Thursday, October 29, 2009

Mythbusting the USD and Future Interest Rates

 During these days of Dazing and Confusion, there are two polar-opposite arguments for the near and mid-term future of the US Dollar.

On the one hand:

Is This the Death of the Dollar?

Protecting Yourself Against the US Dollar Collapse

Is the Dollar Going Down Forever?

And the other:

Deleveraging Pushes the Dollar Up

And that's about all I could find by typing in "US dollar going up" in Google that is recent and credible.  Otherwise you'll find mostly Ask Yahoo! questions like "is the US Dollar going up or down?"

Which goes to illustrate a point that I have been trying to get across for some time, but is secondary for this particular article:  Almost everyone out there has bought into the "Death of the Dollar" scenario.  There are very very few left on my side of the trade.  (Which is why I'm there, remember?)

Tonight, however, I'm not going to focus on  the particular direction the US dollar is going, more on - hypothetically speaking - what both sides of the argument are saying will happen to the interest rates on loans.  Specifically I am going to focus on Treasury Bonds.

The Commonly Cited "Fact" - Interest Rates are determined at treasury bond auctions based on the risk of inflation or deflation. 

  • If the prospect for inflation is very high, treasury yields will rise up to a level where the market thinks the interest earned on the loan will beat the rate of inflation.
  • If deflation is expected, interest rates will be very low, as people are more concerned with simply keeping their cash safe as opposed to putting it into an asset that will be worth less in dollar terms.
This is the general arguments and banter that one will hear when reading mainstream financial news or commentary, listening to the usual economists discuss economic policy, and virtually any other place where Treasury rates are discussed.

Unfortunately this is a partially false assumption, as this aspect of interest rates is actually only a part of the real reason interest rates rise and fall. The usual argument for Treasury bond rates is a far cry from the truth.

I am going to explain to you why I expect BOTH rapid and violent deflation AND higher interest rates in the mid-term, guided specifically by treasury bond yields.

The Investophoria Argument:

The first factor we have to consider in bond interest rates is general supply and demand.  This is the oldest of economic principles and applies not only to potatoes and cars and oil, but to currencies as well.  By issuing a bond, the government is increasing demand for actual dollars, taking from the supply of existing dollars and trading them for a piece of paper that says they will repay them plus interest at a pre-designated future date.  While the Fed is monetizing a large portion of these, the foreign buyer market has still made up a significant portion of the Treasury purchasing crowd.  One of the largest ever, actually.

The second factor we have to look at is a result of the first factor.  As demand increases and supply contracts, the overall value of the dollar actually increases relative to the goods and services in the economy.  This is the result of deflation (shrinking amount of total money).  Bonds' interest rates are not only factoring in possible inflation (i.e. return ON money), but are - more importantly - factoring in the ability to repay the debt at all!  (Return OF money).

If the likelihood of principal repaying is very high, the interest rate will be low - buyers are willing to take a lower yield for the security of knowing their principal is going to be returned to them.

However, if there is a good chance that the borrower is going to default on the bond, then the interest rate is going to be higher - there has to be a higher reward for the higher risk.  Hence the fact that junk-bonds from corporations have far higher yields than AAA rated bonds do.

So here is our forecast - we see a high probability of both deflation AND high interest rates within the next 2-3 years (which most traditional analysts will tell you is not how things work - again, ringing the long-term contrarian bell here!)

How is this possible?

It's pretty simple when it comes down to it.  One-paragraph kind of simple: 

If the USD rapidly deflates, there will be far less US dollars the government can get (from taxes and such) to repay their bonds with, and thus the risk of default is far higher than during inflationary times when there is more dollars in existence every day.  Thus, even though the dollar is going UP in value and interest rates "should" be low, we expect the bond-market to experience the dawning realization that deflation is what could actually cause governments to default on their debt.  Thus, very high interest rates on Treasury bonds hand-in-hand with rapid deflation!

Our recommendation is as follows:

For the mid-term, cash and short-term treasury bills that can be rolled over easily and withdrawn easily are the optimal means of protecting wealth.  As I said in a recent seminar, "Cash is king, and will soon be proven Emperor".  For more aggressive investors selective shorts or LEAPS can make significant returns on top of the appreciation in the underlying USD.

However, once we see interest rates begin to hike back during the final decline in this market, we recommend switching entirely to cash and being ready to purchase stocks.

A note on gold:  We expect that the bottom of this correction in gold to under $700 will be hit long before this, and that gold will experience a quiet bull-market back up to roughly its current price level around $1,000 - $1,100 per ounce (much the same as its quiet rally from 2001 - 2006. 

Once the predicted scenario of rising rates AND a rising dollar unfolds, we expect the real legs of the future rally in precious metals to take off, as a slow trickle of people enter the market realizing that gold is the safest form of money. 

That is some food for though - a tidbit to keep in the corner of the mind until the "wall of worry" comes into play again.

Until then, I want you to remember something:

The psychology toward stocks at the market peak in 1929 was about as positive as it was toward credit:  Namely, that stocks always went up and that credit was the true fuel upon which the fires of the economy must feed.  Why, that's why there was such amazing growth!

The result of this "pro-paper, pro-credit" mind set was a huge bust. On top of the bust - because of the policies of the Federal Reserve and government, slowing down and dragging out the cleansing of the mailinvestments during the "roaring twenties" - what should have been a very sharp and deep (but short) recession with rapid deflation, turned into over a decade of misery.

The perspective toward stocks changed.  Nobody wanted them in 1933.  In fact, it took an entire generation (25 years) just to get back up to that same level in the markets that sentiment hit in 1929.  Remember that, and keep in mind that sentiment toward stocks from 2000 to 2007 was at an all time high period, as represented in percent of net worth, and in percent of GDP.

And finally, this:  "History never repeats itself, but it often rhymes."  Mark Twain

Enjoy your Thursday, Dear Readers!  I've had a ton of questions the past week and I'm sorry if I haven't gotten to them all, but it's been crazily busy - however, I promise I will try to respond within a couple of days from when you send them.

Be Safe out There,



Wednesday, October 28, 2009

One Hell of a Market Cross-Roads

So here's the scoop.  A nice brief article.  No mention of gold (except to mention that I'm not mentioning it right here), or the USD.  I'll stay away from individual stocks and commodities today.

No, dear reader, my concern lies with something I brought to your (and my) attention back on September 14th.

Remember when I said that the most likely place the S&P500 would rally to was 1,132, according to a fibonacci retracement calculation that was further strengthened by that nice downward trend line dating right back to the all-time market top in October of 2007?

I present for you, the updated version:

As you can see here (by clicking the chart), the major downshift in sentiment has a nice trend-line dating all of the way back to the all-time market top.

This is the point where anyone still invested long in stocks should really consider pulling out the majority (if not all) of these holdings and sitting in cash to ride out the next leg of this long-term bear market.

Going short isn't such a bad idea either (and probably 3 or 4 times more profitable than cash), if you are the type - just make sure that your brokerage or trading firm isn't one of the weaker ones as many will be blown away by the sheer volume that is going to come into this decline.  Not to mention some might have a hard time, you know, existing with those awesome capital rations of theirs!

As always, stay safe out there.  The next leg down should break far below that lower trendline in the downward channel and we probably won't see a total low for the market for up to 12 months.  The lower part of the channel should act as overhead resistance for the trendline.

My suspicions, however, (and coincided with studying the market moves of the Great Depression and other market bubbles) is that we won't see that lower trendline for some time once we break through it.

Of course, the unthinkable could happen and we could have a mad dash to new heights first.  However, I'm just not seeing it as the DSI is hovering around 90% or more on practically every market that has be making new highs for weeks!  And the DSI is 93% bearish on the dollar for a MONTH.  Yikes.  Feels like sentiment is way too stretched.

Happy Investing.  Remember Mark Twain's sage advice for these times:

"I am more concerned with the return of my capital than the return on  my capital."  

Truly coined for the depression era.  Sock away every penny folks, save as much cash as you can and be ready for those once-a-century buying opportunities not-too-far down the road. 


Sunday, October 25, 2009

A Shiny Bit of Perspective on the Metals That Gleam.

As the hate-mail has continued to pour into this writer's inbox, my position of selling out of the precious metal stocks that I purchased in late fall 2008 continues to be psychologically fortified.  After all, as I have said many times previously, I am as contrarian as I can be - the more hate mail I get (not that I'm a glutton for punishment or anything!), the more confident I am.

Loneliness, it seems, can be a wonderful thing at times.  In terms of finance it can be the best of things.

It is the state in which I find myself now - alone (or far enough between the few on my side that I might as well be) in my bearish calls on the precious metals.

I know that changing a gold bug's mind is about as likely as Mr. Obama having a personal free-market Renaissance, but I still feel it is my duty to try - the only wish I have at this point of the game is to save folks from making the mistake of trading something that is going to go UP in value for something that is going to go DOWN in valueThis is not the type of decision that makes the least bit of prudential sense, and yet, the number of those making it grows greater and greater daily.

But don't just take my word for it:

Gold Open Interest is far above the previous all-time high in March 2008.  the additional 50,000 open contracts is 500,000 ounces of gold, or  $525,000,000.00 of additional exposure to the gold market.  This is of course not including gold stocks, which have extremely low short ratios (the amount of shares short versus total shares available to trade).

A few examples, you say?  I though you'd never ask!

Barrick Gold - ABX - Despite having such crummy management of their hedge book (the $3.6 Billion in diluted new-share issues is most certainly not enough to cover the hedge book at this gold price), the short interest is at only 1.3%!  Meanwhile, 66,000 Call options contracts this month versus 31,000 Put Options should tell you the story - while the overall market is at 120% calls compared to puts, the most mismanaged major gold producer is at 213% calls to puts.  Sentiment is at major extremes toward all things shiny.

Anglogold - AU - Options for November expiry are at 10,000 Calls vs. 6,000 Puts - a 166% rate.  Over 35% higher than the market average.  Anglogold is trading at almost 5 times its book value, after having negative operating cashflow in the last quarter, and has only 1% short interest.  Again, extremely overdrawn sentiment driven entirely by hope for a massive continued run-up in gold's recent superman-esque run.

Current price inclinations on gold are the result of speculation only and are not fueled by real market fundamentals - credit levels have contracted in the US relative to the levels at the previous high in gold set in March 2008, debunking the Hyperinflationists philosophy.  The US dollar is not nearly at its low point of March 08, whereas gold is at a higher high almost inverse to the comparative difference in the USD from its previous Index price.  See here:

A major non-confirmation in what so many people see as the unflinching connection - that as the USD drops in value, gold goes up - shows us that the last legs of this rally have been driven by sentiment only and have no reflection of real fundamental aspects.

The "flee dollars" panic is so strong, and the "gold to $5,000" crowd getting so big, that any day now we could witness a drastic and sharp reversal that could wipe out these new record prices in gold in one or two trading days.

In the end, most glitter-loyal gold bugs, I recommend selling those mining stocks and closing out any open futures contracts on the shiny metals you might be exposed to.  Gold is about to get a heck of a lot cheaper.

For this, you should be celebrating.  Since your loyalty is undying no matter the economic environment, the opportunity to buy so much more precious metals with those worthless FRN's (Federal Reserve Notes, for those non goldbug-ese speaking readers) should be an occasion for joy and laughter.  Throw pride and unfounded claims to the wind for a moment and seize what may well become the last good buying opportunity for gold and silver as the final corrective wave of this depression takes them down to levels we can really call "cheap".

Our recommendations have not changed, meanwhile, for the broader markets - consider this lengthened (and fast waning) rally in the broad markets as a generous gift from Mr. Market.  You have the opportunity to cash out 50% richer than you were last March, and avoid the massive losses that those who are chasing "break even" are soon to incur.  Hold cash or the safest short-term equivalents and be ready to pounce on a highly depressed and pessimistic market in virtually every asset class under the sun. 

For the more aggressive investor and trader, now is the time to set up fantastic short opportunities in the broad market and the weakest/most overvalued companies. 

As always, be careful out there and watch yourself!


Full Disclosure:  While I own precious metals from years of accumulation, and generally favor silver much more than gold, I have not purchased any physical metals for almost 12 months, and do not plan to until a major correction in dollar terms (est. <$8/oz for silver) has occurred.  I own LEAPS on almost all of the major US banks, several commercial real estate companies, and Barrick Gold.  I also have transferred over 50% of my portfolio in cash form into short-term US treasury bills.

Remember, is the opinions and trading activity of the author only.  Any investment decisions you make are your sole responsibility.