“Investors increase bets on US rate rise.”

Anticipating a rise in rates, rather than another cut, investors sold gold, bonds, and oil. The black goo lost $4 a barrel. Gold got slammed for a $23 loss, while yields on 10-year Treasury Notes rose over 4% (yields rise as prices fall).

Why would the Fed put rates up? Ah…that’s our story for today. It’s a story of numbskullery, tomfoolery, and chicanery…of vigilantes and blazing saddles…of war and forgetting. In short…it’s a typical financial tale, where nothing goes as hoped for…and everything goes as it should.

Let us back up.

Last year, we were writing about a ‘battle’ between inflation and deflation. The markets were deflating…but the feds were inflating. Who was going to win?

Actually, it was a mixed-up, woebegone war…with casualties all over the place and the average American household caught in the crossfire. The poor lumpenconsumer has been taking incoming from both sides for more than a year. His house sustained a direct hit from deflation. Then, his income got whacked by shrapnel from the dollar’s blowup.

Meanwhile, inflation blasts him with higher costs for just about everything – notably the essentials, fuel and food. What can he do but keep his head down?

And pity the poor guy who was lured out to a distant, new suburb by a big, new house with a big subprime mortgage! Now, he’s got to pay $4 a gallon to drive to work, while his house payment goes up and his house value goes down.

Naturally, the feds rushed to help the guy. His real problem was that he had too much credit…but didn’t stop them; they tried to give him more.

Still, when a bubble pops, it is almost impossible to pump it up again.

Henry Kissinger explains why in today’s International Herald Tribune :

“…the role of speculative capital has magnified. For speculative capital, nimbleness is the essential attribute. Rushing in when it sees and opportunity and heading for the exit at the first sign of trouble…”

Speculative capital is what the Feds create when they lend money below the inflation rate. It does not go out and invest in long term projects like steel mills. Instead, it looks for the hot, rising market…the one that will give it a quick payoff. The guy with the big house and the subprime mortgage was not really buying a house…he never paid for it. He was just speculating.

And now his speculation has gone bad…and all the Fed’s hot air goes into a new bubble. When the tech stock bubble popped, for example, the next big thing was a bubble in housing and housing-related debt. When the housing and subprime bubbles popped we guessed that the authorities would pump hard to try to reflate them…but that the Fed’s inflation would go into new bubbles – in commodities, oil, and gold. So far, so good. Oil slid up past $135. Gold shot up over $1,000. And food? Food prices are so high they’ve set off riots all over the world. The OECD says high food prices are here to stay. And farmers in Argentina are setting up roadblocks, again, to try to starve the capital into submission.

Getting back to oil…British truckers clogged up London earlier this week, demanding relief from high fuel taxes; truckers in Marseille shoved against riot police…again, complaining about the high cost of diesel fuel, which is running about $9 a gallon in France. We’re pleased to report than no mobs are forming to demand cheaper gold…but surely some bubble is in the yellow metal is bound to inflate sooner or later.

At the heart of the discontent is a very new, very disturbing, and very predictable fact: these new bubbles are not nearly as nice as the old ones.

*** The bubble in residential property made people feel good. They thought they were wealthy and thought they could ‘take out’ a little of that wealth and spend it. A bubble in oil is an entirely different matter. It makes people feel poorer every time they fill up their gas tank. And it forces them to cut back on spending rather than increase it.

Earlier this week we reported an historic downturn in Americans’ driving habits. For the first time since the ’40s, they’re seeing considerably less of the U.S.A. in their Chevrolets. This morning, comes this headline from Bloomberg:

“Sears posts net loss as consumers slow spending on clothing.”

They’re spending less on imports too – bringing the U.S. trade deficit to a 5-year low.

Remarkably, despite these huge victories for the forces of deflation, the U.S. economy is still growing and the stock market is not falling apart. The latest numbers from Washington tell us that GDP grew 0.9% in the last quarter, rather than the 0.6% previously reported. Knowing how the Labor Department suborns its numbers, however, we would want a good cross-examination before we believe them.

After the Fed intervened to save Bear Stearns, it looked for a while as if they had done the trick – as if they had succeeded in re-inflating the bubble in the financial industry. After the panic, the bank index rallied 22%. But now it’s given up almost all that gain. Banks are about 40% down from their high…amid talk of more pain and suffering in the industry. Wall Street, for example, said it had more layoffs coming later in the year.

Buenos Aires, Argentina May 29, 2008

I was speaking with a friend the other day regarding my concerns about the current situation between the Argentine government and the farmers. Ironically, his reply was “Well, at least the central bank holds nearly $50 billion in foreign reserves”. I immediately responded without any doubts: “That is true… I do not know what would have happened if those reserves were not there…”.

So what exactly is the relationship of the current conflict, between the government and the farmers, and policies governing the accumulation of foreign reserves in the Central Bank of Argentina (BCRA)? At first glance one might think there is “not much” but in fact there is a connection. Were it not for the present level of foreign reserves, the current dispute could have unleashed a major crisis.

The Argentine press certainly cannot complain about the government of Cristina Fernández de Kirchner for journalists now rarely have time to become bored since events are unfolding at an extraordinary pace. There is the unionist, who on the one hand is hoping for a negotiated settlement with the government, while on the other hand is striking in the fields. The current Minister of the Economy is an unknown, while controversial export duties imposed by the former, and better known, Minister remain in place.
And let us not forget there is currently an inflation rate that we are told is supposed to console us… indicating that everything is going to be alright… just wait… patiently… etc, etc, etc….

When Cristina took office expectations were high. The economic situation was going astray and many changes were expected. So what did happen? What is happening currently with the Argentine economy? For one thing, the problems surrounding inflation were never adequately addressed and that is why those problems have not only continued to plague Argentina but also seem to be spiraling out of control. We can look to the current situation with salary negotiations to see an example of what is happening. Many unions are demanding wage increases in excess of 30% while at the same time groups that had already negotiated raises of around 20% are now coming back demanding even greater increases, motivated by the current effects of this inflation – inflation that we are told is meant to console and not to concern us. (i.e. the teacher unions for the province of Buenos Aires received a 24% increase in wages three months ago, yet are currently demanding more.)

Many were hoping with a new government in place that public expenditures would be reduced. But to the contrary, they are currently growing at an expected annual rate of 40%. The country has also seen little improvement with the energy situation and when coupled with expected lowered temperatures this year one can expect adverse effects in its aggregate supply, a situation already hit by the current standoff with striking farmers and disincentives regarding investments in production.

Additionally, rising inflation is pressuring the government to increase the amount of subsidies given to transportation and utility companies (among others) since they are not allowed to raise their rates. All the while the government has tried to sweep all this under the carpet. However, the current situation has become so untenable that they cannot expect to hide these things anymore. So what is going to happen if the government decides to decrease those subsidies? How much longer can they be sustained to avoid price increases?

Six months into Cristina’s new administration, it does not seem that things have improved very much. I would even go on to say that in trying to resolve existing problems, she has created new ones that are far more serious that the ones she was trying to address in the first place. And the most pressing concern so far seems to be the current dispute over the increase in export duties imposed as a means of domestic taxation, to increase current revenues.

This increase in farm export taxes is the straw that broke the camel’s back for it has created a conflict of historic dimensions. This fact has been determined not only by the duration of the conflict but also by the level of support given to the farmers. As an example: last Sunday over 300,000 people attended a rally in Rosario Province in a show of support. That is unheard of in this country. This situation has not only frightened foreign investors, who were the first to reduce their interests in Argentina, but local ones are becoming concerned now as well.