As Goes Goldman Sachs So Goes The Market - PART II

Attached is a link to Mish Shedlock's latest blog at Global Economic Trend Analysis. In it Mish discusses Germany being what was the last bastion of fiscal rectitude in the Euro region planning to significantly increase it's fiscal budget for 2010 resulting in a more than doubling of it's borrowing from 37 to 87B euros.

It is this excert from the article that is most interesting:

"Who Coulda Thunk?

Just a few days ago someone was buying UUP dollar calls (UUP is a long USD ETF). There were 340,000 calls traded vs. 183 puts. Coincidence?

What Happened Since

• Additional downgrades of Greece by Moody’s
• Action by the ECB on covered bonds
• German budget deficit about to balloon

There is a very big difference between a concentrated bet by one or two players and the masses speculating in calls. That trade smacked of someone knowing something (or thinking they did, and in this case correctly)."

courtesy www.globaleconomicanalysis.blogspot.com

Let's recap what I said in my original As Goes Goldman Sachs So Goes The Market post on November 16.

"The blood sucking vampire squids of the financial system generally have a good idea as to where the markets are heading. Even when they are wrong however they can still rely on the good grace of the US Treasury & Federal Reserve to bail them out as was the case in the disgraceful way the AIG bailout was handled.

Observant readers will notice that Goldman Sachs has a rather significant net short exposure to CurrencyShares Euro Trust. This is essentially a short Euro/Long Dollar trade."

Since that post UUP is up 3.8% (9.4% in AUD terms) so I guess Goldman Sachs knew where the market was heading again despite the incessant bearishness towards the USD at the time (which still remains by and large), just as they did when they were shorting the subprime mortgage backed securities they were selling to their clients in 2007.

Traders could do worse than to follow the "if you can't beat em join em" edict.

More evidence to support a strong USD

The attached article from http://www.zerohedge.com/article/apocalypse-not-dollar is a highly tehnical one but I highly recommend reading it.

Essentially the argument the article presents is that their are a whole host of countries in far worse financial condition even than the United States which lends weight to a potential rebound in the USD.

The markets have an excellent ability of doing what everyone expects it not to do. Right now there remains a fair degree of pessimism towards the US Dollar.

In the long run all paper currencies fail and the financial system we have today will like all paper money systems throughout history. The reason being that paper money is nothing more than a promise to repay, the only problem being that the only method of repaying is to print more money (or get banks to create it through new loans).

My positive view on the USD is a 1-2 year view. I think you can do very well out of this trade (please read my previous blogs for my view on the best way to trade this) however in the long run you want to be out of all paper currencies and into hard assets such as precious metals and mining and agricultural commodities, real estate etc. I would however would be cautious in buying these types of assets right now due to the extreme levels of optimism towards them.

END THE FED & related US Dollar discussions

An excellent article from Mish Shedlock completely breaking apart Ben Bernanke's recent Op-Ed in the Washington Post. See the full blog here.

In the same blog Mish links a Youtube video showing how comprehensively wrong Ben Bernanke has been right back to 2005. Why do people still listen to this muppet!! See the video here.

The Fed has to end now, since 1913, the year the US Federal Reserve was enacted the US Dollar has depreciated 98% (against the value of gold). The free market is more than capable (and probably far more efficient) at setting the appropriate interest rate for a given risk than any centrally planned monetary authority privately owned by the same Wall Street banks that benefit from this theft of middle class wealth by stealth.

SO WHY BE BULLISH ON THE USD???

Those who have followed my previous blog posts may wonder why I could possibly be bullish on the US Dollar against the backdrop of a completely malfunctioning Federal Reserve and not to mention political system at the mercy of the Military-Industrial Complex. It is an irony that as the majority of the world's debt is denominated in US Dollars it is the removal from the monetary supply of this debt through an increased deleveraging of the private sector due to high unemployment that causes a reduction in the total USD money supply and relative USD strength against other commodities, currency and financial markets. Now this on its own would not support the case for USD strength as it is important to note what you are comparing the USD to ie USD strength against gold, the Euro or what?

USD v Gold

Gold throughout history has been considered a store of value through its scarcity and relatively finite supply. Now the gold supply is not completely constant as new discoveries will increase the gold supply and industrial use will deplete supplies but for the sake of this argument we can assume that the supply is somewhat constant or at the very least far less volatile than any fiat currency such as the USD. What will change the USD gold price over a long period of time is the increase/decrease in the total supply of US dollars in circulation and to a lesser extent the change in popularity of the gold and USD in the eyes of the investor public.

Source - Steve Keen's Debtwatch http://www.debtdeflation.com/blogs/

In the above chart you can see that US Debt to GDP has reached a staggering 250%. This is extreme and began to turn down when the GFC hit before it began to march upwards again as the US Government stepped in with massive stimulus packages and the US Federal Reserve flooded the financial system with liquidity. This has lead to a rally in global equity and commodity markets including gold. On current forecasts the US Debt to GDP is forecast to hit 300% in 2010 and thats assuming the economy is growing! Obviously if GDP begins to decline again that ratio may be even higher. In my opinion we are close to the end in this government stimulus funded "recovery" that is not really a recovery unless you are a Wall Street banker on record bonuses rather than an unemployed middle class person on Struggle Street!

In my opinion the Fed Reserve & Government will not be given a second chance on increasing federal debt at already extreme levels when they see the fairly muted effects of the original stimulus in its inability to stop private sector deleveraging and actually encourage credit creation. The Fed Reserve has already announced their intention to remove $1.5 Trillion in emergency liquidity by March 2010. This I feel will be a nail in the coffin as the investor public re-shifts its focus back to the systematic private sector deleveraging that began in 2008 and will expand to US municipality bond defaults, large coporate debt/commercial property/residential property defaults and so on and so forth. The government will not be able to offset this rampant deleveraging a second time after the first effort will be shown to have had no effect.

Bringing it back to gold it is my opinion that a precipitous decline in the total USD money supply versus a relatively static supply of gold that will lead to a reduction in the value of gold priced in US dollars. Further to that the widespread mania around gold where Central Banks are announcing large purchases of it, people are calling for the Death of the US Dollar it appears to be a very crowded bullish gold trade at the moment in USD terms. I can't pick the exact timing as to when things will turn but I don't think it is too far away. In the longer term all fiat currencies die as people stop accepting a currency backed by nothing more than a promise but I think we have deflation first through credit deleveraging before we get to that. It already began in 2008, I am only arguing for a continuation of that.

N.B this is not an argument against the holding of gold. I think everyone should own some physical gold as some protection. Who knows these maniacs may never turn of the printing press and completely destroy any remnants of value in the USD. It is merely an argument for USD strength in the near term (ie the next 6-12 months, anything further than that is a complete uneducated guess).

USD v AUD

I am an Australian based investor so what was important to me in forming a view on the USD was how did I think it would compare to my home currency. I encourage those in other non-US countries to conduct their own research as this is purely an AUD perspective.

Source - Steve Keen's Debtwatch - http://www.debtdeflation.com/blogs/

As you can see from the above chart both Australia and USA have had massive expansions in debt over the last half a century, far in excess even of the Great Depression and the Depression of the 1890s. The question is as deleveraging gathers pace to what extent will there be a destruction of the respective money supplies of both the USD & AUD. The above chart courtesy of Dr Steve Keen's Debtwatch blog suggests that the US has a much higher base of debt from which to contract and hence will result in a more extreme contraction in money supply relative to AUD contraction and thus in theory this (assuming all other variables remain constant, which they of course won't and I will discuss some below) will cause a rise in the value of USD relative to the AUD.

The Carry Trade

Lending further to this argument of USD/AUD strength/weakness is the carry trade. This is where an investor borrows in a low yielding currency such as the USD or YEN and invests in a higher yielding currency such as the AUD or NZD. As the investor borrows USD's this increases the total supply of USD money and hence lowering its relative value to AUD and other currencies. Those of you who don't believe in this phenomenon may wish to look at the performance of the AUD/USD over the last 6-8 mths following the beginning of the equities market rally in March to now. As you will see it has mapped a very similar path to the performance of the S&P 500 & the ASX 200. Please follow the link to Google Finance here. When this "mother of all carry trades" as Nouriel Roubini calls it turns there is going to be a correction in equity markets an rally in USD to dwarf that of what we saw in 2008.

Comments/criticisms more than welcome.