The physiology of an 800 lb gorilla

It's sod's law, isn't it? Macro Man writes a piece that attempts to demonstrate why the ECB ain't cutting rates any time soon, and immediately thereafter we get pretty weak business confidence data from Belgium and Germany. (Receiving less press, of course, was yesterday's EU orders data, which showed industrial orders rising 0.6% m/m and 9.9% y/y.) Still, he retains the view that this market is occasionally guilty of cognitive dissonance, ignoring the evidence the runs contrary to its embedded view. While avoiding this pitfall will not necessarily yield a profit (Macro Man has no desire at the moment to make a P/L sacrifice at the altar of Euribor or short sterling), in the current market the avoidance of loss is just as good.

Anyhow, the weak Euro confidence data has unsurprisingly hit the euro while supporting EMU fixed income. Receiving less support, of course, has been US fixed income, where the market now seems keen to trade the economic recovery. This optimism seems relatively misplaced to Macro Man, given that we seem to have jumped immediately from credit crisis mode to recovery mode without ever trading the recession. Now, granted, the consensus is that the US experiences a "mild" recession, partially as a result of the $600 windfall that will wing its way out of IRS headquarters in the next month or two. However, Macro Man believes that the market is ignoring the 800 lb gorilla in the room; the gorilla whose name is "energy."

Now, Macro Man is not an energy specialist, and has no special insight as to what drives short-term price action in that market (other than the dollar effect, which seems to have become paramount recently.) That having been said, he does like to look at it from time to time, particularly when thinking about the macroeconomic impacts of energy prices.

Simply put, Macro Man believes that energy prices have reached the point where they are exerting a critical (downward) influence on discretionary consumer spending, and influence that may only partially be offset by the coming refund bounty. As such, he believes that there is a real risk for the first consumer-led US recession in a quarter century.

The last weekly retail price data that Macro Man can find on Bloomberg suggests an average US retail price of $3.57/gallon. Now, those of us living in Europe would love to pay so little for gasoline; then again, we tend to drive less (and use more fuel-efficient cars) than residents of the U.S. of A. Macro Man's gas price model suggests that current levels of crude and crack spreads should see retail prices climb towards $4.00/gallon in the next few weeks; further rallies in crude and/or a seasonal rise in cracks could mean gas prices rise by even more.

How significant is this? In Macro Man's view, very. If gas prices follow the trajectory of his model, it would take the real inflation-adjusted price of gasoline back towards the all-time high observed in 1980. More significantly, it would also take consumer gasoline outlays as a percentage of total spending back towards the all time high....a period which accompanied the last real bone-crushing consumer recession.
The rise in gasoline outlays naturally acts as a hit to discretionary spending power, as gasoline demand is obviously price inelastic in the short run. Coming at a time when the labour market is weakening and real disposable income growth has dropped sharply towards critical levels, the rise in gasoline prices threatens, in Macro Man's mind, to push the consumer over the edge. Sure, the forthcoming $600 will act as a buffer, and certainly boost incomes in the short run. But if consumers believe that gas and food prices will continue to rise, they may well choose to save more of the windfall than may have been the case a few years ago.
And that, Mr. Bernanke, is why it is worth paying attention to headline inflation as well as core. Some might argue that for a country like the US, rising food and energy prices represent a relative, rather than absolute, shift in prices.

Macro Man's retort is that for those countries that have been the purveyors of low-cost goods and labour for the past several years, these rises represent a boost to the absolute level of prices, and thus have a larger impact on wages/incomes. And that is why we see statistics like a steady rise in US import prices from China, and why Macro Man believes that the ultimate result of the current credit crisis will be a substantial rise in tangible goods and services prices (i.e., CPI/PCE deflator) relative to financial asset prices, which were the primary beneficiary of the shadow banking system that is at the heart of the maelstrom.

Macro Man has taken a look at the physiology of this 800 lb gorilla......and from what he can see, this sucker's an ugly 'un.
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Anonymous
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April 24, 2008 at 1:02 PM ×

Wow, “cognitive dissonance”… sounds pretty thundering and pompous, but correct, to me.

Anyone who happened to know former Bundesbank’s monetary orthodoxy in defending DMark’s purchasing power should not be surprised by ECB officials’ reluctance to pull the trigger and cut rates any time soon Sometimes history might prove more helpful than macroeconomics and that’s why an old book published here in Italy and titled, more or less, “Biography of the DMark” always comes to my mind in these last days.

The major playing ground in the coming weeks will certainly be talks now going on between German trade unions and state and local authorities. As far as I know, trade unions asked for wages of civil servants to raise of at least 10.0% (sic…) and should they see their requests even partially accepted no one will prevent ECB from raising, and not cutting, rates.

My bet as an FX absolute beginner: EUR/USD is not going to correct sharply till next fall, and any dip might prove a good opportunity for writing OTM puts. Other views and ideas are warmly welcomed…

Vielen Grüße, AT

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Anonymous
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April 24, 2008 at 1:14 PM ×

my back of the envelope calc says the 600 bucks covers about 30 weeks of high gas prices (not to mention the pass through effects on food and don't get me started on durables) anyhow might have been simpler for us govt to cut a check to the saudis and cut out the middle man (course that doesn't help win elections) real wages are collapsing in the us and with it we see an ugly and long recession which the numbers will start to show in q3 but started in q1--and its gonna last years--negatvie rates on tips might not be too bad

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Anonymous
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April 24, 2008 at 1:44 PM ×

To AT:
Isn't that 10% over more than 1 year though? It is still going to put pressure on the ECB but not as much as 10% annual increase would.

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Linda P.
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April 24, 2008 at 1:46 PM ×

Thanks MacroMan for the insightful charts.

Here in the Great State of Maine, our lack of any transportation infrastructure, coupled with a huge dependence on tourists driving in from New England, has me just a tad worried about the next 6 months.

Here's hoping for a bountiful lobster crop!

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t
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April 24, 2008 at 1:51 PM ×

http://research.stlouisfed.org/fred2/fredgraphfile/?height=378&width=630&bgcolor=%23B3CDE7&txtcolor=%23000000&recession_bars=On&s[1][id]=OILPRICE&s[1][transformation]=pc1&s[1][scale]=Left&s[1][line_color]=%230000FF&s[1][range]=Max&s[1][cosd]=1946-01-01&s[1][coed]=2008-03-01&s[1][revision_date]=&s[1][vintage_date]=2008-04-24
makes a similar point... spikes in the oil price are inseperable from recessions, barring cases where the gain is unwound.

Throw into the mix that Russian oil production has arguably peaked
http://media.bloomberg.com/bb/avfile/Economics/On_Economy/vMFdt4skJJ00.mp3

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"Cassandra"
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April 24, 2008 at 2:24 PM ×

MM, the relative move can, of course occur in several ways:

(1) higher financial asset prices and even higher tangible goods/services prices; (classical wage/price spiral inflation feedback loop)

(2) stable financial asset prices higher tangible goods/services prices; (A Goldilocks of sorts under the circumstance - gently inflating our way out it w/continuation of real wages converging globally)


(3) lower financial asset prices and stable tangible goods/services prices;
(recession, but not too severe since consumption quantity falls, but terms of trade between ag & tangible goods services rise reducing imbalances. Would feel like Japan in the 90s?)

(4) much lower financial asset prices and less-low tangible goods/services prices; (severe global recession, debt deflation, pushing on a string, demand collapse, last systemic leverage spec in commodity complex gets obliterated).

1 & 4 remain less likely as globalization and labour market slackness keeps lid on wage inflation, and fat margins on capital can contract significantly reallocating to labour in short term, before genie is unleashed. Authorities loose monetary policy, nationalisation of banks etc. will help keep the runaway deflationary vortex on the tail. My guess is convergence occurs somewhere between 2 & 3, closer to 3 since core asset prices (equity and property remain above incomes and incomes cannot rise to those levels as quick as asset values can compress.

p.s. - under this scenario, commodity complex (outside the most genuinely supply-constrained e.g. a few of the ag softs) give commodity HF managers and their investors a severe hazing and "wedgie"

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Macro Man
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April 24, 2008 at 2:28 PM ×

Cassie, you forgot option 5, aka "That 70's Show": Lower financial asset prices and higher tangible goods prices. Given the monetary response from BB, it is still my personal favourite as the liekly outcome...

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sargon TM
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April 24, 2008 at 2:50 PM ×

Reinforcing your perception of the 800-lb gorilla and the unpredictasbility of consumer behaviour in the future. For a while it has been accepted "wisdom" that $3.00 at the pump is the price where consumers shift away from driving, and that $2.50 at the pump is where consumers shift back toward driving.

In this respect note the recent increases in public transit use across NA.

If the price is really above $3.00 to stay it suggests that consumers have made the easy changes, and that their choices are different now. That is, they have moved to a point where gasoline consumption is more inelastic than it was three years ago. How the consumer will balance his budget, if the consumer can balance his budget, where the next line in the sand will be drawn, seem to me the big questions now.

sargon TM

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Anonymous
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April 24, 2008 at 4:00 PM ×

Sargon - durable three buck gasoline might also be the point at which VW diesels, for example, become interesting. If the memory doesn't fail, it was the last go-round of this that put the Asian car makers permanently over the top in NA. 'Course, it was quality that kept them there in contrast to Oldsmobile's fuel miser diesel offering off the day. They merely changed the heads and pistons on the gas block which promptly cracked under the stress of the new compression ratio. Yup.

CB

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Anonymous
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April 24, 2008 at 4:10 PM ×

Saw a reasearch note in the last day or so that claimed thet the DIFFERENCE in crude prices between this year and last will exert a negative effect on the U.S. economy THREE times the stimulative effect of the "tax rebate."

Also, supposedly the correlation between EUR/USD and crude prices has topped ninety-six percent recently. That means that the currency appreciation should shield the Euro Zone from much of the increase in oil prices.

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Macro Man
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April 24, 2008 at 4:25 PM ×

CB, the big 3 might also wish to consider making cars, even their fast ones, with an engine capacity smaller than an Olympic sized swimming pool. The Germans and Japanese can extract pretty damned good performance from a 3 or even a 2 liter engine...why are the US equivalents 5 liters?

Anon #2, because oil prices are much more volatile than currencies, the euro is having only a modest effect; indeed, one could argue that insofar as dollar weakness against the euro is helping to push up oil prices, a higher EUR/USD is inflationary for Europe! (And, more to the point, the Chinese et al who keep buying euros.)

Obviously, the ECB , China etc don't see it that way, but I believe it to be the case.

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April 24, 2008 at 5:27 PM ×

M,

No kidding. The household 140 horse gasoline Civic gets 7lt/100 combined. Got it to nudge 215. But if you translate 1,800 cc into 110 cubic inches and advertise it on the front fender, well I dunno...

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HoosierDaddy
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April 24, 2008 at 9:42 PM ×

Diesel is being hurt here by new emissions rules (which increase the price of both the fuel and the engines and lowers MPG). Diesel is also presently running at a higher crack spread than gasoline. So right now the fuel runs appx $.60/gallon higher than gas. There are several diesels on the way, but I have my doubts on the adoption rate. The upside is those new diesels will spew a lot less soot into urban air and less NOx into the air on the highways.

On the 70's Show rerun, it does seem the economically and politically we're headed that way. Winding down a lost war of choice, commodities inflation, a "change" president (if you squint doesn't Obama look a little like Carter), and an overall negative atmosphere. I'm just waiting for the remakes of "The Road Warrior" and "Escape from New York" (though given recent events maybe it'll be Escape from Maricopa.

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Anonymous
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April 28, 2008 at 2:55 PM ×

Mr Macro,

Does this mean your short sterling against eur/usd basket is off for the time being?

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Macro Man
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April 28, 2008 at 2:57 PM ×

Yeah, it's on the backburner for the time being. It's come a long way, and I think positioning there is finally crowded...

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