"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput


Thursday, May 31, 2012

USDX Pushing Higher as Money Flows into Treasuries

The following chart I put together is interesting in the sense that it reveals exactly what is pushing the US Dollar Index Higher.

Normally, all things considered, the country which possesses the most solid fundamentals in terms of monetary policy, economic growth rate, fiscal policy and above all, YIELD or INTEREST PAID on its government debt, tends to have the strongest currency. At least that is the way it formerly was. These are broad principles and while there are always deviations, if two countries were pretty evenly matched in terms of the first three factors, the nation which had a higher yield on its government debt tended to attract more investment flows and thus had the stronger of the two currencies.

When we think about the US Dollar, we certainly do not think of a nation with sound monetary policy (reckless creation of nearly unlimited units of its currency called Dollars). Nor do we think of a nation with a strong economic growth rate (we were reminded of that today with the lowering of the original 1rst quarter GDP number). And lastly, fiscal policy here in the US is an unmitigated disaster given the enormous and never-ending budget deficits and huge amount of overall indebtedness (the US is now at levels on its GDP to Debt ratio of 100% or higher).

Why then the strength in the US Dollar? It is certainly not fundamentally based.

The truth is investors in Europe are terrified of what is taking place over there and have lost confidence in the bonds of many nations comprising the EuroZone. They are yanking their money and moving it into anything but the Euro which is giving the US Dollar the strength it is currently enjoying.

But how exactly is this being accomplished seeing that the US equity markets are sinking like a lead brick? Money flows from abroad are not moving into the realm of US stocks, that is for certain. The answer is that these investment/safe haven flows are moving into US Treasuries. In other words, there is unprecedented demand for US debt and this is producing the rally in the Dollar as all that foreign currency needs to be EXCHANGED (this is why the currency markets are known as FOREX - Foreign Exchange Markets) for DOllars to buy Treasuries with.

We can see this in graphic form by examining the following chart which basically charts the USDX and the Yield on the Ten Year Note and then charts the difference between the two to see whether or not the Dollar is rising as interest rates rise, falling as interest rates fall or RISING even as INTEREST RATES FALL. The latter is of course somewhat counterintuitive from a purely performance based perspective. After all, why in the world would investors deliberately put their capital into the currency of a nation where the yield they are receiving is actually going down?

Quite simply - we are living through times which are unique and unprecedented. There is almost a type of panic-buying of US Debt as a safe haven. Investors are willing to accept a paltry 1.58% on their money for the next TEN YEARS just to get it out of Euros and out of equities.

How this is demonstrated on the chart shows up as you look at the solid blue line. Note that there have been three occasions during which the Dollar has enjoyed great strength even as interest rates have fallen lower. The first was back in the middle of 2008. We all remember what happened then - the credit crisis erupted and there was a mad rush into the "safety" of the US Dollars, mainly in the form of Treasuries. That buying drove Treasury yields lower (remember- rising bond prices means lower yields).

We can see the same thing occurred in early 2010 when there was fear that QE 1 was ending and there was nothing to take its place on the drawing board. The rush back into Treasuries occured once again and up went the Dollar as interest rates were pushed lower by safe haven flows.
This third occasion can be seen to start in April of last year when it was assumed that QE2 was coming to an end in June. Ever since then, with a brief exception in October of last year, the Dollar has GENERALLY MOVED HIGHER even as INTEREST RATES HAVE MOVED LOWER.

This trend has accelerated in March of this year and continues at the present time as fears over the European Sovereign Debt affair have intensified. Notice how wide the differential has become. What this is charting is the FEAR of traders/investors over the preservation of their wealth. It is at an even higher spread than it was back at the peak of the credit crisis of 2008 even though the USDX is some 6 - 7 points lower than it was on both other occasions when this widening of the differential was taking place.

I would venture to say that if we constructed a chart of Yen, it would look quite similar over the last few months.

My thinking is that if the Fed does come in with another round of QE3, and it is of sufficient size to convince market participants that the threat of deflation has been suspended (at least for the time being), we will see the US Dollar move sharply lower narrowing this spread and will more than likely see longer term interest rates actually rise instead of falling as one might assume woudl occur, as deflation talk will give way to inflation talk and money will flow out of Treasuries pushing yields higher in the process.

Time will tell.

Monthly CCI Chart - May 2012

Monthly Gold Charts for May 2012

I do want to note that since we are facing a very similar set of deflationary factors at the current time as we did back in 2008 when the credit crisis first erupted, that time frame is an analogous year and for that reason provides at least some sort of frame of reference for a guide to price action.

Using MONTHLY CLOSING PRICES only, gold fell from a peak of $975 down to a low of $715 or a drop of 26.5% from it best monthly closing price BEFORE THE FED made clear that a round of Quantitative Easing would commence. You will recall that the purchases consisted mainly of Mortgage Backed Securities which were plummeting in value and wreaking havoc on bank balance sheets.

Fast forward to today - this time around it is Sovereign Debt out of Europe that is the culprit behind the destruction of the European Banks's Balance Sheets. Gold hit a monthly closing peak price of $1828.50. For the month of May it has closed at $1526.60 for a drop of 16.5%.

Worst case scenario would see a fall of another $183 from the current level or down towards $1344. Keep in mind however that back in 2008, the idea that the Fed would actively step in and actually buy up mortgage paper on the open market and serve as a buyer of last resort was a rather novel idea, even though it had been discussed in some circles as an academic type of matter. Now it is pretty much expected that not only will the Fed buy up such paper but also Treasuries themselves. I expect before this is all over, we might even see the Fed buying US stocks or at least stock indices.

Also, gold fell 26.5% from its peak back in 2008 while during the same time period the S&P 500 collapsed at whopping 47.7% from its May 2008 ClOSE to its February 2009 CLOSE. Does anyone really believe that the Fed is going to stand by and allow the US equity markets to lose nearly HALF THEIR VALUE before they act, especially during an election year??? I doubt it! Not when Bernanke and company are FAR MORE FEARFUL of ANY DEFLATIONARY event than they are of INFLATION.

Central Bankers are essentially confident that they can corral inflation if need be but they are terrified of having a deflationary mindset take hold. They will simply not allow the latter to happen, even if it means in engaging in another wholesale round of bond purchases and further money creation.

Again, we are all reduced to sitting around and waiting for signs of sufficient deterioration in the global equity markets and credit spreads to force the Fed to act. When they do finally sally forth, gold and silver will immediately bottom and begin to trend higher as trader sentiment then shifts away from deflation and back towards inflation.

We will also see interest rates reverse and begin rising, even if only for a while.