Sunday, June 26, 2005

Tipping Point

Did you feel it?

Something happened in the stock market and the economy last week that has important political and geopolitical implications. First, some basic background. In addition to setting interest rates, the Federal Reserve maintains a pool of daily liquidity that essentially acts as high-octane fuel for the capital markets. By varying the size of this liquidity pool, the Fed determines how much "juice" is available to go into various financial instruments. On a daily basis, this influences liquidity far more than interest rates, which are less targeted and work with a lag. Since any asset trades as a function of supply and demand, the more liquidity the Fed creates, the more demand there is for stocks, bonds and other assets.

Since the bursting of the technology bubble in 2000, there have been four distinct periods in which the Fed has flooded the system with an extraordinary amount of liquidity in an effort to boost the stock market:

1. Immediately after 9/11.
2. During the second half of 2002 in response to widespread accounting scandals and the meltdown in the corporate bond market.
3. During the summer and fall of last year, just before the presidential election (draw your own conclusions).
4. The past two months.

This usually works pretty well; the Fed deliberately raises the level of its liquidity pool, money flows into the capital markets, and demand increases for stocks. This dynamic is not foolproof, however; the Fed can create the juice, but it cannot determine exactly where it goes. Due to a confluence of factors---the Fed goes overboard, investors' risk preferences change, etc---all that extra money sometimes flows into other things like precious metals or crude oil.

In my opinion, this has been as much a factor in the recent spike in crude oil as anything else. Yes, demand from China is increasing. Yes, the actual supply of oil is decreasing. But both have been happening for years, and neither alone nor combined can they account for the degree of oil's recent rise. It's obvious that liquidity has been a major factor; over the past few months it has reached historic levels, even as the Fed has continued to raise interest rates. It explains the seemingly incongruous concurrent rise in stocks and bonds and oil, which has left many market participants---and the business media---shaking their heads in bewilderment. Excess liquidity is also a major reason why gold is at a multi-month high.

Like politics, monetary policy is the art of the possible. One truism of the financial markets is that there is no free lunch; for every action, there is a reaction. The Federal Reserve does what it can get away with until something forces it to change course. And that something appeared to happen this week. When oil hit $60, the stock market sent a clear message that the tipping point had been reached; above $60, the effect on the economy is enough to prevent stocks from continuing to rise in tandem with oil. A microcosm of this was Federal Express, which fell over 8% on Thursday after citing the impact of higher fuel prices on its business. Other companies in various industries are finding it increasingly difficult to pass along higher input prices to customers.

The Federal Reserve can either damn the torpedoes and continue to inflate, in which case oil will head quickly for $100 and beyond as Goldman Sachs recently predicted. Or it can continue to raise interest rates as well as lower its temporary liquidity pool, and in the process address one factor behind the rise of oil. But draining liquidity is not without risks; because of the Fed's past miscues, our economy has become like that bus in the movie "Speed" which can't slow down. Which course will the Fed choose? Based on its actions over the past few days, it appears the Fed will try to drain slowly and hope for the best; the equity market appeared to recognize that last week. If the Fed does drain and oil does not respond, we are indeed in uncharted and extremely dangerous territory.

Of course, all this illustrates just how much of an Achilles heel oil is for our economy. If we controlled all the oil on the planet, a major constraint on our monetary policy would not exist. But that's not the case, and we must buy it from others. And as long as those sellers can hear our printing press running full bore, they will continue to demand more paper from us for their ever-dwindling and only natural resource.

This has important implications beyond the stock and commodity markets. Despite the fact that the Federal Reserve is supposed to be independent politically, records indicate that Alan Greenspan has been visiting the White House at an ever-increasing rate---far more than he has during any other presidency. One can be absolutely sure that Bush and his advisors are well aware of the liquidity dynamic as well as the Federal Reserve's intentions. If Greenspan has indicated to the White House that the limits of Federal Reserve policy have been reached because of the crippling effect of any further rise in the price of oil, that will influence political and geopolitical strategy. Will the White House sit by idly, knowing that as Greenspan drains liquidity the economy will slow and the stock market will likely fall? Is inaction an option when opinion polls are already low and Iraq is a nightmare? Or was Karl Rove's outburst the opening salvo in a dog-wagging campaign of distraction?

If you can think like a cornered politician or a statist Fed banker, you might be able to anticipate what happens next.

53 Comments:

Anonymous Anonymous said...

Insightful as well as extremely interesting, thank you.

6/26/2005 6:52 AM  
Anonymous Anonymous said...

Ditto. Give us more in this area. You seem to very much on home ground here.

6/26/2005 11:22 AM  
Anonymous Anonymous said...

More evidence that this Administration is dangerously irresponsible in economic policy as well as
foreign policy. You can throw environmental policy into that mix but that is a topic for another discussion.

6/26/2005 11:42 AM  
Anonymous Anonymous said...

My husband still thinks Greenspan is a genius but I'm beginning to think he is just another political hack... a smart one yes, but still as corrupt as the rest of them.

Since there is no such thing as a free lunch economically, when we pay the price for what has been done to this country the last few years, it will be very very high.

6/26/2005 1:17 PM  
Anonymous Anonymous said...

REALLY interesting post, particularly "the art of the possible."

6/26/2005 1:41 PM  
Blogger DrDave said...

This would seem to suggest, as some of us have long suspected, that the economy has been artificially propped up--not unlike a house of cards--by the Fed's manpulation of the money supply.

It has been apparent for many years that as the President and others in his administration continued to insist that the economy and job market was improving that it was never really doing that. But it was never quite deteriotating toward crisis either.

What you suggest here is that the shit is going to hit the fan or that the President is going to need to invent another crisis to divert attention from the sorry state of the economy.

Lunch in Tehran, anyone?

6/26/2005 1:58 PM  
Anonymous Anonymous said...

One of your most interesting posts, and probably the most scary.

6/26/2005 2:53 PM  
Anonymous Anonymous said...

I've been sure for quite some time that the free lunch had to end. A 6th grader knows you can't continue to borrow lunch money without getting beat up in the school yard.
How insulated Bush has been able to make corporate America and his BASE, remains to be seen. For the rest of us ..forgetaboutit!!

6/26/2005 2:58 PM  
Anonymous Anonymous said...

I really like your blog and found this post very informative, as most of your post are. But I have seen information that appears to show that out of some 101 trading days this year there have been only some 15 where the DJIA has been above the level it began the year at. Where is this rise in stocks?

6/26/2005 3:42 PM  
Anonymous Anonymous said...

Great post TCR, one to really think about. Good inside scoop.

6/26/2005 5:16 PM  
Anonymous Anonymous said...

The problems Fed, and therefore all of US have, go back to the Fed charter, in trying to regulate the pool of US currency and its use in investments.

1. Nixon destroyed the underlying value of US currency.
2. Boeski destroyed the underlying value of US investment.
3. Economic theory is still grounded in a solipsist English world-view.
4. E-commerce (hot.money@light.speed) has destroyed any possible mitigating attempt by the Fed to decouple above.

We know by both theory (Delong 1990) and ad hominem that once the fires of speculation flare up, only some major overwhelming event can put them out.
In the case of oil, the potential for a huge new (and available now) supply of crude are: infinitesimal -> zero.

Do the math.

6/26/2005 5:52 PM  
Anonymous Anonymous said...

I would add to the four points, by way of aiding rather than just commenting:

Where does the Fed charter say the US investment bourses may be allowed to speculate in strategic US commodities with huge and potentially catastrophic result? Is this not proscribed by the Patriot Act II, to destroy a nation by speculating in its own life's-blood? Is there any more egregious form of terrorism, economic or otherwise?

Decoupler A: Require the US bourses to notify investors of individual equity and commodity transactions only at the end of the business day, not live and realtime. This mitigates momentum- and day-trading, or as now, minute-trades.

Decoupler B: Institute a transaction tax on all commodity investments not deemed strategic, but which still have an economic consequence to innocents such as foodstuffs, like real estate.

Decoupler C: Abolish passive strategic commodity speculation, limiting plays in oil and energy only to those who can physically take delivery of the commodity they have purchased, as in: A buys a tanker of crude at $38/BBL, and directs it to port where B has agreed to buy it for $46/BBL. Or: A buys 100MW electricity at $0.045/KWH and directs it to grid where B has agreed to buy it for $0.058/KWH.

Decoupler D: Make "round-tripping" and other derivative scamming in strategic commodities a three-strikes felony: the first time three-to-five, the second ten-to-twenty, and the third, twenty-to-life with no deals.

6/26/2005 6:11 PM  
Anonymous Anonymous said...

CR - How do you account for the lack of inflation (other than in oil of course) given all this liquidity infusion? Seems curious to me. Thanks.

6/26/2005 8:47 PM  
Anonymous Anonymous said...

down here in sarasota fl condo building is booming this little town is almost ready to burst with so much goings on i cant even drive downtown anymore with all the street closures
growing up here i know what the land is really worth and 600.000 for 1200sq ft is not worth it and the older homes: down the street from me a home built in 1960 frame construction 1300sq ft 299.500; and new homes poorly built very ill planned floor plan 2100sq ft 517.000
crazy!!

6/26/2005 8:53 PM  
Anonymous Anonymous said...

I enjoy this topic also.

I've read a lot about peak oil, but there isn't much about it in the news.

It does seem like this administration has us over a barrel, and Bush and Cheney can profit handsomely regardless. Did anyone notice the news about a Chinese state-owned oil company hostile bid for Unocal? What would that mean to our economy or what would we do to China? No wonder Rumsfeld said he didn't like the military buildup in China.

If China had the same number of vehicles porportional to the US, they would have 800 million+; 4 times more than the US has. The SUV market in China is just taking off.

Do we give Greenspan too much credit? The stock market will fall anyway as baby boomers move to less risky assets for retirement and withdrawal. The baby boomers contributed to the expansion of the PE, and certainly the opposite will be true. The 401k and private accounts and reliance on the stock market by so many individuals is uncharted.

Maybe Rove is positioning himself for the 2008 race. Certainly Cheney won't be in any shape to run.

6/27/2005 2:45 AM  
Anonymous Anonymous said...

This is a very insightful post indeed.

The whole strategy smells conspiracy to me. The Fed is supposed to be independent and not get involved in politics. And yet since Greenspan is chairman, he very much enjoys giving his speeches in "parabole".

Oil: Bush has invaded Afghanistan primarily to get access to the oil that the Taliban refused to extend the piping.

The thought and realization of invading both Afghanistan and Iraq was OIL. It just so happened, that none of these two expeditions, right now, has been fruitful. Besides, as I have heard it so many times "Bush is not to be undersestimated", we must here come to the conclusion that the "Middle Eastern are not to be underestimated either" They control all the oil and they know that we need it. The $60.00 pbl is
pure speculation and great margin of profit for all concerned: the Bushies enterprises, the oil companies, the oil
providers, at the expenses of the American public.

Enter China, with the
prospect of buying Unocal and a whole
picture can suddenly changes. Bush has not pronounced himself yet to this
proposition, he has referred it to a
committee. The dilemma for Bush, I figure, would be, that if we allow the chinese to control an oil company in the USA, we will not be completely sovereign of our action on one hand, on the other hand, if we reject this proposition, the chinese could very well retaliate. How? they would simply
buy Euro Bonds, and shed the dollar Bonds on the market. Then what will happen?. I would like to see Greespan
put up his so called expertise after this one.

At any rate, the whole thing smells fishy and dangerous for all investors
on the corporate and the personal level.

6/27/2005 4:00 AM  
Anonymous Anonymous said...

Out of curiousity, how do you track the Fed's liquidity injections? I know Ed Yardeni used to monitor the money supply when he was at Pru but since he left, I haven't consistantly seen any similar measurements. Thanks!

6/27/2005 9:35 AM  
Anonymous Anonymous said...

At the beginning of 2003, when the drums for Iraq were beating, I went out and bought a dozen diverse magazines. This one was particularly interesting on the oil issue.
The Thirty-Year Itch: "Three decades ago, in the throes of the energy crisis, Washington's hawks conceived of a strategy for US control of the Persian Gulf's oil. Now, with the same strategists firmly in control of the White House, the Bush administration is playing out their script for global dominance." map

I'm too interested in tracking liquidity. I use FRB data. Enjoy it while you can, there is a trend to charge for government data (beyond our taxes). The recent is by Sen. Rick Santorum to prevent the NOAA from providing weather data. Companies like the weather channel,accuweather, weatherbank want to commercialize government data and privatize weather service.

6/27/2005 11:10 AM  
Anonymous Anonymous said...

For those new to peak oil and it's geopolitical and economic implications, I suggest Wikipedia's Hubbert peak article as a primer. Useful links can also be found there.

"The Hubbert peak theory, also known as peak oil, is an influential theory concerning the long-term rate of conventional oil and other fossil fuels extraction and depletion. It predicts that future world oil production will soon reach a peak and then rapidly decline. The actual peak year will only be known after it has passed. Based on available production data, proponents have predicted the peak years to be 1989, 1995, 1995-2000, or, according to one influential group, 2007 for oil and somewhat later for natural gas. This may lead to either minor economic or major catastrophic consequences for the world since modern civilization is dependent on cheap and abundant fossil fuels, especially for transportation."

The peak can certainly be seen as a major event in the course of western civilizations. After all, money pretty much equals energy. How we will cope after cheap oil, I have no idea.

6/27/2005 12:13 PM  
Anonymous Anonymous said...

One interesting story about the 'dependency on oil', and the efforts made to decrease the very same, which you might not have read in the U.S. news:


"ETH Zurich has set a new world record for fuel efficiency. This now stands at 5134 kilometres per litre of petrol. The world-record holding PAC-Car operates on a hydrogen powered fuel cell.

(...) he only "emission" from PAC-Car is pure water. The car is lightweight, weighing in at only about 30 kilograms. [...] it finished the course at the Shell Eco-Marathon taking place on the Michelin test track at Ladoux, France, using only 1.07 grams of hydrogen. This converts to about 5134 kilometres per litre of petrol, a new world record in economical fuel."

http://idw-online.de/pages/de/news118739


That's about 2 gallons for a trip around the world (ideally).

Here's to the swiss: Way to go! Take that, SUV drivers!

6/27/2005 2:07 PM  
Anonymous Anonymous said...

"Or was Karl Rove's outburst the opening salvo in a dog-wagging campaign of distraction?

This blogger has a great response to Karl Rove's statement last week about liberals and conservatives after 9/11:
Take it To Karl Blog. "Don't worry, Karl. While your punk ass is hiding behind the safe walls of the White House, I'll protect America. In the meantime you can kiss my liberal soldier ass."

I think the real reason we don't get good debates and news in this country is because this Republican party knows that its policies can't stand up on their own and that they are afraid to be confronted because they can't deal. That's why they had to control, and still do, who attends a Republican event.

6/28/2005 1:01 AM  
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