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Sent to Daily Update Subscribers on July 28, 2011

August 2, 2011

The song remains the same day after day with market players fleeing the trading arena and sucking the liquidity out of most markets. An early morning rally fizzled as participants remained glued to every word from the Washington clowns. The hapless and ever losing Washington Generals could do a better job with a little help from the Harlem Globetrotters. It’s all about politics and the next election with potential voters sitting and waiting like those on death row knowing the inevitable is coming sooner than later praying for a pardon from the governor. The pardon in this case is dealing with increased spending (that buys votes) and a debt that will soon overwhelm the private bond market and is one of many reasons corporations are sitting on billions in cash with no plans for expansion that could create new jobs. Friday’s economic reports will be a non-event despite the fact they give us important information about GDP, consumer confidence and the Chicago Purchasing Managers Index. The S&P fell for a fourth consecutive day (-.32%) as investors wait and wait and wait for a 60 day extension? or something that will be hailed in Washington as a grand solution but in reality nothing more than another band-aid for a patient in ICU.

Many are worried about a downgrade of the US governments AAA rating and the cost to the country from higher interest rates. In reality this event which may occur despite an increase in the debt ceiling has a good chance of marking the low point for the economy and if history repeats might push us in the right direction. A year ago Ireland’s debt was downgraded and although they are mired in debt markets trade with the assumption things won’t get worse and might be getting better. Iceland in May 2008 was the story heard round the world with rising interest rates being used by the central bank to attract investors and save the declining currency. It’s didn’t work but did force the country to accept what was deemed intolerable only a few months earlier and again they appear to have hit bottom. Canada in the summer of 1994 was suffering from a high debt/GDP ratio that drove investors fleeing the country. Australia in 1986 and Sweden in January 1991 were both downgraded and worries spread around the world they would never recover but they did and although it takes years of slicing and dicing through very dark days they saw clear skies within a few years. The US has spent the last 20 years printing $$$ whenever there was a problem with the economy but slowly its affect on the patient has diminished and now it clearly doesn’t work as we have seen with stubbornly high unemployment and a government that spends 25% of GDP to make it rise less than 2% a year.

Interest rates
Today’s 7 year auction ($29 billion) was a disaster as I wrote last night with the final bid at 2.28% despite the fact the bid level at the deadline (9:59am) was 2.264%. The 10 year Treasury fell 3bp (2.95%) but the inflation component rose 1bp (2.46%). The big problem and it is growing daily comes from the long end of the yield curve where investors has left the scene for safer ground in the short end. The 30 year Treasury fell 3bp (4.26%) but the inflation component rose 2bp (2.76%).  Normally this kind of market behavior would have me waving the big red flag of higher rates but a default would send rates tumbling due to a dramatic decrease in government spending. In all of the above cases where a country’s debt was downgraded from AAA to AA interest rates fell sharply for at least a few months and readers should remember that important fact if any loans need to be locked and borrowers panic at the first sign of a government debt downgrade. Open interest has been rising in the 10 year futures contract (bullish) but the 10yr-30 yr. spread remains wide at 31bp. A move below 120 bp would be the first sign demand for the long end of the curve had returned.

Banks accept new form of collateral
With the price of real estate falling the past few years banks have begun to accept other forms of collateral for loans to customers. A Spanish group of savings banks that financed Real Madrid’s acquisition of its star player Ronaldo is no now offering him as collateral for a loan they are seeking from the European Central Bank.   I wonder if Lebron James has been contacted by Treasury Secretary Geithner about a loan to the US government but he might demand more in collateral than the government can access quickly.

The yellow metal has become the anti-currency, anti-equity and anti-bond and rises the most when those markets decline. 90% of traders are betting on higher prices signaling a much needed rest is coming that can be used as a buying opportunity by those under-invested or needing a hedge against more government craziness. One of the items not talked about much in the debt ceiling circus is the fact the US government owns 261.5 million ounces of gold that are carried on its balance sheet at a book value of $42.22 an ounce or $11 billion. A sale at current prices would net $419 billion or enough to cover the deficit until next year’s presidential election. I’m sure China would be very interested in converting their rapidly depreciating dollars for gold and could wire the dollars to the US Treasury in less than an hour. The problem for China would be what to do with its remaining hoard which would surely fall sharply in value after news of the gold sale. Obama did authorize a sale from the SPR (Strategic Petroleum Reserve) which lowered oil prices for a few days but the benefit of a gold sale might be fleeting and I’m not sure would win him any political points from anyone (especially Ron Paul).

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.