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*This newsletter was written by Mr. Forshaw on 12/20/07. Unfortunately, the holiday break caused it to be delayed until today. Although a little out-dated, Alex's analysis is always insightful and there is still much to learn here.
Editor's note: Thanks to Jim Miller for kindly substituting for me last week. --Alex Forshaw
The Central Banks' Vichy Momen
On December 17, the hastily improvised dam that was European Central Bank credibility disintegrated in spectacular fashion, with a $500 billion injection into the European banking system.
Jean-Claude Trichet, chairman of the ECB, has built up for himself a substantial wellspring of respect for currency observers as a currency hawk, even as private bankers fumed with self-entitled rage. While the Federal Reserve reacted to Wall Street's panic-mongering with all the icy, calculating deliberation of a lab monkey at a cocaine switch, Trichet paid much more heed to rising inflation, rising inflation expectations, and soaring commodities prices. Although the ECB used repo operations very liberally, it stood firm on interest rates. Bankers were aghast at the thought of taking pseudo-responsibility for bad decisions (they were still drenched in temporary repos), but the euro soared as the currency markets quietly applauded Trichet's independence.
As I noted in the December 5 newsletter, the falling dollar – which also brought down the dollar-pegged yuan – has crippled future growth of the medium-end export economies of Europe, the PIGS (Portugal, Italy, Greece, Spain) plus France. The yuan-driven dollar devaluation will not be allowed to continue, and at best, the ECB must now play the competitive devaluation game.
The ECB's favored form of devaluation took the form of an EUR340bn (US$500 billion) injection of 14-day repurchase agreements. Another ABCP crunch in January will coincide with these repurchase agreements coming due, so I fully expect another huge injection in January to replace the maturing repurchase agreements issued on Monday. If Trichet does not re-print a healthy majority of Monday's $500 billion repo agreements, he will be faced with an even bigger explosion in the spread between Libor and the ECB interest rate target.
Trichet seems to understand that the causes of the current problem are structural, i.e., he doesn't buy the propaganda that this is a “temporary” crisis, or the idea that the financial industry should bear no responsibility for a massive, endogenous increase in volatility. However, political considerations are forcing him to “turn to the dark side” of competitive devaluation, and the euro has retreated from $1.50 to $1.43, a depreciation of over 4 percent against the dollar.
The supremacy of the UK pound sterling has also crashed as the Northern Rock imbroglio has mushroomed. “Northern Crock” was the most hyperextended mortgage lender in the UK for its size, much the same as Countrywide Financial in the United States. Northern Rock's entire portfolio, including derivative positions, was valued at approximately US$230 billion. The company itself is approximately US$114 billion in debt to the British government, and the UK taxpayer will be forced to eat most (if not all) of that debt. The utterly politicized and haphazard mismanagement of the affair by the UK government constituted the main reason why this newsletter turned very bearish on the sterling about a month too early. Gordon Brown's politicization of The Crock will probably cost him his job, whether or not Labour allows Brown to lead them into the next election. The pound sterling is now trading at approximately US$1.99, down from $2.12 only weeks ago.
The UK has been the destination of choice for hundreds of billions of dollars in “hot money,” mostly from Russian oligarchs in exile. Hot money is generally very intelligent, forward-looking, and allergic to political mismanagement. Given the UK's dismal economic prospects in 2008-09 – their housing boom was even more overextended than the United States' – as well as its high deficits and enormous size of government, the UK is no longer the investment magnet it has been from 2005-07.
The US dollar has rebounded significantly, but to me, the recent dollar rally does not really add up. The United States has its own Northern Rock situation – actually, two of them. However, the enormity of the American situation is not nearly as well understood.
Countrywide, Citigroup, the Term Auction Facility, & FHLBs
It was no coincidence that Citigroup announced it was taking $58 billion of its SIVs onto its balance sheet, merely one day after the Federal Reserve set up its “Term Auction Facility.” The TAF is structurally and operationally identical to the planned, and equally awfully named, “Master Liquidity Enhancement Conduit” (MLEC), which predictably failed when the private sector refused to bail out Citigroup. The only difference with the TAF is that it is actually owned and operated by the Federal Reserve. The fact that the M-LEC is now up and running with the Fed imprimatur does not make it any better of an idea. It makes it even worse.
However, beyond Citigroup, the TAF is not very relevant The Federal Home Loan Banks are the true source of money creation. Not to be pompous here, but month and a half ago, this very newsletter pointed out the explosive growth and importance of the FHLBs:
There has been a massive surge in the liabilities of the Federal Home Loan Banks in the past month [of November]. This Depression-era agency, bigger and badder than Fannie Mae and Freddie Mac, has taken a ton of CDOs ($150bn or so) on its books in the third quarter (through September 30), and in all probability its liabilities increased even more rapidly in October. Taxpayers have already footed the bill for some of the CDO debacle through blatant depreciation of the dollar, but they will pay more when the government is faced with the price of insuring FHLB debt, which currently stands at approximately $1.15 trillion.
According to the FHLB financials (see http://www.fhlb-of.com/specialinterest/financialframe.html), FHLB consolidated obligations have increased by 21 percent in the previous nine months. Even in the dog days of 2003-2004, FHLB obligations increased by a “mere” 12 percent year-on-year. Government-sponsored enterprises are notoriously lax when it comes to lending practices, but unless the FHLBs tend to significantly reduce liabilities in every fourth quarter – in other words, the only market in the United States to tighten its belt during the holiday season – this cost will be paid by taxpayers in the form of higher interest rates and a cheaper dollar, or higher taxes.
On December 12, the Financial Times' sharp-eyed Gillian Tett finally “broke the news” that the FHLBs have injected more than $250 billion into the shattered mortgage sector. Countrywide, a $6 billion company, owes the FHLBs more than $55 billion alone. The vast majority of Countrywide's debt will not be repaid by CFC, and that means the taxpayer will pay for it instead. In the meantime, we now know why the mortgage industry still “exists”: it has been nationalized by the FHLBs in all but name.
The FHLBs, with the help of the Fed, have apparently dumped so much money into the system that the January-August “Minsky Moment” has now reversed and shot upwards. Commercial lending, as of November 1, 2007 (the latest available data), is growing at its fastest rate in history. Even more alarmingly, MZM – a measurement of “safe,” “liquid” cash – is also growing at a historically rapid rate, and the combined MZM and business loan growth rate is by far the highest in history since 1973. Business lending should be negatively correlated with MZM, and the extent to which both rise at the same time constitutes a decent measurement of monetary expansion.
Predictably, inflation – even as measured in the suspect CPI (indicated by the red line) – has soared.
As also suggested by the graph, the dollar is poised to spike relative to other currencies – and commercial lending (light green) is poised for collapse. However, Bernanke has given every indication that a corrective collapse in commercial lending is unacceptable; hence the FHLB intervention and the Fed's cutting interest rates in the midst of an alleged economic expansion.
I am bullish on the dollar relative to other currencies, but I think all currencies currently make very poor bets compared to commodities right now. I am bearish on both the sterling and the euro, and bullish on the yen (yes, here I am predicting the yen again). The competitive devaluation game is on, and the commodities boom is far from over.
As a final afterthought, note that as the dollar has rallied 5 percent globally (and seems primed for a much bigger rally), the prices of gold and oil are rising in dollar terms, even as the dollar continues to strengthen. Commodities prices are no longer a barometer of dollar weakness: they will be a measure of other currencies' weakness.
With 30-day gold trading at $806, and 30-day oil futures trading at $92, gold is slightly above its recent $845 high, after accounting for recent dollar appreciation. Oil, in terms of the “weakest” dollar of a month or so ago, has surpassed $96/barrel. Non-dollar money is flowing disproportionately into commodities. The commodities boom will rage longer yet.
There will be no newsletter for Dec. 26 (next week). In the meantime, have a great Christmas, and know that gold will be the Christmas present that will keep on giving.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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