Archive for October, 2010

Will there be a surprise rally in the USD?

Wednesday, October 27th, 2010

Everyone knows that the US Federal Reserve is going to print money (quantitative easing) in November. Hence, the financial markets have already priced that in. To them, this is a foregone conclusion. Surely, Bernanke is going to print trillions of dollars right? There?s no way he?s not going to do that right?

At this point, investors should be alert. When almost everyone thinks that a future outcome is a slam-dunk certainty, it?s the time when the market is most vulnerable to a significant setback. Since everyone is expecting that Bernanke is going to print so and so amount of money, and if it turns out that he is not printing as much as expected, the reaction by the financial markets can be savage. Any hints of dithering by Bernanke will be very negative for asset prices in the very short term.

Surely it wouldn?t happen right?

Well, who knows.

As the Americans accused the Chinese of manipulating their yuan, the Chinese will be accusing the Americans of manipulating their dollar through money-printing devaluation. Perhaps behind the scenes, both sides are negotiating a middle road. Maybe the Chinese will promise the Americans that they will appreciate their currency a little more than expected and the Americans will promise the Chinese that they will print a little less than expected. That way, the Chinese can cool their economy and pop their speculative property bubble while the Americans can benefit from a sell-off in gold and commodity prices and trigger a mad scramble for US Treasuries, which the US government will happily oblige because they are in need of cash to borrow.

Be ready for surprises!

The #1 reason why gold prices collapsed this week

Thursday, October 21st, 2010

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China’s Aluminum Industry – where to from here?

Sunday, October 17th, 2010

Today, we will be having a guest post by Paul Adkins, Managing Director of AZ China Limited. Paul lives in Beijing and thus, has a first hand view of what is going on in China. Many of our readers appreciate the insights offered by Paul that can be found in no where else.

One issue facing China?s government as it mulls the next five-year plan: What to do about the country?s aluminium industry? While this might seem a minor matter, it symbolizes a major dilemma that faces the country, namely, how to balance concerns for economic growth with those for energy use and environmental protection.

China is now the largest single producer?and consumer?of aluminium and will make about 17 million tonnes this year, up 20 percent from last year. But that record comes at a steep price. Aluminium production not only consumes about 8% of all electric power in China, but also is responsible for large amounts of carbon dioxide (CO2) emissions.  And the electricity needed to power the industry has a multiplier effect on pollution problems because 70% of China?s electricity comes from coal, a major contributor of CO2 emissions.

The China Nonferrous Industry Association (CNIA), which represents the aluminium industry, recently published a draft plan calling for aluminium capacity to be limited to 20 million tonnes in the next five-year plan. But China is already over that cap, with about 21 million tonnes right now. Given the new smelters already under construction, total capacity could reach as much as 28 million tonnes by 2012.

Beijing recently indicated it is serious about reducing energy intensity ? the amount of energy consumed per unit of GDP ? and sees aluminium as a major culprit. As an example, it takes at least 12,000 kilowatt hours (kwh) to produce one tonne of metal. But so far, the authorities have chosen to target the steel and cement sectors, and largely left aluminium untouched.

The choices now in front of the planners and politicians are profound. They could simply allow market forces to dictate the industry?s future, with the laws of supply and demand determining not only metal production, but also energy use and CO2 emissions. Then again, the China aluminium industry has not shown itself to be totally subject to such forces. Smelter capacity has run well ahead of consumption, especially in the last few years. Meanwhile, proprietors have struggled to make a decent return on the huge investment needed for a smelter, as the price of aluminium is determined on the Shanghai Futures Exchange, and may have no relation to operating costs, much less capital costs.  Because of the huge capital costs, long-term contracts for electricity and other key inputs, and the cash flows involved, producers often run at full operating speed to maximise efficiency, despite apparent losses on the metal price.

Alternatively, they could put limitations on the aluminium industry, with the caveat that such efforts can have unintended repercussions. In 2003, for example, the Government decided to crack down on old inefficient smelters and ordered those with less than 50,000 tonnes of annual capacity to shut by the end of 2004.  Many proprietors simply built expansions or upgraded their technology, and industry capacity shot up, not down.. Indeed, even the CNIA has admitted that it is virtually impossible for the government to control the industry. One risk is that Beijing could be left embarrassed if the industry ignores new edicts.

Even if Beijing were successful in reducing aluminium capacity, it would come with economic costs. In addition to the loss of thousands of jobs in the country?s 120 smelters, it would cause ripples in associated businesses, including raw materials suppliers, downstream factories, and the many support industries that surround a smelter. For stockholders, any limitation on capacity would cause the share price of China Aluminium (Chalco) and other publicly listed smelters to soften. Investors needed to see growth strategies, which would not be available in the Aluminium industry. (Chalco has already started alternative strategies, embarking into iron ore, copper, gold and now rare earths.) As well, such a decision could affect billions in loans outlaid for the many new projects currently under construction.

There is also a global dimension to this dilemma. Russia stands poised to sell aluminium to China in the event of supply shortages. The world?s aluminium companies source many of their raw materials from China. If Chinese smelters are constrained, the value of China’s exports of raw materials will decline.

In the end, the decision on aluminium might come down to one of the country?s scarcest commodities: energy. Aluminium is called ?frozen electricity? because of the huge amounts of electricity needed to produce it. It seems more sensible for China to import aluminium, even at the cost of lost jobs, to gain the benefits of saving energy and limiting pollution.

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).

Reserve Bank of Australia (RBA)- property spruiker?

Monday, October 4th, 2010

In page 12 of the September issue of the Reserve Bank of Australia (RBA)’s Financial Stability Review, you will find that this chart is presented:

Graph 21-Dwelling Prices

Graph 21-Dwelling Prices

According to Alan Kohler, one of the most prominent financial talking head in Australia, this chart shows that

Australia has not had the biggest rise in house prices in the past 8 years, New Zealand has

So, what’s wrong with this analysis? The answer can be found on the last paragraph of page 18 of How To Foolproof Yourself Against Salesmen & Media Bias.

Is the RBA spruiking property? Well, take a read at this paragraph in this article:

So who are the people most likely to snap up investment properties? Interestingly, it appears that Reserve Bank officials are the keenest investors in rental properties. ?We are not sure whether to be relieved or concerned that of the five central bankers who were brave enough to note their occupation on their tax form, all five had an investment property!?, the report says. ?Of the 200 occupations classified by the Australian Tax Office, the employees at the Reserve Bank topped the list with respect to their investment property exposure.?