Stephen Yu's  Instablog

Yesterday, a good friend showed me his insightful analysis of gold in an email. His email goes something like this:

The ratio of oil/natural gas price is near 18.  According to Bespoke, each of the three times this ratio topped 18 in 1990-'91, it proved a good time to bet on gas relative to crude. Twice, the subsequent outperformance of gas was dramatic, the other time merely impressive.  On a BTU per dollar basis, a proper ratio (I call it the energy-equivalent ratio) is closer to 6.  So at the present price of $72 oil, gas should be at $12 per MMBTU.  But gas is under $4 per MMBTU now.  Granted, oil and gas are not the same.  Oil is used mostly in transporation, whereas gas is used in power plants.  Also, the infrastructure for gas is not as well developed as it is for oil.  So it is not a surprise that gas trades at a discount to oil.  Yet, these characteristics do not explain the wide gap between the present oil/gas ratio of 18 and the energy-equivalent ratio of 6.  Furthermore, while oil has retrenched about 50% from peak, gas has fallen nearly 75%.  It is quite obvious that the plunge in gas price cannot be justified by a slowing economy.  Finally, production costs at some natural gas producers are now above the current gas price.  So if natural gas price stays at current level, producers will cut back production thus reducing supply and pushing price up.

In March, I wrote about the win-win situation for commodities. In an article, I argued that commodities are going to rise whether the economy turns up or down. This time, I am writing about an opposite asset class – long-term U.S. Treasuries. No matter what the economy does, I believe that long-term Treasuries are in a lose-lose situation.

But then again, with so many structural problems in the world’s economy, who really believes that the economy will heal any time soon? So suppose we stay in this trough for a while longer, and suppose the Keynesians continue to rule the world, a likely scenario, the government will spend, spend, and spend even more to get things going again. With dwindling tax revenues, the government will then have to issue more Treasuries to finance new spending. The liability side of the government’s balance sheet will then bloat; and debt ratios will deteriorate. Natu... credit ratings, and hence prices, of U.S. Treasuries will plummet! Is that how it will end? Not necessarily. There is an alternative, but similarly tragic, ending.  The FED may emerge to make a desperate rescue attempt. But we already know this rescue will be in vain, because we have already seen this movie before. Back in March, the FED announced that it was going to buy $300 billion worth of long-dated Treasuries. Treas... jumped for a day or two after the announcement, but then they have resumed falling since. And even if the FED succeeds at propping up Treasuries, it will only be because of the printing press. In the end, Treasuries will be repaid with paper that, may not exactly be worthless, but will definitely be worth less. Long-term Treasuries buyers, choose your poison!

While the recent stock market rally may seem to signal that the worst is past, a look at the big picture tells us otherwise. Look at the following obstacles, and you will know what I mean.