By Doug Gentry, on July 20th, 2011
This is a time of the year when I meet new people or get reacquainted with old friends, and once we run out of the usual “status update” conversation, someone often asks about the economy and the current crisis about the debt ceiling. I’m going to break a self-imposed guideline for this blog, and actually represent my opinions in a pretty straightforward manner. Usually my goal is to help students reach their own, informed opinion. This time – straight to the punch line…
- The 2011 deficit (estimated at $1.5 trillion) and the accumulated national debt (over $14.3 trillion) are not the most pressing economic issues facing the country right now. They are important, but several notches down from the top of the list. This year’s deficit is just over 10% of GDP, which is high, but not crushing. There are ways to deal with these issues, as I’ll share further down. They are presented as a crisis only because the Republican Party and the Tea Party are using them to push a small government agenda. While I don’t agree with that goal, it’s fine for some to support it, but holding the economy hostage by manufacturing a crisis tied around the debt ceiling makes no sense.
- Investment in economic growth has slowed dramatically. This is particularly true in education – at all levels. It is also true in basic research. Up until the last 20 years or so the U.S. has surfed the wave of economic change, by investing in new thinkers, and making infrastructure and other investments that will improve productivity. These seem left out of current debate options.
- The slow recovery and weak demand for goods and services is the number one problem facing the country. The Federal stimulus is winding down, the Federal Reserve has decided that they don’t need more quantitative easing, and government at all levels is cutting employment. All the while personal consumption dropped in the most recent quarter, along with the fixed asset portion of Investment (inventories increased as a partial offset.) The uptick in unemployment and the very slow growth in employment drags down demand for goods and services. We are sliding down the same hill that the U.S. economy did in 1937-38, when Congress and President Roosevelt worried more about public concern for the debt than about sustained growth. Then we slid into a quick, nasty recession. That’s a danger now, too.
- Inflation is not a pressing problem. The inflation we have seen this year is in food/commodities and energy. The food price spiral might well continue for awhile – I don’t have an independent sense of the true drivers. Even if food prices rise there are other elements of the Consumer Price Index that are holding steady. The rising energy prices are probably related to uncertainty about political conditions in the Middle East. Those concerns should soften soon.Inflation is something to watch out for, particularly with all of the money created by the Federal Reserve in the last three years – money created to help stabilize the economy. It is important that the Fed watch for signs of incipient inflation, driven by very high money supply, but I am confident they will act correctly and aggressively when that happens. That point is not now.
- Bond investors are not abandoning US Treasuries for fear of default. US bonds respond to typical market forces, though they have an element of future gazing in them. If you hold a 10 year bond, and a potential buyer thinks the US might default on that bond, then the buyer will expect a higher yield (lower price/higher interest rate). That isn’t happening now. The bond market for US Treasuries is not showing signs of investors being worried about US debt.
So, what to do….
- To tackle the most pressing problem – the slow recovery – the Federal government should be stimulating demand, through more government spending (on the part of Congress) and more quantitative easing (on the part of the Federal Reserve). Tax cuts can be part of this but they should not be across the board. The most effective, stimulative tax cut on the Federal level is the payroll tax for Social Security and Medicare. Those funds need help, and there are ways to fix them, but a payroll tax benefits mostly working people who will use the increased take home pay to consume.
- To help with the deficit, we should remove the Bush tax cuts, and speed our exit from Iraq and Afghanistan. The Bush tax cuts disproportionately benefited higher income families, who use the extra money for non-consumption activities. When some politicians complain that raising taxes on the wealthy takes money away from job creators, there is no empirical evidence and scant theoretical basis for that claim. Along with repealing those tax cuts there are plenty of opportunities to strengthen the tax code and reduce the dreaded loopholes. Despite what many politicians say and the media parrot, this is not hard. It just takes clear headed thinking and political courage.
- The real budget deficit challenge, at the Federal and State levels primarily, is the cost of healthcare. Increasing costs and inefficient uses of services put pressure on Medicare, Medicaid (which impacts states as well), the VA, the Dept. of Defense, and government employment costs at all levels. We should be strengthening and extending the healthcare reform efforts beyond just extending coverage – to include incentives for cost efficiency and efficacious treatments.
- Restore and enhance funding for education at all levels. Resist the temptation to make education accountable on a short term basis, while hobbling it from producing the long term benefits derived from basic research and liberal arts education. This is an area in particular where Federal spending, even if they result in deficits, is a good investment. Cutting taxes on the wealthy is not a good use of a deficit. Deficit spending should support short term stimulative needs and long term productivity enhancements.
By The Energy Report, on May 26th, 2011
 Platform Advisors Founder Adam Michael searches the globe for oil and gas discovery stories with established cash flows that support share value in reasonably secure political environments. In this exclusive interview with The Energy Report, Adam reveals some names from his own portfolio holdings that he believes could generate considerable upside production growth to return significant multiples for investors, even if oil prices hover at $90/bbl for the next year.
The Energy Report: We’ve had a 10% correction in Brent crude since the end of April, and oil has been a bit weak as we’re starting to see some real signs of improvement in the U.S. economy where it really counts—employment. What factors are putting downward pressure on oil?
Adam Michael: I think the biggest factor over the last year has been quantitative easing (QE), which has led to speculators entering into the crude futures market in proportions that I haven’t seen before. For instance, the net long in crude oil futures by speculators is more than twice as high as it was back in 2008. This has gotten the attention of Congress, and recently we’ve seen the Chicago Mercantile Exchange, CME Group (NASDAQ:CME), begin to raise margin requirements for crude futures. I think the goal is to get some of the speculative money out of crude futures, and that’s one of the reasons we’ve seen a decline over the last month.
TER: Sounds like a healthy thing that could dampen the potential for a bubble.
AM: I think so. Crude oil dropped $20 in a matter of a couple of weeks. That’s a pretty sharp correction, but I think it was healthy because it helped wipe out some of the excess speculation. There could be some more downside to go but, historically, crude kind of tops out sometimes during the summer and maybe late June and early July. I don’t see any reason why that wouldn’t play out this year. We’re still in a kind of historically strong period for crude oil. I’m not sure how much down side there is from here.
TER: In terms of oil price per barrel, is there a sweet spot where the macroeconomy can remain vigorous? What is the upside price-per-barrel limit on commodity oil?
AM: Well, I have read various opinions on this and I have to think that a good price for oil right now would be somewhere in that $90–$100/bbl range. That would allow the economy to keep taking steps and provide for improvement in global industrial production and gross domestic product (GDP) without choking off too much demand. So, I think $90–$100 is a great price for crude oil, and that is kind of a sweet spot. The kind of volatility we could see is $80–$120/bbl. I don’t know how long it will remain there at those swing points. So, I think $90–100 is the right price.
TER: Do you have a forecast for oil?
AM: I don’t really have a forecast, but for the longer term I use $90/bbl crude in my models and for my sensitivity analysis. I look at what kind of cash flow a company can generate with $100 or $80 oil. I think $90 is a good, safe number to use.
TER: Do you feel that $90 oil is a conservative enough estimate to build your models for the next 12 months? The next 24 months?
AM: Well, I think it is a good number through the end of 2011. As global demand continues to creep higher, eventually, we’re going to soak up that spare capacity that OPEC has, and that’s when things will get a little more interesting. That’s probably a 2012 event, but then we’re talking $110–$120/bbl oil. At some point, the price will get high enough that it will support some demand destruction—but we’re not there yet.
TER: The U.S. just ran up against the federal debt ceiling of $14.3 trillion back on May 16, and the credit and equity markets really want that ceiling to be exceeded (at least temporarily). But it seems pretty obvious that something must be done to reduce debt to a lower percentage of GDP. What impact would this kind of austerity have on the economy? Will it strengthen the U.S. dollar? Will it hurt oil? Will it hurt energy companies?
AM: Obviously, the debt ceiling is a hot topic right now. I am guessing that Congress will probably negotiate with the president, and the negotiations might go all the way up to the deadline on August 2. I’m not sure how big of an effect it’s going to have, and one of the reasons is that there seems to be a shortage of bonds because investors are having a tough time finding yield. So, there’s a really healthy credit market out there right now.
Clearly, a default by the U.S. Treasury on government bonds would be a very bad thing, but I think there’s about a 0% chance of that happening. There will be much talk over the summer as it’s negotiating. Cooler heads will prevail, and I’m sure we will do what needs to be done on the debt ceiling with a combination of austerity measures; but the bottom line is that there’s a healthy economy out there. If it weren’t, credit spreads would not be this tight. So, I’m actually pretty positive on the economy right now. This summer could be a little tricky as we hear more about the debt ceiling and as, you know, investors can be short-term minded sometimes. Ultimately, I think this plays out well for the economy. The dollar is probably due for a rally, but it doesn’t necessarily mean that commodity prices will go down. Sometimes they go up with a stronger dollar; it doesn’t happen often, but it can. So, the bottom line is I am positive on the global economy. I think we will get our debt ceiling figured out and we will just keep humming along.
TER: Aside from buying small caps for your portfolios, what is your general investment thesis?
AM: I like to look at companies that have a proven reserve, cash flow or something else that I can get my hands around for a base-case evaluation. In addition to that, I like to see some kind of embedded call option in the form of a large land package—that is at the top of the learning curve where there’s a lot of leverage for upside.
TER: Is it hard to find stable cash flows and rising production, especially in politically stable jurisdictions?
AM: I don’t think so. Domestically, in this latest cycle, we’ve seen the emergence of unconventional oil through the development of the Bakken Shale, which is probably the most widely known unconventional oil play. But other plays are developing now that have a lot of upside running room. And it’s very much analogous to what we saw in the last cycle with the emergence of unconventional shale gas. Now, I think we’re just seeing the same thing as history repeats—or let me say, ‘as history rhymes’—this time it’s the emergence of unconventional oil, where I think there’s a lot of running room. And there are other sources out there besides the Bakken that are starting to emerge, which also have good running room.
TER: Where are you finding these characteristics right now?
AM: Not to be confused with the Bakken Shale in North Dakota, there’s an emerging play called the Alberta Bakken that stretches through Montana and into Southern Alberta. I think it’s going to see a lot of drilling and appraisal work done over the summer. You can’t do much over the winter. In Alberta, a lot of the roads are closed for spring break up, and now we’re just getting on the other side of that.
Rosetta Resources Inc. (NASDAQ:ROSE) and Newfield Exploration Co. (NYSE:NFX) are the two big players south of the border in Montana, and they’ve been doing science and vertical wells to test the Alberta Bakken. From what we’ve heard on recent conference calls, both companies are pretty excited about it and are going to start horizontal wells.
On the northern side in Southern Alberta, you’ve got a handful of micro-cap players with good land positions. Just in the last couple of weeks, we’ve seen the first results come out that were made public by DeeThree Exploration Ltd. (TSX.V:DTX). I think we’re at the top of the learning curve, and the initial results look really good. So, there’s a lot of running room here for these guys.
TER: Is DeeThree a company that you own?
AM: It is.
TER: DeeThree is mostly natural gas, which is expected to be stable over the next 12 months at best. Where does the upside come from here?
AM: Well, it is currently doing a couple thousand barrels oil equivalent per day (boe/d), and most of that is gas—probably 70% gas and the rest a mixture of light oil and liquids—so you have a little bit of cash flow there, which I like to see. It also has a couple hundred thousand acres in the Southern Alberta Bakken play, and I think, at least 70,000 acres in what I call the “sweet spot.” So, there’s a lot of running room there. DeeThree just drilled its first well and completed a frack. The average one-day test rate was 250 boe/d. The company is now removing the frack string and putting in production pipe. That’s a very positive first result for its first horizontal well. And there are other excited players also in the play—big players, at that.
Murphy Oil Corp. (NYSE:MUR) signed a joint venture (JV) with DeeThree and has drilled a couple of wells that are rumored to be pretty good. Murphy has committed to drilling four wells on DeeThree’s acreage by year-end to earn a 60% working interest in about 15,000 acres. DeeThree is being carried on the wells and will receive revenue from first production.
TER: Is that JV with Murphy on the Lethbridge property?
AM: It sure is.
TER: You sound optimistic about this play.
AM: Well, I’ve seen the cycle repeat over and over wherein you have an unconventional play that’s in its drilling stages, and it takes a few months for industry to crack the right science to produce the most assets in the most optimal way. The wells should become more prolific with time, and drilling cost should trend lower.
TER: Where else are you looking?
AM: Well, there’s a company I mentioned in my interview a year ago with The Energy Report that I really like over in Egypt called TransGlobe Energy Corp. (TSX:TGL; NASDAQ:TGA). Since then, the company has identified a new play called the Nukhul Fairway, and it extends across several of TransGlobe’s acreage blocks in Egypt. The wells cost $1M–$1.5M, and some of them are coming on at 1,000 barrels per day (bpd) and holding up fairly well. It’s become more of a developmental play where the company just keeps punching holes, and production is going to increase pretty rapidly this year.
Last year, about 30% of TransGlobe’s production came from Yemen—most of which has been shut down due to the political turmoil there, but the Egyptian production has ramped-up so strongly that it’s already eclipsed the Yemen production. This has allowed the company to keep its guidance that originally included Yemen. I expect that to continue this year, and I like the strong cash flow that’s associated with the wells TransGlobe is drilling right now. There’s just a lot of upside there and a lot of strong cash flow backing up the stock. So, TransGlobe is a company I am still very excited about.
TER: Amazing that the stock could be up 76% over the past 52 weeks with the shutdown in Yemen, which was producing 2,300 bpd.
AM: The Egyptian play has a lot of running room, and it has more than made up for the Yemen shortfall. Eventually, Yemen will become straightened out. I don’t know if it will be three months from now or six months from now, but that production will come back. I am not counting on it, and I can get a good valuation without it at the current stock price level. So, I think there’s a lot of upside for TransGlobe based on the rapid production increase in Egypt and possibly bringing Yemen back online later this year.
TER: Ok, you’re in Egypt and the Alberta Bakken in Canada. Where else in the world are you currently looking?
AM: Well, the Colombian oil companies have been hit hard over the last six months, after having been a little frothy last year. We’re now starting to figure out which ones are the real players and which ones are not. The premier oil company in Colombia is Pacific Rubiales Energy Corp. (TSX:PRE; BVC:PREC). I still think it has the best land package with more than 10 million acres for exploration upside. But what I really like about Pacific Rubiales is that the stock has been beaten down a bit and there are some very strong cash flows. It will increase production by about 20% to more than 110,000 boe/d by year-end, and I have it generating over $2B in EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) this year. It has a very strong, healthy balance sheet and it’s proven the premier operator in Colombia. So, for Colombia, I’m going to stick with the “best of breed” and that’s Pacific Rubiales.
TER: The company has a $7B market cap and is buying back up to 4.3% of its outstanding equity. That shows some confidence, I would think.
AM: Yes, Pacific Rubiales has a strong balance sheet, which gives it the ability to buy back stock when its value is not reflected in the market. I agree with management, and I think the stock has tremendous value here. It’s going to generate $2B in EBITDA this year, and it’s trading at about one-half the multiples that we see here in the States. I like the stable production profile, strong cash flow, management team and, like I said, I think this is the blue chip of Colombia and a great way to play Colombia.
TER: Is there any place in the U.S. that you’re looking?
AM: Well, I like to go back to the old Permian Basin. It’s been a long-standing producing region for Texas. We still keep finding new ways to get more oil out of the ground, as technology gets better and we do horizontal drilling and multistage fracking. One company I like, in particular, is Approach Resources Inc. (NASDAQ:AREX), which has some good reserves on the books.
What’s gotten me excited is its new 130,000-acre Wolffork oil shale play. The first wells have just recently been announced and the horizontal wells are producing 200–300 bpd. I think the ultimate recoveries on these wells could be as high as 200,000–300,000 bpd. I should also mention that EOG Resources (NYSE:EOG) is just north of that play and is seeing a little better rates in the 400- to 500-bpd range on its first producers, and it’s also rumored that Apache Corporation (NYSE:APA) is acquiring acreage in the area. So, there’s a lot of running room with 130,000 acres in Approach’s portfolio, and the company believes it has derisked about 70,000 acres of it—more than 1,000 locations. The returns on these wells are going to be good, and they’re only going to get better as Approach works down the learning curve. It fits my preferred profile, as you have some base reserves to kind of get a conservative valuation of maybe $20/share. You have a lot of upside and running room as this new play is being developed.
TER: Is there anything else interesting you’d like to hit on?
AM: Well, I would like to mention one speculative name in Colombia. I know we already talked about one with a larger market cap, Pacific Rubiales, but the other one that has gotten my attention is Canacol Energy Ltd. (TSX:CNE), which has about 10,000 bpd light oil production. That is good for both cash flow and funding for growth initiatives. But it also has one of the best heavy oil land packages that I’ve seen in the Putumayo Basin, and that’s something that’s going to take some time to derisk. Once the company derisks this, there’s a lot of upside to the heavy oil component of the company—and it makes it an extremely attractive acquisition target. I do like the fact that Canacol has some good cash flow to back up its valuation. I think it’s an excellent acquisition candidate.
TER: It’s been a pleasure speaking with you today, Adam.
AM: Thank you.
Adam R. Michael, 36, founded Platform Advisors, a California registered investment advisor that manages the Platform Energy Fund. Mr. Michael has over 10 years of experience in the energy industry in various capacities. With the majority of his career based in Houston, Texas, he is able to use his energy background and industry contacts alongside his investment experience to identify energy investment opportunities in geopolitically stable countries with attractive geological prospects and fiscal regimes. Mr. Michael has a bachelor’s degree in industrial distribution from Texas A&M University (1997) and an MBA from Rice University (2004).
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By Claus Vistesen, on January 5th, 2011
Just before we turned the clock on 2010 I commented on the recent increase in US yields and noted the following simple issue;
How investors perceive and interpret this will [rising yields] determine great many things; is it a reflection of higher growth in the future and thus a sooner than expected normalisation by the Fed. Or is it a result of supply concerns and the continuing double digit budget deficit by the Fed and thus the bond vigilantes attempt to go for the biggest prey in the park.
Obviously, interpretation, animal spirits and sunspots can never be entirely disconnected from real economic activity on the ground, but the underlying point is important.
If rising yields are seen as a reflection of growing concerns over the US authorities’ ability and willingness to control to the deficit it could hamper ability to maneuver for the Fed and the Treasury. If on the other rising yields are seen as a reflection of policy makers’ success in reviving back growth through QE and an extension of tax cuts, it goes together with an altogether more benign narrative about how the deficit will pay for itself as higher growth leads to higher income and more leeway in managing public finances.
So which is it?
Well, a recent piece by Bloomberg’s Daniel Krueger suggests that the latter discourse is emerging and thus that whoever playing the part as bond vigilante these days, he or she has failed in their attempt to drive the conversation (so far).
Quote Bloomberg
The worst performance by Treasuries since the second quarter of 2009 reflects prospects for faster U.S. economic growth rather than concern that rising budget deficits will drive investors away from government debt.
(…)
Even as deficits remain at almost record highs, the bond market is giving the U.S. time to address structural budget imbalances. A Bloomberg News survey of the 18 bond dealers that serve as counterparties to the Federal Reserve in its open market transactions show they forecast the 10-year Treasury yield to rise to 3.65 percent from 3.30 percent on Dec. 31, below its average of 4.33 percent since 2000. Two-year yields will climb to 1.05 percent from 0.59 percent, holding below the average of 3.03 percent since the beginning of 2000.
(…)
“The market is starting to believe the Fed will be successful in creating growth,” said Ray Humphrey, who manages inflation-indexed bond portfolios in Hartford, Connecticut for Hartford Investment Management Co., which has $161.7 billion in assets. “Nominal bonds are frankly reflecting those higher growth rates.”
This is interesting for a host of reasons. First of all, with an estimated budget deficit of 10-11% of GDP in 2011, it seems that the old adage that the US economy is indeed different still holds true. Consequently, and local government debt/muni ghosts notwithstanding it appears the US economy is getting all the leash other economies in the OECD are not.
Looking at the charts, I would not hold it against you if you thought that this was much ado about nothing though.
(click for larger image)
In general, the US yield curve has steepened considerably since the infamous March-09 low in risky assets mainly as a result of the fact that although short term yields have been kept tightly in check by the Fed’s policies, yields on longer dated bonds slowly crept upward in 2009 with both the 10y2y and 20y2y increasing notably. This in turn, albeit with a lag, has sparked comment from both Fed officials and prominent analysts that the Fed would use additional QE measures to massage the long end of the yield curve especially as it is the long end which determines the rate on mortgages which is a gauge strongly watched by the Fed.
In 2010 and much contrary to the talk about rising yields; both long term and short term yields have actually declined on the year. From December to January it is pretty much status quo on the yield curve measured by the 2y10y though with 2 year nominal yield declining 31.3 basis points and 10 year nominal yields declining 44 basis points.
The action and talk on rising yields come from the fact that in Q4 yields have increased across the board with longer dated bonds taking the worst hit as the curve steepened across all spreads. 10 year yields rose the most from October to December rising 75 basis points while 2 year yields increased by a mere 24 basis points in comparison. As such, what turned out to be a good year for bond investors has turned sour right at the end.
The real important thing going forward is how long US policy makers can benefit from the win-win discourse of rising yields and a strenghtening economy. One would be tempted to say that if only the Fed came out openly and targeted a level of the SP500 then the world would be much more transparent. What I am basically saying is that one key part of the Fed’s current policies is the explicit targeting of equity prices and the subsequent positive wealth effect perceived as well as real.
Fundamentally, it is bit of tighthrope walk since the main condition for the good days to continue is a very fine balance epitomized by the notion of a “mild-goldilocks” scenario. In short, yields can go up as long as they want except if it translates into the actual expectation of an interest rate hike by the Fed. As such, the economy should continue growing but not so strong as to force the Fed’s hand into a more hawkish discourse.
By Claus Vistesen, on December 20th, 2010
So what gives here.
The extra yield Treasury investors demand to hold 10-year notes over 2-year securities touched the widest since February on speculation an extension of tax cuts will spur growth and increase deficits. The benchmark 10-year yield rose this week to the highest level in seven months as retail sales advanced in November more than economists forecast and the Federal Reserve said the recovery is continuing. The U.S. economy grew at a faster pace in the third quarter, a report is forecast to show next week.
How investors perceive and interpret this will determine great many things; is it a reflection of higher growth in the future and thus a sooner than expected normalisation by the Fed. Or is it a result of supply concerns and the continuing double digit budget deficit by the Fed and thus the bond vigilantes attempt to go for the biggest prey in the park.
Now, to be fair I am stealing this argument from the latest G&F from CLSA penned by the always excellent Chris Wood. Here is what he says.
This raises the question of whether this rise in bond yields has been driven by growing optimism on the US economy or growing supply concerns. Note that the fiscal deficit in the US is now estimated to be about 9.5% of GDP in FY11 ending 30 September 2011, compared with 8.9% in FY10 and a recent high of 10% reached in FY09. GREED & fear’s view is that the answer to that question is a bit of both. Still it is also worth pointing out that the rise in government bond yields, like so much else, has been correlated globally. Thus, German bund yields have picked up by an almost commensurate amount as have Treasuries. The 10-year German bund yield has risen by 91bps to 3.03% since bottoming at the end of August. Again this market move could be influenced by a growing conviction about improving growth dynamics. Or it could reflect the reality that any move towards fiscal union in Euroland is going to cost the German taxpayer a lot of money.
Now, Chris Wood comes in favor of a neither one or the other explanation, but I would submit that the ultimate way investors choose to interpret rising yields in the US will matter a lot for general volatility and dynamics going into 2011. Indeed, this may all be a blip, but I believe that since the US has now effectively “postponed” any attempts to reign in public finances until 2011, US bond yields may turn out to be a recurring theme in 2011. Long bond trend followers, beware! (Although I agree with G&F that this is not the end of the long bull market in US bonds, the Fed is still here).
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By Claus Vistesen, on August 23rd, 2010
I know this is a cheap shot, but still. Team Macro Man picks up an all time favorite over at MM and asks 20 questions (check this out for other answers) to which I have offered 20 answers.,
- Will the 10yr Treasury yield breach 2% this year?
- When will the Japanese intervene?
- Will the US finally get tough with China in the run up to the mid-terms?
- When will the UK have a 4% CPI print?
- What will US GDP be for 2H 2010?
- Will SNB LLC resume macro punting (aka EURCHF interventions) this year?
- Does the SPX trade 1040 or 1140 first?
- Will Simon Hughes cause the ConDem coalition to collapse?
- Who will win the Labour leadership contest?
- Are we turning Japanese?
- Who will be the first to hike? Fed, BoE or ECB?
- Does Drukenmiller’s departure herald the end of Macro trading?
- When will the divergence between Eurozone and US growth surprises begin to close, and how? Eurozone weakness or US strength?
- Will the Republicans capture the House?
- Will Voldemort ever stop taking the piss?
- Which will be the next Macro fund to call it quits?
- Is the Bank of England losing control of inflation?
- Is there a bond bubble?
- When will the Fed move the Interest On Reserves (IOR) Rate negative?
- What will happen to the GSEs?
And my answers …
1: Yes (Q4)
2: If the USD/JPY hits 80 or if it stays at 85 til Q4
3: No
4: They won’t
5: (qoq) Q3 0.3%, Q4 0.2%
6: No
7: 1040
8: No Idea
9: Ibid
10: Europe is, the US is touch and go; I think they might just make it!
11: Fed in Q4 2011
12: Who?
13: In H02 2010 (Eurozone weakness)
14: Yes
15: No
16: Not yours I hope!
17: No
18: Yes, but it has some time still to run
19: H01 2011
20: Nothing in the next 18 months.
Don’t bet all your portfolio on this though. It is just fun and sports!
By Claus Vistesen, on August 17th, 2010
It has been a while since I have had a round of these and in the current macro/market environment I thought it an excellent occasion to take some pot-shots at the market discourse. So, read on if you want to see what it looks like when I am being (excessively) smug, an econometric model of Eurozone industrial production and a look at them US treasury yields which have gotten an awful lot of attention lately.
Don’t ya just love it when you are right?
Well I do and while this is not making a killer profit kind of right I still take comfort in the fact that the themes I am talking and thinking about also seem to be moving much closer to the center of the financial market discourse. First off, do you remember my notion of the Old Maid in the context of G3 currency markets?
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.
I hope the, albeit convoluted, introduction above will give you an idea of where I am going with this. Never mind of course that I was not entirely right in terms of which currency that would turn out Old Maid since I predicted the USD to strengthen (it has against the Euro) consistently in 2010 and while I believe this to come through eventually, the story so far has been a bit more complicated. First off, the USD did start 2010 holding Old Maid as tensions in the Eurozone saw the Euro plummet, but contrary to expectations, the remarkable strength of the JPY is becoming a story which cannot be ignored; in particular, its ill-recovered role as safe haven currency of choice in times of risk-off sentiment is something I did not expect.
To that end I feel vindicated in my overall theme and as such I welcome the Economist on my side of the fence as they articulate, this week, the idea of a race to the bottom among G3 currencies. I like the following in particular;
A cheap currency is especially prized now, when aggregate demand in the rich world is so scarce and exports to emerging markets seem the best hope of economic salvation. (…) The battle for a cheap currency may eventually cause transatlantic (and transpacific) tension: not everyone can push down their exchange rates at once. For now, though, the dollar holds the cheap-money prize.
Now, I am ready to repeat this almost to the degree of my readers potentially reaching insanity; the G3 are now effeftively dependent on exports to grow and since they are all looking to the same customers you end up with too much supply (of savings) relative to demand. Or … we can turn it around and say that there is too much demand for yield (excess supply of savings) relative to supply (capacity to absorb it). See, this is not so difficult.
The important part of course and where it all comes together is that this export dependency/propensity to save is not a deus ex macina but has a concrete and real driving force. In that vein, two recent contributions to the debate are very important. First off, we have Előd Takáts’ BIS paper on ageing and asset prices which provides evidence to show how ageing, in the context of real estate prices, are deflationary [1]. Now, I might take issue with the theoretical framework being a life cycle and not a life course model (wonk alert!) and I might also take issue with the empirical framework, but I wholeheartedly support the paper’s conclusion.
The estimates show that demographic factors affect real house prices significantly. Combining the results with UN population projections suggests that ageing will lower real house prices substantially over the next forty years. The headwind is around 80 basis points per annum in the United States and much stronger in Europe and Japan. Based on the analysis, global asset prices are likely to face substantial headwinds from ageing.
Note here his sample is only the OECD and thus global is somewhat a misnomer here.
Secondly, I welcome no other than almighty Goldman Sachs on my side of the fence (hat tip FT Alphaville) with their recent exposition on how global imbalances might not actually get better, but worse, and how all this is down to demographics.
Up to the age of 35, the population appears to be a drag on the current account position—in other words, people invest more than they save, on average. Between ages 35 and 69, people on average appear to save more than they invest. These are the so-called ‘prime savers’, and having more of them in the population would tend to improve the current account position …
In Alpha.Sources land this is a well known tune and while it may actually be a little more complicated than this I find it extraordinarily refreshing to be arguing alongside the Illuminati in the future. Now, I should make it immediately clear here that Goldman’s final conclusion is problematic;
These shifts could push towards a cleaner split between EM (mostly in surplus) and DM (mostly in deficit) than is the case in the current, more complex picture. In particular, demographic pressures could see the largest DM surplus countries (Japan and Germany) move into deficit and the largest EM deficit countries (Brazil, India and Turkey) move into surplus.
Well actually, they are just plain wrong here. Basically, they are scratching in the right places but end up with the wrong conclusions because they neglect the effect from ageing on aggregate demand. The argument above hinges on a link between dissaving and external deficits which is difficult to reconcile with rational economic behaviour. Finally though, and as a perspective I have only recently started to think about the role of (lagged) capital deepening in emerging markets is very, very significant as well.
What about that double-dip then?
So, Eurozone industrial production took a turn for the worse in June with the drop driven by weakness in durable consumer goods such as furniture and home appliances according to Bloomberg. To that end I thought that I would try to asses the potential for a double dip (in Europe) based on Alpha.Sources’ (only) proprietary econometric model.
I remain bearish on the macro environment in Europe and indeed I think that deflation will ultimately be a continent wide outcome, but timing is of the essence here. We learned today that Germany put in an all time excellent economic performance in Q2-10 which does indeed seem to be paving the way for a downward turn in H2 2010 (especially since my guess is much of this was driven by inventories). This view is somewhat supported by the evolution in industrial production which seems to be signalling a turning point in the annual change. This is consistent with mean reversion of the index in annual changes and, in economic terms, with a slowdown in momentum. This is interesting as the turning point would occur at a point where the level of industrial production was still some 10-15% lower than pre-crisis peaks and indeed still lower than in 2005 (2005 = 100 in the charts above).
Further evidence today comes from the overall Flash estimate of Q2-10 European GDP which shows that Germany remains the only real stellar growth story. Over the quarter both EU27 and EU16 grew an impressive 1.0% driven by strong growth rates in Germany and France. Greece on the other hand saw its contraction accelerating and over the year both Greece and Spain saw contractions (Spain saw a 0.2 expansion over the quarter).
In this sense, European growth remains very skittish and I think we will see a double dip in the Eurozone in H2-10 while the US should just avoid one. Finally, I maintain my view that although growth will slow to the detriment of risk assets, there is almost no risk of a global double dip due to continuing strong growth in Asia and Latin America.
Where goes them US treasury yields?
Probably the most hotly debated lately has been the relentless decline in US treasury yields and by extension the idea that deflation has become an entrenched reality at the same time as stock markets have soared. Now, there are a lot of ways to skin this cat which should be evident on the basis of the absolute storm of punditry on this issue lately. A couple of important general points are worth mentioning here. First of all, this is closely tied to the the prospects of a double-dip recession in the US where some commentators have recently flagged the issue that while conventional recession indicators point to sustained growth these very same indicators rely heavily on the slope of the yield curve (e.g. Albert Edwards from Soc Gen and BCA have recently made this point in their research). The point is that since short term rates (and by derivative yields) are already close to zero there is no way that the yield curve can invert (a traditional harbringer of recession) even if a recession is imminent. Secondly, it would be nice to be able to argue on the basis of some simple arithmetic rule here such as e.g. mean reversion, but the problem is that even when deflated by the annual change in CPI the real yield on US treasuries (2y and 10y in this case) are still trending (downwards).
I will neatly sidestep any discussion about whether this is end of the bull market in government bonds since this is a chicken-and-egg type of discussion. If you believe in perma-deflation, short term yields will hover around zero and, c.f. the latest from Rosenberg, the Fed will try flatten the yield curve by moving in on the long end. I am leaning towards this scenario for 2011 and thus lower yields are here to stay (at least in nominal terms). If we take the current message from the 2y and 10 year yields at face value and assume, naively, that the average inflation rate for 2010 will prevail as an average over the next 10 years the outlook is poor with real yields on the 2y notes negative and only slightly positive for the 10y horizon. Going back to Rosenberg, what he is essentially saying is that bringing on additional QE might serve to flatten yield curve from the long end of the spectrum as the Fed begins to massage yields at longer maturity.
Indeed, as a result of record low yields on 2y notes the 10y2y curve has never been steeper than is currently the case and while we would expect short term interest rate to flatten it as we move into recovery, this time might be different (going back to Rosenberg’s argument again even though 10y is not long term in the ultimate sense of the word when talking about treasury yields).
So where do they go? Let me answer that question with another (rhetorical) question. Do I believe that QEI, II, III etc will work and ward off deflation in the US? Yep, I do and as such I see higher yields going forward, but for now I am very comfortable with the call that short term yields will remain low for at least the next 12 months and that Rosenberg is likely to be right. So, not quite time yet to take a random pot sho(r)t at them bonds.
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[1] – Link this to the notion that global imbalances are driven by real estate price fluctuations and housing market dynamics and you should have that fuzzy feeling by now.
Data is from the ECB and FRED (St. Louis Fed)
By Eldon Mast, on February 11th, 2010
Treasury Secretary Timothy Geithner said the country’s debt rating is not at risk because of the trillions of dollars of government spending to shore up the economy.
Asked on ABC’s “This Week” Sunday whether the government would lose its triple AAA sovereign debt rating, Geithner said: “Absolutely not and that will never happen to this country.”
Geithner said there was less risk now that the economy would slip back into recession, a pattern known as a “double-dip” recession.
“We have much, much lower risk of that today than at any time over the last 12 months,” Geithner said.
The labor market which was under significant strain last year at this time is now on the cusp of creating a substantial number of new jobs. The unemployment rate is already beginning to reflect that turn falling from 10% in Dec to 9.7% in Jan.
“We had a huge shock to the American economy and we’re still living with the aftershocks,” Geithner said. “You’re seeing the first signs now of business starting to take some risks again.”
Geither went on to dismiss earlier comments by Sen. Scott Brown (R-Mass.) — calling his assessment of the $787 billion stimulus package — “Flat wrong!”
After winning the Massachusetts election, Brown was quoted as saying that the stimulus did not create or save any jobs.
“I don’t think there is any basis for that judgment,” Geithner said.
The White House and independent economists (including our job charts here) have illustrated that the stimulus package has saved at least several million jobs and is on the verge of creating several million more by later this year.
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By Thersites, on February 10th, 2010
From Bloomberg:
Treasury Secretary Timothy F. Geithner said the U.S. is in no danger of losing its Aaa debt rating even though the Obama administration has predicted a $1.6 trillion budget deficit in 2010.
“Absolutely not,” Geithner said, when asked in an ABC News interview broadcast today whether a downgrade is a concern. “That will never happen to this country.”
The U.S. plans to rein in the deficit once the labor market recovers, Geithner said. In the short run, that means focusing on ways to “make sure that this economy is growing again,” he said. The administration says the deficit will shrink over the next four years as more Americans find jobs and the economy accelerates.
“This is within our capacity to do,” Geithner said.
Where to begin? First off, I have long believed that Tim Geithner is in fact the fall guy for the economy in the Obama administration. He has been involved with the bailouts from day one including perhaps a criminal one with AIG, come off as smarmy and weaselly in testimony and been perceived as less competent and well-liked than Bernanke in the court of public opinion. If I had to guess, when it becomes clear that we are stuck in the economic doldrums (probably closer to the 2010 elections), Barack Obama will fire Geithner and trudge out a man with more panache and credibility, likely Paul Volcker.
On the substance of Geithner’s comments, that anyone in this administration can actually believe that the economy is going to accelerate and the deficit will shrink over the next four years is laughable. Even if you had breakneck economic growth, and there are absolutely no signs of that on the horizon, the deficit is still growing at an exponential rate, and Congress has shown no signs that it is going to take the steps to deal with the most bloated line items — namely entitlements. The most expensive parts of our budget are considered sacred, and for a politician to touch them would be considered a sin.
How could Geithner be right that we will never lose our rating? Well, the ratings agencies are US companies, granted an oligopoly by the state, so it is possible that government could threaten them were they to consider downgrading us. In this scenario we could have a de facto downgrade however if yields spike up in the bond markets on US debt with Treasuries trading effectively as if we have been downgraded. Another scenario is that the government builds false demand (or an artificial “bid” in trader lingo) to keep the yields on our debt low by either pressuring the primary dealers to continue to gobble up our bonds (and then at times selling them back to the Fed shortly thereafter), threatening foreign nations to prop us up or creating some kind of incentive to get Americans to invest in Treasuries. Otherwise, I don’t see how America can be considered fiscally Aaa, but then again the ratings agencies rate a lot of junk Aaa. They can in fact put lipstick on a pig.
By Trace Mayer, on January 28th, 2010
The Great Credit Contraction grinds on as the system continues evaporating. People are realizing the true nature of the worldwide fiat currency and fractional reserve banking system that is built on a fraudulent premise and has become a Ponzi scam of epic proportions, the largest in the history of the world. Capital, both real and fictions, has begun burrowing down the liquidity pyramid while the upper layers evaporate. Recent developments in the one month United States Treasuries appear to portend another round of credit crisis. 
 THE TREASURY BUBBLE
A year ago I discussed how the Treasury bubble was the largest of all and explained both how and why it would burst. I prognosticated:
However, as more capital piles into them it drives rates lower and lower. Eventually Treasury Bill rates reach 0% or even go negative. This presents a problem.
Why hold a Treasury Bill with a bank, broker, custodian bank or the Federal Reserve itself when you could take possession of physical Federal Reserve Notes?
Taking possession eliminates at least two types of risks. First, is any potential counter-party risk with whoever is holding the Treasury Bill for you. Second, ‘political risk’ which is a much larger threat. …
As the yields on Treasury Bills approach 0% they have the return of cash but do not have the benefits of cash as they may be impregnated with counter-party risk or have decreased liquidity. In other words, Treasury Bills and cash have the same benefit profile but not the same safety and liquidity profile. This analysis also applies to demand deposits with the bank such as checking accounts or CDs. All the downside but none of the upside.
Predictably the Treasury bubble burst. Poof!
PILING INTO ONE MONTH TREASURIES
The one month Treasury has recently traded with negative rates. This portends another round of the credit crisis which could very easily have its catalyst in either another sovereign debt downgrade of either Japan or Portugal or in Austria with banks owning a large amounts of primarily mortgage assets denominated in foreign currency in primarily Slovakia but also the Czech Republic, Hungary and Croatia.
The last few weeks shows just how close the rates are towards 0%. Of course, real interest rates are already negative. But a weak FRN$ would help meet Obama’s goal to double exports which would not be helped by his proposed discretionary spending freeze.
MONEY MARKET FUNDS
One tool many investors use as a proxy for their cash are money market funds. Many view these as like-cash vehicles just like many viewed auction-rate securities as like-cash vehicles for 25 years. On 18 September 2009 I explained that I closed my Paypal money market fund because money market funds had lost government backing. On 27 January 2010 Nasdaq.com reported:
The U.S. Securities and Exchange Commission approved by a 4-1 vote Wednesday rules designed to shore up the resiliency of money- market mutual funds, with general support from the industry, although fund representatives are uncomfortable with a few points. …
The rules also would permit a money-market fund’s board of directors to suspend redemptions if the fund is about to “break the buck” by having a net asset value fall below $1 per share. Currently the board must request an order from the SEC to suspend redemptions.
“The halting of redemptions will stem the motivation for runs. It also will eliminate the need for a failing fund to sell securities into a potentially de- stabilized market and further drive down prices,” Schapiro said.
For those with too much time on their hands who want to see what the proposed rule looked like I would direct you to page 32,714 of the 8 July 2009 Federal Register under proposed rule 22(e)-3. I find the discretion of the Director of the Division of Investment Management in this instance to be particularly egregious.
Treasuries are below money market funds in the liquidity pyramid because there is more safety and liquidity. If a money market fund has redemptions suspended then that asset is not very liquid and will likely find their value evaporate. This is precisely what happened with auction-rate securities and in some cases overnight investors went from thinking they held a like-cash instrument to finding themselves holding 40 year student loans that received no payments for several years.
WHERE IS REAL SAFETY AND LIQUIDITY
On May 20, 1999 Alan Greenspan testified before Congress, “And gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and in the ultimate value of the currency and that historically has always been the reason why governments hold gold.”
During the 1990’s Mr. Rubin had devised the gold leasing scheme with the intent being elucidated by Dr. Greenspan’s testimony in 1998, “Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.”
Because of massive governmental intervention for decades through either patent activities such as legal tender laws, the tax code, etc. or latent activities such as surreptitious leasing of gold into the market the result is a massively suppressed gold price.
The tremendous amount of evidence accumulated by the Gold Anti-Trust Action Committee ought to be examined by any serious investor or money manager. As Mr. Robert Landis, a graduate of Princeton University, Harvard Law School and member of the New York Bar, asserted years ago, “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”
Nevertheless it is very difficult to assess an accurate value of gold, silver or platinum in this era and for a specific time period where almost all financial professionals are infected with the financial insanity virus, the system is riddled with chronic fingers of instability and it somehow muddles along like a terrifically abused zombie. There is already a one world currency, gold, and it poses a mortal threat to fiat currency.
CONCLUSION
As the next round of the credit crisis plays out it may be worse than the earlier iterations. All of the interventions have not addressed the root causes and are actually textbook responses for someone who would want to intentionally exacerbate the greater depression.
As Ludwig von Mises predicted decades ago in chapter 20 of Human Action, ‘The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. … But then finally the masses wake up. … A breakdown occurs. The crack-up boom appears.’
New credit creation is nearly non-existant, banks are hoarding reserves so they can win the Friday bank failure lottery and the velocity of currency has slowed to glacial speeds. Because gold and the FRN$ abut in the liquidity pyramid they tend to have an inverse correlation. Buying gold and other tangible assets, I particularly like the extremely rare and useful platinum, is the only place to go for safety from the specter of the FRN$ evaporating through hyperinflation because of all the quantitative easing.
After all, with a gold coin in hand, or with a reputable third party like the company GoldMoney, I can remain solvent longer than the market can remain irrational. Gold is not an investment but real cash because it is ‘risk-free’ and an instrument for wealth preservation not wealth generation. Far into the future and long after these money market funds are frozen, retirement accounts are nationalized to buy FRN$s that are evaporated into nothing via hyperinflation the gold or platinum coin will still have value because they are tangible assets that are not subject to counter-party risk.
DISCLOSURE: Long physical gold, silver and platinum with no interest TLT, the problematic SLV or GLD ETFs or the platinum ETFs.
By Trace Mayer, on January 12th, 2010
The Federal Government is running massive budget deficits which is creating a massive supply of Treasuries. But there is no demand and so the Federal Reserve is monetizing the debt. But these colored coupons merely amount to certificates of confiscation. Where will Congress find the capital to buy Treasuries? Most likely, your retirement account and screwing up your retirement calculator. 
MASSIVE BUDGET DEFICITS
The Obama administration is on track to need approximately $2T of new debt sales or about 300% of 2008 debt to fund their aggressive spending. But an disproptionately large amount of purchases come from the ‘Household Sector’. Eric Sprott of Sprott Asset Management enlightens us:
We must admit that we were surprised to discover that “Households” had bought so many Treasuries in 2009. They bought 35 times more government debt than they did in 2008. … Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can’t be slotted into the other group headings. …
Our concern now is that this is all starting to resemble one giant Ponzi scheme. We all know that the Fed has been active in the market for T-bills. Under the auspices of Quantitative Easing, they bought almost 50% of new Treasury issues in Q2 and almost 30% in Q3. It serves to remember that the whole point of selling new US Treasury bonds is to attract outside capital to finance deficits or to pay off existing debts that are maturing. We are now in a situation, however, where the Fed is printing dollars to buy Treasuries as a means of faking the Treasury’s ability to attract outside capital. …
As we have seen so illustriously over the past year, all Ponzi schemes eventually fail under their own weight. The US debt scheme is no different.
Ponzi schemes fail when capital seeks safer and more liquid assets by burrowing down the liquidity pyramid. This is similar to the process that happens in a credit contraction. As I wrote earlier, the Federal Reserve will fail with quantitative easing.
CERTIFICATES OF CONFISCATION
Treasury instruments have been, are and most likely always will be certificates of confiscation. The saving retirement calculators are almost guaranteed to fail because of this uncertainty. Here is a visual explanation so you can understand the math.
So likewise Treasury Inflation Protected Securities (TIPS) are just an invitation to be stolen from. This makes your simple retirement calculator even less useful.
RETIREMENT ACCOUNTS
Congress looted the Social Security Ponzi scam many years ago. The social security retirement calculator is completely broken and predictably riddled with fraud.
Where is the next largest pool of capital for these vampire squids? Yes, your 401k (now a 104k), SEP-IRA, Roth IRA, etc. How will these tax eating parasites slurp that value?
The Telegraph reported,
The Argentine state is taking control of the country’s privately-managed pension funds in a drastic move to raise cash. … So, over $29bn of Argentine civic savings are to be used as a funding kitty for the populist antics of President Cristina Kirchner.
On 8 January 2010 Kirchner has attempted to fire the chairman of the central bank because he has refused to use about $6.6B of the funds to pay international debt that falls due in 2010 but a federal judge has ruled Mr. Redrado should be reinstated at the independent central bank. What a mess! The President wants to fire the banker because he will not hand over everyone’s pension money to overseas bankers.
Businessweek has reported,
Seven in 10 U.S. households object to the idea of the government requiring retirees to convert part of their savings into annuities guaranteeing a steady payment for life, according to an institute-funded report today. … The institute’s member companies manage $11.6 trillion of assets in mutual funds, including employer-sponsored 401(k) accounts.
While the state sponsored retirement accounts may appear alluring, particularly when your employer matches your contribution, you may get more than you bargained for. Like this English man if you contribute to your state sponsored retirement accounts then you may find unwittingly find yourself in an uncomfortable situation and have no one to blame but yourself. The tax eating looters and moochers will attempt to force you to become infected with their lecherous colored coupons.
CONCLUSION
The nation does not need Washington DC and individuals do not need Washington DC usurping their retirement accounts and forcing the purchase of Treasuries. Doing so is simply attempting to sustain the unsustainable. But that is most likely what will happen.
Now is the time to begin reducing your exposure to this political risk and safely sheath your capital in safer assets outside of these retirement accounts. For a reliable and free retirement calculator use the Numeraire Spreadsheet and realize that for hundreds of years a one ounce silver coin will buy you approximately one steak dinner. For the ultimate no confidence vote just buy gold, silver or platinum and learn some good hawala techniques like the Argentines.
DISCLOSURES: Long physical gold, silver and platinum with no position the problematic SLV or GLD ETFs.
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