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When you have some time – here are a few recent articles relating to commodity pricing, hyperinflation and the U.S. dollar. They’re somewhat long – but contain accurate information and are worth reading.
October 14, 2009
When money is worthless
By Martin Hutchinson
The Financial Times on October 6 noted a disturbing new trend – hedge fund and other investors are increasingly seeking to invest in physical commodities themselves, rather than in futures. Given the excess of global liquidity, this is not entirely surprising. It does, however, raise an ominous possibility of a supply shortage in one or more commodities, caused by investor demand that exceeds available mine output and inventory. That could potentially produce a collapse in economic activity similar to that from the 1837-41 and 1929-33 liquidity busts, but with the opposite cause.
The problem arises because of the size of the world’s capital pools in relation to its volume of trade. The total assets of US hedge funds in September 2009 were US$1.95 trillion (down from almost $3 trillion a year earlier). That compares with total US imports of goods and services in 2008 of $2.1 trillion.
However, in addition to the hedge funds, there are other huge pools of money available for deployment in commodities markets. For example, China and Japan each have around $2 trillion of foreign exchange reserves, while Saudi Arabia and the Gulf states have comparable-sized pools of liquid assets available for investment. Since the available inventory of commodities is a fraction of their annual production, we could potentially end up with an extreme case of too much money chasing too few goods.
This would not matter much if investment were concentrated in futures markets. The open interest in such markets is controlled by the traders, who arbitrage to close positions as the settlement date nears. Thus when huge speculative money flows pour into futures markets, they drive up the price of the commodity concerned, but do not significantly interfere with the production of that commodity, nor with the flow of the commodity from producer to consumer.
Normally, commodity investment is confined to futures markets because it is much more convenient. The cost to a hedge fund or other financial investor of holding stocks of a commodity is quite high, normally sufficient to deter investors from attempting to buy commodities directly. They will only buy commodities directly if they are afraid that the normal arbitrage mechanisms between the futures markets and the commodity markets will be overwhelmed by the volume of demand, so that investment in futures will prove less profitable than it “should”.
When investment moves to physical commodities, as it may now be doing, it potentially disrupts trade flows. A ship laden with copper ore that would normally have sailed from Chile to a smelter on the US West Coast is instead parked in a holding area in order that investors can profit from the rise in value of that copper. That reduces the amount of ore available to smelters.
Since the balance between supply and demand of most commodities is quite delicate, and supply cannot be ramped up by more than a modest percentage at short notice, that could result in a physical shortage of the commodity at the smelter, shutting down the smelter for a period and depriving its customers of the copper products they need for their own operations.
Disruptions of commodity flows of this kind can potentially cause both hyperinflation and a major recession. The value of copper to the smelter and its customers is much higher in a shortage than if it is available normally because the cost of closing their own operations is large – hence the price of any spare copper that might be available locally zooms upwards. Equally, the economic cost of shutting down the smelter and its customers far exceeds the value of the copper ore shipment. Products containing copper are suddenly in short supply, while workers lose their paychecks and so are forced to stop consuming at the same level.
The effect of a gross liquidity surplus is thus quite similar to that of a sudden shortage. In the shortage case, as in 1837-41 and 1929-33, prices decline sharply – in those two cases by as much as 20-25% – economic activity is hugely reduced as businesses are unable to obtain financing and workers are laid off. The resultant decrease in demand causes producers to lose money, eventually closing their doors, as well as bankrupting the financial system.
In a gross liquidity surplus, in which investment capital disrupts commodity trade flows, inflation rather than deflation results, probably very rapid inflation rather than the moderate 5% to 10% inflation we became used to in the 1970s. That inflation still further increases demand for commodities, worsening the problem. Businesses unable to obtain raw materials close their doors, workers’ real incomes decline sharply (even when they keep their jobs) and gross domestic product declines similarly to the deflationary case.
We have never experienced a global hyperinflation, in which money is unable to purchase goods, so it becomes worthless. In particular countries, wars have produced this effect, notably in the revolutionary wars in both the United States and France, when the “continentals” and “assignats” became of no value. Similar effects have been produced by excess money printing in Latin America; in hyperinflationary periods citizens of Argentina have starved, even though the country is one of the world’s greatest food producers. However, globally we have experienced nothing worse than the moderate worldwide inflation of the 1970s, in which trade flows were disrupted and incomes and assets affected, but commodities generally remained available in the market and output weakened but did not decline sharply.
The fascination of adding another chapter to economic historians’ textbooks is not sufficient to make global hyperinflation anything other than an event to be avoided at all costs. It might help the Ben Bernanke of 2080 to make better monetary policy decisions than the present Federal Reserve chairman, since he would have the chance to be the world’s greatest expert on the hyperinflationary crash of 2011. However, as far as this column is concerned, future generations can take their chances – we need to avoid hyperinflation happening to this generation.
The cost of avoiding this disaster appears to be steadily increasing. Once articles start appearing in the Financial Times about investors choosing to buy physical commodities rather than futures, many more such investors will be drawn into this activity. A moderate tightening of monetary policy that might well have deflected the forces of hyperinflation if it had been instituted several months ago may well prove ineffectual at this stage.
In determining the necessary monetary policy, the gold price provides a very useful signaling device (and its definitive breakout through previous highs last week provides a stern warning). It does not matter one whit whether investors demand physical gold rather than futures because gold has only insignificant industrial uses and the stocks of gold available in “inventories” such as Fort Knox are far more than sufficient to supply those uses for a decade if necessary.
However, the commodity investment impulse is closely tied to the gold investment impulse; both reflect a well-warranted distrust of fiat money and a desire to hold items of secure long-term value. Hence the gold price is available to show policymakers whether their monetary policy is appropriate.
If, following the recent breakthrough, the gold price continues to increase, heading for $2,400 per ounce, the equivalent in today’s money of the 1980 high, that will be an excellent signal that monetary policy urgently needs tightening.
If, after a first monetary tightening, the gold price retreats for a few weeks and then breaks through its recent highs, that development will be a signal that monetary policy must be tightened further, as the flight to commodities has not halted.
Only when the gold price breaks definitively downwards, dropping 25% or more from its high, will policymakers know that they have succeeded in breaking the commodity investment mania. Such a development is however likely to occur only after a definitive crack in government bond markets, forcing policymakers to address their gigantic budget deficits as a matter of urgency.
Given the predilections of today’s policymakers, it is unfortunately unlikely that they will tighten monetary policy sufficiently to break the commodity flight, whatever the gold price does. Instead, led by the determined Keynesians of the International Monetary Fund, they are much more likely to attempt to control the gold price itself, either surreptitiously by selling off massive quantities of the world’s gold reserves, or openly by imposing limits on gold futures trading and possibly, like Franklin Roosevelt in 1933, making it illegal for ordinary individuals to own gold or to buy gold futures.
That will of course only make matters worse; it would be equivalent to trying to avoid a speeding ticket by smashing the car’s speedometer. Manipulating the gold price to pretend that liquidity is not excessive does not stop liquidity from being excessive. Nor does it lead any but the stupidest institutional investor to believe that his urge to invest in physical commodities is misguided.
Rather, it will cause commodities investment to be carried out through shell companies in tax havens, away from regulators’ radar screens. The effect on global supply chains will be equally damaging, but policymakers will no longer have a straightforward way of determining how to avoid the resulting economic depression.
I wrote last week that tightening liquidity directly by entering into a central bank “exit strategy” is dangerous. However, the Financial Time’s story itself and the gold price breakthrough have significantly increased the size of the hike in interest rates necessary to halt the flight to commodities.
Time is short, and the probability of disaster is rising.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) – details can be found at http://www.greatconservatives.com/.
Trending Towards Hyperinflation
Economics / HyperInflation Oct 09, 2009 – 02:00 PM
Seven short steps to the cost of living doubling or more inside 3 years…
HYPERINFLATION is widely accepted as a period of out of control price rises, doubling the cost of living inside three years.
It occurs when a currency loses its ability to store value, encouraging long-term savings to pour into circulation where they swamp the much narrower supply of consumer money, and cause the whole lot to lose purchasing power.
There is no specific recipe, but the pattern we risk repeating today would be typical.
Step #1: Savers, already aware of very real inflation in the cost of living, find it applies more and more to their non-discretionary purchases, such as food and energy;
Step #2: They become increasingly irritated that their currency assets earn interest at the very low official rates – typically less than 1% in the West. To beat this, they need to take big risks by lending to minor institutions. These are the smaller banks which are insignificant enough to be allowed to fail, and therefore do not get access to cheap central-bank money. They are the institutions which have to bid market rate to get depositors’ money. And of course, they will eventually fail, because they are competing in the loans market against megabanks with unfairly cheap money and a government guarantee to protect them;
Step #3: Savers also begin to understand that the government cannot adjust to higher rates because its own enormous borrowing costs forbid it;
Step #4: Savers then cash in their deposits and steadily sell/redeem their bonds, anticipating that bonds in general will repeat their 1970s’ performance, shedding value continually over the medium to long term. (By 1980 the bond market was a shriveled rump, and it didn’t re-appear until 1986, when inflation was well under control.)
Step #5: Central banks will collect the unwanted bonds (quantitative easing programs have so far collected nearly $1 trillion) and create new cash to pay the sellers – again, large and favored client banks;
Step #6: Savers now re-invest, carefully avoiding things which will repay them nominal dollars (i.e. deposits and bonds). Everything else will go up in price as the new Fed cash seeks better stores of value;
Step #7: More and more savers will reach their inflation pain threshold and start at Step 1 above.
Is this spiral increasingly likely? Below are four important indicators:
Commodity price inflation;
Large debts, particularly government debt;
Long-term low returns for savers;
A source of new money – usually the printing press.
Unusually, they are all now pointing in the hyperinflationary direction. They are worth looking at in some detail today…
TIPS Show Bernanke Isn’t Whipping Inflation Concerns (Update2)
By Daniel Kruger
Oct. 13 (Bloomberg) — Treasury Inflation Protected Securities are the bonds money managers can’t afford not to own.
BlackRock Inc., Pacific Investment Management Co. and Vanguard Group Inc., which together manage $3.45 trillion, say investors are pouring money into inflation-linked debt even as consumer prices post the longest series of contractions since Dwight D. Eisenhower was president in 1955. TIPS have gained 7.9 percent this year, according to Merrill Lynch & Co. indexes, while Treasuries overall lost 2.8 percent. That’s the biggest outperformance since the U.S. first issued TIPS in 1997.
After getting bludgeoned by the subprime mortgage collapse, investors are preparing for another potential crisis: a surge in the cost of living spurred by the $11.6 trillion the Federal Reserve and the government have lent, spent or guaranteed to shore up the economy and the financial system. While inflation is tame now, they see danger signs in the doubling of crude oil futures since January, gold trading at record highs and the 14.5 percent tumble in the trade-weighted Dollar Index since March.
“Investors are really taking the long view and trying to hedge inflation risk,” said Mihir Worah, who oversees the $15.4 billion Real Return Fund for Newport Beach, California-based Pimco, the world’s biggest bond manager. “That’s the biggest reason why we’re seeing the flows.”
The Real Return Fund’s assets under management have increased 25 percent this year, Worah said. The fund has returned 16.5 percent since December, according to Bloomberg data. Pimco manages $60 billion in inflation-linked debt.
Returns are accelerating, with TIPS rallying 2 percent in September, the most this year after a 6 percent surge in March. Returns are similar elsewhere around the world. Excluding the U.S., a Merrill Lynch index that tracks the performance of inflation-linked bonds has gained 7.63 percent so far this year.
TIPS returned 1.1 percentage points on average more than Treasuries each year since 1999. In each of the five years when the difference was 2 percentage points or more, inflation accelerated the following year by an average of 0.8 percentage point. The biggest rise was 1.2 percentage points in 1999, with the smallest being a 0.4 point gain in 2004. Consumer prices rose after TIPS outperformed in 2003, 2005 and 2008.
Fed Chairman Ben S. Bernanke said at a Board of Governors conference Oct. 8 in Washington that while “accommodative policies” will be in place for an extended period, the central bank will be prepared to tighten monetary policy “to prevent the emergence of an inflation problem down the road.”
‘First Brick To Fall’
Last week’s auction by the Treasury of $7 billion of 10- year TIPS shows the strength of demand for the securities. The Oct. 5 sale drew bids equal to 3.12 times the amount offered, the highest bid-to-cover ratio since January 1999. The notes drew a yield of 1.51 percent, compared with a forecast of 1.56 percent in a Bloomberg News survey of seven of the 18 primary dealers that underwrite U.S. debt auctions.
Pension funds, central banks and individuals are all buying TIPS, according to Brian Weinstein, who manages $9 billion of the securities for BlackRock in New York.
“The first brick in the inflation wall to fall is the expectation brick,” said Weinstein. “If people are calling me worried about inflation it means that they’re acting differently. It means they’re actually starting to worry about inflation, and that should scare the heck out of central banks.”
BlackRock’s TIPS fund for individual investors, the Inflation Protected Bond Portfolio, has more than doubled its assets to $1.75 billion from $800 million at the start of the year, Weinstein said, while the firm’s overall inflation-linked assets have risen to $19 billion from $12 billion. Weinstein’s fund gained 8.2 percent this year, according to Bloomberg data.
By historical measures TIPS remain cheap. The difference in yield between 10-year TIPS and 10-year notes is 1.86 percentage points, compared with an average of 2.18 over the past five years. The gap, known as the breakeven rate, has been 2 percentage points or more for 79 percent of that time, Bloomberg data shows.
Weinstein and Pimco’s Worah both recommend 10-year TIPS because of the risk falling prices still pose for securities maturing in less than five years.
The Labor Department will report on Oct. 15 that the consumer price index rose 0.2 percent in September from August, while declining 1.4 percent from the year-earlier period, according to a Bloomberg survey. It would be the seventh consecutive monthly decline on an annual basis.
“TIPS are the rope-a-dope strategy of the bond market,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management. Rope-a- dope refers to boxer Muhammad Ali’s strategy of hunkering into a protective stance against which his opponent would flail, wearing himself out — at which point Ali would strike. “These things perform best when people are talking about deflation.”
The benchmark 1.875 percent 10-year inflation-indexed Treasury note ended last week at 103 4/32 to yield 1.53 percent, according to BGCantor Market Data. The breakeven rate rose 14 basis points, or 0.14 percentage point, in the period, the most in seven weeks. The coupon compares with 3.625 percent on the benchmark 10-year Treasury.
Investors are willing to accept lower yields on TIPS because the principal increases annually at the rate of the consumer price index. The securities pay semi-annual interest on the adjusted principal. Their face value is protected against deflation, because the principal can’t fall below par.
‘Going To Suffer’
Some policy makers say deflation is a greater threat to economic recovery than inflation.
“We would not need much of a decline in inflation to run the risk of an outright deflation,” Fed Bank of New York President William Dudley said in a speech in New York on Oct 5. “Outright deflation, in turn, would be a dangerous development because it would drive up real debt burdens and make it much more difficult for households and businesses to deleverage.”
Investors concerned about falling prices should buy long- term Treasuries, said Alex Li, an interest-rate strategist in New York at primary dealer Credit Suisse Group AG.
The benchmark 30-year bond, a 4.5 percent security due August 2039, closed last week at 104 20/32 to yield 4.23 percent, or 3.26 percentage points more than the two-year note. The so- called yield curve is steeper than the mean of 1.5 percentage points over the last 20 years.
“At the beginning of next year or later this year people are going to realize low inflation’s going to stay with us at least over the near- to medium-term,” Li said. “That’s the time when TIPS are going to suffer.”
September’s larger-than-forecast decline in non-farm payrolls indicates the recovery may take more time to take root. A sluggish economy is a negative for TIPS investors, who could lose money if consumer prices rise on average less than the 1.86 percent breakeven rate.
“The risk to owning TIPS would be a double-dip zero percent or negative inflationary period for a number of years,” said Kenneth Volpert, who oversees $180 billion as head of taxable fixed-income at Vanguard Group in Valley Forge, Pennsylvania.
TIPS holders also run the risk of getting burned if the Fed begins raising interest rates “with greater force than is customary,” as Fed Governor Kevin Warsh warned on Sept. 25, when an economy recovery takes hold.
The Fed has kept its target rate for overnight loans between banks at zero to 0.25 percent since December in an effort to hold down borrowing costs and boost lending. The seizure in credit markets triggered $1.62 trillion of writedowns and credit losses at financial institutions since the start of 2007, sending the global economy into its first recession since World War II.
Inflation expectations as measured by the Fed’s five- year/five-year forward breakeven rate rose to 2.80 percentage points on Oct. 6 from a low of 2.03 percentage points on Nov. 20. The rate plots forward rates measuring investor expectations for inflation in five years. The gauge was at 3.06 percentage points on June 30, 2004, when the Fed last raised its target rate.
Crude oil futures are more than double their January low of $32.70. Spending by U.S. consumers climbed by 1.3 percent in August, the most since 2001, and followed a 0.3 percent gain in the prior month that was bigger than previously estimated, the Commerce Department reported on Oct. 1 in Washington.
Dollar loses reserve status to yen & euro
By PAUL THARP
Last Updated: 3:16 AM, October 13, 2009
Posted: 1:44 AM, October 13, 2009
Ben Bernanke’s dollar crisis went into a wider mode yesterday as the greenback was shockingly upstaged by the euro and yen, both of which can lay claim to the world title as the currency favored by central banks as their reserve currency.
Over the last three months, banks put 63 percent of their new cash into euros and yen — not the greenbacks — a nearly complete reversal of the dollar’s onetime dominance for reserves, according to Barclays Capital. The dollar’s share of new cash in the central banks was down to 37 percent — compared with two-thirds a decade ago.
Fed boss Ben Bernanke may be forced to raise rates in order to restore faith in the dollar — and help bring the euro and the yen back to earth.
Currently, dollars account for about 62 percent of the currency reserve at central banks — the lowest on record, said the International Monetary Fund.
Bernanke could go down in economic history as the man who killed the greenback on the operating table.
After printing up trillions of new dollars and new bonds to stimulate the US economy, the Federal Reserve chief is now boxed into a corner battling two separate monsters that could devour the economy — ravenous inflation on one hand, and a perilous recession on the other.
“He’s in a crisis worse than the meltdown ever was,” said Peter Schiff, president of Euro Pacific Capital. “I fear that he could be the Fed chairman who brought down the whole thing.”
Investors and central banks are snubbing dollars because the greenback is kept too weak by zero interest rates and a flood of greenbacks in the global economy.
They grumble that they’ve loaned the US record amounts to cover its mounting debt, but are getting paid back by a currency that’s worth 10 percent less in the past three months alone. In a decade, it’s down nearly one-third.
Dollar to Hit 50 Yen, Cease as Reserve, Sumitomo Says (Update1)
By Shigeki Nozawa
Oct. 15 (Bloomberg) — The dollar may drop to 50 yen next year and eventually lose its role as the global reserve currency, Sumitomo Mitsui Banking Corp.’s chief strategist said, citing trading patterns and a likely double dip in the U.S. economy.
“The U.S. economy will deteriorate into 2011 as the effects of excess consumption and the financial bubble linger,” said Daisuke Uno at Sumitomo Mitsui, a unit of Japan’s third- biggest bank. “The dollar’s fall won’t stop until there’s a change to the global currency system.”
The dollar last week dropped to the lowest in almost a year against the yen as record U.S. government borrowings and interest rates near zero sapped demand for the U.S. currency. The Dollar Index, which tracks the greenback against the currencies of six major U.S. trading partners, has fallen 15 percent from its peak this year to as low as 75.211 today, the lowest since August 2008.
The gauge is about five points away from its record low in March 2008, and the dollar is 2.5 percent away from a 14-year low against the yen.
“We can no longer stop the big wave of dollar weakness,” said Uno, who correctly predicted the dollar would fall under 100 yen and the Dow Jones Industrial Average would sink below 7,000 after the bankruptcy of Lehman Brothers Holdings Inc. last year. If the U.S. currency breaks through record levels, “there will be no downside limit, and even coordinated intervention won’t work,” he said.