Tag Archives: Saudis

Jan 23 late update

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Monoline problem addressed, stocks suddenly oversold as that risk fades.

Most earning look strong. Guidance may be soft but that’s at least partially a function of the expectation of a recession as per the media reporting and will get ignored as those fears continue to fade.

If initial claims tomorrow are around 325,000 as expected, and continuing claims are reasonably stable, it will indicate the labor markets may not have deteriorated from Q4 as feared.

Existing home sales are still winter numbers, but could surprise on the upside as anecdotal reports indicate aggressive selling of excess inventories.

The Fed and the stock market share the same fears. As the market’s fears fade so will the Fed’s, and the markets and the Fed could start to take away a the cut now priced in for the meeting next week.

This leaves FF futures and ED futures maybe 100 bp over priced, as the improving outlook will price in the possibility that fewer future cuts will be appropriate.

And the fiscal package is growing. This is the first time I’ve ever seen the Fed encouraging adding to the deficit, and in an election year it’s hard to imagine Congress and the President not taking advantage of that opening and in the spirit of bipartisan cooperation expanding the package so all get their favorite tax cut and spending initiative. $250-300 billion wouldn’t surprise me. And they need to do it quick before it’s discovered there is no recession problem, but instead an inflation problem.

Also note WTI and Brent crude have converged quite a bit in the sell off, which probably means WTI was sold off by speculators, and a bounce back to the Saudi’s target price (whatever that is) can be expected.

Exports are also likely to be underestimated in next week’s GDP preview, so there’s a good chance it will be revised up when December trade numbers are announced in February.

And without a rise in unemployment and a meaningful drop in personal income housing can come back very quickly from a very low base. Affordability is up nicely, and the production of new homes is down by maybe a million vs last year.

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2008-01-21 Update

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Major themes intact:

  • weak economy
  • higher prices

Weakness:

US demand soft but supported by exports.

US export strength resulting from non resident ‘desires’ to reduce the rate of accumulation of $US net financial assets. This driving force is ideologically entrenched and not likely to reverse in the next several months.

In previous posts, I suggested the world is ‘leveraged’ to the US demand for $700 billion per year in net imports, as determined by the non resident desire to accumulate 700 billion in $US net financial assets.

US net imports were something over 2% of rest of world GDP, and the investment to support that demand as it grew was probably worth another 1% or more of world GDP.

The shift from an increasing to decreasing US trade deficit is a negative demand shock to rest of world economies.

This comes at a time when most nations have decreasing government budget deficits as a percent of their GDP, also reducing demand.

The shift away from the rest of world accumulation of $US financial assets should continue. Much of it came from foreign CB’s. And now, with Tsy Sec Paulson threatening to call any CB that buys $US a ‘currency manipulator’, it is unlikely the desire to accumulate $US financial assets will reverse sufficiently to stop the increase in US exports. I’m sure, for example, Japan would already have bought $US in substantial size if not for the US ‘weak dollar’ policy.

All else equal, increasing exports is a decrease in the standard of living (exports are a real cost, imports a benefit), so Americans will be continuing to work but consuming less, as higher prices slow incomes, and output goes to non residents.

I also expect a quick fiscal package that will add about 1% to US GDP for a few quarters, further supporting a ‘muddling through’ of US GDP.

Additional fiscal proposals will be coming forward and likely to be passed by Congress. It’s an election year and Congress doesn’t connect fiscal policy with inflation, and the Fed probably doesn’t either, as they consider it strictly a monetary phenomena as a point of rhetoric.

Higher Prices:

Higher prices world wide are coming from both increased competition for resources and imperfect competition in the production and distribution of crude oil. In particular, the Saudis, and maybe the Russians as well, are acting as swing producer. They simply set price and let output adjust to demand conditions.

So the question is how high they will set price. President Bush recently visited the Saudis asking for lower prices, and perhaps the recent drop in prices can be attributed to those meetings. But the current dip in prices may also be speculators reducing positions, which creates short term dips in price, which the Saudis slowly follow down with their posted prices to disguise the fact they are price setters, before resuming their price hikes.

At current prices, Saudi production has actually been slowly increasing, indicating demand is firm at current prices and the Saudis are free to continue raising them as long as desired.

The current US fiscal proposals are designed to help people pay the higher energy prices, further supporting demand for Saudi oil.

They may also be realizing that if they spend their increased income on US goods and services, US GDP is sustained and real terms of trade shift towards the oil producers.

Conclusion:

  • The real economy muddling through
  • Inflation pressures continuing

A word on the financial sector’s continuing interruptions:

With floating exchange rates and countercyclical tax structures we won’t see the old fixed exchange rate types of real sector collapses.

The Eurozone banking sector is the exception, and remains vulnerable to systemic failure, as they don’t have credible deposit insurance in place, and, in fact, the one institution that can readily ‘write the check’ (the ECB) is specifically prohibited by treaty from doing so.

Today, in most major economies, fiscal balances move to substantial, demand supporting deficits with an increase in unemployment of only a few percentage points. Note the US is already proactively adding 1% to the budget deficit with unemployment rising only 0.3% at the last initial observation in December. In fact, fiscal relaxation is being undertaken to relieve financial sector stress, and not stress in the real economy.

Food and energy have had near triple digit increases over the last year or so. Even if they level off, or fall modestly, the cost pressures will continue to move through the economy for several quarters, and can keep core inflation prices above Fed comfort zones for a considerable period of time.

Fiscal measures to support GDP will add to the perception of inflationary pressures.

The popular press is starting to discuss how inflation is hurting working people. For example, I just saw Glen Beck note that with inflation at 4.1% for 07 real wages fell for the first time in a long time, and he proclaimed inflation the bigger fundamental threat than the weakening economy.

I also discussed the mortgage market with a small but national mortgage banker. He’s down 50% year over year, but said the absolute declines leveled off in October, including California. He also pointed out one of my old trade ideas is back – when discounts on pools become excessive to current market rates, buy discounted pools of mortgages and then pay mortgage bankers enough of that discount to be able refinance the individual loans at below market rates.

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Why I expect US exports to continue to be very strong..

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The desire to accumulate $US financial assets has been diminished for at least the following reasons:

  1. Treasury policy – Paulson is actively pushing both a strong yuan and threatening any other CB that buys $US with the label of ‘currency manipulator.’ CB’s had been perhaps the largest source of $US financial assets accumulation and are now limited to compounding of interest.
  2. US foreign policy is probably driving CB’s in less than friendly nations to diversify their reserves away from $US financial assets.
  3. Fed policy has the appearance of a ‘beggar thy neighbor’/’inflate your way out of debt’ policy, as the Fed aggressively cuts rates in the face of inflation not seen in 25 years.

This all sets in motion a downward pricing of the $US as non residents sell them to each other at lower and lower prices in this effort to lower their rate of accumulation of $US financial assets. But these financial assets can only ‘go away’ when they get spent or invested in the US, when US prices are low enough to cause this to happen. The rapid rise in exports and accelerated non resident buying of US real estate and other assets is anecdotal evidence this is taking place as theory predicts.

This is a very large cyclical force that should continue to drive rapidly rising exports for perhaps a year or more. Weak foreign economies should have little effect on this process, as that weakness doesn’t reduce the desire of portfolio managers to shift out of $US financial assets.

This is also highly inflationary for the US. This buying by non residents both drives down the $US and drives up the prices of US exports, now rising at a 7% clip last I checked.

The desired shift is probably well over $1 trillion which means exports will increase by a good part of that to facilitate this transfer.

This can sustain US GDP in the face of falling domestic demand, which will stay relatively low until housing picks up. Employment will remain reasonably good, but standards of living fall as we produce as much, but export more and consume less. We get paid to work but can buy less due to high prices, with our remaining production exported to those wishing to reduce their accumulated $US financial assets.

We’ve been talking about this possibility about a long time, but seems our trade negotiators have finally got their wish.

Meanwhile, Saudis continue to act the swing producer. In fact, they told Bush today they have 2 million bpd capacity in reserve, and that markets are well supplied. At their price, of course.

Probably have been some year end allocations out of crude by pension funds as with the price hikes they would need to sell some to keep the same ‘weight’ in their portfolios. That should be ending soon.

And I agree with Karim, the Fed is not likely to act on inflation until core starts to rise or their measures of inflation expectations start to rise, despite the fact that mainstream theory clearly says if any of that happens it’s too late. Seems to me the senior FOMC members are putting their jobs on the line by taking that kind of systemic risk, which their own theory tells them is far higher than the risk of any lost output from a .

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The subprime mess

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On Jan 5, 2008 9:40 PM, Steve Martyak wrote:
> http://www.autodogmatic.com/index.php/sst/2007/02/02/subprime_credit_crunch_could_trigger_col
>
>
> also….
>
> 9/4/2006
> Cover of Business Week: How Toxic Is Your Mortgage? :.
>
> The option ARM is “like the neutron bomb,” says George McCarthy, a housing
> economist at New York’s Ford Foundation. “It’s going to kill all the people
> but leave the houses standing.”
>
> Some people saw it all coming….
>

The subprime setback actually hit about 18 months ago. Investors stopped funding new loans, and would be buyers were were no longer able to buy, thereby reducing demand. Housing fell and has been down for a long time. There are signs it bottomed October/November but maybe not.

I wrote about it then as well, and have been forecasting the slowdown since I noted the fed’s financial obligations ratio was at levels in March 2006 that indicated the credit expansion had to slow as private debt would not be able to increase sufficiently to sustain former levels of GDP growth. And that the reason was the tailwind from the 2003 federal deficits was winding down. as the deficit fell below 2% of GDP, and it was no longer enough to support the credit structure.

Also, while pension funds were still adding to demand with their commodity allocations, that had stopped accelerating as well and
wouldn’t be as strong a factor.

Lastly, I noted exports should pick up some, but I didn’t think enough to sustain growth.

I underestimated export strength, and while GDP hasn’t been stellar as before, it’s been a bit higher than i expected as exports boomed.

That was my first ‘major theme’ – slowing demand.

The second major theme was rising prices – Saudis acting the swing producer and setting price. This was interrupted when Goldman changed their commodity index in aug 06 triggering a massive liquidation as pension funds rebalanced, and oil prices fell from near 80 to about 50, pushed down a second time at year end by Goldman (and AIG as well this time) doing it again. As the liquidation subsided the Saudis were again in control and prices have marched up ever since, and with Putin gaining control of Russian pricing we now have to ‘price setters’ who can act a swing producers and simply set price at any level they want as long as net demand holds up. So far demand has been more than holding up, so it doesn’t seem we are anywhere near the limits of how high they can hike prices.

Saudi production for December should be out tomorrow. It indicates how much demand there is at current prices. If it’s up that means they have lots of room to hike prices further. Only if their production falls are they in danger of losing control on the downside. And I estimate it would have to fall below 7 million bpd for that to happen. It has been running closer to 9 million.

What I have missed is the fed’s response to all this.

I thought the inflation trend would keep them from cutting, as they had previously been strict adherents to the notion that price
stability is a necessary condition for optimal employment and growth.

This is how they fulfilled their ‘dual mandate’ of full employment and price stability, as dictated by ‘law’ and as per their regular reports to congress.

The theory is that if the fed acts to keep inflation low and stable markets will function to optimize employment and growth, and keep long term interest rates low.

What happened back in September is they became preoccupied with ‘market functioning’ which they see as a necessary condition for low inflation to be translated into optimal employment and growth.

What was revealed was the FOMC’s lack of understanding of not only market functioning outside of the fed, but a lack of understanding of their own monetary operations, reserve accounting, and the operation of their member bank interbank markets and pricing mechanisms.

In short, the Fed still isn’t fully aware that ‘it’s about price (interest rates), not quantity (‘money supply, whatever that may be)’.

(Note they are still limiting the size of the TAF operation using an auction methodology rather than simply setting a yield and letting quantity float)

The first clue to this knowledge shortfall was the 2003 change to put the discount rate higher than the fed funds rate, and make the discount rate a ‘penalty rate.’ This made no sense at all, as i wrote back then.

The discount rate is not and can not be a source of ‘market discipline’ and all the change did was create an ‘unstable equilibrium’ condition in the fed funds market. (They can’t keep the system ‘net borrowed’ as before) it all works fine during ‘normal’ periods but when the tree is shaken the NY Fed has it’s hands full keeping the funds rate on target, as we’ve seen for the last 6 months
or so.

While much of this FOMC wasn’t around in 2002-2003, several members were.

Back to September 2007. The FOMC was concerned enough about ‘market functioning’ to act, They saw credit spreads widening, and in particular the fed funds/libor spread was troubling as it indicated their own member banks were pricing each other’s risk at higher levels than the FOMC wanted. If they had a clear, working knowledge of monetary ops and reserve accounting, they would have recognized that either the discount window could be ‘opened’ by cutting the rate to the fed funds rate, removing the ‘stigma’ of using it, and expanding the eligible collateral. (Alternatively, the current TAF is functionally the same thing, and could have been implemented in September as well.)

Instead, they cut the fed funds rate 50 bp, and left the discount rate above it, along with the stigma. and this did little or nothing for the FF/LIBOR spread and for market functioning in general.

This was followed by two more 25 cuts and libor was still trading at 9% over year end until they finally came up with the TAF which immediately brought ff/libor down. It didn’t come all the way down to where the fed wanted it because the limited the size of the TAFs to $20 billion, again hard evidence of a shortfall in their understanding of monetary ops.

Simple textbook analysis shows it’s about price and not quantity. Charles Goodhart has over 65 volumes to read on this, and the first half of Basil Moore’s 1988 ‘Horizontalists and Verticalsists’ is a good review as well.

The ECB’s actions indicate they understand it. Their ‘TAF’ operation set the interest rate and let the banks do all they wanted, and over 500 billion euro cleared that day. And, of course- goes without saying- none of the ‘quantity needles’ moved at all.

In fact, some in the financial press have been noting that with all the ‘pumping in of liquidity’ around the world various monetary
aggregates have generally remained as before.

Rather than go into more detail about monetary ops, and why the CB’s have no effect on quantities, suffice to say for this post that the Fed still doesn’t get it, but maybe they are getting closer.

So back to the point.

Major themes are:

  • Weakness due to low govt budget deficit
  • Inflation due to monopolists/price setters hiking price

And more recently, the Fed cutting interest rates due to ‘market functioning’ in a mistaken notion that ff cuts would address that issue, followed by the TAF which did address the issue. The latest announced tafs are to be 30 billion, up from 20, but still short of the understanding that it’s about price, not quantity.

The last four months have also given the markets the impression that the Fed in actual fact cares not at all about inflation, and will only talk about it, but at the end of the day will act to support growth and employment.

Markets acknowledge that market functioning has been substantially improved, with risk repriced at wider spreads.

However, GDP prospects remain subdued, with a rising number of economists raising the odds of negative real growth.

While this has been the forecast for several quarters, and so far each quarter has seen substantial upward revisions from the initial forecasts, nonetheless the lower forecasts for Q1 have to be taken seriously, as that’s all we have.

I am in the dwindling camp that the Fed does care about inflation, and particularly the risk of inflation expectations elevating which would be considered the ultimate Central Bank blunder. All you hear from FOMC members is ‘yes, we let that happen in the 70’s, and we’re not going to let that happen again’.

And once ‘markets are functioning’ low inflation can again be translated via market forces into optimal employment and growth, thereby meeting the dual mandate.

i can’t even imagine a Fed chairman addressing congress with the reverse – ‘by keeping the economy at full employment market forces will keep inflation and long term interest rates low’.

Congress does not want inflation. Inflation will cost them their jobs. Voters hate inflation. They call it the govt robbing their
savings. Govt confiscation of their wealth. They start looking to the Ron Paul’s who advocate return to the gold standard.

That’s why low inflation is in the Fed’s mandate.

And the Fed also knows they are facing a triple negative supply shock of fuel, food, and import prices/weak $.

While they can’t control fuel prices, what they see there job as is keeping it all a relative value story and not ‘monetizing it into an
inflation story’ which means to them not accommodating it with low real rates that elevate inflation expectations, followed by
accelerating inflation.

There is no other way to see if based on their models. Deep down all their models are relative value models, with no source of the ‘price level.’ ‘Money’ is a numeraire that expresses the relative values. The current price level is there as a consequence of history, and will stay at that level only if ‘inflation expectations are well anchored.’ The ‘expectations operator’ is the only source of the price level in their models.

(See ‘Mandatory Readings‘ for how it all actually works.)

They also know that food/fuel prices are a leading cause of elevated inflation expectations.

In their world, this means that if demand is high enough to drive up CPI it’s simply too high and they need to not accommodate it with low real rates, but instead lean against that wind with higher real rates, or risk letting the inflation cat out of the bag and face a long, expensive, multi year battle to get it back in.

They knew this at the Sept 18 meeting when they cut 50, and twice after that with the following 25 cuts, all as ‘insurance to forestall’ the possible shutdown of ‘market functioning’.

And they knew and saw the price of this insurance – falling dollar, rising food, fuel, and import prices, and CPI soaring past 4% year over year.

To me these cuts in the face of the negative supply shocks define the level of fear, uncertainty, and panic of the FOMC.

It’s perhaps something like the fear felt by a new pilot accidentally flying into a thunderstorm in his first flight in an unfamiliar plane without an instructor or a manual.

The FOCM feared a total collapse of the financial structure. The possibility GDP going to 0 as the economy ‘froze.’ Better to do
something to buy some time, pay whatever inflation price that may follow, than do nothing.

The attitude has been there are two issues- recession due to market failure and inflation.

The response has been to address the ‘crisis’ first, then regroup and address the inflation issue.

And hopefully inflation expectations are well enough anchored to avoid disaster on the inflation front.

So now with the TAF’s ‘working’ (duh…) and market functions restored (even commercial paper is expanding again) the question is what they will do next.

They may decide markets are still too fragile to risk not cutting, as priced in by Feb fed funds futures, and risk a relapse into market dysfunction. Recent history suggests that’s what they would do if the Jan meeting were today.

But it isn’t today, and a lot of data will come out in the next few weeks. Both market functioning data and economic data.

Yes, the economy may weaken, and may go into recession, but with inflation on the rise, that’s the ‘non inflationary speed limit’ and the Fed would see cutting rates to support demand as accomplishing nothing for the real economy, but only increasing inflation and risking elevated inflation expectations. The see real growth as supply side constrained, and their job is keeping demand balanced at a non inflationary level.

But that assumes markets continue to function, and the supply side of credit doesn’t shut down and send GDP to zero in a financial panic.

With a good working knowledge of monetary ops and reserve accounting, and banking in general that fear would vanish, as the FOMC would know what indicators to watch and what buttons to push to safely fly the plane.

Without that knowledge another FF cut is a lot more likely.

more later…

warren

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Saudi/Fed teamwork

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Looks like markets are still trading with the assumption that as the Saudis/Russians hike prices the Fed will accommodate with rate cut.

That’s a pretty good incentive for more Saudi/Russian oil price hikes, as if they needed any!

Likewise, the US is a large exporter of grains and foods.

Those prices are now linked to crude via biofuels.

And the new US energy bill just passed with about $36 billion in subsidies for biofuels to help us keep burning up our food for fuel and keeping their prices linked.

This means cpi will continue to trend higher, and drag core up with it as costs get passed through via a variety of channels. In the early 70’s core didn’t go through 3% until cpi went through 6%, for example.

Ultimately everything is made of food and energy, and margins don’t contract forever with softer demand. In fact, much of the private sector is straight cost plus pricing, and govt is insensitive to ‘demand’ and insensitive to the prices of what it buys. And the US govt. indexes compensation and most transfer payments to (headline) cpi.

And while the US may be able to pay it’s rising oil bill with help from its rising export prices for food, much of the rest of the world is on the wrong end of both and will see its real terms of trade continue to deteriorate. Not to mention the likelihood of increased outright starvation as ultra low income people lose their ability to buy enough calories to stay alive as they compete with the more affluent filling up their tanks.

At the Jan 30 meeting I expect the Fed to be looking at accelerating inflation due to rising food/crude, and an economy muddling through with a q4 gdp forecast of 2-3%. Markets will be functioning, banks getting recapitalized, and while there has been a touch of spillover from Wall st. to Main st. the risk of a sudden, catastrophic collapse has to appear greatly diminished.

They have probably learned that the fed funds cuts did little or nothing for ‘market functioning’ and that the TAF brought ff/libor under control by accepting an expanded collateral list from its member banks.

(In fact, the TAF is functionally equiv of expanding the collateral accepted at the discount window, cutting the rate, and removing the stigma as recommended back in August and several times since.)

And they have to know their all important inflation expectations are at the verge of elevating.

They will know demand is strong enough to be driving up cpi, and the discussion will be the appropriate level of demand and the fed funds rate most likely to sustain non inflationary growth.

Their ‘forward looking’ models probably will still use futures prices, and with the contangos in the grains and energy markets, the forecasts will be for moderating prices. But by Jan 30 they will have seen a full 6 months of such forecasts turn out to be incorrect, and 6 months of futures prices not being reliable indicators of future inflation.

Feb ff futures are currently pricing in another 25 cut, indicating market consensus is the Fed still doesn’t care about inflation. Might be the case!

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