Weighing the US Dollar

Debt is the New Equity

The relationship between the yield on stocks and the yield on bonds is inverting in a way that hasn't been really since before the 1950s. But the concern regarding this "strange" behavior should stop. The strength of bonds (both Corporate and Government alike) is a reflection of a healthy and necessary shift in the capital structure of our economy.

Investors have pulled 50 billion out of the US stock market this year. This money has gone into cash (both Savings Accounts and Gov't Bonds), corporate bonds (Junk and Investment Grade), and ex-first world equities.

The foreign equity story is simple. Countries with strong property laws, stable governments and a youthful demographic, will see an increase in economic growth as people compete to raise their own standard of living.

But the massive amount of money that has moved into fixed income, has bewildered many market commentators. The extremely low yield of both regular and inflation-protected Government Bonds has many people worrying about deflation. They are right to worry. Cash parked with the government is money not spent. The momentum of money is slowed down.

This adjustment is part of a larger system of balanced interactions. The shifts in money flows cause prices to change. These prices act as signals, encouraging shifts in the behavior of participants. These behavioral changes in turn, affect money flows and the process is repeated.

Lets trace the path of these signals. Falling stock prices scare people. This is because these prices telegraph signals about the health of an economy. People decide to hold more cash, which means either directly or indirectly purchasing government bonds. This allows the government pay a lower rate to borrow money.

But message contained in Gov't Bond rates is more multi-faceted than simple warning of deflation . It is also a reminder to investors that if they want to earn any return on their money at all they will have to take some risks. If they are forced to invest in something, their best option is to choose the second safest thing to cash, loaning their money to corporations. We can confirm this behavior signal by observing the large money flows into Corporate Bonds beginning about a year and a half ago and continuing to the present day.

This behavior shift has lowered corporate borrowing rates to the lower range of their historical levels (and when I say historical I mean as far back as two hundred years.) We have seen an enormous shift in the cost of borrowing for corporations since the darkest depths of the financial meltdown. In December 2008, the price at which an investor could be persuaded to lend money to riskiest corporations hit a level which implied he figured his risk was 50/50. Even the rates on the best run corporations were implying defaults of nearly 10%.

This flow of money, signaled by the extremely low corporate rates (I.B.M. just borrowed some money for less than two years at a rate of 1%) is telling us that the best run companies in their respective fields are going to be allowed to continue to do good work. Times will get tough in the months ahead, the stock market will fall. But the necessary shifts in our economy will now have the chance to occur. The process of creative-destruction will remain in balance and the engines of creation will not be helter-skelter destroyed.

All we are witnessing is a cyclical transformation in our economy from its recent youthful speculative exuberance to a more considered, mature and frankly world-weary countenance. Keep hustling, and it will be ok.

Knees and Toes

The U.S. Stock Market is currently tracing out the final part of a head and shoulders pattern. While I've stated before that most technical analysis is bunk, the H&S is a common "topping" pattern that can occur at major tops and bottoms of long market trends. It begins when an asset is bid up to unsustainable levels. A correction follows, encouraging the types of people who "buy on dips" to enter the market. The asset then rises to slightly above the previous peak, but runs out of steam as no further buyers enter the market. It then falls again to around its previous lows. I suppose the same buy on dips argument could be made for what drives the asset to rally a second time. I also feel however that the movement of stock prices often tends to take the path that would most frustrate the largest number of people. So perhaps the second rally simply exists to frustrate the less sophisticated short sellers. Perhaps the professional short sellers close their bets in anticipation of this pattern forming. This is the great thing about the markets, there is never one explanation.

I can tell you that three weeks ago I felt there was a large chance of this pattern forming. (A fact which I conveniently failed to mention on this blog.) Here's why. The stock market tends to never behave the same way twice. People's observations of the market's past behavior cause them to change the way they react when they encounter a similar situation. The last time the Dow Jones Industrial Average broke through 10,000 in 2008 it smashed through it. Its that simple. It was unlikely to do so again. The stupidest money would bet on the same thing re-occurring facsimile.

If this sounds like bullshit, I assure you, it is. You cannot approach something that acts so irrationally, rationally. But I can also assure you, if I've learned one thing in the past four years, the market and its participants are seldom rational. And the more obviously an effect should follow a cause, it almost never does. This, mind you, is not the same as being contrarian. It is more subtle than that. But now there I go... more bullshit.

There were two other reasons it was unlikely to smash through 10,000 three weeks ago. There was very strong resistance around 10,000 due to the fact it marked the previous low from February 2010, and the fact that big round numbers tend to act as psychological landmarks and consequently many people make decisions around them. (Furthermore, many world indexes were battling up against large psychological resistance numbers, the FTSE 100 @ 5000, the Shanghai Composite @ 2500, Gold @ $1250, Euro/USD @ 1.20, Copper @ $3.00) Secondly, large lasting trends do not simply reverse course on a dime. A trend reversal is a large scale battle between two groups with opposing opinion. It takes time for them to fight it out and a victor to emerge.

The Dow will most likely stall before 10,800 (just north of the first peak in the pattern from January) There will be a lot of congestion, as people start to recognize this pattern and the market moves to frustrate the greatest number of people possible. But then it will fall and not stop until at least slightly south of 8000.

Here are a few head and shoulders examples... (Click to view larger.)

The Large Cap (Dow) 2007 Peak:










The Small Cap 2007 Stock Top and 2008 Gold Bottom:

















A possible long term H&S?!? (I saw this theory advanced by some quack but who knows...):










Of course, this is the true underlying picture. (Inflation adjusted, Log Scale, 1950-2010):

Inflation

The wide ranging criticisms of the ECB's performance are bullshit. An inflation target necessarily implies restraining deflation.

There are several independent, but non-mutually exclusive causes of inflationary pressure. Academically, the two classical causes are termed demand-pull and cost-push. Additionally, one must consider the Milton Friedman fallacy that "inflation is always and everywhere a monetary phenomenon."

Demand pull inflation is always and everywhere a monetary phenomena. People can ask for all of the increases in wages they want... But in totality, if the central bank doesn't print enough money to keep up with economic growth, an employer's ability to increase wages will be constrained by their employee's ability to increase his productivity. There will simply not be enough money in the system to stimulate the economic growth needed to encourage an additional consumption of products.

This goes both ways. When Arthur Burns ran the Federal Reserve, he allowed Richard Nixon to bully him into printing money. The continuation of Johnson's "Great Society" push to appease the opposition to Vietnam through increased social spending coupled with the credit creation abetted by the Burns Fed. This double-whammy over-stimulated a strong economy already close to its natural limit of unemployment. The additional money in the system temporarily drove the unemployment rate below 4%. As people were driven off their couches by rising wages, so to were people driven to ask for higher wages to stay at their current jobs. With rising wages came higher expenses, and the demand-pull wage spiral took off.

This is not at all the case today. Europe is on the verge of a terrific period of stagnation and deflation. (inflation=up, deflation=down, dis-inflation=steady) We will see no economic growth, and no additional jobs in the periphery of the Eurozone until the artificially uncompetitive wages of the peripheral economies come back down. America is going to be relatively okay, but with lackadaisical wage growth, stagnant real-estate prices and impressively high unemployment for four years at a minimum.

The price mechanism is a powerful signal. Despite the extremely bearish situation in the world economy, the prices of many key commodities are at extreme levels. This tells us several things: Coffee and cocoa are expensive. Global income/consumption is rising.
Oil is expensive. We are running out of oil.
Coal is somewhat expensive. We will find more coal.
Wheat, soybeans, and corn are cheap. We have had three years of excellent harvests worldwide... we also have powerful subsidies in the U.S. for these crops.
The prices of many rare earth metals have been relatively unaffected by the panic of '08/'09. Global income and the consumption of advanced technological goods is rising and perhaps we are running low on these metals.

Get it? We will find more of the things we are short of globally, except the things we are running out of, namely oil. But on a macro scale, the developed countries are printing more money, and the developing countries are consuming more products. The deflationary impulse of the developed world is being countered by both the printing of money (Friedman inflation), the demand pull of economic growth in the developing world, and the cost push of the world transitioning from an oil based economy. Add in a few years of bad harvests and we will move beyond academic disputes over the nature of the Phillips curve (the reciprocal relationship between rate of inflation and and the rate of unemployment) into a general acceptance of Gregor Macdonald's concept of compartflation...

Basically we are talking really shitty stagflation in the developed world, with the slim possibility of outright deflation if we get a trade war, or a real war, or a European banking collapse, or a revolution in China... etc, etc. In either case, developed world real estate prices will not appreciate in nominal terms for 8 years at least. Stocks and and paper stores of value look terrible.

It is essential to recognize that the dichotomy between deflation and inflation is false. They can easily coexist as a growing differentiation between assets values intensifies along the classic lines of supply and demand. As we enter into a world where the values of the dollar and the euro depreciate together due to both the decreased demand for currency and the increased supply of money, we will see the price of many assets in high supply (real estate, stocks) stay stagnant. Thus the inflation of the money supply will cause a subtle but dramatic deflation in the price of over-abundant assets. However, as we run of of cheap energy the price of oil and coal will continue to inflate with drastic consequences for the world economy.

This will of course work itself out. Indeed, as these events come to pass, market prices are no more than the manifestation of this process of self renewal.

Stop freaking out, you know you're okay.

The Dow is going somewhere just south of 9000. The Euro is going to $1.15. Gold is eventually going to $2400, once the dollar turns around.

Will everyone please calm down? The markets are working.

The only present concern is the fact that everyone who can is bailing out of long-term European peripheral-economy debt by selling it to the European Central Bank. The amount the ECB is actually purchasing is the only relevant data point. If they are forced to purchase excessive amounts, they will not be able to sterilize their purchases, turning so called "credit easing" (I've also heard the nonsense term "qualitative easing" used) into "quantitative easing." In fact, the Federal Reserve fell into a liquidity trap when they attempted their form of "sterilized" quantitative easing, and were forced to print money to prop up the falling money supply.

If their hand is forced there is a real danger the Euro will hit parity to the dollar. (Or as my fiancee suggested, falls below parity... "It's only fair.") So far the adjustment is in line with events, and the re-balancing of the Euro is equating supply and demand of money and goods judiciously. But if parity happens, America and Europe will be in deep shit.

Moody Blues

Moody's downgraded Moody's Investment Services today, in response to Moody's receipt of a Wells notice from the S.E.C. which threatens to revoke its NRSRO status.

God I wish this were true. Who knows?... stranger things have happened.

Re: Letter to Trichet

Uh... so I guess he got the memo. I was thinking something more on the order of 2 trillion dollars, but $962 billion sounds reasonable. Glad I could be of service.

Letter to Trichet

At the risk of sounding brash, I believe that Jean-Claude Trichet made a major tactical error Thursday morning by muting calls for the ECB to initiate quantitative easing.

The argument against QE in Europe is that the ECB's actions would necessarily be political, possibly opening up the ECB to scrutiny and jeopardizing the central bank's independence. However, the exigencies of the crisis necessitate bold action and I am surprised that Trichet would allow himself to be caught flat footed on this issue. He was unique amongst central bank governors in the summer of 2007 when he (by fax from the beach) provided unlimited liquidity to the European banking system. This bold action ameliorated the onset of the panic of '07.

Trichet is attempting to restore normality to the markets by withdrawing this liquidity support. This is a mistake. Trichet should have said that the ECB was prepared to come into the market with overwhelming force to drive down the unproductive interest rates on European government debt. With the TED spread and the LIBOR-OIS spread approaching panic levels (in plain English, European banks are no longer lending to each other overnight) he should have reiterated his commitment to provide unlimited liquidity.

If he feels that the "traditional" QE is unpalatable or unworkable, he should initiate a political process by which German bunds (the yields on which are currently plunging do to "safe-haven" searching) are issued and the proceeds used to purchase the debt of weaker European countries (which are in danger of being priced out of the lending markets due to their surging yields.) If this were implemented on a significant scale, it could go a long way towards driving a convergence between bond yields on the debt of European countries.

This may be a good opportunity to raise a domestic issue I've been kicking about in the back of my mind. The political separation between the two control levers of the economy, Fiscal Policy (the Spending and Taxation decisions made by Congress) and Monetary Policy (the control of overnight interest rates by the central banks) is necessary but unworkable. If I were in charge, I would make a commitment to restrain overnight interest rates around 0% for three years. Any adjustment necessary to restrain inflation by choking economic activity should be made on a quarterly basis by manipulating the tax rate on corporations and individuals. This is of course politically impossible, however, it cuts to the heart of the biggest danger facing the economy today, the surging national deficit and the possibility, however remote of a U.S. sovereign default. By increasing taxes temporarily if necessary to restrain economic growth, the government would bide its time by funding the exploding national deficit. This would increase its ability to maneuver by stocking some dry powder in the case that additional Keynesian stimulus is required. Which it will be.

Dance Casa

Also, what the fuck happened at the art sales this week?!? Excuse me for swearing three times in three posts within this hour, (I'm sorry, I got bored and stopped paying attention for three weeks worth of trading days) but $25,842,500 for a 28 inch forearm/hand by Giacometti???

Felix Salmon had an excellent post a few weeks ago. He suggested that works of art produced in limited multiples had a higher value than a unique work of art. That the cache derived from the narrative surrounding the provenance of the sister pieces would speak to the sophistication of the new buyer... to brutally paraphrase his excellent article.

But the fact of the article was that a huge Giacometti had just sold for something like $50 million dollars.

So here we have: the beginnings of bond vigilantism in the European Debt markets, the beginnings of a"1930s U.S. depression style" overproduction thing happening in China, massive surpluses of oil and basic industrial commodities, shortages of rare earth metals and soft commodities (such as coffee, cocoa, orange juice), a severe long term shortage of oil, a short term shortage of coal, Japan done and borrowed twice its GDP, excellent harvests several-years-running depressing the prices of agricultural products, and a tiny fucking Giacometti selling for half the price a monumental sized Giacometti sculpture.

Again. What is going on???

Here's the deal. We are, luckily, not going to have a post-banking system collapse how the fuck do we pay the police if the ATMs don't work kind of situation. But things are very bad. Terrible in Europe. Terrible in New York. Terrible in China.

Less than perfect in L.A., Austin, Brazil... but go to any of these places if you need to. There is oddly enough work.

Thirty-Nine Percent

39% of investors in the iShares/FTSE Xinhau A50 China Index ETF have lent their shares to short sellers. In the words of the immortal Drake, "Who the fuck are y'all?"

Holy shit.

(Update 5/6/10) Yep...

Strong demand for U.S. Debt Auction

The liquidity trap has a floor. It also apparently has a ceiling.

Bids for the $21 billion auction of 10-year U.S. government debt attracted the highest demand on record today, as investors, scared, bet on deflation or couldn't think up any better use for their money.

Homage to Clyfford Still

The depreciation of the Euro (blue) and the Dollar (orange) against Gold.
[The purple has no significance in itself. It's simply caused by the overlap of the two colors. Sometimes it's the Euro and sometimes it's the Dollar. It depends on which currency is stronger and thus in the background.]

From Gregor.us

The most disturbing thing here is the breakdown of the price mechanism- the contraction in non-OPEC oil supply despite the 2008 price surge.

It is clear that oil supply is plateauing. The price surged for coal in 2008 as well, but its discount relative to oil encouraged adoption. Gregor Macdonald predicts recapitulation into a predominately coal-biased global economy within five years.

Luxury Goods

"Luxury is a necessity that starts where necessity stops."

- Coco Chanel (attrib.)

The story of civilization, if told with economy yet in all its comprehensive beauty, can most cogently be explained through the evolution of the unnecessary goods of society. These are the most interesting aspects of civilization and in many ways the quintessence of peaceful society. Civilization is the story of the specialization of labour, the rise of trade, and the creation of a leisure class of scholars and artists and dissipated wealthy. All of these narratives revolve around the unnecessary good.

The unnecessary good exists outside of the dynamic equilibrium that governs supply and demand because its logic befuddles the balancing power of price. Sadie and I have a toast to the unnecessary. It's simply, "Fearless luxury."

If you wanted to ask my 17 year-old self his opinion, he'd tell you, "The moment a good's fundamental utility disappears, it becomes art."

These days I'm more of a Pierre Bonnard man.

Risk on.

Prices are starting to look somewhat reasonable for the first time in over a year:
Coal Company stocks and physical Lead are both down 20%.



























Brazil and India down about 15%






























I hadn't been aware of the recent performance of the Estonian economy until today, but for the very compelling reasons outlined in John Dizard's article in the FM section of the FT the other day, I believe this fund would provide good diversification to a not-Dollar portfolio. Estonia is on track to join the EU next year, so investing in its stock market provides Euro exposure without the structural weaknesses of the European economy.

SEB Eastern Europe Small Cap Fund

The Dollar is close to median value against the Euro ($1.35) and strong against the basket of currencies which make up the dollar index.















I think we are entering the moment where the paths diverge between the V-shaped recovery of low debt, youth oriented, growing economies, and the W-shaped recovery of the over-leveraged, sluggish, aging countries.

Remember the international investing formula detailed before on these pages. An successful economy and candidate for investment must contain Attractive Women + Quality Music + Decent Educational Opportunities + Young Population + Low Debt/GDP ratios + Accelerating Credit Expansion (installment plans, mortgages, etc.)

With Quality of Music and rate of Credit Expansion counting the most in projections.

Non-Specific Observations of the Energy Markets

This is a picture of the incredibly tight correlation between the price of wholesale gasoline and the yields on 10-year U.S. Treasury Bonds. I've suggested before that this may be due to the fact that unleaded gasoline is a perishable commodity and thus its supply is most tightly coupled to the short-term economic outlook, but I don't know. It's interesting though, no?












This is a picture of KOL, an ETF comprised of coal related companies. Though most markets are exhibiting classic technical analysis resistance patterns, this chart wins the award for pristine textbook example. (If your new to T.A. here's a hint... ignore the bullshit. All you need to know are 'Resistance can become Support', the Head and Shoulders formation (on long-term charts only) and 50 & 200 day moving averages. Everything else is worthless.)

By the way, maps show you where to go. Charts show you where not to go. This is important.

Anyway... the consumption of coal has sky-rocketed this year relative to oil because it is a much cheaper alternative. There are some posts on my favorite economics blog, gregor.com, related to this subject which are excellent for both the quality and inventiveness of Mr. Macdonalds' writing and the accompanying charts. In addition to his theories on our current inflationary depression ("compartflation,") today he made the bold and sensible prediction that, "It was only 55 years ago that the world crossed over to use more oil than coal. In another five years, we will be going back to coal." Here is a link to a post of his with jaw dropping charts of recent trends in world coal consumption.

[btw/fyi... Gregor Macdonald, George Cooper, Satyajit Das, Bill Gross, and Mr. Soros (back in his prime)... the smartest guys in the proverbial room]

Missed Connections

A few thoughts on the State of the Union address. Not on what Obama said, but on what he didn't say and perhaps should have mentioned:

1) "The dollar is much stronger now then it was before I became recognized as a viable candidate for president... in fact, almost to the day of my speech at the Brandenburg Gate."

(Not that this is necessarily a good thing, or necessarily indicative of a casual relationship... though I personally believe that in the midst of the Freddie and Fannie nationalization of July 2008, Obama's appearance on the world stage marshaled confidence in the Dollar, which immediately began to pull forward against all other currencies. This was in no small part a consequence of the stamp of imprimatur bestowed by Paul Volcker's early presence on Obama's economics team... Conveyed correctly, the above statement could have been the most positive populist thing he could have said to the "American people" as they, a bit bullheadedly, really favor a strong dollar. It's simply patriotic chauvinism.)

[Incidentally, the so called "Palin effect" in the first three weeks of her candidacy on John McCain's rising poll numbers was I believe due instead to Obama's initial effect on the dollar. Dollar strength knocked the wind out of commodity prices and gasoline prices came rapidly down. This caused the widespread elation for a moment, as it seemed (to the uninitiated) that the "economy" was getting better. Of course, in short order the tail began to wag the dog as falling demand began a collapse in commodity prices which amplified the dollars surge. And then Lehman... and McCain/Palin was history. Flight to safety, indeed.]

2) "This trillion dollars I have spent since taking office is largely in line (proportionally) with the total amount spent by Europe to combat the panic and as such we are no worse off fiscally on a relative basis."

(Also a brief explanation of what an overnight shift in household savings from -2% of GDP to +6% of GDP does to an economy, along with an explanation of why only government spending can make up for the shock of such a sudden chasm in consumption... Yeah, that would have been helpful.)

Here we go!

So as the forecast on December 8th, 2009 predicted ("Short-Term Dollar Strength on Worldwide Crappiness") the Euro is now within spitting distance of $1.40 to the dollar. So far so good. But the ferociousness with which it smashed though its 200 day moving average makes me inclined to wait for further weakness rather then booking profits now. I believe that the Dollar will certainly hit $1.35. Depending on the management of the Grecian crisis, the Euro easily could fall further but $1.35 is a recurring motif I feel comfortable with.
(It was the exchange rate when I first started paying attention to the markets in 2005, it was the rate just before the panic began in late July 2007, and there has been a lot of congestion around $1.35 over the past year.)












In other news, readers of this blog will note that I have been pretty bearish throughout the past year. Not to the point of outright shorting the S&P 500, but certainly not holding any long U.S. equity positions either. The theme since December 6th, 2008 has been to pursue a simple "reflationary" strategy, with a diversified portfolio split between base metals (LD, +141%), rare metals (1211.HK, +524%), junk-bonds (PHDAX , 46%), Brazilian and Indian Equities (EWZ, +156%, INP, +129%), and Inflation-Protected Government Bonds (TIP, +11%). This strategy was intended to be long only, with a "buy on dips" mentality.

I believe it is time to close out this portfolio and move to cash. Investor bullishness is the highest its been since 2006. China is removing liquidity. The VIX is near its 3-year lows and Junk-Bonds have returned to yields not seen since the moments before the panic in July 2007.

We may be moving into a new phase of the crisis. The big story of the Panic of 2008 was the run on the "cyber" banks, the money-market accounts where investors park their cash. The sudden withdrawal of cash from these accounts after the Primary Reserve fund "broke the buck" ushered in a wave of forced selling as money-market accounts sold their investment holdings to meet redemptions. We are unlikely to see a liquidity panic of this sort again. It is likely that the troubles in Europe will spread in unexpected ways. The specter of a Greek sovereign default will seriously undermine faith in the European Monetary Union, and until there is a clear protocol for dealing with the Greek crisis, we may very well see a solvency panic of the sort which accompanied the failure of Lehman Brothers.

I am not suggesting that this crisis is imminent, simply that the December 6th, 2008 portfolio reallocation has made stunning, one-in-a-lifetime returns, and there is enough uncertainty to the outlook to take a breather and reflect.

I am a firm believer that equity investors must be burned three times before a true bull market can begin. I've never read this anywhere, it simply seems like a prerequisite to the necessary capitulation which allows assets values to reach appropriate valuations for the onset of a bull market. I mark the bursting of the tech bubble as burn #1 and the panic of '08 as burn #2.

As a corollary to this thought however, I would reiterate my comments of last spring. The questions regarding L, W, or V shaped recoveries are misplaced. With the increasing globalization of the world financial markets and the shifting demographic patterns between developing and developed markets, I believe we will see a W-shaped recovery in the 1st world and a V-shaped recovery in Brazil and India.

We may very well be approaching half-time in this (so far) three year long bear market. Don't let anyone try to fool you into thinking otherwise.

Sovereign Default Swaps and Corporate Risk Premiums

The price of insuring the European Union against a member's default rose above the price to insure Europe's companies against default today for the first time since the height of the financial crisis in March 2009.

Meanwhile, the risk premium to own the riskiest safe corporate bonds instead of 30 year government bonds (and their "risk free" rate of return), has narrowed to the smallest spread since July 2007... the moment just before the panic began.

Debt Deflation : The Echo of Inflation

When one spends using credit and the interest rate on that debt is hiked, (arbitrarily to 29.99% in my case) it is the same as a sudden burst of price inflation on every good that one has ever bought with that credit.

It is almost like a strong echo.

This has been happening nationwide ever since the passage of the new consumer finance laws last fall. While the rules are excellent in many ways, they also severely restrict a bank's ability to price risk appropriately. They also have the effect of modifying, in a sense, the contracts that govern credit card master trusts- one of the securitization vehicles that made credit so cheap over the past decade. This dramatic change in their financial architecture has happened without the underlying contracts being strictly violated. The foundations of their profitability, however, been shaken, and since these trusts a revolving this may have caused a profound shift in their desirability as investments. This marks a permanent shift in the credit landscape, partially ameliorated by this recent skulduggery, but likely to have continuing consequences as new credit issuance is restricted to consumers and small businesses.

The jacking up of interest rates on everyone's credit card balances will prove to be highly deflationary. We will see the effects of this disgraceful practice by May.