“The steepest market plunges on record (e.g. those following the 1973-74, 1987, 2000 and 2007 peaks, among others) have generally followed an overvalued speculative blowoff coupled with divergent interest rate pressures. This is why we take the "overvalued, overbought, overbullish, rising yields" syndrome so seriously. Indeed, the outcomes are usually negative on average even without rising yields, but the yield pressures tend to add immediacy. Notably, the emergence of this syndrome has provided accurate warning of oncoming losses both historically, and also as recently as 2010 and 2011.
“These syndromes are useful because the combination of several conditions often carries far more information than any of them individually. To ignore syndromes like the ones we've increasingly observed in recent weeks is like having nausea, sudden lower-right abdominal pain - especially following a period of dull pain in the upper abdomen, coupled with an inability to even consider jumping, and shrugging it off as a stomach ache instead of recognizing that, in all likelihood, your appendix has just burst.”
- John Hussman
You might remember last year, when commodity prices were rising, Ben Bernanke referred to the pressure of rising prices as being transitory ... and refused to recognize it as plain and simple inflation.
The financial media gave him plenty of well-deserved flak for that view. But so what?
Here we are again with crude oil (and its derivatives) on the verge of applying major pressure to economic growth. I was asked two weeks ago to share some comments with an online news publisher regarding the United States’ energy policy. Specifically, 1) will the President’s newly proposed task force effectively stem price pressure brought on by speculation, and 2) does the current US energy policy influence crude oil speculation?
Here is what I said:
The public tends to think government officials need to do something in order to fulfill their duties. History suggests task forces like this amount to basically a PR campaign and don’t have an actual impact on stemming speculation. Speculation is typically an effective form of price discovery; speculation alone is not a guilty party but rather a scapegoat to explain away uncomfortably high prices. Speculation and rising prices are mere symptoms of excess liquidity (loose monetary policy). What the task force needs to address is this root cause of the symptoms, not the symptoms themselves. Sadly, as past experience tells me, I doubt that will be the case. I don’t think the task force will have any effect on prices.
It’s clear that speculators consider all these [energy policy problems], but there are more immediate influences [on the price of crude oil] ... especially now.
First, monetary policy has created a system of endless credit and artificially low interest rates that push investors further out the risk curve. In other words, excess liquidity incentivizes speculation in inherently risky assets like crude oil.
Second, geopolitical risk premium is a major concern that has the potential to dramatically influence crude oil’s underlying fundamentals, at least in the short-run. Even though plenty can be done to mitigate the risks from an inconsistent US foreign policy, there is no quick fix and investors realize how quickly Middle East tension can escalate ... and how sharply prices could react.
But as it pertains to domestic energy policy, investors and speculators certainly use US policy as a foundation for crude oil price direction. Unfortunately, though, I’d say the piecemeal energy policy of the US is actually supportive of higher prices. The pushback on pipeline development and offshore drilling projects suppresses production. And that exacerbates the pressure on refineries responsible for the high-priced gasoline that consumers are so stressed about. Even though crude oil production is increasing because of shale and improved drilling technologies, it’s not increasing at a rate it could, and input costs remain too restrictive for regional refineries that are bogged down by overregulation and inefficient national infrastructure. And if you really wanted to dig in, you’d see how policy is forcing the economy to adopt still-unfeasible alternative energy development at the expense of crude oil development. When the government tries to pick winners they almost always lose.
Although, if you have the central bank on your side, who needs government subsidies?
In a recent lecture to George Washington University, Fed Chairmen openly admitted the Federal Reserve is not just an “ordinary commercial bank, but a government agency.” That’s been no secret to anyone who pays attention, but I didn’t realize the Fed was so blunt about that fact. Maybe I should have checked their Facebook page. But I digress ...
I found this blog post quite informative since it sort of offers additional angles to the speculation concept that aren’t often discussed. The “inflation-hedge” idea is also very much a symptom of the excess liquidity dynamic of easy monetary policy. As for the “intermediaries” (investment banks), after digging through the nitty-gritty and interconnectedness of our fractional reserve and shadow banking system, that angle could also be considered a bit of a symptom; though it may actually be a place where a task force could make some notable progress; but again, I doubt that’s going to happen because the US corporatocracy reigns.
The point I want to make is this:
The Federal Reserve is directly responsible, via their money creation policy, for the rising price of crude oil et al. The Fed isn’t solely responsible, but just as there can be geopolitical risk premium in the price of crude oil, so can there be quantitative easing premium in the price. And there is. But you’ll never hear the Fed Chairmen be so blunt about that because even Joe Six-pack would demand the Fed head on a platter.
Instead, we get more comments from him this morning hinting of more quantitative easing?
Moreover, we cannot yet be sure that the recent pace of improvement in the labor market will be sustained. Notably, an examination of recent deviations from Okun's law suggests that the recent decline in the unemployment rate may reflect, at least in part, a reversal of the unusually large layoffs that occurred during late 2008 and over 2009. To the extent that this reversal has been completed, further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.
Interestingly, the Fed’s counterpart in the Eurozone, the European Central Bank, is allegedly investigating (albeit after the fact) how it’s latest quantitative easing policies (LTRO I & II) are actually impacting the economy and markets, i.e. maybe the liquidity did not go to reviving credit markets but rather to shoring up bank balance sheets. [Again, no surprise here ...]
The European Central Bank won’t provide more long-term loans until it has studied how the funds are distributed into the economy, council member Joerg Asmussen told newspaper Helsingin Sanomat.
“We need to see how this liquidity feeds through over the next few months,” Asmussen said, according to a transcript of an interview with the Finnish newspaper on March 24 and published today.
I think many market watchers will agree that the LTRO initiatives helped to stabilize markets in Europe. Of course, this has been the Federal Reserve’s stated goal as well since quantitative easing has now been determined to have little impact (if any) on the real economy.
And doesn’t this stabilization in markets lead to rising prices of risk assets, like crude oil?
As suggested by news this morning on a German confidence number, the knock-on effects of high energy prices are apparently not yet being felt. From Reuters:
In Europe, the German Ifo think tank's business climate index rose to 109.8, beating expectations of a steady reading of 109.6 and surprising many traders who were bracing for a soft number after last week's weak reading of flash purchasing managers' indices (PMIs) across the euro zone.
Last week I proposed US consumer confidence as the true driver of economic expectations (rather than the recently improved US payrolls numbers.) The story looks a bit different in Europe, as PMI numbers are reflecting an economic slump but sentiment numbers remain firm.
With German business sentiment seemingly following the markets rather than the economy, could the markets be lagging the economy in Europe?
The US economy has “improved” in the face of rising energy prices, but the eurozone economy has deteriorated. What happens if crude prices go higher due to the monetary accommodation? Can either economy afford the generosity of their central bank, much less all the speculation from traders, inflation-hedgers and investment banks who are certainly taking notes?