Greece and Oil, and Gold

By DoctoRx

Knowing the Greek fix was in, my view is that the traders moved markets around the past week to suit themselves. Yours truly has been calling for $90 as the first stop in an oil bear market. Oil did bottom exactly at $90, helped to go that low by the announcement of the release of a day or two’s worth of global oil use from various national reserves (which news was likely front-run from the short side by the favored few). Typical of a short-covering sneak rally, oil then shot up $5.50/bbl in the last two days on no major economic news. The Greek vote was the headline excuse, but I don’t believe that. The amounts of gasoline you and I use, and that China and Germany use, are unaffected by how much the tiny economy of Greece takes a hit. Add in Portugal and Ireland and you still have fewer people than live in Texas. I have gotten cynical about these crises in economically insignificant countries. The Greek situation is a real problem, but the losses should be small; the Europeans can print up the amount they might lose in a default in a jiffy and ultimately their markets would hardly notice it. A little more inflation, that would be all. 

I think these crises are over-hyped to garner profits for traders. You can guess which traders. Does TBTF come to mind? 

The same thing happened in the often faux“crises” in basically sound Asian countries in 1997-98 that the speculators attacked one after another. All this really did from the standpoint of an American investor back then was to gyrate markets that were going up due to balanced budgets (therefore no unusual Fed money-printing), a back-to-work emphasis (welfare reform), the peace dividend from the end of the Cold War, cheap oil, and of course the tech revolution. Eventually our giant, sub-continental economy did what it was going to do without caring how the Thai baht was faring. The same for Greece today IMHO. Deutsche Bank has already disclosed that it’s largely resolved for a Greek default. The Greek de facto default is mostly a distraction for American investors, as well as being impenetrable from the standpoint of both figuring out what’s going to happen when and then guessing what is already priced in. The Greeks took the loans and wasted/stole much of the money. Now the imprudent/unlucky lenders and the Greeks are going to do whatever they do. So be it. Again, it is a real problem, but I’m saying that it’s not a crisis that should move American markets much if at all. All this concern about contagion? It’s when they don’t advertise such a problem in advance that the major problems occur, a la summer/fall 2008. Think Lehman/AIG and the aftermath, about which no one was talking beforehand. Just wait. You’ll start hearing about Portugal, Spain, Italy etc. anyway if the traders so desire. And of course Greece has not been cured. And there are any number of other countries that could “worry” traders. 

The most important thing for US markets is, as Econophile said, that there has been no recovery. The proof, or at least strong evidence of this, is that there has also been no recovery in the stock market from its March 2009 bottom when priced in gold. The gold/stock market ratio remains near its high for the cycle, but historically has gone much, much higher during times of crisis. Watch for it. Maybe gold $3000/Dow 10K for a start? (Not that I really have a great deal of conviction about the markets given how weird the entire scene is.) 

Meanwhile, the Greek news and the rapid collapse of oil from over $110 to $90 in almost no time (a 20% move and therefore already a bear market) led to the typical move away from the US dollar and Treasurys. Risk on, in other words for the last couple of days. If my view of the macro economy is correct, eventually the markets should reacquire a taste for the US dollar and it will be “risk off”, again. August through October are classic times for that. In that case, if the real economy is decelerating and/or shrinking, and thus credit demands from private sources are also shrinking, we couldsee the trifecta of a strengthening dollar, lower US interest rates, and a rising gold price. That’s a classic “risk off” portfolio trend. It would not reflect good times, though it might be a necessary part of the healing process, just as detox is very unpleasant for the unfortunates who get hooked on alcohol or narcotics. 

The S&P 500 is up exactly 2% in price from July 1, 2008. (Of course, it was already well off its 2007 highs by then.) Add in 2% dividends per year and you get at best a 3% annual return from stocks over these 3 years. In the same time, gold is up 73%, which is 20% per year. And gold has achieved this with less volatility than stocks. Yet this outperformance by gold has only brought it to a historically normal ratio to the major averages. 

This outperformance by gold from a historically record undervaluation as of the year 2000 may continue for some of the reasons that Econophile described today in discussing Europe’s financial problems. Remember that capital deficiencies become most visible when economic activity slows a good deal. Then we start to see who’s been swimming naked, so to speak. It is my suspicion that the amazing complexity of today’s financial system exists to hide capital holes. Otherwise, why go to the trouble? It’s cheaper to keep it simple. Unless you believe that silver is money (I’m long silver but I don’t believe it is money; I believe it might become money again, though), then the only money in the world that is not simultaneously a liability is gold. Thus if the S starts hitting the F for some of Europe’s big banks, Europe has lots of fiat money that the Europeans will want to exchange for the ultimate hard currency. In this scenario, I can see a lot of demand for US Treasurys, but in financial panics due to unsound lending, people simply want gold first and foremost. Even today. Some barbarous relic (sarcasm on).

I don’t know just what happened in Greece with all the loans. I do know that less than three years ago, the unthinkable happened in the United States. The largest financial companies simply disappeared as solvent companies, though most of them were either kept alive by the authorities or were parceled out to the TBTFs to be absorbed while matters were sorted out later. And of course some of the TBTFs themselves were kept alive by all sorts of strategems. Nothing like this happened in this country even in 1929-33. The money center banks were quite sound despite massive price deflation. When the Bank of United States failed in 1930, it set off a panic. Yet despite the deflationary depression that lay ahead, depositors recovered 83 cents on the dollar. Not so bad. What would depositors in Citi have received had it been allowed to fail and had there been no deposit insurance, as was the case in 1930? I have to suspect the answer would be discouraging, especially if one adds in all the junky SIV $trillion Citigroup was keeping off the books. And what happened in America in 2008-9 happened with minimal if any net price deflation.

So, there has been no recovery because a highly leveraged system came crashing down in 2008-9 due to excessive and unsound lending during the boom, related to central bank-induced cheap money. And as bad as matters remain in this country, Europe might be even worse off, considering all the PIIGS (Italy and Spain being economically significant but still solvent) plus a financially challenged Britain. Zero interest rate policy (ZIRP) might thus persist here year after year until finally the financial recapitalization process is complete. Obviously, the whole situation is unprecedented and differs in some key ways from Japan’s ZIRP experience. To date, with limited ZIRP experience in this country, the Fed keeps getting it wrong and stops printing money after flooding the system with it, at which time of turning off the spigot the economic cycle turns down and more money needs to be injected to keep the system afloat. That’s my base case for the months ahead. As the curse goes, it should be an interesting time for us in this brave new world of capitalism lacking (enough) real capital. And meanwhile so far as the VIX (fear index) goes, happy days are here again already.

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What Explains Gold? Dollar, Oil, Inflation or Trade Deficit?

By Andrew Butter

The latest idea coming out of the “Hedge-Fund” camp that I saw to explain the recent climb in the price of gold as expressed in US dollars is “Real” interest rate.

Leaving aside what is “real” and what is illusion for a moment, if you take a timeline of the US 10-Year Treasury yield and subtract the published CPI number you get to one (of many) estimates of “real” interest rates. Then you cumulate that number, you can build a reasonably decent “explanatory” model to explain the price of gold, since say January 2002.

Month on month the correlation between those two lines is 95% , so you can say that the changes in the “real” interest rates since January 2004 can “explain” 95% of the changes in the price of gold.

And the logic there is I suppose that the price of gold “ought” to give you a “real” return on your money, although over the past seven years gold went up nearly five times but the “real” return on a 10-Year Treasury was about 13%.

If you buy that logic then to know where the price of gold is going, all you need to do is guess where American CPI and where the 10-Year Treasury yield is going. There again, there are plenty of other explanations for the current price of gold. Here are three good ones:

The Austrians

The “Austrians” say that “fiat money-printing” by central bankers debased and destroyed the value of money in general, so the value of “real” money (gold) went up. That’s a logical argument; certainly the explosion of the price of gold tracks (sort of) the explosion of the US Federal Reserve balance sheet over the past few years.

Although it’s quite hard to fit facts to the reality, gold started going up before the Fed started expanding its balance sheet, and in any case the connection between the balance sheet and “money printing” is tenuous.

That’s because the Fed is supposed to lodge collateral (US Treasuries or MBS for example) with the Federal Reserve Agent (a government employee), prior to printing money. So the idea of “Helicopter Ben” just irresponsibly turning on the printing presses whenever he feels like it; is a bit of an old-wives-tale.

Of course you can debate what value the Federal Reserve Agent accepted for the $1.5 trillion of MBS that the Fed put up as collateral, but most of that money just turned straight round to be put on deposit with the Fed so the affected banks could bolster their capital adequacy.

Thus the logic in the Austrian camp tends to be weighted towards philosophical arguments (often quite long-winded), which may be right, but they are as hard to pin-down. The problem I have with all that is the idea that central bankers and those who sail with them were FIVE times more venal and/or incompetent, over the past seven years than they were in the past twenty years (when gold was much cheaper).

Oil and Gold

There is a pretty good correlation between the price of oil and the price of gold since 1971 when gold was “liberated” from the grasp of central bankers (74% R-Squared).

There is an attractive logic there in the sense that gold has a fundamental irreplaceable value in society and so does oil. The problem with that logic is that at $125 oil the “fundamental” price of gold should be $1,100 or so, so either (a) there is a bubble or (b) the valuation model does not stack up, or (c) oil is on it’s way up to $175 a barrel and gold is simply front-running that inevitability.

The issue on that count is at what point the “fundamental” price of oil will migrate from what it is as dictated by “Parasite Economics” (how much the world can pay without it’s economy being damaged – currently about $90), into the “replacement cost” which is how much it will cost to find new supplies, which potentially can go up exponentially if the “Peak Oil” argument holds water.

“Effective Current Account Deficit”

The idea there is that

1. The fundamental value of the dollar (i.e. against something with “fundamental value” ought to be reflected in the cumulative US trade deficit (goods + services)
2. Except since 2000 you have to treat any “US Securities Other Than US Treasuries” (line 66 of the BEA International Transactions – sometimes called “Toxic Assets”), as “exports”, as in the loans won’t get serviced so the net result is that USA “exported” the title to a proportion of their homes.

Add that up and you get a line that tracks the price of gold pretty accurately since 1993, in fact it explains the changes in the price of gold expressed in dollars much better than either the price of oil (well oil had a bubble and a bust), or “real” interest rates.

I admit that’s a pretty whacky line of logic, but it does at least provide a measure of the cost to America of living beyond its means, in comparison to the reality of its economy compared to that of the rest of the world. Only by that logic the “correct” price of gold is $1,200 today.

Comparing the three approaches

Discussion

• The problem with “real” interest rates as an explanatory variable is that it only started to “work” in about 2004. One thought that comes to my mind is that perhaps the clever hedge fund herd is tracking that variable these days…and perhaps they have the wrong end of the stick? That wouldn’t be the first time the too-clever-by-half hedge-fund boys got it wrong.
• Oil is a big part of why America runs a trade deficit, but it’s not the only thing.
• The best correlation is the trade deficit, which at least does not require a long-convoluted argument to explain away; if (a) gold is a substance that accurately measures value long-term in the world as a whole, and (b) America is living beyond its means reference the whole world (and in that regard the trillions it spends “defending” itself sound more and more like narcissism as time passes), then ultimately, what America will be able to afford to buy from the rest of the world, will go down, thus the dollar compared to “value” in the rest of the world will go down.

That story-line suggests there may have been some “over-cooking” over the past six months, only time will tell.

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Inflation Does Not Look Transitory to Us

By Tom Sowanick

In our view, inflation is on the verge of becoming a significant concern for the global economy. In nearly every corner of the world, inflation is running roughly 100 basis points (bps) higher than a year ago with no sign of slowing down.

This morning we heard that Canada’s CPI came in at 3.7 percent for May versus 3.3 percent in April this year and is now 230 bps higher than a year ago. In Europe, inflation is running at 3.0 percent pace versus 1.6 percent last year.

In the US, inflation has risen to 3.4 percent from 2.0 percent twelve months ago. Federal Reserve Chairman Ben Bernanke has repeatedly said that inflation in the US is simply “transitory”, meaning that the Fed will take no action to raise interest rates in an effort to battle this phenomenon. We can only hope that his assessment on inflation is correct. 

“Transitory” is not a term that is embraced by any other Central Bank. In fact, it is now widely expected that the European Central Bank (ECB) will raise rates on July 7th from 1.25 percent to 1.50 percent, as ECB president Jean-Claude Trichet stated this week that the ECB needs to remain “vigilant” against the threat of inflation.

Regionally, we find that inflation is stubbornly high in Latin America, with an average year-over-year inflation rate of 7.24 percent. High inflation has pushed LATAM (Latin America) Central Banks to raise interest rates sufficiently high enough to push real interest rates into positive territory.

The same is true with most of Asia. As a result, we would expect rates of inflation in these two regions to be tamed first. This will be bullish for their respective local debt markets Core Europe and the US are lagging considerably in the fight against inflation relative to other Central Banks because Asia and Latin America largely escaped the economic ravages caused by the financial meltdown.

It is now critical that the ECB, the Bank of Canada (BoC) and the Fed begin to work in unison to address this global issue or else bond and currency vigilantes will begin to surface in earnest.

Unfortunately, of the three Central Banks mentioned above, the Fed is the least anxious to reverse its near 3-year, 0 percent interest rate regime. Consequently, there is little reason to expect the US dollar to appreciate against the euro, Canadian-dollar and Brazilian real over the balance of the summer.

In terms of owning inflation protected securities (TIPS), we find that at current price levels they offer absolutely no protection against further increases in the US inflation rate.

Rather, we believe that you should (at this point) own real assets such as commodities for protection or small cap stocks, which have proven to be a decent hedge against inflation historically.

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China's Soaring Pork Prices to Spur Inflation

By IBTimse HK Staff Reporter

China's pork prices broke the record with the increase of 4.5 percent from a week earlier to 24.68 yuan ($3.81) a kilogram as of June 24 last week, according to the Country's Ministry of Commerce.

The pork prices, a major contributor of China's soaring inflation, contributed 1.2 percentage points to the 5.5 percent CPI inflation in May.

In addition, China's biggest driver of its headline consumer price index, food inflation increased 11.7 percent in the year to May, raising the annual inflation to the 34-month-high in May.


China government has been struggling to curb inflation. It has raised interest rates four times since October last year. Furthermore, China's central bank has raised the reserve requirement ratio six times this year.


China's Premier Wen Jiabao on Monday said it would be difficult to hold the country's inflation under 4 percent this year. It indicated Beijing may feel hard to reach this goal. 

Many agencies and analysts released CPI forecasts in June saying China's CPI will exceed 6 percent. Some of them, including Bank of Communications, Shanghai Pudong Development Bank and Citibank, forecast that the CPI in June would hit 6.2 percent.


CPI inflation may reach 6.3 percent in June, with 1.6 percentage points contributed by pork prices, said Lu Ting, economist at Bank of America Merrill Lynch in China.


"With no significant diseases, rising profits of pig farming driven by surging pork prices likely will soon attract new supply, which would curb pork prices." the WSJ cited Lu as saying.

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THE MOSLER PLAN FOR GREECE

By Warren Mosler

The Mosler Plan, as previously posted on this website, is now making the rounds in Europe as an alternative to the French Plan that is currently under serious consideration:

Abstract:

The following is an outline for a proposed new Greek government bond issue to provide all required medium term euro funding for Greece on very attractive terms.

The new bond issue includes an addition to the default provisions that eliminates the risk of loss to investors. The language added to the default provisions states that while in default, and only in the case of default, these transferable securities can be used directly, by the bearer on demand, at face value plus accrued interest, for payment of any debts, including taxes, owed to the Greek government.

By eliminating the risk of loss, Greece will be able to independently fund all required financial obligations in the market place for the foreseeable future. The immediate benefits are both reduced interest costs that substantially contribute to deficit reduction, and the elimination of the need for the funding assistance from the European Union and the IMF.

Introduction- Restoring National Sovereignty:

Current institutional arrangements have resulted in Greece being faced with escalating interest costs when it attempts to fund itself in the market place, to the point where timely funding is not currently available without external assistance. This requirement for external assistance to avoid default has further resulted in a loss of sovereignty, with the EU and IMF offering funding only on their approval of deficit reduction plans by the Greek government that meet specific requirements. Compliance with these demands from the EU and IMF not only include tax increases, spending cuts, and privatizations, but also include aggressive time lines for achieving their deficit reduction goals. It is also understood by all parties that the immediate near term consequences of these imposed austerity measures will include further slowing of the economy, and rising unemployment.

Greece will restore national sovereignty, and regain control of the process of full compliance with the general EU requirements for all member nations, only when it restores its financial independence. Financial independence will allow Greece to again be master of its own destiny, on an equal basis with the other EU members. And the lower interest rate that result(s) from this proposed bond issue will itself be a substantial down payment on the required deficit reduction, easing the requirements for tax increases, spending cuts, and privatizations.

While this proposal restores Greek national sovereignty, and eases funding burdens, we recognize that it is only the first step in restoring the Greek economy. Even with funding independence and low interest rates the Greek government still faces a monumental task in bringing Greece into full compliance with EU requirements and restoring economic output and employment. However, it should also be recognized that financial independence and low cost funding are the critical first steps to long term success.

The Bond Issue- No Risk of Financial Loss:

Market based funding at the lowest possible interest rates requires investors who understand there is no ultimate risk of financial loss, and that the promise to pay principal and interest by the issuer is credible. To be credible, a borrower must have the means to meet all contractual euro obligations on a timely basis. For Greece this has meant investors must have the confidence that Greece can generate sufficient revenues through taxing and borrowing to repay its debts.

The credit worthiness of any loan begins with the default provisions. While there may be unconditional promises to pay, investors nonetheless value what their rights are in the event the borrower does not pay. Corporate debt often includes rights to specific collateral, priorities in specific revenues, and other credit enhancing support.

The new proposed Greek bond issue, with its provision that in the event of default the bonds can be used at face value, plus interest, for the payment of taxes by the bearer on demand, gives the bond holder absolute assurance that full maturity value in euro can always be achieved. And with this absolute assurance that these new securities are necessarily ‘money good’ the ability to refinance is established which dramatically reduces the risk of the default provisions actually being triggered. And, again, should there be a default event, the investor will still get full value for his investment as the entire euro value of the defaulted securities can be used at any time for the payment of Greek taxes. So while this discussion concerns the case of default, the removal of the risk of loss means there will always be demand for them at near risk free market interest rates, and that the default discussion is, for all practical purposes, hypothetical.

These new Greek government bonds will be of particular interest to banks, which, again, encourages bank ownership, which makes default that much more remote a possibility. This is because, in the case of default, a bank holding any of these defaulted securities will be able to use them for payment of taxes on behalf of bank clients (using that bank for payment of their taxes). Under these circumstances, a bank depositor client making payment of euro would, in effect, simultaneously buy the defaulted securities from the bank and use them to pay the Greek government taxes due. Again, the fact that the bank would be fully paid for its defaulted securities in the process of depositors paying their taxes means there will be no default in the first place, as these favorable consequences mean there will be continuous demand for new securities of this type at competitive market interest rates, to facilitate all Greek refinancing requirements.

The new ‘money good’ Greek bonds will be attractive to all global investors, both private and public. This will include international banks, insurance companies, pension funds, and other private investors, as well as sovereign wealth funds and foreign central banks which are accumulating euro reserves.

Fiscal Responsibility:

As a member in good standing of the European Union, Greece, like all the member nations, is required to be in full compliance of all EU requirements. Therefore, while this proposal will restore national sovereignty, financial independence, and lower interest rates for Greece, austerity measures will continue to be required to bring Greece into EU compliance. However, Greece will gain substantial flexibility with regard to timing and other specific detail, and will be able to work to achieve its goals in an organized, orderly manner, without the continued pressures of default risk and without the specific terms and conditions currently being demanded by the EU and the IMF. Nor will the ECB be required to buy Greek bonds in the market place, obviating those demands as well.

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A 30% RALLY IN CHINA IN THE SECOND HALF?

by Cullen Roche

More from the contrarian view on China. And this would certainly light a fire under the global economy. Citic, CIC and Shenyin & Wanguo Securities Co. say the Shanghai Composite is due for a serious second half rally as expectations of a hard landing have become too pervasive (via China Daily):

“The Shanghai Composite Index’s 6.2 percent retreat this quarter sent the gauge to 11.6 times estimated profit, data compiled by Bloomberg show. It took the global financial crisis and a decline in China’s growth rate to a seven-year low of 6.8 percent to push valuations this low in November 2008. The Shanghai gauge rebounded 49 percent in the next six months.

CITIC Securities Co and China International Capital Corp, which predicted the drop this quarter, say the market will rally in the second half as inflation peaks and the government sustains the economic expansion by easing credit. Even Nouriel Roubini, the New York University economist who says China may face a “hard landing” after 2013, expects growth of at least 8.8 percent in 2011 and 2012.

“The market has basically priced in a very pessimistic outlook for the economy,” said Ling Peng, chief strategist at Shanghai-based Shenyin & Wanguo Securities Co, ranked China’s most influential research provider by New Fortune magazine last year. “A hard landing of the economy is very unlikely,” he said, forecasting that the Shanghai index will advance as much as 15 percent by the end of the year to about 3150.

…CITIC Securities recommended shares of property developers and cement companies because of the government’s housing measures. China’s biggest brokerage, which turned “positive” on the nation’s stocks in a June 20 report after being “cautious” since April, has a six-month target of 3500 for the Shanghai index.”

3500 is approximately a 30% rally from here and would represent the highest levels since the middle of 2009 after the Shanghai’s incredible 100%+ rally off the 2008 lows. Of course, this index has tended to lead other equity markets as China’s economy remains the single most important leg in the global economic chair. 

Although I’ve been bullish just recently I have to think the macro evidence leads one to conclude that you should probably take the under on 3500. Range bound is probably more like it. And that means my approach won’t change much. This is still a traders market.

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