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Minyan Mailbag: Evaluating the Economy


Remember, globalization has a downside too...



I am still chewing on the bathtub rationale. The things that I see differently, (and therefore need to try to see from another perspective to challenge my base assumptions), is that in 1999-2000 I view the Fed as intentionally providing liquidity through Jan 1, 2000, then intentionally beginning to drain it post Y2K non-event.

1) I don't view the Fed in 2000-2001 as being accommodative and the market just falling under its own weight.

The reason that is important is that although the Fed is currently raising short-term interest rates, (to compensate foreign capital?), it "seems" like it is still pumping liquidity unlike it did post Y2K. IF that is true, how long will it last and how should we expect this scenario play out differently?

Second, I am trying to get my arms around Asian excess savings going to real assets vs. treasuries and the US dollar. As long as China is determined to maintain some sort of currency peg relative to the dollar, (more crass translation would be - as long as they won't allow the dollar to crash), they MUST choke down the excess dollars that the US pukes into the global currency markets. I think the Chinese are signing long-term contracts for hard assets in dollars as fast as they can, thus garnering fixed commitments to exchange the US dollars they are accumulating for hard assets in a future series of exchanges, (and hedging with precious metals purchases). That offloads their US dollar risk without dumping the dollars immediately back into the global currency markets. So I am saying that it seems that:

2) The Asians are buying treasuries AND real assets simultaneously. They create currency as well, so there should be no lack of liquidity to do both, particularly when keeping their currencies from appreciating is their desired outcome. The question, it would seem, is when do they strategically no longer want to buy dollars anymore? That begs the question of what their motives are, and how they see the endgame. They are in the driver's seat, so they will dictate the dollar's decline at any point they want to make the call.

Third, I do think that excess global capacity will persist and is a disinflationary global force. The caveats are that the deflationary tendency created by technology and low-cost producing countries still have some constraints in the supply/cost of raw materials on the input side. (The emerging economies can put up lots of factories with cheap labor, but the increased production strains the availability and thus pushes up the cost of raw materials.)

3) So rapidly growing global capacity being absorbed/perpetuated via global liquidity is the primary driver of rising prices of real assets regardless of who consumes what is produced. There is currently sufficient liquidity to grow capacity faster than resources can keep up with.

More unique to my current expectations however, is that I believe that the US will ultimately pay a currency-induced inflationary penalty that will surpass the global deflationary benefit. Too many economists are overweighting conclusions from models that worked fine in a more closed system. 21st century global trade and currency fluctuations are not adequately factored in the majority of economic prognostication.

Over-simplistic translation: Economists don't adequately factor what is entirely different in today's global economy to create a scenario where all these things "could" happen simultaneously:

  • The US dollar falls
  • US interest rates rise
  • US inflation increases
  • the global economy grows
  • US recession persists
  • Asian and European interest rates stay low
  • Asian and European inflation falls...

I really am asking questions but don't know how to do it better than to just lay out my current thinking and allow you to FREELY and CRITICALLY pick apart my reasoning as merited.

Thanks for the dialog and your valuable insight.

Minyan Jeff

Minyan Jeff,

To address your point:

"The reason that is important is that although the Fed is currently raising short-term interest rates (to compensate foreign capital?), it "seems" like it is still pumping liquidity unlike it did post Y2K. IF that is true, how long will it last and how should we expect this scenario play out differently?"

It is not clear to what extent the Fed is "pumping" precisely: Treasury sec's on the Fed balance sheet have grown by double digits in the past few months and repos have been somewhat higher than normal (with permanent injections running at pretty much the same rate as the last 6 months). But we suspect as you do that they are attempting to be quite accommodative. But our measure of Real liquidity, a more encompassing yet subjective method of measuring liquidity (Money AMS - or Austrian money supply), is showing substantial declines from the summer of 2004.

Real liquidity takes into account not only the supply of money (credit) being created by commercial banks via the Fed, but also the demand for money (credit) from corporations and consumers, which the Fed does not control. It is also affected by the amount of recycling of dollars into the US financial system by the Chinese and the Japanese: The more they divert to hard assets, the more real liquidity will drop. It is also affected by the degree of the Yen carry trade in which insurance companies, pensions, hedge funds, etc. all step to one side of the boat by selling the Yen short and buying all manner of US ('liquid', 'safe' etc.) securities, mostly short term treasuries.

The net of all the above is that it's almost moot what the fed is doing NOW: The global supply of money - all currencies - was up 15% y/y in 2004 (from 0% in 2000). THESE monies are the ones that are flowing around the world, being pyramided again and again through various banking intermediaries and making their way into any instrument that can be purchased in dollars. One alarming possibility, one that we put a reasonable probability on, is that it is central banks themselves that are using these monies to buy risky assets to support (reflate) markets. This is what we refer to as socialization.

Until the demand for credit by users (traders, consumers, corporations) wanes sufficiently enough AND the appetite of lenders too, for risky lending abates, this liquidity will slosh around: lowering volatility, causing investors to stretch for yield, causing emerging market bond yields to be lower than GNMA US government-backed yields, etc. Our work suggests that indeed we are very close (unless central banks are willing to monetize these risky assets forever) to this tipping point where the liquidity is about to be overwhelmed by these other factors; that the credit boom is about to turn to credit bust.

"Asians are buying treasuries AND real assets simultaneously."

We have no data whatsoever to confirm this, only assumptions based on the prices we see. The TIC data suggests strongly they are buying treasuries MOSTLY (if not exclusively), and are going out the curve as well, but we cannot refute that they might be buying hard assets.

Of course who and why are the operative questions to ask: If it's private individuals and corporations, then it is simply a global economic demand issue - commodity demand follows economic growth. Though it has been suggested that the Chinese are hoarding hard commodities in order to diversify their USD holdings, there is almost no evidence whatsoever to confirm that. In fact the only data available says they are not, but that means little. We have suggested that the Chinese and Japanese might be buying metals to hedge against a future devaluation of the dollar.

"Third, I do think that excess global capacity will persist and is a dis-inflationary global force."

We agree 100%. It is HIGHLY deflationary.

"The US dollar falls
US interest rates rise
US inflation increases
The global economy grows
US recession persists
Asian and European interest rates stay low
Asian and European inflation falls..."

Our view: the highest probability is that the USD will fall, but only after a larger mean reverting bounce to play out this year/early next (this of course would change if our Fed refuses to allow the natural deflationary forces to take hold and hyper-inflate; then it would fall rapidly first).

Afterward, it collapses (against other currencies). We think rates come DOWN in a recession (but rise relative to foreign rates) which almost certainly will be GLOBAL in nature owing to the tight correlation and US-centric structures that most Asian countries find themselves in. So does inflation fall (deflation)? Like Japan in 90-2002 there will be times when real CPI figures are negative y/y. We agree on the last two, but for reasons of global economic recession and low inflation/outright deflation.

Remember, globalization has a downside too: all economies are much more linked together and there is nowhere to hide.

Scott Reamer and John Succo


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