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By Greg Peel

In the first quarter last year it was raining Pennies from Kevin. "I don't care what you do with them,"said Kevin, "eat them, drink them, stick 'em in the pokies, buy something you can't really afford – whatever. As long as you don't save them or use them to pay off your Amex. I want you to spend, spend, spend!"

And spend we did. As a fallout from the GFC, retail analysts were reasonable expecting discretionary spending to tank, impacting on the likes of David Jones ((DJS)), Harvey Norman ((HVN)) and JB Hi-Fi ((JBH)). Indeed, the stock prices of those companies did take an initial bath. But with emergency rate cuts from the RBA, and generous cash hand-outs from the government, Australians did what they do best – they bought flat screen teles.

And they bought computers and iPods and furniture and anything else they didn't really need and all of a sudden it became apparent that Australia wasn't going to have a recession at all. History will long debate whether it was the RBA, Kevin's pennies or actually China that pulled Australia back from the brink, but with some smart management from said respected retailers, share prices soon bounced and bounced hard.

But the honeymoon may now be over. The pennies have been spent. Kevin was also very generous in handing out deposits to first home buyers so they could snap up a variable mortgage they couldn't afford based on a cash rate never to be seen again. The latest housing finance data show demand has fallen 17% from March to March. House prices might still be going up, but it's not because of the natural attrition of new buyers entering the market.

This morning Macquarie noted that sales of plasma teles are down 15% in the March quarter compared to the last March quarter. Sales were also down in LCD teles, cameras, gaming devices and peripherals, and are only just managing to hold up in IT.

The strongest performer in this sector – JB Hi-Fi – has noted flat comparable sales between the two periods. Given the level of stimulus last year, this is a good result. Indeed, Macquarie is maintaining an Outperform on the stock.

Macquarie notes retailers that "dominate" a space tend to achieve around 30% market share. JBH is still growing, but its 21% market share suggests more upside. The company's simple retailing model, concentration on electronics, and preference for shopping centres puts it in good stead, suggests Macquarie, compared to Harvey Norman's franchise, property development and landlord model, spread of products into whitegoods and furniture etc, and preference for bulky goods centres.

Macquarie rates Harvey Norman Underperform, suggesting JBH compares more favourably on potential return on investment capital. Macquarie also rates David Jones Underperform.

The stockbroker has price targets of $23.43 (JB Hi-Fi), $3.77 (Harvey Norman) and $4.45 (David Jones) respectively. Only the latter target is below the present share price.  Macquarie's targets compare with FNArena's consensus price targets of $22.37, $4.28 and $5.28 respectively. For more info see Stock Analysis and R-Factor on the FNArena website.

In the period after the GFC, when the market had assumed the worst for discretionary retailers, the obvious offset trade was to switch into recession-proof consumer staple retailers. Hence stocks like Woolworths ((WOW)) ultimately held up quite well. But while even food & liquor retailers saw a few Pennies from Kevin hitting tills, the immediate outlook for the supermarkets is not one of comparing last year's stimulus period. Problems run deeper than that.

BA-Merrill Lynch has long held concerns over Australia's consumer staples sector. Of all the brokers in the FNArena database, Merrills has been most critical and most pessimistic about Wesfarmers' ((WES)) acquisition of Coles. To that end Merrills has long maintained an Underperform rating on the Wesfarmers conglomerate, suggesting misplaced euphoria over a Coles rebound is sending the WES price into overbought territory, even when one takes coal price increases into consideration.

On the flipside is the all-conquering Woolworths. But Woolies' biggest problem is just that – it has conquered all. Woolies' only avenue from here is to spend money on sprucing up its stores in an attempt to ward off any Coles revival, and to keep its foot on the neck of the pretender Metcash ((MTS)), and to stymie precocious foreigners such as Aldi and Costco. Actually generating decent returns out of cosmetics is a tough ask.

And the market expects a lot out of Woolies. It also expects Coles to make a comeback, and Metcash is working hard at providing the "independent" alternative. Where Merrills sees the real problem, nevertheless, is that all three expect to grow profits in the food & liquor space over the next five years.

It's as if three teams have all declared they will win the premiership – and we know they all can't. Merrills calculates that for all three to be right about their profit growth forecasts, a total of $3bn in growth will be needed. This is a big increase on the $1bn in profit growth in the food & liquor market over the past five years.

And in the past five years Woolies and Coles moved into liquor, and into petrol. They spent a good deal of effort in buying up their supply chains and squeezing their suppliers. Food prices were also rising sharply. If ever the big supermarkets were going to make extraordinary profits, it was over that period.

But now, food inflation is falling. The supermarkets have exhausted obvious market expansion options such as pharmacy (which was disallowed) and have turned to the more costly business of hardware warehouses. They can otherwise only turn to store upgrades, customer offers and competitive discounting – not a formula for excess profits. In other words, Merrills believes that three profit forecasts cannot be right. One, two or all three will soon have to suffer this realisation.

This is not a new opinion from Merrills, but recent market strength has now forced the analysts' hands. They today downgraded both Woolworths and Metcash to Underperform, thus joining Wesfarmers.

All of the above only goes to highlight the problem as discussed yesterday in Australia's Two-Speed Conundrum. A lack of new building, record immigration and a return of investor confidence is creating a house price bubble, and skyrocketing bulk commodity prices are threatening to send Australia's GDP growth into "above trend" territory. On this basis, the RBA is tightening monetary policy with a view to returning rates to "normal". And "normal" implies no lingering effects from the GFC.

But the retail sectors are telling a different story. Discretionary is set to struggle, in many a broker's opinion, in a rising interest rate environment and without further stimulus. Competition is going to weigh on staples, which might be good for consumers but not for investors. While the mining and energy sectors drive the Australian economy, other sectors are slipping back.

Australia is experiencing a two-speed economy, both across industries and across the geographical locations (states) where those industries are concentrated. It is a difficult problem for the RBA.

By Chris Shaw

Investors and media are increasingly focusing on speculation the Chinese Government is considering revaluing its renminbi (RMB) peg against the US dollar. Analysts at Citi note this speculation comes at the same time as the US Treasury has postponed its currency report and top officials have increased the level of bilateral contact between the two countries.

While this implies the US is trying to offer a time window for China to revalue its currency higher, Citi suggests it may actually force an agreement to be reached within a 3-month period. If no agreement can be reached Citi suggests the odds of the US naming China as a currency manipulator have increased.

Such an outcome would be less friendly than if the US Treasury were to release its report and not name China as a manipulator, with China to then revalue its currency soon after.

In Morgan Stanley's view China will exit the RMB's hard money peg against the US dollar in coming months as there are benefits to China in doing so. In particular, an appreciation in the RMB would help contain near-term inflationary pressures, which are increasing from a rapid increase in international commodity prices.

There would also be political benefits from such a move, as Morgan Stanley notes China's major trading partners consider the RMB to be undervalued, making the hard peg against the US dollar a form of bias in China's foreign trade policy.

Longer-term, a stronger RMB would likely assist in re-balancing the economy in Morgan Stanley's view, as it would cause an adjustment in relative prices between the tradeable and non-tradeable sectors of the economy.

As well, a revaluation of the RMB would help China move towards a more flexible exchange rate agreement, which is required for any move to a more independent monetary policy.

In terms of the timing of any RMB appreciation Citi expects some appreciation in the second quarter of this year, while Morgan Stanley takes the view the most likely window for any such move is early summer or during the third quarter of this year.

Morgan Stanley expects an initial adjustment of 2-3%, to be followed by a more gradual appreciation in subsequent months. JP Morgan suggests any revaluation is likely to be in a range of 2-5%.

For the full year appreciation is likely to be in the order of 4-5% in Morgan Stanley's view and it estimates the US dollar rate against the renminbi will be around 6.54 by the end of this year and 6.17 by the end of 2011.

JP Morgan takes the view any subsequent appreciation of the RMB would be a positive for commodity prices, in particular those commodities where China is a large, high cost producer and a significant consumer.

In JP Morgan's view any change would be particularly meaningful for iron ore prices and to a lesser extent for aluminium prices, as a stronger RMB would raise the marginal cost of Chinese production in US dollar terms. In both industries China is at the upper end of the production cost curve.

In iron ore China accounts for 20% of global production but domestic producers are in the 90th percentile with respect to costs, while in aluminium China accounts for 38% of world output and is also in the 90th percentile in cost terms.

Assuming the RMB is allowed to appreciate, JP Morgan expects the major impact on the iron ore market wold be to accelerate the long-term trend of China increasing its reliance on seaborne imports. This is occurring at the expense of domestic supply and is an obvious benefit for Australian iron ore producers given their position as exporters to China.

In aluminium a stronger RMB would be expected to assist in the progressive marginalisation of China's domestic industry, as it would add upward pressure to the top end of the cost curve. Despite this, JP Morgan doubts China will reduce domestic aluminium production in favour of imports as a stronger RMB implies cheaper raw materials.

JP Morgan suggests the other potential commodity beneficiaries of a stronger RMB could be thermal and coking coal, while a firmer RMB could also offer a boost to manufacturing globally as China's domestic export based manufacturers would become less competitive.

With respect to Rio Tinto ((RIO)) and BHP Billiton ((BHP)), JP Morgan notes Rio has the biggest earnings exposure to RMB-intensive commodities at around 80% of earnings before interest and tax, while BHP's exposure is around 60%.

By Greg Peel

It began with coking coal price negotiations between BHP Billiton ((BHP)) and Japanese steel makers earlier in the month, and as FNArena posited in Big Win For BHP Coal, Iron Ore Next, speculation was that an upheaval was also imminent in iron ore price negotiations.

After five years of trying, BHP has won.

Yesterday BHP announced it had reached agreements with a significant number of Asian iron ore customers to sell its iron ore on a quarterly basis only, and for a "landed" price. This means BHP had achieved two major breakthroughs in one, both of which represent the company's long held desire to sell iron ore at prices closer to spot prices rather than via annual fixed-price contracts.

As explained in the article cited above, the entry of China as a net iron ore importer into the market, along with India as an exporter, and joining the established importers in Japan and South Korea, and the major exporter Brazil, and various other smaller import/export players across the globe, has meant that the iron ore spot market has become a significant driver of price. When benchmark annual contract pricing was established half a century ago between Australian producers and Japan, the spot market was virtually non-existent and used only in "emergencies".

Contract pricing disadvantages the producer, given it is the producer who loses out both through production delays and through failures of buyers to make good on contract volumes. But when Australian iron ore and coal producers were first trying to woo Japan as a buyer decades ago, they were prepared to make concessions. When China came storming into the market, it expected the same concessions.

One of those concessions, aside from annual benchmark pricing, was freight cost. In short, Australia agreed to bear the freight cost within the pricing schedule such that it sold its ore "freight on board" (FOB). When Brazil joined as a seaborne exporter, it complained that the greater distance of travel meant it would be disadvantaged on an FOB price, so Brazil was granted contracts at a "cost, insurance and freight" (CIF) price, or what is best known as a "landed" price.

It's a little bit more complex than that in actual fact, but let's stick with the simple version. One way of looking at it is that Brazil's Vale sold iron ore to China in Brazil while BHP sold iron ore to China in China. Vale didn't have to pick up the freight bill, but BHP did. Prices came in for some adjustment, but not to the full amount of the difference.

This freight differential is one thing BHP has been fighting about years, long before it started trying to push for spot pricing. The only way it was ever going to win, however, was for rival Rio Tinto ((RIO)) to join forces. Finally, two years ago Rio did come to the party to create necessary leverage, and last year some concessions were made, albeit not to the full amount of the difference. But Vale could see where this was heading.

Having won the support of Rio, BHP's next step was to force its customers to abandon annual contract pricing. Volatility of supply and demand has been sending the spot price way, way over the annual price over the past year or more and BHP was not going to take its disadvantage lying down. Last year, however, the GFC forced the annual contract price down some 44% with Japan. China held out for a bigger price concession. BHP baulked, China wouldn't budge, and in the end no deal was struck. The move backfired on China, which ended up buying most of its iron ore at the Japanese price anyway in the interim and also excess volumes at spot. Indeed, strong demand from China is what has pushed the spot price up, and up, and up in the period.

Over the past twelve months BHP sold two-thirds of its iron ore at annual pricing and one third at spot.

As I noted, Vale could see where all this was heading for the 2010 negotiations. Preempting its Australian rivals, Vale suddenly announced it would sell only on quarterly contracts and only at a price which more closely represented the spot price, or at that stage a 114% increase over last year's Japanese contract price. BHP would have popped the champagne that night, given Vale was now effectively onside. The crack was opening up in the benchmark system, and BHP intended to drive a bulk carrier right through to the centre.

The pricing agreement BHP has now reached with Asian customers is summed up as one of a "market clearing" price. What price "clears" a market of outstanding demand and supply? A spot price. And for pricing equality's sake, a "landed" price, meaning all producers are working off the same benchmark. The one concession to pure spot pricing is the fact that prices will be good for three months. This is, after all, a major seaborne market, so some concessions need to be made on timing of production and sale.

So the two breakthroughs of which I spoke earlier are the end of annual pricing and the end of the freight differential which are, both jointly and severably, history making in their significance.

To put this into perspective, BHP should be looking at a possible 100% price increase to US$120/t. However, the initial price rise will not be so great given BHP is graciously allowing a "transition phase" under a sort of arrears pricing system, in which the previous quarter's price will be used to set the current quarter price. But over time BHP will move the "current quarter" price to spot.

As such, resource analysts are not yet quite sure at what price the first of these quarterly contracts will be set. But for most, this news has provided sufficient confirmation to now lift expectations above earlier 60-70% conservative estimates. And spot is still much higher at US$150/t presently.

This has meant a rush to reset earnings expectations for BHP, Rio and other Australian producers, the magnitudes of which are dependent upon where analysts had previously set their forecasts. But as delighted as all analysts are with BHP's breakthrough, the new system actually ushers in a complication – analysts use one-year average price forecasts in their valuation models.

So now analysts have the task of trying to forecast just how each quarter's contract price might translate into a yearly average. Can spot iron ore prices just keep going up? JP Morgan, for one, doesn't think so. The JPM analysts have set a 65% annual average price increase as their forecast given they assume the iron ore market to be currently overheated. Therefore the first price might look fantastic, but subsequent prices perhaps not quite as fantastic.

Most other analysts have satisfied themselves with simply speculating for now, until more detail is forthcoming. This mostly involves plugging in yearly numbers which hold a 100% or so price rise steady, and watching what earnings increases fall out the bottom.

Suffice to say, they are significant. For the common or garden investor, it must be appreciated that yesterday's announcement did not come out of the blue. There is a lot of positive expectation already built into the prices of BHP, Rio and others.

Stay tuned for more news.

In the meantime, note that BA-Merryll Lynch is the most recent broker to point out that steel prices have been rising recently in line with raw material prices.

The fear is that the recovery in global steel demand could quickly be scuppered by extreme increases in the costs of steel making raw materials – coal and iron ore. Margins in the steel game are tight. But the evidence suggests to date that demand destruction is not occurring, and that steel producers are so far be able to pass on raw material price increases into steel price increases without dangerous margin pressure.

Of Australia's two major steel producers, OneSteel ((OST)) also produces its own iron ore but Bluescope ((BSL)) does not. Merrills has Bluescope on a Buy rating, assuming equivalent steel price increases, but Neutral on OneSteel given its share price has already been running.

By Greg Peel

Said the Macquarie resources analysts yesterday morning, "We have incorporated material changes to our commodity price deck. As a general rule, we see high prices being sustained for an extended period".

Now where have we heard that before? On yes – we began to hear it suggested some time after about 2004 and by 2006 it was all anyone in the sector could talk about. China was on the move, far more quickly than even the most bullish predictions had assumed. A nation of over a billion people was industrialising and urbanising in a catch-up process that would take decades. And behind China loomed India.

The world would have to readjust its thinking, some analysts suggested. There was a secular shift underway which would ensure the longer term prices of scarce global resources would step-jump to much higher average levels. Prices would remain "stronger for longer". Commodity prices had traditionally followed cycles of boom and bust, but there was a new "super-cycle" upon us given the demand impact from emerging markets.

Crusty old analysts shook their heads in disbelief. Smug in knowledge gleaned from decades of experience, many analysts suggested the "super-cycle" would only last as long as it took for supply to catch up with demand, as it always had. There would be a lag, but "scarce" resources were not necessarily that scarce. The cycle ebb of the 1990s had simply meant underinvestment in new projects. High prices would reawaken the sleeping giants, new supply would hit the market, and prices would fall. The amplitude of the cycle might extend, but "super" was a bit of a naïve assumption.

It all became academic when the GFC hit. Commodity prices "blew off" in mid-2008 and then plummeted faster than anyone had ever experienced. The GFC was the super-cycle's kryptonite.

But – and this is an important "but" – the reality is that both analyst views expressed above proved to a varying extent to be correct long before Americans started defaulting on their sub-prime mortgages. Oil might have peaked out in 2008 at an amazing US$147/bbl but nickel, for example, entered 2006 at US$6/lb, hit US$24/lb within the year and then collapsed, spending all of 2007 no higher than US$15/lb before the GFC hit.

Zinc followed a similar pattern, and copper and aluminium also suffered pullbacks before pushing back towards previous highs. Lead and tin had been slow to move and thus peaked just before the GFC.

So while the "crusty old" analysts were forced to admit they had overestimated the speed of the supply-side catch-up, they were right in that a "super-cycle" would not imply prices just kept going up forever. There would still be booms and busts based on demand and supply cycle leads and lags.

But the GFC was a game-changer. Suddenly the word "super-cycle" disappeared from the lexicon.

There was also another game-changer going on behind the scenes, starting around 2003 and then accelerating at a rapid pace into the GFC and beyond. And that was the emergence of commodities as an "asset class".

Way back in the twentieth century, investors would attempt to profit from rising commodity prices by investing in mining companies. And they would hedge against the inflation implied by rising commodity prices by investing in gold. Simple stuff.

They didn't play in futures markets – those were only for cowboys. Indeed any derivatives market was deemed too risky by the bulk of mutual funds and bans against using such instruments were even written into fund constitutions. But in the mid-noughties the issue was clouded by the rapid growth of exchange traded funds. These are listed on exchanges – just like stocks – and thus don't necessarily breach fund constitutions. They allowed direct investment in commodities.

The prices of mining stocks have always been leveraged to commodity prices. But mining brings with it a lot of other risks. ETFs provided the opportunity to invest directly in commodities and thereby bypass those risks.

Inflation is caused either by price rises or money "printing" or both. Commodity prices are behind all (non service sector) goods prices, so it made sense that the best hedge against inflation was to buy those commodities themselves. And if the reserve currency weakened as a result of the GFC, well again – buy commodities on the inverse US dollar relationship.

"It seems obvious to us," said the resources analysts at RBS yesterday, "that financial speculators and investors are exerting increasing influence on industrial commodity prices, as we note that as much as US$4 trillion has entered these markets over the past ten years, far outstripping growth in physical trade".

So not only have we had the emergence of the Chinas and Indias pushing commodity prices higher this past decade, we've had the emergence of a new breed of direct commodity investment which has pushed up prices in anticipation of the Chinas and Indias pushing up prices. And as a direct inflation hedge against the US deficit.

This is pretty much what happened to nickel, as our example, in 2006. Speculation was very much behind the parabolic price curve of that year, but what speculators failed to realise was that the price of stainless steel could not just keep going up accordingly. Demand was being destroyed. So stainless steel producers simply switched to chromium alloys and it was all over for nickel.

And zinc is not the only metal which can be used for galvanising, lead is not the only metal suitable for car batteries and tin is not the only plating that can be used to make "tin cans". Only copper and aluminium, of this group, can boast by their sheer utility that they are not substitutable (although light-weight composite plastics are beginning to replace aluminium). Yet copper and aluminium still suffered big dips in 2006 before recovering.

Another factor was the rapid response in China to rising prices (which China was feeding) as metal producers and smelters and fabricators sprung up like mushrooms, uncontrolled by an inexperienced government. Soon there were just too many players and not enough spectators.

When metals prices fell out of bed in the second half of 2008, and here we can include bulk minerals (reflected in 2009 contract price drops) and oil, the unprecedented price collapse came about due to a combination of demand collapse, the rapid destocking of high-priced inventories, and the panicked exit of speculators. All hope seemed lost. Super-cycle? Forget it.

But China began turning things around, in a desperate attempt to single-handedly revive the global economy and restore its much-needed export market for manufactured goods. If the speed of the collapse of commodity prices surprised many, the speed of the recovery (as so far as prices have recovered to date) has been even more of a shock, so quickly after the supposed worst economic disaster since the Great Depression.

China aside, for most of 2009 many market observers could not justify this rapid bounce in prices. It was clearly a lot more to do with a growing US deficit and weakening US dollar than any concept of global demand recovery. Inventories were rising just as fast as prices, and such a contradictory dichotomy implied at some point it would all end in tears.

But it hasn't.

"There is a growing body of evidence," said the resources analysts at Barclays Capital yesterday, "that the biggest ever recovery in global base metals demand is taking shape. Scepticism over the sustainability of this recovery and, in some cases, total blindness over any recovery at all, means that prices have yet to fully reflect what are turning into very positive demand dynamics indeed".

The sceptics include those who are not only sceptical about the speculative nature of recent commodity price increases, but also those who are sceptical about the strength of economic recovery in the developed world. With massive universal government stimulus now winding down, there are grave fears of a "double-dip", whether or not the developing world is driving the train. And Greece has a lot of investors spooked.

Barclays acknowledges that "market attention is still squarely focused on macro themes and news flow". That is why, the analysts suggest, commodity prices are yet to reflect the "increasingly positive demand backdrop".

Critical to Barclays' view is that global consumption of base metals is now growing at a double-digit pace, according to the data. Moreover, those inventories that kept growing in 2009 are now falling. If supply is yet again slow to catch up to demand growth, those inventories will rapidly diminish and prices can only rise. In short, Barclays believes the magnitude of the 2008 commodity price collapse is about to be equaled in the subsequent bounce.

"If demand continues to recover for the rest of the first quarter at the pace of growth implied in January [the latest data]," say the analysts, "then global base metals demand will be on track for the strongest recovery on record".

It's a bold statement. Indeed, Barclays actually expects second quarter growth to accelerate even further beyond first quarter growth. The implication is that the world will return to pre-GFC settings very quickly – just as if nothing had ever gone wrong.

You won't get much of an argument out of Macquarie. In fact, the Macquarie analysts suggest the GFC provided "valuable insight into the dynamic relationship that exists between commodity prices and supply". It's as if we needed the GFC to set the valuation models straight, because prior to the GFC we were just running into largely unknown territory – this "super-cycle" concept.

Macquarie has just revised up all of its long-term commodity price forecasts, by "material" amounts. For example, copper has been given a 10% boost. That's a small increase for a spot price forecast, but a very large increase for a long-term price. This was the whole basis of the super-cycle argument once upon a time. The "crusty old" analysts bleated that "prices always return to long term averages". The more progressive analysts said "that's true, but China is influencing a secular jump that will increase those long term averages".

And here we are. Macquarie has upgraded its listed mining company valuations across its resources universe as a result of its forecast price increases. The analysts have also increased energy price assumptions in a similar fashion – their long-term oil price has been increased by 13% – and taken this into consideration on the cost side in mining company valuations.

So is the "super-cycle" back on? Barclays sees "record demand recovery" ahead. Macquarie sees "high prices being sustained for an extended period". It sure sounds like it.

And reports last night suggested the biggest iron ore producer in the world – Vale – is demanding a 114% increase in iron ore prices for 2010. When the iron ore price near doubled in 2007, no one could quite believe it.

Before we all get a little too carried away, let's return for a moment to the speculation theme. Barclays and Macquarie are focused on physical demand, but RBS suggests that "While demand has been often discussed, mostly in the context of an urbanising emerging world, supply has been less of a concern for investors. We believe that this is about to change, and that significant speculative flows could reverse".

In short, we're back to the old argument again. The "super-cyclers" always saw demand outstripping supply, while the sceptics always saw supply catching up eventually. RBS believes that "secular drivers" – the "stronger for longer" demand argument – are already reflected in current resource sector share prices. Those secular drivers are likely to subside, say the analysts, while supply will continue to grow at an "elevated pace".

In the twentieth century, notes RBS, the US was the largest consumer of the world's base metal output with a 20% share. In 2003, China passed the US and today consumes 43%. Take China out of the equation in 2010 and "everything else is largely irrelevant".

The apparent global demand for commodities at present has been driven by global fiscal and monetary stimulus as an emergency response to the GFC and China's major initiative to stockpile commodities for various reasons, including cementing its own cost base and also helping to restart "customer" economies. In 2009, estimates RBS, China's metal imports increased by a record 18%. Over the same period, US demand fell 19%.

Barclays has noted that global metal inventories have begun to fall. But they are falling from very high levels and in the meantime, RBS's Chinese analysts assure them Chinese inventories are still in excess after the 2009 spree. Those stockpiles were built not just on government initiatives but also on local speculation, suggests RBS, and many other analysts agree.

Outside of China, RBS notes that developed world financial participants (meaning investors and speculators) now range from retail investors in ETFs, through hedge funds and short-term futures traders, to institutional asset allocators, pension funds and endowments. Investment banks are assembling whole new teams of traders and advisers to service the new "asset class". To RBS, it all adds up to the word "bubble".

In the short-term, RBS cannot see any real improvement in developed world demand. In the short-term, assuming China's GDP growth carries on at 10% (and Premier Wen is targeting 8% now), China will be drawing down stockpiles before it pays overly inflated prices. In the long-term, RBS does not see the pace of urbanisation in China in the next ten years matching the rapid pace of growth in the last ten years. Indeed, for global commodities supply to go into under-supply, as was the case in 2001 before China really burst onto the scene, the pace of Chinese GDP growth would actually have to accelerate from here, not just hold current levels, and RBS suggests this is "highly unlikely".

To take some writer's licence, RBS sees 2006 approaching.

The RBS analysts are suggesting that if investors don't have to be in the resources sector, then get out now. If they do have to be in commodities, choose soft commodities. If they do have to be in hard commodities, the bulks are a better bet than the base metals. For traders, pairs-trading (long/short across miners of different metals) is an option.

It takes two opposing points of view to make a market. We have been down this path before and we will surely be down it again in the future. The trick is simply not to be the last investor in and the last investor out.

Current indicators suggest short-term increases in commodity prices. But if it all starts getting carried away, be wary.

By Greg Peel

Said the Macquarie resources analysts yesterday morning, "We have incorporated material changes to our commodity price deck. As a general rule, we see high prices being sustained for an extended period".

Now where have we heard that before? On yes – we began to hear it suggested some time after about 2004 and by 2006 it was all anyone in the sector could talk about. China was on the move, far more quickly than even the most bullish predictions had assumed. A nation of over a billion people was industrialising and urbanising in a catch-up process that would take decades. And behind China loomed India.

The world would have to readjust its thinking, some analysts suggested. There was a secular shift underway which would ensure the longer term prices of scarce global resources would step-jump to much higher average levels. Prices would remain "stronger for longer". Commodity prices had traditionally followed cycles of boom and bust, but there was a new "super-cycle" upon us given the demand impact from emerging markets.

Crusty old analysts shook their heads in disbelief. Smug in knowledge gleaned from decades of experience, many analysts suggested the "super-cycle" would only last as long as it took for supply to catch up with demand, as it always had. There would be a lag, but "scarce" resources were not necessarily that scarce. The cycle ebb of the 1990s had simply meant underinvestment in new projects. High prices would reawaken the sleeping giants, new supply would hit the market, and prices would fall. The amplitude of the cycle might extend, but "super" was a bit of a naïve assumption.

It all became academic when the GFC hit. Commodity prices "blew off" in mid-2008 and then plummeted faster than anyone had ever experienced. The GFC was the super-cycle's kryptonite.

But – and this is an important "but" – the reality is that both analyst views expressed above proved to a varying extent to be correct long before Americans started defaulting on their sub-prime mortgages. Oil might have peaked out in 2008 at an amazing US$147/bbl but nickel, for example, entered 2006 at US$6/lb, hit US$24/lb within the year and then collapsed, spending all of 2007 no higher than US$15/lb before the GFC hit.

Zinc followed a similar pattern, and copper and aluminium also suffered pullbacks before pushing back towards previous highs. Lead and tin had been slow to move and thus peaked just before the GFC.

So while the "crusty old" analysts were forced to admit they had overestimated the speed of the supply-side catch-up, they were right in that a "super-cycle" would not imply prices just kept going up forever. There would still be booms and busts based on demand and supply cycle leads and lags.

But the GFC was a game-changer. Suddenly the word "super-cycle" disappeared from the lexicon.

There was also another game-changer going on behind the scenes, starting around 2003 and then accelerating at a rapid pace into the GFC and beyond. And that was the emergence of commodities as an "asset class".

Way back in the twentieth century, investors would attempt to profit from rising commodity prices by investing in mining companies. And they would hedge against the inflation implied by rising commodity prices by investing in gold. Simple stuff.

They didn't play in futures markets – those were only for cowboys. Indeed any derivatives market was deemed too risky by the bulk of mutual funds and bans against using such instruments were even written into fund constitutions. But in the mid-noughties the issue was clouded by the rapid growth of exchange traded funds. These are listed on exchanges – just like stocks – and thus don't necessarily breach fund constitutions. They allowed direct investment in commodities.

The prices of mining stocks have always been leveraged to commodity prices. But mining brings with it a lot of other risks. ETFs provided the opportunity to invest directly in commodities and thereby bypass those risks.

Inflation is caused either by price rises or money "printing" or both. Commodity prices are behind all (non service sector) goods prices, so it made sense that the best hedge against inflation was to buy those commodities themselves. And if the reserve currency weakened as a result of the GFC, well again – buy commodities on the inverse US dollar relationship.

"It seems obvious to us," said the resources analysts at RBS yesterday, "that financial speculators and investors are exerting increasing influence on industrial commodity prices, as we note that as much as US$4 trillion has entered these markets over the past ten years, far outstripping growth in physical trade".

So not only have we had the emergence of the Chinas and Indias pushing commodity prices higher this past decade, we've had the emergence of a new breed of direct commodity investment which has pushed up prices in anticipation of the Chinas and Indias pushing up prices. And as a direct inflation hedge against the US deficit.

This is pretty much what happened to nickel, as our example, in 2006. Speculation was very much behind the parabolic price curve of that year, but what speculators failed to realise was that the price of stainless steel could not just keep going up accordingly. Demand was being destroyed. So stainless steel producers simply switched to chromium alloys and it was all over for nickel.

And zinc is not the only metal which can be used for galvanising, lead is not the only metal suitable for car batteries and tin is not the only plating that can be used to make "tin cans". Only copper and aluminium, of this group, can boast by their sheer utility that they are not substitutable (although light-weight composite plastics are beginning to replace aluminium). Yet copper and aluminium still suffered big dips in 2006 before recovering.

Another factor was the rapid response in China to rising prices (which China was feeding) as metal producers and smelters and fabricators sprung up like mushrooms, uncontrolled by an inexperienced government. Soon there were just too many players and not enough spectators.

When metals prices fell out of bed in the second half of 2008, and here we can include bulk minerals (reflected in 2009 contract price drops) and oil, the unprecedented price collapse came about due to a combination of demand collapse, the rapid destocking of high-priced inventories, and the panicked exit of speculators. All hope seemed lost. Super-cycle? Forget it.

But China began turning things around, in a desperate attempt to single-handedly revive the global economy and restore its much-needed export market for manufactured goods. If the speed of the collapse of commodity prices surprised many, the speed of the recovery (as so far as prices have recovered to date) has been even more of a shock, so quickly after the supposed worst economic disaster since the Great Depression.

China aside, for most of 2009 many market observers could not justify this rapid bounce in prices. It was clearly a lot more to do with a growing US deficit and weakening US dollar than any concept of global demand recovery. Inventories were rising just as fast as prices, and such a contradictory dichotomy implied at some point it would all end in tears.

But it hasn't.

"There is a growing body of evidence," said the resources analysts at Barclays Capital yesterday, "that the biggest ever recovery in global base metals demand is taking shape. Scepticism over the sustainability of this recovery and, in some cases, total blindness over any recovery at all, means that prices have yet to fully reflect what are turning into very positive demand dynamics indeed".

The sceptics include those who are not only sceptical about the speculative nature of recent commodity price increases, but also those who are sceptical about the strength of economic recovery in the developed world. With massive universal government stimulus now winding down, there are grave fears of a "double-dip", whether or not the developing world is driving the train. And Greece has a lot of investors spooked.

Barclays acknowledges that "market attention is still squarely focused on macro themes and news flow". That is why, the analysts suggest, commodity prices are yet to reflect the "increasingly positive demand backdrop".

Critical to Barclays' view is that global consumption of base metals is now growing at a double-digit pace, according to the data. Moreover, those inventories that kept growing in 2009 are now falling. If supply is yet again slow to catch up to demand growth, those inventories will rapidly diminish and prices can only rise. In short, Barclays believes the magnitude of the 2008 commodity price collapse is about to be equaled in the subsequent bounce.

"If demand continues to recover for the rest of the first quarter at the pace of growth implied in January [the latest data]," say the analysts, "then global base metals demand will be on track for the strongest recovery on record".

It's a bold statement. Indeed, Barclays actually expects second quarter growth to accelerate even further beyond first quarter growth. The implication is that the world will return to pre-GFC settings very quickly – just as if nothing had ever gone wrong.

You won't get much of an argument out of Macquarie. In fact, the Macquarie analysts suggest the GFC provided "valuable insight into the dynamic relationship that exists between commodity prices and supply". It's as if we needed the GFC to set the valuation models straight, because prior to the GFC we were just running into largely unknown territory – this "super-cycle" concept.

Macquarie has just revised up all of its long-term commodity price forecasts, by "material" amounts. For example, copper has been given a 10% boost. That's a small increase for a spot price forecast, but a very large increase for a long-term price. This was the whole basis of the super-cycle argument once upon a time. The "crusty old" analysts bleated that "prices always return to long term averages". The more progressive analysts said "that's true, but China is influencing a secular jump that will increase those long term averages".

And here we are. Macquarie has upgraded its listed mining company valuations across its resources universe as a result of its forecast price increases. The analysts have also increased energy price assumptions in a similar fashion – their long-term oil price has been increased by 13% – and taken this into consideration on the cost side in mining company valuations.

So is the "super-cycle" back on? Barclays sees "record demand recovery" ahead. Macquarie sees "high prices being sustained for an extended period". It sure sounds like it.

And reports last night suggested the biggest iron ore producer in the world – Vale – is demanding a 114% increase in iron ore prices for 2010. When the iron ore price near doubled in 2007, no one could quite believe it.

Before we all get a little too carried away, let's return for a moment to the speculation theme. Barclays and Macquarie are focused on physical demand, but RBS suggests that "While demand has been often discussed, mostly in the context of an urbanising emerging world, supply has been less of a concern for investors. We believe that this is about to change, and that significant speculative flows could reverse".

In short, we're back to the old argument again. The "super-cyclers" always saw demand outstripping supply, while the sceptics always saw supply catching up eventually. RBS believes that "secular drivers" – the "stronger for longer" demand argument – are already reflected in current resource sector share prices. Those secular drivers are likely to subside, say the analysts, while supply will continue to grow at an "elevated pace".

In the twentieth century, notes RBS, the US was the largest consumer of the world's base metal output with a 20% share. In 2003, China passed the US and today consumes 43%. Take China out of the equation in 2010 and "everything else is largely irrelevant".

The apparent global demand for commodities at present has been driven by global fiscal and monetary stimulus as an emergency response to the GFC and China's major initiative to stockpile commodities for various reasons, including cementing its own cost base and also helping to restart "customer" economies. In 2009, estimates RBS, China's metal imports increased by a record 18%. Over the same period, US demand fell 19%.

Barclays has noted that global metal inventories have begun to fall. But they are falling from very high levels and in the meantime, RBS's Chinese analysts assure them Chinese inventories are still in excess after the 2009 spree. Those stockpiles were built not just on government initiatives but also on local speculation, suggests RBS, and many other analysts agree.

Outside of China, RBS notes that developed world financial participants (meaning investors and speculators) now range from retail investors in ETFs, through hedge funds and short-term futures traders, to institutional asset allocators, pension funds and endowments. Investment banks are assembling whole new teams of traders and advisers to service the new "asset class". To RBS, it all adds up to the word "bubble".

In the short-term, RBS cannot see any real improvement in developed world demand. In the short-term, assuming China's GDP growth carries on at 10% (and Premier Wen is targeting 8% now), China will be drawing down stockpiles before it pays overly inflated prices. In the long-term, RBS does not see the pace of urbanisation in China in the next ten years matching the rapid pace of growth in the last ten years. Indeed, for global commodities supply to go into under-supply, as was the case in 2001 before China really burst onto the scene, the pace of Chinese GDP growth would actually have to accelerate from here, not just hold current levels, and RBS suggests this is "highly unlikely".

To take some writer's licence, RBS sees 2006 approaching.

The RBS analysts are suggesting that if investors don't have to be in the resources sector, then get out now. If they do have to be in commodities, choose soft commodities. If they do have to be in hard commodities, the bulks are a better bet than the base metals. For traders, pairs-trading (long/short across miners of different metals) is an option.

It takes two opposing points of view to make a market. We have been down this path before and we will surely be down it again in the future. The trick is simply not to be the last investor in and the last investor out.

Current indicators suggest short-term increases in commodity prices. But if it all starts getting carried away, be wary.

By Greg Peel

When a country calls in the International Monetary Fund to save it from financial ruin, which is reflected in a potential default on government borrowings, the first thing the IMF does is to require an immediate devaluation of currency. The resultant drop in purchasing power forces that country to immediately become more frugal.

Had Greece still been operating under its own currency of the drachma, then it is quite likely Greece would have called in the IMF in January rather than having to face stiff austerity measured forced by the European Union. However, because Greece is part of the eurozone it no longer has a unique currency but one shared by 15 other nations including Germany. There is thus no mechanism available for the IMF to force currency devaluation.

In the 1990s the "Little Tiger" economies of South East Asia were enjoying unprecedented economic growth as they emerged out of a peasant-style existence. Loathe to upset this wonderful growth, and inexperienced as to its potential consequences, government and monetary authorities did nothing to control the runaway train. The result was rampant inflation and soaring currency values, leading to a bursting of the bubble in 1997 and the resultant Asian Currency Crisis. The Little Tigers have been struggling to recover ever since.

Watching across the fence was China, which despite its size was still further back down the peasant existence graph and still more resolutely communist than capitalist. But China had plans to become a Big Tiger. One reason China has succeeded so spectacularly in such a short space of time is it elected to peg its currency to the world's reserve currency – the US dollar – so to avoid another Asian currency disaster.

The pegged currency meant America could shift its manufacturing base to China to exploit very low wages while the manufactured goods coming back were too temptingly cheap for Americans not to run up mountains of debt in buying them. The Chinese economy ran away faster than even China had expected, forcing a gradual shifting of the currency peg to a higher renminbi valuation. But China didn't want to risk derailing the economy by revaluing too fast, and hence China achieved 13% GDP growth in the mid-noughties when 8% was the target.

China got a shock, and was angry, when the GFC hit. But really Chinese monetary policy was fundamentally a contributing factor.

China's now back with some harsh lessons learned. Fourth quarter GDP growth hit 10.7% and the latest January-February economic data released this week have economists now extrapolating 11%. China is again explicitly targeting 8% growth, so it has some monetary tightening to do, beyond small steps already taken in 2010. China revalued the renminbi slowly by a total of 21% between 2005 and 2008 before the GFC hit in earnest, but in early 2008 CPI inflation had hit double digits. Clearly the process was too slow, and in looking for anyone else to blame, America screamed blue murder over China's artificially "manipulated" currency.

China's CPI inflation is nowhere near double digits this time, but this time China wants to fall into line with decade-long Western central bank policy by restricting inflation to 3%. Having returned from the negative in January, February CPI growth hit 2.7%. Wholesale inflation growth hit 5.4%. It's only a matter of time.

The People's Bank of China dictates not just the lending rate, as the RBA does for example, but also the deposit rate. The deposit rate is currently set at 2.25% which implies a negative real rate of minus 0.45% after inflation of 2.7%. It needs to rise, and the lending rate needs to rise in order to slow 11% growth down to 8%. In the meantime, speculative foreign capital (known as "hot money") is flowing into China in anticipation of higher rates and a revalued currency – an unavoidable by-product of capitalism which seriously angers Beijing. The hot money encourages further economic growth and thus forces the issue on revaluation.

Domestically, Beijing is very concerned about a building property bubble which is driven by stimulus money being directed toward speculation rather than expanded housing and infrastructure construction as intended. China's property prices are now 30% higher than a year ago.

This is slightly misleading, given one year ago the Chinese property market suffered a bit of a crash post-GFC, and in fact the January price increase measured a more sedate 1.7% following some minor tightening measures. Thus Beijing does not wish to withdraw stimulus, and risk blowing the success the package has achieved to date, but it will affect a redirection of funds by offering more rural and regional support while at the same time raising bank lending rates to slow down the runaway cities.

To that end, economist consensus has the first rate rise occurring next month or in May or both. Thereafter, consensus has a 5% revaluation of the renminbi by at least year-end but probably sooner.

The effect of a stronger renminbi is to first render Chinese exports more expensive in the US and elsewhere. Rampant investment and strong competition in China has meant many businesses run on the barest of margins. A stronger renminbi means raw materials become effectively cheaper, but demand destruction could well wipe out those slim margins. It has been noted that while the average steel-producer's margin over time on HRC steel is US$50/t, currently it is only US$10/t on an HRC price of US$630/t.

However, Beijing will not mind weaker operations going to the wall, leaving a more robust industry base of the stronger operations. This is simply capitalism at work. What's more, it is noted that after 21% of currency revaluation from 2005 to the GFC, China's GDP growth had only receded slightly from its peak, not dramatically. In other words, the economy can handle it.

And last month's data suggest strong export growth has all but returned China's exports to pre-GFC levels.

Which leads ANZ's economists to suggest that a 5% revaluation may only be the low end of the range of possibilities. ANZ points out that incremental revaluation will only attract more speculative hot money, and that the only way to avoid this is to nip the situation in the bud. Bang. One full revaluation move. But ANZ also suggests anything below 5% will be too little, while anything over 10% would destroy too many export businesses in one hit. In other words, ANZ is predicting something in between, rather than the simple 5% consensus expectation, but with an accompanying widening of the trading "band". (While the renminbi is "pegged" it is pegged within a band of values to allow a little bit of easier transaction fluctuation). A widened band could act as a precursor to an eventual free float, suggests ANZ.

And ANZ also thinks it will happen fast – faster than most "by year-end" forecasts. One reason is the US Treasury's pending April 15 decision whether or not to officially brand China a "currency manipulator". So branded, the US government is given the power to impose punitive tariffs on Chinese exports.

Among economists, ANZ is at the "hawkish" end of the forecasting scale. Macquarie, on the other hand, is more "dovish".

While others are focusing on industrial production numbers to extrapolate GDP, Macquarie notes that history suggests as the Chinese property market goes, so goes the Chinese economy. Property is a hefty proportion of GDP and provides a large slice of taxes to be returned into infrastructure stimulus. Given the rate of property price growth slowed in January following tightening measures, Macquarie argues the risk of "a lot of aggressive policy moves still to come" is reduced.

Never mind that Premier Wen described the Chinese property market last Friday as a "wild horse" in some cities.

The key, says Macquarie, is to watch fixed asset investment (FAI) data. Writing earlier in the week, Macquarie suggested a level of FAI around 25% would suggest investment is under control but a number around 30% would suggest overheating. Yesterday that number came in at 26.6%.

So Macquarie would likely be sticking to its guns, and not expecting swift and aggressive interest rate rises and revaluations. ANZ thinks differently. They say that if you lined all the economists in the world end to end they still wouldn't reach a conclusion.

What would a revaluation of the renminbi mean for Australia? Well for one thing, China could afford to buy more iron ore at the same US dollar price, which should be good news. But we will have to pay more for Chinese fridges and televisions. It's all a bit academic anyway, given our own currency floats freely. With rates on the rise in Australia while the US sits on hold, the Aussie is pushing up again. This undermines iron ore profits locally but makes imports cheaper.

Were the Chinese economy to slow to 8% then one must expect a similar dampening effect on Australia's GDP growth, which in turn takes the pressure off rates and the Aussie. But at least China won't be heading towards a Japanese-style bust, which should be good news for everyone in the longer term, even if stock market investors are stymied by China pulling on the reins in the short term.

By Rudi Filapek-Vandyck

A recent sector report by Canadian stockbrokers Haywood Securities has revealed that price charts for many international uranium stocks carry the so-called "Cross of Death". This is when a shorter term trendline moves below the longer term trendline and stays beneath it.

From a technical-market momentum point of view, such occurrence indicates the underlying trend has now become negative (bearish), which was probably a give-away by the name widely used to describe the phenomenon.

FNArena subscribers can view the price chart for Paladin Energy ((PDN)) in Stock Analysis on the website. It clearly shows how the 60 day moving average is now firmly below the 200 day moving average – and has been ever since both crossed paths in late December.

A similar event took place for Rio Tinto ((RIO)) owned Energy Resources of Australia ((ERA)) – only a little bit later; in mid-January.

Two Death Crosses on price charts for Australia's two leading producers of uranium. What does this tell investors?

Probably that, overall, things are not exactly looking too rosy for the industry, to say the least. Note that not all price charts mentioned in the Haywood Securities report show a Cross of Death, but many do, including the price chart for Uranium Participation Corp, a leading investor in the sector listed on the Toronto Stock Exchange.

Spot prices for U3O8 managed to climb back above US$50/lb in June last year, but they have been sliding back ever since.

Last week, both spot prices and long term price benchmarks for the uranium industry, as set by two independent, leading sector consultants, both fell back in line with each other – it had been a while. Unfortunately, the convergence emerged from another week of falling prices.

Both Ux Consulting and TradeTech lowered their spot prices to US$41.75/lb last week. More remarkably, however, is that long term price benchmarks at both consultants are now also back at similar levels again.

Twelve weeks ago UXC lowered its long term price benchmark by US$2 to US$62/lb. Since then, the difference with the equivalent long term price benchmark at TradeTech was US$2. Last week UXC again lowered by US$2. Both long term price benchmarks are now sitting at US$60/lb.

On Friday, TradeTech sliced off another full US dollar from its weekly spot price, now reading US$40.75/lb. The consultant notes market demand remains discretionary. With sellers prepared to lower their prices to get deals done, surely it now has to be feared spot uranium prices this year might sink even lower than they did in 2009.

Last year, spot uranium bottomed on April 6, at US$40/lb – only US75c below the latest update provided by TradeTech.

It is probable continued willingness by sellers to turn ever more aggressive when trying to sell their product is due to the announced intention of the US Department of Energy to sell 200 tonnes uranium in the form of UF6. This is the second lot of material offered by DOE under its program to sell excess uranium inventories in order to fund clean-up efforts at the Portsmouth, Ohio enrichment facility.

The first DOE sale was successfully concluded in December.

In its monthly update, TradeTech reports February saw the spot U3O8 price decline by US$1.75/lb. This was due to the fact that sellers gradually accepted lower and lower prices as the month progressed.

In the end, 15 deals were successfully concluded on spot market terms, good for a total volume of 2.8m pounds in U3O8 equivalent to change ownership during the month.

Another remarkable event during the month was that Uranium Investment Corp, a proposed new investment vehicle for the industry, deferred its official launch due to weak economic conditions.

Note also that political turmoil in Niger, an important producer of uranium, had no effect on the market whatsoever.

TradeTech also has a Mid-Term U3O8 Price Indicator which remained unchanged in February from the previous month at US$50.00 per pound U3O8.

Spot U3O8 prices peaked in 2007 at US$136 (UxC) and US$138 (TradeTech) respectively.

By Greg Peel

On Tuesday night the US Treasury auctioned US$44bn of two-year notes. Last night it auctioned US$42bn of five-year notes. Tonight it will auction US$32bn of seven-year notes. Commentators have long ago stopped noting that such sales amounts often break previous records.

Last week the US Treasury auctioned US$40bn of three-year notes, US$25bn of ten-years and US$16bn of thirty-years. Indeed, every month the US Treasury auctions off billions upon billions in bonds, notes, and shorter dated bills. This is the mechanism by which the US funds its massive fiscal and current account deficits. America goes cap in hand to the world, seeking support for the maintenance of a lifestyle to which America has become accustomed. Since around 1975, net US debt has skyrocketed, far, far beyond the growth rate of US household income. This is not debt for which the principal is ever going to be returned – ever. Only interest payments will be forthcoming.

And the world laps it up. Or at least, the world has been lapping it up so far. Everyone across the globe wants to sell goods and services into the biggest consumer market on the planet, and the only way this can be done is to lend those consumers the money to spend. It's a vicious circle which cannot be broken because a point of no return was passed decades ago. Cut off America, and you cut off your own export receipts and your own lifestyle.

Obviously the whole system is no better than a house of cards, or as others have suggested, the world's biggest Ponzi scheme. The house nearly collapsed in 2008, but given the vicious circle meant everyone would be a loser, the simple solution was to print enough "paper" money to counter the deflationary forces of economic recession. And here we are.

The GFC has brought into focus the need to address the "global imbalance" which in simple terms can be defined as China, Germany and Japan selling goods to the US on credit while saving all the receipts. Those receipts have to be parked somewhere safe, and what better safe haven is there than in debt issued by the government of the economy which is still bigger than the other three put together? And that's before we talk about who has the most bombs.

So keen is the world, and the domestic US investment market, to park its funds in this safe haven that recently US one-month Treasury bills fell to a negative nominal yield. That means even ignoring inflation, investors are paying America for the right to lend America money. How will the globe ever be rebalanced when this sort of attitude prevails?

One alternative which was previously favoured by the creditor nations post-GFC was to start diversifying out of US-only investments and to spread funds around into other sufficiently safe havens including IMF bonds, euro-denominated assets and gold. Gold provides no interest payment, nevertheless, and is volatile in price. There is no eurozone bond, and now Greece has thrown a spanner in the works of any euro-denominated assets being some sort of safe haven. IMF bonds are fine but limited, and they still have a 40% US dollar weighting.

So over there's a rock, and over there's a hard place. And the conundrum is made even rockier and harder by the fact that any full-scale withdrawal of credit to the US would result in existing investments being trashed in value. Damned if you do…

Another major problem creating global imbalance is China's pegged currency. While Japan and Germany helped America into its endless credit cycle mess, China's non-floating currency opened up a whole new world of artificial spending opportunity for Americans. There has been no one more vocal in its desires to diversify away from its massive US investments than China, but to do so is to risk both wiping out the value of its investments to date and derailing Chinese economic growth.

But Chinese economic growth would also be derailed if the renminbi was allowed to float, because suddenly China's US investments would be worth far less in its own currency and Americans would no longer find Chinese goods "cheap". Post-GFC, China has not been selling as much to the US as previously so it is not buying quite the same amount of US debt, but China still has to buy at least some US debt. Euro investments are now off the cards, and China produces enough of its own gold, it would seem. It has already loaded up on what IMF bonds are available.

China has more recently been exploiting a different way to diversify its investments while still preventing a US dollar collapse, and that is simply to cut out the middle man and buy US dollar-denominated commodities – iron ore, copper, you name it. And China has been cutting out further middle men by actually buying into the companies that produce those commodities, which it has been doing across the length and breadth of the earth including in Australia.

There is only so much iron ore and copper etc China can buy nevertheless, particularly at a time when the US and West in general are no longer spending like mad on Chinese manufactured goods. Another earlier form of diversification was for China to buy not only US Treasury bonds, but US state and municipal bonds as well.

But in the latter case, Greece changed the picture, it is believed. China instructed its state investment body to withdraw from lower-rated debt and stick only to higher rated Treasury debt for fear that the building European crisis would serve to blow out credit spreads on less all reliable economies, including those of US states and municipalities. [See China Battening Down The Hatches].

Which means China is once again buying only US Treasuries. This should be some sort of comfort for America, except for one problem. It would appear China, and the world, is beginning to see the US as too much of a risk out to any length of time. In the aforementioned Treasury auctions, while foreign central bank demand for up to two-year US debt remains strong, demand any further out is waning, and waning fast. If America cannot find backers to support its printed money out to time – time for which the US deficit is expected to go on and on – then the next risk is hyperinflation, Zimbabwe-style.

The world has become tired and nervous of buying more and more longer-dated US debt. The more it buys, the more becomes available. Foreign participation rates in longer-date US Treasury auctions has been dropping alarmingly. Greece is not the only problem nation. All the world has managed to do post-GFC is take all the debt burden out of the private sector and re-establish it in the public sector. We no longer fear investment banks going down, we fear countries going down.

Another reason why China in particular would want to re-concentrate its US investments into short-date debt is because very soon China will revalue its currency by an expected 5% in order to ease off its runaway economy. This immediately has the effect of devaluing US investments, but the shorter the date the lesser the valuation impact. The same goes for wider credit spread debt such as state and municipal debt.

But there is more to the story. China has clearly been selling US bonds in recent months, rather than just not buying them. Is this just part of switching into shorter dates or is there a more insidious agenda behind the sales?

China is now in a position of considerable global power. The US may still be the world's undisputed superpower, but China holds the kryptonite. For if China was to call in its US marker (sell all its US bonds) the US economy would collapse. Mind you, the result would be largely internecine, given China's surplus and export market would be wiped out, but China is not beyond flexing a bit of muscle and letting the US know just who is holding the cards here (pardon the mixed metaphor).

And China has two areas of ongoing frustration. They're called Taiwan and Tibet, and from an imperial perspective China believes it holds unalienable rights over those "countries". China gets very upset when world leaders meet with China's "enemy" in the Dalai Lama, which President Obama did last week, and was previously furious when America agreed to sell arms to Taiwan.

On the Taiwanese front, China holds considerable power. As soon as arms contracts were announced between Taiwan and the likes of Boeing, for example, China threatened to stop buying Boeing aircraft. Given over 50% of China's airline fleet is made up of Boeing planes, and the total is rapidly growing, Boeing found itself with a difficult decision to make.

Meetings with the Dalai Lama have not elicited quite such a direct response, but suffice to say the London Telegraph has pointed out that the day Obama met with the Tibetan leader the (Communist) China Daily praised moves by the Chinese authorities to "slash" holdings of US debt.

And we won't even begin to speculate on Google's problems, general computer hacking and intellectual property theft.

What is of concern here is that a political rift is building which goes far beyond sensible notions of risk diversification. Tensions between the US and China are mounting. Just how much damage is China prepared to inflict via US debt markets before the mutual ramifications outweigh a simple show of force?

Notes the Telegraph's Ambrose Evans-Pritchard, "China and America are locked together by fate. Any petulant action by either side involves a degree of 'mutual assured destruction'. But sometimes in politics – as in life – emotion flies out of control".

By Greg Peel

Over the last week we have seen first half earnings results from Commonwealth Bank ((CBA)) and Bendigo & Adelaide Bank ((BEN)). The other three of the Big Four banks report on an off-cycle, but as such provide quarterly trading updates to coincide with the regular reporting season. Westpac ((WBC)) provided such an update this week with National Bank ((NAB)) due to follow tomorrow and ANZ Bank ((ANZ)) next week.

From late 2007 to now, bank analysts have cycled through phases of first not believing Australian banks to have anything to fear from a US subprime crisis, to believing they had everything to fear and more from a GFC, to suggesting things aren't so bad after all but it will be FY11 before real earnings growth recovers, to realising earnings growth is recovering rather quickly.

There have always been several factors underlying analyst opinions, including credit demand, market share, margins, funding costs and government stimulus, but of most importance in considerations has been the level of bad debts banks were likely to suffer. Bad debts are a leveraged bank's worst enemy, as emphasised by Westpac's near death experience in the recession of 1992.

Bad debts were expected to impact on the banking sector in three phases. First would come the big name implosions, such as we had in late 2007 and early 2008, then would come a wave of aggregate smaller business implosions, followed finally by a consumer wave featuring credit card defaults. Eventually analysts were forced to admit the level of bad debts might match or even exceed the lofty peaks of 1992, and that a long tail of defaults, even after the economic tide had turned, would mean little opportunity for healthy earnings until at least FY11, assuming the Australian economy recovered from recession.

In the meantime, banks would be forced to set aside sufficient provisions against debt defaults from the what meager earnings were dribbling in, having also cut dividends and madly raised fresh capital. Over the past two years there has been a lot of wailing and gnashing of teeth over whether or not each bank was sufficiently provisioned.

What has since happened is that Australia has avoided a (technical) recession, government housing stimulus has landed right in the big banks' laps, depositors and borrowers have run screaming to the safety of the big banks and away from small and non-bank lenders, thus pushing up Big Four market share, and the economy has recovered far more swiftly than anybody ever imagined. This has been particularly manifested in a mere blip in unemployment, which is important given unemployment is a key driver of mortgage and credit card defaults.

As a result of all of the above, Australian banks were sold down very heavily in 2008 and have bounced back very strongly in 2009 in stock price terms. Behind a lot of this price rebound, particularly in the Big Four, have been moves by analysts to all but discount FY10 and "look through" to FY11 and even FY12 for valuation purposes. FY10 was expected to be a turnaround year featuring the aforementioned tail of bad debts and a slow return to credit demand, while FY11 was perceived as the year of strong rebound out the other side.

Which, flippantly, might beg the question "why don't we just take FY10 off then?" If banks are already priced for FY11 and beyond, then what upside exists for shareholders as FY10 plays out?

As flippant as this question may be, the point is that at various stages of the rally over 2009, analysts often declared bank stocks to already be fully or even overvalued. Yet prices kept rising, all the way through to January – at least as far as CommBank and Bendigo are concerned. All other bank share prices peaked in October last year and have been on a sliding path since. We have since January had somewhat of a market correction, so the task at hand now is to ascertain whether the market is fully set up for FY11 or whether the events of FY10 can still push those valuations higher before we move closer to FY11 (which will begin in six month's time).

Overriding all decisions at present is also a small matter of European debt concerns – a situation which many in the market fear has similar overtones to the subprime crisis becomes Bear Stearns becomes Lehman Bros story. But we'll leave that aside for now, other than to note CBA reported on a day when global sentiment was weak and Westpac on a day when global sentiment had much improved, and that as such specific share price movements on the day were qualified.

Bank analysts have largely been surprised by the results posted by CBA and Westpac. While market share has increased and margins have improved, and trading profits have been strong due to market volatility, the bad debt situation has not reached the sort of heights most recently assumed. One might say therefore that the recovery expected in FY11 is sneaking forward into FY10.

The swing factor is bad debts. If the timing of the peak in bad debts has now moved forward, then FY10 earnings forecasts should merely improve at the expense of FY11. But if the extent of the peak of bad debts is now assumed to be less than previously forecast, earnings forecasts should rise across both years. In a nutshell, this is what has happened.

Analysts have raised their earnings assumptions in both FY10 and FY11. However, the extent of absolute increase in FY10 has mostly been greater than the extent of absolute increase in FY11. This implies that analysts have been forced as a response to solid bank results to assume both the timing of the peak of bad debts will be earlier and the extent of the peak of bad debts not as great. In absolute terms earnings forecasts have moved up, but in relative terms some of the anticipated earnings growth spurt has been brought forward into FY10.

It is important to note here that while analysts may still be anticipating FY11 as the year of more emphatic recovery in earnings, the further out in time the greater a discount must be applied to that valuation given the sheer uncertainty of what could happen in between. It is only when analysts receive confirmation, such as an interim earnings report, that they can reduce the discount applied to outer forecasts and "roll forward" their valuations. When applying ratings, analysts are still only looking about six months ahead, so even if they see a big earnings jump in the future they will not assume such a jump as a given until we get closer to that period and the numbers stack up.

It's here that ongoing guidance from management is useful, but specific bank guidance and commentary in the current round of updates has not been a great deal of help. CBA remained downbeat, warning that while the bad debt situation was improving it would be foolish to hastily assume it was all but over. Westpac was a lot more upbeat on the other hand, largely seeing bad debts as no longer the threat they had been. Is one being too conservative or the other too bold?

Bank analysts also warn that the Big Four in particular have enjoyed a purple patch of increased market share and margins, monetary and fiscal stimulus, and extra-ordinary trading profits. As stimulus now subsides, and the economy recovers by itself, margins will tighten. There will not be as much volatility ahead from which to enjoy trading profits. So while Australia's economy is turning around, this actually becomes somewhat of a headwind for the banks.

CBA and Westpac also enjoy a premium to the sector, given their size and solid branding and "safe haven" attraction over the GFC, which should mean they head into FY11 best placed. But how much of a premium is too much? Premiums have already blown out.

The biggest premium is enjoyed by CBA, and thus while analysts upgraded their earnings forecasts for the bank only one rating upgrade was recorded among the FNArena broker database, from Sell to Hold. Two brokers downgraded to Hold from Buy, suggesting all that should be priced in already has been.

Westpac, which enjoys a slightly smaller premium, nevertheless scored two upgrades from Hold to Buy and one from Sell to Hold, with one downgrade to Hold. Westpac was the bigger "surprise", and offered the more upbeat commentary, but then Westpac shares have flown these last couple of days.

From the ten brokers and researchers in the FNArena database, CBA now scores a Buy/Hold/Sell ratio of 2/8/0 to Westpac's 5/5/0. This suggests some brokers see upside in both but the majority believes current prices are set around fair value. This is despite general forecast earnings upgrades following the results.

The smaller Bendigo was expected to suffer a lot more than the Big Four, having lost market share, lost funding sources, and not having put all that much aside for bad debts. But again the bad debt blow-out has not been as bad as expected, so Bendigo, too, has managed to surprise brokers with a solid result. And thus it enjoyed two upgrades to Buy, leaving a ratio of 5/4/1. Yet brokers remain concerned Bendigo is under-provisioned.

Those analysts sitting back on Hold ratings have also warned of other factors. The world is currently assessing an overhaul to bank regulations, which is unlikely to be positive to bank bottom lines whatever the outcome. The local wealth management business is also undergoing a regulatory overhaul. And the better the big banks perform in Australia, the more ire they draw politically. This, suggest some analysts, only means building up a risk of some retaliation.

So as we move into the next quarter and half, it's all eyes on those bad debts. If bad debts peak earlier and at a lower level than previously expected, we have upside. Watch unemployment, as that is key. There is also overhanging regulatory risk and a likelihood that the extraordinary margins and trading profits of the tumultuous 2009 period will begin to subside.

Analysts are still predicting big things for FY11, such that current bank share prices provide quite low FY11 PE multiples and thus imply "cheapness". But for CBA and Westpac in particular, the majority of brokers are happy to remain cautious and watchful, suggesting current prices are about right when one contemplates the near term. There is supposedly plenty of upside available in the not-quite-so-near-term, but more confirmation will be required.

We now await updates from NAB and ANZ.

By Andrew Nelson

If you've switched on a TV or picked up a paper lately, you'd know that the eurozone's public finances are under a lot of scrutiny these days. While it may not be wise to lump in the good countries with the bad, it would be prudent to know who the mischief makers are, as these countries are staring down the barrel of a sharp rise in sovereign risk if they don't get their ducks in a row, and soon.

This is especially the case in countries that have traditionally demonstrated poor budget management, like Greece and Portugal, and to a lesser degree, Italy. However, economies such as Spain and Ireland, which have gone though some severe cyclical corrections on the tail end of housing bubbles, are also looking at trouble on the horizon.

Economists from Credit Agricole point out that in Ireland and Spain, the deterioration of government finances and the build-up of public debt are fairly recent phenomena. In fact, as late as 2007 the budget situation in both of these countries was fairly healthy, with an average GDP surplus of 0.25% and 1.49%, which compares favourably with an average eurozone deficit of 1.85%.

However, in southern Europe, there is a long history of governmental struggle with public finances. Italy and Greece have traditionally been highly indebted countries where public deficits are mainly structural in nature. This is primarily due to a lack of public spending effectiveness and poor budgetary management. Thus, Greece, Italy and Portugal have also had considerably higher structural deficits than the eurozone average.

Italy, Greece and Ireland saw veritable boom times in 2000-2005, while Portugal's most recent time in the sun was 1995-2000. But the problem was that none of these five countries used their years of strong growth as an opportunity to reform their public finances while they had the chance. Because of this, the last ten years or more in Italy and Greece have been a time where public debt ratios surpassed 100% of GDP, while interest charges, which are admittedly lower than pre-erurozone years, still siphoned off over 5% of GDP each year.

During the boom times, Portugal, Spain and Ireland were able to maintain significantly lower levels of public debt, but now these are the countries that have experienced the worst deterioration in their public finances since the start of the global financial crisis.

The team from Credit Agricole thinks the pressures on public finances in all of the above mentioned countries are unlikely to get any better in the foreseeable future. The team predicts that government deficits and debt will undoubtedly grow in 2010, while the output gap will remain sharply negative.

However, the team also thinks it would be incorrect to lump all of these countries into the same basket, thus Credit Agricole has looked at a combination of factors to determine a sort of ranking system.

The team says their ranking system can be best explained by the level of primary deficit and of public debt forecast for 2010. Italy comes out with the lowest risk because of the low primary deficit forecast this year, which is only 0.6% of GDP. Conversely, Greece has the highest risk, as it combines a high initial primary deficit and public debt, at 125% of GDP.

There is an even bigger cloud looming on the horizon, though, and that is the increasingly strong impact of population ageing on state spending. Given the proportion of older people in the European population is steadily growing, CA believes the situation of public finances will inevitably continue to deteriorate in both the near and long term.

Citing European Commission projections, the team predicts that population ageing will severely impact public finances by decreasing government revenues and increasing spending, most notably on healthcare and pensions. Credit Agricole notes this is particularly the case for countries in southern Europe, where demographic changes are even more apparent and pensions particularly generous.

Major reforms have been implemented in Italy and Portugal to cope with these problems, but in Spain and even more so in Greece, little has been done to soften the impact of the demographic shock. In fact, by 2060 age-related expenditure will increase most in Greece, then Spain, while if current reforms are properly implemented, the rise in spending will be less pronounced in Portugal and Italy.

Yet the team thinks it is Ireland that will have to make the biggest fiscal effort given the recent and very severe deterioration in its structural primary deficit. Greece will also have to make a very substantial fiscal effort, due to the scale of its age-related spending, with ageing alone implying an additional fiscal effort of 7.7 points of GDP by 2060.

On the other hand, Italy has the lowest risk according to Credit Agricole, with the age-related related issues less of a problem because of a better overall fiscal situation and recent work towards structural reforms.

So what is the overall ranking between these bottom five of Europe?

In the short and, more importantly, the long term, Credit Agricole finds that Greece is by far the riskiest country. With a cocktail of high public debt, a severely degraded budgetary position and major demographic concerns.

Ireland and Spain come next, although the recent deterioration in their public finances is at least taking place in an environment where initial public debt levels are lower.

Portugal is facing problems that are more short-term in nature, with the longer term, age-related risks looking less problematic. However, the team notes that the structural weaknesses surrounding the Portuguese economy will continue to impact on public finances over the longer term.

That leaves us with Italy, which Credit Agricole sees as being the country with the lowest public finance related risk thanks to the fiscal efforts made in recent years combined with structural pension reforms.