TraderDaily's  Instablog

From Waverly Advisors comes a missive discussing yesterday’s FOMC decision to continue expanding the Fed’s balance sheet, as well as as a hard look at whether policy actions of the past two years represent deflationary or inflationary threats. Picking up Waverly’s most recent Macro Report:

“From a macro perspective, U.S. policy makers face a dilemma as they push ahead, illustrated in part by the charts nearby measuring U.S. monetary base, consumer inflation and wage growth during the last several decades. In the present, Bernanke’s biggest threat are lingering high unemployment and the specter of deflation in a softening economic landscape.

In discussing prices, we need to remember that from a policy standpoint there are pros as well as cons to both deflation and inflation. Deflation, or sustained low inflation, creates a cost of living cushion for the bottom three quarters of the social pyramid who have experienced modest wage growth during the course of recent decades (note wage chart) and may also encourage more employment by sustaining that earnings trend —but it will weigh on demand like an anchor.  Inflation on the other hand provides a huge political incentive by shrinking the perception of federal, state and municipal debt loads —but it will also be viscous for the working poor and lower middle class while wage levels play catch up.  Essentially this conundrum decides who pays the bill, the poor in terms of standard of living or the affluent and business in the form of lower growth and higher tax burdens.  In the face of two unappealing options the course that has been chosen instead is bold, audacious even.  Our leaders are attempting to squeeze inflation selectively into specific asset classes as a form of quasi wealth transfer via policy, while fighting inflation elsewhere.

There are obvious examples of this course of action.  Perhaps the most visible is housing, with aggressive efforts by both the Fed and the legislative branch to prop up home values to cushion the middle and lower class.  Less obvious is the impact of recent financial reform, which was inspired in part by veteran inflation jockey Paul Volker.  By castrating Wall Street banks in the name of reform, there is a convenient potential to alleviate unwanted inflationary pressure in other asset markets like securities and commodities while rates stay low. The granularity of this approach is significant, and mind bogglingly complex.

Note that the big losers in this scenario of course are savers, who are penalized for their virtue by low interest rates directly and price pressure from either direction indirectly.  Many pundits like to compare the US with Japan to illustrate certain risk but it is certain that the cultural differenced between the two nations are profound regardless of economic sensitivities.  Capital in the US has a profound tendency to follow risk wherever it presents itself,  and with limited options it will naturally concentrate (more on this later).

As we said, this is a bold course, and there are no real historical corollaries ( no successful ones at any rate) to draw from.  It is our stance that for this to work that our policy makers must be deft in their actions, free to make decisions independent of political pressure and very, very lucky.  Additionally, the external event risk is huge since another Greece level crisis could cause the whole strategy to come off balance.  Although we will give them the benefit of the doubt on their personal skills, we hold no such hope out for the abilities (or character) of our elected politicians and thus have a negative bias even without factoring in event risk.

What we took from yesterday’s FOMC can be summed up as follows:

+  The decision to extend the Fed’s balance sheet by buying treasuries accomplishes several short term positives. First, it provides an appearance of action which will alleviate some political pressure in the near term. Second, by buying treasuries rather than mortgages, the balance sheet is hedged somewhat against future rate increases (mortgages will fall faster than treasuries in a rising rate environment). By abstaining from buying mortgages the Fed takes action while also maintaining the appearance of a degree of independence (surely our elected leaders would prefer more boosts for the mortgage market).  Lastly, by accentuating the negative, the Fed has a hedge against making dramatic reversals of its public stance later.  The slaughter in the stock market today is likely seen as short term, and thus an acceptable price to pay by Bernanke & Co.

+  The negatives in this action are equally clear:  By delivering something more than promises today, they raise expectations for future intervention.  Managing expectations is a tricky business, full of risk, and by increasing the prospect of more action sooner rather than later the Fed may not modify market behaviors in the way hoped.

In the near term we expect that the equity market very may well shake off concerns about lower growth prospects that have hammered it today and rally again as risk capital with nowhere else to go returns (as per our earlier discussion of savings). If this does occur, be advised that this will be a traders market only, and long-term players should avoid it and probably use that strength to trim exposures.  Note that this set up also continues to support the thesis for our small cap underperformance relative value trade (long S&P/short Russell) as hot money favors well-capitalized operators with scalable cost structures. We realize that we remain somewhat contrarian in this call and, despite the fact that it has already done well for us, we retain high conviction in that trade at present levels.

In the long term we remain uniformly bearish across all domestic non-commodity asset classes and continue to expect that, despite the best attempts of policy makers, strong inflation ultimately is the likely result of our present situation.

At the same time, however, silver has been keeping its head up in recent months – yet hardly anyone seems to care.

Earlier in the summer, precious metals expert Jim Rogers told  Market Folly that while he was bullish on gold, some other metals were relatively cheap. “If I had to buy a metal right now, I’d focus on depressed metals such as silver or palladium,” Rogers said.

“Rogers points out that silver is 60-70% below its all-time high while palladium is around 50-60% below its all-time high.”

Analysis and graphic data from Goldscents point to an unusual disconnect between gold and silver prices.

Invariably silver follows gold and it usually magnifies any move, especially on the down side. So if gold drops 1% silver can be expected to shed 2-3%. At intermediate cycle bottoms silver will almost always fall apart. Often it will slice right through key technical levels. Without fail at intermediate cycle lows silver will look broken.

During the current intermediate bottom however silver did something that up to this point was just unheard of. As gold dropped into the intermediate low silver diverged positively from gold.

One assessment from Motley Fool cites several long plays based on the belief that silver prices are on a long-term upward trend–Silver Wheaton, Hecla Mining, Endeavour Silver, and Silver Standard Resources.

At the same time, rising prices may put pressure on businesses whose manufacturing process draws on raw silver. One such company is diagnostic imager Carestream Health, according to Cardiovascular Business, which says the company is raising prices on imaging film and related materials:

The increases of up to double-digit percentages vary depending on global market conditions, and are “driven by significant price increases of commodities such as silver, polyester, oil and electricity required to produce and ship imaging films and supplies,” according to the company, adding that silver prices have increased by more than 70 percent over the last 18 months.

We continue to watch the US Dollar Index with interest.  Several conflicting factors preclude a simple trade setup at this time:  Short-term momentum is overwhelmingly negative (bearish).  In fact, the downward momentum is so strong that the first bounce in this market is most likely a shorting opportunity.

On the other hand, we are reaching an important support area and the market is possibly oversold.  These factors put the bears on warning.  We have no clear trade at this time, but are watching this market for a setup over the coming weeks.