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Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

Sunday, October 10th, 2010

Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

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Pay attention to China-US currency tension

Monday, September 27th, 2010

Last week, in What can you do to protect yourself from increasing currency volatility?, we wrote about the rising currency/trade tension between the US and China is flaring up again. While such tensions are hardly common occurrence in the love-hate mutual co-dependency relationship between the two giants, this current one has reached a a new high point.

Last week, US politicians have agreed to vote on a bill to retaliate against perceived Chinese currency ?manipulation? with trade sanctions (see US Congress committee approves China sanctions bill). For this bill to become law, the two Houses of Congress (House of Representatives and Senate) have to approve of the bill. This coming week, the House of Representatives is going to vote for it. But it is unclear whether the Senate will support this bill before the November mid-term elections.

If this bill comes into law, and if the Obama Administration decide to slap China with draconian trade sanctions against China, then outcome will be a trade war between the world?s two largest economies. The Chinese will definitely retaliate, sparking another round of retaliation from the United States. The outcome will be mutually assured economic destruction.

Some prominent American economists (e.g. Paul Krugman) in the United States that a trade war will hurt China more than it will hurt the US. This is because they subscribe to the theory that a trade war will disrupt vast swathes of the Chinese export-oriented economy, which in turn will result in social and political instability that will threaten the legitimacy of the government. Hence, these economists are very keen and aggressive with the idea of imposing trade sanctions on China. But as we wrote in Will China fall under popular revolt?,

? this school of thought do not understand the cultural and political reality of modern China.

However, there is a subtlety that you have to understand- Yes, the immediate impact of a trade war will probably be more painful for China initially. The idea is that, as we wrote in Can China really ?de-couple? from a US recession?,

This will translate into a disproportionate contraction in the higher stages of production, which is China?s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production.

But we do not subscribe to the theory that this will result in political upheaval in China. Instead, we believe a trade war will fan the flame of nationalism in China and strengthen the position of the Chinese regime.

Regardless of who wins in a US-China trade war, countries like Australia and the rest of Asia will suffer as collateral damage. As the saying goes, when two elephants fight, the grass below will suffer.

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Is Chinese iron ore demand going to crash (thereby crashing the Australian economy)?

Sunday, September 12th, 2010

Last Thursday, an article in the Sydney Morning Herald screamed, Slump likely in iron ore demand,

Chinese demand for iron ore seems set to slump after Beijing’s extraordinary move to turn off the power supply to its industrial heartlands.

There seemed to be fears in the industry that the Chinese government is slamming on the brakes on their economy. As the article continued,

Radical power cuts across the country reflect the promise of the Premier, Wen Jiabao, to use an "iron fist" to achieve tough, five-year energy intensity targets that expire this year.

There seemed to be an air of incredulity floating around. Is the Chinese government really hell-bent in crashing their own economy? As one of Macquarie Bank?s commodities analyst said,

You can’t just turn steel production off and expect the economy to function – it’s insane.

If the Chinese government are really that insane, then it doesn?t take a genius to figure out that iron ore prices will slump significantly going forward. Share prices of companies like BHP will follow as well.

But are they really that insane?

To answer this question, we recalled a comment by one of our readers (Paul in Beijing) in Concerns about China?s slowdown,

Put this in your diary. The restrictions will last until November. By December this year, production of key items such as steel and cement will be returning to full pelt.

As Paul said in Do you think China will crash soon?, we are now at the final months of China?s 11th five-year plans.

The first is that the 11th 5-year plan is now just a few months away from concluding. As in all political situations, it is of paramount importance for the current leadership to return an unblemished report card at the next Plenary meeting of the Communist Party. Hence the attacks on inflation, energy intensity and other issues.

What we think has happened is that on the issue of emission targets, the Chinese government realised that they were not going to reach it at that rate it was going. They had a set of numbers for the targets to reach by the end of this year and they realised that they weren?t going achieve that based on the status quo. Hence, the urgency to slam on the brakes so that at least where the aggregate numbers were concerned, they had done their job.

Why is it so important to reach the targeted numbers? Some say it?s a matter of saving face. That is, not reaching the targeted numbers is humiliating for the government. Others say it is a matter of having a perfect report card for the Hu-Wen team. That is, reaching the targeted numbers is another tick in their report card.

But assuming that by December, the restrictions are relaxed, the Australian economy is still not out of the hook yet. As Paul said,

The second point is that the 12th 5-year plan has not yet been promulgated. Already there are rumblings as to what it might include. The China Nonferrous Industry Association, for instance, has drafted a plan that would limit the capacity of alumina, aluminium and copper over the next 5 years. If such a plan were to be introduced, it would have massive repercussions for the world (buy UC Rusal shares for a start!).

In hand with this is the fact that the current leadership has only 18 months left in their tenure. The next generation of leaders has apparently been tapped and is being groomed. But unlike the present pair, the next generation come from opposite factions within the CPC. their ability to lead harmoniously may well be sorely tested! (Should they fall out, it would leave the Howard-Costello schism, or the Gillard-Rudd antagonism, for dead.

This is what we have to watch out for!

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Divergent view of Australian economy between domestic and foreign investors

Sunday, September 5th, 2010

Back in If the Australian economy ?booms? further, how is it setting the stage for a bigger bust later?, we wrote that

? as Australian-based investors, we are looking into increasing our allocations to investments that have greater exposure overseas

Increasingly, foreign investors seem to be concurring with our outlook. For example, as we wrote in What do overseas property investors see that Australian property investors don?t? foreign investors are getting more nervous about Australia?s housing market.

As this article in The Australian reported,

The Weekend Australian spoke to senior traders in New York, London and Hong Kong to gauge the appetite for investing in Australia. The overwhelming response was that global institutional investors are wary, despite the economy having emerged as one of the best performing in the world and avoiding a recession.

In fact, the debt market is predicting a small chance of interest rates cut next year. Currently, financial markets is pricing in a 40% of a rate cut of 0.25% by the first half of 2011. You can be sure that if the RBA ever cut rates, it will be in the context of bad news in the economy. As we wrote in What will happen if RBA cuts to zero?,

If Australia?s interest rates ever reach zero, it will happen in the context of a hard landing or even a depression.

Yet, on the other hand, forecasters in Australia are expecting that rates will continue to rise in 2011. For those of us residing in Australia, it is very clear from observing the mainstream media reports that the mood is pretty optimistic.

Since foreign investors have less of a stake in Australia than domestic investors, they will have the attitude of shooting first and asking questions later when they see trouble. That will translate to volatility in the AUD and stock market. That in itself can become a self-fulfilling prophecy.

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Bernanke warming up the printing press

Sunday, August 29th, 2010

Last month, we wrote in Prepare to pull the trigger on speculating! about the signs to watch out for the timing to speculate. Well, the sign arrived over the weekend.

Last Friday, Ben Bernanke gave the strongest hint about money printing. As this article reported,

Federal Reserve chairman Ben Bernanke has laid out four "unconventional" policy options to boost the US economy.

Top of the list is more "quantitative easing" – mass purchases of debt.

"Quantitative easing? sounds technical, but it basically means printing money. In another article, Bernanke is talking tough against deflation,

Federal Reserve Board Chairman Ben Bernanke said Friday that the central bank would not sit idly and let the U.S. economy sink into a period of deflation.

"The Federal Open Market Committee will strongly resist deviations from price stability in the downward direction," Bernanke said in a speech opening the Fed’s annual summer policy retreat.

The Fed would be "vigilant and proactive" if inflation falls by a significant amount, he said, though he downplayed concern that the economy would fall back into another downturn, or a double-dip recession.

As we wrote in our book, How to buy and invest in physical gold and silver bullion,

The United States, with ?helicopter? Ben Bernanke at the helm of the Federal Reserve, is committed to money printing to solve America?s economic woes. To the extent that the US dollar is the world reserve currency, it will affect the rest of the world.

In essence, for investors who still believe in deflation, Bernanke is saying, ?Try me. I dare you.?

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What if Australia?s banking system needs a Government bailout?

Tuesday, August 17th, 2010

As most of us are aware, Australia has the ?four pillars? ? four large banks that provide the majority of Australia?s local banking credit. Over the last few decades, these four banks have increased their exposure to residential mortgages, even in the face of what appears to be a large housing bubble.

Mark Joiner, NAB?s finance director is confirms in this article:

[CBA and Westpac] ?with mortgages accounting for more than 60 per cent of the Sydney banks’ balance sheets?

“Australia should have a balanced economy; not a big skew to mortgage or business lending”

Each of these four banks lends money to each other and has enough influence on the economy to be considered ?too big to fail? by most – the failure of one bank potentially triggering the collapse of another and so on.

Popular opinion suggests that if such a scenario were to occur, the Australian Government would step in to bail out the banks and prevent them from collapsing. This would require the Government to acquire money, either by borrowing it, selling bonds or ?printing? it.

If we make the assumption that the Government would be forced to act in this way, the repercussions of such action could be that borrowing or bond sales increase the Government?s financial liability. This increases the risk of lending to the Government, possibly even our AAA debt rating. Such increased risk will:

  • increase the cost of borrowing for the Government and local companies including banks
  • decrease the amount of credit easily available
  • increase the Government deficit and annual interest payable
  • increase local interest rates, making it more expensive for the public to service debt or take on new debt, possibly reducing the ability of the public to purchase property

If the Government resorted to money printing (or equivalent), it is likely that the value of the Australian dollar would depreciate, causing credit problems similar to the ones mentioned above. And if such problems persist, they would form part of a feedback loop that amplified them over time (see Serious vulnerability in the Australian banking system).

However, this does not mean that the problems would be inescapable. Strong fiscal policy, increased taxes, reduced spending ? all of these could contribute to bringing Australia back into healthy financial territory.

But what are we missing? Even now, people are crying out for spending on infrastructure in NSW, VIC and QLD by the state and federal governments. How will the Australian Government have the funding to pay for any of this if it is trying to pay down debt, or if the cost of debt is increasing? Every dollar of government spending sourced through taxes, services, bond sales or borrowing has been labelled to be spent on something. If the Government allocates money to bail out banks, it is taking it away from spending on other items. From this we get a mis-allocation of spending, which will create market distortion and potentially hamper the economy at a time when Australia can least afford it.

From this we can deduce that there must be a limit to how much money the Government would realistically allocate to a bank bailout. At some point the risk of bank failure to the economy will become less than the risk of removing Government spending from the economy. Whether from this point the banks will actually fail or not cannot be known at this point.

And a final point to consider is that after bank bailouts, will the banks be very cautious lenders who have learned valuable lessons about asset risk and reserve requirements, or will they have an increased risk appetite due to a feeling of assurance that the Government will always step in and save them from ruin?



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Do you think China will crash soon?

Thursday, August 5th, 2010

Today, we will be doing something a little different. Instead of us doing the talking, we will let you discuss and brainstorm this question.

A little background about this question. In many of the interviews with Marc Faber, he correctly predicted that China will slow down. Furthermore, he suggested that there’s a possibility that China may crash, though he stressed that he’s not predicting that it will happen. Interestingly, he mentioned about “loan-sharking” creating credit problems in China:

Well, I?m not sure. Because if [the Chinese government]? ease off again, the speculation [of property] will go on. But we have credit problems in the property market undoubtedly. We have Ponzi schemes like of loan sharking operations all over China. That?s a very dangerous, and so forth.

We find the word “loan sharking” very interesting. It seems to imply something about the Chinese credit market that is by definition, underground. That is where Black Swans lie.

On the other hand, one of our readers, Paul, who lives in Beijing, has different views about China (see Concerns about China?s slowdown):

It takes years to understand the Chinese psyche, and it’s virtually impossible to get even close from outside the country. Yes, there’s a correction going on, but it’s controlled at the core. Outcomes and reactions will of course be wild and woolly, such as the steel production slowdown.

…

As for ghost cities, well of course, if you don’t understand how the chinese work, you will think they are ghost cities. But that’s how they do things here – they build the whole damn thing, then move the people in. As I said, you have to understand the Chinese way of thinking.

Put this in your diary. The restrictions will last until November. By December this year, production of key items such as steel and cement will be returning to full pelt.

So, do you think China will crash soon? Please vote below and feel free to contribute your opinions.

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Interview with Marc Faber (inflationist) and Michael Shedlock (deflationist)

Wednesday, August 4th, 2010

A few months ago, we found this interview with Marc Faber and Michael Shedlock (aka “Mish”). Faber once said in an interview that he was “100% sure” that the US will fall into hyperinflation. Mish, on the other hand, is a very staunch deflationist (see Are deflationists missing the elephant in the room? Or are they believing in something more sinister?).

What if you put the two together in an interview? Will they clash? Surprisingly not, as you can see…

In particular, pay attention to what Mish said in the final moments of this video.

The takeaway lesson is this: the unfolding train wreck will be something the world has never seen before (as one of our reader, DavidL said). Whatever ‘flation it is, it would not follow the script of the past.

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Are deflationists missing the elephant in the room? Or are they believing in something more sinister?

Sunday, August 1st, 2010

As you scour around the blogsphere, you will see that there are contrarians who still believe that it is impossible for the US to prevail against deflation. The most extreme of deflationists is Robert Prechter (from Elliot Wave International), who is still predicting that the Dow Jones will go all the way down to 1000. Up till March 2009, it seemed that the deflationists’ argument was correct. In the Panic of 2008, deflationary forces were so strong that asset prices were even more oversold than the infamous 1987 crash. Unfortunately for the deflationists, the subsequent rally (reflation) till May 2010 was so enduring that their argument was discredited in the eyes of many.

Our view, on the other hand, belongs to the inflationists’ camp. From what we can see, there is a big elephant in the room that deflationists miss. But as we think about the deflationists’ argument, it suddenly dawn on us that perhaps deep in the soul of the deflationists’ argument is the belief of what some may call a “conspiracy theory.” Of course, we guess not all deflationists hold (or even aware of) such a belief. But the more extreme and strident a deflationist hold on to the deflation argument, the more we suspect that they are holding on to the belief of the “conspiracy theory.” Although we do not know whether that “conspiracy theory” is true or not, it certainly helps to explain the extreme position held by some deflationists.

To understand our view, we must first understand the crux of the deflationists’ argument. Professor Steve Keen had the best explanation for? the deflationist argument:

Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

The implication of this paragraph is that Bernanke does not understand how the credit-money system works and hence, does not know how to engineer inflation. Elsewhere, Steve Keen wrote that,

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed?so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Based on the deflationists’? credit-money model of the economy, the forces propelling the credit destruction will be so strong that Bernanke will not print money fast enough to cause inflation.

So, where is the elephant in the room?

First, remember that the credit-money model of the economy is just a representation of the real, living and breathing economy- it is not the real thing. The biggest mistake any investor can make is to believe that the model is as good as the real thing and believe whatever the results produced by the model. In other words, a model is just an abstract of reality i.e. a subset of reality.

In the real world, there are many events and happenings that can never be captured by the model. By definition, these events and happenings are Black Swans to the model. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias,

In the same way, many financial market analysts and economists are highly skilled in creating artificial lab-created models of the real world. These models are highly predictable, with the ?rules? well-defined.

What if the ‘rules’ get broken by real world events? Obviously, the model breaks down. As we wrote in Recipe for hyperinflation,

The main point is, once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

…

One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.

Currently, the Federal Reserve alone, with the powers they have on hand, cannot easily create inflation. What if the Federal Reserve, in conjunction with the government, changes the ‘rules’ and act on the changes?

Think about it: the Federal Reserve have more powers today than in 2007. Today, it can buy toxic assets from the banks as collateral, which is something that was against the ‘rules’ prior to the GFC.

Mind you, these breaking of ‘rules’ are just the beginning. Bernanke and his staff had written lots of papers and gave lots of speeches on the crazy ideas they have in mind to fight deflation. These crazy ideas are in the public record. As you can see in Bernankeism and hyper-inflation, some of these crazy ideas are already implemented in response to the GFC. However, there are many more that are yet to be implemented.

But remember this very important point: Many of these ideas are currently illegal. This is where the confluence between economics, politics and law come together. The deflationists have excellent models on the credit-based economy. But law and politics are outside the scope of their models. That is, their models cannot see what’s happening in the legal and political arena. Unfortunately for them, events from these arenas will be the ones breaking their credit-money models. That can only be achieved by overturning some of the existing laws.

Michael Shedlock? (aka “Mish”), who is one of the most strident deflationists insists that it is not in the interest of the powers to be to break the credit-based system. It seems that he sees the Federal Reserve System as some kind of powerful privately owned cartel that wants to preserve the status quo. Hyperinflation will screw up the wealth and power of such a cartel because in such a scenario, credit can no longer play any role in the economy (which is what Steve Keen calls a “fiat-money” system as opposed to the current “credit-money” system). On the other hand, between deflation and some forms of inflation, they would prefer the latter.

Please note that we are now venturing into unknown Black Swan territory. What follows is murky, dark and just our guesses…

For such a cartel to have its way of preserving the status quo, it has to be powerful enough to even subject the US government to the rules of credit. That is, if the US government monetise its debt (by selling its bonds to the Federal Reserve), it is accountable to the cartel (whatever it is). We could be wrong, but we guess this must be what Mish believes? in- a cartel of extremely powerful and secretive bankers is controlling America via control of the credit-based monetary system. In fact, we remembered that in one of his blog articles, he mentioned that contrary to popular belief, the Federal Reserve is a privately owned institution. Contrasts that with what the Federal Reserve describe itself as a “quasi-public” institution.

If this is what Mish believes in, than it makes sense to take the deflationary view. This is because only a cartel that is more powerful than the US government can have the power to prevent the confluence of law and politics from breaking the ‘rules,’ causing hyperinflation and breaking the credit-based system.

Of course, a hyper-deflation scenario? will do the cartel no good too because that scenario implies a total breakdown of the financial system.

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Posted in Economics/Finance, Looking Forward, Market Observations | 9 Comments »

Prepare to pull the trigger on speculating!

Thursday, July 29th, 2010

Back in When to start speculating again?, we mentioned that

When governments do ?something? about the deflationary pain, it will be a signal to shuffle your money back into speculation.

So, what will be the signs to watch out for?

Just a month ago, RBS warned their clients to get read for this:

Andrew Roberts, credit chief at RBS, is advising clients to read the Bernanke text very closely because the Fed is soon going to have to the pull the lever on “monster” quantitative easing (QE)”.

Marc Faber reckoned that it will happen soon and has given a rough time-frame…

When the money spigot turns on again, that’s the sign to start speculating again (note: speculate at your own risk). For those who are new, please read Bernankeism and hyper-inflation to understand the context of this article.

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Posted in Looking Forward | 8 Comments »

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