Wednesday, 21 May 2008

Information Asymmetry & Inflation: Have the inmates taken over the asylum, again!?! [Part 3: The "speculative pressure"]

Posted by: Ash Khanna

Part 3: The “speculative pressure”

On the 21st of May 2008:
Oil futures for 2016 were US$140.
Oil crossed US$132 in the spot market.

Over the last 2 to 3 years we have seen a huge increase in volatility due to moving more from a physical group of companies trading to a financial – based scenario. Further, according to Mr. Lie, a trader at Statoil – one of the largest exporters of oil: “If it’s a weak market we have to go out and sell it more actively, if it’s a strong market they come and buy it from us.” J P Morgan will begin physical trading in oil by the end of the year! From Goldman Sachs to J.P Morgan, investment banks are sharply increasing commodities and energy trading desks. In 2007, J P Morgan increased its desk by 50 and suggestions are of an equivalent increase this year. Financial Crisis?????

– Poker ;-)!!!!!

The convenience of commodity derivatives is responsible for the ongoing price rises. The ‘trader’ of these financial instruments is very distant from the physical product and hence the value chain of production – i.e. he’s a speculator. He does not want to receive (nor does he have) a tanker load of oil or a million bushels of wheat at his door-step when a derivative contract expires. Speculating involves transferring products from a point in time where the product is valued less to a point in time where it is valued more. But commodity derivatives are risk mitigating instruments - contracts.

“Value creation through the arbitrage across space and time of risk,” is a sophisticated economic concept meant for economists. It is not a market creating / sustaining communication (i.e. ‘sales-pitch’) - and will have limited (if any) market appeal. What markets need is a simple & compelling “story”.

On the other hand – “China & India will continue to grow at the current scorching rates at least for the next decade – 2.5 BILLION people are rapidly increasing their standard of living – they NEED MORE FOOD, MORE CONSTRUCTION, and MORE ENERGY.”

It is this well broadcasted (and accepted - I have to admit) story-line that is giving (the false sense of) the value to these (overpriced) commodity derivates - contracts. It’s more ‘hope’ than ‘value’ in my opinion – i.e. China & India will HAVE TO buy, eventually.

Pretty compelling stuff, but the “story” is incomplete!
What prices can they afford (are willing to buy at) in the short to medium term from this market, and how much? China & India are still regulated economies and essentials at reasonable prices for sustained growth and ‘sustenance’ are subject to government oversight & controls! [Enron’s Dhabol (India) – misadventure!]

Look at some recent (& well known) events:
China & India are aggressively pursuing bilateral trade agreements with major commodity and energy producers. India bans export of certain commodities. India bans futures trading of certain commodities. Thailand, wants to set up an OPEC like cartel for major rice exporters. Kazakhstan, a major wheat exporter, temporarily bans wheat exports.
The point I’m trying to make is that there is cognitive dissonance between the ‘sales-pitch’ and real demand.

The recent momentum in prices is because of big hedge funds and financial institutions, which makes the market move by % points rather that 30 – 40 cents like it was 3 or 4 years ago. These sudden big movements affect ‘trust’ – as traders can never be ‘off-duty’. Hence they are in high stress 24 hour jobs which makes market sentiment prone to extreme reactions. That means that minor news of fundamentals, such as the output of a single refinery, may be given too much weight.

Further, the recent humongous bail out, from the credit crisis, was not free of cost. These FIs have to not only get their books to ‘show’ healthy-profits, but pay central banks ‘interest’ for the liquidity which has been pumped into the financial system, and that to FAST! – Else they will lose the trust of their investors and confidence in the current financial system (their system) might be irrevocably damaged.

Till fall 2007 property prices were rising, globally, at unsustainable rates, now it is energy and commodity prices! The ‘activity’ has just shifted from the mortgage securities trading desks to the commodities and energy trading desks. Hence we are told Wall Street is near the end of its (recent) troubles (thanks to the recent bail-outs) but the long agony of Main Street has begun (i.e. sharp rises in energy and commodity prices). Till fall 2007 only home buyers were paying exorbitant prices now everyone has to pay a lot more for ‘essentials’. Especially the ‘unprotected’ consumer, for example: the Indian consumer is currently protected from the exorbitant rise in oil prices as compared to the US or UK. Well someone has to absorb the recent losses of the bankers and get them back to good health (i.e. billions of dollars in quarterly profits!) – Else there will be a “melt-down!”

Despite significant shrinkages in the mortgage markets (i.e. sub-prime write-offs – market correction), the infusion of liquidity by the central banks to kick-start the money markets, has (un-intentionally) managed to maintain excessive liquidity (created since the post 9/11 low interest rate era) in the financial system. Due to the lack of trust & confidence in the market (and because of fears of regulatory retaliation) most positions are being kept on the balance sheet, hence the money shows in the system. Further, due to the near freezing of the mortgage markets the liquidity available with the banks is being diverted towards the commodity and energy markets as safe value investments.

No body seems to have the answers or rather the right (responsibility) to solve the problem. The US Fed, ECB, BoE, BoJ or other central banks have the responsibility of controlling ‘aggregate’ inflation. An ‘independent’ central bank does not have the right to influence ‘asset price bubbles’. If ‘fisc’ intervenes (significantly – to affect some change) then it will be labeled as anti-market – “ANTI-BUSINESS!”

I’m sure the economists; technocrats (including some central bankers) are beginning to realize that they have been made suckers of. Hence recent out-bursts like those from: Horst Kohler, the former head of the IMF and President of Germany, comparing bankers with alchemists who were responsible for “massive destruction of assets” and that the Global financial markets have become “a monster” that “must be put back in its place”; Or the suggestion of the Jean Claude Trichet, the President of the ECB, on the 20th of May, 2008, that we are still in the ‘middle’ of the financial crisis.

To get to grips with this seemingly vicious circle of events we need to get back to basics:
· Price rise is caused by inflation not the other way around i.e. monetary inflation causes price inflation.
· The risks (limitations, abuse) associated with the monopolistic position of the US dollar as the international reserve currency. There has to be healthy competition for value reserves in this era of rapid globalization – Else the global economy will remain at the mercy of the mistakes and excesses of the few. [ I would recommend that you read Ian’s posting on the “Future of Money” ]

Here is the other, significant, bit of information that is not available, reliably – relevant ‘monetary inflation’ figures – and more specifically, the US M3 money supply. ( )

Some private analysts claim that the year–on–year M3 money supply is currently more than 16% (e.g. - and some claim it is as high as 20% ). [If these figures are right inflation data, globally, grossly understates actual inflation – i.e. the rate of price rise.]

The authoritative source i.e. the US Federal Reserve stopped publishing the M3 money supply figures in March 2006!

The current inflation is not the about the China & India ‘story’. It is actually about the limitations & abuses (risks) to the world economy of a single value reserve (i.e. currency – USD) in a rapidly globalizing world.

The solution is not economic to begin with; it is about ‘soft-power’ and ‘the will to power’. Do Japan (a deeper and diversified engagement, more than just carry-trade), the Euro-zone countries China, India, Brazil, Mexico, Singapore, the (currently under negotiation) Gulf Common Currency countries have the capability and capacity to compete with the United States of America and the most successful product ever created, the US$?

Part 1:

Part 2:

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