Anatomy of a Crisis: 2011 (April 25, 2011)
What's behind the disturbance in the financial Force? QE, ZIRP, the dollar peg and inflation, to name a few factors.
There is a great disturbance in the world's financial Force. Many sense it as a storm on the horizon, something not yet visible but telegraphed by a rising, swirling wind and a new electric scent in the air.
I don't claim to have a complete narrative that accounts for all the points of friction wearing down the moving parts, nor do I claim a "solution." But a few observations might help inform our awareness of the disturbance.
As many of you know, readers provide most of the intelligence on this site ("of two minds, yours and mine"). I am the student and skeptic who learns from you and tries to make sense of a few dynamics, and extend them to some sort of coherent end-state. We share the same project of encouraging critical thinking.
1. There is a rising loss of faith in the conventional (i.e. propaganda) account of the U.S. economy. Readers tell me their local coin store has no silver coinage left, as the public has been buying with a vengeance. This is significant. (Silver has long been called "the poor man's gold.")
In the conventional view, the "herd" always gets it wrong: the "retail" "small speculator" investing public buy stocks and real estate at the top just as the "smart money" is distributing/selling. This "dumb money" cycle is certainly evident in manias and bubbles.
But there are also examples of "the public" acting well in advance (perhaps a form of "crowdsourcing") of the "experts."
One of the most remarkable trends of the past decade is the steady rise of the classic hedges against inflation and financial disorder: precious metals.
While the Federal government and a veritable army of conventional economists have repeatedly assured us over the past 10 years that the economy and the dollar are both sound, gold has quintupled from under $300 an ounce to over $1,500 an ounce.
Given that official inflation measured 26% for the decade 2001 - 2011, then clearly the public isn't "buying" the "sound dollar, sound economy" story.
They're also not buying the "you can't afford not to own stocks in the New Bull market" story: the public has sold some $350 billion of domestic mutual funds in the past two years.
These are unmistakable signs that the public has lost faith in the Federal Reserve's account of the dollar, U.S. stocks and the economy.
2. The idea that quantitative easing is benign has lost credibility. Even the MSM is reporting the dismal real-world results of QE2, for example, Stimulus by Fed Is Disappointing (understatement of the year?).
Another conventional view of QE--that it isn't "injecting liquidity" because it's simply an asset swap-- The end of QE and what it means for the market--misses the point, which is that boosting bank reserves (what QE accomplishes) enables additional leveraged 20-to-1 (or more) lending. QE also keeps U.S. interest rates near-zero, which encourages a carry-trade of dollars flowing around the globe seeking higher returns and offsets to global inflation, which is certainly higher than officially recognized. Itís this flow of cash thatís driving up commodity costs.
A T-Bill sits there earning interest but cash is mobile--it can go anywhere to seek a return. A T-bill cannot. So QE is not just some benign asset swap--it has the pernicious effect of feeding a vast risk trade in stocks, emerging markets and commodities.
If that flow of new cash ceases (QE ends), then the risk trade (and Treasury bonds) both lose a key support.
3. Much of the analysis of U.S. policy is narrowly U.S.-centric. The U.S. has often ignored the international consequence of its parochial concern with domestic politics. Indeed, the U.S. has dropped 5 million tons of bombs and killed 500,000 people (as well as cost its own citizens their lives) overseas in pursuit of domestic policy ("we can't 'afford' to lose Vietnam to the Commies because that would cost me the election.")
This blindness to the consequences of domestic policy is most striking when it comes to China.
The key dynamic is the linkage of the renminbi (yuan) and the U.S. dollar. When the dollar tanks, oil rises when priced in dollars--and thus it also rises when priced in yuan. Thus the decline of the dollar and the consequent rise in commodities has directly fueled inflation in China, which is more dependent on a per capita basis on materials than the U.S.
Yes, the yuan peg has declined from the 8.5 range down to 6.5 to the USD, but it is still firmly pegged. As the cost of materials priced in dollars soars, it feeds higher input costs in China.
China's policy-makers have exacerbated inflation by excessive money creation and lending by their own banks, but that alone is not sufficient cause for gasoline/petrol to cost as much in China as it does in the U.S. Oil is the foundation for petrochemicals, fertilizers, transport, plastics, etc., so the rise of oil driven by dollar depreciation is a driver of inflation throughout the Chinese economy.
No wonder the Chinese leadership is unhappy with the Fed's crush-the-dollar strategy.
Though the cost of soy beans imported from the U.S. remains fixed in terms of currency, the relentless rise in oil is also raising the cost of China's imports which are heavily dependent on oil, such as soy beans from the U.S.
4. China appears to be in the grip of a classic wage-price spiral inflation. Minimum wages are leaping by 25%, prices of many food items are doubling--this self-reinforcing dynamic is clearly visible in China. That is not the case in the U.S., which is being throttled by stagflation (rising prices and stagnant wages except for the top tier).
As I have noted before, price inflation in essentials hurts the lower income citizenry much harder than the top tier, as essentials make up a much larger percentage of the household expenses. A 30% jump in the cost of gasoline means little to a household in which gasoline accounts for 2% of total net income, but it certainly hurts a household in which gas accounts for 10% of total net income.
As noted in Your Pick, Ben, But One Goes Off the Cliff, the Fed's ZIRP and QE policies have pared future policy down to a stark fork in the road: end ZIRP and QE, and send the risk trade (stocks and commodities) off the cliff, or keep pushing the dollar down and the rising cost of oil will shove the U.S. economy over the cliff.
That would also feed inflation in China, which already threatens to destabilize its economy. Correspondents within China recall that rising inflation was an important (if conveniently forgotten) dynamic in the 1989 era of dissent and disruption. The heavy-handed repression of domestic dissent and foreign reporting is evidence that the leadership in China has a keen appreciation of the connection between instability and rampant inflation.
So why is the Fed carpet-bombing the global economy? To protect the domestic economy? That makes no sense, for the Fed's policies are pushing oil up to the point where there is no way to keep the U.S. economy from tipping into recession. It isn't acting on behalf of the domestic economy, of course; it's acting on behalf of domestic banking and Wall Street.
The Fed is busily destroying the village, suposedly to save it--only it's the global village. But the Fed
isn't the only player with a stake in its game, and the other players, notably China,
are tipping their hand that they will have to act, and soon, to
protect their own domestic economies from the Fed's destructive policies.
Important reminder: all "investments" are speculations; the only difference is the time-frame (short, medium or long-term). One reader opined that I was a danger to my readers in describing a "Contrarian Trade" in the U.S. dollar ETF, UUP. Please note I highlight topics as "food for thought," not as investment recommendations. If anyone ignored my disclaimer and followed me into UUP, please set stops to exit the trade if the DXY (dollar index) breaks its 40-year support level around 71. It seems suicidal for the Fed to push the dollar down into uncharted territory where the risks of global destabilization increase enormously, but they may well do so. As individual investors, we assess the probabilities and make bets on what appear to be the most likely outcomes within whatever time-frame we are working. Lower probability events occur with great regularity, so we have to protect our capital if a trade goes south.
It wouldn't surprise me in the least to see the DXY dip to a new low just to sweep all the stops sitting there, and then stage a sharp rally in the short-term. But that is merely a guess, one possibility of many.
In addition to capital preservation, I am also very careful to follow Ed Seykota's trading rule
to never risk more than you can afford to lose.
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