Archive for the ‘Economics/Finance’ Category

Suspension of demand/supply law for base metals

Sunday, March 7th, 2010

According to the economic law of supply and demand, if there is more and more supply for a given commodity, the prices should decrease if everything else remains equal. Conversely, if the supply decreases, prices should rise.

Normally this is the case for commodities like base metals. The level of stock for a given metal in the London Metal Exchange (LME) should give a good indication of the quantity supplied. So, we invite our readers to take a look at the supply/demand situation for lead, nickel, zinc, copper and aluminium. In particular look at the 5-year charts for the trend starting in January 2009. What do you see?

When? you look at the charts, you will notice something very strange. Since January 2009, the prices of these base metals rose as the supply grew as well. What is going on? Had the economic law of supply and demand being suspended as well?

Good question.

Remember what we wrote in Does rising house prices imply a housing shortage??

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today?s a fiat credit system).

Indeed, this is our interpretation of what happened to base metals as well. The expectation of rising prices acts as a sink-hole for whatever quantity of supply. The most common word used to sum up this phenomenon is “speculation.” Another word that is also often used is “investment demand.”


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When you look at the big picture, there is a big growth in “speculation” and “investment demand” over the past 10 years. From real estate, stocks, bonds, commodities, foreign exchange and even art-work (see Epic, unprecedented inflation). Today, with advances in financial engineering and information technology, it is possible to speculate in the global commodities market in the comforts of your home with the click of a mouse.

What is the root cause of this? As we wrote in Why oil cannot function as currency reserves?,

… when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?).

For the fundamental economic law of supply and demand to work, prices have to convey accurate market information. Prices are expressed in terms of monetary units. That means the monetary unit is the yardstick which is used to measure the relative value of things. What if the integrity of this yardstick is being compromised? As we wrote in our book, How to buy and invest in physical gold and silver bullion,

Let?s suppose you want to compare the length of two boxes. You may use a ruler to measure their lengths and from the results of your measurement, conclude which one of them is longer. A ruler can do such a job because its length is reasonably consistent for the foreseeable future.

Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the boxes? An elastic ruler is useless because you can always make up the measurement of the boxes to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let?s take a look at oil prices. Since oil is priced in US dollars and if the supply of money and credit (in US dollars) can be expanded and contracted by monetary inflation and deflation, how useful do you think it is as a calibration for measuring the value of oil relative to other things?

The rise of “speculation” and “investment demand” is a sign of a funny monetary system.

Why oil cannot function as currency reserves?

Sunday, February 28th, 2010

Not long ago, we were talking to an analyst from a pretty reputable value fund manager. He was adamant that gold is in a bubble because “everyone is buying it.” When we heard his rationale for this belief, we knew straight away that he had not clearly thought through his underlying beliefs about gold and the nature of money.

In fact, his understanding about the nature of money is closer to the level of an uninformed person on the street than what we expect from an investment professional. For example, this analyst was completely blind to the colossal difference between the rarity of gold and the rarity of rocks, citing that there are heaps of gold in the world! It is one thing to have a different opinion about gold because one belongs to the deflation camp. But it is just simply too shocking to hear a suit-wearing investment professional from a reputable fund manager sprouting such nonsense! If a person cannot see the difference between the rarity of gold and rocks, then it will be beyond his level to even understand the properties of good money, which is critical to understanding gold.

Now, if you are new to this blog, you may wonder whether gold is a bubble or not, since there is no (or rather, very limited, to satisfy the pedantic) industrial use for it. If this is your question, we recommend that you read If gold has no intrinsic value, is it a bubble?. Or better still, you may want to read our book, How to buy and invest in physical gold and silver bullion for a fuller picture.

At this point, this analyst posed a very good question. Given that everyone agrees that the US dollar is going to depreciate further in the long run, then wouldn’t oil be a better substitute (e.g. as currency reserves) for it than gold? As that analyst said, oil should be a better substitute because it is a vital commodity, whereas gold has hardly any practical and industrial use? In other words, will oil function better as money than gold?

To answer this question, first we have to understand what money is. At the root of its nature, it is a medium of exchange. From this nature, it then follows that money functions as unit of accounting, store of wealth and so on. The question then becomes, is oil a better medium of exchange than gold?

At first glance, it seems that the answer is yes. But if you think carefully, if oil ever becomes a medium of exchange tomorrow, it will bring about disaster to humanity. To understand why, let’s have a thought experiment. Remember, back in If gold has no intrinsic value, is it a bubble?, we wrote,

Now, imagine if one day the US government decree that all tooth-pastes become legal tender for payment and settlement of debt (i.e. function as money), how would you feel if you have to physically consume your money daily for the sake of oral hygiene?

Let’s say the government declares that 30 days from now, tooth-pastes will function as legal tender money. What will happen? Firstly, the prices of tooth-pastes will sky-rocket. Next, tooth-pastes will disappear from the shelves of supermarkets. People will be hoarding and stockpiling tooth-pastes. After 30 days, when tooth-paste officially becomes legal tender money, people will start to have bad breath, especially the poor, who can’t afford to consume tooth-pastes for the sake of oral hygiene. Then the demand for tooth pastes will rise to the moon, not because the demand for oral hygiene increases, but because the demand for tooth-pastes as money increases. Not only that, no matter how much tooth-pastes Colgate produces, there will always be shortages because there will be mass-hoarding of them as money.

This may be a funny though-experiment. But if oil should ever function as medium of exchange, the outcome will not be funny. There will be an acute shortage of oil, as nations will be hoarding and stock-piling oil in a frenzy. Guess what will happen if we have acute oil shortages in a Peak Oil world that is addicted to oil? The way of life as we know will grind to halt and we will all be back to travelling in horse-drawn carriages.

That is why, when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?). That also explains why the housing ‘shortage’ situation in Australia is an intractable problem (see Does rising house prices imply a housing shortage?).

That is the reason why gold and silver?functioned as money historically. The free market tried using scarce, useful and vital commodities (e.g. salt, sugar, tobacco, cattle) as money before and it didn’t work out. Those that did probably did not evolve into more advanced civilisations.

Of course, just because it is stupid to let oil function as currency reserves does not necessarily mean it wouldn’t. As Albert Einstein said, two things are infinite: the universe and stupidity.

How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate

Sunday, February 7th, 2010

Whenever we hear that the Federal Reserve is going to keep the interest rate close to zero, we may wonder what is meant by “interest rate?” Specifically, which interest rate does it mean? After all, there are many “interest rates,” from 30-day bank bill rates to 30-year Treasury bond yields. As it turns out, the “interest rate” that the Federal Reserve controls is the Fed Funds Rate.

The Fed Funds Rate is basically the rate that banks lend to each other overnight. Also, the Federal Reserve (so do many other central banks like our RBA) does not set the interest rate in the form of a decree to be followed. Instead, the Fed Funds Rate ‘sets’ the Fed Funds Rate by adjusting the supply of money such that it reaches a target that is intended (see How does a central bank ?set? interest rates?). The Fed Funds Rate in turn influences the interest rates in the market.

Well, not quite.

At least that’s true for the past two decades before the Panic of 2008. Ever since the September 2008 bankruptcy of Lehman Brothers, the Fed has lost control of the target Fed Funds Rate, as it begin to ‘print’ copious amount of money to save the world from a Greater Depression. As you may recall from How does a central bank ?set? interest rates?, the central bank can either control the quantity of money or the target Fed Funds Rate- it cannot control both. The GFC forced the Fed to flood the financial system with heaps of ‘printed’ money, which undermined its ability to control the target Fed Funds Rate.

So now the problem is to find another “interest rate” that is more relevant. As this Bloomberg article wrote,

Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they?ve used for the last two decades.

One of the “interest rates” that is under consideration is the interest rates paid by the Federal Reserve to commercial banks’ reserves. A simple way to understand what “reserves” are is to imagine the Federal Reserve being the bank of commercial banks. “Reserves” are simply the ‘cash’ that they ‘saved’ at the Federal Reserve.

Originally, the Federal Reserve did not pay any interests on reserves. After all, the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ‘productive.’ As you can see by now, buying supposedly ultra-safe Treasury bonds at whatever yield was even better than keeping the reserves at the Fed at zero yield.

But the GFC messed everything up.

On October 6 2008, the Fed announced that they will be paying interests on banks’ reserves. The reason for doing so is to allow the Fed to control market interest rates and the quantity of money (reserves) via its various liquidity facilities. As the Fed said in that announcement, it

… give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets [e.g. banks refusing to lend to each other] while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

In other words, the interest rates on reserves is now the only tool at the hands of the the Fed to influence market interest rates. (Note: if you want to understand why, you can read this paper from the Federal Reserve here).

Now, there is a worry that with so much excess bank reserves (thanks to money printing) in the financial system, inflation will take hold once banks start lending them out again. What is the Fed going to do to restrain the banks from lending, thus causing inflation?

We will look into it in the next article.

Will gold mining shares hedge against deflation again since the Great Depression?

Sunday, January 31st, 2010

During the Great Depression, gold mining stock prices were the only bright light in the darkness. As one of our readers found a 1931 newspaper quote,

Gold mining stocks have been among the strongest performers since year-end; earnings this year seen exceeding both 1930 and 1929; miners are benefiting from stable price as production costs decline.

As we quoted the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?,

Leaving aside the industry of manufacturing books on crises and cycles, there are two big industries likely to prosper inversely to the depression, the armaments industry and the gold-mining industry.

Does that mean that gold mining shares are going to do well in times of deflation because it did well during the deflationary period of the Great Depression?

No.

Here, we have to be careful in applying the lessons learnt from history correctly. There is a reason why gold mining shares did well during the Great Depression. Unfortunately, that reason does not apply in today’s context. What is the difference between today and the Great Depression?

The gold standard.

You see, back in 1931, one ounce of gold was defined as approximately US$20. Back then, as we introduced the history of money in our book How to buy and invest in physical gold and silver, currencies (e.g. dollar, pound, franc) were merely warehouse receipts for physical gold. In a sense, the central bank was a government granted monopoly gold warehouse.

In other words, the Federal Reserve was the only institution in the world that would buy and sell gold at a guaranteed fixed price (because the US was the only country still under the gold standard). The were two implications:

  1. There was an infinite ‘demand’ for the produce of gold mining companies.
  2. The price of the what the gold mining companies produced had a minimum price.

As the Great Depression was a period of deflation, prices of everything were falling. That means the costs of gold mining companies were falling as well. So, if you have a business in which the things that it produces:

  1. Have infinite demand
  2. Have a guaranteed minimum price
  3. Are getting cheaper to produce

Wouldn’t that be a windfall for you business? Indeed, that was the fortunate position faced by gold mining companies back then. That’s why their share prices were rising. Today, no country is under the gold standard and thus, currencies are backed by nothing. Therefore, gold mining companies are facing an entire different situation:

  1. Their produce have finite demand
  2. Prices of their produce fluctuate
  3. Costs of producing are increasing

Even if real deflation is to happen today, falling cost of production will be accompanied by a fall in price of gold.

So, if you find any experts, tip-sheets and research reports justifying buying gold mining shares as a hedge against deflation by using the example of the Great Depression as the basis of their recommendation, then you know what to do.

Turkeys fattened for slaughter in the Chi-tralia bubble

Sunday, January 17th, 2010

In our previous article (Is the coming ?crash? in China not a real crash?), one of our readers sent us a link to a very good article (Trapped Inside a Property Bubble) written by a former Morgan Stanley economist named Andy Xie. He is a very contrarian and provocative analyst who called China’s economy as a “Panda Economy” (named after the cartoon movie,? “Kung Fu Panda”). His bearish call on the Chinese economy attracted a fair amount of criticism from Chinese government officials.

One of our readers, Pete, had highlighted sections of Andy’s article, with some good questions and comments…

Once a country loses export market share on rising costs, it stagnates because property bubbles during high growth periods deter consumption while overwhelming the middle class with housing expenses.

As property bubble grows further, debt servicing burden will grow as well. That in turn will deter consumption further as more and more of income will be spent on repaying debts. The only way to increase consumption whilst debt servicing burden is increasing is to increase debt further. Obviously, if a consumption-based economy is dependent on increasing debt to sustain consumption, then it is an economy that is addicted to debt. Once credit growth stalls, the die is cast for the economy. Back in January 2007, we wrote in Myth of asset-driven growth,

… asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuity. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight.

Since the Chinese economy is still dependent on cheap labour to achieve low cost production, labour costs increase will kill its competitiveness. As a result, exports will decline. If at that point in time, citizens are burdened heavily with debt, there is no way they can increase their consumption to replace the lost exports.

Similarly, Australia is already a highly indebted nation. The only thing preventing the Australian economy from falling into deflation is Chinese demand for Australian resources. As we wrote before in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

There are some signs that Australian consumers are binging on debt once again. Should this translate into a resumption of increasing credit growth, it will mean that Australia is increasing its vulnerability to any slowdown in the Chinese economy. Worse still, Australia is selling more and more of its businesses, capital and resource companies to China, which means that more and more future economic growth will no longer benefit the next generation.

Enough about Australia. Let’s look at Andy Xie’s article further,

The dollar has bottomed. The Fed will begin raising interest rates in 2010.

Andy Xie reckons that the US dollar has bottomed and that the interest rate cycle has bottomed as well. What are our views?

As we wrote in Permanently low interest rates for Uncle Sam?, the more indebted the US government is, the harder it is for them to raise interest rates. According to Marc Faber, currently, 12 percent of US government’s tax receipts goes to interest payment on their debt. In 5 years time, it could be at 35 percent. Should the US raise interest rates to combat any potential price inflation, that will increase the debt burden of the US government unless the US economy can put on a miraculous feat of super-turbo-charged growth. This means that the higher interest rates goes, the higher the risk of the US government becomes insolvent sooner.

Next, Andy Xie wrote,

One possible way to prolong the bubble is to appreciate the currency, as Japan did after the Plaza Accord, to contain inflation and attract hot money. Such a strategy will not work in China. Japan’s businesses were already at the cutting edge in production technologies and had pricing power during currency appreciation. They could raise export prices to partly offset currency appreciation. Chinese companies don’t have such advantages but rely on low costs to compete.

That’s a reason why China cannot let the yuan appreciate too much too soon. Next, Andy wrote,

China has been trying to promote consumption for a decade. However, consumption’s share of GDP has declined annually. The reason is the policy environment has been squeezing China’s nascent middle class through high property and auto prices along with high income tax rates.

Recently, there’s a Chinese soap opera titled “Dwelling Narrowness.” That was a very highly popular show because it strikes a cord with the Chinese middle-class, who are burdened with taxes, corruption, high property prices, inflation and so on. Unfortunately, that soap opera was terminated early by the Chinese government.

As we wrote in Chinese government cornered by inflation, bubbles & rich-poor gap,

In other words, the paradox is that the further the Chinese government delay in tackling inflation, the more reliant they will have to rely on American consumers, which means it is harder for them to let the yuan appreciate.

The inflationary policies of the Chinese government are hurting Chinese consumption more and more.

Andy wrote further,

China’s property market is creating winners and losers based on timing. All other factors ? including education and experience — have been marginalized as the economy rewards speculators. And as more play the game, the speculator ranks rise and fewer people work, perhaps contributing to a labor shortage.

Our reader, Pete was wondering how could it be that China can have labour shortage. Our take is that it is skilled labour shortage that China is increasingly short of. Anyway, as we wrote in Harmful effects of inflation, an economy based on inflation and asset price bubble to sustain growth is an economy that rewards speculation instead of hard work.

Finally, Andy wrote,

The killer is inflation driven by a surge in money printing. The average lag between currency creation and inflation is 18 months in the United States. China’s lag could be two years since the government uses subsidies to suppress inflation. By 2012, China could experience 1990s-like inflation. And that’s when the property bubble will probably burst.

We will add this: in a highly indebted society, price inflation without adequate wage inflation will contribute to the bursting of the asset price bubble.

Many of what Andy Xie wrote also applies to Australia. When the Chinese bubble burst, Australia’s bubble will burst too. Marc Faber, while he agrees with Jim Chanos that China is in a bubble, believes that the implosion of the Chinese economy will not happen soon (see China bubble will not burst right away: Marc Faber). If this is true, it means that many Australians will be suckered into more debt (property prices may even be inflated further), which is akin to a turkey being fattened for the day of slaughter. The difference between 2008 and that day of reckoning is that more Australian businesses, mines and capital will be under Chinese control by then.

Is gold going parabolic?

Tuesday, December 8th, 2009

No doubt, as gold prices run up in the latter half of 2009, a lot of commentators are saying that gold is in a bubble territory. Their justification for such a claim is that when an industrially useless metal to go up in price so quickly, irrationality is the only explanation. Hence, according to them, it can only be described as a “bubble.” Even the Sydney Morning Herald, came up with an article titled, Gold a ‘useless asset to own’.

But as contrarian investors, we welcome such ignorance. That is how wealth is transferred from the weak hands to the strong hands. If you have not already, we recommend that you read If gold has no intrinsic value, is it a bubble?. Those who believe that gold is in a bubble do not understand the fundamental of what money is- they fail to see the mirror image irrationality. With that, we shall take a quote from Marco Polo in our book, How to buy and invest in physical gold and silver bullion,

With regard to the money of Kambalu the great be called a perfect alchymist for he makes it himself. He orders people to collect the bark of a whose leaves are eaten by the worms that spin silk thin rind between the bark and the interior wood is taken and from it cards are formed like those of paper all black He then causes them to be cut into pieces and each is declared worth respectively half a livre a whole one a silver grosso of Venice and so on to the value of ten bezants All these cards are stamped with his seal and so many are fabricated that they would buy all the treasuries in the world He makes all his payments in them and circulates them through the kingdoms and provinces over which he holds dominion and none dares to refuse them under pain of death All the nations under his sway receive and pay this money for their merchandise gold silver precious stones and whatever they transport buy or sell The merchants often bring to him goods worth 400,000 bezants and he pays them all in these cards which they willingly accept because they can make purchases with them throughout the whole empire He frequently commands those who have gold silver cloths of silk and gold or other precious commodities to bring them to him Then he calls twelve men skilful in these matters and commands them to look at the articles and fix their price Whatever they name is paid in these cards which the merchant cordially receives In this manner the great sire possesses all the gold silver pearls and precious stones in his dominions When any of the cards are torn or spoiled the owner carries them to the place whence they were issued and receives fresh ones with a deduction of 3 per cent If a man wishes gold or silver to make plate girdles or other ornaments he goes to the office carrying a sufficient number of cards and gives them in payment for the quantity which he requires. This is the reason why the khan has more treasure than other lord in the world nay all the princes in the together have not an equal amount.

Chapter XXVI, Paper Money Immense Wealth of the Great Khan, The Travels of Marco Polo

To understand gold, one needs to understand the history of money (which our book, How to buy and invest in physical gold and silver bullion has more information on). If we can laugh at the irrationality of the ancients as described in Marco Polo’s memoirs, then we certainly have to laugh at humanity’s irrationality today with regards to money.

But at the same time, we are not saying that gold is the cure-all for the the ills of today’s monetary system. In other words, we are not worshipping gold (see When to sell your gold?).

But if you are still worried that gold prices are running up too fast, you ain’t seen nothing yet. This speed in price increase is nothing compared to what happened in 1980. Let’s take a look at the gold price chart back then:

Gold price from 1975

Gold price from 1975

By 1979, inflation in most countries was running in double digits in most countries. Oil prices was spiking and the Iranian revolution toppled the Shahs. The Soviets was entering Afghanistan. Back then, there was a real fear that the world will end and that seemed like the end of fiat currencies (8 years after President Nixon cut the final link between gold and the US dollar). The price of gold doubled in a few weeks between December 1979 and January 1980. That’s really a parabolic movement. Today’s run up in gold prices is nothing compared what happened in 1979/1980. We have friends who bought gold in 1980 at around US$800. Back then, there was talk that gold price would be hitting US$1000. Unfortunately, gold price fell and our friends lost half their capital in a flash.

But fortunately, fiat currencies survived and the world did not end. But those who ridiculed gold used that as a basis to believe fiat currencies will still survive i.e. fiat currencies will survive because they did survive after 1979. This is an example of a mental pitfall that we call “lazy induction” (see Mental pitfall: Lazy Induction). That’s because if you take an even bigger picture view, there were many countless examples whereby all the other fiat currencies in the entire history of human civilisation failed to survive. The Mongol currency during Marco Polo’s time was such an example.

As Nassimb Nicholas Taleb wrote in The Black Swan: The Impact of the Highly Improbable, the wrong way to learn from history and looked at happened and then extrapolate it into today. It is equally important to look at what could have happened and evaluate whether it is still applicable today. In his words, we have to study the “alternative paths” of history. For all we know, fiat currencies could have died after 1979. Maybe, someone powerful back then could have made a slightly different decision and that could have set a chain reaction that would culminate in the death of fiat currencies.

We never know whether the “alternative path” of history will happen today. But it pays to be prepared.

Is the Chinese economy a house of cards?

Thursday, November 26th, 2009

When you trawl through the mainstream media, blogs and pundits’ opinions, you will notice that there’s increasing reservation on China’s ‘impressive’ economic growth. One of the world’s most notorious short-seller, Jim Chanos recently announced his intention to short China. He’s the one who famously shorted Enron and Macquarie Bank.

Jimmy Rogers, on the other hand, is bullish on China. But that’s not mean that he believes that it’ll be forever blue skies ahead for China. In fact, he acknowledges that China will experience problems from time to time. Unfortunately, his bullishness gets the more attention from people. We do not know whether it’s because he seldom talks about his reservations on China, if any, or it’s selective hearing from the ears of people.

Anyway, this new-found bearishness on China is based on the idea that China’s economic growth is:

  1. An artificially induced bubbly boom through the force feeding of credit into the economy and government stimulated infrastructure investments (white elephant infrastructure projects??)
  2. Based on doctored figures

Back in July, we wrote of the massive force-feeding of credit in China:

  1. Is China setting itself up for a credit bust?
  2. How big is the credit bubble in China?

Indeed, there is a burgeoning asset price bubble in China. Hong Kong luxury apartments have sky-rocketed in price. There are even stories of speculators stockpiling physical base metals. There are also many anecdotal evidences that China infrastructure oriented stimulus is resulting in huge white elephant infrastructure. For example, this YouTube video showed a huge Chinese ghost city built from scratch in Inner Mongolia. We heard of reports of massive 5-lane motorways with no traffic.

Yu Yongding, economics professor at the Chinese Academy of Social Sciences (and formerly a member of the People’s Bank of China monetary policy committee), has recently sounded the alarm (see China bubble puts our recovery in doubt). We first mentioned this economist back in October 2007 at China considers leaking money to overseas stock when he warned the Chinese government on certain policies.

More ominously, we are seeing signs that the Chinese government is repenting on their extremely lax credit policies. As China’s banking regulator warned (see Capital crunch for Chinese banks),

China’s banking regulator has warned it would refuse approvals for expansion and limit banking operations if lenders did not meet new capital adequacy requirements, a move that has prompted the country’s largest state-owned banks to prepare capital-raising plans for next year and beyond.

Even the adviser to the People’s Bank of China is sounding the alarm on asset price bubbles. As China Faces Asset-Bubble Risk, PBOC Adviser Fan Says (Update2),

?The real risk is really asset bubbles,? Fan, who heads the National Institute of Economic Research, said at a business conference in Hong Kong today. A ?Chinese asset bubble would be something very dangerous, that would cause the overheating? elsewhere as well, he said.

Also, Bloomberg reported that China is taking the first steps in capital control in a bid to stem its asset price bubbles (see China Tightens Rules on Transfers to Stop ?Hot Money? (Update1)) from overseas speculative capital.

If Australia has to thank China’s economic strength for protecting its economy from a hard landing, what will a bust in China do to Australia?

Permanently low interest rates for Uncle Sam?

Sunday, November 22nd, 2009

Imagine you owe a lot of credit card debt. And also imagine you have a prodigal son who blew lots of money away in gambling debts and asked you for a bailout. So, you borrow more from your credit card to help bail out your son. Also, your yearly expenditure is projected to keep on rising.

As you borrow more, more and more of your yearly income is spent on debt repayment. What if, in 5 to 10 years time, half of your annual income has to be set aside for the interest payments alone for your debt? In addition to that, what if you have already made promises to your aged parents that you will be responsible for their aged care expense in that time? Eventually, it will come a time when you have to borrow more and more money to pay the interests on your debt. When that day comes, your debt will explode exponentially.

Well, this is the situation of the United States government. In this story, the prodigal son is Wall Street. The aged parents is the coming unfunded social security and Medicare liability of the US government. As the graph from this news article showed,

Interests on US debt

Interests on US debt

Now, what if you can choose the interest rates of your debt repayment. Obviously, you will select the lowest possible rates in order to reduce your debt burden. This is what the Federal Reserve will have to do. As we quoted Marc Faber in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

The Fed controls the short-term interest rates. It has keep the rates low because by pursuing tight monetary policy now, the short-run cost of servicing the US government’s debt will be significantly increased. As this?news article reported,

A Treasury borrowing advisory committee reported in early November that “approximately 40 percent of the debt will need to be refinanced in less than one year.

If the US wants to pursue tight monetary policy soon, it will have to deal with the short-term government. One way to deal with it is to refinance the government debt with more expensive longer-term treasury bonds. But the further the term of the government debt, the less the Fed has control on the interest rates.

What if, the free market insists that the US government pay higher interest rates? In that case, the Fed will have to buy up the government debt (i.e. print money), which artificially pushes up the government bond prices (i.e. push down the yield on the government debt). This is highly price inflationary, which in turn will make the government debt even more undesirable by the free market. That will result in the Fed having to print even more!

What will be the next market panic?

Tuesday, November 17th, 2009

It is an open secret that the zero interest rate policy (ZIRP) by the Federal Reserve is fuelling a carry trade bubble as described in Return (and potential crash) of the great Aussie carry trade. In fact, the Chinese are seething with anger as they blasted the Americans as the root cause of blowing asset price bubbles all over the world. As this article wrote,

The US Federal Reserve is fuelling ?speculative investments? and endangering global recovery through loose monetary policy, a senior Chinese official warned on Sunday just hours before President Barack Obama arrived in China for his first visit.

As far as Wall Street and their buddies in the US government is concerned, an orderly decline of the US dollar is not their problem. It is the problem of

  1. The American people because a depreciating US dollar means a lower standard of living for them via price inflation
  2. Export-oriented economies because it makes their wares more expensive to Americans
  3. Countries who more or less peg their currencies to the US dollar because lose American monetary policy implies a lose domestic monetary policy, which helps to ignite asset price bubbles.

Right now, there are two possibilities for the US dollar: a short-term rebound or a Black Swan trigger that turns an orderly decline into a disorderly rout.

The first possibility should be familiar to you- it will probably look similar to the Panic of 2008. Based on technical analysis, the USD is extremely oversold and ought to be very vulnerable to a rebound. Most likely, it will turn out that way: a ‘surprise’ deflationary event (e.g. see Looming Black Swan that can bring the market back into panic) triggers a USD short covering (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which will result in a return of fear and panic and then followed by more money printing, stimulus and bailouts.

The second possibility is the really unpredictable one. The flight away from the US dollar may not necessarily be towards the non-US currencies (e.g. AUD)- instead it could be towards precious metals. In that case, we can see some strengthening of the US dollar plus the soaring gold prices in all currencies. Our hunch is that the next big move in the markets is not going to follow the familiar deflationary script of the first possibility- it is just too predictable. Because it is too predictable, Wall Street, Bernanke and the authorities must have already anticipated them and manipulated the markets to prevent it from happening. Hence, perhaps the much anticipated correction will not happen in the conventional form that we expect? Perhaps the deflationists have severely underestimated the cunning of the gang?

But there is a limit to how far that gang can manipulate the markets. When they have a rival nation (China) that follows different set of rules, different forms of governments and whose national interests are incompatible, things are much trickier. We have no doubt that the Chinese, in the quest of their own national interests, are undermining the national interests of the US, whether as an deliberative active policy or as a consequence of their mercantilist pursuits. The intersection between this clash of interests is where miscalculations and loss of control of the markets happen. This is where economics and politics collide.

Our hunch is that the next panic may have something to do with currencies. Should this occur, the only safe haven we can think of is precious metals. As to when and how the panic will look like, we do not know.

Next wave of defaults to come?

Sunday, November 8th, 2009

Is the worst of the mortgage crisis over in the US? This chart below shows that the next wave of mortgage defaults is yet to come:

Upcoming surge of mortgage loan reset

Upcoming surge of mortgage loan reset

For our Aussie reader, the options ARM mortgage is similar to a variable rate mortgage with a few twists, including the ability to choose the payment options. Typically, option ARM mortgages have a very low teaser rate, after which it will reset after a certain period of time (see this Wikipedia article for more information).

The above chart shows that there will be a growing wave of interest rate resets in the coming months, peaking at around September 2011. If the US economy is still mired in higher and higher unemployment by then, then this will mean even more bad debts in the financial system.

This ought to be deflationary (in terms of asset prices). But the Federal Reserve will be stepping up its printing press and the government will step up more ‘stimulus,’ bailouts and so on. The Federal Reserve will be saddled with more dodgy ‘assets’ as well. So, what will happen to asset prices?

No one knows.

But we suspect that we will get to see more and more contradictory news like this:

Newspaper photo cut-out

Newspaper photo cut-out

Thank you, David for kindly emailing this recent photo cut-out on the business section of The Australian.