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

Volatility Crashes but for How Long?

The big action in global markets since early March remains largely confined to trends in equities. As fears of an extended global market meltdown have receded since March, the VIX, or CBOE Volatility Index, or fear gauge, has collapsed a cumulative 28% since March 2.

Outside of stocks, barely anything is really moving at all, including government bonds, most corporate bonds, commodities and even currencies.

The lack of volatility in currency markets has been especially mysterious considering the relationship between the dollar and risk adversity since the onset of the credit crisis almost 20 months ago. As markets bled, investors dumped risky assets and piled into the dollar amid a wholesale liquidation of risk; the dollar has been rising only because institutions have been flooded with investor redemptions, which generated aggressive dollar accumulation.

The worst performing major currency, however, belongs to the Japanese yen, down over 14% since hitting an 11-year high earlier in March. The Japanese economy certainly doesn’t deserve a strong currency considering a whole range of economic data has literally crashed since January.

If risk is re-entering global markets then the U.S. dollar should be next on the firing line as investors move out of low-yielding Treasury bonds and sell dollars in the process. This should benefit hard assets, including oil and gold as investors once again seek to hedge their dollar assets from fears of rising inflation over the next 36 months.

Yet the U.S. Dollar Index (see below) is still hanging in there and remains above its important 200-day moving average but below its 50-day moving average. If the U.S. Dollar Index breaks below 81.70 then it’s quite probable the dollar will have peaked in the post-2007 credit crash.



Other assets, including crude oil – the largest single constituent in commodities indices – has also been confined to a trading range over the last few weeks. Crude oil has been unable to decisively break above $55 a barrel on this rally following a low of $33.87 earlier this year.

One of the most interesting market anomalies exist in the government bond market. Volatility has been markedly low even though investors have been selling Treasury bonds to buy stocks.

The United States, along with several other countries, is now heavily engaged in quantitative easing, which is basically a fancy term that equates to long-term inflation creation through debt monetization. Even though the Fed has been aggressively buying back Treasury debt over the last few weeks, yields on the entire range of Treasury debt has actually climbed, not declined.

If the Fed was not buying back Treasury debt over the last few weeks it’s highly probable that the entire Treasury yield curve would have steepened much further; hopes for an economic recovery – confirmed by the ongoing equity market rally since March 9 – should be accompanied by rising, not declining Treasury yields and therefore much higher volatility.

Volatility is now approaching an attractive level for speculators. The VIX can now be traded as an exchange-traded-note, or ETN, in the United States (symbols VXX and VXZ) while providing an easy route for investors to hedge their portfolio risk from the next correction. From its all-time high of 80.86 last fall, the VIX is now down 53%.

With the economy likely to be mired in a sluggish state over the next few years amid a deep credit deflation, investors would be wise to build some portfolio protection following a 30% gain for stocks since March.

Swiss Franc Devaluation Triggers New Currency Wars in 2009

Nobody wants a strong currency. That’s the central theme over the last 20 years and especially since the emergence of the credit crisis and the ensuing global economic recession – the deepest since 1982.

The Swiss franc is now the latest victim of this year’s currency wars and the Japanese yen will follow shortly as the global exchange rate mechanism comes undone in spectacular fashion. On Thursday, the Swiss National Bank (SNB) stated that it sought “quantitative easing” in order to depress the franc and keep deflation from accelerating. The franc thereafter tumbled 3% against the dollar.

In their quest to remain export competitive, global currencies continuously devalue against each other, causing all sorts of trade imbalances, currency volatility and, ultimately, inflationary consequences. That’s the history of foreign exchange markets since Nixon broke the gold window in August 1971.

With painful regularity, currencies have devalued violently vis-à-vis the dollar since July 2008 when the buck emerged as a false “safe haven” among global investors as global de-leveraging blew wide open. The dollar, of course, is not a “safe haven” but instead the recipient of massive inflows by institutional investors seeking to raise liquidity and meet almost unprecedented investor redemptions. This entire process, a phenomenon in currency markets, has indeed pushed the dollar to multi-year highs against a range of currencies everywhere – except Japan.

Last week, I mused about being disenchanted with paper currencies because they all seemed to be celebrating like a bunch of drunks – devaluing against each other and reducing our long-term inflation-adjusted purchasing power. The whole currency system is a joke with units everywhere down 10% or more over the last few months and in many cases, off more than 20% since last July. That’s not a prescription for global exchange rate stability. It’s a prescription for inflation.

I’m disappointed the Swiss relented to deflation. I also think the SNB was pressured heavily by the European Union (EU) to let some air out of the Swiss franc because regional economies in neighboring Eastern Europe are getting pounded – largely because of leveraged loans tied to the Swiss franc to fund domestic mortgages.

Now the Swiss join a parade of other currencies devaluing in order to stem deadly deflation. My argument last week for heading into the franc to protect my purchasing power has now been thrown out the window. No currency is worth its salt.

Over the last several years I’ve continuously recommended gold for long-term investors. It’s the only currency outside of the credit system that’s nobody else’s liability. It’s portable, liquid and, like the old adage goes, “an ounce still buys a man a good suit.”

Eventually, the Japanese will join the Swiss and depress the yen. Central banks haven’t been active in foreign exchange markets since 2004 before last week yet I suppose it’s only a matter of time before the Japanese begin a new round of intervention. The high yen is killing the Japanese economy.

In the end, the dollar will also join the bar and get slammed with other currencies. For me, gold remains at the forefront of monetary responsibility, inflation protection and, above all, truth in a world duped by fiat paper.

Japanese Yen and U.S. Dollar in Bubble Territory

Since the emergence of this credit crisis more than 19 months ago, the Japanese yen and the U.S. dollar have charged ahead vis-à-vis all foreign currencies. And over the last 12 months, both currencies are even higher against gold. Recently, the dollar began to rally versus the yen.

Both currencies are also among the most overvalued units in the world, offering almost no yield while intoxicated by high debt levels. In my book, both currencies are short-sale candidates as this credit crisis draws to a conclusion over the next 6-12 months. Once risk aversion returns, the dollar and yen will fall very rapidly.

The death of the carry-trade – borrowing in cheap and low-yielding yen and reinvesting those proceeds into higher yielding currencies – resulted in a wave of yen buying until recently as traders scrambled to reduce risk.

The Japanese economy has slowed sharply over the last six months with double-digit losses recorded in exports, manufacturing, industrial production and Q4 GDP – the worst batch of statistics since the early 1970s. Why would I buy the yen?



Yet unlike the overvalued yen, Japanese stocks are incredibly cheap. Stocks in Tokyo have been cheap for years and keep getting cheaper every day, ravaged by this bear market. Stocks traded on the Topix sell at roughly a 20% discount to book-value and yield almost 3.5%. No other major market offers better value.

But the yen should be avoided. Along with the dollar, both currencies are now in bubble-land, mired by poor economic fundamentals and high debt levels.

The U.S. dollar is the beneficiary of an accounting phenomenon tied to a desperate flight to cash and redemptions by institutional investors. There is no such thing as the dollar being a “safe-haven” currency. Rather, the dollar is at the epicenter of this financial disaster and, I suspect, it will crash once this crisis finally ebbs.

The beginning of the end of American financial hegemony has commenced as the United States emerges as a much weaker economic power since 2008. Gargantuan Treasury issuance, more Obama New Deals, the reluctance to let bad banks fail and poor economic growth for the next several years are a recipe for an eventual dollar crisis.

Since most investment accounts and funds are denominated in dollars worldwide, the crash in global capital markets since late 2007 has accelerated the flight to liquidity; it has nothing to do with a new bull market for the dollar. Historically, bull markets for the dollar or most currencies, for that matter, don’t begin with interest rates at 0%. I can’t think of any other currency in the world that offers such bad economic fundamentals other than the Zimbabwe dollar.

As the dollar eventually heads lower again once this seemingly never-ending global panic concludes, I plan on hedging my dollar-based portfolio into Canadian dollars or Swiss francs. I’m already holding 10% in gold and will increase that position to 15% should it break below $850 on this correction. I have little faith in most currencies, central banks or governments. Indeed, central banks have lost control of the financial system and investors should protect themselves accordingly.

Euro Bull Market Declared Over as Eastern Europe Crashes

Since January the economies of East and Central Europe, including the Baltic Republics and the Balkans, have started to rapidly deflate as banks crash, stock markets collapse and local currencies plunge. In many ways, what’s happening now across Eastern Europe, including Russia, is reminiscent of the Asian economic depression that began in Thailand in July 1997.



Punch-drunk amid easy credit in the 2002-2007 period, regional economies aggressively borrowed from abroad, mainly from Austria and other EU members that included leveraged mortgage loans tied to low interest rate currencies like the Swiss franc. That strategy has violently backfired since last summer as investors fled risky assets en masse.

In some East European countries, Swiss franc-denominated mortgages comprised more than 50% of all outstanding mortgage loans; combined with plunging local currencies this year the cost to service those loans has surged as foreclosures and defaults skyrocket.

Auf Wiedersehen Bull Market

After a multi-year bull market against most major currencies since 2002, the euro is now hemorrhaging since last July as Europe’s economic miracle comes undone with lightening speed. The euro’s decline pales compared to the outright plunge of numerous currencies in emerging Europe, especially since mid-January.

Eastern Europe’s largest economies – core manufacturing hubs for many Western European companies – have seen their currencies crash almost 20% versus the euro already this year as funding concerns grow louder amid a rapid acceleration of deflation across local economies. In December, Hungary received assistance from the International Monetary Fund (IMF). Now governments in the region, including the Austrians, are pressuring the European Union (EU) and specifically, Germany, to open its vast purse strings to save Eastern Europe from collapse and preserve the euro.

Against the sagging euro, many of the regions’ once fast-growing economies in East and Central Europe are now in the midst of significant economic contraction and sharply declining currencies. Credit spreads have surged, credit default swaps are widening and rapidly dwindling foreign-exchange reserves in the region threaten market capitalism, which, until recently, served as a model for emerging economies in the post-1991 Communist era.

Austrians Plea for Euro Zone Bailout

A fresh full-scale banking crisis affecting Western European institutions is now accelerating this month with Austrian banks on the hook for €278 billion ($354 billion) to Eastern Europe – the largest exposure among euro-zone members. Western banks are saddled with $1.6 trillion dollars’ worth of Eastern European loans, mostly tied to banks in Austria, Germany, Italy, France, Belgium and Sweden, according to the Bank of International Settlements.

Austrian bank losses are enormous and the cry for help couldn’t be louder. Austria has been the most aggressive investor in Eastern Europe over the last decade. Local banks rank as the largest investors in the Czech Republic, Hungary and Romania ($142 billion dollars) with several Austrian banks now attempting to secure government guarantees – including Raiffeisen Zentralbank, one of the largest lenders in the region along with Erste Bank.

Emerging European Collapse

Whereas the Austrians -- harboring strong historical trading ties to the region -- were heavily exposed to Eastern European banks, Swedish banks lent heavily to the Baltic Republics. Lithuania, Latvia and Estonia are also fiercely contracting since October with banks struggling to maintain solvency. Other countries in the region, including Ukraine, are barely solvent and require additional IMF funding while Kazakhstan’s largest bank saw on run on its deposits earlier this week. The list goes on and on with several other markets in trouble as funding gaps widen in an environment of tight credit and shrinking bank capital.

Teutonic Shift as Euro Must Survive

Germany, the euro zone’s largest economy measured by output, is now at the forefront of the crisis since earlier this month. Over 25% of Germany’s exports head to Eastern Europe – a vital market for her multinationals. As the region heads quickly into a full-blown fiscal and currency crisis, Germany, and, possibly, even France might have to bailout the former Soviet satellite states that are part of the wider European Economic Area (EEA).

German finance minister, Peer Steinbrueck, breached the subject on February 18, stating “some of the 16 euro nations are getting into difficulties and may need help.” He went further, adding “Germany would act if fellow euro members got into financial trouble.”

The markets are screaming for an Eastern European rescue and fast. Thus far, European deficits have ballooned with more than $1.5 trillion dollars committed to fiscal spending packages, including bank rescues and partial or full government bank nationalization.

Credit spreads for the most troubled economies in the region continue to rise vis-à-vis German bunds, the euro zone’s largest and most liquid government bond market. And it’s not just Eastern Europe that’s feeling the pain; several high deficit countries in the euro zone, including Greece, Ireland, Italy, Portugal and Spain have seen their financing costs rise on the heels of credit downgrades or failed bond auctions.

Inevitably, the Germans will finance most of a pan-European rescue for the weakest economies, especially those already part of the single currency euro zone. That’s because the euro’s viability is at stake; the Germans would rather keep the most vulnerable euro zone members a part of the single currency. The consequences of losing one or more euro zone members would imply higher funding costs for healthier members while probably devastating the economies of those members that abort the euro as financing costs skyrocket.

The endgame for the Europeans is inevitably higher long-term interest rates for all government bond markets. Like the United States, the Europeans will spend a record sum of capital in 2009 and 2010 to fund unprecedented fiscal spending plans and bank bailouts. This includes the Germans, who have now abandoned their mantra of fiscal responsibility to save the euro zone from near financial ruin.

Germany might have been reluctant at first to participate in a broad based European rescue effort. That tone has decidedly changed since January as the Merckel government unloads a tirade of spending ultimately leading to the first German budget deficit in decades.

Now Europe watches and waits for the Germans to come to the rescue. The future of the euro depends on Berlin’s quick response.

Canada Swings from Budget Surplus to Deficit Amid Crisis

Just twelve months ago Canada was basking amid a commodity boom accompanied by a bull market in the Canadian dollar, which actually surpassed par-value against the American dollar in late 2007.

In the span of just six months, the Canadian economy has come unglued in a bad way as exports plunge, manufacturing slides deeper into recession and commodity prices collapse. The Canadian dollar, which hit a 7% premium above the U.S. dollar in late 2007 at C$0.93 cents, tanked more than 20% last year.

Canada, which was mired in a string of deficits starting in 1975 finally cleaned house under former finance minister and prime minister, Paul Martin. By 1995, Martin took Canada into budget surplus.

Canada, however, ranks among those countries in the G-7 with the highest ratio of total bank deposits to liabilities, according to Credit Suisse. Only Japanese banks have a higher ratio. At 70%, that figure is high and exceeds the United States and Europe, excluding the UK, by more than 20%.

Unlike the United States and other European banks, Canadian financial institutions didn’t go whole-hog on mortgage derivatives or subprime loans over the last several years. In Canada, a prospective homeowner actually needs a job to support his mortgage payments and must typically put down a 25% deposit – not exactly the keen requirement in the United States before the subprime crisis surfaced in 2007.

Canadian banks, however, did suffer large losses on asset-backed commercial paper starting in late 2007 with a few hundred billion dollars written off bank balance sheets.

Still, despite harboring one of the lowest leveraged economies in the industrialized world, Canada is highly reliant on Asian demand for its raw materials and, of course, U.S. consumption, which is responsible for more than 85% of Canadian exports.

Canada is now in a recession. Economic growth has stalled, the loonie has declined by a third since its peak and exports climbed only 3% in November compared to a year ago.

After reveling in a string of impressive budget surpluses for more than a decade, the Harper Conservative government announced its 2009 budget yesterday – sinking Canada into its first deficit hole in more than ten years as a result of rapidly declining economic growth, rising unemployment and a housing boom gone bust.

Canadian finance minister, Jim Flaherty, announced a series of big spending initiatives to spur the economy. Canada will spend C$165 billion dollars ($135 billion) on infrastructure projects across the country, tax breaks for companies and individuals while extending unemployment insurance for the more than 2.3 million out of a job.

Canada is entering a recession with the best relative balance sheet among the world’s largest economies. Despite Ottawa’s first budget deficit in more than ten years, the banking system remains relatively strong with none of its major six banks requiring government support or bailouts – at least not yet.

If this economic downturn persists beyond 2010 and commodities don’t recover, Canada will probably head back into the economic abyss circa 1970s. China is a major consumer of her raw materials along with the United States and both economies don’t look set to rebound until 2010 at the earliest. That spells more trouble for Canada and, possibly, a banking crisis that has yet to hit her financial markets.

My 2009 Mini Q&A

Over the last several weeks I’ve received numerous questions from Sovereign Society subscribers, including individuals who frequent this daily blog.

As we start 2009, I thought this would be an ideal forum to collect some of these important questions and attempt to give you my best conclusions. I can’t reprint all of these inquiries; yet I’ve compiled several I think are excellent questions from our members.

Overall, I don’t like forecasting. I generally believe it’s a total waste of time and most consensus estimates ahead of 2008 ended in the basement with the majority of analysts dead wrong about the economy, the market and just about everything else.

I have to admit that I never expected the markets to crash, the banking system to go bust or the dollar to skyrocket in the midst of the worst financial crisis in 75 years. To be fair, I think most pros failed to make accurate predictions.

Question: I’m a retired investor living on income. Prior to the big rally in Treasury bonds, I held most of my savings in short-term Treasury’s and bank term deposits. But with short-term rates under 1% and government bonds yielding a pittance, I’m nervous. What should I do to supplement my income?

Comment: This is perhaps the most challenging environment for retirees in more than a generation. With money-market funds yielding almost nothing, Treasury bonds yielding around 2% and bank CDs paying under 1%, retirees must supplement their income.

My advice is to take a small portion of your savings, say 20%, and scatter that sum across a dozen or more investment grade corporate bonds. I emphasize “investment grade” and not junk debt. Investment grade debt includes anything rated BBB or better in my book and, to make it easier, I would stick to issues rated A- or higher.

The Dow Jones Corporate Bond Index now yields 6.90% -- down from its post-crash high yield of 8.87% in early October. Still, investors can tap into non-financial bonds like IBM, Johnson & Johnson, Wal-Mart and Kraft Foods – all paying 5.5% or more. Or, look at corporate bonds issued by America’s largest banks, including JP Morgan Chase, Goldman Sachs, Well Fargo and US Bancorp. These banks won’t default.

A good strategy to keep things simple is to buy a laddered portfolio of corporate bonds ranging from two years all the way to seven years. This should at least give your nest-egg a boost and if you feel comfortable with this formula, then increase your position to say 35% of your portfolio. But remember, don’t go whole-hog; at some point over the next 12 months, perhaps later, Treasury bond prices will get smashed and long-term rates will head higher as the government expands credit to the Moon. Keep your powder dry.

Question: Do you think we’ll avoid another Great Depression? Despite all the money thrown at the markets since late 2007 we’re still in the midst of a severe credit contraction and the global economy has literally fallen off a cliff since October.

Comment: I think we’ll avoid another Great Depression but only because government will nationalize or partially nationalize key industries. Without government intervention, the free market would have resulted in massive failures and a total collapse of the banking system and the broader global economy. There’s no doubt in my mind that the government made a big mistake not rescuing Lehman Brothers last September. Once you’re bailing out major banks, then do it right. But in all honesty, we don’t know what transpires behind the Fed’s walls or the Treasury’s. There’s some crazy buddy system in progress with special interests influencing government policy. The government doesn’t give a damn about you or me. What they care about is protecting their interests. That’s why we must protect our assets and, in the end, I believe gold will triumph above all paper money, especially against the dollar.

I don’t advocate government intervention; but these are not normal times and the consequences might have resulted in the death of capitalism and perhaps the emergence of a new social order, similar to what occurred in post-Weimar Germany in the 1920s. Harsh economic times usually result in a new socio-economic regime. If the Fed and Treasury fail to rescue the credit system, then we might face similar consequences. The world as we know it will come to an end.

It’s hard to know exactly what goes on behind the Federal Reserve’s closed doors and at the Treasury’s. Thus far, government efforts have been bold since the October crash, including major central banks worldwide. Major credit indicators have indeed improved since November but the housing market – the crux of the crisis – is still in a freefall. Housing must stabilize before this severe recession ends.

In my eyes, it seems that bailouts and backstops are not addressing the real problem; most TARP money is ending up in bank coffers again and, in most cases, these institutions aren’t lending. The core of this credit crisis lies with the consumer and with housing. If you’re going to fork out several trillion dollars to fix or remedy this crisis then give the money to the consumer – not the banks. The consumer is in a severe bear market with personal assets plummeting over the last 18 months, including real estate, stocks, most bonds and now, possibly his or her job might be next on the chopping block.

Give consumer households $50,000 or more and allow them to clean-up their busted balance sheets, keep their homes (service mortgages) and pay off installment debt. You might not agree with me and, in all fairness, it’s against the tenets of the Sovereign Individual; but what good will all this money do if it’s basically squandered by government and ending up in the pockets of reckless bankers again? I have serious doubts about how the government is dealing with this crisis and I don’t think Obama’s spending package will help much at all despite perhaps growing the economy for a few quarters.

Question: What about the banks? With governments now standing behind their biggest financial institutions, is the worst over?

Comment: The global banking system, for all intents and purposes, is effectively bust or bankrupt. This is especially the case in the United States, Europe and, to a lesser extent, in Japan. More than a dozen emerging market banks are totally bust, including Iceland, the Baltics, Hungary, Romania, Bolivia, Ukraine, Ecuador, Argentina, etc. Not a pretty picture.

I think we’re more than 75% through the worst at this juncture. Governments now stand behind the largest banks in each country and, in some cases, even guarantee entire deposits until 2010 (e.g. European Union). I wouldn’t worry about the largest banks failing at this point. The worst is now behind us.

Question: I know you’re a big gold bug, but isn’t the euro a strong currency and do you think it’s a better hedge against the dollar than gold? Is it too late to purchase gold coins and, if not, where would you suggest I buy coins?

Comment: I have absolutely zero faith in the U.S. dollar and other currencies, including the euro or yen. In the end, all currencies will decline vis-à-vis gold and, in fact, since 2005 the world’s currencies have been losing their relative value to gold bullion. Despite big moves by the yen and euro over the last several years, they pale against gold.

Increasingly, the average man in the street will realize that paper money is not protecting his purchasing power and will revolt against fiat money. At Sovereign Society, we’ve driven home this message since our first year of publication in 1997. Gold is the only asset in this world that isn’t someone else’s liability; with U.S. interest rates effectively at 0%, paper money now competes with gold, which also pays 0% interest. In a zero percent world, which asset would you rather own? I think the answer is obvious.

The government’s enormous spending plans to rescue the financial system and bailout almost every ailing industry assures dollar destruction because the Fed is now on course to print money like never before to quash deflation. We all better hope and prey that the Fed can drain excess bank liquidity very quickly when this credit crisis ends. If not, we’ll have some serious inflation – much worse than what we saw prior to July 2008.

I think every investor should hold at least 10% of his assets in physical gold. This means coins, wafers or bars. Getting gold coins today is difficult because the U.S. Mint has stopped selling Eagles since last summer while other dealers are complaining about tight supplies amid booming investor demand. I suggest KITCO (www.kitco.com) or First Federal Coin Corporation (www.govmint.com).

Also, I would not hold or store all of my physical gold at my home domicile. I strongly suggest parking some of your gold in Switzerland, too. Remember, you must report assets outside of the United States and Canada.

I’m convinced we’ll see some sort of government confiscation of gold again just like we did in the 1930s. Back then, FDR did allow Americans to hold a maximum of 100 ounces. I’m not so sure the next confiscation will be so generous.

I hope you found this helpful. See you tomorrow.

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.

The View from London is Grim

I always love visiting London. It’s an amazing city with a great vibe and fantastic museums. Like New York, it’s pretty hard to be bored in London.

Yet things are grim at the moment, very grim…

Britain is in the midst of its worst economic contraction since 1992. Sixteen years ago, the United Kingdom exited the ERM, or the European Exchange Rate Mechanism, and devalued the pound by a fifth almost overnight; George Soros infamously made over a billion dollars betting on that outcome and sterling was humiliated along with the Italian lira, which also collapsed.

Prior to July, the pound was surging versus the dollar and, until recently, had traded more than 2 to the dollar – an all-time high. But in the span of just a few months the pound has crashed, plunging more than 25% vis-à-vis the buck at 1.48.

At first glance the City of London seemingly looks busy enough and traffic remains as chaotic as ever in this bustling European capital. But make no mistake about it: London is hurting.

Approximately 6% of the United Kingdom’s GDP, or gross domestic product, is derived from financial services and more than 20% in London alone. It’s a significant statistic that continues to handcuff this great country because, like the United States, the U.K. ran wild in real estate speculation and is now paying the consequences for “bubbles” that were created in many cities, including London.

British banks, like most of those in the United States, are effectively bankrupt. The U.K. government has already nationalized or partially nationalized several banks, including recently, Royal Bank of Scotland.

The Bank of England was late to the interest rate cutting party this year and probably caused the country more harm than good at balking at larger interest rate cuts earlier in 2008. British lending rates now sit at their lowest levels in more than 40 years.

But in one of the most sobering developments in credit markets lately, I notice it now costs more to insure the United Kingdom against bond default than some of its banks, such as HSBC and Lloyds. Credit default swaps, which insure against bond defaults, hit an all-time high last week for several countries, including the U.K., the United States, Germany, France, Italy and Spain.

Like many European nations, the U.K. is now on course to issue a record amount of financing through gilt issuance. When credit markets finally recover and calm down, I expect long-term interest rates for the world’s biggest borrowers in this crisis to rise significantly, including the United Kingdom and, of course, the United States.

Government bonds are enjoying a safe-haven label over the last 16 months; at some point, however, investors will turn this story upside down and demand higher rates as issuance overwhelms the market. The Europeans, including Britain, will issue more than $1.3 trillion dollars in bonds in 2009.

Today I’m visiting several successful British money-managers that have earned more than 20% in profits this year – a remarkable achievement amid the worst calendar year for U.S stocks since 1931 and global equities since 1974. I’ll share their insights tomorrow.

More Countries to Impose FX Controls

Indonesia announced foreign exchange controls last week, triggering the first round of restrictions or limits on foreign currency trading. Other nations are sure to follow as economic growth falls off a cliff this quarter compounded by plunging exports.

As the global financial crisis deepens and spreads to the real economy, more countries will resort to protectionist policies in the emerging markets, eventually imposing semi or hard foreign exchange controls.

The G-20 Summit last weekend in Washington saw a pledge by all members to keep trade flows free of protectionist sentiment; one of the main drags on the 1930s Great Depression was the introduction of the Smoot-Hawley Tariff Act of 1930, which raised imports tariffs on foreign goods and, in some cases, shuttered access to U.S. markets. In retrospect, Smoot-Hawley was a disaster, prolonging the Depression in the United States and elsewhere until World War II commenced in September 1939.

With countries like Russia now drowning amid a market meltdown and draining its reserves, I would not be surprised if Russia is next imposing foreign currency controls.

Just a few months ago, Russia was boasting its vast oil and gas reserves, asserting an aggressive foreign policy in the region and demanding more political muscle in the G-7. With oil prices crashing more than 60% since July and Moscow’s stock market literally in a freefall, the Russians have moderated their opposition.

Russia continues to bleed foreign currency reserves since September following a $250 billion dollar stimulus package. The rouble, however, has remained relatively strong compared to the euro; in 2008 the rouble has declined 12% versus the dollar but has risen 4% against the euro. Still, some sort of quasi-foreign exchange control is likely in Russia.

Other prospective countries on the FX control block include Ecuador, Bolivia, Kazakhstan, Ukraine, Turkey, South Africa and, possibly, South Korea, where the won has collapsed 55% this year.

Venezuela, a major oil exporter, has already absorbed big losses financing Ecuador, which is contemplating a bond default this week. Venezuela’s hard Bolivar, or Bolivar fuerte, is fixed by the central bank and the currency has been non-convertible for more than 15 years.

Extreme economic conditions usually result in severe policy responses by government – including major economies.

Starting in 1997, several Asian countries imposed foreign exchange controls or restrictions following a regional economic collapse. Many countries restricted foreign currency trading, conversion and some imposed outright controls, including Malaysia.

In the early 1970s, the United Kingdom, mired in economic turmoil, imposed foreign exchange controls. And in 1934, FDR confiscated gold.

It’s not unlikely that some major industrialized countries might do the same or, at the very least, implement the first stages of foreign asset restrictions or foreign property ownership.

The United States, Europe and Japan are getting hit hard over the last few months as economic growth contracts and even deepens in Q4. Gold confiscation, foreign exchange restrictions and new reporting rules for personal assets lie ahead as Big Brother delves deeper into our daily economic lives in a time of rapidly declining prosperity.

Is the Dollar Rally History?

Is the U.S. dollar’s rally since July topping out?

From its all-time low of 1.605 versus the euro the U.S. dollar has gained a cumulative 18%. The buck now ranks among the world’s strongest currencies since July, trailing behind the Japanese yen. The dollar has soared versus all majors units since July causing all sorts of losses for hedge funds, companies and individual investors. It’s been a disaster.

But let’s not confuse dollar strength with a bull market for the greenback. The dollar has enjoyed a short-term accounting anomaly since July in the face of a global credit squeeze and a mad-dash for dollar liquidity. It has absolutely nothing to do with improving economic fundamentals. This is a dollar liquidity story and not the start of a secular bull market like we last saw in 1995.

Just a few months ago the dollar was on everyone’s short list, including hedge funds and individual investors. As the dollar has recovered spectacularly since July a whole series of leveraged bets on currencies, commodities, stocks and leveraged loans have all come home to roost. This unwinding of the carry-trade has also enormously benefited the yen.

The dollar is now coming under pressure again. For the first time in 100 days the dollar is showing signs of fatigue following the Fed’s interest rate cut on Wednesday. Other economies are also slowing rapidly this fall and a host of central banks are now cutting rates, too, including the Chinese, Norwegians, Australians, Canadians, the ECB – you name it. The name of the game now is global reflation.

The market has been incorrect awarding a dollar premium since July. The consensus is that the United States is doing everything it can to fix its economy while other countries, namely in Europe, remain far behind the U.S. recovery curve. This, in part, is true. Economic problems in Europe are worse in many ways with severe turbulence now brewing in its Eastern European backyard as the IMF, EU and World Bank come to the assistance of Hungary and others.
The Europeans are right in the middle of accelerated deflation as credit markets are busted, liquidity at banks has collapsed and currencies in the region tank.

The dollar is not a safe haven in this crisis. It’s a “liquidity” haven. If the dollar was truly King of the Hill it should be strengthening, not weakening, against the yen.

I suspect the dollar’s rally is not over. I’m still expecting the market to eventually test its October 2002 lows and that event will likely be dollar bullish. But a short-term correction seems likely at this point and is consistent with a big global stock market rally and a compression of credit spreads over the last 10 days. More risk is entering the market and that’s bad news for the dollar and the yen.

Again, if we’re expecting markets to test the October 2002 lows, then the dollar’s short-term decline is only temporary; the bulk of the credit bear market is over at this point but the real economy now faces serious challenges to consumption.

The Fed cut rates to 1% yesterday. Before it’s all over I expect the Federal Funds rate to be 0%. We’re heading exactly down the same road as the Japanese almost 20 years ago. The only difference is that this hard recession won’t last 10 years like it did in Japan because U.S. authorities aren’t vacillating like the Japanese did. But the resultant cost of this extraordinary spending blitz will be enormous and exacting on U.S. finances and ultimately, the dollar.