For the past four years, the big-3 central banks were the world’s “serial bubble blowers,” flooding the world with cheap money via historically low interest rates, in order to pump up stock markets and real estate values. However, with global economic growth running at 5% in the first half of 2006 -- the most robust multi-year expansion since the 1970’s -- there were serious side effects of surging energy and commodity prices that are now feeding into consumer inflation.
Bank of England chief Mervyn King admitted on June 12th that “During the fastest 3-year period of world economic growth in a generation, monetary policy around the world may simply have been too accommodative.”
However, in order to correct the imbalance, a tighter global liquidity environment is required. “After a period of robust world economic growth, we approach a bumpier stretch of the road. A rebalancing of global demand is desirable, but the way ahead may not be smooth,” King said.
Recent signals that a concerted tightening campaign by the big-3 central banks and smaller mid-tier banks is underway have spooked the commodity and stock markets around the globe since May 11th. There is a growing realization that higher interest rates are on the horizon to combat gold and the “Commodity Super Cycle,” even at the expense of slower economic growth and sharply lower stock markets.
On June 5th, Federal Reserve chief Ben Bernanke shocked the global markets, when he identified inflation as the biggest threat to the US economy, despite clear signs of weakening US employment growth. The new Fed chief is distraught over his reputation as a super-dove, and wants to earn his inflation fighting credentials, and strongly hinted at a 0.25% rate hike to 5.25% on June 29th.
“The Fed will be vigilant to insure that the recent pattern of elevated monthly core inflation readings is not sustained. We must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation,” Bernanke declared. “These are unwelcome developments. The medium term outlook for inflation will receive particular scrutiny,” he warned.
Since peaking at a 25-year high of 365.42 on May 11th, the Reuter’s Commodity index (Pending:CRB) has been sliding alongside weakening global stock markets, which might be heralding the beginning of a global economic slowdown, and weaker demand for commodities. The Reuter’s CRB index has retreated by 9%, led by a 12% slide in the MSCI World stock market index, on fears of tighter global liquidity.
On June 10th, US Treasury Secretary John Snow backed up Bernanke’s tough talk against inflation giving the Fed a green light to act appropriately with another rate hike. “We have seen inflation picking up a bit but not at an alarming rate. It is important central bank governors take note of that,” Snow told a news conference following a Group of Eight finance ministers' meeting.
Soon after, mid-tier central bankers caught the global commodity and stock markets off guard with a barrage of higher interest rates. Central bankers from Denmark, India, South Africa, and South Korea, Thailand, and Turkey, hiked their overnight loan rates last week, to keep pace with the European Central Bank’s third rate hike since December, and the Fed’s strong hint of a US rate hike for June 29th.
The Swiss National Bank is sure to follow in the footsteps of the ECB, and is expected to lift its Libor target rate by 0.25% to 1.50% this week. The dovish Bank of England was the lone hold-out, looking more foolish each passing day, with its M4 money supply exploding at an annualized 12.4 percent.
The huge global liquidity injections since the bursting of the high-tech bubble had fueled gold and the “Commodity Super Cycle” to 25-year highs. This is the most important lesson that central bankers are suddenly beginning to recognize. Especially, Japan’s financial warlords, who over the past few years were the biggest suppliers of global liquidity, with the European Central Bank running a close second.
But for the first time in five years, Japanese short term Libor rates are moving away from zero percent, with the Bank of Japan draining 26 trillion yen out of the Tokyo money markets. The BOJ will probably lift its overnight loan rate above zero percent in July, for the first time in almost six years. “There is no change to our view that interest rates should be normalized as the overall economy returns to a normal state,” Deputy Governor Kazumasa Iwata said June 8th.
If the Bank of Japan raises rates this year, it would also be the first time since 2000 that the big-3 central banks have tightened liquidity in tandem. The last time Japan raised its overnight loan rate in August 2000, it pushed Japan into a economic recession. “A major difference with 2000 is that in Japan's private sector, both companies and financial institutions have cleaned up the problems they had with their balance sheets,” said BOJ chief Toshiko Fukui said on May 31st.
Hind-sight is the best sight, but it’s interesting to note, that the peak in global commodity and stock markets coincided with a G-10 central banker communiqué from Basel, Switzerland, calling for very special attention to prevent strong economic growth from turning inflationary. Traders are accustomed to such empty rhetoric, and few believed the G-10 would be true to its word.
Jean-Claude Trichet, the ECB chief and spokesman for the G-10 group of central bankers said on May 8th, “It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation.” The hawkish comments came as the MSCI World Index eclipsed its previous record highs reached during the 2000 tech bubble.
"Global economic growth remains strong and steady. There are elements there that call for very special attention, especially in terms of inflationary risks. We all concluded what was very important to prevent the second round effect because once they are there, it is too late,” Trichet warned on May 8th.
But global traders have routinely ignored Trichet’s empty rhetoric about his self-proclaimed vigilance against inflation for the past few years, and instead focused on the explosive growth of the Euro zone’s M3 money supply, which is 8.8% higher than a year ago. The ECB says a 4.5% growth rate for M3 is consistent with low inflation. The Euro zone’s consumer price index is 2.5% higher than a year ago, and has hovered above the ECB’s 2% target for the past four years.
Thus, it comes as a shock, that Trichet, the Boy who cried wolf on dozens of occasions in the past, might actually mean what he says this time around. "There is a connection between the wealth effects and domestic demand that could trigger inflationary pressure," Trichet admitted on June 5th, adding that central bankers need to take the "excessive dynamism in asset prices into account.”
Rodrigo Rato, the IMF’s managing director, said on May 24th, that higher interest rates are healthy for the global economy. “US rates need to accommodate a more neutral stance. Monetary stimulus, if it is sustained over a long period of time, will create very difficult monetary and inflationary consequences, so it's healthy that monetary stimulus is reduced and that monetary policy move to more neutral levels. Of course, that has consequences for interest rates and people should be aware.”
Global Stock Markets Suffer Under De-Facto Gold Standard
Working within the context of a de-facto gold standard, only a global stock market meltdown could convince a deeply skeptical gold market, that the G-10 central banks are serious about combating inflation and deflating the “Commodity Super Cycle.” Central bankers must refrain from their reflexive instinct to rescue plunging stock markets with super easy money, in order to slowdown the global economy and weaken demand for super-stars, such as crude oil, copper gold, silver, and zinc.
Japan’s Nikkei-225 stock index suffered its biggest one-day percentage fall in two years on June 13th, tumbling 4.1%, or 614 points to 14,218, its lowest close since November 16th, 2005. The plunge wiped out 16.56 trillion yen ($145 billion) in market value from the Tokyo Stock Exchange's first section, an amount nearly equal to Malaysia's GDP. Decliners swamped advancers by a ratio of about 10 to 1. The Nikkei-225 has now tumbled about 20% since April 7th, when hit a 6-year high.
A stiff 20% decline in the value of Nikkei-225 stocks, was the price the Bank of Japan had to pay, in order to knock the Japanese gold price 18% off its 18-year high of 80,000 yen to around 65.600-yen on June 13th. BOJ chief Fukui has drained close to 26 trillion yen ($220 billion) out of the Tokyo money markets since March 9th, and appears to still be on course to hike the overnight loan rate in July.
Fukui brushed off accusations that the BOJ’s dismantling of its ultra easy monetary policy in March had triggered the latest meltdown in global stock markets. “Markets are becoming slightly worried whether economic growth can be sustained while capping inflation, with oil prices rising. Because of concerns over inflation, central banks around the world are adjusting their loose monetary policies very carefully. Investors are rushing to adjust their positions, mainly in stocks," he said.
However, Japan’s financial warlords are not about to let their beloved Nikkei-255 go down too far, without some type of intervention down the road. “So far, they have not had a strong impact on economic fundamentals at home and abroad. There is always the possibility that the market will move irregularly at any given time. When that happens, there is risk of it having a strong impact on the real economy. We would like to keep a close eye on what effect market moves will have on the real economy," Fukui told the Japanese parliament on June 13th.
European stock market meltdown cools off Gold market
European central bankers played down risks from tumbling stock markets on June 9th, as a needed pull-back from frothy heights and not a sign of bad economic times ahead. ECB deputy Lucas Papademos remained calm as the EuroStoxx-600 skidded 12.7% to a seven-month low. “At present, despite increased market volatility and signs of a potential slowdown in the US economy, the baseline scenario is that global growth, outside theEeuro area, will remain robust at rates above 5 percent,” he said.
His colleague, Gertrude Tumpel-Gugerell, was similarly sanguine about the EuroStoxx-600 meltdown. “It has to be seen in the context of strong gains in values, and some correction to that. I think it's a re-evaluation of risks." Austrian central banker Klaus Liebscher, sought to calm stock markets, which have fallen sharply with talk of an end to the 3-year bull run. “From time to time, a correction is something that is necessary, this is a normal development and one should not over-exaggerate this development,” Liebscher said.
European central bankers have received a favorable rate of return for the EuroStoxx-600 meltdown. In return for a 12.7% decline in the EuroStoxx-600 index, the ECB was rewarded with a larger 19.6% drop in the price of gold to 453 Euros per ounce. The BOJ suffered a 20% loss of the Nikkei in return for a 18% drop in gold, a negative rate of return for keeping its overnight loan rate at zero percent, while the ECB pegs its repo rate at a higher 2.75%.
The ECB will continue to raise interest rates if inflation risks persist and economic growth in the Euro zone is close to potential, said Belgium central banker Guy Quaden on June 12th. “If the risks for inflation persist, if economic activity in the Euro area remains close to, or above the growth potential, we will continue to withdraw the monetary accommodation which is still included in our current rate. I am in favor of gradual moves, based on new data on inflation and activity,” he said.
Futures traders in Frankfurt have been already discounting an eventual hike in the ECB’s repo rate to 3.25% for the past 3-months. The ECB is tightening liquidity in baby steps, spreading out its rate hikes every three months, so the next rate hike to 3.00%, would probably follow by September. However, while this go-slow approach might be necessary to keep the Euro from appreciating against the US dollar, it is inadequate to contain the explosive growth of the M3 money supply.
Federal Reserve Scores Points in Battle Against Inflation
While the Bank of Japan and the ECB are in the earliest stages of their tightening campaigns, the Federal Reserve is nearing the end game of its rate hike campaign. The hawkish Cleveland Fed chief Sandra Pianalto said on June 12th, that a 5% fed funds rate is close to the elusive neutral rate. According to Pianalto,
"The core CPI has increased at an annualized rate of more than 3% during the past three months. This inflation picture, if sustained, exceeds my comfort level. However, there is a time lag between monetary policy actions and their ultimate effect on inflation. I think the current 5% federal funds rate is near a point that is consistent with a gradual improvement in the inflation outlook."
With the highest interest rate among the big-3 central banks, the Federal Reserve paid the smallest price to knock gold and inflation expectations lower. Since the Fed hiked the fed funds rate to 5.00% on May 10th, the big-daddy Dow Jones Industrials lost 7% of its value, while gold plunged by a whopping 22% to roughly $562 per ounce on June 13th. That has strengthened the DJI to gold ratio from a low of 15.9 ounces of gold to as high as 19.1 ounces of gold over the past four weeks.
The Fed is signaling one more rate hike to 5.25% during this tightening campaign, and won’t rescue the US stock market with an easier money policy anytime soon. “Obviously we watch the stock market for signals. But I don't take any important policy decisions from the recent movements in equity markets over the last few weeks, said Atlanta Fed chief Jack Guynn on June 7th.
Bank of Korea Joins the Battle Against the “Commodity Super Cycle”
Bank of Korea chief Lee Seong-Tae has joined the big-3 central banks in the battle against global inflation, and indicated on June 12th, that the central bank will tighten its monetary policy again to absorb liquidity, after a quarter-point rate hike to 4.25% last week. “The environment for the central bank’s monetary policy is changing drastically in line with changing economic conditions both at home and abroad.”
Lee said that low inflation became a global trend since the beginning of the 2000’s, forcing the central bank to alter its view on monetary policy and price stability. “If we approach prices with the same old monetary policy stance, it could cause excess liquidity. While effectively coping with economic conditions, we are going to run our monetary policy in a way to preemptively react to inflationary pressure,” he said.
The Korean Kospi index was one of the world’s top performers in 2005, gaining 54%, helped along by the story of booming exports to China. The Kospi was awash with hot money from abroad, and foreigners owning nearly 40% of outstanding shares.
The BOK believes that this ample liquidity is allowing financial firms to expand their housing loans and raising home and land prices. Mindful of this, Lee said that the bank will closely monitor movements of real estate prices, and strongly hinted at tighter money conditions ahead.
South Korea's economy expanded a faster-than-expected 1.3% in the first quarter, as exports climbed to a record and consumer spending increased. From a year earlier, the economy expanded 6.2%, the fastest in three years. But hot money is exiting for safer havens, and South Korea’s Kospi index was swept 18.4% lower by global contagion to 1,204, its lowest close in seven months. A global economic slowdown and a tighter BOK policy is putting the squeeze on Korean blue-chips.
The Rise and Fall of the UAE-Dubai Share Index
In the battle against inflation and the “Commodity Super Cycle,” G-10 central banks aim to engineer a soft landing for the global economy. The meltdown in global stock markets in the past month however, does go a long way to proving that blue chips were inflated beyond fundamental valuations, much like commodities and real estate. But in engineering a global economic slowdown, G-10 central bankers hope to avoid the experience of the Persian Gulf stock markets.
Shares across the Persian Gulf region have crashed over the past six months, as burned retail investors bailed out, long before the recent tremors in other emerging markets. Markets in the Gulf region climbed an average of 92% in 2005 on soaring oil prices but have tumbled in 2006 on fears of overvaluation, making them among the worst-performing markets in the world. Dubai's bourse is down 54% this year, while the Saudi market lost half its value or $400 billion since late February.
Trading on Persian Gulf markets is limited largely to residents, with governments restricting foreign ownership of stocks, eliminating a key safety net for domestic investors. A downturn in other emerging markets would normally lead to more cash coming back home to the Gulf, but so far, the local bourses have not received a bounce.
Yet traders got the good news they were betting on in 2005, on June 12th, when the United Arab Emirates said its gross domestic product in current prices rose 26.4% in 2005 to 485 billion Dirhams ($132 billion), mainly due to a rise in oil revenue. The UAE’s trade surplus rose 61.4% over the year to 163 billion Dirhams with crude oil making up 38% of the country's total exports.
"Oil revenue still plays an important role in the country's economy in general. The big rise in oil prices had a positive impact on the GDP growth," the UAE economics ministry. The increase in oil revenue produced the Gulf country's first state budget surplus in two decades of 38.2 billion Dirhams compared to a deficit of 1.5 billion Dirhams in 2004," it said.
The oil sector's contribution to GDP stood at 35.7% of the total, after the oil price average rose 49.6% to $54 a barrel in 2005. The UAE produced an average of 2.46 million barrels per day of oil in 2005 compared to 2.35 million bpd in 2004. Non-oil sectors' contribution to GDP was up 18.6% to 312 billion Dirhams. But the UAE’s stellar economic performance in 2005, apparently did not live up to the hefty expectations of Dubai’s main share bourse as it entered into 2006