US lawmakers have revived efforts to brand China as a currency manipulator. Hence mass liquidations of treasuries would only fuel bilateral antagonism. And a trade war isn’t in the interest of China.
Another, it isn’t also a certainty that the underlying motivation behind China’s purchases of US assets reflects on the same paradigm of “promoting exports” as it had been in the past. Past performance doesn’t guarantee future results-that’s because the incentives behind today’s conditions have radically changed. The US consumer model as the world’s growth engine has apparently been broken. And China appears to be well cognizant of this.
Moreover, since China holds massive amount of US dollar assets- estimated at an astounding 82% of foreign currency reserves (Standard Chartered/New York Times)-any mass liquidation will most likely impact the markets extensively and stoke disorder. Where such actions will likely be mutually destructive, such policy directions will likely be avoided.
Hence, China’s political actions should also be seen from a different prism- China may want to be seen in good light with the US, where she would continually support the US even at the risks of incurring substantial losses in its portfolio of US dollar assets.
As Luo Ping, a director-general at the China Banking Regulatory Commission recently justified, ``Except for U.S. Treasuries, what can you hold?”
Moreover, China may want to project that in case a possible mayhem emerges in the financial markets this isn’t going be due to her doing. In other words, China seems to be placing the onus of the consequences from policy choices squarely on US shoulders.
Nevertheless, actions demonstrate preferences. While China remains supportive of the US in terms of buying assets, the composition of its acquisitions has materially changed.
According to the Keith Bradsher of the New York Times, ``China has also changed which Treasuries it buys. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none.
``But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.” (bold emphasis mine)
So yes, China has been increasing its purchases of US treasuries to appease the US government, but has been concentrating these activities towards short term maturities. And by doing so she has been acting to reduce her risk exposure as well as balancing political rhetoric (bleating about US policies, announcement of past ‘covert’ gold purchases) with market actions (diversifying portfolio holdings into commodities) and political goals.
And aside from heavily buying into commodities, as previously discussed in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency, China has been utilizing its currency as an instrument to expand its political and economic influence across the globe by increasing swap agreements, by providing project financing and conducting trade in the remimbi or ex-US dollar currencies. Recently Brazil and China concluded an accord to conduct transactions using their national currencies instead of the US dollar.
In all, China could be working to insure herself from the risks of substantial US inflation, to expand its influence globally with its currency and possibly to challenge the US hegemony in terms of having the remimbi as a global currency reserve sometime in the future.
The Global Inflation Train Speeds Faster
And as we keep repeating, in the world of unprecedented scale of government intervention in the marketplace combined with unparalleled degree of applied inflationary measures, the repercussions intended or unintended will be vented on the currency markets.
And we agree with Professor Steve Hanke where he wrote in a Forbes article ``There are tectonic moves afoot in the currency markets these days.”
Tectonic moves afoot in the currency markets will also be parlayed in the Oil Market see Figure 4.
Figure 4: stockcharts.com: Inverse Correlation of Oil and the US Dollar
Visibly, oil in the past has moved in consonance with the US dollar, albeit in an inverse scale (see blue trend lines).
This dynamic seems to be a classic rerun as the recent weakness of the US dollar index (USD) has equally coincided with rising oil prices (WTIC-main window).
Alongside this development has been the rise of 10-year US Treasury yields (TNX) in spite of the recent activities from the US Federal Reserve where the ``Fed bought $18.277 billion of U.S. debt in three purchase operations this week and minutes of the central bank’s April 28-29.” (Bloomberg).
The US Federal Reserve in its March 18th press release has earmarked $300 billion to purchase long term Treasury securities.
But there seems to be one missing ingredient. In the past, the falling US dollar had been accompanied by falling treasury yields-perhaps reflecting what Former Fed Chair Alan Greenspan’s calls as a conundrum of low bond yields. And this phenomenon was suspected to have been influenced by foreign purchases of US treasuries that have kept yields low.
But since recent treasury issuance to fund US government deficits has surged far more than what foreigners or China has recently bought as shown in the chart earlier, where according to the same Bloomberg report, ``President Barack Obama has pushed the nation’s marketable debt to an unprecedented $6.36 trillion. [bold highlight--mine] His administration raised on May 11 its estimate for the deficit this year to a record $1.84 trillion, up 5 percent from the February estimate, and equal to about 13 percent of the nation’s GDP”, yields have materially risen!
And as we have previously discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, the colossal government spending by the US and elsewhere and the prospective surges of government treasury issuance are posing as risks towards hefty inflation or national bankruptcies.
Hence, today’s rapidly deteriorating US Dollar, rising treasury yields and rising oil prices seem to be solidifying the manifestations of inflation gaining traction globally.
Credit Rating Downgrades Amidst Exploding Deficits
The recent spate of massive waves of deficit spending in many crisis havocked economies has put pressure on their respective credit rating standings.
The S&P recently issued a downgrade from “stable” to “negative” on UK’s outlook which means the country is at risk of losing its coveted AAA status.
Concerns over the same predicament has apparently spilled over to the US considering the huge planned dosages of government spending aimed at jumpstarting the economy as shown in Figure 5.
Well the impact of concerns over these deficits, aside from rising treasury yields, has been deterioration in credit default swaps, which function as insurance against the risks of credit default.
According to Bloomberg, ``The cost to hedge against losses on U.S. government bonds for five years climbed to a three-week high, indicating perceptions the nation’s credit quality is deteriorating. Credit-default swaps on U.S. debt rose 3.5 basis points to 41, the highest since April 29, according to prices from CMA Datavision in New York. An investor would have to pay $41,000 a year to protect $10 million of debt from default.” (bold highlight mine)
Mainstream Calls For More Inflation Ensures Oil at $200!
These credit rating warnings should serve as call to action on governments to limit overspending. Remember there is no free lunch. Ultimately taxpayers will pay for government profligacy.
But will these warnings be heeded? Apparently not.
On the contrary the mainstream has vociferously been desiring for more inflation.
The Bond King, PIMCO’s William Gross, recently predicted that the US will eventually lose its AAA rating according to Bloomberg.
Yet his prescriptions to support the economy account for the same factors that would ensure the US will likely lose its prime credit rating.
It’s because Mr. Gross subscribes to the Keynesian methodology of printing money as a cure, where the same report quotes Mr. Gross, ``We need more than that,” Gross said at the time. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”
And the policy prescriptions of Mr. Gross have been joined by the similar calls from well known Harvard experts-Kenneth Rogoff and Greg Mankiw.
``I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.” (Bloomberg)
Meanwhile, Mr. Mankiw former chairman of the Council of Economic Advisors under President George W. Bush said ``Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt” (Bloomberg)
So in the face of rising risks of default, these mainstream experts sporting a good clout over at the officialdom may be reflective of the policy directions of the present administration.
Of course inflation can be achieved through massive credit expansion (through public or private channels) or via the government spending route or both.
And if Mr. Bond King’s suggestion will be adhered to and if it’ll likewise be copied elsewhere the risk of a runaway inflation will be tremendous.
Figure 6: BIS: Balance Sheets of the Central Banks of the US, UK and ECB
Since the advent of the crisis the balance sheets of the US Federal Reserve, the ECB and the Bank of England have surged see figure 6.
So policymakers have made sure that inflation will likely take hold; inflation is what they ask for hence inflation is what we will get.
As Dr. John Hussman admonished in his latest weekly outlook (bold highlight mine),
``The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.”
Even Yale’s David Swenson told Bloomberg that everyone must own inflation protected securities in the face of substantial inflation, ``We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation, or at least pretty substantial risk of inflation,” Swensen, Yale University’s investment chief, said in an interview on the “Consuelo Mack WealthTrack” television show that aired yesterday. Treasury Inflation- Protected Securities “should be in every investor’s portfolio," he said.”
Finally fund manager David Dreman has another unorthodox suggestion for the US government.
He posits that the US stimulus package be directed at the commodity markets.
According to Mr. Dreman, ``My idea is that we accumulate useful resources, such as crude for our strategic oil reserve. This would create new jobs, halt a deflationary spiral and give us some protection against the next international oil crisis. If the government allocated $500 billion at current prices, it would add 10 billion barrels of oil, which amounts to 17 months' consumption. The government could undertake similar purchase programs for copper, aluminum, lead and other essential industrial commodities now trading at very depressed prices.
``An oil-buying binge would be a win for taxpayers as well. Oil bought today below $60 a barrel can be released back into the market at $120 after economic activity has picked up and inflation has resumed.”
Mr. Dreman’s suggestion implies that the US government should engage with China and the rest of the world in a bidding war over oil and other commodities. The idea is to directly stoke inflation by means of direct intervention in the commodity markets.
However, high commodity prices reduce the purchasing power of consumers or the taxpayers, so it is a contradiction how taxpayers/consumers would benefit from high commodity prices. Put differently, the US government may earn from a spread alright, but the world in general will be poorer because of the lesser amount of goods the Americans and people around the world can acquire.
Moreover he seems to suggest that the US government should be transformed into a proprietary trading desk. Governments don’t work for profit but for social concerns.
Besides a policy directed at a race to own commodities could serve as a casus belli for a world war at war or a world resource war.
What have these “inflationists” have been smoking, anyway?
Overall, the inflationary policies of global governments are key drivers to oil prices at over $200 per barrel!
