Con-tango

"To
me the US is in a recession. I know that if the US is not in a
recession, we will be in a recession within a year. The housing sector
is in worse than in a recession, the automobile sector is worse than in
a recession, the subprime financial sector is worse than in recession,
and I know that before the year is over we will be in a recession, I
know the yield curve is inverted, …we’re overdue for a recession, …
not the end of the world, I see a normal cyclical recession…"

And if so, how much deeper or how far will it spread?

The main triggers of this recession
As I see it, there are two major events which could trigger an abrupt derailing of the consensus

Goldilocks view of the global economy. One of them is, of course, that foreign central banks could very well reduce their willingness to lend the funds which the US sorely needs to cover its deficits, which in turn would ignite an immediate spike in US interest rates. The next trigger would be an escalation of the Iranian crisis, which would take out a significant portion (8%) of the tight oil world supplies, spiking oil prices.

Today… both of these triggers are making headlines. Furthermore, the surrounding foul odor is slowly emerging: the US dollar is falling, short term interest rates are rising in the US (and Europe) for lack of bidders, tariffs are being imposed which will escalate inflation in the US… and investors are losing their confidence in US, European and Asian stocks —they’re selling.

The US dollar liquidity countering the global wage arbitrage
Let’s step back for a moment. The big picture, as I’ve pointed out in previous posts, stands against the backdrop of the slow US wage deterioration due to the global assimilation of low wage (Asian, Indian and East European) labor —better described as the labor arbitrage. And slow must be underscored. The printing of US Treasuries has allowed the US… so far… to soften (or slow down) to tolerable levels an otherwise painful deterioration of the US wages and US economy —the soft landing scenario, which nevertheless, has the unequivocal traits of a declining US economy, heavily burdened by the US government overspending.

An important consequence of having globalized lower priced goods has been the strong rise in commodity prices. This is due to multiple reasons, which reinforce each other. First, as I already mentioned, lower prices increase the demand of goods, which translates into a higher demand of commodities. Also, investments are overcrowding themselves to get into lower wage areas (such as China) to the detriment of the higher wage areas, which are rightfully perceived as undesirably uncompetitive zones. This investment bottleneck provokes a liquidity glut, which has the effect of lowering global interest rates, which in turn, fuels an increased demand for commodities as a strategic investment venue —which triggers additional speculative buying, spiraling prices further into orbit. Oil and metals are a good example.

But, it’s also a fact, that growing deficits nurtured by foreign CB lending is a train wreck waiting to happen. And central banks are slowly moving away from US dollars, as their lower USD reserve levels show. Further, their reluctance to lend has been rearing its ugly face at Treasury auctions for a while too.

To sum it all up, the US is wearing out its unique and extraordinary capacity to print US dollars, to counter the foreign low wage arbitrage effect on its economy, mainly, by cushioning and buying time for the readjustments to the US labor pool in their downhill slide in buying power —or wage deterioration.

Who benefits?
It is also worth mentioning, that this is not an entirely geographic issue —the US against lower wage areas. There are many US companies and individuals taking advantage of the diminishing weight of the US labor negotiators. For example, the recently approved US Commerce higher tariffs will be detrimental for those who used to enjoy from lower cost imported coated sheets. And, as we all know, most of the Fortune 500 corporations are doing business in China and India —they need to, in order to compete. The growth of Walmart, Sears and others highlights the advantages to be reaped by taking advantage of the global wage conjuncture.

Liquidity or low volatility in the markets has also been a source of great profits for traders on the right side of the trade. But, it is interesting to realize that the healing properties of liquidity, which should make all endeavors safer, has gradually faded away. An increase in volatility may awaken unimaginable monsters from the deep seas —unaccounted for and highly leveraged derivatives in carry trades and swaps on credit insurance are unsettling European CB presidents to the point of insomnia.

Walking on water
If the US economy is not in a recession, it sure looks like the US economy is walking over water —a true miracle by now.

After the Fed raised its short term interest rates to 5.25%, many times from their 1% low, the housing bubble is bursting and getting very painful in some of the areas where real estate prices were most effervescent. Jim Rogers alarmingly remarked the following in his Reuters Russian interview,

"You can’t believe how bad it’s going to get before it gets any
better," the prominent U.S. fund manager told Reuters by telephone from
New York.

"It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops.

"It is going to be a huge mess," said Rogers, who has put his $15
million belle epoque mansion on Manhattan’s Upper West Side on the
market and is planning to move to Asia.

[…]

"Real estate prices will go down 40-50 percent in bubble areas.
There will be massive defaults. This time it’ll be worse because we
haven’t had this kind of speculative buying in U.S. history," Rogers
said.

"When markets turn from bubble to reality, a lot of people get burned."

The trend towards higher US import tariffs is an important detour from the status quo. The newly elected Democrats represent a major change taking place —US labor will have a say as a reaction to their deteriorating conditions; most likely, in the form of protections. And higher tariffs are already being contested by the Chinese. Will they retaliate by further curtailing US Treasury buying?

So, if any of the triggers mentioned is activated, we can safely expect that Mr. Bernanke will not be able to continue to walk the talk, splashing the rest of the world as the US economy falls into the waters of a global recession.

A recession, how ugly?
Will we see a combination of a spiraling drop in the US dollar with a spike in interest rates?

I don’t think so. This would be Armageddon for all involved. If the US dollar falls too much against the currency of country X, then country X has a problem with its exports —they’re priced out of the market. Nobody wants that, printing more country X currency is a quick and easy fix.

Having said that, I do expect a continuing deterioration of the US dollar. Although, as Soros points out, markets may and usually do travel in the wrong direction for long periods of time. And, the US dollar should definitely continue to lose ground against the Yuan and the Yen. China is showing signs of a commodity induced problem inflation, including bubbles, which make more evident for China the benefits of a Yuan appreciation. In the case of Japan, inflation is also rearing its ugly head and the Yen carry trade is bound to unwind itself —its been a while, the risk of a violent reversal is ever more present.

In conclusion, I don’t see a nasty recession, but, like Rogers, I think things will get worse before they get better. Higher tariffs will further undermine the US dollar, which in turn will scare (or anger) away CB lenders, which in turn will deliver a global recession as a consequence of the higher interest rates required to attract the necessary funds into the US.

Iran? I don’t know. Apart from further debilitating the US economy, and taking a far reaching guess, I have the feeling that it could well escalate into an unbelievable mess.

One final advice, do stay away from currencies in emerging countries —the unraveling of the carry trades is bound to hurt them, except for China and countries with heavy commodity exports, such as oil and metal exporters.