Notes from my scorecard

June 13, 2011

This week the world gold council released its world central bank report through April 2011 and the largest buyer this year is the same country that was #1 last year – Russia. We know through the financial media of the large hedge funds that have accumulated gold the past two years but little is ever published about the one country that continues to make a very large bet on world wide economic instability. In the first four months of this year Russia purchased 36.2 tonnes of gold and follows the 139.8 tonnes bought in 2010 and the 117.70 in 2009. Have they taken the proceeds from the sale of oil and other natural resources and moved them into the ultimate hedge against currency depreciation? If gold moves above $2000 or higher they may soon have the reserves that put them in the league of China, US and Germany.

Fed report shows increase in bank stock trading
The Fed’s weekly h.8 report had a couple of interesting nuggets on Friday afternoon that tell us where banks are placing their newly printed dollars courtesy of the Fed.   Although total bank credit rose on $1.1 billion and remains stalled banks increased their trading assets $16.5 billion or 9.2% in the past week along with their cash assets $16.5 bullion (+0.9%). Both of these stats are subject to revision but the trend is staggering and sends a clear message of Fed approval or we would be hearing from Uncle Ben thru the media that banks need to cut back on their trading risk. The chart of the day shows the performance of the S&P since the beginning of this year versus the increase in banks willingness to take a risk supported by the Fed.  We know that close to $600 billion has been printed and sent into the banking system by the Fed since late last year with a portion used to purchase US equities and yet the S&P is only 1% higher than its close on the last day of 2010. Has the smart money being selling to the dumb (banks) money the last six weeks knowing when the bulk of Fed printing ends on June 30 there won’t be anyone remaining to hold up the market?

Market action
Friday stocks ended yet another down week and the streak has now at six with only three other times since 1931 where it has gone to 7 or 8. (May 1970, March 1980, March 2001).  With US stocks down 5.31% since the beginning of the month the decline represents the worst start for June in the history of the S&P. Interest rates fell as they have done almost every day when stocks declined and the 10 year Treasury fell to 2.97% with the inflation component at 2.25% while the 30 year dropped to 4.18% with its inflation component at 2.42%.  Next week retail sales, CPI and consumer sentiment lead the parade of news releases and the important part for readers to watch is not the level for each index but how they report versus the greatly reduced expectations of the “experts’. As I showed last week in a chart of indicators versus forecasts the analysts have been far too optimistic the last two months and this had led to disappointments and selling from investors/traders (sheep) that had become accustomed to upside surprises. The next Fed meeting is scheduled for Wednesday June 22 and although Uncle Ben has made it clear the Fed printing program will change to only the re-investment of coupons and maturing securities many are hoping a continued decline in US stock prices will lead the Fed head to consider (similar to 2010) another injection of high powered sugar (QE3).

Better than working for a living
We know how much the Fed has helped the struggling economic recovery with money printing and the federal government with its tax credit programs and bailouts but how much spending has been created by consumers living rent-free? Many homeowners have not made mortgage payments in over a year with a few living rent free for up to five years. 4.2 million mortgage borrowers are either seriously delinquent or have had their cases referred for foreclosure according to an article from CNN/Money with two-thirds of those homeowners making no payments for over a year and half of those have skipped two years of payments.  According to the article its takes an average of 565 days to foreclose on a borrower after they have missed their their first mortgage payment. If you are not paying a mortgage or rent your ability to spend rises and is surely giving a boost to monthly consumer spending numbers. What happens when they are foreclosed? Do they find a job or become homeless and apply for government assistance? Or are they currently working and just taking advantage of the system to maintain an old lifestyle or increase their wealth?

What happens when the Fed drastically reduces the recent amount of Treasuries purchased?
Last week the Fed published it quarterly flow of funds report, 125 pages of mostly boring numbers only someone like myself or a highly paid economist would spend hours reading in hopes of finding a couple of nuggets.  Since the markets are quiet most nights between 11pm-5am it wasn’t difficult to find the time to dig in to the report in hopes of finding who has been investing in what over the past year. Obviously we know the Fed has been printing money at a record pace the past six months and using it to purchase Treasury securities so the fact that Treasury holdings by monetary authorities rose by $319 billion in the first quarter was not a surprise.  But did household Treasuries really fall by $155 billion? Yes, but this sector includes domestic hedge funds (sheep) as the household category is the result of everything remaining after subtracting foreign holders, monetary authorities, commercial banks, pension funds, money market funds, mutual funds and broker/dealers. And of course this data is subject to the usual frequent government revisions. Foreigners continue to purchase Treasuries (+$67 billion in 1st quarter) but importantly their share of total outstanding government debt fell to 30.2% from 46.2% last year as the Fed’s portion rose sharply. The question is who will buy the new debt issued after June 30 if the Fed is pulling back? The obvious answer is no one and that is why so many have been betting on higher interest rates (and been wrong) the last three months in anticipation of the big day (6-30). The Fed is not going to pull back to zero as the NY Fed announced Friday the final part of the $600 purchase program and reminded everyone the Fed will be reinvesting the proceeds from maturing agency debt and mortgage backed securities on July 6 and July 11. The good news is the sheep appear to be short based on end of March data and may not have covered all of their short positions. Notice in the above grid how their timing continues to be awful (painful losses) as the other time they were heavily short (higher rates) Treasuries was in the fourth quarter of 2008 when the 10 year fell from 4.08% to 2.05% in less than 90 days. It is doubtful commerical banks or pension funds will step up to purchase the excess Treasury supply unless the inflation component falls below 2.00% in the 10 year. The only other entity that can replace the Fed is foreign holders and they probably would step up if the dollar rose significantly in value and Treasuries became a safe haven play based on sovereign risk or stress in European economies (Greece, Italy, Portugal?). Fundamentally the case is strong for higher interest rates but markets often disregard fundamentals (Japan) for many years and those betting on higher US interest rates have suffered large losses as they wait for an event that may not occur as soon as needed by heavily leveraged funds with high negative carrying costs.

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