Oil, the Yuan and the dollar-based monetary system

January 16, 2018

[This post is an excerpt from a commentary posted at TSI about two weeks ago]

Some commentators have made a big deal over the Yuan-denominated oil futures contract that will soon begin trading in Shanghai, but in terms of effect on the global currency market this appears to be a very small deal.

With or without a Yuan-denominated oil futures market there is nothing preventing the suppliers of oil to China from accepting payment in Yuan. In fact, some of the oil imported by China is already paid for in Yuan. Having a Yuan-denominated oil futures contract may encourage some additional oil trading to be done in China’s currency because it would enable suppliers to reduce their risk via hedging, but the main issue is that the Yuan is not a useful currency outside China. Unless an international oil exporter was interested in making a large investment in China, getting paid in Yuan would create a problem of what to do with the Yuan.

In any case, the monetary value of the world’s daily oil consumption is less than 0.1% of daily trading volume on the foreign exchange market, and the foreign exchange market is dominated by the US$. Despite the popular (in some quarters) notion that the US$ is in danger of losing its leading role within the monetary system, at last count the US$ was on one side of 88% of all international transactions. The euro, the world’s other senior fiat currency, was at around 30% (and falling). The Yuan’s share of the global currency market is very small (less than 3%), and according to the following chart could be in a declining trend.

The point we were trying to make in the above paragraph is that a change in how any country pays for its oil imports will not have a big effect on the global currency market. Actually, the cause-effect works the other way around. The pricing of oil in US dollars is not, or at least is no longer, even a small part of the reason that the US$ dominates the global currency system, but the fact that the US$ dominates the global currency system causes most international oil exporters to demand payment in US dollars.

The US$ sometimes rises and sometimes falls in value relative to other currencies, but it always dominates global money flows. Like it or not, that’s the nature of today’s monetary system.

The current monetary system is US$-based and in all likelihood will remain so until it collapses and gets replaced by something different. In other words, it’s unlikely — we almost would go as far as to say impossible — for the current system to persist while another currency gradually superseded the US$. The reason is that there is no viable alternative to the US$ among today’s other major fiat currencies.

We don’t have a strong opinion on what the post-collapse “something different” will be. One possibility is a system based on gold, but there could also be an attempt to create a global fiat currency. The world’s political leadership and financial establishment would certainly favour the latter possibility, but we fail to see how it could work as it would essentially be the botched euro experiment on a much grander scale.

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A reality check regarding China purchases of US debt

January 12, 2018

1. According to news reports, unnamed senior government officials in China have recommended slowing or halting the purchase of US Treasury securities.

2. If China’s government really was planning to reduce its investment or rate of investment in US government debt, why would it announce the change beforehand given that doing so would potentially lower the market value of its holdings?

3. The only reason to make the announcement is if there is no intention to implement a change but there is something to be gained by making the threat.

4. Clearly, the announcement is part of a negotiation strategy regarding China-US trade.

5. The reality is that China’s government buys and sells Treasury securities and other international reserve assets as part of its effort to manage (that is, manipulate) the Yuan’s exchange rate. When the Yuan is strengthening, international reserves will be bought — using newly-created local currency — to slow or stop the advance. When the Yuan is weakening, international reserves will be sold to slow the decline. That’s why China’s stash of US Treasury debt trended upward for many years prior to 2014 (when the Yuan was strengthening relative to the US$), trended downward during 2014-2016 (when the Yuan was weakening relative to the US$), and trended upward over the past 12 months (when the Yuan was strengthening relative to the US$).

6. China’s total investment in US Treasury securities was significantly greater 4 years ago than it is today. This is evidenced by the following chart, which shows that the combined Treasury holdings of China and Belgium (Belgium must be added to get the complete picture because that’s where China’s government keeps its custodial accounts) dropped from about 1.65 trillion in early-2014 to 1.2 trillion in May-2017. It’s likely that the holding is now about $100B larger, which implies that China’s government has been a net seller of about $350B of Treasury debt over the past four years.

ChinaTholding_110118

7. China’s government will continue to do what it has been doing — buy US Treasury debt when it feels the need to weaken the Yuan and sell US Treasury debt when it feels the need to strengthen/support the Yuan.

8. There are good reasons to expect that yields on US T-Bonds and T-Notes will be significantly higher in 6 months’ time, but the recent deliberately-misleading news emanating from China is not one of them.

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Monetary Policy Madness?

January 8, 2018

In a recent newsletter John Mauldin wrote: “It is monetary policy madness to raise rates and undertake quantitative tightening at the same time.” However, this is exactly what the Fed plans to do in 2018. Has the Fed gone mad?

If mad is defined as diverging in an irrational way from normal practice then the answer to the above question is no. The Fed is following the same rule book it has always followed.

It should first be understood that earlier rate-hiking campaigns were always accompanied by quantitative tightening (QT). Otherwise, how could the Fed have caused its targeted interest rate (the Fed Funds rate) to rise? The Fed is powerful, but not powerful enough to command the interest rate to perform in a certain way. Instead, it has always manipulated the rate upward by reducing the supply of reserves to the banking system via a process that also reduces the money supply within the economy; that is, via QT. In other words, far from there being something unusual about the Fed simultaneously raising rates and undertaking QT, it is standard procedure.

What’s unusual about the current cycle is the scale. Having created orders of magnitude more money and bank reserves than normal during the easing part of the cycle the Fed must now implement QT on a much larger scale than ever before. At least, that’s what the Fed must do if it follows its rule book.

A plausible argument can be made that the Fed should now deviate from its rule book, but the argument isn’t that the economy is too weak to cope with tighter monetary policy. The correct argument is that the damage in the form of misdirected investment and resource wastage was done by the earlier quantitative easing (QE) programs and this damage cannot be undone or even mitigated by deflating the money supply. In effect, the incredibly loose monetary policy of 2008-2014 has made a painful economic denouement inevitable. At this point, reducing the money supply — as opposed to stopping the inflation of the money supply, which would be beneficial as it would prevent new mal-investment from being added to the pile — would exacerbate the pain for no good reason.

In other words, the damage done by monetary inflation cannot be subsequently undone by monetary deflation.

A plausible argument can also be made that for the first time ever the Fed now has the option of hiking interest rates without doing any QT. This is due to its ability to pay interest on bank reserves. This ability was acquired about 9 years ago solely for the purpose of enabling the Fed to hike its targeted interest rate while leaving the banking system inundated with “excess reserves” (refer to my March-2015 blog post for more detail). That is, this ability was acquired so that the Fed would not be forced to undertake QT at the same time as it was hiking rates.

However, the Fed is not going to deviate from its rule book. This is mainly because the Fed’s leadership believes that a new QE program will be required in the future.

To explain, a Fed decision not to implement QT would create an expectations-management problem in the future. Specifically, an announcement by the Fed that it was going to maintain its balance sheet at the current bloated level would be a tacit admission that QE involved a permanent addition to the money supply rather than a temporary exchange of money for securities. If the Fed were to admit this then the next time a QE program was announced there would be a surge in inflation expectations.

There has been monetary policy madness in spades over the past two decades, but within this context there is nothing especially mad about the Fed’s plan to raise rates and undertake quantitative tightening at the same time.

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You can bet on the continuing popularity of superficial economics

January 1, 2018

It is appropriate to think of Keynesian economics as superficial economics*, because this school of thought generally considers what’s seen and ignores what’s unseen. To put it another way, Keynesianism focuses on the readily-observable situation and the immediate/direct effects of a policy while paying little or no attention to why the current situation came about and the indirect (not immediately obvious) consequences of a policy. This leads to nonsensical conclusions, such as that the economy can sometimes be helped by the destruction of wealth (the idea being that after assets are destroyed people can be ‘gainfully’ employed rebuilding them).

To further explain, when a shop window is broken the typical Keynesian would account for the additional work and income of the glazier hired to fix the window but would make no effort to understand how the shopkeeper would have allocated his scarce resources if his window had remained intact. And in a case where resources are ‘idle’, the Keynesian would focus exclusively on the direct effect of using increased government spending or central bank money-printing to put these resources to work. He would pay scant attention to why the resources were idle in the first place and would ignore the longer-term effects of creating artificial demand for some resources and forcing the private sector to fund projects that it would otherwise choose not to fund**.

Due to its shallow nature, Keynesian economics is not useful when attempting to understand the real-world drivers of production and consumption. However, it can be put to good use when attempting to understand and predict the actions of policy-makers.

Aside from the fact that almost all politicians are economically illiterate, if your overriding goal is to win the next election then what you want are policy-related effects that are short-term, obvious and direct. What you want is to be able to point to a bunch of guys in hard hats hammering away on a government-funded project, and say: “Without the bill I sponsored, these guys would not have jobs”. The longer-term economic negatives aren’t relevant because not one voter in a thousand will see the link between these negatives and the “stimulus” bill.

There will come a day when Keynesian economics has been totally discredited again***, but until that day there will be many opportunities to make money by betting on policy-makers acting stupidly.

    *In a blog post in May-2015 I suggested that Keynesian Economics should be renamed ASS (Ad-hoc, Superficial and Shortsighted) Economics.

    **The “idle resources” fallacy that underlies the justifications for various government stimulus programs was debunked by William Hutt in a book published way back in 1939 and was more more briefly — but still thoroughly — debunked by Robert Murphy in a January-2009 article.

    ***Keynesian economics was discredited during the 1970s but subsequently managed to claw its way back to a position of great influence. It is resilient because it seemingly gives politicians the scientific justification for doing what they already want to do, which is make themselves appear benevolent — and thus garner the support of more than 50% of the voters — by spending the money of some people to provide short-term benefits to other people.

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It’s not a gold bull market

December 26, 2017

A popular view is that a new cyclical gold bull market commenced in December-2015. If so, the gold bull is now two years old. At the same time, the following weekly chart shows that the gold/SPX ratio (the US$ gold price divided by the S&P500 Index) recently made a 10-year low. Is it possible for gold to be hitting 10-year lows relative to the SPX two years into a gold bull market?

gold_SPX_261217

If the sole measuring stick is a depreciating currency then the answer is yes, but if a more practical measuring stick is used then the answer is no.

I explained in an earlier blog post that for a bull-market definition to be practical it must take into account the fact that what people really want from an investment is an increase in purchasing power, not just an increase in price. Unfortunately, it isn’t possible to accurately determine how an investment is doing in purchasing-power terms, but a reasonable alternative is to eliminate the poor measuring stick known as fiat currency from the equation by looking at the performances of different investments relative to each other. The ones that are in bull markets are the ones that are relatively strong.

The definition I arrived at was: An investment is in a bull market if it is in a multi-year upward trend in nominal currency terms AND relative to its main competition.

As also explained in the post linked above, measuring one market against another works especially well for gold bullion and the SPX. This is because they are effectively at opposite ends of an investment seesaw, with the SPX doing best when confidence in money, central banking and government is rising and gold doing best when confidence in money, central banking and government is falling.

I think that it makes no sense to define what happened since December-2015 as a gold bull market. I also think that it is important not to get hung up on bull/bear labels. Bull market or not, January through August of 2016 was a great time to own gold-mining stocks. And bull market or not, the period since August-2016 has been a not-so-great time to be heavily invested in gold-mining stocks.

Rather than being committed to the theory that a gold bull market began in December-2015 or the opposing theory that a gold bear market remains in force, it is better to use sentiment, price action and fundamentals to identify good buying and good selling opportunities in real time.

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The yield curve and the boom-bust cycle

December 15, 2017

[This post is an excerpt from a TSI commentary published on 6th December]

The central bank is not the root cause of the boom-bust cycle. The root cause is fractional reserve banking (the ability of banks to create money and credit out of nothing). The central bank’s effect on the cycle is to extend the booms, make the busts more severe and prevent the investment errors of the boom from being fully corrected prior to the start of the next cycle. Consequently, there are some important relationships between interest rates and the performance of the economy that would hold with or without a central bank, provided that the practice of fractional reserve banking was widespread. One of these relationships is the link between a reversal in the yield curve from flattening to steepening and the start of an economic recession/depression.

Unfortunately, the data we have at our disposal doesn’t go back anywhere near as far as we’d like, where “as far as we’d like” in this case means 150 years or more. For example, the data we have for the 10year-2year spread, which is our favourite indicator of the US yield curve, only goes back to the mid-1970s.

For a longer-term look at the performance of the US yield curve the best we can do on short notice is use the Fed’s data for the 10year-3month spread, which goes back to the early-1960s. However, going back to the early-1960s is good enough for government work and is still satisfactory for the private sector.

As explained in many previous commentaries, the boom phase of the cycle is characterised by borrowing short-term to lend/invest long-term in order to take advantage of the artificial abundance of cheap financing enabled by the creation of money and credit out of nothing. This puts upward pressure on short-term interest rates relative to long-term interest rates, meaning that it causes the yield curve to flatten.

At some point, usually after the boom has been in progress for several years, it becomes apparent that some of the investments that were incentivised by the money/credit inflation were ill-conceived. Losses start being realised, the quantity of loan defaults begins to rise, and the opportunities to profit from short-term leverage become scarcer. At this point everything still seems fine to casual observers, central bankers, the average economist and the vast majority of commentators on the financial markets, but the telltale sign that the cycle has begun the transition from boom to bust is a trend reversal in the yield curve. Short-term interest rates begin to fall relative to long-term interest rates, that is, the yield curve begins to steepen.

The following monthly chart of the 10year-3month spread illustrates the process described above. On this chart, the boom periods roughly coincide with the major downward trends (the yield-curve ‘flattenings’) and the bust periods roughly coincide with the major upward trends (the yield-curve ‘steepenings’). The shaded areas are the periods when the US economy was officially in recession.

The black arrows on the chart mark the major trend reversals from flattening to steepening. With two exceptions, such a reversal occurred shortly before the start of every recession.

The first exception occurred in the mid-1960s, when a reversal in the yield spread from a depressed level was not followed by a recession. It seems that something happened at that time to suddenly and temporarily elevate the 10year yield relative to the 3month yield.

The second exception was associated with the first part of the famous double-dip recession of 1980-1982. Thanks to the extreme interest-rate volatility of the period, the yield spread reversed from down to up shortly before the start of the recession in 1980, which is typical, but during the first month of the recession it plunged to a new low before making a sustained reversal.

Due to the downward pressure being maintained on short-term interest rates by the Fed, the yield curve reversal from flattening to steepening that signals an imminent end to the current boom probably will happen with the above-charted yield spread at an unusually high level. We can’t know at what level or exactly when it will happen, but it hasn’t happened yet.

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Interesting Links

December 11, 2017

1) Stockman on fire

Former Reagan budget director and current proprietor of the eponymous “David Stockman’s Contra Corner” was on fire in the Bloomberg interview linked below. Within the space of 8 minutes he manages to explain:

a) Why the tax reform package being negotiated in the US will add upwards of $1.5 trillion to the US federal debt over the next several years without prompting a significant increase in domestic investment or providing any other real help to the US economy.

b) That former Trump National Security Advisor Flynn was caught in a perjury trap as part of a political witch-hunt and that the entire “Russiagate” drama is an attempt to unravel last year’s election.

c) That a US fiscal crisis is ‘baked into the cake’ and that the impending deficit-funded tax cut will accelerate the crisis.

2) Mortgage fraud in China

Imagine if one bank robber sued another on the basis that the loot from the robbery was not divvied up in the agreed-upon way. This is similar to a recent court case in China that involved one participant in a fraudulent property transaction suing another — and winning! — on the basis that the ill-gotten gains were not dispersed as originally agreed.

The article linked below discusses the above-mentioned case and the fraudulent practices that are now prevalent throughout China’s residential real-estate market as buyers, sellers, banks, property agents, property valuers and mortgage brokers break the rules in an effort to profit from the investment bubble. It’s a familiar story.

https://www.reuters.com/investigates/special-report/china-risk-mortgages/

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State-sponsored cryptocurrencies revisited

December 6, 2017

In a blog post earlier this week I briefly argued that “government-controlled cryptocurrency” was a contradiction in terms. It depends on what is meant by “cryptocurrency”, but now that I’ve done some more research on the subject I understand how a central bank could make use of blockchain technology and why the government would want to implement a type of cryptocurrency.

My understanding of the subject was improved by reading the white paper on the “Fedcoin” published a few months ago by Yale University. I also read about the difference between “permissioned” and “permissionless” blockchains. As a result, I now understand that a blockchain is a data structure that can be either distributed, as is the case with Bitcoin, or centrally controlled, as would be the case with a “cryptocurrency” issued by a central bank.

I also understand how the commercial banks could profit from the advent of a centrally-controlled cryptocurrency. This is an important consideration because the way the world currently works it is unrealistic to expect the introduction of a new form of official money that would result in substantially-reduced profits for the major banks.

The Fedcoin paper linked above lays out how a state-sponsored cryptocurrency could work. Here are some of the salient aspects:

1. The system comprises a central ledger of all transactions (the blockchain) maintained by the Fed, nodes (commercial banks) and users (anyone who wants to spend or receive a Fedcoin).

2. A user of Fedcoins must have an account at the Fed. Opening an account would involve providing the KYC (Know Your Customer) identity information that anyone who has dealt with a financial institution over the past few years would be familiar with.

3. Users would have digital wallets that held encrypted funds and all transactions would have to be digitally signed, so in this respect the term “cryptocurrency” would apply. However, the Fed and the government would be able to determine the identity of the users involved in any/every transaction (due to item 2 above), so the encryption would not result in genuine privacy. Moreover, the government would have the power to “blacklist” a Fedcoin account, effectively freezing the account.

4. Commercial banks (the “nodes” of the system) would maintain copies of the central ledger and would verify transactions to ensure no double spending. Also, all Fedcoin transactions would be announced to the network of nodes.

5. The Fed would audit and allocate fees to the nodes, with bonuses going to the fastest nodes. I suspect that the payments would be high enough to make this a lucrative business for the nodes (the banks).

6. Nodes would send sealed low-level blocks to the Fed for incorporation into high-level blocks that get added to the blockchain.

7. The Fed would guarantee that one Fedcoin could be converted into one dollar. This would ensure that the Fedcoin had the same stability as the dollar.

8. From an accounting perspective, a Fedcoin would be equivalent to a dollar note. In particular, like physical notes and coins, Fedcoins would be liabilities on the Fed’s balance sheet.

9. The Fed would have total control over the supply of Fedcoins, so the advent of this cryptocurrency would not reduce the central bank’s ability to manipulate the money supply and interest rates. On the contrary, the central bank’s ability to manipulate would be enhanced, because it’s likely that the Fedcoin would replace physical cash. Among other things, this would simplify the imposition of negative interest rates should such a policy be deemed necessary by central planners.

What would be the advantages and disadvantages of a government-controlled cryptocurrency such as Fedcoin?

According to the Bank of England (BOE), digital currency could permanently raise GDP by up to 3% due to reductions in real interest rates and monetary transaction costs. Also, the central bank would be more able to stabilise the business cycle.

The BOE’s arguments amount to unadulterated hogwash, for reasons that many of my readers already know and that I won’t rehash at this time.

Clearly, the driving force behind a centrally-controlled cryptocurrency would be the maximisation of tax revenue, in that the replacement of physical cash with a digital system that enabled every transaction to be monitored would eliminate a popular means of doing business below the government radar. Fighting crime and promoting economic growth would be nothing more than pretexts.

That being said, a currency such as Fedcoin would offer one significant advantage to the average person, which is that people could do on-line transfers and payments without having an account with a commercial bank. This is because currency transfers could be done directly between digital wallets.

Also, an official cryptocurrency such as Fedcoin would offer some advantages over Bitcoin, the most popular unofficial cryptocurrency. First, Fedcoin would not have the Bitcoin volatility problem. Second, Fedcoin would be vastly more efficient.

With regard to the efficiency issue, the Proof of Work (POW) aspect of Bitcoin is a massive waste of resources (electricity, mainly). Furthermore, Bitcoin’s inefficiency is deliberately built into the system to limit the rate of supply increase. To explain using an analogy, the high and steadily-increasing costs deliberately imposed on Bitcoin transaction verification and the resultant creation of new coins would be akin to forcing all gold mining to be done by hand, and then, after a certain amount of gold was extracted, making a new rule that required all gold mining to be manually done by crippled miners.

In a way, Bitcoin and the “altcoins” constitute a large and rapidly-expanding Keynesian make-work project. Too bad that such projects result in long-term wealth destruction.

Given the benefits that the government, the central bank and the most influential economists (all of whom are Keynesian) would perceive, it’s a good bet that state-sponsored cryptocurrencies are on the way. For the private sector the introduction of such currencies would lead to cost savings in the money-transfer area, but enhancing the ability of the government to divert resources to itself and enabling even greater central bank control of money definitely would be a barrier to economic progress.

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Are state-sponsored cryptocurrencies on the way?

December 4, 2017

The theme of a recent report from Casey Research was that the Russian government is planning to issue its own cryptocurrency (the “CryptoRuble”) that would be created, tracked and held on a state-controlled digital ledger. This was portrayed as being a huge plus for the Russian economy. I don’t see how giving the government greater ability to monitor financial transactions and thus divert more money into its own coffers could be anything other than a negative for any economy, but the Casey report got me thinking about whether a state-sponsored cryptocurrency is a valid concept.

I’m far from an expert on cryptocurrencies and so I could be missing something (please let me know if I am), but it seems to me that it is not a valid concept. The essence of the blockchain technology that underlies cryptocurrencies such as Bitcoin is that the ledger is DISTRIBUTED. This is what makes the system secure. Cryptocurrency exchanges and wallets can be hacked, but the blockchain itself is, for all intents and purposes, ‘unhackable’.

If a digital currency exists on a centrally-controlled ledger it is not a cryptocurrency, it is a garden variety electronic currency like the dollars in your bank account.

Central banks and governments want to eliminate physical cash so that there is a digital record of all transactions. This is not to promote economic growth or to fight terrorism or to reduce crime or to further any other noble cause; it is primarily to maximise tax revenue and secondarily to cut off a way of escaping from negative interest rates. Therefore, it’s a good bet that physical cash will be outlawed in the not-too-distant future. For exactly the same reason (they make it more difficult for the government to monitor financial transactions and thus maximise tax revenue) it’s likely that cryptocurrencies will be outlawed at some stage.

Another relevant point is that commercial banks generate a lot of profit by lending new money into existence and monetising securities. Given the banking industry’s influence on government and the reliance of government on the financial support of banks, there is no chance of the government implementing a monetary system that substantially reduces the profitability of commercial banks.

In summary, I expect that governments will attempt to make the official currency 100% digital/electronic, but not introduce their own cryptocurrencies. As far as I can tell, “government-controlled cryptocurrency” is a contradiction in terms.

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The Boom Continues

December 2, 2017

[This post is a brief excerpt from a TSI commentary published a week ago]

The US economic boom is still in progress, where a boom is defined as a period during which monetary inflation and the suppression of interest rates create the false impression of a growing/healthy economy*. We know that it is still in progress because the gap between 10-year and 2-year Treasury yields — our favourite proxy for the US yield curve — continues to shrink and is now the narrowest it has been in 10 years.

Reiterating an explanation we’ve provided numerous times in the past, an important characteristic of a boom is an increasing desire to borrow short to lend/invest long. This puts upward pressure on short-term interest rates relative to long-term interest rates, which is why economic booms are associated with flattening yield curves. The following chart shows the accelerating upward trend in the US 2-year yield that was the driving force behind the recent sharp reduction in the 10yr-2yr yield spread.

The above paragraph explains why a yield-curve trend reversal from flattening to steepening invariably occurs around the time of a shift from economic boom to economic bust. Such a reversal is a sign that the willingness and/or ability to take on additional short-term debt to support investments in stocks, real estate, factors of production and long-term bonds has diminished beyond a critical level. From that point forward, a new self-reinforcing trend involving debt reduction and the liquidation of investments becomes increasingly dominant.

The recent performance of the yield curve indicates that the US economy hasn’t yet begun the transition from boom to bust.

*The remnants of capitalism enable some genuine progress to be made during the boom phase, but the bulk of the apparent economic vibrancy is associated with monetary-inflation-fueled price rises and activities that essentially consume the ‘seed corn’.

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