Rebel Traders – Analysis Without The Hype

As the recovery (or at least the first signs of one) confirms, the focus of the attention moved from checking whether the stimulus would be enough to kick-start the economic activity to checking how to pull it “out of the system” without killing the economy in the process.

Andy Xie thus proposes an analysis of the pitfalls of pulling out the stimulus. In essence, his argument runs that the excess liquidity is liable to create inflation, as that is the only acceptable alternative to deleveraging by bankruptcy.

(…)

Financial markets had been chattering about economic stimuli exits for about a month before Canberra’s move. The consensus was that central banks would keep rates extremely low through 2010, and possibly beyond, on grounds that the economic recovery is still shaky.

Central banks also have been discussing the subject. Their messages are, first, that they know how to exit and will exit before inflation becomes a problem and, second, that they don’t see the need to exit anytime soon. They try to assure bond inventors not to worry about their holdings, despite low bond yields, while trying to persuade stock investors they need not worry about high stock prices, as liquidity will remain strong for the foreseeable future. So far, central banks have made both groups happy. But Australia’s action is likely to raise concern among financial investors who hold expensive stocks and bonds.

Each economy will exit at its own pace, according to local conditions. First, the United States and Britain, where property bubbles have burst and could not be revived through low interest rates, will increase rates next year at a pace in line with the speed of inflation expectation. Their goal is to keep real interest rates as low as possible to support financial institutions still sitting on mountains of bad assets. They don’t want to stop inflation, but want to limit the pace of its increase. Through low real interest rates, their economies could decrease debt leverage. I think the Fed would raise interest rate by 100 bps in 2010, 150 bps in 2011, and 200 bps in 2012. The United States could be stuck with an inflation rate of 4 to 5 percent by 2012 – and for years to come.

As Andy Xie stresses, the stimulus exit will be a combined effort of all the central banks and it will not be exempt of risks: one central bank alone could derail the whole process.

My central point is that the global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. But this equilibrium is balanced on a pinhead. It requires central banks to constantly manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.

In modern economics, monetary stimulus is considered an effective tool to soften the economic cycle. While there are many theories about why monetary policy works, the dirty little secret is that it works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.

It is difficult to reverse this kind of stimulus. A complete reversal requires that household, business and government sectors decrease debts to pre-stimulus levels. This is why national ratios of indebtedness-debt to GDP have been rising over the past three decades while central bankers smoothed economic cycles through monetary policy. It led to a massive debt bubble that burst, leading to the ongoing slump.

Of course, the bailouts have brought in essence to transfer the non-performing debt from private actors (where it could be cleansed through bankruptcy) to government actors and central banks. The issue being here that it would be impossible to call these loans in without bankrupting the originators.

By some estimates, US$ 9 trillion has been spent to shore up failing financial institutions. A big chunk of that money was borrowed against illiquid and problematic assets on bank balance sheets. As the debt market refused to accept that collateral, governments and central banks stepped in. Today, it is impossible for banks to liquidate such assets without huge paper losses. Hence, if central banks call the loans, they are likely to go bankrupt.

Of course, central banks can suck in money from elsewhere to substitute money that’s tied up in non-performing loans. They are unlikely to do so, however, as it would depress a good part of the economy in order to support the bad. And that could easily lead to another recession.

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

What Andy Xie shows is that while the originating issue is the same, the exit strategies will have to be quite different according to each country or zone, each having its own specificity.

Some may argue that Britain is not expensive anymore. The problem is that being less expensive is not good enough. Prices have to be low enough to attract non-financial economic activities despite a rising tax burden. The pound’s value must be very low to achieve that goal. Five years ago, I predicted the pound and euro would reach parity. It seems the day is finally here. But I’m not sure parity would be enough; the pound may have to be cheaper.

Of course, the euro zone is a mess, too. With high unemployment rates, a stagnant economy and imploding property markets in southern Europe, shouldn’t the euro’s value decline, too? Yes, it should. But it won’t. The European Central Bank was structured solely to maintain price stability. With so many governments and one central bank, ECB is unlikely to change anytime soon. (…)

At some point, euro zone monetary policy may change. It would require governments in the zone’s major economies come together and change the ECB. That may come in three years, but not now. The trigger could be one country threatening to exit the euro. Italy and Spain come to mind.

Meanwhile, Japan is an enigma. It has been locked in a vicious cycle of economic decline with a strong yen and deflation. Most Japanese people have a strong yen psychology. (…)  But I think various theories that explain Japan’s behavior are not good enough. The best explanation is that Japan is run by incompetents, and some are downright stupid. They have locked Japan in an icebox and refuse to come out.

Japan is a giant debt bubble. Its zero interest rate, supported by a strong yen and deflation, has turned the debt bubble into an iceberg. You don’t have to worry — until it melts. Unfortunately, when the temperature reaches a critical point, the iceberg will melt suddenly, all at once. That turning point will come when Japan begins to run a significant current account deficit. The day may be near.

For Japan to avoid calamity, it should deal with deflation and skyrocketing government debt now. The only way forward is for the central bank to monetize Japanese Government Bonds. That would lead to yen devaluation and inflation. Pensioners will complain, but it’s better than a complete meltdown later.

Japan’s new ruling party DPJ has no vision like that. It doesn’t have the guts to go against popular preference for a strong yen. Without a growing economy, though, the DPJ has little to play with. The whole country has sworn to debt, led by a government with a massive fiscal deficit. The DPJ may only reallocate some spending, which would make no difference for the economy. It seems Japan will remain in the icebox until the day of reckoning.

These snapshots of Britain, the euro zone and Japan suggest everyone needs a weak currency. Those that don’t have one simply don’t know yet. They’ll come around eventually. One outcome could be rotating devaluations and high inflation for the global economy.

Developing countries with healthy banks have a different problem on their hands. By responding to falling imports with stimuli, they inflated their property markets. China, India, South Korea and Hong Kong have inflated property bubbles in spite of slower economic growth rates. The contradictions between a property bubble and a weak economy can lead to zigzags in policymaking.

As China is one-third of the emerging economy bloc — and exerts a great deal of influence over commodity prices that other emerging economies depend upon — its monetary policy has a big impact on global financial markets. Its monetary stimulus in the first half of 2009 went disproportionately into property, stock and commodity markets. As profitability for the businesses that serve the real economy remain weak, little monetary stimulus went into private sector capital formation.

It seems limiting credit growth is the current policy focus. But if the economy shows further signs of weakness in the fourth quarter 2009 and first quarter 2010, the policy may revert to loose bank lending again. The zigzagging will stop when China’s loan deposit ratio is high enough, i.e. when increased lending increases interest rates. As the yuan is pegged to the dollar, China’s monetary policy would become much less flexible after excess liquidity in the banking system is gone.

And so, for Andy Xie, the big challenge ahead is creating sufficient income to favor deleveraging, while holding inflation under control (easier said than done). While it transpires from his writings that inflation is the final outcome he sees looming, it can be noticed that Andy Xie took a more cautious tone in this latter piece. As of today, nobody can really predict with certainty the outcome within a few months.

Could it be that, after the “Black Swan”, we may have the “Black Butterfly” effect ?

Chinese stats (as collected by a Private actor, the bank HSBC, for those who don’t believe any government stats, whether US or Chinese), continue keeping up a strong front, despite the plateauing that could be observed in the US, where new orders met with some pullback in September.

The Chinese purchasing managers index kept above 50 %, thus indicating a continued expansion in the month of September, even if the number fell by 0.1 %. The greatest challenge to be observed so far for China has been its excessive reliance on exports as a motor for its economy. However, despite these issues, it would appear that the majority of the rise in new orders came from internal demand. And this is a factor worth noticing, as the big challenge for the Chinese is managing to develop an internal market. So far, it would appear that this has been done mainly thanks to stimulus and directive instructions to buy or spend (very efficient in a dictatorship).

As the HSBC analysts seem to indicate, the operation by the Chinese government may have pushed up consumption via the gigantic infrastructure spending (which also pulled up employment, in a textbook illustration of traditional keynesianism).

China’s purchasing managers’ index fell by 0.1 percentage points to 55 points in September, the sixth consecutive month the indicator has been above 50, HSBC said in an email statement on Sept. 30.The 50 point mark is the dividing line between expansion and contraction in purchasing, the statement said. Despite the slight decline, the index still indicates strong growth in factory output, orders and employment.

Factory output has expanded for six months in a row due to an improving economy, while overseas orders have risen for the past four months as demand has rebounded, it said.

The majority of the rise in new orders, however, came from domestic demand, it said.

The growth in sales has helped push employment in the manufacturing sector to a two-year high, the statement said.

Overall product prices have risen slowly but steadily over the past three months, but larger hikes in the prices of corn, iron ore, oil and steel have pushed up overall costs, it said.

“The figures indicate a continued rebound of domestic and overseas demand, and the rise in employment levels in manufacturing shows the massive infrastructure investment has pulled up consumption,” HSBC’s chief China economist Qu Hongbin said.

HSBC began publishing monthly PMI figures on Sept. 1. It collects data from 400 companies.

The other aspect of this massive investment spending has been the overcapacity being developed in China. The Chinese government decided to tackle that too, in order to create what would appear as maybe an attempt to foster penuria in some areas (silicon and wind power among others). While curbing the overcapacity in steel or cement makes sense given the quantities being produced, the curbing of wind power (a “clean” energy source) leaves one wondering if this is not an attempt to keep the coal production buoyant (the greatest part of China’s power comes from extremely polluting coal power generators). A very near-sighted operation if ever there was one, but which translates the worries of Beijing on its social front.

The Cabinet has laid out detailed plans to curb overcapacity in industries such as steel, aluminum, cement and wind power, warning that the country’s economic recovery could otherwise be hampered.

In a reiteration of existing policy targets, the State Council said meeting the government’s long-standing goal of reducing overcapacity was urgent because the result of inaction would be factory closures, job losses and rising bad bank loans.

In a notice posted on the Internet it said, “What especially requires our attention is that it is not only traditional industries such as steel and cement that suffer from productive overcapacity and are still blindly expanding.”

While highlighting overcapacity in sectors such as steel and cement — both energy-guzzling and polluting — it also aimed at new industries such as wind power equipment and silicon.

The Cabinet said it would no longer approve or support any new steel projects or any expansion in existing projects.

Shenzhen Daily also reports that the wind power industry was mentioned which is, perhaps, surprising. It said that in 2010 Chinese companies would produce equipment equivalent to 20 million kilowatts of capacity, but that the country would install only 10 million kilowatts of actual capacity.

To tackle this oversupply, the Cabinet said it would in principle refuse approval the construction of complete wind-power equipment factories. It also banned investors in the sector from using locally produced equipment, aiming to prevent local governments from building their own equipment plants.

We pointed out a previous economic analysis by Andy Xie on the subject of a crash predicted for 2010 by the Chinese economist… Back in June 2009.

However, as economy is a living human science, economists are bound to adapt their analysis with the evolution of the economy.  However, Andy Xie confirms his outlook of a second dip by 2010, taking into account the new bubble created by the assets.

Short-term however, Andy Xie points out that the markets should do well for the coming two months. He also reaffirms his belief in an inflationary scenario, which, for me, is somewhat questionable. True enough, expectations and market games can push assets prices upwards (the “self-realizing” prediction to which Andy Xie is affectionate). But in the end, the realization that the economy is moving slower than expected should just kill that inflationary play, lowering assets prices and at that point the question would be whether the dip in assets prices would kill the economy or give it the oxygen it needs to continue recovering.

Needless to say, Andy Xie finds that a keynesian policy will not work in the US, for the simple reason that the US consumers have been shocked into saving. Recreating another bubble seems the policy being effected right now and whereas it will be effective for a while, it may (and probably will) backfire on the long run. In short, a worthwhile analysis to read by anyone who has the desire to go look behind the media coverage and look at the workings of the economy. Also, it brings some much needed discussion of Keynesian theses vs the governments’ policies.

In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won’t it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.

The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.

Many policymakers actually don’t think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven’t done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don’t think so.

The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble’s lifespan takes time to consume. And a bust destroys the credit system.

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A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn’t take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble’s burst.

What we are seeing now in the global economy is a pure liquidity bubble. It’s been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.

What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.

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Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.

Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One’s outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.

If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan’s bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.

(..)

Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don’t think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.

This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn’t believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.

Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down — and keep them down for a long time.

Andy Xie, who publishes regularly some interesting pieces on caijing.com published this week-end a quite interesting piece on the current rally and the progression of assets and shares prices these last few months. For all the bears who visit this site, this will sound as a sweet consolation, albeit with some disappointment as to the timeframe.

In essence, what he says is that, as opposed to the first part of the rally, the last three weeks have seen a resurgence of the “inflation play”.

What’s more interesting is his pointing out to another cause for a drop in the markets, namely a possible crisis around the $.

A drop in the $ would encourage hyperinflation expectations by the market, of course drive the market higher for a while… And be a self-realizing prediction as to the inflation. He also points out that the central banks are having less say in determining the treasurys price… thus driving yields higher and ultimately bringing about a dangerous play for the Fed and the government.

However, argues Xie, if the Fed and the government give some signs that they will rein in the money supply… They should manage to calm the markets (and ensure some further growth).

In many ways, from a FA point of view, Andy Xie does a lot to vindicate Chuck’s analysis, and message but his analysis goes so far as to say that the strategy of reinflating the bubble will succeed for a while (which means no immediate crash as well), and he places the second crash by 2010, when inflation rears its ugly face. His view (and it appears justified to a a degree is that “the markets are trading on imagination”. Now again, while that is absolutely true, what Xie does not take into account in his analysis is the remote possibility that the government’s strategy may succeed at some point. To read the whole article, go here. I stressed some interesting points here and there.

A combination of growth optimism and inflation fear has catapulted asset markets in the past few weeks. These two concerns should drive markets in different directions: Inflation fear, for example, should limit room for stimulus and prompt stock markets to retreat. But the investment camps expressing these opposite concerns go separate ways, each pumping up what seems believable. As a result, stock and commodity markets are mirroring the behavior seen during the giddy days of 2007.

Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn’t sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They’re jumping in, in droves.

When the least informed and most credulous get into the market, the market is usually peaking. A rising economy and growing income produces more funds to fuel the market. But the global economy is now stuck with years of slow growth. Strong economic growth won’t follow the current stock market surge. This is a bear market rally. People who jump in now will lose big.

Over the past three weeks, the dollar dove while oil and treasury yields surged. These price movements exhibited typical symptoms of inflation fear, which is complicating policymaking around the world. The United States, in particular, could be bottled in. (…) Such a massive amount of federal debt paper needs a buoyant Treasury to absorb. If the Treasury market is a bear market, absorption becomes a huge problem.

U.S. Treasury Secretary Timothy Geithner recently visited China to, among other things, persuade China to buy more Treasuries. According to a Brookings Institution estimate, China holds US$ 1.7 trillion in U.S. Treasuries and GSE paper (about 15 percent of the total stock). If China stops buying, it could plunge the Treasury market into deep bear territory. If China does not buy, the Treasury market will get worse. But China can’t prop up the market by buying.

In the past few years, purchases by central banks around the world have dominated demand for Treasuries. Central banks have been buying because their currencies are linked to the dollar. Hence, such demand is not price sensitive. The demand level is proportionate to the U.S. current account deficit, which determines the amount of dollars held by foreign central banks. The bigger the U.S. current account deficit, the greater the demand for Treasuries. This is why the Treasury yield was trending down during the bulging U.S. current account deficit period 2001-’08.

This dynamic in the Treasury market was changed by the bursting of the U.S. credit-cum-property bubble. It is decreasing U.S. consumption and the U.S. current account deficit. The 2009 deficit is probably under US$ 400 billion, halved from the peak. That means non-U.S. central banks have much less money to buy, while the supply is surging. It means central banks no longer determine Treasury pricing. American institutions and families are now marginal buyers. This switch in who determines price is shifting Treasury yields significantly higher.

The 10-year Treasury yield historically averages about 6 percent, with about 3.5 percent inflation and a real yield of 2.5 percent. This reflects the preferences of marginal buyers in the United States. Foreign central banks have pushed down the yield requirement substantially over the past seven years. If marginal buyers become American again, as I believe, Treasury yields will surge even higher from current levels. Future inflation will average more than 3.5 percent, I believe. Some policy thinkers in the United States believe the Fed should target inflation between 5 and 6 percent. The Treasury yield could rise to between 7.5 and 8.5 percent from the current 3.5 percent.

A massive supply of Treasuries would only worsen the market. The Federal Reserve has been trying to prop the Treasury market by buying more than US$ 300 billion – a purchase that’s backfired. Treasury investors are terrified by the inflation implication of the Fed action. It is equivalent to monetizing national debt. As the federal deficit will remain sky-high for years to come, the monetization could become much larger, which might lead to hyperinflation. This is why the Treasury yield has surged in the past three weeks.

One possible response is to finance the U.S. budget deficit with short-term financing. As the Fed controls short-term interest rates, such a strategy could avoid the pain of high interest rates. But this strategy could crash the dollar.

(…) Most U.S. analysts think the dollar’s weakness is due to foreigners buying less of it. This is probably incorrect.

The dollar’s weakness can limit Fed policy options. It heightens inflation risks; a weak dollar imports inflation and, more importantly, increases inflation expectations, which can be self-fulfilling in today’s environment. The Fed has released and committed US$ 12 trillion (83 percent of GDP) for bailing out the financial system. This massive overhang in money supply could cause hyperinflation if not withdrawn in time. So far, the market is still giving the Fed the benefit of the doubt, believing it will indeed withdraw the money. Dollar weakness reflects the market’s wavering confidence in the Fed. If the wavering continues, it could lead to a dollar collapse and make inflation self-fulfilling.

The Fed may have to change its stance, even using token gestures, to assure the market it won’t release too much money. For example, signaling rate hikes would soothe the market. But the economy is still in terrible shape; unemployment may surpass 10 percent this year. Any suggestion of hiking interest rates would dampen growth expectations. The Fed is caught between a rock and a hard place.

Oil prices have doubled since a March low, even though global demand continues to decline. The driving forces again are expectations of inflation and a weaker dollar. As U.S.-based funds flee, some of the money has flowed into oil ETFs. This initially impacted futures prices, creating a huge gap between cash and futures prices. The gap increased inventory demand as investors tried to profit from the gap. Rising inventory demand caused spot prices to reach parity with futures prices. Rising oil prices, though, lead to inflation and depress growth. It is a stagflation factor. If the Fed doesn’t rein in weak dollar expectations, stagflation will arrive sooner than I previously expected.

Stagflation in the 1970s spawned the development of rational expectation theory in economics. Monetary stimulus works by fooling people into believing in money’s value while the central bank cheapens it. This perception gap stimulates the economy by fooling people into demanding more money than they should. Rational expectation theory clarified the underpinning for Keynesian liquidity theory. However, as they say, people can’t be fooled three times. Central banks that tried to use stimuli to solve structural problems in the ’70s saw their stimuli didn’t work. People saw through what they tried again and again, and began behaving accordingly, which translated monetary stimulus straight into inflation without stimulating economic growth.

Rational expectation theory discredited Keynesian theory and laid the foundation for Paul Volker’s tough love policy, which jagged up interest rates and triggered a recession. The recession convinced people that the central bank was serious about cooling inflation, so they adjusted their behavior accordingly. Inflation expectations fell sharply afterward. The credibility that Volker brought to the Fed was exploited by Alan Greenspan, who kept pumping money to solve economic problems. As I have argued before, special factors made Greenspan’s approach effective at the same. Its byproduct was asset bubbles. As the environment has changed, rational expectation theory will again exert force on the impact of monetary policy.

Movements in Treasury yields, oil and the dollar underscore the return of rational expectation. Policymakers have to take actions to dent the speed of its returning. Otherwise, the stimulus will lose traction everywhere, and the global economy will slump. I expect at least gestures from U.S. policymakers to assuage market concerns about rampant fiscal and monetary expansion. The noise would be to emphasize the “temporary” nature of the stimulus. The market will probably be fooled again. It will fully wake up only in 2010. The United States has no way out but to print money. As a rational country, it will do what it has to, regardless of its rhetoric. This is why I expect a second dip for the global economy in 2010.

While inflation expectations are causing some in the investor community to act, the rest are betting on strong economic recovery. Massive amounts of money have flowed into emerging markets, making it look like a runaway train. Many bystanders can’t take it any longer and are jumping in. Markets, after trending up for three months, are gapping up. Unfortunately for the last-minute bulls, current market movements suggest peaking. If you buy now, you have a 90 percent chance of losing money when you try to get out.

Contrary to all the market noise, there are no signs of a significant economic recovery. So-called green shoots in the global economy are mostly due to inventory cycles. Stimuli might juice up growth a bit in the second half 2009. Nothing, however, suggests a lasting recovery. Markets are trading on imagination.

The return of funds flowing into property is even more ridiculous.  A property burst usually lasts for more than three years. The current burst is larger than usual. The property market is likely to remain in bear territory for much longer. The bulls are talking about inflation as the bullish factor for property. Unfortunately, property prices have risen already and need to come down even as CPI rises. Then the two can reach parity.

While rational expectation is returning to part of the investment community, most investors are still trapped by institutional weakness, which makes them behave irrationally. The Greenspan era has nurtured a vast financial sector. All the people in this business need something to do. Since they invest other people’s money, they are biased toward bullish sentiment. Otherwise, if they say it’s all bad, their investors will take back the money, and they will lose their jobs. Governments know that, and create noise to give them excuses to be bullish.

This institutional weakness has been a catastrophe for people who trust investment professionals. In the past two decades, equity investors have done worse than those who held U.S. market bonds, and who lost big in Japan and emerging markets in general. It is astonishing that a value-destroying industry has lasted so long. The greater irony is that salaries in this industry have been two to three times above what’s paid in other sector. The key to its survival is volatility. As markets collapse and surge, possibilities for getting rich quickly are created. Unfortunately, most people don’t get out when markets are high, as they are now. They only take a ride.

Indeed, most people who invest in the stock market get poorer. Look at Japan, Korea and Taiwan: Even though their per capita incomes have risen enormously over the past three decades, investors in these stock markets lost money. Economic growth is a necessary but not sufficient condition for investors to make money in the stock market. Most countries, unfortunately, don’t possess the conditions for stock markets to reflect economic growth. The key is good corporate governance. It requires rule of law and good morality. Neither is apparent in most markets.

It’s a widely accepted notion that long term stock investors make money. Actually, this is not true. Most companies don’t last for more than 20 years. How can long term investment make money for you? The bankruptcy of General Motors should remind people that this notion is ridiculous. General Motors was a symbol of the U.S. economy, a century-old company that succumbed to bankruptcy. In the long run, all companies go bankrupt.

Property on the surface is better than the stock market. It is something physical that investors can touch. However, it doesn’t hold much value in the long run either. Look at Japan: Its property prices are lower than they were three decades ago. U.S. property prices will likely bottom below levels of 20 years ago, after adjusting for inflation.

China’s property market holds even less value in the long run. Chinese properties are sitting on land leased for 70 years for residential properties and 50 years for commercial properties. Their residual values are zero at the end. The hope for perpetual appreciation is a joke. If you accept zero value at the end of 70 years, the property value should only be the use value during those 70 years. The use value is fully reflected in rental yield. The current rental yield is half the mortgage interest rate. How could properties not be overvalued? The bulls want buyers to ignore rental yield and focus on appreciation. But appreciation in the long run isn’t possible. Depreciation is, as the end value is zero.

The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come.

If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.

Some headlines from FOMC member Lacker:

FED’S LACKER: REAL INTEREST RATE IS ‘EXCEPTIONALLY LOW’, LOWEST IN THE POST WAR PERIOD; INFLATION NEWS HAS BEEN RELATIVELY ADVERSE
- Chance of recession ahead.
- Hard to gauge when housing will bottom.
- Substantial uncertainty remains about total mortgage losses.
- Commercial construction is a risk for H2.

Producer Price Index (PPI) data reveals inflation still rising…

FEB U.S. PPI TABLE
Table Of PPI Data From Labor Department, In Percent Changes

                                             FEB.     JAN.     DEC.

PPI, Finished Goods           0.3      1.0     -0.3
PPI, Ex. Food, Energy         0.5      0.4      0.2
Energy                                    0.8      1.5     -3.0
Foods                                   -0.5      1.7      1.4
Consumer Goods                0.3      1.1     -0.4
Residential Electricity       -0.4     -1.2      0.6
Residential Gas                 5.7      0.7     -1.5
Gasoline                             2.9      2.9     -7.6
Home Heating Oil            -3.7      8.5     -0.3
Drugs                                  1.3      1.5      0.4
Autos                                  0.8      0.3     -0.5
Tobacco                              0.1     -0.1      0.6
Capital Equipment             0.5      0.4      0.1
Intermediate Goods            0.8      1.4     -0.2
Ex, Food, Energy               0.6      0.8      0.0
Crude Goods                     3.7      2.5      1.1
Ex. Food, Energy              3.3      4.0      0.2

Goldman Sachs (GS) and Lehman (LEH) reported earnings and each has reported a ‘better than expected’. Oh goodie, the crisis is over (if you listen to the talking heads). No need for any rate cuts now… LOL

Today is a wait and watch day. 2:15pm is when we find out what the Federal Reserve will do. I can’t remember a time when the market has been so convinced that the Federal reserve will cut the Fed Funds rate by so much and with so much confidence it will happen. Makes me think of a ’sell the news’ once it happens, if it happens.