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PARIS (MNI) – With eurozone HICP at a record high and inflation
risks on the horizon as far as the eye can see, the European Central
Bank’s Governing Council is stiffening its resolve as the defender of
price stability, even at a time of great uncertainty about economic
growth, well-informed monetary sources have told Market News
International.

The ECB is still piloting the monetary aircraft in a thick fog as
inflation rises well above the bank’s comfort level and ongoing market
turmoil, accompanied by a sharp slowdown or recession in the United
States, clouds the view, these sources said.

But the thinking in Eurosystem monetary circles appears to have
shifted recently, as oil continues its steady rise and workers in
Germany win bigger-than-usual pay increases.

In recent months, as unabated turbulence roiled markets and the
U.S. economy slipped towards the abyss, many eurozone monetary
policy-makers saw price risks as an obstacle to cutting rates. Now, the
ascending view is that a lack of clarity over how sharply growth will
slow is what’s keeping the ECB from putting up rates.

“Nobody talks about an interest rate cut anymore,” said one source.
“It’s a wait-and-see policy, as it has been for awhile, but the bias has
moved.”

That is not to say the ECB has formally returned to a tightening
bias. But there is an awareness that unless inflation behaves, the next
move could very conceivably be a rate hike — in contrast to market
expectations, albeit receding ones, for a cut.

“With inflation running at 3.6%, the ECB could be forced to tighten
monetary policy,” said one senior Eurosystem official. “This will depend
on whether inflationary pressures from oil and food price hikes create a
second round of increases in wages and consumer products.”

Another official put it more bluntly: “The fact is that if the
money markets can be stabilized, then rate hikes would have to be put
back on the agenda,” he said.

But such a move, if it comes at all, may still be a long way off.

The official who observed that “the bias has moved” also said,
“It’s difficult to see rates going up at the moment, with the financial
sector still weak and the U.S. maybe in recession. Higher rates here
will make it worse for financial institutions. They are still
leveraged.”

He also noted that “there is already some tightening effect in the
markets,” given the strong euro and the rise in three- and six-month
rates, which are now well above 4.8% — more than 80 basis points north
of the ECB’s main policy rate.

The senior Eurosystem source made it clear that while perceptions
may have hardened with regard to inflation, no imminent action by the
ECB is likely because the economic picture is just too cloudy for now.

“The markets should not expect monetary policy changes during the
coming months, despite market and political pressures,” he said. “We are
in no position to make a medium-term assessment, since we are not fully
aware of the banking sector’s exposure to the financial market crisis.”

Therefore, policy is still finely balanced for now between two
conflicting pressures, he said. “The one is an interest rate increase
and the other is a rate cut. As a result, the Council has decided to
freeze any action and continue to inject the market with liquidity.”

Nonetheless, the more hawkish comments by MNI’s sources —
including that senior official — jibe with recent public remarks by
some members of the ECB Governing Council, who have resurrected the idea
of hiking rates in the face of what they see as an extremely worrisome
inflation picture.

In a newspaper interview published today, Luxembourg Central Bank
Governor Yves Mersch said the ECB staff would probably revise upward its
inflation forecasts for 2008 and 2009. Asked if this implied the ECB
would have to hike interest rates, he said the question was “entirely
justified.”

Bundesbank President Axel Weber, expressing great alarm about
inflation developments, said Monday that the ECB must “decide whether
the current level of interest rates ensures the fulfillment of our
mission.” And Bank of Greece Governor Nicholas Garganas pointedly noted
on Friday that he had not ruled out a rate hike.

The only way the ECB can reconcile higher interest rates *and* pacify the hyperleveraged, debt-glutted Club Med, would be by swapping quality debt, Bernanke-style, for the banks’ asset-backed garbage, and subsidizing the Club Med/ Ireland banking sector commensurate with the size of those countries’ gargantuan trade deficits.

Italy will be the one to watch. We will soon see whether the fulcrum of Berlusconi’s coalition, Umberto Bossi’s anti-euro Lega Nord, can be bought off or not.

But at least the ECB is trying.

On another note, Bernanke is said to be heavily influenced by the work of Athanasios Orphanides, the chairman of the Bank of Cyprus, whose philosophy can be summarized as, “When there’s a recession, cut interest rates until interest-rate expectations begin to become unmoored.” By every indicator, including the laggardly consumer surveys, inflation expectations have become significantly unmoored. If there is any time for Bernanke to stun Wall St. and the commodities markets with a 25 basis-point rate hike, it would be on April 29-30. (Not that I think Bernanke will.)

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It’s almost as if the ECB wants Italy to quit the euro.

BERLIN (Reuters) – Wage and fiscal policy in the euro zone could buoy inflation and the European Central Bank may need to act, ECB Governing Council member Axel Weber said in a newspaper interview released on Saturday.

“I am concerned that, with regard to the conduct of wage and fiscal policy, the recent temporary heightened inflation rate could be consolidated for longer than is necessary above the tolerance level of the Eurosystem,” Weber said.

“Should indications of this increase, we must react with interest rate policy,” he added in an interview with Germany’s Welt am Sonntag. “We are therefore observing the current wage agreements and finance policy decisions very closely.”

The ECB has kept interest rates at 4 percent for the last 10 months while the U.S. Federal Reserve, the Bank of England and the Bank of Canada have cut their benchmark rates in the face of accelerating inflation and uncertainty about the impact of a global credit crisis on the world economy.

Another ECB Governing Council member, Austria’s Klaus Liebscher, told Reuters on Friday that no room exists to cut euro zone interest rates and rate rises could not be ruled out.

Weber told Welt am Sonntag: “Our primary goal is price stability.”

Surging energy and food prices pushed euro zone inflation to a new high of 3.6 percent in March, well above the ECB’s target of just below 2 percent.

“We must make sure that inflation expectations remain stable, and that the higher prices now do not lead to higher wages and salaries. Because that would inevitably start off a wage-price spiral,” Weber said.

Cultural attitudes towards default — and its stepchild, inflation — are deep-seated. Whenever the liquidity party runs out, currency unions in the past have erupted over differing attitudes towards debt. I believe the eurozone will see such a rupture.

Fundamentally Italy has too much debt, and too high a proportion of old people. France’s problems aren’t quite as acute, but Sarkozy has been agitating in the same direction.

In Europe, the only meaningful difference that I can tell between left and right lies in euro attitudes. Internationalist “leftists” are pro-euro, and nationalist/subsidiarist “rightists” despise it.

Most of Europe is now under nationalist control. Spain and Ireland are still ruled by “leftist” (pro-euro) parties, and their attitudes are viable only because Spain’s banks, and probably Ireland’s as well, are able to swap their mortgage-backed garbage for government bonds en masse.

ECB aid to Spanish banks matches Rock rescue

By Ambrose Evans-Pritchard, International Business Editor

Spanish banks are issuing mortgage securities and asset-backed bonds on a massive scale to park at the European Central Bank, using them as collateral to raise money at favourable rates from the official credit window in Frankfurt.

The rating agency Moody’s said lenders had issued a record €53bn (£39bn) in the fourth quarter, yet almost none of the securities have actually been placed on the open market. Most have been sent directly to the ECB for use in “repo” operations.

Eurozone CPI is not abating, despite a slowdown across much of the region, because the ECB is inflating via a mechanism separate from interest rates. As such, most eurozone economies are experiencing the early stages of stagflation, despite “high” nominal interest rates.

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Silvio Berlusconi’s election victory, a landslide by Italian standards, has major ramifications for the euro, warns Ambrose Evans-Pritchard:

Silvio Berlusconi’s return to power in Italy is a nightmare come true for the European Central Bank, opening the way for a Rome-Paris axis with the political muscle to force a change in monetary policy.

The billionaire politician has pledged an alliance with France’s Nicolas Sarkozy aimed at humbling the bank and asserting the primacy of elected leaders over interest rates and the currency.

“A very strong euro is hurting Italy’s economy. I will discuss intervening with the ECB with Sarkozy,” he said.

The threat brought a sharp retort yesterday from the ECB’s German governor and chief economist Jurgen Stark. “I would recommend to political leaders in Europe, newly elected and re-elected, to read the European law on the ECB,” he said.

Mr Berlusconi – who is setting up a temporary office in Naples to tackle the city’s long-running rubbish crisis – inherits an economy trapped in near slump conditions. The country has lost 40pc in unit labour cost competitiveness against Germany since 1995, largely due to anaemic productivity gains and an inflationary wage-bargaining culture. Yet it cannot use the old method of devaluation to claw back parity.

The International Monetary Fund forecasts growth of just 0.3pc in both 2008 and 2009, levels that are certain to cause a renewed rise in the country’s national debt. Italian car sales plunged 18.8pc in March, and the Alpine lender Credito Valtellinese has just become the first European bank in living memory to miss a redemption on a callable bond – raising concerns of deeper troubles brewing in Italy’s financial system.

Mr Sarkozy has repeatedly attacked the ECB’s tight money policies, blaming it for causing the euro to surge 27pc in two years to a record $1.59 against the dollar. He says the ECB risks bankrupting Airbus and driving much of Europe’s industry off-shore. Until now he has lacked the allies needed to impose his will.

“Politics is everything in EMU, and the re-election of Berlusconi represents a big shift in the political balance of power,” said Bernard Connolly, global strategist at Banque AIG. “Spain will probably join France and Italy before too long, so you will have three of the big four eurozone countries in the same camp.

They can set ‘broad guidelines’ for the ECB. It is a total misperception that the ECB should not be subject to political influence.”

Article 111 of the Nice Treaty gives politicians power to set a fixed exchange rate for the euro (by unanimous vote), or to shape the exchange rate (by qualified majority vote). This power gives EU ministers an indirect means to force the ECB to cut interest rates. The treaty article has never been invoked but it hovers in EU affairs like Banquo’s Ghost.

Mr Berlusconi does not share the EU-loyalities of the outgoing government. Ex-premier Romano Prodi was once the president of the European Commission, the public face of the euro. His finance minster Tommaso Padoa-Schioppa was a founder of Europe’s monetary union.

The last time Mr Berlusconi was in power, two ministers from his coalition partner ‘La Lega Nord’ called for a return to the lira to escape the constraints of the euro system. While he did not endorse the comments, he appeared to relish their effect on his enemies in Brussels and Frankfurt.

Berlusconi’s ally, Lega Nord (Northern League), gained about 8.6 points out of about 46 percent, meaning that they have approximately 20 percent of the votes in Berlusconi’s coalition, and hold the balance of power. Lega Nord is vociferously anti-euro.

I have said for months that the euro is incapable of absorbing global savings, and exporting its manufacturing base, to the extent that the United States has.

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via Bloomberg:

Dollar Bottom Proves Elusive as G-7 Meets, Bearish Bets Double

By Bo Nielsen

April 7 (Bloomberg) — Optimism for a dollar rebound that pervaded the currency market at the start of the year is fading.

Futures traders doubled bets against the greenback in the past two months, data from the Commodity Futures Trading Commission in Washington show. Citigroup Inc., Deutsche Bank AG and Royal Bank of Scotland Group Plc, which handle almost 40 percent of global foreign exchange trading, say the currency may slump to $1.65 per euro by October, from $1.57 on April 4.

While the dollar rose April 1 when UBS AG and Lehman Brothers Holdings Inc. said they’re raising $19 billion to shore up their capital, it retreated for the rest of the week after Federal Reserve Chairman Ben S. Bernanke acknowledged for the first time that a recession is possible. Officials of the Group of Seven nations meet this week in Washington, and are unlikely to agree on a plan to boost the currency because rising exports may be the only blessing of a weak currency in a weakening economy.

“The dollar will continue to move lower in the next couple of months until the U.S. economy improves markedly,” said Adam Boyton, senior currency strategist in New York at Deutsche Bank.

The Dollar Index, which measures the currency against six of its main counterparts, tumbled the past two months after trading little changed between October and mid-February. It’s down 6.2 percent in 2008, after dropping 8.3 percent in each of the past two years.

Futures traders have grown more bearish, as three Fed interest rate cuts in 2008 totaling 2 percentage points reduced demand for U.S. deposits. They amassed a net total of 246,101 futures contracts betting on a dollar decline versus eight other currencies, up from 126,342 on Jan. 22, CFTC data show.

Relative Rates

Dollar-denominated deposits hold little appeal after the Fed lowered its target rate for overnight loans between banks to 2.25 percent. That’s the second-lowest among the G-7 after Japan’s 0.5 percent. The European Central Bank will keep its rate at 4 percent at its April 10 meeting, a Bloomberg survey shows.

“We are close to a tipping point where, I mean, the willingness to hold dollars is definitely impaired,” billionaire George Soros, 77, said in an interview in New York on April 3. His bet against the British pound in 1992 helped drive the U.K. out of Europe’s system of linked exchange rates.

Foreign private investors sold a net $37.6 billion of U.S. stocks and bonds in the six months ended Jan. 31, the most recent Treasury Department data show. The last time sales exceeded purchases over a six-month period was April 1996.

Two-year Treasuries yield 1.65 percentage points less than similar-maturity German bunds. As recently as October they were the same. Over the past decade, the U.S. notes yielded an average of 0.51 percentage point more than bunds.

Dollar Reprieve

The U.S. currency received a reprieve last week. The dollar rose 0.4 percent against the euro and 2.2 percent to 101.47 yen as the recapitalization plans by UBS and Lehman Brothers boosted investor confidence in financial institutions shaken by $232 billion of losses and writedowns from the freeze in capital markets.

“The dollar is bottoming out,” said Benedikt Germanier, a currency analyst in Stamford, Connecticut, at UBS, the second- biggest currency trader after Deutsche Bank. It may rise to $1.45 per euro by June, he said.

The median of 41 estimates in a Bloomberg News survey is for the dollar to appreciate to $1.51 per euro by Sept. 30 and to $1.48 at year-end as the U.S. economy recovers and Europe slows.

Cutting Estimates

“The U.S. economy is deteriorating so fast that it’s hard to believe economies outside of the U.S. won’t get affected,” said Tom Fitzpatrick, global head of currency strategy at Citigroup in New York. “As the slowdown in the U.S. reverberates to Europe, the ECB can’t be sitting this one out. They have to cut,’‘ which may limit dollar losses, he said.

Analysts have predicted a rebound before only to be proven wrong. At the start of 2008, they expected the dollar to gain to $1.48 per euro by June and reach 110 yen, according to Bloomberg surveys. They now see it at $1.55 to the euro and 98 yen.

And even though the dollar rallied last week, it declined April 4 as the Labor Department said payrolls fell for a third straight month in March.

Citigroup predicts it will depreciate to $1.65 per euro next quarter, compared with an earlier forecast of $1.51. Deutsche Bank’s Boyton and Adrian Schmidt, a senior currency strategist at Edinburgh-based RBS, say it may reach that level by July.

Exports Rise

“It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly,” Bernanke said in testimony to Congress’s Joint Economic Committee on April 2. The central bank chairman also predicted the U.S. will recover in the second half.

U.S. growth likely declined to a 0.2 percent annual pace last quarter, the weakest since 2002, according to the median forecast of 85 economists in a Bloomberg survey.

Deutsche Bank revised its six-month euro forecast to $1.55 in March, from $1.41 in February. RBS, the fourth-biggest currency trader, sees it at $1.57 on June 30, compared with an earlier estimate of $1.47.

The weakening dollar is making American goods cheaper abroad, giving U.S. officials less incentive to halt the currency’s depreciation. Exports rose 1.6 percent in January to a record, according to the Commerce Department.

G-7 Meets

Foreign sales contributed 1.02 percentage points to gross domestic product in the fourth quarter, compared with 0.85 percent the previous year, government data show. Without the improvement in trade, the economy would have contracted at a 0.4 percent annual pace, the first decline since the last recession in 2001, instead of expanding 0.6 percent.

The G-7 — the U.S., Japan, Germany, the U.K., France, Italy and Canada — hasn’t intervened in currency markets since supporting the euro in 2000. They are unlikely to buy or sell currencies to prop up the dollar after meeting April 11, according to Deutsche Bank, Citigroup and Bank of America Corp. in Charlotte, North Carolina.

In a statement following their Feb. 9 session in Tokyo, the group said “excess volatility and disorderly movements in exchange rates are undesirable.” The dollar has fallen 8 percent against the euro since then.

“For verbal intervention or actual intervention to work you need some substantive policy behind it and the last thing you will see right now is a monetary tightening by the Fed,” said Robert Sinche, head of global currency strategy at Bank of America. He expects the dollar may fall past $1.60 per euro this quarter.

It’s hard to see what could arrest the USD’s decline, besides grudging ECB rate cuts (in the face of strong inflationary headwinds).

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Foreign banks flee Spanish property debt

By Ambrose Evans-Pritchard in Madrid

Last Updated: 1:28am BST 05/04/2008

International banks are scrambling to sell their holdings of Spanish mortgage debt at a steep discount, fearing that the country may be sliding into the worst economic downturn in its modern history.

A blizzard of grim data has soured the mood, capped yesterday by a plunge in PMI purchasing managers’ index to an all-time low of 40.9. Car sales fell 28pc in March, and even Madrid’s legendary tapas bars seem to have lost their late-night sparkle.

Inmobiliaria Colonial – once the country’s biggest property group –is in emergency talks with banks after Dubai’s Investment Corporation pulled out of a rescue deal.

Developer Martinsa Fadesa is struggling to restructure €5bn of debt to stave off insolvency.

Traders says the market price for Spanish mortgage securities has begun to slide abruptly, replicating the pattern seen in the US last year. Large French and German funds and insurers appear to be liquidating assets in a pre-emptive move, afraid being caught yet again in a violent downturn.

Ismael Clemente, head of Deutsche Bank’s property arm RREEF in Spain, told a panel of experts in Madrid that foreign banks were now dumping Spansih mortgaged debt at a 40pc discount.

Mikel Echavarren, director of the property consultancy Irea, said Spain’s housing market was far weaker than the official statistics suggest, warning that prices could fall 20pc to 25pc.

“All kinds of ploys have been used to disguise the true extent of the price falls, which we think are 5pc to 7pc already. Buyers have totally abandoned the market. We’ve had a wave of negative sales as people pull out of commitments already made,” he said.

“We have a very worrying situation. The developers simply cannot refinance their debts. We need to cut interest rates by 2pc, which is obviously not going to happen,” he said, adding that the crash could be sharper than the property crisis in the early 1990s.

Santiago Baena, head of Spain’s estate agents lobby API, said the downturn had already forced 40,000 agents to close their doors, laying off 120,000 staff.

The Bank of Spain said default rates would rise but insisted that the Spanish banking system remains in good health, without much exposure to the US subprime debacle. The loan-to-value ratio on mortgages was kept to 70pc – although a report in Germany’s Die Welt newspaper today alleges that false pricing was often used to circumvent the rule.

The authorities said that a crisis comparable to the early 1990s (when bad debts reached 13.1pc) would erode the capital base of the banking system by 63pc, a manageable level. The developers owe €290bn to the banks and lenders, known as “cajas”.

The government is preparing a €20bn spending blitz on high speed railways and other mega-projects to cushion the downturn. Spain’s trump card is a budget surplus of 2pc of GDP last year, leaving in ample scope for fiscal stimulus – in sharp contrast to Italy, France, and Britain.

The root cause of the crisis is in a sense Europe’s monetary union. The euro effect halved Spain’s interest rates almost overnight. Rates then fell below Spain’s inflation rate for several years, fuelling an explosive credit boom. The country’s current account deficit has reached 10pc of GDP, the highest of any major economy.

The process has now kicked into reverse. Mortgage rates – priced off three-month Euribor – have nearly doubled since late 2005.

David Owen, Europe economists at Dresdner Kleinwort, said Spain was waking up to the reality that there will be no quick-fix. “They are no longer arguing about whether there will be a recession, but about how deep it will be,” he said.

“Spain is no longer able to set monetary policy for its own needs. It could face zero-growth for five years,” he said.

ABC newspaper reported that the Bank of Spain rushed its Financial Stability Report into print two months early in order to refute “tendentious” claims in the British media that Spain’s banks had become reliant on emergency funding from the ECB after the capital markets seized up.

The banks have been issuing mortgage bonds on a large scale to use a collateral at the ECB’s lending window, raising concerns that they are becoming dependent on taxpayer funding. The Bank of Spain said they had borrowed €44bn from the ECB, insisting that this was “fully consistent” with EU rules.

The ECB said its latest €25bn auction of six-month funding this week was heavily over-subscribed, with €103bn of bids from 177 banks at rates as high as 4.88 pc. It did not reveal how much of the bidding came from Spain.

Deutsche Bank expects house prices to fall 8pc this year as the market struggles to clear a glut of unsold homes. Construction peaked in 2006 when last year when 740,000 new housing units were built – more than in Germany and Britain combined.

Standard & Poor’s said Spain risked a “major collapse” in construction after a 40pc fall in housing permits. Building has accounted on a fifth of all jobs created in Spain since 2000. It said the country faced a “major and likely painful adjstment”.

Did Evans-Pritchard write this at a tapas bar? I just corrected about 15 blatant typos. Anyway …

The over-leveraged European countries (and the euro by extension) are the countries to watch.

The US has flooded its banking system with enough paper to put off problems for a while. I think John Mauldin is exactly right in his assessment, that the Fed will turn a blind eye to banks’ technical insolvency as they rebuild their balance sheets and write off their debts over the next five or so years.

Europe, however, is a different matter. The ECB was taking on lots of garbage debt, especially from Spain, but perhaps there’s a limit to what Trichet is willing to do for Spain’s banking sector.

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Fannie, Freddie Surplus Capital Requirement Is Eased (Update3)
By James Tyson

March 19 (Bloomberg) — Regulators for Fannie Mae and Freddie Mac cut the companies’ surplus capital requirement in an effort to expand their combined $1.5 trillion in mortgage investments and revive the U.S. home-loan market.

The requirement was lowered to 20 percent from 30 percent, the Office of Federal Housing Enterprise Oversight said in a news release today. The government-chartered companies, the largest sources of money for home loans, also agreed to raise a “significant” amount of new capital, Ofheo said.

The initiative may immediately pump $200 billion into the mortgage-backed securities market, Ofheo Director James Lockhart said at news conference in Washington today. Combined with a lifting of portfolio caps on March 1 and the companies’ existing capabilities, this should allow Fannie Mae and Freddie Mac to buy or guarantee about $2 trillion in mortgages a year, Ofheo said.

This will “go a long way to stabilizing panicky markets,” Howard Shapiro, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, wrote in a report to clients yesterday.

Fannie Mae and Freddie Mac led the Standard & Poor’s 500 stock index higher today, and U.S. Treasuries pared gains amid reduced concerns that credit market losses will deepen. Fannie Mae rose $2.98, or 11 percent, to $31.20 as of 10:24 a.m. in New York Stock Exchange composite trading. Freddie Mac was up $2.18, or 8 percent, to $28.20, after rising the most ever yesterday.

Housing Slump

The worst housing slump since the Great Depression is being exacerbated by the limited ability of Americans to get mortgages or refinance loans amid tightened standards at money-losing banks. Issuance of non-agency mortgage bonds fell 33 percent last year to $707 billion, according to newsletter Inside MBS & ABS.

“Our hope is that it will help restart the housing engine that powers our economy,” Fannie Mae Chief Executive Officer Daniel Mudd said at a news conference in Washington today with Freddie Mac CEO Richard Syron and Ofheo Director James Lockhart. “This is what the GSE’s were put in place for, to deal with situations like this and we will deliver,” Mudd said.

Created by Congress to boost homeownership, Fannie Mae and Freddie Mac profit by holding mortgages and mortgage bonds as investments and by charging a fee to guarantee and package loans as securities. They own or guarantee at least 40 percent of the $11.5 trillion in U.S. residential-mortgage debt outstanding.

$53 Billion

Fannie Mae and Freddie Mac have said they were limited in how much assistance they could offer amid regulatory constraints and rising losses. Fannie Mae, the largest source of money for home loans, posted a record $3.55 billion fourth-quarter loss as rising foreclosures sent credit costs soaring. Freddie Mac reported a record $2.45 billion net loss for the period.

The 30 percent surplus capital constraint most recently tied up as much as $53 billion at the two companies combined — based on core capital on Dec. 31 — that could have been invested in the mortgage market.

Yields on Fannie Mae’s five-year debt over five-year U.S. Treasuries fell 2 basis points to 88.5 basis points at 9:45 a.m. in New York, down from 115 basis points on March 14, the lowest since Feb. 29, according to data complied by Bloomberg. The difference in yields on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes fell about 17 basis points, to 168 basis points, matching a three-week low on March 17.

Raising Capital

The companies didn’t say today how or when they would raise the additional capital.

Fannie Mae in December raised $7 billion in a preferred stock sale and cut its dividend by 30 percent, while Freddie Mac in November sold $6 billion in preferred stock and halved its dividend to bolster cash reserves amid mounting credit losses and asset writedowns stemming from the housing market collapse.

“It’s critical for them to have additional capital,” Lockhart said at the new conference. “These companies are safe and sound and we’re going to ensure by our everyday oversight that they continue to be safe and sound,” Lockhart said.

Credit-default swaps tied to Fannie Mae’s senior bonds dropped 8 basis points to 50 basis points, according to broker Phoenix Partners Group in New York, suggesting a decline in perceived risk. Freddie Mac fell 7 basis points to 51.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Profit Potential

The capital surcharge is one of the last remaining restrictions imposed on the companies after $11.3 billion of accounting misstatements. The Bush administration, trying to stem the crisis, has gradually eased constraints on Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac. Ofheo lifted a ceiling on the companies’ mortgage assets and raised a limit on the loans they buy to $729,750 from $417,000 in some counties.

Lawmakers including Senate Banking Committee Chairman Christopher Dodd and Senator Charles Schumer have called on Ofheo this year to relax the excess capital requirement.

“These are extraordinarily difficult times for the markets, and targeted, immediate action is necessary,” Schumer, a New York Democrat, said yesterday in a statement. “A nickel-and-dime approach to freeing the GSEs to become more active in the market will not suffice.”

Translation: Despite the objections of James Lockhart — that rare jewel of competent integrity within the Bush Administration — Fannie and Freddie can lever up from about 2.33-1 to 4-1. Once again, the only thing worse than the Bush Administration’s “domestic policy” is the idiocy spouted by the representatives of the “reality-based community.”

Fannie and Freddie own or guarantee over $4.5 trillion in mortgage-backed securities. I don’t know too much about Fannie and Freddie, but how can you not be bankrupt if you are at least 3x levered long in US mortgages over the past year, and dig deeper with each dip in the mortgage market?

And no, I have no clue why gold cratered $75/oz. The dollar is still pretty close ($1.57/EUR) to its historic lows; interest rates haven’t gone down by much; etc.

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CURRENCIES

  VALUE CHANGE % CHANGE
EUR-USD 1.5105 0.0130 0.87
USD-JPY 106.4700 -0.8100 -0.76
GBP-USD 1.9903 0.0032 0.16

COMMODITY FUTURES

  VALUE CHANGE % CHANGE
Oil 100.68 -0.20 -0.20
Gold 958.40 9.50 1.00

Fannie Mae, Freddie Portfolio Limits to Be Lifted, Ofheo Says
By Jody Shenn

Feb. 27 (Bloomberg) — Fannie Mae and Freddie Mac, the two largest providers of money for U.S. home loans, will have restrictions on the sizes of their portfolios removed.

The limits, imposed after accounting errors at the government-chartered companies, will be lifted on March 1, according to a statement sent by e-mail today from the Office of Federal Housing Enterprise Oversight.

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Klaus Baader was one of the professional forecasters who defied conventional wisdom in 2006 and predicted that Trichet would continue raising interest rates, despite mounting political pressure.

He was proven correct then. Now he is going against the grain again, saying that Trichet will not cut rates, i.e., the euro is too cheap at the moment.

Trichet is in an impossibly complex spot right now, particularly after Kosovo’s secession from Serbia. Kosovo has already threatened to disturb a hornet’s nest of secessionist movements throughout Europe, the strongest of which are in Belgium, northern Italy, and Hungarian nationalists in Serbia and Slovakia. The lower interest rates are, the more economic laggards are subsidized at the expense of the wealthy powers, and the weaker secessionist influences are.

Feb. 21 (Bloomberg) — Financial markets have it wrong: Jean-Claude Trichet isn’t about to cut interest rates, according to the Merrill Lynch & Co. economist who defied conventional wisdom by correctly predicting the European Central Bank president’s course two years ago.

Klaus Baader, Merrill’s London-based chief European economist, said he doesn’t expect Trichet to lower borrowing costs this year. His view, shared by economists at Goldman Sachs Group Inc., ABN Amro Holding NV and Morgan Stanley, conflicts with the opinion of most investors and economists that the bank will reduce its key rate from 4 percent.

“The gap between market expectations and the ECB’s thinking is unusually wide,” said Baader, who two years ago bucked the consensus by forecasting accurately that Trichet would keep increasing borrowing costs. “The inflation outlook is too strong for rate cuts.”

Investors increased bets on a cut after Trichet on Feb. 7 withdrew a threat to raise rates and expressed concern that the outlook for growth had deteriorated. The yield on interest-rate contracts maturing in December is at 3.64 percent, down from 4.18 percent at the start of the year.

Baader’s view that the bank will keep rates higher than anticipated amounts to a bet that inflation, currently above the bank’s target, will remain Trichet’s chief concern, and that a U.S. slowdown won’t derail Europe’s economic expansion as it did in 2001.

Reversing Bets

If he and the other contrarians are right, investors will have to reverse their recent wagers that Trichet will cut rates by selling two-year government bonds or buying the euro.

Europe’s pace of growth halved in the fourth quarter to 0.4 percent, while retail sales and industrial production fell in December. UBS AG predicts the ECB will lower its key rate by a percentage point to 3 percent this year.

“We now have the economic circumstances in place for the ECB to embark upon easing,” said Julian Callow, chief European economist at Barclays Capital, who expects two reductions after starting the year forecasting none.

Erik Nielsen, Goldman Sachs’s chief European economist, disagrees. He said the ECB’s primary mandate is to preserve price stability, so it has no room to follow the Federal Reserve and the Bank of England, even as economic growth weakens. The Fed slashed its main rate by 1.25 percentage points last month, and the Bank of England cut its benchmark by a quarter point Feb. 7 for the second time in three months.

`Hurdle’

“Inflation and expectations for it are a hurdle for a cut,” Nielsen said. “Inflation is very stubborn” in Europe.

The annual pace of consumer-price increases in the euro region accelerated to a 14-year high of 3.2 percent in January, pushed above the ECB’s 2 percent limit for a fifth month by food and energy costs. Inflation in France, the euro-area’s second largest economy, accelerated in January to the fastest pace in at least 12 years, according to data released today.

Labor unions are demanding higher wages, and companies may compensate by boosting prices. IG Metall, Germany’s biggest union, yesterday won a 5.2 percent raise for steel workers at companies including Dusseldorf-based ThyssenKrupp AG, Germany’s largest steelmaker.

Commission Forecasts

The Brussels-based European Commission today highlighted the ECB’s dilemma by cutting its forecast for growth in the euro-area this year to 1.8 percent from 2.2 percent, while increasing its prediction for inflation to 2.6 percent from 2.1 percent.

History also suggests the ECB probably won’t act soon. While the bank reduced rates in 2001, even when inflation was above its target, inflation expectations, business confidence and money-supply growth were all lower than they are today, said Elga Bartsch, a Morgan Stanley economist. The ECB’s benchmark rate was also higher, at 4.75 percent.

“The data will likely deteriorate in the coming months, but it will need to cover some distance before it resembles 2001,” Bartsch said. She expects the ECB to raise rates next year.

The contrarians acknowledge risks to their forecasts. Data to be released tomorrow will show services and manufacturing industries close to contraction, according to the median estimate of economists surveyed by Bloomberg News.

`High Uncertainty’

Still, Baader and Nielsen said the ECB would have to cut its 2008 growth forecast next month to about 1.5 percent from 2 percent for them to rethink their stance.

While Trichet acknowledged on Feb. 7 “unusually high uncertainty” about growth, he also noted “upside” inflation risks. Bundesbank President Axel Weber and ECB Vice President Lucas Papademos have said since then that rate-cut expectations may be misguided.

“Market expectations for cuts are overdone,” said Nick Kounis, an economist at Fortis Bank NV in Amsterdam, who also expects the ECB to keep rates on hold this year. “Trichet was starting to move away from a tightening bias and is no longer set to raise rates, but in no way is he ready to move to an easing bias and cut rates.”

Record-low unemployment and increased spending by German consumers mean economic growth will “remain fairly solid in 2008, and even if it falls somewhat below trend, this won’t prompt ECB rate cuts,” said Dario Perkins, ABN Amro’s senior European economist in London.

Comparisons to 2006

Baader, 45, sees some similarities to 2006. At the start of that year, he predicted the ECB would push its benchmark rate, then 2.25 percent, to 3.5 percent by yearend, at a time when the median forecast among economists surveyed by Bloomberg News was for a smaller increase, to 2.75 percent. In December of that year, just as he predicted, the rate hit 3.5 percent.

This year as in 2006, the ECB will pay more attention than investors realize to its so-called monetary pillar, which uses money-supply growth as an early indicator of inflation, Baader said. On that score, he sees no “concrete evidence” that banks are reducing lending, with loans to the private nonbank sector growing 8.2 percent in November and 7.1 percent in December.

Does that last paragraph sound familiar? This is what I’ve been saying for a while with regards to USD lending …

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Tax evasion has become something of a national pastime in major Western countries, thanks to symbiotic cooperation between legislators and lobbyists. Governments are realizing that there are trillions of dollars percolating around Lichtenstein, Luxembourg, the Cayman Islands, the Bahamas, the Virgin Islands, Jersey, Mauritius, Switzerland, Cyprus, etc.

However, the “war on tax evasion” is as stupid as the “war on drugs.” Tax havens have a supply and demand function just like any other product. Intelligent people with capital will always create new havens to the extent that they need them.

Getting to the main point: Lichtenstein has found itself dead in the middle of the scope of the German BND intelligence agency, which blatantly violated its extraterritorial mandate to hound the assets of wealthy Germans, by literally infiltrating a Lichtenstein bank and bribing an employee to leak data. Apparently a bunch of Americans’ and other non-Germans’ information was also leaked.

Mammoth tax evasion probe widens

By Hugh Wiliamson in Berlin

Published: February 21 2008 21:48 | Last updated: February 21 2008 21:48

Germany’s mammoth tax evasion investigation widened on Thursday as German bankers came under suspicion of assisting wealthy clients to hide millions of euros in Liechtenstein.

Metzler, the private Frankfurt-based bank, said that three of its staff were under investigation by prosecutors for assisting with tax evasion on funds totalling “less than €6m [$8.9m, £4.5m]”.

Prosecutors have raided several banks this week, including branches of Dresdner Bank and UBS, the Swiss finance institution, although they stressed the banks themselves were not under investigation. German bank staff were involved in administering about 50 specialist foundations in Liechtenstein, according to German media reports. Prosecutors declined to comment on how many bankers were under investigation.

The Financial Times on Wednesday quoted a spokesman for the Bochum prosecutor’s office, which is leading the inquiry, as saying it was following leads that “individual [bank] employees may have abetted tax fraud”. Since the affair came to light a week ago “several thousand people” have contacted authorities to own up to tax evasion or plan to make contact, the head of the association of tax inspectors said on Thursday.

The investigation was widened as legislators from Germany’s ruling coalition told the FT Liechtenstein’s membership of the European Union’s border-free Schengen zone should, if necessary, be delayed until the tax haven had taken steps to reduce bank secrecy.

The German government has accused Liechtenstein of aiding tax evasion by refusing to disclose details of clients investing in foundations. Angela Merkel, the chancellor, said on Wednesday that Vaduz must “move quickly” to ease secrecy, and hinted that the German parliament might link this issue to Liechtenstein’s Schengen membership, which it is due to ratify this later this year.

Joachim Poss, deputy parliamentary leader of the Social Democrats, the junior coalition partner said: “We should use all the political levers available to put pressure on Liechtenstein, and its entry into the Schengen zone is one important element.”

The chairman of the Swiss banking association was right, when he called the German intelligence “Nazis.

Swiss apology for ‘Nazi’ tax insult

By Bertrand Benoit in Berlin

Published: February 21 2008 20:37 | Last updated: February 21 2008 20:37

The Swiss banking association was forced to apologise on Thursday night for remarks by its chairman that the activities of Germany’s BND intelligence agency in a nationwide crackdown on tax evaders were reminiscent of the Gestapo.

In a statement issued last night, the Swiss banking association said Pierre Mirabaud, its president, “regretted the impression that could have been conveyed when he talked about Gestapo methods in relation to the German intelligence service”.

Mr Mirabaud drew the inflammatory comparison with the Nazi secret police in an interview with French-speaking Swiss television on Wednesday night. “He only meant to express his uneasiness about such methods being used by intelligence services against friendly states,” the banking association said.

Mr Mirabaud’s remarks and subsequent apology highlight the furore in Switzerland and neighbouring Liechtenstein over a tax investigation that has unfolded over the past week. They reflect the concerns felt by German-speaking neighbours over Germany’s economic dominance in central Europe.

Allusions to the Nazi-era are taboo in Germany’s political debate. Off-the-cuff comparisons have led to ministerial resignation in the past and Nazi symbols are banned from public display.

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Each way of my recent Chicago-NYC trip required a total of 18 hours, from five initially. Air travel in this country simply defies belief.

Part of my trip was occupied by Paul Kedrosky’s Money:Tech conference, which was a great occasion to meet some very smart hedge fund people. More on that later.

On that note:

February 9, 2008 1939 GMT
The China Banking Regulatory Commission (CBRC) said it is drawing up an ordinance on the bankruptcy of banks and financial institutions in order to create a market-oriented bail-out mechanism, Xinhua reported Feb. 9. The mechanism would augment the revised corporate bankruptcy law, which took effect in June 2007, and focus on the special characteristics of financial areas. The CBRC did not give a time frame for the legislative process of the ordinance.
February 10, 2008 1552 GMT
The Organization of Petroleum Exporting Countries (OPEC) is considering switching the currency for oil price denominations from the U.S. dollar to the euro within the next 10 years, OPEC Secretary-General Abdullah al-Badri told the London-based Middle East Economic Digest in an interview published Feb. 10. OPEC members are pressuring the organization to make the switch amid the sharp decline in the value of the dollar against the euro since 2000.

Iran banks seek to sidestep US curbs

By Anna Fifield in Tehran

Published: February 10 2008 22:08 | Last updated: February 10 2008 22:08

Iran’s first investment banks will start operating next month, part of Tehran’s strat­egy of opening new banking channels but also part of its effort to circumvent US restrictions on its financial sector.

The three banks will also play a key role in Iran’s plans to step up aggressively on the privatisation of national industries including steel, banking, shipping, airlines and telecommunications, said Heidari Kord Zangeneh, deputy finance minister and head of the Iranian privatisation organisation.

“We are going to activate our private sector and our private banks. . . in order to fight against these [US] sanctions,” Mr Kord Zangeneh told the Financial Times.

The banks, called Amin, Novin and Pasargad, are run by consortia that include privately owned investment companies, some of which are affiliated to private banks, he said.

“This is the first time we have had investment banks and they will do what other investment banks all over the world do,” Mr Kord Zangeneh said. “They will take share subscriptions and act as an intermediary between the privatisation organisation and the stock exchange, helping us divest our state-owned enterprises.”

Iran’s economy is dominated by the state sector, with economists estimating that four-fifths of the country’s value-added gross domestic product comes from the government, especially from oil.

Iran has for years been trying to sell off parts of state-owned companies not deemed crucial to national security – ruling out the main energy companies. However, progress has been painfully slow, despite entreaties from Ayatollah Ali Khamenei, Iran’s supreme leader, that privatisation is the “most effective way” to counteract the “economic war” being waged by the west.

Mr Kord Zangeneh said Iran would accelerate the process of privatisation, pledging that his organisation would complete the sale of all public companies before the 2015 deadline set out in Iran’s economic plan.

“I promise that if I am here for the next two years, between 80 and 90 per cent of the government will be sold,” he said.

In the short term, Iran will sell a quarter of the National Copper Industry Company, one of the largest Iranian businesses, through the Malaysian stock exchange within the next two months, a stake that Mr Kord Zangeneh said would raise much more than its current $1.5bn (€1bn, £770m) book value.

Tehran was also in talks with the bourses in Hong Kong and Jakarta about floating Iranian state companies there, he said.

Such moves are likely to increase western concerns that Iran is looking east to find investors more concerned about securing energy supplies for themselves than about punishing Iran for pursuing a nuclear programme.

Over the next several months, China will air a lot of bad-debt dirty laundry with another bailout vehicle. The $200 billion CIC isn’t nearly enough to bury all the garbage held by Chinese banks.The Iranian ‘shariabanks’ are indicative of yet another massive pool of capital seeking out Western and Asian markets, and they provide still more support for Western asset prices despite dumb decisions by Western investment banks.

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Bernanke Ease Makes Bulls out of Dollar Bears Seeing New GrowthBy Bo Nielsen

Feb. 4 (Bloomberg) — Ben S. Bernanke’s decision to lower interest rates 1.25 percentage points last month will end the dollar’s two-year slide, according to the world’s biggest currency traders.

For the first time since 2003, investors are focused on relative growth prospects rather than absolute borrowing costs, according to Geoffrey Yu, a London-based strategist with UBS AG, the No. 2 trader. The steepest cuts by a Federal Reserve chairman in seven years will support economic growth in the U.S. as Europe slows, said BNP Paribas SA, the most accurate currency forecaster Bloomberg tracks. The dollar will gain at least 9 percent against the euro this year, UBS and BNP predict.

“We’re not chasing dollar weakness any lower,” said Robert Robis, a fixed-income manager in New York at OppenheimerFunds Inc., which oversees $260 billion. “The Fed’s actions have avoided a long recession and we may start to see a recovery later this year.”

Robis has reduced the share of euro-denominated assets versus those linked to the dollar in his $9 billion portfolio. It now holds less than the benchmark index because he expects the U.S. currency to outperform. As recently as November, he was “overweight” the euro against the dollar.

Futures traders cut the value of contracts benefiting from a drop in the dollar to $13.9 billion as of Jan. 29, according to Charlotte, North Carolina-based Bank of America Corp., the second-largest U.S. bank by assets. That’s down from a record $32.3 billion in November.

[…]

The dollar has benefited from Fed rate cuts before. During the first six months of 2001, the currency gained 10 percent against the euro as the central bank slashed its target 2.75 percentage points to below the ECB’s benchmark refinance rate following the bursting of the technology bubble.

… “If aggressive cuts by the Fed can stimulate the economy, then the U.S. will definitely lead the way in terms of economic recovery,” Yu said. “The ECB is behind the curve, so it’s time to move back” into the dollar, he said.

Huh?

That’s like an employee saying: “Now that my boss has slashed prices below cost, I’m VERY optimistic about our future because of all the business we’re about to steal from our competitor!” It’s completely missing the point: yes, more people will come in and buy your stuff, but in aggregate, you’re still going to be a lot worse off than before, it’s not sustainable, and at some point you will have to readjust prices back to their natural levels.

All other things equal, the interest rate differential between the USD and all global currencies has yawned 200 basis points wider in the past six months — and not in the dollar’s favor. You’d expect variable-dollar assets, i.e., stocks, real estate and commodities, to thrive in such an environment. But the aggregate has still been very negative for the dollar’s standing in the world.

Also, I can’t overemphasize how tired I am of meaningless, unfalsifiable commentary such as, “Blah Blah Central Bank is behind the curve.” What the hell does that mean? Is a central bank “behind the curve” whenever it doesn’t track LIBOR? Whenever it doesn’t track a certain treasury yield curve? Why have a central bank if it had no job other than to track the curve? Obviously, a central bank has duties other than following the curve. If there are concerns about currency stability, for example, it might be worth it for a central bank to stay a little bit behind the curve, so as to reassure investors that it places a high premium on currency stability, within meaningful parameters.

You never hear bankers clamoring about how “behind the curve” the Fed is when the Fed is raising rates. Somehow the Fed is only behind the curve when it isn’t cutting rates fast enough. The more I see mechanistically predictable comments such as Yu’s, the more I am convinced that these white-shoe institutional banking types have no clue what they’re doing.

I guess after the Fed cut 125 basis points in eight days, Wall Street finally has enough shame to adopt a party line besides, “Bernanke is behind the curve.”

“We still believe the U.S. promises good returns,” Sultan bin Sulayem, the chairman of state-owned investment group Dubai World, said Jan. 25 at the World Economic Forum in Davos, Switzerland. Dubai World agreed in August to invest as much as $5.1 billion in Kirk Kerkorian’s Las Vegas-based casino group MGM Mirage.

Foreign Holdings

Middle Eastern and Asian investors have poured up to $39 billion into U.S. banks since August, according to Bloomberg calculations. Foreign holdings of U.S. securities rose a net $149.9 billion in November, the most in 22 months, the Treasury Department said last month in Washington. In October, the gain was $92.2 billion.

Maybe America really is exceptional. Maybe, despite the best efforts of policymakers, “up” is the manifest destiny of the dollar.

Just kidding.

Stay short the dollar. Tone down the leverage, though. Apparently there are some very fundamental misapprehensions about what does and doesn’t constitute sound currency policy at some of our “commanding heights” institutions …

I remain where I have been for some weeks: very bullish about stocks, especially US ones if you don’t count dollar fluctuations, and very bearish on bonds. It’s up to you whether you want to dip in now or later, after the monolines bull has knocked over some more china in the china shop.

My sense is that “the drift” will be all upwards over the coming two to four weeks, but whenever any bad monolines headline crops up on Bloomberg, the market will drop 250 points before you can say “WTF, mate?”

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We now know that the European Central Bank bailed out Spanish banks to the same tune that the UK bailed out Northern Rock (although not nearly as much as the FHLB and Fed have in the United States).

This kind of secretive bailing out reinforces my conviction that central banks must be abolished. European savers were taxed without their knowledge, to save some overspeculative Spanish banks.

When I blew up not so long ago, I didn’t get a dime’s worth of repos, interest-rate basis points, discount FHLB loans, or discount Fed loans. And I didn’t deserve any.

Neither do these people.

The ECB seems to be trying to have it both ways, taking a publicly hawkish stand while quietly funneling bailouts to the worst-afflicted banks. It all amounts to politically driven currency devaluation. It’s yet another reason to go longer on gold. The exporter central banks, with their trillions of depreciating euros and dollars, haven’t even begun to crack.

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On the heels of Mervyn King’s not-quite-credible vow [*] to continue fighting inflation (which he predicted would surge), Jean-Claude Trichet has effectively signalled that he will bring Europe into recession if that’s what it takes to attract global savings to Europe. He is not interested in following in the Fed’s inflationistic footsteps.

Jan. 23 (Bloomberg) — European Central Bank President Jean- Claude Trichet said he’s committed to fighting inflation, attempting to quash speculation he’ll follow the U.S. Federal Reserve in cutting interest rates after stocks plunged.

Particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility,” Trichet told the European Parliament in Brussels today. [Any way we can print a few billion USD and rent him as Fed Chairman for a few years?–ed]

Bond investors dismissed his comments and raised bets on an ECB interest-rate cut. European two-year government notes rose the most since September 2001 and yields on June rate futures dropped as much as 21 basis points. The U.S. central bank cut its benchmark by three quarters of a percentage point to 3.5 percent yesterday after global stocks tumbled on concern a recession in the world’s largest economy will curb global growth.

“Europe is not going to get special dispensation from a global slowdown,” Stephen Roach, chairman of Morgan Stanley in Asia, said on a panel at the World Economic Forum in Davos, Switzerland. “Europe is not this dynamic, rapidly growing economy.”

Euro-region service industries grew this month at the slowest pace in more than four years after credit tightened and the euro neared a record, an industry report showed today.

Room for Maneuver?

Trichet on Jan. 10 threatened to raise the bank’s key rate from 4 percent if unions push through wage increases that take the jump in inflation into account. Euro-region inflation was 3.1 percent in December, the fastest in six years and well above the ECB’s 2 percent limit.

He suggested today that slowing growth may give the Frankfurt-based ECB more room for maneuver. While the bank is sticking to its base scenario that the economy of the 15 euro nations will expand about 2 percent this year, there are “downside” risks to the outlook, Trichet said.

“We’ll see how the real economy develops in the future because it can have an effect on inflation,” he said.

That remark “suggests any cut in rates by the ECB will only come on the back of poor economic data,” said James Nixon, an economist at Societe Generale in London. The Fed’s “concerns of a credit crunch appear to be absent in Frankfurt, even though European bank stocks have been hit just as hard as in the U.S.”

European stocks extended declines. The Dow Jones Stoxx 600 Index shed 1.6 percent as of 3:20 p.m. in London, erasing yesterday’s gain that was triggered by the Fed’s cuts. The index has plunged 15 percent already this year.

Summers Concerned

“The outlook for Europe is being revised downwards quite rapidly,” former U.S. Treasury Secretary Lawrence Summers in a Bloomberg Television interview in Davos. “One has to be concerned about financial strains and what they bring in Europe.”

European bonds rallied on speculation the ECB will be forced to follow the Fed and cut interest rates. The yield on the two- year note fell as much as 24 basis points, the biggest decline since the day after the terrorist attacks of Sept. 11, 2001, and was at 3.22 percent at 2:49 p.m. in London.

“Trichet’s warning about inflation risks today does not mean that he won’t cut interest rates in three months,” said Marco Kramer, co-head of European economics at UniCredit MIB in Munich. “It’s only rhetoric to fight inflation expectations.”

BNP Paribas SA today said it now expects the ECB to lower its key rate to 3.75 percent in June rather than September. Barclays Capital said the central bank will reduce rates twice this year instead of keeping them unchanged.

`Difficult Year’

“We’re already in a recession in the U.S.,” Klaus Kleinfeld, chief operating officer at Alcoa Inc., the world’s third-largest aluminum producer, said in Davos. “2008 will be a difficult year. I don’t think that the world can decouple itself from what’s happening in the U.S.”

Still, ECB council member Axel Weber said last night that any impact in Europe from a U.S. slowdown “could emerge with a time lag” and may “be less strong than in former times.”

ECB Vice-President Lucas Papademos and Executive Board member Juergen Stark also said yesterday that economic fundamentals in Europe remain sound.

European manufacturing unexpectedly maintained its pace of expansion in January. A gauge of manufacturing held at 52.6, beating economists’ forecasts for a decline to 52.1, a report from Royal Bank of Scotland Plc showed today.

“Our mandate consists of ensuring price stability for European citizens in the medium term,” Trichet said. The ECB has to be “credible in guaranteeing price stability.” Policy makers next meet to decide on interest rates on Feb. 7 in Frankfurt.

Before the Fed’s rate cut, the Bank of England was cautious about reducing its interest rates further. Policy makers on Jan. 10 voted 8-1 to keep the benchmark rate unchanged at 5.5 percent, minutes of the meeting published today showed.

We will see. According to conventional wisdom, ECB doves outnumbered hawks even before accounting for some German hawks’ shifting to dovish positions on the ECB central committee. Southern Europe is already in recession, and under the euro regime, it does not have the option of monetizing its debts.

If European central bankers shift towards more hawkishness, they will make a second play at dramatically raising the euro’s currency market share, at the price of a sharper European recession. Their comments must be watched closely.

[*] See: “Northern Rock”

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… on the back of European rate-cutting noises. Even Axel Weber, the German chairman of the ECB, suggested that European central bankers “shouldn’t over-dramatize” the current rates of inflation. Yves Mersch, the banker whose comments triggered today’s euro sell-off, is also considered a hawk.

“Mersch is considered to be a hawk,” said Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt. “It’s a change in tone to hear him talking down the growth outlook. The discussion about a cut is about to start.”

Mersch is the latest policy maker to note either downside risks to the economic outlook or the temporary nature of the jump in inflation.

Inflation, which held at 3.1 percent in December, may return to the ECB’s 2 percent limit next year if oil prices ease and wages don’t rise excessively, Bonello, Weber and Executive Board member Lorenzo Bini Smaghi said.

The ECB can afford to ignore an oil-driven surge in inflation if it doesn’t inflate wage settlements, Mersch said. “If there’s no pass-through of these temporary factors to the general price level, we’re able to look through if need be.”

While rising oil and food costs have increased the likelihood of so-called second-round effects materializing, they “haven’t materialized so far,” Mersch said. Financial-market uncertainty and “other international developments” may “weigh on the inflation development.”

Asked if the ECB will act to curb inflation, Mersch said: “If needed. But we will keep all flexibility in order to assess whether there is a need at each meeting of the governing council.”

My prediction of a US equities rally today really crapped out, unfortunately. But I wasn’t too far off when I called the euro’s peak. Unless Trichet plans on shoving Italy and Greece out of the eurozone, he will have to start easing.

Now, according to my framework, European money should start plowing into precious metals to hedge against a round of ECB devaluation. That definitely didn’t happen today: gold dropped 2.3 percent in dollar terms (1.3 percent real).

European monetary policy is torn between German uberhawks and Mediterranean doves. With the accession of Bank of Cyprus chairman Athanasios Orphanides, however, Mediterranean doves have an ECB majority for the first time in the Bank’s history. The consequences for the euro will be real as well as punitive.

Meanwhile, inflation remains at secular highs all over the world, notwithstanding a six-month drumbeat of recession psychology.

December and January are the seasonal peaks for gold, and so I’m not surprised at today’s selloff, particularly given today’s USD surge on the back of dovish ECB comments. But I think gold has life in her yet.

However, I think general US equities–dare I say financials?–offer the best value right now. With inflation surging and T-bill rates already so low, why would anybody want to buy more Treasuries?

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CURRENCIES

VALUE CHANGE % CHANGE
EUR-USD 1.4725 0.0132 0.90
USD-JPY 109.4790 -2.1660 -1.94
GBP-USD 1.9802 -0.0062 -0.31

COMMODITY FUTURES

VALUE CHANGE % CHANGE
Oil 99.46 3.48 3.63
Gold 861.60 23.60 2.82
Natural Gas 7.76 0.27 3.63

The dollar is 2-3% stronger than it was at the previous gold/oil highs. Interestingly, the Treasury market is still discounting dollar pessimism. When the yield curve goes down, bonds are going up.

_treasurys.gif

How far will commodities go?

Geopolitical volatility doesn’t explain the current commodities movements, unless Israel is about to bomb Iran.

Furthermore, Albertan tar sand is going to drive the “long run equilibrium” of the oil down to a maximum of $50/bbl. Brazil has just discovered a massive new oil field. And, of course, if America ever drops its insane and superstitious environmental regulations, America could shrug off the Middle East within five years. Israel has become extremely quiet recently, and as discussed in previous posts, Israel has no choice but to unilaterally scuttle the present ‘arrangement’ in the Middle East.

However, at present, wasteful Chinese consumption is growing faster than new commodities structures can evolve. Commodities prices will have to rise until a “convention” evolves among non-Chinese that the Chinese government must be hemorrhaging cash — to such an extent that its $1.5 trillion-plus pile of dollars will seem small in comparison. The commodities supercycle will prevail until just before the Beijing Olympics  — and with it, continued dollar weakness. (I am even more bearish on the euro and the sterling than the dollar.) Insurance against inflation has been, and will remain, the great bull market of this decade, the bond market notwithstanding.

Because the Fed is losing credibility with virtually every move it makes, TIPS — a federally administered instrument — will lose credibility as well. Commodities are much more volatile than bonds, but there’s no question in my mind that they provide a much clearer picture of inflation expectations than TIPS do. The Singapore numbers notwithstanding, the global inflation glut is colossal and growing.

There’s one final reason why I’m much more bullish on gold than I am on any other metal. Imagine yourself as a central banker in the Middle East or Asia, with a trillion or so dollars, watching the value of the dollar erode. The dollar has fallen something like 10 percent in 2007. If you’re China, that means you lost $150 billion in January 2006 dollars. You will not sleep well until you vastly reduce dollar vulnerability.

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mzm_totci_dtwexm.png

Plunging MZM = bullish. MZM has been historically high, and is now dropping rapidly.

Plunging commercial lending ( = TOTCI) = bearish. Commercial credit is also at a secular extreme — although the 2001-04 plunge was also a secular extreme.

The dollar has tanked a lot in recent days, which implies that MZM is falling with it (more so than the graph suggests, because MZM data is about 2 weeks old). The dollar is at $1.47/euro again, and 112 yen per dollar instead of 114.5 or so. So the dollar is once again pretty weak. I previously thought it would strengthen dramatically, as the disparity between MZM and USD converged, to the benefit of general asset prices and the value of the dollar.

But that doesn’t seem to be happening … and probably won’t, until the US trade deficit is below 2.5% of GDP. The most recent figures clocked in at 5.1 percent, but dropping.

The sterling has tanked along with the dollar. All of the sudden nobody wants to invest in the UK anymore. Its budget deficit is about 3.5% of GDP, and its trade deficit is even bigger than the United States’.

I wonder if the forex market is pricing in a seismic shift in the yuan/dollar relationship by knocking DTWEXM out of line with MZM until the yuan revalues. The US trade deficit ex-oil is overwhelmingly centered on China, which means it won’t come down as long as the yuan remains unconvertible. And as long as China continues its bull(####) market, commodities will keep going up, so the US deficit will, if anything, increase. But as the dollar goes down, the yuan will come down with it, and continue exacerbating the problem.

In the PBOC’s “dollar sterilization” procedure, as I understand it, dollars are handed over to the central bank in exchange for yuan, at what is basically a state-set rate. Those yuan are not useful outside of China, so China has what amounts to a domestic inflation glut, in line with its accumulated foreign exchange surplus (its “savings glut”). Only massive, systematic rioting will force Beijing to change their ways, and nobody is convinced that that will happen until after the Olympic Games.

Gold, however, is still rising at a blistering rate. I’m surprised the “GOLD AT 28-YEAR HIGH” canard hasn’t been plastered all over the headlines by now. I guess that will come over the weekend and Monday after everybody has gotten the point about Bhutto.

CURRENCIES

  VALUE CHANGE % CHANGE
EUR-USD 1.4706 0.0080 0.55
USD-JPY 112.9300 -0.8055 -0.71
GBP-USD 1.9919 -0.0042 -0.21

COMMODITY FUTURES

  VALUE CHANGE % CHANGE
Oil 96.72 0.10 0.10
Gold 842.70 10.90 1.31
Natural Gas 7.23 0.03 0.42

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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.

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, and the 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.

 

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 of this graph) – 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 dollar 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.

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While the mainstream morons predictably spam the information spectrum with ex post finger-pointing over what happened 4 months ago, the monoline-insurance earthquake is the one that forward-looking traders should be worried about.

Via Bloomberg:

Ambac, MBIA Outlook Lowered by S&P, ACA Cut to CCC (Update2)
By Christine Richard

Dec. 19 (Bloomberg) — MBIA Inc. and Ambac Financial Group Inc., the world’s largest bond insurers, had the outlook on their AAA credit ratings lowered to negative from stable by Standard & Poor’s, while ACA Capital Holdings Inc.’s guaranty ranking was cut to CCC from A.

S&P also reduced its outlook for Financial Guaranty Insurance Co. and XL Capital Assurance Inc. to negative. The actions were “prompted by worsening expectations” for insured nonprime residential mortgage bonds and collateralized debt obligations of asset-backed securities, New York-based S&P said in a statement. …

Industrywide downgrades would lead to losses of as much as $200 billion on securities being insured as some holders would be forced to sell their bonds in a depressed market because of their investment guidelines, according to data compiled by Bloomberg. A downgrade would also stifle the guaranty businesses that make up the majority of revenue at MBIA and Ambac.

MBIA and Ambac lost more than half their stock market value this year on concerns they may lose their top ratings because they have insured securities linked to failing subprime mortgages. The companies reported combined losses of $2.9 billion in the third quarter after writing down the value of some debt they guarantee. …

Basically, the “monoline insurers” promised to insure trillions of dollars of medium- and low-grade debt against default. As the subprime seizure spread to all corners of the debt market, even formerly AAA-rated debt has cratered, which has effectively pushed the monolines’ working capital into significantly negative territory. Debt insured by the monolines is only as good as the monolines’ credit ratings themselves, so downgrades of the monolines means downgrades of all the debt the monolines had previously insured, which comes into the trillions of dollars.

Everybody knows that Ambac and MBIA are operationally billions of dollars in the red. If they get downgraded, the muni market will drown in its own blood. The banks themselves are already extremely strapped for cash (another chunk of ABCP will crunch in January, and the banks are hoarding cash to prepare). Now they are pondering an enormous bailout of the monolines, or the fission of the market for municipal debt.

At the end of the day, there’s a raging forest fire and a lot of firefighters, but no water left in the water cannon. The only long-run option is to let the bloodbath happen and surrender material economic power to Abu Dhabi, Riyadh, Singapore and Beijing. Unfortunately, as the FHLB’s $250 billion-plus lending has already proven, Wall Street has the political leverage to enforce the much more damaging “solution” of forcing a government-sponsored credit hyperinflation alongside private credit hyperdeflation.

Interestingly enough, the price of gold has actually risen slightly even as the dollar has bounced back dramatically from its lows. After the ECB’s half-trillion-dollar injection cum capitulation, the euro is no longer a credible safe haven from the dollar. The competitive devaluation is underway, and now non-dollar currencies are flowing disproportionately into gold. The result is that gold is little better than constant in dollar terms, but thanks to the dollar’s recent bounce, the dollar value of gold itself is now ~5% higher in global terms, than it was two weeks ago.

In unrelated doomster news, Bespoke notes that one of the ironclad technical bearish indicators, the cross between the shorter-run 50-day moving average and the longer-run 200-day moving average, is nigh. Returns following a shorter MA crossing over a longer MA have historically been quite poor.

Buy gold.

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Japan’s latest export bound for the European market: tried and failed monetary policy.

By Ralph Atkins in Frankfurt, Gillian Tett in London and Krishna Guha in Washington 1 hour, 1 minute ago

Emergency help for financial markets entered new territory on Monday night as the European Central Bank announced it would on Tuesday offer unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis.

The surprise move, which follows last week’s co-ordinated barrage of measures by the world’s central banks to increase market liquidity, suggests the ECB is still frustrated at the failure to ease market tensions.

The measure was reminiscent of the ECB’s operation on August 9, at the start of the global credit squeeze. But that was for overnight loans while the new offer is for two weeks.

Analysts warned that the measure risked increasing market volatility and saw the central bank breaking new ground in helping out the banking sector.

This is basically Father Christmas to those who have access,” said Erik Nielsen, economist at Goldman Sachs.They are bailing out people who have not really adjusted their balance sheets to the new reality.

But Julian Callow, economist at Barclays Capital in London, said the funds injected on Tuesday would later be “mopped up” by the ECB, which was “simply doing their job at being lender of last resort”.

The ECB had already announced that Tuesday’s regular weekly money market operation would mature on January 4 – covering the year-end when financial institutions will be under pressure to show strong liquidity on their books.

But on Monday night it said in addition that it would satisfy all bids offering 4.21 per cent or more. Prior to the announcement, the cost of borrowing two-week money had soared to 4.9 per cent but fell sharply afterwards as the ECB’s move in effect put a cap on market interest rates.

The move could trigger a surge in demand for ECB liquidity. In last week’s regular seven-day auction, the ECB allocated EU218.5bn [approx. US$300 billion–ed] at an average rate of 4.21 per cent – the rate chosen as the cap for Tuesday’s operation.

The ECB offered little explanation for its move beyond saying that it was “fully consistent” with its aim of keeping interest rates close to its main policy rate of 4 per cent.

The latest move underlines the limited impact of last week’s co-ordinated intervention which included a new liquidity facility at the US Federal Reserve.

The Fed held the first of its new credit auctions on Monday, offering $20bn in one-month loans in an effort to ease strains in the term money market.

The Bank for International Settlements on Monday published a report on the different money market operations that are used by central banks – the first such study that has ever been conducted by this Basel-based group.

It refrained from drawing precise policy conclusions but it noted that there is a striking variation in the techniques used.

US$300bn, just like that?

If you’re an investor, you’d do well to dust off economic histories of 1990-2007 Japan. That’s what’s happening on a global level, now. There is this ideological refusal to allow asset prices to come back down to remotely realistic levels.

I hate to say it, but the Goldman guy is right.

See also:

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My money is on 50 basis points at the Fed’s December meeting. Contrary to the now red-faced predictions of the GaveKal crowd, 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 big inflation indicators.

inflation.png

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 even had a government for six months. 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 good “floor” for 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 about that amount. That’s simply a staggering increase.

The Chinese government is facing extremely high domestic inflation. Bernanke, by depreciating the dollar, has effectively raised the price of Chinese currency policy and raised future Chinese inflation. Chinese monetary authorities, especially 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 would probably see the collapse of tens of millions of jobs’ worth of businesses, which would probably stoke as much domestic unrest as exponentially increasing inflation. Politically the Chinese do not seem able or willing to revalue their currency, even as Bernanke has turned the screws.

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 and coordinated riots over food or fuel, both of which have been aggressively rationed to hold down official inflation numbers.

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.

I see oil as especially prone to another spike, because of geopolitical factors. As I have noted in previous posts, Russia (which is heavily invested in prolonging Mideaster turmoil) will begin the countdown to war with Iran if it delivers nuclear fuel to Bushehr. Even though these kinds of impending crises are almost always muddled through, local factors make that less likely, and the significant rise in the probability of war will severely rattle the oil market.

The bottom line is that 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, even 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 to bail out the US financial industry. Cash hoarders will continue converting into gold, with Russia leading the way.

I am bullish on the commodities currencies, still–especially the ruble. But why buy the paper when you can just buy the underlying commodity itself and not have your asset stolen from you.

I think equities can’t do too badly in an inflationary environment, especially exporters. (Note that the GM/F/Chrysler liabilities will depreciate more as inflation rises, and as the value of the dollar goes down their exports will rise significantly). However, I also think equities markets will have this jittery “recession just around the corner” mentality, as worldwide inflation and pain aversion keeps the world economy on the cusp of a bubble that theoretically is only about three central bank decisions away from being popped.

Also, there is a long stream of bad news from the banking sector on the way, and that has a big multiplier effect on other sectors. Bernanke is obviously scrambling the helicopters to carpet-bomb the banks with money as fast as he can, but the banks’ problems are (I believe) far beyond Bernanke’s power to help, and the problems will get worse in light of the recent “mark to reality event” at E*Trade. Mike Shedlock explains:

Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.

“The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers’ balance sheets,” Credit Suisse analyst Susan Roth Katzke said.

Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel’s received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.

Goldman Sachs analysts said they were surprised by the size of the discount on the E*Trade portfolio because 73 percent of the assets were backed by prime mortgages, or loans to people with solid credit.

While admitting using simplistic analysis Credit Suisse analyst Susan Katzke estimates the following writedowns based on what happened at E*Trade, assuming pricing at 26 cents on the dollar.

  • Merrill Lynch (MER) could take a $9 billion after-tax hit to the valuation of assets underpinned by subprime mortgages.
  • Citigroup’s (C) after-tax write-down could be $26 billion.

Note that in reference to Merrill Lynch, Susa Katzke said $9 billion was related to subprime. Note that 73% of E*Trade’s portfolio was prime. That is quite a haircut on so called prime paper.

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.

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