Sunday, March 16, 2008


This is a bit of a long piece but worth your time.

It has been an eventful weekend for the financial markets.

The Fed emergency lending to Bear Stearns via JP Morgan Chase on Friday was an unpleasant surprise. (JPMorgan became the intermediary as Bear was a non-depository institution and therefore not technically allowed to access the discount window.)

On Sunday evening it was announced that JPMorganChase would acquire Bear Stearns for $2 a share in stock. That's a heartwrenching 93% discount to the $30 that Bear had closed on Friday which was already down 47% from Friday's open.

For all intents and purposes JPMChase is buying Bear for free. I should say taking on their assets and liabilities for the pittance of $236 million. This means that whatever liquidity crunch or what have you that Bear came up against is much more toxic than even Friday's events suggested.

AT THE SAME TIME THE FED ANNOUNCED THAT IT WAS CUTTING THE DISCOUNT RATE BY 25 BP. Gold rallied sharply on the news to 1030 from about 1000 at close of business Friday. The dollar sank another cent vs. the euro and stock markets are getting smoked. The fact that the Fed felt it had to act a mere 48 hours before the FOMC meeting suggests deep concern.

It is a real possibility that the FOMC could cut the Fed Funds rate a full point on Tuesday down to 2%. This expectation would drive the weakening dollar even lower and concomitantly cause dollar priced commodities like crude and gold to surge.

I noted in this space in December that I thought the dollar would fall as low as 1.60-65 at its nadir this year and gold would see a high of 1200. The dollar may sink as low as 1.60 to the euro THIS WEEK and even for someone whose experience argues that markets need to find their level by themselves this is starting to go too far too fast AND WITHOUT ANY INDICATION THAT THE FALL IS NEAR ITS BOTTOM.

A major problem for the US and for global markets is the skyrocketing price of crude oil. AT $110 a barrel it is driving headline inflation everywhere and will make it harder for the Fed to cut much further (not that it has that much further to go) but is also preventing the hawkish ECB from even considering cuts. The high price of energy also hurts in that it causes basic staples to rise in price and indirectly encourages bad energy decisions (like the ethanol idiocy in the US which drives up the price of corn and beef and...). According to folks in the energy sector there has been very little fundamental demand for crude at these prices or at anywhere above $90. In other words, the furious rally of past two weeks has been nearly completely driven by speculators.

I view the unrelenting strength of crude oil as one of the primary forces weakening the dollar. And at the moment there seems to be no upside limit in sight. This past week crude inventories rose sharply which should have caused a selloff in crude oil as the opposite had caused a $10 spike the week before. At the end of the day crude ended HIGHER than before the data was released. This suggests heavy, heavy demand or potential manipulation.

In sum my concern for the financial markets and for the health of the United States economy and the dollar derives from the fact that at the moment buying commodities, particularly crude, and selling the dollar is a free ride. And free rides are bad- they eventually end but before they do they often a prodigious amount of damage. Look at the bulk of how pegged currency regimes ended in the past 11 years starting with the Thai baht in 1997.

In my debate with Monk I've argued that while a stronger dollar would benefit virtually everyone, practically there's not that much that can done unilaterally with the market so heavily biased. Fed intervention to stem the dollar's decline without the commitment of our trading partners would simply line the pockets of speculators.

However in recent weeks I have come to feel strongly that, for the health of the Republic, something needs to be done now.

Nothing short of serious fundamental changes will correct the secular decline of the dollar. A fundamental change, for example, would be the US economy finding a bottom and starting to bounce, a significant slowdown in China and/or Europe leading to potential rate cuts OR a steep correction in commodity prices. Since affecting anything fundamental will take time what needs to be done immediately is to put serious doubt in the minds of speculators who are significantly driving certain markets.

A quick history lesson: a generation ago the Hunt Brothers tried to corner the silver market and by buying 200 million ounces they drove silver from $2 to $50. Upon ignoring demands that they stop the Comex with the approval of regulators squeezed them out. The COMEX did this by increasing sharply margins required to hold positions. The Hunts went bankrupt and silver quickly fell back to single digits for a generation.

Today it takes approximately $7700 of initial margin to control 1 lot of WTI which has a value of $110,000. (This is a correction of a mathematical error, originally it said $1,100,000) Allowing speculators nearly 15 times leverage is too much.

TRIPLING the initial and maintenance margins would CRUSH speculation immediately as the impact of requiring 200% more immediately would force speculators or the exchange to liquidate positions. The CME and IPE on which world crude is primarily traded are now for-profit organizations who would be extremely loath to do anything that might cut trading volume but the cooperation of US and UK authorities to even THREATEN this through regulatory changes along with initiating demands that identities of those behind large bloc trades be made public would likely trigger a fire sale in crude. Ideally this would be coordinated with a statement by the US that it will sell 20% of the Strategic Petroleum Reserve which would amount to something in excess of 100 million barrels. This left-right would see crude shed 25-30% of its value in A WEEK. It would quite literally disembowel speculators and hedge funds would fall like leaves in late autumn after a early, bitter frost.

Combine this with coordinated central bank intervention supporting the dollar and the ECB indicating a willingness to cut rates by perhaps evening offering a token cut and we would go a long, long way to putting uncertainty back into one-way markets and likely buy time for the US economy to recover and change some of the fundamental factors driving the secular decline of the dollar.

As a free-marketer and a conservative this type of meddling in the markets would generally be anathema. However the furious and economically unjustified rally in crude coupled with a collapsing dollar that is driving inflation and making stagflation even a remote possibility is doing material damage to the Republic. Measures need to be taken.

The leader in this enterprise has to be Secretary of the Treasury Henry Paulson. Robert Rubin built a legend of mythic proportions on the back of coordinating the bailout of Long Term Capital Management in 1998. While that was a sudden, serious shock to the system it was a case of the sniffles compared to the raging infection that ails the economy today. We needed a money guy at Treasury for times like this. Mr. Paulson, it's time to step up to the plate.

No comments: