Don't Fall For The Fed's Latest Hat Trick

While the latest Treasury auction seemed to go well, author Lee Adler isn't so impressed. As the usual US Treasury buyers, Japan and China, deal with their own set of problems the oil producing countries appear to be picking up the slack - for now. But Adler is concerned that this won't last for long, and come July, he thinks we will be facing higher interest rates - along with other economic turbulence. For more on this, continue reading Adler's article below from Money Morning.

The market waltzed through a week of heavy Treasury auction supply, but it did not have to pay the piper until Friday and Monday, May 2, when all the new paper was due to settle. Thursday's settlement actually saw bills paid down by $11 billion. That and $16 billion in POMO gave the markets plenty of juice for Ben's coming out party. The US Government, just like Colonel Kadaffy, sent out wads of cash to its minions to insure that cheering, fist pumping crowds would show up for Ben's appearance before the scripted, adoring mob of ink stained wretches. It was sickening. And I'm not even talking about the so called reporters in the room with him. I'm talking about the security market apparatus. Anyone who dared protest that the market show had gone too far was beaten to a pulp. Even venerable bear David Rosenberg of Gluskin Sheff was cowed into submission.

Friday and Monday the market has a big pile of new paper to settle. We have to wonder whether having spent every last penny they had in propping things up earlier in the week, the dealers have anything left come Monday. The markets "should" sell off, if not today, then Monday.

The indirect bid at the auctions continues to weaken, suggesting that foreign central bank (FCB) players continue to withdraw from the game, but the Fed's custodial data on FCB holdings went the other way, showing an explosion of FCB buying the prior week.

It can't be Japan and probably isn't China, which has its own problems, so by process of elimination, the only ones with that kind of cash are the oil producing nations. That game can only go on as long as the Fed keeps pumping up the price of gas. It's a market double whammy. What happens after June? Poof! It's gone. But until then, the potential for this light show to go ballistic should not be discounted.

As I reported last week, corporate tax collections were negative versus last year but not as bad as the earlier indications suggested they would be. The big squeeze I expected from materials cost increases hasn't shown up, probably because materials aren't that big an input for most businesses. So corporations are doing great; it's just people who aren't doing so hot, and that, dear friends, is completely irrelevant when it comes to the market. Withholding taxes are now barely higher year over year, with a stall particularly evident over the past 2 weeks suggesting that the economic "recovery" has probably stalled. As tax refund stimulus rapidly subsides and emergency stimulus spending recedes, the economy could weaken rapidly, causing revenues to fall. Even though government spending should be reduced, the deficit, and hence Treasury supply, would start growing again right around the time the Fed stops propping up the market with its money pumping.

When the Fed withdraws the pump feed at the end of June, as the Bernanke has essentially confirmed it would, there's every reason to believe that the markets will face a liquidity crisis. (4/22/11) I don't think that any of that $1.5 trillion in bank reserves on deposit at the Fed will be pried loose to backstop the markets. I remain stumped as to how the Fed might fund that, even if the banks wanted to do it. The only alternative I can imagine at this point is a rapid, perhaps cataclysmic rise in interest rates and yields. I look at these conditions, and all I can see is a black hole.

Lord Bernanke's press conference broke no new ground. Dr. Quiver Lip You Can Tell He's Lying Because His Lips Are Moving told all the standard lies and revealed all the same delusions that I have catalogued here month after month since his tenure began 5 years ago. The part that I found most laughable was his use of the FOMC members' and district bank presidents' economic forecasts as some kind of Holy Grail. After all, I showed last year just how hopelessly incompetent these boobs are at even understanding the present, let alone predicting the future. Ben Bernanke emphasized that the Fed bases its policy decisions on these forecasts. How insane is that? Wouldn't it make more sense to base it on something more esoteric like, say... reality?

The most frightening aspect of this is how few people seem to "get it." None of the reporters seriously questioned Bernanke about the Fed's track record of badly misunderstanding the economy. None confronted him about the Fed's money pumping causing the runaway gas price inflation which Bernanke blames on worldwide demand. Well, there was a lot of demand for housing in the US in 2005 too. There's real demand and there's speculative bubble driven demand. The Fed refuses to admit the difference and the mainstream financial media blindly supports that delusion. Virtually everyone is happy to ride down Bernanke's Highway to Hell without so much as a vaguely serious question about the Fed's competence, even after it has proven itself to be totally, and probably willfully, ignorant of the facts on the ground time and time again.

By: Lee Adler, WallStreetExaminer.com

This article was republished with permission from Money Morning.

One Investors Strategy For The New Year

Are you trying to figure out what to invest in this year? Well Toni Straka from Prudent Investor, knows what his investment portfolio will be made up of in 2011. Read the following post to learn more about Straka's strategies and predictions for the new year.

BONDS: The 20-year interest rate downtrend reversed in 4Q10: Short all government bonds (and hope your counter party will remain solvent.)

Rising rates will become the tightening noose for all debtors. Mortgage holders may find comfort by switching to fixed rate contracts as far out as possible.

SHARES: As inflation heats up, go long energy, food stocks (and convert ensuing profits into gold.) Underweight consumer (durables) products in a cool economic environment, short debt-laden financials, especially the "dumb money" insurance sector.

DERIVATIVES: Stay away from all OTC instruments as your contract will ultimately only be worth as much as your counter party can pay. Square all derivatives in disguise like ETFs.

COMMODITIES: Buy silver as it is still 70% away from its nominal high seen in 1980 and has a dual use as money and industrial resource. Take profits once gold:silver ratio has descended to 1:30 and reenter after technical consolidation. All other commodities have reversed and have overshot the mean by now.

CURRENCIES: Buy the real stuff - gold. All other fiat currencies are just a claim on some central bank counter party and historically they have all wrecked their product via inflation in the last 300 years.

Once you have done this handful of trades, turn off the charts, lean back, contemplate the world and check back here in January 2012.

This post was republished with permission from The Prudent Investor.

Is China Bluffing About Being Wary About Gold?

Although a recent article appeared to indicate that China was looking to reduce its aggressive gold acquisition program while reaffirming its commitment to the purchase of US government-issued debt, the actual reality in the market may be significantly different. Given the perceived risk of long-term investment in US Treasuries, it is likely that their purchasing activity will continue to put positive pressure on gold prices in the future. See the following post from Expected Returns.

This is one of the more amusing articles I've read in some time. From the headline of the Reuters article, China says committed to U.S. debt, wary on gold, I was sure China announced some kind of monumental shift in policy. But alas, upon reading the article, I realized China was playing the same game Soros did when he called gold "the ultimate bubble"- before, of course, doubling his holdings of gold and investing $75 million dollars on a gold mining company. From Reuters:

"The U.S. Treasury market is the world's largest government bond market. Our foreign exchange reserves are huge, so you can imagine that the U.S. Treasury market is an important one to us," Yi Gang, head of the State Administration of Foreign Exchange (SAFE), told a news conference.

Yi dampened hopes of gold bulls that China might be itching to add to the 1,054 tonnes of the metal in its reserves.

On a 30-year horizon gold was not a great investment, he said, and China would simply drive up prices if it piled into the market.

"It is, in fact, impossible for gold to become a major investment channel for China'sBold foreign exchange reserves. I have 1,000 tonnes now, and even if I doubled that holding, according to current prices, that would be about $30 billion," Yi said.

Yi Gang is actually wrong. Gold was a horrible investment for a 20-year period, not 30. He should know, since China has increased their gold reserves from 454 to 1054 tons since 2003- a period in which gold has risen from $340 dollars an ounce to $1,120 dollars an ounce. Indeed, what a "horrible" investment.

I don't know what Yi Gang told us that we don't already know. Of course gold, which currently makes up 1.5% of China's forex reserves, can't make up a significant portion of China's portfolio. (For some perspective, France and Germany hold over 64% of their reserves in gold). But that's exactly what makes the outlook for gold so bullish, since even a modest increase of gold's allocation in China's portfolio would send gold prices to the stratosphere.

It's interesting that people are so quick to latch on to what China says, and not what it does. China is not only adding to its gold reserves, but it has pared its holdings of U.S. treasuries. No one in their right mind would own U.S. debt for the long run. It's going to be pretty clear in the years ahead that gold trumps U.S. Treasuries as an investment.

This post has been republished from Moses Kim's blog, Expected Returns.

The Highest Real Yields For Treasuries In 15 Years

Treasury notes are looking very attractive due to the deflation of the consumer price index in the first half of the year. A nominal 10-year Treasury note at 3.5% would translate into a real yield of nearly 5.5%. However, if you believe that inflation is around the corner, treasuries may be a very unprofitable investment. James Picerno from The Capital Spectator explains.
The highest real (inflation-adjusted) yields in 15 years for Treasuries are boosting demand, Bloomberg reported at the end of last month.

Halfway through August, there's no reason to think otherwise. The 10-year's yield hasn't changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.

The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.

On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it's temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out, wasn't set in stone either. But the damage to the inflation numbers was done and that legacy remains intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines.

Meanwhile, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else. A repeat performance isn't likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won't be falling on a year-over-year basis when we look at the numbers in the quarters ahead.

Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging broad price indices down the rat hole in the process. Once we get to December 2009's CPI numbers, however, we're likely to see the case for deflation on a 12-month basis looking a heck of a lot weaker if not evaporating completely, assuming we don't resume an apocalyptic decline, which looks unlikely at this point.

Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year's CPI-adjusted yield was 5.46%, up from September 2008's negative 1.25%.

By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?

We're suspicious. Unless you're expecting deflation to roar on, which we don't, the real yield in nominal Treasuries looks like a trap. Here's our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.

For instance, let's say you bought the nominal 10-year Treasury at last night's close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI's running at, say, a positive 2% year-over-year pace, which isn't beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)

As it turns out, a 10-year TIPS currently offers a similar real yield—1.80% as of last night's close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.

The bottom line: unless you're expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn't own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.

To be fair, no one can predict inflation with any certainty and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year—indeed, over the past generation, the hour is late for expecting continued success with "risk free" bonds sans inflation protection.

This article has been republished from James Picerno's blog, The Capital Spectator.