In today’s lightning fast and violent markets, where a constant barrage of news and noise flows into the marketplace each day, it’s easy to forget a vital piece of information that was released just a few hours or days earlier. Trader sentiment is often swayed by the price action of the moment, and it’s easy to lose sight of the core issues and mega-trends, that move the markets over the longer-term.
It was nearly one-year ago, on July 17, 2007, when Bear Stearns (NYSE:BSC) said, in a letter to investors, that two of its troubled hedge funds that bet heavily on risky sub-prime mortgages had very little value.
The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund, as of June 30, 2007.
BSC said the net asset value for the High-Grade Structured Credit Strategies Fund was about 9-cents on the dollar. Bear Stearns Asset Management said it would
...seek an orderly wind-down of the funds over time. This is a difficult development for investors in these funds and it is certainly uncharacteristic of BSAM’s overall strong record of performance. The losses reflected unprecedented declines in the valuations of a number of highly-rated AA and AAA securities.
At the time, few traders could envision the chain of events that would follow from that letter. But since the $1.6 trillion US sub-prime mortgage crisis began to appear on investors’ radar screens, about $11 trillion of wealth has evaporated from the global stock markets. Global banks and brokers have been forced to recognize $420 billion of losses from investments in the sub-prime mortgage market, and the IMF projects total losses to ultimately reach $1 trillion.
Major stock market indexes around the world just wrapped up their worst first half in six-years. The Dow Jones Industrials lost 14.5% in the six-months through June 30, its worst start to a year in four-decades. The Euro-Stoxx-50 Index, a top gauge of the 15-nation Euro-zone, lost 24 percent. Shanghai red-chips plunged 48%, the worst half-year since 1992, and India’s Sensex Index lost 38 percent. That’s left the MSCI All World Stock Market Index entering into bear market territory, for the first time since the dot-com bubble burst at the beginning of the decade.
Besides the biggest banking crisis since the Great Depression, global stock market are also haunted by the ghost of “Stagflation,” - a stagnant economy plagued by high and rising inflation, rearing its ugly head for the first time in three decades. “Stagflation,” is a toxic witching brew for the global economy. A historic commodity boom has doubled agricultural and energy prices, while wage gains are lagging far behind. Factory profit margins are squeezed by soaring energy, raw material, and transportation costs. Trade balances are worsening in oil importing nations.
“Stagflation” was last seen in the 1970s, when high oil prices fueled double-digit inflation. Back then, every time the Fed lowered interest rates to boost job growth, inflation took off, causing a vicious price spiral. On April 9th, former Fed chief Paul Volcker, said the present climate reminded him of the early 1970s. Then, as now, certain commodity prices were rising fast, - he cited crude oil and soybeans as two examples. Then, as now, these were explained away by government officials as speculative price run-ups and not as a harbinger of a big inflationary trend.
The Fed let inflation rage for so long that Volcker pursued a policy of targeting the money supply in 1979-82, in order to rein-in a 14% inflation rate. However, the cost of bottling-up the inflation genie was a deep recession, with unemployment hitting 11% in 1982. With commodity prices spiking again – soybeans are $16 a bushel today compared to $7 a year ago, crude oil at $135 /barrel compared with $70, Mr. Volcker warned US Treasury chief Henry Paulson, and Fed chief Ben Bernanke against letting inflationary expectations become embedded once again.
“There must be a forceful response to confront the danger that inflation expectations could rise appreciably, with all the attendant problems that would bring,” said BIS chief Malcolm Knight on June 24th. “With inflation a clear and present threat, and with real policy rates in most countries low by historical standards, a global bias towards monetary tightening would seem appropriate, even though economic growth is likely to be hit harder than most observers expect,” the BIS said.
So far, the Fed and US Treasury have ignored Volcker’s advice, and instead, are pegging the fed funds rate at -2.25% below the inflation rate, while inflating the MZM Money supply at a +16.5% annualized rate, a prescription for hyper-inflation. Yet the Fed’s aggressive rate cuts have failed to stop the bleeding in the S&P Financial Sector Index, which is off 50% from its 2007 record high. On July 9th, the S&P Financial Index fell 5.2% on the day, the biggest one-day percentage drop in six-years, led by Freddie Mac, which dropped 24% to $10.26, and Fannie Mae fell 13% to $15.31, to their lowest levels in 16-years.
It’s worthy to note that on Sept 18th 2007, two famed investors, Jimmy Rodgers and Marc Faber, warned the Bernanke Fed to avoid the temptation to lower interest rates, as a quick-fix to solve the sub-prime debt crisis. Rodgers said on Sept 18, 2007:
Every time the Fed turns around to save its friends on Wall Street, it makes the situation worse. If Bernanke starts running those printing presses even faster than he’s doing already, yes we are going to have a serious recession. The dollar’s going to collapse. There’s going to be a lot of problems in the US.
“The cause of the problems we have today, they are due to artificially low interest rates, expansionary monetary policies, and extremely rapid credit growth that was fueled by a totally irresponsible Fed,” said Mr Faber, who oversees a Hong Kong-based investment company. “It’s suicidal to cut interest rates,” Faber warned.
Mr Rodgers added:
They should do something to stop inflation as soon as they can. If you don’t do something now, if you don’t nip it in the bud, it gets much worse down the road.
A few hours later however, the Fed shocked the markets, with a larger than expected half-point rate cut to 5.75 percent.
Ten months later, on July 7th, 2008, after a doubling of agricultural and energy commodities, and a 20% slide in the Dow Jones Industrials, San Francisco Fed chief Janet Yellen told her audience to grin and bear the pain:
I see inflation expectations as reasonably well anchored. There is little monetary policy can do about rising commodities prices. If rising commodity prices reflect supply and demand fundamentals, then the situation is not likely to turn around any time soon.
Beijing Takes Aggressive Stance Against Inflation
However, other central banks are not willing to go down to defeat at the hands of inflation, without a fight. The People’s Bank of China (PBoC) is very worried about commodity inflation generated by the Fed, especially since food and energy make-up 40% of the average Chinese household budget. To counter commodity inflation, the PBoC has allowed the yuan to rise about 1% per month against the dollar, twice as fast as a year-ago, to dampen the cost of raw material and oil imports.
The PBoC has also sold huge blocks of government bills to soak up liquidity, and lifted bank reserve requirements to a record high of 17.5% last month. PBoC chief Zhou Xiaochuan said on June 27th:
Food and oil-driven inflation is a global phenomenon, because oil and food are traded on international markets, and impacts the whole world. Monetary policy needs to deal with this.
Last year, Chinese investors open 33-million new stock trading accounts, about ten times the amount of the previous year, bringing China’s investor population to 136-million. They poured half of their savings stashed away in bank deposits, into the stock market, and bid the Shanghai red-chip market about five-fold higher in less than two years, hitting an all-time high of 6,150 in October 2007.
Chinese investors ignored the warnings of Cheng Siwei, vice-chairman of the National People’s Congress, who warned in February 2007, that:
There is a bubble growing. Investors should be concerned about the risks. But in a bubble market, people will invest irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice.
Ten months later, on October 16, 2007, PBoC chief Zhou warned speculators that the central bank’s top priority was combating inflation, and the stock market’s value was not a key factor in setting monetary policy. Few traders took Zhou’s warning seriously at the height of the Shanghai bubble, since Chinese leaders had a long-history of broken promises to control the explosive growth of the money supply.
But the PBoC stunned stock market speculators by engineering a 60% correction in the Shanghai red-chip index from its peak of 6,150 to as low as 2,500 last month, even before the upcoming Olympics in August. Nearly $2.4 trillion of shareholder wealth was wiped out in Shanghai over the past eight months.
The PBoC is tightening its monetary policy, even at a time when China’s factory orders have plunged due to a sharp drop-off in exports, falling to a reading of 50.2 in June, the lowest in three-years, from 59.1 in April. At the same time, raw-material and fuel costs for Chinese factories rose to an all-time high, and squeezing profit margins. Wages for Chinese factory workers are +18% higher from a year ago. Net income for Chinese industrialists fell to 1.1 trillion yuan ($160 billion) in the first five months of 2008, or 55% less than a year earlier, ravaged by “Stagflation.”
Single Needle in the ECB’s Compass – Price Stability
The most precious commodity a central bank chief has is credibility. With inflation spiraling higher around the globe, most of it inspired by US-dollar weakness, “price stability” is the key buzzword at the ECB this year, even when signs of recession abound, and politicians are calling upon the central bank to turn up the printing presses, in order to shore up a flagging economy. Much like the PBoC, the ECB hawks are proving their mettle under stressful “Stagflation” conditions.
The Euro-zone Purchasing Managers’ Indices for services companies and factories both fell below the 50-mark last month, signaling the first contraction in the Euro-zone economy in five-years. German factory orders fell for a sixth straight month in May, adding further evidence that Europe’s largest economy is losing momentum. But Euro zone inflation jumped to a record 4% in June, and the ECB stands ready to hike rates again, to prevent inflation expectations from getting out of control.
“We know where we must go, and there is no doubt about our goal,” ECB chief Jean “Tricky” Trichet said on Dec 17th. "We don’t know whether and when there will be a thunder storm, when the sea will remain calm, whether we will get a headwind or a tailwind. But everyone knows that the ship’s crew will make all the necessary decisions to arrive at its destination - price stability."
Two days later, on Dec 19th, 2007, Trichet was asked on German television channel N-TV if the bigger danger to the Euro zone economy was the banking crisis or inflation? Trichet said:
The response is very clear. We have a mandate. The primary goal is to preserve price stability. We are alert, and everybody must know that we will do whatever is needed, to deliver price stability in the medium term, and be credible in that delivery. The single needle in our compass is price stability.
A few days later, the German DAX index began to melt down, tumbling 20% before hitting a panic bottom low of 6,400. On January 21st, the DAX-30 plunged -7.2%, the French CAC-40 fell -6.8% and London’s Footise-100 lost -5.5%, their biggest one-day slides since the Sept 11, 2001 attacks, on signs the US economy was sliding into recession, and massive write downs in the financial sector sparked a panic sell-off. The plunge in Europe’s top-3 stock markets wiped out $350 billion of equity on Jan 21st, equal to the gross domestic product of Hungary and Greece.
But Trichet and the ECB hawks had little sympathy for the plight of stock market speculators. After surveying the damage from the meltdown storm, Bundesbank deputy Juergen Stark told the Belgian business paper De Tijd on Jan 25th:
We must not dramatize and panic over the current stock market turbulence. The current market volatility is turbulence, rather than a full-scale financial crisis.
Ruling out an ECB bailout with rate cuts, Stark added:
An inflation rate of more than 3% is not acceptable. The ECB’s goal is to keep inflation close to 2 percent.
Seizing the mantle as the G-7’s sole inflation fighter, the ECB hawks shocked the markets on June 5th, by signaling a quarter-point rate hike to 4.25% for July. “Tricky” Trichet, who has a penchant for fooling most traders most of the time, guided the German 2-year schatz yield to a seven-year high of 4.80%, aiming to block the upward spiral in the North Sea Brent oil market.
By anchoring the Euro near its all-time highs with a rate hike, the ECB is also shielding industrial companies and consumers from the full brunt of soaring energy and raw material import prices. However, the ECB’s anti-inflation crusade is thwarted by the other G-7 central banks, which are afraid to raise their interest rates to combat speculators in commodities.
Legions of “yen carry” traders have migrated from the global stock markets to the crude oil pits since the rescue of Bear Stearns in mid-March. A continuation of the “Commodity Super Cycle” to new high ground could trigger another ECB rate hike to 4.50% in the months ahead, putting enormous pressure on Bernanke to lift the fed funds rate to defend the dollar, or surrender the last ounce of the Fed’s credibility.
South Korea Declares War on FX Speculators
Most major foreign currencies have risen sharply against the US dollar since the Bernanke Fed began its rate cutting spree last August. But one currency that went in the opposite direction, the Korean won, fell by 10% against the dollar from a year ago, even though the won enjoys a hefty 300-basis point interest rate advantage. Foreign investors have been fleeing Korea’s bond and stock markets since the central bank is ratcheting up the growth of its M2 money supply to +15.8%, its fastest in ten-years, weakening the won and fanning the flames of inflation.
When President Lee Myung Bak took office earlier this year, he said stimulating economic growth was his top priority, and currency traders assumed that Seoul would be happy with a weaker won, to help boost exports, the key engine of growth for Asia’s fourth largest economy. But the sharp slide of the Korean won is also intensifying upward pressure on inflation in the local economy, which imports almost all of its energy and natural resources to fuel its huge industrial base.
Korea’s consumer inflation rate hit +5.5% last month, a seven-year high, and the producer price index is +15.2% higher from a year ago. Korea’s industrial giants are watching their profit margins shrink, as input prices for key raw materials are rising much faster than their ability to pass the cost increases along. Meanwhile, slowing economies abroad led to a $2 billion drop in exports last month. Korea is caught in the “Stagflation” trap, but Lee Myung Bak is opposed to giving the central bank a green light for a rate hike, to control the explosive money supply growth.
However, the Korean bond market vigilantes took matters into their own hands and jacked-up the government’s 5-year bond yield by 110-basis points, to as high as 6.15%, tracking the direction of crude oil. In turn, the Korean Kospi Index has been slammed by a “double whammy” - soaring oil prices and higher interest rates, and went into a nosedive, losing 20% of its value in the past two months.
On June 24th Myung-bak told his cabinet that “price stability” is the government’s top policy goal, and that the battle against inflation would center on foreign currency intervention. On Wednesday night, the Bank of Korea stepped up its intervention in the FX market, by selling $5 billion US dollars to buy Korean won. In a market that trades an average $27 billion per day, the BoK sales knocked the US-dollar about 4% lower, its biggest single daily decline in 10-years.
According to estimate by dealers, the BoK has spent $17 billion from its foreign currency stash, for intervention since the beginning of March, from a treasure chest that was originally $265 billion. By draining Korean won out of the banking system through intervention, the BoK is clandestinely tightening its monetary policy. It’s an unorthodox approach to dealing with “Stagflation,” but it’s a smarter approach than the Bernanke Fed’s, which is eroding the purchasing power of its citizens.
Gold – a Safe Haven From Global Instability
The clock is ticking on George W Bush’s presidency, with his approval rating stuck at 23-percent. Since Bush took office in 2001, the US national debt has ballooned by $4 trillion dollars, and 2.6 million manufacturing jobs were shipped overseas. The US banking industry is mired in its worst crisis since the Great Depression, and the US economy has lost 432,000 jobs over the past six months. Washington is spending $10 billion per month in Iraq, and the American electorate wants change.
According to traders at Dublin-based inntrade.com, the Democrats will gain complete control over the White House and Congress in 2009, and if correct, could lead to sweeping changes in trade policies with China, and a quick withdrawal of US troops from Iraq within sixteen months. Such big changes could have a major impact on the foreign exchange and metals markets in the years ahead.
Will President Bush leave the file on Iran’s nuclear weapons program to Illinois Senator Barrack Obama, or will he opt for a naval blockade of Iran before the November elections? The saber rattling between Jerusalem and Tehran has ratcheted to very high decibels, but this is “nothing new under the sun,” in the Middle East. Still, the war of words heightens risks of a clash in the Gulf, and is lending support to safe-haven gold, while inflating an Iranian “war premium” in oil prices.
On July 5th, Iran’s elite Revolutionary Guards General Mohammad Ali Jafari, warned if his country came under attack, “the Guards are equipped with the most advanced missiles that can strike the enemies’ vessels and naval equipment with fatal blows,” and would shut down the Strait of Hormuz, a vital outlet for 40% of the world’s oil exports. “Blitzkrieg tactics and operations of the Guards’ boats will not leave a chance for the enemies to run away,” Jafari warned.
On July 8th, Ali Shirazi, an aide to Iran’s Supreme Leader, Ayatollah Ali Khamenei, warned:
The first bullet fired by America at Iran will be followed by Iran burning down its vital interests around the globe. If they commit such a stupidity, Tel Aviv and US shipping in the Persian Gulf will be Iran’s first targets, and they will be burned.
In April, Israeli minister Binyamin Ben-Eliezer, told Israeli media, “An Iranian attack will prompt a severe reaction from Israel, which will destroy the Iranian nation,” as he hinted at a nuclear response.
Iranian President Mahmoud Ahmadinejad, a very high-skilled poker player, said the Washington neo-cons are not in a position to make an assault on Iran.
In the US, wise scholars will not allow Mr. Bush to commit political suicide, and of course the economic, political and military situation will not allow Mr. Bush to do that. Bush is not in a situation to change circumstances in his favor. I assure you, and don’t be worried, that there will not be a war in the future.
Yet only eight-hours later, Iran tested nine long and medium-range missiles, including a new version of the Shahab-3 missile with a range of 1,250 miles, and armed with a 1-ton conventional warhead. A missile with that range could strike Israel, Turkey, the Arabian Peninsula, Afghanistan or Pakistan. An Iranian military official said “the missile tests would show Iran’s enemies its resolve and might.”
In June, Israel conducted aerial exercises involving its best jet fighters, widely seen as a rehearsal for a strike against Iranian nuclear facilities. Arizona’s Republican Senator John McCain said on July 9th, there is “continuing, mounting evidence that Iran is pursuing the acquisition of nuclear weapons.”
The House Foreign Affairs Committee Chairman Howard Berman, Democrat-California, said that “stopping Iran’s nuclear threat is our most urgent strategic challenge. No one knows precisely when Iran will produce a nuclear bomb. But it will be soon,” Berman warned.
During times of extreme stress in the global banking system, fireworks in the Middle East, explosive growth of the world’s money supply, the biggest energy crisis in history, and the bungling of the Fed’s monetary policy, investors have fled the global stock markets and found a safe-haven in gold. When measured against an ounce of gold, the MSCI World Stock market index lost 40% of its value and can only fetch 1.5 ounces of gold today, compared to 2.5 ounces when the BSC hedge fund revelations first came to light in July 2007.
In emerging markets such as in China and India, gold and silver are widely revered as traditional hedges against inflation that preserve wealth when central banks are running the printing presses at full speed. In China, the M2 money supply has been growing at an 18% clip for the past five years, and India’s M3 is 21% higher from a year ago. So it’s not surprising that wholesale inflation in China is raging ahead at an 8.6% clip, and 11.6% in India, its fastest in 16-years.
However, there was a fanciful notion among many of the Chinese and Indian masses that “paper assets” that couldn’t be printed by central banks, such as company shares on the Bombay and Shanghai stock market, could also serve as a viable hedge against inflation.
Such fairy tales are often peddled by Wall Street salesmen. But when food and energy prices began to skyrocket this year, and central banks in China and India tightened their monetary policies, investors in Bombay and Shanghai listed stocks were left holding accounts stuffed with “fool's gold.” Meanwhile, the “Yellow Metal” is within striking distance of its all-time high.