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8/9/08

Paul van Eeden, metals prices, China and the New York Fed

Regarding the metals prices, a friend of mine wrote to me yesterday and told me that Paul van Eeden (he of Cranberry Capital and non-stop talkinghead appearances) is shorting US treasuries and asked me what I thought of the trade. So I put together an answer for him that along the way helped me synthesize a few thoughts. The following gives reasons that point to a metals rebound Sept/October. (FWIW, i think PVE is very good on gold but not very good on other things).

I'd appreciate any thoughts/criticisms/feedback on what follows via comments or mail as you prefer. I'm not trying to claim victory here, but if you can punch a hole in this it would help us both, I'd think. TIA.

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If PVE is shorting the US treasuries, I suppose he thinks this will happen:

1) The coupon drops
2) Therefore the yield rises
3) Therefore I presume he thinks this current deflationary move in the dollar, reflected by oil and commods, is a headfake. He's presumably betting on a weaker dollar and a non stagflation scenario.

He's betting on the logic that the market is currently ignoring. I'd say it's a 50/50 shot that he loses all his money.

Have a read of this.

http://blogs.cfr.org/setser/2008/08/08/the-quiet-bailout-continues-2/

(Or click on this link to go to the same place)

Brad Setser is the blogger who most understands capital flows between the world and the USA (I think). He's also very smart on China. He's been saying over the last few weeks that "one of the Central Banks" (presuming China) has been adding net funds to the US treasury without anybody noticing. This is the kind of thing that can continue until it doesn't. It's an artificial way of deflating the US (and therefore world) economy. This is the reaction we're seeing from the market, with Kellogg's up 4% and PCU down 4%. Margins are being tightened at the primary end and loosened at the service end, thus food manufacturers, Nike sneakers, WalMart, Citibank etc etc rise and Petrobras, BHP, and the spot price of copper fall.

If it is (as I suppose) China who has stocked the New York Fed with $29Bn just last week, there is an obvious end to this. It goes like this

1) USA in serious financial trouble

2) Commodity prices rising

3) China doesn't want rising commods (adds to inflation and stops its own expansion).

4) China reaches agreement with US. Instead of buying bonds as international reserves, it adds to foreign holdings inside USA via NY Fed reserve, and note that the inflows go directly to US treasuries according to Setser's data (he provides a link in his post).

5) The US therefore reflates the dollar, and thus deflating other things (oil, bonds yields, internal inflation etc). This is what we've seen these last two weeks, no? USD from 72 to 75, oil from 140 to 115 etc etc.

Point 5 is where we are right now. This is how i THINK it continues:

6) China wants commods to drop so that it can continue its growth program with less inflationary pressure.

7) USA gets itself out of a tight spot (temporarily, or permanently...i don't know. Probably temporary).

8) Once commods are lower (which is basically now), China goes back to growth policies.

9) Important: This has already been decided upon by the Chinese politburo and reported by such companies as Merrill Lynch, Morgan Stanley, UBS. (Here's a link to the story run by The Economist). The Chinese policy is to return to full growth pattern once the Olympics is over.

10) Therefore there must be an end to the presumed large scale capital inflows from China. This flow to the US via the Fed will end either now, after the Olympics or maybe a few more weeks.

11) The data that Brad Setser follows (and we should follow it too, now) will give the clearest indication possible to when commodity prices will recover. Once foreign capital inflows return to normal (e.g. neutral) levels, it means the FED will not have the ammunition. The dollar drops, US bond yields rise, PVE makes his money and Zinc (for example) goes above $1 again.

12) However, WHEN is the key question, because by the time the inflows stop, PVE may already be bankrupt (once again we remember JM Keynes; "The market can remain irrational longer than you can remain solvent" or words similar).

13) Therefore we keep our powder dry and stay away from a dangerous market that is being pulled around by very large non-supply/demand forces.

14) Any questions?