More Plastic, Please When discussing price the laws of supply and demand are commonly cited as the principal arbiters of price. But psychology, or the collective consciousness may in fact be more important. Consider that there was a time when the nutmeg was such a valuable commodity that the Dutch relinquished possession of New Amsterdam, now Manhattan, for the island of Ran where the spice grew. For a full account read, Nathaniel's Nutmeg, by Giles Milton. (FSG, 1999)
In our current era decades of equity appreciation have made stock more valuable than currency. Consider the case of X.com. The owners of this coveted domain name refused an offer of nearly one million dollars insisting instead on stock in the nascent financial services site. "We weren't really interested in a onetime cash thing," explained the owner an engineer at Netscape, It's all about upside." (WSJ, Sept 2, 1999) Silicone Valleyspeak doesn't know from the downside.
This week the Commodity Research Bureau Index made new highs for the year. The Index is heavily weighted toward grains which are about to be harvested. The purpose of this paper is to study external influences on the grain market. Specifically the effects of unbridled credit creation of the past several years and foreign exchange movements on prices.
It is in the area of derivatives that the leverage endemic in unbridled credit creation is truly evident. According to Fed Chairman Alan Greenspan, US commercial banks at the end of 1998 had an outstanding derivative position of $33 trillion of which fully $29 trillion were over the counter. The total equity of the commercial banking system is $460 billion. Total global derivative positions are estimated at over $100 trillion. Indeed the Bank for International Settlements estimated at the end of June that there were $50 trillion of interest rate derivative outstanding at the end of 1998. Far from being alarmed at the exponential growth of financial derivatives the Fed Chairman and former Treasury Secretary Rubin consistently fought any regulation of these markets.
In March of this year Fed Chairman Alan Greenspan gave a speech to the Futures Industry Association extolling their virtue. "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives." Mr Greenspan looks on this innovation as a blessing to the economy: "A vast array of debt, equity, and hybrid instruments, as well as newly crafted derivative products have fostered an unbundling of risks, which, in turn has enabled investors to optimize their portfolios of financial assets…. The result, especially in the United States, where financial innovations are most advanced, has been an evident acceleration in productivity and standards of living, and, owing to the financial sector's increased contribution to the process, a greater share of national income earned by it over the past decade."
The litany of problems arising from derivatives is not short. The latest is part of the Ecuador default. The September 2nd WSJ ran a story stating that how it handles its $13 billion of debt (65% of its GDP) will closely affect investor sentiment to all of S. America and other emerging markets. Ecuador has announced it will defer for 30 days a $96 million payment due on Brady bonds that was due yesterday. It is the first missed payment on Brady bonds, which are repackaged loans that were defaulted on in the late 80s. However a "credit derivative" linked to Ecuadorian government bonds and underwritten by Merrill Lynch has lost almost all of its value. Credit derivatives are the fastest growing derivative product jumping 110% year on year to an estimated $400 billion still less than 5% of the notional value of all derivatives. JP Morgan is the largest player with 109 billion in exposure to credit derivatives. Interestingly, these structures allow banks to understate their loan exposure, while overstating capital capacity. (The above from Charles Peabody Mitchell Securities.)
The trouble with derivatives is they have a habit of inflicting losses—examples in recent years have been Barings with a loss of $1.6 billion; Orange County with a loss of $1.7 billion; and Sumitomo with a loss 2.6 billion . An interesting anecdote on the attitude of derivatives sellers is provided by Edward Chancellor in his book "Devil Take the Hindmost"(FSG, 1999): "When Procter & Gamble sued Bankers Trust to recover derivative losses of $102 million incurred in 1994, it produced a transcript of a Bankers Trust derivatives salesman stating that he aimed to "lure people into the calm and then just totally fuck 'em."
We can only speculate as to the eventual outcome of other "credit derivatives." Brazil's currency is under pressure and while reporting a budget surplus of $12 billion for the first half of 1999, it is running a deficit of 12% of GDP, including interest expense. Argentina must soon refund $15 billion of debt and issue $5-10 billion more with interest rates currently in the neighborhood of 20%.
If derivative growth represents the big kahuna it is mirrored by the increase in debt. Stuart Feldstein, founder and President of SMR Research (www.smrresearch.com) states. "Since 1990 debt has risen from $4.76 trillion to $7.96 trillion, an increase of $3.2 trillion. Most of it in mortgage credit. These figures do not include medical or utility debt. We believe that a credit problem is developing. It's not solely because of the amount of debt. The problem is a decline in people's ability to pay debt. By 1995 nearly 40% of all households had liquid savings of less than $1000. Another 22% has $1001 to $5000. In other words, 60% of the population has less than $5000. A third of the population has no cash assets." In a recession what will people do? According to his figures, outstanding consumer credit increased form $202 billion in 1992 to $454 billion in 1998. However available credit lines increased from $772 billion to $2.52 trillion. Put another way the number of inactive accounts has grown to 45% of all accounts which leaves a tremendous amount of money available to increase purchasing power in a downturn.
Since 1992, consumer (non-mortgage debt has increased $565 billion to $1.4 trillion, or 70%. Over the same period, household mortgage debt has exploded 1.4 trillion to $4.2 trillion or 50%.
Unfortunately current economists neglect the role of instability of credit. The IMF for example has stated that financial crises are "inherently unforecastable" because "their occurrence and especially their timing are intimately linked to sudden changes in investor confidence."(WSJ, Dec 22, 1997.)
In my paper Asia in Turmoil, Implications for Agriculture Jan 22, 1998, I argued that such an approach meant that ignoring the possibility of a crisis because it was hard to predict was of little comfort to actual participants. I pointed to the experience of deflation in the thirties as instructive to examine how it affects agriculture. In 1929/30 the average price of No2 Hard Winter Wheat at Kansas City averaged $1.20. In 1930/31 the average fell to 76 cents. A year later it was 47 cents. This was not due to an increase in supply. Stocks/usage in 1929 (excluding China and Russia) was 28% and it fell to 24% in 1930. At the beginning of 1998 Chicago wheat at $3.20 was close to the lows it has traded at since 1994. The same can be said for wheat at he beginning of 1929.It was close to its recent lows and without the benefit of hindsight it would have been hard to imagine the depths to which it would then plummet. …. In a deflationary environment, the only external force capable of making a lasting change is a supply shortfall caused by a crop failure.
Late in 1998 spot wheat traded down to 2.34 ½ which remained the low until July of this year when we made a low of 230 ¼. Since then spot wheat has traded back to 2.70.
In the United States people are not used to thinking about the implications of interest rates on the dollar or for that matter, the implications of the dollar exchange rate of commodity prices. This has come from a protracted period where the dollar as the world reserve currency has enjoyed a special status that allowed a current account deficit to increase with no detrimental effects. Indeed this belief is so ingrained that Marc Chandler the chief currency strategist of Mellon Bank could write in the Aug 9th edition of Barron's "Structurally, the dollar will remain the world's key reserve currency for years to come. The dollar is not just as good as gold. It's better."
Other countries are not so fortunate and their foreign exchange rates have a very real impact on the profitability of agriculture. Witness the fact that Australia has remained competitive and their farmers profitable throughout the decline in the wheat market. It happened to coincide with a decline in the Australian dollar to lows of 54.65 in August 1998. (Sept was the low for the wheat market.) The weakness in the real earlier this year caused Brazil to reap a windfall and sell their entire soybean crop much sooner than in the year ago period. It also was in great part responsible for the Feb break in spot soybean futures from a high of $5.19 to a low of $4.49.
So the question is if we were to see a protracted period where the dollar lost value vs. other currencies what would be the implications of dollar based commodities?
An early proponent of floating exchange rates was Milton Friedman. It was his paper, "The Need for Futures Markets in Foreign Currencies," that was instrumental in the establishment of currency futures at the Chicago Mercantile Exchange in 1972. Friedman claimed in his paper that currency futures would have a stabilizing effect on exchange rates. A cursory glance at any forex chart since that time might give one pause as to the accuracy of that prediction. Nevertheless earlier this week in an interview with a German newspaper he said that the US economy was "very, very overheated." He stated that it could lead to "a stock market crash". He also said that if there were a crash that we would not see the deflationary policies of the thirties; that monetary authorities would ameliorate that.
One can argue if indeed the Federal Reserve did actually pursue such policies. There is evidence that like the current Japanese example the authorities attempted to flood the market with liquidity but that there was no demand. The celebrated "pushing on a string." But that is grist for another paper.
The fact is that despite vocal support for a strong dollar by Washington and sales of yen by the Bank of Japan totaling more than the equivalent of $25 billion, the dollar has broken to 109 vs. the yen. The June trade deficit rose to $24.6 billion, a new record. The increase in the deficit far from being a demonstration of American financial prowess as the Administration attempts to portray it is another example of a country willing to live far in excess of its means. The second quarter deficit is scheduled to be released on September 21st. A figure that exceeds 3% of GDP is likely to have negative psychological implications as it will be in close proximity to the 3.4% of GDP that was established on the second quarter of 1987.
While this may be lost on the domestic market foreign investors are voting with their feet, especially the Japanese who increasingly see the US equity market in the same place that their own was in 1989. The continued weakness in the dollar is not positive for capital inflows into the US. Net foreign inflows have been easing this year at the same time as the US current account deficit grows.
All this is happening at a time when the US Bond market is under pressure. The Bank Credit Analyst in its Aug 23rd Foretrends noted, "Our view remains that the Fed will have to raise the funds rate by a further 50-75 points. Nevertheless, the total amount will depend heavily on the reaction of credit and equity markets. The Fed has worried for some time about the implications of a possible bubble in the equity market. Bubbles are not known to deflate in an orderly fashion. Now the Fed has to again contend with the prospect of a liquidity squeeze in the credit market."
Foreign investors own 35% of the outstanding stock of Treasurys and 17% of corporate Bonds. The question is have the timid rate of interest rate increases been enough? The Economist, a magazine not normally associated with hysterical overstatement wrote in an Aug 28th editorial: "By increasing interest rates so timidly, the Fed is allowing investors to believe that each rate rise may be the last. This belief is dangerously misplaced… The Economist has long been fretting about America's financial bubble. But it is not just a level of share prices that gives us sleepless nights; it is also the fact that it has been accompanied by a mushrooming consumer and corporate debt. Negative personal savings and the increase in private sector financial deficit rose to a record 5% of GDP, all point the same way. Spending cannot increase faster than income forever. Faced with this truism a prudent central banker would have tightened policy more aggressively by now."
But increasing interest rates aggressively would negatively impact equities and as Fed Chairman Greenspan stated in his now famous Jackson Hole speech, "We no longer have the luxury to look primarily to the flow of goods and services." (when making decisions about interest rates).
However he also stated in response to criticism that the Fed intervention was asymmetric, acting only to support prices that "while it may appear that central bankers react "asymmetrically" to prices and price declines this is not the case." He added, "Central bankers don't respond to gradually rising asset prices," and also, "We do respond to quickly declining asset prices."
Greenspan said that if asset prices jumped suddenly and threatened market stability they would respond. "If it occurred, we would react to it." In fact", Greenspan said, "the problem is, markets rarely rise suddenly, though they do decline suddenly…markets are asymmetric; we are not."
As Frank Veneroso argues "the definition of a sudden or quick decline or rise in asset prices is peculiar. The stock market rose more that 30% per annum for three years in a row,1995-97—the single largest rise in the history of the stock market. Since the Fed did not 'react' to arrest the rise in stock prices, it was apparently a 'gradual' rise rather than a 'sudden jump'. Second, if the Fed will 'react' in the stock market, but only to curb 'sudden' or 'quick' moves in price, and if such high velocity moves occur only on price declines, Fed policy will in fact prove to be asymmetric in that the Fed will 'react' only to support prices. If market participants are coming to this conclusion, Greenspan should not be surprised." (Veneroso Associates, Aug. 30th)
Bluntly put if speculators see no downside risk there is a good chance that the equity market will see a melt up as all caution is finally abrogated. Witness the record one-day rise in the Nasdaq on September 3rd.
The idea that liquidity is the determinant of prices is not new. In the 17th Century John Law argued that share prices were determined by liquidity rather than a reflection of inherent values. (Devil Take the Hindmost, FSG, 1999)
But what happens when the eventual decline become precipitous, or to use the Fed's own description the market "declines suddenly." If the Fed reacts by injecting liquidity, how will the dollar react? Our guess would be that it will decline, perhaps precipitously. After all it is backed only by confidence which while currently strong is easily swayed.
Anyone of a certain age can remember the dollar weakness of the seventies and its effect on the psychology of commodities. Back then commodities were described as "The Fastest Game in Town," a role now supplied by purveyors of Internet IPOs.
We would argue that central bankers in general and policy makers in particular have an innate inability to let markets clear. The idea that they know where the markets should be is deeply ingrained. It has fostered policies that have caused arguably the most extreme dislocations in history.
Take for example the IMF which over the past two years has transferred about US $185 billion of taxpayers moneys to foreigners so they could settle their debts, most of which are owed to US entities. The agreement under which these funds are provided remain secret. The oversight of this organization borders on the nonexistent.
Federal officials are investigating the apparent transfer of some $10 billion from Russia to the Bank of New York. Treasury Secretary Summers states that "the US will not support disbursement of the next loan installment with out adequate safeguards." Regarding the Russian food aid worth $1.1 billion, an Administration report stated that "based on our limited observations, the controls appeared to be working to provide reasonable assurance that the commodities are getting to the intended recipients." But it notes that the team did not track whether proceeds from commodity sales were actually being deposited in the Russian government pension plan. As was intended. But department officials said they noticed no problem in that area. We would observe that if one fails to look there is a good chance one will not notice. This same cavalier attitude is displayed by the justice department who said on Sept 1st that it has no evidence of laundering or diversions in the Bank of New York case.
IMF chief M Camdesus stated on Sept 1st that he sees no reason to block the release of more funds to Russia. The WSJ reported that "the IMF has adopted a new payment system to Russia, that helps guarantee the funds can't be stolen. Payments go electronically from one account in the IMF to another, without passing through Moscow, and are used to pay Russian debts."
In his treatise "Credit and Economic Crises" Von Mises states that "banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their part or whether because they had to defer to legislative restrictions concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that the restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. .... Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse and the reaction against the bull tendency of the market the stronger, the longer the period during which the rate of interest on loans has been below the natural rate of interest and the greater the extent to which the roundabout process of production that are not justified by the state of the capital market have been adopted."
It is this writer's conclusion that the last decade has witnessed just such an experiment. What James Grant called "the miracle cure of American credit" has been utilized to an extent that was hitherto not only unthinkable but probably unimaginable. In his book, "The Trouble with Prosperity" (Random House, 1996) Grant concludes that: "By suppressing crises, the modern financial welfare state has inadvertently promoted speculation. Never before has such a boom ended except in crisis."
In the interim despite the Asian financial crises, the Russian crises and the LTCM, the great financial experiment of exponential credit creation rolls on.
To conclude we believe that the process of maintaining interest rates below the market level can only continue to encourage further speculative froth which will make itself felt in higher inflation and commodity prices. We believe that the Fed will continue to attempt to maintain the status quo. The resulting liquidity, or put another way, excessive credit creation is behind a great deal of the speculative buying in commodities and the rise in the CRB Index to new annual highs after having taken out the Feb low on July 13th.
The new chairman of the CFTC (Commodity Futures Trading Commission), Mr. Rainer is also a co- founder of Greenwich Capital Markets, a bond trading firm. The CFTC last week proposed a rule change that would allow Commodity Trading Advisors to smooth out past returns in performance records that they present to prospective investors. The New York Times (Sept 2, 1999) commented that "the proposal could bolster business by making commodities trading look less prone to wild swings, which have been known to frighten away potential investors." The futures industry which has $35 billion under management has proposed the change for the last twelve years.
George Painter, one of two administrative law judges that hear cases brought before the CFTC is vocal in his dissent, "My problem is that adopting this proposal means that they are not required to disclose the true results of what happened on those accounts. It's to enable C.T.A's (Commodity Trading Advisors) not to disclose a disastrous result of old accounts. It's absurd."
Risk is an inherent part of our existence. All our actions, or inactions, constitute speculation of the possible course of future events. To pretend otherwise is folly. Yet it is this essential law of nature that financial authorities seek to insulate market participants from. Thus the current specter of rising prices in an environment where stock/usage levels are more than adequate. The largest commercial concerns today realize today that they do not have the capital to take on the funds. This in turn will increase volatility and we must expect that prices will be more influenced by the dictates of momentum trading. A seemingly inane answer to the question "Why are you buying beans?" is "Because they're going up." But this is the rationale behind momentum investing and one which any fundamental trader ignores at his peril.
Gregory Pickup Sept 8, 1999
The author is a commodity advisor for commercial concerns and well-capitalized individuals. He writes a daily commentary on the markets. This is available on a one-day delay at http://www.chicagoperspective.com
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