Friday, May 19, 2006

5/19 Financial Markets' Increased Downside Volatility a Small Dress Rehearsal? "Blame Game” Not Working

"The run on the dollar is largely being ignored by Washington and Wall Street"--WSJ Op-ed, 5/18

May 19--Yesterday's WSJ has an op-ed titled “In Gold We Trust” by two principals of H.C. Wainwright. Some of its points are similar to those made in my recent previous two posts on “The Silent Dollar Crash” link and “Dollar Weakness Getting Too Big to Ignore” link.

Quoting from this WSJ op-ed: “What we are facing is a money crisis: an alarming outbreak of inflation and all its consequences. It's silly to blame the rise in commodity prices on foreigners. … The real culprit is the precipitous decline in the world's mightiest currency, the dollar, which has lost more than 60% of its gold value in just four years … When the dollar price of gold is on the rise, the dollar prices of oil and other commodities have historically kept pace … [gold's sharp rise] represents an equally sharp decline in the confidence of investors in the likelihood that Washington will pay back its mounting obligations in undepreciated money … Gold is the barometer of public confidence in fiat money, and it is difficult to rebuild confidence in a currency once it has been allowed to slide … The dollar's collapse is nothing less than a body blow to capitalism.”

I will deal with the very provocative last line of the above quote in the last section of this article. Since the WSJ is the journalist bastion of so-called "free market" capitalism, this op-ed might help make it possible to discuss the dollar without being dismissed as too alarmist, cynical, etc. It should be noted that the WSJ editorial board has had a pro-gold bias since the Reagan era of Robert Bartley and Jude Wanniski, both deceased. My own biases and interests are indicated by my blog's name and long tagline link.

Not Just Oil, Real Estate Perhaps Best Indicator of Dollar's Loss of Purchasing Power

My favorite example regarding the loss of purchasing power of the dollar is not the price of oil discussed in this WSJ op-ed, but rather that of real estate. A $700,000 fifty-year old ranch on a slab foundation on a postage-stamp lot on a treeless, sun-baked street on a fault line in Silicon Valley, which has lost about 20% of its jobs this decade, says less about its actual value and more about the value of the dollar, with it taking twice as many inflated dollars to buy real estate, which most view as a store of value and ATM, from a relatively short time ago.

In what seems like a classic case of closing the barn door after all the horses have run out, yesterday Fed head Bernanke "said lenders needed to be careful when providing "non-traditional" mortgages such as interest-only loans and option adjustable-rate mortgages, which accounted for 30-40 per cent of approvals last year. He said the Fed expected to release guidelines for non-traditional mortgage lending in due course. This guidance could result in a tightening of bank lending procedures that would further cool the housing market. "We do have some concerns about the non-traditional mortgage lending."" link

"The New Fed Chairman Faces the Same Old Dilemma" -- Bloomberg, 5/18

The issues raised by the WSJ op-ed above are long-term in nature. Due to the length of this post, I can not treat in detail here the very real and very legitimate current concerns of investors re various financial markets, inflation, interest rates, leading indicators, consumer confidence, real estate, emerging markets, etc. With increased uncertainty about the Fed's next move and currency rates, it is difficult sorting out recent volatility in various financial markets, which are sometimes contradicting each other lately.

The FT's Philip Coggan market comment today (May 19) on the recent turmoil in financial markets downplays an inflation scare and lack of confidence in Bernanke, saying that "it seems more likely that the primary driver is risk aversion. Emerging market currencies, small cap stocks and commodities have taken the biggest hits.. Furthermore, volatility seems to beget volatility."

Regarding the recent economic data, for now I will refer readers to veteran journalist Caroline Baum's yesterday's (May 18) Bloomberg column, "The New Fed Chairman Faces the Same Old Dilemma" link. I.e. "what to do in the face of slowing growth and rising inflation. The economic indicators released this week pretty much encapsulate Bernanke's dilemma. Housing is falling fast, and core inflation is accelerating."

My guess on the stock market outlook on March 24 link said: “Although most investors wouldn't know it just looking at the major U.S. stock market averages, overall financial market euphoria is at one of the highest levels in the past twenty years, best indicated by extremely low credit spreads across the board (similar to stratospheric p/e's during the massive TMT equity bubble in the late 1990s). It perhaps wouldn't take too much to start the mass psychology pendulum downward in the other direction (unless the pendulum flies right off in another huge speculative blow-off, as occurred at the end of 1999 and early 2000). If normal seasonal and four-year presidential cycles still hold, then the U.S. stock market may top out in the next month or so, then decline, perhaps much more sharply then many might currently expect, into an October low. Whether a strong rally ensues from that low, as usually occurs to a high next year, would depend on the larger secular bear vs. bull debate.”

For the moment, late April has been a stock market short-term top. Hopefully I will have something to say on emerging markets in a post soon. I won't take up in my blog whether gold has seen an "island reversal" and commodity trading issues, sorry.

Could This Time be More Difficult for Dollar Then Early 1970s?

On May 10, Martin Wolf, the FT's well-regarded chief economics columnist, wrote: "the chances of a row even worse than the one accompanying the end of the Bretton Woods exchange-rate system in the early 1970s grow ever bigger."

According to a May 14 article in the "Guardian" titled "IMF acts to avoid markets meltdown" link, "the International Monetary Fund is in behind-the-scenes talks with the US, China and other major powers to arrange a series of top-level meetings about tackling imbalances in the global economy, as the dollar sell-off reverberates through financial markets. Amid tumultuous trading, which sent the dollar to its lowest level in a year against the euro in late trading on Friday and gave the FTSE its worst day for three years, the IMF was working privately to exercise its new powers to bring decision-makers together."

During the huge dollar crisis of the late 1960’s and early 1970s, another Texan, then Secretary of Treasury Connally, infamously said, “It may be our currency, but it’s their problem,” “they” being the Europeans at the time.

I don’t think that type of “benign neglect” (to be charitable) of the dollar is going to work very well this time around, should a full-scale monetary crisis develop again, in part because the potential financial/monetary problems are far worse after decades of hyper-speculative bingeing, in part because the global economy is now so much larger and key nations, such as China, Russia, India, Brazil (the BRIC), Saudi Arabia, S. Korea, Nigeria, Mexico, and others must be included in the solutions.

Currency "Blame Game" is Not Working

In a May 9 article titled “Global Game of Musical Chairs May End Badly,” Bloomberg columnist William Pesek Jr. (see link for this and his other recent columns) wrote:

“The tensions are over global imbalances. The rift is an old one, but like any disagreement that's allowed to fester below the surface, the risks it will become a huge problem are growing … As is often the case, the latest East-West flashpoint is currencies … All this is code for ``the world's economic imbalances aren't my fault, but yours.'' … the blame game that's become a common feature of the global economy is entering a new and more dangerous phase. What's even more worrisome is that there's no adult in the room in which this game is playing out. The G-7 can't act as referee because its members are part of the problem.”

The G-7 recently has passed the global economic imbalances hot potato to the IMF, which Pesek believes can’t handle it (although he omits that Asians don’t trust the IMF after the so-called “Asian,” what they sometimes call the “IMF,” financial crisis of 1997-98). Pesek notes: “The thread of truth that runs through each accusation was nicely articulated in Hyderabad by Li Yong, China's vice finance minister: ``We are all on the same boat. No one will escape if this boat sinks.''”

"The notion of a free market in currencies is in any case nonsensical"--WSJ editorial, 5/15

China's currency has been flirting with breaking through 8 to the dollar this week. The WSJ had another interesting take on the blame game, in a May 15 editorial titled "Currency Games." Responding to the Bush Admin mantra to let the "free market" determine currency rates, the WSJ said:

"The notion of a free market in currencies is in any case nonsensical: All currencies are manipulated, since governments print as many bank notes as they wish. Exchange rates are set by a central banking cartel. By pegging the yuan to the dollar, all the Chinese have done is outsource their monetary policy to the U.S. Federal Reserve [ital in original] ... As for the U.S. trade deficit, there is no guarantee that a weaker dollar (the reverse of a stronger yuan) would make any difference."

"The currency peg has been a rare anchor of stability for China, which has enticed foreign investors and allowed it to escape the serial devaluations that devastated other Asian economies in 1997." "Markets are already nervous that the Fed may have misjudged inflationary pressures, and a run on the greenback would only make the Fed's choices more difficult. As for President George W. Bush, the very last thing he needs right now is a dollar crisis."

A View from London on the "Blame Game"

A somewhat similar view re the "blame game" is in May 16 letter to the FT by a London-based well-known financial expert, Avinash Persaud:

“The critical problem is not that the dollar adjustment may prove too narrow tomorrow; but that the necessary policy measures are not being taken today - and do not look like happening soon. This is partly because too many economists have colluded with protectionists to blame China, a relatively poor country, for the policy mistakes of the world's richest economies. This not only morally questionable; it is a factual fallacy … [a large Chinese revaluation] would lead to deflation given China's near-zero inflation rate and enormous bad debts. Should deflation be avoided like the plague in the US, but considered an acceptable risk for China? Exchange rates have a secondary part to play in this act. But Sadakazu Tanigaki, Japan's finance minister, got the right balance when he argued that it is dangerous to overemphasise [sic] exchange rate realignments before there is the will to initiate the necessary accompanying domestic policies.” [itals in original]

What is already happening, as expected, is that the EU and Japan are complaining about the rise of their currencies, believing that they are once again being forced to bear the brunt of the dollar's depreciation that might choke off nascent recoveries in their regions.

Btw, I do not share the views of those I have quoted on the "blame game" with respect to the need for austerity in the U.S. With the average weekly real earnings of U.S. workers down 17% since 1972 and flat over the past five years, that is hardly fair, and it would threaten a global recession.

Just Signed "Investor" Tax Cuts Indicates to World U.S. Not Serious about Deficit Reduction

Because of the reserve currency status of the U.S. dollar, and because U.S. financial corporations and government essentially run the hyper-speculative global monetary/financial system, the U.S. has special responsibility to see that it works.

Rather, the U.S. seems to be trying to put the burden of adjustment on others via their currency appreciation. That is not going to work, dollar depreciation alone is not going to solve the U.S. current account and other global economic problems, as large dollar declines in the past have shown.

This is especially so if the world does not think the U.S. is serious about getting its own house in order. And it’s not, as most recently indicated by the tax cut bill for “investors” that Bush just signed, despite the fact that the U.S. capital investment which these cuts were promised to deliver have been sub-par during this business cycle. (see yesterday's 5/18 article by Bloomberg columnist John M. Berry, “Make-Believe, Deceit Are Behind Latest Tax Cut,” link)

The Bush administration has lost a great deal of its credibility, as shown in public opinion polls, earlier in the eyes of much of the world, and more recently in the U.S. Whatever one’s political views about Bush, etc., this loss of U.S. credibility is not a good thing, most especially if a severe monetary/financial crisis were to occur on Bush's watch, especially since the Democrats have offered little viable governing alternatives.

Cheney Pushing Bush Admin to Focus on Iran and Central Asia

Rather than adequately address critical economic issues, Cheney, in particular, seems intent on focusing the Bush Administration on Iran and now Russia. According to a front-page story in the May 18 FT titled, “Bush may cold shoulder Putin at G8 summit,” Cheney "is said to be leading the Washington charge for a tougher line towards Russia - as seen in his broadside launched from Lithuania when he accused Mr Putin of backsliding on democracy and using oil and gas for blackmail and intimidation. For Mr Cheney, according to administration insiders, the key issue is Iran. They say he is furious at Russia's arms sales to Tehran and its resistance to United Nations sanctions over the Islamic republic's nuclear programme.”

A May 16 article in the WSJ titled "Central Asia Emerges As Strategic Battleground" said it "is emerging with its oil and gas riches as the first strategic battleground of the "Multipolar Era" among the U.S., China and Moscow ... [on his recent trip] former oilman Mr. Cheney befriended Kazakhstan's Nursultan Nazarbayev and solidified his support for energy cooperation, including agreement in principle for a new pipeline across the Caspian Sea that would cut out the Kremlin. That in turn would help break Moscow's near-stranglehold on gas exports out of landlocked Central Asia to Europe. The trip followed a White House visit from Azerbaijani leader Ilham Aliyev, who is participating in energy projects of like motivation in the neighboring Caucasus ... The White House's embrace of Mr. Nazarbayev and Mr. Aliyev also marks its return in the region to realpolitik from the democratic missionary work."

I have not discussed Iran, nor North Korea, on my blog, which are difficult issues that must be dealt with very seriously on their own merits devoid of politics. However, Cheney does have a well-documented track record leading up to the Iraq invasion, which I will not dwell on, so his actions bear watching in terms of the impact of the Iran situation on global energy and other markets, especially if financial markets become more volatile.

No Viable Mainstream Alternatives Waiting in the Wings Should Markets Really Start to Unravel

But it is not just Cheney and the Bush Administration that sees the world through much different lenses than the rest of world currently sees the U.S. So does much of the foreign policy establishment, which almost universally overestimates U.S. economic/financial strength as the putatitve "sole superpower."

The following quote is perhaps representative of how the mainstream of the U.S. foreign policy elite currently views things, taken from the Introduction of a 2005 book “The Case for Goliath” link by Michael Mandelbaum, a leading IR professor. Mandelbaum presented these views to John Stewart's “hip” audience in an amicable interview on “The Daily Show” link, which I don’t watch.

“the United States has undertaken broad responsibilities that redound to the benefit of others … If America is a Goliath, it is a benign one … the United States furnishes services to other countries ... The United States therefore functions as the world’s government … the United States helps to assure global access to the economically indispensable mineral, oil … The American dollar serves as the world’s money … the huge American appetite for consumer products has helped to sustain economic activity the world over, especially in East Asia … Whether the United States continues to function as the world’s government depends on whether the American public continues to support the policies involved …The governmental services that the United States provides that affect the largest number of people—reassurance and enforcement—are the least controversial ... but also unappreciated; and they are unappreciated because they are invisible … Nor do the recipients and beneficiaries of these services manifest enthusiasm either for what the United States does for them or for the American power that makes the services possible.”

I will just note that the U.S. military accounts for half of world spending and has bases all over the globe. For another view, from an IR "realist" perspective, see the 2005 book by Harvard prof Stephen Walt, "Taming American Power: The Global Response to U.S. Primacy" link.

Most of Wall Street Continues to Ignore Increasing Potential Risks

As for Wall Street, as I've noted in my two most recent posts link and link, and as the WSJ op-ed quoted above notes, it is largely ignoring the potential seriousness of the current economic/financial situation.

To the best of my knowledge, only one macroeconomist at a leading investment bank consistently focuses on the price of gold as critical economic indicator. Another, Andy Xie at Morgan Stanley, whom I’ve mentioned in the past, is perhaps the only one who consistently incorporates the role of speculative finance in his macro-analysis, and has recently written pieces on China's real estate markets link , and its inflation and environmental costs link. Xie's colleague Stephen Roach of course has for many years focused on the dangers of global economic imbalances.

As for the U.S. population itself, its confidence, and hence how it will react to any potential future crises, is being strongly affected by the slowdown in real estate and the high price of gas and other things, both of which are well chronicled in the local daily press and newscasts throughout the country, now easily accessible on the web. Unfortunately, the real reasons behind the sources of people's financial stress are generally obscure in the mainstream media, though increasingly analyzed on the web.

"What If" Globalization Has Another Collapse as It Did in the Twentieth Century?

The WSJ op-ed noted above says: "The dollar's collapse is nothing less than a body blow to capitalism."

Obviously let's hope not. Mandelbaum, quoted above, does make a very important point. "The United States is the best source of global governance because, in the first decade of the twenty-first century, there is no other." How long that will last is not only up to the U.S. population, as he says, but also to how the rest of the world sees the benefit/cost tradeoffs of the "services" that Mandelbaum says the U.S. provides. Specifically, as I've noted before, how long China, Saudi Arabia and others are willing to finance the U.S. if they come to view its policies as too destabilizing.

Very few in both the elite and the general population currently believe that should hyper-speculative globalization start to collapse under its own weight of credit without a viable alternative in the wings, then things may become far worse then all but a very few, who currently might be considered crackpots, currently care to imagine. (I am pro-globalization, which in any event has been an inexorable trend since the beginning of civilization, just not of the current hyper-speculative version, hence my blog's tagline.)

For those who are understandably skeptical of how bad things might get should the current era of globalization run into serious trouble, just recall the horrors unimaginable beforehand that happened in the twentieth century when the earlier era of globalized capitalism badly faltered, leading to massive internal strife and a global "Thirty Years War" in the first half of that century, before there were nuclear and other wmd, and then another forty-five years of global Cold War and MAD (e.g., see Harvard professor Jeffry Frieden’s new book, “Global Capitalism,” link).

Given what happened in the previous century, no sane person wants to even slightly flirt with such possibilities once again, i.e., the potential stakes are extremely high, especially with wmd. Unfortunately, as in most potential deep crisis, it is once again getting very late in the game before the vast majority of people realize what might hit them, especially because their current leadership seems inadequate.

And as every successful person knows, one key is being as well-prepared as possible so that one can be singularly focused on rapidly changing reality. Perhaps this past week in the financial markets was a very small dress rehearsal of how rapidly reality might change sometime in the future.

Thursday, May 11, 2006

5/11 Dollar weakness getting too big to ignore as gold skyrockets

"Silent Dollar Crash" Becoming Louder

The "silent dollar crash" that I wrote about in my last article link is getting too large to ignore by the mainstream, including the ongoing disparity between the skyrocketing price of gold and financial markets continuing euphoria.

Gold is up around 40% this year, touching $728 today, with the Fed funds rate at 5%, reported inflation still low, and the MSCI World equity index setting a record this week, surpassing its March 2000 high at the end of the TMT bubble. This is the highest gold price since 1980, a year in which the consumer price index rose 13.5% and the Fed funds rate touched 19%, and two years before the end of a secular bear equity market that lasted more than a decade (inflation adjusted).

What Does Gold's Rise Signify?

At the moment, equity markets are reacting negatively to the belief that Fed tightening might not have ended, while the dollar has been under pressure recently partly from the opposite belief, i.e. that yield differentials in its favor will be less supportive if the Fed stops tightening.

FT market columnist Philip Coggan asks Thursday: "is bullion's rise a signal that investors are worried about inflationary pressures and a dollar collapse or is it simply a symptom of speculative enthusiasm? The answer has enormous implications for investors." Energy, geopolitical and other issues also strongly factor into interpreting the significance of gold's rise.

Also in Thursday's FT, Helmut Eschwey, the chief executive of Heraeus, a family-owned German group that is the world's largest precious metals trader, "said it was "impossible to predict" when the bubble would burst for silver and gold but that it would take place," certainly sufficiently vague but still worth noting.

With hedge funds and other hot money crowding into smaller asset classes such as precious metals, emerging markets and anything else going up, liquidity issues are important, in both directions.

In Parallel Investment Universes, Wall Street Remains Optimistic

As I mentioned in my last article, the strong divergences of price action and differences of expert market opinions right now almost makes it feel as if there are parallel investment universes.

On Wall Street, with investor euphoria remaining at 20-year highs, a couple of the perennially cautious voices have become more positive in recent weeks, e.g. economist Roach at Morgan whom I mentioned in my last article and now strategist Bernstein at Merrill, who has upped his equity weighting from 40% to 50% and joins the already long-running party preferring the lower-quality stocks.

While Others Express Rising Concern about a Possible Dollar Crisis

On the other hand, away from the sell side, some respectable mainstream voices are expressing more concern about a possible dollar crisis. E.g., an article by Peter Brimelow in MarketWatch today link quotes the May 10 Daily Letter headlined "The Tremors Before the Big One" from Bridgewater Associates, a well-regarded firm, "We believe the odds of a dollar/ U.S. debt crisis in the next twelve months are elevated (say 50 percent)."

In an earlier Letter Bridgewater said: "Today's imbalances are much larger and global in scale." ... "bigger imbalances that have taken longer to build, have been sewn deeper into the economic fabric, and will take much longer to unwind, with dramatically larger financial consequences." "...Now you've got a new, academic, waffling Fed chairman, a falling dollar, a falling bond market, rising gold and commodities prices, and an underperforming stock market all with a giant current account deficit ..." Bridgewater concludes, "Bernanke is rapidly losing control."

Edwin Truman (of the D.C. think-tank Institute for International Economics, who directed the Fed's Division of International Finance from 1977 to 1998 and was on the staff of the Fed's Open Market Committee from 1983 to 1998 under Volcker and Greenspan before serving as assistant Treasury secretary for International Affairs to 2001), according to a May 8 article in the WSJ link, "isn't among the doomsayers; he predicts that there's just a 10% or 15% probability of a "catastrophic collapse of the financial system." "But I wouldn't rule it out," he says. "The possibility of somebody doing something foolish or stupid has gone up, and there's no doubt about that.""

And the Risks of Unwinding Carry Trades

Concerns about the effects of rising rates, especially in Japan, on carry trades that are helping to fund the continuing huge run-up in emerging markets, among other things, are voiced in a report by GaveKal posted at "InvestorsInsight" link: "The leverage in the system has continued to grow in the face of rising interest rates from most central banks ... the overall leverage in the system today is probably more prevalent, and widespread than most realize ... a fair amount of the leverage has taken place in Yen ... if the central banks are serious about taming the global inflationary pressures, then the tightening now has to happen in Japan. In a sense, this tightening has already begun."

Similar remarks about carry trades were also recently made by Dr. Kurt Richebächer at "The Daily Reckoning" link: "Due to the gigantic leverage implicit to carry trade, a modest rise of the yen, euro and Swiss franc against the dollar by just 2-3 percentage points is enough to abruptly torpedo the whole carry trade in these currencies, triggering a fire sale of unimaginable proportions of both dollars and U.S. bonds. In our view, this is plainly written on the wall, and a true miracle is needed to avoid this debacle. ... There is no way to know the depth and pervasiveness of the U.S. carry trade funded in foreign currencies. In our view, it must be immense, simply because there exist no domestic savings to fund the rampant credit expansion. The whole U.S. financial system is built on carry trade, borrowing short and lending long."

A "Silent Accord" to Deal with Global Economic Imbalances?

One hypothesis on how to deal with these problems was floated in an FT story on May 10: "David Bloom, currency analyst at HSBC, lent his weight to the intriguing theory that the G7, at its recent summit of foreign ministers, might have hatched a tacit plan to allow the dollar to weaken across the board as a way to ameliorate global imbalances without one country or region having to take a disproportionate share of the pain ... "There is this idea of burden sharing, that some sort of silent accord has been done," he said. "If the decision is not to name China [as a currency manipulator] and the dollar/renminbi starts trading below Rmb8, then some sort of agreement may have been made behind the scenes. If we see 7 as the big number [i.e. the Rmb trading below 8] the market will catch fire."

If all this talk of possible dollar crisis, carry trades, leverage and secret deals seems too far-fetched, consider the potential size of the problem. Morgan Stanley's chief Asian economist, Andy Xie, tossed out this number link: "The global asset overvaluation (property, stocks, bonds, antiques, arts, gold, etc.) to GDP ratio is probably 50% above its norm, which puts this bubble at around US$20 trillion, by far the biggest to date in absolute and relative terms."

Marginal Record Highs in a Secular Bear Market?

In my intro I noted the seeming disparity of gold making highs along with record highs in the MSCI world equity index, when compared with gold's record highs in 1980 during a long secular bear equity market. But what if the new equity record is simply a rally in another secular bear market that began in 2000? Recent articles on volatility and valuation by serious analysts would seem to support that view, including two at "PrudentBear" by Easterling link and Solow and Kitces link.

Not Just Commentators, Nations Also Becoming Increasingly Concerned about Dollar

Of course it's one thing if just the "usual suspects" commentators seem concerned. But real nations in the real world also seem to be getting increasingly agitated.

Martin Wolf, the FT's main economics columnist, wrote on May 10: "Last week, I had the pleasure of moderating a governors' seminar on global payments imbalances at the annual meeting of the Asian Development Bank in Hyderabad. The discussion made even clearer than before how far the irresistible force of US desire for exchange-rate movement - well expressed by US Treasury undersecretary Timothy Adams - meets the immoveable object of Asian resistance. As a result, I fear, the chances of a row even worse than the one accompanying the end of the Bretton Woods exchange-rate system in the early 1970s grow ever bigger."

Commenting on the same ADB conference, Andy Mukherjee of Bloomberg wrote link: "Li Yong, China's deputy finance minister, said he had heard a "rumor" that the U.S. dollar was headed for a 25 percent drop. If the gossip was true, the consequences would be "shocking," he said. Li's comment, which he made at a discussion on global financial imbalances last week at the annual meeting of the Asian Development Bank in the Indian city of Hyderabad, was aimed directly at fellow panelist Tim Adams, the under secretary of international affairs at the Treasury Department."

Asian Currency Unit (ACU) Initiative of Asean +3 and ADB

This article then goes on to talk about a revival of interest in an Asian Currency Unit, ACU, which will be studied by Asean + 3 (China, Japan, S. Korea).

"Asia may be getting ready to fix its currencies to a local anchor, dumping the region's unofficial dollar peg. Even as they continue to pile up U.S. debt in their foreign- exchange reserves to keep their currencies stable against the dollar, Asian nations, China among them, are preparing for a scenario where the dollar does indeed collapse under the weight of a record U.S. current-account deficit." Also see link.

At this time I don't put too much weight on the ACU initiative for various reasons, one being the jockeying between Japan and China for regional leadership (India is currently left out of the ACU study), another being the many years, even decades, for such a project compared with a possible impending crisis link and link. But the effort at least is indicative of increased concern, as more practically was a pledge to enhance the Chiang Mai Initiative of Central Bank swaps and work on the development of the Asian Bond Market Initiative link.

According to a WSJ article, Adams of the U.S. Treasury said "I worry about mission creep in this institution," referring to the ADB. According to a NYT story link, "From the Americans there was an outcry [re the ACU], seeing it as a danger to the dollar," Volker Ducklau, the Asian Development Bank's executive director for Germany and Britain, told Emerging Markets, a newsletter published during bank meetings ... "We don't oppose it,"' said Timothy D. Adams, the Treasury under secretary for international affairs. "I have no concerns about this issue.""

Btw, during the so-called "Asian Financial Crisis" of 1997-98, then Treasury Secretary Rubin and his deputy Summers shot down Japan's briefly tabled proposal for an Asian Monetary Fund.

(For those interested in discussions of Asian monetary/financial integration by leading academic international economists, in the next day or two I will post brief excerpts from four very recent papers in an appendix to this article on my blog link.)

Weakened U.S. Leaders a Liability if Dollar Unravels

While a potential dollar crisis may be slowly building, with the U.S. deeply in debt to foreign creditors, Bush's rating and the standing of the U.S. abroad at very low levels (see new book based on Pew Research Center polls link), the actions of the Bush administration do not appear to be helping global confidence in the U.S. and the dollar.

In particular, Cheney's recent negative remarks about Russia has not only brought a response from Putin, whose co-operation, along with that of China, is critical on Iran, but probably got China's attention also, especially since the leading Democrats are also trying to outdo Cheney on Iran.

China watched as Russia collapsed during its free market "shock therapy" in the 1990s; then as the Asian "tigers" were forced by the U.S. Treasury to submit to IMF austerity; and finally as Putin played ball with Bush following 9/11, with his reward being U.S.-funded "color revolutions" and NATO on his borders.

What lessons do you think China has drawn from all this? China has immense internal development issues that it must focus on, and it needs economic and geopolitical stability to do so. It prefers to take a low-key role in foreign affairs, while focusing on trade, resource and other deals. I mentioned in my April 20 post increased activity in The Shanghai Cooperation Organization of China, Russia and others link.

But at Least the Wealthy Get Their Investment Tax Cuts Extended

The Republicans in the Senate just passed today an extension of the large tax cuts for "investors," which often seems to be all that really matters to the Bush administration, even though these tax cuts have not produced the promised strong corporate investment, which has been sub-par in this business cycle.

Correction: In my 5/1 article: "The IMF's April "World Economic Outlook" raised its global growth forecast for 2006 0.6% to 4.9%, which would be the fourth straight year above 4%," rather than 0.5% to 4.8%, my apology.

Monday, May 01, 2006

5/1 The Silent Dollar Crash and Parallel Investment Universes

When Will the Mainstream Recognize the Silent Dollar Crash?

When measured in the price of gold, the dollar and U.S. financial assets have already crashed. For example, relative to gold, as of Friday’s close, since their last relative highs in June-July 2005, the U.S. dollar index has declined 39%, the 10-year Treasury bond 43%, and the S&P 500 31%. These declines have become free-fall in the last month or so.

Yet as of now, the financial markets and mainstream media barely seem to acknowledge this silent yet huge dollar crash, rather quite the opposite. In terms of risk premia, credit spreads and volatility, global financial markets continue to be more euphoric than at any time in the past twenty years, as I pointed out on 3/24 link. The IMF's April "World Economic Outlook" link raised its global growth forecast for 2006 0.6% to 4.9%, which would be the fourth straight year above 4%.

In the U.S., this complacency is perhaps mainly because the housing market has not collapsed, though mortgage applications are down over 20% from last summer, and inventories have built up to 5-6 months for single family homes and 7 months for condos. Forward-looking indicators such as NAHB home sales expectations and housing market index and the U of Michigan home buying intentions are at their lowest levels in years. There are numerous anecdotal news stories of previously hot real estate markets slowing down, e.g. link and link.

As the IMF "Outlook" report notes, "the withdrawal of equity from the housing market--which amounted to 7.5 percent of household disposable income in the first three quarters of 2005," has been critical for the U.S. economy.

Since gold was money for millenia up until 35 years ago, it is still possible that, should the real estate market decline accelerate, large segments of the U.S. population may start to put two and two together and finally realize what the core problem really is, rather than being diverted into blaming various “others.” (See my 4/4 article link.)

Parallel Investment Universes That Have Not Yet Intersected

To me there appears to be three parallel investment universes. There is the mainstream Wall Street world, where investor euphoria remains at a 20-year high, especially in terms of credit and emerging market spreads.

Then there is officialdom, represented by the G-7 recently handing to the IMF the hot potato of trying to do something about the seemingly intractable global economic imbalances, which imho will be a futile effort without fundamental monetary/financial system reforms that as of yet are not being even remotely considered.

Finally, there is the growing Internet world of wealth preservation investors focused on gold and other commodities. (A few of these web sites are listed in my links section.)

Unlike in the TMT equity bubble of the late 1990s, when the existence of a bubble was at least open to debate on Wall Street, these parallel universes have not intersected at all in this credit cycle. Specifically, there is simply no acknowledgement on Wall Street as of yet that the price of gold may be signaling a dramatically changed financial situation.

To Wall Street, commodity inflation is directly linked to very strong growth in emerging markets, especially that of China, which again has been higher than expected, but it doesn’t go beyond that, to the role of excess dollar credit as indicated by the price of gold, because it can't, due to self interest.

The IMF has recently released two of its key periodic reports, "World Economic Outlook" and "Global Financial Stability Report." I may have missed it, but I do not recall the more than doubling in the gold price over the past few years mentioned even once in these otherwise authoritative and exhaustive reports, from which I will quote liberally in the next few sections.

Rather than try to deal with the fact, it's as if the rise in gold simply hasn't happened or has no meaning as far as Wall Street and the global monetary authorities are concerned. Evidently the price of gold is one market signal that the so-called "free market" types would rather ignore.

"Exogenous" Shocks are Endemic to Highly Leveraged Speculative Finance Globalization

The IMF's April 2006 “Global Financial Stability Report” link says “it is difficult to make a case that realistic economic developments all by themselves could—at least over a 6–12 month time horizon—seriously affect the global financial system in a systemic way.”

But the IMF's new "Outlook" report also says "the baseline forecast is for continued strong growth, although risks remain slanted to the downside, the more so since key vulnerabilities—notably the global imbalances—continue to increase."

The IMF "Stability" report notes that “sudden and negative developments—such as military confrontation, major terrorist attacks, a sharp fall in the supply of crude oil or other vital sources of energy, and maybe, more realistically, a significant rise in protectionism—could change the rational framework for global asset allocation and trigger a disorderly unwinding of global imbalances. These uncertainties, however, are difficult, if not impossible, to quantify.” It also talks about avian flu in this manner.

Just because they can not be easily modeled, there is no reason to consider these "exogenous” shock risks from "outside" the global market system, rather they are endemic to the current version of hyper speculative globalization, especially because the enormous use of financial leverage gives less leeway for major problems.

No Let Up to Higher Energy Prices, While Oil Companies Maximize Shareholder Value

In particular, the energy game continues to play out with no end in sight. The April 29 FT lead headline says, “Bush woos Asian energy allies to thwart Moscow.” Immediately after meeting with Bush, China’s President flew to Saudi Arabia then Nigeria to sign major deals, and of course China has close energy ties with Iran. Hedge funds and other speculators are taking advantage of these very real energy problems, making the situation worse, as Enron had done earlier (hyper speculation nowadays almost always tends to be of the destabilizing herd mentality type).

Chapter 2 of the IMF "Outlook" report says: "IMF staff believes that the IEA’s [International Energy Agency] and OPEC’s projections in the 1.2 mbd range for non-OPEC supply growth in 2006 may be optimistic. Even if OPEC’s capacity increases by a projected 1 mbd, spare capacity will likely continue to remain low, and consist mostly of the heavy grades, for which refining capacity is limited."

It then makes the following key point: "The IEA estimates that investment in the oil sector is probably 20 percent below what is needed to meet projected demand over the medium to long term. In contrast, oil-exporting countries and major oil companies argue that they are investing as rapidly as is appropriate ... To date, oil corporations appear to have used a large part of their profits to distribute to shareholders, buy back shares, accumulate cash reserves, or acquire other companies ... new investment, while significant in nominal terms, may not be large in real terms."

I.e. according to the IMF, oil companies have been using their robust cash flow to enhance "shareholder value," my term, not the IMF's. How effectively energy companies invest their currently high profits to actually increase energy supplies eventually will be a critical test for the current version of speculative finance globalization, far surpassing in importance the outrageous "compensation" their CEOs have been granting themselves.

Why Aren't Non-Financial Corporations Investing Their Record Cash Flows?

This behavior by energy companies is consistent with the more general use of record profits and cash flows by corporate America in this economic cycle. The IMF notes in Chapter 4 of the "Outlook," worldwide "the strong increase in profits has been used by nonfinancial corporates to acquire financial assets—including a substantial amount of liquid assets (“cash” for short) during 2003–04—or to repay debt, rather than to finance new capital investments or to increase distributions to shareholders through dividends."

"While higher profits explain part of the rise in NFCS [non-financial corporate sector] excess saving in recent years, the decline in nominal capital spending explains around three-quarters of the increase in NFCS net lending since 2000 in the G-7 countries. Simply put, firms have been investing a smaller share of their profits in upgrading and expanding their capital stock."

Interestingly, the IMF also notes that "a closer examination reveals that the increase in profits is mainly due to lower tax and interest payments and, in some countries, to higher profits received from foreign operations, rather than to a rise in gross operating surplus."

Indeed, this economic cycle has seen profound shifts from previous ones. Again, according to the IMF "Outlook," "capital is flowing from emerging markets to industrial countries (notably the United States), the opposite of what would be predicted by economic theory." And, according to the IMF "Stability" report, "the transfer of risk, at least in part, to the household sector [from the corporate one] has somewhat changed the nature of moral hazard from “too big to fail” for some key financial institutions to whole market segments being “too important to fall.”"

Inflation Risks Still Exist

Btw, the IMF "Outlook" also notes "increased financial investment in commodity markets," i.e. more hyper speculation by hedge funds, etc., as one of the three "factors [that] are contributing to the current upsurge" in commodity prices overall.

In Chapter 3 of the "Outlook," the IMF makes another key point: "globalization cannot be relied upon to keep a lid on inflationary pressures in present circumstances. Strong global growth and diminishing economic slack have reduced the restraining impact of declining import prices on inflation, and with strong global growth expected to continue, the primary risk is that a further upturn in import prices could result in stronger inflationary pressures going forward, particularly in countries that are well advanced in the economic cycle. The possibility of further, partly globalization-related, commodity price increases adds to these upside risks from the external sector."

The Liquidity Risks in the Secondary Markets for Structured Credit Products

The IMF "Stability" report notes liquidity risks. Specifically, “credit derivative products have significantly enhanced the “transferability” of credit risks by allowing for the increased specificity of credit exposures, to meet different investor demands, particularly in the “primary” risk transfer markets. However, once transferred, secondary market liquidity risks and related contagion effects remain, and may constitute the most significant stability risk emanating from the structured credit markets.”

Again, “the potential for secondary [credit derivative] market liquidity disruptions, often related to the homogeneity of market participants in a particular segment and to gaps between real and perceived liquidity, remains a stability concern.”

Concluding, “in the structured credit markets, we believe the risk of liquidity disturbances is material. Whether and how these new risks materialize, and the severity of their impact, will critically depend on the degree to which the diversity of market participants increases, the various structural frictions are reduced, and market surveillance is improved.”

G-7-IMF Effort to Address Global Economic Imbalances Too Little Too Late?

Roach at Morgan Stanley, who has for years focused on global economic imbalances but whose call for a "new global [financial] architecture" link is probably too little too late imho, has just become more optimistic today because he believes "the world is finally taking its medicine--or at least considering the possibility of doing so" link.

At present I do not share Roach's new-found optimism. It has taken the U.S. more than thirty years to get itself into its current economic/financial situation, I believe that it will take a long time to reverse it, capabilities and habits can not change over night. Given the daunting arithmetic of the U.S. current account and fiscal deficits going forward, and because profound, long-lasting structural changes to the global economy have been made, I can not see any feasible size dollar depreciation that would have a significant impact on the U.S. balance of payments.

As for other views, Roach's colleague Xie is perhaps the only i-bank macroeconomist, and MIT economics PhD, who routinely incorporates the dominant role of global speculative finance in his core analysis of global imbalances, e.g. "the global financial system is running the global economy," link.

Also among the reputable mainstream economist bloggers, see Nouriel Roubini's May 1 post, "Is the US Dollar Reaching a Tipping-or Tripping-Point?" link along with various blog posts by his colleague, Brad Setser, at the same site link.

Gross at Pimco, the mega bond manager, continues to point out the U.S. dollar risk, "need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies," link. Some old-time continental European-trained economists, e.g. Richebacher, Faber link, have come from a more “sound money” tradition than their American counterparts.

The mainstream academic international economists, while usually more honest than Wall Street, also continue to have trouble coming to grips with the key issues, saying for years that the current global imbalances are unsustainable, but otherwise at a loss as to how this situation can continue so long, let alone when it might change, again simply not acknowledging what gold might be signaling, e.g., in recent separate swipes at the global imbalances piñata by Eichengreen link, Krugman, and Summers link, and global inequality by Wolf (at the FT) and Krugman.

How Long Will China and Saudi Arabia Finance U.S. Twin Deficits, Hence Its Military Policy?

As I said in my April 20 article link, “to much of the world, the U.S. appears to be unilaterally, "pre-emptively" embarked on policies which seem to have the effect, well-intended, unintended or otherwise, of helping to destabilize key regions, such as the Mideast, Iran, central Asia, North Korea, the former Soviet republics, etc. East Asia and Saudi Arabia are in effect financing the ability of the U.S. to pursue these unilateral policies by holding huge amounts of very low-yielding U.S. debt securities which will most likely significantly depreciate.

Stability in these key regions is critical to the paramount interest of most of these Eurasian nations, economic development. In addition, most of East and South Asia have huge internal infrastructure development needs, on the order of $400 billion per year, which are not being met, about equal to the amount it is adding to its forex reserves.

Thus, taking into account other costs and benefits (access to U.S. market, technology, management, etc), how much longer will the rest of the world finance U.S. military policy? How Iran is resolved might go some way to resolving that question.”

As I put it in my 3/24 article link, "especially if the geopolitical stuff below, such as in the Mideast or friction with China, starts to really go against the U.S., and a Eurasian "balancing coalition" starts to form, around national and energy security issues, against the sole U.S. "superpower" hegemon, then "feedback loops" with the above areas could accelerate. E.g. having to raise interest rates, which would further jeopardize the real estate market, thus consumer spending, thus capex spending, starting a downward spiral in the dollar."

How Much Longer the Golden Age of Goldman Sachs?

There needs to be some very creative thinking on how to solve these huge issues, and to date there isn’t, as far as I can see. Instead, the market euphoria that I noted in my March 24 Economic/Financial Monitor link has continued, especially in the commodity and emerging markets.

“The Economist” has two puff pieces on Goldman Sachs in its current issue. The lead says, “The average pay-packet of its 24,000 staff last year was $520,000—and that includes a lot of assistants and secretaries.” Even with such high “compensation,” return on equity is near 40%.

Meanwhile, the recent first quarter U.S. employment cost index again confirms that the rest of the population has been going nowhere for the past five years. (Inflation as defined by the Fed would be if real wages ever went up merely in line with productivity, rather than everything that Goldman trades currently going parabolic.)

Goldman makes much of its money in proprietary trading, i.e. speculating. Despite the cover's sub-head, "Goldman Sachs and the culture of risk," the leader says, "If the much vaunted systems do not work, then the central banks will have to step in (as the Federal Reserve did with LTCM)." Why, what risk culture is that?

U.S. Goes from High-Tech Leader to Global Hyper Speculator

In the late 1990s, the U.S. “brand image” was built on high-tech leadership and productivity, which presumably was why the rest of the world would be willing to finance ever larger U.S. twin deficits. Now look at the ongoing troubles of Intel and Microsoft. Notwithstanding the huge success of Google, E-Bay and a few others, mainly oriented to media and advertising, tech investing generally has been reduced nowadays to playing short-term product and inventory/capacity cycles, e.g. fiber optic/telecom lately.

(Former technology hedge fund manager Kessler trotted out a version of his “margin surplus” views from his "Running Money" book once again recently in WSJ op-ed, no surprise there, the Silicon Valley slice-and-dice horizontal asset-light outsourcing business model certainly has helped hedge funds and venture capitalists.

The outsourcing cost-cutting supply-chain business model is also favored by the Wal-Marts of the world, whose "stack 'em high" monopsonist link merchant mentality simply has very little conception of the real nature and true costs of development of new innovative products and services, readily apparent in books on that company.

Prestowitz has a more accurate view of what such a model has meant for the U.S. in his "Three Billion New Capitalists," soon in paperback, which incidentally is one of the very few mainstream books to mention the effects of the dollar's role as reserve currency, also see the "Curse of the Dollar" section in my 4/20 article.)

Emerging Market Growth Drives Financial System, Not Vice Versa

In the past five years, the Goldman's of the world have greatly benefited from the extraordinary growth of China, India and the rest of the developing world helping to drive the world economy, rather than the other way. China’s development has been heavily dependent on huge foreign direct investment (FDI), not speculative “hot money,” the latter still might be its undoing (as it was in the so-called Asian Financial Crisis of 1997-98), especially given China's inadequate financial/corporate governance systems. China President Hu recently visited Microsoft and Boeing, not Wall Street.

The global speculative financial system “free rides” on this real growth, it doesn’t create it, as is commonly thought in the U.S. The sooner corporate America realizes this the better, since despite all its problems, it is a main repository of critical technology and know-how needed to help solve the world's most pressing issues, such as sustainable energy development.

The rest of the world knows what really drives growth, even while it continues to play along, for now, with the U.S. dominated hyper speculative monetary/financial system. The central banks of Sweden and others now seem to be looking to diversify out of this game.

I'm not a libertarian, but I recommend the April 25 and Feb 15 speeches by Rep. Ron Paul, "What the Price of Gold is Telling Us," link and "The End of Dollar Hegemony" link.

Paul is one of the very few principled politicians seemingly left in Washington. Hopefully someone with a little more clout will finally figure out what he has before it’s too late, but I’m not holding my breath waiting.