Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Avoid or Underweight Municipal Bonds in 2009

If major sovereign borrowers like Germany and the Netherlands are having difficulties raising weekly bond auctions since October, imagine what lies ahead for many distressed U.S. municipalities in 2009. The picture isn’t pretty, unless the Federal government under Obama bails out the weakest credits, including California, now in the midst of yet another full-blown budget crisis.

Municipal bonds have already suffered huge historical declines this year with most of those losses occurring earlier in the year. Muni bonds are offered on a tax-free basis at the Federal level and currently provide hefty tax equivalent yields to investors.

Indeed, even now the spread between municipal bonds and the ten-year Treasury bond remains wide at 2.27%, or 227 basis points. That’s near the high recorded about ten months ago (5.02%) when the sector began to unravel on funding concerns and fears of default. In September, the sector crashed again only much harder following Lehman’s bankruptcy. The Merrill Lynch Muni Master Index currently yields 4.43%.

Earlier this fall, investment grade municipalities, New York and New Jersey, attempted to raise money for the Port Authority, part of the bi-state transportation chain. Despite offering attractive terms on a short-term note, the sponsors scrapped the auction because of tepid interest. Not a bullish sign in times of acute credit stress.

If you own municipal bonds or mutual funds invested in municipal bond securities my advice is to make sure they’re not more than 5% of your portfolio.

I really don’t care about the attractive tax-equivalent yields now offered; fears of rising defaults make holding these securities risky amid a credit crunch. Many cities and towns are now entering a crisis funding environment and unless Obama offers fast relief, a wave of defaults is likely in 2009.

I’m off to Florida until Monday, January 5 and I won’t be blogging while on holiday.

On behalf of the fine team at The Sovereign Society, have a happy and healthy New Year and I certainly hope 2009 is a better year for investors. We can all use some holiday cheer.

See you on January 5.

Is Investment Grade Corporate Debt Safer than Government Bonds?

Several segments of the credit markets have come back to life in December after crushing losses recorded in September and October. Though it’s too early to celebrate a broad based credit revival, the largest issuers of investment grade debt have surged this month as yields plunge. Mortgage-backed bonds, or agency debt, have also rallied sharply in December on the heels of government guarantees and the Fed’s plan to spend $500 billion dollars to shore up the sector.

With the United States and other governments amassing a truckload of debt to finance state sponsored bailouts of financial services and fiscal spending plans, it is conceivable that investors will increasingly swap low-yielding T-bonds for high quality corporate debt in 2009.

Since hitting a post-crisis peak of 4.88% in October, three-month LIBOR (London Interbank Offered Rate) has plunged to 1.52% on December 19. On December 1, LIBOR stood at 2.22%. A lower LIBOR rate is the first indicator to finally emerge from stress amid the credit crisis. Banks are still largely hoarding cash but several large institutions have started to lend in overnight markets this month for the first time since late 2007.

The Growing Yield Dilemma

The Federal Reserve’s latest interest rate cut to effectively 0% on December 16 has laid the foundations for more trouble at money-market funds where yields for 30-day and 90-day Treasury bills continues to fetch just 0.01% -- the lowest in more than six decades. Earlier in December 30-day bills actually turned negative for the first time since 1940. That means investors are paying the government to park cash.

Money market funds are now sitting on potential losses as management fees erode the yield generated by Treasury bills and other short-term paper. Though other debt securities yield more than T-bills, investors might be embracing more credit risk as fund companies look to boost yield.

A better alternative to money market funds include one-year term deposits (CDs), short-term investment grade bonds and even intermediate-term corporate debt. Term deposits should be held only at the nation’s biggest banks, including J.P. Morgan Chase, Wells Fargo and Bank of America.

Yield Hungry? Here’s a Free Lunch

The Fed’s latest moves to spur lending in a massive credit inflicted bear market since 2007 is forcing many investors to turn to distressed corporate investment grade bonds. The effective yield on the benchmark Dow Jones Corporate Bond Index is 7.23%, down from a record high of 8.88% just a few months ago and down from 8.06% on November 30. A lower yield means corporate bond prices are rising in value.

In September, investment grade bonds were hammered following the collapse of Lehman Brothers Holdings and posted their single worst month of performance since February 1981. Many bonds plunged more than 15% alone in September.

More than half of the investment grade bond sector is comprised of financial services debt or bonds issued by some of the largest banks in the United States and Europe. With the Fed’s implicit guarantee on the largest issuers of such debt, investors can now tap into bank issued bonds trading at a 5.16% premium to expensive Treasury bonds.

For a portion of an investor’s liquidity, corporate high quality debt is literally a “free lunch.” The largest issuers of corporate paper have started to return to the market since November, including IBM and other large cap companies. In Europe, some banks without government guarantees have managed to raise sizable offerings – a positive development.

Corporate Debt: The New Safe-Haven?

Since October, governments in the United States and Europe have swapped government paper for toxic mortgage-backed assets previously held at banks. Despite these efforts, most banks are still laced with all sorts of other clogged credits like leverage loans, auction rate securities and repo credits.

The credit crisis has not disappeared because of aggressive government and central bank action; rather, swaths of credit risk has been transferred from bank balance sheets to government balance sheets, effectively polluting central bank coffers with largely illiquid and near worthless paper. Since August, the Fed’s balance sheet has mushroomed from $850 billion dollars to more than $1.5 trillion dollars – and still rising.

Indeed, credit default swap rates since October have risen sharply on government paper while swap rates have decreased for the highest quality companies. This suggests investors are starting to place a risk premium on government issued bonds.

Are we at the cusp of a major transition in the credit markets whereby investors might increasingly purchase investment grade debt as a hedge against rising yields on government bonds? After all, outside of the financial sector many industries harbour their highest net cash levels in more than a decade. For some companies, especially the food and beverages and fast-food companies, cash flow is largely generated internally and, in most cases, these companies don’t need to raise cash to finance operations. I would argue that companies like Kraft Foods, General Mills and McDonald’s are a better long-term credit risk than most sovereign borrowers.

Failed Auctions Rising

To confirm the above theory that perhaps investors are starting to embrace riskier bonds like investment grade debt because of bulging government deficits, consider the trend in Europe since October whereby several governments have scrapped bond auctions.

Over the last sixty days, Germany, the Netherlands, Italy, Spain, Austria and the United Kingdom have either scrapped bond auctions or reduced their planned offerings because of tepid investor interest. These governments, including Germany, the largest and most liquid, are paying higher yields to draw institutional buyers. This could mark the beginning of a bear market for government bonds at some point later in 2009, once credit markets stabilize and risk taking is resumed.

In the United States, demand for Treasury’s remains strong because of fears of deflation. The current environment – a disaster for just about every asset class except T-bonds – has supported the dollar to an extent. Foreigners are chasing Treasury securities as they scramble for safe havens. Yet even Treasury is not immune to the deluge of supply coming our way in 2008.

Over the next 12 months Treasury estimates it will have to raise about $1.5 trillion dollars to fund gargantuan fiscal spending plans, bailouts and, possibly, tax cuts. Treasury will re-introduce one-year, three-year and five-year T-bonds in 2009 to finance part of this spending spree. At some point, investors will force long-term rates higher. The Fed will try to influence the long end of the yield curve but will ultimately be unsuccessful. The Fed can only control short-term lending rates.

Investment grade bonds shouldn’t supplement T-bills. The risk spectrum is normally quite significant in a normal economic environment. Yet these are anything but normal economic times. It is possible that as 2009 progresses and, assuming credit markets continue to grudgingly normalize, the new safe haven in bonds will be high quality investment grade bonds at the expense of super low-yielding Treasury debt.

Managed Futures Shine in 2008 Massacre

Managed futures funds or Commodity Trading Advisors (CTAs) rank as the second best performing alternative index in 2008, according to Credit Suisse-Tremont.

This year, the CSFB/Tremont Hedge Fund Index has declined 19% through November compared to a 15.6% gain for the CSFB/Tremont Managed Futures Index. Only dedicated short-sellers have outpaced CTAs, up 16.8% in 2008.

Hedge funds are suffering their worst calendar year of performance in history and have attracted a blizzard of redemptions only exacerbated by the recent Madoff scam. Estimates point to approximately a 35% shrinkage of hedge fund assets in 2008 with many shops set to close as margins collapse and assets nosedive.

It’s a different story altogether for managed futures this year.

For example, as global markets crashed about 19% in October, managed futures as a group earned 5%. That’s the sort of diversification investors need now.

Managed futures funds or CTAs, trade over 100 highly liquid global futures contracts, including stock indexes, bond indexes, currencies and commodities. Provided there’s a trend to maximize, either up or down, CTAs can make money in any market.

Managed futures are certainly not a new asset class. They first started trading as a collective investment vehicle back in the late 1960s and were pioneered by such legends as Richard Dennis, Monroe Trout, Luis Bacon and John W. Henry.

The most popular trading model used by CTAs is the computer-generated trend-following system pioneered by Richard Dennis. There’s been no shortage of trends this year, especially for those traders selling short a host of global indices, including commodities.

The only major caveat is volatility; CTAs experience sudden and protracted draw-downs exceeding 15% when long-term market trends change forcing their trading models to adjust. That’s why for most investors a maximum 10% allocation is sufficient.

Unlike hedge funds, which can be largely illiquid products, managed futures are highly liquid with settlement of most contracts available on most major global exchanges. They’re also policed far more regularly by the NASD and the CFTC in the United States. You really don’t hear about managed futures or CTA scandals very often whereas some hedge funds seem to blow-up every year.

In the United States the individual investor must be accredited to purchase a managed futures limited partnership. This typically requires a gross income of at least $250,000 or a net worth of $500,000. But offshore, many of the same U.S. managers are available starting at just $30,000 and don’t require you to be accredited. Of course, if you’re an American citizen there are potentially onerous tax consequences on offshore funds, unless you tuck that investment away in a tax-deferred plan.

In a year when most asset classes failed to protect investors, managed futures did the job. These products thrive on short-term volatility. I’m sure we’ll see much more of that in 2009 and beyond as markets remain on edge. CTAs should flourish.

Elastic Band Theory Stretches Oil Price Crash

The “Elastic Rubber Band” theory is a popular investment term to describe wide price swings in asset markets. Market moves are usually exaggerated on both sides of the trade and this year’s volatility in oil prices is a testament to that swing.

In a bull market, trends tend to rise far above anyone’s boldest predictions while the same is true when a major reversal lends to big price declines. Could anyone have possibly predicted crude oil would be trading at $35 six or even twelve months ago?

Now oil producing countries are looking to arrest a crash in oil prices – down a formidable 76% since peaking in July at $147 a barrel. Oil now trades at a 4-year low and is down a dizzy 62% in 2008 – its first calendar year decline since 2001. In late 1998, amid the Asian economic crisis and the Russian debt default, oil prices bottomed at $10.50 a barrel (see above chart).

Is it possible we’ll see $10 oil again? I think it won’t happen, barring another Great Depression.

Global governments are in the midst of the greatest expansion of credit in modern history. As liquidity eventually finds its way back into credit markets and lending commences once again, commodities, including oil, should find a bottom. That’s what happened in 1998 as the Asian economic crisis ended; ten years later, oil is still trading 233% higher though down a mind-boggling 76% from its all-time high in July.

O.P.E.C. (Organization of Petroleum Exporting Countries) announced production cuts of 2.2 million barrels per day this week to stem the rapid decline in crude. With the global economy now either in recession or heading into a serious period of economic contraction in 2009, demand for oil and other distillate products has declined sharply since September. China, the largest importer of most raw materials and the world’s third largest importer of oil, saw exports decline in November for the first time in years.

It would seem logical to assume that oil prices have clearly overshot to the downside at this point. I would imagine most of the decline in global demand has already been priced into oil at $35 a barrel. Facts are global long-term supplies are not being replaced by annual production, with most oil fields now in decline.

Only several months ago, the world stood at a net deficit of about 2 million barrels per day or, roughly, 86 million barrels of demand per day against supplies of 84 million barrels. Now that gap has not only narrowed but, in the span of just three short months, has turned into a gusher as supplies overwhelm producers.

It’s unlikely that a new bull market is taking hold in oil any time soon. We’ve just had a bust. Yet it would be a mistake to dump oil and the energy stocks at this point after huge declines since July. If anything, this is the time to buy oil ahead of aggressive U.S., European, Chinese and Japanese economic stimulus in 2009. If history is any guide – the Asian experience ten years ago, a depression by all accounts, eventually saw oil bottom at a ridiculously low level – it’s hard to believe we’ll see $10 oil again.

Have a good weekend. See you on Monday.

Money-Market Fund Investors Face Yield Dilemma

Where should an investor park cash?

The Federal Reserve’s interest rate cut on Tuesday to 0.25% to 0% poses some serious challenges to cash management for investors. The yield on 30-day and 90-day T-bills is now at just 0.01% this morning and actually turned negative briefly last week as nervous investors continue to lunge after super-safe bills.

A negative interest rate implies investors are paying the government to park cash and not the other way around. It marks the first time since 1940 that short-term bills have turned negative, if only temporarily.

But the Fed’s historical rate cut this week now poses serious business risks to mutual fund companies offering money-market and government money-market funds because the yield is too low to cover fund expenses. Several mutual fund companies have recently closed their money-market funds, including Credit Suisse and an institutional money-market fund managed by Dreyfus Funds.

The seven-day average yield on taxable money funds fell to 0.88% on Tuesday from 0.94% a week earlier, according to iMoneyNet. Last year, money-market funds yielded north of 4%. The Fed has cut short-term lending rates ten times over the last fifteen months to quash the ongoing credit squeeze still plaguing U.S. and international capital markets.

Money-market funds are about to yield much less now that the Fed Funds rate is effectively almost 0% -- less than Japan’s target rate of 0.30%. Pretty soon, investors will start to lose money as fund expenses devour principal.

If you hold money-market funds, I strongly suggest redeeming these funds and placing them into a combination of 12-month CDs at two or more banks (J.P. Morgan Chase, Wells Fargo), short-term U.S. Treasury bonds and even investment-grade corporate debt. The latter is especially attractive now following a rare crash in September and October; the biggest U.S. banks continue to pay about 7% or more for investment-grade bonds that are now guaranteed by Uncle Sam.

I would also suggest gold. With interest rates now at 0%, the cost disadvantage to holding gold has vanished because high quality Treasury bond yields have plummeted while T-bills pay nothing. Gold will probably safeguard your capital better than paper money in this environment.

The lowest interest rates in more than six decades will undoubtedly fuel a wave of yield-hungry investors seeking higher returns. The best defense to protect your cash balances is to diversify among the above sectors to boost your effective yield without compromising on safety of principal. With rates basically at 0%, investors have no choice but to look elsewhere as deflation continues to gain momentum, threatening income based investors.

LIBOR Thaw Bullish for Investment Grade Corporate Bonds

Since peaking in October at 4.88%, three-month LIBOR, or the London Interbank Offered Rate, has plunged to 1.58% this morning. Although other credit indicators are mixed, a lower LIBOR rate is bullish for the short-term direction of credit markets and equities.

To be sure, this key lending rate affecting trillions of dollars in loans has started to finally track the decline in the Federal Reserve’s target Fed Funds rate. On Tuesday, the Fed cut its Federal Funds rate to a target range of 0.25% to 0%, even lower than the Bank of Japan’s current 0.30% target rate.

Despite the plunge in LIBOR lately most banks continue to hoard cash, including those institutions that have recently received government capital through TARP, or the Troubled Asset Relief Program. This suggests that even a lower LIBOR rate isn’t encouraging lending.

Meanwhile, the non-investment grade sector is still suffering as we shortly conclude 2008.

Funding for many companies in the high yield or junk bond sector remains largely elusive. Junk bond spreads are now at 16% above the ten-year U.S. Treasury bond yield – up from just 6% in September. I would still avoid junk bonds and emerging market debt. Default rates will rise in 2009.

Yet the spectrum for investment grade bonds continues to improve markedly since crashing in mid-September following the collapse of Lehman Brothers Holdings.

Investment grade corporate credit spreads continue to narrow since November. Combined with successful funding auctions over the last four weeks, including capital raised for some non-state guaranteed bank debt securities, investors are warming to investment grade credits.

I continue to recommend investment grade bonds for 2009. This sector should continue to recover ahead of other riskier credit indices. The yield flow from these bonds is attractive and bond prices are still roughly 10-15% below their pre-September highs.

Many financial sector bonds, now implicitly guaranteed by the U.S. government continue to offer attractive yields in excess of 500 basis points above T-bonds.

The Barclays U.S. Corporate AA-Rated Index has declined just 1% this year; the index now yields 6.25% compared to a multi-year high of 7.61% in October.

The Barclays U.S. Corporate Bond Index, a broader composite of investment grade paper, is yielding an effective 8.08% this morning compared to 9.09% in October. That’s a juicy 5.85% above ten-year T-bonds. This index has declined 7.8% in 2008 – its worst calendar year of performance since 1981.

Consider the risk/return profile now for investment grade bonds compared to stocks.

Over the last 20 years, the S&P 500 Index has returned only 2% more than the investment grade corporate bond market but accompanied by nearly three times the associated volatility. And over the last 16 months, I think investors have seen enough volatility to last a lifetime.

Why take on more risk in stocks when you can sit tight in corporate debt and get paid at least 6% while possibly securing some capital gains on any price appreciation?

It’s true that stocks have declined sharply over the last 12 months and might be poised for a massive bear market rally. Perhaps stocks are the better choice compared to corporate bonds. But if we’re heading into deflation, even a mild bout of falling prices, then look no further to the Japanese experience since 1990. There’s no assurance that stocks will hold above current levels – now up 21% off the November 20 low. Each rally since October 2007 has been met by a hungry bear taking stocks to new bear market lows.

Investment grade corporate bonds should be accumulated at these levels. The bargains remain abundant and yields north of 6% look pretty darn good in a low-to-no-yielding money-market and T-bill environment.

In-House Statements, Opaque Auditor Red Flags at Madoff

As news of the world’s greatest investment fraud continues to unravel this week, one of several important warning flags is worth heeding for new and existing investors in mutual funds, hedge funds and other investment products.

Bernie Madoff was arrested by the FBI last Thursday after admitting to his sons that his hedge fund business was a “total lie.” One of his boys, an investor in the Ponzi scheme, immediately went to the FBI in New York following his father’s shocking admission and tipped off the authorities. Madoff subsequently posted $10 million dollar bail.

It’s estimated that global investors lost over $50 billion dollars with Madoff in his several offshore phantom hedge funds. This is truly a staggering figure. For more than 15 years, Madoff claimed to have earned over 10% per annum with very few losing months invested in a strategy tied to low volatility split-strike option arbitrage. If you don’t know how this strategy works, you’re not alone.

But here’s a point worth heeding if you’re an existing investor in a collective investment vehicle or considering taking a punt in a hedge fund: Bernie Madoff issued in-house statements to clients reflecting the value of their investments in the now defunct firm. That’s not kosher conduct.

Mutual funds and hedge funds must use a third-party custodian to conduct monthly net asset value prices, shareholder services and other fund administrative functions. But Madoff didn’t use a custodian and instead issued his own statements (Madoff Securities) to clients reflecting the value of their investments at any given time. That’s a major red flag. An advisor should not use a subsidiary to conduct client valuations and issue statements.

Another warning was Madoff’s audit firm, a single person operation located in up-state New York. It seems pretty odd to have a $50 billion dollar operation audited by a tiny opaque one man show somewhere out in the sticks.

Did Madoff’s investors consider these points? Did some of the big institutions invested in his funds ever visit the auditor?

The list of the super rich and high net worth investors, including European private banks and Israeli foundations tied to Madoff, is impressive. What’s even more astonishing is that these and other investors failed to conduct proper due diligence.

Tremont Advisors, one of the leading hedge fund investment and research firms in the United States is reported to have lost half of its total assets in Madoff’s hedge funds. Another unit invested everything with Madoff.

In hindsight it’s easy to point blame after a high profile hedge fund failure shows the laundry list of failed compliance directives by private banks, foundations and other investors. Yet it’s truly amazing that considering the level of sophistication and assets under management that these companies so blatantly failed to acknowledge and investigate these and other red flags.

The real winners in this scandal, unfortunately, won’t be investors. Instead, the lawyers involved in this fiasco will earn millions as it takes years to unravel Madoff’s intricate web of lies.

Madoff Hedge Fund Scam Further Blow to Industry

After landing at Vienna International Airport last Friday, my colleague and good friend at an Austrian private bank informed me of the Bernie Madoff hedge fund scandal. I was truly shocked and, thereafter, disgusted.

Approximately $50 billion dollars has been lost in the biggest hedge fund scam in history. Though it’s still too early to ascertain exactly how much, if any, investor capital will be recovered, the odds are pretty high most Madoff investors won’t see a nickel.

How can someone knowingly rip-off his investors, including his own son, friends and large international investors year after year without any remorse, no shame? This is truly unbelievable.

How can Bernie Madoff live with himself?

The damage done by this scandal will add even more insult to injury to hedge funds. The industry is now suffering its worst public relations disaster since the Bernie Kornfeld IOS scam in the early 1970s. Hedge funds are estimated to have lost about one-third of their total assets in 2008 and now, more investors will probably run for the exits because the investment community has been shattered by a huge fraud.

Madoff ran several offshore and domestic hedge funds specializing in something called “option arbitrage,” a strategy I barely understand yet alone would attempt to trade. Big institutional investors in Switzerland, Austria, Israel and elsewhere have suffered major losses following revelations last Thursday by Madoff that his entire hedge fund business was “one big lie.”

A classic Ponzi scheme, Madoff Securities would raise capital from new investors and then pay existing investors who redeemed. It was a massive gamble that worked for more than ten years producing low volatility returns while rarely recording a losing month. Investors with Madoff earned about 10% per annum in his hedge funds.

The jig was up for Madoff starting in November when a rash of redemptions overwhelmed his business or Ponzi model; many top performing hedge funds this year have unfortunately been victimized by a global liquidity crunch, including Madoff.

I actually reviewed one of Madoff’s prospectuses about three years ago. I was initially lured by his consistent returns; but after reading the prospectus, I determined that I didn’t understand his strategy and decided not to invest.

If you don’t understand an investment strategy, no matter how seemingly spectacular the returns, then avoid it. Yet amazingly, some very smart investors, including several I know personally have now lost millions with Madoff.

In the end, institutional and individual investors alike failed to conduct their own due diligence on Madoff Securities. Perhaps it would not have made a difference anyway.

I make it a point to travel and meet my advisors, conduct rigorous due diligence and ensure that I truly understand the investment strategy. If not, it’s see ya later. I also look to see how a prospective manager performed amid market carnage or big systemic-induced declines; if a manager consistently makes money under extreme market volatility then you’ve got to wonder what strategy can produce that sort of alpha or absolute return. This was the case with Madoff.

Still, you’ve got to wonder what Chris Cox at the Securities and Exchange Commission (SEC) does at work every day. This guy is a joke.

Regulators last performed a review of Madoff Securities in 2006; what were these guys doing at the SEC? It’s unimaginable that the nation’s regulator didn’t catch this fraud, especially considering that Madoff was overseeing $50 billion in assets.

As a side note, Madoff did make regular political contributions to several parties. I’m not sure what role, if any, this played in lax oversight.

The first thing I would do if I was president-elect Obama in January is purge the SEC. Cox must be fired. The SEC is totally out of control, with no oversight and in my book, gets a massive “F” for failing to properly regulate the entire securities industry.

Inflation on “Sale” as Deflation Dominates Global Markets

The time to start building fresh positions in oil, gold, silver and TIPs has arrived. Even distressed real estate should be accumulated if credit can be secured.

Over the next 6-12 months the United States, Europeans, Japanese and Chinese will eventually arrest deflation. And, long before that materializes, hard assets will begin a major reversal following months of crippling losses.

Since peaking in July, the entire gamut of inflation assets has collapsed amid a growing threat of deflation, or an environment of accelerated price declines. The last deflation in the United States occurred in the 1930s, purging household balance sheets, corporations, states, municipalities and even the government following two New Deals.

Thus far, U.S. CPI, or the consumer price index, has not turned negative year-over-year. Yet as oil prices continue to lose altitude and other commodities have been crushed, input costs and price pressures continue to decline dramatically since October. The only major component of CPI that continues to post modest year-over-year gains is wages. With unemployment now rising aggressively this quarter, it’s highly likely wage demands will also come to a screeching halt.

Plunging Bond Yields Discount Danger

In the span of just six months, foreign currencies (except the yen), commodities, stocks, non-Treasury debt, real estate and art have all declined sharply in value in the worst panic-related sell off in decades. More than $10 trillion dollars’ worth of assets has been lost worldwide in 2008.

What’s working since July? U.S. Treasury bonds and the U.S. dollar as investors scramble for safety and liquidity.

On December 5, 30-day and 60-day T-bills yielded just 0.01% -- the lowest since the 1930s while the benchmark 10-year T-bond traded below 2.55% -- its lowest yield since Eisenhower was president in 1955. Even 30-year bonds have surged as the yield recently dropped below 3% for the first time in more than four decades.

The market is now pricing a severe recession and, possibly, another Great Depression. Despite a series of formidable regular market interventions by central banks since August 2007, the credit crisis is still alive and kicking. The authorities have not won the battle – at least not yet.

Heightened inter-bank lending rates, soaring credit default swaps for sovereign government debt and plunging Treasury yields all confirm the primary trend is still deflation.

To be sure, credit markets worldwide have improved markedly since the dark days of early October. Investment grade corporate debt is rallying, commercial paper is flowing again and companies are starting to issue debt once more – but only the highest and most liquid of companies. For the most part, banks are still hoarding cash and borrowers can’t obtain credit.

The real economy is now feeling the bite as consumption falls off a cliff, foreclosures soar and the unemployment rate surges higher. These primary trends are deflationary as broad consumption is severely curtailed, with consumers preparing for the worst economy since 1981 and rebuilding devastated household balance sheets.

But at some point over the next 12 months, the market might transition from outright deflation or negative consumer prices to some sort of disinflation or at least an environment of stable prices. That’s when inflation assets should start rallying again.

Inflate or Die in 2009

The battle now facing global central banks, including the Federal Reserve, is an outright attack on deflation. Through the massive expansion of credit, the Fed and her overseas colleagues are on course to print money like there’s no tomorrow to finance bulging fiscal spending plans, bailouts, tax cuts and anything else that helps to alleviate economic stress.

Earlier in November, the Fed announced it would target “quantitative easing” and “monetization,” unorthodox monetary policy tools rarely or never used in the post-WW II era.

Without getting too technical, the term “quantitative easing” implies the Fed will act as the buyer of last resort to monetize Treasury debt and other government agency paper in an attempt to bring interest rates down. Quantitative easing, however, aims to flood the financial system with liquidity and absorbs excess cash through monetization or purchasing government securities.

Through monetary policy, the Fed controls short-term lending rates but cannot influence long-term rates that are largely set by the markets; the Fed now hopes it can influence long-term rates through quantitative easing and since its announcement two weeks ago long-term fixed mortgage rates have declined sharply.

These and other open market operations directed by the Fed and Treasury will eventually arrest the broad based deflation engulfing asset prices. It will take time. Inflation is the desired goal and is the preferred evil compared to deflation, a monetary phenomenon that threatens to destroy or seriously compromise the financial system. Policy makers have studied the Great Depression, including Fed Chairman Bernanke, and the consequences of failed central bank and government intervention in times of severe economic duress are unthinkable.

According to Federal Reserve Board data, the Fed is now embarking on a spectacular expansion of credit unseen in the history of modern financial markets.

The total amount of Federal Reserve bank credit has increased from $800 billion dollars to $2.2 trillion dollars (or from 6% to 15% of gross domestic product) as the central bank expands its various liquidity facilities in an attempt to preserve normal functioning of the financial system.

The Fed’s ongoing operations to arrest falling prices are targeted namely at housing – the epicentre of this financial crisis. It is highly unlikely that the United States economy will bottom until housing prices find a floor. Quantitative easing hopes to stabilize this market.

Buy Gold Now

Relative to other assets in 2008, gold prices have declined far less. The ongoing liquidity squeeze has forced investors to dump assets, including gold to raise dollars. I suspect this short-term phenomenon to end in 2009 once the ongoing panic subsides and credit markets become largely functional again.

Gold should be accumulated now ahead of market stabilization. As the financial system gradually comes back to life over the next several months or sooner, the dollar should commence another period of weakness; there will be little incentive to hold dollars with short-term rates at or close to zero percent. The Fed will be in no hurry to raise lending rates.

Still, the Japanese experience in the 1990s warns investors of the travails of long-term deflation.

The Japanese, unlike the United States, only started to seriously attack falling prices in the economy in 1998 through massive fiscal spending. In contrast, the U.S. is already throwing everything at the crisis after just 17 months.

I expect the United States to print its way out of misery and, over time, conquer deflation. But the cost will be humungous and at the expense of the dollar, U.S. financial hegemony and calls for a new monetary system anchored by gold.

It’s literally “inflate or die” for global central banks. Inflation will win.

What the Smart Money is Doing Now in London

The weather in London today is cold and rainy but some of the best money-managers in the City (London’s Wall Street equivalent) have some compelling ideas and comments about the ongoing global financial crisis and prospects for 2009.

On Wednesday, I visited several large, established British hedge funds and managed futures advisors. Both breeds of alternative investments are different.

Hedge funds, which have plunged about 20% this year, have become the markets’ whipping boy as Congress and market regulators seek to curb their “black box” mentality and impose greater rules, especially on leverage. The industry is estimated to have lost about 20% of its assets this year, including high profile losses for many managers.

Managed futures or Commodity Trading Advisors (CTA) trade over 100 global futures and options markets 24 hours per day typically using trend-following models generated by computers. Managed futures are the only subsector of the alternative funds industry to actually post a gain in 2008, up about 10% thus far. More than any other asset class, futures strive amid extreme market volatility as trends emerge on both the long and short side of the market. And, unlike hedge funds, futures are highly liquid.

By far my most interesting encounter was with a global macro long/short hedge fund manager who is one of the best stock-pickers in the world since 2001. This British manager has gained a cumulative 364% over the last seven years with no calendar losses and is up a spectacular 27% in 2008, mostly from shorts. His minimum investment is $500,000.

According to Mr. X, the link between central banks and commercial banks has been broken and will take time to repair. There remains a huge degree of distrust among counter-parties and banks are still flush with toxic assets. His macro view is bearish, forecasting another difficult year in 2009 coupled with high volatility and an environment of declining corporate profits. He remains net short of the banks, investment banks, money-management companies and utilities. This manager is also shorting, or betting against, Berkshire Hathaway believing the Oracle of Omaha’s insurance unit will suffer losses coupled with bad bets on derivatives.

Though Mr. X believes we’ve already witnessed the bulk of the stock market’s decline, he still thinks trading the market on a net short basis is the smartest strategy in 2009.

The managed futures team I visited doesn’t employ a directional strategy based on market fundamentals. Rather, it is a trend-following strategy guided by market algorithms; there are no hunches or assumptions. The computer directs trades.

This managed futures advisor or Mr. CTA has gained 19% this year and is up an average 19.4% per annum since 1999 with no losing years.

Mr. CTA is currently long government bond indices, the dollar and short global stock indexes, the euro, sterling and commodities.

Another group of managers I visited are among the most successful in the conservative multi-manager hedge fund arena. These guys specialize in All-Weather hedge fund investing, mainly in distressed debt, asset backed lending, event driven, merger arbitrage and convertible arbitrage. Since 1994, the group’s flagship product has gained 9% per annum – pretty impressive for a low-risk strategy.

Unfortunately, this All-Weather fund is down more than 15% in 2008 with big losses booked in September, October and November. This marks the first loss for this strategy since its inception 14 years ago.

Still, this multi-manager team is incredibly bullish on distressed debt and bankruptcy reorganization strategies as most of the debt spectrum trades at a big discount to face value in late 2008. Though they believe the markets will continue to trend lower and spreads will continue to widen, we are approaching the best environment for distressed debt since 1991. They believe busted credits, or distressed debt, will double rather quickly once a bottom in this market is formed.

Overall, the consensus among the managers I visited is that we are in a prolonged global economic recession that will extend beyond 2009. Investors should maintain low stock market exposure while keeping cash levels high. We’re not out of the woods yet.