Enzio's Clock

Background

1. Deja vu

Markets were ebullient when the Fed "suddenly" announced that it would buy $300 bn worth of Treasury bonds - and another $850 billion worth of mortgage securities.

But none of this is new: the Fed already last December announced its intention to buy Treasury bonds. Besides, the Fed already did something like this from 1942 - 1951. The objective was the same: to keep a lid on bond yields. Everything worked well for  couple of years:

• inflation decelerated  from an annual 13.2% in May, 1942, to 0.0% in May, 1944, so

• (corporate) bond yields fell by 14% - from 2.9% in May, 1942 to 2.5% in February, 1946.

But then the inflationary snakes slithered back in:

• Inflation shot up to nearly 20% by May, 1947, so 
• bond yields rose to 3.5% by June, 1953.

Of course, with inflation running at 20% in May, 1947, and with bond yields running at 3.5% at the time, those unlucky holders of bonds were losing a real 16.5% a year!

But beyond downloading historical parallels, one more point is worth noting: even if the Fed is seeking to keep a lid on yields, do not think that this  lid will stoke mortgage lending: banks just don't want to lend. Full stop. 

Indeed, we suggested this to subscribers  in another December note on stock markets and lending cycles that American home owners have gone through two majorly nasty down-legs when seeking to obtain mortgages. With mortgage lending having peaked only in 2007, our back of the envelope arithmetic underlines that mortgage lending will bottom at the earliest towards the end of 2011. So a fifty basis point drop in Treasury bond yields, and more purchases of mortgage-backed securities by the Fed won't really help so much. 

The bottom line is truly deja vu: if banks don't want to lend, they won't. Falling  mortgage rates may increase demand for mortgages, but not the supply of mortgages!

2. So what about the dollar?

We all know that it tanked yesterday, underlining our view of the yen continuing to strengthen in trend.  But moving beyond such short-term commentary: what happens when the market deems that the Fed's $300 bn purchase of Treasury bonds "won't work", i.e. that this purchase in itself will not keep a lid on yields?

At that point, there will be a huge bond sell off: investors will panic about the extent of the U.S. budget deficit and will want to exit.

That, of course, will drive the dollar down.  So where do people go?

 4. What about commodities?

Once the Fed "suddently" announced its intention to purchase those Treasury bonds, commodities went through the roof. The market logic was that one should hedge against inflation, and commodities do that.

Correct. But if the Fed is having to buy bonds, then surely it must be concerned about what our Economic Clock® calls an "excess supply of goods". This being the case, how can inflation possibly be a concern that is relevant at this time to investors?  Indeed, even if we go back to the Fed's first quantitative easing, the one back in 1942, inflation took a long time to return.

With increased globalization and offshore production now, inflation will take even longer to return. So watch those high commodity prices fall off sharply, once the market catches that inflation is not a near-term threat worth positioning one's portfolio for.

But gold will be a currency of choice. This is because maintaining a "store of value" is not related just to inflation. In fact, with the increased issuance of US debt, investors at some point will wonder just how this can be re-paid; at that point, the "store of value" is defined by credibility, not by price! And at that point, gold sparkles.  

4. How to Make Money Off TheseIdeas

1. Always consult your financial adviser first.
2. Sell into the strength of commodities.
3. Buy a large ETF that is backed by holdings of gold, e.g. GLD:US
4. Short the US long term government bonds, for instance via the ETF, TBT:US