Silver Lining

Market shift in equities

2009-12-03T22:17:00.000-08:00

I believe that we are about to witness a market shift. For three weeks now the S&P 500 has been pushing above 1100 only to close below that level. Given the fact that there has been very little in the way of selling over the past 8 months, and given the extremely low volume, I think the preponderance of evidence suggests that we are at a market top. I would give equal chances to the S&P first touching either 900 or 1150. Therefore I believe the risk profile of the market justifies being flat or short equities over the next 2 months or until there is a 10% correction.

I'm not sure how this will affect precious metals in the short run. The question becomes - if the equity markets do start to tank like last Sept/Oct. will the dollar keep its anti-correlation or will the dollar fall alongside? If the dollar falls with the stock market than gold and silver could very well rally (particularly gold.) At this point however, I am rather skeptical. Until silver breaks $21.5 and gold demonstrates it is uncorrelated with the stock market, I would be lightening exposure to precious metals as well.

Close to meeting the final condition for a gold breakout

2009-12-02T19:11:00.000-08:00

Although it is totally obvious that gold has made strong price advances in the past few weeks, I thought it was worthwhile to mention the three conditions that I felt were needed for a sustainable gold advance. The first and most obvious, was for gold to break and hold above its previous nominal high of $1035. This happened in October. The second condition, which was met in November was for the dollar index (dx z9) to hit 75. The third is for silver and the gold equity index to break to new decade highs (~$21.5 in silver and 520 for the HUI.) Although this still has not occurred, we got very close to a new high in the HUI today (516.6).
It is also worth mentioning that in the past week gold has made and sustained a new all time high in euros.

The most important rule in money management is to establish and follow intelligent and appropriate levels of leverage and the use of debt/margin. A level of margin that is appropriate for one asset class, is most certainly inappropriate for another. Financial crisis is almost always born out of using too much leverage for a given asset class, or making false assumptions about future valuation/income. The market where this was most obvious in the past decade was the real estate market.

2 conditions of gold breakout are met

2009-11-09T08:51:00.000-08:00

This will be a short post simply to observe that 2 of the 3 conditions that I listed for a sustainable gold breakout have now been met. First, gold broke above nominal highs back at the beginning of last month. More recently the dollar broke important support at 76 and has now confirmed the break, touching 75 and "rejecting" a rally above 77. There is heavy selling in the dollar this morning.
The final condition - silver and the HUI index breaking to new decade highs- has not yet been met, but the HUI is looking particularly strong this morning, and is at a 20 month high. I expect silver to play catch up if and when doubt fades about the reality of our economic recovery.
There are plenty of reasons to think that economic recovery could continue for another few quarters. As I posted last month, the last 40 years of data show that moderate input prices lead to above trend growth. I define moderate input prices as quarterly prices that are below the local three year high. For example, crude prices reached an average of ~$120 in 2008Q2. As long as prices stay below that level, I would guess that the effect on the economy would be positive. Translating this to physical reality, prices below their old highs indicate the presence of slack in the system - in this case the ability of Saudi Arabia and the UAE to increase oil production by 1 to 1.5 million barrels a day.
The contraction of consumer credit is worrying but the increase in government debt can substitute for this. The economy can grow in spite of being run poorly and/or in an unsustainable way.
Until there is some sort of crisis in the interest rate market, or a major shift in the faith placed in the US dollar, the economy can continue to grow in an unsustainable way. And so long as this is true, it is very likely that the gold:silver ratio will continue to fall.
Since gold has already advanced so strongly, I am thinking of buying silver on a break out. Thus if silver breaks above $21.5 I would expect it to advance strongly and play "catch up" to the gold break out.

Inflation in China--->default in the US

2009-10-31T11:20:00.001-07:00

An interesting truth emerges from the discussion in the previous post http://outsidetheboxecon.blogspot.com/2009/10/some-graphics-on-us-fiscal-position.html: for a given theoretical maximum rate of repayment of debt (government budget surplus), the interest on the debt must be less than (rate of repayment)*GDP/(total debt). Let me give an example. If the theoretical maximum budget surplus is 5% of GDP, and debt is 80% of GDP, then any interest rate over 6.25% would mean the country was insolvent. In this case, inflation and economic growth are an enemy of the state, for if nominal GDP growth>6.25% the country is insolvent, but so long as inflation+GDP growth<6.25% the country can remain solvent. For a country like Japan with a debt 170% of GDP, a maximum budget surplus of 5% of GDP would imply that nominal GDP growth>3% implies insolvency for the country. This is a worry that has been getting no small amount of play in the media recently, as the demographics of Japan are decreasing the savings rate and major Japanese investment entities are starting to divest themselves of Japanese (Samurai) bonds. Looking back at this reality though, it is no wonder they have had a lost decade!

The issue of a necessary current account surplus presents another dilemma for US policy makers. How do we get a budget surplus without an accompanying current account surplus? This is, by definition, limited by the amount that savings exceeds investment:
(1) Budget surplus/deficit (taxes-gov spending) + domestic (saving-investment) = CA (exports-imports)
And how do we get a Current Account surplus without decreasing the relative value of our currency (which in turn stokes inflation)? The only way that I can see this is possible is if there is significant deflation in other countries. This would allow us to devalue our currency while not stoking domestic inflation. However, is this likely in an era of tightening supplies of oil and other natural materials? Not unless we have a concurrent worldwide depression. Healthy economic activity will lead to higher natural resource prices and worldwide inflation pressures.

Of course, this dilemma is inoperative until there is some demand for repayment of money loaned to the US government. But when that day comes, healthy economic activity and inflation abroad would lead to a default on US borrowing.

Some graphics on the US fiscal position

2009-10-31T09:23:00.000-07:00

At the end of my last post, (http://outsidetheboxecon.blogspot.com/2009/10/revisiting-effects-of-oil-on-gdp.html) I mentioned that we were between a rock and a hard place as far as the fiscal situation of the US goes. Below are some graphics to show the history of our government expenditures, receipts, and deficit. All of the underlying data in this post are taken from two pages (GDP, FISCAL sections) of the St. Louis Fed website. http://research.stlouisfed.org/fred2/

Perhaps the most salient point is that since 1947, expenditures have never represented a higher percentage of GDP while government receipts are the lowest percentage of GDP since 1967! (PLEASE CLICK ON THE PICTURES TO ENLARGE)

Peter Bernholz's work studying hyperinflation has been cited widely in the financial press recently. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures. This is mathematically equivalent to when expenditures>1.67*receipts. The graph below illustrates this ratio through 2009q2; it will continue to deteriorate for at least 2 more quarters and probably several more after that.

Just as alarming from a creditor perspective is that government receipts are lower now, in real terms, than they were in 2000! The fundamental ability of any entity to service its debt has an upper bound determined by two variables: available revenue, and creditor faith. Of course practically speaking, costs cannot drop to zero, but from a strictly theoretical perspective, revenue provides an upper bound to how fast the debt can be repaid.

The faith of creditors is integral because it determines the interest on the debt. If the interest on the debt was >30% we would already be incapable of servicing our debt even if the government had zero expenditures. It is amazing how quickly a country can go from totally credit worthy to bankrupt just based on the perception of risk from investors. As David Einhorn put it in a recent newsletter: "events can move from the impossible to the inevitable without ever stopping at the probable."http://www.google.com/url?sa=t&source=web&ct=res&cd=1&ved=0CAwQFjAA&url=http%3A%2F%2Fblogs.reuters.com%2Frolfe-winkler%2Ffiles%2F2009%2F10%2Feinhorn-vic-2009-speech.pdf&ei=IpjsSqPFLIPitQO9wqkI&usg=AFQjCNFgutUHC6D5SrkLIdnsRYQUnfSJMQ&sig2=PuTUGdIgrXiJf3ej-OVFtA a pithy interpretation

A FIRST PASS AT FUTURE DEBT REPAYMENT
To get an idea of what would be necessary to repay the government debt, we look at revenue stream, future expenditures, perception of risk, and nominal GDP growth.

First let's suggest a maximum theoretical revenue stream available to the US. The historical maximum (in % of GDP) for receipts is 31.9%, achieved in the first quarter of 2000. [WWII and the early 1980s both had percentages approaching 30% of GDP]. There is good reason to think that we cannot achieve a rate much greater than 30% of GDP. This is because the incentive to dodge taxes goes up exponentially with the tax rate. There is also an argument that high tax rates disincentivize the activity that is being taxed (particularly true for capital gains taxes.) For the purpose of argument, let's be generous and assume that we can achieve a sustainable rate of taxation of 32% of GDP. With this assumption, we can say that the US must default if the interest payments on our debt exceed 32% of our GDP. We are far off from that point now, as the interest on our debt represents only 5% of our receipts, and a little over 1% of GDP.

At first glance, 1% appears to be a pretty safe number. However, there are several things that must be true to keep it at that level. Most obviously, we must stop increasing the debt:GDP ratio. Most importantly however, market interest rates cannot rise. The current low cost of servicing out debt is merely a function of record low interest rates. These record low interest rates are dependent on two things: the nominal market interest rate must continue to hover around zero, and creditors must not perceive a risk of default. Market interest rates are (essentially) zero now only because those are the current expectations for returns. If the market shifts to the perception that GDP growth is sustainable, then interest rates will increase by an amount corresponding to the shift in perception. It is likely that fiscal and monetary policy will remain accommodative
until this perception changes! Therefore, we will continue to increase debt levels and increase monetary stimulus until perceptions of future growth, and the real interest rate, shift. So it is only a matter of time until the interest on the US debt will rise. If the average interest on US debt rose to a very modest 5%, interest payments would suddenly jump to 10% of our maximum receipts. Keep in mind that these calculations are made on our maximum receipts, not maximum budget surplus. Expenditures in the future will certainly not be zero.

Incorporating a realistic but austere forecast of expenditures, let's say that the country can cut government expenditures to 15% of GDP (which is less than half of our current expenditures of 35.5% of GDP). To be clear, cutting government spending to this level would seem draconian: social safety nets would be cut, defense spending would be decimated, medicare and social security would only be token programs, etc. We would be down essentially to education, a reduced military, bare-bones infrastructure spending, and emergency local and state services. With this austere assumption, the budget surplus could theoretically be 15% of GDP; even in this best-case scenario however, a 5% market interest rate would imply 20% of our budget surplus would go simply to service debt, and only 80% to pay down the principal.

Finally, and most importantly, we come to the risk premium demanded by investors. If investors think (for whatever reason) that there is an "x" percent chance of default, than the interest on government bonds will be approximately x%+real market rate. Let's illustrate this with an example: if the market perceives a 10% risk that the US will default on half its debt, then the risk premium charged on debt would be 5%. So if the nominal market rate of interest was 5%, and investors felt they were risking 5%(10% chance of losing half their principal) of their capital to default, the real rate would be 10%. A budget surplus of 5% of GDP with an interest rate of 10% on our current debt would imply that we were spending 120% of our surplus on servicing the debt. If we could not increase this rate of repayment, then we would be in default. You can see how quickly a loss of faith results in insolvency.

Adding in the element of inflation and GDP growth completes the picture. I talk about this more in the next post http://outsidetheboxecon.blogspot.com/2009/10/inflation-in-china-default-in-us.html, but briefly, the rate of inflation needs to be added to the real interest rate to give a nominal interest rate. If there is a 5% rate of inflation and 3% rate of GDP growth, even with a zero percent risk of default, the nominal interest rate would be about 8%. This would mean even a 5% current account surplus would not be sufficient even to service the debt on the US balance sheet.

Revisiting effects of oil on GDP

2009-10-24T15:25:00.000-07:00

Over the next week, I will revisit a paper that I wrote last year predicting the effect of high oil prices on GDP. In short, however, I would say that the lion's share of the effects of high oil prices on the economy have passed for now. Of course it is impossible to know what prices lie in the future, but so long as oil prices stay below $115, the effects on the economy will be minimal. In fact, since there appears to still be at least some resource slack in the system, there is room for above-trend growth starting in 2010q3 and lasting until 2011q2 or until oil prices move above their previous highs.

My prediction for quarterly growth (using oil price and consumption as the only determinant!) is as follows:
2009q3:+0.7%
2009q4:+1.4%
2010q1:+2.3%
2010q2:+2.8%
2010q3:+3.6%
2010q4:+3.8%
2011q1:+4.4%
2011q2:+4.4%
Of course there are wide error bars on these predictions and there are other determinants of GDP, but the wide brush prediction here is that resource prices are supportive of improving economic growth in the US.

The other determinant I would keeping a close eye on is of course the degree to which fiscal and monetary authorities continue their stimulative efforts. If the stimulative efforts are withdrawn, then this is going to create a negative effect on GDP for several quarters. Note also that we may be between a rock and a hard place when it comes to this subject. If we try to continue stimulative efforts (either fiscal or monetary) and foreigners balk at further bond purchases, or lower the value of the dollar, then this will undoubtedly cause oil prices to spike. So we will see.

Conclusion: although there is a menacing cloud still on the horizon, the weather should be good for the next several quarters!

Revisiting Triffin's Dilemma, and gold as an escape hatch

2009-10-07T12:40:00.000-07:00

This will probably be my last post on gold for awhile. I want to move back into energy issues over the next few weeks, but I felt there were a few more things that I wanted to say about gold. I will return to the paper I wrote in March on the dollar and comment on what appears to be a growing reality - that gold's use as a monetary asset is waxing.

The paper I wrote in March commented on the special dynamics that apply to the US dollar, that prevent the adjustments one would expect from a country with a large and persistent trade deficit. http://outsidetheboxecon.blogspot.com/2009/03/dollar-and-impending-currency-crisis_24.html While there seems to have been a marginal resumption of the bearish dollar trend, anecdotal evidence appears to support the idea that foreign asset preferences remain favorable to the dollar (the past 5 months of TIC reports are one piece of anecdotal evidence that this is the case.) Furthermore, although foreign creditors such as China have been vocal in their opposition to large US deficits, their actions do not match their words. Trade deficits and budget deficits have a strong correlation http://en.wikipedia.org/wiki/Twin_deficit_hypothesis. The Chinese might want the US to have more fiscal responsibility. However, the continued pegging of the Yuan (and pegging of other trade partners) to the dollar means that either the US government or the US citizenry must be in deficit. It has been widely observed that the US consumer is "tapped out" and is not going into more debt. So long as the Chinese, Saudis, etc, keep their exchange rates pegged at stimulative levels, either the US consumer or the US government will have to be in deficit. Actions speak louder than words, and the continued currency peg means that the Chinese prefer a US deficit (either public or private) to a fairly valued currency.
As much as the Chinese want a pegged currency for economic reasons however, they are now realizing that at some point their store of dollars will not be worth much in real terms. The possibility of replacing the dollar as the reserve currency is immaterial to this fact. Regardless of whether the US dollar is replaced as the reserve currency, its value will decline so long as economic activity is healthy. The fact that gold remains as a monetary asset that cannot be devalued is a fact that I think is slowly dawning on the large dollar holders of the world. It is for this reason, more than any other, that the continued increase in gold price is assured. Gold will be the safety valve, the escape hatch, and the attempted route out of the dollar holder dilemma.

I like to theorize about various options the Chinese face in dealing with their large dollar foreign exchange holdings. Assuming that they will at some point realize their dilemma of dollar exposure, how might they go about a change? If you feel I have missed any possibilities, please feel free to comment below.

Option 1: Increase the value of the Yuan
Costs: 1) decrease in exports, employment, and GDP
2) a decrease in the value of the dollar relative to the Yuan decreases the nominal Yuan value of foreign exchange holdings.

Benefits: 1) Increased purchasing power of the Yuan.
2) Long-term financial and economic health of the US is increased. Since the majority of foreign exchange is held in US dollars, this means the long term real value of these holdings might be stabilized.

Option 2: Continue the pegging of the Yuan.

This is the inverse of option 1
Costs: 1) Supporting a dynamic that results in continued budget deficits or private deficits (S-I<0) in the United States. Since the majority of foreign exchange is held in dollars, this destabilizes the long term real value of the large Chinese foreign exchange. This is a cost that may well be discontinuous, meaning that it will seem to be a small cost, and then dramatically shift to being a huge or total loss. Amazingly, this cost seems not to have dawned on the Chinese monetary authorities until after the 2008 financial crisis.
2) Decreased purchasing power of the Yuan; so long as economic activity is robust, this increases the price of real goods (particularly energy) and would stimulate inflation in China, (in spite of sterilization by the CB.)

Benefits: 1) Continued strength in exports support short-term employment and GDP goals.
2) Continued pegging allows the nominal value of Chinese foreign exchange to remain high in Yuan terms.

Option 3: Continue pegging but divest foreign exchange into gold and other real assets

Benefits: 1) Allows the continuation of advantageous trade terms. Exports>Imports keeps employment and GDP numbers high.
2) Nominal Yuan value of foreign exchange holdings are maintained.
3) Real value of foreign exchange holdings are maintained due to a diversification into real assets.
4) Dependence on the long-term solvency and productive capacity of the US is decreased.

Costs: 1) Potential for a bubble to form in real assets (particularly real monetary assets such as silver and gold).
2) The real value of foreign exchange will still go down since the possible scale of divestment into real assets is limited compared to the size of forex reserves.

In essence the costs of option 3 are more subtle but still present: either the amount of divestment is not significant, or it will create bubble values in the assets that are chosen for diversification. In spite of these costs, I think that option 3 probably represents the smoothest transition for Chinese and other dollar holders out of their dollar trap dilemma.

For the US the implications of this strategy will be increased financial stability, but an increase in the cost of real goods in the US market. The Federal Reserve will continue to be placed in an untenable position: any attempt to head off inflation will increase the value of the dollar but immediately crash the US economy. This appears to be the holding pattern that we are currently in, but I imagine that we will need to go through at least one more iteration of crashing the economy before the Fed catches on to this dynamic.

Speculation on the Gold/S&P ratio

2009-10-07T11:45:00.000-07:00

Above and below you see a picture of the ratio between gold and the S&P (click for a larger picture.) This is a chart from 2000-present representing the fraction of one S&P index that can be purchased for one ounce of gold. It is a logarithmic chart, and you can see that from the minimum to the maximum, there was an increase of roughly a factor of 8.

To my eye, it looks like gold will likely advance on the S&P once again. It may be that there is a longer correction, or that there will be further consolidation, but it seems very likely that before any sustainable decline in this ratio, there would be one more retest of the maximum.

The ratio had its recent maximum value of 1.366 on March 6, 2009, one day before the low in the S&P. The ratio has backed off quite a bit in the past 6 months, reflecting the fact that the S&P has rallied more strongly than gold. The thing that I would like to point out is that it is very likely that we will see at the very least some sort of retest of the previous high in this ratio. The recent low in this ratio of 0.914 was put in on August 24th. A 50% retrace of the ratio to 1.14 would represent a pretty large shift in either gold or S&P at this point. Assuming the S&P stays put at 1050, this would imply gold would hit $1197. If gold stays put between $1000 and $1040, this would imply a correction of the S&P to between 880 to 910. A retest of the 1.36 ratio would put gold at $1425 or the S&P at 764. Take a good long look at the chart of the ratio again, and I think it is pretty clear that gold will make one more advance on the S&P.

New high in gold

2009-10-06T08:55:00.000-07:00

We had a new high in gold this morning. The precious metal markets were looking jumpy on Sunday night, and we were seeing almost no determined selling. Almost all of the big market orders were buy orders, and you can see this on the charts by steep or parabolic moves up in price followed by largely lateral movement. This indicates large amounts of buying motivated by time, followed by consolidations with a firm bid to take any sellers.

This new high is NOT confirmed by either the dollar, silver, or the gold stock index. As I outlined at the beginning of last month http://outsidetheboxecon.blogspot.com/2009/09/silvergold-cleared-for-take-off.html this is the first of three events necessary to assure a healthy breakout. We are well on our way to the second condition being met. The dollar is close to breaking below support at 76, and getting to 75 would probably follow shortly. The third condition (a new high in the HUI and in silver) is still some ways distant, but that distance could be made up very quickly as these markets are capable of moving 5 or 6% in a day.

I had a funny dream over the weekend. I was with a friend and we were trading gold at an old board, the way things used to be traded back in the day. It was a large board with electronic prices of gold, silver, platinum, various gold and silver stocks, etc., essentially a trading pit dedicated to precious metals. In the dream, I had a large physical position that I had established with my friend, and we were watching the price of gold as it broke out through its old highs. It then went from $1000 to $10,000 in about 6 minutes, literally burning through the numbers! In the dream I remember frantically searching for a firm bid for physical, because I wanted to sell at $9,500. All of the orders getting filled were futures positions, and I was struggling to find a firm bid for the physical. It was a fun dream though.

Cheers to all,

Matt

End of the quarter and social security

2009-10-01T23:06:00.000-07:00

The quarter ended yesterday with gold above $1000. This is actually a new high for the end of a quarter and the end of a month. I believe this to be yet another signal that gold is likely to move higher; I think that we will have a new high in the gold price in October, and will challenge $1200 by the end of the year. It will be interesting to see what happens to the price of gold once it breaks significantly above the 2008 highs. Will the increase be gradual? Will it inspire some frenzy buying and then crash? Will it trigger a larger shift in consciousness or sentiment about fiat money?
We will see, and I don't think there will be long to wait.

On a related front, there was a news item over the last weekend on social security that surprised me. Apparently the social security system will be paying out more than it is taking in the year 2010! Wow.

http://news.yahoo.com/s/ap/us_social_security_early_retirements

If you read through the article it says at some point:

"Social Security has accumulated surpluses from previous years totaling $2.5 trillion"

You have to have a finely developed sense of irony and Orwellian humor to fully grasp this surplus. This "surplus" is nothing more than US treasury bonds, meaning that the government borrowed this money to pay for other things and deposited treasury bonds (debt) in its place. Kind of hard to wrap your mind around isn't it?

The bottom line is this: there is no surplus. A true surplus would be represented by some store of value such as cash, ownership in productive capacity, crude oil reserves, gold, real estate, etc! Instead, any social security taxes that were in excess of social security payments (the surpluses) were borrowed by the government and spent somewhere else on something else. There is no direct or proportional way that this spending will be returned to the social security trust fund. Thus the surplus has already been spent.

What will happen now is that the US will have to go into debt that much faster because the social security will be in deficit each year instead of surplus. The fact that the "trust fund" will not run out until 2037 is largely irrelevant. The trust fund can only be turned into real goods to the extent that the government can increase real taxes on the American population. The rubber hits the road in 2010, because that is the year that social security is in deficit, and there is no surplus of real goods or cash sitting anywhere.

This is one of the three most important economic challenges facing America. The other two are expensive/constrained energy production, and the end result of a monetary system based on debt and paper.

COT report and Barrick

2009-09-14T23:23:00.000-07:00

I'm sticking to posts on precious metals, as gold continues to brush against $1000. The two things that I want to mention today have to do with the commitment of traders report, and the admission by Barrick that they plan to close a large portion of their hedge book.

First the COT reports for gold and silver can be found here with nice graphic options: http://www.timingcharts.com/index.php.

Of course, we first have to realize that this is not showing over the counter positions, nor is it showing positions in GLD or other ETFs. This is purely a measure of the US futures market. Be that as it may, it is clear that the commercial short position in gold is as large as it has ever been, and the commercial short position in silver has grown but is not as large as in previous extremes.

Looking at gold, it appears that commercials are short 75,000 more contracts now than they were at similar price levels in February. Generally, commercial entities have a very good trading record with precious metals. Their strategy appears to be rather simplistic: if the price goes up, they sell and if the price goes down they buy. If the price goes up more, they sell more, and eventually I think they figure that the price will come down and then they can cover all their positions at a profit. Generally speaking, this seems to work pretty well for short-term price movements. However, there have been 2 instances in the past 5 years of commercial entities being very short at precisely the wrong time. These instances were October 2005-May 2006, and October 2007-March 2008.
Taking a closer look at these two instances, the maximum commercial short position in October 2005 was 212,000 contracts. At the price top in May, the commercials had roughly 170,000 contracts. Between the two points, the price of gold moved from $450 to $700. It is noteworthy that gold has not yet been back to the $450 level, so some commercial entity lost a lot of money covering these positions (or leaving them open.) In the second instance, the maximum commercial short position was between 240,000 and 250,000 contracts, and hovered around this level for much of the period between Oct 07 and March 08. This time the price went from roughly $750 to $1000. There wasn't the same phenomena of short covering by the commercials this time however. The commercials just basically sat on the same short position the whole way up, and then covered their positions only when prices fell in fall of last year.
Now, with gold challenging $1000 again, commercial entities have increased their short positions yet again to a new relative high of roughly 270,000 contracts. Aso, zooming in on the past three weeks, there has been a dramatic rise of both large trader AND small trader long positions to offset the commercial shorts. What does this portend for prices?

Well, generally speaking, commercials are right more often than they are wrong, so statistically it is likely that we are at a top in gold. Also, the rise in small trader positions is unusual, and generally speaking small traders have the worst track record. So this would also point to a bearish outcome.

However, the commercials have been notably incorrect in a big way a couple of times, so we can't rule out the possibility of prices moving higher. Also, it seems that the short position must be concentrated in banks rather than gold producers. Whether this is bullish or bearish, I am not sure, but it seems likely that a break higher would be made more explosive by the fact that the majority of the shorts are almost certainly banks.

What clued me in to this difference was all of the attention recently about Barrick's decision to close all of their fixed hedges this year and a portion of the rest of their gold hedge book. http://www.marketwatch.com/story/gold-miners-abandon-hedges-but-at-slower-pace-2009-09-14?link=kiosk

First of all, isn't it a bit strange that they are announcing their hedge closure in advance of actually doing the deed? When they closed a large portion of their hedges in 2006, there was no mention of it until after the fact. I'm not sure what it means, but I just found it strange that they would announce such a fact. I mean, it would be a little like telling a used car salesman that you absolutely had to walk off the lot with a car, that you had just raised a large amount of money to buy the car, and that you only had 10 minutes to make the deal. The salesman would fleece you because he knows that you are a forced buyer and knows you have a time limitation. So why are they announcing their intentions to close their hedges (i.e. buy 3 million ounces of gold?) Was it just that they were desperate to raise the money they felt would be necessary to do the deed? Are they lying? Are they really increasing their shorts even as they say the opposite? Who knows but I think it is an interesting puzzle.

The other question this news report brings up is what I already alluded to: if all the gold producers have busily been reducing their hedge positions over the past 3 and a half years, who in the world is now short 900 tons of gold in the futures market? After all we have the largest commercial short position ever seen in the COT report; and yet we are learning simultaneously that producers have been closing their hedges. So what commercial entity could be left? Banks.

My feeling is that it is an entity or group of entities who is playing the game "heads I win, tails you lose." And the firm that likes that game more than any other is GS.
HEADS I WIN: The price of gold falls, and gold shorts make 27 million times however far it falls.
TAILS YOU LOSE: Gold breaks out and never looks back, and the short holders can default through a paper settlement or some government sanctioned order. Even if the shorts could deliver, 900 tons is a lot of gold. It is more than Japan's official reserves, and almost 1/3 of the gold that the IMF holds. Is it possible that short entities hold this much gold? Yes, it is certainly possible, but if this much gold actually changed hands it would represent a huge shift in wealth. I would submit that a mining company hedging its production is a much different animal than a bank delivering its holdings of gold.

So, we will continue to wait and see what happens with gold and silver over the next few weeks. My feeling continues to be that we are in the middle of a breakout, and that there will not be any meaningful retrace below $1000 gold.

One final note about Barrick. Because Barrick is such a large percentage of the HUI, it has been dragging down its performance in the week since they made this hedge book announcement. While the rest of the index is up 2-3%, Barrick is down more than 6%. This has created a drag on the HUI of almost about 1%. Not a great deal but worthy of noting. There has been a lot of question about why gold stocks have performed badly compared to the metal itself over the past few years. These hedges have obviously played some role in the under-performance of gold stocks.

Formal devaluation is unlikely

2009-09-11T16:19:00.000-07:00

I am coming back to this idea of devaluation today. I think that a formal devaluation is unlikely because there is nobody capable of undertaking such a devaluation who has an incentive to announce it formally. I think that the two groups that have the power to devalue the US currency are:
1) The Federal Reserve
2) Foreign countries who maintain a peg with the US dollar

There is a third group that I would group together and generally call "private investors"; this group is also powerful enough to devalue the currency. But this group is not cohesive to the point that they would make an announcement, or an overnight adjustment. Investors can affect the value of the dollar if a critical mass of them completely lose trust in the dollar and shift their preferences to exclude any sort of dollar based asset. This has happened on a microscopic scale, and could be a growing force in the coming months. But the two groups who are powerful enough to create an overnight adjustment both have incentives not to do so. Let's start by looking at the Fed.

The Federal Reserve will not announce a devaluation, even if their policy indicates that a significantly weaker currency would help the economic situation of the world. The reasons for this are complicated, but I think a short summary would be that they would find an abrupt devaluation to be too blunt and unrefined of a tool. There would also be (legitimate) worries about what such an action would do to future expectations; once a monetary authority loses the faith of its citizens it requires years, if not decades to regain that faith. I think that the Federal Reserve rightfully considers inflation expectations to be one of the most important determinants of monetary policy. Finally, the Federal Reserve, like all dominant institutions, suffers from hubris, and they will continue to think they can find a more elegant solution to continued problems. Thus far, I should note, they have been correct in that assumption. The Federal Reserve may come under political pressure should economic conditions worsen from where they are (or not get better for a long time.) But I think that it is safe to assume that the Fed will be resistant to extreme ideas such as announcing a double digit inflation target or anything else that could constitute a devaluation.

The second group, countries who peg their currency to the dollar above the market rate, could devalue the dollar simply by getting rid of the peg. Countries such as Saudi Arabia, UAE, Kuwait, and China fall into this category. These countries may abandon their peg, but I think that the most powerful devaluing effects would come from shifts in asset preferences rather than peg abandonment. If the large dollar hoders of the world switched out of dollar assets into real assets (plants, equipment, natural resources, equity in existing firms, precious metals, energy storage, commodity storage, etc.) there would be a powerful effect depreciating effect on the dollar. I believe this is the source for future devaluation of the dollar, but countries who take this strategy have every incentive to cloak their intentions and prop up the value of the dollar while they are making these purchases. As I have talked about in other posts, it appears more and more likely that China is taking exactly this tack. As the strategy becomes more clear, it could escalate in such a way that the dollar (and all other currencies to a lesser extent) could come under an incredible amount of downward pressure. This is the type of devaluation that I am watching for, but it will not be formal. It will start slowly and build in speed. It is pretty clear to me that, barring another deflationary/de-leveraging wave, we are already well underway in the process I have just described.

Comments for Tuesday September 8th

2009-09-08T16:41:00.000-07:00

Gold and silver pushed higher in early morning trading, as the dollar broke to multi-month lows. However, after pushing above $1000, gold fell in New York trading, with the price closing at roughly the point where it opened. Silver and the HUI gold equity index had similar action with strong advances followed by a fall in price into the close. Usually, this type of action can indicate a price top, particularly after a strong run-up in prices. However, I am still of the opinion that there is more strength in the market, and that this will later appear as a false top. It would be particularly noteworthy if a break to new highs occurred during the Asian trading hours tonight or tomorrow night.

I have gotten a late start on the article I intended to write on dollar devaluation, but I will give my argument in a nutshell now and expand upon the argument tomorrow. I will begin by citing 2 historic cases of devaluations (America 1933, and Argentina 2001) and then compare these cases to the current situation. In both of the previous cases, the money being devalued was "pegged" to the money it was devalued against. In the case of America 1933, dollars were pegged to gold, and in the case of Argentina 2001, pesos were pegged to the dollar. Currently, the dollar is not pegged to gold or any other currency. The dollar is pegged to an ephemeral substance called faith. Therefore, any devaluation will occur due to a shift in faith.

However, this does not make an overnight devaluation any more difficult. In fact an argument can be made that such a devaluation was already announced on March 18th, 2009, when the Fed announced purchases of $1.75 trillion in US treasuries, agency debt, and mortgage backed securities. The difference lies in that the meaning of the devaluation is more difficult to gauge, and takes longer to have an effect because it must first work through the perceptions of the market.

The reason the devaluation of 1933 had an instant effect was because it allowed the holders of gold, both foreign and domestic, more purchasing power for everything else that was priced in dollars. This higher purchasing power included the price of labor. In fact, there would have been much the same effect if the government had simply confiscated gold and then ordered by decree that all prices in the economy, including labor, were to be cut by 40%. One problem with that solution is that people's perception of their worth is often tied to the number on their wage statements, and so a devaluation of the purchasing medium (gold) was more practical, more easily enforced, and more politically savvy.

Fast-forward to today. Today, people still attach a great deal of psychological value to the number on their pay-check. "5 figures, low 6 figures, high 6 figures, etc." And that number has lost all formal pegging to gold, so most Americans are oblivious to that relationship. Additionally, Americans seem to accept that there is a 2% decrease in purchasing power every year; I think that most don't realize or don't care that the depreciation acts as a seigniorage tax that benefits the government. The honest truth is that most Americans don't care simply because life is so good! The loss of purchasing power is subtle, and many of the side-effects of money debasement are confusing and can't be understood without honest and diligent study. The ultimate example of confusion came with the housing bubble in the last few years. People were buying houses that were worth 15 times their yearly salary with no money down. This to me is the best example that Americans have accepted that the relationship between money and what it can buy is esoteric. It is because of this that I think it is unlikely - very unlikely - that the dollar will debase from within because Americans are too busy and too happy to lose their faith in the dollar. The debasement of the dollar will come from abroad, as foreign countries lose their faith in the future value of the dollar. The foreign countries that matter, China, Japan, OPEC, and to a lesser degree Russian and Brazil, will want a store of value. Since they are opposed to letting their own currencies appreciate, they will look for an alternative that is not a currency. Gold is an obvious choice, as well as oil, copper, or any other commodity that can be inexpensively hoarded for long periods of time. In the long run, gold and silver will return as the most logical choices because their of their inherent monetary properties. Oil is another possibility even though the storage and transportation is much more difficult.

The productive capacity of the US is below where it needs to be in order to maintain the faith of the world. Ultimately the buck stops here: by the amount of goods and services that foreigners can purchase from Americans with their dollars. Our productive capacity has been decimated by mal-investment in houses, cars, and domestic services. Thus, the foundation for a loss of faith.
When debasement comes, it won't come as an announcement from the POTUS. It will come as foreign holders of dollars slowly and silently abandon ship.

One final note. The larger the deflationary contraction the US experiences in the near future, the better for these foreign holders of large dollar stashes. Ultimately, the worth of the dollar is tied to the productive capacity of the US. But in the short term, if holders of dollars can exit by purchasing assets on the cheap, so much the better for them. The worst possible outcome for the US as a nation would be another round of devaluation, allowing China et all to buy even more assets in their exit from the dollar. I believe that our current predicament is best characterized as a dance between the Fed and foreign holders of the dollar. The Chinese try to goad the Fed into tightening money and credit, to ensure another wave of deflation and increase the purchasing power of the Chinese hoard yet more. The Fed tries to pretend as though they might tighten money and credit in order to head off any abandonment by the Chinese and others. I think the Chinese understand the strategy of the game, but the Fed only sees the tactics of the game.

In 1933, shortly after being elected, FDR called for a bank holiday, simultaneously passing an edict that made it illegal to hold gold bullion. This type of event is highly unlikely simply because the dollar is not pegged to gold anymore. Holders of gold are seen as a curiosity but not as a force of deflation in the economy. Some sort of announcement by foreign powers is even more unlikely. After firing a few shots over the bow, foreign powers will speak with their feet and leave the dollar quietly.

I'll end today with the executive order given by Roosevelt to confiscate gold. I found this to be a fascinating historical record, even if I don't see anything similar happening during present times.

Executive order: By virtue of the authority vested in me by Section 5(B) of The Act of Oct. 6, 1917, as amended by section 2 of the Act of March 9, 1933, in which Congress declared thata serious emergency exists, I as
President, do declare that the nationalemergency still exists; That the continued private hoarding of gold and silver by subjects of the UnitedStates poses a
grave threat to the peace, equal justice, and well-being of the United
States; and that appropriate measures must be taken immediately
to protect the interests of our people.

"Therefore, pursuant to the above authority, I herby proclaim that such gold
and silver holdings are prohibited, and that all such coin, bullion or other possessions of gold and silver be tendered within fourteen days to agents of the Government of the United States for compensation at the official price, in the legal tender of the Government. All safe deposit boxes in banks or financial institutions have been sealed, pending action in the due course of the law. All sales or purchases or movements of such gold and silver within the borders of the United
States and its territories, and all foreign exchange transactions or movements of such metals across the border are hereby prohibited.

"Your possession of these proscribed metals and/or your maintenance
of a safe-deposit box to store them is known to the
Government from bank and insurance records. Therefore, be advised
that your vault box must remain sealed, and may only be opened in the
presence of an agent of The Internal Revenue Service.

"By lawful Order given this day,
the President of the United States."

After confiscating gold and silver, he then changed the underlying relationship between gold and the dollar, from roughly $20/ounce to $35/ounce. This was a devaluation of roughly 40%.

If gold is money, why quote it in dollars?

2009-09-07T15:15:00.000-07:00

Commodities are quoted in dollars out of habit and because New York and Washington command so much economic and military power. The dollar was the most stable currency for almost 200 years. For more than 100 years, the value hardly moved at all. It has only been in the past 40 years that the value of the dollar has dropped significantly. Gold is quoted in dollars because that is still the milieu de jour. Dollars have been the numeraire of world commerce for the past 70 years and so they are the de facto quote. If the dollar loses its numeraire status than people will quote the price of goods in terms of the numeraire, and the dollar will have lost its worth, unless it is somehow convincingly tied to the new numeraire. But in the meantime gold theorists would appear out of touch if they did not quote gold in terms of dollars but chose instead barrels of oil of BTUs of natural gas or some other metric. The dollar is still the most commonly used monetary metric in the world, but that does NOT ensure it has any intrinsic value. In that sense a dollar is kind of like an out of the money option. It has time value, and the possibility of intrinsic value so long as the US financial ship remains in decent condition. But if and when enough holes are poked in the financial ship of the US then the dollar will expire worthless at some unmarked point in the future.
I recently listened to a podcast from a website called Financial Sense Newshour.
http://www.financialsense.com/fsn/main.html On this podcast, the host Jim Puplava indicated one possibility for the future was a dollar devaluation. A number of his listeners called in to ask him what a dollar devaluation would look like. I have started to think about this question and will post on this tomorrow. Come back and read the post if you'd like!

Advantages and Disadvantages of a Fiat currency

2009-09-07T15:14:00.000-07:00

The important distinction between gold and fiat money is that fiat money can and is created in arbitrary amounts, and is made available on a favorable basis to the government and commercial banks. Now I admit there are both advantages and disadvantages to flexible money creation. You can't meaningfully increase the supply of gold over a short period of time. Think about what happened to the Fed balance sheet last fall - in 10 weeks the Fed increased supply by more than 100%! You couldn't do that with gold.

The advantage of being able to do that is that you can manipulate the system to mitigate panics and disasters. Last fall would have definitely been a bigger mess if gold was the monetary numeraire. However, the downside is that the advantages of the credit creation are distributed unfairly - big banks vs little banks, GM and Chrysler vs. other manufacturers, etc - and generally have been rewarding failure. Long-term that isn't good. Plus, it concentrates power in Washington and New York, because that is where the money is coming from - also not good. And finally it is a common and I believe correct argument that it tends to concentrate money in the banks that are closest to the policy decisions (read Goldman and JP Morgan) - really bad! That's what I meant by available to a select few - the big banks, particularly the ones influencing policy decisions, and industries selected by the government. That couldn't happen if gold was the numeraire.

Again, the downside would be that last fall, instead of a scare there would have been a catastrophe.

The upside is that when using gold as money, failure, thievery, oligarchy, corruption, etc. get washed out of the system more regularly.

How can the dollar crash without the world ending?

2009-09-07T14:07:00.000-07:00

I would like to address a question that I have seen over the past few years that I think belies a basic misunderstanding of gold, the dollar, and their relationship. Many people in the US (and actually in many parts of the world) consider the dollar to be inviolable. Therefore, the end of the dollar is always somehow equated with the end of civilization. I have seen this sentiment voiced by friends, family, and all over the internet. Let me make an analogy: GM was the greatest car company in the world for decades. The bankruptcy of GM was inconceivable to many (including Rick Wagonner up to a month before the event.) And yet we all know that GM did go belly up, and that the world continued on much as it did before.

Likewise, the US dollar was as good as gold for close to 200 years, and to most in the world it would have been inconceivable that the dollar would be worth just a few percent of its value early last century. Fast forward to the present day, and we are in a situation where the dollar has been depreciated by a roughly 2 percent for the better part of a century, but it has been managed so well that it is inconceivable to most that it would spin out of control (and create a dollar crash.)

The following are typical of the comments that I regularly see, most recently from some intelligent posters on MarketForum:

"When I see gold's value stated, it is always stated in terms of the dollar...

If - according to the gold theorists - the US dollar is not worth anything because it is not backed by anything, then how does a gold bug come out ahead if he is investing in something that is valued in another entity (dollar) that is itself essentially worthless?

Your home, garden, tractor, truck, irrigation system... they have real value.
Gold and the dollar are worthless in the end."

These are attractive arguments but there are valid counter-arguments. There is a widespread belief that if the dollar was worthless, then essentially we are at the point of armageddon. I have felt the same way before so I understand the impulse, but I think taking a hundred steps back or so, it is pretty clear that this viewpoint could stem from cultural hubris. I suggest that there are items of tangible intrinsic value but that even intrinsic value is relative to circumstances. If you can't breathe, then you have no use for staying warm and dry. If you can't stay warm and dry, then you have no use for hydration. If you can't get hydrated, then you have no use for food, etc. True, you cannot eat gold or put it over your head to keep you dry. But people have valued "money" for eons now - because of the efficiency and convenience it contributes to trade. If we are talking about a survival situation then, yes, gold is useless. But we are so far from survival living that it is a joke! I was in India for four months a few years back, so I know a few things about what "subsistence" living looks like. And let me tell you - our standard of living can drop a heck of a long way and we still won't be at subsistence, let alone survival, levels of existence.
America has an incredibly productive population - we have some of the most creative, entrepreneurial, intelligent spirits in the world. Ask any foreigner that and they will tell you the same. True, the average American has dumbed down over the past couple of decades, but that is simply the result of easy living, much of it subsidized by a currency system that allows us to over-consume on the backs of future generations and on the back of a powerful currency. If the brown stuff hit the fan we would return to our hard working roots within a decade. And I seriously doubt - given the amount of capital and natural resource available in this country - that a decade is enough to get us to subsistence, much less survival levels of consumption.

Therefore, assuming we are above subsistence levels of consumption, then there will still be the existence of normal commerce, just as there exists in the backwaters of India. And from the backwaters of India to the richest chateau in France, people have always needed a convenient way of settling accounts. Gold has an intrinsic value not just because it makes pretty jewelery, but most of all because it has historically functioned as money; that is (1) a numeraire for all other goods, (2) a means of exchange, (3) a store of value (i.e. it doesn't go bad) (4) a source of liquidity (5) easy to transport and identify, (6) durable, (7) easily divisible, (8)hard to counterfeit (9) easy to store and (10) not arbitrarily available to a select few (as is fiat money.) If Americans lose their faith in the dollar which they could in any number of scenarios, they will still want something to function as money. And they won't want to carry tractors or trucks or gardens or irrigation systems around in their back pocket to negotiate business.

US dollars derive their value from the same place as gold: its use as money. However, US dollars have an Achilles heel: the US dollar has no intrinsic value if people lose faith: faith in the issuing agency (Federal Reserve) printing policies, faith in the future growth of the US economy, or faith in the political structure of the US. Therefore, I would suggest that the intrinsic value of US dollars is on a lower rung than that of gold. Gold has an intrinsic value so long as we need an efficient means to trade. The intrinsic value of the dollar also requires faith in a list of other things.

The reason that I feel, like so many others, that the US is behind the 8 ball is that our increased debt levels. Our financial situation, and particularly our net international investment position has deteriorated so much in the past 30 years. I would add to this the possibility that natural resource constraints will lower the natural rate of growth in GDP over the next decade. If the natural rate of growth is low or negative, than this affects all of the debt-GDP ratios negatively. If the natural rate of growth goes negative for a 5 year period, there could be a game changer regarding the incentive to save and invest. I think we are starting to see this in China, as the central government is focusing more on consumption and less on investment.

Fed balance sheet

2009-09-05T12:20:00.001-07:00

Thought of the day: the Fed announced in August that they would slow the pace of treasury purchases in order to last through October:

To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.

http://www.federalreserve.gov/newsevents/press/monetary/20090812a.htm

However, as of September 2nd, they already hold 288 billion in treasuries. They have been averaging 12.5 billion of purchases a week since April, and 8.5 billion/week over the past 2 weeks. With only a total of 12 billion of purchases left over the next 8 weeks, they will either
a) be purchasing an inconsequential amount (1.5 billion/week) for the remaining 8 weeks
b) will finish their purchases sooner than the end of October
c) purchase more than 300 billion total.

I'm guessing "c" is the correct answer and that they will taper down about a billion a week (8 7 6 5 4 3 2 1) and overshoot by 25 billion. That's a rounding error.

With $700 billion of purchases left in the MBS and agency debt markets, does it really matter that they are ending treasury purchases anyway? The MBS is a lot bigger deal, since that will be harder to get off their balance sheet without losses. We will see, but no matter how you count it, we are past the halfway mark on the intended Fed purchases.

Silver/gold cleared for take-off

2009-09-04T10:34:00.000-07:00

THIS WEEK'S ACTION WAS BULLISH
There was a powerful rally in precious metals this week, with silver up close to 10% and gold up 4%. To my eye, this rally looks like the start of a much larger move. As I remarked on Tuesday, there was an unusual divergence in the first couple of days with the gold equity index (HUI) falling while silver was rising. The vast majority of the time HUI leads the markets, but in this case HUI wound up following precious metals higher - rallying 10% on Wednesday, 5% yesterday, and 1% today. So the divergence was resolved in a bullish manner, with the HUI now leading the market higher.
LOTS OF GOLD SOLD AT $1000
Gold has traded up to $1000 3 or 4 times now, so it would be very unusual to not see a significant breakout above those levels after testing it for so long. The reasoning for this? There are only so many sellers and so many ounces that are up for sale in the $950 to $1000 range. Since the market has traded into that range a number of times, there are less ounces up for sale than if this was the first or second time we traded to $1000.
SENTIMENT IS NEUTRAL
From my sample size of intelligent traders and associates, the majority are not bullish precious metals right now. My sample size is small, but I would say that roughly 1/3 are bullish, 1/3 are neutral, and 1/3 think gold and silver will trade to much lower levels. What is remarkable is that most people in my sample are normally quite bullish on gold. I have a friend who was long silver for years and has sold the majority of his physical over the past 6 months. Every retail gold/silver shop I've been to in the past couple of weeks has been bulging at the seams with bullion, and seemed to be short cash. Perhaps gold bugs have been exhausted by precious metal prices advancing less (or falling more in the case of silver) than was expected. I think there may be a subconscious feeling that if precious metals didn't perform in the past twelve months, then under what circumstances could they possibly perform? Also, the majority of intelligent market watchers are now convinced that deflation is the likely outcome and inflation is almost impossible given the capacity utilization levels. So a lot of people are on the sidelines right now.
The most convincing breakouts are (ironically) the ones with the fewest people already "on board." This makes technical sense because it means there is a lot of sidelined money that can change its mind. Neutral money in particular can easily switch to bullish, and I think that a significant break of $1000 in gold would bring in a lot of neutral money.
DOLLAR IS LOOKING SICKLY
As this week's action proved, you don't need the dollar to fall to get a big rally in precious metals. But a falling dollar would probably contribute to a rally. I've been pretty well convinced by friends and associates that the dollar will rally in a second wave of deflationary recession, but the technical appearance of the chart points in the other direction. Rallies above 79 have been rejected last week and this week. We broke an important support at 78 several weeks ago, so there isn't much to support the dollar if it starts to fall.
MANY SIGNS POINT TO A BIG RALLY
The bottom line is this: there was an impulsive move up this week (I define "impulsive" as a trend move on high volume and a low degree of variance from the trend) in precious metals. Silver led the way higher, and HUI and silver are both rallying more in percentage terms than gold. Sentiment is at a level that is consistent with a breakout as well.

The next steps to watch for in a breakout would be:
1)Gold takes out its March 2008 highs (70%)
2)The dollar falls to 75 (65%)
3)HUI and silver take out their highs from March 2008 (50%)

Silver-interesting action today

2009-09-01T10:28:00.000-07:00

There is a lot of interesting action in the silver market today. After two minor sell offs earlier in the session, silver has now spiked up to a daily high on high volume, with 20% of a average daily volume trading in 3 minutes.

This was unexpected, because there are many reasons to expect silver to be significantly down today.

1) Weakness in the HUI index yesterday and today
2) commodities are down today
3) the dollar is up today

This combination rarely occurs on days when silver is up.

First, the HUI index has been weak, and was particularly weak yesterday. Silver/gold and HUI are a classic case of co-integration and error correction. (Google "drunk and her dog" for an amusing presentation of what co-integrated series with error correction looks like.) The error correction terms are larger for silver and gold than they are for the HUI. This means that when HUI moves a large percentage in a given day or over a given period and silver/gold does NOT, then silver/gold will likely move in that direction in subsequent sessions/periods.
Second, silver has correlated highly with the overall commodity index for the past 12 months.
Finally, there is the long-standing and obvious inverse correlation between the dollar index and precious metals.

So a peculiar movement today, made more-so by the heavy volume buying silver into the pit close.

Natural Gas-I've changed my tune

2009-08-31T15:03:00.000-07:00

The last 4 weeks of inventory reports have gotten progressively more bearish. In my previous post making a bull case for natural gas, I calculated that there was a supply/demand imbalance of roughly 25-30 BCF per week. After accounting for changes in weather, it appeared that the supply/demand disposition was very bullish through July. However, that imbalance has since completely disappeared. So now we have a very distended inventory (which is bearish) and a flow that is neutral (rather than bullish.)
It is still likely that natural gas will bounce back to the $5 area in the near future, but that is already priced into the strip (January natural gas is already at $5) so there is no money to be made on that expectation. The fact that back months have continued to hold up so well in price may be evidence that we are still a good distance from the next bull market.
Generally speaking, bull markets are born out of pessimism, and the steep contango (Dec 10 futures are more than double Oct. 09 futures) is still evidence that the pessimism does not exist. We have started to see some selling in the back months over just the past couple of days. Whether this turns into something more serious remains to be seen, but the capitulation in the front month has not yet been matched by capitulation in the back months.
There are other signs that lead me to believe we are in a bear market. Mergers and acquisitions are proceeding at a snail's pace in the energy sector. This is another sign of lack of capitulation, and until we see mergers, gas companies will likely continue to try to bleed each other into submission. Witness Aubrey McClendon's recent comments at a Chesapeake conference call:

I think the second thing is, given where storage is it was our analysis that we are going to be full up on storage by the end of the year. As we get closer to that, pipeline pressures are going to increase and that is going to cause involuntary curtailments. I think our view was that there was no reason for us to voluntarily curtail gas, when pretty soon, everybody is going to start involuntarily curtailing gas and so, we didn't see any reason to take it on the chin for the team, more than we did and instead, we will just let the system work, to spread the pain across the whole industry here over the next couple of months.

http://seekingalpha.com/article/153691-chesapeake-energy-corporation-q2-2009-earnings-call-transcript?page=3

While prices did bounce back relatively quickly from their absolute lows in 1999 and 2002, there was still a 6-12 month period after that before prices really took off. Also, looking over the data carefully, it seems the industry is more concerned with stock of storage than the flow of storage. Prices don't bottom until the excess stock of storage over normal has come in by 200 BCF or so. And bull markets don't seem to start until stocks of storage return to their 5 year average.

And finally, I'm still waiting for some sort of pronouncement from a major media source (time, newsweek, etc.) that we have infinite amounts of natural gas, and it will serve all of our future energy needs. Publications like that often mark extremes in sentiment and price.

So, we are in a bear market. Before the bear market ends, there will be a number of signposts, and they are:
1) We need to see a less steep strip, and would particularly like to see some more backwardation between March 10 and May 10.
2) We need to see lots of gas driller/producer bankruptcies, and a high level of M&A.
3) Storage excess over norms needs to reduce by 200 BCF before prices will bottom. This will probably happen going into October as inventories get full.
4) Storage levels need to return to 5 year averages before a bull market can really get started.
5) Some sort of marker from a major media outlet would be a nice confirmation, although they don't always occur.

Two items of interest for dollar followers

2009-08-30T15:52:00.000-07:00

There were two news items this week that have potentially substantial implications for the US dollar.

The first is that a new political party, the Democratic Party of Japan, has swept into power in a landslide election victory. While these results will not be a surprise to the markets, it is a potential concern for the dollar. This is because the DPJ has a much cooler stance on Japan's relationship with the US, and certain officials have taken the stance that Japan should reduce its exposure to dollar holdings. http://www.bloomberg.com/apps/news?pid=20601068&sid=acmzAQiv_eQI
More recently, officials from the DPJ have seemed more reticent about the possibility of dumping the dollar, focusing as usual on the assumed valuation effects of their savings. I still don't understand how they are savings if the act of spending them reduces their value. This truth underlies how the currency manipulators of the world will get their comeuppance. This election is not a direct threat to the US dollar, but the new power in Japan at least pays lip service to increased flexibility in their relationship with the US and monetary issues. If you want to read a op-ed piece from the leader of the party you can do so here:
http://www.csmonitor.com/2009/0819/p09s07-coop.html

The second item has to do with announcements made by the Chinese sovereign wealth fund CIC. http://bloomberg.com/apps/news?pid=20601208&sid=a4FINX22BV8c
It appears that the CIC is starting to increase its risk exposure, and thus far the investments seem to favor non-US entities. A short list of the possible investment already made include Teck Resources limited, Canada
and Songbird Estates PLC, England. The fund also has been active in the domestic banking market, and is rumored to be looking at Japanese equities. The reason that this has implications for the US dollar is simply a matter of asset preferences. If the CIC uses cash equivalents (the majority of which are dollars) to purchase equity and to finance debt (the majority of which are not denominated in dollars) then this will depreciate the dollar, all else equal. We saw the reverse of this in the financial crisis last fall when US and non-US entities both liquidated non-US investments in order to cover dollar obligations and to raise dollar liquidity. So long as we avoid a further financial crisis, the tide on asset preferences will now be heading in the other direction, and the CIC purchases and planned purchases are an excellent and important example of this.

From a technical perspective, the dollar is in an ambiguous stance. The recent break below below 78.5 in the dollar index was short lived; however, the rally since then has also been lackluster. We now sit at the support area around 78.5. As trading picks up in the next couple weeks, we will likely see a new trend develop. A higher dollar is likely (but not a sure thing) if the market perception starts to lean toward a further deflationary contraction of the economy. Likewise, a lower dollar is likely if the market perception continues to expect a market expansion.

The Bullish Case for Natural Gas Prices

2009-07-22T21:47:00.000-07:00

1. Supply and Demand
2. EIA inventory reports – why aren’t they bearish anymore? Over the past 2 weeks, demand is outstripping supply by 25 BCF/week, and the infamous NG glut would disappear in 16 weeks at that rate.
3. Supply: rig counts. Rig counts continue to fall. Since supply continues to fall even after rig counts start to grow again, we can be assured that supply will continue to fall for at least another three or four months.
4. Demand: If the recession has in fact bottomed, then we can expect natural gas demand to boomerang higher, as economy wide production levels are currently below economy wide consumption levels, and inventories are down 10% YOY. Inventory/sales ratio is still higher than it was in 2006-2008, so industrial demand may remain weak in the short term.
5. Previous examples of rig lay downs, their duration, scope, and the related price action. There are two cases where the number of rigs decreased by 40-45% (1999 and 2002). They were both in similar periods of excess gas storage and the correlated low price. In our current situation, the number of rigs has decreased by 59%(‼)There is a gap between where a company will lay down a rig and start one up again. It requires a significant move higher in price before companies will increase the rig count. If a company will lay down a rig at $4, they won’t necessarily put it back into operation until $5 or even higher. In previous examples, prices moved by 50-75% off their lows within 2 months.
6. Technical price support for a bullish conclusion
7. Conclusion

1. Supply and Demand

2009-07-22T21:42:00.000-07:00

On Thursday every week, the Energy Information Agency (Note that all the data presented in this report are taken from the EIA unless otherwise noted) releases national storage data for natural gas. This report is an important data piece for traders and economists who are looking for clues to the supply/demand disposition of natural gas. The inventory follows a similar pattern every year, whereby inventories build from late March to mid November, and then draw down quickly during the cold winter months (Figure 1).
Figure 1 Natural Gas Storage (Source EIA)

Note the cyclical nature of gas inventories. Since the spring and fall has neither excessive heat nor excessive cold, these periods are called the shoulder months and have the least demand for natural gas. Demand is elevated in the summer due to air conditioning, but inventories still grow in the summer, just at a slower pace. Since the expected number of degree days is different in every calendar week, the most meaningful comparisons of natural gas disposition are achieved by comparing the same week in different years. Additionally, other factors affecting demand (holidays and scheduled industrial furloughs) generally fall in the same calendar week and are neutralized by comparing year over year data.
While comparing the same week on a YOY basis can provide “first-order” estimation for changes in supply and demand (footnote 2: When speaking of supply and demand in this paper I do so informally; I intend to mean quantity supplied (excluding changes in inventory) and quantity demanded. Thus if I say “supply exceeds demand by 20 BCF” the reader can take it to mean that, ceteris paribus, the quantity supplied is 20 BCF greater than the quantity demanded, and that difference is made up by inventory levels) , it will only give an accurate depiction averaged over many weeks of data. This is because one finds that even in the same calendar week the weather can vary greatly from one year to the next. Therefore, a more sophisticated approach must account for changes in weather between the two years. This is done by constructing a regression using weather data as explanatory variables and inventory changes as the dependant variable. Once you know the predicted effects of changes in heating and cooling demand, you can then back out a decent estimate for the year over year change in supply and demand disposition.

2. Why The EIA reports aren’t bearish anymore

2009-07-22T21:34:00.000-07:00

First two weeks of July 2009 (i.e. the last two inventory reports)
Average cooling degree days for the past two weeks=62
Average inventory fill for the past two weeks=82.5
First two weeks of July (2006-2008)
Average cooling degree days for the first two weeks= 75
Average inventory fill=85.5
Look at the difference in cooling degree days between this year and the average over the past 3 years (62 versus 75). How big of a difference could that make in cooling demand?
That big of a difference in CDDs is good for about 25 BCF less use per week,
(Footnote 3
I ran a least squares regression using the difference between changes in inventory in two consecutive years as the dependant variable and changes in heating degree and cooling degree days as the independent (or explanatory) variables. I use terms for the differences in the square of the CDDs and HDDs as well to allow for a non-linear relationship (for example, if 10% of the population uses an air conditioner at 80° F, but 50% use an air conditioner at 90° F, then a linear specification won’t give us as accurate of a specification). The equation generated by the least squares regressions to explain inventory changes based on differences in degree days is the following:
d(dINV)= -2+0.97*d(HDD)+0.79*d(CDD)+0.0013*d(HDD^2)+0.0096*d(CDD^2)
where:
dINV=change in EIA natural gas inventory from one week to the next
d(dINV)= difference in dINV for a given week, between year x and year (x+1).
d(HDD)=difference in Heating Degree Days for a given week, between year x and year (x+1).
d(CDD)=difference in Cooling Degree Days for a given week, between year x and year (x+1).
D(HDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).
D(CDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).

The fact that the constant term at the beginning of the equation is -2 instead of 0 reflects the fact that we have had a YOY inventory build of approximately 100 BCF per year over the past three years. In the long run this constant term will equal 0! end footnote)

so based on simple weather YOY comparisons, we would have predicted fills in the 110 range over the past two weeks. Instead we got 82.5, a fact that signifies less gas was put in storage than what is predicted based on the regression.
Based on the past two weeks of data, and assuming the regression is roughly accurate, demand is outstripping supply by 25 BCF/week or almost 4 BCF a day! Normally this level of discrepancy would create an absolute panic in the market. However, because the stock of natural gas is currently 450 BCF above average, the market reaction was muted. Still, the price has moved up 10% since before the release of the July 3rd inventory report.
One way to think of the current situation is to parse the bearish or bullish reality in terms of stock versus flow.
The stock:
Stock of natural gas is 450 BCF above normal. VERY BEARISH
1st derivative (The flow):
After accounting for changes in weather and other exogenous factors, I estimate that demand has outstripped supply by 25 BCF/ week for the past two weeks. Over the past 4 weeks, demand outstripped supply by 21 BCF/week. While four weeks is a small sample size, this level of discrepancy is statistically significant. Future inventory reports will continue to confirm, deny, or accelerate this apparent disparity between supply and demand. BULLISH

2nd derivative (change in the flow):
In 2009Q1, the supply demand disparity was the opposite: supply outstripped demand by 40 BCF/week. Thus, in one quarter, the market went from a 40 BCF/week surplus to a 25 BCF/week deficiency. Obviously, this implies the second derivative of the stock (change in the change of the stock) is negative and steeply so. Why this is and whether it will continue will be the focus of my discussion in sections 3 and 4. BULLISH

In summary, if a trader were to focus only on the stock of natural gas, they will see a 450 BCF glut. Examples of natural gas prices getting driven into the ground during the fall shoulder months abound (and under much less extreme storage gluts then the current one). However, if the trader considers the flow (1st derivative) and change in flow (2nd derivative) a different perspective emerges. Assuming the previous calculations are accurate we are currently running 25 BCF/week below expectations, at which rate the entire storage glut would be gone in 18 weeks. If the 2nd derivative (change in flow) is negative, then the glut could disappear even faster. How can we estimate which effect will dominate prices in the near future? Well, this is not the first time the market has been in this scenario: we had a natural gas glut in both 1999 and 2002, and history can be our guide. In section 5, we look for possible rhymes in these previous instances to divine the probable outcome of our current situation.

3. Rig Counts

2009-07-22T21:22:00.000-07:00

Every week, Baker Hughes publishes the number of active gas rigs operating in the world and in the United States. This rig count data correlates with the number of new gas wells that can be expected to be drilled in any given week. In order to simply maintain supply, a certain number of rigs need to operate. The necessary number depends on the initial flow rate of new wells, and the depletion rate of the existing resource. If the number of new drilled wells goes above this number, then supply well increase, and vice-versa. One of the important metrics to know is what the average depletion rate is in existing wells. Unfortunately, that piece of data is extremely difficult to calculate because there are so many types of wells in different types of rock and the overall distribution of quality and type is constantly changing. What we do know is that
1. Depletion rates steadily increased between 1980-2006 (see http://www.eia.doe.gov/oiaf/servicerpt/depletion/pdf/app_g.pdf and
http://gswindell.com/tx-depl.htm)
2. Average flow rates have been decreasing over the past 30 years (Figure 2)
3. Initial flow rates for shale gas are impressively high (anecdotal)
4. Depletion in shale wells is very high, particularly in the first few months of operation (Also anecdotal)

Figure 2

The only two years in the past decade when production per well increased were 1999 and 2007. These years featured relatively low prices in natural gas, so the increase in per well production may be due to producers:
1. Only drilling their best prospects that year
2. Reducing the number of existing wells since the low price did not justify the existence of marginal wells.
It is also clear that 1998-1999 represented a turning point in the production per well. This could be due to a number of different factors:
1. A decrease in the quality of available resource
2. A shift in the type of well being drilled (conventional versus unconventional)
3. An increase in the rate of drilling after 1999. Starting in 1999, there was an explosion in the rig count and the number of new wells drilled. The acceleration of drilling would more quickly change the demographic of total wells toward lesser quality or unconventional wells.
This is consistent with data on the number of operating drill rigs. Glancing at a graph of drill rigs, it is clear that there was a noticeable increase in rigs starting in 1999 (Figure 3).
Figure 3 (Source: Baker Hughes)

While supply stayed more or less constant from 1998, the number of existing wells increased dramatically, and the rig count exploded. This trend continued through 2007 when shale natural gas wells started changing the dynamics of the market.
Take a close look at Figure 3 and you will see that there have been 3 dramatic falls in rig counts in the past ten years: 1997-1999, 2001-2002, and 2008-current. These drops in drilling activity correspond to very low prices for natural gas (as the famous quip goes: low prices are the cure for low prices). In section 5 the rig drops in 1998 and 2001 are examined and used to model what might be expected in 2009. Speaking generally, as drilling activity slows, there is a point at which depletion of the total existing supply exceeds new marginal supply, and total supply starts to fall. Because the rig count falls below the maintenance level, supply continues to fall even after the rig count starts to climb. This is because it takes a period of time to activate the number of rigs necessary just to drill at the level necessary to maintain supply. In Figure 4, there is a graphical estimation to prove the point.

Figure 4 Rig count starts at exactly the level necessary to maintain supply. We assume an annual depletion rate of 25% and also assume a 40% decline in drill rigs from peak to trough that declines linearly over a period of 40 weeks. Finally we assume that once the rig count has bottomed, the rig count then has a linear increase back to the initial rig level in 25 weeks.

This figure gives a first approximation for how supply responds to decreased rig counts. In order to try to model the 2006-2009 period a little bit more accurately, some assumptions need to be made. First, it is pretty clear that we were expanding supply from 2006-2008 at a meaningful (some would say blistering) pace. Therefore, the drill level was above the level necessary to maintain supply, and this is confirmed by the increase in supply during 2008. Furthermore, the increase in rigs during this time period was particularly marked for horizontal rigs in shale deposits (footnote 5:The emergence of horizontal drilling for shale natural gas is probably the most significant development in the energy sector over the past 3 decades. Some market participants have noted the extremely fast depletion rates of shale natural gas wells. While a fast depletion rate will present a challenge after the supply of shale gas peaks, it actually makes the resource more flexible and responsive so long as the resource is increasing. While this paper generally holds the view that natural gas prices could spike in the next 12 months, shale natural gas and its high depletion rate will actually act as a damper on this price increase. Since initial flow rates are so high and a larger percentage of a shale well’s production occurs in the first few months, this decreases the amount of time necessary to increase supply by significant quantities) : the number of these rigs expanded by more than 100%. When the total number of drill rigs peaked in late 2008, producers could very well have been drilling 50% more wells then was necessary to maintain then-current levels of supply. That will be the baseline assumption in the estimate that follows.(footnote 6:Other assumptions include: horizontal rigs are modeled to drill twice as much gas per rig as other types of rigs to reflect the elevated initial flow rate of shale gas. Depletion rates are assumed: horizontal wells deplete at 70-80% per annum, and other wells deplete at 40-50% per annum. I am not suggesting that Figure 5 is a completely accurate depiction of reality; for one thing, it does not account for supply that was lost during Hurricanes Katrina, Rita, Gustav, and Ike. It also aggregates different types of wells, and makes assumptions about depletion rates that may or may not be accurate. But it will give a better broad view of supply then what is suggested in Figure 4. The red curve at the end of the graph reflects an estimate of what future supply would look like if rig counts started increasing next week and increased linearly at a rate of 30 rigs a week.)
Figure 5 Rig Data from Baker Hughes. Curve depends on depletion rates estimated by author

This figure is meant to illustrate the concept that supply will continue to fall even after rig counts start to recover. This is because we have now overshot the number of rigs necessary to maintain supply, and so supply will fall until we return to that number of rigs.
In conclusion, by comparing to past instances where rig counts fell below the level necessary to maintain supply, we can expect that supply will continue to fall for at least another month or two. If rig counts stay at current levels (or continue to fall) then the nadir in supply will be pushed out that much further. To relate this back to section 2, an expected reduction in supply would cause, everything else equal, the second derivative of natural gas storage (that is, the change in the flow rate) to be negative

4. Demand

2009-07-22T20:29:00.000-07:00

Evidence is starting to accumulate that production of goods is stabilizing. Consumption data also appears to have stabilized. According to the most recent Census report, sales did not drop between March and May. While inventories are still dropping, the underlying production levels seem to have stopped declining, and are at a level slightly below consumption levels. Again we are faced with a stock versus flow situation. The stock of goods is too high, but the flow is now negative (that is, the production of goods is lower than consumption of goods.) Unless consumption drops further, we can expect production to come up at least to the level of current sales. This point is fleshed out with a particular focus on natural gas by an investor and trader named Rob and with a tag of Robry825. For those interested in looking in more detail at the demand for natural gas, I recommend reading his weekly blog post at http://robry825.blogspot.com, and also his near-daily postings at the Investor Village CWEI message board :(http://www.investorvillage.com/smbd.asp?mb=2234&pt=m&clear=1) for detailed and disaggregated data on demand for natural gas.
A quick comment on weather: one of the big stories in the natural gas market this summer has been the bearish weather. With the exception of several weeks of hot weather in Texas, this summer has been remarkably cool, and there has not even been the threat of tropical storms in the Gulf of Mexico. As of mid-July, we have predictions of continued unseasonably cool weather across most of the CONUS. The psychological effect of weeks and weeks of cool weather may be leading market participants to overemphasize the importance of bearish weather. Weather forecasts are only accurate to 14 days, so we could very easily have a bullish switch in weather, such as a hot August or a cool October.
In conclusion, I think that the demand side for natural gas is uncertain. There exists the possibility that goods consumption and natural gas demand will fall still further, particularly if our fate is to plunge into a deflationary depression. Barring such a worse-case scenario however, we might expect industrial demand to pick up soon, since current industrial production is below current consumption levels. This again points to a flat or negative second derivative for natural gas storage levels.

5. What History Tells Us: Previous Examples of Rig Lay Downs

2009-07-22T15:56:00.000-07:00

Summarizing to this point, the bearish and bullish factors affecting the natural gas market are:

BEARISH
1. incredibly high storage levels
2. consistently bearish weather since February
3. emergence of a new resource (shale gas) with lower costs and high initial flow rates

BULLISH
A. low price (which is below the marginal cost of all but the most cherry new wells)
B. the past few weeks of EIA inventory data
C. the change in the supply and demand disposition over the past 4 months

One might think that the battlefield is level at this point, and the incredible price volatility over the past 2 weeks affirms that market participants are even more uncertain than usual about price. However, previous examples of supply gluts and rig lay downs point to a decidedly bullish outcome.
In Figure 6, we model the last three instances of major rig lay downs.
Figure 6

The first thing to note about Figure 6 is that the percentage of rig lay downs is greater in our current episode than in the previous two episodes (roughly 60% vs. 45%). Therefore, even if drill rates in late 2008 were substantially greater than what was necessary to maintain supply, we have now certainly fallen to a drill rate that will not maintain supply.
In the next two figures the thing to note - and this is crucial - is that in both 1999 and 2002 rig counts continued to fall even after the price had reached its nadir (Figures 9 and 10).
Figure 7

Figure 8

The fact that rig counts did not start rising until 8-12 weeks after the price nadir has serious implications for the current volatility of natural gas prices. If market prices don’t start rising until storage flow is clearly negative (that is quantity supplied is obviously less than quantity demanded), and if rig counts fall even after prices start rising, then the market is set up for a potentially serious shortage. I don’t think it is a coincidence that in both cases (1999 and 2002), prices spiked by more than 500% within 20 months after the rig cont low. Extreme volatility in input prices has been shown to create a drag on the economy.

{(footnote 7: Among others, see Bernanke, 1983; Irreversibility, uncertainty, and cyclical investments. Authors comment: The problem of volatility has no obvious solution and without the futures market, the volatility would likely be greater (and the chances of shortages higher.) As much demonizing as there has been of speculators in the past year, this is clearly a place where speculators can improve Pareto Optimality of the economy. By taking a risk to buy at market bottoms, speculators can smooth what would be an even greater disruption of the natural gas market. It is also true in both cases that rig counts did not start falling until prices had fallen significantly from their peaks, so speculators have a function in both rising and falling markets.)}

To examine the two cases in Figures 7 and 8, it appears that in 1998-1999 producers reduced rig use so long as prices were below $2.50. In the second case (2001-2002), producers reduced rig counts so long as prices were below $3.25. In both cases, these were approximately the same price that producers started to reduce rig counts. The significance of this can be seen by looking at the current situation (Figure 11). Rig counts started to fall in late 2008 after prices had fallen from $13.75 to approximately $8. However, prices have now fallen on top of that by more than 50%! This suggests that prices might have to rise substantially (perhaps greater than 100%) before rig counts start to increase.
Figure 9

Once again, to balance the argument, we must consider shale natural gas. If the shale natural gas resource is large enough, the industry will be able to offset the depletion in the entire resource base by only adding more shale wells. If the marginal cost to drill these wells is significantly below $8 and they can be brought on fast enough, then it is less likely that we would see $8 in the immediate future.
To conclude this section, in previous episodes of natural gas gluts that resulted in laying down a substantial portion of rigs, the rig count did not start to increase until 8-12 weeks after price had reached its ultimate nadir. Since breaking contracts is very expensive, gas producers will operate at a loss (selling gas for less than the cost to produce it) so long as it is less than the substantial loss incurred by capping a well or not using already leased equipment. This retards the rate at which they would otherwise lay up their rigs. On the opposite side, a company will not take a rig out of storage until they are sure the project is profitable. Therefore there is a gap in the price between which companies have neither incentive to lay down nor start up rigs. This is what leads me to predict that supply could continue to decrease for at least another 4 months (2 months until rig counts to start to increase, and another 2 months until supply stops falling.) It is worthwhile to note that in each of the previous episodes, rig counts did not start to rise until prices had achieved the level where rig counts had started to fall. While shale gas could certainly alter the dynamics, this suggests that rig counts may not start increasing until prices reach $8.

6. Technical Price Support for a Bullish Conclusion

2009-07-22T15:50:00.000-07:00

So far this paper has looked exclusively at fundamentals. It concludes with a quick glance at technical price considerations in the natural gas market. Natural gas has been in a price range between $3 and $4.5 for the past 5 months (Figure 10).

When a market trades in a range like it has for the past 5 months, it is because there are large market participants on both sides of the trade. To date, it appears that producers are not willing to produce below $3.5 and will aggressively buy futures below this level. Producers hedge a percentage of their production: to do this they sell futures contracts with the intent to deliver the product at some agreed upon month in the future. Once the futures contract has been sold, a producer still has the option to buy the contract back. If they buy the contract back at a price lower then they sold it they will immediately pocket the difference. They then have the choice of either:
• Selling the (originally hedged) gas on the spot market
• Capping wells, or not drilling them in the first place
It appears that producers have been buying back future contracts when the price is below $3.50. On the other side of the coin, there appears to be a segment of market participants who are willing to short large quantities of gas when prices rise above $4. This segment is most likely large speculators (I say this based on Commitment of Trader Reports), who have been short natural gas for the past 12 months. It also could be large end users (industrial, electric generation plants, utilities) but it seems unlikely they would choose to un-hedge future deliveries at $4 when they have gotten used to $7+ gas over the past 5 years!
Just last week, prices once again tested the sub-$3.5 region and once again this price range was rejected by some market player (most likely natural gas producers). The fact that prices did not break the April low can be seen as bullish. However, sometimes a break to new lows is necessary to create a capitulation in the market. If prices were to break below $3.15 we would likely see a capitulation; prices would probably fall for an additional week or two in this scenario, but then turn around quickly. However, since prices did not break to new lows, it suggests that the most likely outcome is that medium term or even permanent lows have now been made in this (historic) bear market.
Zooming in our time frame to the past few weeks (Figure 11), we can see that Wednesday’s selling last week was vehemently rejected by buying after the Thursday inventory report. While it is dangerous to read too much into an isolated price movement, the current formation is at least consistent with the beginning of a powerful rally.

7. CONCLUSION

2009-07-22T15:49:00.000-07:00

As Peter Bernstein was famous for saying, “we simply do not know what the future holds.” For me, the art of investing and trading is a constant reminder that I can only guess at what the future holds and that I am always reliant to a large degree on chance (or something greater) for my trade ideas to work. However, to quote another famous man “in the fields of observation, chance favors only the prepared mind.” While Louis Pasteur was speaking about microbiology, I believe the same principle applies to investing. While there is no guarantee that the natural gas prices will rise in the next few months, I have laid out a case for why they might, and I stand ready to profit if I get my chance.

All Bulled Up on Natural Gas

2009-07-22T15:39:00.000-07:00

The Bullish Case for Natural Gas Prices

1. Supply and Demand
2. EIA inventory reports – why aren’t they bearish anymore? Over the past 2 weeks, demand is outstripping supply by 25 BCF/week, and the infamous NG glut would disappear in 16 weeks at that rate.
3. Supply: rig counts. Rig counts continue to fall. Since supply continues to fall even after rig counts start to grow again, we can be assured that supply will continue to fall for at least half a year.
4. Demand: If the recession has in fact bottomed, then we can expect natural gas demand to boomerang higher, as economy wide production levels are currently below economy wide consumption levels, and inventories are down 10% YOY. Inventory/sales ratio is still higher than it was in 2006-2008, so industrial demand may remain weak in the short term.
5. Previous examples of rig lay downs, their duration, scope, and the related price action. There are two cases where the number of rigs decreased by 40-45% (1999 and 2002). They were both in similar periods of excess gas storage and the correlated low price. In our current situation, the number of rigs has decreased by 59%(‼)There is a gap between where a company will lay down a rig and start one up again. It requires a significant move higher in price before companies will increase the rig count. If a company will lay down a rig at $4, they won’t necessarily put it back into operation until $5 or even higher. In previous examples, prices moved by 50-75% off their lows within 2 months.
6. Technical price support for a bullish conclusion
7. Conclusion

Informal thoughts on China forex and US/China situation

2009-07-16T15:43:00.000-07:00

China forex above 2 trillion now; up 180 bill in the three months to June.

All back of napkin estimates but let's parse that a little.
Trade surplus for those three months~$33 Billion. Interest payments on US, EURO, and Japanese bonds~$6-10 billion.
Valuation effects on Euro, Japan, and other assets due to the (on average) 7.5% appreciation of Yen, Euro, etc: $45 billion.

Which leaves us roughly $95 billion of "hot" money; multinationals trading their dollars in for yuan to invest or build capital in China, plus some investors who manage to slip through the cracks.

In other posts I've talked about how asset preference shifts are a major determinant in exchange rates, and this is a wonderful example. As risk aversion subsided, dollars sought opportunities on foreign shores (in this case China) and I'm sure this was responsible for part of the drop in the dollar, in spite of China's currency peg.

So the US is damned if we do damned if we don't. Either we have a strong currency paired with risk aversion, or we have an improving economy paired with a falling dollar. No way around it.

People like to compare US/China situation to Britain/US 100 years ago. They point out that the dollar didn't become reserve currency for 25 years after US became dominant economic player. This comparison leaves much to be desired though. For one thing, US is roughly same land mass as China, is natural resource rich. That would argue that China will not overtake the US as the world leading economic power, much less depose our currency.
We still have the best universities and a tradition like none other of risk taking (which definitely correlates with high economic activity).

On the OTHER hand, we are definitely in a funk, particularly K-12 education; we are in much worse fiscal/debt shape then UK was at the same time; we have a fiat currency; and face potentially serious resource constraints. FWIW, I think all of this research coming out (SF FED for example) pointing to a lower d(potential GDP) is nothing more than a REFLECTION of resource constraints experienced between 2005-2008 (expensive oil as exhibit 1). As usual, the standard interpretation puts the cart in front of the horse and says that the recession is leading to a lower potential GDP. Hogwash. I'm not saying that it isn't an integral part of the mechanism, and I'm sure the granger causality tests are rejected, but it is still putting the cart in front of the horse. The REASON we had the downturn in the first place, and the REASON people switched to feeling quite pessimistic about things stem from resource constraints. Same goes for the credit crisis IMHO, but that is harder to show.

For those that want evidence that the resource constraint could have been responsible for the great recession (with credit channel intermediaries acting only as a delivery mechanism) check out my paper on oil at http://outsidetheboxecon.blogspot.com/ or any of Hamilton's papers on the same subject. Fits the data very well: much better in fact than the monetary theories.

Any way, I have kind of wandered away from my initial point.

My point is that the US/China situation does not have a good comparison. The US is an awesome country. However, we are hamstrung by debt, and that could create an out-sized setback to our economy if the world experiences meaningful resource constraints over the next decade.

The Dollar and an Impending Currency Crisis-Introduction

2009-03-24T17:36:00.000-07:00

Executive Summary
The US has run a current account deficit for much of the past thirty years. This paper presents reasons for why this dynamic has persisted, paying particular attention to the importance of the reserve currency status of the dollar. The status as reserve currency has created a special dynamic whereby the short-run value of the dollar is affected by shifts in asset preferences of both foreign and domestic investors. A mechanism which increases the attractiveness of dollar assets will increase the dollar value in the short run; a stronger dollar then acts as a tax on US production and a subsidy for US consumption. In the long run, asset preference shifts toward dollar assets decrease the equilibrium value of the dollar and increase the equilibrium level of debt for the US. This paper presents three reasons for asset preference shifts into dollars and dollar denominated assets: international transaction demand, safety from balance of payment crises, and export led growth through an artificially competitive currency peg. I review work by Triffin (1960) that presents the dilemma of transaction demand for the holder of the reserve currency, and present historical evidence of the safety and export growth mechanisms. In the second section, this paper presents and extends work on the long run value of the dollar following a model by Blanchard, Giavazzi, and Sa (2005). Asset preference shifts that have occurred in past year are modeled, and finally I speculate on the future path of the dollar and international investment position of the US.

Introduction
One of the most interesting and rich topics in macroeconomic theory revolves around the study of currency movements and exchange rates. Over the past three decades, academic and financial analysis that argued the US would suffer dollar devaluation due to national consumption exceeding national production has been largely wrong. That such an intuitive argument has been so consistently wrong is the source of much frustration and consternation. What has become clear is that when discussing exchange rates and determinants of exchange rates, there is a necessary delineation between the dollar and the rest of the world currencies. Because the dollar is the world reserve currency, special dynamics exist for it in addition to the normal trade and monetary dynamics one would expect. In this paper, I identify three mechanisms that create a demand for dollars independent of trade dynamics: liquidity needs of the non-US world, security of assets for countries with irresponsible fiscal policy, and strategic export driven growth by developing countries. I argue that any force which increases this demand for dollars will also increase the trade and current account deficits, and vice-versa.
The position of this paper is that the US dollar is significantly overvalued in relation to its long run equilibrium value. I define equilibrium value for the dollar as the value at which the current account equals to zero . Since interest payments on net international debt are a key determinant of the current account, I also examine recent developments in that area.
The current account is made up by the trade balance plus any difference in payments between domestic owned foreign assets and foreign owned domestic assets. It is assumed in the paper that the Marshall-Lerner condition holds, and a depreciation of the currency not only increases exports, but improves the trade balance. Since US carries its debt in dollars, a depreciation of the dollar will also improve the current account balance. I feel the current account is the most effective measure of equilibrium in the long run because on some level it represents the relative competitiveness of US made goods and services on the international stage.
In the second part of the paper, I extend work done by Blanchard, Giavazzi, and Sa (2005) using phase diagrams to model global shifts in asset preferences. The three mechanisms which have created exogenous demand for dollars can be modeled as asset preference shifts. I model a specific shift that occurred in the last 9 months (August 2008-March 2009), and conclude with two alternative future paths that the dollar may take to achieve steady state in the model. These two paths are a discontinuous devaluation of the dollar probably accompanied by a shedding of the reserve currency status, and a relatively slower devaluation of the dollar accompanied by an ever-growing net international debt position of the US.
A Picture of Imbalance
The U.S. has run a current account deficit for almost all of the past thirty years, and it has recently increased in both absolute terms and as a percentage of GDP (Figure 1; Data from Fred Fed).
Figure 1: US Current Account.

Source: St. Louis Fed
It has been suggested that the current account (CA) deficit of the US is sustainable due to dark matter (Hausmann and Sturzenegger, 2007); generally speaking, theories along these lines suffer from a dangerous combination of wishful thinking, attempts to fit theory to the short term facts, and obfuscation of simple truths through complex and impressive mathematical arguments. The same types of theories have been developed in the past to explain that securitization of mortgages reduces systemic risk, and why housing prices and other assets must always go up. Relying on assertions that the US has complete markets, or that US investors can return a higher yield on their investments is both speculative and dangerous. While risk-averse foreign investors with poorly developed financial markets might make a marginally lower yield in the long run, this difference is greatly exaggerated during economic booms (when risk- taking is rewarded) and reversed in economic busts (when risk-taking is punished). The negative change of more than $2 trillion in the net foreign asset position of the US during 2008 (Figure 2) casts an already long shadow upon theories that the US can offset its CA deficit with financial genius.
Figure 2: Cumulative Net International Investment Position of the US.

Source: Gian Maria Milessi Ferreti; http://www.voxeu.eu/index.php?q=node/2902

I assert that the safe and logical assumption for the present time should be that the US cannot earn a significantly higher rate of return on foreign assets than vice-versa. This point becomes important for long-run considerations of equilibrium in the current account – namely, the US will have to run a trade surplus equal to interest payments on its net foreign debt position.
Nevertheless, strong arguments do exist for why the dollar remains strong. There are (at least) three sources of demand for dollars that exert an exogenous force on normal balance of trade dynamics: (1) a demand for dollar liquidity for transaction needs; (2) a foreign desire for asset security found in the dollar’s role as a reserve currency; and (3) developing country attempts to accelerate economic growth through an export dominated economy. To date all three factors have increased the incentive for foreigners to collect dollars (by selling goods and services in exchange for dollars) and decreased the incentive to dishoard dollars (by buying goods and services with the dollars). If these dynamics were to reverse, they would exert pressure to devalue the dollar above and beyond pressures exerted by the balance of trade dynamics. Below I expand on each of these exogenous sources of demand for dollars.

Three Important Historic Sources of Demand for US Dollars

2009-03-24T17:31:00.000-07:00

Liquidity and The Triffin Dilemma
An illuminating historical discussion of liquidity needs is provided by Robert Triffin (1960). Briefly, after World War 2 and the Bretton Woods agreement, the world actually suffered from a shortage of dollars for the purposes of transactions. Since the dollar became the reserve currency for the world, countries needed to hold a certain amount of dollars throughout the year simply to conduct transactions with other countries. Particularly for countries with seasonal industries, large fluctuations in dollar holdings created a shortage of dollars; this resulted in a substantial demand for US dollars simply for liquidity purposes. Immediately after World War 2, the US ran a current account surplus, so a problem of that day (contemporaneously known as The Dollar Gap) was that foreign countries, particularly European countries, were chronically short of the dollars they needed for transaction purposes. In the late 1950s, as the US started to run a trade deficit, the dollar shortage was relieved. The fact that the dollar gap and liquidity shortage was relieved only after the US started to run a trade deficit was not a coincidence. A flow of excess goods and services in one direction must be offset by a financial flow in the other direction. Therefore, as the US began to consume more than they produced, the foreign world (in aggregate) began to accumulate more dollars than they spent.
The seriousness of dollar liquidity needs from the foreign world was reflected by one of two worries that Triffin had in 1960: namely, that if the US returned to a trade surplus it would choke off liquidity and growth for the rest of the world, and set off a Great Depression type of deflationary spiral. Triffin’s other worry – that the US would continue to increase its current account deficit until it became necessary to default on the gold agreement – was the one that actually came to pass.
This global demand for liquidity purposes mirrors the transaction portion of domestic demand for money, and both grow in proportion to the economy. So as the world economy grew and the size of transactions grew in dollar terms, the foreign demand for US dollars specifically intended for liquidity purposes necessarily grew. Since the world economy has grown by approximately twenty times, in nominal terms, since 1970, the liquidity demand for dollars has grown by a proportional amount.
Security: The Safety Trade
The so-called “safety trade” into dollars that occurred in the second half of 2008, while ironic in two ways, is not surprising. That the dollar represents security to foreign entities is partly due to historical good behavior and partly due to wishful thinking on the part of foreign entities . Certainly through 1960, the US had a virtually unblemished record in paying its debts and honoring its obligations. This historical precedent combined with geopolitical considerations and force of habit has created the foreign perception that exists to this day that the US dollar is “as good as gold.” Thus, historically, we observe that when a country suffered from a balance of payment crisis, the most common alternative to the home currency was the dollar. The list of countries whose private citizens hoard dollars as an alternative to the home currency is long: virtually any Latin American country, Russia, Eastern Europe, south-east Asia, etc.
The reason for this hoarding is fairly easy to understand. If a country pegs its currency to the dollar and the peg is kept too high, citizens of the country will consume more than they produce and the country will run a current account deficit. Mirroring this current account deficit, a country will run a financial account surplus which decreases its supply of dollars. As the supply of dollars approaches a critical point, citizens will speculate that the peg cannot be maintained and will “make a run” on the currency, trading all of their domestic currency for dollars in anticipation of the devaluation. This is referred to as a balance of payments crisis, and results in a devaluation of the national currency. Examples of recent balance of payment crises include the Argentine economic crisis (2001-2002) and the Asian financial crisis (1997). Citizens in countries who have suffered balance of payment crises will often hold a portion or even a majority of their wealth in dollars in anticipation of another currency devaluation.
As an additional demand, it is commonly considered good practice for a developing country to carry reserves in excess of what is necessary for transactions as a preventative measure against balance of payments crises. Thus, there is actually an incentive to peg a currency too low, as a method for accumulating a protective supply of dollars to prevent balance of payment crises.
Strategic Export Growth:
In addition to a proactive measure to prevent BOP crises, both developing and developed nations can create an artificially competitive export market by intentionally holding down the value of their currency. This artificially competitive export market increases production in the country, whose effects then multiply within the economy. In the short-run, or on a small scale, it is not clear that the effects of this are negative for the US. Although a depreciated foreign currency makes US domestic industries less competitive, a loss on the productive side is offset by an increased purchasing power of the dollar for consumption. However, as the effects persist and grow in magnitude it clearly creates imbalances (Figure 1) which almost certainly contain Pareto inefficiencies and deadweight loss.
This dynamic of strategic export growth is most easily seen in present day China. Examining China’s actions, we see a replay of a historical pattern that has worked well for economic growth in the world. Starting with Europe in the 1950s, Japan in the 1960s, Tiger Asia in the 1970s, and China, Southeast Asia and others in the 1980s, countries around the world have followed a similar blueprint for accelerated economic development. That blueprint consists of devaluing their currency to a level that makes goods produced in their economy attractive to foreigners. Then, as the balance of payment surplus grows, their central bank neutralizes the inflow of dollars by selling bonds into the market as it continues to buy dollars. By doing so, the quantity of Yuan in the economy remains the same. If the private market was left to assign value to the dollar, it would result in a depreciation of the dollar. By buying dollars, and neutralizing foreign exchange, their central bank is pegging the currency. In this circumstance, they also proxy for an investor with an extreme (100%) preference for US assets; this will become important to discussions later in the paper. The money that the export sector makes acts as a multiplier to the general economy in these countries, and this dynamic underlies the astronomical growth experienced by Europe in the 1950s, Japan (1960-1990), South Korea and the so-called Tiger countries (1970-2000), and China and South-East Asia (1980-2008).
Summary of Exchange Rate Dynamics
While all other countries have two primary mechanisms that determine their exchange rate, the US dollar has five. The two mechanisms present for all currencies are: the relative supply of the currency (determined by the central bank); and the terms and attractiveness to foreigners of domestically produced goods and services. All else equal, the greater the supply of currency the higher the exchange rate (depreciated), and the more attractive the terms of domestically produced goods the lower the exchange rate (appreciated). Both of these mechanisms are reflected in the current account: if a country devalues its currency through an increase in money supply, it will have higher interest payments on foreign denominated assets. In this circumstance, a net debtor will generally see a deterioration in the current account, and a net creditor will see an improvement. If a country increases the attractiveness of terms on its production to foreigners, it will improve the current account.
In addition to these two factors, the US also has the three exogenous mechanisms discussed above--liquidity, safety, and export growth. These exist primarily in the US, but are endogenous to any country holding the world reserve currency. These dynamics usually act to appreciate the dollar, which goes a long way toward explaining the peculiar ability of the US to run persistent current account deficits. However, if the mechanics reverse, then the mechanisms would likely act to depreciate the dollar. Thus, any expectations that transaction liquidity demand will decrease, that faith in the safety of the US dollar will decrease, or that the dynamics of export-driven growth strategy would reverse would serve to lower the expected value of the dollar. I now demonstrate why it is likely that all three of these dynamics will work in precisely this way in 2009.

Will the exogenous demand for dollars reverse in 2009?

2009-03-24T17:24:00.000-07:00

Less International Transactions in 2009
The easiest dynamic to demonstrate is a decrease in transactional liquidity needs. The world is experiencing a contraction in both real and nominal GDP. And while GDP has contracted on the order of a few percent, exports have contracted by much more. Over the span of a year, China's exports in February fell by 25.7% , Germany’s exports in January fell by 20.7%, and Japanese exports in January fell by 45.7%. While it is possible that we have reached the trough for export numbers, it is very likely that exports for the year of 2009 will fall by more than 10%. This decrease in trade means that the world will need fewer dollars for transaction purposes. As countries come to realize this fact, we can expect a marginal dis-hoarding of dollars allocated for transaction purposes.
Foreign Investment Opportunities Improve
There is no question that the desire for security of asset value has been a factor driving up the value of the dollar over the past 8 months. Why, then, might this trend reverse? There are two reasons:
1. Foreign holders of dollars might judge that the dollars are better spent on domestic consumption than on savings, or might judge domestic investment more attractive than dollar alternatives.
2. It may be judged that the US dollar is actually less secure than an alternative monetary asset.

The potential for the first reason can already be seen in China’s plan to spend $583 billion dollars on infrastructure and domestic growth for 2009 and 2010. I assert that much of the private savings in the world will shift toward investments such as this. Although the first reaction to a marginal decrease in yield on investments is for savings to seek a safe harbor, the next step is to spend those savings on consumption goods. This spending on consumption, in turn, improves the expectation of yield on investments and leads capital back into so-called risky assets. Thus, the first reaction of the world economy to a poor growth outlook was to seek a safe harbor (US treasuries). I predict that the next step will be for countries to reduce the stock of savings by spending a portion on real consumable goods and services. This leads to the final step of increasing expectations on investment yields. I expect that independent of other factors, the savings rate in China, Japan, and Germany will decline by the end of 2009, and that expected yields on private investment will increase over 2010 and 2011.
The second reason the trend might reverse is a Black Swan type of event (the Black Swan theory (in Nassim Nicholas Talib’s version) refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations). One possibility of such an unpredictable event might be that a powerful individual within the Chinese government became convinced that the US could not honor its debts with real production, either now or in the future. An argument I would like to refute is that the Chinese can’t stop accumulating treasuries or the value of their savings would go down. What kind of logic is this?
"See, if you try to spend it, it isn’t worth anything; therefore you should continue to accumulate it. So send what you produce with your hard labor to us instead of consuming it yourself and you can guarantee more of this asset that isn’t worth anything if you try to spend it."
This line of argument is simply rationalizing throwing good money after bad. If the only way to maintain the value of the dollar is by buying more of them (with yuan), than every dollar bought now will essentially be guaranteed a lower value when exchanged for yuan in the future.

A Zero-Growth World Economy
Finally, I believe that the strategy for export-led growth will change. A shift in this strategy could be led in the short-term by the increase in saving in the U.S. As the U.S. has been the primary engine of the export growth strategy, a secular reduction in U.S. consumption could make the strategy less attractive. However, there is a more fundamental and non-transitory reason why I believe this shift will occur: if the medium-term growth rate for the production of real goods and services in the world is zero or negative, then export driven growth is irrational.
To see this requires a bit of a thought experiment. First, take two extremes: imagine one world where the next period availability of goods is vastly greater and superior, and a second world where the next period availability of goods and services is vastly smaller and inferior. In the first world, export-led growth would make sense because the accumulation of savings in period one would lead to investments and projects that yielded a vastly greater amount of consumable goods in the second period. In the second world, export-led growth would backfire because the savings in period one would lead to investments and projects that yielded vastly fewer amounts of consumable goods in the second period. In a zero-growth case, large savings would yield the same amount of consumable goods in the second period. However, if the savings were in a medium that decreased in value, then it would be irrational. Using the same argument as presented above, if an accumulation of dollars increases its value, than a dishoarding of dollars decreases its value. Thus, the strategy of export led growth through pegging (saving in dollars) in a no-growth or negative growth world yields a lower level of consumable goods in the future.
As a side-note, the myth of never-ending growth is something so entrenched in economic theory and thinking, that some economic models aren’t even well defined when using a negative long-term growth rate. An analogy to this myth is the belief that the world was flat and the importance of this belief to clergy in the time of Galileo. While Christianity survived the realization that the world was round, religious leaders of the time could not imagine it to be so, and the very thought threatened their understanding of the world, including the place of religious dogma. So it is with the myth of never-ending growth: economics and human existence will continue after the myth has been dispelled, but any current suggestion that the economy will not grow forever often is discounted or treated as heresy. Among other things, a careful inspection of the recent history of marginal costs for producing new oil fields suggests that we should develop theories for zero-growth, as well as contingency theories for medium-term negative growth scenarios. Even the finest golden rule steady-state loses utility if its reality is confined to textbooks.
A Question of Probabilities
The US has a Current Account deficit of close to 6% of GDP, and has a net foreign asset position of negative five trillion dollars. The economy is contracting and this will lead to a lower demand for dollars for the purpose of transactions. Both of these factors unambiguously work to depreciate the dollar. While a reversal of the other two mechanisms is more speculative, consider this question: is it more likely to reverse or to continue the way it is? Put another way: are countries more likely to abandon export-led growth or to redouble their efforts? Are foreign investors and countries more likely to increase US treasury demand above their current level, or to increase their exposure to domestic industries and investments in other countries? I believe that the greater likelihood is that these mechanisms will reverse. Because these mechanisms have the potential to be discontinuous (such as when China abandons its currency peg), I believe that the time frame for a drastic adjustment in the dollar value could be quite short. In fact, I speculate that before the end of 2009, the majority of financial agents will see “the writing on the wall” and that a stampede out of dollars will ensue. Independent of timing, eventually the value of a currency needs to be tied directly to the relative supply of the currency and the relative attractiveness of goods produced by that country. Just as the US has enjoyed the benefits of exogenous factors of demand for its currency (in the form of increased purchasing power, and producing less than it consumes), so must the US suffer through the tax of exogenous factors that lead to the dis-hoarding of its currency.

Fitting the Theory to a Model

2009-03-24T17:11:00.000-07:00

Fitting the Theory to a Model

In 2005, Blanchard, Giavazzi, and Sa (The US Current Account and the Dollar) attempt to quantify the extent of dollar depreciation necessary to achieve equilibrium in the current account. They arrive at the conclusion that this depreciation would need to be on the order of 40-90%. They arrive at this conclusion by estimating that the dollar would need to depreciate by 15% to improve the trade deficit by 1%. At the time (February 2005), the US trade deficit was about 5% of GDP and they calculated payments on the US external net debt at the time to add an additional 1%. Thus, they theorized that the dollar would need to depreciate by 6*15%=90% in order to achieve Current Account Balance. Acting as an offset, valuation effects (due to the increase in dollar value of US owned foreign assets) would make the necessary depreciation only 65%.
A quick word on valuation effects: A tempting argument for our current environment is that we won’t have to worry about interest payments on our net foreign debt because the interest rate on treasuries is so low. Although treasury yields are low, the relevant comparison is to US owned foreign assets, which have seen a large decrease in their principal value. This is what lies behind the deterioration in the net foreign asset position of the US in 2008 (Figure 2). Investors who are getting a small return on their principal are doing better than investors who are getting a small return of their principal! However, (if and) when other asset markets offer an expectation of positive return, then yields on US treasuries will rise commensurately. In addition, I think that if the dollar depreciated to the point that foreigners were being finessed out of 8 trillion dollars in net wealth (through the valuation effect) that this offset would in turn be offset by foreigners demanding incredibly high interest rates on US assets.
Since the paper was written, the trade deficit has actually decreased by approximately 35% or about 2% of GDP. While the dollar has depreciated by roughly 20% versus the Yuan and 10% versus the Yen, the trade weighted exchange rate has actually appreciated by 4% from the time the paper was written. So what could be going on? The theory stated by Blanchard et all implied that the dollar would have to depreciate by approximately 30% to achieve a 2% reduction in the trade deficit as a percent of GDP. The answer lies in further shifts in asset preference toward US assets. This shift occurred to a lesser degree through continued pegging by Saudi Arabia and other large petroleum exporters, and mainly through the panicked rush into treasuries and dollar assets seen in the last 6 months. Before the financial panic started, the value of the dollar had actually decreased against the trade weighted basket by 15%, and the Trade Balance had just started to decrease as a percent of GDP. Thus, the theory that an asset preference shift is wholly responsible for the dollar appreciation is consistent with the statistical facts. Significantly, while a shift in asset preference toward US assets appreciates the dollar in the short run, it causes the eventual steady state of the dollar to decrease still further.
At this point I will find it useful to start referring to a phase diagram (Figure 3). The phase diagram shows the dynamic path of the dollar.

A Movement in Equilibrium or a Shift?
When citizens prefer to invest in their own country’s assets (i.e. home bias and α+α*-1>0), we would expect to associate an increase in net debt with a shift of wealth abroad and a depreciation of the dollar. This is what the equilibrium condition ( dE/dt=0) tells us. However, in spite of a large increase in net debt in 2008, there was a significant appreciation of the dollar. This speaks again to the likelihood that the appreciation was due to a shift in asset preferences, as opposed to a movement in equilibrium.
I refer the reader again to the Blanchard paper for more details on steady state conditions and the more detailed dynamics of the system. However, I will briefly note the three most salient points for my arguments:
1. The stable saddle path runs from the north-west quadrant to the south-east quadrant.
2. Shift in asset preferences toward US assets causes the dE/dt=0 locus to shift to the right causing an immediate appreciation of the dollar and increase in net foreign debt level (in the figure, an increase in "F") of the US. This movement also shifts the equilibrium debt position of the US out (increases) and shifts the equilibrium exchange rate down (further depreciation).
3. Although dE/dt=0 and dF/dt=0 appear linear, they are not linear in the limit, so that in both cases the locus would cross the x-axis only when net debt was infinite. The fact that there is historical precedent for important currencies to reach near worthlessness suggests that in practice, this distinction may be a formality.

In Figure 3 above, we start at a hypothetical equilibrium at point “1”. Each shift out in the asymptote is caused by some mechanism which causes a portfolio shift toward US assets. For simplicity, I model the dF/dt=0 asymptote as stationary; it would be expected to shift under certain conditions such as a change in the US interest rate or a shift in the trade deficit (Blachard, Giavazzi, Sa 2005). I hypothesize a shift from “1” to “2” to be caused by an exogenous increase in the demand for dollars for “transaction liquidity” purposes. In the phase diagram, I then model the dollar as beginning to depreciate and the net debt position beginning to increase as it heads for the equilibrium point at “2a”. Next, I model the “flight to safety trade” trade as a shift to point “3”. Again the currency starts to depreciate toward a new equilibrium. The pegging associated with export-growth strategies is denoted by the shift toward point “4” on the graph. Finally, the asset allocation shift associated with the 2008 financial panic is represented as a shift to point “5”, which is our current position.
I believe that the dynamics of the system are so skewed that the natural dynamic adjustment of the system could lead the dollar to be essentially worthless (point 6a). The path to equilibrium associated with this adjustment is a relatively slow depreciation accompanied by an ever increasing level of the net foreign debt position. Another option that is possible is an immediate and unexpected depreciation of the dollar, which would lead us to point 6b. Since much of the foreign claim to US assets is priced in dollars, a depreciation in dollars simultaneously reduces the net foreign debt of the US. Foreign assets held by US citizens would increase in dollar value, so the net foreign debt position would decrease. Since the level of US borrowing in foreign denominated currency is close to nil, we have the luxury of this possibility. Undoubtedly, taking this path would lead to onerous future terms on debt for the US However, this would be negated by a new level of competitiveness of US industry and the US would naturally run a Current Account surplus. Note that in this case we would shift to the south-east quadrant and the stable saddle path would then lead us to an appreciating currency and lower levels of net debt!
Of note, there are at least two possible ways for arriving at point 6b. One possibility would be for the US to announce its intention to devalue the currency, renounce the role of reserve currency, and suggest a discontinuous change in exchange rates (on the order of 90% depreciation.) A determined and extreme increase of the money supply could discourage competitive devaluation (a first-mover advantage of sorts). The other possibility is the possibility that was presented in the first part of the paper: foreign countries abandon pegs and shift asset preferences back to their own foreign markets. Whether this occurs due to a domestic or foreign decision, the net result is a discontinuous shift back to an equilibrium level of exchange rate that is determined strictly by money supply and production of goods and services.

Conclusion

2009-03-24T17:08:00.000-07:00

Conclusion

In this paper, I have presented three mechanisms that have historically created an exogenous demand for dollars. These mechanisms can be modeled as global asset preference shifts which increase both the debt of the US and appreciate the exchange rate of the dollar in the short run. I suggest reasons for why these mechanisms may reverse and asset preferences will shift back toward foreign assets. I conclude with a discussion of how these mechanisms might be reversed and what their implications would be for the U.S. and the rest of the world.
Neither of these options is attractive, but as a nation and world, we need to be honest about the position in which we find ourselves. Either the dollar will experience a slow but complete devaluation accompanied by eventual bankruptcy of the U.S., or the dollar will experience a quick devaluation (but not to worthlessness), followed by a return to equilibrium. Both options will have an associated level of chaos as the world grapples with a need to find a new way to settle accounts. Both options will lead to some level of default by the U.S., which will increase hostile feelings toward the U.S. However, point “6b” represents the potential for redemption, while point “6a” represents total and complete bankruptcy.

A review of dynamic equations from Blanchard, Filipa, and Sa

2009-03-21T16:18:00.000-07:00

Microsoft Word - Review of Blanchard

Publish at Scribd or explore others: Academic Work reivew of blanchardd

Silver closed in backwardation

2009-03-09T15:03:00.000-07:00

March silver closed one cent higher than May silver; the bid on March silver is now 2 cents higher than May silver.

This is a repeat of a situation that occurred in December when the December contract was going off the board and entities were taking delivery of contracts.

Crude/NG spread has blown out again

2009-03-09T13:28:00.000-07:00

Crude is at 100 day MA, and NG has dropped 3 days in a row. The ratio is 12.25; since NG changes so much with the seasons I keep track of a seasonally adjusted ratio - which is 11 now. This is up from a ratio of 6 in late December, and down from 14 in August. Anyway, I think the ratio is at a maximum, at least locally.

What Do Oil Prices Predict for GDP in 2009?

2009-03-07T17:34:00.000-08:00

Relying on standard regression techniques, I estimate the effect of oil price shocks on GDP. present findings based on both aggregated data from 1970 to present, and disaggregated periods associated with different oil shock events. I find that the oil price increases of 2007-2008 are predictive of a significant underperformance of GDP in 2009 (a rather safe prediction at this juncture!) Specifically, my estimates are that quarterly GDP performance bottoms in 2009q3 at more than 10% below trend; and that GDP for the whole year of 2009 will be almost 7% below trend.

Below I list the magnitude of the shocks (measured in standard deviations of my variable) for the period 2007q4 to 2009q1.

Period	Oil Shock in S.D.
2007q4	2.70
2008q1	1.81
2008q2	5.93
2008q3	2.50
2008q4	-0.33
2009q1*est.	-0.33

Based on a regression of quarterly data from 1970-2008 I found the estimated effects on GDP of a one standard deviation oil shock. I list the estimated effect (based on a best fit analysis of the data) for quarters 1-8 after the shock. These are not the cumulative effects; each represents an effect on a particular quarter.

Quarters after shock	Effect on GDP of a one standard deviation oil shock
1	-0.65%
2	-0.33%
3	-0.91%
4	-1.10%
5	-0.36%
6	-0.31%
7	-0.20%
8	-0.18%

Finally, I list the net predicted effect on GDP in 2009 based on this data:

Period	Predicted effect (quarterly) of the 2007-2008 oil shock on GDP	Year over year predicted effect on trend GDP (trend GDP~3%)
2008q2	-2.2%
2008q3	-7.6%
2008q4	-8.4%
2009q1	-9.2%	-6.9% (2008q2 to 2009q1)
2009q2	-10.1%	-8.8% (2008q3 to 2009q2)
2009q3	-5.3%	-8.2% (2008q4 to 2009q3)
2009q4	-2.1%	-6.7% (2009)

Those who got us into this mess

2009-03-07T16:25:00.001-08:00

There is a popular saying: "those who got us into this mess won't know how to get us out of it."

It is getting to the point now where I'm starting to feel like "those who saw this mess coming, also won't know how to get us out of it!"

First Post

2009-03-07T12:50:00.000-08:00

Hello All,

This blog is intended to provide stimulating outside-the-box analysis of economics and financial markets. The silver lining is a double-entendres because I believe that there is a silver lining to the financial mess that we are in, and I also think that silver is a beautiful and undervalued commodity and monetary medium.

Enjoy!

Matt