Thursday, May 13, 2010

Is the World Heading Towards Parity?

Paul Nathan writes in commodityonline, The ugly face of deflation:
I am always amazed at how quickly a deflationary/recession threat can emerge. I've seen them appear many times over the last decade. Usually it's when everyone is involved in an exciting up trend in the economy, stocks, and commodities. The perceived threat appears to be possible inflation, then Wham! The near 1000 point drop of the stock market on Thursday is a good example of this phenomenon. But more about the stock market later.

Just two weeks ago I went short treasury bonds as interest rates appeared to be making their move upward. Interest rates abruptly reversed and to date have broken violently lower. The 10 year bond rate has come very near to its yearly low. Falling interest rates in the middle of both a rising economy and rising prices is very unusual. It could be explained by a flight to safety, but it can also be explained by a developing disinflationary trend, or both.

It may be premature to call the end of the inflationary trend and the beginning of a disinflationary trend, let alone a deflationary trend, but I want to bring a few facts into focus. The flight to "safety" as money pours into America from around the world is truly amazing. The fear of a collapsing Europe and Euro is pushing money into US Treasuries and pushing interest rates down and the dollar up. The dollar is at a new yearly high. It has gone straight up since the beginning of the year.

Which other country has a strong currency and low interest rates? Japan. It has been mired in a deflationary recession for years. Abnormally low interest rates and a rising currency could indicate an imminent return to the hole we just climbed out of. Meanwhile China is trying to slow its economy by increasing reserve requirements. Soon they may revalue their currency. They have indicated they will continue to "tap the brakes" to slow economic growth to slow inflation. A slowdown in China equals a slow down in world growth. America will not be immune. Nor will Europe. This suggests the possible return to the recession/deflation bias of months gone by.

Then there's the CRB. The CRB has fallen and just broke through both its 50 day and it's 200 day moving average. I thought that we were ready to bounce off this "oversold" level. That was wrong. The fact that we continue to fall and break to new lows could mean a further fall in commodities directly ahead. A break of oil could lead to 2 dollar gas rather than 4 dollar gas as many have been predicting.

While gold has stayed firm as a currency hedge, copper, nickel, oil, and steel and most base metals have diverged and fallen dramatically indicating to me a concern over future falling world growth rates. Interestingly, most commodities are falling in terms of the dollar and gold -- which is in fact commodity deflation.

And there's the M's. All money supply measures have begun a dramatic downturn. M1, M2, and M3 have all turned south in a steep dive. A stable and slightly increasing supply of money is the objective to secure monetary stability. The reduction in the increase of the money supply is disinflationary at best and deflationary at worse. In addition, Europe is experiencing a deflationary/recession threat that could reach America. And remember. These are the good times. These are the "inflationary times".

Today we witness riots in the streets as unions and government employees fight to preserve their gains. This, as the government has threatened to fire many of them and/or cut their benefits. The battle lines have been drawn in Greece but all nations are getting the message. This is a vision of things to come in all nations that choose to live way beyond their means. At the end of the day it will be the belt tightening of austerity that nations in debt will have to endure.

Many Germans say kick Greece out of the EU for violating their promise to maintain fiscal discipline. Others say Germany itself should drop out of the EU since it is the German people that are being targeted to bail out all the other "PIGS" in the EU. If either one of these alternatives are exercised, we can expect the IMF to be looked to, to save Europe. And it is the American taxpayer that finances the IMF in large amounts. About 7 billion dollars of taxpayer money could go to bailing out Greece. Greece represents the collapse of a modern day welfare state. I, and many others, say "let them go". It is the price of failing to live up to their political promises of fiscal responsibility. Why should we, the American taxpayer subsidize Greek benefits more generous than our own? Why should Germany?

The greatest threat from this crisis is an IMF bailout. However, it is not higher taxes that is the real threat, it is the potential of new issuances of SDR's that will breed inflation longer term. Gold may be "mobilized" to back the creation of huge new issuances of SDR's in an attempt to restructure all world debt to buy time. As long as it is assumed that new debt can be created to "cure" the problem of old debt, the world will be digging a deeper and deeper hole for themselves to climb out of.

Just as issuing more debt to cure the problem of too much debt is absurd, so is issuing more paper reserves in the form of SDR's to solve the lack of confidence in paper money. Euro leaders have pledged to support the Euro currency by setting up a huge new fund to buy Euros if it falls. One again, the same principle: create paper to save paper. Policy makers just don't get it! But some do...

For the first time there is actually talk of gold as the new reserve currency. Returning to a gold standard is being debated in some circles. My thoughts on the subject can be found easily by clicking my name at the top of this page under "more articles". The following is from "Are The Fiat And Gold Standards Converging?":

"I am not suggesting that we are returning to the gold standard. But I am suggesting we are moving toward it. Gold has been mobilized. It is moving into the hands of investors and savers all over the world. It is being rediscovered by central banks as a currency of last resort. Gold reserves are being increased by surplus nations. And paper currency is being sold for gold everywhere. Gold as a reserve asset among governments, and a preferred asset among individuals, investors, and institutions, is once again in vogue.

And every day the value of the dollar drops on international markets there are fresh calls for the need for a stable reserve currency. The dollar (and all paper currencies) continue to fall against gold and become less desirable and gold more desirable to satisfy that function.

This, I submit, is a reduction in the confidence of the fiat standard and an increase in the interest gold can play in the monetary systems throughout the world. As we speak, individuals in every corner of the world are trading paper for gold. And this trend, in my opinion, is not a fad. I give you the huge increase in Gold ETF's in the last five years as just one example." (Nov. 2009)

The international fiat system is built on confidence. Debt is based on trust. Once trust and confidence begin to erode, it is only a matter of time until money begins to come under suspicion. We are in such a situation today. Gold is the barometer of confidence and trust.

All in all, the appetite for debt in general by investors all over the world is waning. The need to replace paper promises with something more reliable is growing. Enter gold.

The alternative to borrowing is inflating, raising taxes, defaulting, or cutting government spending. I am for the last alternative. It's time for governments to suffer the discipline of austerity. The private market has borne more than its share. People sense now is the time to reduce the size of government. I expect the riots of Greece to replay throughout the nations of the world for years to come.

The Keynesian experiment has reached the end game. Government's ability to issue debt is coming to an end. It is becoming clear that Government spending does not equal prosperity. There truly is "no such thing as a free lunch". What we have just witnessed in Greece is small change. It consisted of trying to deal with a crisis in the billions. What comes next is dealing with a debt crisis in the trillions. The fiat system is being tested, and the world hangs in the balance. That's what, I believe, spooked the market last week.

Market Update:

Thursday's market crash was reported as either a glitch in the computer systems or a "fat fingered" mistake. It's possible but I doubt that. Besides, even if it were we are clearly trending downward and closed at a weekly low. The unstoppable momentum over the last year in the stock market -- has stopped. I lived through the crash of '87 and Thursday's crash felt a lot like that. I believe we are witnessing the birth of the next bear market. I think the sink hole we fell into Thursday was caused by fear and a loss of confidence in governments ability to solve economic problems.

As I wrote in my annual "Looking Forward: Year In Transition", in December 2009...

"The question is 'when will the markets begin to discount the end of the artificial recovery and start discounting the new world we are entering'? As we move through the first quarter of 2010 things are probably going to look better than most people expect today. The economy is like a booster rocket. It is surging higher on the thrust of it's booster engines. But once the fuel is exhausted the booster engines ( the markets) will separate and return to earth. It will be then that I will want to be in mostly cash and/or outright short many markets. My guess is that will beginin late springor early summer. While the economy may continue to grow until the end of the year the booster rocket - the markets - will simply run out of gas..."

"At best we should be left with an L shaped recovery for as far as the eye can see. Whether we have a double dip recession or an L shaped economy, there is no getting around the fact that we are about to hit a mountain of debt accumulation that will serve as a wall against any return to the robust growth of the last 25 years. That era is over.

"Then there is the debt crisis. Not the one we had, the one yet to come. Portugal, Ireland, Greece, and Spain, known as the PIGS, all have mounting debt, so much so that a default by any or all of them is not out of the question. Add to this the debt problems of the developed nations like England and Japan who are running in excess of 200% debt to GDP and you end up with a lot of ticking debt bombs and the potential of new crises. And let us not forget about Illinois, California, and New York. Add them to the debt melting pot and one can see why there is more than just a little concern going forward."

I do not know if this recent break in the market is the beginning of a trending bear market. But I believe, if it is not, we are close. The rebound of markets around the world is in response to a trillion dollars being committed by the EU to prevent contagion within it's banking system and shore up confidence in its currency. But, even if ratified by all countries, which is not a slam dunk, that will do nothing to stop the austerity ahead in all countries to deal with too much debt. In my opinion it's time to get defensive.

I have gone short the stock market via TZA in an attempt to build a long term short position based on what I believe will be a prolonged bear market. I may be premature, but I figure, pay me now or pay me later. I have re-entered RBY and added to Copper Fox and US Silver Corp.
Mr. Nathan raises several important points, some that I agree with and others that I think are exaggerated or biased towards gold as the ultimate refuge.

Let me pause here and state my personal biases towards gold. Everywhere I look, there are new articles explaining why gold is rising in these uncertain times. I can sum them all up in this one sentence: as investors lose confidence in the debt laden fiat system, they seek refuge in hard assets, with gold being their number one choice.

Add to this articles about famous hedge fund managers loading up on gold futures and gold shares, as well as countless TV commercials telling us to protect our wealth by investing in gold, and you see the beginning of a mania developing. In fact, gold bullion is being hailed as "one of the most popular asset classes" among buyers.

I remain skeptical on gold, and believe that once calm is restored, and risk premiums decline, gold will give up a lot of the gains made over the past few weeks. But for now, tensions rise in interbank markets:

Tensions rose in the money markets on Thursday as the rate banks pay for loans jumped because of concerns over counterparty risk.

Key measures of credit risk of the banks hit nine-month peaks amid rising nervousness over the €750bn international rescue package.

Steven Major, head of fixed-income research at HSBC, said: “There are still concerns because of the state of the public finances in the eurozone. Until the budget deficits have been reduced, these worries will remain.”

Don Smith, economist at Icap, added: “The package at the weekend was gargantuan, but it hasn’t completely reduced concerns about the banking sector and its exposure to crisis-hit countries.”

The most important indicator in the markets, the spread between three-month dollar Libor and so-called “risk-free” overnight rates – deemed a pure measure of risk – rose to its highest level since August. This spread rose to 0.215 per cent on Thursday, having been below 0.10 per cent before the most recent funding jitters emerged.

Three-month dollar Libor edged higher to 0.434 per cent – also a nine-month high. This daily setting has steadily risen from below 0.30 per cent just more than a month ago.

As this key benchmark for floating rate loans and mortgages has risen, so the contributing rates supplied by a panel of 16 banks has diverged. Thursday’s setting of 0.435 per cent came as West LB supplied the highest rate of 0.5 per cent, while HSBC contributed the lowest rate of 0.37 per cent, reflecting risk perceptions of different banks.

“The range of quotes from banks for Libor is starting to blow out,” said John Brady, senior vice-president at MF Global. “Libor markets are once again the canary in the coalmine. If Libor cracks 50 [bps] it will be hard for the market to price where it should be set.”

Forward spreads, which are often the most sensitive to risk, also widened. For the dollar, June contracts rose to 0.306 per cent from 0.277 per cent, while the June euro spread rose to 0.334 per cent from 0.314 per cent.

Mr Smith said: “It underscores the need for markets to see hard evidence of large-scale fiscal reform. Good intentions and supportive gestures, however large, are simply not enough to convince the markets that the situation will ultimately be corrected.”

However, he added that the forward spreads were not as high as their peaks for the year seen last week, and nowhere near the highs seen at the height of the financial crisis following the collapse of Lehman Brothers in September 2008.
So where does this leave us? I was talking with a friend of mine who trades currencies and we both agreed that bond vigilantes will continue going after other targets now that the EU has acted forcefully to protect its more vulnerable members.

And we think the next targets will be the UK and then Japan. What does this mean? If their central banks are also forced to engage in more quantitative easing to defend their sovereign debt, their currencies will take a hit.

This is why I openly ask whether the world is heading towards parity. What will happen once austerity measures kick in around the world - not just Greece - and how will central banks react? In a world of ZIRP and QE, the only tool left is competitive devaluation.

I agree with Gary Shilling (see video below), we might see parity in the euro. But beyond that, there is no reason why the pound won't also lose more value as the British economy struggles to regain its footing. Importantly, as we "socialize debt", we risk seeing more drastic adjustments in currency markets, and the world could very well be heading towards parity.