The Inflation Trade, Alcoa EPS, Obama's New Stimulus Plan, Australia's Interest Rate Increase, Commercial Real Estate Woes

Today we are going to follow the footprints of the hyper-inflation/stagflation trade that I have been writing so much about. By simply understanding the impact of the important news stories and avoiding the noise of the traditional media outlets, tracking our quarry will be relatively easy.

Footprint number one: Alcoa has a much better than expected earnings number. However, the key takeaway here is not that a 33.8% decline y0y was better than analysts thought. The gem in this story is that Alcoa beat expectations because of rising prices. Revenues beat expectations because the price of the commodity is rising. We call this little phenomenon INFLATION.

AA Alcoa beats by $0.13, beats on revs (14.20 +0.31)
Reports Q3 (Sep) earnings of $0.04 per share, excluding restructuring and non-recurring items, $0.13 better than the First Call consensus of ($0.09); revenues fell 33.8% year/year to $4.62 bln vs the $4.55 bln consensus. Sequentially, revenues were helped by an increase in realized prices for primary aluminum to $1,972 per metric ton from $1,667 per metric ton in the second quarter, as well as stabilization in the end markets. Co reports cash sustainability are exceeding targets. "In the second half of 2009, there are signs that key markets the Company operates in are stabilizing. Due to low inventories at distributors and rising shipments, regional premiums are improving and global aluminum consumption is expected to increase 11% in the second half of 2009." (Stock is halted.)

Footprint number two: The administration recognizes the economic recovery is in trouble and is preparing another stimulus package. So, we have rising commodity prices and no economic recovery. This combination is called STAGFLATION.

Oct. 6 (Bloomberg) -- President Barack Obama is considering a mix of spending programs and tax cuts to respond to widening job losses that would amount to an additional economic stimulus without carrying that label. Read More

Footprint number three: The commodity based economy of Australia heats up and its central bank raises rates. This morsel of a development will have a significant impact on the value of the U.S.$ going forward. The Australian announcement obviously strengthens our case for higher commodity prices and in turn inflation, but the real important consequence of the move will be its influence on the carry trade. The currency of choice for the carry traders of the world is now the U.S.$.

In years past the Japanese Yen was the whipping boy of the currency carry trade as traders sold Yen and bought U.S. treasuries or other assets to benefit from the spread in interest rates. Now, with interest rates held down by the Fed, carry traders can sell U.S. dollars and invest in, for instance, Australian government debt and profit on the interest rate spread. This trade also benefits as the Aussi $ goes up in value versus the U.S.$. As you can see, this behavior begins to feed on itself. The more U.S.$ sold and Aussi bonds bought with Aussi $s the faster the value of one currency goes down while the other goes up adding to the profits of the trade. The result is a progressively weakening U.S.$ leading to a nasty little thing called HYPER-INFLATION.

SYDNEY (Reuters) - Australia's central bank raised its key cash rate by 25 basis points to 3.25 percent on Tuesday and heralded more to come, saying it was safe to row-back on stimulus now that the worst danger for the economy had passed. The Australian dollar jumped to a 14-month high and interbank futures slid as investors rushed to price in at least one more hike by Christmas, and rates above 4 percent in a year. Read More

Why don't the powers that be do something to prevent the tsunami of U.S.$ selling you ask? Well, their hands are tied as the story below illustrates. With commercial real estate teetering on the brink, an increase in interest rates is out of the question. You can forget all the verbal attempts the Fed and Treasury secretary Pinocchio (Geithner) make to support the greenback.
Fed frets about commercial real estate - WSJ
The Wall Street Journal reports banks in the U.S. "are slow" to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month. The remarks suggest that banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst.

"Banks will be slow to recognize the severity of the loss -- just as they were in residential," according to the Fed presentation, which was reviewed by The Wall Street Journal. A Fed official confirmed the authenticity of the document, prepared by an Atlanta Fed real-estate expert who is part of the central bank's Rapid Response program to spread information about emerging problem areas to federal and state banking examiners throughout the U.S. I

In another sign that many U.S. financial institutions are inadequately protected against potential losses on commercial real-estate loans, banks with heavy exposure to such loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans, according to an analysis of regulatory filings by The Wall Street Journal. That is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007. The Journal's analysis includes more than 800 banks that reported having more half of their loans tied up in commercial real-estate, ranging from apartments to office buildings to warehouses.
Tune in next time for a discussion on the best way for an investment portfolio to benefit from the scenario discussed above....