The hurricane is gone, why aren't gasoline prices going lower?

It's amazing how some highly educated people refuse to see the facts in front of them. We continue to get comments that the reason for the recent rise in gasoline prices had to do with the hurricane Isaac threatening US refining facilities in Louisiana.

OK, the hurricane is gone and there has been no material damage. Why aren't gasoline prices beginning to decline?

Gasoline active futures contract (Bloomberg)

The answer is simple. Market participants, in anticipation of US monetary expansion, are bullish energy commodities -  irrespective of supply/demand fundamentals (discussed here).

MarketWatch: - Fund managers beefed up their exposure to bets oil will go higher, or long positions, on the week to Aug. 28, data from the Commodity Futures Trading Commission showed late Friday. That has made oil the most overbought since May 1, said in a note to clients Tim Evans, an analyst with Citigroup's Citi Futures Perspective. Money also flowed to gasoline long positions, the most since May as well and "unusually overbought for this late stage of the U.S. driving season," Evans said. Oil futures rallied Friday, up 2% to $96.47 a barrel and notching gains of nearly 10% for the month.

And of course the elevated futures prices are now reflected in prices at the pump, as the damage to the economy in anticipation of QE continues. At $3.80 per gallon the national average price is the highest ever recorded for Labor Day weekend. People will however continue to blame it on the hurricane for some time to come.

SoberLook.com

"Moral hazard 101" with professor Draghi

The ECB has been quite clear about focusing their bond buying on the short end of the curve (see this discussion). There has been some speculation that Draghi will only buy short-term bills, but we got some clarification today. The ECB will target the short end of the curve of up to 3 years.

Bloomberg: - European Central Bank President Mario Draghi told lawmakers he’d be comfortable buying bonds with maturities of up to about three years, said Jean-Paul Gauzes, a member of the European Parliament.

Purchasing short-dated bonds doesn't constitute state financing, Draghi said during a closed-door parliamentary session in Brussels today, Gauzes told reporters afterwards. “He thinks it’s not a violation of the treaty and you can do it under the current legal framework,” Gauzes said. “He said for example three years is ok, 15 years no.”

Of course it's not "state financing" because that would be outside of ECB's mandate. Right.

The market is reflecting just such a policy with the Spanish sovereign curve staying quite steep at the short end. This policy is basically the reverse of what the Fed has been trying to do via Operation Twist.

Spain's sovereign curve - now and 2 months ago (Bloomberg)

When the bond buying program is in place, this "reverse Twist" will become easy pickings with low risk for hedge funds. Traders will buy bonds just outside the three year range and wait for them to roll down the curve. They are going to capture the relatively high income as well as the capital appreciation from the rapidly declining yield as the maturity shortens with time. And once the bonds are within the range, there is a "free put option" from the ECB who will not permit yields from rising above a certain levels.

We all know what happens when central banks provide a free put option (such as lowering rates every time the housing market sneezed during the boom years in the US - see this chart for example). Welcome to "moral hazard 101" with professor Draghi.

SoberLook.com

Student loan delinquencies soar (right after OWS protests end) leaving the taxpayer on the hook

Take a look at the chart below. It represents the total consumer debt outstanding in the US. What stands out?

Source: NY Fed (click to enlarge)

That's right, student loans. Mortgage balances are moving lower, home equity and credit cards look stable or declining slightly, car loans have been constant for years. Yet student loan balances are rising.

But that is just one side of the story. Not only do we have rapidly rising student loan balances but we are also looking at an unprecedented spike in delinquencies - the highest increase on record.

Source: JPMorgan

This may be just a coincidence (although there is some anecdotal evidence out there), but around the time the Occupy Wall Street protests ended, numerous borrowers around the country chose to just stop paying - all to punish the "fat cats" of course. Given that it takes 30 days after a missed payment for loans to be called "delinquent" and 90 days for the "seriously delinquent" label, the chart above lines up quite well with the OWS movement.

Whatever the case, this trend is quite troubling because the US taxpayers are on the hook. The Obamacare bill has a less well known component in it called the Student Aid and Fiscal Responsibility Act. It makes the US government the sole originator of student loans. That's why the loans owned directly by the federal government have spiked since 2009 (chart below).

Student loans owned directly by the federal government (source: FRB)

The chart above of course does not include loans owned by banks but guaranteed by the government.

The Republican Party, sensing a unique opportunity here, has made getting the US government out of the student loan origination business part of their national campaign platform.

The GOP: - The federal government should not be in the business of originating student loans; however, it should serve as an insurance guarantor for the private sector as they offer loans to students. Private sector participation in student financing should be welcomed. Any regulation that drives tuition costs higher must be reevaluated to balance its worth against its negative impact on students and their parents.

The private sector however will not get involved on any material scale without the federal guarantees. One way or another the US government will absorb the losses associated with student loan delinquencies. And in the mean time the balances continue to grow. Here are the latest facts from the NY Fed pertaining to the current student loan problem in the US (also discussed here):

• Outstanding educational debt stood at $914 billion as of June 30, 2012. 

• Since the peak in household debt in 2008Q3, student loan debt has increased by $303 billion, while other forms of debt fell a combined $1.6 trillion. 

• Student loan delinquency rates increased for the second consecutive quarter; The percent of student loan balances 90 or more days delinquent increased to 8.9% from 8.7% during the second quarter of 2012.

SoberLook.com

Alarming parallels between current Middle East tensions and events leading up to WWI

JPMorgan's commodities analysts draw some frightening parallels between the current Israel - Iran tensions (discussed here) and the events leading up to World War I. They first point out that since the tensions have not escalated into a military conflict so far, in spite of numerous predictions, the public has lost "interest" and the markets moved on to other issues. The web search interest for the phrase "iran war" has dropped off significantly since the peak of early 2012.

Source: Google Insights for Search

But that does not mean the risks have dissipated, particularly as Syria becomes a "wildcard".

JPM: In our view, the probability of a unilateral military strike by Israel against Iran has increased from low single digits (2% to 5%) in January 2012 to low double digits (10% to 15%) in August 2012. We think conventional wisdom vastly overestimated this risk in 1H2012, lost interest when missile volleys did not occur by June, and now underestimates the importance of recent threats by the Israeli leadership and the soul-searching public debate taking place within Israel about the wisdom of a preemptive strike.

Israel's highly "optimistic" assessment of the costs of such a conflict (see this article) ignores history and raises the possibility of a major strategic error.

JPM: - It is a red flag when any state claims a military conflict it unilaterally starts will be contained to a short duration (30 days, say the Israelis) and limited homeland casualties (500 dead). This bluster ignores important lessons from history, such as are found in Barbara Tuchman’s masterpiece analysis of the causes of World War I, The Guns of August. We spotlight 10 lessons from that analysis and how they apply to commodity risk today.

JPMorgan sees 10 parallels with the errors made during the period leading up to World War I (based on Barbara Tuchman’s The Guns of August.)

JPM:... the principal lessons as we see them are: (1) mobilization for war—“to send a message”—can create unexpected momentum that results in a massive war no one intended actually to start, (2) expectation for swift war can be a tragic miscalculation, (3) casualties and human carnage can be far higher than thought possible, (4) beware of fighting the last battle—military planning based on historical experience and stale assumptions leads to mistakes, (5) who strikes first matters—global public opinion may turn against the first striker, especially if that state tries to use subterfuge to implicate wrongly its opponent as the first striker, (6) the best laid plans are vulnerable to chaos, (7) unilateral actions can be perceived as reckless, forcing surprising shifts in formerly rock-solid alliances and forcing neutral sovereigns into active engagement, (8) significant economic integration is insufficient inoculation to prevent total war and prosecution of war can persist even if it means economic devastation, (9) appeals to national pride are insufficient to prevent political backlash to and moral condemnation of voluntary war, and (10) random events in proxy conflicts can be the catalyst for general war.

The table below is an overview of these parallels as well as the actual outcomes of each of the decisions.

Source: JPM (click to enlarge)

Based on the fact that such a conflict risks becoming far broader and deadlier than the early assessments, JMorgan's view is that oil prices would spike initially but would then decline below current levels as global demand comes to a halt.

JPM: - It is a nearly universally held belief that an Israeli attack must result in a large oil price spike, at least at first. Markets seem to be ill-prepared for the very real potential outcome that an attack could be followed by a strong downdraft in petroleum prices, like the one that followed Japan’s Tohoku earthquake last year, despite the loss of 1.2 mbd in Libyan crude output. If an attack occurred, we would not be surprised if the initial impulse were a smaller-than-expected and briefer-than-expected oil price spike followed by a stronger-than-expected oil price decline. ... [The decline would be driven by] large and unexpected damage to global commodity demand, while simultaneously boosting oil supply through release of strategic oil stocks.

SoberLook.com

Mainstream economists do not understand how monetary policy is transmitted

Guest Post by Lee Adler (The Wall Street Examiner)

Barry Ritholtz called attention this morning to a Monetary Policy Transmission flow chart by Bloomberg’s Joe Bruesuelas this morning that purports to show the reason behind “ZIRP’s more modest impact on the broader economy than the outsized impact we see on risk assets.”  I don’t mean to single out Mr. Brusuelas here. He’s a great guy, and from the things I’ve seen of him, he’s usually right on target with his economic analyses. But like all other economists who are puzzled by the reason the Fed’s policies have not had much apparent impact on the economy as they have had on the markets, he misses the most important and critical access of the route through which Fed policy reaches the economy.  Here’s his flow chart.

Click to enlarge

What this chart illustrates is not so much the blockages to monetary policy transmission as the failure of mainstream economists and pundits to grasp the simplest and most important fact of how monetary policy is transmitted.

Sentiment indicators point to a deepening recession in the Eurozone, including "core" economies

Since we've been discussing sentiment indicators recently, let's turn our attention for a moment to business and consumer sentiment in the Eurozone. The confidence index from the European Commission now shows the Eurozone recession deepening.

European Commission Economic Sentiment Indicator Eurozone (Bloomberg)

This weakness in sentiment is to be expected given the Eurozone's unemployment rate of 11.3% and the under-25 unemployment of exactly double that rate. What is new here is the low confidence reading in the Eurozone's core.

WSJ: - Confidence among euro-zone consumers and businesses fell to its lowest level in three years in August, official data showed, suggesting economic weakness in the debt-saddled currency bloc will continue, and is likely to spread further to core economies, such as Germany.

The European Commission said Thursday its monthly Economic Sentiment Indicator fell to 86.1 in August from 87.9 in July, the fifth-straight monthly drop and the weakest level for the combined gauge of business and household sentiment since August 2009.

The most severe decline was not surprisingly in Spain, while Italy had the lowest reading among the largest nations of the Eurozone. France showed a slight uptick, though the confidence measure remains low.

European Commission Economic Sentiment Indicator Eurozone by nation (Bloomberg) 

It is becoming clear that it's no longer just an issue for the periphery nations, as Germany now also

US consumer spending has been surprisingly brisk

US consumer confidence (discussed here) may end up being somewhat better than initially thought. The sentiment figures from the University of Michigan (as opposed to the Conference Board measure) actually improved in August, though remain below the pre-recession average.

Bloomberg/BW: - Consumer confidence improved more than projected in August as merchant discounts and record-low interest rates help U.S. households bolster finances. The Thomson Reuters/University of Michigan final sentiment index climbed to 74.3, a three-month high, from 72.3 in July. The gauge averaged 89 in the five years leading up to the recession.

If consumer spending is any indication of confidence, the U Michigan numbers may be closer to reality (see this discussion comparing the two sentiment indicators). US chain store sales figures for August have been surprisingly robust.

ICSC: - The preliminary tally of major chain store sales for August (fiscal month ending August 25) is up 6.0% (less drug stores) and appreciably above the 4.6% comp-store pace for July. Comments about back-to-school sales are generally favorable. The August growth rate is the strongest reading since March 2012 (+6.8%).

The broader gauge of consumer spending from the Commerce Department looks to be reasonably strong as well.

Reuters: - U.S. consumer spending got off to a fairly firm start in the third quarter, rising by the most in five months and offering hope economic growth would pick up this quarter. ... The Commerce Department said consumer spending increased 0.4 percent in July after a flat reading in June. 

US consumers remain uncertain about the future yet seem to have a healthy appetite for shopping. Consumer spending has improved materially since the recession.

Source: ISI Group

This is fairly good news for the US economy, but let's hope that rising food and energy prices (especially if exacerbated by the US monetary policy) don't bring consumer spending to a grinding halt.

SoberLook.com

China's companies are unprepared for the nation's economic slowdown

A rising tide lifts all boats, and double digit growth did that for China's corporate sector. Built for rapid expansion (and unprepared for "steady state" or a contraction in sales), China's firms are having difficulties dealing with the current environment. In another sign of difficult conditions for companies, and to forecasters' surprise, China's manufacturing contracted in August.

Source: Markit/HSBC

As China's residential construction growth stumbles and with the manufacturing sector beginning to shrink, Chinese firms are struggling to maintain cash reserves. Cash for many of China's companies was never a problem as new sales always generated more than enough to cover inventory and payroll expenses.  In some cases it's been a bit of a Ponzy scheme that works only when new sales exceed those in the previous cycle. But that's no longer the case.