ProTrader's Blog editor Bill Henner is also now editor of Institutional Trend Insight, a publisher of genuine institutional research and information recently made available to individual investors.   The weekly Reports & Events analysis that is part of ITI’s Institutional Financials Review is now posted on the ProTrader's Blog as well.  It is only a small part of ITI’s research offerings, and is normally only available by subscription.

Reports & Events (Highlights)

2008 May 12 (Monday)
▪ The influence of the central banks is daunting this week, including extensive reports and exposition on all manner of sensitive topics. Yet, inflation numbers will play an important role in the face of late week US housing and consumer confidence data.

▪ Limited talking heads had an influence last week, and this week is a talk tsunami!
While some of it is a bit commonplace, the speeches and discussions on topics from Fed’s Bernanke speaking on Liquidity Measures and Risk Management at Banking Organizations to the ECB’s Trichet expounding on The Economy and the Open Society, and the Fed’s Mishkin speaking on Asset Price Bubbles: How Should Central Banks Respond? is just a small taste of the hindsight on failure and current tightening of conditions that the equity markets might not find too appetizing.

▪ In addition to all the chatter, other central bank influences are also critical this week.
Wednesday into Thursday is particularly telling, from the Bank of England Quarterly Inflation Report to Thursday’s contemporaneous release of the ECB Monthly Bulletin and the latest EU Commission Gross Domestic Production Forecast revisions.

▪ Significant bond auctions; but are they more critical than equity market influences?
As the fixed income trends have been both strong until just last month on a loosely opposite psychology to previously weak equity markets, the equity market influence might still be more prominent that a major blast of intermediate-to-long dated supply in Europe and the UK. Especially with this Thursday’s settlement date for last week’s longer term US auctions, the ability of the bond markets to withstand supply pressures likely rests with the whether the equities continue to weaken.

▪ Equities will also be very interesting in light of some upbeat ‘whisper’ estimates.
While some stronger than expected economic data also turned up last week, the net effect of the expressions from financial luminaries was the pernicious factor which kept equities under pressure, especially the seeming disconnect at the Fed. Confirmation of weaker US housing to come (with a late week assist from Mr. Greenspan) along with the sentiment that the Fed is not inclined to ease was a source of pressure in the face of better than expected data.

▪ Inflation figures prominent again, yet US housing and consumers cap off the week.
Of course there will be the overt influence of inflation numbers on the perception of just how much wiggle room the central banks may have. Yet, with the Bank of England holding steady last week in the face of continued deteriorating data, and the ECB as hawkish as ever at the post-rate decision press conference, even a bit softer inflation numbers will not do much to encourage expectations of easing. That still leaves equities vulnerable and long dated fixed income possibly buoyant from any negative economic sentiments from central bankers, and especially the end of week US housing and Michigan Consumer Sentiment data.

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Chairman Bernanke made clear at last night's speech that the housing market's problems are worsening at the current time.  This may help to explain the stock market's lack of upside progress in the face of a string of better than expected economic data recently.--Pro Trader

"As my listeners know, conditions in mortgage markets remain quite difficult, and mortgage delinquencies have climbed steeply.  The sharpest increases have been among subprime mortgages, particularly those with adjustable interest rates:  About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure.  Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector.  As a consequence of rising delinquencies, foreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.  Not all foreclosure starts result in the borrower's loss of the home; sometimes the borrower is able to make up the missed payments or other arrangements are made with the lender.  But, given the number of borrowers in distress and the weakness of the general housing market, the share of foreclosure initiations that ultimately result in the loss of the home seems likely to be higher in the current episode than customarily has been the case."

Complete speech

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Fedpseak is now exacerbated by Mr. Greenspan’s comments last Thursday, as he expects US house prices still have a long way to fall. In the context of the previous speeches, that is a toxic brew for the US economy and stock markets. -ProTrader

Our associates at ITI had noted in our blog last week that Mr. Greenspan’s comments might be influential. Below is an excerpt from last Friday’s ITI Institutional Financials Review market letter (now available to individual investors through our exclusive relationship with ITI):

"…the equities’ loose Double Bottom basing pattern UP Breaks (above February highs) are starting to unravel, as DJIA drops back below 12,768 after a lengthy push above it. Back below 12,700 late this week… …(it) has a minimum downside Objective of a return to the Bear Stearns capitulation low at 11,757. That would be quite a shock to the system for most of the ‘basing’ camp who believe that things are going to continue to improve. That weaker sister S&P 500 future has already been below 1,401 for the past couple of days only adds weight on the markets." << MORE >>

The dollar danger is not over yet

Published: May 8 2008 19:35 | Last updated: May 8 2008 19:35

When a currency rises after government officials say that it should, you learn one thing: that the
fundamentals were pushing it up anyway. It makes sense for senior US and European officials to talk up
the dollar against the euro – as they did this week in the Financial Times – especially now that optimism
about the US economy makes their arguments plausible. In the long run, however, the real risk of a dollar
crisis is against the managed currencies of Asia and the Middle East.

Early March was a time of danger for the dollar. There were forecasts of a deep depression, liquidity fears
around some of the mightiest banks on Wall Street, and the dollar’s decline against the euro, already
rapid, began to accelerate. That decline could have become self-sustaining if investors had begun to
dump US assets, but the decisive rescue of Bear Stearns by the Federal Reserve shifted expectations
about future US interest rates and restored confidence.

Through good judgment, as well as a little good luck, policymakers have so far avoided turning a credit
crisis into a currency crisis. Without a run of fresh bad news on the US economy there is little reason for
the dollar to fall further.

But while the dollar may now be stable, it is stable at well above $1.50 to the euro, a level that is below
most estimates of its fundamental value. That probably suits the US – a cheap but stable dollar should
boost exports and encourage foreigners to invest – even if it raises the bill for imported oil. The drag on
exports is less comfortable for the eurozone, but while the US is an important trading partner, it takes less
than 15 per cent of total eurozone exports.

But the trouble for both the US and Europe is not each other – it is China, India, Middle Eastern oil
producers and a host of other countries that peg or manage their currencies against the dollar.
For the eurozone that means that currency overvaluation against the dollar puts pressure not just on
exports to the US, but on exports to most of the rest of the world.

For the US it is both blessing and curse. Dollar falls would have been far more severe had Asian central
banks stopped buying it, but as long as Asian currencies are held down it will be impossible to resolve
global imbalances, and the risk of a dollar crash, one day, will grow. The pressure mounts steadily: with
US interest rates down at 2 per cent, China is now losing vast sums of money on its foreign exchange
reserves. Verbal intervention on the dollar and euro is welcome – but it is time for verbal intervention on
the rupee and renminbi as well.

Financial Times Online

Crude Oil rallied to a new intra-day high of $126.98 today, before pulling back to close the session close to $126/barrel. The trigger for the rally was a International Energy Agency report that the stockpiles of distillates in Europe were down 6.7% in March over the same time year ago. Last week's EIA's report had shown a similar reduction in US distillates stockpiles, with a 2.6% year to year decline. Heating oil, a proxy for distillates, rallied to a new high, with the June contract closing at $3.6989; heating oil prices have doubled over the past year and are up 40% year to date.

All the News is Bullish

It is clear that the market has an incredibly bullish tone after Goldman Sachs' call for a super-spike which could take oil to as high as $200/barrel in the next 6-24 months. The market is focusing only on the good news and ignoring anything bearish.

Today's rally came in spite of news that IEA had again cuts its forecast for demand for crude-oil (to 1.03 million bpd); the current estimates for growth of oil demand are more than 50% less than the forecast put out in July, 2007 (2.2 million bpd). The IEA expects a further reduction in the forecast as high crude prices, and a slowdown in the developed economies are likely to cut demand further. There is even talk of reduced demand projections in the non-OECD oil importing countries (emerging economies), since the cost of subsidies is sky-rocketing and can no longer be sustained by their respective governments.

Even in oil exporting countries, where gas often sells for less than a $1/gallon, the government is bearing the cost of lost export revenues at prices which are almost an order of magnitude higher. Iran, OPEC's second largest oil producer, imports 40% of its gasoline.

Iran & Venezuela: Flag Bearers of the $200 Oil

Another factor contributing to the rally was a news report which suggested that Iran was seeking a cut in its crude oil output. This news of impending cuts was later refuted, though the Iranian spokesman did confirm that some discussions had taken place.

Earlier this month, Iran's oil minister had made statements that disruption in Nigeria and the weak US dollar meant that crude oil could reach $200. Not the one to be left out, Mr. Chaves of Venezuela had declared that oil would hit $200 if the US attacked Iran.

Both Iran and Venezuela rely on their oil exports to fund their local economy; a fall in oil revenues can have a drastic effect on their ruler's ability to continue to rule.

Goldman's Long Term Projection: $75 in 2012?

Lost in the bullish talk of $200 oil was Goldman's notes about demand destruction. The same report which predicted the super-spike also said that by 2012 the price of crude oil would fall to $75 normalized. Goldman expects the current euphoria to lead to a spike in crude oil prices, which will spur new supply development and also lead to permanent demand destruction.

OPEC has been using volatility in the oil market as a tool to limit the development of new oil fields. Volatile oil prices discourage investments in new oil fields if the cost of extracting the oil is significantly more than the current fields. Volatility keeps the average price of crude reasonably high, but the sharp dips in oil price make big investments in more expensive fields risky.

However, with oil projected to remain close to the $100 mark, a lot of these undeveloped fields will now become financially viable. Advances in technology also mean that oil sources like oil sands, shale oil and deep-sea oil, which were once considered too risky can now be harvested at a competitive cost.

In this article I shed some light on how high oil prices are resulting in a dramatic change in the energy industry and politics. High oil prices are accelerating the adoption of alternative energy resources and may signal the emergence of a new kind of peak oil fever: Peak Demand.

Political Rumblings: Congress Acts

The United States Senate today voted to approve a bill which will prevent any new additions to the Strategic Petroleum Reserve until crude-oil falls to $75, and stays below that level for 90 days at a stretch. The bill passed in the senate with a 97-1 margin which puts beyond any presidential veto.

Though the impact of the 70,000 barrels per day which are put into the SPR everyday is going to be minimal, it signals a shift in the political landscape where President Bush' significant opposition for any interference with the SPR is being steam-rolled. The vote comes at just as President Bush begins a tour of the Middle-East and sends a message to the oil exporting countries of the region to take his requests to increase supplies seriously.

The vote is significant because it signals a shift in oil politics, and may be a harbinger of a complete overhaul of US energy policy after the Presidential election is over and the Corn Belt vote becomes less important.

Emerging Economies: Subsidies under Scrutiny

In the emerging economies of India and China, the cost of oil subsidies is becoming a significant economic issue. There is a limit to which the governments can subsidize petroleum products and like the developed economies higher fuel prices are likely to result in demand destruction or at least much slower growth than what may be priced in.

In China subsidies given out to oil companies for imported oil were at $45B and accounted for 5% of the government's total revenue; they were as high as $87B if domestic production was also accounted for. The government of China is reluctant to pass on the increase to keep a lid on inflation. They also want to ensure that the summer Olympics do not suffer from any Energy shortages. But once the show is over, expect the Chinese government to start taking measures to increase the elasticity in the demand of oil by passing on the price increases.

In India, the price of gasoline (petrol) is close to what we pay here in the USA, but the price of distillates like diesel and kerosene is subsidized. Though it is unlikely that the subsidies on diesel will disappear, the gasoline and jet-fuel prices are likely to move higher.

New Discoveries and Supplies Coming On Line

A big contributing factor to the current bloom in the oil complex is the fear of peak oil production. There is a lot of talk about the gap between available spare capacity and demand narrowing, with demand likely to exceed supply soon. A lot of these forecasts tend to discount the discovery and harnessing of newer oil fields in non-traditional regions of the world.

Case Study: Brazil Deep Sea Fields

Amid the oil patch euphoria last week, Brazil's state-owned Petrobras announced that it will start producing oil from the 8-billion barrel Tupi oil field in 2009, a year ahead of schedule. Brazil which is already a leader in ethanol harvested from sugar-cane (which does not come with the baggage associated with corn based ethanol) now wants to join OPEC!

The news about the production from the Tupi fields was a pleasant surprise since a lot of the peak oil proponents were very skeptical of the massive deep-sea finds off the coast of Brazil. The nearby Carioca oil fields could contain 33 Billion barrel equivalents and could be the world's third largest oil field.

Case Study: India's Deccan Traps

India's state owned Oil and Natural Gas Corporation [ONGC] reported that it has found oil and gas bellow the Deccan Traps. The Deccan Traps, considered to be 65 million years old, consist of marine sediments uplifted during the formation of the Himalayas which were subsequently covered by hard volcanic rock. Most of the world's oil is found in Mesozoic formations, and geographical surveys have found sub-trappean Mesozoic-Gondwana sediments with a maximum thickness of 3 km (2 miles) in this area.

This is the first time ONGC decided to explore this region which has long been considered to have huge potential but never explored since it lies below layers of deep and hard rock. The research paper about this study is available online. According to the former Indian oil minister, Mani S. Aiyer, this area can have more oil than the Gulf.

Though it is clear that harvesting deep-sea or Deccan Trap oil is going to be a lot more expensive than harvesting oil from the deserts of the Middle-East, at a $100/barrel, these ventures can be commercially viable.

Alternative Sources

High energy prices are also driving investment in alternative sources, especially renewable carbon neutral resources like wind, solar and hydro-electric power. Since most of the oil consumed in the US goes into transportation, electricity from renewable sources cannot be pumped in directly into the transportation network. Though electric cars are also coming they still have limitation when it comes to range and performance, which limits their utility.

On the other hand ethanol can easily replace gasoline in cars and will require a less drastic change in our lifestyle.

Ethanol: Getting over Corn

Ethanol is widely being touted as a renewable fuel which can replace petroleum when it comes to transportation needs. In the United States ethanol is being produced using corn as the input. Since corn is starch and needs to be converted into sugar before being fermented to alcohol, the cost of producing corn based ethanol is high.

It is estimated that the energy produced by corn-ethanol is just 1.3 times the energy consumed. In contrast sugar base ethanol produces 8 times the energy used to produce it. The use of corn for ethanol has driven up food prices and is being blamed for inflation.

After the election is over, there is expectation of big changes in US ethanol policy. It is likely that the high import-duty on sugar cane based ethanol (54c/gallon) will see its end, making Brazilian sugar-ethanol a viable alternative in the USA.

The following table taken from Wikipedia shows how sugar-cane ethanol is a cost-effective alternative to oil. One important item to note is that Brazil has 23% of the world's arable land and at least 40% of that land is not being used and this is without any rain-forests being destroyed. Sugar cane is one of the most efficient crops when it comes to capturing solar energy and can be grown in a large part of Brazil and other semi-tropical regions.

Comparison of key characteristics between the ethanol industries in the United States and Brazil
Characteristic	Brazil	U.S.	Units/comments
Feedstock	Sugar cane	Maize	Main cash crop for ethanol production, the US has less than 2% from other crops.
Total ethanol production (2007) [32]	5,019.2	6,498.6	Million U.S. liquid gallons
Total arable land [45]	355	270(1)	Million hectares.
Total area used for ethanol crop [45][51]	3.6 (1%)	10 (3.7%)	Million hectares (% total arable)
Productivity per hectare [45][35][51]	7,500	3,000	Liters of ethanol per hectare. Brazil is 727 to 870 gal/acre (2006), US is 321 gal/acre (2005/06)
Energy balance (input energy productivity) [37][51][73]	8.3 to 10.2 times	1.3 to 1.6 times	Ratio of the energy obtained from ethanol to the energy expended in its production
Estimated greenhouse gas emission reduction [44][51][74]	86-90%(2)	10-30%(2)	% GHGs avoided by using ethanol instead of gasoline, using existing crop land.
Ethanol fueling stations in the country[35][36]	33,000 (100%)	873 (0,5%)	As % of total fueling gas stations in the country. U.S. has 170,000 (see Inslee, op cit pp. 161)
Fuel ethanol used by the road transport sector [39][38]	20%(3)	3.6%	As % of the sector's total on a volumetric basis for 2006.
Cost of production (USD/gallon) [35]	0.83	1.14	2006/2007 for Brazil (22¢/liter), 2004 for U.S. (35¢/liter)
Government subsidy (in USD) [45][36]		0.51/gallon	U.S. as of 2008-04-30. Brazilian ethanol production is no longer subsidized.
Import tariffs (in USD) [37][35]		0.54/gallon	As of April 2008, Brazil does not import ethanol, the U.S. does
Notes: (1) Only contiguous U.S., excludes Alaska. (2) Assuming no land use change. [74] (3) Excluding diesel-powered vehicles, ethanol consumption in the road sector is more than 40% [35][36]

Brew your Fuel @ $1/gallon and Run your own Station!

A Silicon Valley start-up, EFuel100, has come with a washer sized fermenting machine which you can use to brew your own ethanol using sugar. With Federal tax breaks and E-Fuel carbon credits, they estimate that you can brew your own ethanol at about a $1/gallon. Their machine can also take discarded alcohol and generate ethanol at 10c/gallon! The machine costs less than $7000 after Federal rebates, and if gas continues to be close to $4.00, can pay for itself over 2300 gallons (or 46,000 miles @2mpg).

The machine comes complete with a 50 ft pipe and a fueling nozzle which allows you to pump as much ethanol as you would like to use. The company expects users to blend ethanol into regular gas. For those who want to kick the gas habit completely, conversions kits are available which can allow your car to run on 100% ethanol.

click to enlarge

Pre-production prototype (Picture taken from www.efuel100.com)

OPEC: Who is in Control?

In the past decades Saudi Arabia was the leading voice in OPEC and helped manage supply and demand. With their immense reserves, the Saudis had the ability to suppress any dissent when it came to supply increases. Over the past decade, the maverick regimes of Iran and Venezuela have become vocal powers within OPEC. These nations' economies are strongly dependent on oil revenue and short term spikes in oil prices help them strengthen their power. However, this approach is short-sighted. The oil spike is likely to accelerate the development of alternative fuel technologies, energize efforts to develop new fields, and eventually result in a peak in the demand for oil; especially exported oil.

Iran has run out of storage capacity and is hiring tanker ships to store oil off-shore. They cannot find buyers for their crude production at the current price, and the rental rates for oil-tankers is spiking. Perhaps this is a sign of things to come which other OPEC members should pay heed to.

Disclosure: Author holds equity, equity options and futures positions (both long/short) in oil and energy related industries.

This piece is excerpted from Governor Mishkin's speech at the Princeton University Center for Economic Policy Studies Dinner on April 3, 2008.--Pro Trader

Starting in the 1970s, the economics profession began to recognize that the evolution of economic activity and inflation--and hence the design of optimal monetary policy--depends crucially on how households, firms, and financial market investors form their expectations regarding the future course of policy. This recognition of the central role of expectations in macroeconomic outcomes led to the discovery of the time-inconsistency problem, a concept that sounds highfalutin but is actually quite intuitive.

This problem arises whenever the possibility of short-run gains creates a temptation to renege on an existing plan, even though following that plan would produce a better outcome over the longer run. In essence, if a good long-run plan will not be followed consistently over time because the short-run gains of deviating from the plan are too tempting, then that plan is said to be time-inconsistent. In such a setting, the time-consistent policy is to reoptimize every period, whereas the preferable alternative would be to establish a firm commitment to the optimal long-run plan.

To take a common example that illustrates the time-inconsistency problem, someone may make a New Year’s resolution about starting a diet. At some point thereafter, however, it becomes hard to resist having a little bit of Rocky Road ice cream, and then a bit more, and pretty soon the weight begins to pile back on.

The time-inconsistency problem arises in the context of monetary policy, because there is a temptation to give a short-run boost to economic output and employment by pursuing a course of policy that is more expansionary than firms or workers had initially expected. Nevertheless, if the economy is already at full employment, then this boost is merely transitory: As economic activity rises above its sustainable level, wages and prices begin to rise, and the private sector's inflation expectations start to pick up. Of course, the central bank must eventually remove the policy stimulus to avoid a continuous upward spiral of inflation. At that point, economic activity drops back to a sustainable level. However, inflation settles in at a permanently higher rate because prospects of future monetary expansions become embedded in expectations, and hence in wage and price adjustments, and the higher average inflation rate generates undesirable economic distortions. Thus, failing to address the time-inconsistency problem poses the risk of ending up with a higher average inflation rate, with detrimental long-run consequences for economic efficiency and the general standard of living.

As my mother often told me when I was growing up, "The road to hell is paved with good intentions." Similarly, discretionary monetary policy, even though well intended, can lead to poor economic outcomes.

For text of entire speech visit the Federal Reserve website.

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In this article, I will debunk the many articles that attribute inflation to rising prices and rising oil prices to nefarious OPEC nations that squeeze production and gouge Western nations. With the use of four charts, I can explain most succinctly what is the predominant factor in contributing to rising oil prices.

Just as inflation causes rising prices, and not the other way around, the falling dollar is the greatest single determinant of soaring oil prices, not speculators and not a shortage of supply. Sure, these other factors contribute to rising oil prices and shortage of supplies will certainly drive oil prices even higher in the future, but they are not THE main contributor today despite all the articles to the contrary. That honor goes to the falling dollar. To understand, take a look at the four charts below.

I have plotted the USO [AMEX], the United States Oil Fund, LP against gold, silver, the euro and the U.S. dollar for the last 3 years. The United States Oil Fund, LP (USO) invests in futures contracts for light, sweet crude oil and other types of crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the New York Mercantile Exchange [NYMEX], International Currency Exchange [ICE] Futures or other United States and foreign exchanges, so generally it acts as a very good proxy for the price of crude oil (and gas).

If we look at the USO plotted against fiat currencies, it indeed appears that the price of oil is soaring. The USO has soared about 52% against the Euro in the last 3 years. On any terms, this is quite a hefty rise, but even this hefty increase pales in comparison when we observe the 3-year chart of the USO priced in U.S. dollars.

In U.S. dollars, the USO has soared by more than twice the rate it has against the Euro at 115%. However, because both the Euro and the Dollar are fiat currencies backed by nothing but the full faith and credit of governments, they theoretically can both be debased into worthlessness.

So now let’s price the USO in gold and silver for the past three years. When we do so, a markedly different picture emerges. The USO, over three years, despite having soared by 52% and 115% when respectively priced in Euros and Dollars, has incredibly dropped in value by 11.5% over the same time period when it is priced in gold. This means that oil would actually be cheaper than its price from 3 years ago were we to price its cost in ounces of gold. In other words, if the dollar was on a true gold standard today, nobody would be talking about soaring oil prices.

And what about when priced in terms of silver? If we price the USO in ounces of silver, we see from the below chart that the price of the USO has plunged a monumental 25% in price over the last 3 years.

So what does this tell us? In very simple terms, when goods are priced in stable currencies, their prices remain much more stable as well. When goods are priced in unstable, highly inflated currencies, then their prices soar primarily due to the significant debasement of the currency they are priced in. Furthermore, as I explained in this previous article, the debasement of currency often gives rise to an illusion of wealth creation while in reality, it actually destroys real wealth.

Though many others wish to confuse you with complex algorithms that include 50 different variables that determine why prices rise, in our current environment, dollar debasement is the top contributor. Yes, I do understand that it REALLY is not that simple, as the dollar has risen in recent weeks and so has oil, but you get my point, right? I’m not here to discuss other factors such as the spreads between futures and spot prices which move markets and what not, but just to discuss a very important point that I never see discussed in the mainstream media.

So if oil had been priced in Euros for the past 3 years, analysts would only now begin to start discussing rising oil prices. And if the world had been forced to keep large reserves of silver and gold for the past 3 years to pay for their oil, well, the only discussion that would be happening today would be within the meeting rooms of OPEC as they tried to figure out how to increase diminishing profit margins from falling oil prices.

Of course, one could argue that were oil priced in gold from 1980 to 2001, oil would have soared in price as gold spent 21 years in a bear market during those years. However, were the U.S. dollar backed by a true gold standard during these years, the price of gold would not have plummeted either (this analysis is much too complex for the scope of this short article). So when people say that oil is heading towards $150 to $200 a barrel, this prediction, though they will never admit it, is primarily based upon the untenable situation of the dollar, not the dwindling supply of oil as they state.

In terms of gold bullion, the price of oil will most likely only get cheaper or remain stable in the next few years. And due to continuing debasement of the dollar, we are highly unlikely to see oil prices retreat past $80 a barrel anytime in the foreseeable future.

I have always found many stories reported in the media to be humorous. For example, this past month, recent IMF officials stated that rising prices of food and oil are creating raging inflation rates worldwide that are quite worrisome. This is comparable to blaming a destroyed orange crop in Florida for creating frigid temperatures instead of correctly attributing the frigid temperatures to the destruction of the orange crop.

Yesterday, a news article out of Washington stated the following: “US President George W Bush will discuss rising oil prices and subsequent effects on global economies with Saudi Arabia’s King Abdullah later this week.” The report further stated that “A White House spokeswoman also said that Bush would raise the issue of how high oil prices are draining the world economy.” While the debasement of the dollar is not the only contributing factor to rising oil prices, of all the factors, including dwindling supply, it is the largest singular contributor.

So again to use my analogy of the orange crops, singling out supply and production rates as being the most problematic factors in rising oil prices would be similar to discovering that 5% of all oranges destroyed by severe weather were also infested by bugs and then calling on a pesticide manufacturer to develop better pesticides as the solution. Of course, the best pesticides in the world still wouldn’t have saved the other 95% of oranges from being destroyed. In conclusion all the negotiation in the world won’t stop rising oil prices. Only a strong currency will stabilize prices and effectively moderate rates of inflation.

John Mauldin's thoughts on the ongoing bull market in commodities--Pro Trader

Just a few quick thoughts about the drop in commodity prices we saw this week. First, it was about time. Gold and other commodities went too far, too fast in a largely speculative frenzy. A correction was overdue. Gold saw the largest one-day drop in 28 years, since the bubble days of the '80s. When everyone is on the same side of the boat, the boat is likely to tip over. Gold still probably has some room to fall before it catches support. But I seriously doubt that we have seen the highs for gold against a whole host of paper currencies.

A few weeks ago, I sent you an article by David Galland on why the gold stocks have not kept up with gold. For those of you who want to put some of your assets into gold, I would use this pullback to get positioned. If you have not yet read it, click on the following link and see why David thinks gold stocks are getting ready to rise. http://www.frontlinethoughts.com/txt/jmotb022508.htm

But we could continue to see pull-backs in other commodities. China is getting serious about curbing inflation, and that means they need to slow down their economy, raise rates, and allow the yuan to rise. They increased the requirements for bank margins this week. Along with a slowing US consumer and generally slower US economy, which will be felt worldwide, we could see commodity prices come under pressure before a growing world increases demand.

Part of the reason is that the dollar is no longer a one-way play. A falling dollar may no longer lead inevitably to higher oil and commodity prices.

And Greg Weldon makes a strong case that oil prices are set to come down from their lofty highs. Demand is softening and supplies are rising. Gasoline supplies are at a multi-decade high, and the number of days of supply is rising as well. This is quite bearish for oil.

It also means that the inflation caused by food and energy might actually subside, giving the Fed cover to lower rates again at their next meeting, which I think they will do.

Falling demand is what you should expect in a recession, especially with prices as high as they are.

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The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes – those belonging to builders and investors – have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

The American housing bubble peaked in early 2006, followed by an abrupt and rapid retreat over the past two years. Since summer 2006, hundreds of thousands of homeowners, many forced by foreclosure, have moved out of single-family homes into rental housing, creating an excess of approximately 600,000 vacant, largely investor-owned single-family units for sale. Homebuilders caught by the market’s rapid contraction have involuntarily added an additional 200,000 newly built homes to the “empty-house-for-sale” market.

Home prices have been receding rapidly under the weight of this inventory overhang. Single-family housing starts have declined by 60 per cent since early 2006, but have only recently fallen below single-family home demand. Indeed, this sharply lower level of pending housing additions, together with the expected 1m increase in the number of US households this year as well as underlying demand for second homes and replacement homes, together imply a decline in the stock of vacant single-family homes for sale of approximately 400,000 over the course of 2008.

The pace of liquidation is likely to pick up even more as new-home construction falls further. The level of home prices will probably stabilise as soon as the rate of inventory liquidation reaches its maximum, well before the ultimate elimination of inventory excess. That point, however, is still an indeterminate number of months in the future.

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years. To be sure, the systems of setting bank capital requirements, both economic and regulatory, which have developed over the past two decades will be overhauled substantially in light of recent experience. Indeed, private investors are already demanding larger capital buffers and collateral, and the mavens convened under the auspices of the Bank for International Settlements will surely amend the newly minted Basel II international regulatory accord. Also being questioned, tangentially, are the mathematically elegant economic forecasting models that once again have been unable to anticipate a financial crisis or the onset of recession.

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase, which is driven by a slow but cumulative build-up of euphoria. Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

If we could adequately model each phase of the cycle separately and divine the signals that tell us when the shift in regimes is about to occur, risk management systems would be improved significantly. One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.

Risk management seeks to maximise risk-adjusted rates of return on equity; often, in the process, underused capital is considered “waste”. Gone are the days when banks prided themselves on triple-A ratings and sometimes hinted at hidden balance-sheet reserves (often true) that conveyed an aura of invulnerability. Today, or at least prior to August 9 2007, the assets and capital that define triple-A status, or seemed to, entailed too high a competitive cost.

I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world. The exploration of the benefits of diversification in risk-management models is unquestionably sound and the use of an elaborate macroeconometric model does enforce forecasting discipline. It requires, for example, that saving equal investment, that the marginal propensity to consume be positive, and that inventories be non-negative. These restraints, among others, eliminated most of the distressing inconsistencies of the unsophisticated forecasting world of a half century ago.

But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic.

This, to me, is the large missing “explanatory variable” in both risk-management and macroeconometric models. Current practice is to introduce notions of “animal spirits”, as John Maynard Keynes put it, through “add factors”. That is, we arbitrarily change the outcome of our model’s equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not sufficiently address the problem of the missing variable.

We will never be able to anticipate all discontinuities in financial markets. Discontinuities are, of necessity, a surprise. Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response.

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

Originally published at Financial Times Online on 3/16/2008

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The Federal Reserve announced new measures to provide liquidity on Tuesday.  After a spectacular one day rally the market is once again focusing on the bigger picture.--Pro Trader

Two money market interventions by the US Federal Reserve in three working days are confirmation, if any
were needed, that the credit markets remain sickly. Though the Fed is right to try, its latest action is
unlikely to have much effect.

In addition to rate cuts, Fed intervention has escalated since it cut its discount rate last August. Last
December it began offering $20bn of 28-day loans twice a month, it increased that to $30bn in January,
and has now upped it to $50bn. Last Friday it announced another $100bn of term liquidity, so there will
soon be a total of $200bn in longer-term Fed finance that was not on offer three months ago. It has not
prevented another spike in the rate at which banks will lend to each other.

Yesterday's move was different. The Fed is not offering to lend cash in exchange for bonds, it is offering to
lend up to $200bn of Treasury bonds in exchange for triple-A mortgage-backed bonds. Unlike mortgage
bonds, Treasuries are still easy to borrow against in the private markets, so making it possible to
exchange one for the other is a sensible attempt to ease the short-term pressure on leveraged investors.
Whether it has any effect depends, as it has with every central bank intervention since last July, on
whether this is a crisis of liquidity or solvency. If it is simply the case that banks do not have the cash to
lend against mortgage bonds then this will have an effect. If, on the other hand, banks are worried that the
mortgage bonds or their owners will default, then they will be unlikely to lend even if they can refinance at
the Fed.

Banks' need for liquidity is hard to observe directly, but the evidence implies that the greater problem is
solvency, and that the latest intervention will therefore have little effect. First, the price of insuring the
credit risk of banks' own debt has soared, suggesting worries about their solvency. Second, even triple-A
mortgage bonds have fallen in price, and a number of leveraged investors, such as Peloton Capital, have
failed. That suggests ample reason to worry about repayment. Third, Wall Street banks insist that they
have plenty of cash.

There is something the Fed can do about solvency - take all of the credit risk on to its own books. It has
already taken the first steps in that direction: if any of its primary dealers default, the Fed will be fully
exposed to the risk of the mortgage bonds that are deposited with it. But the Fed should not bail out the
banks unless there is a systemic crisis. We are not there yet. Whether we get there depends on how far
house prices fall and how bad the real economy becomes.

Originally published at Financial Times on 3/12/2008

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