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Oil Vigilantes vs. the Big Three

In a fascinating evolution, the former "bond vigilantes" who terrorized central bankers are resurfacing in the Nymex oil pits...

IN THIS AGE where political parties of every stripe fudge economic statistics to promote their own self-interests, it's not surprising that government apparatchniks are presenting inflation data wildly at odds with the reality faced by consumers and businesses, writes Gary Dorsch of SirChartsaLot.

   That's why the data are regarded with utter disbelief. More disconcerting, the mainstream media is easily duped by the government propaganda.

Perhaps the most intellectually dishonest statistic is the "core rate" of inflation, which strips out the basic essentials of life, such as food and energy, and is given special attention by the mainstream media. In turn, the manipulated inflation data provides central bankers with the political cover to covertly expand the nation's money supply and engage in quiet currency devaluations.

Naturally, the politburo at the US Federal Reserve and its closest allies – Wall Street and politicians – say there is nothing to worry about. The Fed says it can open the monetary flood gates, because a weaker economy will eventually translate into lower inflation. Therefore, the Fed is ignoring such forward-looking inflation signals as the sinking US Dollar, and soaring crude oil and Gold Prices.

Instead, the Fed is focusing on misleading indicators such as the rigged "core rate" of inflation.

The upshot? The US economy lost 232,000 jobs in the first quarter as Americans grappled with the worst housing slump since the Great Depression, and a clogged banking system that is choking on $1.8 trillion of toxic sub-prime mortgages.

"Under these circumstances, the Fed should err on the side of doing too much, despite signs of rising inflation," said Cleveland Fed chief Sandra Pianalto on March 5th.

Once the US economy recovers, the Fed can reverse course, and tighten the money supply later this year. Or so the theory runs.

That puts a great deal of faith in the Bernanke Fed, whose credibility is running on empty. In fact, the Fed is hinting at deeper rate cuts.

   "Clearly you can't get interest rates below zero, but we actually have interest rates now at 2.25% and clearly there is some room to lower them if it's needed," the Fed's ultra inflationist Frederic Mishkin told the Senate on April 16th.

Over the past 12 months, the US Labor Dept. says that consumer price inflation is up 4%, led by higher energy costs (up 17%) and food prices (up 4.4%). But should US consumers and businesses trust the US government's fuzzy math in calculating the cost of living?

Or rather, should we believe the trends in the commodities markets, for a more reliable gauge on inflation expectations?

In the futures markets, crude oil is up 80% from a year ago, unleaded gasoline up 40% natural gas up 39%.

Soybeans are up 83%, corn up 65%, wheat up 95%, sugar up 30%, coffee up 25%, Gold up 36%, and rough rice is 125% higher from a year ago.

The cost of shipping dry commodities across the high seas, as measured by the Baltic Dry Index, is up 43% from a year ago.

Using this simple-minded approach, it sure seems like the US government is fudging the inflation statistics. Labor's latest report on the producer price index, which comes closer to tracking raw material prices, showed a 6.9% annual inflation rate, but that's still far short of the 23% annual increase in the Dow Jones AIG Commodity Index, a diversified basket of 19 exchange-traded commodities.

However, many big investors are locking in 10-year US Treasury yields, at negative rates of interest when adjusted for inflation, seeking shelter from junk bonds and risky mortgage debt.

Foreign central banks in Brazil, China, and the Arab oil kingdoms have bought a combined $135 billion US Treasuries since August, after purchasing US Dollars through currency intervention in order to manage their fixed or crawling currency pegs to the US Dollar.

  • The Opec oil cartel could amass $1 trillion of petro-dollars this year thanks to soaring oil exports, up 45% from last year's intake of $676 billion;
  • China's foreign-exchange reserves mushroomed by $154 billion in the first quarter, and are 40% higher from a year earlier;
  • Net inflows of US Dollars into Brazil totaled $5.4 billion month-to-date through April 11th, compared with $8 billion for all of March.

Yet by recycling their surplus Dollars into US Treasuries at negative rates of interest, these central banks are also nurturing fertile ground for speculators in commodities.

   In the 1980s and early '90s, sharply higher commodity prices would have rung alarm bells in the US Treasury markets, arousing the ire of the "bond vigilantes" to jack-up long-term yields by as much as 20-basis points in a single day.

But today, the "bond vigilantes" have been stripped of their legendary powers, manhandled by foreign central banks which control huge sums of surplus Dollars.

Yet in one of the most fascinating evolutions in market history, the former vigilantes who terrorized central bankers from the Chicago bond pits in the 1980s, are resurfacing in the Nymex oil pits.

Nowadays, whenever Mr Bernanke and the other G7 central bankers slash their interest rates and pump up the money supply, the Nymex "oil vigilantes" respond by jacking up the price of "black gold".

On March 5th, Saudi oil chief Ali al-Naimi pointed to the growing influence of speculators who have ploughed $200 billion into crude oil and commodity markets as a hedge against the exploding global money supply and the weakening US Dollar.

   "The current oil price has no relation to market fundamentals," he warned. "It is linked to futures, which are witnessing tremendous speculation. There are even those who buy futures and speculate that oil prices will reach more than $200 per barrel."

On March 28th, Opec chief Chakib Khelil agreed there was no link between the current oil price and supply. "Stocks are high and there is an economic recession in the United States, which will impact the global economy, so demand will fall by 1.2 million barrels per day in the second quarter.

"However, we have to recognize that there is no link between the price and supply. Therefore, there is no need to increase output. If we increase output the oil price would not go down."

There are numerous supply and demand factors that drive oil prices in the global marketplace. Earlier in April, Texas oilman T. Boone Pickens predicted global demand would outstrip supply by two million barrels per day in the third quarter.

"It will go up," he told Bloomberg. "Oil is moving to a substantially higher level – say above $125 a barrel."

But behind the curtain, the Wizard of the Printing Press – Ben Bernanke – is expanding the US money supply at a 17.5% annual rate on the M3 measure, its fastest growth in history.

Only Dallas Fed chief Richard Fisher is calling for an end to the hyper-inflationist campaign at the US central bank. "I have maintained a strong reluctance to further general monetary accommodation," he has said.

"The answer is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament, with a wing-and-a-prayer promise that it can always be reined in later."

But the noble Fisher is out-numbered by a wide margin at the Bernanke Fed.

Bank of England Lends a Hand

Within the G7 cartel of central banks, the Bernanke Fed has enlisted the support of two other members, the Bank of England and Canada, who have agreed to slash their interest rates and pump up their money supply.

This lends artificial support to the US Dollar in the foreign exchange markets, as the British Pound and Canadian Loonie move into similar over-supply to that of the US Dollar. But as is often the case, the net result is too much money chasing too few barrels of oil and precious ounces of Gold Bullion.

Under heavy political pressure from British prime minister Gordon Brown, the Bank of England has abandoned its fight against global inflation. Instead, it has begun a series of rate cuts designed to put a floor under British home prices, which tumbled 2.5% in March, their biggest monthly decline since the early 1990s.

Annual British real estate price inflation fell to 1.1% last month, the slowest in 12 years, and could go negative as the credit crunch bites into the UK economy.

The Bank of England is also engineering a devaluation of the British Pound against the Euro in order to boost UK exports and inflate multinational income earned in the Eurozone.

But traders in London's North Sea oil trading pits are behaving in a similar manner to their counterparts on the Nymex, and are buying crude oil as an inflation hedge against the BoE's devaluation of the British Pound and the 12.5% expansion of the UK's broad M4 money supply.

With Brent crude oil prices spiraling over $116 a barrel – plus deepening concern in oil guzzling nations that a spike in energy costs could cause severe economic damage – prime minister Gordon Brown made a desperate plea for the Opec oil cartel to boost its oil production.

   "We are not producing enough oil, and we can take collective action to persuade Opec and others to get the oil price down," Brown told Sky Television on April 15th.

But the Saudis recognize the shell game that the BoE and Fed are playing with their currencies, and cut oil production by 200,000 bps to 9.0 million barrels in mid-April. "I'm not going to dump crude on the market," Saudi oil chief Naimi said in Paris on April 10th.

"In my perspective, the oil market is well-supplied. The price is not at that level because of any shortage in supply," Naimi declared.

Bank of Canada Corrals the Petro-Dollar

Foreign exchange traders are just starting to learn about the philosophical bent of Canada's new central bank chief, the 42-year old rookie Mark Carney, a former investment banker at Goldman Sachs.

In his first interest-rate decision, Carney sounded a gloomy warning on the US economy and slashed the bank's key rate by a half point, the biggest cut since 2001.

He also signaled more to come.

"There are clear signs that the US economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. These developments suggest that important downside risks to Canada's economic outlook and, in some respects, are intensifying," the BoC explained.

Yet there is scant evidence to support Carney's justification for opening the Canadian money spigots. Canada's employment rate hit a record 68% in March, when 34,000 new part-time jobs were logged, the largest increase in the sector since November 2006. During the past 12 months, employment grew by 325,000 jobs. The jobless rate has been steady at 5.8% since October, a 33-year low.

Canada sells three-quarters of its exports to the US market, however, making it highly vulnerable to a slide in US demand. And yet the latest data shows that Canadian exports rose 3.8% in January to $39.3 billion, and the trade surplus with the United States rose to $8.1 billion.

So if the Canadian job market and exports are holding up fairly well, what could be the reason for Mr. Carney slashing the key overnight rate by a king-sized 50 basis points to 3.00% at the monetary meeting on April 22?

Well, on April 13th, Carney signaled his opposition to intervention in foreign-exchange markets, saying central banks have little chance in the $3.2 trillion per day markets. "History has shown that intervention in the absence of appropriate policy consistent with that action rarely works.

"We have probably the longest history with flexible exchange rates in the world. Canada has been very well-served by that framework."

   But the BoC is corralling the Canadian Petro-Dollar within a tight range between 0.98 to 1.03 vs the US Dollar, using radical interest-rate adjustments to prevent an appreciation. Anticipating a Fed rate cut on April 30th, Carney might have aimed to leap frog Ben Bernanke himself with that sizeable rate cut of his own.

Matching or exceeding the next Fed rate cut is expected to keep the Loonie steady within its targeted zone. Whereas, in the absence of BoC rate cuts, one might have expected the Canadian Petro-Dollar to zoom 10% higher in line with the surge in crude oil prices to $119 barrel.

Trying to put a lid on the Canadian Petro-Loonie by increasing the money supply and slashing interest rates only exerts more upward pressure on crude oil, Gold, and other commodities. Undaunted, Ottawa is paving the way for the next BoC rate cut, saying that the Canadian economy is surprisingly immune to the inflation pressures that are plaguing the rest of the world.

Overall Canadian inflation fell to 1.4% in March from 1.8% in February, with sharply higher food and energy prices trumped by lower car and computer prices. Thus, while the cost of every day life is soaring, government apparatchniks can offset these price increases with items that are purchased once every few years.

If that doesn't help, there is always the "core rate" of inflation that central bankers can focus on.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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