Corn Facts

* Farmers grow five times as much corn as in the 1930s on 20% less land.

* Reduced tillage and other farm management practices have reduced soil erosion 43% in 20 years.

* Farmers produce 70% more corn per pound of fertilizer than as recently as the 1970s.

* Less than 1% of the nation's corn crop is sweet corn bought frozen, canned or on the cob at the grocery store; the vast majority is commercial "field corn" used for other purposes.

* The 2008 corn crop was worth $52 billion.

* Only 19 cents of our food dollar goes to farmers, and less than a nickel goes to corn farmers.

* If corn prices were rising as fast as oil, a bushel would sell for $13.50 today instead of around $3.50.

* By the end of 2008, the amount of ethanol produced domestically in a month nearly equaled the amount of gasoline refined from the oil imported from Saudi Arabia.

* Half of the U.S. corn crop goes to feed cattle, pigs and poultry, a quarter goes to ethanol and 20% is exported. The rest goes to make food ingredients, chemicals, fabrics and plastic.

* One in every five rows of corn is exported.

* Individuals or families own 82% of corn farms; another 6% are family-held corporations.

* Increased ethanol production will add more than $1.7 trillion to the economy from 2008 to 2022.

Taking Down Michael Masters

Scott Irwin takes down Michael Masters

Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply."

An important and related point is that a very large number of futures and derivative contracts can be created at a given price level. In theory, there is no limit. This is another way of saying that flows of money, no matter how large, do not necessarily affect the futures price of a commodity at a given point in time. Prices will change if new information emerges that causes market participants to revise their estimates of supply and/or demand. Note that a contemporaneous correlation can exist between money flows (position changes) and price changes if information on fundamentals is changing at the same time. Contrary to what Mr. Masters asserts, simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen substantially does not necessarily prove anything. Mr. Masters is likely making the classical statistical mistake of confusing correlation with causation. One needs a test that accounts for changes in money flow and fundamentals before a conclusion can be reached (more on this later).

Mr. Masters' second error is to argue that index fund investors artificially raise both futures and cash commodity prices when they only participate in futures and related derivatives markets. In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets. This is sensible because trading can be conducted more quickly and cheaply in futures compared to cash markets. However, equilibrium prices are ultimately determined in cash markets where buying and selling of physical commodities must reflect fundamental supply and demand forces. This is precisely why all commodity futures contracts have some type of delivery or cash settlement system to tie futures and cash market prices together. (This is not to say that delivery systems always work as well as one would hope. See my earlier post here.)

It is crucial to understand that there is no change of ownership (title) of physical quantities until delivery occurs at or just before expiration of a commodity futures contract. These contracts are financial transactions that only rarely involve the actual delivery of physical commodities. In order to impact the equilibrium price of commodities in the cash market, index investors would have to take delivery and/or buy quantities in the cash market and hold these inventories off the market. There is absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities. Furthermore, the scale of this effort would have to be immense to manipulate a world-wide cash market as large as the crude oil market, and there simply is no evidence that index funds are engaged in the necessary cash market activities.

This discussion should make it crystal clear that Mr. Masters is wrong to draw a parallel between current index fund positions and past efforts to "corner" commodity markets, such as the Hunt brother's effort to manipulate the silver market in 1979-80 . The Hunt brothers spent tens of millions of dollars buying silver in the cash market, as well as accumulating and financing huge positions in the silver futures market. All attempts at such corners eventually have to buy large, and usually increasing, quantities in the cash market. As Tom Hieronymus noted so colorfully, there is always a corpse (inventory) that has to be disposed of eventually. Since there is no evidence that index funds have any participation in the delivery process of commodity futures markets or the cash market in general, there is no logical reason to expect their trading to impact equilibrium cash prices.

A third error made by Mr. Masters, and unfortunately, many other observers of futures and derivatives markets, is an unrealistic understanding of the trading activities of hedgers and speculators. In the standard story, hedgers are benign risk-avoiders and speculators are potentially harmful risk-seekers. This ignores nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne Peck, and others, showing that the behavior of hedgers and speculators is actually better described as a continuum between pure risk avoidance and pure speculation. Nearly all commercial firms labeled as "hedgers" speculate on price direction and/or relative price movements, some frequently, others not as frequently. In the parlance of modern financial economics, this is described as hedgers "taking a view on the market." Just last week, when commenting on new survey results of swap dealers and index traders , the CFTC stated that, "The current data received by the CFTC classifies positions by entity (commercial versus noncommercial) and not by trading activity (speculation versus hedging). These trader classifications have grown less precise over time, as both groups may be engaging in hedging and speculative activity." (p. 2)

What all this means is that the entry of index funds into commodity futures markets did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure risk-seeking speculators, but instead the funds entered a dynamic and ever changing "game" between commercial firms and speculators with various motivations and strategies. Since commercial firms have the considerable advantage of information gleaned from their far-flung cash market operations, they have traditionally dominated commodity futures markets and speculators have tended to be at a disadvantage. (If you are skeptical, I recommend reading the classic study by Michael Hartzmark about who wins and loses in futures markets.) In this light, entry of large index fund speculators has the potential to improve competition in commodity futures and derivatives markets, particularly as index funds become smarter about moving in and out of their positions.

I believe the points made here already build a persuasive case against Mr. Masters and his bubble theory. But there is more. It is possible to conduct a formal test of the hypothesis that money flows from index funds aided and abetted the recent boom in commodity prices. This can be done by running what are known as "Granger causality" tests between futures price changes and index fund position changes in commodity futures markets. To begin, the evidence available before the current commodity price boom ( summarized here ) would lead one to be highly skeptical of the hypothesis that positions for any group in commodity futures markets consistently lead futures price changes (this will not be true for individual traders with real skill). The CFTC has conducted thorough Granger causality tests in the crude oil futures markets, and guess what? They found absolutely nothing using non-public data on the daily positions of commercial and non-commercial traders. I am working with a Ph.D. student here at the University of Illinois to extend this testing to other commodities using the same daily database of trader positions, including those for index fund traders. As you might guess, I do not expect to find much evidence of a connection between index fund trading and futures price movements in other commodity markets. If we find anything, I expect the relationship to be small and fleeting.

While it is always possible to dither over the power of Granger causality tests or whether the specifications adequately control for changing fundamentals, I think most unbiased observers will reach the same conclusion: there is virtually no hard evidence to date of a link between index fund investment and commodity price changes. Isn't it about time for Mr. Masters to exit stage left?

Understanding Commodity Arbitrage

from Econbrowser:

Commodity arbitrage

Scott Irwin is the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. He has been doing some fascinating research on the relation between spot and futures prices in agricultural markets that may shed some light on the role of speculation in recent commodity price movements. We are delighted that Scott agreed to share some of the results of his research with Econbrowser readers.

Commodity Arbitrage
by Scott Irwin

The performance of commodity futures markets during delivery periods is normally little-noticed and followed only by a few economists with an inordinate interest in these markets. However, that has changed in recent months due to skyrocketing interest in commodity markets in general and the odd behavior of cash and futures prices during delivery periods for grain futures contracts at the CME Group (formerly the CBOT).

First, some background. Most storable commodity futures markets, such as those for corn, soybeans, and wheat, are still based on physical delivery. If I buy one December 2008 corn futures contract and hold the contract to the delivery period (normally the first half of the expiration month), then I, the "long," will receive 5,000 bushels of corn at one of the specified delivery locations from the "short" on the other side of the contract. The short (seller) must supply the corn either out of their inventory or purchase the grain in the cash market. It is important to note that the vast majority of futures contracts are offset before the delivery period and only a small percentage of futures contracts typically are settled by actual physical delivery. However, the delivery process is nonetheless essential as it ties the futures price to the cash price at delivery locations. In a perfect market with costless delivery at one location and one date, arbitrage should force the futures price at expiration to equal the cash price. Otherwise there would be a violation of the law of one price.

In reality, delivery on grain futures contracts is not costless (who really wants corn on a barge at an Illinois River shipping station) and complicated by the existence of grade, location, and timing delivery "options" that have a demonstrated value to sellers of contracts. So it is better to think of a zone of convergence between cash and futures prices during delivery periods, with the bounds of convergence determined by the cost of participating in the delivery process.

This is where things get interesting. The charts shown below are drawn from an ongoing research project to examine the delivery performance of CBOT grain futures contracts over the last several years. (My collaborators on the project at the University of Illinois are Darrel Good, Phil Garcia, and Eugene Kunda.)

The charts show the difference between cash and futures prices (the basis) on the first and last day of the delivery period for corn and wheat futures contracts expiring between December (Z) 2001 and March (H) 2008 and soybean futures contracts expiring between November (X) 2001 and March (H) 2008. (For those readers unfamiliar with the letter designations for contract months, the monthly codes can be found here.) As an example, the soybean delivery location basis for the November 2001 contract (in the Illinois River North of Peoria shipping zone) was -25.75 cents per bushel on the first day of delivery and -16.75 cents/bushel on the last day of delivery. Note that a negative basis means the futures price is greater than the cash price and a positive basis means that the futures price is less than the cash price. Also keep in mind that there are two delivery zones for corn, four for soybeans, and three for wheat. Convergence patterns at the presented location for a given commodity are representative of the convergence patterns at other locations.

In each of the three markets, convergence generally is within reasonable bounds through 2005 (ignoring problems created by hurricane Katrina in September 2005). Starting in early 2006, convergence performance deteriorates in all three markets, reaching a nadir in September (U) 2006 when the cash price of wheat ended up 90 cents below futures on the last day of the delivery period. Corn and soybean contracts recovered somewhat by late 2006 and early 2007, but wheat continued to perform very poorly. It is interesting to observe that these patterns reversed during the remainder of 2007 and early 2008. Now it is the soybean market that is performing the worst, with the cash price 85 cents below futures on the last day of the delivery period for the March (H) 2008 contract.

While the recent convergence failures are dramatic, in isolation each episode is not necessarily damaging to the overall economic functioning of the markets. The real economic damage is associated with increased uncertainty in basis behavior as markets bounce unpredictably between converging and not converging. This is damaging because, as first pointed out by Holbrook Working many years ago, basis in storable commodity futures markets should provide a rational storage signal to commodity inventory holders. If the difference between the current cash price and futures for later delivery is wide (cash well below futures) this should be a signal to store and vice versa. However, this depends on the signal being accurate. That is, the basis should narrow over time thereby earning "the carry" for someone holding stocks of the commodity and simultaneously selling the futures.

The following chart dramatically illustrates the deterioration in basis predictability for soybean futures contracts since 2006.

The x-axis measures the level of the delivery location basis on the day after the preceding contract expires (except new crop November contracts, which start on the first trading day of October). The y-axis measures the change in the delivery location basis from the day after the preceding contract expires to the first day of delivery. If delivery location basis is perfectly predictable, then all points will lie on a line with a slope of -1 that runs through the origin. In other words, if basis is -50 cents/bushel two months before expiration, the change in the basis over the subsequent two months should be +50 cents/bushel. The blue regression line indicates the soybean futures market performed reasonably well before 2006 compared to this theoretical benchmark. The red regression line shows the precipitous drop in basis predictability over the last two years. Not only does basis change by far less than the initial basis (slope = -0.36), the wide scatter of points indicates very little precision in predicting the change. More formally, R² is an indicator of hedging effectiveness and it drops from a respectable 78% pre-2006 to only 19% post-2006. I believe this is an underlying reason for much of the current uproar over convergence problems.

An obvious question is what caused this mess. One line of thinking is that this reflects a temporary imbalance in the markets due to the extraordinary structural changes going on in commodity markets. While it is certainly true that the markets have gone through once-in-a-generation changes in price levels, extraordinary tight supplies, and unprecedented speculative investment, this still does not answer why arbitrage was unable to bring cash and futures prices together during delivery. It is difficult to envision an increase in delivery costs that would explain the magnitude of convergence failure we have seen. Another line of argument is that the influx of investment in commodity futures by so-called long-only index funds has created bubbles in futures prices. Aside from the fact that there is a seller for every buyer of a futures contract, the fund/bubble argument has a difficult time explaining the fact that convergence problems do not have the same pattern over time in corn, soybeans, and wheat. The third line of argument is that contract specifications need to be changed to increase storage premiums paid by takers of delivery or that takers should be compelled to ship grain instead of holding it in storage. These may be useful changes, but it is not yet clear how these factors could explain the observed convergence failures.

Congress is now interested and the CFTC is holding a hearing on April 22^nd. Let's hope that cooler heads prevail and we seek a better understanding of the source of convergence problems before reaching conclusions about what changes are needed or mandated.

Speculation in Commodity Markets

from Econbrowser:

By Scott Irwin

Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois, and today offers some insights from his research on the current debate concerning commodity speculation.

Index Funds and Commodity Prices... Here We Go Again
by Scott Irwin

Some issues just will not go quietly into the night. The U.S. Senate's Permanent Subcommittee on Investigations released a report on June 23, 2009 concluding that excessive speculation by large index funds in the Chicago Board of Trade (CBOT) wheat futures market resulted in over-valued futures prices, a large "carry" in the futures price structure, and a wide divergence between futures and cash prices during the 2006 through 2008 period. These are serious charges, and judging by recent newspaper headlines, there is a receptive audience in the halls of Congress and on the part of some regulators.

If you read my previous Econbrowser posts on commodity markets ( here and here ) you should not be surprised to discover that I disagree with Subcommittee's conclusions. Rather than citing rigorous academic analysis of the problems in the CBOT wheat contract the Subcommittee chose to rely on finger-pointing by industry participants who were adversely affected by high prices and weak basis and on cursory analysis of temporal price, basis, and trading activity data. You can find an extended commentary on the Subcommittee report here by our research group at the University of Illinois.

To begin, the Subcommittee repeats the mistake of other "bubble" proponents by equating index fund money flows into wheat futures with demand for the physical commodity. Simply observing that large investment dollars flowed into the long side of the wheat futures market at the same time that futures prices rose substantially does not necessarily prove anything. Several recent studies use "Granger causality tests" and "cross-sectional" regression tests to establish that lagged position changes by any group, including index traders, do not help to forecast current futures price changes in a statistically significant manner (see our commentary and this paper for a brief review of the studies). This provides compelling evidence that index funds were not responsible for the run-up in grain and oilseed markets, particularly in the wheat market. Historically, price "spikes" have not been uncommon in the grain markets as market participants react to developments that are less permanent than anticipated. Such episodes are frequently attributed to speculation rather than the underlying fundamental factors responsible for the market situation.

If problems in the CBOT wheat futures market were not due to a speculative bubble in futures prices, then what was the problem? Our research at the University of Illinois pinpoints two major factors contributing to the lack of convergence between cash and futures price in wheat. The first factor is the tendency for spreads in the futures market to reflect a relatively high percent of full carry (contango) since 2006. The second factor is long-term structural deficiencies in the delivery system for CBOT wheat.

Large carrying charge markets contribute to lack of convergence by "uncoupling" cash and futures markets when futures prices are above cash prices. The delivery instrument for wheat was a warehouse receipt until recently when it was changed to a shipping certificate (starting with the July 2008 contract). Those longs who receive certificates or receipts from shorts in the delivery process are not required to cancel those instruments for shipment. The instruments can be held indefinitely with the holder paying "storage" costs at the official rates specified by the CBOT in contract rules. The taker in delivery (the long) may choose to hold the delivery instrument rather than cancelling the instrument by load out of physical grain if the spread between the price of the expiring and next-to-expire futures contracts exceeds the cost of owning the delivery instrument. Therefore, as the magnitude of the nearby spread exceeds the full cost of carry for market participants with access to low-cost capital, those participants can (and do) stand for delivery but do not cancel delivery certificates or receipts for load out. The lack of load out, then, means that deliveries do not result in cash commodity purchases by the taker that would contribute towards higher cash prices and better convergence.

The chart below illustrates the relationship between the magnitude of the carry in wheat and the basis (cash - futures price) at the primary delivery location for wheat, Toledo , on the first delivery date of each expiring wheat futures contract over March 2000 through July 2009. The percent of full carry is computed as (price of next-to-expire contract minus price of expiring contract)/(storage plus interest costs).

The chart is constructed so that the zero line for basis on the left y -axis scale corresponds to 80% of full carry on the right y -axis scale. While the pattern is not perfect, there is a consistent tendency towards poor convergence (wide basis) whenever the carry exceeds about 80% and better convergence when the carry is below 80%. Note that this pattern is evident not only during recent years but also in 2000-2001, when wheat experienced another period of non-convergence, albeit at much smaller basis levels. A similar relationship exists for corn and soybeans.

Of course, this only moves the debate back one step to explaining the large carrying charge in the wheat futures contract since 2006. The Senate Subcommittee concludes that the rolling of positions by index funds is responsible for the persistence of the large carry. Rolling refers to in dex funds entering market positions in the nearby contract and then moving the positions to the next contract before the maturity of the nearby contract. The evidence, however, does not support a conclusion that such rolling widened the spreads.

The following chart shows the behavior of nearby spreads for CBOT wheat during the first 13 business days of the calendar month prior to contract expiration for the March 1995 through March 2009 contracts. The time window for the analysis is centered on days 5 through 9, the time period of the so-called "Goldman roll" when index funds tend to roll their positions from the nearby to the next deferred contract.

The averages reveal a consistent increase in the size of the spread to the next contract (expressed as a percent of full carry) during "Goldman roll" days 5 through 9. However, the spike in the magnitude of the spread either disappears entirely or noticeably recedes during days 10 through 13, so rolling did not necessarily lead to a permanent increase in the magnitude of the spread. The spike in the magnitude of the spread during the roll period was also present long before convergence became an issue and before index funds had a major presence in these markets. This is not surprising since the time window when index funds roll to the next contract is also the same time period when many other traders roll their positions.

As noted above, the second factor contributing to recent convergence problems is underlying structural problems with the CBOT wheat delivery system. The fundamental problem is that changes in wheat production patterns, transportation logistics, and trade flows have left the contract with an increasingly narrow commercial flow of wheat to draw upon in the delivery process. For example, annual commercial shipments of wheat at facilities regular for CBOT delivery averaged only 28 million bushels over 2000-2008. By comparison, annual commercial shipments for corn and soybeans at delivery facilities averaged of 260 and 170 million bushels, respectively, over the same time period. This raises substantial doubts about the representativeness of Chicago and Toledo as wheat pricing and delivery points. Furthermore, there is a constant potential for congestion in the delivery process of CBOT wheat futures and the attendant distortion of cash and futures prices.

The underlying structural problems were generally ignored until recently when additional delivery locations were added by the CBOT starting with the July 2009 contract. Whether these additional wheat delivery locations will contribute to improved convergence performance is debatable due to the "safety valve" nature of the new location price differentials. Early evidence from the expiration of the July 2009 CBOT wheat contract is not encouraging.

Fundamental questions still remain regarding the performance of the CBOT wheat futures contract. First, what explains the increase in the level of carrying charges in the wheat futures markets since 2006? I believe it is likely a combination of CBOT contract storage rates that lagged market rates, congestion in the delivery process, and an increase in risk that had a large impact on stockholding behavior. Second, why does t he CBOT wheat contract, the most popular wheat contract in the world, appear to be widely used to trade "wheat" generically when the delivery market locations make the contract a soft red winter wheat contract at maturity? To the extent that world wheat and soft red winter wheat supply and demand fundamentals diverge, this can lead to a systematic tendency towards poor convergence performance. Third , what explains the seemingly anomalous behavior of commercial grain firms (e.g. ADM , Bunge , and Cargill ) during recent episodes of non-convergence? These firms are "regular" for delivery and can create delivery certificates virtually at will. As Craig Pirrong noted recently, it is not clear why these firms have apparently left so much money on the table by not arbitraging the very large differences between cash and futures prices. Understanding the motivation and strategies of these firms would be a far more informative line of inquiry than the current obsession with index funds.

Federal Reserve Paper Says Speculators Not Driving Oil Prices

from the New Republic:

Not according to a Federal Reserve paper released today. The study, written by George Korniotis, looks at a number of different factors that could suggest speculators' influence on commodity prices, but finds little evidence that any of them have been at work.

First, we should see a break-down in the correlation of price changes between tradable and non-tradable commodities once speculators started trading commodity futures in larger volumes at the beginning of this decade. (The theory being that speculation wouldn't affect the prices of non-tradable commodities):

I test the comovement hypothesis by studying the time patterns of metals with and without futures contracts. Over the period 1991 to 2008, I find that the correlation of metal price growth rates was consistently positive and did not decrease after 2000.

Second, Korniotis thinks that the big jump in nearly all commodity prices earlier this decade can be explained by the surge in global economic growth:

I use the world GDP growth rate to capture world economic activity. I find that world growth rate is positively correlated with metal price growth. Also, similar to metal price growth rates, world growth started to steadily rise after 2002. Therefore, accounting for world growth reduces the statistical significance of the structural break in metal spot prices.

(If you're unfamiliar with the term, the easiest way to think about a structural break is to imagine a smooth looking chart of stock prices or population growth, etc. which all of a sudden jumps to a new level. It typically means that something about the state of the world has changed. Here's a nice example.)

Third, Korniotis finds that there's no relationship between the returns of the S&P Goldman-Sachs Commodity Index--which he argues is a proxy for profits earned by investors--and commodity price changes. And fourth, Korniotis tests the theory that commodity suppliers could be affecting prices by hoarding inventories and then entering into futures contracts with speculators:

My analysis finds no evidence of physical hoarding. In particular, inventory growth is negatively correlated with price growth. Also, this negative relationship is present even after 2002.

This first chart from the paper shows the quarterly annualized growth rates in spot (i.e., current rather than futures) prices for traded and non-traded metals. The shaded area is the time period when prices accelerated upward:

And this next chart shows the annual correlations across all metals (solid line) and between traded and non-traded metals (dashed line) and that they have remained fairly constant over time:

While this is all circumstantial evidence, it should give the CFTC at least some pause before going ahead with stricter limits on speculative activity. On the other hand, there are some very suspicious signs right now that hoarding is influencing oil prices (and which are too recent to appear in the Korniotis paper). From Paul Krugman:

This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up.

Now, “speculation” isn’t a synonym for “bad”. If the underlying assumptions that seem to have been driving oil markets were right — namely, that a vigorous recovery is just around the corner, and demand will shoot up soon — then it would be perfectly reasonable to accumulate oil inventories right now. But those assumptions are looking less reasonable by the day.

Since this is such a contentious issue these days, it's also worth pointing out that the paper doesn't necessarily represent the views of the Fed and Ben Bernanke, just the author.

--Zubin Jelveh

New Uptrend, Fresh High for Treasuries

We’ve seen a new high today for treasuries, and a solid uptrend with no end in sight. This is a sign of fear in the markets.

Rebounding Stocks

Collapsing Crude

Stocks Have Been In a Downtrend for Past Month

U Mich Consumer Sentiment Falls to Lowest Since March

July 10 (Bloomberg) -- Confidence among U.S. consumers fell more than forecast this month, reflecting unemployment approaching 10 percent and higher gasoline prices.

The Reuters/University of Michigan preliminary index of consumer sentiment decreased to 64.6, the lowest since March, from 70.8 in June. During the expansion that began in late 2001 and ended in December 2007, the index averaged 89.2.

Unemployment last month rose to the highest level since 1983 while lower home values and rising gasoline costs are eroding Americans’ wealth. The report signals that consumer spending, which accounts for about 70 percent of growth, may remain subdued even as the economy starts to recover.

“It’s a reality check,” said Jonathan Basile, an economist at Credit Suisse Holdings Inc. in New York, who had predicted the index would drop. “It speaks to job and income concerns. This suggests a sluggish profile for consumer spending.”

The confidence index was forecast to dip to 70, according to the median of 59 economists surveyed by Bloomberg News. Estimates ranged from 65 to 72. The measure averaged 63.8 in 2008.

Stocks fell after the report on concerns the economic recovery will be delayed. The Standard & Poor’s 500 Stock Index was down 0.3 percent to 879.78 at 10:51 a.m. today in New York. The index is still 30 percent higher than on March 9, when it hit 676.53, the lowest level in more than 12 years.

The index of consumer expectations for six months from now, which more closely projects the direction of consumer spending, plunged to 60.9, the biggest drop since October, from 69.2.

Dollar, Yen Rise

Dollar is trading in a very tight range like a yo-yo.

July 10 (Bloomberg) -- The yen and Treasuries rose on speculation the global recovery is faltering while stocks fell in Europe after Renault SA Chief Executive Officer Carlos Ghosn ruled out an economic rebound before 2011.

The yen strengthened against all 16 most-traded currencies as of 12:48 p.m. in London, gaining 1.1 percent versus the euro and 0.4 percent compared with the dollar. The Dow Jones Stoxx 600 Index of European shares slipped 0.7 percent, extending its fourth weekly drop, the longest streak since March.

China’s exports declined for an eighth month, the state-run Xinhua News Agency cited customs data as showing, underscoring the economy’s dependence on government spending to boost growth. Renault’s Ghosn said on Europe1 radio that next year will be “as difficult as 2009.” The global economy will shrink 1.4 percent this year before expanding 2.5 percent in 2010, the International Monetary Fund said July 8.

“Divergent indications from data will cloud the picture and keep investors on the defensive in the near term,” Morgan Stanley currency strategists Sophia Drossos in New York and London-based Emma Lawson wrote in a report. “The yen is likely to be the biggest beneficiary in such an environment.”

Futures on the Standard & Poor’s 500 Index retreated 0.8 percent, indicating the benchmark gauge for U.S. equities may extend its fourth straight weekly decline.

Stocks Weak, Treasuries Rise!

U.S. stock futures declined Friday as worries over earnings and the economy were back in the spotlight.

Stocks Weak -- will we hold above support?
Treasuries Rise

Inflation is Back... On Import Prices!

from Bloomberg:
Prices of goods imported into the U.S. rose in June for a fourth straight month as oil costs jumped by the most in a decade.

The 3.2 percent gain in the import price index followed a revised 1.4 percent increase the month before that was larger than previously estimated, according to a Labor Department report today in Washington. While prices excluding fuels rose 0.2 percent, they were down a record 6.5 percent from June 2008.

Rising commodity costs will hurt company profits because the worst recession in half a century has made it difficult for businesses to pass on expenses to customers. Projections for a slow economic recovery and sluggish job market indicate inflation pressures will continue to be subdued.

“You can’t ignore the amount of slack in the economy,” Ellen Zentner, senior U.S. macroeconomist at Bank of Tokyo- Mitsubishi UFJ Ltd. in New York, said before the report. Referring to Federal Reserve policy makers, she said, “how much can they let the possibility of a resurgence in inflation sway them when they’re starting at such a high unemployment rate and such low capacity utilization?”

Not All Derivatives Are to Blame For the Financial Crisis

from WSJ:
Any doubt about how broadly U.S. corporations rely on fancy financial instruments vanishes with a look at who's lobbying Congress to forestall tougher regulation.

Companies from Caterpillar Inc. and Boeing Co. to 3M Co. are pushing back on proposals to regulate the over-the-counter derivatives market, where companies can make private deals to hedge against sudden moves in commodity prices or interest rates.

Many in Congress blame such instruments for exacerbating the financial crisis last fall. To fix the problem, a White House plan unveiled last month calls for more of the trades to take place on exchanges where regulators can monitor them, and requires dealers -- and ultimately companies -- to put more money aside to secure against big losses if trades turn bad.

This naturally has Wall Street in a stir, but it has also sent dozens of big manufacturers and other major corporations scurrying to Washington.

Caterpillar, which uses derivatives to offset increases in the price of copper, says new regulations may drive U.S. companies to seek financing overseas.

MillerCoors LLC, Bayer AG's U.S. unit., and Delta Air Lines are among those lobbying on derivatives, which they use to manage fluctuations in materials prices, commodities, fuel, interest rates and foreign-currency swings.

At least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives, according to a Wall Street Journal analysis of lobbying disclosure forms filed through April.

That's more than triple the 14 nonfinancial companies that lobbied on derivatives in all of 2008 and zero in 2005. The figures include only companies that specifically name derivatives as a lobbying issue.

"Not all derivatives have put the financial system at risk and they should not all be treated the same," Janet Yeomans, treasurer of 3M, wrote in a letter to Sen. Mike Crapo (R., Idaho).

The companies argue the White House plan will make it more expensive to manage risks and force them to put aside cash as collateral that could otherwise be used more productively.

Treasury officials say their aim is to prevent another financial meltdown caused by hidden exposure to derivatives risk.

The issue will be fleshed out Friday as lawmakers question Treasury Secretary Timothy Geithner in a joint hearing hosted by the House Financial Services and House Agriculture committees as they grapple with crafting legislation. Some lawmakers say they hear the concerns and fear the new rules will hurt American companies, but there are others who want to push for more regulation.

Companies use derivatives to hedge risk. A company that borrows money at a variable interest rate might buy instruments to turn the borrowing into fixed-rate debt. Others use derivatives as protection against swings in currencies or the price of commodities such as food and oil.

Lobbyists say at least 90% of Fortune 500 companies use over-the-counter derivatives.

The administration's proposal calls for all "standard" derivative contracts to be cleared through a central body and traded on an exchange or equivalent electronic platform.

The clearinghouse would require daily pricing of the assets, which could require companies to post additional collateral, in the form of cash or short-term securities. Customized contracts would be permitted, but the proposal would require higher levels of capital to secure against risks.

Nonfinancial companies say it's unfair for them to be put in the same boat as Wall Street speculators, some of whom use derivatives to make bets on market movements. They also say they typically have collateral backing the risk and standardized contracts aren't necessary.

Chesapeake Energy said it had $6.3 billion in over-the-counter derivatives as of June 2008, against which it posted $11 billion in collateral, backed by letters of credit and mortgages on its gas and oil properties.

"This is how most end-users utilize this market and, as a result, help alleviate systemic risk," Chesapeake said in a letter to the Treasury Department.

Energy companies are particularly worried because the swings in oil and gas prices are so wide. Barry Russell, president of the Independent Petroleum Association of America, warns that restricting hedging would have "a devastating impact."

The National Association of Manufacturers has intensified its meetings with lawmakers, officials said, as has the Business Roundtable and U.S. Chamber of Commerce.

At a recent hearing, Sen. Crapo said he agrees regulation is needed to protect the economy against systemic risk, but "if Congress overreaches ... I believe there could be very significant negative implications on how companies manage risk."

Link to original

Dollar Takes A Hit

...but still appears to be trading with recent ranges. Still, the bearish maribozu candle today is a big one! I'm surprised the crude oil hasn't surged today!

Treasuries Grind Lower, Off the Deep End Following Auction

Interesting chart. Treasuries began to grind lower over night, but bounced at the hour of the auction, only to begin selling off soon thereafter. Now, treasuries are about where they were before the auction.

FItch Cuts California Debt Rating

This is sounding like a broken record.

from Reuters:
California suffered a new setback in its financial crisis on Monday when Fitch Ratings cut its rating on the state's general obligation debt to just two notches above junk status.

Fitch cut its rating on California's long-term bonds to "BBB," two notches above speculative grade, citing the state's budget and revenue crisis.

The state last week started issuing "IOU" promissory notes for some bills to conserve cash for priority payments, including payments to investors holding the state's debt.

The rating agency also kept the debt of the most populous U.S. state on watch for additional downgrades. California ranks as the lowest-rated state general obligation credit by Fitch, followed by Louisiana, at "A+."

New Jobs Claims Falls, But Seen As Distorted

The number of U.S. workers filing new claims for jobless benefits fell sharply last week but the data was distorted by an unusual pattern of layoffs in the automotive industry, which amplified the decline.

The Labor Department said on Thursday that initial claims for state unemployment insurance fell 52,000, the largest drop since December, to a much lower-than-expected seasonally adjusted 565,000 in the week ended July 4, from 617,000 the prior week.

It was the lowest reading since January. Analysts polled by Reuters had forecast claims to drop to 605,000 from a previously reported 614,000.

However, in a sign of ongoing employment weakness, so-called continued claims of people still on jobless aid after an initial week of benefits rose by 159,000 to a record 6.883 million in the week ending June 27, the latest for which data is available.

A Labor Department official said that there had been far fewer automotive and other manufacturing layoffs last week than anticipated on the basis of past experience of claims over July, when many plants are commonly idled.

The "seasonal factors" the department uses to adjust the data to provide a better sense of the underlying trend had expected a large increase in claims in the latest week. Actual claims in fact rose by a much smaller amount, which when seasonally adjusted, generated a large fall.

A number of states said that auto sector layoffs apparently had already happened, reflecting closures in the battered U.S. automotive industry, while other states said they did not get the layoffs they had anticipated.

"I would expect the underlying trend (in claims) is probably diminishing but it's hard to tell from this number how much is noise," said Keith Hembre, chief economist at First American Funds in Minneapolis.

The 4-week moving average for new claims declined by 10,000 to 606,000, the lowest reading since February. This measure is closely watched because it irons out weekly volatility, and it has now declined in four out of the last five weeks.

Crude Drops Below $60

Banks Say "No Thanks", Reject California IOU's

China Surpasses U.S. As World's Largest Auto Market

What impact will this have on the price of oil?

from Bloomberg:

China’s passenger-vehicle sales rose 48 percent in June, the biggest jump since February 2006, as government stimulus spending spurred a revival in the world’s third-largest economy.

Chinese motorists bought 872,900 cars, sport-utility vehicles and other passenger vehicles last month, the China Association of Automobile Manufacturers said in a statement today. Overall auto sales, including buses and trucks, rose 36 percent from a year earlier to 1.14 million.

A 4 trillion yuan ($585 billion) economic package has helped China surpass the U.S. as the world’s largest auto market this year and boosted sales for companies from General Motors Corp. to Alcoa Inc. The country is “a positive force” that will help drive growth as the world emerges from the global recession, billionaire George Soros said yesterday.

“China’s downward slide is clearly over,” said Wang Qingtao, an analyst at First Capital Securities Co. in Shenzhen. “There is also huge natural demand for vehicles, which will continue to drive the industry for years to come.”

Pimco's Withdrawal Raises Doubts About PPIP

The U.S. plan to help buy as much as $40 billion in assets from banks got started almost four months after it was proposed and without Pacific Investment Management Co., the world’s biggest bond manager and an early supporter.

The U.S. Treasury Department picked nine money managers yesterday for the Public-Private Investment Program, or PPIP, including BlackRock Inc. and Invesco Ltd. Pimco, which in March announced plans to apply, said it withdrew its application in June because of “uncertainties” about the plan’s design.

The government’s plan is a scaled-down version of a program that was once envisioned to buy as much as $1 trillion in devalued real-estate loans and mortgage-backed assets. Pimco’s reversal raises questions about the complexity and potential returns from the program, said Eric Petroff, director of research at Wurts & Associates, a Seattle-based consultant to institutional investors.

“My initial concern is that institutional investors will be a lot more cautious signing up,” Petroff said. “The mosaic is more complicated and the expected returns are less clear” than those from other government programs such as the Term Asset-Backed Securities Loan Facility, he said.

Treasury Secretary Timothy Geithner in March promoted PPIP as a way to help speed recovery of the financial markets by removing distressed debt from bank balance sheets and spurring purchases of mortgage-linked securities. At the time, Bill Gross, Pimco’s co-chief investment officer, described the program in an interview as “win-win-win.”

Pimco’s Plans

Mark Porterfield, a spokesman for Pimco, the Newport Beach, California-based unit of insurer Allianz SE of Munich, declined to comment on specific reasons that prompted the firm to withdraw. He said in an e-mail that Pimco plans to continue taking part in other financial-rescue efforts, such as TALF, designed to restart the market for consumer loans.

The 19 largest U.S. banks have raised more than $100 billion since March by selling equity, debt and assets, and some have repaid government rescue funds, easing concerns that they couldn’t handle a severe recession. The Federal Reserve has trimmed its emergency programs as the financial crisis has lessened.

“The program is a mere shadow of the original thought,” Geoff Bobroff, an independent fund consultant in East Greenwich, Rhode Island, said in an interview.

The government will invest as much as $30 billion and the nine participants may raise $10 billion or more.

Rival Managers

Pimco’s withdrawal opens the field to competitors such as New York-based BlackRock, which said it plans to raise $4 billion to $5 billion from investors. The company is eligible for as much as $1.1 billion in government funds, according to Bobbie Collins, a BlackRock spokeswoman.

The Treasury requires companies to raise at least $500 million from private investors within 12 weeks to participate.

Pimco was interested in two parts of PPIP, one buying whole loans and the other managing funds that purchase mortgage-backed securities, Gross said in March. The Treasury delayed the portion of the program targeting whole mortgages last month.

The program will start out targeting commercial mortgage- backed securities and non-agency mortgage-backed securities issued before 2009, with an initial rating of AAA or its equivalent, the Treasury said.

Pimco manages $756 billion in assets, including the largest bond fund, Pimco Total Return. The company was selected to manage other programs for the government, including one to purchase mortgage-backed securities.

We're All News Junkies Now!

There is an odd phenomenon that we seek to know the news in order to either guide our trades -- or justify them. More often than not, the news has already influenced prices before most of us are aware of that news. News is, by its very nature, a "lagging indicator"; the news media can't report it until after it occurs. It's the nature of the beast -- baked into the cake, so to speak.

Thus, in this day of instantaneous news availability (esp. online) it becomes increasingly irrelevant because of its instantaneousness, since nearly all news quickly becomes "old news". Still, we seek that news fix. It's part of our psyche! It is a constant temptation to seek more news, but as soon as we have some bite of news, we then seek even more news. We seek more current news, more instantaneous news! We have become news junkies! I still feel the draw, but the more I am able to disconnect my trading from news-related events, and concentrate on the charts instead, the more effective my trading becomes. Strange, but true, phenomenon!

Several months ago, someone in this forum suggested I turn off the news media and just watch the charts. He said it improved his trading. Now, it is improving mine!

Crude Oil At $60

Stocks Confirm Head and Shoulders, Then Rebound

Crude Oil Drops Below $61

Hurrah! Cheaper gasoline finally!

Grains Beginning to Stabilize?

All three major grain futures are flat over night. Perhaps we are forming a bottom near multi-year lows?

Crude Edges Below $62

BRIC Countries at G8 Call for New Global Currency

China Slowly Starting to Move Away from Dollar

- Huang Xinyuan, who sells mining equipment and pesticides to customers across China’s border with Vietnam, says he no longer wants payment in U.S. dollars and prefers the yuan.

Sales using the greenback at Guangxi Jinbei Group, where Huang is vice president, dropped to 30 percent of contracts in 2008 from 87 percent in 2007. The yuan, which has gained 21 percent since it was allowed to strengthen against the dollar starting in 2005, offers greater stability, he said.

“In recent years, the dollar has gone in only one direction and that is down,” said Huang, 45, in his second- floor office in Pingxiang, a town set amongst karst limestone hills and sugar-cane fields in China’s southwest Guangxi Zhuang Autonomous Region, three kilometers (1.9 miles) from Vietnam. “Settling our orders in yuan removes a major risk.”

China expanded yuan settlement agreements last week from border zones to its largest financial centers, including Shanghai, Guangzhou and Hong Kong. The program is being rolled out across Malaysia, Indonesia, Brazil and Russia, all nations seeking to reduce the dollar’s role as the linchpin of world finance and trade.

The central bank first brought up the concept of a supranational currency to replace the greenback in reserves in March. It will sponsor use of the yuan in trade by arranging export tax rebates. Russia and India said the global financial crisis had highlighted the dollar’s flaws and called for a debate before the Group of Eight leaders meet in L’Aquila, Italy, starting today.

‘Raise Questions’

“It does give you an idea of what the future could look like,” said Ben Simpfendorfer, chief China economist in Hong Kong at Royal Bank of Scotland Group Plc, the fifth-biggest foreign-exchange trader. “The Chinese see an opportunity at this point to raise questions about the dollar and its status as a reserve currency.”

China, the biggest overseas holder of U.S. Treasuries, trimmed its holdings of government notes and bonds by $4.4 billion to $763.5 billion in April. Premier Wen Jiabao said in March that he was “worried” the dollar would weaken as U.S. President Barack Obama sells record amounts of debt to fund his $787 billion economic stimulus plan.

“The objective is to develop a substitute for the dollar as the world’s reserve currency,” said Tim Condon, Singapore- based head of Asia research at ING Groep NV, part of the largest Dutch financial-services group. “That will reduce the ability of the U.S. government to finance deficits with impunity.”

‘Justifiable Confidence’

Treasury Secretary Timothy Geithner said during a visit to Beijing on June 2 that Chinese officials expressed “justifiable confidence” in the strength of the American economy. China expects the greenback to maintain its role for “many years to come,” Deputy Foreign Minister He Yafei told reporters in Rome on July 5.

In Pingxiang’s Puzhai border zone, traders prefer the yuan. A parking lot that doubles as a wholesale market is jammed with container trucks with license plates from as far as Shandong, about 1,930 kilometers to the north. Garlic-laden motorcycles snake through a checkpoint to the border control.

Traders from Vietnam bring harvests of lychees and dragon fruit, departing with toys, household appliances and medical supplies to sell back home.

Luo Huiguang, 27, who sells as much as 100 tons daily of onions and garlic, collects payment in yuan wired from Vietnam.

“I prefer it to the Vietnam dong or U.S. dollar,” said Luo as he shuttled between warehouses and trucks. “There’s less hassle and we don’t need to convert the currency.”

Erase Profits

Exporters typically set prices to earn 5 percent profit on sales, so 1 percent currency transaction costs and swings in the value of the dollar can wipe out returns, Simpfendorfer said. Many businesses lack the scale to hedge foreign-exchange risks, said Huang at Jinbei, which did $50 million in trade last year.

Limited use of the yuan has been allowed since 2003 in border trade with Vietnam and Laos to the south and Mongolia and Russia in the north, according to a book published by the Beijing-based State Administration of Foreign Exchange.

The central bank extended settlement last week by offering companies in Shanghai and four southern cities tax breaks to start conducting trade in the currency with Hong Kong, Macau and the 10 members of the Association of Southeast Asian Nations, which includes Indonesia, Thailand and Malaysia.

In five years, yuan contracts may account for 50 percent of China’s trade with Hong Kong, which totaled $204 billion in 2008, according to Lian Ping, chief economist in Shanghai at Bank of Communications Co., the nation’s fifth-largest lender. They may make up 30 percent of shipments between the nation and Asean countries that last year reached $231 billion, he said.

Yuan Appreciation

“The yuan will resume appreciation next year,” Lian said. “More people will use the yuan in international trade.”

China’s central bank has limited the yuan’s gains in the past year to 0.3 percent to help support exports during the global recession. The dollar may depreciate by 5 percent annually against the currency over the next two years, ING’s Condon said. Simpfendorfer forecast the yuan will rise 5 percent to 6.5 per dollar from 6.833 by the middle of next year. The median forecast of 27 analysts in a Bloomberg survey was 6.7.

For all the concern that the dollar’s role is waning, China has continued to lead buying of U.S. assets. The greenback accounted for 65 percent of central bank reserves on March 31, up from 62.8 percent in June 2008, according to the International Monetary Fund in Washington.

‘China’s Desire’

“This is not a six-month or one-year story,” said Kenneth Akintewe, a Singapore-based fund manager who helps oversee $138 billion of assets at Aberdeen Asset Management Plc. “China’s desire to control the currency, particularly in the current environment, will supersede its ambitions for the yuan.”

China’s currency isn’t fully convertible for investment purposes. HSBC Holdings Plc, based in London, and Bank of East Asia Ltd. in Hong Kong won approval in May to be the first foreign banks to sell yuan bonds in Hong Kong.

Asian companies may be willing to accept yuan to win market share in the world’s fastest-growing economy, said Pushpanathan Sundram, a deputy secretary-general of Asean. The U.S. economy will contract 3 percent in 2009, while China expands 7.2 percent and the Asia-Pacific region grows 5 percent, according to World Bank forecasts.

“The use of the yuan may eventually boil down to simple economics,” Pushpanathan said. “Given China’s growing share in international trade, traders may find it makes economic sense to make settlements in the yuan.”

Russia, Brazil

Since December, the People’s Bank of China has provided 650 billion yuan ($95 billion) to Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea through so-called currency swaps, encouraging its use in trade and finance. Russia and China agreed to expand use of the ruble and yuan in bilateral trade on June 17. Brazil and China began studying a similar proposal in May.

Converting payments to a third currency “seems to be unreasonable” when Chinese partners are both supplying equipment and buying processed raw materials, said Pavel Maslovsky, deputy chairman of Peter Hambro Mining Plc, Russia’s second-largest gold producer. It develops iron ore projects in the Amur region bordering China.

“The Chinese economy is in such a shape now that their project to export yuan may turn highly efficient,” said Eduard Taran, chairman of OOO RATM Holding, a Siberian cement producer also considering buying Chinese machinery in yuan and exporting output in the currency.

About 160 kilometers north of Pingxiang, yellow cranes jut skywards from a dusty 3 square-kilometer construction site in the provincial capital of Nanning. The plot will house trade missions and businesses from the Asean countries.

“Many countries view China as the savior in this global economic crisis,” said Pan Hejun, vice-mayor. “It’s natural that other countries will be willing to use the yuan to settle trade and hold it among their reserves.”

--Chua Kong Ho, Judy Chen. With assistance from Shanthy Nambiar in Bangkok, Lilian Karunungan in Singapore and Brad Cook and Ilya Khrennikov in Moscow. Editors: Sandy Hendry, Neil Western

United States Is the Saudi Arabia of Natural Gas

A new study has indicated that the United States has more natural gas reserves than any nation in the world. However, we are also the world's #1 importer of natural gas. What gives?

More Costly -- and Worthless -- Stimulus Coming

Haven't these guys learned anything? Every stimulus so far has failed. Now, the staggering amount of debt is beginning to sink the markets. And now, they are determined to do more! They must be insane! The more it fails, the more they do!

Dow Broke Through Support

...but the S&P is still holding slightly above the May support levels. The Dow not only broke through the previous support between 8125-8150, but closed below it! I'm looking at S&P 500 support around 870-875. The S&P futures closed today at about 876 -- just a hair's breadth away!

Stock Market Stumble

Crushed Commodities

Crude oil, natural gas, corn, wheat, soybeans, and other commodities prices are collapsing like a house of cards. The financial markets have turned very bearish over the past week. Even the once-proud soybean dropped nearly limit down today.

Make Sure You Get This One Right

This article sent out by John Mauldin this week, explains how both inflation and deflation can occur simultaneously, both feeding off each other.

By Niels C. Jensen

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won't have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those 'make or break' decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or 'quantitative easing' as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don't understand the world of finance or you don't want to understand. Shame on those who fall for cheap tactics.

Let's begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won't rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Good question - counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn't go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest 'must have' amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry's leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. 'Get long and get loud' it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

Original link.