John Dalt's  Instablog

A few years ago, a friend of mine started a business importing manufactured goods from China.  He acted as a broker/agent.  He had contacts with different manufacturers in China, and depending on what widget you wanted built; he could ‘get ‘er done.’  This was a Wild West sort of business, as contracts meant nothing to the Chinese, if someone was willing to pay a little more they would move production to the more profitable item.

My friend told me of the competitive advantages China had; cheap labor and lack of restrictive regulation.  People wanted jobs and the government wanted full employment for political reasons, so they stayed out of the way.  I was aware of these advantages, but the one that surprised me, was energy costs.  My friends point was made on an expansive basis.  He emphatically told me, “Every country that has created an economic boom, an industrial revolution, did it with cheap energy.  Cheap and plentiful energy is the one common denominator in every business expansion, and China has cheap energy.”

This morning I received a press release that drove home the silliness behind negotiating with the Chinese on ‘Global Warming’ or ‘Climate Change’.  The Chinese raised electric rates for business on Friday by 5.7%  This was the first increase since July 2008 when rates went up 5%.  Residential rates have not increased since July of 2006, when they increased 1%

The Chinese are publicly questioning the cheap dollar and concern for the U.S. budget deficits.  This is all talk aimed at the Europeans.  It does not upset the Chinese.  They tie their currency, the Yuan, to the U.S. dollar.  As the dollar becomes cheaper, their exports gain advantage against every other major currency.  They are crying in their beer.

The U.S. has pressured China to let their currency float, which would take away their competitive advantage in exports to the U.S.  They will not do it.  There was a small adjustment in 2008, but since the credit crisis began, the currencies have moved in lockstep.

American International Group (AIG) received $70 billion dollars in TARP funds to cover the Credit Default Swaps (CDS) they issued to banks.  These CDS were sold as ‘insurance’ that the loans the banks held would not default.  Since the CDS were not technically ‘insurance’ AIG did not put aside reserves in case the covered assets turned sour.

We have just come through the credit crisis and real estate implosion, brought on by easy credit and questionable loan procedures.  A buying frenzy in real estate, fueled by ever increasing home prices and cheap easy money created a bubble that was sure to pop, to those observers experienced enough to see it.

When any bubble pops, buyers are slow to come back to buy the assets that have seen the greatest fall in value.  These are the times of ‘maximum pessimism’.  The normal cycle takes time to complete as the asset builds a base, and buyers re-enter the market as they see an opportunity to profit.  This creates a problem, as politicians don’t like falling home prices and slow economic growth.

The NYSE observed two minutes of silence this morning before the opening bell, followed by a lone Marine playing TAPS.  It was moving.

Subscriber T.M writes, “I don't understand HOW they inflate the dollar?  How does that occur?  Through the cost of the commodities?

T.M., inflation is simply more money without an increase of productivity or goods.  The Fed has been printing (creating) money since 1913, when they were founded by congress, and loaning it to banks at low interest rates.  When they create more money than is destroyed, they inflate the money supply.  Keynesian economists believe this helps the economy and politicians.  If the economy is growing, even falsely by money growth, unemployment is lower.  Thus, politicians are re-elected because voters have jobs.

Treasury released their refunding statement on Wednesday.  Refunding occurs quarterly, the next announcement will be February 3, 2010  Next week the U.S. Treasury is auctioning $81 billion in notes and bonds.  $42.5 billion will be new money, and $38.5 will be to refund maturing securities.  Refinancing maturing securities will add to the financing problem facing the U.S.  The government needs to borrow money to meet the deficit, but has to borrow even more to pay off maturing debt.  This looks like the snowball that will get larger and move faster as it rolls down the hill.  Hold on, the ride could get interesting.

Buyers have other options for investment returns.  Money seeks the highest return, or perceived return.  When the expected return, on a percentage bases, is higher in another asset class, fixed rate securities MUST offer a higher interest rate (return) equal to or greater than the other investment.

The Treasury auctions have been successful in the last year, in part, because of the volatility of the stock market.  Investors moved to the ‘sidelines’ to avoid the big ups and downs in stocks.  As investors feel safer returning to equities, will they accept 3.5% for a ten-year bond?

Crude oil inventory reports came out yesterday from the Energy Information Administration (EIA).  Is the trend towards higher prices supported by the numbers?

Crude oil inventories were down four million barrels but still 7.7% above last year’s level.  This was a larger drop in inventory than the market was expecting.  Imports dropped 764 thousand barrels, 486 thousand barrels below the four-week average.  Imports for the week were 1.846 million barrels less than one year ago.

Against the backdrop of falling crude oil inventories, gasoline stocks were down 400 thousand barrels and distillate inventories were down 300 thousand barrels.  Gasoline inventories are tracking 6% above one-year ago levels.  The 800-pound gorilla (40 million barrels) on the airplane is distillate stocks.  At 31% above last year’s inventory, it is still a weight on the market, not only for crude oil but also for refiners.