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Wednesday, July 16, 2008


another step toward 1931?

headline inflation surged in june, per bloomberg.

``Inflation has galloped,'' Michael Feroli, an economist at JPMorgan Chase & Co. in New York, said before the report. ``It puts the Fed in a really tricky position. I don't see how they can change rates this year.''

Consumer prices were forecast to rise 0.7 percent, according to the median forecast of 79 economists in a Bloomberg News survey. Estimates ranged from gains of 0.2 percent to 1.1 percent. Costs excluding food and energy were forecast to rise 0.2 percent, the survey showed.

Prices increased 5 percent in the 12 months to June, the most since May 1991. They were forecast to climb 4.5 percent from a year earlier, according to the survey median.

... Wholesale prices rose 1.8 percent in June, the most in seven months, the Labor Department reported yesterday. From a year ago, prices climbed 9.2 percent, the biggest surge since 1981.

it is essential to note that these effects are largely a product of commodity price increases -- and they are decidedly not inflation per se, that is the expansion of the supply of money. northern trust's paul kasriel demonstrates that bank credit is crashing as it hasn't since the depression. costs are not passing through to consumers as measured by core rates, and that is exemplified best by kasriel's chart 20. profit margins in american business are being annihiliated by the inversion of input costs and output revenues -- fewer and fewer are making any money -- just as their ability to finance themselves through a bad spell has totally evaporated.

when such a condition arrives in the aftermath of a debt boom, the consequences are bankrupting. when it arrives in the aftermath of the greatest debt boom in the history of this nation, the consequences are potentially catastrophic. corporate bankruptcies have only just begun. only the cash-rich weather this kind of thing well.

consider this in light of the banks, who have thusfar largely suffered as a result of loan malperformance in the residential and residential construction space -- and this has been enough for some. only recently have they begun to see deterioration in credit cards and auto loans. now plaster these same institutions with expanding corporate failures and defaults.

many nonfinancial companies, it has been noted, have been drawing down credit facilities in recent months in an effort to stockpile cash. this created a burst of m3 expansion that many casual observers confused for federal reserve printing, as those drawn funds found their way into broad money market aggregates. but the net effect has been to further weaken the credit position of the banks. should such debt-heavy corporations as drew down those lines in anticipation of their cancellation start to fail, creating yet another wave of losses for american finance, the ramifications will be felt internationally.

the federal reserve under ben bernanke is now stuck with respect to interest rates. deeply negative real rates -- the difference between trailing headline CPI and fed funds is over (-3%) -- have proven completely ineffective in generating credit expansion because banks are capitally incapacitated and becoming moreso as housing falls further into the post-securitization abyss. what they have likely facilitated, however, is a massive binge of speculation and runaway inflation and hoarding in dollar-peg economies in the third world. both are contributing to the massive rise in raw material input costs. low policy rates are not helping american business -- they are now destroying it.

what low policy rates are also doing, however, is minimizing the cost of funding for american banks and keeping them minimally liquid via positive carry -- that is, the fed is playing directly to its banking constituency, at the expense of american manufacturing and services industries. if they reverse course, it would likely be a 1931 moment in the face of now-collapsing money supply.

damned if they do, damned if they don't.

the federal reserve has been concentrating on the 'full employment' aspect of its mandate -- but if the oil bubble does not break proximately, i don't know what alternative the fed will have but to follow the ECB and hike rates to quash speculation and kill third world demand for the sake of 'price stability'. certainly raising margin requirements in commodities markets would be welcome. moreover, any thoughts about guaranteeing the debt instruments of fannie mae and freddie mac must be backburnered -- as accrued interest noted, united states treasury debt sold off on credit quality concerns for the first time since the 1970s. did anyone even know that one could buy a credit default swap on the united states before the FNM/FRE bailout talk started? the price of one has suddenly risen elevenfold. merrill lynch can credibly talk about the government of the united states facing a "financing crisis within months".

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors.

"Japan was able to cut its interest rates to zero," said Alex Patelis, Merrill's head of international economics.

"It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies."

they're absolutely right to point out that not only is this as bad as previous financial crises, but that it might be worse than the most notorious one of the last thirty years because of foreign financing dependence. (UPDATE: and, as a corollary, a near-zero consumer savings rate.) the dollar has been conveniently neglected for a long time, but its turn has come to be protected on some level.

that said, i think the oil bubble is breaking as margined speculators are feeling the credit pinch and fearing anything like a significant fall. that would probably allow the fed to stay on a neutral course with policy rates. one has merely to hope that george w. bush doesn't attempt to remove all doubt that he is the least competent executive in the history of the united states. this is a very important caveat, as -- following up on months of preparing the battlefield -- the idiot-in-chief is apparently 'amber-lighting' plans for the american-mideastern proxy state to instigate what may well end up being a regional war. short oil stocks -- but keep a stop-loss order in the system beneath them.

even with amenable oil, however, there are other, more inexorable forces afoot in the currency sphere. per michael pettis, pressure is increasing in china for the appreciation of the yuan to accelerate. this would have the great intermediate-term benefit of moderating chinese inflation and cutting speculative inflows to the country, even though the transition could be disruptive. it is also the long term policy goal of the chinese government as they move to a free floating currency from a dollar peg, which will likely allow the yuan to become the de facto reserve currency of the far east (with all the implied benefits). as demonstrated by private research i've had the pleasure of reading, many highlight the potential cost to china -- particularly forex losses on its massive dollar-debt holdings -- but ignore the manifold benefits. a stronger yuan would reduce the cost of oil for china in local terms, and this benefit alone given the rate of oil consumption in china would all but offset all the forex losses. its export sector would be hampered on the lowest end, but china is already in the process of moving its manufacturing capacity up the scale of finished goods into more complicated products (such as cars and semiconductors) where there are simply no viable competitors in the world on quantity and price. the net cost to china of revaluation is widely overestimated in the united states -- largely out of wishful thinking, i suspect.

again, the hope is that a fall in oil prices thanks to demand destruction and clipped speculation would forestall the pressure to appreciate the yuan, at least out beyond the six months that merrill is speculating above. but for the united states, increasingly rapid yuan revaluation would almost certainly mean the end of the debt supercycle and vendor finance -- and would shift the current credit contraction into a much higher gear, as it would effectively remove from the field the primary creditor of both the american government and the GSEs. the kind of collapse that would come in america following a sudden yuan appreciation would be a life-changing event for all americans. it is going to happen in the not-so-distant future -- but i think we should universally hope that it doesn't this year or next.

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hi gm, great post. i've always said china would not pull any plugs before the olympics. i think they will be quick about it afterwards though. hope i'm wrong.

love your comments on bush - please check out my simple blog. (see my short sections "about the blog" and "about me.") i'd be honored. also, got your blog listed as one of my faves. thanks and best regards - - darkcloud

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