The past week saw a sharp uptick in certain commodity prices as well as global equities. Starting with the incredible intraday reversal on Tuesday afternoon, investors seemed to cheer the seemingly innocuous words out of Europe that something would be done to contain the debt crisis, as well as a better-than-expected US jobs report.
It is our opinion that the partial recovery last week was nothing more than short covering within the context of a bear market, and that these rallies provide excellent opportunities to sell into strength.
The problems of Europe are only becoming worse by the day, and there is bound to be no positive solution. The only solutions remain either letting countries default, or printing euros to finance the debt; neither of these options are currently being tabled. While the market cheered the ECB's lack of interest rate cut on Thursday, Trichet's statements were overwhelmingly bearish for the situation. Trichet confirmed that the ECB is not supportive of leveraging the EFSF, coinciding with the view of Germany but contradicting the thoughts of the EC. If the use of these acronyms is starting to confuse you, don't worry, because it is ridiculously confusing. Getting Europe to act involves not only getting 17 countries that historically dislike each other to agree, but also getting the overall governing parties to sign off, including but not limited to the European Central Bank, the European Commission, the IMF and countless other groups.
The primary risk at this point is becoming the impending stand-off between Germany and France. Although Slovakia and Malta have not yet approved the EFSF expansion, it stands to reason that they most likely will if given enough time. Of course if they don't, things will deteriorate extremely rapidly, but since they are small countries, the pressure on them to not hold things up will most likely prove too large.
However, Germany and France still disagree on the prospective uses for the EFSF. Since France's banks and financial system are much more exposed to PIIGS debt and their banks are already under attack, France would prefer using the EFSF to recapitalize the French banking system immediately. Germany would rather use the EFSF as a "last resort" while having each country recap their own banks first. This split represents a significant divergence in logic, which will ultimately cause things to get much worse before they get better. Germany is losing public support for continued bailouts, with polls showing that a majority of the population did not approve of the EFSF expansion. Merkel is now forced to act with a minimalist stance toward helping the rest of Europe, only taking absolutely necessary steps that are defensible to the German people. With the bailouts already unpopular with a majority of voters, and the austerity responses clearly not working, it seems only a matter of time before this situation comes to a very ugly head.
If France is forced to accept the German position on the use of the EFSF, it represents a huge threat to Eurozone stability. Starting with this week's Dexia bailout, France is going to have to take on more and more private banking debts onto the public balance sheet. While the ratings agencies have not indicated France is likely to be downgraded, if France recapitalizes their main banks along with participating in guarantees for Dexia, it would seem a farce that France remains AAA while the US is AA. Even if France does not get immediately downgraded, the market will put downward pressure on French bond prices as they take on more and more banking risk. With France and Germany the last two stalwarts of the European economy, this would represent a death blow to the hopes of Europe averting recession.
On the other hand, if Germany accepts France's position, Germany's credit rating would become at risk due to Germany's large participation in the EFSF. While 440 billion euros is a substantial sum, it is not nearly enough to solve even just France's problems in the banking sector. With the leveraging of the EFSF off the table, Germany would almost certainly be hit with more capital calls from the EFSF at some point for further backstopping, at which point Germany would balk because of the risk to its credit.
The most likely outcome is what has become par for the course in Europe now: an incomplete, ineffective compromise. While there is no way to know what such a scenario would entail, the urgency to recapitalize Europe's banks in a convincing fashion is simply not there.
It is our opinion that the US and Europe will both wait for a significantly negative catalyst to galvanize political support for what needs to be done. In the US, massive fiscal and monetary stimulus is needed to avert recession and promote job growth. In Europe, a European version of the TARP needs to be enacted to remove the solvency risk of the entire European banking system. However, neither of these necessary and inevitable steps will gain the requisite political traction until things get so bad that the population is screaming for change.
For this reason, we believe things will get much worse before they get better. Even if Bernanke ends up printing a ton of money, the deflationary forces that will work upon the global economy before that step gets enacted will be destructive to risk asset prices and beneficial to the dollar. As policy makers run out of bullets, the deleveraging we saw begin in 2008 will continue until politicians make an about face on fiscal policy. The coming environment could be grim for the economy as a whole, but thankfully it also presents enormous opportunity. With that in mind, we turn to our weekly analysis.
As can be seen, both commodity measures saw an increase this week, although the CRB Raw Industrials increased only 0.37% while the GSCI Index appreciated 2.65%. Since the CRB Raw Industrials measure non-speculative commodities, it is a good gauge of overall commodity demand. This week's increase is a slightly encouraging sign, although it will take quite a bit more rallying for it to retake any of its previous high levels. We will continue to monitor this index closely for signs of renewed commodity demand or deteriorating fundamentals.
The GSCI Index appreciated mainly due to higher crude and copper prices. With all commodities so beaten down lately, a rally was certainly not out of the question, and should be expected in a bear market. We continue to favor short risk asset strategies and long dollar strategies in the face of an economic slowdown.
The US Dollar and Precious Metals
The following chart shows the balance sheets of the Fed in white, ECB in orange, BOJ in green and BOE in purple.
Chart courtesy of The 10/7 Commodity Analyst Newsletter
As can be seen, the ECB balance sheet is rising parabolically. The continued purchases of European sovereign debt on the secondary market, as well as liquidity injections, are causing the ECB balance sheet to explode.
At the same time, due to Operation Twist being enacted instead of QE3, the Fed balance sheet has stayed remarkably stable over the past 3 months. It is no coincidence that during this time the US dollar has appreciated remarkably against almost every currency with the exception of the yen.
Because the Fed has quietly started to move toward more responsible monetary policy (or at least as it compares to the rest of the developed world), the US dollar is finally regaining its status as a safe haven. While the debt ceiling debacle in August saw investors question whether the dollar would remain a safe haven, and had them increasingly turning to gold and other assets as alternatives, investors are beginning to realize that the historical position of the US dollar as a prized asset in times of turmoil is returning.
The Fed's newfound caution coupled with efforts by countries such as Japan, and Switzerland, to tarnish their own safe haven status will cause an even larger flight to the dollar. As Europe slows and the developed world experiences paltry growth at best and a recession at worst, the US dollar will again reign supreme.
For this reason, while ECB money-printing would normally be considered inflationary and precious metals-positive, we believe it is turning into a negative. As investors consider the US dollar safer than all other currencies and as global growth slows, investors will increasingly flock toward the dollar and US treasuries to gain some sort of risk-free yield. With the Fed's money-printing on hold for the moment, the US monetary base appears to be stagnant. Ironically as stocks fell in August, gold appreciated due to increased expectations of monetary base expansion. In October, the opposite is becoming true. Gold and especially silver are moving with equities, as the risk-on trade of buying stocks indicates inflationary expectations, while equity selling denotes deflationary expectations. We believe the current environment favors deflation much more strongly than inflation, and as such, precious metals are an ideal short.
The great X factor in all of this is clearly the Fed's ability to initiate more quantitative easing. However, given the Republican's penchant for turning monetary policy into a political weapon, further quantitative easing appears to be unlikely until a strong negative catalyst, such as marked deterioration in the stock market, unemployment, or inflation expectations. While all of the above are likely to occur in the coming months, current prices of risk assets and precious metals do not accurately reflect the coming economic environment and will likely fall quite a bit before the Fed is forced into acting again.
We recommend shorting all currencies against the US dollar, especially those with the most commodity and emerging market linkage. The Australian dollar appears to be an ideal candidate due to its heavy reliance on both China and the mining sector. If and when China slows due to Europe's contraction, Australia will have to cut interest rates, removing many traders from the carry trade of holding Australian dollars. For this reason, the Australian dollar is a leveraged play on a global slowdown, and should be traded with caution.
We recommend shorting the Australian dollar at a price of 0.9823 or better. Such a trade should be kept small, as volatility on the Australian dollar is extremely high, but the trade seems to have a very good chance of profit over the 6 month to 1 year term.
We also believe that silver is an ideal short given its large industrial demand as well as its precious metals status. We recommend shorting silver futures at a price of 31.75 or better. This is also a highly volatile trade, so size should be kept to a minimum, but we view a silver price of between 20-25 as likely at some point over the coming year.
Disclosure: Short silver futures, short euro futures, short yen futures, short australian dollar futures