2010: Economic Pandemonium
The true financial crisis begins when the world realizes that there are couple months food supply missing from 2010. The last two years were a gentle, mild preview of the real thing.
Total Panic
The sudden, shocking discovery that food supplies are running out will produce total panic. The reaction will inventory building — hoarding –at all levels. Major food producing nation will export bans (India has already banned food exports). Producers, Middlemen, And Households will rush the acquire supplies. All this hoarding will wrosen the crisis by throwing supply and demand further out of balance: export bans cut supply available on international market and inventory building increases demand. Food prices will more than double.
Central bank exodus from the dollar
With one out of eight Americans on food stamps, foreign central banks are subsidizing US food consumption by funding the US government with their treasury purchases. Once the food crisis begins next year, they will be faced with the choice:
1) Continue subsidizing US food consumptions as triple digit food inflation ravages their economy and their people starve.
2) Dump their treasury holdings onto the market to rapidly appreciate their currencies, lowering the cost of food imports and preventing widespread domestic starvation.
Not much of choice. China, for example, will drop the dollar peg without a second thought to prevent triple digit food inflation from damaging its economy and causing widespread of social unrest. Chinese exporters will be badly hurt, but that will be a small cost if it can keep food prices down.
In India, the government is ALREADY under pressure to selloff the country’s $270 billion in forex reserves.
Food prices are rising faster than any other commodity and food prices hit the poor the most.
While overall inflation is just 3 per cent, food prices are rising at unforgivable 17.7 per cent. Prices of rice and wheat have gone up in double digits in one year (10 per cent).
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Perhaps the most surprising is that while food prices are rising, the government seems to be doing nothing, although it is fortunate to have many policy options at hand.
One option is to release food grain stocks [which unfortunately, DON’T EXIST], say analysts. They argue why should wheat and rice prices rise when India has near record stocks of food grains.
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The second option that the government has to reduce the inflation in potatoes, onions and pulses is to use some of India’s enormous reserves of foreign exchange to import these food items so crucial for the poor.
India today has $270 billion in forex reserves. A small fraction of this could be used to import food and help the poorest.
“But the dollar can’t collapse because there is no alternative to the US dollar for a reserve currency…”
I love the “there is no alternative to the US dollar for a reserve currency” argument. Every time I hear it, I imagine someone standing on the deck of the Titanic on the night of April 14, 1912, and declaring, “This boat can’t possibly sink because there aren’t enough lifeboats!”
The lack of viable alternatives doesn’t mean the dollar can’t sink, it simply means that when it does go down, it will result in a tragedy of epic proportions which will be remembered for centuries to come.
Political Fallout of 2010 Food Panic
While a food crisis was unavoidable to some extent because of the abnormal weather and financial crisis, the total panic which will soon grip world agricultural markets is a creation of the USDA and its fictitious production estimates. If not for the USDA’s interference, food prices would have risen in the first half of 2009 in anticipation of the 2009/10 shortage. The United States Department of Agriculture, has caused incalculable damage to the world economy by encouraging overconsumption of rapidly diminishing food supplies.
Once the 2010 Food Crisis starts, confidence in the US government will be shattered as a result of the USDA’s faulty estimates. The starvation and misery caused by higher food prices will also create a lot of anger…
Insolvent Midwestern banks
With failed crops, farmers across the Midwest are bankrupt, and so are their banks. This is especially important considering that the FDIC is out of money. Every bank failure is now being financed with the immediate sale of treasuries.
Whether the US choose to bail out Midwest banks with billions of emergency aid for bankrupt farmers or finances the FDIC takeover of their banks, the outcome will be the same. The enormous quantity of debt which the US will need to sell to finance emergency aid and resolve bank failures in the Midwest will pressure an already collapsing market for US treasuries.
Panic selling of distressed debt
When the dollar starts rapidly losing value, the flaw in the whole “hold to maturity strategy” will be revealed. Financial institutions around the world will realize that the dollar will lose all value years before their toxic assets ever have the chance to mature. They will then begin dumping trillions of toxic US debt at firesale prices, simply to escape the dollar’s devaluation.
Self-reinforcing Breakdown of derivative markets and US financial system
Short term treasuries function as the collateral backing derivative markets and US financial system. When the dollar and treasuries start falling in value with exit of foreign central banks, investors will lose confidence in that collateral and start withdrawing from derivative markets. This will result in a flood of new treasuries coming onto the market as collateral is liquidated, causing further loss of confidence, and so on.
To image how this damaging dynamic would work, take a look at the Portfolio Allocation of PIMCO Commodity Real Ret Strat C Fund (PCRCX). PCRCX is a commodity fund which uses derivatives to gain its exposure to commodities.
PIMCO Commodity Real Ret Strat C Fund (PCRCX) Portfolio Allocation
Track portfolio allocation change of PIMCO Commodity Real Ret Strat C fund (PCRCX)
| Date | Cash | Stock | Bond | Other |
| 06/2009 | 11.56% | 0% | 75.75% | 12.7% |
| 03/2009 | 27.7% | 0% | 62.97% | 9.34% |
| 12/2008 | 34.59% | 0% | 57.76% | 7.64% |
Most Recent Top 10 Holdings in PIMCO Commodity Real Ret Strat C Fund (PCRCX)
| 30-Jun-09 | |
| Pimco Cayman Cmdty Fd Ltd Instl | 13.41% |
| US Treasury Note 3% | 10.07% |
| US Treasury Note 2% | 10.04% |
| US Treasury Note 1.875% | 9.84% |
| FNMA | 9.70% |
| US Treasury Note 2.5% | 8.68% |
| US Treasury Note 2.625% | 8.29% |
| US TREASURY NOTE | 7.82% |
| US Treasury Note 2% | 6.79% |
| PIMCO FDS PRIVATE ACCOUNT PORTFOLIO SER | 5.63% |
It is easy to see why, with the treasury market breaking down, investors will question the wisdom of investing in a fund that has over 76% of its assets in US bonds. Investors will start withdrawing their money from the fund, and PCRCX will have to sell treasuries into a market already filled with only sellers. This “run on the bank” dynamic will gain steam until it leads to the collapse of derivative markets and the US financial system.
The use of a single asset class as collateral for an entire financial system is idiotic. There is no such thing as liquidity of investment for the community as a whole.
Derivative casino will be bankrupt
derivatives are essentially bets (about future value of commodities, currencies, bonds, etc). Like gambling at casinos, to make money in derivative markets requires meeting two conditions:
1) Being on the winning side of the bet.
2) Being able to collect on the bet.
The point here is that it doesn’t matter how many chips are won if the casino goes bankrupt before they can be traded in.
There is about $14 Trillion collateral behind listed/OTC derivative markets, and this collateral is invested in short term dollar-denominated debt. As the dollar and credit markets collapse, this collateral will lose all value (the equivalent of a casino going bankrupt). Investors trying to collect on profitable bets (ie: call options on gold) will find their derivative contracts backed by insolvent counterparties and worthless debt.
Warped perception of risk
Right now, the entire commodity derivative market is built on the idea of no default risk. This is to say, investor are now taking default risks very seriously in the credit markets (after experiencing horrible loses due to financial crisis), but these concerns over counterparty solvency are completely absent in commodity derivatives. When the the dollar, treasuries and derative markets start collapsing, concerned investors will start wondering who is on the other side of their commodity investments, and they will be horrified at what they find out.
Deflationary panic in commodity markets
The biggest sellers of commodity IOUs are insolvent institutions desperate for funding. They are taking advantage of the warped perception of risk to raise capital cheaply. For example, investors in commodity derivatives will be thrilled to learn that completely-insolvent, taxpayer-bailed-out AIG Financial Product is a key player in commodity derivatives.
AIG Financial Products and it subsidiary Banque AIG have been key players in the development of commodities as an asset class and has been active in this space since 1991. AIG Financial Products provides clients with a full suite of commodity offerings, including OTC derivatives on both individual commodities and commodity indices, structured products, and bespoke commodity investment solutions. As the creator of a leading benchmark for commodities investing, the Dow Jones – AIG Commodity IndexSM, AIG Financial Products helped spearhead the rapid growth of commodity-based investment in recent years and as of the end of the third quarter of 2006, there was an estimated $30 billion tracking the DJ-AIGCI.
Insolvent institutions like AIGFP have been very active and creative in selling all kinds of commodity investments to anyone foolish enough to buy them. Take for examplecommodity linked structured notes being sold to retail investors, banks, and commodity funds.
Retail and institutional investors alike are piling into commodity-linked structured notes according to the firm MTN-I, even as overall sales of structured notes declined.
Sales of commodity-linked notes rose to $15.8 billion over the first half of 2008, up from $7.8 billion over the same period a year ago, according to MTN-I…
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About 77% of all commodity-linked structured notes sold so far this year were issued by investment banks. MTN-I’s research showed Deutsche Bank leading sales in the first half of 2008, with 59% of all sales. Barclays was second with 13% and Credit Suisse third with 5%. Merrill Lynch, across various entities, represented a little over 5% of sales.
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Typically structured notes are unsecured, which puts buyers at risk if issuers go into bankruptcy. That wasn’t a concern of most institutional investors until the events of this fall. The bankruptcy of Lehman Brothers, however, quickly left buyers on the hook and possibly unable to recoup their capital.
Other troubled financial institutions that have issued commodity structured notes include insurance giant American International Group (AIG), UBS AG (UBS), Morgan Stanley (MS) and French bank Dexia (HIB4.BE).
AIG Financial Products Corp is also actively involved in commodity ETFs. From the prospectus of DJ-AIGCI:
(Who in their right mind would buy an AIG-backed commodity ETF?)
ETFS Agriculture DJ-AIGCI
Investment objective
ETFS Agriculture DJ-AIGCISM (AIGA) is designed to track the DJ-AIG Agriculture Sub-IndexSM and pays a capitalised interest return which cumulates daily. The Sub-Index is an “excess return” index and the interest component combines to give a total return investment.
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AIGA is backed by matching Commodity Contracts purchased from AIG Financial Products Corp. (AIG-FP) whose payment obligations are guaranteed by American International Group, Inc (AIG) and backed 100% by collateral held by the collateral manager BNY Mellon in a separate account and adjusted daily.
As investors realize who is on the other side of their investments, it will lead to a deflationary panic in commodity markets, with all but the most trusted commodity investments being abandoned. Insolvent institutions like AIG will lose a critical source of funding and, more importantly, investment demand, instead of being absorbed by the IOUs of insolvent institutions, will flow directly into physical commodities, driving up prices.
The Federal Reserve will print trillions
If the treasury market collapses, the government will lose the ability to sell debt to fund itself, which isn’t an option. To preventing such a collapse, the Federal Reserve will have to make purchases in the trillions despite already having run out of room on its balance sheet, which means it will have to print money. A massive expansion of the Fed’s balance sheet at a time of when inflation is spiraling out of control will destroy all confidence in the dollar, worsening the currency crisis.
What life looks like during hyperinflation
Below is an extract from Paper Money by “Adam Smith,” covering Germany’s hyperinflation in 1923, which offers a good account of what life looks like during hyperinflation.
The German Hyperinflation, 1923
Before World War I Germany was a prosperous country, with a gold-backed currency, expanding industry, and world leadership in optics, chemicals, and machinery. The German Mark, the British shilling, the French franc, and the Italian lira all had about equal value, and all were exchanged four or five to the dollar. That was in 1914. In 1923, at the most fevered moment of the German hyperinflation, the exchange rate between the dollar and the Mark was one trillion Marks to one dollar, and a wheelbarrow full of money would not even buy a newspaper. Most Germans were taken by surprise by the financial tornado.
“My father was a lawyer,” says Walter Levy, an internationally known German-born oil consultant in New York, “and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread.”
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More than inflation, the Germans feared unemployment. In 1919 Communists had tried to take over, and severe unemployment might give the Communists another chance. The great German industrial combines — Krupp, Thyssen, Farben, Stinnes — condoned the inflation and survived it well. A cheaper Mark, they reasoned, would make German goods cheap and easy to export, and they needed the export earnings to buy raw materials abroad. Inflation kept everyone working.
So the printing presses ran, and once they began to run, they were hard to stop. The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. “If you want to save money,” he was told, “and you want two cups of coffee, you should order them both at the same time.”
The presses of the Reichsbank could not keep up though they ran through the night. Individual cities and states began to issue their own money. …
The flight from currency that had begun with the buying of diamonds, gold, country houses, and antiques now extended to minor and almost useless items — bric-a-brac, soap, hairpins. The law-abiding country crumbled into petty thievery. Copper pipes and brass armatures weren’t safe. Gasoline was siphoned from cars. People bought things they didn’t need and used them to barter — a pair of shoes for a shirt, some crockery for coffee. Berlin had a “witches’ Sabbath” atmosphere. Prostitutes of both sexes roamed the streets. Cocaine was the fashionable drug. In the cabarets the newly rich and their foreign friends could dance and spend money. Other reports noted that not all the young people had a bad time. Their parents had taught them to work and save, and that was clearly wrong, so they could spend money, enjoy themselves, and flout the old.
The publisher Leopold Ullstein wrote: “People just didn’t understand what was happening. All the economic theory they had been taught didn’t provide for the phenomenon. There was a feeling of utter dependence on anonymous powers — almost as a primitive people believed in magic — that somebody must be in the know, and that this small group of ‘somebodies’ must be a conspiracy.”
When the 1,000-billion Mark note came out, few bothered to collect the change when they spent it. By November 1923, with one dollar equal to one trillion Marks, the breakdown was complete. The currency had lost meaning.
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But although the country functioned again, the savings were never restored, nor were the values of hard work and decency that had accompanied the savings. There was a different temper in the country, a temper that Hitler would later exploit with diabolical talent. Thomas Mann wrote: “The market woman who without batting an eyelash demanded 100 million for an egg lost the capacity for surprise. And nothing that has happened since has been insane or cruel enough to surprise her.”
With the currency went many of the lifetime plans of average citizens. It was the custom for the bride to bring some money to a marriage; many marriages were called off. Widows dependent on insurance found themselves destitute. People who had worked a lifetime found that their pensions would not buy one cup of coffee.
Pearl Buck, the American writer who became famous for her novels of China, was in Germany in 1923. She wrote later: “The cities were still there, the houses not yet bombed and in ruins, but the victims were millions of people. They had lost their fortunes, their savings; they were dazed and inflation-shocked and did not understand how it had happened to them and who the foe was who had defeated them. Yet they had lost their self-assurance, their feeling that they themselves could be the masters of their own lives if only they worked hard enough; and lost, too, were the old values of morals, of ethics, of decency.”
The death of the “US consumer”
The famous “US consumer” has been the driving force of the global economy for decades. This ends in 2010, as the dollar’s collapse will wipe out America’s purchasing power.
US Economic Disintegration
70% of the US economy is consumer spending, with at least 20% of it directly tied to commercial retail real estate. Less than 10% of our economy is related to the production of basic goods and services. This style of economy cannot handle a pull back in consumer spending.
America is facing a terrifying future. As the dollar loses most of its value, America’s savings will be wiped out. The US service economy will disintegrate as consumer spending in real terms (ie: gold or other stable currencies) drops like a rock, bringing unemployment to levels exceeding the great depression. Public health services/programs will be cut back, as individuals will have no savings/credit/income to pay for medical care.
What has already happened in the last year offers a good preview of what to expect in the next:
‘tent cities’ are growing all around the country
California is experiencing a meltdown
Police cars are being repossessed due to falling tax revenues
Major retailers, hotel chains, and theme parks are going bankrupt
Loan quality at American banks is the worst in at least a quarter century and is deteriorating at the fastest pace ever
The victims of this financial disaster don’t have the money to bury their loved ones.
US states have started printing their own currencies
Recession has put a major strain on social security trust fund
US Contract law torn apart
Given the food shortage in 2010, there is also the potential for famine in the US
The US will not fall alone
With the free falling dollar spreading doubt about all paper currencies, and countries with weak financial health will join the US in hyperinflation. Two countries which will follow the US into economic oblivion are Britain and Japan
Britain is probably the only country worse off than the US, and they know it. Privately,something close to desperation is starting to develop inside government, with cabinet ministers being quoted as saying things such as. “The banks are f***ed, we’re f***ed, the country’s f***ed.” The last time Britain built up this much debt was when it was fighting half of Europe.
Japan meanwhile is facing a demographic collapse and its debt to GDP is approaching 200%. The dollar’s collapse is going to wipe out the value of Japan’s foreign reserves and destroy the country’s largest export market (the US), heavily damaging the economy. The yen, like the pound and dollar, will not survive.
Financially Surviving 2010
Here is some investment advice for surviving the 2010 Food Crisis.
Avoid all commodity futures!
DO NOT BUY agricultural futures! While it might be tempting to buy futures contract for soybeans and other agricultural commodities, this is a mistake. Look at the backwardation which happened at the end of August this year: shortage sent cash price of soybeans over $13 while futures contracts hovered around $11. Futures contracts missed out on most of the price spike by nearly 25%.
The 2010 Food Crisis will send futures into permanent backwardation. In other words, shortages will send cash prices into steep backwardation, and then, when the dollar and treasuries collapse, defaults fears will cause that backwardation to grow. Fears that CME might collapse could easily lead futures to trade at a fraction of the commodities they track.
Avoid all other derivatives
It is impossible to hedge against the dollar’s fall with derivatives! Since global derivatives markets operate on the assumption of the continued stable value of the dollar and short term US debt, Using derivatives to bet against the dollar is NOT a good idea. The panic in 2010 will see the majority of derivatives end up worthless.
Avoid all US debt
The biggest buyers of US debt, foreign central banks, are about to become the biggest sellers. Get out while you still can!
Avoid all investments dependent on US consumer
The dollar’s collapse will rob US consumers of all purchasing power, and any investment depend on US consumption will lose most of its value.
Avoid investments in oil (at least for the next year)
While I am bullish on oil for the long term, there are several reasons to be underweight oil in the near term:
1) There is a supply glut (volumes of oil products stored at sea have risen to more than 90 million barrels.)
2) The dollar’s collapse wipe out a huge amount of demand for oil. While demand from emerging economies like India and China will replace this lost demand, it will take in one to two years.
3) Higher food prices will hurt demand for everything else, including oil.
4) There is a very high the entire Strategic Petroleum Reserve will hit the market next year after the treasury market collapses and the US government is desperate for cash.
Investments in oil won’t be complete disaster as the dollar’s collapse will generate a lot of demand for “real” assets, but I expect oil to be the worst performing commodity in 2010.
Avoid Margin Accounts
If your broker fails, you are virtually guaranteed to be left with nothing.
Invest in Physical gold
With the Gold Market already Reaching The Breaking Point, the 2010 Food Crisis is guaranteed to trigger a gold banking crisis. Those who own physical gold (and not some paper derivative) will do well.
Invest in agriculture sector
Anything (non-derivative) related to agriculture is going to have a good year. The stocks of fertilizer and seed producers should do well for example.
The best investment in agriculture is to buy farmland in countries which don’t subsidies their agricultural sector (subsidies for their booming agriculture sector is the first thing cash-strapped governments will cut).
Invest In commodity producers
Commodities will have a great year next year as the dollar collapse. Agricultural commodities will be the best performing and oil will be the worst. Everything else should fall somewhere in between. Commodities not consumed in the US but heavily consumed in China, like coal, will do best.
Invest in service sector of emerging economies
America’s lost purchasing power will be transfer to nations exporting nations with large foreign reserves. Investments in the service sector of places like Russia, China, Brazil, India, etc should do well.
Invest in the debt of stable currencies
For the short term, I would stick with short term debt (in stable currencies) or, better yet, gold. However, after the 2010 Food Crisis begins, interests rates around the world will jump significantly in response to spiking food prices, and this will probably be a good opportunity to acquire long term bonds at attractive rates (in stable currencies like the yuan, ruble, etc).
Conclusion
There is no precedence for the panic and chaos that will occur next year. The global food supply/demand picture has NEVER been so out of balance. The 2010 food crisis will rearrange economic, financial, and political order of the world, and those who aren’t prepared will suffer terrible losses…
Credit: MarketSkeptics
