Toro's Running of the Bulls Market Blog

Euro Bailout Bullish for Gold, Bearish for the Euro

I never understood the arguments of those who said the dollar was going to "collapse."  Collapse against what?  The euro?  The yen?  The pound?  The yuan?

As the world's reserve currency, the dollar acts as an anchor to which all other fiat currencies are attached.  The euro replace the dollar?  Please.  We already see the structural deficiencies of the euro, but Europe grows slower than America and is generally more politically hostile towards capital.  The yen?  Japan still has enormous structural problems and will have serious demographic issues in the future.  The pound?  Sterling is merely the dollar on steroids.  The yuan?  Can you freely convert your Chinese currency into dollars yet?  I thought not.  Plus, there's this wee issue of the massive housing bubble in China.

No, if the dollar were to collapse, it would take all other fiat currencies with it, the euro included.

It should be painfully obvious why the euro isn't about to replace the dollar anytime soon.  A currency union can only work if the union has a valve that releases economic pressure for weak regions.  If one region is economically stronger than another within the currency union, then there must be some mechanism which alleviates the economic pain in the weak region at the expense of the strong region.

There are two ways of doing this - free movement of labour and/or direct monetary transfers from the strong region to the weak region.

In America, there has been a migration away from the Rust Belt to the South.  The former manufacturing powerhouse of America, which encircled the Great Lakes from Wisconsin to New England, was gutted in the 1970s and 1980s as manufacturers re-located to the cheaper South.  As plants shut down in the Northeast and Midwest, labour migrated out of the Rust Belt and into the South.  Also, because of social programs, money paid by taxpayers in the economically strong states flowed to the weaker states.  The pressure valves in the dollar currency union were the free movement of labor from the Rust Belt to the South, and the wealth transfers of social program payments via the government.

Canada offers an even more stark example of how a monetary should work.  The richest provinces in Canada have generally been Ontario, Alberta, BC and sometimes Saskatchewan.  The poorest provinces have generally been Quebec, Manitoba, sometimes Saskatchewan and the Maritime provinces.  The flow of labour has been from east to west, as lack of employment opportunities in the Maritimes has prompted many Maritimers to move to Ontario and the West, alleviating excess labor capacity in Eastern Canada.  Canada also has a mechanism of direct wealth transference from the rich provinces to the poor provinces known as Equalization.  Based on a formula, every year wealthy provinces directly transfer funds to the poorer provinces, much of which is used for social programs and job creation in the poorer provinces.

In theory, the Eurozone has both wealth transfers and free movement of labor.  In the EU, poorer countries are subsidized by richer countries, and any EU citizen can freely work in any EU member country.  In practice, the subsidies are not great enough and there are barriers to the movement of labour.  Theoretically, a large number Greeks could migrate to Germany or Sweden.  However, it is difficult for Greeks to easily assimilate in those countries, and the subsidies from the rest of the EU are not large enough to release the pressure from an over-valued currency in Greece.  Greek labour was over-priced relative to German labour, so the Greek government borrowed to maintain the country's standard of living given that Greece could not devalue its currency relative to Germany.  But this is untenable over the long-run and thus we have a currency crisis in Europe.

The actions of the EU are unequivocally bearish for the euro.  German and French banks are large owners of Greek bonds.  Debt - Greek debt - is being transferred from German and French banks to the German and French states as well as to the European Central Bank.  This is what happened in the US and the UK.  American and British bank liabilities were transferred directly from the banks to the state after the housing collapse.  When the state takes on a greater amount of liabilities relative to GDP, it weakens the currency.  The core nations of the EU are now devaluing the euro by hoisting more liabilities onto the currency by absorbing the debt of Greece via French and German banks.

Devaluation of fiat currencies is ultimately bullish for real assets.  It is good for stocks, commodities, real estate, art, wine, stamps, you name it.  And it is best for real assets in structural bull markets, such as gold.

It is difficult for a value investor such as myself to invest in assets hitting all-time highs, but I do not see how the policy responses by governments are anything but bullish for gold over the intermediate-term.  Countries have assumed massive liabilities, and the coming demographic problems regarding state-funded pensions and medical systems will only make the situations worse.  I do not know how gold is going to do anything but rise over the next several years.

During the past few months, gold has decoupled from its inverse relationship with the dollar.  This is the ultimate end game.  Because the dollar is the anchor for all fiat currencies, a falling dollar eventually leads to all fiat currencies falling against real assets. This is now happening.

How will the gold bull market end?  I see three ways. 

One way is through increased supply.  Gold output rose last year but has been falling for the past decade.

Another way is through significant monetary tightening.  And I mean "significant," where the real rate of interest is substantially positive.  The Fed funds rate was 6.25% in 2007 and the price of gold was double what it was five years earlier.  Given all the problems in the world today, it is hard to see central banks jacking up interest rates significantly for some time. 

Finally, the price of gold will get so stupid that it eventually falls under it's own weight.  But we aren't there yet.

Ultimately, I think it will be some combination of the three that kills the gold market, with the price ultimately getting really stupid being the biggest reason.

I am long gold.  I own calls on the GLD, to which I added my position today.  I am expecting a pullback in the price of gold followed by a successful re-test of the highs, leading to new highs in the future.  But the price action today was fantastic, and new highs may come sooner than I am expecting.

Crash

I have no idea what caused the collapse intra-day today, whether it was a bad trade or the withdrawal of liquidity by the machines or what.  What I do know is that it was amazing to watch.  At one point, the Dow was down nearly 1,000 points.  I have never seen anything like it.

I got lucky.  On Monday near the close, I hedged out all my equities positions to net flat.  I had also been buying gold calls the past week and have been long the dollar since the beginning of April.  So my book since Monday's close has been long gold, long the dollar.  

I closed out most of my dollar long position and have kept only a small position.  That does not mean the euro is going to rise.  In fact, it will probably keep melting down.  Remember, it was 85 cents several years ago.  And on a purchasing power parity basis, it is worth $1.15-$1.20, so it is still expensive.

I am a long-term bull in gold but have traded in and out of the yellow metal over the past eight years.  I started buying a week ago when the price action was acting very well.  I expect that we will go back and re-test the $1225 highs, back off a bit, then blast through it.  I expect to add to positions on a break to new highs or on a light pullback.

My equities book right now looks primarily like this - long small banks, long semiconductors, short the S&P 500 and Russell 2000. 

Over the past year, I have been buying banks, primarily very small banks.  My criteria for banks has been to buy stocks trading below tangible book value that made money through the crisis and are forecasted to make money this and next year.  I own 14 banks, most that trade by appointment.  I hope to add to my bank position during this sell-off.

My semiconductors position is now a residual of a basket that I began building in 2008, and continued to buy through the end of the year and into the Spring of 2009.  At one point, I owned 18 different chip companies.  I have sold most of my basket and now own six names.  I will sell into strength.

The hedges I own are the Direxion Russell 2000 3X Bear ETF, ticker TZA.  I own the double inverse Horizons S&P 500 Bear Plus ETF in my Canadian RRSP account, ticker HSD.TO.  I also hold the double inverse Horizons S&P/TSX 60 Bear Plus Fund, ticker HXD.TO for other accounts I manage in Canada. 

My intention in buying the leveraged inverse ETFs was not to short the market but to eliminate equity beta.  Since Monday afternoon, my net position became net short, so I peeled a small part of my hedge.  Interestingly, during the 600 point 20-minute plunge this afternoon, I tried to sell some TZA, which is normally pretty liquid.  However, it did not get filled, even though I kept it open for 20 minutes. I pulled the order as the market bounced.

I have been expecting a 5%-10% correction for some time now.  Today, we got it, with the S&P 500 down 13% intra-day from the highs of a few weeks ago.  I had thought it would merely be a correction in the midst of a cyclical bull market. I'm not so sure now.  This may be a correction within a cyclical bear market but I must respect the action, and the market action today was just horrible, no matter what the reason for the sell-off. 

Sovereign debt crises are very serious, and must be respected.  I expect more downside pressure in the near-term.

Europe, a Parable

There are two neighbors who live in a subdivision.  One neighbor is Hans, the other is Nikos.  They both bought similar houses next to each other at about the same time for the same price.  Hans put 20% down to buy his house and borrowed 80%.  It has a fixed interest rate and his payment is well within his means. Nikos also has a mortgage, but he put 5% down and borrowed 95% with a variable interest rate.  Nikos stretches to meet his mortgage payment every month.

Hans is an automobile engineer.  Nikos is a clerk for the government.  Hans is more productive than Nikos and earns more money.  Hans works 50 hours a week while Nikos works 35 hours a week and gets every third Friday off.  Nikos could work longer, but the weather’s nice so he chooses not to.  Hans plans to retire at 67 and is saving for retirement.  Nikos plans to retire at 57, but he doesn’t have much savings and is running up his credit cards buying lots of stuff.

But Nikos is putting too much on his credit card. He can no longer maintain his lifestyle and pay his debts.  One day, Nikos skips a mortgage payment.  The bank decides to check his credit rating.  It has fallen dramatically.  The bank then checks Nikos’s income.  The bank discovers that Nikos lied about how much money he made on his mortgage application.  So the bank calls Nikos and tells him they have to either raise his interest rate or cancel the mortgage.  This is a problem for Nikos because he’s maxed out his credit card and can’t borrow from anywhere else.

So Nikos goes to his neighbor, Hans, and asks him for a loan.  Hans, who likes Nikos but disapproves of his free-spending ways, says OK, but on the following conditions

• Nikos has to get a higher paying job, which would require him to work longer and not take a long weekend every three weeks.
• Nikos can’t retire at 57.  He has to work to 67.
• Nikos has to start paying down all his other debt.
• Nikos has to start saving more.

Nikos says “No way.  I like my lifestyle.  I’m not giving it up.”  

Hans replies, “Well, I work hard for my money. If you aren’t willing to alter your lifestyle, I’m not lending you anything.  Why should I lend you my hard-earned savings if you aren’t willing to change your free-spending ways?”

“But I deserve to live this way!”  Nikos yells.

“Sorry,” says Hans.

Nikos goes across the street to Francois.  Francois and Nikos have always gotten along pretty well, so Nikos asks for Francois for a loan.  Francois is afraid that Nikos may have to sell his home and move.  Francois doesn’t want Nikos to move because he is having an affair with Nikos’s beautiful Greek wife, so he lends him the money.

And that is the eurozone.

 

Greece Gets Bailed Out. Who is Next?

First, right up front, full disclosure - I am long the US dollar, so I'm talking my book.

A deal has been struck between Greece and the EU.  Greece may receive a loan of €30 billion, paying ~5% interest.  Merkel must be pretty confident of upcoming regional elections.

Euro-zone finance ministers agreed Sunday that if heavily indebted Greece were to get a bailout, it could receive as much as €30 billion in loans this year at about 5% interest from fellow euro nations.

The move puts Greece closer to a bailout as it heads into a week headlined by an auction of Greek treasury bills Tuesday. That is seen as a crucial test of whether Greece can still borrow from capital markets. If it can't, it would likely have to turn to the European Union package.

The ministers didn't decide to give Greece the aid; that step would require the unanimous assent of euro-zone leaders. But they laid out terms—especially an interest rate—in an attempt to convince wary financial markets that the European Union does indeed have a plan in place.

I am not sure why this is bullish for the euro.  The euro gets its strength from the fiscal strength of its core region - France, Germany and the Benelux countries - or at least its relative strength.  Bailing out Greece transfers liabilities of the profligate countries in the south to the core. 

This deal had to get done.  Banks in Greece were getting their lines pulled and were on the verge of collapse.  It does temper a run on Greece but it weakens the foundation of the euro in the same way that the US bailing out its financial system weakened the structural foundations of the dollar, especially if larger countries like Italy and Spain are next in line with cap in hand.

UPDATE - Bloomberg is saying it is €45 billion, including €15 billion from the IMF.

European governments offered debt- burdened Greece a rescue package worth as much as 45 billion euros ($61 billion) at below-market interest rates as they try to end its fiscal crisis and restore confidence in the euro.

Forced into action by a surge in Greek borrowing costs to an 11-year high, euro-region finance ministers said they would offer as much as 30 billion euros in three-year loans in 2010 at around 5 percent. That’s less than the current three-year Greek bond yield of 6.98 percent. Another 15 billion euros would come from the International Monetary Fund.

China's Currency Peg and Bubbles

The global economy is characterized by enormous imbalances, particularly the $2 trillion or so in reserves parked at the People’s Bank of China.  This build-up of reserves is one culprit of the asset-driven economy.

Make no mistake, our problems are not because of China.  Our problems are because of ourselves.  But China’s currency peg has dramatically exacerbated the problems of the global economy.

The past decade has been characterized by two of the most deflationary forces of our time – the Internet and the inclusion of China as a major player in the global economy.  The Internet is deflationary because of dis-intermediation – it cuts out the middleman, lowering costs for consumers.  The opening of China is deflationary because its wages are low, effectively lowering the global cost curve for corporations.

In a balanced economy, these deflationary forces should have caused prices to fall.  However, prices did not fall.  The Federal Reserve would not allow that to happen.  To keep prices from falling, the Fed injected money into the economy to keep prices stable.  That money had to go somewhere, and it went into asset markets.

China supplied us with cheap goods and ran a massive trade surplus.  The yuan should have risen against the dollar, but the Chinese government would not allow that to happen, and China built up a ridiculous amount of reserves.  Had the yuan risen, Chinese labor would not have been so cheap, and the deflationary forces emanating from China would have been less.  With less deflation, less money would have been created and less liquidity would have flowed into asset markets.

With trillions of dollars in reserves, China had to put that money somewhere.  Much of China's reserves were recycled back into the US Treasury market, increasing demand for Treasuries which lowered interest rates.  Lower interest rates allowed people to finance purchases of assets cheaply – from homes to CDOs  – fueling the housing bubble.  Had China not pegged its currency to the dollar, it would have had fewer dollars to recycle into the US bond market, demand for bonds would have been less and interest rates would have been higher. Had interest rates been higher (and the Fed could have kept rates higher regardless of what China did) then there would have been no housing bubble, or at least the housing bubble would not have grown as large as it did. 

(This criticism can also be labeled at Japan and other Asian countries whose economies were geared towards exports to the American consumer.  They too ran up enormous currency reserves.)

Over the long run, a floating yuan is good for the global economy.  It will clear out many of the destabilizing structural imbalances.  It is good for China as well.  A rising yuan will increase consumer spending in China as imports become cheaper, re-balancing the Chinese economy away from its heavy (and unhealthy) reliance on exports and capital spending.

In the near and intermediate-term, however, it is bad for our asset markets.  A rising yuan means less demand for Treasuries, which means higher interest rates, which means less support for asset markets such as stocks, bonds and housing.   In our asset-driven economy, less liquidity is bad for our markets.

In the long-run, a floating yuan is positive for the US economy.  Our heavy reliance on asset markets is unhealthy.  Less trading things and more making things is ultimately good for America.

Dollar to Lose Reserve Status - PIMCO

From Bloomberg

Pacific Investment Management Co., which runs the world’s biggest bond fund, said the dollar will probably fall as it loses its status as a reserve currency.

The dollar will especially drop against emerging-market counterparts, Curtis A. Mewbourne , a Pimco portfolio manager, wrote in a report on the company’s Web site. Investors should consider cutting their holdings of the U.S. currency, he said.

“While we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative,” Mewbourne wrote

Though I agree that the US dollar is losing status and will continue to fall against currencies of fast-growing emerging nations, it is difficult to see any alternative to the dollar as a reserve currency in the foreseeable future.

Having said that, I am long gold, and expect to see gold hit new highs as all fiat currencies lose value relative to real assets.

Dollar Reserves Increase

Despite all the gnashing of teeth regarding the dollar ...

The IMF's authoritative Currency Composition of Official Foreign Exchange Reserves (COFER) report last week indicated that the dollar's share of global reserves (where the allocation is reported) rose to 65%, to stand at its highest since 2007.

Though one would expect diversification by central banks into other currencies simply as prudent portfolio management, the simple fact is that there is no credible alternative to replace the dollar, nor will there be for many, many years. 

Peter Schiff was Wrong

From Mish.

Schiff's Overall Thesis

• US Equity Markets Will Crash.
• US Dollar Will Go To Zero (Hyperinflation).
• Decoupling (The rest of the world would be immune to a US slowdown.
• Buy foreign equities and commodities and hold them with no exit strategy.

Schiff was correct about point number 1 above. The US equity markets crashed. That was a very good call. Unfortunately, his investment thesis centered on shorting the dollar in a hyperinflation bet, and buying foreign equities rather than shorting US equities.

Furthermore, Schiff made no allowances for being wrong and had no exit strategy whatsoever.

What happened in 2008 was that foreign equities sold off much harder than US equities, and a strengthening US dollar compounded the situation.

In other words, Schiff failed where it matters most: Peter Schiff did not protect his client's assets. Let's take a look how, and more importantly why, starting with charts of various foreign indices.

I've never understood the reasoning behind a dollar collapse. 

The US dollar is not going to collapse, at least not relative to other fiat currencies.  It cannot without doing enormous damage to the global economy.

Fiat currencies have a natural range by which they are bound.  If the dollar went to three against the euro, the American economy would boom because American goods and services would be enormously cheap relative to the euro.  Conversely, the European economy would collapse because their export markets would disappear. 

So no, the US dollar will not collapse against other fiat currencies.

Against real assets however...

UPDATE - EuroPacificCapital has responded.

Intraday Yen Chart

Take a look at what happened to the yen today.

The yen gained an astonishing 3 points in an hour this morning.

Unless someone can educate me otherwise, that, no doubt, is a very large carry trade (where one borrows in yen and invests in dollars) being unwound and jammed into the market.

Pondering the Euro and Precious Metals

The euro has achieved a 50% retracement of its move from $1.60 to $1.23.  I never got into my euro short call I made some time back.  I will be watching it closely for an entry point, which I suspect will be sometime in the new year as opportunities arise to sell stocks.

One has to be very heartened by the move in gold and silver if one is a precious metals bull.  If one shorts the euro against the dollar, I would not necessarily expect gold and silver to hold up.

Gold will go down if the world is in a deflationary spiral.  The gold perma-bulls/bugs are trying to have cake and eat too arguing that gold will rise in either an inflationary or a deflationary.  I think this argument is nonsense, and gold’s descent this year from $1032 to $682, and silver’s decline from $21 to $8 is indicative of what happens to precious metals during deflation.

However, I have always maintained that the end game for the precious metals would when nations are engaging in competitive devaluations of each other's fiat currencies against one another.  If so, then a rise in the dollar would not necessarily be met with a concurrent decline in gold and silver.