FX Alpha Macro Forecast: The End Is Not Nigh—But Inflation Is
For us average retail investors, “the credit crunch” no longer offers much in the way of profit opportunities. We will have to watch it closely, so that we are not too surprised by the occasional, unpredictable Citigroup or Merrill writedown that will send implied volatility up 20 percent in one day. There will be more of those.
After a lackadaisical analyst wrote that E*Trade was near bankruptcy, a run began on E*Trade accounts, forcing them to fire-sell many of their assets, including a $3.1 billion securitized-debt portfolio, to Citadel Investment Group.
The E*Trade sale informed us exactly how high the losses would be for a firm in a similar position – say, Citigroup – which might be forced to liquidate a large securitized debt holding. E*Trade's overall portfolio, which consisted of mostly prime debt, was sold at 11 cents on the dollar. Observers are calling it a “mark to reality event,” and it means that other banks with huge debt portfolios are facing some devastating choices. E*Trade's rescue was a very specific, open-market transaction of securitized debt very similar to what many investment banks are holding.
In the end, the Abu Dhabis of the world will come in – once there's enough blood in the water. There is a saying among speculators that “the time to buy is when blood runs in the streets,” but that means that there will be moments over the next several quarters in which panic will suddenly seize up nearly every market. They cannot be predicted. The only option for the small trader is to reduce leverage, with the calm knowledge that there will be many superb opportunities over the next year – but high overall volatility and systemic risk will claim even more livelihoods than they have so far.
The financial industry is using the specter of a debt-market seizure to browbeat central banks around the world into cutting interest rates. If the world capital markets are facing a long-feared debt depression, the sad fact of the matter is that there is nothing the central banks can do about it, and no way for the central banks to know whether it's happening or not until it's far too late. In the meantime, it's a much safer bet that private bankers are being alarmists who do not want to bear full responsibility for their mistakes. There will be still more instances of Citigroup or any other bank veering frighteningly close to bankruptcy, only to be rescued by a large, cash-rich outside investor at the last minute after weaker hands have bailed out of Citigroup and made it still cheaper than it is currently.
Looking beyond the financial sector, inflation is breaking out everywhere.
My money is on 50 basis points at the Fed’s December meeting. Contrary to the now red-faced predictions of the GaveKal permabulls, inflation, even by their favored indicators, has not abated, despite the total chaos in the private market for loans. Inflation is still accelerating, according to CPI-U, PPI, and chained PCE, the three main inflation indicators.
Source: Cleveland Fed
While I expect the dollar’s cratering to reflect itself in higher inflation going forward (loss of value of a currency is inflation, after all, and if markets are efficient, the forex change will ricochet its way down through all other prices), eurozone inflation is at a 6-year high. The ECB is in no position to cut rates. However, stresses on the Euro union have become very acute, especially among the “PIGS” (Portugal, Italy, Greece, Spain), plus France and Belgium, which do not fit so well into the acronym.
Belgium has not had a government for six months, and shows no prospect of forming another one in the near future; Belgium is divided very distinctly between Flemish and Walloon Belgians, and there is no urgent reason for the two Belgian regions to be one union. Italy’s presidency and half its cabinet ministries are controlled by communists (Yes. Communists.) However, the ECB and the Bank of England appear determined to hold their rates steady. My guess is that the ECB will ultimately acquiesce to 4-6% inflation in order to keep the union glued together.
The euro is currently undergoing its first existential test. The Fed’s depreciation of the dollar (to which the Chinese yuan is pegged), while not changing the balance of Chinese-US trade, has dramatically widened the euro-yuan differential. Chinese exports are flooding into Europe and crushing the lower-end “Club Med” (PIGS plus France). As evidenced by the explosion in spreads of French and PIGS bonds over German bunds, the market has begun to price in the possibility of a fracturing of the eurozone.
Meanwhile, the Chinese government is dealing with massive inflows of liquidity.
The PBoC has not only to mop up an expected $30-40 billion of foreign currency inflows every month, a Herculean task as it is (October’s reserve increase was $21 billion, probably low because of transfers to the CIC, but it has averaged $39 billion a month in 2007), but it must add to the mop-up the maturing of a substantially larger amount of maturing central bank bills during the next four months.
But there’s more. Wright argues that the maturing of repurchase agreements will add another RMB 250 billion over the four months, bringing the total amount of money entering the system to nearly $60 billion a month, not counting the PBoC purchase of net foreign currency inflows, which could mean managing $80-100 billion a month of new liquidity. In addition the recent amount and structure of fiscal revenues will add to the liquidity far more than it normally does. Wright explains:
Fiscal revenue is sky-high this year, up from last year’s total of 3.87 trillion yuan to an estimated 5 trillion yuan this year, according to a report from Yao Jingyuan, chief economist of the National Bureau of Statistics, cited in the Shanghai Securities News on November 26. The targeted revenue level was 4.4 trillion yuan.
Fiscal revenue went up from RMB3.9 trillion to RMB5trillion. That’s a 27.5% increase in one year.
Taxes are a reliable “floor” for all kinds of economic statistics. People do everything they can to avoid taxes, so if taxes go up by a certain amount, you can bet that, all else being equal, liquidity rose by at least the same proportion. China's 27.5 percent increase in revenue, then, is simply a staggering increase.
The Chinese government is facing extremely high domestic inflation. Bernanke, by depreciating the dollar, has raised the price of China's current currency policy. Chinese monetary authorities, especially PBOC chairman Zhou Xiaochuan, see an RMB revaluation as urgent (if not extremely so), but China’s regional economies are completely addicted to artificially cheap currency. A one-off 20 percent revaluation of the yuan would throw tens of millions of workers into the streets and destabilize both regional governments – which call most of the shots in China – as well as Beijing. Politically the Chinese do not seem able or willing to revalue their currency, even as Bernanke's calculated dollar bludgeoning has “strongly encouraged” them to do so.
Six months ago, I would have said that the dollar or the yuan needed to break. Today, the same either/or applies to the yuan and the euro. Until one of those break points occurs, the global financial party will go on. The euro cannot carry the weight that the dollar did, because European manufacturers will not stand for it. But for a while, the euro will be “the overvalued currency” which the dollar was in 1998-2005.
I expect all asset classes, especially metals, oil, gold and Chinese equities, to reflate until that break point occurs–which would be signalled by either 1) a widening of Italian, Belgian, Greek and/or Portuguese (probably Italian) bond spreads to over 80 bps over German bunds, the precedent for a eurozone breakup; or 2) in the case of China, massive, nationwide riots over food or fuel, both of which have been aggressively rationed to hold down official inflation numbers. Two things must be remembered about China: its inflation significantly exceeds official statistics, and inflation is the one factor which could destabilize the government. The Tiananmen riots, although Westerners think of it as a stand for democracy, freedom, justice and all that, were actually about food inflation. The reformist university students' ideological motives were a convenient rallying cry for popular discontent, but food inflation was the main cause of the 1989 Tiananmen Square riots.
I expect the dollar to generally continue skidding downwards, and I believe a sudden rise of dollar will be the canary in the coal mine for a crackup in either the eurozone or the Chinese bubble.
The Bottom Line
There’s a worldwide inflation glut. Even Japan is recording meaningful inflation (from fuel costs), and the thinking is that Japanese competition is causing a lot of Japanese companies to eat price increases instead of passing them on to consumers. If you compensate for that uniquely Japanese effect, even deflation-ridden Japan is experiencing accelerating inflation.
In the medium term, states with large cash reserves will become increasingly uncomfortable with the value of said cash as Bernanke insanely continues to plunge rates at Wall Street's behest. Cash hoarders will continue converting into gold and equities, with Russia leading the way.
And I think bonds are going to get hammered. Bloomberg notes that yields on 10-year Treasuries are practically even with consumer price inflation, and also notes the widespread skepticism that those numbers are rational and justified. Inflation has not abated at all, and in light of that, bonds are not going to represent safety.
So basically, I’m bullish on gold.
Thanks for reading. As always, e-mail me with questions or comments at alex.forshaw@gmail.com, and check out my blog at http://cartmanist.wordpress.com for further updates.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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