The Credibility Fairy

The SNB has to pick its poison. It is damned for one set of reasons if it holds the currency peg, and damned for another set if it ditches the peg. Welcome to the world of horrible dilemmas facing modern central banks.

Ambrose Evans-Pritchard, 15 Jan 2015

For every credibility gap, there is a gullibility gap

Richard Cobden

The decision by the Swiss National Bank (SNB) to release the Swiss Franc from the peg it had to the Euro, and indeed the consensus reaction to that decision, should disavow the notion that the current economic situation is not one that is based on the whims of central bankers. Since the Global Recession of 2008, the major central banks of the world have been trusted with the task of ‘fixing things.’ Owing to a shared economic philosophy of intervention in markets when things don’t go according to plan, the majority of mainstream economic commentators have a tremendous amount of faith in central banks, only quibbling with them on secondary issues.

In removing the peg, the SNB effectively tightened its monetary policy, thus doing an about face in a world in which the conventional view is that there is no such thing as monetary policy which is too easy. Thus, the SNB invited upon itself a torrent of criticism. Most of the criticism revolved around two ideas, the first being that the SNB decision is simply bad for growth prospects.

The second, and more interesting point of criticism, is the perceived loss of credibility the SNB has now sustained. Given the elevated stature the central banks have attained post-2008 as the ‘saviors’ of the world, their every policy announcement, press conference and media appearance has been treated by market participants and economic reporters as though it were the Word of God being delivered by Moses from Mount Sinai. When viewed in that context, it is easy to understand the disappointment in the SNB. An institution viewed by many as infallible abruptly reversed course, essentially admitting it wasn’t as foolproof as once thought. The ultimate significance of this, however, lies in the fact that the situation the SNB got itself in was a microcosm of the situation global central banks have gotten themselves into.

Less than two weeks after the SNB relieved itself of the peg, the European Central Bank (ECB) embarked upon a period which will be similarly trying. The much awaited entrance into the QE game went relatively smoothly, but it is the Greek elections that are sure to increase the tension across the continent. Should the victorious Syriza stick to its guns, the fabric of the status quo will surely be ruptured, further calling into question the fortitude of central bankers and other bureaucrats who have thus far been able to hold things together with mere assertions.  Alarmingly, it is this brand of ‘credibility’ upon which global markets rest.

The Critics of the Swiss National Bank Have It Wrong

Before delving into the wider significance of the SNB decision, the more proximate perceived consequence – a descent into recession – deserves further treatment. This view, of course, is nothing more than the old canard that deflation is bad, and thus, the instant appreciation of the Swiss Franc (CHF) is bad because will result in deflation, which in turn will lead to disaster. Below is a chart of EUR/CHF in the aftermath of the SNB announcement:


Violent as that move is, the move downward (stronger CHF) was a move in keeping with the underlying trend. Observe the following, which is a chart of EUR/CHF over the last 10 years.


EUR/CHF made its last major top in October 2007, at a price of roughly 1.682. It then spent the better part of 4 years trending lower, flirting with parity, before the SNB acted in September of 2011 to peg EUR/CHF at 1.20. The critics claim that the ending of this peg, and the resumption of the downtrend (EUR/CHF traded as low as 0.85 after the announcement), will lead to recession for the Swiss economy. If the move from 1.20 to 0.85 will usher in pain and suffering, then surely we can look to the move from 1.68 to parity for some insight as to how much damage will occur, and what the Swiss can do to brace themselves. The following is a chart of Swiss inflation during the time in question:


As one can see, the inflation rate was less than 1.5% for all but 18 months of the nearly 9 year period depicted. This is particularly worrisome for modern economists who believe that inflation rates that are ‘too low,’ as defined as being below 2%, are the starting point for economic disaster. Given the Swiss economy spent the best part of 9 years in this condition, one would expect Switzerland to be an economic wasteland by now.

The following is a look at the unemployment from 2007, through to the present:


Now Exports from the same time period:


Retail Sales:


Hardly gloom and doom, and hardly what one would expect if one accepts mainstream economic theory with respect to strong currencies and falling prices. To put it plainly, price movements are the effects of changes in real economic developments. Modern economists mistakenly treat price movements as the cause of real economic developments. It is not the change of price that should be feared or welcomed in isolation; it is whatever caused that price change that needs to be assessed to determine the positivity or negativity thereof. With respect to the Swiss economy, it is on relatively sound footing, and Swiss companies in general produce high quality products that are widely sought.  The result of that is continued demand for Swiss Francs, as well as downward pressure on prices thanks to high productivity.

Unfortunately, the recognition of the unambiguously positive condition of economic stability/progress has been trumped by the modern fear of falling prices. This has led central bankers, fervent adherents of these faulty views, to prioritize the state of price trends above all else. The fact that the SNB felt it had to initiate the peg, in the face of positive real economic developments was Munchausen-like. Yet it was viewed as sound policy across the sphere of economic commenters.

Redefining Credibility

If taking putting the peg on – to keep the Deflation Boogeyman at bay – was sound policy, then taking it off must be suicide. So it was reported, in the aftermath of the SNB decision. Apart from the predictable calls for Swiss recession, the belief that the SNB had completely lost its credibility was the most revealing one to me.

What the SNB essentially did was admit that it could no longer fight the trend of CHF appreciation. In order to prevent CHF from rising, it had to purchase large quantities of Euros, thereby saddling its balance sheet with assets that were more likely than not to continue depreciating.

Furthermore, the sheer size of these purchases, in comparison to the size of the Swiss economy meant that the SNB was taking great risks in creating dislocations elsewhere. The drastic reduction of interest rates triggered by the SNB actions enticed borrowing in CHF, mostly for mortgages. Both domestically, and in neighboring parts of Central and Eastern Europe, household borrowing increased, leading to a Swiss property market which is frothy, if not an outright bubble.

In ending the peg, the SNB prevented further losses to its balance sheet, and prevented the continuation of a negative process in which cheap loans foster unsustainable asset increases, which in turn begets more credit creation to sustain further asset price increases, and so forth, before an inevitable bust. That this behavior constitutes irresponsibility, and signifies a loss of creditability should give one insight into the Orwellian nature of modern economics.

Some point to the fact that the SNB made the move in a surprising fashion. To use modern econospeak, the SNB did not ‘telegraph’ their intentions beforehand, even stating that the peg was the centerpiece of its policy only days before the January 15th announcement. For market participants to take umbrage with this sort of bait and switch further underlines the importance of central bankers over the state of affairs. In other words, market participants have now elevated the central banker to deity, and without his or her guiding hand at every step of the way, the market is lost. The kicker is that most of those people will turn around and claim we have free markets.

The bottom line is that the SNB peg made no discernable economic impact that could be credited to the policy itself, rather than the intrinsic nature of the Swiss economy. Yet it was creating problems in the shape of a possible credit boom and future risks of increased prices. Modern economic dogma completely disregards any risks of central bank policy as long as it is done in the name of deflation prevention.  According to most economic commentators, the ‘dilemma’ Ambrose Evans-Pritchard alludes to in the opening quote does not really exist. As long as deflation is avoided, the belief is, nothing else matters. Any problems that do occur are rationalized away, misattributed to some other reason, or simply ignored.

The myopia of deflation-phobia is so acute that Larry Fink, CEO of BlackRock, thinks that the Swiss not going into recession as a result of CHF appreciation is a risk. His rationale is that the Swiss negotiating the CHF appreciation smoothly will send the message to Germany that ‘de-pegging’ from the Euro in the shape of returning to the Deutschmark will be sound policy. The truth is that it probably is the right course of action, but the message is clear from Fink: the Status Quo must be defended.

When it comes down to it, this is the heart of the matter. The SNB and the Swiss economy in general have simultaneously shattered two, if not three tenants of status quo economic belief. The first is regarding the perniciousness of strong currencies, which I have discussed before.

The second is the more general view that central authorities can reliably and indefinitely counteract trends in real economic conditions through printing money, and can stop at any time without negative effects. Recall the EURCHF chart from the time of the SNB announcement, reproduced here:


Also, recall that the 3.5 year peg did not prevent the underlying trend from resuming. Real economic conditions always win out, regardless of the actions of central bankers. The only thing the SNB succeed in doing was change the date when the EURCHF traded down to 0.85. Instead of happening in 2012 or 2013, or some other time, it happened in 2015. But it was always going to happen. What the SNB did accomplish was enabling that move to happen in the space 30 minutes instead of 30 months. In other words, as a result of the peg, the move was far more violent and disruptive, as virtually nobody had time to adjust to the movement, a feeling that many in the financial world as well as Eastern European debtors can attest to. A much more protracted and orderly decline would have been much better.

What is truly alarming is that every major central bank across the developed world has done the same thing as the SNB did, writ large. They have not necessarily employed the same tactics as the SNB in that a currency peg was not the tool of choice. However, the major central banks of the world have all done the same thing in that they have all engaged in expansionary policy to fight real economic conditions. More specifically, they have engaged to fight the effect of weakening economies – deflation – rather than to cure the causes.

In essence, the 3.5 year period of peg-induced stasis on the EURCHF chart is analogous to the stimulus-induced stasis in low growth rates experienced by much of the developed economies. As Evans-Pritchard suggests, the dilemma for central bankers will come when they stimulate to the point where prices are too great and debt loads to excessive for the average consumer to bear. From there, the choice is either to further stimulate, risking total destruction of the currency, or the cessation of stimulus, which will see a sharp drop in growth rivaling that of the EURCHF chart after de-pegging. One thing is for certain, and it is that real economic conditions will assert themselves once again. They always do. To the extent that policymakers keep fighting the effects of these conditions rather than their causes will be the extent that they further expose the futility of their efforts, This in turn exposes the futility of the ideology it is based on, thus terminally losing the credibility they seem to hold so dear.

The Car Crash

Two colleagues, Ludwig and John, decided to embark on a trip together. Their destination was the Land of Abundance, a land in which every need and want one could desire could be attained as easily as one draws breath. The path to this Land was not so easily laid out for them, but they both had a good idea how to get there.

Before the trip, they met to discuss strategy. John believed that if they drove at an increasingly higher speed, slowly accelerating by the same amount each hour (a process he bizarrely called velocity stability), they would get to the Land of Abundance in no time, thus having more time to enjoy the spoils. Ludwig pointed out that constantly increasing speed regardless of the outside factors such as traffic, elevation changes, changes in the road etc would pose a problem and endanger their safety as they drove. Furthermore, the car has a maximum speed which will alter John’s plans of getting there in ‘no time.’

John brushed aside Ludwig’s concerns as primitive and barbarous, stating that Modern Driving was much more suited to his approach. When it came time to begin the trip, he strongarmed Ludwig and took the wheel, rendering Ludwing and his ideas to the passenger seat. (more…)

SNB Removes Currency Peg

This morning, the Swiss National Bank (SNB) removed its policy of setting a minimum exchange rate against the Euro (EURCHF) of 1.20.  This decision is the reversal of the decision it made in September 2011, when, in response to a rapidly appreciating Swiss Franc, the SNB chose to set and maintain the aforementioned minimum exchange rate. It defended its actions in a further statement following the announcement this morning:

The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.

As for why the SNB felt that now was the right time to make the move, it said the following:

Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.

Indeed, when the policy was implemented in September of 2011, the EUR/USD traded at roughly 1.40. In the hours before the announcement, it had been trading between 1.17 and 1.18. The SNB had been buying Euros all the way down from EUR/USD 1.40, to defend the EUR/CHF peg at 1.20, and with the prospect of the ECB announcing QE next week, odds are it would have had to escalate its Euro purchases even further as it faced the prospect of a further declining Euro. To date, the SNB purchases of Euros in defense of the peg were extraordinary in comparison to the size of its balance sheet – a fact which was not widely mentioned, but to a few astute commentators this presented a potential ticking time bomb.


Apparently the SNB saw the writing on the wall and feared it would have to expand its balance sheet to an even more dangerous degree to continue buying continually depreciating Euros. In essence, it has decided that continuing to print good Swiss Francs and throwing them after bad Euros was a bad idea, and it’s time to cut its losses.

Despite a return to relative sanity, the SNB has come under fire from some elements of the investment and business community. From Reuters:

Swatch Group Chief Executive Nick Hayek called the Swiss National Bank’s decision to discontinue the minimum exchange rate on the Swiss franc a “tsunami” for the Alpine country and its economy.

“Words fail me! Jordan is not only the name of the SNB president, but also of a river and today’s SNB action is a tsunami; for the export industry and for tourism, and finally for the entire country,” Hayek said in an emailed statement on Thursday.


“Absolutely shocking … For companies with international operations – translated earnings are going to be lower and if companies make products in Switzerland it is going to hurt margin. It is a terrible day for corporate Switzerland,” Kepler Cheuvreux analyst Jon Cox said.

Beyond that, much has been said about the ‘loss of credibility’ the SNB has brought upon itself by not telegraphing its move, and making it a complete and total surprise. Dennis Gartman, speaking on CNBC earlier, called it the ‘worst decision made by a central bank’ in his 40 years of time in the markets.

This consternation stems from two ideas. The first is that the SNB originally acted in 2011 to prevent a strong CHF-induced ‘deflationary spiral.’ This feeds into the bog standard deflation-phobia that permeates the economic understanding in the developed world. The story is that a strong currency hampers exports, and reduces economic growth.

I have responded to that claim a few times on this blog, most recently when discussing Abenomics in Japan, a policy which is founded on that same basic idea. The bottom line is that currency depreciation makes it easier for exporters to sell goods overseas, swelling their coffers. This is merely a short term effect, however, as the rise in input costs tends to reduce any advantages provided by the weakened currency. As non-exporters, and any other entity of the currency loses out via reduced purchasing power, the end result is that any currency devaluation scheme does nothing more than transfer wealth from the holders of currency to the exporters. It is noticeable that the early voices of dissent at this move have been such large multinational exporters and financial institutions. It is important to understand that their concerns are largely based on a removal of the policy driven subsidies that they once enjoyed, rather than a true deterioration in the prospects of the Swiss economy.

Those fortunes will be determined by one thing – the ability of Swiss producers to manufacture high quality products. This has not changed with the SNB announcement, and has always been true. What the SNB announcement, and the appreciating Franc does is to force Swiss producers to maintain their competitiveness through continued efficiency, rather than ‘coasting’ as an artificially cheap Franc artificially boosted their sales.

The horror stories put forth by mainstream economists and large exporters simply do not jive with the historical record. If the EURCHF going from 1.20 to parity is to cause the Swiss economy to implode, why didn’t an even more precipitous move – the 2007 to 2011 move from 1.67 to parity – already destroy the Swiss economy? Furthermore, the Swiss Franc has been on a terminal ascent since the 1970s, yet Swiss companies have been able to thrive. This is because they have been consistently producing high quality goods and services, and doing so in an efficient manner. The experience of the Swiss economy over the last number of decades gives the lie to the idea that weak currencies are the key to economic growth, such that a central bank is wise when it engages in a policy to weaken its currency.

The other idea which has driven disappointment in the SNB is related to the ‘deflation is bad so currency strength must be prevented’ argument. It is the fundamental belief that central banks have everything under control, are able to manipulate markets flawlessly, and are steady hands that can guide the ship through the turbulent waters of uncertainty. The actions of the SNB should render this view, which is pretty much ubiquitous throughout mainstream academia, Wall Street and the government, to be foolhardy, but I doubt it will have that effect.

Ultimately, the SNB engaged in price fixing, holding the CHF at an artificially low level against the Euro for nearly 3.5 years. Price fixing in any capacity does nothing but create imbalances. In this case, these imbalances were exposed when, after the peg was dropped the EURCHF fell nearly 40% in less than 30 minutes. The speed of this move has been another talking point in this saga, with large multinationals, financial institutions, and hedge funds all potentially caught out in a negative manner. Undoubtedly such a rapid, unpredictable move resulted in some bloodshed. The blood is on the SNBs hands, not for removing the peg, but for having it in the first place. Absent the peg, today’s move would have happened over 3.5 years, rather than 3.5 minutes.

Do those in opposition of today’s decision think that the SNB could have kept the peg on indefinitely? The economic realities determined that the Swiss Franc was to be bid higher. Central bankers are powerless to alter real economic conditions. The only thing they have at their disposal is the ability to postpone the effects of those economic realities via a printing press. This is what the SNB did, and as a result of their continuous printing, they ignited a real estate bubble. Defending the peg against what was to be a further onslaught driven by European QE would have only meant a further buildup of inflationary pressures, and a further squandering of capital in an unsustainable, depreciating Franc-driven mania. The SNB was right to end its peg, because in doing so it corrected the mistake it made when it put the peg on in the first place.

Today a central bank essentially admitted it can’t control real economic conditions, and that it can’t hold the hand of market participants while it walks on water to the Promise Land. That this is considered to be a ‘loss of credibility’ by the vast majority of commentators and economic participants tells you all you need to know about the state of economic thought and the reverence central bankers have attained in the 21st century. The bottom line is that the SNB learned a dear lesson today, which I doubt will be acknowledged by it, or any other central bank. Whatever moves the SNB was so afraid of back in 2011 happened anyway, except today, these moves happened in minutes as opposed to months or years, creating the very instability they thought the peg was preserving. Furthermore, they have given birth to a housing bubble, which too will lead to instability where they thought stability was assured. It is the same lesson which central bankers across the developed world refuse to learn, which is that economic problems can’t be solved via intervention in markets.


On the Failure of Abenomics

In a period when all politicians are either dull or unwilling to break away from routine – “tradition,” when it seems that in every Western nation the spring of imagination is dried up; Mussolini gives the impression of an ever-welling source. One may object to any form of dictatorship, but one cannot help being stimulated by the phenomenal vitality of this man who, in his role of dictator, has commanded the barren soil of Italy to produce wheat within a given time; ordered his territory to be expanded (by reclaiming swamps) without extending his frontiers; and, not content with summoning new cities into existence, is changing the face of the Eternal City by digging up the buried glories of Imperial Rome.

Valentine Thomson, NYT, 1933


In a sense, the really remarkable thing about “Abenomics” — the sharp turn toward monetary and fiscal stimulus adopted by the government of Prime Minster Shinzo Abe — is that nobody else in the advanced world is trying anything similar. In fact, the Western world seems overtaken by economic defeatism…the overall verdict on Japan’s effort to turn its economy around is so far, so good. And let’s hope that this verdict both stands and strengthens over time. For if Abenomics works, it will serve a dual purpose, giving Japan itself a much-needed boost and the rest of us an even more-needed antidote to policy lethargy.

As I said at the beginning, at this point the Western world has seemingly succumbed to a severe case of economic defeatism; we’re not even trying to solve our problems. That needs to change — and maybe, just maybe, Japan can be the instrument of that change.

Paul Krugman, NYT, 2013




Right off the bat, I would like to quash the notion, borne from lazy reasoning, that I am comparing Shinzo Abe to Benito Mussolini. What I’m doing is highlighting the fact that it is extraordinarily popular to believe that, in the face of crisis (particularly an economic one), some sort of supreme, bold, decisive action is required from those in leadership positions, to the extent that any action, no matter how dubious in nature, is to be applauded merely because it is perceived as bold. In 1933, during the depths of the Great Depression, the likes of Mussolini stood out on the global stage as purveyor of such bold and decisive actions, which were lauded in the NYT article I quoted, among others of the period, because the end results were positive. You could take issue with the tactics involved, but who could argue with the idea that wheat springing from the barren fields of Italy was bad thing?

Eighty years on, the majority of the economic establishment similarly extolled the virtues of Shinzo Abe and his economic doctrine, known as “Abenomics.” This economic plan was comprised of three prongs, or ‘arrows’: Fiscal stimulus, monetary stimulus, and structural reform. On its face, this initiative is bog standard policy talk. The boldness comes from the nature of its goals, and the stated commitments to those goals given by Abe and the Bank of Japan. In implementing Abenomics, they’ve made it clear that they will not stop until they reach their stated metrics – regardless of how much money gets printed or how much debt must be undertaken. It is this attitude that many have praised as being bold. (more…)

Market Views 23 December 2014

As I write this, the S&P 500 futures (ES) are flirting with fresh all time highs. Santa has been kind to Wall Street this year. The following is an hourly chart of the December action in ES.


The while oval represents the two hours during which the Federal Open Market Committee released it’s latest economic outlook, along with the press conference of chairwoman Janet Yellen to explain it all to reporters. The biggest story from it all, was a semantics change from the FOMC. With reference to the process of raising rates, the next step on the march to monetary policy normalization, the FOMC pledged it would exert ‘patience’ in carrying out the process, rather than merely keeping rates at zero for a ‘considerable time.’ While Yellen asserted that the change of language meant nothing in terms of a change in action, the markets took off from there. Whether these new attempts at all time highs can be upheld remains to be seen.

One thing about the month so far that has been evident is the difficulty in being a bear at this time. Despite the fact that pre-Yellen, ES had sold off 100 points from the highs of the month, there were sharp rallies of 27, 33, 25 and 50 points which meant that it was extremely difficult to actually make money on the short side. That sort of volatility may actually embolden the bearish case going forward, but for now it seems as though the bears will have to retreat until further notice. A two year view of ES:


Up 33% in 2013, and another 13% in 2014 with 8 days left in the year, with no signs of stopping. So what is the bearish case? That requires the consideration of two factors: time frame, and the adherence to reality. Quite frankly, over the long run I don’t think a bearish case exists for the US stock market, at least in nominal terms. This is because FOMC is fully committed to preventing asset prices from ever falling, and will print infinite dollars to do so if that’s what it takes. The issue is that monetary policy induced perpetual rises in stock prices tend to be divorced from economic reality. See: Argentine and Venezuelan stock market appreciation vs economic realities in those countries.

The creation of more currency does not drive real economic growth, but it can increase stock prices, which ostensibly reflect greater economic growth prospects, creating a discrepancy between real economic prosepcts and the supposed barometer of such. Thus it is possible to have a situation where on one hand, there are shortages of toilet paper, as the stock market makes new all time highs, as it was in Venezuela earlier this year. Or closer to home, last year, the US market making a fresh all time high on the day Detroit, once a symbol of American industrial might, filed for bankruptcy.

What these sort of discrepancies mean is that the bullish case has been, and can continue to be right for the wrong reasons. As being on the right side of the trade is all that really matters in the long term, it’s really hard to argue with the idea that one should just blindly buy and forget about it.

None of this precludes a shorter term attempt by the market to ‘revert to the mean.’ In fact, in order for the long term ultrabullishness to play out, this sort of short term ‘correction’ is necessary, as policy makers won’t flood the market with even more currency unless there is a threat of sustained asset price declines. Thus, the bearish case is really a case of a brief temporary adjustment to economic realities before policymakers step in to resume the voyage to Fantasyland. As I’ve been discussing over the last week, the most likely catalyst for such a short term correction is the oil situation. A long term chart of oil, spanning 20 years:



Based on the rise from $10.65 low in 1999, the current price in the mid 50s still seems ridiculously high. That is until you consider that for the majority of the last 10 years, oil was trading over $50. Most commentators have pegged $40 as the ultimate resting place, which is roughly where it bottomed in 2009 after the crash from the $147 all time high of 2008. Based on chart analysis, specifically the Elliott Wave principle of a three wave correction, I believe that $20-30, rather than $40 will be the ultimate place oil bottoms.

That is, the price action from $147 until now is all part of a longer term correction, after which price will resume higher eventually, ultimately taking out the $147 high nominally. From $147 to $35 in 2008-2009 was the first leg. The second leg was up, from $35 in 2009 until June 2014 (chart below), and the third leg from June 2014 to its ultimate bottom, perhaps in the $20-30 range, which coincides with the last major low before oil prices really took off for the stratosphere in late 2001.


This is consistent with my views above, namely that in the longer term we are going to be in for severe price appreciation, however this will take place after a deflationary event induces the Federal Reserve to go even more ‘all in’ than it already has. Oil seems to be the first domino in that deflationary chain.

Technically speaking, the triangle formation that took about 4 years to form broke in August, as shown in the above chart. On that break, I drew in the support lines pictured. The manner in which price scythed through these levels suggests there is a real force behind this move. In the immediate term, this move lower could be overdone. The penultimate green candle represents last weeks action, and if the low from last week isn’t broken this week, it will portend a slight respite in the decline. Perhaps a move back to $65-80. But the trend is clearly down, and it will take some doing to arrest the decline. Particularly as Yellen and Co. do not see any real threats from the falling oil price at this time, which suggests they will do nothing to arrest it.

The next immediate place to look after the oil domino falls is the Junk Bond space, as a lot of the financing for oil related projects came through junk bonds. The following is the JNK etf action for the last two years:



Despite the market as a whole being up over 10%, junk has diverged, to this point down a little over 3% for the year. Something to keep an eye on in 2015.

As for other areas, US dollar strength continues apace:


The above is the US Dollar Index ($DXY), over the last two years. I mentioned in October that my target for  $DXY was 92.5, which seems to be on the cards. This coincides with multi year support on various dollar related currencies, including EUR/USD, GBP/USD, AUD/USD, USD/CHF, USD/JPY, and NZD/USD. With all the sentiment biased in favor of a strong dollar, it wouldn’t be surprising to see at the very least a correction in dollar bullishness, if not a major reversal.


More On the Oil Price Developments

The consensus view on the recent plunge in oil prices is that it is a net positive. The logic involved is that the falling price represents a transfer of wealth from oil producers to oil consumers, and as there are far more of the latter, the boost to consumer spending will outweigh any difficulty faced by oil producers.

This logic would be sound if it was simply a case of increasing production satisfying consistent demand. The following chart suggests that is not the case:


While supply has risen over the last 5 plus years, the extent to which it has risen has been exaggerated a bit in relation to the explanations for the oil plunge. The supply rise has been relatively consistent, and even with the recent boom in US shale oil, the additions to the global supply from that boom have not been so dramatic as to send the global supply kiting through the roof. The main issue has been the lack of demand for oil at the levels that prevailed for most of the last 5 years, between $70-110/barrel. In the face of the recent flattening of demand (which OPEC expects to further decline in 2015), combined with the unchanged supply situation, a price drop is to be expected.

The next issue to resolve is the reason for the declining demand. As Irving Fisher wrote in his 1913 article The Monetary Side of the Cost of Living Problem, analysis of the supply and demand conditions relating to the good itself is only half of the picture. The monetary condition is equally as important for determining the whole story. From that standpoint, we turn to the Fed. The following is a chart displaying the year over year change in the Fed balance sheet compared with the price of oil.


The heavy pre 2010 year over year changes in the Fed balance sheet reflect the magnitude of the original Quantitative Easing program. The subsequent iterations of QE had less of an impact on the growth of balance sheet in relative terms, each time ‘only’ increasing the Fed Balance sheet roughly 40% year over year. This has been accompanied by price action in oil which has basically oscillated in a $40 range. I’ve mentioned multiple times that for QE to achieve the goal of constant price increases, each increase of the balance sheet has to be larger than the last, in relative terms. Since the original QE increased the balance sheet by 100%, subsequent increases of the balance sheet have to be in excess of 100%. Failure to do this will result in downward pressure on prices as the relative flow that is responsible for boosting prices starts to deteriorate. As I wrote in ‘Underpants Gnome Economics’:

Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.

Despite engaging in unprecedented easing of monetary policy in absolute terms, the fact that the Fed has been relatively tight (especially with the tapering of QE3 beginning in September 2013) means that deflationary pressures are certain to reassert themselves.

A few have been speculating in recent weeks that oil may be the first place in which this deflationary pressure appears. I joined them the other day in examining the implications of an oil collapse. Since then, the line of reasoning I presented (that the oil decline might reveal a layer of bad debt and pose a threat to the financial system) has been buttressed by a number of news articles with gloomy implications. From Bloomberg this morning:

In a stunning analysis this week, Goldman Sachs found almost $1 trillion in investments in future oil projects at risk. They looked at 400 of the world’s largest new oil and gas fields — excluding U.S. shale — and found projects representing $930 billion of future investment that are no longer profitable with Brent crude at $70.


The Goldman tally takes the long view of project finance as it plays out over the next decade or more. But the initial impact of low prices may be swift. Next year alone, oil and gas companies will make final investment decisions on 800 projects worth $500 billion, said Lars Eirik Nicolaisen, a partner at Oslo-based Rystad Energy. If the price of oil averages $70 in 2015, he wrote in an email, $150 billion will be pulled from oil and gas exploration around the world.

An oil price of $65 dollars a barrel next year would trigger the biggest drop in project finance in decades, according to a Sanford C. Bernstein analysis last week.

Unprofitability at a lower price means a reduction in outlays for future production. This means a decline in employment and utilization of capital, as this BBC article mentions:

“It’s almost impossible to make money at these oil prices”, Mr Allan, who is a director of Premier Oil in addition to chairing Brindex, told the BBC. “It’s a huge crisis.”

“This has happened before, and the industry adapts, but the adaptation is one of slashing people, slashing projects and reducing costs wherever possible, and that’s painful for our staff, painful for companies and painful for the country.

“It’s close to collapse. In terms of new investments – there will be none, everyone is retreating, people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”

Mr Allan said many of the job cuts across the industry would not have been publicly announced. Oil workers are often employed as contractors, which are easier for employers to cut.

His remarks echo comments made by the veteran oil man and government adviser Sir Ian Wood, who last week predicted a wave of job losses in the North Sea over the next 18 months.

The US-based oil giant ConocoPhillips is cutting 230 out of 1,650 jobs in the UK.

This month it announced a 20% reduction in its worldwide capital expenditure budget, in response to falling oil prices.

Other big oil firms are expected to make similar cuts to their drilling and exploration budgets. Research from the investment bank Goldman Sachs predicted that they would need to cut capital expenditure by 30% to restore their profitability at current prices.

Service providers to the industry have also been hit. Texas-based oilfield services company Schlumberger cut back its UK-based fleet of geological survey ships in December, taking an $800m loss and cutting an unspecified number of jobs.

On Wednesday Aberdeen-based Wood Group announced a pay freeze for staff, and cut rates for its contractors.

Apache, one of the North Sea’s biggest producers, has followed suit and will impose a 10 percent reduction on its contractors’ wages from January 1st.

Capital Expenditure reduction. Employment reduction. Wage freezes/reductions. All of these have knock on effects in the shape of reductions in spending in other areas, not to mention the pressure that bad loans puts on the financial sector. The oil decline is a classic debt deflation in the making, which is a totally different prospect to the positive ‘it’s like a tax cut’ interpretation which is the consensus view at the moment.

Despite the potential bleak situation, the solution is to actually embrace the oil declines, because the falling price is the cure. The real problem was the proliferation of credit and debt issuance which roughly tripled the oil price rise from the 2009 depths to its stasis in the $70-110 range, enabling an expansion of investment, capital formation, and an increase in production costs. These unsustainable developments have now been revealed, as the inability for the economy as a whole to sustain high oil prices has led to a drop in demand, and thus the price. The drop in price now renders a lot of the credit undertaken in the past dubious in nature. Inevitable credit contraction and liquidation will follow, perhaps culminating in a reduction in oil supply. However, the end result is a situation in which stability returns. Costs of production will fall along with the price, to a point where investment projects can be undertaken profitably again, leading to the resumption of hiring and production. This is how markets work to correct imbalances.

Unfortunately, central bankers do not like the way markets work, so they will attempt to intervene. As it stands now, the Federal Reserve seems unperturbed by the move in oil prices, based on Janet Yellen’s press conference yesterday. If and when the issues I’ve mentioned rear their heads, the interpretation of any troubling situation will be that it is the low price which is the problem. The erroneous view that price moves cause changes in economic fortunes, rather than merely being effects of those changes, will lead the FOMC to resume easing, in ever greater amounts, to bail out anyone who may have been harmed by the pitfalls of a contraction of bad debt. The end result of this intervention will likely be a propping up of prices at elevated levels, the exact phenomenon which enabled an unsustainable edifice of oil development funded by leveraged financial institutions to be constructed in the first place. Let’s not get too far ahead of ourselves though, these developments are a few steps down the road, but it’s a road we’ve travelled on multiple times in the last 15 years. It’s hard not to be concerned.