The euphoria over avoiding the US fiscal cliff lasted about 24 hours. Stocks that rallied Wednesday sold off on Thursday in the US after the minutes of the US Federal Reserve’s December meeting were released. The minutes expose a rift at the Fed over whether bond-buying (Quantitative Easing) actually helps the economy and whether it should be stopped immediately or no later than the end of 2013.
Aussie stocks were mixed early Friday as investors tried to digest the Fed’s confusion sandwich. And make no mistake, there is now a fair bit of confusion in the markets over what the Fed’s intentions are for the remainder of 2013. The minutes have introduced a new note of uncertainy into the markets.
The issue is that ‘several’ Fed members are not convinced the Fed’s various bond-buying programs are lowering unemployment or helping the economy. Some of those members appaerntly argued to stop the bond-buying right away, or no later than the end of this year. Bernanke will have his hands full keeping the committee in line.
It’s no secret to Fed members that the bond-buying really only supports stock prices. By driving interest rates on government debt down, the Fed drives down yields everywhere in the fixed income market, including on savings (the value of cash). By default, investors move out of other assets and into shares.
You can see from the chart above that 10-year US Treasury yields are moving up to the top of the range they’ve been in since the Fed announced its bond-buying intentions in September of last year. Bond prices are key signals. They tell you how much confidence the market has in the Fed’s ability to manage the economy. Rising bond yields are not a good sign, and are the inevitable consequence of the Fed not intervening in the market.
The question now is what will happen to shares. On the one hand, rising bond yields could send investors out of bonds and into stocks. The net result of the Fed’s internal division could be a loss of confidence in the bond market. Again, stocks might benefit by default.
On the other hand, without the Fed juicing the market, you could see a return to overall asset deflation, which would obviouly include falling stock prices. With the punchbowl in shattered pieces on the ground, the party could be over for awhile.
There is yet another possibility: the Fed is bluffing for the sake of its own credibility. It wants to appear sober and responsible, like a good guardian should be. But you have to wonder if the Fed would really tolerate a big fall in stocks that not only made investors poorer, but caused them to lose confidence.
Either way, the whole thing is just a confidence game now. It’s clear that some Fed members now realise that you can’t use interest rates to control the job market. It may also be possible that this the Fed’s way of telling the US President and the US Congress that deficits DO matter.
Rising interest rates will make US government debt much more expensive to refinance. This would force the parties in Washington to get serious about cutting spending…before the ratings agencies cut the US credit rating.
Is the end-game upon us?
All of this brings me back to a subject I promised to explore in Markets and Money this week, before I forgot that Greg Canavan writes on Thursdays and Fridays. The subject is the deflationary ‘prophecy’ of former Fed Vice President John Exter.
There are some things in life that are less interesting than a debate between inflationists and deflationists, but not many. And in any event, it is impossible to win such a debate. My own view is that we’ll have both: a massive deflation in financial asset prices followed by a huge inflation in the currency driven by panic money printing.
Exter’s own views on the matter are quite clear. His liquidity pyramid both explained and predicted how money would move in the financinal system during a financial crisis. He believed investors would move out of less liquid assets that were based on debt and into more liquid, real assets. You can see what it looks like below.
Based on the pyramid, you won’t be surprised to learn that Exter put all of his money into gold…back in the late 1960s. He foresaw the day when the US dollar would no longer be exchangeable for gold. He knew US deficits would rise and the dollar would be devalued over time.
Yet the facts of the matter are that there is really only one documented case of outright price deflation in the US in the last 100 years. Bank failures in the 1930s led to a contraction of the money supplly and falling prices. In theoery, this can’t happen again as long as the Federal Reserve utilises its capacity to print an unlimited amount of money.
So was Exter wrong about the necessity of a deflationary crisis as the end game of currency manipulation? It’s too soon to say. The main difference between now and when he first made his prediction is that the whole world now uses money not backed by gold. This has allowed for a huge expansion in credit and even larger bubbles in asset prices (and derivatives).
But this expansion has arguably made the inevitable bust bigger and more destructive. You could further argue that everything central banks have done since 2007 has been designed to prevent this deflationary busy and prevent the flight of capital ‘down the pyramid’ and into gold.
Enough of the arguing though. If you want to read about Exter in detail, I’ve reformatted my original report to make it more accssible. You can read Exter’s Prophecy at your leisure sometime this weekend. And stay tuned to Markets and Money for further commentary.
Other real asset options
It remains to be seen if investors can and will move from intangible assets and derivatives to more real assets as the end game develops. It’s really a proposition about how things will work. But let’s assume the proposition is correct. Other than gold, are there any other ‘real assets’ worth investing in or owning?
I’ve alwayst thought oil and energy are just as compelling as precious metals, when it comes to real, tangible assets. There are obvious differences, though, when it comes to ‘investability’. You can carry around gold and silver in your pocket. To buy oil and energy, you either have to use the futures market or the share market. And of course in the share market, you’re not really buying the commodity, you’re buying a business that either explores for or produces oil and gas.
That raises another issue about how shares behave in Exter’s world. As claims on real wealth, are they above or below government bonds? And really, what is the nature of your claim? As a shareholder, you have a claim on a company’s future earnings. That is not the same thing as, say, owning a five kilos of silver bullion that you can also use as a door stop.
Still, for punters and speculators, the energy markets are full of interesting opporunities. Some of those opportunities are being driven by the spread between the two benchmark prices of oil: Brent Crude and West Texas Intermediate. Check out the chart below.
The ‘spread’ between the price of a barrel of Brent Crude oil and West Texas Intermmediate (WTI) crude oil is pretty intriguing. Brent Crude averaged $112 a barrel in 2012. In fact for most of the last two years, Brent has consistently traded over $100 a barrel. By contrast, WTI crude remained below $100 a barrel for all of 2012. What’s going on?
On the WTI side, it’s largely a supply-side story. US crude oil production in 2012 was the highest its been since 1996. Production of oil and ehanced extraction from oil fields using fracking technology has led to a surge in US crude production. There’s been a basic increase in supply.
On the demand side of the US equation, a series of planned and unplanned refinery outages have led to less demand from refineries for crude oil. The result is a stockpile of some 43 million barrels of oil at Cushing in Oklahoma. The abundant supply and tapered off demand have capped US crude prices.
By contrast, Brent crude is linked to oil prices from the North Sea. North Sea production is in decline. You have a slow contraction in supply. You also have a lot of Asian demand for Brent Crude. Those two factors have led to Brent becoming the new global benchmark for oil prices.
But shale gas is the elephant in the room here. The US still imports about eight million barrels of crude oil per day. But the surge in natural gas production and the subsequent decline in natural gas prices has been a cheap energy boon to US industry. The country is now a net exporter of refined fuels, as you can see on the chart below from the US Department of Energy.
Australia is in a position to have its own energy revolution. Unconventional gas from shale could lower energy costs for consumers and producers. It could make manufacturing more competitive through lower energy costs. And it could lessen Australia’s reliance on importing refined fuels.
But that’s only if it happens. So will it?
A key month to watch is April. That’s when one of the pioneers in Aussie shale gas will drill its first horizontal well. After the well is drilled, it will be sequentially fracked. Then the company will see the flow rates of gas, including the composition of the gas (wet or dry). All of this will tell the world whether Australian unconventional gas can be produced economically and in commercial quantities.
Between now and then, I expect a lot of interest in the companies that are furthest along in proving up their gas resources. This is why I still have four shale shares recommend as ‘buys’ in The Denning Report. They are speculations, of course. But so far, so good.
In the big picture, energy is just as important an input as credit or capital in an economy. This is why I’m convinced that oil and energy shares will do well even if John Exter is right. They are essentially call options on energy. Even as financial assets deflate, I believe it’s possible for real assets to become even more valuable.
Time will tell, of course. But the advantage of considering these arguments now is that you can make your decisions calmly and reasonably. That’s the time to make them, before you find yourself reaching for the panic button in a big sell off, or ruing a missed opportunity.
for Markets and Money