Central Bankers Operating behind "Smoke and Mirrors"

By: Gary Dorsch | Tue, Aug 8, 2006
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The synchronized phase of monetary tightening by the world's three largest central banks, the Federal Reserve, the Bank of Japan (BoJ), and the European Central Bank (ECB), appears to be fizzling-out almost as soon as it started. The Fed is widely expected to wind down its rate hike campaign on August 8th, less than a month after the BoJ raised its overnight rate for the first time in five years.

The Fed is moving to the sidelines to join the central banks of Canada and Korea, which declined to raise their overnight loan rates last month. That might encourage other central banks to keep their interest rates on hold. A residual quarter-point rate hike by the BoJ to 0.50% in the fourth quarter, and two quarter-point rate hikes by the ECB to 3.50% are expected, before the big-3 tightening spree flickers out.

Central bankers are utilizing a strategy of "Smoke and Mirrors," mesmerizing the traders with baby-step rate hikes, but falling far short of the levels needed to shrink their money supply. Whether the central bank is printing money to maintain an artificially low exchange rate, or flooding the banking system with money to peg an artificially low interest rate, the net result is the same - monetary inflation.

The strategy of "smoke and mirrors" was first announced on May 8th, when G-10 central bankers agreed that a new approach was needed to combat the "Commodity Super Cycle," the culprit behind upward pressure on global inflation. "It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation," declared G-10 spokesman and ECB chief Jean "Tricky" Trichet.

The G-10 started to sound hawkish on inflation, and unveiled baby-step rate hikes over the next few months. Much to the G-10's satisfaction, the central banks in China and India also chipped in with monetary tightening to combat the common enemy. Last week, central bankers from Australia, Denmark, the Euro zone, England, India, Russia, and South Africa launched a round of baby-step rate hikes. Most surprising, the Bank of England lifted its base rate for the first time in 2-years.

Caught off-guard, the Morgan Stanley World Index and the gold market went into a meltdown from May 11th thru June 13th. In the initial phase, global stocks and gold were hammered on a shake-out of over-extended speculative positions. In the second phase, markets fell on exaggerated fears of monetary tightening, knocking the MSCI All-World index 12% and gold 26% lower during the four-week rout.

In the aftermath of the four-week plunge, the MSCI All-World Index and gold have recovered roughly half of their losses since June 13th, based on the growing realization that the world's central banks have no real desire to switch from accommodative to restrictive monetary policies. On August 3rd, ECB member Guy Quaden summed up the G-10's thinking, "Keeping a grip on inflation does not mean killing economic growth, the two objectives are not irreconcilable," he said.

Indeed, money supply growth in Europe is still explosive, and in big emerging economies, such as China, India, Russia, and South Africa, the money supply is growing at rates ranging from 18% to 45 percent. Tokyo's 0.25% overnight loan rate is the cheapest source of credit on the planet. And now, the Federal Reserve, the world's most powerful central bank, is laying down its weapon in the fight against global inflation. Operating behind the haze of "Smoke and Mirrors," global central bankers won't be draining the swamp of global liquidity in any meaningful way.

Monetizing the price of Crude oil

If not for the inexorable rise of crude oil and the "Commodity Super Cycle," it is doubtful that central bankers would be lifting their lending rates at all. Although central bank rate hikes can't produce an extra barrel of oil, a gentle round of monetary tightening might prevent the world's demand for crude oil from exceeding a razor thin 2.2 million bpd of spare capacity, mostly from Saudi Arabia.

The soaring price of crude oil, if elevated long enough, transmits secondary knock-on inflation pressures. Until recently, central bankers insulated their stock markets from the taxation of oil price shocks, by expanding their nation's money supplies. But in September 2005, the gold market became very suspicious of the scheme, and rocketed 50% to 100% against most currencies around the world until May 2006.

Most central banks prefer to monetize the price of crude oil, but there are limitations to this practice. Double digit money supply growth can eventually lead to deterioration in local bond prices, and higher long-term interest rates. Recently, the Bank of England was punished with a sharp slide in British gilt prices, for expanding the M4 money supply by 13.7% over the past 12-months.

However, the G-10 strategy of capping crude oil prices with higher interest rates is running into a snag, with Iran's mullahs orchestrating a mini-war against Israel thru their Hizbollah proxy army in Lebanon. Tehran is showing the world a sneak preview of a much more destructive war that would be centered on the Gulf of Hormuz, shutting down 17 million bpd of crude oil exports, if the United Nations adopts crippling economic sanctions on Iran.

With an eye beyond the US Congressional elections in November, Venezuelan leader Hugo Chavez cemented an "Oil Weapon" alliance with Iran's president Mahmoud Ahmadinejad on July 24th in Tehran. Chavez and Ahmadinejad boasted they are steeled for any military assault the United States might launch. Venezuela's Energy Minister Rafael Ramirez echoed the defiant spirit by threatening to cut oil exports to the United States if Washington did not drop its hostile stance towards Tehran.

Chavez and Ahmadinejad could potentially withdraw their combined 4.8 million bpd of oil exports from global markets, even for just a few weeks, and ratchet oil prices toward $100 per barrel. Iran's Foreign Relations Vice Minister Manuchehr Mohammadi warned on August 2nd. "The first consequence of these UN sanctions would be an increase in the price of oil to around $200 per barrel."

But halting Iran's nuclear ambitions is more important than preventing high crude oil prices, US Energy Secretary Sam Bodman said on August 8th. "We are as prepared as we can be for a disruption of Iranian oil exports. As important as the price of oil is, stopping Iranian nuclear enrichment is more important than the price of oil." Central bankers couldn't print that much money to rescue global stock markets from a spike in oil prices to $200 per barrel, without sending gold above $1000 /oz.

Federal Reserve winding down its Rate Hike Campaign

With the ink barely dry on the July US payrolls report, some traders are jumping the gun, and guessing when the Fed might start trimming interest rates. US gross domestic product grew just 2.5% in the second quarter, well down from 5.6% in the first quarter. The US economy added 113,000 jobs in July, after averaging 112,000 jobs in the past four months, down from 176,000 jobs a month in the first quarter.

But the US economy is caught in the "Stagflation" trap, with producer price inflation running at 4.5%, and exceeding the economy's 2.5% growth rate. The only sensible way to wiggle out of the "Stagflation" trap for the long-term is to lift the fed funds rates higher towards 6.00%, to break the back of inflation. However, Bernanke is a Bush political appointee, and wants avoid any further interest rate increases that could undermine the Republican majority in the US Congress in November.

Instead, Fed chief Bernanke is trying to brainwash traders with his propaganda, that slower US growth can reduce inflation pressures. But behind this game of "smoke and mirrors," a weaker US economy can also translate into a weaker US dollar, which in turn, can lift the "Commodity Super Cycle" to new record highs. Thus, a premature pause in the Fed's rate hike campaign in August, could set the stage for a speculative attack against the US dollar, and lead to higher inflation.

British Pound Soars to 15-month highs, but British Gilts Tumble

The Bank of England shocked the foreign exchange market on August 3rd, by hiking its base lending rate a quarter-point to 4.75%, the first rate increase in two years. The surprise rate hike catapulted the British pound above the psychological $1.90-level, to a 15-month high hit against the dollar, buoyed by expectations that UK inflation would stay above the BOE's 2.0% target through 2007, and ratcheting the pressure for more British rate hikes this year.

The British pound got an extra shot of adrenalin from news that Italy's central bank slashed its US dollar holdings and switched 25% of its reserves into sterling. The Bank of Italy said it had cut the share of its US dollar reserves to 63% from 84% and also trimmed reserves in the Japanese yen, while holdings of sterling rose to 25% from zero in 2004. At the end of the first half of 2006, the value of official Italian reserves was equal to 61.2 billion Euros ($79 billion).

Britain's Daily Telegraph newspaper cited an Italian official as saying the Bank of Italy was acting in advance of an expected slide in the US dollar as the Federal Reserve prepares to end a two-year credit tightening campaign, leaving traders to focus again on a gaping US current account deficit. Central banks in the United Arab Emirates, Sweden and Russia are shifting out of dollars and into the Euro.

The Bank of England's surprise rate hike to 4.75% is a departure from its strategy of massively inflating the UK money supply, to keep short-term interest rates artificially low, and buoy the British stock markets. The UK's M4 money supply rate jumped 2% in June to an annualized 13.7% rate, its fastest rate of acceleration in 16-years. The BOE is trying to hold interest rates, to help British households saddled with more than a trillion pounds of debt. UK bankruptcies are also at record highs and banks have been lining up to complain about bad debts.

The BoE has desperately tried to insulate the British stock market from oil shocks, but a 50% surge in gold prices and a sharp slide in British gilts, has cornered the central bank into a dead-end. The August 2005 rate cut to 4.50%, designed to prop-up a 160% increase in UK home prices since 2001, badly tarnished the BOE's image as an inflation fighter. However, the BOE's money printing scheme is starting to unravel with British 10-year gilts teetering on very shaky ground.

According to London futures markets, the BOE is still far behind the inflation curve, and is widely expected to hike its base rate by a quarter-point to 5.00% by year's end. Still, a possible rate hike to 5.00% would only take a tiny bite out the M4 money supply, so the BoE would still be pursing a "smoke and mirrors" monetary policy, with its double-digit money supply growth intact.

The European Central Bank is far behind the Inflation Curve

The European Central Bank is slowly removing the monetary morphine that it injected into the European stock markets over the past three years. The ECB hiked its repo rate 0.25% to 3.00% on August 3rd, and is starting to take a small bite out of the Euro M3 money supply, whose annual growth rate fell 0.4% to 8.5% in June, while European bank loans are 11% higher from a year ago.

ECB chief Jean "Tricky" Trichet said on August 3rd, he expects Euro zone inflation, currently at 2.5%, to remain above the ECB's 2% ceiling through 2007, due to the secondary knock-on effects of past oil price rises and sales tax rises due next year. He saw further dangers that inflation could be even higher if oil prices move higher, and that dynamic money and credit growth also required a careful watch.

Trichet says it's necessary to keep inflation expectations well anchored, adding that monetary policy was still accommodative. So on the surface, it looks like the ECB is actually tightening its monetary policy, but behind all the "smoke and mirrors" the central bank is still pegging the repo rate far below the Euro inflation curve. Moving with baby step rate hikes, the ECB aims to slow the Euro's climb against the US dollar, and to cushion European stock markets from oil price shocks.

Australian Inflation and Interest Rates on the Rise

Australia's central bank hiked its cash rate a quarter-point to 6.00% on August 2nd, as expected and warned of increasing inflation pressures, leaving markets braced for further tightening. The quarter-point hike was the second in four months and took cash rates to their highest since early 2001. The decision helped to push the Australian dollar to as high as 76.75 US-cents.

The Reserve Bank of Australia (RBA), pointed to several reasons to justify the move, which faced little political opposition. "The board's assessment, based on the gradual increase in underlying inflation this year, and the wider background of above-average global growth and strong domestic demand, was that underlying inflation in the period ahead was likely to exceed previous forecasts."

Australia's consumer price inflation jumped to an annual 4.0% in the second quarter, the highest reading in six years and well above the central bank's target zone of 2% to 3 percent. The rise in inflation was partly due to external factors like high oil prices, broad-based increases in commodity prices, and a general pick-up in output prices at all stages of production, with a tight labor market in the background.

The RBA also noted that businesses and households continued to find it attractive to borrow and that intense competition among lenders meant interest rates paid by borrowers were lower than otherwise. On the surface it looks as though the RBA is tightening its monetary policy. But behind all the "smoke and mirrors", the RBA is still pegging interest rates at artificially low levels, by pumping the Aussie M3 money supply 10.3% higher from a year ago. In a long delayed reaction, after three years of double-digit money supply growth, gold soared 54% to 850 Aussie dollars /oz.

China Fiddles with its Over-heated Economy

Is China embarking on a monetary tightening cycle that can slow its juggernaut economy? Beijing raised commercial banks' reserve requirements by 0.50% to 8.50% for the second time in five weeks on July 21st, to cool its overheating economy, which grew an annualized 11.3% in the second quarter. The tightening follows a similar move on June 16th that requires banks to tie up 150 billion yuan ($18.75 billion) at the People's Bank of China (PBoC).

The PBoC also stepped up open market operations, draining 120 billion yuan ($15 billion) from the banking system, thru the sale of short-term Treasury bills. Combined with a 1% increase in bank reserve requirements to 8.5%, the PBoC has drained about 420 billion yuan ($52.5 billion) over the past six weeks. Still, the central bank's latest tightening moves are actually quite gentle, when compared to the more than 7 trillion yuan ($875 billion) of liquid assets held by local banks.

The PBoC prefers to tighten via higher reserve requirements rather than interest rates, because an increase in interest rates encourages more speculative capital inflows, and upward pressure on the Chinese yuan. Because of Beijing's tight control of the yuan, the PBoC is forced to print yuan in exchange for foreign currency flowing into the country from trade surpluses and investment. Beijing inflated its M2 money supply at an annualized 18.4% in June.

Much of the excess liquidity is channeled into China's 7-year Treasury bond, where yields fell to as low as 2.75% in the first quarter of 2006, and down from 5.00% in late 2004. The scope of the PBoC's monetary tightening can best be measured by M2 growth, and the level of China's 7-year Treasury bond yield. Although the 7-year yield has crept upwards to 3.02% in recent weeks, it remains far below the 5% level that prevailed in 2004. The PBoC would need to increase reserve requirements by 3% to 11.5% by early 2007, to put a sizeable dent in rapid M2 growth.

But Chinese central bank chief Zhou Xiaochuan said on June 24th, that China did want to risk an economic slowdown. "We have to try and keep growth stable and sustainable, not deliberately repress the potential of economic growth. China is still a developing country. We are trying to make a balance between economic growth and stability." So behind the "smoke and mirrors" Chinese monetary policy remains super-easy, aiming for an explosive 10% economic growth rate.

India hikes rates again, but can't control its Money Supply

The Reserve Bank of India (RBI) raised its overnight rate by 0.25% to 6.00% on August 1st, to its highest level in four years, to fight mounting price pressures in its fast-growing economy. RBI chief Yaga Venugopal Reddy said the central bank had a self-imposed inflation ceiling of 5.0 percent. Wholesale prices, the most closely watched measure of inflation, rose 4.68% in the year to July 8th, after touching a one-year high of 5.44% in mid-June.

However, record high prices for crude oil and robust domestic demand could push wholesale prices above 5% again in coming months. "On balance, a modest pre-emptive action in monetary policy is appropriate at this juncture while being ready to respond flexibly and promptly by closely monitoring the related developments," the RBI said on August 1st. The RBI is aiming for an environment that steady India's economic growth rate around 8.0% through 2007.

Although on the surface, it appears that the RBI is tightening its monetary policy, the central bank is still pegging its interest rates at artificially low levels, by increasing the money supply. India's M3 money supply grew at an annual 19.5% in mid-July, above the central bank's target of 15.0% for the year, while bank loans are 30% higher from a year ago, compared with the RBI's target of 20 percent. Although gold traders keep a careful eye on Indian jewelry demand, the RBI's ultra-easy money policy helped to lift the gold price by 92% from a year ago to 300 rupees /oz.

Explosive money supply growth is a common trait within emerging economies, as central banks attempt to devalue their way to prosperity. Indeed, India's rupee fell to a three year low of 46.83 per US dollar last week. Bombay's Sensex rallied in line with other global stock markets, once traders understood that the RBI's rate hike campaign was clouded with "smoke and mirrors" and not designed to tighten the Indian M3 money supply. Inflating India's way to prosperity carries longer term risks of a rupee devaluation, sharply higher bond yields, and a flight into gold.

South African Inflation Soars with weaker Rand

Without the shield of a stronger rand, South Africa's inflation rate escalating along with higher crude oil and other dollar-denominated import prices. South African producer prices surged by 3% in June, or 7.5% higher from a year earlier, to a 3-½ year peak. The rand has weakened by 9% versus the US dollar so far in 2006, forcing the Reserve Bank of South Africa (RBSA) to hike short-term rates.

The impact of soaring crude oil prices and a weaker rand is feeding into consumer prices, which rose by 4.8% in the year to June from 4.1% in May. The annual rise in the CPIX has remained inside its 3-6% target range for 34 consecutive months, but the RBSA warned in June it would breach the upper end early in 2007 on rising price pressures fueled mainly by the cost of crude oil.

The US dollar's dramatic slide from a record 13.5 rand to around 6.5 rand in 2002-03, shielded South Africa from higher import prices, and knocked the annual producer price index from as high as 14.5% to a negative 2.2%. However, with the US dollar finding a floor at 6 rand for the past two years, South Africa's has lost its defensive shield from higher crude oil prices, and inflation has gotten worse with the recent weakening of the rand.

In order to shore up the rand, the RBSA hiked its overnight loan rate for a second time in the past three months, by 0.50% to 8.00 on August 1st, widening the rand's wide interest rate advantage over the US dollar. Since peaking at 7.53 rand on June 23rd, the US dollar has tumbled towards 6.77 rand, and if sustained, can reduce the magnitude of future RBSA rate hikes to control domestic inflation.

On the surface, the RBSA appears to be taking a tough stand against inflation, by lifting the overnight loan rate by 100 basis points to 8 percent. However, behind the "smoke and mirrors" is an out-of-control M3 money supply. The RBSA doubled the rand M3 money supply growth rate in the past year, in a determined effort to put a floor under the US dollar at 6-rand to protect S African exporters and miners.

The RBSA's expansion of the M3 money supply at a 24% annualized rate, pegged short-term interest rates at historic lows and finally weakened the rand against the US dollar. But another side-effect was a 78% surge in rand gold prices to as high as 4825 rand per ounce. So far, the last two RBSA rate hikes to 8% have capped the rand gold prices, but still awaiting new data on the M3 money supply.

The August 1st RBSA rate hike to 8.00%, combined with the US dollar's slide from 7.53 rand towards 6.75 rand, did cap the surge in S African 10-year bond yields at 8.80 percent. However, another half-point RBSA rate hike to 8.50% is still in the cards, to rein in the growth of M3 and anchor the rand in a range of 6.50 to 7.0 against the US dollar. That could set the stage for a decline in 10-year bond yields.

Russian Money Supply Spigot Wide Open

Russia's central bank raised its short-term interest rates by a half-point on August 4th, taking advantage of tightening global monetary conditions and to curb runaway M2 money supply growth.  The hike, the third this year, is part of a central bank push to tackle annual inflation running at nearly 10% by soaking up some of the liquidity created by its dollar-buying currency market intervention.

The Russian central bank prints rubles in exchange for US dollars and Euros gushing into the world's #2 oil exporter. Russia's M2 money supply growth accelerated in the 12 months to July 1st to 43.9 percent. Meanwhile, the central bank's reserves of gold and foreign exchange, the largest of any country outside Asia, soared 53% this year to a record $266 billion. The Kremlin is reaping a huge windfall from soaring Urals crude oil, and huge weapons exports to the Iranian-Syrian axis, while underpinning the balance of terror and tension in the Middle East, and the "war premium" for oil.

Russia's foreign trade surplus soared to $75.1 billion in the first half of 2006 compared to $54.7 billion in the same period of 2005, exerting strong upward pressure on the ruble. The Russian central bank has decided to print fewer rubles this year to fight domestic inflation, and allowed the US dollar to fall about 4% to 26.75 rubles. With Russia's abolition of capital controls from July 1st of this year, Moscow is sending a clear signal to foreign investors to bring capital into Russia, lured by foreign currency profits from a stronger ruble.

Moscow can strengthen the ruble further by tightening its monetary policy, where short-term interest rates are pegged about 8% below the inflation rate. Gold has gained 66% to 17,600 rubles /oz from a year ago as Russian traders try to stay ahead of monetary inflation and double digit inflation. The alternative to gold is Russian blue chip stocks, especially those in the base metals and oil sector, in the Russian Trading System index. Before the ruble could become a viable reserve currency, Russia's inflation rate must be brought down to low single-digit levels.

Final Conclusion

After the residual rounds of the central bank tightening are unveiled in the months ahead, the global markets would still be awash in a giant ocean of liquidity, with cheap financing available in financial centers such as Tokyo and Zurich for leveraged positions. Above average money supply growth in developed and emerging economies are designed to buffer the global stock markets from the impact of sharply higher oil prices. Slower US economic growth can also lead to a weaker US dollar and higher commodity prices, and "Stagflation".

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Gary Dorsch

Author: Gary Dorsch

Gary Dorsch

Gary Dorsch

Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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