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Wednesday December 17, 2008 - 14:20:05 GMT
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Blam! Liquidity Trap? Is it over for the buck?

Key News
• U.K. unemployment rose at the fastest pace since 1991 in November.  (Bloomberg)
• “If you take a full assessment of the credit markets, conditions have certainly eased from their worst, but they still are at extraordinary tight levels, which are far from normal,” said Michael Darda, the chief economist at MKM Partners LP in Greenwich, Connecticut. “Short-term funding spreads are all still very wide relative to historical norms. There is a massive pullback going on in the private sector.”  (Bloomberg)
Key Reports (WSJ):
7:00 a.m. MBA Mortgage Application Survey: Previous: -7.1%.
8:30 a.m. 3Q Current Account Balance: Expected: -$179B. Previous: -$183.1B.
10:35 a.m. US Energy Dept Oil Inventories for Dec 12
10:35 a.m. API Oil Industry Report for Dec 12

Quotable ( A bit long today…)
In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. Let us suppose an economy with a given supply of money. Some of the money is spent in consumption; the rest is saved and invested in a mighty structure of capital, in various orders of production. The proportion of consumption to saving or investment is determined by people’s time preferences—the degree to which they prefer present to future satisfactions. The less they prefer them in the present, the lower will their time preference rate be, and the lower therefore will be the pure interest rate, which is determined by the time preferences of the individuals in society.
A lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production, and a building-up of capital. Higher time preferences, on the other hand, will be reflected in higher pure interest rates and a lower proportion of investment to consumption. The final market rates of interest reflect the pure interest rate plus or minus entrepreneurial risk and purchasing power components.  Varying degrees of entrepreneurial risk bring about a structure of
interest rates instead of a single uniform one, and purchasing power components reflect changes in the purchasing power of the dollar, as well as in the specific position of an entrepreneur in relation to price changes. The crucial factor, however, is the pure interest rate. This interest rate first manifests itself in the “natural rate” or what is generally called the going “rate of profit.” This going rate is reflected in the interest rate on the loan market, a rate which is determined by the going profit rate.

Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business? The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in “longer processes of production,” i.e., the capital structure is lengthened, especially in the “higher orders” most remote from the consumer. Businessmen take their newly acquired funds and bid up the prices of capital and other producers’ goods, and this stimulates a shift of
investment from the “lower” (near the consumer) to the “higher” orders of production (furthest from the consumer)—from consumer goods to capital goods industries.7

If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption–investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

Murray Rothbard’s, America’s Great Depression

FX Trading – Blam!  Liquidity Trap? Is it over for the buck?
The dollar was blasted yesterday by Ben’s Quantitative Easing cannons.  It’s game over for the buck, right? Well, maybe…

This morning, so far, we don’t see the wholesale follow-through against the buck (euro, yen, and Swissie doing well).  In fact, the pound is today’s whipping boy.  [From Bloomberg this morning: “Bank of England policy makers voted unanimously to cut the benchmark interest rate to 2 percent this month and refrained from a bigger reduction on concern it may prompt about an ‘excessive’ drop in the pound.”]

The Fed’s move looked very scary to us.  Former Fed Vice Chairman and Princeton Economist Alan Blinder said on CNBC yesterday, moments after the lengthy and very unusually candid Fed statement: “Mr. Bernanke just shot all his cannons.” 

And there ain’t no bullets left in the gun!

Some observations that give the liquidity trap argument a whole lot of reality here:

1) Private sector borrowing doesn’t seem likely to pick up when jobs are evaporating and small- and medium-sized businesses are struggling to stay afloat—not to mention the big name plate large ones hanging on by a thread.
2) Many banks are loaded with money.  But, they aren’t earning anything on it and they seem to have trouble finding credit worthy borrowers—so they don’t lend.
3) With inflation slipping into negative territory, real interest rates (defined as nominal rates minus the inflation rate) are increasing!

So, we are all Keynesians now! 

The background point that we continue to ponder is that if the Fed had to take such dire measures, basically opening its balance sheet to buy anything and everything that still has a pulse; it must be bad out there.  And if it is this bad here, then it’s not exactly peachy anywhere else.  This move by the Fed says the US economy is staring into the abyss.  And as we’ve indicated before, a whole lot of the world’s demand rides in the US consumer showing some degree of buying power. [As an aside, a stronger dollar provides the US consumer more buying power, a weaker one does not.]

Already, global trade seems to have evaporated overnight.  There are three key players that seem highly dependent on trade, a la in form of exports to drive most growth—Japan, Germany, and China.
Baltic Exchange Dry Index (BDI)   Source: Investment Tools
 (Chart unavailable in text format.)

This plunge in trade is why we haven’t abandoned our longer term dollar story (though granted we may only be talking our book here and may not be as “objective” as we should be): Germany is still considered to be in relatively decent shape.  That is the tacit implication that ECB President Trichet gave in his recent interview.  In fact, Mr. T seemed pleased that Germany wasn’t jumping on the stimulus band wagon as the other European countries had done—saving those bullets just as the ECB was doing.  After all, things will be getting better by the second-half of 2009 in Europe, don’t you know!

But the jury is still out on German growth, though we know how we are voting.  The market seems to believe Germany will hold the Eurozone together; it is the underlying structure supporting the euro as safe haven argument.  We believe Germany will disappoint in the same way both Japan’s and China’s economies are disappointing: big time to the downside. And this we think will lead to major back-tracking on the part of the ECB as the last best hope—German growth—fades. 

We could be very-very wrong about this, obviously.  But if you’ve been trying to trade in this market (as we have unfortunately), you know just how fluid it is in terms of volatility in prices and rationales about the fundamentals.  Yesterday the story was the Fed has surrendered, the dollar yield gap will say wide, US growth is finished.  All may prove true.  All may be bad for the dollar. 

But, if Germany stutters in a big way, or Italy/Greece/Spain/Ireland start screaming louder for more rate relief and decide it’s is time to throw off the shackles of the European Stability and Growth Pact, two things change: 1) the ECB likely moves to the Fed rate and uses its remaining bullets, the market then perceives ECB behind the “growth” curve, so dollar negative yield differential argument fades and maybe the US grows first argument gains some traction; and 2) shows the market that this thing called the euro is not based on any broad set of cohesive economic and political stability. 

As we said this week: it’s only a story.  With the euro back over 1.40, price is at least whispering to us that we need to be concerned it’s not just a fairy tale. 


EURUSD Daily: Euro is testing a 50% retracement level. 

 (Chart unavailable in text format.)

Stay tuned.  Either way it will be an interesting ending.

Jack Crooks, Black Swan Capital LLC


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