SUMMARY: The recent rise in the Baltic Dry Index may result from a glut of unused oil rather than reflect economic strength. It may be sending a false bullish signal.
In recent years, a new measure of economic activity has gained popularity: The Baltic Dry Index, which measures the price of shipping raw materials by sea. It climbed during the global growth period of 2003-2007 as China's surging economy consumed huge amounts of iron ore, soybeans, etc.
When the economy hit the wall in September and October of 2008, the Baltic Dry Index plunged as well. Since mid-January, it has rebounded sharply, causing many optimists to view it as a bullish leading indicator. They dreamily speak of a "reflation trade," dismissing stark deflationary warning lights flashing across virtually every economic report.
While I believe thoroughly in data and study charts, I always try to ask: "Does this make any sense?" In this case, my answer is emphatically NO. That's why I am warning people not to be lulled into a false sense of bullishness by the Baltic Dry Index. It might be a lie.
Thanks to the global economic slowdown, oil prices have completely collapsed. Many people who paid $50-60 a barrel (or more!) last year now face the prospect of selling it into a market priced in the mid-30s. So, they are holding on to it in hopes of selling it later at a higher price. On-land storage tanks are already full. (For readers with more knowledge of the market, this results from "contango" in the crude oil curve.)
This is from a recent report in the Calgary Herald:
Inventories at the storage hub at Cushing, Okla.--the delivery point for U.S. crude futures--have surged a whop-ping 139 per cent to near the available capacity since early October, as sliding energy demand makes holding oil more profitable than refining it.
Energy analyst Stephen Shork recently summed it up on on Bloomberg Radio: "You can't swing a cat without hitting a barrel of crude oil in the United States."
Because there is so much extra crude around, people are leaving it on oil tankers at sea. This is apparently removing tanker capacity from the system and driving up shipping rates. (Despite its name, the Baltic Dry Index also covers shipping rates for liquid cargoes.)
In other words, the weak global economy has depressed oil prices so much that people are holding crude hoping for better prices down the road. This is creating an artificial demand for shipping. As Shork further explained:
"Every trader who wants to buy oil now will buy oil, put it into tanks and sell the much more expensive contract down the road. It's actually an incentive to build storage."
I have been suspecting this for several weeks and have not yet seen anyone put the pieces together. At first, I thought I was just missing something, but today my suspicions were validated. I was attending a meeting of market analysts and asked this exact question. One of the moderators, who is well known and respected, dismissed my question out of hand as "too complicated" to worry about. "We're just trying to make money," he said, shrugging off my inquiry.
As a journalist, I have learned that the most important questions are often those that people don't want to answer, so I thought I was on to something. Immediately after the meeting, a fellow who identified himself as a hedge-fund consultant came up to me and praised my question. I don't remember the number he gave me, but he told me that I had hit the nail on the head and that the recent rise in the Baltic Dry Index reflected little more than all the tanker capacity getting tied up at sea.
My argument remains the same: We are in the early stages of another Great Depression. The first depression ultimately resulted from the inability of the global economy to absorb all the productive capacity of the U.S. economy, which had DOUBLED in size during the World War I.
It was also caused by less global trade, which resulted from the collapse of the British gold standard. For more than a century, the world's economy grew as gold seamlessly flowed from one country to another. That abruptly ended in 1914. Is it any surprise the whole global economy shut down as a result?
This time, the global economy has grown on the back of the U.S. consumer. Instead of a gold standard, we had a real-estate standard. Credit growth was ultimately based on the value of U.S. home prices. It was a perverse cycle that most people are still not fully aware of: Houses never lost value, so banks gladly lent against them. That helped drive prices higher, which in turn made Americans richer. This allowed them to buy more consumer products.
Because of globalization, an increasing number of those products came from abroad. The more we bought from overseas, the more dollars foreigners had. Instead of exhanging their dollars for rupees, yuan or dinars, they invested those dollars back into the U.S. bond market. This resulted in a credit bubble, which in turn pushed home prices even higher. (See this blog entry and this one for more.)
In sum, credit creation was based on the value of U.S. home prices, which in turn drove the global economy. (The U.S. consumer was the one buying all those items coming out of China, and the U.S. consumer got his money from his house.)
This was a sick and bizarre non-system that was destined to crash at some point. Most people would probably think I am crazy to make these these points. But most people just 18-24 months ago would have thought Ben Bernanke crazy for talking about providing several trillion dollars of extra liquidity, or pushing rates close to zero. Most traditional-thinking economists would also think it's crazy that we can print money at such a pace without triggering runaway inflation. But, that's exactly what Japan did and what we're doing now.
(While I cannot help but fear we'll get inflation at some point, I am increasingly convinced we're going to experience significant price declines first. Inflation fell by at least 1% in the last three months of 2008. The last time that happened was Dec. 1930-Feb. 1931! It's time to stop pussy-footing about and accept this reality. The Depression is here.)
I suspect this distorted house-based money standard results from our abandonment of the gold standard over the course of the previous century. In days of old, countries needed to possess actual gold bullion in order to create money, providing a natural brake on credit growth. I think that something like this was bound to happen, given the gradual rise of a completely fiat-based money system. A frenzy of unchecked lending, fueled by a global trade bubble and the alchemical cult of securitization, fueled the construction of millions of extra houses and a surge in productive capacity around the world to fill them with flat-screen TVs, furniture and clothing.
Previously, money was "priced" in gold, not the other way around. You needed more actual gold to have more money. It was a one-way street. Under the real-estate money standard, houses were priced in money and money was derived from real-estate values. More lending pushed home prices higher, which begot more credit. It was a monetary perpetual-motion machine.
(Another point on monetary economics is the recent strength in gold and silver. People are buying these metals expecting a long-term paper-money crisis. This is a nascent trend, but could be hugely important. This is a different kind of bull market for gold than we saw in the 2003-2007 period, when it served as a hedge against inflation and a falling dollar.)
This is reminicent of what happened during WWI, when JP Morgan Jr.'s decision to prop up the UK and France perpetuated a conflict that killed millions of people and gave a false stimulus to the U.S. economy, which in turn ushered in the Great Depression.
Eighty years ago, the U.S. provided ammunition, meat and fuel to the Allied war effort. This time, China provided everything from sneakers, pharmacueticals and wallboard to the American consumption effort. Now we have too many houses to live in, and they have too many factories and workers to provide our economy.
Readers might be tempted to dismiss my fears about the economy as too dire. But I am in the very best company. Heavy hitters at Pimco are essentially arguing the same points. For instance, I have not heard Pimco CEO Mohamed El-Erian say a single positive word on CNBC or Bloomberg in months. Don't just take my word for it, check out his last appearance:
"I think the employment number is very concerning. The acceleration of job losses is of particular concern... We are in the midst of something very different. It's more than just a synchronized and severe global recession. It's more than just a banking system that's not functioning... Even those who can spend are not spending."Of course, El-Erian is extremely pleasant and gives this grim news with a smile. Don't be fooled. He's both extremely bearish and one of the smartest people alive.
Now Pimco's Asian head of credit research, Koyo Ozeki, is weighing in. This guy, who seems to know the Japanese crisis inside and out, tells us what we have coming:
He says that the government cannot stop asset prices (real estate prices) from falling, which could trigger 3+ years of deflation. Declining prices and falling employment will cause more companies to go out of business. Looking to Japan...
"The slump in share prices was even greater in this second wave. In the present global turmoil, a similar second-wave crisis is likely, and it is unclear whether capital injections of the current magnitude can counter such an impact."
And, as I have warned in previous postings, the lower home prices could impair a huge chunk of the loans on banks' balance sheets for years to come. (Mortgages are paid back when people sell their houses. If homes lose too much value over time, all the loans will be impaired. People don't have to go delinquent for this to happen.)
...the economic setback is still in its early stages, and any further decline in housing prices could accelerate the downturn, intensifying the pernicious feedback loop and possibly leading to a second wave in the financial crisis in the next 6–12 months.