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Editor's Note: I want to start off by apologizing for not writing a letter last week. I have been absolutely swamped with outside work. I apologize for the unannounced interruption. --Alex
Items of interest:
--A week ago, we learned that the “Super Siv,” which I had prematurely pronounced as dead, was back after all. The article also declared that the fund would not distinguish between different kinds of risky assets. As a small-timer in the financial markets, this is the kind of phraseology that should snap psychological tripwires. Wall Street does nothing if it doesn't distinguish between different shades of risk; what's going on here?
--The fault-line of panic in the financial markets has shifted to the “monoline insurers” Municipal Bond Insurance Association (MBIA), Ambac Financial, and five smaller agencies. When a city or municipality wants to issue a bond to pay for a road or a school, for example, it can go to a monoline insurer, who agrees to insure the bond against the risk of the municipality's default. Thus, the municipality can secure a much higher credit rating than it otherwise could.
--MBIA has $6.96 billion in capital and $652 billion in bond guarantees; Ambac has about $5.7bn capital and $550bn in bond guarantees. The ratings agencies Moody's, Fitch, and S&P are only too aware of what happened when Arthur Andersen guaranteed Enron's accounting for too long, and they are apparently demanding that the monoline insurers “mark to ABX.” Had the monolines taken writedowns to the same extent that Merrill and Citi have, they would be sitting on losses 9 times as the ones they have announced, and they would be wiped out. The financiers (investment banks or hedge funds) appear poised to back the monolines to prevent the crisis from spreading, but it's not clear where the money will come from.
--According to CNBC, Larry Fink (Merrill's presumed replacement for Stan O'Neal) said that he would become Merrill's CEO only if Merrill wrote down the full extent of its CDO losses. Merrill then chose John Thain.
--On Thursday, the Federal Reserve pumped $47.25 billion into the financial system. Media reports emphasized the Fed's line that it was “effectively” “only” a $6.25bn injection, because the rest was replacing the $41bn repo operation the Fed performed at the beginning of the month. This should snap another of your psychological tripwires. Repos are supposed to expire. They aren't supposed to be continually refunded. The $47bn repo was the largest single operation in US history.
--The Fed has essentially been performing continual repo operations since August. This does not show up as inflation (it will, much later); and it doesn't show up as a lower interest-rate differential between the dollar and other world currencies. It's still money injected into the system, and it's still inflation. The markets do not yet appear to have priced this in.
--Over the weekend, at least two more OPEC members (Angola and Nigeria) lent support to the Venezuelan and Iranian position to denominate oil in a basket of currencies, rather than the US dollar.
--The EURJPY indicator has, for a very long time, been an unimpeachable indicator of global risk tolerance. Today (Sunday night, Monday morning in Asian markets) marks the first day in memory, so far, in which Asian stocks have diverged from what EURJPY would have predicted. Asian markets were up slightly as EURJPY was down slightly.
--The Wall Street Journal quoted a Chinese source as saying that China had ordered a freeze on commercial lending. According to Bloomberg, the Chinese banking regulator denied the report.
--According to an American monetary academic in Beijing, a bank in Shenzhen has implemented the first known cap on withdrawals. Monetary theory has predicted, for some time now, severe internal price and asset inflation, and an existential crisis in the Chinese banking system. The end result would be either a radically painful solution from Beijing, or a run on traditional banking institutions by depositors seeking positive real interest rates. There have been several reports of killings by people fighting to keep their place in lines (caused by price caps designed to keep inflation down).
Beijing remembers that the proximate cause of the Tian An Men protests was a surge in food inflation. The mandarins are extremely worried about inflation, but they do not appear able to muster the political consensus required to implement necessary, but (in the short term) painful reforms for the Chinese banking sector.
So what?
So where does all that leave us?
I guess it would be pretty lame for me to come out of hibernation after the most volatile week since August and say, “I told you so.” But for those of you who stomached the rise of the GBP and held onto your short position, you have finally been rewarded, and rewarded extremely well (~500 pips). This was why I said to short both the dollar and the pound!
The British economy is in even worse shape than the United States', and more of their recent investment has been in the form of capricious hot money, especially from Russian political emigres. Even worse, judging by consumption patterns as reported by UK media, the British seem to be on a spending bender even worse than the Americans' (and the Americans are slowing down extremely rapidly). The UK will lower its interest rates in line with the Federal Reserve (I wouldn't be surprised if they actually lowered at an even faster rate).
The Chinese economy is on a drunken binge unparalleled since at least the 1920's in the United States, if not even more so. Foreigners are unable to invest in Chinese currency in any meaningful quantity; to “buy yuan” they must buy Chinese real estate or stocks. Unfortunately, millions of foreigners have already figured that out, so Chinese hard assets are valued at least three times as richly as comparable assets elsewhere in the world. China is impossible to buy at the moment.
Whither the euro?
The euro is in an extremely interesting position.
With the Fed’s drastic devaluation of the dollar, Chinese exports to Europe have more than offset lower exports to the United States. European political instability is increasing, and European bankers (not to mention politicians) are not going to play that game for nearly as long as the United States did.
However, the USD has already been gutted. The GBP has begun to follow. The Euro is the only currency still backed by currency hawks. While the ECB does have a significant hawkish bias (if only to capture more “world reserve currency market share” from the USD), it cannot stray too far from the pack. Germany, Austria, Netherlands, Scandinavia, UK, and Ireland are indifferent to a strong euro–their exports are highly specialized, and so demand for their exports is inelastic relative to the price of the euro–and in the meantime, their citizens have gained enormous international purchasing power from the euro’s appreciation.
However, the ECB must also pay heed to the Mediterranean and Eastern European economies in its currency union, especially Spain, France and Italy. The Eastern European economies are experiencing double-digit inflation and double-digit trade deficits as a percentage of GDP, while France, Italy and Spain–lower-end exporters more dependent on fluctuations in the value of the euro–have seen their competitiveness crippled by the stronger euro. Thus, the eastern and southern Europeans are howling for euro depreciation, and judging from Trichet’s latest rhetoric, the ECB has begun to fear the consonance of the depreciators’ collective demands.
The political equilibrium of the ‘guzzler’ economies thus seems heavily tilted in favor of inflation. US inflation is now at 3.5%, and almost certainly rising. Who will be left to mop up global liquidity if the ECB begins to ease? Or will everyone just wait until Chinese peasants (once again) choose revolution over asphyxiation-by-inflation?
Trichet's decisions over the next several months will be extremely significant ones. The Federal Reserve is no longer outsourcing currency policy to the People's Bank of China. As a result, the euro seems poised to be a victim of its own success, as political tensions across the Eurozone force the ECB to begin to ease until China drastically up-values the yuan.
However, if Trichet maintains a strong euro in the face of rising political opposition, the global economy will continue to fire on all cylinders for a while yet – especially the European economy, notwithstanding the protests of the Mediterranean economies.
The euro is entering a new, much less certain regime. The dollar's decline was briefly arrested, but it's on the way down again, too; the Federal Reserve remains dogmatically committed to “avoiding a recession,” and blatantly misinterpreting its mandate to pursue “full [intertemporal] employment.” (A Fed that is goosing employment now, at massive expense to employment fairly shortly down the road as foreign capital rejects dollar devaluation and leaves the country, is not a Fed that is “maintaining full employment.” The Fed must account for employment at different phases in time, not just the present.)
That's all for this week's newsletter. I hope you enjoyed it. Don't forget to email (alex.forshaw@gmail.com) with feedback. And check out my blog (http://cartmanist.wordpress.com) for additional forex updates and speculation.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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