Boom, Gloom and the New Normal

Some things are too ‘obvious’ for highly-paid professionals in the financial world to accept. If life was this simple, then clients might ask why their fees were so high. Therefore they maintain a fiction that what is obvious is not the full story.

Interest rates are a classic example of a simple issue which is over-complicated by the professionals. They really depend on just one factor:

• Do I trust you to repay the money?

If the answer is ‘no’, then I won’t lend the money. This is what happened to Greece, and now threatens the other PIIGS (Portugal, Ireland, Italy, Greece, Spain). As the chart shows, their interest rates have risen sharply since May 2010, when the blog began warning of the crisis ahead.

Spain’s new prime minister summed up the issue this week, when he warned:

“Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves.”

Spain is the 12th largest economy in the world. Its $1.4tn GDP is larger than S Korea’s ($1tn), and similar to India’s ($1.6tn). If it is in “extreme difficulty”, then any investor is going to become even more concerned about return of capital, rather than return on capital.

Investing with the JUUGS (Japan, UK, USA, Germany, Switzerland) thus becomes an even simpler decision. As the chart also shows, their interest rates continue to fall, as more and more savers seek safety.

It really is that simple.

A year ago, Petromatrix highlighted the short-term ‘triangle’ that was being drawn by oil prices. This describes a period when sellers and buyers are evenly balanced, and neither side can gain momentum to take prices in their favoured direction.

It usually leads to a sharp move, either up or down, when one side wins.

At that time, Brent was ~$60/bbl. And the ‘triangle’ was eventually broken by the bulls, using liquidity provided by the US Federal Reserve’s QE2 programme. The move led to a doubling of oil prices, as buyers had to scramble to obtain supplies.

Now, as the blog noted back in June, a longer-term triangle is busy tracing itself out. The chart above highlights the peaks from 2008 and earlier this year. Its downside is the green ‘support line’ that has marked the bottom of the range since then.

Last year, the US Fed’s $600bn QE2 stimulus provided the cash to fund the surge in the oil price. So far, its new replacement Operation Twist seems to have provided less firepower, although prices have risen $10/bbl since it was announced last month.

However, demand continues to slow under the influence of today’s high prices, which have always led to recession in the past. In particular, the Reuters chart above shows China’s implied oil demand last month was up only 0.6% versus September 2010.

Traders will clearly try to maximise their year-end bonuses by pushing prices higher again. But the fundamentals of supply/demand are even less supportive than last year. The blog will continue to watch the triangle to see what may happen next.

The above chart, from the invaluable American Chemistry Council (ACC) weekly report, highlights the scale of Q1′s inventory build in N American polymer markets (polyethylene, polypropylene, PVC).

This build took place as consumers down the value chain rushed to buy forward, as WTI oil prices surged 41% between November – April.

Their buying was not based on actual demand, but on their need to protect margins. Most companies set sales prices for 90 or 180 days ahead, so anyone who had not bought forward could have seen planned profits turn into losses:

• The orange line shows the 22% rise in thermoplastic inventories from 4.25bn lbs (1.93Mt) to 5.2bn lbs (2.35Mt). Q2 saw this start to be worked through downstream, as consumers reduced new orders.
• Worryingly, however, we seem now to be entering the second stage of the downturn. The blue line shows that consumers are now seeing lower demand, and the ACC note the 3 month moving average dropped to 4.56bn lbs in July.

This two-stage process is exactly in line with the experience of previous oil-price induced recessions, as the blog highlighted in mid-April.

September will therefore be a crucial month.

History suggests end-user demand will remain weak, as individuals worry about the state of their finances and rising job insecurity. But, of course, we can still hope that ‘this time will be different’.

Today’s 419 point fall on the Dow Jones Average, and $6/bbl fall in WTI crude oil prices, may not be just another example of the wild volatility that has come to seem normal in financial markets.

It may also mark the end of an era.

Since 1994, the US Federal Reserve has used all its resources to support the stock market in times of strain. This took it well beyond its official mandate of fighting inflation and supporting employment.

Instead, it meant interest rates were lowered, and liquidity provided, any time the market experienced a major sell-off. It created the dot-com bubble in 1999-2000; the subprime housing disaster; and more recently the bubble in energy and commodity markets.

Today, for the very first time in 15 years, 2 senior US Federal Reserve Governors have spoken out against this policy:

• Philadelphia Fed chief Charles Plosser said taking action after stocks tumbled “signalled that we are in the business of supporting the stock market.”
• Richard Fisher, the Dallas Fed chief, said the Fed “should never enact such asymmetric policies to protect stock market traders and investors.”

It remains to be seen whether this change of policy becomes permanent. There are very powerful forces, not only on Wall Street, ranged against it. Will the Fed really do nothing, if today’s falls continue next week?

But if it does, then financial markets will be quite different in 5 years time:

• Markets will not be protected from their own follies
• Investors who cannot evaluate credit risk will lose money
• Commodity prices will be driven by fundamentals of supply and demand
• Computerised high frequency trading will disappear

Unfortunately, it is almost certain that the path back to reality will be extremely painful. 15 years of Fed ‘bubble-blowing’ will take a long time to put right. But if Plosser and Fisher really mean what they say, then Fed policy is indeed headed Back to the Future.