The Top 10 Hints of Global Reflation
By Frank Barbera CMT. October 14, 2008
Welcome to the new world of financial uncertainty and topsy-turvy markets. So you thought the stock market was down and out, time to run for cover and exit those IRA and 401K positions. Well, undoubtedly many were surprised by yesterday's strong stock market resurgence. With stocks acting like an elevator with a lunatic at the controls, it is enough to make anyone wonder, what the heck do I do with my money? Should I be in defensive assets like cash and money market funds? Or Should I be looking to invest capital in equities now that the stock market is relatively depressed? These are the daunting questions of the day and these decisions are not easy with much of the world now concerned about fading global growth, and indeed the possibility of a global recession or worse. In order to start making good decisions, perhaps the best approach is to step back and take stock of the larger picture.
Over the last two decades, capitalism was exported to the global stage, and in doing so, began to extend its tentacles forming a web of interlocking relationships. Over time, these inter-country economic relations, all centering on trade and economic growth laid down deep roots. It is today a fact that perhaps never in world history have so many nations been so deeply intertwined. Pulling back from this economic arena for any nation would run steep risks, as there is a very high degree of mutual interdependence. To that end, it is not surprising that the stock markets of the world applauded at least in some fashion the statements issued by the G-7 this weekend which showed a strong resolve to combat the credit market contagion which has seized up the global arteries of lending. Without credit markets moving back to a more normalized condition, the downside risks to a 1929-1932 style Depression will remain very much at hand. Thus, we arrive at the now widely agreed upon need for government intervention to try and stabilize the situation. While we do not disagree with those in the hard money school who argue that free-markets should be left alone and that government intervention may only make the problem worse, the fact is, that when the lives of millions and millions of people are being negatively affected worldwide, government will be on the move, like it or not.
So the question now becomes, just what happens next if the government has any level of success? The answer to that is two words: Monetary Reflation. Consider it an attempt at building a new even bigger pile of debt on top of the now imploding useless pile of debt. Where reflation’s are concerned, the whole ball game ultimately resides on whether or not the new credit instilled into the system actually generates something of productive value, or whether it is bad money poured down a rather non-productive rat hole. In the U.S, the country badly needs a definitive energy policy, something along the lines of the Pickens Plan (www.pickensplan.com) where the US can begin to move away from its towering dependence on foreign oil. “Job One” for the new president come January should be the development and implementation of a new national energy policy that includes the addition of added Refining capacity, more nuclear power, expanding incentives for alternative energy for automobiles, especially those using compressed natural gas (CNG) along with initiatives to promote Solar, Wind and Shale alternatives. Without a coherent strategy on Energy, the US is doomed to wallow economically and faces a lost decade of negative economic growth, widespread and rising unemployment and a forced retreat from the global stage.
Infrastructure spending should also be very high on the domestic ‘to do’ list, repairing aging bridges, building new light rail systems in many cities to improve low cost public transportation, all of which will help put more people to work, and create jobs. What the US does not need are more programs that encourage consumer discretionary spending. For the country to move forward, America must pair down its bad debt, pay off its credit cards, save more and consume less. In short, a modicum of fiscal balance needs to be restored on both the individual and national level.
At the moment, government is engaged in step one of what could be a multi-year turnaround process. This first step is to stop the bleeding and has involved the Federal Reserve and the Treasury stepping into the Financial markets as lender of last resort with the Fed Ballooning its balance sheet. To be sure, this is a potentially perilous step that is being taken, a bridge that once crossed has no path back. Inflating the currency to provide a stop-gap measure against a bad debt implosion had better be followed by intelligent and productive leadership and a lot of global co-operation, otherwise widespread inflation will occur. In fact, inflation on a substantial scale is all but guaranteed as an outcome, however, it is the degree of inflation that is now open for debate. If a very successful set of policies were adopted, it is possible that the US could face a few years of higher inflation, but with the currency surviving and a reasonable portion of the nation's wealth coming through the ordeal still intact.
In every economy there is a delicate balance between the quantity of money in circulation and the quantity of goods and services available. Hold the quantity of goods and services available relatively flat and dramatically expand the supply of paper money and you have a recipe for disaster. What is the old saying, “inflation occurs when you have too much money chasing too few goods” or alternatively, “greatly increased quantities of money chasing the same amount of goods.” Bottom Line: without a very thoughtful approach, a failure at this juncture could quickly lead to massive hyper-inflation, a total destruction of the currency (devaluation) and a total debt repudiation. Of one thing readers can be sure, as the charts below make clear, the US has now crossed this bridge with the Fed balance sheet ballooning in super dramatic fashion.
Above: Step 1 in creating Reflation – Fed Balloons its balance sheet
Thus, looking ahead, we turn to survey the smoking, bombed out landscape to see which assets could be providing useful clues as to the traction of any reflationary campaign.
2. Short Term 90 day T-Bill Rate: This key interest rate is pinned just above zero. The 50 day Rate of Change is collapsing below –10% annualized. The 50 day moving average is at 1.30% and declining sharply. A first indication that the government TARP Plan is working, and that credit is starting to flow, would be to see T-Bill yields rise toward the .50% to .70% zone. Since it should be very difficult for T-Bill rates to sustain this kind of declining rate of change, any kind of normalization in rates would be a sign that the credit markets are at least becoming partially unlocked.
Above: 90 day T-Bills with 50 day Rate of Change (lower clip)
3. The Credit Spreads: It doesn’t matter to a great degree which spread you follow, be it Commercial Paper/T-Bills, or Treasury-EuroDollars (the TED Spread), most credit market quality spreads have exploded to the upside, and need to begin coming in. If confidence cannot be restored, these spreads will continue to remain high, or even widen further. In my view, there is a good chance that Quality spreads will narrow as some of the government aid begins to flow in the days just ahead, that should help underpin financial market confidence even as poor fundamental earnings reports begin to surface in the days ahead. This does not mean that the stock market can’t go back and retest the lows, but a narrowing in quality spreads would suggest that the system as a whole could be taking an important step back from the brink of a larger melt down. So, narrowing credit spreads would be a sign that perhaps a more important low could develop in the weeks ahead where equity markets are concerned.
Above: The Ted Spread
4. Resurgence in Natural Resource Currencies: While it is possible that the phrase “global economic growth” will soon become an oxymoron amid a worldwide economic collapse, at the moment, with a 26% decline in just a few weeks, some of the more important natural resource currencies (Canadian Dollar, Aussie Dollar, Kiwi Dollar) appear priced for Financial Armageddon. Given this kind of massacre, with medium term RSI readings that now read out as once a decade type oversold values, we have to wonder whether or not a sharp bounce isn’t in the cards dead ahead. In our view, a bounce in these currencies would be yet another signal that markets are unwinding their ultra pessimistic “world coming to an end” view and moving back to something perhaps a shade more reasonable. The first step to a successful reflation is a restoration of hope and confidence, right now, the decline in these currencies is a forecast for collapsing final demand, which in our view, looks to be a good deal over done.
Above: Unweighted Natural Resource Currencies – CAD, AUD, KIWI
5. Precious Metals to Base Metals Relative Ratio: The next expansionary economic cycle will be more inflationary then any seen since the very late 1980’s more likely then not. In this vein, it is very likely that commodity bull market leadership will rotate and that smart money will maintain a strong position in precious metals as a hedge against loss of purchasing power. In the last cycle, Base Metals led Precious Metals. In markets that emerge from bear trends and/or deep corrections, there is always a shift in leadership. In our view, this Ratio is shifting already into a Pro-Precious Metals mode, with Base metals likely to play second fiddle over the next few years. In the last few years, Zinc, Tin and Lead outperformed Gold and Silver, now that process will reverse.
Above: Precious Metals to Base Metals Relative Strength Ratio (lower clip) moving up to new highs already. In our view, this is a sign of strength and a sign of things to come.
6. Precious Metal to Base Metal Stocks R/S Ratio: Same logic as Number 5. We see in the chart immediately below, the dramatic decline in Base Metal shares, vulnerable to the global recession/slow down now unfolding. In the second chart, we show Base Metal stocks in the top clip, Precious Metal stocks in the middle, and the Relative Strength Ratio of Precious Metals to Base Metals in the lower clip. This has broken out of a multi-year downtrend and probably suggests a larger change in secular leadership with the bulk of the focus on precious metal miners. This does not mean that Base metal stocks will not recover, but it does suggest that the recovery of precious metal mining shares will be more impressive and that Gold Stocks could move into a leadership mode.
Above: Base Metal Stocks Unweighted, down big time, retracing 50% of prior Bull.
Above: Precious Metals versus Base Metals, the R/S Ratio is rising and suggests that Precious Metal stocks should begin to outperform base metals in any recovery cycle just ahead.
Above: close up view, Relative Strength Ratio of Precious Metals
stocks versus Base Metal stocks.
7. The Emergence of Junior Miners: These stocks have been beaten unmercifully into the ground. Importantly, the collapse in the Juniors led, by many months, the collapse in larger cap names throughout the natural resource world. The emergence of the Credit Contraction severely impacted many of these names which are in some cases, credit dependent in order to finance on going exploration efforts. Of interest, despite the waterfall collapse in recent weeks, these stocks appear to be sold out, and are actually gaining relative strength. That combined with some of the most oversold values on record, could make for an impressive turnaround in the small cap mining segment. A powerful rally in these stocks, would almost certainly suggest that the powers of reflation were gaining traction over the powers of deflation, which for the time being continue to prevail.
Above: FSO Junior Mining Index with the McClellan Summation Index,
as oversold as we have on record.
Above: Gold Stocks relative to Gold, an overlay showing Gold Stocks (in general) very depressed relative to physical metal, gold stocks have a very good nose for sniffing out reflation.
Above: Importantly, this Ratio, the Relative Strength of Juniors to Seniors has NOT been making new lows, this despite a stock market collapse. A sign of a sold out market? Maybe.
8. Gold to Silver Ratio: While Gold prices are likely to be a bell-wether investment for a reflationary cycle, the price of Silver will be the real super star. With public perception focused on the industrial side of Silver, Silver prices have fallen much more radically then Gold during the recent turmoil. If reflation is gaining traction, Silver stands to become a prime benefit. In our view, the downside risks to Silver from a slow down in Industrial demand are being vastly overweighted at the current time, with Silver in tight supply and the forward production curve in serious question. Silver should produced ultra leveraged returns in the next advancing cycle and the Gold to Silver Ratio, now at the high of the range, should soon begin to narrow. Our nominee for investment idea of the next decade, Silver could indeed be “the restless metal” poised to move explosively higher.
Above: the Gold to Silver Ratio now in the high 70 to low 80 range. Peaking ?
9. Bond Yields: Our nominee for “Biggest Loser” in the next decade, long term government bonds. Last week, yields were unable to move lower amid a stock market crash, and have subsequently spiked higher even with the US Dollar relatively stable. If that doesn’t speak to the situation that is over taking the bond market then we don’t know what will. Bonds are moving into a bear market, with the 10 Year yield just under the 200 day moving average. A move above 3.89% and things will get uglier still for these Certificates of Guaranteed Confiscation.
Above: 10 Year Bond Yields with 200 day average
10. Emerging Market Currencies: Finally, in tandem with the theme shown earlier of Natural Resource Currencies, we would add in a note to watch for a recovery in Emerging Market Bond Funds that have been badly hit in recent days. Many of the currencies that underpin the mutual funds in this sector, including Korean Won, Mexican Peso, Turkish Lira, Russian Ruble are ultra oversold, and a recovery in this area would suggest that confidence is being restored.
Above: Emerging Market Bonds
That’s all for now,
© 2008 Frank Barbera