The Pause That Refreshes

We saw a short reversal in the recovery trade that has benefited the risk currencies, especially Australia, New Zealand and the Eurozone. As of last Tuesday morning when I began this column, the risk push is back on: The euro and Kiwi are pushing new yearly highs with the Aussie hot on their heels. Poor Canada got dumped on due to its poor retail sales but will likely fall back in line.

Let’s look first at the euro. This really looks like a gasping market. It resembles all those that make higher highs on a relentless basis. And when you talk about relentless, the mighty euro sure fits the bill. Until Monday, the euro had not seen two down days in a row for the entire month. That’s remarkable.

But the real question is, does that movement arise from its own strength, or is it something else? I have long been a proponent of an impending euro disaster — and I’ve positioned my paid Master FX Options Trader readers accordingly.

The one thing that would forestall my forecast of disaster would be an intermediate recovery. Please notice two words in that previous sentence — “forestall” and “intermediate.” The euro disaster is not over — it has only been delayed. Like all excesses, it must eventually come to light and be dealt with. A foundation can only be undermined for so long before the structure it supports has to topple.

That’s what has been going on in the United States. And without a doubt, the euro problems are much, much bigger. Moreover, the European Central Bank’s remedies thus far have not been nearly as effective as they have been in the United States. But the second item of note — “intermediate” — is the type of recovery that will allow the Eurozone to gloss over their immediate problems.

Thus it looks like “business as usual” for European banks and businesses. During the boom-boom years, the systemic problems of the Eurozone were easily glossed over. If we can return to that sense of “normalcy” — and believe me, that’s what every central bank is working toward — then the euro and the U.S. dollar will continue to part ways. Mainly because the U.S. problems are all exposed and out there for everyone to see. The Eurozone has managed to weather the storm, keeping its central bank rates higher than the U.S. rates, so it has all the appearances of not needing the drastic measures that America has taken. Ipso facto, it must not be in as bad shape as its North American counterpart.

But the way things seem is not always the way they are. Everybody has to pay the piper, and what you sow is what you reap. There are NO exceptions. So when we sow thievery and oppression, crushing economies to benefit the friends of central bankers, there will be hell to pay. And I’m not just using a figure of speech.

So then, the euro has posted a new high. It doesn’t have the internal strength on its own to continue higher. But as “good” recovery-style news comes out, they keep the Ponzi going.

So what will be the real drive going forward? Let’s take a look.

The Dollar Carries On

First of all, the U.S. dollar is in danger of becoming the currency of choice for the new “carry trade.” We’ve discussed this before, but it’s worth mentioning again — especially for new readers.

Plainly put, the carry trade is when a trader borrows money in a currency with a low interest rate, then uses the proceeds to buy a currency with a higher interest rate. So even though he has to pay interest on the currency he borrowed, he’s making even more in interest with the currency he bought.

Since the interest rate difference is so small, the carry trade is only worthwhile if it involves a tremendous amount of cash. That’s why it’s generally done by the really big, big players. Here’s an example of how it works.

Say an institutional investor borrows a bunch of dollars at a .25% interest rate. Then he uses those dollars to buy, say, Australian dollars, which are paying a 2.75% interest rate. So, he’s losing .25% on the dollars he borrowed, but making 2.75% on the Australian dollars he bought. And he earns that in perpetuity. He doesn’t have to do anything. It just keeps earning money day after day.

For years this has been done with the yen, as it always had the lowest rate of interest. It helped to keep the yen very cheap, which is exactly what the Bank of Japan wanted. It hoped the cheap currency would expand their perpetually receding economy.

Now this same scheme is being done to the dollar. So far, it’s only been in “bite-sized” chunks — but only because no one is very sure if the world economy is out of the woods. Still, unless more bad news comes, this is a profitable trade.

Also, higher interest rates tend to attract more money going forward (as all the scared money comes back into the market) — so the higher-yielding currencies also appreciate against the lower-yielding ones. Therefore, the investor makes a double boon: the interest and the appreciation.

So the big institutions have an interest in depressing the dollar. Any gain in strength or interest rates threatens the easy money of the carry trade.

But, as noted, the institutional players aren’t the only ones who want to keep the dollar down.

Bad Politics = Bad Currency

As I mentioned, the Bank of Japan was all too happy to let the yen carry trade go on, since a weaker currency was seen as a way out of its economic mess. The U.S. government is essentially taking the same route. Without a doubt, it is complicit in driving the dollar lower.

Like in Japan, a cheaper currency helps service ever-increasing debt (I’m certain they have long since abandoned any prayer of paying it off). And the indebtedness is increasing at a faster rate than at any time in history. As long as the major economic power wants to see its currency cheaper, it will do whatever it takes to get that done.

By the time you read this missive, the Fed will be ending their two days of meetings to determine what to do about U.S. interest rates. If you haven’t already heard the answer, what do you think it will be? It is important to formulate an answer to that with all the evidence before you, because it will give you an added insight into how the central bank works. Here’s my answer. They will not be raising rates.

Now that, of course, is no new revelation. But what will they do looking ahead? When will they start earnestly looking at raising rates? The answer to that question lies in our own recovery.

While data appear to show that the economy might be coming out of recession, unemployment is still at multiyear highs and is not decreasing. Housing numbers are improving, but they will NOT be coming back to what they were. All the weight put on housing starts, new purchases, purchases of existing homes, new permits issued, etc., are all a smokescreen. And if not intentionally an “illusion,” it certainly will not make a difference to the economy. Here’s why…

Under the “old economy” (two years ago), a house was a store of value. We all implicitly knew that our savings were not “safe” in a bank, and if they were, they certainly were not growing to keep pace with inflation. So we invested in real estate. I don’t mean that everyone went out and bought rental properties or tried to flip houses. What I really mean is this:

If you ever refinanced your house and took “cash out,” you invested in real estate. If you ever used a home equity loan or a home equity line of credit — you invested in real estate. The unwritten assumption was that your house would continue to increase in value, even as you were using the equity. We became a nation of equity spenders. Treating our homes like ATM machines, we attempted to increase our wealth by means of a bubble market. Even if you didn’t think you understood the nature of a bubble market, implicitly, or even instinctively, you did.

Spending a house’s future earnings meant that we believed our money would be worth less in the future than it is now. We believed its value was decreasing. (Incidentally, we were right.) But we were on the “safe side of the bet.” Because we would spend valuable dollars now, but repay our bill with less valuable dollars later. This is why a 30-year mortgage in a centrally managed and inflationary economy is such a good deal. You lock in today’s price, but pay it off with increasingly inflated money. It is that very inflation that makes your house go up in “value.” Any reasonable consideration would conclude that a house is not as “valuable” after 30 years of living in it. It must depreciate, because it “wears out.” Anybody who has ever owned a home knows this to be true. Defer just a few years of maintenance, and it will soon overwhelm you. Before long, you begin to wonder if you own the house, or if the house owns you.

But in the end, when houses were all in debt up to their value, and many far more than their value, we stopped investing in real estate. Mainly because we couldn’t afford it any more. Either our payments were already too high, or our equity was too low. At any rate, when people stopped “investing,” the residential market began crashing. It will not return to what it was, and vainly hoping for more increases in housing numbers to do that will only bring to pass the old proverb, “He that sows to the wind will reap the whirlwind.” In other words, vain hope isn’t gonna save the farm.

Getting back to the moral of our story, the government, which will not control or reduce its spending, can only raise taxes, cut services or inflate the currency in order to get us out of this mess.

Of course, raising taxes or cutting services are the easiest ways for a politician to lose his or her job. So the third option is always exercised. If done properly (according to prevailing monetary theory), it will be painless, and the effects of inflation will be partially offset by the ever-popular cost of living increase. That way everyone shares in the illusion that they are “keeping up with” inflation. But that’s all it is… an illusion.

So we’re up to two entities with a vested interest in keeping the dollar down — the institutional investors who want the carry trade to continue, and the U.S. government, which needs a weak dollar to plaster over its massive debt.

And the dollar has yet another enemy…

Neither a Borrower Nor a Lender Be

It’s easy to overlook, but when you buy bonds, you’re buying debt. You are loaning the issuer your money and getting their interest rate as your profit. Corporate bonds represent the debt of individual companies. When you buy Treasury bills and the like, you’re buying the debt of the U.S. government.

No nation in the world sells more debt every single month than the United States. Because of our existing budget (that’s using the term very loosely), we are forced to borrow money every 30 days. To pay Social Security, welfare, medical payments, elected officials and bureaucrats, the military, foreign aid, student loans — anything and everything that gets money with a federal stamp on the check.

And we have to borrow it. Somebody has to give us their money with the expectation that they are going to get it back, plus interest (uninflated).

Now, imagine your neighbor asked you to loan him some money, promising to pay it back with interest. A week later, all that money has been spent… so your neighbor asks for another loan. And another. Then another. How much longer would you keep lending him money? Even if he continues to pay the interest he owes you, you still have to wonder how long before he needs to borrow money just to pay the interest he owes you for borrowing the money.

That’s why everyone I know is casting a wary eye on America’s “neighbors” — the countries holding much of the U.S. debt. With our massive spending plans and dim economic outlook, other nations must be worried about our ability to repay our debt. What will we do when the Chinese stop buying? What will happen when the European Central Bank stops buying? What will we do when Japan stops buying? Will the government stop spending even then?

One way or another, the you-know-what is going to hit the fan. Oddly enough, however, foreign investment is higher this year (43.1%) versus last year (only 27.1%). That’s a year-over-year increase of 60%!

So instead of being worried, the U.S. government feels invincible. Foreign countries will always be happy to buy our debt, it thinks, so there’s no reason to adjust our destructive spending plans. It’s like giving more liquor to an alcoholic to sooth his tremors — a short-term fix that doesn’t do anything to solve the problem. Make him feel good enough, and soon he won’t feel anything ever again.

If I were you, I’d position my short-term and long-term currency savings accordingly.

Regards,
Bill Jenkins

September 30, 2009

The Euro, the Dollar and the Future of the Forex was originally featured on Whiskey and Gunpowder

But some things are for sure and provide “reasonable markers” to see what a currency is doing. One of my “favorites,” although I hate to call it that, is the “civil unrest factor.”

Across the Eurozone riots and outbreaks of violence have been touched off by escalating economic problems and disagreements between members and neighbors. People involved in civil unrest are a multifold problem. First, they have too much time on their hands because they are not working. Jobless citizens, especially in a heavily socialist culture, are a continual drag on the system. Second, it costs money to keep repressing social upheaval — presenting another drag on the system. Additionally, the passions and fears of men being what they are, such activities tend to draw in more normally productive folks as the snowball gains speed and volume.

Here in the United States, we are not facing such difficulties (yet). This means a more reasonable system of work and distribution of goods and labor. All in all, this is good for a culture, the body politic and the economy. As a result, it also breeds greater confidence in the currency. And when all is said and done, investment money will go where there is a reasonable likelihood of return, even if the return may be lower.

Specifically, there are several exotic currencies that have offered high rates of return for speculative investors and traders, like the Brazilian real and the Indian rupee, just to name two. But it is difficult to place large sums of money there simply for the sake of the wild swings in value. A high interest rate is no good if the principle of the investment is destroyed by currency depreciation.

This is what has been good up to this point in the recession/depression for the U.S. dollar. And if this continues to unfold over the next year or two in similar fashion, this would still produce U.S. dollar strength compared to the euro simply by the “fear factor.”

Additionally, as I have tried to show, the situation in Europe is actually more severe than in the United States. I believe in the end that will make them copy, at least percentage wise, the same devaluing practices that have happened here. Should that occur, it would once again be advantage-USD.

If, in addition to those previous considerations, one or more of the countries leaves the Eurozone, I think the fear and disturbance that would produce again favors the U.S. dollar.

Longer term, I have to wonder if the euro has what it takes to survive this crisis. I have no doubt that the United States will emerge out the other side with all 50 states still members of the Union. I don’t know that such can be said for the European Union.

At the end of the Mel Gibson movie, The Patriot, there is a shot of Lord Cornwallis overlooking the field of battle as the colonists finish the rout of the British at Yorktown. He says, “How could it have come to this? Everything will change. Everything HAS changed.”

When I look at the dollar, I feel the same way. What we have done may be past the point of no return, the point of repair or recovery. The next generation may well find that the U.S. dollar has gone the way of all fiat currencies before her. What will replace it? I can’t say. But in the present environment, more shocks to the system will ultimately favor the dollar… at least for the time being, because it is supported by stability. And in unstable times — stability draws the highest premium.

Now let’s end with a look at my favorite currency, the Australian dollar.

Aussie Firm Despite Chinese Unrest

The Aussie dollar chart looks remarkably like the euro — going back to the beginning of June. All things considered, that’s rather remarkable given the relative strength of the Aussie economy compared to the Eurozone. Nevertheless, fundamentals will eventually rule the day, and though we may have to wait it out a bit, we look for the Aussie to rebound in the future.

One of the difficult parts of the equation at this point is the widely reported and detrimental riots in China’s western Urumqi (pronuonced U-rum-CHEE) province. Ethnic fighting between Muslims and Chinese citizens has threatened to overpower the police force.

As you know, Australia’s success going forward is inextricably tied to China. So worries about riots in one part of the country can certainly be detrimental in other parts as well. Even though the violence in other provinces may not be ethnically related, once a group of people feel they have been wronged and have the sheer numbers to overpower a military or police crackdown, all heck can break loose.

Remember, there is significant fear of unrest all over China as the depression sets in. The people were just getting their first dose of “la dolce vida,” only to have it stripped away. And gone are the days when they trusted their government to provide for them. Now it is beginning to look more like the enemy than a loving “big brother.”

For now, though, the Aussie dollar hasn’t been impacted by the fray. It has been well supported at the 78.25 level. A strong close below 78 on the daily chart would invalidate that forecast, and likely lead to more downside. We’ll just keep our eyes open.

Regards,
Bill Jenkins

July 20, 2009

Dollar Bad, Euro Worse was originally featured on Whiskey and Gunpowder

The table is to be found of Page 37 of the FT for April 2, and is always to be found on the page labeled “Market Data,” along with global equity prices, volatility indexes, and variegated statistics. It is labeled “Ten Year Gov’t Bond Spreads.” It lists the yields on 21 different government bonds, all with a 10-year life.

It gives the spread based on German bonds and on U.S. T-Bills, but its greatest interest is that it gives a Germanocentric view of the world. It makes very clear the central role of Germany in the eurozone, just as the deutsche mark had a central role in the Exchange Rate Mechanism before the European currencies, or most of them, converted to the euro.

Conveniently, the 10-year German bond, denominated in terms of euros, is the strongest of the euro bonds, and the only one that currently has a yield below four percent. The range of euro bonds is quite wide, though they are all an expression of the same currency. The most expensive euro bond is the German, which yields 3.96 percent; the cheapest is the Greek, which yields 4.46 percent.

That is precisely 0.5 percent above the German yield. I do not know who fixes this market, but it looks as though someone does, and they do it in the interest of the euro as a currency. The German-Greek spread is remarkably stable. There seems to be an underlying determination not to allow the spread to widen to the point at which the euro itself would be threatened.

Clearly, the Greek bonds are overvalued in terms of long-term risk. There is no risk at all that Germany will have to leave the euro — certainly no foreseeable risk. I suppose some explosion of the oil market might threaten the whole eurozone, as the oil shocks of the 1970s caused global inflation. But apart from that, one would have to invent terrorist fantasies to create a scenario in which Germany might be forced out of the euro system.

Not so with Greece, which has the weakest of the euro currencies. If Greece was not a member of the eurozone, Greek interest rates would presumably be higher than the six percent of Australia or New Zealand, on any normal financial criteria. Moreover, this applies to a tier of southern European countries in the eurozone. Greece yields a half percent above Germany, but Italy is very close to that level, at 0.47 percent, as is Portugal. Only Spain, at 0.28 percent, is level with a central eurozone country such as Austria.

The risk that is being underpriced is the risk of two Europes. Politically, two Europes could come into being if German and British policy were to diverge, on the issue of federation — the next British government may be more anti-federalist than the present one — or in response to competition for oil supplies. Financially, the two Europes could come into existence because the southern four — Greece, Italy, Spain, Portugal — could no longer stand the strain of a high-priced euro.

At present, I would not myself put the two Europes as a very high risk, either on political or financial grounds. But the risk is there, and it is almost certainly underpriced, because of intervention, presumably by sources close to the European Central Bank. On a 10-year view — and these are 10-year bonds — I would put the two Europe risk as significant. The Lisbon Treaty, which Britain will ratify without the government daring to have the promised referendum, will raise the two Europe risk, rather than reduce it.

Regards,
Lord William Rees-Mogg
April 7, 2008

European Bond Spreads was originally featured on Whiskey and Gunpowder

“Those who oppose reform may get revolution.”

— John F. Kennedy, speaking of Latin America in 1962

THE EURO HIT FRESH ALL-TIME HIGHS VERSUS THE DOLLAR already this month — and we’re only one trading week in.

So might U.S. investors want to switch out of gold bullion ahead of Easter this year and move into the single currency, instead?

After all, the euro still pays 4.0% interest per year — a feat that dumb gold could never promise or achieve — and with eurozone inflation holding at a record 3.2% year on year in February, the European Central Bank (ECB) is clearly in no mood to start slashing rates now.

“Inflation will not slow as markedly as supposed,” warned the ECB’s Axel Weber last week. Colleague Juergen Stark added that he was “highly dissatisfied” with the current surge in the cost of living.

Tight money to come, right? Well, the gold market doesn’t buy it. Not at $1.52 to the dollar — with European manufacturing squeaking and Mediterranean house prices slipping:

The gold price for French, German, and Italian savers just keeps on rising, gaining for six of the last seven months.

Yet luxury carmaker BMW says it can’t bear a further “sustained rise” in the euro above $1.50 to the dollar. Last week, it cut 5,600 jobs.

Dassault Aviation in France says it can’t compete at this kind of exchange rate, either. “The natural step is to shift to the dollar zone [including most of Asia, remember] or low-cost areas as they have done in the car industry,” said CEO and Chairman Charles Edelstenne to Le Monde last week.

“This could include parts of our factory plant and some research tasks.”

Put another way, Europe has got the worst of both worlds right now — a high-value currency that’s crimping exports, and surging inflation at the very same time. So the European Central Bank needs to talk tough while doing nothing, hoping the inflationary and currency pressures don’t squash the economy both at once.

Good thing the old economies retain such political importance, as well. Right?

“To have an increase in the [voting] quotas of emerging countries — China, India, Brazil — is very difficult because the sum has to add up to 100%,” noted Dominique Strauss-Kahn, head of the International Monetary Fund in late February, “so some others must lose.

“The ones who are going to lose are mainly the European countries, and that is the reason why they may be reluctant [to vote for change].”

The debate goes far beyond the IMF, however, that brave remnant of postwar global planning. All top-level political groupings now face the problem of too many powers, with too much at stake, all wanting to be members of the top few spots in the oh-so-crucial club.

The G-7 group of industrialized nations, for instance, currently invites three eurozone nations to the party — Germany, France, and Italy — as well as Canada, Japan, and the United States.

The United Kingdom gets to tag along too, not least because it’s still vying with China for the No. 4 slot in world GDP, behind the U.S., Japan, and Germany. It also prints the world’s No. 3 reserve currency, the British pound. And my, but how it prints it!

Growing by 12.9% in January from a year earlier, the broad supply of pounds sterling has now been expanding at a two-decade record since March 2005.

No wonder the gold price in British pounds is surging alongside the U.K.’s trade and government deficits. But “When are we gonna get the real players, with the money, in the middle of these [G-7] debates?” asks Jack Welch, former head of General Electric. He was talking to Larry Summers, U.S. Treasury secretary at the tail end of the last Clinton presidency, on CNBC last week.

“It seems like some of our government institutions are living the last war — for example, the G-7. Four European economies, Canada, Japan, and you guys [the U.S. Treasury], all meet…but the money’s somewhere else.”

“Oh, you know how these things go, Jack,” replied Summers, former president of Harvard University and now a part-time hedge fund consultant in New York. “It’s much easier to get people in than it is to get other people out…

“You want to have a reasonably small group. We worked with the Canadians to set up the G-20 for exactly the reasons you give. And I think [U.S. Treasury] Secretary Paulson is to be commended for the effort he has put into having a regular financial dialogue with China on a bilateral basis.

“I think you’re going to see this kind of evolution. Look, if we want to address this issue of sovereign wealth funds — which I think is a concern, though it’s a concern that has to be kept in perspective — the way we’re going to do it is by having dialogue with the countries that, just as you say, have the money. Some of them are China, some of them are in the Middle East, and I think we do need to recognize more than we probably have before that the distribution of financial power and influence and capacity is pretty different from the distribution of the sort of political congeniality with U.S. interests across the board.

“That means we may need to have a somewhat different grouping for the foreign ministers and the finance ministers.”

Can political and financial power really be split into two different groups…with the United States at the head of both, choosing its allies here, but inviting a different clique of friends there?

Perhaps with Europe gnashing its teeth about the high euro, it’s actually time for the dollar itself to bounce, rallying from new all-time record lows on its trade-weighted index and forcing U.S. gold prices lower.

Sure — it might require higher interest rates from the Federal Reserve, rather than the campaign of monetary destruction begun by Ben Bernanke back in August. Or conversely, those new record lows in the world value of the U.S. dollar might help stoke U.S. export sales so fast that they revive the major Wall Street stock indexes and erase the last five months of losses.

No?

Should the dollar and Wall Street’s collapse continue, meanwhile, some kind of new monetary world order will only continue to look ever more likely. Russia is preparing to price and sell crude oil in rubles, for example, rather than dollars. The ruble might also be used as one means of payment on a forthcoming Iranian oil exchange in Tehran, according to Iran’s ambassador to Moscow last month.

But whatever comes, and no matter what happens to the price of gold, don’t expect the chocolate bunnies of today’s monetary order to vote for either Easter or a heat wave…let alone both at the same time.

Regards,
Adrian Ash
BullionVault
March 7, 2008

The Dollar’s Continued Fall was originally featured on Whiskey and Gunpowder

“The U.S. recession is sure to send inflation to zero — just as it didn’t in four of the last five recessions.”

WORRIED ABOUT INFLATION? Oh, stop your carping and set an extra place at dinner for the fast-looming recession instead.

See, your cost of living can’t possibly keep rising now that Europe and the United States are plunging into a credit-led slowdown. Inflation is dead, killed by the slump. The value of money is going to stop sliding, even as interest rates fall.

Says who? Says just about everyone.

“A U.S. recession is now an even bet as job losses and the housing contraction jeopardize the longest-ever expansion in consumer spending,” says Bloomberg, reporting its latest survey of professional number crunchers.

“The world’s largest economy will grow at a 0.5% annual rate from January-March, capping the weakest six months since the last economic slump in 2001, according to the median estimate of 62 economists polled from Jan. 30-Feb. 7.”

And your cost of living can NEVER go up during a recession, right?

Oh, sure, inflation in U.S. consumer prices accelerated by one-half during the recession of 1973-75. It then hit an all-time peak during the short recession of 1980.

Inflation went on to beat its previous 30-year average during every month of the 1981-82 recession. (Don’t misread that “fall” from 10% to 5% year on year; the dollar’s buying power still shrank by almost one-tenth inside 16 months.) And the cost of living then spiked higher again when recession next struck, in 1991.

But this time, well…this time it’s just going to be different, OK? Think 2001, rather than the four previous U.S. recessions. And not just in the United States, either.

“The eurozone economy is now clearly slowing down,” says Michael Hennigan, founder and editor of Finfacts, the leading financial news site in Ireland. “Oil prices are also off their peak, [so] combined, these factors should act to dampen inflationary pressures in the economy. In particular, it should help prevent excessive wage increases that could endanger price stability.”

Here in the United Kingdom — the world’s fourth or fifth largest economy, depending on how you count China’s boom — growth just slid to 0.5% in the three months ending January, says the National Institute of Economic and Social Research. And that slowdown, the worst rate of growth since 2005, gives the Bank of England “room for further cautious reductions in interest rates,” reckons Martin Weale, the NIESR’s director in London.

“I don’t see the risk of inflation being a constraint.”

Back across the Atlantic, “The economy is rapidly slowing on all fronts, Wal-Mart [is] slashing prices again, and rising unemployment and delinquencies are going to further restrict bank lending,” says Mike Shedlock in his Global Economic Trend Analysis blog.

Hands down, inflation — properly defined as an increase in the money supply — continues to rise. Growth in the M2 measure “is running at almost a 6% year on year,” admits David Rosenberg at Merrill Lynch. But “Of course it is,” he then spits.

“Most of [this new money] is situated in nontransaction savings accounts, and these are up almost 8% from a year ago. So transaction balances are falling and precautionary balances are rising — what does that tell you about consumer spending and saving behavior?

“This is all, from our lens, very deflationary. Not the other way around.”

Big picture, even the euro-crats of the European Central Bank agree: Slower growth will result in lower inflation — even if the ECB did sit on the eurozone’s 4% interest rates once more on Thursday. Pressured to repeat the magic words “vigilant on inflation” at the press conference that followed, Jean-Claude Trichet managed instead to send the euro plunging to a near three-week low by hinting at cheaper money to come.

“Some of the menace behind [his] anti-inflation comments in previous months seems to have been softened,” as David Brown at Bear Stearns noted to Thomson Finance, “and there appears to be greater stress on the downside risks to growth.”

Put another way, lower growth — if not recession — will take the heat of prices. Because lower growth means falling demand. And only rising demand can ever push prices higher. Or so everyone says. Which is odd, given the facts.

“Few empirical regularities in economics are so well documented as the comovement of money [supply] and inflation,” as Mervyn King, now governor at the Bank of England in London, said in a late 2001 speech.

And the world’s supply of money is surging right now, even as “deflation” hits U.S. housing and stocks:

“Over the 30 year horizon 1968-98,” King went on back in 2001, “the correlation coefficient between the growth rates of both narrow and broad money, on the one hand, and inflation, on the other, was 0.99.”

Narrow money means cash in circulation, but as King said, the relationship with cost-price inflation holds just the same for “broad money” (shown above) — meaning all notes and coins; cash on deposit; and short-term bills, notes and bonds.

0.99 is as near perfect as you’ll find in any pair of data. An absolute 1.00 only ever exists for the very same thing measured against itself — say, the cost of living mapped onto the cost of living, or gold prices correlated with gold prices, for example.

Yet if we now race back to the present, and reappoint Mervyn King for his second term running U.K. monetary policy, “The disruption to global financial markets has continued,” explained the Bank of England — with King at the helm — when it cut U.K. rates on Thursday.

“Credit conditions for households and businesses are tightening,” the BoE explained. “Consumer spending growth appears to have eased…Output growth has moderated to around its historical average rate, and business surveys suggest that further slowing is in prospect.”

In sum, “These developments pose downside risks to the outlook for inflation.”

Phew! And to think that five- and 10-year bond yields had finally shot higher just before the credit crunch bit in summer 2007 because inflation — whether in prices or the money supply — had finally became the No.1 worry for fixed-income investors.

“Underscoring inflation concerns, the benchmark 10-year U.S. Treasury note last week had its biggest decline in price in more than two years, as investors abandoned projections the Fed would need to lower rates by year-end to stimulate growth,” reported Bloomberg on June 11.

“Mounting concerns about U.S. inflation levels have sent short-term bond yields in Australia to their highest level since mid-2002,” said The Australian Financial Review on June 20.

“The global economy in 2007 is still expected to register close to 5% growth for the fourth year in a row,” added Fidelity Investments on July 20. “In response to this rapid growth, central banks around the world have continued to tighten their monetary policies, with the eurozone, United Kingdom, Japan, China, and India all raising short-term rates.”

You might wonder whether that sudden surge in bond yields sparked the banking crisis of August. But either way, here in Feb. ‘08, “Persistent fears over a possible U.S.-led global slowdown [have] fueled further profit taking in crude oil,” as one London analyst told Agence France-Presse at the start of this week.

And here starts the chain of logic linking the housing slump to falling inflation and bypassing the impact of monetary inflation altogether.

“Between January 2003-January 2008 alone,” as the Financial Times quotes Goldman Sachs, “the world price of metals rose by 180% and of energy by 170%…in good part because of China’s demand.” That demand in turn came thanks to America’s credit-led bubble in consumer spending, but now the U.S. consumer’s tapped out — and his house keys are back with the lender.

So China can’t grow, because the U.S. can’t shop. Therefore, oil prices and base metals will sink and inflation worldwide will now vanish.

Who knows? Things might just pan out that way. But ignoring the flood of money — first created as credit and now stacked up in Treasury bonds across the emerging economies — would mean ignoring the connection between growth in the money supply and inflation in prices.

• The People’s Bank of China is rumored to want money supply growth of 15% per year, down from the current 18% plus
• India’s broad M3 money supply is rising 22.4% per year
• Singapore’s money supply increased by 14% in 2007
• Britain’s broad M4 measure of money has expanded by 12.3% since Jan. ‘07
• Western Europe is “enjoying” monetary inflation of 11.5% per year, three times the central bank’s target
• Last year saw 16% money supply growth in Australia, 13% in Canada and 22% in Saudi Arabia
• The U.S. money supply — if the Fed still reported M3 — is now guesstimated to be showing 15% annual expansion.

Remember, that near-perfect connection between money supply growth and consumer-price inflation is one of the few clearly established facts in economics. Over a 30-year horizon, they match each other almost exactly. Which is to say they won’t necessarily move together this week or next.

Similarly, the last time runaway inflation hit, the cost of living for Western consumers raced ahead AFTER raw commodity prices had begun to slow down:

During the inflationary ‘70s, the price of commodities — as measured by the Reuters/CRB continuous index — peaked out in November 1980. For the next 21 years, it was then downhill all the way.

Adjusted for inflation, however, the price of raw materials had, in fact, been falling since February 1974. That was when the rate of U.S. consumer-price inflation overtook growth in the CRB index, surging on the previous commodity price hikes and feeding into service prices and wage demands. Inflation in the cost of living finally peaked out in April 1980, hitting an all-time record high of 14.7% year on year.

How did consumer-price inflation keep soaring for more than five years after commodity-price inflation began slowing? No doubt things really are different today, starting with the fact that the current bull market in commodity prices — beginning in 2002 — represents the only real secular bull run for raw materials since the Reuters/CRB index began in 1956.

The 1973 doubling of commodity prices came thanks to the first OPEC oil shock. Might the Federal Reserve be taking things a little too coolly — not least with the value of dollars — by saying it “expects inflation to moderate in coming quarters” as it cuts the returns paid to dollar holders?

“The OPEC [oil cartel] would trim output if oil prices slip to $80 per barrel,” according to a Bloomberg report. It cites one unnamed OPEC delegate for the price target; two other members told the newswire that $70 would be “unacceptable.”

Says Johannes Benigni of JBC Energy in Vienna, “It wasn’t OPEC’s fault it moved above $80, but now it’s there, they justify keeping it.”

And then there’s the pile of dollars stashed away by the central bank in Beijing…up from $156 billion at the start of 2000 to more than $1.5 trillion at last count. If the sorry demise of the U.S. consumer really does dent the buying power of China, might the Chinese government not step in — and bid for crude oil, copper, soybeans and grain — to keep the fastest growing economy growing just as fast as it can?

Conjecture and guesswork are no substitutes for an answer, of course. And for as long as gold prices keep screaming that somewhere something is amiss between inflation and bond yields, that dumb lump of metal might just keep finding a bid.

Gold has now risen in 18 of the last 24 weeks. On Friday alone, it hit new record highs against both pounds sterling and euros.

Still, nothing to worry about. The U.S. recession is sure to send inflation to zero — just as it didn’t in four of the last five recessions.

Regards,
Adrian Ash
BullionVault
February 13, 2008

Inflation During Recession was originally featured on Whiskey and Gunpowder

“Living in a credit era, we cannot go back to a currency era without massive upheavals.”

— Robert L. Smitley, Popular Financial Delusions (1933)

WHY DON’T WE JUST DO AWAY WITH all the different currencies of the world and settle on one single money to buy, sell, invest and light our cigars with?

Because as it is, the Babel we live in — where 143 different kinds of currency either change hands or act as a way of measuring prices around the globe — keeps finding itself in no end of trouble.

“The rupee rose on [Feb. 1],” reports Livemint, The Wall Street Journal’s Mumbai offering, “as investors bought the Indian unit for its higher yields after a hefty interest rate cut by the U.S. Federal Reserve.

“But concerns weighed that the Indian central bank would intervene against the local unit, as it is widely suspected of doing in recent months.”

“There was some suspected intervention against the Singapore dollar at 1.427,” a currency trader in the tiny Asian state told Reuters in January, “so I guess players are wary.” Across the Pacific, meanwhile, the Argentine peso has lost more than 10% of its value against the U.S. dollar over the last four years thanks to “continued central bank intervention,” says the newswire elsewhere.

And as the world’s stock markets tumbled last month, the central banks of the Philippines, Malaysia and Turkey are also rumored to have stepped into the open market, dumping their own currencies and buying the U.S. dollar in a bid to support it and thus keep their export economies cheap for foreign customers.

Put another way, as Benn Steil of the Council on Foreign Relations said at a recent meeting (or so The Washington Post reports), “The United States is exporting inflation worldwide” by forcing these sovereign nations to print up mountains of their own currency with which to buy the ailing greenback.

Countries like China and the Middle Eastern petro-kingdoms peg their currencies to the dollar — the world’s No.1 reserve currency, and still top dog after all these years. So they “thus [peg themselves] to U.S. monetary policy” too.

And U.S. monetary policy, quite clearly, is inflationary right now. That makes monetary policy inflationary everywhere from Abu Dhabi to Beijing. Even those of us lucky enough to sit outside the “dollar zone” can expect rates to slide in tandem.

Slashing almost a third off the cost of borrowing dollars inside eight days — and then offering to lend U.S. banks $60 billion in 28-day loans every two weeks — makes for quite the game of “follow the leader,” don’t you think?

Ah, but over in the dozy spires of pan-global political daydreams, abolishing sovereign currencies and anointing one single money in their place would smooth the wheels of commerce and boost world GDP overnight. Apparently.

“Annual transaction costs of $400 billion [would] be eliminated,” reckons Morrison Bonpasse, editor of The Single Global Currency (2007 edition), published by Munich University. “Global currency imbalances will [also] be eliminated,” he adds, along with “all balance of payments problems…currency crises…currency speculation…and the need for foreign exchange reserves (with a current annual opportunity cost of approximately $470 billion).”

Indeed, “Worldwide interest rates will be lower than the current average due to the elimination of currency risk” — and you’ve just got to love cheaper money!

So what’s not to like? “National currencies and global markets simply do not mix,” wrote Benn Steil in the policy wonk’s favorite glossy, Foreign Affairs, last May.

“Together, they make a deadly brew of currency crises and geopolitical tension and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of today’s instability.”

Instability being a bad thing — the kind of thing that knocks the S&P lower by 7% inside one month, for instance — it should be abolished, right? The beautiful stability of Western Europe’s economies just goes to show how remarkable a single currency could prove:

“Spanish and Italian manufacturers are clearly struggling in the head winds of weaker global growth, the strong euro, high oil prices and eroding demand in domestic markets,” said Jacques Cailloux, economist at the Royal Bank of Scotland in London, to Dow Jones Newswires Feb. 1 after the eurozone’s Purchasing Managers’ Index for January showed a slight rise overall.

“Against this, French and German manufacturers continue to do well, at least for the time being, but German producers have failed to fully make up the pace lost last autumn.”

Why the disparity? According to most Spanish, Italian, Portuguese and Greek politicians, the cost of borrowing euros is too high. According to the latest inflation data for the 14-nation currency zone, however, it’s still way too low.

“Annual inflation in the eurozone jumped to a new high of 3.2% in January, the European Union’s statistics bureau Eurostat estimated on Friday,” reports the China Daily.

“The figure, including new eurozone members Malta and Cyprus for the first time, was the highest since the single currency was introduced to world markets as an accounting currency in 1999. It rose from 3.1% in the previous two months and stayed well above the 2% ceiling preferred by the European Central Bank (ECB) for the fifth consecutive month.”

Spain’s minister of finance, Pedro Solbes, said Jan. 24 that “there’s significant debate” inside the European Central Bank about whether or not to cut interest rates as the global slowdown looms over Europe. But then again, he faces re-election in March — and no one seemed to mind too much about interest rates being too low during the Spanish real estate bubble that began bursting last year.

Property prices nearly tripled in Spain between 1997-2007, thanks to a wave of British expats in search of a perma-tan and the sudden collapse in borrowing costs that preceded the birth of the euro in 1999. Mortgage rates went from 11% in 1995 to below 6% and then 5% as the single currency delivered the hope of German-style monetary policy and interest rates.

Across the sea in Ireland, house prices trebled in just seven short years after the introduction of the euro. But not even a peak of just 4% in the eurozone’s cost of money could keep the bubble inflating forever.

Now “Spanish banks are issuing mortgage securities and asset-backed bonds on a massive scale to park at the European Central Bank,” reports the London Telegraph, “using them as collateral to raise money at favorable rates from the official credit window in Frankfurt.

“The rating agency Moody’s said lenders had issued a record €53 billion [$78 billion] of mortgage- and asset-backed bonds in the fourth quarter of 2007, yet almost none of the securities have actually been placed on the open market. Most have been sent directly to the ECB for use in ‘repo’ operations.”

So for all its tough talk on inflation, the European Central Bank is still feeding the growth of credit and money supplies in Europe. Any wonder the broad M3 money supply is swelling at a three-decade record rate? Any surprise that consumer price inflation is surging beyond the ECB’s grasp?

And does anyone really imagine this isn’t a problem?

“Living in a credit era,” wrote Robert L. Smitley in his 1933 classic, Popular Financial Delusions, “we cannot go back to a currency era without massive upheavals. The cause of the great boom was credit expansion to an abnormal degree — the same cause as that for all booms under a credit system.”

The world’s central bankers know this all too well. Few of them, if any, believe a return to “cash only” possible, let alone desirable. So if the world’s consumers and investors choose to shut down the credit markets — both as borrowers and lenders — and pile into cash instead, then the world’s central banks will just have to destroy cash in the hope of forcing a flight back into credit.

How else would you characterize a cut of 125 basis points in the rewards paid on dollars inside eight days?

The panic starting last August — a panic that closed the West’s mortgage markets almost entirely — can be beaten by central banks buying mortgage-backed bonds themselves if need be. The stock market panic of January — a panic that knocked almost one-tenth off the value of equities worldwide — can be reversed by historic cuts to interest rates and a fresh flood of short-term loans to the banks.

Or so the central banks think. But the panic they’re then causing as a direct result — a panic revealed by the surging gold price since August — might prove worse than the flight into cash that they’re fighting:

A complete loss of faith in all official currency.

Might that lead to the one single money that daydreaming economists think can cure the world’s evils? Whatever comes when the dust settles, you can be sure the world won’t turn to using gold coins again.

Yes, Ben Bernanke’s depression theories might be disputed — and yes, his current credit inflation panic looks absurd. But history would seem to make clear that during the 1930s deflation those nations that abandoned the gold standard soonest turned the corner the fastest and began to recover.

The “barbarous relic” of tying the supply of money to a real quantity of gold bullion can’t make a comeback for as long as “deflation” and “depression” are still blamed on gold hoarders.

But that doesn’t mean you can’t hoard a little real wealth in the meantime. You might want to consider it if you’re losing your faith in government money.

Regards,
Adrian Ash
BullionVault
February 5, 2008

The Global Effect of the U.S. Dollar was originally featured on Whiskey and Gunpowder