Be the Bid, Ben (Please)

The previous section (to be posted seperately) dealt with some of the reasons the market is stronger. Now we move to some of the danger zones that still need to be navigated.

There was a great deal of hand wringing in the market over the stress tests, thanks to multiple leaks and trial balloons on the subject. While there were a couple of individual nasty surprises, the overall scale and order of banks from best to worst wasn't much of a shock. That's as it should be; analysts have been stirring these entrails for months. Traders don't like the dilution banks suffer to get more capital, but that was bad news everyone knew was coming.

It's clear that unemployment will not look “good” for quite a while. Employment is a lagging indicator. Markets turn well before unemployment peaks, but it still has an impact. Employmen... have to get much, much better before aggregate income for Americans is reducing debt loads. The US economy won’t see anything like potential growth before that happens. As much as we want to be cheery about it, its clear that the American consumer cannot affort to pull the economic train any longer. Shoppers aren't dissapearing, but it will be a long, long time before that sort of spending is a giving US GDP a major lift the way it did in the last cycle.

Speaking of debt, we note that some credit market indicators we watch have seen big improvements this month. The TED (treasury-Eurodollar) spread is down to 74 bps, a level not seen since last summer and LIBOR is back below 1% and sitting near all time lows.

One rate that doesn’t look so good is the TNX or ten year note yield shown in the chart below. 3% was thought to be Bernanke’s “line in the sand” which prompted his quantitative easing announcement in mid March. That announcement generate the drop to 24.64 in mid March but that respite was short lived. The rate is now at 3.10% after reaching a six month high of 3.38%, and it will be tough to hold it there with so much new treasury paper being sold.

click to enlarge

After the last Fed meeting, Bernanke said he did not expect to add to debt purchases. We&rsq... not buying that thanks to the scary message of this TNX chart. To our minds, Bernanke on the bid is not about growing the money supply so much as its about holding treasury rates down. Ben has to be the bid, or US rates could easily run far higher as new treasury debt swamps the market.

The US absolutely cannot afford skyrocketing interest rates for the next couple of years. We expect a lot more money supply creation. The latest Treasury estimates point to the need for $3 trillion in issuance this year. Only a fraction of that has been done and the "bid to cover" ratio has been dropping, while its still healthy. We realize that there are many who assume that the Fed will simply mop up whatever excess liquidity it generates when things start looking better. While the Fed may ultimately be able to do that, its not realistic to think the massive transactions being undertaken now can be reversed the way small overnight refi transactions were in the past. Bernanke will not be able to close out these trades until the US economy is much stronger. The market will not be able to absorb it without interest rates rocketing higher.

The combination of expected new money supply and moves to riskier assets is impacting the Dollar, as shown in the next chart. The dollar index has broken through the trend line it held every since the dollar bottomed last July. Its now sitting at the level it fell to when Bernanke made the quantitative easing announcement in March.

Looming supply and generally better numbers in other economies could and should push the USD index down to at least the level it fell to in December and an ultimate low below last July's low is a real possibility. Most currency traders are chartists after all; violating the trend generated more selling and breaking support levels will generate more. There is no great mystery here. The US has to expand its money supply and its debt as it tries to navigate this disaster.

We've said since the start of this debacle that we do not think the US will lead the world out of this one. Increasingly, we believe the US will use the time honoured method of debt reduction - inflating as much of it away as possible before starting to pay it off. That sort of value destruction for the US currency means further gains for both base and precious metals and other commodities. That should generate some higher highs in the resource space, at least in May.

Where this all ends ultimately is a tougher call. We are very comfortable about longer term commodity prices on a supply/demand basis. Charts will not tell anyone where prices for most commodites will base. They will and have based at levels that generate supply destruction, which means at or above sector cash operating costs. Miners are not willing to produce at a loss for extended periods. The current downturn has included the most rapid closures of production capacity we've ever seen. Metal prices will move to levels that will allow the mining sector to generate adequate supply at a profit longer term. The price levels required for most metals to meet that basic condition is much higher than most people realize. The developing world is the marginal demand generator for most commodities. That is the reason most commodity prices have fared better than expected by others and should do even better longer term. Most of these areas are still growing, as bad as things are and we expect demand from these areas will overwhelm demand destruction in the G8 as we move forward and the world economy heals itself. There will simply not be enough metals supply unless prices justify more mine startups.

Part of what makes the longer term call tricky is that commodities may well be prices in some other dominant currency or currency basket so changes in the value of the USD will become less meaningful. That is an issue for another day however. We don't see that happening quickly enough to be a basis for valuing commodity explorers and producers&nbs... now. We do think its coming however.

Disclosure: No positions

Comments

[Dave Wrixon:]

A well argued article completely undermined by the assumption that moving from Treasuries to other investments implies taking on more risk. Almost nothing is more risky than US Government debt. Even if there is no outright default, no sensible investor is going to take on the inflation downside and the risk of a dollar implosion for such a feeble return .

May 15 08:03 AM

[altaman:]

The Fed/Treasury complex may try this or try that but bottomline is that interest rates are headed much higher whether or not "the US absolutely cannot afford skyrocketing interest rates for the next couple of years." How else can they get investors to gag down even a fraction of the inevitable blizzard of paper?

Obama - “We can’t keep on just borrowing from China,” Obama said at a town-hall meeting in Rio Rancho, New Mexico, outside Albuquerque. “We have to pay interest on that debt, and that means we are mortgaging our children’s future with more and more debt.”

Thanks for telling us exactly what you are doing and will continue to do dude!!

May 15 04:26 PM

[MarkitWacha:]

I agree completely.

To the author: What ratios would you hold commodities vs. short treasury vs. short dollar?

Where can you find out about the treasury auctions and their amounts first?

May 16 11:55 AM