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

Don’t Underestimate the Power of Deflation

In a span of just three months the great safe-haven trade has violently unwound in favor of risk-taking across stocks, speculative bonds, commodities and currencies. And Treasury bonds, which rallied to their lowest yield levels since the 1950s in December, have posted their worst losses since 1994 the first six months of 2009.

Dumping T-bonds has been a great trade this year for several reasons.

First, the yield on the entire Treasury curve was absurdly low heading into January. The bear market in stocks and other risky assets drove investors en masse into safe-haven trades – mostly Treasury bonds starting in August 2007. Then fiscal spending was unleashed as the government attempts to quash deflation in the economy.

The massive supply of Treasury issuance this year has resulted in a deluge of paper hitting the marketplace and investors are increasingly balking at funding America’s multi-trillion dollar deficits at current rates. The Chinese, by far the largest holders of T-bonds at roughly 37% of total outstanding supply, have been unusually vocal expressing their concerns about monster-sized U.S. borrowing since April. Alarmingly, intermediate and long-term rates are violently reversing since May despite aggressive Federal Reserve T-bond purchases as part of its quantitative easing program. Investors should be nervous.

In short, this is the first bear market for Treasury bonds since 1994 and threatens to kill-off the bull market in Treasury securities since it was first unleashed in 1982 – mainly because of too much supply. The era of falling inflation or disinflation has given way to outright deflation since late 2008 – a boon for Treasury bonds. But now the market is concerned about over-supply and the threat of rising inflation as the United States prints its way out of misery.

These concerns are misplaced – at least for now.

The United States currently sports a savings rate of barely 6% of disposable income. That’s not a lot of firepower to spur new borrowing or domestic consumption – especially following a massive bear market in consumer balance sheets, including real estate, stocks and growing job losses. Twelve months ago, the savings rate was barely positive. It’s premature to believe consumers will draw down their newly fortified savings with a parade of fresh spending. That’s unlikely.

The Japanese, who suffered their own version of the “lost decade” in the 1990s, embarked on deflation in 1990 with a 13% savings rate – considerably higher than America’s current rate. Japanese consumers represent 55% of GDP, whereas American consumers represent 70% of total consumption. It’s highly likely that debt reduction and balance-sheet repair will inhibit this recovery and possibly force a repeat of the Japanese malaise more than 18 years ago. Government can print all the money it needs but it can’t force consumers to borrow, spend or purchase a home.

Next, interest rates at the long end are rising rapidly. This has the potential to chock-off any “green shoots” in the economy as refinancing collapses – delaying a recovery in residential real estate.

With stocks seemingly fully priced and certainly not cheap at current levels, Treasury bonds are once again competing with equities. Stock index dividend yields have markedly compressed since March and speculation is now widespread across the same investments that powered the pre-2007 bull market – emerging markets, commodities, foreign currencies. In a new bull market, leadership typically changes; but not since March.

A five-year T-bond currently yields 2.8% and like all T-bonds are heavily oversold while stocks are overbought. Treasury bonds are also selling below par so an investor can lock-in a small capital gain if they hold that security to maturity.

Inflation will make a comeback. No doubt about it. Obama won’t stop until we have inflation again. Yet the transition from a period of historical credit destruction (deflation) – still underway – to rising inflation is still a few years away. Wage inflation is bordering deflation or negative wage growth, housing prices are still deflating and consumer spending remains lethargic. Combined with the lack of bank credit flowing into the real economy, it’s hard to believe the stock market has truly discounted the worst.

This won’t be your typical post-WW II economic recovery.

I’ve started to nibble at five year Treasury bonds. Rates have ratcheted sharply higher since May and, in my view, the next 12 months will see a re-testing of the March 9 lows as deflation returns as a primary threat to recovery. By that time, this round of fiscal stimulus will have run its course and the market will be begging for another New Deal.

Toxic Bank Assets Still on the Books

Montreal, Canada

Since the stock market low on March 9 investors have been drunk with enthusiasm sending all risk-based assets skyrocketing following a relentless pounding since late 2007. And bank stocks, which hit a 19-year low on March 6 have since rallied a cumulative 104% as measured by the iShares Financial Select SPDRs or XLF.

But one of the major triggers of this financial crisis has yet to be cleansed: Toxic bank assets.

Since late 2007, former Treasury Secretary Hank Paulson and newly appointed Obama Treasury Secretary Tim Geithner have proposed different solutions to clean battered bank balance sheets by segregating bad assets vis-à-vis TARP or PPIP. Yet nothing has been done to eradicate bad loans still sitting on bank balance sheets.

The U.S. government initially pledged to buy toxic assets from banks to help them recover from the crisis but this directive has yet to be legislated or put into action. Bad loans are still on the books and other segments of distressed or potentially bad loans like commercial real estate are now starting to waffle.

Instead, the FASB (Financial Accounting Standards Board), under pressure from Congress and bank lobbyists fudged the accounting rules last month allowing toxic assets some leeway in how they’re valued. Allowing bank CEOs to determine the value of toxic assets is not true accounting; hocus-pocus trickery won’t fix the problem.

Also, U.S. banks – in the auspices of a soaring stock market – have successfully raised about $65 billion of fresh capital since April.

With the U.S. banking system apparently stabilizing since April, investors have decided to boost the value of financial services stocks – apparently disregarding the crisis and the underlying fact that many of the largest banks have not cleaned house.

From the beginning of this credit collapse the idea was to segregate bad assets into a separate entity allowing banks to finally write the value of bad loans off their books. This has not happened. Instead, every time the market has tanked since late 2008, either Paulson or Geithner have rushed to present new ideas to rescue the banking sector with zero follow-through or no policy action.

Eventually the government will have to either partially or fully nationalize the likes of Citigroup, Bank of America and other battle-scarred institutions. The problem won’t go away until bank books are cleansed. In the meantime, Federal Reserve bank-loan surveys continue to show anemic lending since late last year as financial institutions largely hoard cash and rebuild capital to cushion more bad loans in the future.

In the absence of the expansion of bank credit it’s pretty hard to envision a sustainable economic recovery this year. The economy won’t grow without bank lending – and that won’t happen until banks are confident bad loans are finally at their nadir, which is certainly not the case in mid-2009.

Junk Bonds Heavily Overbought Amid Tight Credit Noose

Montreal, Canada

One of the greatest asset reversals has occurred over the last three months with stunning velocity.

Junk bonds, or high-yield bonds, have seen their yields crash since peaking in early March from 17% to just 9.3% now, according to the Merrill Lynch-Bank of America High Yield 100 Index. The index has gained 17% in 2009 – better than U.S. stocks and other segments of risky credit.

According to Moody’s, the U.S. speculative-grade default rate on junk bonds surged to 9.2% in April compared to 8% in March and 2% a year earlier.

Moody’s, however, predicts the default rate will peak at 14.8% in the fourth quarter before declining to 10.4% twelve months from now.

Overall, 89 of the 112 defaults year-to-date were by North American issuers while European companies accounted for another 11 defaults.

With all due respect, these are the same guys that gave high credit ratings to mortgage insurers and a host of banks and investment banks with little or no tangible assets ahead of the credit crash in late 2007. I’m not sure the default rate will peak in the fourth quarter. In fact, I’m betting the opposite will occur.

Historically, the default rate on junk bonds has peaked at around 10-15% in previous post-WW II recessions. But this isn’t a normal recession; we’re still trying to climb out of the worst credit environment since the 1930s with banks mostly hoarding cash and the government still heavily involved in consumer and mortgage-backed lending facilities. This will not be a “normal” post-war recovery because credit expansion remains anemic.

More importantly, if credit to the best rated companies remains challenging then imagine what lies ahead for junk bond rated companies? This group has a tsunami of refinancing coming due from now until 2014 to the tune of $950 billion dollars. If the strongest credits are still struggling to raise capital and certainly paying a premium over short-term lending rates to secure that credit then it only seems logical that junk bond financing will struggle.

In other words, there’s an avalanche of defaults coming our way in the high-yield sector – assuming the economy isn’t in a new bull market. And historically, you never buy junk bonds when the default rate is still rising; still, as default rates have climbed markedly recently junk bond prices have soared. Something is wrong with this picture.

Bear market rallies are always convincing. The worst of the lot get swept away with the short-term trend making an ugly duckling look like a golden goose. This is still a very challenging macro credit environment whereby financing and refinancing trends have not returned to pre-crisis levels.

Yes, the government has done a good job masking the damage and insolvency of the banking system -- including fudging the accounting rules -- but now the real economy is next on the chopping block. This will be a much harder magic trick to follow. We’re nowhere near the end of this bear market in credit.

In the recent issue of my Accelerated Income I just issued a recommendation to short or bet against junk bonds – up 29% since the March low. Moody’s is wrong; the default rate will probably peak north of 20% in this cycle just like it did more than 75 years ago.

Have a good weekend. See you on Monday.

Blow-Off Stage on the Horizon for Stocks, Junk Bonds

Montreal, Canada

Bull markets might climb a wall of worry. But this rally is defying reality as it pertains to corporate earnings, domestic consumption, tepid bank credit expansion and surging long-term interest rates. The market is now more dangerous than at any other time since late 2007.

The biggest fear right now is the big move in long-term Treasury and mortgage rates.

The spike in yields is killing an already heavily leveraged economy in the process of recovering. Refinancing activity is now falling off a cliff again. At J.P. Morgan (quoted in today’s Wall Street Journal), “refinancing activity is already really down since rates began rising. A rate of 4.75% seemed to be the switch that turned on refinance activity.” The rate on 30-year fixed-rate mortgages is now at 5.78% this morning – up from 5% just two weeks ago.

By the way, foreclosures continue to hit records through April – and May won’t look any better as mortgage financing has plunged again amid soaring rates. Basically, housing hasn’t bottomed.

Yet the stock market is watching a different movie and it’s bullish…

Since the intermittent lows of March 9, risk-based assets have progressively rallied with some indexes breaking above important 200-day moving averages recently. Two weeks ago, the S&P 500 Index crossed its 200-day moving average – typically a bullish signal.

Unlike previous bear market rallies since October 2007 this one admittedly looks much brighter with liquidity returning en masse into several important credit markets and speculative bond yields plummeting. LIBOR rates have also plunged, corporate investment grade credit spreads have declined and investors are finally leaving the low-to-no-yielding sanctuary of money-market funds for stock funds since May.

Over the last three months the S&P 500 Index has surged more than 41% and the MSCI World Index has gained 34%. High-yield or junk bonds have rallied more than 35%, including interest income. Just about everything with a risk bias has skyrocketed since early March – including some mind-blowing gains in the emerging markets. I find the latter development especially odd since a chunk of this index is insolvent; banks in Eastern and Central Europe are largely bust and there remains the real possibility of a default in the Baltic Republics, namely Latvia.

So is this really a new bull market? If the Dow Jones Transportation Average closes above 3,404.11 then, according to Richard Russell (Dow Theory Letters), we’ve got a significant reason to be less bearish. That index would confirm the rising trend of the Dow Jones Industrials Average.

Even if this is a new bull market, I’m largely avoiding common stocks because risk is high and values are now scarce. The only stocks I like are the food and beverages like Néstle, Kraft Foods and McDonald’s.

The parallels between this credit crisis and the 1930s is close enough to warrant extreme caution; banks are still not lending, the Fed has not disengaged from several infected credit markets and the consumer isn’t spending in an environment of balance sheet repair and rising job losses. It’s naïve to believe China alone can save the world economy.

It’s just too risky to buy stocks here. At the very least, I’m compelled to wait for a pullback this summer and then add to some equity positions. But not at these levels.

Instead, I’ve been accumulating convertible bonds, investment grade corporate bonds and,recently, natural gas where the gas-to-oil ratio now stands at its widest since 1991.

We’ve possibly seen the lows in 2009. The amount of money being thrown at the financial system and into the real economy has been enormous – about $4.5 trillion in the United States alone.

Still, I’m looking carefully at the big spike in long-term interest rates and I don’t like what I see. I remind myself that we’re living in uncertain economic times and that this is a new world since 2007.

Investors seem to be lunging after risk again like its 2006 or Party Time, hopelessly relying on government to boost domestic consumption and sustain this bourgeoning recovery. Not me.

The Hunt for Value in Norwegian Bonds

Oslo, Norway.

Depending on your outlook for the global economy and corporate earnings over the next 12 months, Norwegian stocks are either a great buy or a timely sell. In my view, the investment-grade corporate bond market looks far more attractive – especially for dollar and euro based investors.

From an all-time high of about 520 in June 2008, the Oslo Børs or Stock Exchange has declined a cumulative 45%. Recently, the stock market broke above its important 200-day moving average – as did many foreign markets, including the S&P 500 Index. And despite offering attractive multiples and decent dividends the stock market remains hostage to events in New York; the Norwegian market was hammered last summer and along with the kroner (NOK) suffered a dramatic decline in just weeks.

Another correction or stock market plunge in the United States will undoubtedly drive equities lower here, too. The correlation between New York and other major economy remains high and diversification in the worst of economic times is almost futile. We all digested that fact in 2008 – the worst year for stocks since 1937.

Government bonds in Norway are not cheap at this stage, particularly the shorter end of the curve. The entire yield curve is fairly valued and offers little in the scope of additional gains with four-year Norwegian government bonds yielding 3.15% and trading north of NOK 112.

It’s another story altogether for investment grade Norwegian corporate bonds.

Many mid-sized to large-cap Norwegian companies now yield about 5-6% and some even north of 7%. Even better, many issuers are still trading below par value.

For example, Størebrand A/S, Norway’s second-largest insurance company, has a May 2012 issue selling at NOK 97.56 and yielding 5.03% or roughly 182 basis points more than comparable Norwegian government bonds. For dollar based and euro based investors – two screwball currencies with poor fundamentals, the NOK looks far superior.

If you’re looking to add some NOK to your portfolio I’d consider waiting for a correction in oil prices. Norway is mostly about oil. If prices come down this summer then the NOK will follow south. The NOK has already gained about 10% against the dollar and 8% versus the EUR in 2009. The dollar is also oversold and might rebound sharply, if only temporarily.

Yet here’s the primary reason why I like the NOK more than any other currency over the next five years: Norway has a superb balance sheet. The country’s current account balance as a percentage of GDP is a whopping 10.5% compared to 4.4% for Germany, 6.9% for China and 7.5% for Switzerland. Its trade balance stands at $70 billion dollars compared to big deficits as far as the eye can see for the United States, England and several other large European economies.

In a nutshell, strong fundamentals support the NOK – unlike most other currencies.

Of course, gold has outpaced the NOK and other currencies since 2005. I still prefer gold more than any other paper currency in the world and cling to my view that we’re probably approaching the next phase of this economic crisis as currency chaos envelops the United States, Europe and other sovereign nations. The global exchange rate system is sick and largely dysfunctional with crashes, devaluations, revaluations now a regular event since 1992.

Gold is completely outside of the credit system and is not a liability to the investor – unlike fiat money. Also, with central banks cutting rates aggressively the cost advantage of owning gold continues to improve.

Still, we can’t just sit on gold. As the U.S. dollar musters some additional strength this summer in another bear market rally consider selling the buck, euro and most other currencies for the Norwegian kroner, the Canadian dollar and gold. These currencies should lead the charge forward in the future namely because of their commodity wealth and strong balance sheets. Also, the Chinese yuan is part of this special club but only once it becomes fully convertible.

I’ll be in-transit tomorrow from Oslo. See you on Thursday.

Baltic Dry Index Boosts Denmark’s Maersk

Copenhagen, Denmark.

Is this index for real?

This morning I’m on the way to meet Jyske Bank Private Banking in beautiful Copenhagen. The flight is just under an hour from Oslo so I won’t be bothering with bags or anything to check-in – exactly how I like to travel for day trips.

Denmark is about a lot of things but especially shipping. And the biggest company on the Copenhagen Stock Exchange is Maersk A/S, a formidable global container shipping company that’s easily recognizable the world over.

Since collapsing a spectacular 97% from its all-time high last year the Baltic Dry Index (see chart below) has managed a pretty impressive rebound. After hitting a low in December the index has surged more than six-fold as rising demand for raw materials in China leads to a recovery in rates charged by Cape-sized vessels.

Day rates for Cape-sized vessels, which transport iron ore and coal, have risen sharply in recent weeks; rates have more than doubled from $22,000 at the beginning of May to $57,000 on May 28.

With the Baltic Dry Index soaring over the last five months it’s no wonder the commodity bulls are coming out of hibernation. Like copper, the Baltic Dry Index acts as a leading economic indicator for the world economy and broad-based commodity consumption.

But is this index ahead of itself considering the state of the global economy and the likely sluggish recovery that lies ahead following the biggest boom from 2003 to 2008?
I would have to argue that the Baltic Dry Index is way ahead of itself and the fundamentals supporting the global economy and the state of shipping.

Shipping rates might be enjoying a dead-cat bounce since December. Yet it would seem logical that day rates are likely to decline again later this summer or fall as new shipping tonnage hits the marketplace.

The South Korean shipbuilders – the world’s largest -- were overwhelmed with new contracts until mid-2008 when the global economy fell off a cliff; that new supply is coming soon. That alone won’t help shipping rates as a supply glut hits industry.

As for China, it’s naïve to believe her economy will enjoy another pre-2008 boom or recovery. I have serious doubts about the sustainability of China’s demand for iron ore or steel in mid-2009. Also, the outlook for shipping rates will depend on how quickly the congestion outside China’s ports eased.

Commodities, the Baltic Dry Index and natural resource currencies are posting some big gains since March. Judging by the big rally in bulk carrier day rates and crude oil prices this just might be the beginning of a new bull market for raw materials. But considering the significant damage caused by the collapse of bank lending, credit and global consumption, I’m also wondering if this is just a bear market rally or the real thing? I tend to believe it’s the former.

Sell Dollars on Next Rally…

Oslo, Norway

This is my second visit to Norway since May. Oslo is a great city and a superb walking town. Just 100 meters from my hotel is the Norwegian Parliament building and from there a great “Handler Ømradet” or shopping area littered with all sorts of interesting things to see and buy.

I’ve always been fascinated by Scandinavia and its rich history. I first visited the Nordic region in 1996 when I established a private banking relationship for my investors in Copenhagen. Today, that relationship has grown as Jyske Bank Private Banking represents about 20% of my total assets under management.

I’m in Norway this week to explore asset management potential. This is a country where investors get into bed with foreigners very slowly, especially after the Bernie Madoff fraud and other international fiascos. Norwegians take their time before making an investment – something many of us can learn from to avoid painful and costly mistakes later.

Norway's currency now ranks as one of this year's best-performing major currencies in Europe and isn’t far behind the Brazilian real for the world’s top currency title. In 2009, the Norwegian kroner is up about 10% and has appreciated 8% against the EUR. The British pound has surged 12% in 2009 but only after crashing in 2008; the pound remains a bad bet over the next several years amid a flood of debt issuance to finance its almost insolvent banking sector.

In a world laced with debt-infested currencies the kroner probably has the best balance sheet. Norway is sitting on bulging trade surpluses – mainly because of oil and gas exports – and is home to the world’s largest national pension scheme valued at roughly $350 billion dollars. If you’re looking for a model currency then Norway fits the bill. The country has a positive trade balance and a budget surplus. This is why the currency is strong.

The U.S. dollar, of course, has been heading to the relics of history since Nixon closed the gold window almost 38 years ago this summer. With the exception of a few big counter-trend rallies in the 1980s and 1990s, the dollar has been progressively hitting newer lows every decade. No wonder; out of control spending, two military conflicts and a seemingly never-ending budget deficit don’t bode well for the American dollar. Yet despite all of this overwhelming data the dollar might just be at the cusp of another big bear market rally.

Longer term, no rational investor can make a compelling for the dollar. Yet it seems plausible that if the United States was the first to enter a hard recession in December 2007 that it might also emerge out of recession before any other country, except China and India. The dollar has been pounded over the last few weeks and is oversold. I’m also not so sure why the EUR and other currencies are rallying because they’re just as bad. Yes, the dollar is a total drunk but so are her other trading partners; it’s just a question of how much each currency has consumed at the bar. Since last year it’s been Happy Hour – everyone is piling on debt.

The dollar is therefore likely to post a major counter-trend rally this summer or fall – fooling a lot of investors. This is especially true if the stock market and other risky investments begin to falter again; the dollar would recover rather quickly as short positions are rapidly closed.

As profit-taking eventually sets in this summer I suggest unloading dollars for Norwegian kroner and Canadian dollars. I don’t especially like the EUR or the Swiss franc. I also think most Brazilian assets, including the real, are overbought. The Aussie and kiwi are okay but Norway and Canada offer stronger balance sheets. I’m also a long-term oil bull – something Australia does not produce, unlike Norway and Canada (oil sands and natural gas).

Don’t dump dollars now. At some point later this year or even this summer investors will have another chance to sell dollars for NOK and CAD. Also, don’t forget about gold, which is also likely to crack and possibly test $900 or $850 before finally breaking the $1,000 an ounce level for good. Gold is by far the best monetary value (no one else’s liability) in a world filled with currency drunks, bulging deficits and ultimately, serious inflationary consequences once central banks kill deflation.

Loonie Best of the Drunken Bunch as Canada’s Balance Sheet Stands Above the G-7

As risk returns to global markets since March, the Canadian dollar along with a host of other foreign currencies, including commodity currencies, has surged versus the American dollar. In May, the Canadian dollar logged its strongest month versus the U.S. dollar in more than a decade gaining 8.5%.

Over the same period, the loonie has also proved to be highly correlated to crude oil; commodities posted their best month in May since July 1974 with oil prices surging 30%.

To be sure, the Canadian dollar is overbought at these levels and will probably correct lower along with commodities at some stage this summer as profit-taking finally emerges following big gains in stocks, speculative and investment-grade debt and commodities since March 9.

But Canada does have its share of problems in 2009.

Red ink has started to emerge following years of budget surpluses while in some provinces, namely Ontario, have amassed big deficits amid a manufacturing recession and General Motors’ recent bailout. Ontario’s budget deficit has already surged 31% this year compared to 12 months earlier.

Canada is now poised to record its first budget deficit in more than twelve years.

According to the Department of Finance the estimated deficit for 2008-2009 stands at C$2.25 billion dollars or double January’s projected C$1.1 billion dollar shortfall.

The global credit crisis has hit Canada’s manufacturing belt in Ontario and Quebec particularly hard with unemployment rates above the 8% national average through April.

Government revenues are also on the slide.

Tax receipts in March dove 20.8% in Canada led by a stunning 46.8% plunge in corporate tax revenue. In the first quarter Canada’s gross domestic product, or GDP, contracted 5.4%.

Canadian trade is also taking it on the chin this year. The country’s current-account deficit for the first three months of 2009 was a negative C$9.1 billion dollars, up from a revised C$7.8 billion dollars in the fourth quarter. The first quarter trade deficit was the largest since Statistics Canada first began compiling records back in 1946.

The federal government now projects a C$50 billion dollar deficit in 2009. Though that’s certainly nothing to sneeze at it certainly pales to the gargantuan C$1.9 trillion dollars estimated by the U.S. Congressional Budget Office for fiscal 2009. Other countries, mainly in the G-7, are also on course to record huge deficits as a result of monster-sized fiscal spending; the United Kingdom, in particular, will probably borrow more than the entire size of the British economy over the next 12 months.

And yet despite all the challenges facing Canada amid the worst destruction in credit since the 1930s, the country is the best of the G-7 bunch.

In both absolute and relative terms, Canada looks much better than other major economies with a manageable debt level and a strong inventory of raw materials should the global economy recover.

Versus the U.S. dollar, the loonie is a far better store of value as the former amasses record budget deficits for the next several years to pay for seemingly never-ending bailouts and, eventually, a second round of stimulus spending.

Over the next several months or sooner, the loonie is also likely to fetch more than the U.S. dollar or break par value once again.

For American investors, gold, the Canadian dollar and the Norwegian kroner are among the best currency plays for the next three years and beyond.

The United States will have to keep interest low in the absence of organic domestic consumption, a long-term housing bust and the implications of the governments’ socioeconomic bailout of roughly 35% of U.S. GDP since 2008 – mainly in banking. Credit will be slow to return to pre-2007 levels while demand for debt accumulation remains virtually non-existent as consumers grow frugal for the first time since the 1970s.

Canadians, however, should accumulate gold with the loonie at these high levels. Gold prices have been declining versus the Canadian dollar since March but that trend is only temporary; since 2005 gold prices have appreciated versus all currencies, including the loonie. Apart from gold, only the Norwegian kroner offers a better balance sheet than Canada with tremendous oil surpluses and the world’s largest national state pension fund.

Canada has been fortunate. The country has not suffered a bank bailout, maintains a relatively strong balance sheet compared to its biggest trading partner and has mountains of commodity wealth to feed the world as inflation finally rears its ugly head once central banks finally defeat deflation and the ongoing destruction of credit.

Just Sweep it Under the Rug

Montreal, Canada.

According to Bianco Research, the aggregate cost of the U.S. bail-out program is now estimated at $4.2 trillion dollars – larger than the inflation-adjusted cost of WW II.

Grant’s Interest Rate Observer pegs the current stimulus at roughly 30% of GDP, or gross domestic product. To put this monster into perspective, the total sum of all fiscal and monetary measures during the 12 previous U.S. economic downturns since 1929 comes to a mere 39% of GDP.

No doubt this is the Mother of all crises since the Great Depression. Anyone countering this argument isn’t doing his homework.

By far the most expensive bailout in history, the United States is only rivaled by the United Kingdom whose total bailout thus far is greater than that nation’s total GDP or roughly 100% of its economy. The British are in the hole more than any other nation based on relative debt-to-GDP ratios with the government now owning about two-thirds of U.K. banking.

Over the last 12 months we’ve witnessed one of the most stunning economic crashes in history whereby bank balance sheet risk has been transferred from the private sector to government. And, with the printing presses now on full blast, it’s no wonder investors – especially the Chinese – are growing nervous as Treasury prints bonds like there’s no tomorrow. Almost on a weekly basis Treasury is auctioning tens of billions of dollars of U.S. paper.

What’s truly alarming is not only the aggressive attempt to balloon credit but the failure of the Federal Reserve to mop-up excess Treasury sales; like Britain, Germany, Holland and Ireland among others, the United States has struggled to sell longer dated government bonds recently. The risk is growing that one or several sovereign issuers will fail to auction off debt; this has already happened four times in Germany since last October – a spectacular upset because Germany is the world’s second most liquid bond market and in my eyes a far stronger credit risk that any other nation – including the United States.

Government has swept this crisis under the rug. We all better hope that investors don’t force government bond yields much higher because it might result in another disaster as mortgage-backed securities, CDOs, mortgage rates, housing prices and other loans tied to intermediate term rates are forced higher. Consumers can’t handle high rates.

We are now in the latter stages of debt deflation – saved by government. World governments will eventually succeed in growing the economy again through the monetization of debt and ultimately will fail to arrest inflation as it develops again over the next 12-36 months.

The consequences of this policy action will be horrendous down the road for most assets, except gold, commodities and TIPS as another dollar and possibly, euro crisis, hits the fan.

Surging Bond Yields Spell Serious Trouble

Montreal, Canada.

While global stock markets and speculative debt continue to run with the wind since March, the specter of sharply rising long-term interest rates spells big trouble for a still fractured mortgage market.

Mortgage rates are stickier than Treasury bond yields but are influenced by the intermediate curve – and that price action has been bearish since late March. Despite massive amounts of money spent by the Federal Reserve to control longer term rates since last winter the yield on a host of intermediate and long-term Treasury bonds has soared. Already the Fed has purchased $480 billion to mortgage-backed securities and another $130 billion of Treasury bonds.

The Fed’s failure to contain rising long-term interest rates – despite gobs of money thrown at the market – strongly suggests sellers have overwhelmed the central bank.

In a nutshell, the Fed is losing control of the mortgage market.

In the span of just four weeks the 30-year fixed-rate mortgage has climbed to 5.33% from 5.10% -- a significant spike in a short period of time. A spike of just ten basis points (0.10%) has a dramatic effect on financing costs and activity.

The biggest risk to the economy at this stage is housing and mortgage refinancing. Every incremental hike in mortgage rates spells doom for a fragile housing sector that’s still in the midst of the worst price deflation since the 1930s.

The next shoe to drop on the market won’t be a busted bank or a major cyclical company; it might be an acceleration of the housing bear market where prices have crashed more than 30% since peaking in 2006 and still show no signs of stabilizing.

Meanwhile, don’t be bothered chasing this ridiculous bear market rally. The macroeconomic picture might be improving but only temporarily; once government fiscal spending runs dry for this round the dollar and Treasury’s will begin a rapid u-turn that will take many investors to the cleaners -- again.

Stocks, commodities and foreign currencies now dominate the price action over the last 30 days – almost an exact replay of the pre-2007 blow-up. Amazingly, the global economy expanded at more than 3% in 2007 when oil prices were last at $66 a barrel. Yet with the IMF forecasting the worst global recession since WW II in 2009 (-1.3% GDP contraction) oil prices are off to the races and poised to hit $70 soon.

There’s just something wrong with this picture. Watch mortgage rates and Treasury bonds. A potential disaster is quickly unfolding in this segment of credit.