Can the Big-3 Central Banks Derail the "Commodity Super Cycle"?
Shortly after climbing to its highest level in 25-years, the Reuters Jefferies Commodity index (CRB Index) went into a nosedive in early February, and lost about 8% of its value. The sell-off in the CRB index was linked to unusual movements in Japanese yen interest rate futures (Euro-yen) in Singapore, which signaled for the first time in five years, that the Bank of Japan is prepared to tighten its money policy, and allow for higher Japanese interest rates.
The Bank of Japan's ultra-easy money policy, combined with the super-easy policies of the European Central Bank, inflated many asset bubbles worldwide, and also igniting inflation in industrialized nations. But the BOJ's Kiyohiko Nishimura warned on February 16th, that "Japan is no longer a sick patient and the time to stop administering morphine to the economy is getting closer."
Short-term Japanese bond yields jumped to five-year highs last week, after the Bank of Japan governor Toshihiko Fukui warned the global markets that the five-year era of ultra-easy money in Tokyo is near an end. The central bank will "eventually move step by step to a neutral interest rate level. The CPI should show a relatively clear uptrend from January. Therefore, it is becoming even more crucial than before to assess the rate of year-on-year gains in core CPI," he said.
Adding fuel to the fire, the Yomiuri newspaper reported on February 24 th that Fukui and senior central bank officials might to start to unwind the BOJ's ultra-easy policy as early as the March 8-9th policy board meeting. That would be earlier than market expectations for a policy shift in late April. Benchmark Euro-yen futures slumped in Singapore and Chicago, matching their lowest level in 16-months and are now fully pricing in a quarter-point yen Libor rate by September. And Japan's 10-year bond yield rose above key resistance at 1.62%, exerting upward pressure on bond yields in Australia, Brazil, Canada, the Euro zone, the US, and elsewhere.
From a technical point of view, the CRB index appeared to be ripe for profit-taking near the 350-area, with a few technical indicators flashing an overbought condition. Schizophrenic commodity day traders quickly decided to turn their enormous paper profits into hard cash at a moment's notice.
However, the 8% sell-off in the CRB index in the first half of February, relieved the overbought technical condition, with the Relative Strength index falling from around the 75 level to the low 40's. At that point, buyers stepped back into the CRB index, near the key upward sloping trend-line at the 320-level. After forming a double-bottom pattern near the 320-mark, the CRB rallied 3.5% to close at 331.34 on March 3rd, accompanied by rebounds in copper, crude oil, gold and silver futures contracts, the premier leaders of the "Commodity Super Cycle".
For the first time in five years, the big-3 central banks, the Bank of Japan, the Federal Reserve, and the European Central Bank, would be tightening their monetary policies in unison. According to futures markets in Chicago, Frankfurt, and Singapore, the big-3 central banks are expected to guide their short-term Libor rates about a half-percent higher from current levels by year's end.
Last week, interest rate futures contracts for the Euro (Euribor) and Japanese yen (Euro-yen) fell below key horizontal support levels, joining the US Eurodollar bear market, which itself, has trended lower since June 2004. According to the global futures markets, the Federal Reserve could lift the federal funds rate to 5.00%, the European Central Bank could lift its repo rate a half-point to 3.00%, and the Bank of Japan would guide its 3-month Libor rate a half-point higher to 0.50%, although its overnight rate would still remain at zero percent.
If the downturn in yen, Euro, and US dollar interest rate futures continues unabated into lower ground, then the global bond and stock markets could be in for a rude awakening. The appearance of "Head and Shoulders" top patterns in the Euribor and Euroyen suggest that the ECB and BOJ might have to bare the brunt of the global tightening campaign after the Fed moves to the sidelines by June, to contain the inflationary pressures they created over the past four years. On March 3rd, Japan said its core consumer price index was 0.5% higher in January from a year earlier, sending the 5-year cash JGB yield to 1.12%, the highest since November 2000, just months before the BOJ introduced its unprecedented policy of flooding money markets with 32 to 35 trillion yen ($300 billion) at zero percent to inflate its economy to prosperity.
Finally, the LDP ruling elite admit that Japanese "core" consumer prices are emerging from eight years of deflation. But the price of gold has soared by 118% to as high as 68,400 yen per ounce, at an annualized rate of 23.6%, since the BOJ implemented its ultra-easy monetary policy in March 2001. Only a novice investor would believe the phony inflation statistics coming out of Tokyo, and prefer JGB's over gold.
Japan's financial warlords have amassed 774 trillion yen ($6.6 trillion) of outstanding debt, and have brainwashed Japanese households to accept the lowest bond yields in the industrialized world for the past decade. Foreigners abandoned the Japanese bond market long ago, and only hold about 5% of the low yielding debt. The rest is held by Japanese investors, who hold almost half of their 1,454 trillion yen ($12.5 trillion) of savings in the Japanese debt market. Japan's financial warlords are afraid that the average investor might stampede for the exits, as the central bank mops up trillions of yen in liquidity in the money market, thereby driving bond yields up and bond prices down.
LDP ministers are jittery over any sudden rises in government bond yields (JGB yields) that could increase the cost of financing the deficit, and send short-term interest rates soaring from near zero percent and choke off the economy's long-awaited recovery. Tokyo has worked tirelessly through direct intervention and jawboning in currency markets to engineer a rally in the Nikkei-225 stock to 5-year highs, but it could unravel from a tighter BOJ policy and a stronger Japanese yen.
Japan's ruling elite are having nightmares over the shift towards a tighter supply of yen in Tokyo. "We can't have a situation where the BOJ shifts policy, and then have to reverse course should things go wrong," Japanese PM Koizumi told a parliament committee on March 6 th, which BOJ chief Fukui also attended. "Governor Fukui is wise and I expect he will make a decision by considering various situations, including what I have said," as Koizumi demanded a further delay in BOJ tightening.
"We cannot allow a setback in the current recovery track. There are signs of deflation ending, but I am wary of whether deflation has been beaten. It must be judged cautiously," argued Koizumi. Japan's economy grew at a 5.5% annualized rate in the fourth quarter 2005. For Fukui, the independence of the BOJ is now at stake.
The Bank of Japan has not raised short-term rates since an ill-fated quarter-point rate hike in August 2000 that put an end to 18 months of zero interest rates and was blamed by politicians for snuffing out a fragile recovery in Japan's economy. The Nikkei-225 stock index had already begun to descend from the 20,000 level towards the 17,000-mark in the summer of 2000, when former BOJ chief Masusru Hayami warned of the need to tighten rates to contain inflation pressures.
But the tiny quarter-point rate hike to 0.25% proved to be fatal, and after Japan's 2-year bond yield spiked up 35 basis points to 1.72% in September 2000, the Nikkei-225 began to crumble, sliding to as low as the 12,000 level. The Ministry of Finance stepped in to support the Nikkei below 12,000 by purchasing Nikkei futures contracts, and putting a squeeze on short sellers. The intervention resulted in a rally back to the 14,000 level, just in time for the fiscal year end, March 31st, 2001.
But the damage had already been done. Japan slipped into a new economic downturn. Unemployment rose to a postwar high of 5.4%, Japan's debt was downgraded by two US credit rating agencies to AA, with the debt to GDP ratio at 130%, (today at 151%), and deflation was intensifying. Most alarming, Japan's government had exhausted all conventional policy tools to tackle the downturn.
But Fukui has said the BOJ should not fear failure when conducting monetary policy that has haunted LDP kingpins since Hayami's ill-fated quarter-point rate hike in August 2000. "We cannot always fear failure. Policy is something that takes future conditions into account, so we take risks. We would like to make a calm and appropriate judgment on whether our three conditions are met by looking at not only CPI figures on the surface, but also economic conditions behind them."
In the Euro zone, the European Central Bank, under the leadership of Jean "Tricky" Trichet, has been inflating the Euro M3 money supply to hold borrowing costs near 60-year lows, even as private bank lending soared at an annual rate of 9.7% last year. The self proclaimed anti-inflation vigilante, "Tricky" Trichet has presided over a massive 43% devaluation of the Euro against gold since August 2005, while inflating European stock markets to 5-year highs. That in turn, has elevated the confidence of German businessmen, to 14-year highs, according to the latest Ifo survey.
But after coiling in a tight side-ways trading range between 300 and 350 Euros per ounce since 2002, European investors woke up to Trichet's scheme in the summer of 2005, and rushed into the gold market to protect their Euro purchasing power. With the price of gold spiraling above 400 Euros per ounce, despite heavy ECB gold sales, and with the Euro M3 money supply expanding at an 8.5% annual rate, Trichet was finally cornered, and forced to begin an un-popular rate hike campaign, amid howls of protest from European finance chiefs and labor unions.
"Tricky" Trichet turned 180 degrees from remarks he made to the Federal Reserve Bank of Chicago and the World Bank on April 23. 2002. Then, he warned that central bankers must be cautious in considering volatile asset prices such as the stock market and housing prices when setting monetary policy. "My feeling is that we should remain extremely cautious about it because it would be like opening Pandora's box if we set our key policy rates according to asset price changes."
"Not only could the large swings, misalignments or even bubbles of assets prices endanger price stability, which is the main objective of most central banks, but also they could impinge upon financial stability. Price stability is the bedrock on which financial stability is built," he said. "However, it is clearly not opportune to introduce asset prices into a monetary policy rule," Trichet said.
But three years later, on May 14th, 2005, Trichet was justifying his ultra-easy money policy after leaving the repo rate unchanged at 2%, despite a 26% surge in North Sea Brent crude oil to $57.65, which was fueling the "Commodity Super Cycle." "Clearly our credibility and vigilance explains the low inflation expectations in the French bond market. The fact that we are credible and vigilant allows us to anticipate inflation in line with our definition of price stability." But Trichet's famous last words, heralded a massive 42% devaluation of the Euro in terms of the gold ounce.
Trichet's "asset targeting" or inflating the M3 money supply to support higher equity markets has simply pushed the Euro zone economy into the "Stagflation" trap. Germany's economy crawled to a complete halt in the fourth quarter of 2005, while its producer price index is 5.7% higher from a year ago. French GDP rose just 0.2% in the fourth quarter compared with the previous three months, far less than the 0.7% of the third quarter. Growth in the Euro zone slipped to about 1.3% for 2005 from 2.1% in 2004, with producer prices 5.3% higher across the region.
So while the spectacular German DAX-30 rally of 40% since May 2005 looks great on paper, in "hard money" terms, it is actually 2% lower, falling behind gold's 42% rally against the Euro to 470 Euros per ounce. The ECB's super easy money policy has enriched the fortunes of investment bankers at Deutsche Bank, Societe General, and UBS and Goldman Sachs, but has robbed the average European of purchasing power of the Euro. The hard money men at the Bundesbank are nowhere to be found.
Trichet drags his heels on lifting the repo rate, even as it becomes readily apparent that the ECB is far behind the inflation curve. "Upside risks to price stability prevail," he said on March 2 nd, after lifting the bank's repo rate a quarter-point to 2.50 percent. "The adjustment of interest rates will continue to insure that medium to long-term inflation expectations remain solidly anchored. Interest rates across the entire maturity spectrum still remain at very low levels in both nominal and real terms, and our monetary policy remains accommodative," he said. Yet the ECB's repo rate is pegged 280 basis points below the Euro zone producer price index.
Asked if the next rise might also come in three months' time in June, as seems to be the habit of the lazy ECB, Trichet left the door open. "There are no rules such as increases every month or increases every three months. We do increase rates if necessary, when necessary and when we judge it is appropriate." So "Tricky" Trichet is aiming to keep the repo rate at 2% below the US fed funds rate to keep the Euro anchored near $1.20 for as long as possible.
The new Italian banker chief Mario Draghi, tried to brainwash the local media on March 4th, and said the ECB had earned credibility in fighting inflation that would help underpin growth. "This credibility is precious and needs to be preserved. It is the reason, especially in the Euro area, why monetary conditions continue to be very relaxed, interest rates remain near the lowest levels ever."
But Draghi also sent a discreet signal to European investment bankers that their takeover mania has carried European equity prices too high. "Such low historic interest rates, not only in Europe but around the world, may be fueling too much optimism among investors. While an adjustment in risk premiums would probably be orderly, there's a risk that they won't be," he said.
In his Capitol Hill debut as Federal Reserve chief, Ben Bernanke on Feb 15th said higher interest rates may be needed to counter the risk of inflation. Bernanke wants to shed some of his dovish feathers, and establish his credentials as an inflation "hawk". "The risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately in the absence of countervailing monetary policy action to further upward pressure on inflation," he said, trying to sound more like a wise old owl.
Bernanke played down fears a housing slowdown could derail the US economy and was confident that demand from elsewhere would "pick up the slack." "There are some straws in the wind that housing markets are cooling a bit. If the housing market does cool, that would still be consistent with a strong economy. A leveling out or a modest softening of housing activity seems more likely than a sharp contraction, although significant uncertainty attends the outlook," he said.
He said a yield curve inversion in the US bond market, where short-term rates are higher than long-term rates, did not signal an economic slowdown, as they have often in the past. "The decline in long-term yields resulted from an excess of desired global saving. Long term inflation expectations appear to have been contained."
Eurodollar futures on the Chicago Mercantile Exchange are pricing in two quarter-point rate hikes by the Fed to 5% by June, before the US central bank moves to the sidelines for the remainder of the year. So the Reuters commodity index was hit by a tripe whammy, from sliding Yen, Euro, and US dollar interest rate futures in February and early March. Tighter monetary conditions could make the landscape for the "Commodity Super Cycle" a bit more slippery in 2006.
St Louis Fed chief William Poole thinks the Fed should tighten beyond the neutral rate of 4.50% to keep the "Commodity Super Cycle" under wraps. "Could we make a mistake by carrying the restriction too far? The answer is yes we could. But we have to balance the inflation risk against the risks of undershooting on progress in increasing employment," he said on February 24th. The US consumer price index jumped 0.7% in January, taking its year-on-year inflation rate to 4.0 percent. US producer prices were 5.6% higher from a year ago, the US government said.
"The economy is not fragile. There is a great deal of momentum, and should we make a policy mistake, we should be able to back off without a recession developing. I think that we are in a very solid, robust policy framework. Because momentum is good, inflation expectations are firmly held," Poole told the main stream media that loves to dissect food and energy from inflation statistics.
But Minneapolis Fed chief Gary Stern is un-easy with the Fed's tightening campaign beyond the neutral rate of 4.50%, and said underlying inflation will not "deviate materially" from the low range of recent years, and there were no signs of broad-based wage pressures. Outgoing Fed Vice chairman Roger Ferguson said the economy is "solidly on track" but it faced "significant risks," including the possibilities of a sharp downturn in housing and a further spike in energy prices.
Both Fed officials said there could be some reversal of the wealth effects that have boosted consumer spending if housing prices flatten out or decline, backing the view they are nearing an end to a rate-hike campaign that started in June 2004 and has produced 14 quarter-point increases so far.
The bearish outlook of the interest rate futures markets in Chicago, Frankfurt, and Tokyo, if realized, could lead to a deflating of the US housing bubble, snuff out the fledgling European economic recovery, or strengthen the Japanese yen and unravel the Nikkei-225 stock index. That might be a price too high for the big-3 central bankers to pay, in order to combat the "Commodity Super Cycle." The Bernanke Fed might panic at the sight of falling US home prices.
Likewise, the bullish case for Reuters CRB index rests on the fact that it has become a viable alternative to equities. If the tightening campaign by the big-3 central banks does not lead to a slowdown in the global economy, nor trigger a significant sell-off in the major global stock market indexes, then it is unlikely that commodities would surrender much ground either. At this point, there is a fair amount of skepticism about the anti-inflation resolve of the big-3 central banks, which created the worldwide asset bubbles in the first place.
Investment bankers such as Goldman Sachs and Morgan Stanley UBS, Merrill Lynch, and Credit Suisse have bolstered their positions in the various CRB sectors to cash in on the boom in commodities prices, and each earned more than $1.5 billion trading commodity contracts in 2005.
Also looming on the horizon is a crisis over Iran's nuclear weapons program that is supporting a "war premium" for crude oil and buoying gold. Iran's Ayatollah might not give into US demands to halt his plans to enrich uranium, nor surrender his goal of nuclear invincibility. "Going to the Security Council will certainly not make Iran go back on research and development," said Ali Larijnai, secretary of Iran's Supreme National Security Council on March 5th. "If our case is referred to the Security Council we will resume large-scale uranium enrichment," he said, upping the ante.
Britain , France and Germany bowed to some of the Ayatollah's demands over the weekend, and offered Iran the technology to build a nuclear weapon, in return for a 10-year moratorium on uranium enrichment. However, the appeasement backfired, and Tehran has sounded more defiant than ever. Asked about plans to use its oil exports as a weapon in a clash over its clandestine nuclear weapons program, "We are not interested in using oil as a weapon, but if the conditions change it could affect our decision," added Ali Larijani.
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