It is a pressure cooker waiting to explode! Similar “Recovery” rally as in 1929/1930

[CrackSmokeRepublican]

It is a pressure cooker waiting to explode!

Similar "Recovery" rally as in 1929/1930

Since March 2009, investors have been borrowing the weak US dollar (whilst it is the reserve currency), investing the proceeds in higher yielding asset classes such as equities, commodities, currencies and bonds. Most asset classes have since shown gains in excess of 50%, similar to the recovery rally of 1929/1930.

The improvement in the stock market following the quantitative easing (QE) and thus zero cost money has artificially boosted investors' confidence through strongly improving markets, though in our point of view this confidence is paper thin and it won't take much to rock investors' confidence. The moment the stock market drops steeply the confidence will be gone.

The economy is not improving and will not improve, with widespread unemployment of 17%, a constantly deteriorating housing market, and huge private and public debt resulting in some corporate bonds (Berkshire Hathaway, P&G, J&J, Lowe's Cos)  trading at yields below treasury yields. Imagine, if the hundreds of billions of stimulus dollars were able to create only 114,000 (162,000 minus 48,000) jobs in March of this year, what the job creation will be once the stimulus drops away.

The "manipulated" stock market (comparable to a pressure cooker) will have to give way for its second leg down which will be much more devastating than the first  because investors will not be able to cope psychologically. Next to that, the Government will not be able to come to the rescue because they will have no credibility left and because treasuries will be exhausted, forcing much higher interest rates which will reverse the carry trade.

Robert Reich says "It is a sham recovery"

Robert Reich, the former Secretary of Labor, talks about the sham recovery in a recent publication of the Huffington Post. He says "The US economy grew at a 5.9 percent annual rate in the fourth quarter of 2009. That sounds good until you realize GDP figures are badly distorted by structural changes in the economy. For example, part of the increase is due to rising health care costs. When WellPoint ratchets up premiums that enlarges the GDP. But you'd have to be out of your mind to consider this evidence of a recovery. Part of the perceived growth in GDP is due to rising government expenditures. But this is smoke and mirrors. The stimulus is reaching its peak and will be smaller in months to come. And a bigger federal debt eventually has to be repaid."

He also states that the "only people doing better are the people and private-sector institutions at the top. Many of America's biggest companies are sitting on huge amounts of cash right now, but that says nothing about the health of the U.S. economy. He mentions that companies in the Standard & Poor 500 stock index had sales of $2.18 trillion in the fourth quarter, up from $2.02 trillion last year, and their earnings tripled. Why? Mainly because they're global and selling into fast-growing markets in places like India, China, and Brazil".

"America's biggest companies are also showing fat profits and productivity gains because they continue to slash payrolls and cut expenditures. Alcoa, for example, had $1.5 billion in cash at the end of last year, double what it had on hand at the end of 2008. Sounds terrific until you realize how it was done. By cutting 28,000 jobs – 32 percent of workforce – and slashed capital expenditures by 43 percent". In other words a real improvement will show itself though strong top line growth from its US activities.

According to Robert Reich "firms in the S&P 500 are now holding a whopping $932 billion in cash and short-term investments. And they can borrow money cheaply. Corporate bond sales are brisk. So far in 2010, big U.S. corporations have issued $195.2 billion of debt, excluding government-guaranteed bonds. Does this spell a recovery? It all depends on what the CEO's of the big companies are doing with all of this cash". In fact, they're doing two things that don't help at all in addressing unemployment, making acquisitions and buy backs fuelling the share price of their companies, increasing their pay package.

He also mentioned that "the Federal Reserve reported Thursday that American consumers are shedding their debts at a rapid rate. Total US household debt, including mortgages and credit card balances, fell 1.7 percent last year – the first drop since the government began recording consumer debt in 1945. Much of the debt-shedding has been through default – consumers simply not repaying and walking away from homes and big-ticket purchases". As is the case with many other published data when one starts digging deeper the story often takes a totally different turn.

It is fair to assume that Robert Reich has some understanding about employment and the economy! So you draw your own conclusions about the recovery.

The economy is not recovering and will not recover.

We share Reich's view and in our point of view there are three factors why the US economy is not improving and will not improve:

1.) The U6, the broadest unemployment measurement, is 16-17% and the capacity utilization of the workforce is 70%; some 70% of US GDP stems from consumer spending though consumers without jobs don't spend;

2.) House price declines are being temporarily stalled because of the $1.25trn mortgage buy-back program of the Government (although February existing and new home sales were about the worst ever) which will end in March 2010 and is keeping mortgage rates artificially low. Cost of building a house is higher than prices of repossessed houses. Banks are not cooperating in modificating mortgages (only 168,000 mortgages, out of 11.3m that have negative equity (in total there are 47m mortgages), have been modified of which 50% will default again) in other words the ripple effect of lower housing prices will continue. The banks are estimated to keep some 7m+ repossessed houses on their books in the hope that the market will recover. Lastly between 2010 and 2014 $1.4trn in commercial real estate has to be refinanced and with price declines of 40% since 2007, nearly 50% is showing negative equity which again the banks are not very willing to refinance;

3.) The enormous private and public debt levels which are increasing at stellar speed with budget deficits also increasing. Deficit/GDP ratios are increasing to new danger levels. According to a Barclay's study studying 6 developed nations over the last 20-30 years, they found that a 1% change in deficit/GDP caused a 32 bps increase in 10 year rates.  Based on this, we are due for a substantial rise in global rates.

Credit represents the use of future income to fund current expenditure. Going forward we will pay dearly for our irresponsible behavior. We believe that if investors really understood what is happening in the markets, long-term rates would be at 10-15%. Not because of inflation, there is no inflation in the West, contrary to China, but because of the crowding out with respect to loan demand.

QE is showing with swap rates and corporate yields trading below sovereign yields!!

For years, bond markets have paid close attention to how much of each Treasury auction goes to indirect bidders,  which include foreign central banks and are considered a real-time proxy for what sovereign investors – who hold almost half of all outstanding Treasuries – think about buying U.S. debt. But in recent months direct bidders, non-primary dealers that place their bids directly with the Treasury, have become more important with their share of the auction gone up from about 1% to 30% (for 30-y bonds a record) of any given bond auction. Direct bidders are domestic money managers or firms that want to become primary dealers, joining the 18 existing dealers who are basically market makers (and normally flip their treasuries straight away)— required to bid at Treasury auctions. Direct bidders can also be domestic fund managers that are shifting their bids away from dealers and going directly to the Fed via the electronic system.  Though we believe that the Fed has also started buying government paper as a direct bidder in order to prevent the auctions from failing and as such preventing higher interest rates, well at least for the moment.

Treasury prices plunged Wednesday March 24, sending 10-year yields up more dramatically than in any session since July, bidders offered to buy 2.55 times the amount debt being sold, and the lowest demand since September. Indirect bidders (a class of investors that includes "foreign" central banks) bought 39.6% of the offering, compared with an average of 49.6% of recent sales and the lowest since July. Direct bidders, including domestic money managers, purchased another 10.8%, versus 9% on average.

The system is starting to show the strains of the QE with the 10-y UK gilt rates trading below the swap rates since December last year and the 10-y US Treasuries trading for the first time on Wednesday March 24 above the swap rates. We view the inversion in 10-year swap spreads as a harbinger of the massive supply of U.S. Treasury debt that will ultimately drive yields higher.

Swap rates that are based on interbanking lending rates normally yield higher than government debt yields which are regarded as no risk investments; though this is clearly changing.  The negative swap spread, trading below treasury rates, is indicative for the excessive sovereign debt issuance by the governments whilst the economies are not really improving hence the increased market risk for sovereign debt. Next to that, as mentioned above, we have the extraordinary situation that some corporate bond yields trade lower than the treasury rates.

Iceland was too small but Greece has made us aware of the increasing sovereign risk problem, a problem looming for a long time. We believe the swap and corporate bonds now yielding lower than government bond yields is the first step towards a downgrade of the triple A ratings of US and UK government debt resulting in higher interest rates. This will further propel the US dollar and thus trigger the reversal of the carry trade. We furthermore want to emphasize that a bear market in the bond markets is much more devastating than one in the equity markets and that such a bear market takes much longer to recover.

Structural problems are being neglected, the disease is not cured

We should take a step back and understand that we don't easily get into the situation we are in worldwide. It takes many years of excessive and irresponsible behavior from governments and financial institutions.  And there will not be a quick resolution to solving the dire situation we are in because the structure of the society that created it will have to be changed. Politicians are more interested in securing their re-election through pork and looking after their own interest rather than complying with the mandate for which they were ultimately elected, i.e. looking after the greater good and striving for fiscally balanced budgets, whilst CEO's do everything to secure the highest pay package at any cost, hence the buyback programs that don't create any new jobs. Next to that the politicians and CEOs don't have to worry about their pensions, they take care of themselves!!

We see this trend of rescuing institutions for the wrong political reasons all over the world. The symptoms are patched up instead of curing the disease. As a result with all of the potential problems being stretched to the max and little tolerance for adversity, it will only take a small event for one of these problems to explode creating a strong chain reaction because as a result of globalization all countries have become intertwined. The banks are exposed to all of the hot spots and basically connect all of the chains and will trigger this chain reaction in our view. As an example German and French banks have an $119bn exposure to Greek borrowers and more than $900bn to Portugal, Ireland and Spain. Together, French and German banks account for 50% of all European banks' exposure to those countries and almost half of the outstanding debt is with Spain (BIS data, the data includes government bonds, corporate debt and loans to individuals). This shows the potential contagion and systemic risk to the banking system. Next to that we don't believe that any country can really extract itself because in the end all economies are connected to each other through the currencies.

It is like we don't want to see the bigger picture

We all know what the problems are although we seem to neglect them: the sovereign debt issues with Greece, UAE, the other PIIGS countries (now STUPID, Spain, Turkey, United Kingdom, Portugal, Italy and Dubai); Spain has public and private debt of $4.9trn, GDP of $1.6trn and unemployment of 20%; The start of the sale of government bonds by the Japanese Pension Fund to fund pension payments for its aging population (Japan is a good example of what is in store for the West); the residential as well commercial real estate problems in the US (The banks, that seem to ignore that real estate is the cornerstone of the economy and the financial system and thus banking system, are not facilitating the modification of the mortgage conditions and as a result less than 1% of the troubled residential mortgages have been modified). The new mortgage solution plan by the Government sounds to ridiculous to be through; the current deficits of California and Illinois and other states. It is estimated that the underfunded pensions have created a shortfall of $3trn because the states have been using an actuarial interest rate of 8%. Bondholders beware according to state law states are required by law to pay pensions before bondholders; defaulting Muni's; the ending of the purchasing of the MBS worth $1.25trn keeping mortgage rates artificially low; record 3m repossessions in the US in 2010;  US February record budget deficit of $221bn (to put this into context Greece needs to raise about €53bn ($72bn) this year, which would take its debts to €290bn ($391bn), nearly 120% of gross domestic product); a looming downgrade of UK and US AAA  debt status foreboded by swap rates being lower than government bond yields and some corporate yields (Exxon, J&J, Berkshire Hathaway). The former CBO director Holz-Eakin states in NYT that the health bill will raise the deficit by more than $500bn over 10 years i.e. as usual there are a lot of different versions. Every interested party is creating their own truth further increasing the mistrust of citizens in the government.

The unwinding of the carry trade will strengthen the US Dollar

The unwinding of the carry trade will mean that all asset classes will be sold off and that investors will have to cover their short positions/borrowings in US Dollars. The US Dollar will strengthen for purely technical reasons and not fundamental reasons; moreover the US economy is in shambles. Barring some extreme circumstances, i.e. an Israeli attack on Iran (the Russians have announced that they will start the Bushehr reactor in Iran this summer), we believe gold will also be sold off initially because of its inverse correlation with the US dollar and the need for redemptions. And when the technical strengthening of the US Dollar reaches its peak, investors will wonder why they hold dollars considering the bleak economic circumstances in the US and will likely switch massively back from US Dollars to gold.

This will be the moment that precious metals will really perform because gold only performs when all other asset classes are exhausted. During the banking crisis in 2008 investors could, despite the perfect storm for gold, still seek refuge in US Treasury bonds. With the QE not having its desired effect and with the Fed forced to purchase an estimated $690bn of treasuries under the title of direct bidders in 2009 due to diminished loan demand interest rates are bound to rise not because of inflation but because lacking loan demand from the private sector investors will need a much higher risk remuneration (showing in higher interest rates and CDS rates) as already demonstrated by investors investing in Greek sovereign debt and debt of the UAE.

Very high leverage in carry trade

The carry trade can be unforgiving, whereby billions of dollars are wagered daily in the "carry trade." In a carry trade investors sell the weak currencies of countries with low interest rates like the U.S. and Japan, while simultaneously buying the currency of countries with higher rates, like Australia and Brazil, or buying higher yielding asset plays such as commodities or corporate bonds. Because currency trading typically involves heavy financial leverage—traders borrow as much as $500 for each dollar they invest to amplify results—the carry trade can from one moment to the other moment cause huge losses. That is what happened in the fall of 2008, when traders suddenly rushed to the safety of U.S. dollars during the financial crisis since it is the reserve currency. Those who had sold the dollar and Japanese yen to own higher-yielding currencies quickly piled up big losses as these other currencies sank in value. The losses wiped out several years' worth of gains in the carry trade. The carry trade is built on the belief that, over time, high-interest rate currencies appreciate against low-rate currencies. Since March 2009, one of the most popular trades involved selling, or "shorting," the low-yielding U.S. dollar and simultaneously buying the high-yielding Australian dollar. Though it currently looks like the carry trade could be reversed any moment.

The US dollar carry trade is estimated to be $1,500bn which is half as big as the Yen carry trade which between 2004 and 2007 was estimated at $1,000bn. Since the US dollar was used as a funding currency for the carry trade in March 2009, the dollar has declined by 17% till December 2009.  Since then the US dollar has risen by 10% to a 10 month high.  Reasons the Dollar strengthened were, the tightening of credit in China, the problem in Greece thereby weakening the Euro, the raising of the discount rate from 0.5% to 0.75% and the willingness of the UK to extend the QE lead to a relative strengthening of the US dollar.

Conclusion

Despite its strengthening and the fact that the US dollar is the reserve currency, we do not believe that the US dollar will transform from a funding currency to an investment currency. For that to occur, the US economy needs to recover, however the future economic problems are too big to be resolved. We believe we see a temporarily improvement in the market because of better comps and restocking and the stronger stock markets which are artificially boosting consumer confidence.

Some 162,000 new jobs were created in March of which 48,000 were census workers and 40,000 temporary workers whilst the unemployment rate stayed at 9.7%. The economy has to create 100,000 new payrolls a month in order to keep up with the growth in the workforce. From a cyclical point of view the figures were helpful though from a structural point of view it is doubtful if the recovery is sustainable and if the economy has the balance sheet strength to pull us through. With the entire stimulus going on of hundreds of billions of dollars an increase of 114,000 new jobs seem to us as a very poor return on investment! So imagine what the job creation will be when the stimulus drops away.

All the money on the sidelines has to be sucked in before the market can really break down for the second time. Though when the stock market goes the confidence will go. With all the QE and near defaulting sovereign debt we don't believe the "recovery" is sustainable and as mentioned here above we just don't have the balance sheets to back it up. Watch the treasuries (with the 10-year treasury crossing the 4% level) and unexpected events (special purpose vehicles or other off balance structures such as repo 105 we don't know about or geopolitical happenings) that will shock the investors' confidence.

We believe that investors might start taking profits soon since a huge, non-sustainable, improvement in the economies has been discounted and that they might rotate their profits into gold and silver (preservation of assets). Subsequently when the market really starts to sell off investors could sell gold and silver to take profits which could create the buying opportunity of a lifetime for gold and silver.

Invest in gold and silver and the mining companies, water rich agricultural land and water.

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