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Traders Versus Roubini on Inflation, Dollar

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The Financial Times’ John Authers, who called a market turn in bonds in early June of last year, sees another major shift in sentiment on the outlook for inflation and the dollar:

For months, through all the volatility of the credit crisis, one bet has been enough to make profits. It is very simple: bet on the dollar to fall and oil to rise.

Logically, there must come a “tipping point” when this trade no longer works.

Defining that point has provoked intense debate. But the best definition for that point, to use Supreme Court justice Potter Stewart’s definition of hard-core pornography, is simple: “I know it when I see it.”

This week, the market seems to have acted on that dictum. With aggressive words in support of the dollar coming from a procession of the most senior economic policymakers in the US, fixed-income markets capitulated. Futures markets now price as a certainty a rise to 2.5 per cent in the fed funds rate (from 2 per cent) by autumn. Days ago a rise to 2.25 per cent was seen as a less than evens chance.

Bond yields shot up as a result, greatly strengthening the dollar and undoing all the damage done last week by the poor US employment data and by the signal from the European Central Bank that it, too, would be raising rates.

Gold, usually a hedge for uncertainty, seems to be taking its cue from the currency market, falling sharply as the dollar strengthened.

Emerging markets fell badly. They had benefited from dollar weakness and strong commodities. But the tight relationship between oil and the dollar went into reverse. Rises in oil lately have correlated with doses of dollar weakness. But oil initially rose on Tuesday as the dollar strengthened.

Some effects so far look perverse. Bank stocks should be harmed by rising rates. And yet they gained in early trading.

All perhaps are symptoms of a situation in which traders have seen a turning point. They do not yet understand the consequences, but they know one when they see one.

Nouriel Roubini, in a lengthy discussion, “Global Stagflation Ahead? The Interplay of Aggregate Demand and Aggregate Supply Shocks,” doesn’t buy that things have changed all that much. He believes that inflationary pressures will be reduced by economic weakness and currency realignment

We’re in Roubini’s camp for much simpler reasons. The banking sector is much weaker than is widely acknowledged. Regional and local banks are only beginning to experience the stresses that hit their larger brethren. In addition, while financial institutions have marked down their subprime portfolios considerably, they do not appear to have made anywhere near the requisite cuts on their just-about-as-bad Alt As and Option ARM exposures and their even-worse HELOCs (update: some indirect confirmation comes via this Housing Wire post, “Fitch: Problems in Housing Greater than Originally Estimated“.) As we have said repeatedly, the credit default swaps market is a disaster waiting to happen. Not only will it be tested and likely to be found wanting as corporate defaults rise to levels not seen since the market has been operating on a large scale, but litigation to avoid payout can create unexpected side effects.

While the ECB may raise rates (the Europeans have a much greater fear of inflation than we do and are willing to inflict pain to avoid it), the Fed has repeatedly taken the “break glass in case of emergency” approach at any sign of distress in the financial markets. Dean Baker regularly criticizes the New York Times and other media outlets for continuing to solicit opinions on the housing market from economists who completely missed the brewing real estate crisis. Similarly, the markets are putting undue faith in the forecasting ability of a Fed chief that thought the subprime problem would be contained.

Thus, while the Fed may have some intermediate success in jawboning higher interest rates and a stronger dollar, we still believe their desire to raise rates will be dashed by continued wobbliness in the financial sector (mind you, unlike Roubini, we think the Fed is unduly protective of its charges, so we are describing expected outcomes, rather than voting for them). And once traders see that, we’ll see a reversion of the dollar and interest rates, albeit from a higher level. While the Fed may not see enough bad news in the data to hold them back from a 25 basis point rise in August, our guesstimate is that this “eye of the storm” phase won’t last beyond the third quarter.

Note that Roubini continues to mention the idea of an Israeli attack against Iranian nuclear facilities. Although that idea should be relegated to Dr. Strangelove (see the comments in this post for details), since a strike on a operating nuclear reactor would make Chernobyl look tame, it would produce massive dislocations. From RGE Monitor.

A true stagflationary shock requires a negative supply-side shock that increases prices/inflation while reducing output/growth. Instead, positive aggregate demand shocks – like an overheating in emerging markets following a growth in aggregate spending – would be associated with rising inflation and rising growth…..

In the 2004-2006 period global growth was robust while inflation was low. This ideal situation can be interpreted as the outcome a positive global supply shock – the increase in productivity and productive capacity of China, India and emerging markets – that allowed global growth to increase while prices of goods and services remained low or falling….This positive supply side shock was followed – starting in 2006 but more strongly in 2007 – by a positive global demand shock: the fast growth of demand in Chindia and other emerging market economies started to put pressure on the demand and prices of a variety of commodities and lead to a rise in inflationary pressures. Thus, strong global growth in 2007 was associated with the beginning of a rise in global inflation, a phenomenon that with some caveats – the sharp slowdown in growth in the US and some advanced economies – continued in 2008.

The above analysis thus suggest that – barring a true supply side stagflationary shock such as a war with Iran – a true stagflationary outcome (rising inflation and recession) is unlikely in the global economy. The recent rise in oil, energy and other commodity prices is – in spite of the deepening US recession – the result of a variety of factors, rather than a mere negative supply side shock. First, high growth in demand for oil and other commodities among fast growing and urbanizing emerging market economies at the time when the supply of new oil is constrained the political instability – and ensuing lack of enough investment in new oil exploration – of a number of unstable petro-states (Nigeria, Venezuela, Iran, Iraq and, possibly, Russia) while the supply of other commodities is constrained in the short run by productive capacity and need for longer term investments. Second, the weakening US dollar that pushes higher the dollar price of oil as the purchasing power of oil exporter over non-dollar regions is reduced. Third, the discovery of commodities as a new asset class by many investors (hedge funds, pension funds, sovereign wealth funds) leading to both short run speculative and long run investment demand for commodities. Fourth, the diversion of land towards bio-fuels production; this is a phenomenon that has reduced the land available to produce agricultural commodities. Fifth, very easy monetary policy by the US forcing easy monetary policy in countries that formally peg to the US dollar (as in the Gulf) or that heavily manage their exchange rates to maintain undervalued currencies and achieve export led growth (China and other informal members of what is referred to as the Bretton Woods 2 “dollar zone”) leading to a new asset bubble in commodities and overheating of their economies. Most of these factors are akin to global aggregate demand shocks – rather than supply shocks – that should lead to growth overheating and a rise in global inflation.

The last factor – the exchange rate policies of many emerging market economies – is particularly important….Indeed, policies of forex intervention that tried to prevent the nominal appreciation have led to a massive increase in foreign exchange reserves whose effect on base money has been only partially sterilized; thus the ensuing low policy rates and increases in monetary base growth and of credit growth have eventually led to both asset inflation (real estate bubbles and equity bubbles) and, more recently, to goods inflation as the recent rise in inflation in most emerging market economies shows. Thus, the most important way to control inflation – while regaining monetary and credit policy autonomy that requires higher policy rates to control inflation – is to allow currencies in these economies to appreciate significantly rather that prevent such appreciation….

Unfortunately this need for currency appreciation and monetary tightening in overheated emerging market economies is occurring at a time when the effects of the housing bust, the credit crunch and high oil prices in a number of advanced economies (US, parts of Europe and in Japan that depends heavily on US growth) is leading to a sharp economic slowdown in these advanced economies – and outright recession in some of them – that, in due time, will slow down growth in emerging market economies as economic recoupling will emerge. Thus, rising inflation and slowing growth in many advanced and emerging economies is becoming a nightmare for their central banks that should be tightening monetary policy to fight inflation and ease monetary policy to reduce the downside risks to growth.

If the nature of the shock hitting the advanced economies is now a negative aggregate demand shock – a fall in demand driven by the bust of housing and the ensuing credit crunch – inflationary forces should – over time – diminish as there will be, especially in economies entering a recession, three forces that will tend to reduce inflation: a slack of aggregate demand relative to aggregate supply reducing the pricing power of firms (and indeed we are already seeing deflation in the US in home prices, auto prices and consumer durables); a slack in labor markets where a rising unemployment rate will lead to a reduction in wage pressures and labor costs; and eventually a fall in commodity prices from their recent peaks if a severe US contraction leads to a global economic slowdown and lower demand for commodities; indeed a fall in global commodities demand – given short run inelastic supply of commodities –would lead to a relatively sharp – about 20% plus – fall in commodity prices…..

Thus, deflationary pressure in some economies that are contracting could occur in parallel to inflationary pressures in economies that – so far – are still growing fast. Certainly the year ahead will be a much more difficult one for the global economy and central bankers as a combination of rising inflationary risks and downside risks to growth is emerging in complex and different ways for different economies.

The Fed is now signaling its concerns about rising inflation and inflation expectations – especially with a weakening US dollar – but it is still recognizing that there are significant downside risks to growth. Thus, in spite of the new hawkish rhetoric the Fed will stay on hold – and may even ease further – if the US turns out to be severe and prolonged rather than short and shallow. The ECB is even more hawkish given its mandate giving priority to price stability; but its aim to tighten monetary policy to stem inflationary pressures will be challenged by the rapid growth slowdown of Europe where high oil prices, a credit and liquidity crunch, a strong euro, anemic real wage growth, a weakening of the U.S. and the lack of policy rate easing are taking a toll on growth even in Germany while a number of other European and Eurozone economies are headed towards a hard landing (Spain, Ireland, Italy, Portugal and the UK).

For U.S., Europe and Japan a rise in oil and commodity prices is “stagflationary” even if it is driven in part by strong demand in emerging market economies. So while rising inflation caused by the commodity shock may require tighter monetary policy the weakening in demand caused by a different combination of housing busts, credit crunch and other factors weakening growth (such as strong currencies in Europe and Japan) is leading to a rapid slowdown and outright contraction in some economies. Whether monetary policies will be tightened or kept on hold will depend on how much the downside risk to growth become larger than upside risks to inflation.

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24 comments

  1. JKH

    Roubini is right, particularly about the Fed.

    As usual, the market has taken an obtuse view of a Bernanke speech. Read the words in the speech. It’s about risk, not about expectation. The Fed’s expectations are still more in line with Roubini’s views than with the risk/tightening scenario. The speech was a shot over the bow in case tightening is required. But, as usual, the market interprets risk as expectation in the fed funds futures market. It’s an overreaction.

  2. a

    Don’t know, but I think the Fed will try to raise rates to 2.5% pretty soon. Don’t have an idea what it will do afterwards.

  3. Michael McKinlay

    Wow, that’s a lot of analysis.

    Bernanke is breaking the Fed silence on dollar strength for two reasons:

    1. Nobody believes Paulson any more after his doomed Special Purpose Entity to hide derivative losses that everybody immediately saw as a hoax and his pathetic Hope Now program that basically tells people ” We can’t help you” then checks them off the list as have being helped.

    2. Bernanke has to at least threaten to raise interest rates to stop the dollar from falling even further causing the commodities markets to explode risking a worldwide economic implosion. It is not just about the dollar anyymore.

    Other than that its business as usual.

  4. Richard Kline

    I do get the impression that the Fed now understands the strong desirability of having higher rates, unlike prior to April 08. The only thing propping up the US financial system is the willingness of non-nationals to hold dollar debt or leave their holdings under US management. And any discussion with foreign central bankers and sovereign wealth deciders all but certainly begins with, “Further dollar weakening threatens our commitment to you.” With FedFunds at 2 and severely understated official inflation at, what?, 3.6, rates are already _severely_ negative. We are in the alkali desert here, and need to make it back to the freshwater foothills at least.

    The downside for further deterioration within the US as the economic downturn really takes hold and the fat part of the loss curve hits the books severely constrains Fed response, though, as you say, Yves. If they can raise at all, I doubt that this will happen until Q4, and by 25 bips then, but I suspect that they will try to get rates up if at all possible.

  5. Insurance Guy

    I’m not an economic historian, but isn’t this exactly what the Fed did leading up to the Great Depression?

    Cut rates to stimulate demand until gold outflows became untolerable. Raise rates to protect the currency – leading to…

    I find it hard to believe Bernancke would choose this course of action. It just seems to completely ignore the textbook.

  6. Adrem

    I fail to see why Roubini’s talk of an Israeli strike is in Dr Strangelove country. We all know the consequences of such a strike to take out Iran’s nuclear facilities. Disaster is the word commonly used. But that “disaster” is not nearly as disastrous as Iran having nuclear weapons.

  7. Anonymous

    “I fail to see why Roubini’s talk of an Israeli strike is in Dr Strangelove country.”

    Because it is not a politically correct thing to say.

    This delusional attitude says all the aggressive rhetoric coming out of Bush and Israel are for show.

  8. Scott Finch

    if there is one thing I can be fairly certain of it is that risks to growth or financial stability are significant. If my understanding of a material portion of special purpose entities involved in ‘warehousing’ a range of otc derivative products is accurate, or even slightly accurate, then it seems the risks associated with increasing short term borrowing rates, even the slightest amount, may cause an even greater risk in distrupting real output. With my not-too-sophisticated understanding of the spectrum of risks facing the US, among other regions, I get the impression we may be in for a period of serious ‘jawboning’. jaw-sessions.

  9. Anonymous

    US has a huge debt, which is the strongest force behind the oversupply of the US $. Moreover, currencies of the world leading economies are not pegged to the dollar, and their fast appreciation did not help the downslide of the US $. How is it possible that it is the pegged currencies of the emerging economies that carry so much blame for the depreciating dollar?

  10. m

    There seems to be two common misconceptions repeating throughout the comment section of the thread on Iran and Israel, as well as from the OP:

    1) Everyone seems to assume Iran will remain a rational actor once they obtain nuclear weapons. This assumption is based on ignorance, hubris and solopsism – projecting history (the Soviets were rational actors!) and pacifism (everyone just wants to live in peace and prosperity!). Shiite Twelvers – of which Ahmadinejad and Khomenei are fervent believers – hold that the Hidden Imam (a 5 year old who disappeared) will return only after nuclear destruction. While other religions hold this messianic belief, none except Twelvers are required to help bring about the end of days for the Messiah’s return. Iran has remained a rational actor so far because they lack the requisite tools to bring about the end of days. Please do some research into this.

    2) Everyone is also assuming, on top of Iran remaining a rational state actor, that they will nuke Israel themselves. I don’t know why this narrow, short sighted and ignorant view continues to propogate. Most likely, Iran will have one of its proxies – most likely Hezbollah or Hamas – launch the actual weapon. Who will Israel retaliate against? (I also, by the way, don’t buy the argument that the U.S. will nuke Iran for Israel’s sake, especially if Hussein Obama becomes president.)

  11. S

    Bernanke and Kohn are not credible anymore. I have always belived PR is soft. Always hard to calibrate its worth, but in this instance it approximates zero. First, raising rates from 2 to 2.25 is rather immaterial frankly. The rate cuts have really only flowed through to the banks – look at the 30 year mortgage, it is at 6.16 via bankrate vs mid 5 months ago. Admitedly the flattening yeild curve hurts banks to recap themselves, but more that is more an asset side play. On the deposit side, does anyone frankly believe the banks would pass through a rate increase to savers. No chance, just like there was no pass through on the rate cut side. There is certainly a high degree of irony in the fact that the most attractive assets out there are the immvable ones, relative and absolute valuation notwithstanding. buy the short end every time bernanke opens his mouth.

  12. hbl

    “Similarly, the markets are putting undue faith in the forecasting ability of a Fed chief that thought the subprime problem would be contained.”

    Yves, how certain are you that Bernake thought subprime would be contained, versus him simply trying to manage expectations and maintain confidence in the system to reduce the risk of sharp dislocations? (Admittedly I had not yet discovered your blog back when he made these comments…) He could be much more aware of the true state of the economy and banking system than he can afford to indicate in his public comments.

  13. russell1200

    I was of the understanding that the strike would not be on the type of facility where a Chernobyl type blow off was likely. My understanding of course could be incorrect.
    The most dangerous scenario (and you can take a few different paths to get there) has shipping through the Persian Gulf stopped. 90% of the supplies to our troops in Iraq go through the Gulf, and they need an enormous amount of material. The much touted air routes are already stretched and appear to be mostly used in supplying Afghanistan.
    Our MBA lead military now uses a just-in-time method of supply procurement. There are not a lot of extra supplies in theater to see the troops through.
    It could be very ugly. I am not saying that it should not be done, but that the potential costs need to be better understood.

  14. Yves Smith

    On Iran, the Dr. Strangelove comment related specifically to Roubini’s comment that Israel would strike nuclear facilities. When Israel did that previously, they were merely in the planning stage. They are now full blown reactors. Please see the link to the comments earlier for much more extensive discussion. In short, the consequences of a strike on a nuclear reactor would be vastly worse than a Chernobyl because the radioactive material would be dispersed more widely.

    As for Iran’s posture towards the US, Stratfor wrote repeatedly right after the second Iraq war about the “coming US-Iran alliance”. Iran was extremely helpful to us and made quite a few overtures. It appears they were rebuffed.

    Additionally, even though Ahmadinejad is a troubling figure, my understanding is that he actually has little power. I have been told that Khomenei has issued a fatwa against nuclear weapons, so the situation appears to be more complicated than portrayed in the Western media.

  15. Yves Smith

    As to the Bernanke “subprime is contained” theme, while he probably did not use that turn of phrase, this is the message he was conveying as of last July:

    Bernanke does see the impact of subprime lending problems as significant with losses seen in the $50 billion to $100 billion range. But on the real economy, the effects still seem limited.

    That $50 to $100 billion forecast, at the time, was markedly below consensus estimates.

  16. Anonymous

    Chernobyl?

    Yves, no one plans to strike the Buhsehr nuclear power plant. It’s not a proliferation threat. Plutonium from light water moderated reactors like the Buhsehr VVER is not usable in a weapon by a country like Iran. It’s too contaminated in Pu-238, Pu-240 and Pu-242 for that purpose. Plus Iran doesn’t have a spent fuel reprocessing facility to isolate the plutonium. And the fuel is owned by the Russians anyway and they would take a dim view of Iran if it took that fuel away for reprocessing.

    The #1 threat is the uranium enrichment plant in Natanz. It can be used to produce highly enriched uranium (HEU) for a Hiroshima-style weapon as well as it can produce low enriched uranium for reactors like Buhsehr, its stated purpose. Down the target list, you have other nuclear and missile facilities that could be used by Iran to weaponize HEU into warheads.

    And very down the list, there is the Arak heavy water plant which is a precursor for potential low-burnup reactors running on natural uranium to produce weapon-grade plutonium. That’s the same type of D2O-moderated reactors that were run by the US at the Savannah River Site to produce plutonium for its nuclear arsenal, with very low contamination in Pu-240 (and nearly no Pu-238 and Pu-242). But, as mentioned above, Iran doesn’t have a reprocessing plant. It doesn’t have any large heavy water reactor either and won’t have one until a 40 MW reactor of this type opens in 2014. That reactor is also located in Arak, btw.

    So, no. No one will bomb Bushehr once it’s fueled (which should happen sometimes next fall or next winter, according to Iran). No Chernobyl in the making.

    Yet, if a raid happens before Bushehr is fueled, I could easily see the US or Israel bomb the plant just to hurt and piss off the Iranians, the same way the US bombed water plants in Iraq. Not a military target per se but an economic one.

    The real dangers of a bombing for the neighbours and the rest of the world would be retaliations by Iran: guerrilla in Irak, Lebanon and Israel, mining of the Persian Gulf, attacks against oil facilities in the Arabian Peninsula, terrorism here and there, etc.

  17. S

    Stratfor has been remarkably wrong about their calls on Iran and developments broadly. Their reporting on NIE has been rebuffed in and out of governement and around the world. They ran with it becasue it agrees with their thesis on a US/Iran thaw/nexus. Whether that eventually transpires is ? Atimes and former DOD officer appently making comments that any attack on iran was outweighed by their in theater advanatage in responding to an attack. irresponsible to speculate on an attack, but it is worthwhile considering that it was WWII that led us out last time…

  18. m

    Yves: Iran made overtures to us in 2003 because they feared they were next. As soon as it was apparent that the U.S. were bogging down, they withdrew their overtures and began manufacturing IED’s for the insurgents. Great.

    Furthermore, Iran’s nuclear facilities are spread out and deep underground. Their facilities are nothing like Chernobyl’s, which is centralized, or Iraq’s, also centralized and above ground, from 1981. According to Israeli sources (I laughed out loud when you said you had some good ones…give me a break, I lived there for a year and a half and your view on what Israelis think is not anywhere near the target), the Iranian facilities are not quite at the point of no return stage and still succeptable to bombing without huge nuclear collateral damage.

  19. juan

    It may be better to consider the cycle not as a consequence of monetary policies and Fed actions which are primarily reactions, i.e. these policies and actions do not create the cycle which develops in somewhat less superficial levels.

    Yes, the Fed was created with a lobbiests supplied idea that it would be able to prevent the cycle, an idea that within less than a decade had been invalidated.

    Later, ‘prevent’ transformed into ‘mitigate’ and, when mitigation was least required, all seemed fine and good, but the ‘golden age’ ended and ‘mitigation’ increasingly became permanent crisis management.
    Though apparently desired, there is no central controlling authority other than the system’s own internal relations.

  20. juan

    … it is worthwhile considering that it was WWII that led us out last time…

    last time, the u.s. was a rising power competing with others to become the global hegemon.

    this time, we are instead a hegemon in decay, not simply over the last few years but for decades (though the curve has steepened). still exalting in nationalistic exceptionalism, such a failing power is susceptible to undertaking actions that have and can only further undermine.

  21. Francois

    “(I also, by the way, don’t buy the argument that the U.S. will nuke Iran for Israel’s sake, especially if Hussein Obama becomes president.)

    My hope of learning something new (Twelvers) was converted into hysterical laughter when I read the quoted text above.

    Who do you think you are kidding with such a ridiculous statement?

    Would a president called John Adolf Smith be de facto considered a threat to Israel?

    Grow up for Pet’s sake!

  22. m

    Francois: I meant the U.S. nuking Iran in the event of a nuclear attack on Israel by Iran, as announced by Clinton. Sorry for the confusion.

  23. Adrem

    I am afraid it is not relevent whether there will be a chernobyl in that area on an Israeli strike; or that ahmadinejad lacks the power; or that Khomenei has issued a fatwa against nuclear weapons. The only relevent fact for Israel will be if Iran has the ability to make a nuclear weapon. Israel MUST preserve its existence and cannot rely on the possibility – for that is all it is – that the Iranians will be rational. Israel has no other option but to strike come what may. Israel has to deal with FACTS not hopes, wishes, notions, desires, etc., etc.,

  24. Anonymous

    What, pray tell, gives Israel the right to attack a country that has not violated its boundaries or engaged in an act of war? This is no different than Hitler marching into the Sudetenland.

    Actuallly it’s much worse for the reasons above, that the human damage in the area and the global consequences, in terms of limiting or effectively ending access to a considerable amount of a vital resource, would be far worse. If a strike leads to oil over $200 a barrel, you’ll see starvation due to the impact of higher energy costs on agricultural production. But no, you argue that Isreal, a country with a mere, what, 5 million, 6 million people, has the right to act against a mere potential threat, with the likelihood of ultimately causing far more deaths than its entire population as a result of its actions. But hey, they are just poor people in Africa, not members of the chosen race, right?

    Who the hell do you people think you are?

    And similarly, why does Israel have the right to possess nuclear weapons and insist its neighbors have none, particularly if its advocates, as you do, insist it has the right to attack its neighbors without provocation? Has it ever occurred to you that having Israel reduce its nuclear capabilities might be a bargaining chip to get the Iranians to submit to inspections (or have Israel put a certain proportion of its weapons with a neutral party to assure continued Iranian compliance with inspections?)

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