Wednesday, July 26, 2006

Skating on Thin Ice

EUR/USD1.2586 Hi 1.2601 Low 1.2558
USD/JPY116.82 Hi 117.26 Low 116.65
EUR/JPY147.06 Hi 147.50 Low 146.79

Bernanke is back on again this afternoon. His job is simple: convince the markets that there is nothing fundamentally, structurally wrong with the U.S. economy and that everything is going to plan. Think of him as the economic equivalent of Condoleeza Rice: democracy is being born in the Middle East. Everything is going to plan. Yeah right. And if you don’t believe me just ask the lucky people in Lebanon and Iraq. Either country would make a great holiday destination right now.

Bernanke’s brief is to reassure domestic markets that the FED is aware that tighter monetary policy poses risks for domestic economic growth. The assumption being, of course, that an aware FED will not raise rates high enough to tip the economy into recession. This is of course a lie. The FED has to tip the economy into recession because current levels of domestic consumption are being financed by offshore capital inflows. That is: current levels of economic activity in the United States would not be possible without large sums of money coming into the country every day. This dependency makes the U.S. dependency on foreign oil look like very small bananas. If the whims of foreign oil producers make you uncomfortable, don’t even start to think about the goodwill of foreign savers.

Signs of nerves, hints of problems, anything but smooth-talking confidence in Bernanke’s own abilities would be badly received. His main strategy, in line with the strategy of the Bush Administration as a whole, is to deny the existence of big problems, focus on minor difficulties (wages growth, inflation) and announce bad news only when it has become obvious to everyone else on earth. Think of it as message massaging. What is actually taking place is never in question, but how you present it to the wider world determines whether or not you get away with it.

Bernanke’s problem is not that higher rates will eventually choke off the U.S.’s debt-financed, consumption-driven economic expansion. They will. Bernanke’s problem is that the FED needs to choke off the debt-financed, consumption-driven growth (which has created this huge external funding requirement) without sending domestic markets into a tail-spin or scaring off foreign capital inflows in the meantime. And that is a BIG PROBLEM.

The litmus test on how well he is selling his story is the USD. If the USD stays steady or even appreciates, the markets and foreign investors have bought the story.

Meanwhile in Oil Producing Countries in the Middle East there is ominous talk about reviewing the USD currency peg.

Let me spell this out. If OIL exporting nations no longer peg to the USD they will not necessarily keep holding large FX reserves denominated in USDs. That is: they will buy less USDs. That would be one more source of foreign capital down the toilet. And there is not really a long list of foreign countries lining up to offer Uncle Sam financial assistance right now.

The USD has seen precious little safe-haven buying during the recent flare up in the Middle East. No doubt the PPT has been at work, but results have been disappointing. What’s more people like Robert Rubin, Larry Summers and Paul Volcker haven’t exactly been cheerleading the blow-out in the U.S. current account deficit (which is a measure of that external funding requirement). Isn’t that, like, unpatriotic? I mean, there is a war on. Can’t we arrest these guys? Or something.

Meanwhile, Right Wing Think Tanks (an oxymoron in the making?) are apoplectic that the Bush Administration is actually talking to its allies. (As opposed to bombing them, I suppose.) They suggest that Rice has gone all soft on the Middle East, that calling any kind of cease-fire would send the wrong signal to "the terrorists". Yada. Yada. Yada. They were obviously in a different dimension when the present escalation got underway. LINK Not, that it can be expected that they will change their belligerent rhetoric when presented with the facts. The target is Iran. From their point of view they can’t get to Iran unless the present conflict spirals out of control. A cease-fire is the last thing they want.

OIL 73.97
GOLD 630.50

What the Right Wing Think Tanks seem to have missed is that the balance of power in the world has shifted. The U.S. currently depends both on foreign capital and foreign oil. Lots of both. When you become a debtor nation, as the U.S. most assuredly is, you can no longer call the tune. You have to play ball with your creditors. That is the reality. Up till now the creditors in question were still suffering from post-colonial stress. They did what Uncle Sam told them to: namely hand over their cash for safe keeping. Ha. Ha. A couple of generations have grown up since the end of colonialism. And nobody is buying the idea that the rest of the world has to fund the U.S. any more.

Right now the Bush Administration has to talk to its allies, to its enemies and anyone else who will listen. There is no question that the U.S. can just do what ever it wants and tell everyone else later. Times have changed.

Ironically it is the neo-con push for an Iraqi invasion that helped push OIL prices through the roof and increased U.S. dependence on foreign capital (to pay for the bombs, you understand). One day these delusional souls may start to come to terms with how the world actually is, as opposed to how they think it should be.

For the rest of the world it’s a bit like having a mad aunt in the attic. Only this one has nuclear bombs.

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Comments:
"an aware FED will not raise rates high enough to tip the economy into recession. This is of course a lie. The FED has to tip the economy into recession because current levels of domestic consumption are being financed by offshore capital inflows."

Japan depends on the U.S. for its security, so I think it can be relied upon to keep buying those Treasuries for a while longer yet.

A higher domestic savings rate should encourage the consumer to save more and if China can be persuaded to revalue the yuan again the balance of trade should improve. Pressure is certainly being stepped up and the situation can't go on forever as China must surely acknowledge. US senators to meet Paulson on China yuan concern
 
No the situation can't go on forever.

The million dollar question is: can the U.S. correct these imbalances without disruption on financial markets ?
 
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