Category Archives: currencies

Some thoughts on government debt during deflation

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A question of Keynes vs. Kondratieff

Until recently, the sovereign debt of nearly all governments would rally during panic episodes as stocks and commodities fell. This makes sense, as strong sovereign debt is cash for big boys, and investors are forced to reach further and further out for yield as short-rates are driven to zero or negative. However, starting with Greece, this pattern may change, as bonds are likely putting in a secular top in the 2008-2016 window. Their last bottom of course was the early 1980s, and their last top was 1946-47. The indebtedness and unabashed Keynesianism of all of the world’s governments seem to virtually guarantee higher interest rates in the coming years, even though US, German and Japanese bonds are still finding a bid during panics.

We have already seen the beginnings of this development in municipal bonds and the crappiest sovereign debt, but the market may slowly realize that it is all crap, beyond the short-term credit of the strongest governments.

Prechter makes the point in Conquer the Crash that higher rates on risky long-dated sovereign debt are part and parcel of deflation, an increased preference for the safest cash and cash alternatives. Steepening yield curves fit right into that trend. If the long bond sells off hard, this does not mean the end of the dollar, but the opposite. All else being equal, if T-bonds fell with stocks this year, it would just mean that the US government would finally feel the same pinch as everyone else.

Now for the tricky part. We have to keep in mind that interest rates are more than just a mechanical product of fiscal deficits, savings rates and politics. They are a kind of natural social phenomenon, a reflection of forces I can’t fully understand. They are not rational: why were short-term rates in the low single digits during the second world war when the US had just abandoned the gold standard, had a debt:GDP ratio of over 100% and inflation was running at 8-12%? Why were they still double-digit in the mid-1980s when the economy was good and inflation was 3-4%? (For some charts and discussion of the long-term rate cycle, see this post). The only answers that make any sense are that it was time for rates to bottom and then it was time for them to top.

We are certainly entering what *Kondratieff described as winter, when debts are called in and defaulted upon and cash is at a premium. This is associated with low interest rates, reflecting a low demand for credit, provided that the monetary unit retains value, which it tends to do since this unit is how debts are denominated and settled. And with deflation very much a reality, low rates can provide a high real yield so long as the credit is sound. With housing and wages falling by large percentages and every consumer good on sale, what is the real yield on a 10-year note priced at 3.6%?

There is no telling how long rates will stay low or how low they will go. See Japan, 1990-

Those are the market rates on the credit of a horribly indebted nation with terrible demographics that has been trying to spend its way out of recession for 20 years. Is there a better way to explain this than Kondratieff winter?

If social forces demand that governments start to shift towards frugality and default like the rest of society (and government is a reflection of social mood), this would be very supportive of the current fiat regimes. Think about it: what would happen to the Euro if Greece defaulted (which is what they should do)? Billions in euro-denominated balances would go “poof” and the remaining euros would be worth more.

What if younger generations of Americans, the ones who most enthusiastically support Ron Paul and even phonies like the new senator from Massachusetts, start to exert pressure for the rolling back of that $70+ trillion in retirement and health-care promises? Those are contracts that the government can’t honor, so by definition, it won’t. It will try to pretend otherwise, but it won’t. In effect, much of the debt will be repudiated.

There are huge caveats to the above, such as radical socialism or expanded warfare, but there are going to be real deflationary undertones to social mood that may effect policy and prolong the current paper regimes for longer than almost anyone suspects. Kondratieff winters are not short episodes, but generational, and if the last two turning points in the interest rate cycle are a guide, there could even be another ten years to the bottom.

That is hard to believe right now, but it is possible if social forces demand default. I can’t gauge the odds very well, but I have to consider this longer-term bull case for treasury bonds and a few strong currencies. Bottom line — history has not been kind to paper money and government bonds in times of crisis, but the nature of deflation may give them a longer life than we have assumed.

If you just can’t wait to short some sovereign debt, try Japan before America. They may be a generation ahead of the west in the rate cycle, and really, how much lower could they go?

*Kondratieff waves in the US (click image to expand):

welling@weeden, 1.23.09

One thing that strikes me in the above chart is how huge the latest wave is compared to the others. At 60 years and running, it is the longest, and prices, rates and stocks have gone up so much more than during any of the previous three. Just out of proportionality, it would be perfectly fitting if rates and prices fell for another 5-10 years.

Here’s a clearer view of the Aaa corporate bond rate from 1919 to 2010:

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Also see Rothbard and then Mish on Kondratieff theory. As Rothbard makes clear, winter is not necessarily an awful time to be alive, judging from the strong economic growth of the 1830s-40s and 1880s-90s. This means that prolonged unemployment and war can’t be blamed merely on the credit cycle, but that fingers must be pointed at the socialists, Keynesians and fascists who’s actions directly brought about the nightmare of 1929-1945.

Yen and bonds, two of a kind

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I don’t know exactly what to make of this pattern, but it is not unusual to see these two move together. As forms of cash, they each tend to do well when the deflation trade is on. In fact, other than short positions, they are the only things that beat the dollar when everything else falls.

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I don’t know what it means that the Yen has been doing so well even as stocks have risen over the last year. Perhaps it’s a vote of no-confidence.

Even if stocks and commodities roll over hard, I actually wouldn’t count on the Yen rallying as powerfully as of 2008, or even at all. Its long-term trend has been weakening.

Sympathy for the euro

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Sentiment is still really lousy and downside momentum is waning. This is the same condition that persisted in the dollar from August through November before violently clearing. No telling how long this holds up, but I would not want to get caught short without a stop here — one day you could wake up and find out that it’s spiked 3 cents overnight.

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Of course, I am bearish on the commodity currencies CAD, AUD, NZD and ZAR (and actually also JPY as of this evening’s spike), and if these fall the euro is likely to make new lows. Conversely, a euro spike would likely coincide with a general dollar sell-off.

Some kind of news about Greece or other GIPSIs could be a nice catalyst for a rally — it doesn’t quite matter what the news is, just that there is something to get people trading. The crowd’s reaction often makes very little sense and can’t be predicted by news alone.

Gold

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Look at the similarity between the March 2008 peak and immediate aftermath and what we’ve seen since the December high in gold:

Prophet.net

Sure, there could be a little more oomph here for a push like that close second peak in ’08, but just because gold hasn’t dropped like a stone doesn’t mean the mania will go on without a hiccup. Each high was accompanied by extremely high and sustained bullishness, which tends to exhaust the upside for at least a few months, since after such an event everyone has already bought all the gold they want for the time being.

Also, if the euro’s run is over, why not gold’s? For all its timelessness, the markets still treat it like another currency, a highly-speculative one at that. Here is a euro chart where I’ve highlighted the same periods as above:

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I am going to view any near-term upside with an eye towards taking a short position in each of these, though of course I own physical gold for safety’s sake.

Discount window warfare

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I glanced at the markets at 4:30 just in time to see every “risk” market spike down hard together. That kind of instant, coordinated movement only happens on announcements, usually something out of Washington. Turns out the Fed spooked traders with news of a 0.25% hike in the discount rate, the rate at which distressed banks borrow from the central bank.

For release at 4:30 p.m. EDT

The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.

Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve’s lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19.

In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. Primary credit is provided by Reserve Banks on a fully secured basis to depository institutions that are in generally sound condition as a backup source of funds. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010.

Easing the terms of primary credit was one of the Federal Reserve’s first responses to the financial crisis. On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC’s target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days. On December 12, 2007, the Federal Reserve created the TAF to further improve the access of depository institutions to term funding. On March 16, 2008, the Federal Reserve lowered the spread of the primary credit rate over the target federal funds rate to 1/4 percentage point and extended the maximum maturity of primary credit loans to 90 days.

Subsequently, in response to improving conditions in wholesale funding markets, on June 25, 2009, the Federal Reserve initiated a gradual reduction in TAF auction sizes. As announced on November 17, 2009, and implemented on January 14, 2010, the Federal Reserve began the process of normalizing the terms on primary credit by reducing the typical maximum maturity to 28 days.

The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC’s 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds. The Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread.

Ok, so they are finally going to tighten up a bit, just in time for the next wave of home mortgage and commercial real estate defaults. This is a deflationary action, and it fits right into the psychology of a top, where Fed officials would be expected to conclude that the storm had passed.

When thinking about Fed decisions, I assume that it is not actually foolish economists like Bernanke and crew who make them, but their cunning and wealthy bosses — Blankfein, Dimon and company. Why would bank execs want tighter credit at the Fed? JP Morgan and Goldman Sachs likely don’t give a hoot about 0.25%, but this could push smaller banks over the edge and into the FDIC’s Friday lottery, whereby their deposits are gifted to other lucky banks.

As for the significance of this for the markets, it sends a signal that I believe will often be repeated in the coming months and years: bankers do not want to destroy the dollar any faster than they can help it. Hyperinflation is game over for the banking cartel, since the value of debt (and therefore bank assets) goes to zero.

The Fed is likely to look tougher from here on out (and actually they have not created new base money for about 12 months), especially in comparison to their European, Australian and Canadian counterparts. The Aussies and Canadians still have to liquidate their housing bubbles, and it is a very safe bet that the high rates that have made for such a lucrative carry trade are going to fall hard, along with their currencies.

Don’t be surprised if the dollar climbs all the way back to its 2000 peak.

Euro long as a contrary play

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Prophet.net

Note the upsloping daily RSI from very oversold conditions. Sentiment remains highly negative, so any upward movement would surprise the majority of traders and possibly result in a short-squeeze like Sept 08.

You don’t have to be very sure that the euro will rally — I’m not — to take this trade. The recent lows make such a clear and close stop position that the risk/reward balance is quite good.

Euro & Swissie break with the pack

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For most of the last couple of years, the non-dollar, non-yen currencies have moved with a remarkable degree of correlation. Priced in US dollars, over a multi-month time frame (and usually even minute-by-minute) there has been little difference between the Euro, the Canadian dollar, the Australian dollar and the British Pound. The correlations are not perfect, and they break apart from time to time (as when the pound had a relatively crappy summer and fall last year). The last couple of days have been terrible for the Euro (white) and its ever so slightly “harder” twin, the Swiss Franc (purple):

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What to make of this? Well, I have no reason to think that the gap won’t be closed before long. Sentiment on the Euro is so negative that I still think a violent short squeeze is possible, especially if there is continued strength in the equity, commodity and other currency markets.

Another possibility is weakness or sideways behavior in the general risk trade, with the Euro holding a bit firmer than the rest. It is so oversold that something eventually has to give. Of course, as we saw with the dollar from August through November, oversold can become more oversold, but that was a decline of a different nature: a lower slope, with a stair-step pattern. The Euro has basically crashed straight down over the last two months. That pace won’t be sustained for very long without relief rallies like what we’re seeing this week in the other currencies.

As I write, there is some support on of their charts. We’ll see if they bounce or cut through — the latter would be all around bearish and may portend a little panic in stocks, etc.

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Oh — and how about that Euro/Swiss relationship? How do you explain the Swissie’s moves by the Greece situation? The Swiss National Bank won’t be printing anything to bail out Greece, and in fact might be expected to print less, given their talk of intervening to attempt (foolishly and with no lasting effect) to weaken the CHF vs. their biggest trading partners’ script.

Sunday night futures update

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In the first hour of Globex futures trading (starts for the week at 6:00 New York time), I closed up the gold and stock longs that I put on late Friday. I’m letting the Yen run, since it was so deeply oversold and has some support at this level.

Friday’s dollar rally was awesome, and may bode the start of an enormous rally, but it remains highly overbought on a 15-minute scale, so now is a good time to take a wait-and-see approach. Same goes for gold — it’s oversold near-term (from 1228 late Thursday to 1145 Sunday night) but still highly overbought long-term. Because of the extreme overbought condition after a giant parabolic rise, it has the potential to keep dropping straight off a cliff with just brief pauses to keep us guessing. Knife-catchers beware.

Here’s a 1-month view of February gold futures:

Source: Interactive Brokers, LLC

I’m going to watch for good entries on the long side of the dollar and short side of gold and stocks. Things may be aligning for a major downdraft in stocks, now that the dollar is looking up. With the Yen oversold and Nikkei overbought, Japan is also setting up for another try at the deflation trade.

Yen (priced in dollars), 1-month:

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Nikkei stock index futures, 1-month: