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Tuesday, July 01, 2008


abating inflationary pressures

last week it was edwards and montier -- this week john mauldin offers research from gavekal making similar points. credit destruction is afoot and running, with deflationary implications that are being hidden by a speculative spurt in oil prices.

So we are now in a situation where a) The Fed is not printing money and b) US financials are de-leveraging rapidly. Thus, if inflation is "always and everywhere a monetary phenomenon", one may conclude that what we are now seeing in the inflation numbers is the echo of the 2003-2007 credit boom, but that looking ahead, the inflation picture should start improving rather dramatically.

there is, however, a caveat:

But such a conclusion would miss out on the other big contributor to global liquidity growth, namely the US current account deficit.

what follows is a nuanced and important perspective on the united states current account deficit as the transmission of monetary policy from the fed to the world that uses the dollar as the reserve currency of international transaction.

Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway...

This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off.

So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa.

Now today, the US current account deficit still stands at a rather large 6% of GDP. However, the composition of this deficit has changed dramatically: two years ago, around two-thirds of the US deficit went to non-oil producers and one third was for petroleum products. Today, that situation is inversed to the point where one could argue that, while the US is still reflating oil producing countries (which hardly need it), it is now deflating non-oil producing countries by around 2% of GDP. Moreover, should oil prices start pulling back, we would move extremely rapidly into a situation where the US current account deficit was deflating the whole world ...!

The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies. Indeed, over the past few years, the prevalent belief amongst investors of all stripes has been: a) the US runs a large current account deficit, b) that US interest rates are low, and that, consequently c) the value of the US$ could only fall. And if the value of the US$ could only fall, then borrowing in US$ to finance whatever real estate project, factory, or financial market speculation made perfect sense. This is why, in a number of countries, we started to witness a growth in central bank reserves which far outpaced trade surpluses and foreign direct investment inflows; all of a sudden, a number of large countries started to save more than they earned!

But how can one save more than one earns? ... one borrows the difference. ... why borrow in local currency to finance one's capital expenditures or investments? Much better to finance any spending in the ever falling, and cheap to borrow, US$!

So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices:

  1. It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.
  2. It can print money to prevent its currency from rising and then sterilize its FX intervention.
  3. It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices).

And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats.

We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US.

as that has been, what is to happen? in short, the trade deficit will (because of its changed composition, in part due to the revaluation of the yuan) close sharply on a decline in oil prices. that would have a very significant liquidity impact and curtail inflationary pressures around the world -- pressures which have been masking the effects of financial system deleveraging and wholesale credit destruction.

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hi gm, good one. though it will take me a while to digest. (never said i was the sharpest knife in the drawer, eh?) it's humbling to learn how much i don't know.

here's another doozy back at you:


paragraph 13 is my personal highlight - - GDGB (G** D*** George Bush).



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Thanks for the John Mauldin link especially -- I've been thinking for a while that a sharp reversal in oil prices could have some big and likely under-anticipated consequences, particularly with respect to the current account deficit and currencies, and this covers some of that in more detail.

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