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Do Not Forget About Changes in Velocity

September 24, 2007

This week in Outside the Box, Louis-Vincent Gave, Charles Gave, Anatole Kaletsky, and company of GaveKal Research delve into the underlying misconceptions that presumes money velocity is and will remain constant, in the equation that says MV = PQ (Money*Velocity = Prices*Quantity) when M is increased. GaveKal Research strive to show that in application this relationship does not hold, and that investors ought to look to velocity to rebound to gauge market recovery or further deterioration. This is an important concept and holds major implications for the inflation debate.

GaveKal venture on to address the Banking crisis in England, how Mervin King & Co. at the BoE responded to the Northern Rock debacle, and why the appropriate response was hindered by political malaise than by BoE incompetence, though mind you there was some to speak of. Furthermore, the Fed 50bps reduction is taken to light on account of the uncertainty of whether such (and potentially further) reductions will prevent the economy from falling into recession.

GaveKal further discusses how the dollar breaching record lows, will affect the inflationary pressures in China, and how the dollar is affecting the oil markets, which happen to be denominated in dollars. I have attached below graphs of the Euro/Dollar conversion rate, and the current (WTI) cost of oil.

Finally, my publisher is running an advertisement for my friends at International Living. I normally don't think abut the ads, but this one is interesting in that it is two years for the normal one year price for a publication that I enjoy. If you travel or think about living somewhere else, this is a good place for information, or to just dream. Enjoy your week.

John Mauldin, Editor
Outside the Box

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Do Not Forget About Changes in Velocity

GaveKal Five Corners, Semi-Monthly Investment Strategy, September 21, 2007

It has been said that smart people learn from their mistakes (and do not repeat them) and that very smart people learn from other people's mistakes. With that in mind, let us offer up a mistake that we made in the past and which, we fear, a number of people are making again today: forgetting that the velocity of money is not a constant.

In 2001, when the Fed, the BoJ, the BoE and even the ECB started to dump money into the system, we gleefully assumed that either prices or activity would start to pick up over the coming quarters. After all, hadn't Irving Fisher taught us that MV=PQ (Money*Velocity=Prices*Quantity)? And hadn't the monetarist school shown that, over the life of a cycle, velocity was a constant? So couldn't we assume that an increase in M would invariably lead to a rise in either P or Q?

Of course, it did not happen this way, and by early 2002 we had no choice but to review all of our liquidity-based models and figure out where they had failed us. As it turned out, the answer was obvious: our liquidity based models had assumed that velocity was a constant though, in Our Brave New World, it simply was not. The fact that, around the same time, Milton Friedman published a page-long article in the Wall Street Journal drawing the same conclusions further boosted our belief that we needed to rework our investment processes to take into account the changes in the velocity of money.

Which brings us to today. Following the recent central bank actions in the US, Europe and the UK, most commentators seem to expect a sharp acceleration of either inflation, economic activity, or asset prices (or all three). As a result, gold is making new highs, the US$ is plunging to new depths, etc.... But aren't the recent buyers of gold focusing solely on likely changes in the money supply (M), while forgetting why central banks are set to dump money into the system in the first place? Isn't the reason behind the loosening of monetary policies the fact that the velocity of money (V) has been plummeting?

As in 2001, the question investors should thus ask themselves is whether velocity is set to rebound? If it is, then investors are right to position themselves for an ample liquidity environment (long gold, long commodities, long deep cyclicals). But if it isn't, then the investment environment could start getting a lot trickier.

Could the Credit Contraction Still Be in Front of Us?

As highlighted on the previous page, the $100bn question for investors now has to be whether the world's commercial banks will actively multiply the money that the Fed (and other central banks) have been injecting into their economies over the past few weeks. If they do, then the world should witness a roaring boom of unprecedented magnitude. If they do not, then the investment environment will have changed.

On our side, we can think of three reasons why velocity is unlikely to accelerate:

1. OECD banks' balance sheets are already stretched: Usually, the Fed always does the opposite of what US commercial banks are doing. When banks lend, the Fed tightens, and vice-versa. Now in recent months, US bank lending has gone through the roof (see chart), and yet the Fed has cut? Obviously, all the recent loans have been forced onto the balance sheets of banks (previous lines of credit, SIV, conduits, etc...), so in the coming months we should probably expect bank lending to collapse, as banks try to sort out their balance sheets. In other words, the collapse of credit availability could still be in front of us.

2. Ratings agencies have lost investors' trust: In 2001, following the Enron debacle, common wisdom asserted that investors could trust neither the big accounting firms (since they were paid by the companies), nor the companies' accounts (since CEOs and CFOs would cook the books to boost their options plans). This breakdown in trust led to a massive opening of equity risk premiums (which, to some extent, have not yet fully come back). Today, the crisis is not in the equity markets, but on the credit markets. And it is not the accounting firms that are on the firing line but the ratings agencies. So now, instead of investors saying "how do I know if I can trust these accounts?", we hear "how do I know what a AA-rating is really worth? Can it not be downgraded to CCC tomorrow?" And with this kind of breakdown in trust, it is hard to imagine that spreads will come back down in the near future.

3. Regulators and lawmakers will fall on the back of banks like a ton bricks. Let us take Mervyn King as an example. Our guess would be that the BoE governor did not enjoy having to do a massive about-face in 24 hours; nor must he have liked being dragged in front of a parliamentary enquiry to answer questions. In fact, following these experiences, we would imagine that Mervyn King drove back to the bank and, as we say in French, "blew air in the lungs" (souffler dans les bronches) of his underlings who were supposed to a) monitor what Northern Rock was up to and b) keep him informed of important developments. And if this is true of England, it will also be true of the US, Germany, Spain, etc... Everywhere regulators and politicians will ask banks a simple question: How did you get us into this mess? And if Enron gave us the joyful world of Sarbanes-Oxley, what will the current subprime mess bring us? Here is our bet: more regulations, more oversight, and, needless to say, much more careful lending, at least for a while.

Deputy Heads Must Roll

Mervyn King emerged slightly bloodied, but basically unbowed, from his interrogation by the British Parliament Treasury Committee on Thursday. He could have been clearer in explaining some of his zig-zags in monetary policy since August, and he probably should have focused more narrowly on the legal problem that was really at the heart of the Northern Rock debacle--the strange fact that Britain, almost alone of the OECD countries, has no effective insurance system for bank deposits. Instead of focusing on this one issue, which should be fixed quite easily in the next few months, King explained how the efforts to stabilise the Rock were thwarted by four separate legal problems: deposit insurance, takeover law, insolvency law and the EU market-abuse directives.

It seems that the unintended consequence of all this legislation is that central banks can no longer deal with market crises in the quiet way the Bank of England handled previous banking crises. For example, the Market Abuse Directive now makes it impossible for the BoE (or any other EU monetary authority) to pursue any central banker's preferred option - acting secretly as lender of last resort and only disclosing such actions after a crisis has been averted. It turns out that under the EU's muddled legislation, Northern Rock directors would have gone to jail if they had secretly received central bank support - not because they nearly bankrupted their company, but because they asked for a central bank rescue without disclosing this to the stockmarket in advance! King's list of the unexpected financial booby-traps invented by Europe's politicians might have been enough to undermine confidence in the markets, even without a Northern Rock. It also made him sound like a defendant at Nuremberg, explaining that he was only obeying orders, and reeling off a long list of excuses, without ever confronting the central issue of his innocence or guilt.

Luckily for King--and also for Britain's economic future, since he remains one of the world's most skilful central bankers as long as he sticks to monetary policy, rather than market manipulation--the politicians' anger was largely deflected by the Governor's supporting cast. Sir John Gieve, the Deputy Governor, could have been chosen by Hollywood central casting as the perfect fall-guy for last week's mess. Smug-looking, condescending and already implicated in several governmental debacles in his previous job as head of the Home Office, Gieve drew most of the fire away from his boss.

As the Bank's representative on the board of the Financial Service Authority, Gieve should have been the man coordinating the regulatory response to the Rock debacle from the start. His testimony suggested, however, that he was unaware that Northern Rock had any special problems until they were formally brought to Mervyn King's attention by the FSA staff. Worse still, he explained to the dumbfounded politicians that he didn't think asking questions about specific banks which might get into trouble was part of his job, since he was only a "non-executive director" of the FSA. Dealing with the risks of individual businesses was up to the FSA's line managers. Board directors, in his view, had to consider strategic issues, which apparently meant pontificating on general "market conditions" without knowing what was happening in any individual firms.

This new interpretation of corporate governance would have been welcome to directors of companies such as Enron, Hollinger and Equitable Life. But the politicians were clearly unimpressed: Gieve, as Deputy Governor in charge of financial stability, was supposed to be the Bank's eyes and ears in the markets. He should have been involved in the FSA's negotiations with Northern Rock from the start and he should have been reporting back to the central bank daily and making sure that monetary policies were consistent with the FSA's decisions and vice versa. Instead, it turned out that he decided to go on a three-week holiday in August shortly after the liquidity crunch began. The upshot is that Mervyn King's position and the reputation of the Bank of England are probably now safe. If a scapegoat is needed, the Bank will be able to rely on the classic bureaucratic response to a major bungle: "Deputy heads must roll".

Second Guessing the Fed

In 1933, Mellon famously advised Roosevelt to "liquidate labour, liquidate capital, liquidate the financial markets. It will lead to a much more moral society." This, better than any other statement, encompasses the "perma-bear" philosophy: sinners have to pay for their sins; and when the central banks step in to give sinners a helping hand, this can only ensure eternal damnation for the rest of us (either in the fires of an inflationary bust, or those of a deflationary bust, depending on the perma-bear to whom you speak).

Needless to say, with the Fed having just cut 50bp, the prophets of inflationary doom are having a field day. Everywhere we care to turn, we are told to sell the US$ and buy gold. Once again, paper currencies are going to be shown to be worthless.

But is the Fed's track record really that horrendous? As Milton Friedman himself wrote in the WSJ on August 19th, 2003: "Fifteen years ago... I wrote 'no major institution in the US has so poor a record of performance over so long a period as the Federal Reserve, yet so high a public recognition'. As I believe I demonstrated at the time, that judgement is amply justified for the first seven decades or so of the Fed's existence. I am glad to report that it is not valid for the period since".

Indeed, for all of the perma-bears' laments that the Fed keeps on pushing inflation in the system, we are not sure that this assertion is backed up by the data. Indeed, let us ask a very simple question: were recent interest rate cuts by the (according to Milton Friedman) competent Fed followed by a rise in the CPI shortly afterwards? Let us have a look:

Since 1970, most cuts by the Fed (1970, 1974, 1985, 1989, 2001) were followed for at least two years by massive declines in the inflation rate. There were, however, exceptions: 1980 (which was quickly taken back by Mr Volcker) and 1998 (which was also quickly taken back).

Which leaves us with the following question: Will the recent Fed cut prove to be right? Or will it be, like 1980 and 1998, a mistake quickly taken back? We tend to believe that the Fed was right to cut and that, given the massive collapse in velocity, commercial banks will need a steep yield curve in order to recapitalize their fragile balance sheets and avoid a Japanese-style deflationary bust.

However one puts it, we can't escape the conclusion that Milton Friedman was (once again) right: In recent years, the Fed has been more broadly right than wrong (five out of seven). Better yet, when it has been wrong, it was quick to change its course and adjust to the underlying realities. Can the perma-bears claim the same batting ratio and the same intellectual flexibility?

China's Runaway Train

As we never tire of pointing out, there are three things that a central bank can control: the growth rate of its money supply, its interest rate, or the value of its currency. Unfortunately, as the Chinese central bankers are now discovering, it cannot control all three at the same time.

Indeed, as everyone knows, policymakers in China are very keen on preventing the RMB from rising too fast. As a result, money supply growth has been growing above and beyond the PBoC's targets. Indeed, imagine a property developer in Shanghai, or a widget manufacturer in Guangzhou. How should our budding capitalist finance his next project/factory? Should he a) borrow RMB? b) borrow HK$, or c) borrow US$? Obviously, given the widespread belief that the RMB can only rise against the US$, and given that the HK$ is pegged to the US$, borrowing in either HK$ or US$ makes all the sense in the world.

So thereby, the Chinese private sector borrows HK$ or US$, exchanges them for RMB, thus forcing the Chinese central bank to print a lot more money than it wishes to. And given that there exists no domestic bond market to speak of, the PBoC struggles to sterilize this FX intervention. The end result is thus: a) very rapid money growth in China and b) a pace of accumulation of reserves which far outshines the growth in China's FDI and trade surplus. Together, this leads to the kind of asset price appreciation and economic boom that we have lately seen in China.

Of course, with inflation accelerating (August CPI came in at +6.5%), this state of affairs can not continue. But what can the PBoC do? Raise interest rates as it has been doing since late '04? But won't that make foreign liquidity flows into China even stronger? Who in their right mind would borrow RMB at the official lending rate of 7.29% if they can borrow US$ at 4.75% (of course, not everyone in China can borrow US$, but foreign multinationals, HK property developers etc... definitely can)? If the PBoC raises rates again, won't it further encourage the massive US$ carry-trade pictured above?

So far, the Chinese authorities' response has been to loosen up capital exporting rules in the hope that some of the excess money currently being created in China would find its way out of the Chinese economy (first to Hong Kong and, from there, to the rest of the world). But is this happening fast enough to stem China's rising inflationary pressures? So far, it hasn't. And with the Fed now engaged in a new easing cycle, which the PBoC simply cannot afford to follow, it is rapidly becoming crunch time for the RMB. Either the RMB will have to rise a lot in the near future, or the Chinese authorities will have to find some clever way of exporting massive amounts of excess capital. Either way, it is pretty good news for our favourite market: Hong Kong.

Oil is on Fire

The energy markets are clearly at the centre of powerful forces, sometimes cancelling each others, sometimes pulling in the same direction. Currently it seems that these forces are combining once again to set oil on fire, but can it last?

  • Oil demand from Asia remains strong but, with the slowdown in the OECD, the IEA has recently lowered world demand growth for 4Q07 by 250,000 BPD.

  • The North Atlantic Hurricane season is in full swing. But so far there has been no impact on capacity.

  • Refinery capacity utilization in both Europe and the US currently stands at about 92%. At this time of year, it should be higher.

  • US stocks levels are still very healthy and, thanks to three years of playing to stor age from steep contango, almost as high as they have ever been this decade.

  • The US$ stands at a fifteen-year low (and we have amply argued about the strong negative correlation between oil price and the US$).

  • OPEC stance remains somewhat bullish for oil despite the recent concession to add 500,000 BPD to exports.

  • Geopolitics in the Middle East seem as bad as ever.

One could argue that there is nothing particularly exceptional about this background, yet WTI has now reached a new high of $84.10. Just as impressively, winter contracts for heating oil are printing above $95/bbl (or $45 more than three years ago). Record new highs in the absence of solidly bullish news are often seen as very positive news. Moreover, the fact that energy's new highs are occurring when global liquidity growth has been decelerating is undeniably noteworthy. Nevertheless, we tend to believe that we should keep in mind the following possibilities:

The Marginal Cost of the Barrel: Undeniably, marginal costs are now clearly much higher (because of both extraction and refining costs) than they were a few years ago. But there may be some good news in the pipeline or, more appropriately, from the refinery. Indeed, today, low-yield high sulphur fields cannot easily be refined. So while OPEC may promise us an additional 500k barrels of sour crude, what the world really needs is an extra 500kbd of sweet Nigerian crude (which we cannot get). However, China is going to add 700,000 bpd of refining capacity in 2008 (about half of all new capacity to come next year), and most of that will be for high sulphur intake. The infrastructure to better use OPEC's excesses is thus being built. By 2010, estimates are that 10M BDP of new refining capacity will have been built worldwide (the bulk of it in Asia, Central America and the Middle East). This means that by next year onwards, the marginal cost issue should be going down structurally.

The US$-Oil Relationship May Be Getting Overdone: We have strongly emphasised that, as the US$ weakens, OPEC members invariably try to get more for their barrel. However, there comes a point when that relationship breaks down and this point may have been reached. At US$80+/bl, the price of oil is no longer in OPEC's long-term advantage and keeping a bullish bias purely because of a weak dollar basis (and doing so when both Europe and the US are facing a slowdown) seriously risks killing the golden goose. Having said that the weakness of the US$ is clearly a worry for OPEC today.

The recent injection of cash by central banks has lowered the cost of money and increased its foolhardy use. This has clearly benefited a rally in oil. But, as highlighted in the previous pages, while investors focus on the increase in M, they may be missing the collapse in V....

Altogether there still remain issues about OECD economic activity and global liquidity growth. To us, this means that oil prices should ease over the medium-term, though there is no doubt that the short-term looks like fertile ground for a price spike. If WTI fails to close the next few weeks above US$79, then technically the current rally will have to correct to trend support (around $74). By then, a clearer picture for world demand growth in 2008 will have emerged.


Your looking to the fourth quarter for guidance analyst,

John Mauldin

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