Is QE2 Contributing To Unrest In Egypt?

Wall Street is quick to blame Bernanke/the Federal Reserve for just about everything wrong in the financial world.  In fact, many conspiracy theorists present the Federal Reserve as an unnecessary entity that needs to be done away with.

While conspiracy theories usually have little proof to support them, there is evidence that high food prices may have sparked the riots in Yemen, Tunisia and Egypt.  We believe the Federal Reserve’s policy of QE2 is was a catalyst for the hike in food prices.  Let us explain.

Food Prices Rise, Riots Ensue

The following chart is currently very popular within the financial world.  It shows the ” UN Food and Agriculture World Food Price Index.”  It is a monthly index through December 31 showing the “constant trade-weighted average of 55 agricultural commodities quoted internationally.”  The blue line shows the index level while the red line shows its year-over-year rate of change.

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Noted on the chart is the old all-time peak of 213.50 set in June 2008 and the new all-time peak of 214.8 set on December 31.  What happened when food prices were booming into June 2008?

• The Telegraph (UK) – April 8, 2008:  Egyptians riot over bread crisis
  Egypt is in the grip of a serious bread crisis brought on by a combination of the rising cost of wheat on world markets and sky-rocketing inflation. The price of bread has increased fivefold in private bakeries, creating panic in state-run bakeries that the staple may run out. Scuffles in bread queues are a daily occurrence. In recent weeks, they have turned into violent clashes, leaving at least seven people dead, according to police. … Egypt is the world’s biggest consumer of bread, with each Egyptian eating 400 grams of bread a day. That compares with France – the land of the baguette – where the figure is only 130g per day.
• Foreign Policy – April 7, 2008:  Food-riot watch: Egypt protests spook government
  Egypt’s economic and political pressure cooker gave a kick and a hiss yesterday as a crackdown to prevent a general strike resulted in over 200 arrests throughout the country. The unrest was provoked by rising prices and falling wages. As Blake has reported, Egypt is a big wheat importer with a corrupt bread subsidy program, and the country heads into local elections tomorrow.
• India Daily – April 12, 2008:  Food riots in Bangladesh, Egypt and Philippines – many other nations ready to explode
  Nearly two dozen people were injured as police opened fire in air and used batons and tear gas to disperse thousands of protesters who turned violent while demanding a wage hike to meet the steep food prices in Bangladesh capital Dhaka. It is a ‘silent famine’ in the all the poor nations as grains get converted to biofuel and other food products in the chain also rise in price. Recently in Egypt and Philippines similar riots have taken place. African nations are worst hit. Even India and China are facing food shortages and the common people are using credit cards to fulfill their food requirements.

So when food prices boomed in 2008, people in Egypt and other places rioted just as they are doing now.

• The Telegraph (UK) – January 30, 2011: Ambrose Evans-Pritchard: Egypt and Tunisia usher in the new era of global food revolutions
  Political risk has returned with a vengeance. The first food revolutions of our Malthusian era have exposed the weak grip of authoritarian regimes in poor countries that import grain, whether in North Africa today or parts of Asia tomorrow.
  If you insist on joining the emerging market party at this stage of the agflation blow-off, avoid countries with an accelerating gap between rich and poor. Cairo’s EGX stock index has dropped 20pc in nine trading sessions. Events have moved briskly since a Tunisian fruit vendor with a handcart set fire to himself six weeks ago, and in doing so lit the fuse that has detonated Egypt and threatens to topple the political order of the Maghreb, Yemen, and beyond. As we sit glued to Al-Jazeera watching authority crumble in the cultural and political capital of the Arab world, exhilaration can turn quickly to foreboding. This is nothing like the fall of the Berlin Wall. The triumph of secular democracy was hardly in doubt in central Europe. Whatever the mix of aspirations of those on the streets of Cairo, such uprisings are easy prey for tight-knit organizations – known in the revolutionary lexicon as Leninist vanguard parties. In Egypt this means the Muslim Brotherhood, whether or not Nobel laureate Mohammed El Baradei ever served as figleaf. The Brotherhood is of course a different kettle of fish from Iran’s Ayatollahs; and Turkey shows that an ‘Islamic leaning’ government can be part of the liberal world – though Turkish premier Recep Tayyip Erdogan once let slip that democracy was a tram “you ride until you arrive at your destination, then you step off.”
• Bloomberg.com – Janaury 26, 2011:  Grain, Soybeans Rise as Food Riots Spur Demand for U.S. Exports
  Food-exporting countries are “strongly advised” not to restrict shipments to prevent “more uncertainty and disruption” in world markets, the United Nations said. Governments in Egypt, Algeria, Morocco and Yemen have faced protests amid rising costs and high unemployment, and a revolt toppled Tunisia’s leader. … A surge in food and energy costs is stoking inflation in emerging markets and causing riots that may topple governments, Nouriel Roubini, the New York University economist who predicted the financial crisis, said today in an interview in Davos, Switzerland, with Tom Keene on Bloomberg Television’s “The Pulse.” “When you look at what’s happened in the former Soviet Union and Australia, wheat supplies are tight,” said Dan Kuechenmeister, the manager of the commodities department at RBC Dain Rauscher in Minneapolis, Minnesota. “You hear about the food riots in parts of the Middle East. There’s just all sorts of things out there that have people a little bit on edge.”

While these riots have evolved into much more than complaints about high food prices, the catalyst was the same as in 2008, record high food prices.  So, what caused higher food prices?

The Federal Reserve Takes Full Credit For Rising Stocks…

On January 25, 2011 CNBC ran the a clip of Bernanke crowing about the successes of QE2 (starts 35 seconds in):

Bernanke:  The policies have contributed to a strong stock market just as they did in March 2009 when we did the last iteration of this. The S&P 500 is up 20% plus and the Russell 2000, which is about small cap stocks, is up 30% plus.

Let there be absolutely no doubt that the Federal Reserve is targeting the stock market.  The say it loudly and repeatedly.  And to target the stock market, they are engaged in QE2, otherwise known as “money printing“.

We have argued that the goal of QE2 is to drive asset prices higher in hopes that it will change behavior (i.e., to  create a wealth effect) to justify these higher prices.  To us, this is the basic definition of a bubble.

Stocks might not be experiencing a bubble of the same magnitude as tech stocks in March 2000, but this is bubble behavior nevertheless.  What about commodities/food prices?  Are they suffering from the same phenomenon?

… But Not For Rising Food Prices

In his January 18. 2001 letter to partners, David Einhorn of Greenlight Capital wrote:

On August 27, 2010, Federal Reserve Bank Chairman Ben Bernanke gave a speech in Jackson Hole, Wyoming where he hinted that the Fed would provide additional monetary easing. At the time, the S&P 500 was down more than 3% for the year. From that point through the end of the year, the S&P rallied 19%. At the same time, oil prices rose 16%, copper prices rose 32%, coffee prices rose 34%, corn prices rose 43% and cotton prices rose 57%. In front of Congress, Mr. Bernanke credited his policies for “significant improvements in stock prices” which are “contributing to a better outlook for the economy.” Mr. Bernanke also said his policies are not to blame for the sharp increase in the price of oil, which he claimed is the result of strong demand from emerging markets. Does Mr. Bernanke really believe anyone buys that? Ostensibly, it’s a coincidence that many of the necessities of life came into simultaneous shortage and shot up in price just as Mr. Bernanke promised additional monetary stimulus.

Einhorn is exactly correct.  If money printing is driving stocks higher, we believe it is also driving agricultural commodities (food prices) so high that people are rioting and now toppling governments.

The chart below shows the Dow Jones/UBS Agricultural Commodity Index.  It bears a similarity to the UN FAO Food Index above in that it peaked in 2008 and has been going vertical in recent months, although just short of a new all-time high.

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But are rising agricultural commodities related to rising equity prices?  The next chart shows a rolling three-month correlation between agricultural prices and the S&P 500.  The chart goes back 20 years, the start of the DJ/UBS index.

Between 1991 and 2008 the correlation between agricultural prices and the S&P 500 peaked twice, once during the three months ending November 1991 when the Soviet Union was dissolving and once during the financial panic of 2008.  This should not come as a huge surprise since correlations between seemingly unrelated indices often increase during times of crisis.

However, both in the summer of 2009 and now, the correlation between agricultural prices and stocks are higher than ever.  What is the common thread?  The summer of 2009 was the middle of QE1 (which ran from January 2009 to March 31, 2010 and totaled $1.7 trillion) and the current period falls in the middle of QE2 (which started in early November and is scheduled to end on June 30, 2011 for a targeted total of $600 billion).

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The next chart again shows the rolling three-month correlation between the DJ-UBS Agricultural Index and the S&P 500 in blue.  The red line shows the three-month rolling correlation between the JOC Index and the S&P 500.

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For the most part the correlation between stocks and the DJ-UBS Index moves in tandem with the correlation between stocks and the JOC-ECRI Index.  Since QE1 and QE2, however, this is no longer the case.  While the DJ-UBS Index is still hovering around a 60%-70% correlation to stocks, the JOC-ECRI Index is not nearly as correlated, hovering around a 10%-20% correlation to stocks.  As noted above, 9 of the 18 members of the JOC-ECRI index do not have futures contracts.  We believe this is a critical distinction.

The portfolio balance theory states that QE2 gets “printed money” into the financial system.  That money finds its way to speculative markets like U.S. equities.  We believe it also finds its way to commodity markets.  Since Wall Street defines commodities as the futures markets, the commodity indices of these futures markets are more correlated to S&P 500 than the partially non-futures markets commodity indices like the JOC-ECRI.  Does any significant money flow into Tallow or Hides?  Does anyone know how to buy these markets?

Almost all agricultural products have futures contracts attached to them.

Conclusion

To be very clear, we are not arguing that the Federal Reserve is causing the riots in Tunisia, Yemen and Egypt.  Nor are we suggesting the Federal Reserve has a responsibility for the politics of those countries.

Rather, the Federal Reserve’s insistence on the use of the measures of inflation excluding food and energy, such as the core CPI, cause it to turn a blind eye toward food inflation.  Just this past week the Federal Reserve reiterated its belief that core inflation should be its primary target while other major central banks, looking at measures that include food and energy, worried about a return of inflation.

As the Federal Reserve conducts QE2, they happily accept the idea that “money printing” is causing the stock market to head higher.  However, they ignore the idea that commodity prices are rising for the same reason.  Ignoring a problem does not make it go away.