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1 Aug 11 2011 @ 9:36am by Matt Smith in Crude Oil, Economy, Global Energy, Natural Gas, risk management, Risk Strategy

What Would Winston Do?

In times of market turbulence like this, I find it useful to do two things: make simple observations, and seek solace in the wisdom of others. So this week I have turned to the most voracious voice of reason, Winston Churchill, to help me make some sense of this all. This is what he has told me:

‘I never worry about action, but only inaction’

This simple expression from Churchill underlines the conundrum that the US currently faces. It is loose monetary policy (= low interest rates) which has spurred on the rally in equities and commodities in the past two years. Interest rates reached an historic low of 0.25% in December 2008, as the US central bank (= the Federal Reserve = ‘the Fed’)  took extreme steps to boost an economy in the midst of a severe recession.  

The logic was that low interest rates would encourage both individuals and businesses to borrow and spend, leading the economy back into recovery. This was partly effective, as economic data bottomed out and employment, manufacturing, spending, housing, and sentiment all made a tentative comeback.

However, it was not good enough, as the economy started to stall, and the government had to introduce quantitative easing (to the tune of $1.75 trillion in late 2008) and then the sequel, quantitative easing two (QE2 – a further $600 billion in late 2010) to try and revive the economy by essentially pumping liquidity into the system (by printing money, and buying US debt). 

These two endeavors unfortunately did not achieve their goal of spurring on a sustained economic recovery, leaving the Federal Reserve to announce on Tuesday it will be keeping interest rates at a record low until at least mid-2013:   

So while Winston Churchill warns of the perils of inaction, the Fed is left between a rock and a hard place. The rock is interest rates anchored at near-nil. The hard place is considering QE3.

‘If you have an important point to make, don’t try to be subtle or clever. Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time – a tremendous whack’

So the alternative of inaction by the Fed is further monetary stimulus, which would likely take the form of a third round of quantitative easing. This is considered an increasingly plausible option, especially if  the economy continues on its path to recessionary conditions, and inflationary pressures wane and give way to deflationary fears (while inflation can be fought by raising interest rates, there is nothing to fight deflation – ask Japan).

So while QE3 may seem ludicrous, the Fed may be given no choice if conditions turn armageddonesque. And after the failure of the prior two rounds to spur a lasting and robust recovery the Fed would likely feel pressure to really raise the stakes this time around, and hit the market a third time…with a tremendous whack.   

‘Kites rise highest against the wind – not with it’

Perhaps the most surreal event of the last week – that of the US having its debt downgraded for the first time in history – has prompted a similarly surreal event in…US debt. A combination of this news with a bout of poor economic data have sent equities and (most) commodities spiraling lower. This in turn has sent a flood of money heading into the safe-haven of US government bonds, regardless of the downgrade. Bond yields across the curve have hit fresh lows, as buying appetite has been insatiable:

This move into bonds tells us a number of things; that there is a rapidly rising expectation for a double-dip recession; that deflationary concerns are rising; and that the downgrade of US debt is of little material concern to risk-fleeing Treasury buyers. So as the headwinds for the US economy suddenly hit gale-force gusts, the kite of US debt flies to its highest point.

Everyone has his day and some days last longer than others’

Finally, current events are causing heightened volatility across asset classes, which leads us back to commodities. The point of this post was to talk about the bigger picture, as the implications of how current economic events play out will have a profound effect on commodities, and specifically energy. 

With crude oil taking direction from the equity markets (the litmus test for risk appetite and market sentiment), it is only natural to see prices reacting accordingly with such volatility, and with such a sharp correction. And the volatility at least will likely continue over the coming weeks as uncertainty continues to unfurl.

Meanwhile, other commodities such as US natural gas and coal are showing a muted reaction, somewhat insulated by their own market-specific fundamentals. And then there is Dr. Copper (the metal so good at gauging the economy it is considered to have a Ph.D in economics) and gold (the ultimate safe-haven). Copper is crestfallen, while gold is having its day and hitting all new nominal heights. And just as volatility is set to persist in general markets, gold is likely to see its day is lasting longer than others:  

1 Comment on this post:

  1. […] the US economy (third time’s a charm apparently, after QE1 and QE2 – discussed here on the burrito recently), and secondly, because of its […]

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