Ben, inflation, and Tao of markets


“What other political entrepreneurs are robbing us blind [not just railroad workers*]?

Well, teachers get tenure after three years and the worst of them cruise for the next thirty. Cops and firefighters all know now to game the pension and benefits system. How many times have I heard about pensions that clock in at 80 percent of the average of your last three years’ pay, and the untold huge raises in workers’ last three years before retirement?”

Eat People…and other unapologetic rules for game-changing entrepreneurs, Andy Kessler

*Any surprise Obama pushing high speed rail nonsense?

The real reason for progressives’ passion for trains is their goal of diminishing Americans’ individualism in order to make them more amenable to collectivism.
To progressives, the best thing about railroads is that people riding them are not in automobiles, which are subversive of the deference on which progressivism depends. Automobiles go hither and yon, wherever and whenever the driver desires, without timetables. Automobiles encourage people to think they–unsupervised, untutored, and unscripted–are masters of their fates. The automobile encourages people in delusions of adequacy, which make them resistant to government by experts who know what choices people should make.

Time was, the progressive cry was "Workers of the world unite!" or "Power to the people!" Now it is less resonant: "All aboard!"

                                    George Will


Commentary & Analysis
Ben, inflation, and Tao of markets

Last week I summarized an excellent piece by Stephen King, not the scary one, the one that toils away as chief economist for HSBC; but then again, economists can be very scary in their own right. Mr. King, is not one of them, and seems to me have a very good grasp on how the world works. The piece Mr. King penned for the Financial Times effectively said: central banks are ahead of themselves and shouldn’t be so concerned about rising prices that:

1) Effectively represent a tax on the developed world via emerging market growth (when domestic income and wage rates are relatively stable)
2) An inflation in prices central banks can’t control anyway through standard monetary policy without likely doing more harm than good

Point number 2 assumes central banks don’t wish to use recession as a way to control inflation—al la the Paul Volcker scenario in the early 1980’s which proved so effective. But of course, we had Ronnie in the White House to infuse America with confidence instead of the incompetent poser and friends which reside there now—a fact which seems quite hard to comprehend if you had the misfortune of attending the most elite schools in America and were educated in anything less than math and science—and so it goes; or have been inculcated by European PC and liberalism. An excerpt from The Wall Street Journal’s interview with historian Paul Johnson, titled, “Why America Will Stay on Top”…

His *Paul Johnson’s+ concern with the human dimension of history is reflected as well in his attitude toward humor, the subject of another recent book, "Humorists." "The older I get," he tells me, "the more important I think it is to stress jokes." Which is another reason he loves America. "One of the great contributions that America has made to civilization," he deadpans, "is the one-liner." The one-liner, he says, was "invented, or at any rate brought to the forefront, by Benjamin Franklin." Mark Twain’s were the "greatest of all."

And then there was Ronald Reagan. "Mr. Reagan had thousands of one-liners." Here a grin spreads across Mr. Johnson’s face: "That’s what made him a great president."

Jokes, he argues, were a vital communication tool for President Reagan "because he could illustrate points with them." Mr. Johnson adopts a remarkable vocal impression of America’s 40th president and delivers an example: "You know, he said, ‘I’m not too worried about the deficit. It’s big enough to take care of itself.’" Recovering from his own laughter, he adds: "Of course, that’s an excellent one-liner, but it’s also a perfectly valid economic point." Then his expression grows serious again and he concludes: "You don’t get that from Obama. He talks in paragraphs."

All policy wonks and self-appointed intellectual posers talk in paragraphs; and they all seem to confuse that with brains and common sense. Wrong! Thank you Mr. Johnson!

[Editor’s note: For all you whining and complaining Americans who fall for the doom and gloom claptrap, I suggest you read the Journal’s excellent interview with Mr. Johnson in its entirety.]

Back to Mr. King—developed world central banks risk pushing the developed world into recession so they can feel good about their mandates, even though their mandates and use of monetary policy may do nothing to alleviate current rises in resource prices until recession is sustained globally.

Of course we now know the European Central Bank has now come very close to committing on a rate hike next month. But the question is: If they do hike, will they do more harm than good?

Yesterday, in another brilliant piece on the eurozone, Ambrose Evans-Pritchard explained the potential danger that may accompany an ECB rate hike, both economic and political. Interestingly, he cited for authority, which backs Mr. Stephen King’s assertion as summarized above, a paper by none other than Fed Chairman Ben Bernanke.

In a paper written in June of 1997 titled “Systematic Monetary Policy and The Effects of Oil Price Shocks,” Mr. Bernanke summarizes why he believes that central banks make it worse:

"The majority of the impact of an oil price shock on the real economy is attributable to the central bank’s response, not the inflationary pressures engendered by the shock,” wrote Bernanke.

Okay. We think Ben and Stephen have it about right on this one; and Mr. Ambros-Pritchart’s assessment of the ECB move makes a lot of sense.
Now, to bring this back to currencies–below is an excerpt from our free report, at our website, on Methodology:

The fact that currencies tend to move in self-reinforcing trends is why we see the detachment from fundamentals. Self-reinforcing trends, driven by speculative capital flow, are triggered by interest rate differentials (the link back to business conditions) and rising exchange rates.

“Of the two, exchange rates are by far the more important. It does not take much of a decline in a currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events. .. [think Australian dollar during 2008]

“…expectations about future exchange rates constitute the main motivation in speculative capital movements.”

                                    George Soros, Alchemy of Finance

There is a self-reinforcing trend in the euro against the US dollar right now. But if we are right about the negative impact on growth if the ECB hikes rates in the midst of rising austerity measures hitting periphery markets, then the attendant deterioration in growth in Europe relative to the US going forward may change dramatically. If so, it would suggest the euro is either now, or soon will lurch deep into “overshoot” territory relative to the underlying fundamentals; which in the currency game are, well, relative!

We have the following as premise for currency drivers:

  • Hot Money (pools of capital) flows to the highest relative yield and expected rising yields, all things being equal—though they never are.
  • Foreign Direct Investment (long term capital) flows to areas it can expect the highest capital appreciation over time; and even better if the currency has overshot to the downside its long-term fundamentals.

[There are major and powerful exceptions to these premises; think Japanese yen here.]

We also know that one cannot disentangle yield expectations from economic growth expectations; two horses from the same stable that tend to self reinforce. And since we can neither forecast interest rates or growth, it makes the game even that much more interesting. But we can observe existing market expectations regarding these two important factors.

So, we have the setup conditions:

1. Country A’s economic backdrop seems better than its currency reflects (qualitative).
2. The outlines for growth seem to be taking shape to suggest country A’s relative growth will soon exceed that of its key competitors.
3. Rising level of extremely bearish rationales—some true, but many false—are rehashed daily to justify moving more money into the trend of country A’s falling currency.
4. Extreme positioning against country A’s currency (quantitative).

I think we all know who country A may be in this scenario. Within the diagram below—the yin yang symbol—country A’s currency, just before the turning point, is that little white dot in the midst of all the black and despair. This represents the Tao of markets; the way it is and has to be, paraphrasing Mr. Percival. When things look most risky to fight the trend, in reality it is the time when it is least risky to own the bleakness. At times when things look the brightest, bad times are just ahead (the black dot in the diagram below). We see this in all markets. We just tend to see overshoot more constant in currency markets because the real drivers are so nebulous despite appearing so vast.

I am not sure if country A’s currency is the white dot yet. But maybe…just maybe, we are getting close.

US Dollar Index Monthly: