A Review of the Current Road Map

April 26, 2010

On Wednesday April 28 at 6pm (PST) I will be presenting a special “webinar” with a detailed analysis of the US economy, interest rates and many different financial markets. Advance registration is required at:  http://www.earlywarningwire.com/pdf/interestratewebinar2010.pdf
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2010 can best be characterized as a year where too much money has chased too few assets resulting in significantly higher prices for stocks, many commodities (gold), currencies (dollar) and selected interest rates. As we rapidly approach the second half of the year the question that every investor must address is: will current trends continue? If not, will they reverse or hold in patterns awaiting the next leg up in this runaway train fueled by massive liquidity? I will address the key categories in this update but urge readers to subscribe to my daily update for a more detailed analysis and of course all of the subscription fees go to Food on Foot  a non-profit in Los Angeles that provides food, clothing and job opportunities for the homeless and poor.

Federal Reserve

Every market is influenced by Federal Reserve policy because it controls the rate of monetary expansion or tightness which filters through to price movements created by investors based on their expectations. The Bernanke Fed has done an admirable job of making policy transparent since the credit meltdown began in the fall of 2008 and there is little confusion today about the current stance of easy money with an overnight funds rate of 0.25%. It is remarkable that a year ago every word that came out of the mouth of the Fed Chairman was covered by all financial networks and most news stations. In the past month Mr. Bernanke’s testimony to the Senate and House was considered a non-event by these same financial networks and one had to go on the internet to find live coverage. Is Fed policy something that shouldn’t matter to investors? Hardly, the Fed will react to changes in the economic landscape and especially inflationary expectations and job growth. Although many believe the Fed continues to add liquidity to the system it has gone unnoticed that in the past few weeks we have witnessed a very sharp decline in the monetary base. This is important because it shows the Fed is concerned about the recent rise in asset prices (especially stocks) and the base has had a close correlation with recent stock market price moves.   The Fed is acutely aware of inflation expectations which remain contained under the 2.40% level.  U.S. unemployment remains stubbornly high and the length of time the jobless remain unemployed is creating a dangerous situation since job skills (and confidence) begin to erode when one remains unemployed after 12 months. The federal government’s hiring of census workers should boost the next three months payroll numbers giving everyone the false impression the economy is back on track. The key to any recovery is private sector hiring and most small businesses are struggling to maintain revenue levels unless they sell to the government. The National Federal of Independent Businesses releases an excellent monthly report showing the most important items affecting small business and currently they are poor sales, high tax rates and too many regulations. Those items are not the recipe for expansion and hiring unless they include large government contracts. The federal government (with the Fed) ended the rapid deceleration in economic activity last year but unless the private sector becomes convinced business activity is on a sustainable upward path we will have high unemployment for at least the next four years. As a result it will difficult for the Fed to tighten monetary policy through higher short term interest rates as that would make credit more expensive at a time there is little borrowing from the corporate sector. Economics 101 teaches us prices rise when demand increases or supply falls and the demand for credit is currently low and the supply abundant which can be seen by the $1 trillion+ banks have in excess reserves stored at the Fed.

Long term interest rates

The consensus among investors, economists, real estate professionals and anyone else with an opinion is that long term rates must rise in the next year. A Barron’s poll of portfolio managers this week found only 1% forecasting lower rates in the next year versus 78% believing rates would move higher. Increased supply is often used as a reason rates must rise but history has shown long term rates are influenced by supply for only a short period of time (weeks) and that long term movements are a function of a change in inflationary expectations and/or the real rate of return. The 10 year Treasury is currently trading close to 3.80% with the inflation component at 2.36% and the real rate at 1.44% and these are levels we have seen for much of 2010. Most of these bond bears use an increase in inflation due to massive money printing as yet another reason rates must move significantly higher. They are correct about the money printing but that alone does NOT create a surge in inflation pressures as the velocity of money has fallen at a record rate the past two years. Over 99% of the increase in the monetary base in the past year has been sent back to the Fed for safekeeping by banks that are unwilling to lend or invest their new found dollars.  If inflation expectations are contained the only way nominal rates can rise is an increase in the real rate which is usually a function of the expected growth rate of the economy. If world investors become worried the U.S. will not be able to service its debt or pay the full amount owed at maturity we could see a rise in the real rate (happening now in Greece) but the U.S. might benefit first from other countries needing bailouts.

Seasonally rates rise 75% of the time in the first half of the year and fall 75% of the time in the second half of the year. With good jobs news coming soon we could easily see the 10 year Treasury crossing 4% before reaching an unexpected (by the experts) high in June and then falling in the second half of the year. I’m probably the only person in the universe who believes rates are going to move lower but it wouldn’t be the first time (or the last) I have taken a very lonely position on a market’s direction. Market’s often move violently in the opposite direction of where the majority have placed their bets and the extreme negative carry (4%+) bond bears must endure each year would have them scrambling for cover if long term rates began to move down in the second half of the year. It is an investing axiom that markets move the most when investors/traders must liquidate losing positions and then reverse to go the other way (if they have any capital remaining) and the bearishness in government bond land is the most overwhelming I have seen in the last 30 years I have followed this market.

Japanese Yen

My best bet of the year has performed exactly as expected since the beginning of the year. After spending a few weeks under the 90 level we saw a significant break out after the Japanese fiscal year end on March 31. With the Bank of Japan and federal government agreeing deflation is the #1 enemy and must be extinguished at any cost zero interest rates and easy monetary policy will remain in place through the remainder of the year. As other countries begin to raise short term interest rates (China, Australia and soon Canada) the yen will be under pressure as interest rate differentials widen giving traders a bigger incentive to borrow in yen and invest in high yielding currencies. Japan has suffered from debilitating deflation for almost twenty years and creating any inflation won’t be easy or occur this year. As a result my target of 120 yen to the dollar seems attainable in the next 12 months.

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Trading and investing involves high levels of risk. Before entering into any investment, all readers should consult with their investment professional and discuss the possible loss of capital.

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