Just a Pause for the Commodity Bull Market in the Collapse of Bretton Woods and the Pax Americana

The author of this thoughtful piece rests his argument for a resurgence in commodity prices on three pillars: oil is the heart of the commodity price bull market, oil is peaking in production, and overall demand for all commodities will continue to stress against supply levels even with reduced demand for the short term. Commodities trends and production increases are long cycle phenomena.

We have come to a similar conclusion but from a different path. The eye of the commodities storm has not been oil, and peak oil, but rather a collapsing international trade system based on the US dollar.

The heart of the problem is that trading increasingly worthless dollars for hard goods has been a nice protection racket with an amazingly long run under the Pax Americana. The non-G7 countries will stop accepting this arrangement, and the world will adjust.

The markets are searching for a replacement for the Bretton Woods II arrangement of dollars for oil and military protection. Increased demand and peaks in supply will merely accelerate and intensify the storm.

We think that this is already well underway, thanks in great part to the Clinton-Bush Administrations and their careless disregard for the stewardship which the US accepted with the world's reserve currency. The heightened sense of risk and volatility is because the world's markets do not yet see a viable, sustainable solution.

A new equilibrium that will underpin international trade will be discovered. But given the length and breadth of the status quo the seismic shocks of the adjustment may be quite convulsive, taking down more than a few major institutions. The epicenter for this global earthquake is somewhere between New York and Washington DC.


Commodity Bull's Not Dead, Just Resting
Vijay L Bhambwani
Daily News & Analysis - India
August 23, 2008 03:57 IST

Once the deliberate downward pressure on these assets eases, there will be a resurgence in prices

Recent days have seen an intense debate within the analyst community on the hot topic of the year — commodity prices. Many have started writing obituaries for the commodity bull and pronounced an end to the ascent in commodity prices. The impact on the corporate sector was advocated to be salutary and it was widely expected to signal an end to the woes of the equity investors....

I expect the post-US election year to be particularly tough on the global energy front as the supply-side constraints choke the optimists. Once the deliberate downward pressure on these hard assets is eased, there will be a resurgence in prices.

I am afraid the following rally may just surpass the recent one. In my humble opinion, the commodity bull is just taking a breather, forget his obituary for now. The future shock will lie not in rising commodity prices, but in not preparing for it.

A Perfect Storm of a Global Recession - Roubini

Roubini's analysis has been better than most. A worldwide recession is highly probable.

At some point we will most likely see competitive devaluations of currencies as countries vie for exports. We will see a de facto trade war, not explictly until much later in the cycle perhaps, but implicitly through policies and barriers more subtle than overt tariffs. The industrial policies of Japan and China are just a taste of things to come.

A currency devaluation is a very effective means of erecting trade barriers and encouraging exports. But without a global reference point the situation can quickly deteriorate into a relative competition with commodities assuming the more narrow prior position of gold, which would rise with the general tide of commodities. This will break the Central Bank's scheme to maintain Bretton Woods II.

This may be the fuel for the continuing stagflation despite flagging demand in the G7. The BRIC's will slow, but still maintain a positive growth. As currencies devalue the commodities may ironically become more expensive. We may see a repeat of the 1970's but on a global scale. That might be something for the economics professors to puzzle on for a few years as their models get marked to the markets.

The Perfect Storm of a Global Recession
by Nouriel Roubini
Project Syndicate

NEW YORK – The probability is growing that the global economy – not just the United States – will experience a serious recession. Recent developments suggest that all G7 economies are already in recession or close to tipping into one. Other advanced economies or emerging markets (the rest of the euro zone; New Zealand, Iceland, Estonia, Latvia, and some Southeast European economies) are also nearing a recessionary hard landing. When they reach it, there will be a sharp slowdown in the BRICs (Brazil, Russia, India, and China) and other emerging markets.

This looming global recession is being fed by several factors: the collapse of housing bubbles in the US, United Kingdom, Spain, Ireland and other euro-zone members; punctured credit bubbles where money and credit was too easy for too long; the severe credit and liquidity crunch following the US mortgage crisis; the negative wealth and investment effects of falling stock markets (already down by more than 20% globally); the global effects via trade links of the recession in the US (which still counts for about 30% of global GDP); the US dollar’s weakness, which reduces American trading partners’ competitiveness; and the stagflationary effects of high oil and commodity prices, which are forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and financial stability.

Official data suggest that the US economy entered into a recession in the first quarter of this year. The economy rebounded – in a double-dip, W-shaped recession – in the second quarter, boosted by the temporary effects on consumption of $100 billion in tax rebates. But those effects will fade by late summer.

The UK, Spain, and Ireland are experiencing similar developments, with housing bubbles deflating and excessive consumer debt undercutting retail sales, thus leading to recession. Even in Italy, France, Greece, Portugal, Iceland, and the Baltic states, frothy housing markets are starting to slacken. Small wonder, then, that production, sales, and consumer and business confidence are falling throughout the euro zone.

Elsewhere, Japan is contracting, too. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now, exports to the US are falling while the yen has strengthened. Moreover, high oil prices in a country that imports all of its oil needs, together with falling business profitability and confidence, are pushing Japan into a recession.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices, but its GDP shrank in the first quarter, owing to the contracting US economy. Indeed, three quarters of Canada’s exports go to the US, while foreign demand accounts for a quarter of its GDP. (This is why the loon will track US performance more closely than other commodity currencies as we have noted before - Jesse)

So every G7 economy is now headed toward recession. Other smaller economies (mostly the new members of the EU, which all have large current-account deficits) risk a sudden reversal of capital inflows; this may already be occurring in Latvia and Estonia, as well as in Iceland and New Zealand.

This G7 recession will lead to a sharp growth slowdown in emerging markets and likely tip the overall global economy into a recession. Those economies that are dependent on exports to the US and Europe and that have large current-account surpluses (China, most of Asia, and most other emerging markets) will suffer from the G7 recession. Those with large current-account deficits (India, South Africa, and more than 20 economies in East Europe from the Baltics to Turkey) may suffer from the global credit crunch. Commodity exporters (Russia, Brazil, and others in the Middle East, Asia, Africa, and Latin America) will suffer as the G7 recession and global slowdown drive down energy and other commodity prices by as much as 30%. Countries that allowed their currencies to appreciate relative to the dollar will experience a sharp slowdown in export growth. Those experiencing rising and now double-digit inflation will have to raise interest rates, while other high-inflation countries will lose export competitiveness.

Falling oil and commodity prices – already down 15% from their peaks – will somewhat reduce stagflationary forces in the global economy, yet inflation is becoming more entrenched via a vicious circle of rising prices, wages, and costs. This will constrain the ability of central banks to respond to the downside risks to growth. In advanced economies, however, inflation will become less of a problem for central banks by the end of this year, as slack in product markets reduces firms’ pricing power and higher unemployment constrains wage growth.

To be sure, all G7 central banks are worried about the temporary rise in headline inflation, and all are threatening to hike interest rates. Nevertheless, the risk of a severe recession – and of a serious banking and financial crisis – will ultimately force all G7 central banks to cut rates. The problem is that, especially outside the US, this monetary loosening will occur only when the G7 and global recession become entrenched. Thus, the policy response will be too little, and will come too late, to prevent it.

Regional US Banks are Heavily Invested in Fannie and Freddie Preferreds

This may help to understand the Treasury's next moves.

The banksters really do not want Fannie and Freddie to be bailed out and maintained in anything such as their current form. They want Fannie and Freddie's business, more precisely the fees from same. They also want the debt to be made whole.

The big banks do not care so much about the preferred stock. In fact, they might even be in favor of a haircut there, to set up some bargains for the coming wave of bank consolidations. But the Fed doesn't like it, because they see the domino risk to the system.

Again, this might help to explain the solutions that comes out of Washington and New York. There is significant maneuvering behind the scenes by the vested interests. Of course then there are the Democrats. Hank has a window of opportunity to settle the GSE's hash before he loses his grip on power. Let's see what happens.

Fannie and Freddie threat to banks
By Saskia Scholtes in New York and James Politi
The Financial Times
August 23 2008 03:00

Small regional US banks could face substantial writedowns if the government has to rescue Fannie Mae and Freddie Mac, the two giant US mortgage financiers.

Regional banks, together with US insurers, hold the majority of Fannie and Freddie's $36bn of outstanding preferred stock, which could be wiped out in the event of a government rescue.

Few banks have taken any writedowns on the preferred shares, which have lost more than half of their value since June 30. This could exacerbate the impact of losses on the preferred shares at a time when many banks are experiencing losses on residential construction loans and home equity portfolios.

Tom Priore, chief executive of Institutional Credit Partners, a boutique investment bank, said: "If the government takes a senior preferred stake, it will crystallise existing losses for the banks and add to them in a way that damages local lenders at a time when they can least afford it."

Fannie and Freddie's preferred stock ratings were cut by Moody's yesterday from A to Baa3. Moody's said the cut reflected the uncertainty surrounding how these securities would be treated if the US Treasury provided Fannie or Freddie with support and the reduced financial flexibility the two companies would have in the event of a Treasury intervention.

The rating agency said it saw the odds of such an intervention as increasingly likely, pushing Fannie and Freddie's stock prices down by a further 14.5 per cent and 8.25 per cent, respectively. Both stocks have lost more than 40 per cent of their market value this week on fears that government intervention is imminent.

"Given the GSEs more limited ability to raise capital and grow their portfolio to accomplish their public policy role in a time of mortgage market turmoil, we believe that there's an increased probability of actual support coming from the US Treasury," said Brian Harris, analyst at Moody's.

The Treasury was granted powers last month to extend its credit lines to Fannie and Freddie and invest in their debt and equity, but it has not given any further clarity on the structure a rescue for the companies might take.

Many analysts believe the most likely option is for the government to get preferred shares as part of any rescue, eliminating the value of common shares, and ranking higher than existing preferred shareholders, who will probably see their dividends cut.

Philadelphia-based Sovereign bank said this week it holds more than $600m in preferred stock issued by Fannie Mae and Freddie Mac, representing 0.78 per cent of its total assets.

Analysts at CreditSights said a full write-off of Sovereign's preferred stock in Fannie and Freddie could represent as much as four quarters of earnings. Sovereign executives warned there was a possibility they could take a significant writedown in the third quarter.

The Fed's Fatal Attraction with Wall Street Is a Source of Policy Error

Link to Buiter's Complete Paper Presented at Jackson Hole

Fed Attention to Wall Street `Dangerous,' Buiter Says
By John Fraher and Scott Lanman
Bloomberg News

Aug. 23 (Bloomberg) -- The Federal Reserve pays a ``dangerous'' amount of attention to the concerns of Wall Street, constraining its ability to influence the economy, former Bank of England policy maker Willem Buiter said.

``The Fed listens to Wall Street and believes what it hears,'' Buiter said today in a paper presented to the U.S. central bank's annual symposium in Jackson Hole, Wyoming. ``This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.''

The central bank has drawn criticism from some officials in the U.S. and Europe by trying to end the yearlong credit crisis through an expansion of lending. The steepest interest-rate cuts in two decades risk stoking inflation, while the Fed has been too generous in aiding banks, Buiter said.

In addition to rescuing Bear Stearns Cos. from bankruptcy, the Fed created a program to swap Treasuries for mortgage bonds, opened up lending to Wall Street firms and reduced the premium for direct loans to commercial banks.

Buiter, a founding member of the Bank of England's independent rate-setting board in 1997, said the Fed's behavior over the past year represents an example of ``regulatory capture.'' In such a relationship, policy makers take on ``as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest,'' he said.

Heated Debate

Buiter's paper sparked the most heated debate of any item on the two-day conference agenda. Bank of Israel Governor Stanley Fischer opened the question-and-answer session by holding up a fire extinguisher and saying, ``I asked the organizers for some technical assistance in dealing with this discussion.''

Former Fed Vice Chairman Alan Blinder said that the central bank's performance, while not flawless, has been ``pretty good under the circumstances.''

Fed Governor Frederic Mishkin, one the strongest advocates of the ``risk management'' approach to financial crises, said after Buiter's presentation ``there are a lot of unguided missiles that have been shot off.''

Under Bernanke and his predecessor, Alan Greenspan, the Fed has cut rates in response to falling stock prices more than is justified to safeguard economic growth, Buiter said. On Jan. 22, as global stock markets tumbled, the Fed slashed its overnight lending rate by 75 basis points.

Safeguard Economy

Bernanke has argued that policy makers' actions were necessary to safeguard the economy from the impact of the credit crisis. Greenspan engineered rate cuts in 2001 through 2003 at a time when joblessness climbed in the aftermath of the recession seven years ago. The Fed by law is mandated to achieve stable prices and maximize employment.

Buiter also criticized the Fed and other central banks around the world for not providing more information about the valuation of collateral they accept from banks.

Such information would allay concerns financial institutions will use public funds to subsidize financial institutions, he said. This is ``most acute'' in the case of some of the Fed's emergency lending programs created in the past year.

Two economists echoed Buiter's concern in another paper presented today, saying the Fed's program allowing institutions to swap Treasuries for mortgage bonds and other debt enables firms to ``window dress'' their balance sheets.

`Deception Easier'

``Financial institutions can hold low-quality securities for the period where no reporting is required,'' wrote Franklin Allen of the University of Pennsylvania and the University of Frankfurt's Elena Carletti. ``Temporarily increasing the supply of Treasuries makes this kind of deception easier. It helps remove market and regulator discipline.''

The financial crisis is also forcing the European Central Bank to rethink aspects of its money market operations, which provide a flexibility that has been favorably compared with programs at the Fed and the Bank of England.

The ECB plans to tighten collateral rules to head off the risk of abuse by some financial institutions, ECB council member Yves Mersch said in an interview today.

Buiter won some praise for openly confronting the Fed's record at its summer retreat in the Teton Mountains.

``Willem's papers don't pull punches, they have attitude,'' Blinder said. ``You have to give credit to a guy with the nerve to come here with black bears on the outside and the FOMC on the inside and be this critical of the Federal Reserve.''