Oct 31

King Dollar in a Bull Market

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But change your goggles and hey! Commodities in AUD not too bad…!
 

BORING as it sounds, I want to talk a bit about the end of US QE today, writes Greg Canavan in The Daily Reckoning Australia.
 
Because it’s very important to how markets are going to behave over the next few months.
 
As you probably know, yesterday the US Federal Reserve voted to end its policy of quantitative easing. But it will still be reinvesting the interest payments from its $4 trillion plus portfolio and rolling over any maturing treasury securities, so it’s balance sheet will continue to grow, albeit much more slowly.
 
On the surface, US markets didn’t seem too fussed about the end of an era. Shares sold off around the time of the Fed’s statement and then rallied towards the close. Probably a case of “algo’s going wild” as automated high frequency traders tried to make sense of the Fed’s statement.
 
And the Fed did its usual job of promising to hold rates as low as they possibly could, which markets seemed happy enough with.
 
But the real action took place under the surface. That is, the US Dollar spiked higher again. This is an important point because when the US Dollar rallies, it usually signifies tightening global liquidity.
 
Think of it as liquidity returning to the source (US capital markets) and drying up…or disappearing. That’s certainly what has been happening these past few months. Since bottoming in May, the US Dollar index (which measures the greenback’s performance against a basket of currencies) has increased by nearly 9%.
 
That might not sound like a huge spike, but in the world of currency movements, it is. Imagine if you’re an exporter and your product just became 9% more expensive…chances are it will lead to a drop in sales as customers look for a cheaper substitute.
 
This is the problem with the end of QE. It leads to liquidity evaporation as ‘punt money’ returns home…which leads to a strengthening US Dollar…which hurts sales of US multinationals.
 
It’s not going to happen right away though. Most companies have hedging strategies in place that protect them from sharp moves in the FX markets. But if Dollar strength persists…and the chart above says that it will, then you’ll see the strong Dollar hitting companies’ revenue line in the coming quarterly reports.
 
Not only that, but the evaporation of liquidity in general could lead to another bout of selling across global markets. QE is all about providing confidence. Liquidity is synonymous with confidence. Take it away and you’ll see the mood of the market change.
 
Getting back to the Dollar strength…it’s a headache for Australia too. It’s smashing the iron ore price, and the Aussie Dollar isn’t falling fast enough to keep up. In terms of the other commodities though, things aren’t quite so bad.
 
All you seem to hear lately is negative news about commodities. That’s because the world prices commodities in US Dollars, and as you’ve seen, the US Dollar is a picture of strength. But if you look at commodity prices in terms of Aussie Dollars, things look a little better.
 
The chart below shows the CRB commodity index, denominated in Australian Dollars. It’s a weekly chart over the past five years. And y’know what…it doesn’t look that bad! Since bottoming in 2012, it’s made considerable progress in heading back to the 2011 highs.
 
But you’ll want to see it start to bottom around these levels. If it doesn’t, prices could head much lower.
 
 
The thing to note about this chart is that it doesn’t include the bulk commodities – iron ore and coal. These commodities tend to dominate the headlines in Australia. Things like nickel, tin, copper and oil don’t get much of a look in.
 
Which reminds me, in case you missed it, Diggers and Drillers analyst Jason Stevenson recently released a report on some small Aussie oil ‘wildcatters’. With the oil price low, now could be a good time to sniff around the sector.
 
You could say that about commodities across the board. In the space of a few years, they’ve gone from hero to zero…or the penthouse to the…
 
That usually means there could be some good value around. One thing you need to look for in the current environment is a decent demand/supply dynamic. Iron ore in particular is heading towards massive oversupply next year. I reckon that makes it a poor investment choice for the next few years.
 
You’re better off to wait until the China slowdown and supply surge knocks out the juniors and all the marginal producers….leaving the market to BHP and Rio. You’ll then probably be able to pick these mining giants up at much lower levels.
 
Once you find a commodity with good supply/demand fundamentals, you need to make sure the producer is low cost. That protects it against further price falls…or a rise in the Australian Dollar.
 
It also protects it against foreign competition. One of the issues with the Aussie resources sector in recent years is costs. Other countries have much cheaper capital and labour costs and can therefore get stuff out of the ground cheaper than us.
 
That brings me to a final issue: Australia doesn’t really invest in its own resource sector. Via superannuation, we have a huge pool of capital. But this mostly goes into the banks or the major miners. Superannuation capital is not high risk capital.
 
That means a lot of the capital that flows into the resource sector is foreign. And when global financial conditions change…like the end of QE and the strengthening of the US Dollar…that capital departs.
 
This will create problems and opportunities for the sector. But given the bearishness towards commodities in general, it’s probably time to start getting interested again.
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Oct 20

The Fed Spots Inequality, Misses the Point

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Janet Yellen says US inequality is worse than any time since, umm, the Fed was created…
 

IT DIDN’T take long did it? asks Greg Canavan in The Daily Reckoning Australia.
 
Now the Bank of England, the Federal Reserve’s old partner in crime, is at it too. On Friday, the BoE’s chief economist, Andy Haldane, said he favoured delaying interest rate rises in the United Kingdom.
 
That, along with comments from the Fed’s James Bullard on Thursday, helped global markets to rally late last week. It’s having a nice effect on our market so far today too. It was just as well. The situation looked extremely dicey on Wednesday.
 
Given US markets haven’t even had a 10% correction, the coordinated comments have a whiff of panic about them. What…can’t markets even have a half-decent correction these days without central bankers wetting themselves in panic?
 
While the minions were trying to hold things together late last week, boss Janet Yellen was inadvertently making a pretty decent argument to end the Federal Reserve altogether. She just didn’t know it.
 
In a speech on ‘economic opportunity and inequality’ in Boston on Friday, Yellen came out with some clangers. Unfortunately, most observers missed the irony of some of her comments.
 
Yellen drew heavily on data collated from the Fed’s Survey of Consumer Finances, which began back in 1989. Take it away, Janet…
“By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then.”
Hmmm…the past 100 years you say? The Federal Reserve came into being in 1913. A coincidence, do you think?
 
Not convinced? Give us some more stats then, Janet…
“After adjusting for inflation, the average income of the top 5% of households grew by 38% from 1989 to 2013. By comparison, the average real income of the other 95% of households grew less than 10%.
 
“The lower half of households by wealth held just 3% of wealth in 1989 and only 1% in 2013.”
That’s interesting. Go on…
“The average net worth of the lower half of the distribution, representing 62 million households, was $11,000 in 2013. About one-fourth of these families reported zero wealth or negative net worth, and a significant fraction of those said they were ‘underwater’ on their home mortgages, owing more than the value of the home. This $11,000 average is 50% lower than the average wealth of the lower half of families in 1989, adjusted for inflation.”
Wow! The average net worth of 62 million US households is just $11,000…half of what it was back in 1989, despite 25 years of (mostly) economic growth?
 
Is it another coincidence that just two years before 1989 the Federal Reserve embarked on a policy of full-blown central banking activism? In 1987, Alan Greenspan had just taken the helm from the last great central banker, Paul Volcker, when ‘Black Monday’ hit, on the 19th of October (nearly 27 years ago to the day).
 
Greenspan panicked. He promised the market liquidity and support and whatever else he could. The Fed hasn’t looked back since. From that day on, it’s been the market’s socialist tormentor and benefactor…creating crises and then trying to solve them by throwing money at the problem.
 
And where does the money end up? In the hands of the already relatively well-off, which is why Janet Yellen’s statistics look so horrible.
 
The irony of a new Fed Chief pointing all this out is particularly…rich. Actually, it’s nauseating. If you didn’t know any better you’d think she was actually having a laugh. It’s either ingenuous or the work of the devil.
 
In truth, I think it’s genuinely ingenuous on Yellen’s behalf. You don’t set out to become the world’s biggest do-gooder by being a hard-nosed realist.
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Oct 16

What the Panic’s All About

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Stock markets are sinking for nothing. And everything…
 

As RON BURGUNDY said in Anchorman, writes Greg Canavan in The Daily Reckoning Australia, “Boy…that escalated quickly. I mean that really got out of hand fast.”
 
Indeed it did. It was a wild night of trading on US markets Wednesday. The S&P500 was down 3% at one point, before finishing just 0.8% lower. US Treasury yields plunged on fears of lower economic growth while gold momentarily surged $25 an ounce and closed out the session up nearly $20 an ounce.
 
An afternoon rally saved Wall Street. Apparently – and this is really pathetic if there’s any truth to it – rumours surfaced that Janet Yellen thought the US recovery was on track, despite worries coming from Europe.
 
There were no such comments from Mario Draghi in Europe. As a result, European stocks took a beating. French and Spanish stocks fell more than 3.5%, while German and British bourses fell nearly 3%. But the rally in the US came after Europe closed for the day.
 
So what’s all the panic about? Nothing in particular, it seems. Or nothing and everything, all at once.
 
These panic liquidations represent a psychological shift in trader positioning. It’s representative of complacency giving way to risk aversion. And it has given way big time in the past few weeks.
 
You can see this change in the volatility index, the ‘VIX’, in the chart below. Also known as the fear index, you can clearly see the ‘fear spike’ since the start of October. This comes just a few months after volatility levels were the lowest since early 2007.
 
 
In other words, something has clearly changed in the mindset of the market. In the short term, it’s probably gone too far…and you can expect to see a rally soon and a diminishment of the current high levels of fear.
 
But you should take the surge seriously. This is the highest level of fear since the Euro crisis of 2011. Except now there’s no discernible crisis. That’s the worrying bit. The market is saying that something is wrong. It’s not immediately apparent, but something isn’t quite right.
 
Maybe it’s fear of the effects of a slowing global economy…an economy that has a truckload more debt weighing on it than it did before the last downturn. The Telegraph in the UK reports:
“Morgan Stanley calculates that gross global leverage has risen from $105 trillion to $150 trillion since 2007. Debt has risen to 275pc of GDP in the rich world, and to 175pc in emerging markets. Both are up 20 percentage points since 2007, and both are historic records.”
Yep, debt levels are a major problem. And they become a very big problem when economic growth slows. That’s because to service debt, you need to generate growth.
 
When growth stagnates or falls, the debt servicing burden becomes a problem. Debt-to-GDP ratios rise and there is less money left over in the economy for investment, wages and consumption.
 
Debt, especially unproductive government debt, has detrimental long term effects on an economy. Let it grow large enough and it will eventually choke an economy into recession/depression.
 
That the only apparent response to a slowdown in a debt-based monetary system is to increase debt levels tells you something is seriously wrong with the world’s system of ‘wealth creation’.
 
The only question now is how long it will take the Federal Reserve to start back-tracking on its ‘interest rate hike for 2015’ talk. After they do that, I wouldn’t be surprised to see them dip into the QE playbook…again. The big question though, it whether it will be too late to inject another round of confidence into the speculating community.
 
They’re wheeling Janet Yellen out to speak at the end of the week, so we may get an idea of just what the Fed is thinking. Yellen must be careful to retain the market’s confidence. That the US Federal Reserve has no idea what it’s doing is beside the point. What’s important is that the market thinks the Fed knows what it’s doing.
 
Yellen must keep this con game going at all costs. Good luck with that. When you’ve got a bunch of panicked, slobbering trader yahoos in your face desperate for some sign that you’ve got it all under control, any minor slip-up can be dangerous.
 
When traders panic, liquidity disappears in the blink of an eye. That’s because confidence creates liquidity, and fear destroys it. And right now it’s the fear of huge debt levels consuming economies that is weighing on traders’ minds.
 
Why it’s happening right now, when the issue has been around for a while, is irrelevant. The important point is that the punters are beginning to wake up to the risks. The only question is how much longer the Fed can continue to pull the wool over everyone’s eyes.
 
Can another bout of QE do the job for another six or 12 months?
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Sep 16

The Most Important Chart Right Now

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Dollar up, everything down. And the end of QE means it probably isn’t done yet…
 

I WANT to show you the most important chart in the investing world right now. It’s affecting the price of just about everything else, writes Greg Canavan in The Daily Reckoning Australia.
 
If the United States’ superpower status is on the decline, you wouldn’t know it by looking at the chart below – the US Dollar index. As you can see, it’s moved sharply higher over the past few months.
 
The momentum indicators at the top and bottom of the chart are severely ‘overbought’, and the index itself is well above the moving averages. This suggests a correction is imminent, but for now, everything denominated in US Dollars is weak.
 
 
The Aussie Dollar, gold, copper, oil and most other commodities have all been under pressure lately. And it’s why share markets around the world are struggling to push mindlessly higher…as they’ve been doing ever since late 2012 when Ben Bernanke and Co. got jiggy with it on the QE front.
 
But next month, it all changes. For a short time at least, global share markets will experience life without Federal Reserve QE for the first time since 2011.
 
In short, the market is having another ‘taper tantrum’ as the end of QE draws closer. The last such episode was back in June 2013. As you can see in the chart above, that was when the US Dollar last spiked to its current level.
 
Being the world’s reserve currency, US monetary policy is essentially global monetary policy. As the US Federal Reservewinds down QE, you can see the knock on effects starting to emerge.
 
US Dollar strength is just the most notable. Its strength since bottoming in May this year indicates tightening global liquidity. But until recently, the effects of this haven’t been all that obvious.
 
Emerging markets are usually most vulnerable to a strengthening Dollar. But that vulnerability only began to show in the past week or so, as you can see in the emerging markets index chart below…
 
 
Emerging markets rallied to new highs this year despite the strengthening Dollar. Until recently that is – when sharp falls took place, especially in markets like Turkey and Brazil. The Bank for International Settlements warned in its just-released quarterly report that these markets are particularly vulnerable because of increased US Dollar borrowing over the past few years.
 
As you know, borrowing in a strong currency while revenues and earnings are in a weaker currency doesn’t usually work out well. It places greater pressure on a company to service its debts, leaving less left over for shareholders.
 
You’ll have to wait and see whether emerging market resilience can continue, or whether the end of QE will finally have a more definitive impact on these peripheral economies.
 
I don’t know what the outcome will be. But I can say that markets often ignore issues for months on end and then all of a sudden worry about them acutely. Maybe this is just the start of an intense worry phase.
 
Whatever it is, Australia is a part of it. Our stock market and currency are under the pump, thanks to weaker commodities and a weaker iron ore price in particular. That, in turn, is because of a slowing Chinese economy, which, as it turns out, imports US monetary policy through a partially pegged exchange rate.
 
The US Dollar’s tentacles have a wide reach. And it touched China on the weekend with the Middle Kingdom announcing weaker than expected industrial production, fixed asset investment and retail sales growth.
 
The slowdown comes amid a deteriorating property market in China, which for years was the engine of growth for the country. But that engine is sputtering as China’s leaders grapple with trying to rebalance the economy without crashing it. It’s a tough task.
 
Which is why you can expect to hear calls for ‘more stimulus’ from China grow louder this week, because ‘more stimulus’ always works. If only we had done ‘more stimulus’ sooner rather than later, we’d not be in the position of needing ‘more stimulus’ now.
 
Economics really is that simple. Money may not grow on trees but it does lay dormant and abundant inside the computers of our heroic central bankers. (In case you need me to say it, yes…I’m being sarcastic.)
 
For that reason, all eyes will be on the Federal Reserve this week. They gather for a two-day meeting on the 16th and 17th, and boss Janet Yellen gets a chance to move markets with an accompanying press conference at the conclusion of the meeting.
 
Usually, the Federal Reserve provides soothing words about how interest rates won’t go up for ages and everyone can keep punting without any need to worry. That’s worked well for the past few years.
 
But the time is approaching where the Fed will actually start having to do something on the interest rate front. Or at least they’ll have to stop pretending they’ll keep interest rates low forever.
 
In other words, there are fewer rabbits in the hat. Or maybe there are no rabbits left at all?
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Sep 02

Too Much Debt

Gold Price Comments Off on Too Much Debt
Beijing, like Western central banks, can’t force more borrowing on the private sector…
 

CHINA’s policy makers might be able to turn to stimulus when the economy slows, writes Greg Canavan in The Daily Reckoning Australia, but they can’t fire up people’s ‘animal spirits’.
 
Once investor or consumer psychology changes, it generally changes for a while, regardless of official attempts to revive it.
 
And there is increasing evidence in China that housing may not be the great wealth generating investment that all and sundry once thought it was. Protesting property owners and developers dumping inventory are early examples.
 
When it comes to the real economy (not just in China but in much of the developed world) animal spirits are pretty much non-existent. Yet when it comes to financial markets, animal spirits are alive and well. Rabid, almost.
 
The irony is that monetary policy is the root cause of both raging and flagging animal spirits. Let me start with a comment that RBA boss Glenn Stevens made on the issue in a speech last month:
“But the thing that is most needed now is something monetary policy can’t directly cause: more of the sort of ‘animal spirits’ needed to support an expansion of the stock of existing assets (outside the mining sector), not just a re-pricing of existing assets.”
Stevens is saying that monetary policy can’t encourage people to “support an expansion of the stock of existing assets.” I would certainly agree with that. What Stevens didn’t (and wouldn’t) say, is why monetary policy is to blame.
 
What fires up the entrepreneur or the capitalist is an idea to satisfy demand coupled with the prospect of generating a decent return from turning the idea into reality. But when it comes to investing in the real economy, the prospect of making decent returns (given the risk taken on) isn’t overly compelling right now.
 
That’s why companies continue to focus on returning profits to shareholders via dividends and share buy backs, rather than investing in plants and equipment or research and development.
Financial market returns are much more compelling (and easier) than real world returns.
 
So real world animal spirits remain subdued because the prospect of a decent return on capital is low. Why is that? Well, since the 2008 crisis, economic growth has been sluggish and prospects remain weak.
 
Okay, so why is that? This gets to the heart of the problem. Too much debt!
 
Debt is simply future consumption brought forward. The presence of such a huge amount of debt inhabiting the global financial system tells you that much of today’s ‘missing’ consumption already happened…yesterday and the day before.
 
That’s why there’s a lack of ‘animal spirits’. The animals inherently know there’s not a lot of food out there, so they’re not going to expend a huge amount of energy looking for it. Monetary or fiscal policy isn’t going to provide the food; it can only make the path to it easier once it’s there.
 
And this is the problem with today’s monetary policy. It thinks the answer to low growth is to encourage more debt and spending. In other words, it wants to keep dragging consumption from the far distant future all the way into today.
 
It’s such a stupidly idiotic policy that it’s hard to believe that people seriously think it will work. The very reason for the absence of animal spirits is because of too much debt, yet the response is to try and increase the debt load!
 
I’m not just making this stuff up about animal spirits and debt. I researched the topic in depth for the last issue of Sound Money. Sound Investments, drawing on the work of long dead economists Knut Wicksell and Ludwig von Mises.
 
They’re not too popular these days, mainly because their theories don’t accord with modern day central banking. But their ideas are well worth your time and contemplation, because they accurately explain the world’s current economic woes.
 
So let’s turn to Wicksell first. His biggest insight was to come up with a concept called the ‘natural rate of interest’…that mysterious rate of interest that balanced out the needs of savers and borrowers and produced an economic equilibrium.
 
In more technical terms, Wicksell’s natural rate corresponds roughly to the aggregate return on capital in an economy…or to be more precise, the return on additional capital invested.
 
When the natural rate is high, it should bring out people’s animal spirits as they look to take advantage of high rates of return. When low, the animals hibernate.
 
That it’s low now is obvious. And Ludwig von Mises tells us why. He said that the natural rate of interest (he called it ‘originary’ interest) was all about consumer preferences. That is, when people preferred to borrow and consume now, the natural rate would be relatively high. But when people preferred to save and not borrow so much, the natural rate would be low.
 
In theory, the natural rate would fluctuate as consumers’ preferences changed – that is, as they took on debt (leverage) and then paid it down (deleverage). Allowing consumer preferences to ebb and flow naturally would keep the economy in balance over a cycle.
 
But throw modern day central banks into the mix and you get a never ending debt boom. There is no deleveraging or debt reduction in such a situation, because the whole aim of central bankers is to keep the party going.
 
If you judge them on that basis, they’ve done a great job. But they are now coming up against some hard obstacles.
 
First, the natural rate appears to be so low that it’s impeding economic growth. That’s why the ‘recovery’ remains elusive. This makes sense because, after you take on a certain amount of debt, you’re progressively less inclined to take on more. Your preferences change from debt accumulation to debt repayment.
 
After 30 or so years of debt accumulation, the developed world is clearly close to its limits. The normal channel to fire up animal spirits following an economic slowdown is to lower market rates of interest below the natural rate. This provides an economic incentive to invest.
 
That today’s ‘low’ rates aren’t doing this tells you that the natural rate must be very low indeed. So central banks can do all they want to try to encourage borrowing and spending, but if they can’t get market rates below the natural rate, they simply won’t succeed.
 
Meanwhile, over in the financial markets, punters love the cheap money on offer. While central bankers can’t make real investment happen, they are certainly encouraging speculative investment in the financial economy.
 
The real and financial economy can’t keep going their separate ways however. While they look to be doing their own thing, they still feed off each other.
 
That’s why the market greets ‘goldilocks’ data (not too bad, not too good) with applause, because it means no hike in interest rates, and no threat of recession.
 
It’s an unhealthy equilibrium, and certainly not one that can persist. Given the very low natural rate of interest, the developed world seems to be labouring under, my guess is that a recession is a more likely outcome than a rapid growth scenario.
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Aug 03

War Coming in Europe

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So says a Moscow insider dismissing the $50bn Yukos Oil fine…
 

ONE HUNDRED years ago a feisty little Bosnian Serb, Gavrilo Princip, shot and killed the Archduke of Austria, Franz Ferdinand, and his wife Sophie in the city of Sarajevo, writes Greg Canavan in The Daily Reckoning Australia.
 
It was the “shot that rang out across the world”. A month later, the world was at war.
 
While historians have subsequently shown that the war was a long time coming – the result of rising imperialism of the great powers and the faltering old Austro Hungarian and Ottoman Empires – no one saw it at the time.
 
Take this contemporary account from Austrian novelist and playwright, Stefan Zweig, recounted in his memoir, The World of Yesterday. In the days following the assassination, Zweig was holidaying in the Belgian seaside resort of Le Coq…
“The happy vacationists lay under their coloured tents on the beach or went in bathing, children were flying kites, and the young people were dancing in front of the cafes on the digue (a bank or dike). All nationalities were peaceably assembled together, and one heard a good deal of German in particular…The only disturbance came from the newsboy who, to stimulate business, shouted the threatening captions in the Parisian papers: L’Autriche provoque la Russie, L’Allemange prepare la mobilisation.
 
“We could see the faces of those who bought copies grow gloomy, but only for a few minutes. After all, we had been familiar with these diplomatic conflicts for years; they were always happily settled at the last minute, before things grew too serious. Why not this time as well? A half hour later, one saw the same people splashing about in the water, the kites soared aloft, the gulls fluttered about and the sun laughed warm and clear over the peaceful land.”
Within a few days, Belgian soldiers arrived on the beach, with machine guns and dogs pulling carts. Then Austria declared war on Serbia. The resort town become deserted. Zweig quickly booked a train back to Austria.
 
Early in the journey, the train stopped in the middle of an open field. It was dark, but Zweig saw freight trains – open cars covered with tarpaulins – heading in the opposite direction. They were full of German artillery heading for Belgium. The war was underway.
 
What’s the point of recounting this story? Well, there’s the regional conflict in Ukraine that’s heating up. But the main point is that no one knows what the future holds.
 
In early 1914, the (Western) world had experienced a long period of economic expansion and freedom. Zweig travelled freely around the world without needing a passport or ‘papers’. Capital and labour mobility were high. There was virtually no income tax (nor was there a welfare state), the Federal Reserve had only just come into existence, and government involvement in all areas of life was minimal.
 
But that all changed with the Great War. It led to the rise of larger governments, the welfare state, and the unions. It led to greater state control of financial markets and it led to systematic inflation.
 
The world changed massively in 1914, and no one at the time would have picked the direction it was heading. Even after the war started, the general consensus was that it would be over by Christmas. As it turned out, it endured nearly to Christmas 1918.
 
These days, people seem pretty certain that the Fed has things under control. That interest rates will stay low for many, many years, stocks won’t have a meaningful decline. They seem confident in China’s ability to manage an historic credit boom, and confident that Australia’s 25 year property bull market will keep on giving. That could well be true. No one knows.
 
But history tells you that things change…often dramatically. It tells you that bear markets follow bull markets…that cheap prices follow expensive prices. That you can’t see the catalyst doesn’t mean it won’t happen. And just because governments and central banks around the world are trying desperately to levitate markets, doesn’t mean they will succeed.
 
And who would’ve thought that 100 years after the peak of the British Empire, the Commonwealth Games would still be going, or more unbelievably, that people still care? Seriously, what a strange little tournament it is.
 
Getting back to the 1914/2014 parallels (which may be a little closer than you think), last week the Permanent Court of Arbitration in The Hague awarded former shareholders in Yukos Oil US$50 billion in damages for having their assets taken from them by the Russian state.
 
Will Russia pay? It’s unlikely. They’ll just see this as a Western attempt to apply further economic sanctions over the standoff in Ukraine. As the Financial Times reported:
“But if Russian state businesses find themselves hit both by western sanctions and attempts to seize assets by Yukos shareholders, relations between the Kremlin and the West could sour further.
 
“One person close to Mr Putin said the Yukos ruling was insignificant in light of the bigger geopolitical stand-off over Ukraine. ‘There is a war coming in Europe,’ he said. ‘Do you really think this matters?’…”
Maybe that’s just a bluff. But economic sanctions are often a path to war. Russia is an energy powerhouse and can inflict great damage on Europe if it wants to.
 
The repercussions for investors are obvious. It all comes down to confidence. When confidence (the belief that, y’know, everything will be fine) evaporates, so does liquidity. And it can go very quickly.
 
In 1914, the two largest exchanges in the world – the London and New York Stock Exchanges – closed for the first time in their history on July 31 to stop capital flight. New York remained closed for four months, London five months. At the time, no one thought such an occurrence possible.
 
That’s the problem. People, even experts, lack imagination during important historical turning points. Following the global financial crisis, the Queen asked a bunch of experts how no one saw this crisis coming. The response was along the lines of, ‘It was a failure of imagination.’
 
Hubris and overconfidence often inhibit the imagination. And if you look around markets and investors today, well, hubris and overconfidence are leaking out all over the place.
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Jul 03

Here Comes the Parity Chorus

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The Aussie Dollar is strong because of the trade deficit…?!?
 

THIS WEEK, Glenn Stevens at the Reserve Bank of Australia did what was expected and kept interest rates on hold, writes Greg Canavan in The Daily Reckoning Australia.
 
Absent any major shock to the economy, rates will remain on hold for some time to come. But if you read between the lines, Stevens must be getting just a little concerned about the ability of monetary policy to haul the economy back into healthy and sustainable growth.
 
From his statement:
“Financial conditions overall remain very accommodative. Long-term interest rates and risk spreads remain low. Emerging market economies are once again receiving capital inflows. Volatility in many financial prices is currently unusually low. Markets appear to be attaching a very low probability to any rise in global interest rates over the period ahead.
 
“Moderate growth has been occurring in consumer demand. A strong expansion in housing construction is now under way. At the same time, resources sector investment spending is starting to decline significantly. Signs of improvement in investment intentions in some other sectors are emerging, but these plans remain tentative as firms wait for more evidence of improved conditions before committing to significant expansion. Public spending is scheduled to be subdued.
 
“Overall, the Bank still expects growth to be a little below trend over the year ahead.”
In other words, money is everywhere and easy. These financial conditions *should* be generating strong economic activity. But they’re not.
 
Instead, consumer demand is only moderate (and could get worse if sentiment readings don’t improve); resource sector spending will drop dramatically this financial year, with only tentative plans to fill this investment hole. And the government is trying (badly) to fix a structurally weak budget.
 
Put another way, interest rates are at historic lows, and economic growth looks like it will remain below trend this year. The terms of trade (which has a major impact on national incomes) is under pressure and our Aussie Dollar remains stubbornly high.
 
On a positive note, China is so far managing its downturn well. Targeted stimulus seems to be keeping activity elevated. The official manufacturing PMI for June came in at 51, up from 50.8 in May (a reading over 50 indicates expansion). Activity isn’t strong, but it’s not weak either.
 
This is probably why the Aussie Dollar remains so strong in the face of a falling terms of trade. Add to that Japan’s grand monetary experiment, which is fuelling demand for the Aussie from yield starved Japanese savers, and you have a Dollar that “remains high by historical standards” as the RBA put it yesterday.
 
Well, it’s even higher after overnight trading action. As you can see in the chart below, the Australian Dollar popped last night and is now set to breach 95 US cents. The chorus of parity callers will now grow louder. But I think this rally will run out of steam before it gets there. Then the Aussie will be a sell again.
 
 
I’m not sure why the Dollar spiked so much. Was it the RBA leaving rates on hold (as expected) or was it China’s improving manufacturing data (which was also expected)? Who knows, maybe it just reflects a weaker greenback?
 
The Financial Review offers an innovative reason for the Dollar to maintain its strength. Apparently the Dollar will benefit from today’s expected trade deficit. According to the paper:
“The local currency could find added support in Australian trade data as the rising volumes of exports comes on stream, suggesting more offshore investors are having to buy the local currency, and therefore leading to a widening of the trade deficit.”
What the? So a widening trade deficit is now good for a currency? Well, in these no-risk markets, just about anything makes sense.
 
I prefer to think of it like this. The Australian Dollar is a high yielding currency. That’s because it’s risky (our net foreign debt levels are up to $855 billion) and we are overly reliant on one customer (China now takes in around 40% of our exports). When no one cares about risk, you can’t get enough Aussie Dollars…when risk becomes an issue, you can’t dump them quick enough. End of story.
 
Speaking of risk, remember how the Bank for International Settlements (BIS) came out on the weekend warning of euphoric markets? Here’s the excerpt:
“The overall impression is that the global economy is healing but remains unbalanced. Growth has picked up, but long-term prospects are not that bright. Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.”
As always happens in times of ‘euphoric markets’…warnings go unheeded. And sure enough, US markets gave the BIS the old two finger salute overnight by hitting, yet again, another record high.
 
How high can they go? How far can the elastic band stretch? Well, we’re well overdue for a decent correction and that could happen any day now. But at a rough guess, this ‘euphoria’ will keep going until interest rates in the US move back above their ‘natural rate’. What does that mean? Well, the ‘natural’ rate of interest is where interest rates would be if central banks weren’t interfering on a daily basis. It’s the price of credit that satisfies the desires of savers and borrowers.
 
Think of it as the ‘intrinsic value’ of credit.
 
The annoying thing about the ‘natural rate’ is that no one knows what it is. But it’s fair to say that when rates stay below the natural rate for a prolonged period of time, you get a boom. When they move above the natural rate, you get a bust.
 
Global QE has ensured that the cost of credit has been below the natural rate for years. That’s slowly starting to end. The danger comes when central bankers try to raise rates. My guess is that the build up of debt over the past few years, much of it for speculative and non-productive purposes, means the natural rate of interest is probably much lower than people think.
 
So in the same way that rising rates popped the US housing bubble in 2006, there’s a good chance the Fed will screw this one up too and move rates above the ‘natural rate’. And once again, the BIS will sit back and say, ‘I told you so’.
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Jul 02

Remember Risk?

Gold Price Comments Off on Remember Risk?
Few others do, not at 2.7% commercial property yields. Here’s a reminder…
 

WHAT is there to reckon with when our all-conquering central banks have apparently succeeded in removing risk from the investment equation? asks Greg Canavan in The Daily Reckoning Australia.
 
No matter what the data, it’s all just an excuse to buy some asset class, usually equities. ‘Nothing to see here people…buy a stock, and move along.’
 
The reckoning business has become a tough job these days. I see risks wherever I look, but no one seems to agree. In Australia, the population is high on property…really high. The Financial Review reports today that a bunch of retail shops on the popular Chapel Street strip in Melbourne sold on a yield of just 2.7%.
 
Where’s the risk premium in that transaction? Granted, there are all sorts of justifications you could make for paying such a high price for quality property. But the only justification that stands the test of time when it comes to investing, as opposed to speculating on capital gains, is whether you are getting adequate reward for the risk.
 
2.7% for some shops on Chapel Street? Call me sceptical, but that sounds like a lot of risk for not much reward. It’s also a transaction that perfectly illustrates Australia’s screwed up policy towards property. That is, it encourages speculation and the targeting of capital gains over income. It does this via favourable tax treatment (negative gearing, capital gains concessions) and supply side restrictions.
 
But I’m not going to get into that today. Everyone knows that there will be no day of reckoning for Aussie property. It would be un-Australian.
 
Today I’m going to focus on risk…a much neglected concept recently. Thankfully, there are still a few people out there who share our concerns. The Bank for International Settlements (BIS) released its 84th Annual report over the weekend and sounded a cautious note on the state of the markets and the global economy. Here are a few quotes from the introduction to the 200 plus page report…
“The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved. To overcome that legacy, policy needs to go beyond its traditional focus on the business cycle. It also needs to address the longer-term build-up and run-off of macroeconomic risks that characterise the financial cycle and to shift away from debt as the main engine of growth.
 
“By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilised, global equity markets reached new highs and credit spreads continued to narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.
 
“In this second phase of global liquidity, corporations in emerging market economies are raising much of their funding from international markets and thus are facing the risk that their funding may evaporate at the first sign of trouble. More generally, countries could at some point find themselves in a debt trap: seeking to stimulate the economy through low interest rates encourages even more debt, ultimately adding to the problem it is meant to solve.”
In my view, the global economy is already in a debt trap. We haven’t recognised it yet because the leverage that the new debt provides is still working to the upside. The trap has yet to jam shut. But it’s coming.
 
Doug Nolan, of Credit Bubble Bulletin fame, provides ample evidence of the building debt trap. In his regular weekend article, Doug calculated the total amount of marketable debt securities (TMDS) issued through US financial markets and compared the size of the debt outstanding to the size of the economy.
 
In his calculation, total debt includes outstanding treasury securities (as in those traded in financial markets) mortgage backed securities issued by federal agencies like Fanny Mae, corporate debt and municipal debt.
 
TMDS kicked off the 1990s at US$6.28 trillion, or 114% of GDP. During that decade, TMDS grew by 120% and finished it at 147% of GDP. That brought us the tech bubble and bust, which policymakers sought to mitigate by encouraging the use of debt. Geniuses…
 
From 2000 to 2007, TMDS went on to expand by another 102%. Since the 2008 bust, debt has continued its expansionary thrust, growing by another 30% and hitting a record 220% of GDP. No wonder the BIS wants to ‘shift away from debt as the main engine of growth’.
 
But what other engine is there? Structural reform? The promotion of real investment over speculation? Good luck with all that BIS. The punters have had bread and circuses for a while now. The politicians won’t be taking it away from them. Which is why the next crisis is all but assured. The only catalyst for change is a crisis.
 
But I digress. Doug’s not finished. He also calculates ‘total securities’ outstanding by adding the value of equities to debt. He then compares the total to the size of the economy. The results are frightening:
“Even more importantly from a Bubble analysis perspective, in 21 quarters Total Securities (debt & equities) inflated $27.2 trillion, or 61%, to end March 2014 at a record $72.039trn. To put this in context, Total Securities began 1990 at $10.0trn, ended 1999 at $33.0trn and closed 2007 at a then record $53.01trn. Amazingly, Total Securities as a percentage of GDP ended Q1 at 421%. For comparison, Total Securities to GDP began the nineties at 183%, ended Bubbly 1999 at 356% before peaking at 378% in a more Bubbly 2007. No Bubble today? Valuations in historical range?”
No wonder we all worship at the altar of central banking. Total securities now completely overshadow the income produced by the real economy. No wonder central banks the world over constantly need to pump money into the system…without it, prices would begin to deflate.
 
Don’t think the US economy is an isolated case, either. It’s the best of a bad bunch, remember? No, what’s happening in the world’s largest economy is emblematic of what’s happening elsewhere.
 
As debt continues to expand and risks are ignored…and as punters continue to seek yield, thrills and capital gains, an awful reckoning awaits the blind and ignorant.
 
When this will happen nobody knows. But the first cracks will begin to appear when the Fed tries to normalise interest rates. Another step on that path starts tomorrow, when they reduce their debt monetisation program by another US$10 billion per month. By October, the policy of QE will be all but over.
 
Perhaps the punters might start to panic before then? Who knows…but it sets things up nicely for another wild September/October period. Actually, it’s about time, we haven’t had one for a while.
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Jun 23

The Yellen Fed’s Big Gold Rally

Gold Price Comments Off on The Yellen Fed’s Big Gold Rally
US central bank’s weak tone on rates coincides with long-term bottom in gold…
 

THAT was some rally Thursday, writes Greg Canavan in The Daily Reckoning Australia.
 
Clearly a lot of punters expected a different outcome from the US Federal Reserve’s two-day meeting on monetary policy. But what they got was more of the same. That is, interest rates will remain on hold until probably the next World Cup…and so in the meantime, please keep speculating.
 
This seemed to catch traders off guard – in Australia anyway – and a round of short-covering saw the Australian stock market shoot higher for the largest gain in seven months. The thing to watch for now is follow through buying. I suspect it will be tepid.
 
Not so in the gold market though. Having had a day to reflect on Fed boss Janet Yellen’s comments, traders decided to dump the US Dollar and buy commodities. Gold surged, breaking through many layers of resistance. It’s ended the week up about US$50 bucks an ounce from Wednesday night.
 
Last week, in a report to Sound Money. Sound Investments. subscribers, I wrote that there was mounting evidence the gold price was forming an important long-term bottom. We recommended a little known gold stock with huge potential to take advantage of this view.
 
So far, so good on that call. But we’re under no illusions. It was just luck.
 
We could be about to get luckier though. Check out the chart below, which shows gold blasting through resistance. It’s now back above its 50 and 200-day moving average. And it happened on strong volume, which is a good sign.
 
 
The Relative Strength Index, a momentum indicator, is about to move into overbought territory, so you should expect some sort of correction soon. But if gold can gain support above the moving averages, then the bottom of this long bear market may well be in.
 
Why is gold rallying though? In short, nervousness towards central bankers, and Janet Yellen in particular. Her comments Wednesday indicated that the US Federal Reserve wasn’t too concerned about inflation.
 
Well, the market clearly didn’t think much of that.
 
I’ve said for some time that gold isn’t really an inflation play. It’s an anti-central banker play and insurance against a fragile financial system. This could merely be a case of short-covering, or it could be the start of growing wariness towards Yellen’s reign. Keep a close eye on gold to find out.
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Mar 26

China Stimulus: Hope Against Hope?

Gold Price Comments Off on China Stimulus: Hope Against Hope?
Beijing did it before. Stock and FX traders seem to think it will repeat big stimulus…
 

THIS WEEK we got further confirmation that China’s economy is slowing, writes Greg Canavan in The Daily Reckoning Australia.
 
Yet the Aussie Dollar and stock market jumped higher. How does that make sense? Well, it doesn’t really, but here’s the logic…
 
HSBC released preliminary Chinese manufacturing data for March, showing activity in China’s manufacturing sector slowed to an eight-month low. Bad news, right?
 
Wrong. It’s good news. Apparently, it means China is closer to announcing a large stimulus program. (Because the last stimulus program was so successful.) Once this little rumour swirled through the market, the Aussie Dollar and stock market pushed higher.
 
Ahhh stimulus, is there anything you can’t do?
 
Of course, the bubbliest sectors panic first. New York Nasdaq’s biotech sub-index has now doubled from the start of 2013. It’s in the process of taking some of those gains back right now.
 
Why? Hot money – a euphemism for short term, speculative, leveraged funds – is getting out of the ‘hottest’ sectors as the prospect of tighter monetary conditions in the US takes hold. Recent data releases support this view.
 
US manufacturing is humming along. This week’s release of preliminary PMI data for March showed a strong reading of 55.5, down from February’s 57.1, which was the strongest month in over 3.5 years. Anything over 50 signifies expansion.
 
So the US economy continues to show signs of health, which means the Fed’s trajectory of QE reductions and ‘normalisation’ of interest rates (whatever that means when you have a US$4 trillion balance sheet) continues.
 
Meanwhile, over in China momentum is definitely slowing, driving the calls for more stimulus. As the Wall Street Journal reports:
“Some analysts expect the People’s Bank of China to cut banks’ reserve requirements, freeing up funds that can be used for lending. Others think authorities will rely on the type of stimulus spending they’ve used in the past.”
Our feeling is that the authorities in China, under the leadership of President Xi Jinping, have a higher tolerance for pain than they did in the past. Previous efforts to provide stimulus only exacerbated economic imbalances and made the task of trying to normalise the economy even harder.
 
We don’t know how the mind of a central planner works, but we’re thinking that pushing the stimulus button now would not send the signal needed to help reform the Chinese economy. Having said that, the authorities are playing a very dangerous game in trying to gently deflate the credit bubble.
 
Part of the focus is on ridding Chinese industry of overcapacity. An industry with too much capacity generates sub-standard returns and must implicitly be subsidised by other parts of the economy. Steel and cement are two sectors with chronic overcapacity and the authorities are trying to clamp down in these areas.
 
China’s Caixin magazine reports on the problems emerging in the steel sector:
“The largest private steel manufacturer in the northern province of Shanxi has become ensnared in deep debt troubles as the whole industry struggles with overcapacity.
 
“Highsee Iron and Steel Group Co. Ltd. has seen its capital chain broken and creditors including banks line up to try to get their money back, sources with knowledge of the situation said. Highsee’s problems are typical in a sector where a huge debt problem is only beginning to reveal itself, an industry observer said…”
Beijing wants to get rid of excess steel capacity. This means it must allow steel firms to go under. And judging from the news, they are well on their way. But because most have high debt levels, it also means the banks will take a hit via rising bad debts.
 
So does the government stimulate to prevent the firms from going under? Or does it allow the restructuring to take place and focus on containing the fallout in the financial sector? If it’s serious about rebalancing, we’d guess it will focus on the latter. But Aussie investors think it will focus on the former. That’s why the miners and the AUD have rallied yesterday in the face of bad news.
 
On top of that you have the Reserve Bank of Australia mulling interest rate rises, which is why the Dollar remains stubbornly over 90 US cents. The prospect of higher interest rates and a stronger Dollar, at the same time that our most important trading partner slows down, is not a pleasant one.
 
But we think it’s only a prospect. The RBA won’t increase interest rates anytime soon. If it does, it would push Australia towards recession.
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