The Goldwatcher

Oil above $65, mortgage angst & and a credit crunch on the horizon

Goldilocks ruled in the 1990s when US Federal Reserve Chairman Alan Greenspan was being eulogised for his skills at keeping the US economy not too hot, not too cold, but just right for growth with low inflation.  A 1997 feature article: ‘Who needs gold when we have Greenspan?‘ published by the New York Times was in tune with popular belief. When stock market bubbles popped in 2000 and 2001 everyone thought the Goldilocks legend died. Greenspan of course survived and Ben Bernanke is now his successor. Some commentators have been saying Ben is also heir to the Goldilocks legend..

In an article titled ‘Goldilocks is here’  this is what a Forbes columnist had to say only six months ago:  ‘Ben Bernanke can go out for a long lunch hour without worrying about the inflationary bias of a barrel of oil at $75. Now, it may be headed into the mid-$50s……(with) lower energy bills ….the cost of doing business edges down for everybody. Even the balance of trade stats stop bulging.’ With the oil price going up again the cost of doing business for everybody is likely to go up again and the balance of trade stats are likely to bulge some more. So I think we must now accept that Goldilocks is dead and we have to face reality.

In an article titled Grim Reality  Bill Gross, Pimco’s managing Director writes in his April 2007 Investment Outlook that lots of money is going to be lost with mortgage defaults, but the ’subprime crisis is or has been isolated and identified for what it is – a small part of the U.S. economy…..It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses.” The punch lines follow : ‘To prevent a double-digit decline in prices, PIMCO’s statistical chart suggests that mortgage rates must decline a minimum of 60 basis points and the sooner the better. The longer yields stay at current levels, the more downward pricing pressure will build as foreclosures/desperate sellers dominate price trends as opposed to prospective buyers.‘ Supporting his view that Bernanke must reduce rates Gross cites a study sponsored by the Federal Reserve on monetary policy in 18 countries over 35 years after house price falls. His conclusion : ‘the Fed will cut rates and cut them significantly over the next few years in order to revigorate an anemic U.S. economy.‘

What has this got to do with gold? Bill Gross notes that ‘a forecast of home prices almost implicitly carries with it a forecast for interest rates.’   It is hard to flaw his argument or his acumen as a forecaster and low interest rates could be good for gold.  But don’t expect either that on the first challenge Bernanke will  throw in the towel as an inflation fighter or that he can allow a vicious cycle of value destruction to sink the US economy. To put it bluntly the grim reality Bill Gross recognises is that sooner or later Bernanke will have to inflate the US economy out of fallout from an irresponsible mortgage lending spree. And that’s not going to be good for the dollar. 

C John Katz 2007

March 26th, 2007

Delinquencies following an irresponsible mortgage lending spree to unqualified buyers in the US are ringing alarm bells. The media are sporting a medley of commentaries and forecasts on the implications. Some commentators insist that fears about damage to the overall economy have been blown out of all proportion. Others say outcomes will be much worse than we expect. Meantime every item of news on home sales that may shed any light or shadow on the subject causes an over reaction on financial markets. What should we make of conflicting reports on new and existing home sales?

A long and short explanation with the following conclusion came today from a superb financial blogosphere contributor: The Calculated Risk Blog.  ‘………new home sales have been crushed, existing home sales are about to be crushed.
For the general economy, new home sales are far more important, because of the related employment and spending on materials. However, for those directly impacted by existing home sales (real estate agents, appraisers, mortgage brokers, home inspectors, etc.), the coming slump in existing home sales will have a larger impact.’

Investors concerned about risks should remember : there is never only one cockroach. The World Economic Forum listed 23 in their 2007 Global Risks Report .

7 are geopolitical risks; 5 economic, 5 environmental, 4 societal and 2 technological.

The 12 geopolitical and economic risks are listed below. Mortgage delinquicy concerns fall under the item ‘Blow up in asset prices/excessive indebtedness.’  (I have added some # signs to highlight risks already rearing their ugly heads and some comments in brackets on three of the economic risks.)

WEF Geopolitical Risks:

#International terrorism; #Proliferation of weapons of mass destruction (WMD); #Interstate and civil wars’ #Failed and failing states; Transnational crime and corruption; Retrenchment from globalisation; & #Middle East instability

WEF Economic Risks:

#Oil price shock/energy supply interruptions; US current account deficit/fall in US $; Chinese economic hard landing (market reacted severely to fall on Shanghai Stock exchange fall a few weeks ago); #Fiscal crises caused by demographic shift (the other shoe to drop - see note below);#Blow up in asset prices/excessive indebtedness (Mortgage lending losses in the US and possibly elsewhere)

 We will all have opinions and make guesses on the outcomes of geopolitical risks. But there are four key facts. The Iraq ‘mission accomplished’ fiasco is history. The ‘mission impossible’ outcome is obvious. Civil war in Iraq, instability in the region and a nuclear standoff with Iran put oil supplies and global security at risk. And, as is also the case with economic risks,  there is never only one cockroach.

C John Katz 2007

.

Do you remember November 4th, 1979?

Iran’s capture of fifteen of our servicemen last Friday, 23rd March 2007, is cause for anxiety. Captures of servicemen have in the past led to serious repercussions and could again. Market reaction last Friday was …….’Crude-oil futures climbed past $62 a barrel Friday to close at their highest level in two weeks as Iran’s seizure of 15 British naval personnel off the coast of Iraq triggered concerns over disruptions to crude production’………..and ‘Higher crude oil, Iran tensions lift gold -$663 to $665.   Yet by Friday evening gold had fallen to $556.

Neither the Wall Street Journal, the Financial Times, Bloomberg or any other financial paper I read this morning mentioned gold on their front page. It was surprising as there are associations between angst with Iran and the gold price. In 1979,  after the return of Ayatlloah Khomeini to Iran in February gold climbed to a high of $512 in December from a low of $216 at the beginning of the year.

Harvard Professor and economic historian Niall Ferguson has commented that we may have been misguided taking the fall of the Berlin Wall in 1989 as the seminal economic event of recent times and has written: ‘With the benefit of hindsight, 1989 was not the decisive turning point of the late 20th century. That came ten years earlier in 1979 - the year of the Iranian Revolution.’

Perhaps the day to really relate to the present crisis is November 4th 1979. The day  militants stormed, took hostages and occupied the US Embassy in Teheran. When diplomatic safeguards were ravaged our global security took a giant step in the direction of anarchy.

The standoff with Iran may be  old news for markets. Hopefully the capture of our servicemen will be resolved quickly and remembered as only another incident in a region killing on a grand scale. But, as investors, we ignore the crises in Iran and  Middle East risks at our peril.

C John Katz 2007