The Daily Reckoning
The armies of zombie greenbacks did not begin their attack yesterday, as your editor predicted. At least they didn't do so in overwhelming fashion. But if you were looking (and we were), there were signs that the wind has shifted in the stock market and things are about to change.
The challenge of today's Daily Reckoning is to separate the short-term trends in financial markets from the long-term trends in geopolitical history. It's a big challenge. But let's break it down and see where we go. And let's begin with U.S. Bank Wells Fargo.
The Dow Jones slipped under 10,000 at the end of the day Wednesday largely because analyst Dick Bove changed his call on Wells Fargo from "neutral" to "sell." Bove said the quality of the company's third quarter earnings was, "pretty poor." "If you take a close look at the earnings, what you can see is that the improvement is due to a hedging profit made on the mortgage service portfolio, about $3.6 billion…You can also see that they cut their tax rate," he told Dow Jones news wires.
Imagine that; a major bank boosting earnings with one-off events. This is why we said last week that quarterly earnings (and whether they are above or below analyst expectations) don't always tell you what you need to know about a business. Granted, Bove is still bullish on Goldman, Morgan Stanley, and Bank of America. But his comment set off a small chain reaction on the Street.
It was a weird reaction too. Stocks fell and the Aussie dollar briefly faltered against the greenback. But commodities like oil and gold continued to power ahead. Oil is at a 12-month high and trading over US$81. Gold futures again traded above $1,060. And the U.S. dollar kept falling against commodities and other currencies.
So does this disprove our trading idea that the dollar index is due for a rally? Nope. The index could make a new low below 70. And that would certainly confirm what we already know: the rest of the world is on to America's habit of living way above its means. The dollar index could plumb a new low until there is an improvement in America's trade deficit or its fiscal deficit. However…
Don't discount the rally! "We should be prepared for a counter trend rally," wrote Slipstreamer Murray Dawes earlier this week. "RSI are entering long term oversold levels (although in a downtrend they can remain oversold for long periods of time of course and so are not a good trading signal against the trend) and market news is constantly bearish the US dollar so trader positions may be getting a bit full up on the short side."
"A short squeeze would not be out of the question, but I would not be trading a squeeze unless it breached the 81 level to confirm the re-entry into the last year's range," Murray concluded. A short squeeze in the greenback would see oil and gold correct, along with the Aussie dollar and stocks. Mind you this is a trading trend, not a long-term investment call. But we're tracking it and will keep you posted.
For a top-down view of just what's happened to the dollar this year and what it means for your investments, have a read of David Einhorn's speech at the Value Investor's Conference in New York City. It's a real page turner. And it's only eight pages!
Einhorn made a few great points worth considering. The first is that Australians should watch out for a second period of slower growth (maybe even recession) once the effects of the stimulus exhaust themselves. It wouldn't be the first time something like this happened. The attempts to stimulate America out of the Depression boosted GDP for a few years, but didn't solve any of the problems which really ailed the economy.
"An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fallout. Our [America's] choice may be to maintain large annual deficits until our creditors refuse to refinance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline."
Einhorn is writing about the U.S. In Australia, the government is hoping the removal of the fiscal stimulus won't result in "significant economic fallout." It must be hoping that capacity expansion by the mining industry is enough to support employment and consumer spending…and that house prices (and home building) keep the rest of consumer spending buoyant…and that businesses begin to reinvest.
That's a lot of hope. But hope has been pretty easy to sell these days.
The other factor which makes Australia's situation slightly different than Americas is that funding Australia's comparatively small deficits shouldn't be too hard, given the strength of the Aussie dollar. Not that racking up long-term debts to China or other foreign creditors is good, especially when the borrowed money is just going to your mates in the building industry or to prop up select retailers.
But it's probably true that Australia's creditors won't squeeze the government until much later, after the current government has been replaced. That will happen years down the track, when tax payers will still be paying off today's debts. Perhaps they will be wondering why no one [today] thought it was immoral to steal money from the future in order to maintain over-leveraged lifestyles today.
But that is the future's problem. So we'll let them deal with it. Einhorn is right to point out that policy makers tend to favour short-term benefits over long-term prudence because it's easier to get elected that way. And news organisations always spin the policy in terms of who the narrow groups that benefit rather than the unknown parties in the future that don't. But maybe this is just too abstract a point for people to understand these days. In any event, years down the track when Australia is paying off its debt to foreigners, the question may come up again.
Today, there are other more critical events that could rock financial markets. "As we sit here today, the Federal Reserve is propping up the bond market, buying-long dated assets with printed money. It cannot turn around and sell what it has just bought," Einhorn says.
The Fed has no exit strategy! The U.S. bond market has become a quagmire from which Geithner/Westmoreland and Obama/Johnson cannot escape! But hyperbole aside, what does that really mean?
It means that TARP and TALF and CAP may eventually wind down. But the Fed is subsidising mortgage rates and short-term Treasury rates in the U.S . This is what's going to drive the next down move in the dollar and the dollar index (it will make new lows). The Fed will continue "monetising the debt" and there will be fewer and fewer foreign takers (willing to finance U.S. deficits by buying bonds and notes).
This quantitative easing is incredibly bullish for gold. And it's a liquidity trap for the Fed.
"There is a basic rule of liquidity," Einhorn says. "It isn't the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because both the size of my position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up."
We'd argue there already IS inflation, but it's in assets…stocks, bonds, commodities, and real estates. The Fed's nightmare is that it is unable to shrink the monetary base without collapsing the Treasury market (sending yields to the stratosphere). You'd get a collapse in asset values and devaluation in the dollar, which, in the real economy, would lead to rising prices. A loss of net worth coupled with a rising cost of living…is not a good formula for getting re-elected.
And one more point on the U.S. debt. It is now extremely interest rate sensitive, as we wrote here in April. Einhorn writes that, "The Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach a point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort."
Besides taking U.S. monetary policy into the land of the absurd, you would also want to buy long-dated calls on U.S. interest rates if Einhorn is right. You can trade it two ways actually. You can be short U.S. bond prices through exchange traded funds like TLT and IEF, or long U.S. bond yields by buying call options on U.S. Treasury yields.
And what about the other dodgy currencies like the Euro and the Japanese Yen? They are doing well against the Greenback now. But at a fundamental level, both have the same genetic defects as the U.S. dollar. "I believe there is a real possibility that the collapse of the major currencies could have…a domino effect on re-assessing the credit risk of other fiat currencies run by countries with large structural deficits and large, unfunded commitments to ageing populations."
The "domino effect" Einhorn is referring to is the collapse of Lehman Brothers. For at time, until it was clear the government would not allow the other investment banks to fail, it was clear to investors that if Lehman's leveraged model was dead, so was Goldman's and Morgan Stanley's and Merrrill Lynch's.
In a world where credit was not so ready and the unwinding of leveraged assets threatened to wipe out equity capital, those major levered up firms faced an existential threat. The government stepped in at that point and bailed them out, preventing the free market from doing what it was about to do: punishing the firms, their creditors, and their shareholders for incredibly bad risk taking.
Now you have the goofy situation where a government pay Czar is intervening to cut executive salaries at those firms by 90%. If the government hadn't intervened in the first place, the salaries would have been cut by 100% and the bad bets by the firms would have been written off and the economy would be closer to recovery. But that is neither here nor there.
Einhorn's warning is that currency devaluations force investors to revalue the idea that sovereign bonds are risk free. This is another way of saying that the nation state as a fiscal enterprise is every bit the failed model that investment banking is today. Investment banks borrowed money to bid up assets. Governments borrow money, securitised by tax revenues, to "invest" in policy objectives.
But as we are finding out now, those "investments" have not been self-sustaining in an economic sense. Einhorn, if we read him right, is reaching the conclusion that the nation state financial model (the fiscal warfare/welfare state) is in deep, deep trouble. It is the next institution that is "too big to fail." And it's going to fail because its funding model is based on the fraud of an idea that we can all live at one another's expense and that you can get something for nothing.
Here's a question, though: who bails out a failed nation state? Will the IMF bailout America? Will the World Bank lend to Japan? Will China establish a line of credit for Europe?
Speculators who like what Einhorn is saying would consider buying long-term put options on the Euro and the Yen too, not just the U.S. dollar. But what do you do if you're not George Soros? Why not try gold?
"I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible."
Sounds pretty sensible.
Dan Denning for The Daily Reckoning Australia
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