Nightmare on Main Street - The impact of the rise of energy and food prices on US Households

Where is US M1 Velocity of Money heading in 2011? Is a double-dip on the horizon?

In past crisis when Velocity dropped significantly, recession occurred. We have to keep a close eye on the evolution of velocity in the US.

US Business Inventories are still rising:

US Inventories from 1992 to 2010:

But as the title of this post states, storms are gathering as indicated in the latest publication from David Rosenberg, Chief Economist at Gluskin Sheff.

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_011711.pdf

It is the fith time in modern history we have seen both food and energy prices rising in double-digits annual rate: 1979, 1980, 1996 and 2008.
In those five times we experienced two recessions, 2008 was a lead to a major recession. At this rate it is estimated that energy bill is going to amount to 60 billions USD for the US Household and the Food bill by 40 billions USD. Add to this end of debt service, it is another 100 billions USD headwind.
Bye bye Federal Fiscal stimulus...

Gasoline prices since last August in the US have gone from 2.65 USD per gallon to over 3.00 USD per gallon. 50 Billions USD hit for the already struggling US consumers.
John Mauldin (JohnMauldin@InvestorsInsight.com.) in his most recent message, provided the latest letter from Van Hoisington and Dr. Lacy Hunt from the Hoisington Fourth-Quarter Report. They tell us the following:
(Hoisington Investment Management Company: http://www.blogger.com/www.hoisingtonmgt.com)

"For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income. In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011."

Van Hoisington and Dr. Lacy Hunt go on:

"Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy."

Thank you Dr Ben Bernanke, QE2 is a complete failure.

Anterograde Amnesia or Retrograde Amnesia? Or both?

Definitions:

Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

"To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

David Einhorn, President of Greenlight Capital, in John Mauldin' "Outside the box" on the 26th of October 2009

The market moved dramatically tighter following the announcement of the 750 billion euros package and bank share rallied massively in double digits on the Monday.

"Monday, in fact, saw the biggest one-day change in the history of the Markit iTraxx Europe index – tightening from 142bp to 102bp."

http://ftalphaville.ft.com/blog/2010/05/14/232156/cds-report-volte-face/

Well, the euphoria did not last very long...

Itraxx Main CDS 5 year has move again at around 110 bps. Corporate default risk as measured by the Itraxx index is on the rise again after a strong respite:

"The Markit iTraxx Financial Index of swaps on the senior debt of 25 banks and insurers jumped 15 basis points to 147 and the subordinated index rose 19 to 215, JPMorgan prices show."

http://www.businessweek.com/news/2010-05-14/greece-leads-surge-in-credit-risk-as-ackermann-doubts-debt-plan.html

It is very interesting to see that the Itraxx Financial index senior is trading wider than the Itraxx Main Europe as historically, it should trade tighter. Corparate debt is seen safer than bank debt for the time being.

You just can't get rid of a problem by throwing money at it and Deutsche Bank chief Josef Ackermann did not help our politicians by raising doubt on Greek debts currently being snapped up on the secondary markets by European Central banks in a concerted effort.
As a result the Euro currency took another massive beating Rocky Balboa style and broke through a very important support at 1.2450 against USD from March 09 lows:



Euro did fell to lowest level since Lehman Brothers collapse as finally people envisage the probability of a Euro break up:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aqquuYOAN_sE&pos=2

Sounds familiar does it? Be nice, please rewind...

I discussed this exact subject on the 9th of December last year in my post The importance of being earnest, about the Eurozone in general and the Euro in particular.

http://macronomy.blogspot.com/2009/12/importance-of-being-earnest-about.html

I stated at the time:

"The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro."

Looks like Volcker shares my views...

http://www.bloomberg.com/apps/news?pid=20601010&sid=a8CjGqGASv9E

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

Quizz time:
In the above quote, Paul Volcker was thinking about which country?
A. Greece
B. France
C. Spain
D. Portugal
E. Italy
F. All of the above


In this previous post as well I indicated the possibility of a Euro break up. You will find the links to the analysis which had already been made by Nouriel Roubini and Macro Research house Gavekal.

But back to this week price action.

By tearing up the sacred rule book and resorting to the Nuclear Option of Quantitative Easing (the politically correct definition for what really means "screwing your currency"), the Euro could only go down from there. There was the same result for the GBP when the Bank of England resorted to "Quantitative Easing" (I hate these two words).

VIX is now much higher than in my previous post on the 10th of April:



And Gold? New record high as well. The only way is up now that the US, UK and now Europe are all equal in the "Debasing Currency Club".



On the employment front in the US you have the following:

Source Creditsights.com:

https://www.creditsights.com

"There are a total of 10 million claimants receiving some type of unemployment benefits. Furthermore, there are a growing number of individuals (referred to as ‘99ers” in some circles) who have exhausted all 99 weeks of benefits and are waiting for tier 5."

290,000 increase in NFP (Non Farm Payrolls) for April.

But unemployment is still rising and you have, as Creditsights mentioned a growing number of 99ers.



Clearly deleveraging is still in full play which means further headwinds for employment levels in the near future in the US

So much for the "anticipated" V recovery...

Update on the bond vigilantes: FLIGHT TO QUALITY (at least perceived quality...)

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3uJ_8cLNk.A&pos=3

"U.S. two-year notes had their first three-week winning streak since January as demand for the safest assets rose on speculation Europe’s sovereign-debt crisis will damp growth and lead to disintegration of the euro."

BONDS PRICE YIELD (Bloomberg)
10-Year UK 108.13 3.75 yield
10-Year German 101.20 2.86 yield
10-Year French 103.23 3.12 yield
10-Year Italian 101.12 3.90 yield

Bund is the safe haven in Europe.

Spreads of German 10 year Bund versus other European countries 10 years government bonds is on the rise:

Spread BUND VS French OAT 10 year (Bloomberg):



Spread BUND VS Italian BTP 10 year (Bloomberg):



Spread BUND VS Spain 10 year (Bloomberg):



Spread BUND VS Greek 10 year (Bloomberg):



And good old TED spread is moving up as well:

http://en.wikipedia.org/wiki/TED_spread

"The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt. The TED spread is an indicator of perceived credit risk in the general economy."
"
When the TED spread increases, it is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills."



No need to panic yet given long term average of TED is around 30 bps but definitely something to watch.

The theme is still the same deflation then inflation down the road as we are still ongoing the painful deleveraging process which goes with the reduction of public spending and tackling the debt burden. GDP growth will be slow, and slightly positive to negative in some European countries.

Why Paul Krugman is so wrong and his stance is dangerous

Paul Krugman is pushing for a rise of 25% in tariffs on Chinese goods.

http://www.nytimes.com/2010/03/15/opinion/15krugman.html?src=me


If history is a lesson to a Nobel Prize in economics, Paul Krugman should probably revisit the devastating impact the re introduction of tariffs had during the Great Depression with the implementation of the Smoot–Hawley Tariff Act of 1930.

Maybe Paul Krugman should read Wikipedia relating to the Smoot-Hawley Tariff of 1930:

"U.S. imports decreased 66% from US$4.4 billion (1929) to US$1.5 billion (1933), and exports decreased 61% from US$5.4 billion to US$2.1 billion, both decreases much more than the 50% decrease of the GDP."

http://en.wikipedia.org/wiki/Smoot%E2%80%93Hawley_Tariff_Act


"According to government statistics, U.S. imports from Europe decreased from a 1929 high of $1,334 million to just $390 million during 1932, while U.S. exports to Europe decreased from $2,341 million in 1929 to $784 million in 1932. Overall, world trade decreased by some 66% between 1929 and 1934."

"Although the tariff act was passed after the stock-market crash of 1929, some economic historians consider the political discussion leading up to the passing of the act a factor in causing the crash, the recession that began in late 1929, or both, and its eventual passage a factor in deepening the Great Depression.[16] Unemployment was at 7.8% in 1930 when the Smoot-Hawley tariff was passed, but it jumped to 16.3% in 1931, 24.9% in 1932, and 25.1% in 1933."

Why on Earth Paul Krugman thinks this time it is different?(the 5 most dangerous words in the world).

I am completely baffled by such a reckless statement from a Nobel Prize and I am not the only one concerned.

John Mauldin in his latest "Thoughts from the frontline" entitled "The Threat to Muddle Through" shares the same thoughts with his readers:

http://www.frontlinethoughts.com/article.asp?id=mwo032010

"Krugman and the Keynesians are right in this regard. If consumption falls, as it does in recession, then a corresponding increase in "G" helps offset that drop. But Keynes assumed that in good times government would run surpluses. It seems that we forgot that part."

As per above extract from John Mauldin's excellent letter, this is why Keynesian cannot work anymore in our current environment in Western Europe and in the US.

Keynes assumed government would be managing public finances in an efficient and responsible way.

Well Mister Paul Krugman, looks like Portugal, Spain, Italy, France, United Kingdom and of course Greece have been exactly doing that and the US as well!

The only efficient Keynesian policies which have been implemented in fact has been done by China! The main difference is that the Chinese have been managing much more effectively their economy so far!

http://en.wikipedia.org/wiki/China_economic_stimulus_program


"A statement on the government's website said the State Council had approved a plan to invest 4 trillion yuan in infrastructure and social welfare by the end of 2010. This stimulus, equivalent to US$586 billion, represented a pledge comparable to that subsequently announced by the US, but which came from an economy only one third the size. The stimulus package will be invested in key areas such as housing, rural infrastructure, transportation, health and education, environment, industry, disaster rebuilding, income-building, tax cuts, and finance.

China's export driven economy is starting to feel the impact of the economic slowdown in the United States and Europe, and the government has already cut key interest rates three times in less than two months in a bid to spur economic expansion.

The stimulus package was welcomed by world leaders and analysts as larger than expected and a sign that by boosting its own economy, China is helping to stabilize the world economy. World Bank President Robert Zoellick declared that he was ‘delighted’ and believed that China was ‘well positioned given its current account surplus and budget position to have fiscal expansion.'News of the announcement of the stimulus package sent markets up across the world."

It is up to the US to resolve their trade imbalances by being more competitive and to increase the amount of goods and services they export.

I agree with John Mauldin, should the US target as well Japan and Germany with higher tariffs?

Should all the countries with trade surpluses be targeted?

The sad reality behind last Friday Non Farm Payroll Number

I was reading through today an excellent article from John Mauldin, from Thoughts From the Frontline. You can subscribe for free on the following link:

http://www.frontlinethoughts.com/

The article relates to John's prediction for 2010 and it is a good read:

http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2010/01/08/2010-forecast-the-year-of-uncertainty.

In his article John writes the following:
"we will find we have not fixed the causes of the last one. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall, Barney Frank's bill (which was not the one that came out of committee) now makes it exceedingly more difficult to short stocks, we keep in power the same people who missed the problems the last time, and the list of bad policies bought (typo intended) to you by bank lobbyists grows ever longer. If the current bill looks like it was written by the bank lobby, that's because it was. But it means we will have to face the same problems all over again. But that is another story for another day."

I agree with his analysis. We have not resolved any issues, we are in fact compounding them. Glass-Steagall act should be re-instated and CDS like other vanilla derivatives should be cleared and traded on an exchange.

Adding insult to injury, the debt cap ceiling on the two Government agencies, Fannie and Freddie have been removed and it has been decided without consulting the US Congress. The US taxpayers will have to pick up an even larger tab by the end of the day.

Basically you can expect the equity rally to last a little bit longer given current level of inventories and activity picking up.

The importance of being earnest, about the Eurozone in general and the Euro in particular

The Unknown
As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Another change in perception this week, to follow up on my article about the Dubai mirage. This time, Greece in particular and the Eurozone in general!

On Tuesday, Fitch Ratings Inc. cut Greece's rating to BBB+ with a negative outlook and it unnerved the markets.

Markets once again have a short memory. BBB+ was the rating for Greece before the introduction of the Euro in 1999.

http://www.fitchratings.com/shared/sovereign_ratings_history.pdf

Greece managed to fiddle with its stats to get in the Eurozone and benefited from the cheap funding available to all members of the coveted Euro currency. We all know what happened to Spain, cheap funding generated a massive real estate bubble and when it went tumbling down Spain's employment rates went through the roof (Spain unemployment level will rise to 22% in 2010 and some Spanish regional banks are still sitting on hefty losses). Eastern European citizens also played a dangerous game, borrowing in Euros or CHF. All these "cheap" loans went badly wrong when Eastern European currencies had to be devalued as the GDP in these countries dropped like a stone.

As any form of peg, the Euro, although a safe haven for many, has now become some countries worse nightmare. As Greece cheated it's way it, Greece is now facing great troubles as it cannot cheat its way out by massively devaluing its currency and reduce therefore the debt to GDP percentage which currently stands at 110%.

Greece 5 year CDS (232.19 Bps on the 5 year point, source CMA DataVision) is now trading above Turkey 5 year CDS and the spread of Greek debt versus 10 years German Government bonds (Bund) is trading at level not seen since 1999...

I remember a conversation I had with a trader back in 2005, about the spread between 10 years German Bund and 10 years Italian BTP. At some point the spread between both was around 22 bps. This was abnormally tight and at the time I thought it was a fantastic bet to put on and a very simple one: betting that the spread would go back to where it was before the introduction of the Euro, above 120 bps. It did happen. Now the spread has come back to the 60bps level. I don't think that in the near future it will stay there.

The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro.

When I hear Mrs Christine Lagarde saying the following: 'I don't think Greece could go bankrupt,' on RMC radio. I have to disagree.

David Einhorn, who is President of Greenlight Capital, was cited in a recent letter published by John Mauldin' in the excellent "Outside the box" on the 26th of October
Here is an excellent quote relating to Mrs Lagarde foolish statement: "To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

Even France is increasingly at risk. The last time France had a balanced budget was in 1980. Since then, the government has been spending more than it has been collecting and the service of the external debt (payments of the interest only), is not even covered by the receipts coming from the income tax.

As per a Reuter article published today:

http://in.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idINGEE5B80FO20091209

She also said that French debt was popular in financial markets but France would continue to take care to ensure that there was not threat to its credibility.

"By comparison to our partners we are very well rated," Lagarde said. "So France's signature is good. The market likes our paper and we are extremely determined to be very careful to the way we issue."

Asked about the potential size of a new loan that President Nicolas Sarkozy is planning to fund investment projects, Lagarde said: "It must be a figure which does not raise questions about the quality of France's debt signature."
It is once again all about maintaining at all cost perception that everything is fine.

Well, things are not fine.

Because of the euro, governments cannot cheat at the moment by devaluing their currency. France had three devaluations in 1983 as a reminder.

Italy used to regularly devalue the Lira before the introduction of the Euro.

Could Greece or Italy leave the Euro?

For those who would like to evaluate the probability of this event, please find enclosed the link to two very good articles:

One written by Nouriel Roubini on the subject in 2005.

http://www.rgemonitor.com/roubini-monitor/92824/what_happens_if_italy_dumps_emu_and_the_euro_devaluation_default_and_lira-lization_of_euro_debts

The other I recommend reading is the excellent article written by Macro Research House Gavekal on the subject written as well in 2005.

http://gavekal.com/dforum/attach.aspx/51/divorceitallianstyle.pdf

For those who would like to track sovereign risk in the CDS markets, please use the following useful link:

http://cmavision.com/market-data/#riskiest

The CDS market is a good indicator of the perception of risk for both corporate risk as well as sovereign risk.

It is also a very good indicator of possible movements in the equity markets. The equity market took many months to react to the widening of the CDS markets which started in August 2007, following the blow out of the two Bear Stearns Structured Credit Funds, which marked the beginning of the subprime crisis.

We have moved from a financial crisis to an economic crisis and now a sovereign crisis.

To conclude:

Yes, countries can go bankrupt and can go from being very rich to very serious distress. Markets have short memory, and so do Finance ministers...and particularly French ones as well.

Maybe Mrs Lagarde should study the history of Argentina which increased in prosperity and prominence between 1880 and 1929, and emerged as one of the 10 richest countries in the world at the time before completely crumbling down.

In our next episode we will revisit my central theme about perception and facts about the current economic situation.

I will leave you with a final quote from the movie The Matrix from 1999, year of the Euro as an appetizer for my following post

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.