Tag Archives: gdp

Insidious Effects of the Dollar’s Decline

The United States is home to the largest and most liquid investment markets in the world. There’s hardly a market one can think of that isn’t exchange listed. This has made the United States the primary destination for excess global capital placement whether it has gone towards the relative safety of government bonds or been more aggressively allocated towards stocks, ETF’s or even the futures markets. The final destination of the investible funds is less important than the singular characteristic that all these investments have in common. They’re denominated in US Dollars and the Dollar’s value may be more meaningful than the underlying asset class.

Investment securities are not protected from the vagaries of their underlying currencies. Therefore, globally allocated investments owned in US Dollars can lose money in a flat market if the Dollar declines. The Dollar peaked in early July and has since fallen by more than 6%. Therefore, if your US equity portfolio hasn’t gained more than 6% since July, you’ve actually lost money. The Governmental shut down has accelerated the recent slide and pushed the Dollar to a new 30 day low for the second time this week. This is only the second time since May of 2011 that we’ve made multiple 30-day lows in the same trading week.

Perhaps more troubling to global investors than the currency-based loss is the fact that the traditional safe haven investments, even in Dollar terms, have not behaved as expected. The primary relationship between the Dollar and the US equity markets since the financial implosion of 2008 has been negative. This has been embodied by Dollar rallies on stock market declines. Very simply, foreign capital gets converted to US Dollars and placed to work through buying declines in the stock market. Conversely, when foreign investors take profits in a rising stock market and convert back to their base currency, the Dollar falls.

We also see this relationship play out in the gold market. Economists on TV tell us to buy gold as a defense against a declining US Dollar. Sensationalists point to the overwhelming debt being created by our country and tell us to buy gold because our country is on the verge of implosion and our currency will become worthless. Speaking of correlations, it’s amazing how many of the people saying this are the ones selling gold investments. Astute investors would notice that the correlation between these two markets has been trending upwards since early June. This means they’re moving in the same direction more frequently rather than opposite each other as expected.

Foreign purchases of US goods have always been Dollar dependent. Every nation and agricultural enterprise within every nation is forced to tie their commodity purchases accordingly. Therefore, it becomes especially disturbing when a weaker Dollar fails to attract foreign purchases of global staples. Beginning in August of 2012 we started to see the commodity markets decouple from the US Dollar. Wheat was the first market to be sated. Corn followed suit in October of 2012 and hogs joined the new normal last November. This means that even base foreign needs have been filled. Therefore, they are more likely to trade in the same direction as the Dollar going forward rather than the typical negative correlation that we’ve seen from bargain hunters looking for inflation in the commodity markets.

The International Monetary Fund (IMF) stated that world Consumer Price Index (CPI) came in at 3.2% year over year for August. This is down from 4.9% a little over a year ago and ties in rather neatly with gold’s last run at $1,800 per ounce early last October. The US unemployment rate is generally believed to be artificially low in the as reported number of 7.3% and Gross Domestic Product (GDP) here in the US came in at a very tame 2.5%. These statistics, combined with a low global industrial capacity usage number suggest that inflation is nowhere near. Furthermore, the Federal Reserve Board’s recent decision not to implement a tapering of the $85 billion per month in economic stimulus reinforces the notion that their primary concern is deflation, rather than inflation.

Many economists believe that we may be near a tipping point in the bull run that has followed the economic meltdown of 2008. The obvious concern now lies in the protection of the wealth that’s been garnered during the recent run. Clearly, the ownership of alternative investments isn’t going to play out the way the pundits have suggested. Therefore, investment vehicles that will profit from a decline in both asset value and currency depreciation should be seriously considered. These include inverse ETF’s as well the futures markets, which will allow the seamless execution of short trades including currencies. Equity futures spreads selling small caps like the Russell 2000 and buying big caps like the S&P500 are also a good idea when expecting volatile, downward markets. Remember that cash is only king as long as the King’s throne isn’t sinking.

Supporting the Australian Dollar

The Australian Dollar has fallen around 11% over the last month. This is a very large and very rapid move for the currency of a major nation. How would you like to end up with 11% less in next week’s check? This is similar to what the average Australian will feel with every purchase of every imported good or service, just think of it as $4.50 gasoline and you’ll get an idea for the feel of it. Our outlook suggests that the change in the macro is correct but its initial impact has been over cooked.

The primary big picture changes that triggered this sell off are twofold. First, the slowing Chinese economy has been a primary destination for Australian raw materials. Secondly, the U.S. Federal Reserve Board announced its intentions to begin siphoning off the Quantitative Easing stimulus. This has triggered the unwinding of the carry trade.

China is Australia’s largest trading partner with total exports to China comprising more than 5% of Australia’s Gross Domestic Product (GDP). The impact of recent downward revisions to Chinese GDP has taken the wind out of the Australian economy.  The International Monetary Fund (IMF) cut their forecast for Chinese growth from 8% to 7.75% for 2013. HSBC and Barclays announced larger cuts in their projections and see Chinese growth at 7.4% rather than their previous estimates of 8.2% and 8.1% respectively for 2013. GDP forecast revisions of more than .5% tell us two things. First, economists aren’t great at forecasting when their margin of error is +/- 10% per quarter. Secondly, a .5% cut in Chinese GDP still leaves them in the enviable position of having the largest, strongest economy in the world.

The carry trade is based on borrowing cheap money from one country to buy assets in another country. The two primary components of a carry trade are the interest rate differential and the exchange rate between the two countries. The trade makes sense in a stable marketplace. Dollars borrowed in the United States at .25% are used to buy Australian treasuries yielding better than 3% and recently as high as 4.25%.  More importantly the Australian Dollar held its own throughout the global financial crisis. This made it a safe haven as the highly leveraged U.S. and Euro markets raced each other to the zero lower bound leaving Australia to benefit from both higher interest rates and currency appreciation. That’s a win/win in the carry trade.

The money that has poured into Australia can be seen in the rapid growth of their currency reserves. Foreign currencies were repatriated post haste during the financial crisis. Australia’s foreign exchange reserves declined from the all time high of more than $80 billion in May of 2007 down to $30 billion by January of 2008. Australia’s current reserves haven’t been this high since June of last year. June of 2012 also marks the low point for their currency in the last year.

The macro issues surrounding the global currency wars are beyond the scope of my day-to-day trading. However, the knee jerk response in the global currency wars due to Ben Bernanke’s suggestion that the Fed may begin to taper off the Quantitative Easing programs combined with the volatility in the Asian currencies and stock markets has created an overly bearish situation in the Australian Dollar. Their healthy balance sheet, excess foreign reserves and primary business of raw material and agricultural exports places them in a position to control the fortunes of their own currency, stock market and economy as a whole. They still have all the tools that we’ve already used to fight an economic downturn of their own. In fact, I’d say they’re holding a full clip while here in the U.S. we’re hoping we can pull back just long enough to reload. Therefore, the current prognosis lies in favor of a higher Australian Dollar going forward.

The commercial traders are well aware of the situation and they’ve been on a torrid buying spree in the Australian Dollar. In fact, they started buying in earnest once the Australian traded down to par (even money) with the U.S. Dollar, nearly doubling their net position over the last six weeks. We believe that the heavy commercial buying will cause the sell off to grind to a halt and protect us from much more downside risk. Therefore, we’ll be buying the Aussie as soon as we get some type of early technical reversal to trigger our long trade. We will then place a protective sell stop underneath the low for this move. Based on the current ranges and swings, we would expect to take profits between $.9750 and par to the U.S. Dollar.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Effects of Deflating the Yen

The Japanese economy has been on life support since their stock market peaked in late 1989. This is also when they began to lose their productivity gains in manufacturing and technology against their neighbors. Their immigration policy and small family sizes have shrunken the labor pool to a point that even with consistent per capita GDP growth, they continue to fall behind fiscally. Their new Prime Minister, Shinzo Abe is attacking deflation in Japan in a way that makes Ben Bernanke look like a spendthrift. The obvious objective of deflating the currency is to make Japanese exports cheaper on the open market. This will grow GDP and spur new hiring thus, improving the domestic Japanese economy. The big questions are, how long can currency depreciation boost their economy, what are the side effects and lastly, will it work?

Japan is an interesting country in that they are a manufacturing country with very little in the way of raw materials or commodities to use in the production process. Therefore, Japan must import virtually, all of the raw materials they use. They’re becoming a high tech assembly country as opposed to their classic vertical production model. Their days of making the steel that goes into the car is over and so are many of the old jobs. It has become cheaper to import Chinese steel than to make it their selves. Currency depreciation will provide an initial rise in Japanese exports, as the inventory that has already been produced will be cheaper on the open market. However, these gains will be offset by newly purchased production inputs paid for in depreciated Yen.

The export market has been the key to Japan’s post WW2 growth. In fact, Japan’s balance of trade (exports-imports) had been mostly positive for 25 years before the tsunami hit in March of 2011. Prior to the Tsunami, Japan generated about 30% of its energy from nuclear power. They are currently running only 3 nuclear reactors out of 54. Manufacturing countries require large energy inputs and Japan uses more than 25% of their gross revenues to import energy and they are third in global crude oil consumption and imports. Depreciating the Yen will severely impact their energy costs. For example, the Yen has declined by 30% since November. That would be the equivalent of paying around $5.00 per gallon of gasoline, right now. This is what Japan will be paying to fuel their manufacturing centers.

This leads us to the effects of a depreciating currency on the local population. The Japanese private citizens are the ones bearing the brunt of this policy in two ways. First of all, Japanese citizens will be forced to pay more for everything that isn’t locally sourced and produced. This will trim their discretionary spending and put a crimp in local small businesses and service providers. Getting less for your money is never enjoyable. Secondly, the individual Japanese citizens are paying for the currency depreciation because the there is no international market for Japanese bonds selling at artificially low rates. The Japanese government is forcing their citizens with historically high savings to use it to buy underpriced Japanese Government Bonds. This transfers the debt from the government to the taxpayer.

I have no idea why the Japanese people haven’t revolted. I’m sure much of it has to do with culture. We tend to speak out in protest while they tend to tow the party line. It will be very interesting to see how this turns out as pensions go unfunded and taxes rise to pay for the massive social programs Prime Minister Abe has in store. Japan’s total debt (public + private) is now more than 500% of GDP according to The Economist (9/19/2012). The U.S. total debt to GDP ratio ranks 7th in the world at just under 300%.

The massive devaluation that is taking place will allow Japan to gain market share in the short term, especially against high quality German manufacturers. Continuation of this policy will put the European Union in a very uncomfortable spot. Germany is their economic leader and the country that would be hurt most in a competitive devaluation campaign. This may finally force the European Union to ease further in an attempt to remain competitive outside the Euro Zone. Easing euro Zone monetary policy may be the next link in the chain as the race to the currency bottom heats up. Finally, the pundits have coined a new phrase to help the guy on the street differentiate currency wars from fiscal policy. Welcome to, “coordinated global easing.”

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Cyprus Citizens vs. Russian Oligarchs

Cyprus has found its way into the epicenter of the European debt crisis by forcing their government to publicly choose whether they’re on the side of their citizens or whether they’ll side with billions of Rubles. It’s been several months since we’ve discussed the European debt crisis, which has now been brought to the fore by tiny little Cyprus. This little island in the Mediterranean is home to about 1.2 million people and sits on about 3,500 square miles. This makes its population smaller than Dallas and San Diego and slightly larger than San Jose or, Jacksonville while physically it fits between Rhode Island and Delaware.

Cyprus joined the European Union in 2004 amidst reports that Cyprus is primarily a money laundering country used mostly by Russians. Der Spiegel, a German newspaper, published a lengthy article in January based on an investigation by Germany’s Federal Intelligence Service regarding the degree of money laundering in Cyprus. The report found that more than $26 billion of the $80 billion that flowed out of Russia in 2011 ended up in Cypriot banks. The $26 billion that found its way into Cyprus is greater than their entire annual GDP.

The issue that Cyprus faces is that their role as a financial services hub has been severely hampered by the economic collapse of 2008. This has been made worse by the low tax rates and favorable corporate regulations that were used as incentives to attract capital in the first place. Therefore, Cyprus is stuck with the compounded slowdown of a declining economic base due to increased regulation along with a declining domestic tax base. The final blow to the Cypriot banking system is due to the failure of their banks’ investments in Greece.

The Cyprus government is now left with the unenviable task of finding a balance between its residents and the appeasement of its Russian investors. Current proposals suggest sharing the load between the Cypriot citizens and the Russian oligarchs. The European troika, (European Safety Mechanism, European Central Bank and the International Monetary Fund) wants Cyprus to come up with matching funds to bail them out.

The original proposal would have taxed bank accounts under $100,000 6.75% and accounts over $100,000 9.9%. The second proposal has several splits including removing the protection on deposits over $100,000 and taking the money from over funded accounts most likely held by Russian businesses. The downside, according to JP Morgan is that this would cost investors about 15% of their funds above $100,000. The third option is to split the costs of the failing banks by charging  3% on accounts less than $100,000, 10% on accounts between $100,000 – $500,000 and 15% on accounts above $500,000.

These are all logical solutions to an illogical problem that must be addressed by our societies as a whole. We’ve been discussing the flight of capital and capital will always flow towards the greatest possible potential. Cypriot corporate tax rates are half of the Russian rates and their capital gains taxes are even friendlier. The policies that have been put in place to attract capital come at the expense of those with no capital to spare. These morals are not tied to foreign capital and money laundering; they’re based on the collusion and graft of the people making the rules. Unfortunately, those of us with no voice will be expected to pay their share when things turn south.

Cyprus has seen its banks closed for days. There could be a run on the banks but I don’t think there will be. The billions of Rubles that flow through Cyprus will provide enough grease to absorb the bad debts on Grecian investments. Russia has no desire to see the back door closed. There will be a battle between transparency to the general public and the Great Oz who will do everything they can to ensure business as usual, regardless of the income source or destination of profits.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Jumpstarting the Japanese Economy

The Japanese economy has languished in a deflationary environment for years. The recent Parliamentary elections have ushered in the potential for major shifts in policy, both ideologically and practically speaking. The election of Shinzo Abe as the new Prime Minister and overwhelming support for his Liberal Democratic Party will allow the new regime to control both the upper and lower houses. Therefore, no bargains or watered down policy will need to be struck. The sweeping results are a clear statement by the Japanese people that they expect action to be taken to loosen the money supply, inflate the economy and devalue the Yen.

Japan’s economy is roughly 1/4th the size of ours and places them as the fourth largest economy in the world. Therefore, full-scale policy shifts are rare and require a good bit of fortunate timing to implement. There are enough pieces in place to see more unilateral action by Japan as Mr. Abe focuses on the immediate needs of his people rather than finding the right political fit for Japan within the global political dynamic.

Deflation has been the key to the Japanese economy since the late nineties. Over the last 13 years they’ve recorded two inflationary years – 2006 and 2008. Mr. Abe wants to target new inflation and growth targets of 2% and 3%, respectively. Japan hasn’t recorded inflation above 2% annually since 1991. He expects to reach these goals through pressuring the Bank of Japan to loosen lending requirements and purchasing construction bonds for public works projects as their own method of Quantitative Easing. He also expects to include the first steps of domestic military spending to assert their claim to islands in the South China Sea as well as domestic pork barrel subsidies and governmental contracts to boost domestic GDP and help bring them out of recession.

However, considering that Japan already has one of the highest debt to GDP ratios in the world, ranking only behind Zimbabwe, Mr. Abe’s intentions are being watched closely by the credit agencies who already have Japan in a negative watch position and susceptible to further outright credit downgrades. Currently, Moody’s and Standard & Poors rate Japanese debt as equally trustworthy as countries like Chile, Macau and Bermuda. These are drops in the bucket compared to the weight the Japanese economy brings to bear on world trade. Fitch is the only rating company still holding Japanese credit at A+.

Inflating the economy by selling government treasuries is also designed to devalue the Yen against the major world currencies and help fuel their export dependent economy. The Yen has strengthened considerably over the last few years trading from a low of 115 Yen to the U.S. Dollar in July of 2007 to as high as 75 Yen per Dollar this time last year. Currently, the Yen is trading around 84 Yen to the Dollar. Japan is the second largest holder of U.S. Dollar reserves behind only China. Therefore, it could require a tidal wave of selling to make a dent in their $1.25 trillion in U.S. Dollar reserves.

The trading scenario is the mirror image of, “Don’t fight the Fed.” Japan has the financial power Mr. Abe has the political power and the support of the Japanese people. This should manifest itself as cheaper Yen and higher yields on the Japanese Government Bonds. Therefore, I expect the 75 Yen per dollar high set last year to hold and would like to sell Yen at 80. Note that these quotes have been provided in the number of Yen per Dollar while CNBC and U.S. futures quotes will show the inverse, which is what percentage of a Dollar will one Yen buy. Currently, one Yen will buy .00186 worth of a Dollar. Be careful to compare apples to apples when checking market prices.

The next big piece of this puzzle will be the inflationary effect on Japanese Government Bonds (JGB’s). The previous yield high was made in 2007 along with the bottom in the currency. The JGB reaction to the election announcement was swift. The futures have put in a full bearish reversal bar on the monthly chart. This is the first one we’ve seen in this market since June of 2003. Adding to the power of the reversal is the double top formed with the current high nearly matching the June ’03 high to the tick. Looking for places to sell Japanese Treasuries and currency as part of a long-term trade would be well advised as the timing and opportunity for real political and monetary change happens far less than the politicians would have us believe.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Global Glut Going Nowhere

The drop in gas prices over the last month has been a relief to us all. The economic sanctions placed by the European Union, Canada and the U.S. on Iran has simply shifted the flow of Iranian crude oil from west to east. The net result has been more oil on the global market with China, India and Russia picking up cheaper oil from Iran due to the lack of competition from western buyers. One would think that cheaper oil to the BRIC countries would be just the catalyst needed to help them develop their own internal demand for goods and services through the creation and evolution of their own middle class. Unfortunately, we are in an economic phase of global deleveraging and even the stimulus of low fuel prices will not keep their engines turning fast enough to save us from a second half slowdown here in the U.S.

The thesis of those who run our economy has been: If we can just provide enough economic grease to keep our own wheels turning the development of BRIC economies will, eventually, create demand for our goods and services. This is still probably true in the long run and the forward demand projection can be used to our advantage through tracking commercial trader purchases via the commitment of traders report. What a different world it has become when our economic horse has become hitched to someone else’s wagon.

China has been trying to engineer a soft landing for their economy through government expenditures on infrastructure and the attraction of foreign direct investment. The struggle can be seen in their manufacturing output, which has declined for seven straight months. They’ve also lowered their lending reserve requirement to stimulate financing which has dropped by 19% year over year and is at its slowest pace since Q1 of 2007. This may simply add further capacity to an already slack market in the wake of China’s 15-year building boom. This is also a futile attempt to increase home ownership, as home ownership is one of the few ways Chinese people have been allowed to invest their newfound prosperity and therefore, already represents an outsized portion of their personal portfolios. The Chinese result will sacrifice its citizens as the high water mark buyers and lead to further class separation between the builders who profited and the people who got stuck with the bill. This will leave them with little disposable income to buy our Apple computers and Fords.

The Chinese situation looks hopeful compared to India. The trouble in India is as much political as it is structural. Indian politics are confusing even to the Indian newspapers. It’s easy to go from the Times of India to India Press or any one of their nearly 2,000 daily publications and find contradictory information. Foreign businesses find it nearly impossible to find the right agencies for the right permits. Even if one does, it is quite possible that the rules will not only change but, be made retroactive thus, invalidating the entire business plan of the entity that just put the whole package together. This is exactly what happened to Wal-Mart between December of 2011 and February of this year. Permits were voided and taxes created by the new policy were made retroactive. Foreign direct investment is drying up rather than fighting its way through the bureaucratic red tape.

This still leaves Brazil and Russia to save us. Brazil just passed England to become the sixth largest global economy. However, Brazil’s balance of trade slipped into negative territory early this year for the first time since the economic crisis and once again ten years prior to that. Furthermore, their latest GDP readings were just positive enough, 0.34% to escape the technicality of recession. They are battling the decline by cutting interest rates for the seventh time in a row. This easing cycle has seen their rates decline by more than 400 basis points, including May’s cut.

Finally, Russia’s economy is shepherded by the fluctuations of natural resource prices on one hand and Vladimir Putin’s political inclinations on the other. The Russian shadow economy remains one of the largest physical cash exchanges in the world. The government recently limited official cash transactions to approximately $20,000 U.S.  Dollars. The political confusion has led to a flight of foreign capital out of the country. Putin’s sincerest desire seems to be the development of a quasi socialist Russia in which the natural resources are shipped abroad by governmentally monitored, semi state controlled companies. Putin then wants access to these revenues to fund his own programs and basically, become the Arab peninsula of natural resources while triangulating politically with Iran and China.

It doesn’t matter whose horse we hitch our wagons to if we’re all headed down the same path. The global balance sheet expansion experiment that hasn’t worked worth a darn in Japan is now being replicated in Europe just as it has been put to work here in the U.S. The world will pull through it and those countries that have been willing to make the tough choices, either through an enlightened electorate body or, the tight fisted hand of an autocratic leader will be the first ones to rebound. Our future, I’m afraid, looks more like the path of Japan’s lost generation than ever.

Austerity Rebellion

Far too many market events transpired this week to focus on any single event. The general consensus of the week’s events can be summed up as deflationary. Unfortunately, this bodes poorly for global economies and unravels the tenuous global grasp on a Greek default and European Union unrest. We’ll take a brief look at the Greek and French elections, their effect on deflation and social unrest and finish with three places to invest that should beat negative yield Treasuries and deflationary assets.Francois Hollande of the Socialist party, was elected as the next French President. He was widely expected to win and yet the realities of his policy intentions are just beginning to sink in. France has been the peacemaker in the European Union’s economic crisis between the austere and fiscally solvent Germans and the spendthrift southern European nations like Spain and Portugal. France is far from altruistic in their pursuit of bailout money. The fact is France is already at 85% debt to GDP and their balance of trade has been negative for 8 years. President elect Hollande understands that his nation is next and wants to ensure a bailout path for his own people. France is the 10th largest global economy and is too big to bail out economically and too entrenched in their ways to elicit any sympathy from the hard working Germans. President elect Hollande won the election on the basis of remaining French, which means increasing government expenditures. He is in favor of retaining the 35-hour workweek, returning retirement age to 60 and adding 60,000 government paid teachers. His Keynesian approach to the economy will not fly with the austere Germans.

Meanwhile, the Greek elections have led to complete rejection of austerity and economic reforms by its election of two primary winners from parties that have been peripheral parties for the last 40 years. Imagine a runoff here in the U.S. between Ron Paul and Ralph Nader and you’ll get an idea for how strongly the Greek people have rebelled against the two mainstream parties that have been the negotiators of their bailouts. The Greek people have thoroughly rejected the bailout parties leaving Germany’s Chancellor Angela Merkel to reiterate her position that Greece must make its budget targets or Germany will not allow the next bailout of 30 billion Euros to flow through in the next quarter. The Greek people would rather be broke and miserable by their own choice rather than broke and miserable under someone else’s thumb. Some estimate that there is now as much as a 75% chance that Greece will leave the Euro in the next 12 months.

The effect of the French and Greek elections has caused the U.S. equity markets to stumble and U.S. Treasury yields to hit historic lows. Currently, only the 30yr Treasury Bond offers a real rate of return above 0. Those moves have behaved in their normal relationship. Uncertain equity money moves to the safe haven of Treasuries. However, the behavior of other safe haven investments suggests much deeper economic concerns. Gold has begun to lose its status as a safe haven investment as it has declined more than 4% since the election results. We’ve also seen the currencies of commodity based countries fall relative to the U.S. Dollar. Previously, these declines have been buying opportunities as the liquidity that has been pumped into the global economy has been viewed as commodity inflationary.

This brings us to three places where money can be placed and be expected to hold its own and then some. First of all, the U.S. Dollar is going to benefit as the safe haven for the tremendous amounts of cash that get pulled from foreign equity and bond markets as the result of a disorderly Grecian default and an unraveling commitment to German austerity measures. Secondly, as people decide what to do with their money foreign denominated CD’s will become more favorable. For example, Australian Dollar CD’s can yield better than 2.5% and they’re one of the few countries that are both economically developed and debt free. Finally, there are still some supply and demand relationships in sugar, soybeans and platinum that should hold true without too much correlation to the global economic disaster. After all, economic depression has to be pretty serious before people stop putting syrup on their pancakes.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

The Bernanke Put – Euro Style

The Spanish debt auction proceeded in an orderly fashion
even as yields crept higher. The general consensus appears to be that Spain is
too big to fail. I would suggest that Spain might be too big to save. Spain is
the European Union’s fourth largest economy and 14th largest in the
world. Last week, their credit rating was lowered to BBB+ by the Standard &
Poor’s rating agency. This week, they announced that their GDP had contracted
by 0.3%. This quarter’s decline marked the beginning of Spain’s second recession
since 2009. Finally, the composition of their debt makes any positive economic
headway in the next few years nearly impossible.

The interest rate benchmark is the 10-year bond or note.
Spain saw full participation at yields of 5.82%. There are two important points
to be made here. First, the participation rate is measured by the bid to cover
ratio. It was quite a bit stronger than the last auction in March, coming in at
2.9 compared to 2.4 for the last auction. The second point is the yield of
5.82%. The alarm bells sound when Spanish debt yields hit 6% on the 10-year
note. That’s the magic number at which Spain can no longer afford to refinance
or, rollover the financing of their budget. Spanish yields have solid
resistance between 6.125% and 6.25%. They peaked at 6.625% in November 2011.

The International Monetary fund released a report on the
European Union and the global debt issues entitled, “Global Financial Stability
Report.” Spain’s BBB+ credit rating is three notches above junk status. According
to the IMF the probability of default on BBB+ credit has risen from 0.734% in
2007 to 6.05% at the end of 2011. I believe that the recent pitches by the
BRIC’s (Brazil, Russia, India and China) to contribute to the bailout funds and
push the total available reserves to $430 billion has been received by the
markets as restoring confidence, rather than preparing for financial
Armageddon.

Spain’s primary source of trouble is the bursting of a
housing boom bubble. Sound familiar? Here in America we struggled through the
economic crisis as unemployment peaked at 10%. Meanwhile, the number of homes
in foreclosure peaked at 8.12 million in January of 2010 and drove home values
here down approximately 25%. Spain’s unemployment rate is nearly 25% and close
to 50% for people under 25. The Spanish real estate boom put 80% of the
population in home ownership. Foreclosure rates are now topping 10% at some
banks and the unemployment situation is creating a death spiral. This is
leading to marked to market values on repossessed homes as much as 60% below
their peak. Marked to market values leave the repossessing bank with an
over leveraged asset and reduces their capital base further constricting their
economy.

Spanish banks packaged their loans for resale on the
commercial credit market as mortgage backed securities. These securities were
prime at the time of origination. However, as their economy has declined the
nonperformance of these loans has placed more of them in the default category.
Some of these mortgage pools now contain up to 14% of mortgages more than 90
days over due. The obvious conclusion is that many Spanish banks are in
trouble.

The European Central Bank and the IMF have teamed up to try
and save Spain from themselves. The Troubled Asset Relief Program (TARP)
committed $470 billion to U.S. banks and the auto industry in order to keep
people in their homes and on the job. The $430 billion that has been pledged to
save Spain will not be enough to cover the mortgage losses. Furthermore, the
average Spaniard’s primary asset is their home, which accounts for
approximately 80% of their net worth. The Spanish debt will be hard to spread
around.

This leads to the IMF report on national household
deleveraging within the constructs of a banking crisis, which found that the
deleveraging process trims an average of 1.45% of GDP. European corporations
are already hurting. The lowest levels of corporate credit have skyrocketed
from 2% of total corporate credit to almost 16% of total corporate credit in
the last 5yrs. How will the ECB decide which ones are worth saving and how will
Spain feel about relinquishing their sovereignty to the decisions of the ECB
and the IMF? Government has never been very successful at manipulating markets
over the long haul. I believe the bond auction was palliative only because
investors are certain the ECB will backstop their purchases just as we have
grown accustomed to the Bernanke Put here in the U.S. Finally, when government’s
lose control of the markets they have been manipulating, the disaster is
spectacular.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

End of the Metals Rally

The mineral and industrial metal commodities may be nearing the end of their decade long rally. I think a very good case can be made for the highs to be put in sometime in the next twelve months.   Political agendas and inaction should support the metal and mineral markets heading into next year. However declines in global demand, a slow down in infra structure creation, higher production taxes and the eventual global debt crisis will bring these trends to an end.

First of all, the supporting case comes from a global political cycle that is determined to maintain the status quo. Here in the U.S. QE 2 is set to end next week. Most of the money that went into this program that was designed to stimulate the economy never made it out the front door of the lending institutions that received it. The money was used to strengthen the banks’ internal lending reserves, rather than passing it on to the public at the low rates at which they received it. Therefore, the individuals and small businesses never received the assistance and won’t miss it when it ends. Furthermore, the debt ceiling, which has been kicked down the line until August will find a way of being raised, extended, supplemented, etc. Neither political party in the U.S. wants to be responsible for causing a governmental work stoppage or promoting an unpalatable solution in an election year.

Globally, support comes from both the European Union, determined to postpone the situation in Greece as long as possible as well as the coming Chinese elections. This most certainly means bigger problems down the road. Until then, these two will both keep throwing good money after bad in two of the largest economies in the world. Europe has no solution to the Greek debt problem and the Chinese leaders vying for President will keep their individually governed areas rolling in the fiscal stimulus and distorted GDP figures until after their elections in January of 2012.

Unfortunately, the headwinds facing the industrial metals and minerals markets have been gaining traction for quite some time and are far more widespread. The obvious follow up is the pending global slow down. The debt issues of Europe and the U.S. must be reckoned with. When this is combined with cutting Chinese building subsidies and severely raising the mining taxes in Africa and South America, the markets will be forced to absorb the excess capacity of the Chinese buildup in the face of declining profit margins at the mine.

Platinum, copper, and mineral mining have increasingly shifted to African countries. Many of these countries have not received the compensation from the development of these industries they had expected. Some of this is due to corporate accounting that kept revenues off the books. Let’s face it, if General Electric can avoid paying U.S. income tax like it did in 2010, it shouldn’t be too hard to assume that corporate accountants for multi-national mining companies can evade the tax collectors in third world economies like Tanzania, Zambia and Ghana. The local governments, feeling slighted after the metal and mineral price run up in 2008 are enacting much tougher tax laws and strengthening their central governments in order to nationalize (seize) assets that have underpaid. These actions are similar to state run South American enterprises and will make ownership of publicly traded companies less attractive.

Finally, there is no question that global liquidity is at an all time high. Currency depreciation will continue to influence the metal markets as investors look for a safe haven store of value. However, if governmentally stimulated demand dries up or if the sources are over taxed, we will be left with empty buildings and unemployed workers. This decline in demand will outpace the draw on warehouse stores and lead to a decline in prices as the global economy finally comes to terms with itself in 2012.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Over Priced Crude – Not Our Problem

The fall of dictators in North Africa and the refusal of others to leave has created a political mess throughout the oil producing regions. Tunisia, Egypt, Libya, Iran and others are all facing internal military conflicts. Some may turn into civil wars while others may squelch civil unrest through political concessions or direct government aid to their people. However, when it comes to the world’s supply of oil, the method of reconciliation isn’t nearly as noteworthy on the open markets as the fact that there are issues to reconcile in the first place. The era of instant press and relatively equal opportunity to generate information has created millions of on site reporters in the form of the common man producing cell phone videos, Tweets and Facebook networks.

The news has created an oil spike. The manic pursuit to grab the headlines has brought speculation in oil futures trading to new heights. Libya is responsible for 2% of global oil output. Egypt and Tunisia are irrelevant and Iran produces a sour crude of such low quality that they don’t have the domestic capabilities to refine it themselves and have to import 40% of their gasoline. Saudi Arabia has already broken ranks with OPEC and volunteered to increase output to appease the market and I wouldn’t be surprised if Obama tapped the strategic reserves.

There is a fundamental disconnect between the price of oil on the open markets and the fundamentals that move prices over the long term. The crude oil traded in the U.S. is typically referred to as West Texas Intermediate (WTI) while the oil that is produced and traded in the North Sea, Iran and Russia is Brent Crude. Brent crude is a lower quality crude that is both produced and consumed throughout Europe and Asia. WTI is easily refined and produced in the Gulf of Mexico, Alaska and the Black Tar Fields of Canada.

WTI crude oil is stored in Cushing, Oklahoma and the storage tanks are nearly full. Commercial traders of WTI strongly believe the market will not support these prices. In fact, they have accumulated a record short position. They have never sold so much of their future production at market prices as they are doing now. This is exactly opposite the of the Commodity Index Traders (CIT’s) and small speculators who have jumped on board the news events. History has shown that no one knows their market like the people who make their living in it. Therefore, it is not wise to bet against commercial traders for very long.

It is comforting to believe that the commercial traders may be right and that oil won’t stay at these levels for very long. However, Middle Eastern politics is a wild card game at best. The Schork Report states that we could have $4 gasoline with WTI crude trading at $115 per barrel. This is due to the refining and crack spread issues we discussed two weeks ago. Gas didn’t hit $4 in 2008 until oil traded over $145. This would have a serious effect on our economy. Ball State released a paper on January 21st, stating that GDP will decline by 2% if oil climbs to $110. Furthermore, 10 of the last 11 recessions accompanied rapidly rising oil prices.

It’s already been speculated that Obama may tap the strategic reserves to prevent higher energy prices from dragging down our struggling economy. Saudi Arabia isn’t the only oil exporter aware of the bearish fundamentals of the oil market and I suspect that other oil producing countries will sell all the forward production they can at these prices. I don’t expect energy inflation to dictate monetary policy. Ben Bernanke co-authored a paper in 1997 stating that the correlation between high energy prices and recessions had more to do with the over tightening of fiscal policy to clamp down on inflation than did the actual price of energy. Therefore, I don’t expect to see knee jerk rate hikes in response to the howls of inflation hawks.

Currently, the primary beneficiary overseas is Russia. They have the reserves, refining capacity and infrastructure to supply old world Europe and Asia. These are the areas most greatly affected. They are fully industrialized and their economies are heavily reliant on oil imports. The question we should be asking ourselves is why we spend between $50 and $100 billion a year to protect roughly $35 billion dollars worth of the oil we import. This amounts to the 15% of our total U.S. imports that come from the Golden Crescent. Two separate pools of academic research, nearly 10 years apart, 1997 and 2006, have addressed this issue and gone nearly unnoticed. Why is it that we pay the bill to keep the oil flowing overseas to other countries?

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.