Wheat ending stocks took a dive late in the marketing year

You can look at the ending stocks for wheat by quarter from the USDA database to judge the direction in wheat prices. Because the ending stocks are very seasonal, the first quarter pf the marketing year which represents the harvest will show high stocks. These levels will decline as wheat is used. The final balances for the marketing year reflect the ending stock levels.

The stock values follow a similar pattern of decline across the marketing year; however, 2007 data shows that the first quarter did not have a significant decline but the expected decrease in the ending balance is large. This was reflected in prices during the year. The first five months of the year showed almost no change. It was only in the last few months that the market realized that the ending stocks would decline significantly and prices started to take-off.

Using the ending stock changes can provide a good indication of the direction in wheat prices. When stocks are higher than 3-year averages, there is usually a decline in price. When stocks are lower than average there is a corresponding increase in prices.

Low world inventory driving wheat prices

Reviewing the ending stock balances for the world wheat market tells the story for why prices have hit highs. There is no wheat in storage. We are at all time lows with inventory fast approaching 100 million metric tonnes. Clearly, there is a greater risk premium in the wheat market because there is little room for error when the inventory levels decline.

Production has been up from last year but below the records set in 2004. The world will need continued good crops for more than a year to replenish the inventories, but wheat has to compete with other crops which are also at price highs. We will have to get used to this higher price range.

New exchange announced to challenge CME

A group of a dozen banks and brokerage firms have announced that they will form a new futures exchange to challenge the CME. This is not the first time that we have seen challenges to the dominant futures exchange, but all have failed.

Futures exchanges are network monopolies, so once established it is very difficult to develop an alternative network. Liquidity is what customers are buying and the cost of liquidity is much higher than the exchange fees. However, once liquidity is established the fixed fees for trading are high relative to the marginal cost of producing or clearing the trade. The value of the exchange is being the marketplace.

Given the dominance of the exchange, the only place to squeeze costs is with the FCM or broker. Brokers have seen their profits diminish while the CME has seen new highs for its stock price. Banks are the biggest customers for the exchange so it is natural that they would want to fight for lower fees. The banks believe that they can take back this business and provide a lower cost alternative for their trading. Success for these new exchange ventures has usually been forcing a lower cost structure for trading. We will see whether this competitive threat works in 2008.

Case-Shiller housing index down again

The Case-Shiller housing index fell 6.1% YOY for October. This poor number masks some of the very poor regional number in Arizona, Las Vegas, and South Florida which have seen double digit declines over the last year. These are also the places which have seen the greatest number of subprime loans.

As long as housing prices are still declining. the the value of CDO's with subprime debt willl continue to decline. Any foreclosures will face a poor market for selling the collateral hence there will be less funds available for the holder of the securities. There will have to be more writedowns by financial institutions if this continues. Consumer wealth is declining which will lead to lower sales. Conservative behavior by consumer has already shown up in the tepid Christmas retail sales.

Forecasts for stronger dollar from currency strategists

Currency strategists, as surveyed by Bloomberg, are calling for a 1.39 euro/usd by the end of the year versus the current forward rates that are calling for a 1.45 euro/usd. The distribution of forecasts is clearly skewed to a lower euro. What a difference a few weeks make. In late November, the dollar was pushing all time lows yet now forecasters are expecting a strong rebound. The yen at the same time is expected to rally over this same period. So what is driving this forecast? Because we do not have access to all of the explanations behind the forecasts, it is interesting to reverse engineer the conditions that may be needed to get a stronger dollar using simple exchange rate models.

The economic drivers from exchange rate models should be consistent with the forecasts. For example, the forecasters must be assuming that there will be a change in the interest differential which will be favorable for the dollar. Since the current interest difference as determined by the forward rates is zero, the median forecast suggests that Euroland rates will have to fall relative to the US. The ECB will engage in actively pushing rates down relative to the Fed. This is only like to happen if there is a substantial slowdown in European growth and less likelihood of a recession in the US. The Fed will either be on hold or only be willing to engage in moderate cutting during 2008 which will be matched by the ECB. Inflation will have to be relatively stable or more moderate in the US.

The outflow from the dollar will have to be curtailed in 2008 or there will have to be a strong demand for investing in the US as measured by M&A activity. The buying of dollar assets may quicken if there is a fall in equity values in the US relative to the rest of the world.

If you believe that traditional exchange rate relationships will hold, then a dollar rally will have to be consistent with some of these fundamentals otherwise the dollar forecast has to be based on sentiment or relationships which are unexpected. We do not believe in either of these two scenario. Over the next year, we do not believe the dollar will be have sentiment leading to a rally or be out of step with fundamental relationships.

Bank of Japan holds firm

The minutes from the Bank of Japan meeting in November state that rates were held firm because of unstable conditions in the economy. Target rates have stayed fixed at .5 percent. They have maintained the 50 bp target since February contrary to most other Western central banks which have generally been lowering rates in the face of unstable market conditions.

The real growth rate in Japan has been below 2% for the most recent numbers. Sentiment as measured by the Tanken report has fallen across the board, so there is little expectation that Japan will be a growth engine in 2008.

The strength of developing markets – the main theme of 2008

One of the major themes of 2008 will be the continuing growth of emerging and developing markets. This growth theme still has skeptics; however, the old rules and assumptions applied to developing markets do not seem to apply. The new emerging market world is characterized by four conditions.

1. Sustained high growth rates
2. Growth decoupled from United States
3. Growth independent of foreign aid
4. Current account surplus positions

All four of these conditions are counter to what many have expected. Unsustainable independent growth conditions have been the key arguments for avoiding emerging markets, yet the current economic environment for many countries suggests that all of the old assumptions are faulty.

Growth can occur without the United States being a growth leader. Of course, the reason for the high growth may be that the liquidity has been moving from the developed countries to emerging markets. Growth in the United States has slowed, but liquidity has still grown as measured by the decline in real interest rates. Liquidity increases should continue throughout 2008 even if there is a slowdown in rate cuts. The liquidity issue is more tied to the credit risk taking and not the availability of funds. Trade flows have moved away from the US, so emerging markets are less dependent on the growth direction of the US.

Growth can be sustained at relatively high level for a number of years and not just something that is a short-term phenomenon because the market structures for many of these economies have changed. Current account surpluses are also sustainable for emerging markets because there have not been currency adjustments as would be expected if the foreign exchange markets were freer. Of course, the sustained increases in commodity prices have helped many countries which are more dependent on raw material exports.

Nevertheless, the assumption that developing countries can have sustainable growth without foreign aid is probably the most ingrained in Western thought. Yet, we are seeing many countries start to develop strong growth without aid packages. Countries which have been the bets performers have also been independent of large aid packages. This independent development is having a profound effect on global growth. It is also the premise that is most problematic with many Western economic thinkers.

I found reading William Easterly’s The White Man’s Burden: Why the West’s Effort to Aid the Rest Have Done so Much Ill and so Little Good one of the most important books in 2007 which influenced my thinking concerning developing and emerging markets.

William Easterly, who has also written The Elusive Quest for Growth, may be one of the most insightful researchers on economic development and growth. Certainly, he is someone most willing to confront conventional thought. This willingness to question development orthodoxy through thoughtful gathering of evidence makes him essential to thinking about growth and development.

His premise is that there two schools of thought to development. There are planners, who represent the traditional thought of dealing with emerging markets. Planners believe that growth can be fostered through strong and active intervention in developing countries. More aid is always better than less aid. If we provide enough aid to a country, it will grow. There are also searchers who are the agents of change who look for viable solutions to growth based on the circumstances of the country environment. More aid is not always good. It can be detrimental to development if it is wasted and used unproductively.

Easterly destroys the underlying assumption for aid based on the big push theory. The big push argument has driven all World Bank, IMF, and Western aid in general. For growth to be sustained in developing countries there is required large sums of aid to get countries jump started on a high growth trajectory. Without this aid, growth will only be sustained at low levels.

A careful review of research as well as his experiences at the World Bank has Easterly conclude that countries often do not need a big push. Countries do need the rule of law, strong well-defined property rights based on past precedent, governments that will not steal from the people, and aid that is targeted to specific goals which are measurable. High growth has occurred in those countries where the market structure allows individuals to creatively find solutions to specific problems. A good market structure is necessary to finding good economic solutions.

We are seeing those countries that have followed the outline of Easterly flourishing while those that have not have continued to languish. If the market structure allows for entrepreneurship and innovation, there is growth.

Super –SIV, M-LEC, failed

The solution to the commercial paper and subprime credit crisis was supposed to be joint deal between major banks that would fund a new SIV structure that would buy subprime debt from other bank SIV’s. The Treasury was behind this project as a market solution and helped broker the deal, yet on Friday it was announced that the M-LEC deal would not take place.

Cooperation could not be found between the major banks, but the real reason is probably less complex. Swapping funding from one SIV to another does not change the underlying collateral which is where the problem lies. Until the value of the collateral is determined at a market clearing price the sales and funding could not be made. And what is the value of subprime debt? Who knows? The price suggested by buyers is nowhere close to where sellers are willing to part with the debt. The crisis has caused pricing to be made with a broad brush which means that both good and bad debt is lumped together. The only solution is for each piece of debt to be reviewed which takes time. This is the ultimate problem and the issues that will have to be determined as we enter year-end. Unfortunately, there are still too many sellers and not enough buyers and Wall Street does not want to provide liquidity or be an intermediary for this process. Many money funds will have to live with these investments in 2008, so this will be the problem that will keep giving even with the adjustments that have already been made.

Additionally, M-LEC became obsolete because the entire crisis is also moving too fast. Banks are finding their own solutions of placing paper back on their balance sheet. Commercial paper is being retired so that the SIV CP market has shrunk significantly since August. The process is getting done slowly without coordination but through the tedious process of matching buyers and sellers.

Is the dollar that weak?

Taj Mahal and Gisele Bundchen will not accept dollars for payment. Hard to believe that we are the point that cultural icons are refusing to accept dollars. I was referring to the Taj Mahal. However, some of these news reports are extreme dollar bashing.

The Indian rupee has appreciated nicely over the last few years but its growth is more a function of the Indian economy which has seen significant growth. It would be natural to see the currency appreciation. The Indian government actually wants to slow the appreciation of the currency and has added some capital controls for equity investments. May be they should accept more dollars.

Ms Bundchen, a Brazilian supermodel, has declared that she would like to have her contracts in euros not dollars because of currency uncertainty. Payment of contracts is usually made in a home currency or where purchasing power will be needed. If she is spending more time in Europe over the United States, changing contract terms is appropriate regardless of the dollar direction. (Tom Brady should take note.)

Who is willing to stand up and say they want to hold dollars? We have not heard from the Bush administration, but as we close the year there are some buyers that are coming out for the lonely dollar. The dollar has rallied approximately 3 percent against the Euro. The Japanese yen, Canadian dollar and British pound have all fallen in the last month. While this may be more technical driven, the dollar has started to stabilize for year-end. The key issue is what will investors think when they return from their holidays. January has been a volatile period for currency trading as portfolios are adjusted.

Gold reserves mostly unchanged –

The World Gold Council released information on the gold reserves held by central bank in tones as well as percentage of total reserves. This provides one story on how gold is used as a reserve asset. Of course, the data only extends through the first quarter of 2007, but it is the most recent information available. There were two major surprises within the data.

Gold reserves across all central banks over the last reported year declined. There were few cases where gold reserves actually increased. The only large exception was Qatar which actually increased its reserves by 14 times from .6 to 8.4 tonnes. The next largest absolute increase was Russia which increased its holdings by almost 14 tonnes. This increase is consistent with the large inflows from energy production. However, other oil producing countries like Saudi Arabia did not add any gold to their reserves.

Gold as percentage of total reserves also fell but here there was a more variation. The increase in gold prices coupled with the decline in the dollar was the cause for the increase in reserve percentages.

The run up in gold prices over 2007 was driven by private buyers and less by the behavior of central banks at least through the first quarter of the year. The more interesting numbers will arrive in 2008 when we see whether there was a movement out of the dollar and into the hard asset.

What to do now with monetary policy –

Easing by many G-7 central banks has begun to lower economic risks. We have seen the coordinated short-term injection of funds by central banks to provide liquidity over the turn of the year to reduce liquidity needs. We have seen new regulation from the Fed to monitor mortgage bankers. The US Treasury secretary has changed jobs and become the housing and mortgage secretary. What more can be done at this time to solve the credit crisis?

Credit crises are very difficult to solve from both the monetary policy and regulatory perspective. If financial institutions do not want to supply credit, the government cannot force them. Lowering interest rates to provide liquidity is a start but it is a blunt tool and not one that can be easily targeted to a specific sector. Central banks have to worry about the fall-out to the general economy. Providing short-term liquidity is also good but we may not be in a situation yet where the central bank needs to be the lender of last resort; consequently, it is not clear that this is truly necessary. It may not be appropriate to add funds to solve the credit spread problem. The spread widening is a sign that there are risks with banks that need to be disclosed. Regulation is a help, but this policy change is forward looking and does not solve past credit problems. Past credit problems have to be priced in the market and any solution to stop this repricing from happening is not acceptable in the long-run.

Perhaps the best action now is to wait. The markets have increased volatility because it cannot determine what should be done or what is the impact of what has been done. The best Christmas gift may be to let investors reflect on the year and make appropriate adjustments based on the information available.

Helicopter money redux

The end of the year infusion of funds by central banks has taken on a much bigger dimension with the ECB providing $500 billion in short-term funding to banks. You talk about money dropping from the sky as a Christmas gift to the global banking system! And, I thought those who are naughty do not get presents.

The reaction in money markets was swift. Short rates have fallen dramatically. While there is still a wide spread between LIBOR and Treasury rates, the infusion of funds is doing what one would expect. Yet, it gives pause to think about the size of intervention needed to get the very short rates to decline for the end of the year.

The current story is one of circular funding. Banks funded credit but did not want them on their balance sheets so they set up SIV’s. The SIV’s cannot sell their commercial paper so the banks have had to put these assets back on their balance sheets. The same institutions that did not want to fund the SIV’s now do not want to fund the banks, so the central banks have to be the lenders of last resort. If they are not providing the funds, the credit markets will have to shrink and credit conditions will have to tighten.

A friend who is a money market manager mentioned that the Fed wants to keep the Fed funds cuts separate from the TAF funding, but a dollar of new money is the same regardless of the source. The economy does not care how the funds are dispersed. The result is the same especially if the market perceives that these funds that will be needed for some time.

This cash infusion is like a cold medicine. It will mask some of the symptoms but it does not cure the cold. Money is being loaned to needy banks, but what does it mean to be in need at this time. More importantly, what will happen in January when some of this short-term funding matures? The root cause of bad credits held by some banks will not be resolved in the next few months. There will not be more liquidity in January and there may not be more buyers of subprime debt after the end of the year.

This money will have way of finding its way to what will be considered good assets and consumer purchases. This will mean greater inflation. Even if it does not show-up in consumer price indices, there will be a problem of asset price inflation as funds are reallocated in ways that may be unintended by the central banks. We are already seeing the reaction in stock indices in Europe. If the intention is to provide needed funds for banks which are not able to raise them at reasonable rates, the reaction should not be an across the board increase in stock prices. Of course, the stock reaction would be expected if the funding is anticipated to last.

Another trading floor closing

The march to fully electronic trading continues with the announcement that the NYBOT which trades coffee, sugar, and cocoa will close its trading floor at the end of February. The NYBOT was bought by ICE, an electronic exchange, in January.

Trading on the floor has dwindled with the introduction of side-by-side electronic trading, so this announcement was expected. The commodity markets have been holdouts for open outcry because of the lower volume and liquidity relative to financial futures, but the growing importance of index trading sealed the fate of the trading floor. Newer market participants do not find the open outcry system helpful and were more comfortable trading from screens. This will shut more of the trading floor at the World Financial Center which is still a relatively new building.

So, what is going to happen to all of the colored trading jackets?

Inflation up and the dollar rallies

The dollar rallied on the unanticipated increase in CPI inflation today. For some, this appreciation would seem surprising. Increases in inflation are usually expected lead to a depreciation of the currency. Depreciation is what relative purchasing power parity would suggest. PPP models have been the workhorse for many analysts who have been arguing that the dollar fall-off is overdone, yet today was one of the bigger positive dollar moves in months.

The explanation can be found in looking at monetary policy reaction functions. A Taylor rule reaction function would argue for tightening of interest rates if inflation starts to move above target. His would be all the more likely if growth has not fallen significantly. The monetary expectations story is consistent with what happened in the equity markets. Without expected added liquidity, the market does not see a favorable environment for stocks of the next few months.

A significant portion of the recent dollar decline has been interest rate driven. The dollar decline went into overdrive with the cuts from the Fed. With the Fed easing, the interest differential has become less favorable for the US, so the dollar has trended lower especially against the euro. Additionally, the ECB has been firm at current rates even with the increase in supply of funds to meet credit crisis liquidity demands. The higher inflation today suggests that the Fed will be less likely to lower rates early in 2008; consequently, the fall in interest rates should stall. This change in monetary expectations is the current leading driver for the dollar. Whether this will be a short or longer-term dollar rally is hard to say, but there is little changed in the dollar fundamentals except for the possible delay in monetary easing.

Paulson in China – no solution to global imbalances

Treasury secretary Paulson was in China as part of the ongoing Strategic Economic Dialogue. http://www.treas.gov/initiatives/us-china/. While there were substantive talks on product safety, regulation, and policy transparency, there was not any improvement on the key issue of trade imbalances and the evaluation of the yuan. This is the number one global issue facing both countries, yet there is a clear impasse. The US would like a higher yuan and China is not ready to move on this issue.

The Chinese economic environment is becoming more complex. Growth has been strong again in 2007 but inflation is significantly higher. Monetary policy is expected to be tightened to slow growth and inflation. There are also some labor shortages with wages increasing. China may lose its status as the low cost manufacturing producer. Any change in the currency level has to be analyzed with respect to domestic issues and not based on what may happen in the US. Consequently, the current go slow approach is most likely. The Chinese are also concluding that the Bush administration is a lame duck and will not use a change in exchange rate policies too early. They may reserve this option for when potential trade issues heat up either in the summer or after the next election. It is unlikely that Paulson will be able to sway the Chinese of anything significant during his tenure.

The solution to contango blues?

One of the well known secrets of commodity trading is the gains from backwardation. Because back month futures are usually priced below the current spot price, buyers of futures receive a risk premium or compensation for futures convergence. The traditional story is that long speculators are compensated for taking on the risk of short hedgers. If a commodity market is in contango, the futures price is higher than the spot price. Convergence of the basis or price difference will lead to a decline in price. If you are long the futures there will be a drag on performance.

A number of reasons or effects cause backwardation or contango. It could be that futures have a risk premium. There is also the issue of convenience yield for holding a cash commodity. The cost of carry is also a consideration. Overall the difference between cash and futures will change over time as the economic environment changes, so investors cannot bank on normal backwardation or return for trading against hedgers. Unfortunately, it is hard to tell when the market will prefer to be in backwardation. It is the view by some that determining the cash futures basis may be easier than the outright direction, but research suggests that they would be wrong. While the futures basis is less volatile than the futures price, the returns for trading this basis is also lower and may not be more predictive.

A solution is to trade different maturities to reduce the drag from contango and maximize the effect of backwardation. All things equal, you would like to be long the contracts which have the most backwardation and try and avoid or minimize the effect of contango.

S&P has introduced a new GSCI forward index which tries to alleviate some of the negative effect of contango. This is the second index that has been developed in the last two months to trade contracts further from maturity in an effort to minimize the effect of backwardation or contango. This contract should do well during those periods when the market is in contango, albeit most times the most liquid commodities like crude oil are in backwardation.

Adding more indices provides investors with more choices, but it also adds more confusion to the commodity index market. The choice of index becomes even harder. You become an active manager through making your index choice.

How bad is the credit crisis?

One day after the Federal Reserve lowers the Fed funds rate, we have a coordinated policy move across major Western central banks in the US, Canada, UK, Swiss, and the ECB. This was unanticipated though the Fed has been talking about their concerns with liquidity over the end of the year. 

Banks have been reluctant to borrow from the Fed and LIBOR market rates have continued to stay high in spite of the declines in interest rates by central banks In the US, UK, and Canada. The Fed states that its action will be monetary neutral, but that does not seem likely. What really seems to be going on is that central banks are afraid that if the Fed continues to push rates lower without some coordination there will be a further dollar sell-off. 

The process of one bank lowering rates and others waiting to see what happens has not worked. The idea that some banks can hold the line on rates while others become more accommodating is also not working. An issue is whether we will see more coordination on the credit crisis and the dollar decline. Coordination will force more money into G7 economies which may cause further speculative problems in real estate outside of the US. Coordinating the lowering of interest rates or extending credit in G7 countries will do nothing to solve the global imbalance problem. We also wonder what the Fed may know about bank balance sheets that the rest of the market does not know or has not discounted.

Lukoil asking for rubles

Lukoil, Russia’s largest independent oil producer, comments that the company would like to be paid in rubles by 2009. Gasprom, the natural gas producer, has also suggested a similar view. Russia may be one more country trying to take their commodities off the dollar payment system. Russia has not been able to exploit all of their gains from their exploding oil revenues when they are paid in dollars. Most of their trade is with Europe so the goods they purchase are more expensive because of the dollar decline. The ruble actually trades as a managed float between the dollar and euro, so while it has appreciated against the dollar it has actually fallen versus the euro. Of course, the US-Russia relationship is shakier now than in the past which adds to the rumblings about switching payment schemes.

The benefit to Russia and their oil companies would be significant. First, most of the oil company costs are in the local currency so getting paid in rubles would help the profitability for these oil companies. Second, it would increase trading in the ruble which would further integrate Russia in the global markets. The cost would not be great for the US in the short-run since the US is not a large buyer of Russian oil, but the ramifications of the second largest oil producer switching out of the dollar would not be positive for the US.

Who is responsible for the subprime credit mess?

We are seeing another bank write-down by UBS totaling  $10 billion. Bank of America is liquidating a $12 billion enhanced cash fund which broke the buck and will pay-out less than 100 cents on the dollar. This fund saw outflows of over $20 billion in the last two months. This is not a money fund, but probably was marketed as a close substitute for a money fund to institutions with a little more credit and interest rate risk.

We have seen Wall Street chief executive lose their jobs, but most of those executive probably believe that they were not to blame for this crisis. It was the market. It was the greed of others. It certainly was not the manager who pushed for higher yield or greater earnings. So who is to blame? I am not writing to assign blame but suggest that the market managers do not have the ability to be self-reflective. They are not able to comment on what their responsibility for this mess should be because most managers do not have the ability to deal with mistakes.

A new book places a number of these issues in perspective, Mistakes were Made (but not by me): Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts by Carl Tarvis and Elliot Aronson. Their premise is that most of us deal inappropriately with cognitive dissonance, the state of tension that occurs whenever a person holds two cognitions that are psychologically inconsistent. How can you believe you are a good manager if you have to recognize that you were pushing bad credit products to drive profits higher? How could you sell product that you know has a high probability of default. You have to justify this by saying that the investor or the borrower are sophisticated or adults and can understand the consequences of their action. You justify your actions by believing this time is different. You cannot hold yourself responsibility for the action of others even though you may be fully aware of the impact of your activities and the actions of others.

Bubbles are based on the suspension of belief on what is normal. Home prices can go up even with income not growing because the market itself has changed and the old laws of supply and demand do not hold. Those who would suggest otherwise have to be foolish and unaware of the new dynamics.

The only solution is the requirement for constant self-reflection and the simple view that if something is too good to be true it is false. For those who engaged in reflection we praise you. For the rest of the market participants, we ask that you take stock before this problem occurs again.

Cover story signal for grains?

The Economist magazine again placed a macro issue on its cover. This time it is highlighting the commodity markets. The focus is on grains. We have just written about why grain prices are high, but as we have seen in the past, if an issue makes it as a cover story on a business news magazine, there is a good chance for a price reversal. See last week on the match between a cover and the rise of the dollar.

We will be in a volatile period for grains until we have a better idea of the South American harvest, yet the level of current grain prices seems high versus historical standards. Nevertheless, it is hard to determine what history can tell us given the significant changes in the grain marketing structure. The ethanol craze has certainly placed more demand pressure on prices than we have seen five years ago.

Ethanol is a new form of subsidy for farmers but it has greater negative impact on consumers. When we pay farmers not to plant in order to raise prices, we are taking out capacity that can be used later. Any supply shock can be resolved over a growing season. However, when we provide corn subsidies for ethanol, the grain is grown and taken out of the food consumption stream. This production cannot be diverted into add to inventory without having a major impact on the ethanol industry. We will be asking very soon about what were people thinking by developed corn ethanol. The trade-off of food for gasoline does not make sense.

CBT grain contract problems

Futures trading is based on the concept of convergence. Futures and cash prices will move to equality at delivery. This convergence between cash and futures is what makes futures a relevant hedging vehicle. The basis or difference between cash and futures is relatively stable and well defined so hedgers know what the relationship between their specific crop and the general CBT contract. Convergence has been a problem for the grain contracts at the CBT over the last few delivery months.

The CBT called special meeting to discuss this issue with users. A similar meeting was held by the CTFC last week. Unfortunately, there does not seem to be any easy solutions to the problem. This is not the first time that this problem has occurred. A similar issue developed ten years ago which lead to some contract changes to adapt to the changing market conditions for transportation and export of grains. The current problems with the basis at expiration are associated with transportation and warehousing costs for grain. With higher fuel prices and low river levels, the cost of transporting grain becomes higher than normal. When there are good harvests, the costs of storage also become extremely high.

This time the issue may be more complex with index users. As users of the market for index exposure have increased, the divergence between cash and futures has also increased. There is tremendous non-commercial pressure pushing prices above the cash price which drives away commercial users. This is an issue that will have to be fixed or there could be contract failure. This would not help anyone.

Steady march upward for grains

Commodity focus has been on crude oil which approached $100per barrel before falling to the mid 80’s for the current contract, yet the grain markets have seen a steady increase on strong demand and declining inventory and expected production. Soybean prices have hit the highest levels since the big grain shortage of 1973 while corn is again over $4 per bushel. This was not supposed to happen given the significant changes in production dynamics over the last decade. This is also surprising given the strong gains in the US harvest this year.

The grain markets have changed significantly from the 1970’s with South America becoming a dominant player in production and exports. This impact of South America is to lessen the weather supply shock problems that have plagued soybeans and corn in the past. When these grain markets were Northern hemisphere crops, they were always subject to swings associated with the weather cycle in North America. With strong production in South America, the crops were diversified against the weather shocks in the Northern hemisphere. This increase and diversification in supply has been a contributing factor to the real decline in rain prices over the last three decades. But this year we are facing two significant problems which are driving price higher. One is on the demand and the other on the supply side.

On the demand side, world consumption of grains has continued to move upward even at the current higher prices. The increase in world income has shifted diets to meat which is less efficient use of grains for creating protein Coupled with this strong demand were the low inventory levels which stated the 2007 grain year. There was not a strong replenishing of the inventory from the North American harvest in spite of the extra production. Grain prices will stay high as long as the world inventory levels are low. In fact, with growing income and population, the level of inventories should actually be growing to maintain the same level of buffer stock. 

On the supply side for 2007-08, the La Nina weather pattern has led to dry conditions in South America. Because this weather pattern lasts for the crop year, there is the expectation that harvests will be lower than earlier expectations. This only exacerbates the low inventory problem. This has forced prices on the CBT contracts to their high levels.

Instead of January being a relatively low volatile period, we should expect continued dramatic price changes during this critical South America period. This will fold over to planting intention and activity in the spring for the US markets. There is no reason to see significant declines in these markets until planting intentions are disclosed.

Iran does not want to be paid in dollars

It was reported that Iran the fourth largest oil exporter will have all payments made in currencies other than the dollar. Obviously, there is a strong political component to this announcement. The embargo on Iran by the US and the pressure the US has placed on global banks not to deal with Iran has affected their ability to use the dollar acquired from being paid for their oil, but this is just another red flag concerning the decline of the dollar.

If the dollar continues its long-term slide, Iran will look at lot smarter than many of the other Arab countries that have continued to be paid in dollars. There has already been strong talk about diversifying reserves by Arab central banks and the cost of being pegged to the dollar has led to higher inflation.

The declining dollar will continue to have a strain on those countries who have pegged to the dollar. A change in this behavior will have a strong demand impact on dollars and with further deteriorate the financial position of the US. There will be political fall-out from this change in reserve behavior.

Fed meeting and the potential decline in interest rates

The equity markets have been anticipating a Fed cut based on the movement of stocks and a close look at the interest rate options markets tells the same tale. The Federal Reserve Bank of Cleveland reports the probability of a Fed funds change using the Fed funds options market. This information is also available from Bloomberg in a slightly different format.

http://www.clevelandfed.org/Research/policy/fedfunds/index.cfm

With the latest economic announcements being relatively benign for a no change in policy, the market has surged to over a 70% probability of a decline to 4.25%. There is also a 40% probability for another cut in January. The market wants a cut for Christmas and they are expecting their present earlier.

The December Fed meeting and the announcements this week get close to closing the books for year. There usually is not a lot of volume and volatility after the 15^th of the month. However, it has often been the case the trends that area in place in early December continue until the end of the year. The biggest surprises for the credit markets will still be in subprime – SIV markets. The money markets are still behaving like we are facing millennium year-end risks.

The real estate bubble is not just a US issue

The focus of the capital markets has been on the subprime crisis in the US. This credit crisis is a direct result of the slowing of the real estate market. If you do not have rising real estate prices, borrowers cannot sell their home for a gain to offset the loan values. Foreclosures become more expensive because the home cannot be flipped to another buyer to pay-off the loan.

If you think this is just a US problem, take a look at the gains in real estate around the world. The US has not been at the high end of the bubble. Of course, not all countries that have had large increase are in a bubble. Price increases are up because many countries have opened credit markets to home buyers. There has been a shortage of housing in some areas and growth has been strong in many countries. But there also is a strong case for the bubble story. Look at the demographics of Europe. Populations are aging, and birth rates are down. It is hard to imagine that these economies have seen over 100% increases in prices over the last ten years.

The real estate problem is going to be a global problem. There is the subprime paper from the US that is held around the globe and the potential decline in local markets. The real estate problem is going to take on different flavor for the rest of the world because there has not been as much packaging of loans to investors. The credit crisis will affect bank balance sheets and cutting local lending. The decoupling story for the global economy does not hold a lot of water when it comes to real estate.

Treasury subprime plan much to do about nothing

A close review of the Treasury “plan” for the subprime mess suggests that not much is going to happen. The Treasury through its “Hope Now” plan facilitated some arrangements with banks to help standardize adjustments to loan arrangements through allowing for no change to lending rate. The number of borrowers this plan affects will actually be small. Also, the arrangement could have been made without the help of the Treasury and there is no current relieve planned for the billions that will be adjusted in 2008. In short, the financial system will have to work this problem out on its own. Foreclosures are going to build and home inventories in many markets are going to increase.

Paulson, who comes from Wall Street, will not take a populist approach of forcing moratoriums on investors as a solution. He is well aware that government intervention in the contracting of lending arrangements will not just hurt investors and affect the working of capital markets. At this point in time, protecting the capital markets from moral hazard problems is more important. This approach may change as we move through 2008 and get closer to the election, but right now, Treasury wants to look like they are doing something without being heavy handed.

This means that this crisis is going to continue for a long time and it will be the burden of the Fed to solve the problem through the use of the ineffective tool of lowering rates. Lowering rate is generally ineffective when there is an unwillingness to lend and the credit of borrowers is impaired. This solution also may be gradual because the lowering of interest rates will have negative ramifications on the dollar and we have not seen the signs of a recession in the rest of the economy. Expect the slow process of 25 bps cuts. The credit crisis will be one of the main themes of 2008

Dollar is driven interest differential expectations

The dollar has come off its lows since the middle of November because of changing expectations about the direction of interest rates outside of the United States. Up until recently, the United States was alone with its active policy of reducing rates. This lowering of interest rates by the Fed along with the lower rate expectations by fixed income investors caused the interest differential to move either against the US or to less favorable terms. A loose monetary policy in the US relative to the rest of the world will have the impact of increasing relative money supply which will lead to dollar depreciation. The economics are straightforward and transparent. However, the credit issues of the US have spilled over to other countries. In particular, the UK is seeing its own credit crisis issues as measured by short-term LIBOR rates. Consequently, there has been policy change by the Bank of England with a cut of 25 bps by the MPC for the first time in two years. This closes some of the gap that formed between the UK and US. There is similar talk of cutting rates in Europe based on slower growth and there are the longer-term expectations in the US that the economic outside of the housing is doing better than expected.

All these policy adjustments change the future expectations of interest rates which really drive the interest differentials or more precisely the expected interest differentials. If there is less drag from interest differentials, there will be greater opportunity for more dollar upside.

Shadow financial system seeing the potential for runs

The financial system has fragmented from the days when banks were the dominant force in financial markets. This is the shadow financial system which is not controlled by the Fed. Money funds clearly have an important role in short-term lending. Now we see state money funds, who have been the aggregators of smaller pools of cash being affected by the SIV crisis. With smaller investors pulling funds from larger pools like in the state of Florida, there are bank runs. The only way to solve the problem is to close the window to withdrawals.

Assume that there is some small percentage of a large pool holding sub-prime SIV commercial paper. You are a small investor in the fund and decide to pull your money. The percentage that SIV commercial paper represents in the fund will then increase which may lead to greater withdrawals. Who want to be the small investors left in the larger pool that is getting riskier? Florida may not be alone in the bank run scenario. If fact, this could be a problem in a number of states and could spill over to retail money funds. This would be a blow to investor confidence which will have a strong impact on the rest of the markets. The herd can move fast once it hears shots.

LIBOR does not follow the Fed

The monetary policy response to the credit crisis has been to lower the Fed funds rate. The monetary channel for increasing credit is to lower rates to cheapen the costs of banks to lend longer-term. A steep curve is a license to print money for most financial institutions. There is only one problem with this scenario, higher risks associated with banks themselves and the risk of lending. If lending is considered riskier, then the rate on LIBOR will increase. This increase in risk premium may be greater than what stimulus the Fed provides.

There also is a strong desire for window dressing at the end of this year. Who wants to hold risky assets at the turn of the year? This is why we currently see one-month LIBOR at 5.25% and yet one-year LIBOR is at 4.43%, an 80 basis point difference. Now if credit is cut-off over the turn of the year, there will have to be liquidation of assets from balance sheets which will lead to depressed prices for end of year price marks. There could be some wild fluctuation of prices with December 31, on a Monday. This end of the year financial zaniness may not be controlled by the Fed regardless of what they do over the next four weeks.