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Orthocentre

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R.I.P, The Yen Carry Trade

Poor Ben. The real culprit is one Mr. Fukui, who is the Governor of the Bank of Japan. (Do not ask me how to pronounce that name.) While central bankers everywhere are in a struggle to prove their manliness by being harder on inflation than their peers, Mr. Fukui has shown to be the clear cut champion. They have taken massive amounts of liquidity out of the Japanese system in the past few months.

George Soros, commenting last week, brought home the point:

"I think we are in a situation where almost all the asset classes will be under pressure or are under pressure and the main reason for that is the reduction in liquidity. What people do not realize is that the Japanese Central Bank has withdrawn something over $200 billion worth of excess liquidity from Japanese banks. Now that money was not put to work in Japan because there was no room for it, a lot of that went abroad, went into emerging markets, there was a so-called carry trade and it is not that suddenly people are risk averse. It is really that liquidity has been drawn out of the market and that is affecting emerging markets."

$200 billion in a global economy may not sound like a lot. But remember this was money in fractional reserve banks. They could easily multiply it several times. Pretty soon we could be talking a trillion dollars. Much of it went into providing cheap liquidity to global hedge funds and aggressive investors and banks. Thus, as the leverage went away, these groups started liquidating their very profitable emerging market trades, their commodity trades, and so forth. Everything began to go down at once. Markets that had not been historically correlated all of a sudden went down in tandem to the drumbeats of margin clerks everywhere.

To get an idea of how seriously the Bank of Japan has reduced liquidity, let's look at the following chart from my friends at GaveKal.





There have been three large run-ups in the Japanese monetary base in the last 30 years. Not so coincidentally, there were three large periods of asset inflations which accompanied them. When the Bank of Japan began to tighten, we had resulting deflation of those assets. As I quoted GaveKal last April:

"Looking at the past thirty-five years, we find that the Japanese monetary base has been allowed to double over short periods (i.e.: less than three years) three times. Each time, it led to massive bull markets (real estate, share prices, commodities, gold, etc...), followed, some time after the expansion of Japan's money supply was over, by a serious market downturn. Will this time prove any different? So far, it has."

That was at the end of April. At the end of June we can see that it has not been any different. World stock markets have dropped precipitously along with commodity prices.

For several years, speculators have been able to get very low interest rate money in a currency that was purposely being held down. It doesn't get any better than that. Low cost money encouraged speculation in every corner of the investment world. Not just stocks and commodities, but high yield and emerging market debt. The yen carry trade fueled the investment world.

Now Japan has said not only are we going to take massive amounts of money supply from the world, we are going to raise rates and allow the yen to rise. All that "free" money investors and businesses around the world borrowed is going away. It is going to become far less than free. By-by carry trade. Fukui indeed.

We are now going to look at three charts from GaveKal's latest quarterly. They tell a chilling story.

"In our world, two actors can create money out of thin air: the central banks, and the commercial banks. Over the past year, the world's central banks have been busy draining liquidity from the system.




"While the central banks were busy taking money away, the commercial banks were happy to multiply whatever money they had at an ever faster pace. This is now changing; with the increase in volatility, commercial banks are pulling back. As Mark Twain once said, commercial banks lend you an umbrella, then take it away once it is raining."

(Velocity in the next chart is a way to measure commercial lending growth.)




"The divergence between the action of central banks and the action of commercial banks recently reached unprecedented levels. In the past (1997, 2000), once the commercial banks got a whiff of the message the central banks were attempting to convey, they changed their behavior rapidly, and uniformly. Will we now witness a sharp snapback as we did in 1997 and 2000?"

OK, remember they asked the question in April whether Japan taking liquidity off the table would be different this time? It wasn't. And my bet is that commercial banks will also start the process of taking liquidity off the table as well. Loan committees are going to tighten their requirements on all types of lending. Get used to it.

Between the central banks of the world almost universally tightening, commercial banks poised to tighten and the US housing market looking like it is going to slow as interest rates rise, it is very likely the US economy is going to slow down in the last half of the year. The question is, "How much?"

I do not think we will be in an actual recession by the end of the year. But a recession is not out of the question for 2007. If the Fed does not have to go too far (and 5.5% may be too far given the other conditions in the world), then we could see a slowdown on the order of what we saw in the mid-90's. We will have to watch the yield curve and other indicators.

In any event, whether it is slowdown or recession, I think investing in the broad stock market is particularly risky. If you are good at picking stocks and know the companies you are investing in, that is one thing. But most readers invest in mutual funds and broadly diversified stock portfolios. Bluntly, I think there is some real risk to the downside.

And if the US economy slows down, so will the housing market and so will the US consumer. That will be a drag on the world economy and world growth in consumption. If the world slows down too much, you could see oil drop back into the $50's or even $40s

Education vote

Tony Blair could still be forced to rely on the support of Conservative MPs to get his contentious school reform plans through the Commons despite signs that a Labour backbench rebellion against them is crumbling.

Rebel leaders have suggested that 45 Labour MPs could vote against the bill on Wednesday, despite a string of concessions from the government earlier this year.

Mr Blair has made the school reforms a litmus test of Labour’s readiness to grapple with changes to public services that go against the party’s traditional instincts for uniformity and fairness. But the reforms have also become a test of his political authority and of the viability of the government under the final months of his leadership.

The original proposals

The school reforms outlined in a white paper in October are intended to do in primary and secondary education what the government is already doing in health: separate the commissioning of services (in this case by local education authorities) from their supply with competition between a diversity of providers to drive up standards.

The centrepiece of the white paper is a new breed of “trust” schools giving headteachers more control of their assets, staff and admissions policy, subject to a national admissions code. Like business-sponsored city academies, the trust schools would be expected to form partnerships with local companies, universities, community groups or other bodies.

The aim is to encourage all schools to acquire their own culture and identity, and with the help of outside partners, forge a stronger educational ethos to improve performance.

Local education authorities were to be banned from setting up new community schools, the traditional form of comprehensive under their control. LEAs would become the “champion” of parental choice but would, vaguely, retain a “strategic” role over local provision. No-one would be able to stop parents from setting up new schools.

How radical are they?

The reforms were billed as a “historic turning point” by Mr Blair, a pivotal moment when the government would abandon once and for all the left’s “old levelling down mentality which kept us in opposition so long”.

He described trusts as “independent self-governing schools” in a break with the “deadening uniformity” imposed by some local authorities. The role of LEAs would “change fundamentally”.

But in reality the reforms are incremental rather than revolutionary.

As the Commons education select committee pointed out in a report in January, trust schools would not enjoy any more freedoms than those already granted to existing foundation schools. Critics add that schools are already able to take on external partners, although ministers argue these arrangements could be more stable under a trust.

Neither can the prime minister claim to be instigating a radical split between commissioning of schools and their supply. Schools will not be forced to become trusts, so LEAs will continue to “run” traditional community comprehensives for years to come. In any case, as the select committee observed, for nearly 20 years local authorities have not had close control of schools “in the way the white paper implies and some of its critics believe”.

The objections of Labour critics

Nevertheless, the white paper and the way in which the reforms were spun, have infuriated many Labour backbenchers. More than 90 signed an “alternative white paper” criticising Mr Blair’s plans. Several more felt that critique was too soft and refused to lend their names to it.

Their primary concerns are:

- that oversubscribed schools that have more freedom over their admissions policies will resort to covert forms of academic selection (such as parental interviews or point systems) to skew the intake away from less promising pupils.

- that trust schools are unnecessary, would be unaccountable to local communities and could involve unsuitable partners or businesses

- that local authorities need to retain a co-ordinating role over admissions and supply of school places to prevent a “free for all” among competing schools

- that the expansion of popular schools could force others to contract, leaving children stuck for years in failing institutions with falling rolls and diminishing resources.

On top of the specific complaints, many Labour MPs are fundamentally unhappy with the concept of making schools compete with each other for pupils and want to see collaboration rather than rivalry.

Government compromises

Facing a massive backbench rebellion, Mr Blair has offered a series of concessions but has denied that they water down his original plans.

- further safeguards against academic selection. Interviewing will be banned, and schools will be forced to act “in accordance with” a national code on admissions, rather than simply “have regard” to it.

- local authorities will still be allowed to set up new “community” schools, although the decision would be taken by an independent adjudicator with the approval of the education secretary

- admissions forums, comprising local authorities and local schools, will monitor admissions policies and take complaints to the adjudicator

- further reassurances on trusts, with the adjudicator ruling on disputes

Will the concessions be enough?

These changes are likely to win over some of Mr Blair’s more moderate critics. But others intend to press for further concessions and are waiting to see the fine print of the schools bill, expected in mid-February, before deciding whether to vote for it when it comes to the Commons in mid-March.

Even if Labour MPs do vote for it at second reading, ministers are bracing themselves for a series of battles over rebel amendments during later parliamentary stages.

Can Mr Blair rely on Conservative votes and survive?

The prime minister took Britain to war in Iraq with the support of the Conservatives after 139 Labour MPs rebelled. He survived and won re-election in 2005. This time, his fate could be different. He has already announced his departure at some stage during this parliament. A defeat on his flagship public service reform would probably convince even his most loyal supporters that the time had come for a change of leader.

The atom bombshell that is splitting opinion

The atom bombshell that is splitting opinion
By Robert Matthews
Published: March 9 2006 18:41 | Last updated: March 9 2006 18:41

Psychologists call it cognitive dissonance: the mental torment that comes from being confronted by two fundamentally opposed propositions. Deciding between them often provokes powerful emotions – just ask Dr Randell Mills, whose claims have a habit of triggering severe bouts of cognitive dissonance among otherwise perfectly rational people.


And no wonder: this medical student turned physicist claims to have debunked the textbook account of how atoms are put together – and in the process discovered a new source of clean, cheap energy.

By itself, that would provoke little more than eye-rolling boredom from scientists all too familiar with the grand pronouncements of cranks. The trouble is that not many cranks have had their radical new theories about atoms published in dozens of peer-reviewed papers in serious research journals, and the implications replicated in independent laboratories. And fewer still have won the support of big hitters from A-list corporations and hefty financial backing to match.

So which is it: is Dr Mills a crank or a genius? Faced with making up their minds, many scientists have shown the classic symptom of cognitive dissonance: spluttering rage (it is a safe bet that some are even now tapping out letters of complaint to this newspaper). They simply refuse point-blank to believe that Dr Mills could have found a form of atomic energy missed by the likes of Albert Einstein and Ernest Rutherford.

But – again in line with psychological theory – those with rather less investment in the current scientific paradigm tend to have fewer problems countenancing the other possibility: that Dr Mills really is a genius. Some have even gone as far as investing a total of $50m in his New Jersey-based company, Blacklight Power, whose board members include Neil Moskowitz, the chief financial officer of Credit Suisse, and Michael Jordan, chairman of Electronic Data Systems.

Not that Dr Mills cares about what mainstream scientists think about his ­theory: he is too busy extracting ever more insights from it – most recently, formulas describing the properties of molecules, something that has proved beyond the powers of quantum mechanics, the most successful scientific theory ever devised.

But then Dr Mills regards quantum mechanics as fundamentally flawed. Devised around a century ago in response to some baffling discoveries about heat, light and atoms, quantum mechanics is notorious for its counter-intuitive implications, such as the inherent fuzziness of atoms and the ability of energy to appear out of nowhere.

Dr Mills first came across quantum mechanics after graduating in medicine from Harvard and taking up post-graduate studies in electrical engineering at the Massachusetts Institute of Technology. Struck by the weirdness of the theory, he set about devising a radically different account of the sub-atomic world, based on ideas from Victorian physics.

In a series of papers published in academic journals, he argues for a new picture of the hydrogen atom, with the lone electron whizzing around a central proton replaced with a spherical shell of electric charge.

According to Dr Mills, this simple modification utterly transforms the physics of the atom. While all the successes of conventional quantum mechanics are kept, a whole raft of solutions to previously insoluble problems emerge – such as the predictions of the properties of molecules.

But most excitement – and controversy – surrounds Dr Mills’ prediction of a whole new source of atomic energy lurking within hydrogen. According to his theory, if atoms of hydrogen are heated and mixed with other elements, they can be persuaded to release over 100 times more energy than would be generated by combustion alone.

The implications are astonishing. For if Dr Mills is right, the water covering 70 per cent of the world could become a virtually limitless source of cheap, clean energy. Not surprisingly, many scientists are deeply sceptical, pointing to all-too-similar claims made for so-called “cold fusion”, another supposedly miraculous energy source whose existence was revealed by this newspaper in 1989, but which has failed to deliver on its promise.

Yet most of Dr Mills’ critics have probably never bothered to read any of his research papers. Some have, however, and have gone on to attempt the acid test of any scientific claim: replication by independent researchers. Among those to test Dr Mills’ ideas is a team led by Professor Gerrit Kroesen at the University of Technology in Eindhoven, the Netherlands. So far their results have confirmed that hydrogen atoms do indeed behave strangely in the presence of certain elements, in line with Dr Mills’ theory, and they plan to test the key claim of net energy output later this year.

While many scientists express doubts off the record, the fact remains that no one has published a knock-out argument against Dr Mills’ basic theory (though some claim it is so silly it is not worth a rebuttal).

Whether his theory is right is ultimately irrelevant, however. What really matters is whether hot hydrogen can be persuaded to give out more energy than it takes in, making it a viable power source.

The whole controversy will be resolved one way or the other by independent researchers either confirming or refuting Dr Mills’ claims. Or at least, that is what most scientists believe. In practice, things are not always so clear-cut. During the 1960s, many scientists claimed to have confirmed reports of the existence of “polywater”, a new form of H2O, which everyone now agrees does not exist.

On the other hand, many genuine breakthroughs have initially prompted outraged scepticism from experts.

What Dr Mills has already proved beyond doubt is that outsiders who threaten long-held beliefs can expect a rough ride – no matter how great the potential pay-off.

The writer is visiting reader in science at Aston University, Birmingham

THE ONES THE EXPERTS THOUGHT WOULD NEVER GET OFF THE GROUND... BUT DID

Some of the biggest technological breakthroughs were ignored or ridiculed by the scientific establishment when they first appeared:

■ When two American bicycle repairmen claimed to have built the world’s first aircraft in 1903, they were dismissed as cranks. Newspapers refused to send reporters or photographers to witness any of the flights. More than two years later, Scientific American magazine was still insisting that the story was a hoax. By that time, the Wright brothers had completed a half-hour flight covering 24 miles.

■ The claim of Irish engineer Charles Parsons to have developed a radically new form of marine propulsion was scorned by the Admiralty, until his steam turbine vessel made an unauthorised appearance at the 1897 Spithead naval review going at 37 knots – faster than any other vessel in the fleet.

■ The idea that atoms could be a source of energy millions of times more potent than coal or oil was dismissed by the Nobel Prize-winning physicist Ernest Rutherford as “moonshine”. Even Albert Einstein struggled to accept the technological potential of his famous equation E=mc2.

■ During the 1950s, self-taught American physicist Stanford Ovshinsky found a way of creating materials lacking a regular crystal structure – an achievement dismissed as impossible by scientists. They are now standard components in devices ranging from flat-panel displays to solar cells.

■ While developing the technology behind the laser, American physicist Charles Townes was approached by two Nobel-Prize-winning colleagues who told him he was wasting his time and threatening their funding. Even after the first laser was built in 1960, it was described as “a solution looking for a problem”.

■ The Scanning Tunnelling Microscope (STM), invented by scientists at IBM in Zurich in the early 1980s, now plays a key role in fields ranging from biology to nanotechnology. But many scientists remained deeply suspicious of the claims made for the STM until its inventors won the Nobel Prize for physics in 1986.