Flight from Euro Makes Dollar King (for now)

* In the fall of 2008, George W Bush’s admonished Congress to pass the TARP legislation, unless they want to see this “House of Cards” come tumbling down. This was the beginning of the real crisis in confidence, not the Lehman bankruptcy. It still bothers me that everyone blames the Lehman bankruptcy as causing the financial melt-down which followed. The melt-down occurred because confidence was taken out from under the markets by the dire predictions which President Bush and Treasury Secretary Paulson had to make, in order to get TARP passed. Lehman’s bankruptcy was just a symptom of an over-leveraged financial system in the US.


What followed resembled an international revival, in support of economic growth, with each and every country declaring how much money they were going to borrow from the world’s markets in order to revive their part of the world’s economy. It was like being at an AA meeting, where each country would come forth, come clean as to how bad their economy was, and how they planned to spend billions which they did not have. The US being the leader of the group, with planned deficits to total over $4 trillion within 3 years time. US treasury rates were as low as they ever have been during this time period, so borrowing an extra trillion or so did not matter, nor did it seem to affect interest rates; especially when the Federal Reserve was poised to monetize $1.7 trillion of mortgage and treasury debt.


The fun moment, when every country was promising deficit financed spending, to help lift their part of the world’s economy out of a hole, has long faded. Instead the world is left to contemplate how to pay for this mess. In a reversal of the revival spirit from 2008, countries are now declaring how much they are going to cut their budgets. Clearly, the markets for risk assets does not like the idea that the worlds biggest spenders cannot continue spending money as they had. So far, Greece, Spain, Italy, Portugal and Great Britian have jumped on this band-wagon. And this has the markets worried that this will spell out a return to a recession, which in reality will just be a continuation of the depression which began in 2008. Recessions only become depressions when they last too long, and despite the current pick-up in economic activity, the 10% unemployment rate in the US is not a sign that we are out of the recession or depression.


* The discipline of the Gold Standard – Greece’s acceptance of the Euro as their currency, is as if they are living within a Gold Standard’s discipline. This is because Greece cannot arbitrarily increase its money supply, just as countries on the gold standard cannot increase their gold reserves. Instead, the Greek government is being forced to cut its deficit, make significant cuts in spending, and increase taxes. They do not have the option to print money, just as a country on the gold standard cannot create gold out of thin air. Assuming Greece follows through on the spending cuts, it surely suggests that there will be a negative impact on their economy. If the US had to cut its deficit by 2/3 rds, that would equal almost a trillion dollar reduction in the budget, or about 7% of GDP. How do we think we would fare under such a scenario?


The US is inching its way towards a future of a severe recession (depression), or a fiscal crisis with sky high interest rates. Before that happens, however, the US is going to have one last day in the sun, as the current flight from the Euro is making the US dollar king, and dollar denominated bonds, are doing better as well. Since US stocks derive 65% of their earnings from overseas operations, the problems in the Euro-zone is having more of an impact on US stock prices than on debt prices. 


Gold has been a major beneficiary of the EU mess, and while it is $60 an ounce off its recent $1249 high, gold does seem to be holding up in the upper half of the $1100′s. Each subsequent pull-back in price since gold broke above $1000 an ounce last September, seems to be less severe than from whence it came. And while stocks are down about 13% from its April 26th high, the Gold/S&P ratio has moved from 1.0 to 1.1, or a 10% increase in relative value. The funny thing about gold’s nay sayers is that these folks cannot even imagine a world under the gold standard. Instead, they are comforted by the bond vigilantes, who act as a de-facto gold standard to protect the world against run-away borrowers. What these folks do not realize, is that when debt rates for sovereign borrowers soar, so does gold. 


When a country cannot afford to pay back its debt, the bond markets for these countries debt goes south real fast. As with Greece earlier this month, the rate on their 2 year debt rose to 18%. And so it will be with the US. Eventually, someone is going to take notice, and rates will go higher. In fact, there is such a groundswell of negativism toward US government debt, that many fast money types of accounts have been short the treasury market, and for the most part have missed the recent rally, which has moved about 6 points. 


At some point in time, in the not too distant future, the US will be confronted with its deficits. The resurgence of the far right of the republican party and the tea party movement, with its “less government is better” slogan is going to reshape the political landscape this fall. Consistent with this message, President Obama has convened a bipartisan budget panel which is supposed to make recommendations to him on December 1st, about how to cut the budget deficit. However, Obama has said that they cannot touch social security or health care costs, which amounts to about 70% of the current deficit. This means they can cut everything else, and will need to suggest new taxes to attempt to balance the budget. And if a value-added-tax (VAT) is what they recommend, then it will cut demand across the entire economy, and hasten the day the US finds itself in the second dip, or a double dip recession/depression. Or the US can figure out creative ways to monetize the debt. The Federal Reserve has said they will not let that happen, but at what point in time do they acquiesce to the need to stimulate the economy to fight the 10% unemployment rate we are living with. With their dual mandate to promote price stability and economic growth, this is a conundrum the Fed is not looking forward to.


Will the Fed print money to buy US debt if there is a debt crisis? In the  1940s, when the cumulative Federal deficit had risen to 125% of GDP, the Fed added money to the banking system, by purchasing government debt, which in turn, kept interest rates low. This spawned a period of growth with modest inflation, which ultimately brought the debt to GDP ratio back down to a reasonable level by 1960. Creating inflation worked in the 1940s, and it could work again now, if the government can sort out its priorities. Fortunately for the Obama administration and the Fed, they have yet to be confronted with high inflation and funding issues. What they are confronted with is a chronic unemployment situation, which, despite the addition of hundreds of thousands of jobs each month, does not seem to be capable of bringing this rate down. The imperative to fix this problem will cause Obama to lean on the side of deficit spending, so long as a budget crisis, or bond market debacle does not assert itself. I am not sure how much time Obama will have before US rates run start going higher. I believe the current bond market rally is the last hurrah for US interest rates, and encourage you to implement bear market strategies in US treasuries, during this current rally. 


Unlike many who were screaming Chicken Little when the 10 year was at 4%, setting a short, or buying puts, etc_ will prove to be a great strategy over the second half of 2010, and into 2011. Of course, the Fed could print a new batch of money. This would fly against conversations at the last Fed meeting, during which they were contemplating how to unwind the $1.7 trillion of money they just printed. Clearly, there is no easy answer, nor do all the pieces of the puzzle fit together without something giving way. If Obama’s pain avoidance strategies are any clue to the future, then we will create inflation in order to save the economy. If the tea party has its way, then we will be in a deflationary depression. Is it possible that there would be a Mexican standoff, with some bastardized outcome, which translates into a weak economy with some inflation. This is known as stag-flation, which was prevalent in the 1970s. Such an outcome does not bode well for 10 year US treasury rates remaining at 3.2%. As I stated before, I am following the seasonally bullish profile for US interest rates, which has US treasury rates bottoming during the second week of June, as a time target to begin moving from being bullish on US treasury rates to taking a major bearish stand.


* UK watch – last week I pointed out that I was concerned about the markets perception of the UK as a sovereign credit, as the British pound was sinking almost as fast as the euro. One of the signals I am watching is the 1.40 £/$ exchange rate, to see if the pound was going to take out long standing support.


Subsequently, I did a little research on the UK and can report that I am not as concerned as the currency markets seem to be. For instance, while the UK’s budget deficit is running at 11% of GDP, their total debt is 65%, not a horrific number yet, but not great either. That is about the size of the US’s federal deficit when you exclude the $3+ trillion in the social security and medicare trust funds, which invest exclusively in US treasuries. If you add back the trust fund assets, then the US’s debt is almost 90% of GDP. Furthermore, unemployment in the UK is reported at 8%, which is not as bad as US unemployment, so perhaps their circumstances are not so bad. Nonetheless, I will keep an eye on the 1.40 level (it is now at 1.4385), as a first level cause for concern.


* Trading points – the Euro is weaker this morning on the take-over of a mutual savings bank, which was run by a bunch of priests in Spain, by Spain’s FDIC equivalent. This is only going to cost Spain a half billion, so on the surface, it does not seem to be a big deal, yet the Euro is weaker by 1.5% this morning, and global stock markets are lower. Apparently Spain has 45 Caja’s, which are the equivalent of a mutual savings and loan, which no one really owns, and they typically have some sort of charitable purpose. The Spanish government is trying to force all of these types banks to merge with stronger banks, as they appear to have made many bad loans on average. The back-drop of the Spanish banking issues centers on concerns as to how easily can Spain enact budget cut-backs, while they have to rescue their banking system.


* US stocks – I cut my short position from 125% short, to 50% short Friday, in response to the markets ability to bounce out of it’s hole Friday morning, and below the flash crash low of 1065. Accordingly, I have a number of trading scenarios which entail a bounce above 1100 over the next couple of days. (This was reported real time to those on that distribution, which I am happy to include you on). Typically I am wrong about bounces in a bear market, so I would not suggest you buy anything on this comment, but consider protecting some profits if you are short. I hope to return to a 100% short position later this week from higher levels.