Monday, June 23, 2008

PIMCO on Inflation

Todays "Outside the Box" newsletter from John Mauldin is by Paul McCulley, the managing director at PIMCO who offers this missive on inflation, and why he believes the Federal Reserve will hold rates unchanged for some time.

You can subscribe to John Mauldin's free weekly letter here. I always enjoy his articles because of the variety of opinions both he and others bring to the table.


A Kind Word for Inflation

by Paul McCulley

No, I have not lost my mind. I'm fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don't tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed's comfort zone. Needs, you ask?

Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation's terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below tells that simple story.

A Negative Terms of Trade Shock: More Hours Worked for the Same Barrel of Oil

Misery Is as Misery Does
Americans are working more hours for the same barrel of oil. That is a negative real terms of trade shock. Put differently, we are less rich or more poor than we were before oil prices took off. There is no getting ‘round this. In turn, there is no escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment. The question of the hour is how this pain should be apportioned. Last week, Fed Vice Chairman Don Kohn provided the right answer, presuming there is a right answer (my emphasis):

"... an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains."1

Mr. Kohn was preaching the raw, honest truth: a surge in oil prices raises the Misery Index, temporarily lifting both inflation and the unemployment rate. In turn, those outcomes beget lower real wages and, presumably, lower real profits, too. We are less rich or more poor – period. Thus, those who holler and scream at the Fed for letting the inflation genie out of the bottle need to calm down. A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money.

Spiral Risk?
But, you retort, if the Fed surrenders to negative real interest rates, it will set off an inflationary spiral, as second and third round effects on prices and wages take hold: capital and labor will extrapolate what should be viewed as a transitorily higher inflation into permanently higher inflation. In a world of perfectly indexed prices and wages, this could well be the case. The 1970s resembled such a world, and nasty oil price shocks that should have been one-off adjustments in the price level via temporarily higher inflation morphed into a price-wage-price inflationary spiral.

In monetary policy terminology, inflation expectations in the 1970s were not firmly anchored at the pre-oil price shock level. This is true, I think, but more elementally, the highly unionized, closed-economy structure of the American economy price and wage setting process was inherently geared to transforming a one-off inflationary shock into an enduring inflationary shock.

Since the First Oil Price Shock, Unionization in America Has Been Cut in Half

We no longer live in such a world. Most importantly, wage inflation is now only loosely connected to price inflation, in the wake of a more globally competitive, less unionized labor force. As Vice Chairman Kohn hinted, the combination of somewhat higher inflation and higher unemployment is a prescription for diminished pricing power by labor, leading to lower real wages (than would be dictated by labor's productivity growth). Thus, unlike the 1970s, there is little wage fuel to generate over-heating aggregate demand and, thus, a sustained price-wage-price inflationary spiral.

This is good news indeed. Fed officials would make this argument through the lens of well-anchored inflationary expectations, and I have no quarrel with that interpretation, though I think it is but a veil over a more global, more competitive, less oligopolistic price and wage setting structure in the United States. Indeed, I believe the more nasty is the negative terms of trade shock, the fatter is the fat tail of asset price deflation rather than the fat tail of accelerating goods and services inflation.

Avoiding a Modern Day Depression
Deflating asset prices in a highly levered economy are a much more nefarious outcome than temporary increases in inflation in goods and services. This is particularly the case from a starting point of low inflation in goods and services (excluding those involved in the negative terms of trade shock). How so? Simple: a negative terms of trade shock and asset price deflation are a prescription for not just a recession, but a nasty one. More to the point, from a starting point of low goods and services inflation, the Fed is never far from the zero lower limit on nominal short-term interest rates, commonly known as a liquidity trap.

Therefore, the more flexible are wages in the face of a negative terms of trade shock, particularly if it coincides with asset price deflation, the greater is the risk of policy makers losing control of the economy on the downside. In turn, this reality argues for the Fed to tolerate higher headline inflation in the wake of a negative terms of trade shock.

To be sure, the Fed must be aware of the dreaded second and third round effects, constantly checking to make sure that real wages and real profits are being eroded by the aberrantly high headline inflation. But, assuming the evidence supports that thesis, as the following graph displays, it would be an absolute folly for the Fed – or any central bank in similar circumstances – to hike interest rates in an attempt to make the negative terms of trade shock go away. By definition, it can't. And if it tries, it will create an even bigger mess. In this case, the motto of a central bank should be the same as that of a physician: first, do no harm.

I think the Fed thoroughly understands these exigencies in the wake of a negative terms of trade shock. It doesn't mean that the Fed won't or shouldn't rhetorically sound tough at times, in the name of preventing inflationary expectations from becoming unmoored. But the bottom line is that as long as there is a huge gulf between the negative terms of trade cup and the wage inflation lip, the Fed should talk about the cup and focus on the lip.

Wages Are Not Chasing Headline Inflation Higher

Bottom Line
Which means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period. Yes, I know that many believe that it is somehow sinful or immoral for the Fed to hold nominal short rates so low as to render the real return on cash to be negative. I don't buy this proposition. Why should it be that those who only have labor to offer to the market should not be made whole for a negative terms of trade shock, while those with cash should be made whole?

In the wake of a negative terms of trade shock, all factors of production should absorb a negative hit to their real returns. If indexing to headline inflation is inappropriate for labor wages and capital's profits, why should cash yields be indexed by the Fed?

And what if holders of cash don't like it? Then they can step out on the risk spectrum. After all, a basic of capitalism is no risk, no reward. And temporarily higher inflation in the wake of a negative terms of trade shock is an efficient lubricant for the economy to make the necessary real adjustments.

Paul McCulley
Managing Director
June 16, 2008


Sunday, June 22, 2008

GDX 1 year TA

1 year chart of the Market Vectors Gold Mining Index (GDX), click below to enlarge:

Peter Schiff on the Federal Reserve

The Fed Unreserved

Peter Schiff
Jun 21, 2008

Throughout history, governments have always used crises to justify blatant power grabs. Often the crisis subsides, but the expanded government powers remain. In America this week, the tendency came into sharp focus. Congress signaled that it is preparing to perpetuate the Bush Administration's domestic wiretapping program, and has even abandoned the pretense that warrantless surveillance be confined to terrorism. Similarly, even though our financial crisis has yet to reach full flower, Treasury Secretary Paulson announced plans to give the Federal Reserve new and explicit powers to oversee and regulate the financial services industry. However, a sober look at his plan reveals that it is tantamount to giving the fox complete autonomy to guard the henhouse.

What few economic leaders have acknowledged is that the Federal Reserve itself is responsible for the real estate and credit bubbles, which are the source of our current troubles. By keeping interest rates too low for too long, the Fed ignited a speculative fever and engendered a disregard for risk management that pushed asset prices above rational levels. Should we blame the private sector for taking advantage of all the cheap credit, or the Federal Reserve for supplying it? If a kindergarten teacher passes out handfuls of Pixie Sticks, and then leaves her classroom unattended for several hours, should we blame the five year olds for the hysteria that ensues?

The reality is that we should be restricting, rather than expanding, the powers given to the Federal Reserve. Since Greenspan, Bernanke and company have already inflicted so much damage with the weapons already in their arsenal, why provide them with heavier artillery? Only in Washington do those who screw up get rewarded for doing so.

Since the Fed has demonstrated complete incompetence at setting interest rates, why not return that function to the market? Instead of allowing the Fed to inflict unbridled havoc on our economy, why not re-impose some discipline? Instead of looking for new ways to regulate Wall Street, why not find an old way to regulate the Fed? Actually there is a simple answer to all of these questions; it's called the gold standard.

In his speech outlining these proposals, Paulson stated that during the past fifty years the performance of the U.S. economy has been second to none. I do not know what planet Paulson has been living on these past fifty years, but it is certainly not Earth. If Paulson were referring to the prior fifty year period, from 1908-1958, his statement would have been correct. But from 1958 to 2008, the U.S. economy has blown a lead even greater than the one the Lakers enjoyed over the Celtics in game four of the just concluded NBA Finals. In fact, it may well qualify as the biggest economic choke in history.

In 1958 the U.S. enjoyed a standard of living so unmatched that the rest of the world still lived in the Stone Age by comparison. Our per capita income was so far ahead of our nearest rival that it seemed impossible that any other nation would ever catch up. Today not only is per capita income in the U.S. barely in the top ten, but we are being rapidly overtaken by countries that up until a few years ago were barely discernable in our rear-view mirrors. When it comes to economic performance during the past 150 years, the U.S. is the Big Brown of economies. 1858-1908 was the Kentucky Derby, 1908-1958 was the Preakness, and 1958-2008 was the Belmont Stakes.

Not only did the U.S. surrender a substantial lead, but in many respects our current standard of living is lower than the one our grandparents enjoyed. Sure we have a few more gadgets, larger televisions and more prevalent air conditioning, but the quality of life has actually declined. In the 1950's, the average man earned enough money to fully support a wife and four kids, all while saving for retirement and paying off his mortgage. Today the average man can barely support himself. It takes two bread winners in most families to make ends meet, and that is assuming only two children. Even with both parents working, the typical mortgage on the family home will never be paid off and retirement is now a pipe dream. Flush with high pay, low debt, and a strong currency, the Ugly American in the 1950's could vacation in Europe like a king. Now we can now barely afford the gas for a day trip to a Six Flags theme park.

If Paulson can be so completely clueless regarding the Fed's role in the current debacle and in America's economic stumbles over the past two generations, why would anyone place any faith in his proposed remedies? In fact, an unaccountable and unelected Federal Reserve, which nonetheless has lately proven to be as politically craven as any two-bit politician, does not hold the keys to our economic revival. However, with its increased willingness to rescue the big financial firms from their own excesses, perhaps Paulson sees an expanded Fed as the best way to ensure the continued prosperity of his former pals on Wall Street.

Jun 20, 2008
Peter Schiff

Thursday, June 19, 2008

Bank of England sounds the Alarm

A great article from the UK's Telegraph highlighting the Bank of England's recent sounding off of alarm bells.


Things will get worse, warns Bank of England governor Mervyn King

By Edmund Conway and Robert Winnett

Families will see their standard of living stagnate this year while the value of their homes will fall further, the Bank of England Governor has warned. The coming months represent the biggest challenge for the economy for two decades, Mervyn King said, adding that some households will find them "particularly difficult".

In his most sombre message yet, Mr King said families were being squeezed hard by higher electricity and food prices on the one hand and slowly-increasing wages on the other.

The Chancellor of the Exchequer Alistair Darling, the Lord Mayor of the City of London, Alderman David Lewis, and the Governor of the Bank of England Mervyn King
Alistair Darling (left), the Lord Mayor of the City of London, Alderman David Lewis, and the Governor of the Bank of England Mervyn King

He told Alistair Darling and leading City dignitaries in London that the experience would be even tougher than the credit crunch, and warned that the "era of cheap mortgage finance... is over".

Mr King said: "This year our real take-home pay will rise at a slower pace than national productivity. Rising fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this year.

"It will not be an easy time, and I know that some families will find it particularly difficult."

In a blow for The Chancellor of the Exchequer, beside whom he delivered his speech at the annual Mansion House banquet last night, he warned: "The squeeze on real take-home pay will arguably be an even more significant restraint on consumer spending this year than the credit crunch.

"And it will affect the housing market too – lower demand in the high street will go hand in hand with lower demand in the property market." The Governor said house prices would fall in comparison to families’ earnings - an indication that their values have some way further to drop.

The speech was the most austere yet delivered by Mr King, who has previously warned that the so-called NICE decade (standing for non-inflationary consistent expansion) was over. The comments come in a week inflation rose to its highest level in 15 years, outpacing wages and threatening to reduce Britons' standard of living.

Mr King was forced earlier this week to write his second letter of explanation to Mr Darling for allowing inflation to rise above target. However, the Bank Governor urged families not to panic, reassuring them that this tough period would be short-lived. "These changes to our spending power and to the housing market are 'real' shifts that, although not easy to accept, we cannot side-step," he said. "We face the most difficult economic challenge for two decades. But I am confident that we can meet it. Inflation will fall back and growth will recover."

He and the Chancellor urged families not to demand higher wages and push prices even higher. In his first address to the masnion House event since becoming Chancellor, Mr Darling dismissed suggestions that the economy is heading for a 1970s-style meltdown.

But he warned that inflation did need to be brought under control and that people should exercise restraint in pay negotiations to avoid the current economic woes deepening.

On Wednesday it was disclosed that the Shell tankers' driver strike was called off following a 14 per cent pay rise offer. Mr Darling said: "I have seen reports suggesting inflation figures show we are returning to the days of the 70’s. "They are wrong, both in the nature of the problems we face and also in the scale. Today’s inflation must be tackled. We cannot be complacent. "But in comparison to the 1970s when it reached over 26 per cent, it remains low. Even in 1991, it was still at 8 per cent." The Chancellor said that inflation was rising as a result of global economic turbulence which was rapidly pushing up the price of food and energy.

Consumers have been warned that gas and electricity bills could rise by up to 40 per cent this winter. However, Mr Darling urged workers not to make matters worse by pushing for inflation-busting pay rises. "Continued restraint on pay is required from both the public and private sector," he said. "We must recognise the need to reward efforts of people who work hard.

"But to return now to inflationary pay settlements would undermine rather than raise people’s living standards with a damaging circle of wage increases eroded by steadily rising prices. "We must never return to those days." The warning was sounded amid growing disquiet from public sector unions over the pay increases - which are now below inflation - agreed with the police, teachers, nurses and council workers. Many are now threatening strike action and are demanding that the pay agreements are renegotiated. There are growing concerns the resolution of the Shell dispute could encourage further industrial action.

The Government could face a major challenge next week when Unison announces the results of a strike ballot among 600,000 council workers. The workers have rejected a 2.45 per cent pay increase. In a BBC interview, Mr Darling repeatedly declined to reject suggestions that Britons would face a decline in living standards this year - as their wages would rise by less than the cost of living. He also insisted that the economic pain was likely to prove short-lived. "There are very good reasons for people to be optimistic," he said. "Yes it’s tough, but we can get through it."

Tuesday, June 17, 2008

Euro Zone, a Continent Divided

Support for euro in doubt as Germans reject Latin bloc notes

Ambrose Evans-Pritchard

Notes printed in Berlin have more currency for bank customers who fear a 'value crisis' Ordinary Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal, raising concerns that public support for monetary union may be waning in the eurozone's anchor country.

German bank customers are favouring notes that start with the distinctive ‘X’ serial numbers, which show they have come from Berlin Germany's Handelsblatt newspaper says bankers have detected a curious pattern where customers are withdrawing cash directly from branches, screening the notes to determine the origin of issue. They ask for paper from the southern states to be exchanged for German notes.

Each country prints its own notes according to its economic weight, under strict guidelines from the European Central Bank in Frankfurt. The German notes have an "X"' at the start of the serial numbers, showing that they come from the Bundesdruckerei in Berlin. Italian notes have an "S" from the Instituto Poligrafico in Rome, and Spanish notes have a "V" from the Fabrica Nacional de Moneda in Madrid. The notes are entirely interchangeable and circulate freely through the eurozone and, indeed, beyond.

People clearly suspect that southern notes may lose value in a crisis, or if the eurozone breaks apart. This is what happened in the US in the Jackson era of the 1840s when dollar notes from different regions traded at different values. "The scurrilous idea behind this is that if the eurozone should succumb to growing divergences, then it is best to cling to most stable countries," said the Handelsblatt.

"There are no grounds for panic. The Italian state is not Bear Stearns," it said. Germans appear to be responding to a mix of concerns. Many own property in Spain or Portugal and have become aware of the Iberian housing slump. A spate of news articles in the German press has begun to highlight the economic rift between the North and South of eurozone. There is criticism of comments from Italian, Spanish, and French politicians that threaten the independence of the ECB, viewed as sacrosanct in Germany.

But the key concern appears to be price stability. Germany's wholesale inflation rate reached 8.1pc in May, the highest level in 26 years. The cost of bread, milk and other staples has rocketed, adding to the sense that prices are spiralling out of control. Inflation touches a very sensitive nerve in Germany. Holger Schmeiding, from Bank of America, said the country had suffered two traumatic sets of inflation in living memory, first in Weimar in 1923 and then in 1948.

"People suffered a 90pc haircut on financial assets in the currency reform of 1948. The inflationary effects of two world wars were catastrophic," he said. Many have kept a stash of D-Marks hidden in mattresses to this day. A recent IPOS poll showed that 59pc of Germany now had serious doubts about the euro.

Monday, June 16, 2008

Foreign Purchases of US Assets up in April

Net Foreign Purchases of U.S. Assets Up $115.1 Billion in April

By Rebecca Christie

June 16 (Bloomberg) -- Foreign buying of U.S. financial assets rose more than forecast in April to an 11-month high as investors snapped up Treasuries and corporate debt.

holdings of equities, notes and bonds increased by a net $115.1 billion, from $79.6 billion the previous month, the Treasury Department said today in Washington. Including short- term securities such as Treasury bills and non-market trades such as stock swaps, foreigners bought a net $60.6 billion, compared with net sales of $48.7 billion a month earlier.

After the near-collapse of Bear Stearns Cos., which necessitated a Federal Reserve-engineered rescue of the Wall Street firm, the report indicates private investors regained confidence in U.S. assets. The Fed continued to lower interest rates in April to ease a credit crunch and boost growth, stoking investor demand for U.S. government debt.

``Foreign investors fled U.S. money markets in March as concerns about bank counterparty risk spiked,'' said Zach Pandl, an economist at Lehman Brothers Holdings Inc., before the report. ``The significant improvement in market conditions since then likely encouraged flows to return.''

Economists predicted international investors would buy a net $63.3 billion of long-term securities in April, based on the median of 10 estimates in a Bloomberg News survey, down from a previously reported gain of $80.4 in March. Including short-term securities, total net purchases were forecast to be $42.5 billion, according to the median of four estimates.

Purchases of all U.S. financial assets by foreign governments totaled $41.3 billion after a $48.1 billion net gain in March, the report showed. Total purchases of Treasuries increased a net $80.3 billion, compared with a net gain of $53.6 billion in March.

The Treasury's reporting on long-term securities captures international purchases of government notes and bonds, stocks, corporate debt and securities issued by U.S. agencies such as Fannie Mae and Freddie Mac, which buy mortgages.

The U.S. dollar rose 0.2 percent in April, according to the Federal Reserve trade-weighted index of the currency, the first monthly advance since December. Today's report showed international demand for Treasuries increased by $3.3 billion in April, compared with a gain of $27.8 billion in March. Official purchases of Treasuries rose by $13.8 billion, after net sales of $3 billion the previous month.

The yield on the benchmark 10-year note averaged 3.64 percent in April, compared with 3.48 percent the previous month. Holdings of Fannie Mae, Freddie Mac, and other so-called agency debt rose a net $15.3 billion after an $18.7 billion net gain in February.

International sales of U.S. stocks totaled a net $15.9 billion, compared with net purchases of $10.8 billion in March. The
Standard & Poor's 500 Index rose 4.8 percent in April, the first increase since October. The Dow Jones Industrial average was up 4.5 percent in April, the biggest monthly increase in a year. U.S. investors bought a net $10.3 billion of overseas assets in April, after purchases of a net $1.1 billion the month before. Private investors bought a net $63.5 billion in long-term securities, compared with a net $30.5 billion in March. Foreigners accumulated a net $25.1 billion of corporate bonds, compared with net sales of $4.6 billion a month earlier.

Some economists say the difference between the trade gap and securities purchased by foreigners is an indicator of how easily the U.S. can finance its external obligations. The U.S.
trade deficit widened in April, to $60.9 billion, more than the $60 billion economists had predicted, from $56.5 billion in the previous month.

Japan, the largest foreign owner of U.S. Treasury securities, decreased its holdings by $8.5 billion to $592.2 billion. China, the second-largest holder, increased its holdings by $11.4 billion to $502 billion, the Treasury said. The U.K., which through London acts as a transit point for international investors, especially those in the Middle East, bought a net $48.5 billion, bringing holdings to $251.4 billion.

To contact the reporter on this story:
Rebecca Christie in Washington at

Saturday, June 7, 2008

Don Coxe: Basic Points May/June 2008

The May/June 2008 edition of Don Coxe's Basic Points can be found on page #15 of this report.

This report along with this friday's conference call by Mr. Coxe is all a commodity investor needs at this point to stay on track.


Wednesday, June 4, 2008

Canadian Financials Bear TA

Below is a 6 month chart of the Canadian Financials Bear Fund (HFD.TO).

Comprised largely of the Big 5 Canadian banks, the HFD is a double inverse fund on the verge of a possible breakout.


Oil Market Manipulation

Thanks to for this piece from Mexico Mike who makes a valid and critical point:

Investigating the oil market manipulators

by Mexico Mike

CNN ran a show last night on the story of high oil prices and a big part of the commentary focused on the reported investigation through the CFTC regarding alleged oil price manipulations. This was also discussed recently on CNBC during prime time.

I find it ironic that the Gold Anti-Trust Action Committee GATA has been pounding the table for an investigation into ongoing manipulation on the precious metals for years, and along the way has presented some pretty compellingevidence that at least warrants consideration, even for the most skeptical observers. Yet the response has been an abrupt dismissal of all that is brought to light. Even worse, we put up with the 'tinfoil hats' references and the entire story is a wall-to-wall joke from anyone that does care to mention it.

Okay, so there is no manipulation, and those that dare to suggest it are merely conspiracy nuts. So why is the investigation in the oil sector a hot news story with frequent discussion and analysis? The hypocrisy is astounding. Where are the tinfoil hats on the CNBC panel?

I was hoping for some kind of rebuttal regarding the whole concept of manipulation in oil, but instead we can sit back and listen to the crickets chirp. It all comes down to whose oxe is gored. The big money has been short gold all the way up, and there is cheerleading from the media at every downtick for gold. Conversely, the big money has been fading the oil move higher as an irrational move that is unsustainable.

Now that oil is making new highs on a daily basis, some of these parties are starting to squirm. Hence the investigation... And the unprecedented willingness of the CFTC to acknowledge the investigation before it had been concluded should indicate very clearly exactly which side of the debate they are leaning towards. The same agency put out a blatant whitewash on the issue of silver manipulation just a few weeks earlier, yet now they seem to be throwing their influence and moral authority on the line with very suggestive commentary that the allegations are legitimate.

I enjoyed a lively debate with a number of analysts during a recent property tour in Mexico, and most of them politely suggested I was out to lunch when I stated that the metals were heavily manipulated. The moderates would only acknowledge that all markets are manipulated and nothing special was out of line with gold and silver.

Most were unwilling to even consider in our markets that anything unsavory could be ongoing. Now that the genie is out of the bottle, maybe some more balanced consideration may be directed towards what GATA has been saying all along. I do not expect that the talking heads will ever give us the time of day, but I do think there have to be some neutral parties out there that will at least raise serious questions to review the body of evidence.

Even though I personally believe that there is no way that the oil markets can be rigged through manipulation to create such a move higher, this could generate just the kind of attention we need to shine the light on the precious metals, and I suspect there will be a flurry of cockroaches scrambling for cover if that were to happen.