• Home ::
• Fundamental ::
• Market View

• Send
• Print
• Add To
• Rss

Insights Market Outlook(ERROR!! ACTUALIZAR EN MERK INSIGHTS)

This report has been deactivated

Pearls Before Swine – Perils of Free Money

Thu, Apr 30 2009, 15:22 GMT
by Axel Merk

Merk Hard Currency Fund

The swine flu could not have come at a worse time. Just when there were signs of a nascent recovery, confidence takes another hit. As a result, “reflation trades” may be put on ice if investors revert to “panic mode” again. While it is difficult to assess the full economic impact of the swine flu, we believe some of the dynamics are foreshadowed. This flu may reinforce long-term trends and provide an opportunity for investors to position themselves accordingly.

Trade and travel has already been impacted. However, some regions in the world may be better prepared than others. Asia in particular, due to its experience with the bird flu (avian flu or SARS virus) in 2003, has processes in place that allow them to slow the spread of any potential pandemic far better now. Amongst others, airports in many Asian cities scan body temperatures to identify passengers with fever. Such measures will not prevent a virus from spreading, but reduces panic and the feeling of helplessness – key factors in contributing to overall individual and business risk appetite. Similarly, the U.S. and Europe have substantially improved their alert systems and coordination. In California, as a neighbor to Mexico, the continuous threat of earthquakes provides for a culture of coordination and cooperation at various levels of government and emergency services. Conversely, however, Mexico may not be as well prepared to deal with the swine flu.

Some experts say that no matter how severe the flu will be, it is quite likely going to follow seasonal flu patterns. If this forecast comes to pass, it may be to the detriment of the Southern Hemisphere as the flu season is coming to an end in the North. Tourism and trade is likely to be affected all over the world, but the perception of the level of preparedness and actions in different regions may affect which regions will fare better or worse as the extent of the virus evolves.

To get the world out of the financial crisis, governments around the world want to get credit flowing again. The outbreak of the swine flu is yet another headwind policymakers have to deal with. Even if the evolution of this flu is unclear, it is a fair assumption that policymakers will attempt to alleviate its impact nonetheless. In the eyes of the Federal Reserve (Fed), it may be yet another catalyst to keep the floodgates of money supply open. We would caution with so much latent inflationary pressure in the system already, such action may only serve to compound future economic ramifications. Hence our title: the Fed may be creating significant unintended consequences via its market interventions.

Similarly, (and while we cannot know this for certain) odds are that we will get through the swine flu relatively unscathed. This is not to belittle the risk – indeed, it may be only a matter of time until the world faces a truly devastating pandemic. From our initial assessment, the swine flu will be a wake up call to further improve preparedness everywhere in the world, but may not transpire to be as detrimental as some may think. It is our view that we have more to fear from the long-term inflationary impact of the Fed’s printing of money to pay for government spending than the flu.

In a recent commentary published in the Financial Times, we argued that “rather than curing the patient, present initiatives may be over-prescribing the patient with medication that causes significant side effects.” The U.S. economy has been sick for some time and our reference referred to monetary and fiscal policy, not the reaction to the swine flu. We are now not only concerned that the seeds of inflation will bear fruit, but that this latest scare may provide the Fed and government with additional impetus to further drive up the level of inflationary pressure in the system. Cynically (and we in no way want to trivialize the risk), at least policy makers now have a scapegoat in the flu if policies to jumpstart the economy do not pan out.

In our assessment, the dollar rally may be short-lived as the world starts to cope with the realities of the swine flu. Investors may want to consider whether gold, hard or Asian currency components may provide valuable diversification to their portfolios. 

Watch the video for the report in Youtube

Published on  Thu, Apr 30 2009, 15:22 GMT

(Un)Intended Consequences: Uncertainty, Inflation & Inflexibility

Tue, Apr 21 2009, 08:58 GMT
by Axel Merk

Merk Hard Currency Fund

Present policies may be sowing the seeds for the next financial crisis. Despite recent market optimism, we believe present interventions could produce significant future adverse and unintended consequences. Rather than curing the patient, the present initiatives may be overprescribing the patient with medication that cause significant side effects (and leave a bad taste in the mouth).

Prior steps taken by policy makers and central banks seem to have by and large succeeded in stabilizing financial institutions and avoiding a disorderly collapse in markets around the globe. That said, we take great issue with the continued level of intervention in the markets and the “spend at any cost” mindset that appears to predominate Washington and the Federal Reserve (Fed). In our minds, much of the present policies and initiatives, while well intentioned, will have significant unintended consequences and only serve to cause further dilemmas down the road.

Bad Businesses Saved at the Expense of Good Incentives are sorely needed that reward responsible, efficient businesses, not policies that restrict them. In our opinion, present policies are inefficient and likely to foster a deterioration of “good” business models, a situation that may, in itself, precipitate further government spending to get the private sector functioning properly again. Intuitively, if we know the government will intervene regardless when an economy enters a downturn or recession, one would think the government would like resources to be re-allocated from inefficient market participants to more efficient ones. Indeed, efficient markets ensure that in most economic downturns strong businesses tend to strengthen their industry position while weaker, less efficient players fall to the wayside. Yet there are many situations where we see the exact opposite currently taking place.

In Berkshire Hathaway Inc.’s annual letter to shareholders, Warren Buffet bemoans the implications of government intervention within Berkshire’s competitive landscape. He notes that, perversely, those entities that receive government funding are at a distinct funding advantage over higher credit-rated businesses that did not. It appears we are now in a world where bad business models are rewarded with cheap government funding at the expense of those good businesses that never undertook the risky investment decisions their now-bailed-out counterparts did. By not relying on government funding, these “good” businesses now must raise capital in a risk-averse marketplace, where much of the liquidity has fled to “safe” government bonds and T-bills. As a consequence, these businesses are subject to much higher funding costs than those that receive government funding. To many, it is deplorable that bad business models should be saved at the expense of good businesses, but this is just one unintended consequence of present policies.

Uncertainty Breeds Heightened Risk Aversion These unintended consequences create a heightened level of uncertainty in the marketplace that does not foster investment. Combined with a lack of clarity from the present Administration, it is no surprise that many investors seem to abstain: which industry is next to receive preferential treatment; which will suffer; who is next to be bailed out; which accounting standard is next to be reversed; what are the tax implications of such unprecedented spending?... the list goes on. Without clarity, investors become risk-averse, curtailing investment and reinforcing any downturn. Yet the lack of clarity provided by the Administration is pervasive. Just observe any of their recent news conferences – call us cynical, but all we seem to hear is “we’re going to do this; we’re going to do that” with no definitive explanation of what “this” or “that” actually is. More often than not, “this” or “that” is followed by rousing applause (almost appearing as if this were a queued applause track, or if some cryptic meaning were imbedded in the text that we’re not aware of). A classic is the perpetual reiteration that “we’ll go through the budget line-by-line”. Despite the lack of substance one thing seems crystal clear: the government is going to spend, whatever the cost. The problem is that “whatever the cost” quite rightfully scares the hell out of many, ourselves included, because “the cost” may transpire to be much higher than anticipated.

Not only are the government’s intended actions unclear, but many policies quite simply don’t make sense to us. Take the relaxation of mark-to-market accounting rules. Many financial institutions have been criticized (and quite rightfully so) for the opaqueness of their balance sheets; the lack of transparency being a key factor in creating risk-aversion amongst investors. With low confidence in financial institutions prevalent throughout the marketplace, one would think it counterintuitive to allow these firms to lie about the true value of their holdings (perhaps lie is too strong a word – mislead, stretch the truth, “guess-timate”). Yet, ironically, the government now allows this opaqueness to proliferate through the relaxation of mark-to-market accounting rules.

Inflation and Inflexibility Given that the Fed’s printing press has been working overtime, there has been a lot of foreboding talk around pent up inflationary pressures recently. The threat of inflation is definitely front of mind for us, but more worrying is the idea that the Fed may actually want to induce inflation, and moreover, should inflation break out, the Fed may be incapable of reining it in, in-light of its present initiatives.

Many consider Fed Chairman Bernanke’s speeches, publications and testimonies in Congress to be critical of the Fed’s actions in being too hesitant to allow inflation during the Great Depression. Indeed, Bernanke and the Fed may wish for inflation today. Inflation bails out those with debt, and by any measure U.S. consumers are saddled with it. We have touched on this topic before (please see our prior newsletters “Bailout Economics – Politics of Self Destruction” and “Reflation Investing – Which Currencies Benefit”). Suffice to say, in our assessment, this would be a very dangerous route for the Fed to embark on. Should a rise in inflation happen to be greater than anticipated, we believe the Fed’s present initiatives will severely hamstring its ability to mitigate it.

The Fed’s announcement to purchase as much as $1.25 trillion dollars of agency mortgage-backed securities (MBS) not only creates significant latent inflationary pressure (to put the massive size of this program into context, the total size of the Fed’s balance sheet before the crisis began was approximately $870 billion), but also inherently creates an unprecedented level of inflexibility at the Fed. Should the level of inflation exceed expectations, we are concerned that the very purchase of MBS assets may render the Fed incapacitated in addressing such a situation. As opposed to traditional Fed purchases (and most recent initiatives), MBS assets are relatively illiquid and much longer-term. Hence the Fed will find it very difficult to unwind the positions it is presently building, not to mention the fact it has pledged to hold them until maturity. As such, we have growing concerns that the Fed will have its hands tied should inflation break out – especially if the rapidity of accretion is extreme – it seems unlikely the Fed could significantly tighten monetary policy without causing yet another collapse in economic spending, while large-scale sales of these assets may drive yields up, hampering a recovery in the housing market.

Another consequence of the Fed buying Treasury Bonds and agency securities is that the prices of these securities, in our opinion, no longer reflect free market dynamics. As a result, rational buyers may consider these securities overvalued and reduce their appetite to buy them. If foreign buying is reduced as a result of the Fed’s interference in the markets, it may have negative implications for the U.S. dollar. This threat does not only apply to foreign buyers. At a recent conference of institutional foreign exchange traders we attended, there was a discussion that U.S. based investors are increasingly seeking to protect against U.S. dollar currency risk. If U.S. investors progressively move assets abroad, that may obviously also have negative implications for the U.S. dollar.

We believe present actions create more questions than answers. While we don’t have a crystal ball, all these initiatives make us rather concerned about the future state of the U.S. economy. Present policies may very well portend the next financial crisis…

Published on  Tue, Apr 21 2009, 08:58 GMT

Bailout Economics: Politics of Self Destruction

Tue, Mar 31 2009, 14:17 GMT
by Axel Merk

Merk Hard Currency Fund

The patchwork of attempts to prop up the financial system has taken on a life of its own – we call it bailout economics. At every step, Adam Smith’s “invisible hand” to guide the economy has become less evident. Back in the 18th century, the economist coined the term as a metaphor for the self-regulating nature of free markets. Economic booms and busts are as old as mankind, but each time a crisis occurs, policy makers want to ensure that the same disaster will never happen again. Most of the time, instead of fixing crises, policy makers place the seeds for even greater problems down the road. Others argue the government must not do anything and let the free market take care of things entirely; however, it is important to note that we don’t start with a vacuum: we have a complex set of regulations and taxes that influence market behavior. If we are going to change the rules, we must ensure we don’t throw out the baby with the bathwater to preserve the benefits of capitalism.

Much of the public outrage is a result of the privatization of gains and socialization of losses. An executive or hedge fund manager makes a lot of money while risky bets pay off, but if bets turn sour and the firm goes bust, he or she walks away with the mess left behind. A libertarian would argue that those who provided capital or credit only have themselves to blame; after all, they were greedy and took a gamble with the executive. But what happens when this executive works for a public company and shareholders have little influence over the compensation packages? One could argue not to invest in this particular firm, but rather another; but what if there is a culture of compensation prevalent throughout a vast number of firms that, in retrospect, look like management was out to raid the firm? What if management raises the stakes so high to be able to blackmail governments into bailouts?

Risk essential to capitalism

As much as many despise the excesses of it, risk taking is essential to economic growth and prosperity. Without risk taking, investments would not take place. Investment decisions are typically a function of confidence that a reward may be achieved at a level of risk within the comfort zone of the investor; this is not limited to stock market investors, but extends to any form of risk taking, including whether to launch a new business or extend a loan. Confidence is a function not just about the potential revenue and expenses of an investment, but also the certainty over these; they are influenced not only by free market forces, but also by government taxes, regulations and changes in policy.

The reason China’s savings rate is so high is not simply because the government hasn’t handed out credit cards en masse, but foremost because of a lack of investment opportunities. Those with money won’t invest if they are discouraged because of excessive or unpredictable taxation; excessive or unpredictable regulation; or a weak legal system where contracts cannot be enforced. While China still has a long road ahead, the Chinese have been working hard to improve the country’s investment climate, not just for foreign investments, but also for domestic entrepreneurs. Building trust takes many years; it can be destroyed very quickly.

We don’t necessarily need low taxes and regulations to foster investments, but clarity on taxation and regulation. California has been able to attract a lot of investment over the years despite high taxes and a high regulatory burden; the same applies to Europe where many companies thrive despite a high cost of doing business. At the same time, one can never take investor confidence for granted, but one must earn it at all times – this applies to individuals and governments alike.

Limited liability fosters risk taking

Essential components to foster risk taking are the ability to “walk away”, be that from a house with a non-recourse mortgage by mailing the key to the bank; or by declaring bankruptcy. Taking advantage of these “circuit breakers” rightfully ruins the credit history of those taking advantage of them. However, that doesn’t necessarily stop someone discredited from raising money once again: take John Meriwether, whose Long Term Capital Management hedge fund required a government bailout in 1998. Mr. Meriwether was able to raise money for a new fund, only to once again run into trouble in the most recent credit crisis. This does not mean we endorse running away from a contract or allowing a court outside of bankruptcy proceedings to change the terms on mortgages. In most of the private sector, chapter 11 bankruptcy is required to be able to renegotiate contracts at a tremendous cost to equity holders; in the banking sector, insolvent institutions may be seized by the FDIC. Those are established processes that have matured over 200 years. If those processes are not followed – say the government decides that a court can change the terms of a mortgage because it would otherwise cause hardship on the homeowner – all home owners will have a higher cost of borrowing because the risk of random government intervention will now have to be priced in; it’s a risk that’s far more difficult to price than credit risk. In our view, banks will only issue mortgages in such an environment if they are willing to carry the mortgages on their books, i.e. they may not be able to sell them off. While some argue that the securitized mortgage market has some flaws, killing off the market entirely is not the way to fix the shortcomings as fewer mortgages at higher costs result.

Failure must not be rewarded

What doesn’t work is to reward failure. Taking money from prudent people to give it to the imprudent is a recipe for disaster; or, as the outgoing president of the European Union stated, will put the U.S. on a “road to hell.” There are about 8,000 banks in the U.S., most of them sound; however, the government is propping up the largest banks, injecting hundreds of billions of dollars in capital and guarantees. Warren Buffett laments in his letter to shareholders that he cannot compete with businesses that receive government subsidies. The government is not encouraging private sector activity, but replacing private sector activity.

The same applies to homeowners: money is moving from strong hands to weak hands. Worse still, massive subsidies prevent home prices to reflect the purchasing power of buyers. Homeowners who cannot afford their present home are best served by downsizing to a home they can afford. Not only is the re-failure rate of those who get relief on their mortgages very high, homeowners may become slaves of their homes as they are likely to perpetually struggle to make payments and won’t have the cash flow for larger expenditures that come with home ownership. If such homeowners downsize, however, they can start rebuilding equity and may eventually be able to afford a larger home.

Work with the market forces, not against them

The cost of the bailouts is staggering, amongst others, because the government is fighting market forces. In the end, however, you cannot print wealth, only currency. When you print money, you destroy a fundamental attribute of currency, namely that it is supposed to be a store of value. If currency is nothing but a government imposed medium of exchange, a flight to hard assets, including gold, may accelerate. Great Inflation may be upon us as both fiscal and monetary policies are forceful, but ineffective. Policies are ineffective because they prevent prices from reaching a market based equilibrium; because the stimulus package is mostly a spending package that is foremost expensive, but otherwise has mixed signals; because money is taken from strong hands to prop up weak hands – be that consumers of financial institutions; because policies remain without clear direction and change unpredictably; because policies don’t encourage more sustainable consumer spending; because, in our assessment, the Fed has no exit strategy that is viable – it seems impossible to us the Fed could tighten monetary policy if and when inflation breaks out without causing yet another collapse in economic spending; and finally, the Fed – in our view – wants to have inflation as inflation bails out those with debt. By inducing inflation, fewer homeowners will be “under water” on their mortgages, possibly providing relief. It’s a dangerous road to proceed on, and, moreover, runs against the mandate of the Fed.

By the way, when Congressman Ron Paul recently asked Fed Chair Bernanke whether the Fed extends the bust cycles, the Fed Chair responded that the Federal Reserve was created to smoothen the business cycle. Pressed again to clarify whether it wouldn’t be preferable to have a short and painful bust followed by more growth, Bernanke did not disagree, but said that it is his job to follow the Fed’s mandate.

Initiatives for a more sustainable future

So far, all Congress has been able to come up with are policies to destroy even more wealth or well-intended policies that cause unintended consequences. For the sake of not only the U.S., but the world, we have to move away from bailout economics, from the politics of self-destruction. We don’t have all the answers, but what is needed is a discussion that focuses on setting the right incentives.

Some of the key concerns policy makers have is that institutions may be using too much leverage; that their failure may cause uncontrollable ripple effects; that executives do not act in the long-term interest of shareholders. Let us try to address these issues constructively. As we discussed earlier, risk taking is an essential ingredient to achieve a higher standard of living; when used prudently, leverage can be beneficial. To provide incentives, we put forward a couple of proposals:

• Employ tax policy to make leverage less attractive. Merk’s Senior Economic Adviser and former President of the St. Louis Federal Reserve William Poole has proposed to eliminate the tax deductibility of interest (for business an individuals) and in return cut the corporate income tax in half. Using 2005 IRS data, this would be approximately revenue neutral for the government. Such a change could be phased in over time.
•  Move derivatives onto regulated exchanges whenever possible. Regulated exchanges do not prevent participants from employing substantial leverage, but they ensure there are no systemic risks if a party fails. Derivatives on a regulated exchange are marked to market every day: each party has to post collateral for any contract and that collateral is adjusted on a daily basis depending on market values. Even if a position was ultimately profitable, a participant could get wiped out if during the course of the contract the value showed a substantial loss if closed prematurely. The point here is precisely that institutions must be careful in how much leverage they undertake if regulations require them to post sufficient collateral during the course of the entire contract. Compare this with the status quo: institutions argue that theoretical models about future cash flows are sufficient to calculate the value of derivatives held.
• In many cases, especially for legacy positions, it may not be possible to move derivatives onto an exchange. But instead of relying on a model based on future cash flows, the regulator could insist that firms rely on estimates of current market values and post collateral accordingly with their counterparties. Berkshire Hathaway, Warren Buffet’s conglomerate, has always stressed how they avoid engaging in contracts that require the posting of collateral. The firm has always relied on its reputation; however, rating agencies have started to downgrade the debt of even this giant. The point, again, is to provide an incentive for firms to use less leverage. Already the business model of many firms is broken as they rely on huge leverage with low cost of financing. There’s a cost associated with moving towards a world that relies less on leverage.

Before going any further, policy makers should abandon their attempts to persuade failed institutions to increase their lending. If policy makers want to have institutions increase their lending, healthy institutions should do so, not bad ones. The government sponsored entities Fannie Mae and Freddie Mac must be phased out. Providing subsidy to home ownership makes home prices more expensive and, as a result, less affordable to subsequent buyers. It’s a slow-motion Ponzi-scheme that initiated in the 1930s and blew up last year; the solution is not for the government to force them to increase their lending. Further, large financial institutions must be dismembered, not propped up. To avoid disruptions to the markets, one can look across the Atlantic at the ECB; the ECB has provided unlimited liquidity to the banking system. Such a scheme may produce “zombie banks” – banks that are technically insolvent, but remain afloat. Similarly, one can keep failed large institutions afloat to allow an orderly dismembering. The government indeed tries to encourage institutions to sell off healthy businesses, but does so while micro-managing these firms – we may have only seen the beginning of the political fallout of this approach. Everyone should realize the government must disengage from these institutions as soon as possible. The current path does not achieve this. One more market-based approach is to require healthy capital ratios, then force the bank to raise money or shrink. To make this work, however, there must be the political will to allow these institutions to shrink. Policy makers should not focus on these institutions issuing fewer loans as a result, but instead should focus on incentives for healthy institutions to fill the gap (note that, in our assessment, Fannie and Freddie are not part of the club of healthy institutions).

Board Reform

Boards must be held accountable. The outrage at AIG is directed at employees, whereas it should be directed at the board that hired an executive team that allowed the firm to be run into the ground and is ultimately responsible for compensation packages. How about requiring firms with over $x billion in revenue – whatever number determines a “systemically important firm” – to have a Chief Risk Officer report directly to the board, not the CEO or COO. Many financial firms already have a Chief Compliance Officer that reports directly to the board and it could be an integrated role. The function of this officer would be to ensure that the firm adheres to the risk management plan as approved by the board. There may be no need for the government to restrict the types of risks a firm may take, but a board should approve and supervise processes based on best practices. The risk management guidelines should be publicly available to allow shareholders and other stakeholders to have another tool to gauge the riskiness of a firm. A standardized summary report would also be helpful.

We can improve the system without imposing undue burden or stifling innovation. However, one must return to a system where the risk manager can ax a product and not be overruled by a hotshot money maker – in the “old days” until the early ‘90s, the general counsel in an investment bank was in many ways more powerful than the bankers, as he or she could veto projects that jeopardized the franchise of a firm. We must return to a more sustainable model and the above is one proposal. There may be others, possibly better ones, but policy makers must start to earn their salaries by coming up with constructive, not destructive proposals.

Executive compensation will, without a doubt, also need reform. One of the unintended consequences of the Clinton administration’s imposition of an additional tax on incomes over $1 million was the explosive growth of options being awarded. In our view, tax policy can be used to provide incentives to improve incentives. Tax-incentives can be provided to encourage boards to make compensation based on long-term performance. This isn’t always easy at the top executive level as any board hiring an executive from another firm tends to match the value of a compensation package the person is leaving behind. We would like to encourage policy makers not to come to hasty decisions and consider the consequences of any actions before implementing them.

Taxation of capital

Capital should be made more attractive relative to debt; reducing the deductibility of interest expense as discussed earlier is a step in that direction. Shareholders should not be taken for a ride by boards. In our view, policy makers should consider outlawing the re-pricing of options awarded in the past. A firm should award new options if it wants to do so, but rewarding past failure is not in the interest of shareholders. Instead, if firms want to award options, they should consider awarding a modest amount on a monthly basis; the cost averaging would reduce the incentive to change terms retro-actively.

To strengthen shareholders further, policy makers should provide firms with incentives to make dividend payments rather than to buy back their own shares. As the meltdown in the stock market has shown, only a dividend that is distributed is cash an investor can use to re-deploy. Share buybacks may have their place, but, ultimately, a company’s value is dependent on the cash returned to the shareholders, not the currency of a stock price a company can gamble with. Reducing or even eliminating the taxation of dividends would go a long way in encouraging investments in firms that create value.

Beyond that, there is a call for the streamlining of regulation. By all means, let us consolidate regulations, but do not create yet another regulator. Moreover, do not give the government the power to seize non-bank institutions that are “systemically important” – that’s a power you would expect the Soviet Union to have, not the United States. Instead, provide incentives for more prudent risk management. The next boom and bust will happen – but we don’t need to give up all free market principles for the illusion of safety.

In an upcoming analysis, we will expand on the discussion on what governments and individuals can do to seek more sustainable wealth; we believe any reform should focus on incentives: let the free market, not government credit facilities decide where the money flows. We will also resume our discussion on how the U.S. dollar and other currencies may develop as the dynamics amongst policy makers around the globe plays out. We already discussed whether there are any hard currencies left; potential depression currency plays; as well as who may benefit as the world tries to reflate.

Published on  Tue, Mar 31 2009, 14:17 GMT

Reflation Investing – Which Currencies Benefit?

Thu, Mar 19 2009, 08:02 GMT
by Axel Merk

Merk Hard Currency Fund

Reflation refers to policy makers’ attempts to “reflate” the economy, to prop up what many would consider a broken system. Federal Reserve (Fed) Chairman Ben Bernanke made it very clear in his March 15 interview on 60 Minutes that he will attempt to stem the tide of market forces:

Question: “Are you committing, in this interview, that you are not going to let any of these banks fail? That no matter what their balance sheets actually look like, they are not going to fail?”

Bernanke: “They are not going to fail”

Bondholders around the world rejoice: the debt of Citi and AIG may now be as good as U.S. government debt (the inverse of this does not sound particularly enthusing however: that U.S. government debt may now be as good as that of Citi and AIG).

Here’s a brief lesson on the law of unintended consequences: if you rule out failure as an option, your negotiating power is greatly diminished. Take the automotive industry: last fall, politicians touted that bankruptcy was not an option. Unsurprisingly, neither bondholders nor labor unions were willing to give major concessions. However once bankruptcy became an openly discussed option, suddenly all stakeholders became much more flexible. Similarly, why would Goldman Sachs accept cents on the dollar on any outstanding contracts with AIG as the counter-party, if its liabilities appear guaranteed?

Like so many of the initiatives taken with the best of intentions, they slow down any recovery. Another example is the administration’s “stimulus plan.” The only thing clear about the plan is that it is going to be expensive; because taxes and the governments’ cost of borrowing may go up, the impact on the economy will be dampened. There are also conflicting messages, such as bailouts for home owners on the one hand, but reduced mortgage deductibility on the other hand. Ultimately, home prices continue to be out of line with incomes of potential buyers and government price controls masqueraded as interest rate subsidies or bailouts do not get to the heart of the problem. You also don’t fix the banking system by keeping bad banks afloat, but by dismantling them to create good banks.

For those interested in our analysis of what happens if things turn sour, please read our recent analysis on “Depression Investing – Which Currencies to Hide In?” Today, however, we look at the likely scenario that at some point, some of the vast amounts of money thrown at the system will stick. Because of the inefficiencies of the policies employed, it will take longer for the money to stick, but at some point banks may be fed up sitting on what is currently over $600 billion in excess reserves – that’s money literally thrown at the banks by the Fed, but not used to make loans, either because the banks don’t trust their own balance sheets; or they don’t trust their clients balance sheets; or potential clients are not interested in taking out loans. While excess reserves are an important barometer of the Fed’s attempts to get the banks to lend, another measure we monitor is required reserves. Required reserves are reserves that banks need to keep based on deposits held; however, someone’s loan is someone else’s deposit, thus an uptick in required reserves is an indication of increased economic activity. Required reserves have grown from a little over $40 billion last summer to $60 billion in January, before falling back a little in February.

Last October, there was a serious threat of a disorderly collapse of the financial system. Governments around the world rushed to guarantee the banking system. According to Bernanke, the guarantee of the banking system was one of two important steps taken during the Roosevelt administration to get out of the Great Depression. The second step, Bernanke has emphasized in the past, was to devalue the dollar by going off the gold standard. Devaluing the currency allows prices to float higher, bailing out those with debt. Indeed, Bernanke is already working on weakening the dollar: as the Fed buys those securities that foreigners traditionally buy, foreigners are discouraged from making new purchases in these as they are now intentionally overvalued. Specifically, foreigners traditionally buy agency securities (those for Fannie Mae and Freddie Mac) and government bonds; the Fed has been an active buyer in the former and announced it will increase its purchase activities of the latter.

In our view, the U.S. will be a leader when it comes to trying to reflate the economy. Germany in particular has rebuffed efforts by the U.S. administration to commit to spending 2% of Gross Domestic Product (GDP) on a stimulus plan, saying the markets need confidence, not spending. Export driven economies all welcome spending packages, but rely on the U.S. to do much of the heavy lifting. The argument is similar: if the U.S. does not want GM to fail, why should Germany provide capital to Opel, a large employer and subsidiary of GM in Germany – especially since GM has raided the cash from profitable foreign subsidiaries. It almost looks like the U.S. is trying to bail out the entire world. Conversely, resentment in the U.S. is growing against foreign institutions benefiting from U.S. bailout plans.

What does all this mean for investors and currencies in particular? We know that a lot of money is being spent; and we believe that this money is not being spent very efficiently. We also believe the business models of many companies, especially financial institutions, are broken. As a result, we do not see a quick recovery in lending, earnings or hiring. But we are printing all this money, so where does it go?

Some may conclude that as the world reflates, export oriented economies will benefit the most. We caution against making this conclusion as access to credit will continue to be tight – if nothing else, the almost $3 trillion in debt raised by the U.S. government this year is money not available to weaker sovereign countries (or the private sector in the U.S. and abroad); we also expect a recovery in consumer spending to lag the expectations of many. As a result, we continue to caution about currencies of weaker countries in Eastern Europe, Asia and Latin America.

Will the U.S. dollar benefit? Bernanke’s view that currency devaluation may be beneficial to economic growth speaks for itself. But even if there are no active efforts to debase the currency, we are cautious about the U.S. dollar. That’s because we simply do not see a viable exit strategy to all the money that is being thrown at the system. Some of the Fed’s programs can be phased out, but not all. In our view, the Fed may never be able to sell some of the mortgage backed securities (MBS) it has acquired and continues to acquire at a rate of tens of billions a month. Importantly, because we do not see any efforts to put policies in place that encourage consumers to reduce their debt but instead provide cheap money to keep consumers’ leveraged to the hilt, we do not see how interest rates can be raised if and when inflation breaks out. Quite the contrary, we believe the Fed may welcome inflation, as inflation bails out those with debt and allows home prices to rise; or, at the very least, to have the relative prices of homes become less expensive as the general price level rises. This is a policy fraught with many risks.

Not surprisingly, gold has been a main beneficiary of the trends we see. Because industrial activity is likely to lag in this “recovery,” gold being a precious metal with low industrial use, is a barometer of the money being printed. As reflationary efforts take hold, the money is likely to flow to other commodities – we see trends of that already - before possibly reaching corporate earnings. The Australian dollar is highly correlated with the price of gold; we like the Australian dollar as a reflation play because the Australian economy is highly sensitive to the price of commodities; Australia is also a large exporter of commodities to China, the one country that can afford its stimulus plan. Australia is fiscally in much better shape than the U.S., although it also has a high current account deficit. That current account deficit worked against the Australian dollar when commodity prices imploded, but may cause the Australian dollar to have a more pronounced upward move as the world reflates. We like Australia’s smaller neighbor New Zealand, especially because the government there has had much more of a hands off approach to the global crisis; as a result, similar to Australia, the New Zealand dollar was harder hit during the downturn, but may benefit at an above average rate in a reflationary phase.

The Canadian dollar may also benefit from the reflation trend. We would like to caution, however, that we underestimated the vulnerability of Canada to the U.S. economy. Canada has shown restraint in its aid to the banking sector, it has a commodity-oriented economy and has shown fiscal discipline in the past. However, recent moves by the Bank of Canada to consider printing money need to be monitored closely.

In an upcoming analysis, we will discuss Asian currencies and the Chinese yuan in more detail. In recent weeks, we discussed whether there are any hard currencies left; and the shifting landscape of depression currency plays.

Published on  Thu, Mar 19 2009, 08:02 GMT

Depression Investing – Which Currencies to Hide in?

Tue, Mar 10 2009, 13:51 GMT
by Axel Merk

Merk Hard Currency Fund

The world’s a mess and in our eyes policy makers are inadvertently doing their best to worsen a bad situation. Let’s assume you’ve had it and want to hide somewhere safe to ride out the storm. Unfortunately there appears to be no such thing as a safe asset anymore. Therefore you may want to consider taking a diversified approach to something as mundane as cash. Sure, U.S. Treasury Bills are the one “safe” asset – at least by regulation. But will Treasury Bills retain their purchasing power as the U.S. government raises almost $3 trillion in the debt markets this year? As the debt to be raised is going to be in the range of 12% - 15% of GDP (some estimates the Treasury Department take seriously go as high as 18% of GDP), increased U.S. savings simply won’t be enough to fund the shortfall.

Let’s consider the potential outcomes:

• Those loaning money to the U.S. could be rewarded by higher interest rates, but this would mean long-term interest rates would need to rise; – something the Federal Reserve (Fed) does not want because of the negative impact on growth.
• The Federal Reserve could print the money and buy up Treasury Bonds. This may keep the cost of borrowing low, but likely weaken the U.S. dollar substantially. In our view, this is the Fed’s preferred scenario; in his testimony to Congress, Fed Chairman Bernanke reiterated his view that the most important steps to get out of the Great Depression were guarantees on bank deposits and the devaluation of the dollar. The banking system has been guaranteed this time around, but the dollar has not yet devalued.
  
• A crowding out of private sector investments may also allow the financing of all the debt that needs to be issued. Basically, the $3 trillion to be raised is money not available to the corporate sector – or the states – or municipalities – or other sovereign countries. It is very difficult for anyone but the government to raise money. Indeed, Warren Buffett in his annual letter to shareholders, points out that the cost of borrowing for his AAA rated enterprise is higher than for broken businesses that have received government support through implicit or explicit government guarantees. The government with all its well-intended efforts is destroying healthy companies, substituting rather than encouraging private sector participation.

You would think that gold is the place to hide with so much money being printed. Yet despite the immense amounts being “thrown at the system”, the inefficiency of the policies themselves makes little of the money stick. The administration’s spending package includes bailouts for some homeowners, yet a reduction in the tax deductibility for others. Does the government want higher or lower home prices? Similarly, the government is pulling the rug from under Sallie-Mae, the agency in charge of providing student loans, presumably because the system is to be replaced with a different, grant-based system; is that new system up and running or are we simply taking away a source of funding for students? This isn’t about arguing which of these programs are good or bad, but to highlight that it is extremely difficult to make investment decisions when you don’t know what the policy is.

There are many other conflicting ideas in the spending program; in the end, there is only one clear message: if you make a lot of money, your taxes will go up. Importantly, there are no investment incentives for businesses; or other policies for that matter that encourage more prudent financial decision-making by individuals. On that note, with the shambolic state of the banking system, you would think the government would do what it is required to do by law – the FDIC improvement act of ’91 (FDICIA) requires prompt and decisive action to address insolvent institutions, requiring the government to choose the least expensive option for taxpayers. Instead, policy makers continue to apply (very expensive) Band-aids. For the time being, investors are running for the hills as a result and gold is retreating from its recent highs. In our assessment, the inefficiency of the programs will delay any recovery and make it very, very expensive. Eventually, we believe some of that money will stick, economic growth may resume and all the money in the system will prove inflationary. Indeed, because the policies do not encourage consumers to reduce their debt levels, we believe that if and when inflation breaks out the Fed may be unable to contain it – we simply don’t think it is realistic that the economy would be strong enough to institute Volcker-style policies (Volcker was the Fed Chairman from 1979 to 1987 and drove the Federal Funds rate to 20% in 1981 to weed out inflation).

While we believe that inflation will ultimately haunt the U.S., we are presently in a phase of inefficient government policy with the threat of deflation outweighing the threat of inflation. Moreover, we are in a period where a depression, if not a long and drawn-out recession, is a very realistic probability. So where should investors hide? Investors may want to consider adding a diversified selection of currencies to their portfolios. To this end we have some thoughts on currency investing within a depression scenario:

The euro. If, as we believe, the euro zone will not follow in the U.S. footsteps to try to devalue their currency, growth may lag, but the currency could be strong even in face of a serious recession or depression. However, the solvency of the banking system in Europe raises some serious issues. For more details, please see our recent discussion on whether there are any hard currencies left.

The Swiss franc. The Swiss franc has benefited from its reputation as a safe haven. Don’t take our word for it, but the market’s: since last fall, the Swiss National Bank (SNB) has been issuing Swiss franc denominated Treasury bills at par. Investors are willing to lend the Swiss government money at 0% (the return is negative after commission). In the U.S., yields were near zero or dipped negative at the height of the credit crisis, but in Switzerland, this has become the norm. Initially, the SNB was reluctant to issue debt at 0%, but has since opened the floodgates and accepts anyone looking for these bills. One of the criticisms of gold has always been that it doesn’t pay interest; but is the Swiss franc as good as gold?

The Swiss National Bank is working hard to dilute its status as a safe haven. A few weeks ago, the SNB started issuing U.S. dollar denominated Swiss Treasury bills; the yields are a tad higher than Treasury bills issued in the U.S.; for the SNB it is an inexpensive way to fund the dollar denominated guarantees extended to the Swiss bank UBS. However, it does create dollar denominated liabilities, a potential vulnerability.

Switzerland is affected by Eastern Europe’s affection with low interest rates: many Eastern Europeans financed their homes with Swiss franc mortgages; as the currencies in Eastern Europe have plunged, there has been a scramble to obtain Swiss francs. This challenge is not limited to Switzerland (Japan, Sweden and the euro zone face the same challenge), but the Swiss have been particularly proactive in providing temporary credit facilities to Eastern Europe. This, too, may come back to haunt Switzerland, but is perceived the lesser of the evils as it helps prop up Swiss banks (most affected are Austrian banks as they not only extended loans, but were leaders in buying Eastern European banks).

Then there is the issue of whether some of the financial institutions are “too big to bail”. Sweden is suffering from this challenge as their banking system does not enjoy the safe haven status, but has extensive exposure to Eastern Europe in particular. Switzerland, for now, is enjoying its safe haven status. However, the SNB’s active efforts to talk down the Swiss franc is troubling to us; we are less excited about the Swiss franc than we once were.

The Norwegian krone. Norway may replace Switzerland as the place to take refuge in Europe. Norway is a surplus country, an enviable position to be in should we face an extended depression. Norway can afford to get through this crisis; Norway can fix any problems in its economy or banking system. The Norwegian krone is not particularly sexy; indeed it is highly correlated with the euro and Swiss franc; and if the markets recover, risk friendly money may move towards other currencies again. However, in our assessment, the Norwegian krone may be the most appropriate depression trade. If one expects a cascading effect of trouble with further challenges in the banking sector or trouble in giants like General Electric, then investors may want to consider adding Norwegian krone denominated government debt.

The Japanese yen. We consider the Japanese yen the “panic trade” currency. It is noteworthy that the Japanese banking system is one of the healthiest in the world right now; as a result, when there is fear of an implosion of the global financial system, the yen may benefit. However, this benefit requires that there is no intervention by the Bank of Japan. The current composition of the BOJ has not intervened in the markets. Indeed, the finance minister recently resigned when he appeared to be drunk at a G7 meeting in Italy; as long as the leadership in Japan is weak, there may be little intervention. However, the Japanese economy is deeply in depression mode with industrial production down 42.5% from peak levels (in comparison, industrial production fell 55% during the Great Depression in the U.S.); exports are down around 50% to the U.S., Europe and Asia.

There is one area we are in agreement with Fed Chairman Bernanke: those countries that devalue their currency may recover more quickly from a depression. Rather naturally so: if the purchasing power of your savings is slashed, you have a great incentive to work again. Because of high savings levels, the Japanese have so far been able to absorb the implosion, however painful. This is, by the way, our reason for being more optimistic about the euro than many: unless you have a severe current account deficit like the U.S., you don’t necessarily need to have growth to have a strong currency.

We do believe that the “panic trade” is fading out. That’s because policy makers throughout the world have provided guarantees to the banking system and shown they are willing to do anything – including sacrificing their currencies – to protect the financial system. That sharply reduces a disorderly adjustment of the financial system. Instead, we are now faced with either pursuing an orderly adjustment, i.e. a deep recession or depression; or whether we reflate the system. As these forces play out, the panic scenario may move to the background. In a global depression, surplus countries such as Norway may be the ones losing the least; there is really no winner in a depression, but Norway is better positioned than most.

There may be another depression trade – the Chinese yuan. To learn why and be informed as we discuss further currencies, including currencies that may benefit as the world tries to reflate, subscribe to our newsletter at www.merkfund.com/newsletter. We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively.

Published on  Tue, Mar 10 2009, 13:51 GMT

Toxic Securities − Wanted: Market Based Prices

Wed, Mar 4 2009, 10:53 GMT
by Axel Merk

Merk Hard Currency Fund

Shaken insurance giant AIG has argued that fair value accounting is what got the world into this financial crisis. This debate is flaring up once again as it becomes ever more apparent that many of the world’s largest banks would be insolvent if they priced their securities at “fair” market prices.

Recently, Goldman Sachs CEO Lloyd Blankfein, wrote in an editorial to the Financial Times: “For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.”

To be fair, Goldman Sachs has managed this crisis better than most. However, the day after his editorial was published, Blankfein testified in Congress that Goldman uses models to value its assets based on future expected cash flows. Said differently, even one of the more prudent financial firms continues to use models based on subjective inputs to value their securities. Granted, some assets may be difficult to value, but for many of the securities it has come to the point where no one even wants to trade them for fear that they and others would need to price them down significantly, to match the price any rational buyer would be willing to pay.

AIG (which has long advocated abolishing fair value accounting) comes from an insurance culture. Insurance companies are used to model based valuations, such as calculating the life expectancy for life insurances; or the probability of natural disasters striking an area where policies were written that need to pay when disaster strikes. In the insurance world, insurance companies don’t pay into an escrow account if the beneficiary of a life insurance and the policyholder fall gravely ill. But that’s mostly because the risks are well quantified and insurance firms are typically sufficiently capitalized. When it comes to derivatives, however, a new world of opportunity and risk opens up. “Insurance” can be written on third parties. Joe can agree to pay Mary if General Electric (GE) fails. GE doesn’t know about the contract; indeed, a corporate event, such as a re-organization or a takeover, may trigger payment, depending on how the agreement is structured. For years, writing “policies” on credit defaults (commonly known as credit default swaps) was an immensely profitable business, as firms would collect premiums on, say, the likelihood that GE is going to default on its obligations. Impossible, right? Well, not anymore according to the present default swap spread on GE. It is now clear that the market had it wrong. Whilst the likelihood of GE defaulting was low two or three years ago, firms such as AIG should nevertheless have allocated adequate reserves to cover such a situation transpiring. Incidentally, White House Press Secretary Robert Gibbs ridiculed CNBC’s Rick Santelli as he called for a “Chicago Tea Party” protesting government policies. In the process the Press Secretary tried to discredit the traders at the Chicago Board of Trade (CBOT), grouping them with those bankers that are to blame for the mess we are in. To be sure, there is a lot of blame to go around – from bankers to policy makers to consumers, to name a few. However, Mr Press Secretary: if all derivatives were traded on a regulated exchange such as the CBOT, we wouldn’t be in this mess.

Here’s why: derivatives at the CBOT are marked to market every single day. For any position taken, a deposit (margin requirement) is made. If the position shows a loss for the day, a margin call is issued and the trader has to supply additional funds. Conversely, he or she receives funds if there is a gain for the day. When volatility rises, the margin requirements tend to be increased. There is a good reason why margin requirements are low. Traditionally, derivatives were set up to hedge against risks, say hedge your corn production against a decline in corn prices between planting the seeds and the crop. If hedging becomes too expensive as margin requirements are raised, farmers don’t hedge their production anymore, leading to overall lower output and potential supply disruptions. But the producers require that speculators be on the other side of the trade. Without speculators, the producers don’t have anyone to hedge their production with. Please note: this is not supposed to be an encouragement to start trading derivatives, but to highlight some of their attributes and mechanisms.

If a trader cannot meet a margin call, the broker will close the position – the “grace period” may be a few days at most; in a volatile market, the grace period may be as little as a few hours. The counterparty risk is virtually eliminated as the exchange guarantees the functioning of the markets. Let’s take a situation where, say, the price of oil rises to over $140 a barrel before plunging to less than $40. On a regulated exchange, the speculator who shorted oil when it soared above $100 would have ultimately been proven right, but likely was out of money and had the position closed. In comparison, firms such as AIG had never factored in such volatile price movements into their off-exchange derivative exposures. They had, in essence, become the speculator of perpetually favorable economic conditions.

Should we now bail out the speculator because he or she may ultimately be right? No. What is required are fair rules that minimize systemic risks. If derivatives were all traded on an exchange, the systemic risk would virtually be eliminated. We don’t need to restrict speculators from engaging in risky bets, but we need to make sure that if the speculators fail, the rest of the system does not fall apart. Currently, everyone cries for more government intervention, more help. But there is the real risk that the baby is thrown out with the bathwater. Mr. Press Secretary, if you want to destroy the CBOT, Singapore will be waiting to welcome those traders.

Let us consider if these off-exchange derivative products had been regulated and market to market. Take as an example a derivative that insures against the risk of Iceland defaulting on its debt. A few years ago, this may have seemed like easy money (collecting the premiums) for those writing the policies. However the writers of these policies would have likely been forced to close their positions well before disaster struck. And that’s precisely the point – the risk to the system must be contained.

The regulators can influence how much collateral is required – mindful that speculation itself is not the root cause of all evil; instead, given our present situation, we urgently need more risk takers! Odds are that many of the positions in the derivatives market in the hundreds of trillions would have never been taken because more transparency would have made the speculators realize just how risky their bets were.

We need a banking system that encourages sustainable risk taking. All of us have a stake in this; risk is the life and blood of capitalism, but it needs to be applied prudently. The right incentive is not that Uncle Sam takes your jet away, but that there are market incentives to control risk. Creating clearing places for financial instruments should be one of the top priorities of both industry and government. By the way, exchanges are profitable enterprises and profits generate tax revenue; restricting bonuses also restricts tax revenue.

That’s the type of public-private partnership required – not government run banks. Those financial institutions that are insolvent must be dismembered. We need good banks, not bad banks. It’s not just our wish, it’s the law. The FDIC improvement act of ’91 (FDICIA) requires that prompt and decisive actions be taken when financial institutions run into trouble. The act further requires that the action taken minimizes losses to taxpayers. Buying bad assets from banks doesn’t live up to that test. Let’s bite the bullet, do what’s necessary and not drag the economy down further by losing trillions of dollars in taxpayer money through propping up a broken system.

Published on  Wed, Mar 4 2009, 10:53 GMT

The Euro – Are There Any Hard Currencies Left?

Wed, Feb 25 2009, 09:21 GMT
by Axel Merk

Merk Hard Currency Fund

With gold reaching $1,000 an ounce and posting new highs versus all currencies, are there any hard currencies left? Over the past 100 years, we have moved further and further away from the gold standard. We see no indication for that trend to reverse; if anything, it may accelerate. As a result, we have cautioned long before this credit crisis erupted that there is no such thing as a safe asset anymore; investors may want to take a diversified approach to something as mundane as cash. This lack of confidence in cash goes beyond “cash equivalents” such as money market funds, commercial paper, auction rate securities, to currencies themselves. We all rely on cash for liquidity, but are concerned about purchasing power. While we are told that equities outperform in the long run, the deflationary forces in the equity markets, and the threat of a depression, has many looking for ways to avoid systemic risk affecting equity markets. While there are deflationary forces, there is also the threat of inflation because of the governments’ efforts to restart the economy; as a result, investors do not want interest and credit risk, either. Is physical gold the only answer? Possibly, but even the staunchest gold bugs rarely ever invest all their net worth in gold, if for no other reason than it is impractical. The principal motivation to invest in other currencies is to diversify based on concerns that the U.S. dollar’s purchasing power may not hold up and that – on a relative basis – it may hold up better in other currencies. We have long promoted baskets of currencies to mitigate the risks associated with the policies of any one country’s monetary policies. This analysis is intended as an overview of where we believe currencies stand.

The U.S. dollar

We are rather concerned about the U.S. dollar. Because it has been in the interest of other countries to have a strong dollar to export to U.S. consumers, the U.S. has gotten away with policies that – in our assessment – would have been detrimental had the U.S. not enjoyed its safe haven status. But the status as a reserve currency has to be earned on an ongoing basis – at some point, the abuse may come back to haunt the U.S.; some say that they will take action only if and when the dollar falls sharply. We would like to remind everyone that gold has quadrupled from a low of $250 to now around $1000. Further, the dollar nearly halved between October 2000 and the spring of 2007 versus the euro; it has since rebounded a bit, but make no mistake about it: the U.S. dollar has been in a long-term downward trend.

In making investment decisions, we take into account risk based scenarios. We do not know whether policy makers will come to their senses or whether they will continue to pursue policies to the potential detriment of the U.S. dollar. But if investors believe that there is a risk that policy makers will continue to make bad decisions, then investors may want to take that into account in their portfolio allocation.

A key concern we have is that inflation may become embedded long-term into the U.S. dollar. For now long-term inflation expectations influence the way the Federal Reserve (Fed) monitors them – the spread between 10-year inflation protected securities (TIPS) and 10-year government bonds – are low. In our humble opinion, that’s not good enough. Specifically, look ahead at the exit-strategy for the current monetary and fiscal stimuli. Fed Chairman Bernanke, in a speech on February 18, 2009, tried to persuade the public that the Fed can mop up all the liquidity fairly easily: the Fed would simply let many short-term programs expire. That may well be the case with short-term funding facilities. But that is not the case, for example, with the $500 billion program to buy mortgage-backed securities (MBS) before the middle of the year, a program that may be expanded. In our view, it will simply be impossible to sell these securities back to the market. The Fed’s balance sheet before the credit crisis hovered around $800 billion. Adding $500 billion permanently is inflationary unless the Fed somehow “sterilizes” it; quite possibly, the Fed’s recent interest to issue its own debt may serve this purpose (the Fed would be competing with the Treasury if it were to issue its own debt). More importantly, however, the policies we have seen encourage maintaining high levels of consumer debt. Unless we have a surge in real wages, consumers will remain extremely fragile even as the economy shows signs of improving. While we believe that both fiscal and monetary stimuli are rather ineffective, at some point, some of the money will stick. The Fed says it knows how to fight inflation. We don’t believe so: in our view, there is no way that policy makers will be willing to raise interest rates like Volcker did in the early 80’s to weed out inflation – it would cause a collapse of economic activity, if not a revolution. At “best”, the Fed will start to tighten when inflation starts to show in the statistics they follow, but may have to revert course right away as economic activity falters as a result.

In the same speech, Bernanke also said that the Fed’s activities do not add to the budget deficit. That’s why Congress loves the Fed – the Fed can print money that is off balance sheet. However, as the Fed veers closer into fiscal policy by providing not just money to the banking system as a whole, but to specific industries and companies, the love affair with Congress may end. We believe the Fed underestimates the political fallout that will result from all the policies pursued; ultimately, the credibility and with it the effectiveness of the Fed may suffer. This credibility is not bolstered by Bernanke’s comment that Congress will benefit from the Fed’s activities as the Fed starts to pay taxable interest on deposits held by banks with the Fed. This sort of comment shows the audacity of the Fed – John Law could not have made a better sales pitch as the interest the Fed is referring to is printed by the Fed at will. The “benefit” to Congress will be dubious at best.

The Fed has been actively engaged in the purchase of agency securities, those of Fannie and Freddie. In doing so, many have praised how the cost of mortgages has come down. However, the flip side is what has us concerned: in buying agency securities, the Fed drives up their prices (lowers the yields). What rational market participant would want to buy securities that are intentionally overpriced? This is relevant to the dollar as foreigners, in particular the Chinese, are the traditional buyers of these securities. As these securities are now labeled “overpriced”, we fear that foreign buyers may abstain. Last summer the Treasury had to provide an explicit government guarantee to Fannie and Freddie as foreign buying of these securities vanished. Zooming in on China: the Chinese may now be discouraged from buying U.S. agency securities; they may need to deploy their reserves at home for their domestic stimulus package; on top of that, they get insulted by the new administration. It seems like a real possibility to us that at least on the margin, the Chinese may buy less U.S. debt, just as the need to raise money for the U.S. government explodes. We don’t need foreigners to sell the dollar for the dollar to be under pressure: because of the current account deficit, foreigners need to buy over $2 billion dollars every single day, just to keep the dollar from falling. By the way, contrast that with the comments by Wen Jiabao, the Chinese premier, who says he wants to use his country’s reserves to buy U.S. and European technology while downplaying efforts to convert some of their reserves to U.S. dollars. The Chinese have no interest in a plunging dollar and work hard to be constructive in the public policy debate; as we elaborate more below, the Chinese may be the most prudent in the world right now – that in itself should give everyone pause to think .

Should protectionist sentiment flare up further, countries with current account deficits are most vulnerable. Trade barriers punish those who have adjusted to the world we live in. In recent years, when trade barriers have been discussed, the dollar has generally suffered; that’s because we are dependent on foreigners buying U.S. dollar. If there is less trade, there are fewer dollars to be reinvested in the U.S.

So far, the types of protectionist activities we have seen are unconventional, let’s call them “stealth protectionism”, and have actually favored the dollar. Specifically, the expanded guarantees on bank deposits have drawn money away from weaker countries, specifically from Eastern Europe and some Latin American and Asian countries, to the U.S. and the eurozone. Separately, the enormous amount of debt the U.S. government needs to raise this year is a form of protectionism: as over $2 trillion is likely to be raised, this is money not available to the corporate sector or weaker sovereign countries. At home, even if there were a magic wand to cure the ills of the banking system, the clients of financial institutions – corporations and sovereign countries – will continue to pay a high price to access the credit markets; in this environment, economic growth is likely to continue to lag behind expectations. Internationally, however, weaker countries will see the pain in their reduced ability to raise money; we see this already in the downgrades of sovereign debt of Spain and Greece; we see it in Eastern Europe; it is also possible to see both higher borrowing costs and a weaker currency as foreign appetite to provide funding is lackluster – one need to look no further than the U.K. In this environment, protectionist measures will be called upon to counter the stealth-protectionism pursued.

The potentially most serious threat to the dollar: the Fed. In our view, the Fed wants to have a substantially weaker dollar. Bernanke has repeatedly praised Roosevelt for devaluing the dollar during the Great Depression by taking the U.S. off the gold standard. Bernanke argues that the countries that came off the gold standard had more rapid growth recovery. Bernanke is right, naturally so: when your savings lose their purchasing power, you have a greater incentive to work. There are those, however, that don’t love work so much that they would be willing to give up a good portion of their purchasing power for the incentive to work harder. A Fed that doesn’t like home prices to fall because of the fallout of having too many homeowners “upside down” in their mortgages, prefers to have the overall price level rise so that the relative prices of homes aren’t as overvalued anymore. In our view, the Fed wants to have inflation. The purchase of agency securities and the potential increase in purchases of Treasury Bonds speaks for itself. We are concerned that the Fed may be getting more than it is bargaining for, especially since we believe the exit strategy for this risqué approach is doubtful.

The rally in the dollar we saw in the second half of 2008 was reflected in a surge of buying interest in U.S. Treasury Bills. Typically when a currency rises, inflows from abroad are deployed throughout the economy, not just short-term Treasury securities. As the panic abates, we fear that some of this money will flow out of the country again, putting renewed downward pressure on the dollar.

The Euro

Everyone loves to hate the euro these days. We are not as negative about the euro, mostly because the European Central Bank (ECB) for years has shown more restraint. As a result, the bulk of European consumers are in far better shape than their American counterparts. When European consumers were told there would not be money for their retirement, they stopped spending earlier this decade; in contrast, American consumers racked up their credit cards.

Conventional wisdom says one needs growth to have a flourishing currency. True, growth helps, but it is countries with significant current account deficits that require growth to sustain their currencies. The eurozone has a rather small current account deficit – the area’s “worst” deficit of 2008 was still smaller than a single month’s deficit in the U.S. Think about what Bernanke says about countries that went off the gold standard during the Great Depression and devalued their currencies: those who did not devalue recovered more slowly, but had stronger currencies. Indeed, we believe the eurozone is likely to have a rather painful recession; if the U.S. and Asia manage to reflate the world economy, the eurozone may experience a bout of stagflation. However, we believe the euro will be surprisingly strong in this context.

There are both fiscal and monetary reasons why we like the euro more than others. At the peak of the financial crisis in the fall of 2007, Europe (first the UK, then the eurozone) was faster than the U.S. in guaranteeing the banking system. In the meantime, the world has shown that a disorderly collapse of the financial system will be avoided at just about any cost. The next phase should be to allow an orderly adjustment to weed out the excesses of the boom. However, most policy makers around the world are not willing to let the markets adjust; instead, there is a drive to re-inflate the system. In our view, the U.S. will be far more “efficient” at this process than the eurozone. In 2009, the debt to GDP ratio may go as high as 18 percent in the U.S. In contrast, the eurozone growth and stability pact requires that this ratio not exceed 3 percent of GDP. Granted, that pact has more holes than Swiss cheese and member states may deviate from this goal for just about any “emergency” as long as they pledge to revert to the 3 percent ceiling in reasonable time; however, we believe the bureaucratic structures of Europe will prevent the eurozone from being as forceful with its stimulus as the U.S. As a result, growth may lag in the eurozone, but the currency may be stronger as fewer long-term inflationary seeds are planted.

On the monetary side, we also see far more restraint. Trichet, the head of the ECB, has repeatedly expressed his dislike for a zero percent interest rate policy. He seems more concerned about the downside risks of such a policy than its advantages. Instead, the ECB has opted to provide almost unlimited liquidity to financial institutions. Eventually, this may allow zombie (technically insolvent) banks to survive, but it will avoid the inflationary or even hyperinflationary risks that the U.S. approach may be risking.

The ECB has for years been reluctant to join the U.S. and Asian growth frenzy; one can of course argue that this hasn’t helped the eurozone much as they now also suffer in the downturn. However, the ECB policies make European consumers in particular more shock resistant; there will be suffering, but that is nothing new to European consumers. Retail stores in Germany, for example, had an extremely tough couple of years before the credit bubble burst. Even Wal-Mart withdrew from Germany as margins were too thin to compete with domestic discounters.

ECB president Trichet is the only central banker governing a major currency we are aware of that believes money supply plays a role – all other central bankers have joined the academic bandwagon that money supply is irrelevant as long as “inflation expectations are firmly anchored”.

All the prudence at the ECB hasn’t stopped European financial institutions from leveraging up their balance sheets with toxic assets. The motto in Europe has been to copy any idea Goldman Sachs has, but being late to the party, they engaged in greater leverage when pursuing them. A lack of understanding of the instruments purchased was, and in some cases still is, prevailing at many institutions. Whereas in the U.S., money to support the banks can simply be printed, the structure in the eurozone requires that member states – or in some cases regional governments – must finance any bailouts. As a result, the fear that some institutions may be “too big to bail” has spread. Rather than injecting capital, European governments have favored to a “ring fence” approach where the debt of institutions is guaranteed, thereby avoiding the deployment of cash until it is called upon.

While European financial institutions loved all that are now considered toxic securities, they have been suspicious of the U.S. dollar for some time. As a result, many institutions hedged their dollar exposure. Ironically as the value of the toxic securities plunged, the hedging position was still based on the full value of the securities. That meant that those institutions had to buy dollars in 2008 to bring the value of their hedging positions in line with the value of the securities. A good portion of the dollar rally in 2008 may have been attributed to this alignment.

There have been calls to create European bonds, i.e. bonds issued by the European Union rather than member states to address this issue. Currently, when we, or anyone, buy European sovereign debt, one buys, say, German or French government bonds. If the euro were really to break up, one would still be left with the bonds issued by the respective governments and they would revert to, for example, Deutsche mark or French franc bonds. However, the current proposals provide for bonds guaranteed by the member states. Unfortunately that seems too much like a structured product to help the weaker member states Greece and Spain; we don’t think there is a market for such a product at this stage. If one wants to pursue this route, a true European bond issued by an EU Treasury with independent taxing authority would be needed; then, if a member state were to break away or default, the debt would truly be EU debt and not shaken by turmoil in any one country. Having said that, adding another layer of taxation in Europe is the last most want to see. While the idea may work on paper, it may easily create another runaway bureaucracy in the long run. Europeans are also deeply suspicious of whether providing such power could lead to excessive spending.

We don’t think the euro is at the risk of a breakup because a breakup would be far too expensive for all involved; the pain of staying together is the lesser evil. This doesn’t mean that a member state couldn't break out of the eurozone in a bad case scenario, but the euro itself, in our view, is here to stay. In our view, widening risk spreads in different eurozone countries should be embraced, not fought. Member states with fiscally sustainable policies should be rewarded by the markets through lower interest rates; those who promise too much to their pensioners or make too many concessions to unions should pay the price through a higher cost of financing. In the U.S., different states also have varying costs of financing, something to be embraced rather than shunned.

Earlier, we mentioned the stealth protectionism the U.S. and Europe has engaged in by guaranteeing their banking systems. These guarantees have now come back to haunt those institutions that have heavily invested in Eastern Europe. Austrian banks in particular, but also banks in other European states, have bought many Eastern European banks or extended loans to Eastern Europe. The trouble is that Eastern European homeowners and many businesses have been lured by low interest rates available in Europe, particularly Switzerland, taking out loans denominated in Swiss francs or euro. The banking guarantees provided in the eurozone exacerbated a flight of money from Eastern Europe to the eurozone, thereby placing downward pressure on Eastern European currencies. That is a major problem for those who borrowed heavily in euro or Swiss franc as the value of the collateral in local currency has diminished.

In our view, European governments will ultimately provide support to their financial institutions exposed to Eastern Europe. Moreover, after the typical grudging discussions taking place in Europe, support may likely also be provided to Eastern Europe itself. Much of the industry in the European Union has focused on building the infrastructure in Eastern Europe. It may be cheaper for the European Union to subsidize its customer, Eastern Europe, than to allow market forces to cause massive failures. This is not a judgment of whether this is desirable or not from a free market perspective, but our assessment of how the politics will play out.

Note that while it may be cheaper for the European Union to bail out Eastern Europe, the same cannot be said for China; for China, it will be cheaper to stimulate its domestic economy than to prop up U.S. consumer spending through cheap exports. More on China in an upcoming analysis.

Published on  Wed, Feb 25 2009, 09:21 GMT

China and the U.S. Play Chicken: Currency Manipulation

Tue, Jan 27 2009, 14:43 GMT
by Axel Merk

Merk Hard Currency Fund

“China is manipulating its currency,” proclaims incoming Treasury Secretary Geithner. Talking about “manipulation” is helpful only if one’s intent is to impress a local and insult a foreign audience. More productive may be plain talk - the U.S. and China could issue a joint statement along the lines of: “China and the U.S. agree that both will act in their respective self-interest in setting exchange rate policy.”

Many factors including supply and demand for a currency ultimately determine exchange rates. The U.S. is doing its share to try to manipulate the dollar, albeit with mixed results. Amongst others, last summer, the Treasury decided to make the guarantee for the housing agencies Fannie and Freddie more explicit. With the Chinese and other foreigners being the main buyers of U.S. debt in recent years, there was a threat that these buyers would abstain. Foreign investment in the U.S. had fallen off a cliff in the second quarter of 2008; the absence of foreign buying could have caused a panic in the dollar. By providing the guarantees, the U.S. seemed the least risky country for short-term money, giving a boost to the dollar. Note, however, that the inflows were mostly parked in short-term Treasuries, not exactly an endorsement of the U.S. economy, but more likely a panic trade that may be unwound again.

While last summer’s action was aimed at avoiding a disorderly collapse of the dollar, policy makers have made it abundantly clear that they want a weaker dollar. The ritual that Geithner followed to state that a strong dollar is in the interest of the U.S. has become a farce. Suggesting China should allow its currency to appreciate is certainly not compatible with it. Neither are Federal Reserve (Fed) Chairman’s repeated references that weakening the currency by going off the gold standard helped the U.S. out of the Great Depression by “allowing prices to float to the pre 1929 levels.” In our assessment, the Fed is encouraging inflation, so that the relative prices of homes to all other goods and services will come down. That may be the Fed’s “plan B” as it doesn’t want absolute home prices to come down any further; a weaker dollar contributes to achieving this. We have cautioned in the past that a country cannot depreciate itself into prosperity, but that won’t stop policy makers from trying. Pulling interest rates to near zero is also a form of currency manipulation, trying to make the currency less attractive.

While former Fed Chairman Greenspan always avoided discussing the dollar, the current Fed Chairman embraces the confrontation, not just by seeking the discussion, but also through action. Beyond lowering interest rates, the Fed is trying to weaken the dollar with its purchases of agency securities and government bonds. With their government guarantees, Fannie and Freddie are buying billions worth of mortgage securities to lower the cost of borrowing to consumers; the agencies have also lowered their traditionally high standards on who qualifies for subsidized loans. Already Freddie Mac has asked Uncle Sam for another $35 billion as it is throwing taxpayer money at consumers. The activities pursued are in the realm of currency manipulation as the types of securities foreigners would typically want to buy are inflated in price, discouraging the purchases.

Indeed, any market where the Federal Reserve has engaged in purchases – agency securities, mortgage backed securities, providing funding for consumer loans, the commercial paper market, to name a few - the Fed is replacing rational buyers rather than jumpstarting the private sector. Why would a rational person buy securities that are artificially inflated in price? If the Chinese dare to buy these securities anyway, then they must be as guilty as the U.S. of currency manipulation.

Indeed, that’s what it comes down to: the U.S. wants to have a weaker dollar and China wants to be in control of when to allow the yuan to appreciate. Insulting China is not the right way to go about it. China has to recognize that a stronger yuan is in its national interest. While the U.S. is accelerating its market interventions with implications for the dollar, China is working hard to allow for more exchange rate flexibility.

In our view, China cannot grow itself out of the current global economic downturn with a cheap currency. U.S. consumer spending simply may not pick up fast enough because U.S. policies are aimed at propping up the broken system in place with high levels of consumer debt rather than fostering sustainable growth that includes savings and investments. Paradoxically, while the Chinese yuan may be cheap, overall policies continue to be relatively tight. China is aware that it has its own inflated property prices and is willing to allow price declines and failures of real estate developers. China has also not exhausted its potential to provide a stimulus to the economy: infrastructure projects in the pipeline in years to come could be moved forward far more aggressively. We would favor a major campaign to encourage domestic entrepreneurialism to jump-start a more balanced economy not as focused on exports. Part of the reason for the reluctance on China’s part is because of inflationary fears. While everyone talks about deflation right now, inflationary pressures as the world recovers and as a result of the spending programs could be contained if China allowed the yuan to appreciate.

When China recognizes that it is in its interest to have a stronger yuan, China will act. In the meantime, the U.S. and China are playing a game of chicken. However, it is unclear what winning means in this context. The U.S. seems somehow excited to weaken its currency, depriving hundreds of millions of the purchasing power of their savings. Conversely, China’s reluctance leads to more problems than it solves for China. China won’t be bullied by the U.S.; however, a little more diplomacy and a little less populism may be beneficial to both China and the global economy.

Published on  Tue, Jan 27 2009, 14:43 GMT

Live Free Or Die: Capitalism At Risk

Tue, Jan 13 2009, 15:28 GMT
by Axel Merk

Merk Hard Currency Fund

The Federal Reserve (Fed) has gone beyond playing with fire, and may have indeed set the house on fire. It’s one thing to push interest rates to near zero to stimulate the economy; it’s another to “monetize the debt” by printing money to buy government debt. In recent weeks, the Fed has broken outside even those boundaries and become actively engaged in managing the private sector beyond the core banking system. Worse still, the steps taken may be difficult to reverse and as such may shape the U.S. economy for a long time. These steps are taken with the best of intentions, to “save” the economy. The only trouble is that we may be on a slippery slope to destroying capitalism on the way. In “doing whatever it takes” to get the economy back on its feet, the Fed risks destroying the foundation of why the U.S. has been able to establish itself as the world’s leading economic force. Actively participating in credit allocation within the private sector, the Federal Reserve (Fed) jeopardizes the capitalist foundation the U.S. economy is built on. As a result of these actions, the U.S. may be on its way to becoming a modern incarnation of a planned economy.

Why these harsh words? To understand what is so frightening with recent Fed activity, consider that most central banks focus on interest rates, inflation and money supply to promote price stability (and maximum employment in the Fed’s case). Generally, they all influence credit creation by managing the cost of borrowing. Central banks may employ slightly different levers and targets; and while some central banks are better than others at achieving their goals, what they have in common is that they traditionally focus on government debt, mostly short-term Treasuries, to achieve their goals. This is very much by design as good central bank policy leads to an environment of price stability fostering long-term economic prosperity. On the other hand, bad central bank policy may lead to inflation, wide swings in economic activity or unnecessarily high unemployment. However, free market forces will push the private sector to make the best of it. It’s when policy makers start subsidizing ailing sectors of the economy that distortions are created that will come back to haunt us. Traditionally, for better or worse, elected officials decide on the socio-economic fabric of society. Now, the Fed decides which areas of the economy need to be propped up.

Creating Hysteria To Pursue Policies

The hysteria that has been created by policy makers and the media has allowed the Fed to pursue its recent unorthodox policies. In late September, the world financial system looked rather dire; the government was able to play a role to avoid a disorderly collapse; but the government’s role should have been limited to allowing an orderly adjustment of the excesses of the credit bubble. Instead, the latest salvo to promote the bailouts is that payrolls have dropped by the largest amount since World War II. This may be the case in absolute numbers as the population has grown, but more jobs were lost as a percentage of the workforce in a twelve month period in each of 1982, 1961, 1958, 1954, 1948/49; in many of the cases more than twice as many. Recessions are no fun, neither are personal or corporate bankruptcies; but they may be the cure needed to weed out the excesses of the boom. In contrast, today, hedge fund managers that ran their funds into the ground are raising hundreds of millions of dollars to start anew. Some of the folks that ran Long Term Capital Management into the ground in 1998 started fresh only to have another massive failure in the current credit crisis. We don’t expect the new breed of second chances to be any better. And while the blame lies with the managers, excessively low interest rates contribute to irrational risk taking: all of the bailouts focus on those who have been over-leveraged. What about the group of responsible savers that rely on income? With interest rates near zero, many are tempted to engage in highly leveraged strategies to meet their required income objectives. Pension funds “must” return 6% per year, leaving them little leeway but to give money to hedge fund managers to magically turn 1% yields into 20% returns; the way to achieve this is with leverage. Actually, there is another way: the Swiss public pension fund system just announced that it will scale down its long-term return objective to 4% from its current 6% per annum.

Giving Credit Where No Credit is Due

In late December, the Fed Board of Governors approved GMAC’s application to become a bank. The vote was 4-1, and the one board member with experience as a bank regulator, Elizabeth Duke, dissented. There was another hurdle: GMAC, General Motors’ finance arm, did not have sufficient capital to be a bank. That problem was solved, too, in early January, as the Treasury injected $5 billion into GMAC; the Treasury also GM $1 billion, so that GM could inject that money into GMAC. Equipped now with a minimum capital base, GMAC is able to operate as a bank, go to the Fed to access the TARP program, as well as other regular and emergency Fed windows.

In December, car sales fell off the cliff. But it wasn’t only GM that had problems; even Toyota that had access to credit and introduced zero percent financing, recorded a 37% plunge in sales (unlike other car makers, Toyota has traditionally not offered zero percent financing). Shell-shocked consumers are worried about their jobs and have lost a substantial amount of their net worth in 2008; further, incentive programs prior to the bursting of the credit bubble lured consumers into 6-year loans with zero percent financing. Consumers simply don’t want or need a car right now. Policy makers take this as a reason to provide money to GMAC that pursues a business model proven to be ruinous: it simply doesn’t make sense to offer cars at 0% if interest rates are above that, even if they are “close to zero” as they are now. GMAC takes money from the Treasury to be able to request more from the Fed. And the first course of business for GMAC is to extend zero percent financing to consumers with lower credit ratings than had traditionally qualified.

Difficult to Unwind: Long Term Inflation Likely

The Fed is only ramping up its mission to allocate credit where the Fed – rather than the free market - deems it appropriate. A major program announced in the fourth quarter, but rolled out in early January consists of a $500 billion program to buy mortgage-backed securities (MBS). The perceived positive is the plummeting of mortgage rates. Consumers with superb credit now qualify for 30-year mortgages at less than 5%. One problem with such programs is that the Fed intentionally inflates prices (lowers the yields) on these securities; in turn, rational market participants may abstain from buying them. As a result the Fed risks replacing private sector activity, rather than encouraging it. Furthermore, the Fed jeopardizes the dollar as foreigners may be discouraged from buying U.S. government and agency security debt; given that the U.S. has become dependent on foreigners to finance its spending needs as well as the unprecedented debt that will be financed in 2009. This is a very dangerous road to be on.

The Fed may be able to phase out its commercial paper subsidy program or drain liquidity from the TARP program over time; however, the $500 billion MBS program may be difficult, if not impossible to unwind. Indeed, the design of the MBS program calls for holding of the securities until maturity. For practical purposes, this means that the Fed’s balance sheet is not just “temporarily” inflated, but that the Fed will permanently keep more money in the economy. Traditionally, the Fed’s balance sheet is $900 billion. Therefore, even if one gives the Fed the benefit of the doubt that the current escalation to over $2 trillion is temporary, there will be a significant hangover as not all additions can easily be removed. This doesn’t even consider that, quite likely, the MBS purchase program may need to be extended beyond the 6-month period it was put in place for. Watch for bond manager Bill Gross this June, calling for the Fed to continue buying MBS, preferably the ones he has on the books, to save the economy from collapse. Incidentally, his firm, PIMCO, is one of the firms managing the Fed program.

To counter the effects of this added money in the economy, the Fed would need to keep interest rates permanently higher. One realistic alternative, however, is that the additional money will stay in the economy as draining it would cause too much economic hardship. This may well embed inflation into the U.S. economy for years to come. Importantly, note that there is little, if any, accountability at the Fed monitoring its actions; no one is there to ensure that the Fed will, at some point, phase out its programs or added powers.

Live Free Or Die

By engaging in credit allocation to specific sectors of the economy, the U.S. is stepping into a territory traditionally left to governments with a socialist or communist brand. Communism has shown us that planned economies don’t work. New Hampshire in 1945 added the slogan “Live Free or Die” to its state emblem, a quote stemming from a general in the Revolutionary war. Translated to the economic crisis, this should mean that a severe recession ought to be the lesser evil than a planned economy. And to continue the parallel, when communism swept Eastern Europe, the standard of living for everyone dropped. In today’s world, we already see that the “re-failure” rate of those who defaulted, then renegotiated their teaser rate loans, is above 50%. Yet all taxpayers have to pay the price for the bailouts.

To be sure, we are a far cry from communism. But we must keep our eyes open and not be blinded by the perceived “help” of money printed by the Fed. Debt is the origin, not the solution to the problems we face. The Declaration of Independence’s “life, liberty and the pursuit of happiness” may be difficult to achieve when drowned in debt; building sustainable wealth without the shackles of debt may be the more appropriate path. It’s not by mistake that the Founding Fathers be backed by a precious metal that cannot be inflated to give in to the temptation of the day.

Published on  Tue, Jan 13 2009, 15:28 GMT

Fed Fights to Weaken Dollar

Wed, Dec 17 2008, 14:37 GMT
by Axel Merk

Merk Hard Currency Fund

Faced with the threat of deflation, the Federal Reserve (Fed) may be trying to drive the dollar lower to spur inflation. As policy makers don’t want home prices to deteriorate further, an alternative is to inflate the prices of all other goods and services: as a result, the relative prices of homes would be less expensive. Weakening the dollar is an effective policy tool to drive up inflation as the cost of import goes up. Just be careful: the Fed may be getting more than it is bargaining for. Fed Chairman Bernanke believes that a weaker dollar will only drive up inflation modestly; in our humble opinion, we believe he may be mistaken. Foreigners have a limit on how much margin pressure they can absorb before they have to pass on the higher cost of doing business. We saw this phenomenon in the spring time, when higher commodity prices forced Asian exporters to drive up prices; import prices into the U.S. were up over 20% year over year (and still up substantially after factoring out what was soaring oil prices at the time). No country has ever depreciated itself into prosperity and the U.S. is unlikely to be the first.

The Fed has been progressively more aggressive in attacking the dollar. Low interest rates are the traditional policy tool to make a currency less attractive. Short-term interest rates are now at historic lows; interest rates set by the market rather than the Fed are even lower.

Since late September, the Fed has been flooding the banking system with liquidity. By creating money with its printing press, the Fed literally provided hundreds of billions of dollars to the banking system. The Fed does so by buying assets from banks. At first, the program was partially “sterilized” as the Fed provided good quality bills in exchange for whatever the Fed received from the banks. Since then, however, the Fed no longer mops up the liquidity in such transactions and simply provides cash to the banks. Banks, rather than using the money to lend, have hoarded the cash. That’s why some observers claim these actions have not been inflationary as bank reserves are increased, but the money supply in the economy is not. Excess reserves in the banking system, traditionally less than $2 billion, are now about $600 billion.

We believe the excess reserves by the banks will be lent to the public, not private sector. While some money is starting to be used for lending (Verizon was recently able to receive a $17 billion loan to refinance debt in the largest debt offering this year), we believe banks continue to be too weak and don’t think the private sector is strong enough either. Further, the unprecedented amounts that need to be financed next year by the U.S. government will crowd out the market: there may not be enough money for the refinancing of U.S. corporate, European corporate or emerging market corporate and government debt available, keeping the cost of financing high for all those players.

The Fed will be aggressive at lending to those sectors of the economy where it wants to see borrowing costs low. The Fed has announced it will buy agency securities (Fannie & Freddie mortgage securities to keep the cost of home ownership low), Treasury bonds and, according to the Fed minutes released December 16, 2008, will “consider ways of using its balance sheet to further support credit markets and economic activity.” Using the balance sheet means to issue cash created on a keyboard to buy assets in the markets.

As the Fed buys assets in the market, the Fed drives prices higher; in case of debt securities, the yields will be driven lower. Superficially, this will be perceived as good news as the cost of borrowing is kept low for those who are affected by the purchase programs. For example, mortgage rates may remain low. Note, however, mortgage rates are low for those who qualify for a loan, not for everyone. While many are euphoric that the Fed keeps the cost of borrowing low, there are potentially severe unintended consequences. Specifically, through its direct purchases of securities, asset prices are artificially high. Why would private sector participants buy these securities? The Fed risks becoming the backstop of all economic activity with its action. While the Fed has the printing press, it does not have unlimited manpower: there may already be more acronyms in the Fed’s toolbox than staff members. The Fed cannot replace 8,000 banks, but is on its way to doing so. Think of the credit markets: by providing companies like GE direct access to the Fed for its commercial paper needs, GE is kept afloat, but the credit markets remain seized up. The Fed urgently needs to rework its programs to encourage private sector participation, rather than substituting private sector activity.

Importantly, foreign investors are also told their money is not welcome. Foreigners in recent years have been buying the bulk of U.S. Treasury and agency debt. But if these prices are driven artificially high (the yields artificially low), at the very least on the margin – foreign buyers may abstain. Further, Asian investors in particular need their money at home as a domestic stimulus within China is far more efficient than to try to prop up the U.S. economy with debt purchases. The Fed may be able to keep the yield on securities low, but it does so at the expense of the dollar.

The Fed is faced with far greater challenges than Japan. In Japan, there were few foreign creditors. Further, in Japan, all yields – both government and corporate – were low. In the U.S., while the cost of borrowing for the government is low, the private sector is faced with very high financing costs. Rather than the “quantitative easing” that we saw in Japan where the Bank of Japan targeted the reserve levels at banks, we will see a “qualitative easing” in the U.S., where the Fed is going to be closely involved in allocating credit to sectors of the economy it wants to stimulate. This sort of interference with market prices will have unintended consequences, costly side effects. In our view, these will play out in the currency markets. Watch that dollar carefully.

Published on  Wed, Dec 17 2008, 14:37 GMT

China: Carpe Diem!

Wed, Dec 10 2008, 14:43 GMT
by Axel Merk

Merk Hard Currency Fund

China has a unique opportunity and responsibility to shape not only its own future, but also that of the global economy. While China is by no means responsible for the plight the world faces, it has played an important role in allowing global imbalances to be built. If China decides to help prop up the world economic model that got us into trouble in the first place, we may face the same challenges again a few years down the road. Except then, China may not have $2 trillion in reserves to rescue its economy, and could face severe challenges. China will ultimately act in its own best interest, but prudent she must be. The time for China to act is now.

Because of the country's fiscal health, policy makers in China have far more flexibility to turn the global financial crisis into an opportunity than do their U.S. counterparts. Currently, U.S. policymakers mistakenly think they have all the flexibility in the world because of what is perceived to be an almighty Federal Reserve (Fed). In our assessment, the law of unintended consequences is likely to hit the U.S hard: debt monetization will cause inflation; economic growth will falter once the Fed tries to mop up all the liquidity it is throwing at the economy; and the wealth gap will increase further as the wealthy refinance their debt taking advantage of artificially low interest rates, whereas the middle class slides further into recession as they remain locked out from the credit markets. Policies to prevent the middle class from de-leveraging will backfire, causing not just economic misery, but the rise of populist politicians. While these policy mistakes are tragic in the U.S., similar mistakes in China could be catastrophic.

The greatest challenge of a negative feedback loop in an economic downturn is demand destruction. A depression is a state of mind - consumers and businesses are reducing their risk appetite and switch to survival mode no matter how low interest rates are. Banks are more interested in buying government bonds with capital injections received than in lending to the private sector. Uncertainty is a key contributor to demand destruction. U.S. policies are not as effective as policy makers would like them to be because for too long, there has been a lack of leadership to communicate how this crisis will be managed.

A U.S. Congress willing to give a $34 billion "bridge loan" to automakers knowing very well that the money will be spent within months while not placing car makers on a sound footing is a Congress building bridges to nowhere. Speaker of the House Nancy Pelosi said the loan would get the industry ready for the 21 st century; we are almost a decade into the new century - this effort is too little too late. Worse, even if there were a magic wand to heal the carmakers, zero percent financing on six-year loans extended during the credit bubble depresses demand for years to come. Similarly, the stimulus plans to be enacted in January are unlikely to be as effective as intended; foremost, the plans are expensive and should push up the cost of financing for government debt.

The U.S. Treasury has been at the forefront of the crisis, but any leadership taken was not properly communicated. The result is, again, that policies have mostly been expensive, but have failed to unlock credit markets. Too often have the Treasury's rules changed; the policies in place continue to discourage private sector participation in helping to recapitalize financial institutions. Lou Jiwei, chairman of China Investment Corp., the country's sovereign wealth fund, puts it bluntly: "Right now we don't have the courage to invest in financial institutions because we don't know what problems we will put ourselves into." He spoke ahead of U.S. Treasury Secretary Hank Paulson's visit to China and added, "My confidence should come from government policies. But if they are changing every week, how can you expect that to make me confident?"

The only leadership that seems to be emerging is from the Federal Reserve determined to print not just billions, but trillions of dollars to provide the backstop to all economic activity; at the same time the policies are an insult to any potential buyer of securities the Fed has targeted, as the intervention keeps yields artificially low. As China has been one of the premier buyers of these securities, namely Treasury bonds and agency securities, this is a clear message by the Fed that Chinese investments to finance U.S. deficits is no longer welcome; why else would the Fed depress the return for potential buyers during a time when unprecedented amounts of debt need to be raised? While we are provocative in our allegation, it is at best an unintended consequence, at worst highly deliberate. Intentional or not, it may coerce Asian buyers of U.S. debt to reduce their holdings to allow the U.S. dollar to weaken. The Fed may believe that it does not need the free market to set rates as it can use its own balance sheet to set economic policy; this ill-perceived view is also shared by economists that believe modern central banking is stronger than market forces.

China can learn from these mistakes, but has no time to lose. Demand destruction in China is working its way through the economy there as well. The window for Chinese policy makers to lift the spirit of workers is closing fast: the Chinese New Year is an opportunity for workers to reunite with their family and friends; during those days, the mood of the country will be set for the year. Right now, stagnating wages, job losses and the bleak U.S. economy will dominate the dinner table discussions. Consumer spending in China has continued to hold up year over year, but there is a seriously accelerating slowdown under way. Far more effective than a spending program on infrastructure is a program to lift the spirit of Chinese consumers.

Lifting the spirit of Chinese consumers is not done by providing access to credit, but by giving the country a vision. It is already abundantly clear that the toy industry is faltering; but the high tech industry in China is performing well under the circumstances. In its recent history, China has embraced change and must do so now. This is the opportunity to get the country ready for the next phase in its economic growth. To do so, rather than subsidizing industries that have little chance to survive, the country should focus on where its strengths are likely to be in the years to come. China has a tremendous opportunity as the outsourcing partner for goods and services at the higher end of the value chain. Toy production should be left to other Asian countries; China has to focus on technology and innovation. Similarly, while building roads and power plants may provide a buffer to an economic slowdown, policies are required to encourage Chinese entrepreneurs to take risks and invest. An infrastructure stimulus plan will favor state controlled enterprises; to turn the mood in the country, government policies have to provide the general population with a vision, not merely state owned enterprises.

Once a vision for the future is embraced, it will become apparent that it is in China's interest to allow the renminbi to appreciate. Since early 2007, the European Union surpassed the U.S. as China's primary export market. The close link between the renminbi and the dollar reinforces the public's perception that the fate of the Chinese economy is linked to that of the U.S.; China has to become more self confident - removing the shackles of the current exchange rate regime may provide an important catalyst to energize a spirit of change. While a stronger currency would hurt industries that mostly compete on price, such as the toy industry, it would substantially increase the domestic purchasing power. The future of China is a more balanced economy with a stronger domestic sector as well as an export sector that competes on value, not price. China does not want to face the challenges of Vietnam, which only competes on price, ending up with extraordinary inflation and, ultimately, unable to sell to the U.S. anyway because American consumers cannot afford their mortgages.

China is not powerful enough to prop up U.S. consumer spending; as a result, it is far more efficient for China to use its reserves to help transition the economy for the future rather than use its reserves to buy U.S. government securities to stimulate the U.S. economy. The Fed has decided to take China's place in buying U.S. debt; let the Fed pursue its dangerous experiment. In the meantime, China should position itself for the future as the road ahead will, without a doubt, be rough.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively.

Published on  Wed, Dec 10 2008, 14:43 GMT

Monetizing the Debt

Tue, Dec 2 2008, 13:39 GMT
by Axel Merk

Merk Hard Currency Fund

Deflation won't happen here; at least not if Federal Reserve (Fed) Chairman's Ben Bernanke's plan pans out. Deflation is considered a persistent decline in prices of goods and services; in a speech in 2002, Bernanke outlined the steps he would take if the U.S. ever faced the threat of deflation. Deflation is suffocating anyone holding debt as the debt burden becomes more difficult to finance with shrinking income; in contrast, inflation bails out those who have a lot of debt. In our assessment, fighting deflation is the Fed's top priority now; the latest minutes from the Fed's Open Market Committee (FOMC) meeting state: Indeed, some [FOMC members] saw a risk that over time inflation could fall below levels consistent with the Federal Reserve's dual objectives of price stability and maximum employment. [..] the limited scope for reducing the [Federal Funds] target further were reasons for a more aggressive policy adjustment; [..] more aggressive easing should reduce the odds of a deflationary outcome.

To understand how “more aggressive” easing is possible when interest rates are close to zero, a little background is required on how the Fed is “printing” money. Until a few weeks ago, the Fed's main tool to control interest rates was to manage the Federal Funds target rate by engaging in “open market operations” to buy or sell short-term government securities, mostly Treasury Bills. These operations are based on the principle that banks have cash deposits as reserves to lend money; for any dollar on deposit, a multiple may be provided as loans; the basic principal of modern banking assumes that not all depositors will want their money back simultaneously; a ‘run on the bank' would occur in such a situation that would either result in the Fed coming to the rescue or the bank's failure.

The Fed can now “tighten” monetary policy by selling, say, Treasury Bills, to the bank; in return, the Fed will receive the cash; and the bank will have less cash available to lend – because of the multiplier effect, small actions by the Fed tend to have – albeit with a delay of a couple of months - significant impact on lending and thus economic activity. There are no coins exchanging hands; these are entries into the balance sheets at the bank and the Fed. By making cash less available in the banking system, the cost of borrowing, i.e. interest rates, goes up.

Conversely, the Fed can buy Treasury Bills from banks and supply them with cash (providing liquidity) in return. This unleashes lending power at the banks and lowering the cost of borrowing.

This world was shaken when Congress, as part of passing the TARP bank bailout program, authorized the Fed to pay interest on deposits at the Federal Reserve. Theoretically, even if the Fed provides massive amounts of liquidity, interest rates should not go to zero as banks should always be able to go to the Fed and receive interest on deposits there. The idea is that the banking system could be flooded with liquidity while ensuring that interest rates don't go down to zero. Fed officials are fairly miffed that the market hasn't quite worked that way as short term Treasury bills have hovered close to zero with the official target Federal Funds rate at 1% and the interest paid on deposits at the Fed at or near 1%. Note that many of the new programs the Fed has introduced have little or no historic precedent; as a result, the programs may not be as effective or may have unintended consequences.

Aside from paying interest on deposits, the Fed, using the above model, can do a lot more to provide “liquidity”. Namely, the Fed is not limited to buying and selling T-Bills; as recent announcements have shown, the Fed is free to buy just about anything: mortgage backed securities (MBS), car loans, commercial paper, to name a few; the Fed could also buy typewriters, cars, domestic or international stocks, anything. In an announcement on November 25, 2008, the Fed said it would buy up to $600 billion of mortgage-backed securities issued by the government-sponsored entities (GSEs) Fannie and Freddie.

For example, a bank would like some cash, but cannot find a buyer for mortgage-backed securities it holds. The Fed may step in, buy the securities and provide the bank with cash. The bank in turn is now free to lend money – a multiple of the cash received.

How does the Fed get its money? It doesn't need to borrow it; it merely creates an entry into its balance sheet. All the Fed requires to “print” money is a keyboard connected to a computer. The difference between the Fed and the Treasury issuing money is that the Treasury needs to get permission from Congress before selling bonds. In this context, it shall be mentioned that physical cash (coins, bank notes) are entered as liabilities on the Fed's balance sheets; they are rather unique liabilities, however, as you can never redeem your cash: if you went to a bank, the best you can hope for in return for your dollar bill is a piece of paper that states that the bank owes you one dollar. While it is possible for central banks to remove cash in circulation, they are not obliged to do so.

Until recently, the Fed would only temporarily park non-government securities on its balance sheet: a bank would typically receive a temporary, often overnight, loan for depositing top rated securities with the Fed; these “swap agreements” were traditionally intended for very short-term loans, but the crisis has led the Fed and other central banks around the world to engage in 60, 90 day or even longer agreements. Since late September, the idea of swap agreements has been supplemented by outright purchases.

When the Fed issues cash for debt securities it acquires, we talk about “monetizing the debt”.

This can be taken a step further, although this last phase has not yet been implemented: when the government needs to raise money, the Treasury issues debt in form of Treasury bills and Treasury bonds. To keep the cost of borrowing for the government low, the Fed may step in and buy Treasury bonds. Whereas traditionally, the Fed is actively managing short-term interest rates by buying and selling short-term Treasury bills, the Fed may also buy, say, 10 or 30-year bonds. It's a wonderful funding mechanism: if the Treasury needs to raise cash, the Fed could come and provide it.

Isn't this extremely inflationary? Quite possibly, quite likely, but not necessarily is the short answer. First of all, the Fed has the ability to “sterilize” its debt monetization program. Take the situation where the Federal Reserve buys “highly rated”, toxic assets from the bank, but doesn't want the bank to go out and lend a multiple of the cash it receives. What the Fed can do is to sell the same bank, for example, some Treasury bills to “mop up” the extra liquidity. This would have the impact of improving the bank's balance sheet without supercharging the economy. Indeed, in late September the Treasury instructed the Fed to do just that; they even invented “Supplementary Financing Program” (SFP) bills for this purpose. On the chart below, the dark blue line indicates the cumulative growth in the Fed's balance sheet, i.e. the Fed's “printing of money”; the light blue line shows the cumulative activity to mop up the added liquidity by selling SFP bills to banks. The Fed's balance sheet has grown by about $1.2 trillion to currently over $2 trillion; Dallas Fed President Richard W. Fisher said the Fed's balance sheet may reach $3 trillion by January.

As even the untrained eye can see, the Fed has not mopped up all of its liquidity injections; indeed, as of October 22, 2008, the Fed seems to have all but abandoned the program. In our assessment, at least for the time being, the Fed is not interested in mopping up, but to add massive amounts of liquidity.

Well, isn't that extremely inflationary? It depends on your definition of inflation; if it's a growth in money supply, then, yes, this is already extremely inflationary. But so far, this hasn't translated into higher price levels or even higher long-term inflation expectations as measured by the spread of 10 year TIPS versus 10 year Treasury bonds; TIPS are inflation protected Treasuries that provide compensation for increases in the consumer price index (CPI); it is this spread that the Fed is most concerned about when gauging the market's inflation expectations.

Why has it not (yet) been inflationary? Well, the Fed can provide all the money it wants, but it cannot force institutions to lend. Below is a chart of the “excess reserves” in the banking system; these are the reserves banks hold in excess of what they are required to maintain.(Fed statistical release H3, table 1 column 4):

Until September, excess reserved hovered at or below about US $2 billion, but have ballooned to over $600 billion as of November 19, 2008. Read in conjunction with our discussion above on the Fed “printing money”, the Fed has thrown money at the banking system, but the banks are hoarding the cash , they do not lend. For banks to lend money, two basic conditions must be bet: they must feel strong enough to provide credit; and they must feel their customers – be they consumers or businesses – are creditworthy enough.

Before we discuss the next step the Fed has taken in its undeterred will to unlock credit in the economy, let's pause for a second to look at a potential unintended consequence. If you are a bank and don't like to lend to the private sector, but are awash in cash, what do you do? You can deposit the cash at the Fed and earn 1% interest; you can buy Treasury bills and earn approximately zero; or you can lend money to --- the government. In our view, it seems a logical conclusion for banks to buy longer dated Treasury bonds. Banks are in the business of borrowing short and lending long: typically, banks would have deposits (short-term loans from depositors, callable at any time) and lend to finance long-term projects. This may well be the greatest carry trade of all times, except that it has neither credit, nor currency risk; it does have interest risk, i.e. if long-term interest rates go up because the market prices in the risk of inflation, then banks could lose money.

While Congress may be furious that banks are not lending, the Fed has an interest in keeping the long-term cost of borrowing low. Under normal circumstances, the cost of borrowing should group as unprecedented amounts need to be raised to finance the various programs in the pipeline and additional spending programs expected by Congress; the cost of borrowing has the potential of going dramatically higher if Asian buyers don't increase their appetite for U.S. debt; Asian buyers have, in recent years, purchased the majority of debt issued by the U.S. government. Now, however, there's less trade with the U.S., and Asian governments need to stimulate their domestic economies; while some may try to keep their exports cheap, the Chinese approach of investing about US$ 600 billion into their domestic economy is more efficient. And unlike the U.S. government, the Chinese is sitting on over $2 trillion in foreign currency reserves and can afford to have a massive domestic stimulus package. In our view, foreign governments are unlikely to be able to step in and keep U.S. borrowing costs low.

Never underestimate the Fed. If the money thrown at the banking system doesn't stick, i.e. doesn't result in easier credit for the rest of the economy, they can also be more targeted. As of November 25, 2008, the Fed has announced it will buy mortgage-backed securities in the open market to get the cost of borrowing down. Specifically, debt securities issued by Fannie and Freddie, the government sponsored entities, will be purchased. Almost immediately after the announcement, the prices of these securities rose, causing the yields to go down. The goal of the Fed in this program is to keep the cost of borrowing for homebuyers low. While this will keep the cost of borrowing low for those who qualify for a loan, this program may do little to provide access to the mortgage market for those that have been shunned from it. This includes the difficulty for many to refinance their homes when the value of their house is less than the value of the mortgage.

In our assessment, the Fed will do anything to keep the cost of borrowing low. This has included targeted purchases of mortgage-backed securities to help homeowners; this has included purchases of commercial paper to help corporate America; it has included providing banks with massive liquidity; and it may include the outright purchase of government debt to help finance the spending programs in the pipeline.

What happens if the Fed keeps the cost of borrowing artificially low, either directly or indirectly? Traditionally, the Fed only controls the cost of short-term borrowing, but recent Fed actions set the stage for more active involvement throughout the yield curve, i.e. also for longer dated government bonds. Think about it from the vantage point of the potential buyer of Treasury bonds or Fannie and Freddie paper. If the yield offered is artificially low, then potential buyers are likely to abstain; after all, there may be other investments whose price are less, or not at all, manipulated. Investors don't require a high, but a fair return on their money; they want to be compensated for the risk they are taking. This includes those who lend to governments. In a world where the cost of borrowing is artificially lowered, it may be up to the Fed to be the backstop of all economic activity as other buyers may be more reluctant to step in. Paradoxically, it's precisely government debt that investors are looking for because of all the uncertainty in the private sector. However, as the U.S. does not live in a vacuum, international flows of funds do need to be considered. A foreign investor may think twice before buying U.S. government bonds or agency papers if they are not fairly compensated for the risk they are taking. Aside from our argument above that Asian buyers may not be able to finance U.S. spending, they may be put off by unattractive yields.

After all, the massive stimuli under way should be highly inflationary; but if the Fed helps to engineer that markets cannot price inflation into bond prices, there has to be a valve. This valve, in our view, will be the U.S. dollar; we cannot see the dollar hold up in face of the types of intervention that are under way and that we see play out. Incidentally, a substantially weaker dollar may be exactly what Fed Chairman Bernanke wants. He has repeatedly praised Roosevelt for going off the gold standard during the Great Depression to allow the price level to adjust to the pre-1929 level; this is Fed talk for praising the pursuit of inflationary policies. His only criticism has been that he didn't act fast enough. Similarly, his criticism of the Japanese encounter with deflation has been that the Japanese have not acted forceful and fast enough to fight it; what he may underestimate is that the Japanese have traditionally financed their deficits domestically. In the U.S., these days, most of the deficit is financed abroad; the U.S. is lucky that at least the debt is U.S. dollar denominated so that it can, at any time, repay its debt by simply printing more money. However, the value that foreigners may place on the U.S. dollar may be substantially less the more inflationary the policies are the U.S. is pursuing.

Many still believe in the infallibility of the Fed. Foremost, many support the massive liquidity push because they are firmly convinced that the Fed will mop up the excess liquidity when markets normalize. Indeed, without this confidence, the markets might overwhelm the Fed and cause a disorderly outcome for inflation or the dollar. Even we don't doubt that the Fed has the best of intentions. The Fed believes that the end justifies the means; however, we doubt the end will be as intended, thus questioning whether the means are justified. But just as the past 22 months have shown that the markets do not act exactly as Fed official have anticipated, we cannot see that the Fed, Treasury and other government programs will work as designed. While we don't rule out that an inflationary boom is possible, once the liquidity is starting to be mopped up, we are afraid, economic growth is likely to collapse once again. Unless real wages can be improved, consumers must de-leverage. Propping up a broken system will simply make the later crash even more severe.

Similarly, if Asian governments continue to support the dollar, they will seriously weaken their own position; in a best-case scenario, we will then face the same challenges again in 10 to 15 years, but then a country like China won't have $2 trillion in reserves, but have great difficulty to stabilize its economy. The U.S. has taken the attitude that other countries must support the dollar because it is in their interest. But there's a limit to what other countries can do; there's also a limit when it seizes to be in their interest. In particular, it is irresponsible for the U.S. to pursue a policy that is destructive to the dollar while counting on Asian governments to prop it up. In the meantime, responsible savers in the U.S. have their savings put at risk due to all the bailouts.
A substantially weaker dollar may cause price levels to rise; as a result, the dollar may be a better indicator of inflationary pressures to come than the yield curve that is distorted because of the various Fed programs. Fed Chairman Bernanke may want to have a weak dollar and inflation, but may ultimately be getting more than he is bargaining for.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. 

Published on  Tue, Dec 2 2008, 13:39 GMT

The Road to Financial Ruin: We Have to Spend Money Now

Wed, Nov 19 2008, 14:30 GMT
by Axel Merk

Merk Hard Currency Fund

When just about all economists agree, should we rejoice or be scared? During the Weimar Republic, economists at the Reichsbank argued that printing money to finance a war was “exogenous” to the economy and thus not inflationary. Hyperinflation in the ensuing years proved them wrong. We tend to think we are so much smarter today. Economists know how to run regression models; in the absence of a historic precedent, some economists know how to draw shifting supply and demand curves. But common sense seems to be missing in the toolbox of all but a few.

This past Sunday, President-elect Obama was asked by 60 Minutes where the money would come from for the ambitious projects and stimulus plans:

Question: Where is all the money going to come from to do all of these things; and is there a point where just going to the Treasury Department and printing more of it ceases to be an option?

Obama: Look. I think what's interesting about the time that we are in right now is that you actually have a consensus among conservative, Republican leaning economists and liberal, left leaning economists. And the consensus is this: that we have to do whatever it takes to get this economy moving again that we have to, we're going to have to spend money now to stimulate the economy and that we shouldn't worry about the deficit next year or even the year after. That short-term, the most important thing is that we avoid a deepening recession.

Just about every living soul has advice for our president-elect on where to spend money. Had McCain won the election, things would have been no different; indeed, McCain seemed to enjoy the race to bailouts even more than Obama. Economists are worried about deflation, about imploding asset prices, about demand destruction. They argue that the government must step in where the private sector is falling short. The goal is to prop up demand and preserve jobs. Political considerations on how to spend the money will come into play; it will be interesting to see whether healthcare and education will receive injections as spending in these areas doesn't translate to immediate boosts to employment, spending or investments.

Many economists (Keynesians) believe that government spending ought to be countercyclical to dampen the impact of boom-bust cycles. In practice, everyone wants to be a Keynesian during bad times, boosting government spending, but there is no mechanism in place to force restraint, say through increased taxes, during boom times. This ‘restraint' existed when the gold standard was in place as money was backed by a limited supply of gold. But such restraints were inconvenient and central bankers are now in charge.

There are cushions built into the system already; take unemployment benefits as an example: unemployment benefits reduce the impact of lost wages and stimulate demand during tough times. Note that European countries tend to have more generous unemployment benefits than the U.S.; further in the U.S., most states need to balance their budgets. As a result, when state revenues decline, the downturn in the U.S. economy is particularly exacerbated as government services are cut. There are some that argue that such spending cuts are healthy because the faster we weed out the excesses of the boom, the faster one finds a bottom upon which to have sustainable growth. Further, risk takers might be more cautious if they know that the government won't bail them out, reducing the risks of systemic failures in the first place. Some may even recall that there used to be a breed called fiscal conservatives in Congress, an almost extinct species. Democrats and Republicans alike are all Keynesians these days.

There are two major reasons why we may be setting ourselves up for financial ruin: first, spending is unlikely to lead to a sustainable recovery; second, we cannot afford it.

What started as a valuation crisis that sub-prime mortgage portfolios were kept on the books of financial institutions morphed into a liquidity crisis as financial institutions ceased to trust one another, nor their own balance sheets. The Treasury's $700 billion bailout addresses some of this. But the crisis has since moved to Main Street. Demand for goods and services has been destroyed, not only because of the lack of available credit, but because shell-shocked consumers and companies alike are scaling back their risk appetite. Importantly, even if we found a magic cure to the ills of Detroit and if credit was available to consumers, the car makers have already pre-sold cars years out by having offered zero percent financing on six year loans.

During World War II, government spending was ramped up dramatically. Government spending stepped in as soldiers were abroad. As soldiers returned, government spending was scaled down and the private sector picked up again. This time around, we don't have a war, but too much debt. We are mortgaging our grandchildren because we want to ensure enough Chinese made large screen TVs are purchased. The cure to too much debt is a debt reduction program, i.e. more investments, less savings by consumers. It's possible that a fiscal spending program is going to boost demand. But is it sustainable? Unless real wages are boosted in the process, all we do is create even more debt; growth may falter as soon as the government aid is scaled back. We shall also mention that it is not very easy to scale back government programs once put in place. Social Security, the government sponsored entities (GSEs) Fannie and Freddie, Medicare, Medicaid are all programs that were put in place with the best of intentions and have taken on expensive lives of their own. To compete in the decades to come, the U.S. should invest in intellectual capital, in particular education, rather than subsidizing ailing industries.

We cannot afford the massive fiscal stimuli that we are likely to see proposed in the coming months. It is one thing for China to inject $586 billion into its domestic economy as they have a budget surplus as well as enormous reserves. This money will be spent on infrastructure spending, potentially allowing the country to reposition itself in a world that will be more dependent on domestic economic activity than sales to the U.S. We estimate that the U.S. will need to finance about US$2 trillion in 2009. Who will finance this debt? There is less trade with Asia, so there will be fewer dollars to be potentially recycled into the U.S. economy. And Asia now needs its foreign currency reserves to finance its domestic spending programs. We don't think Asia will be financing the upcoming U.S. fiscal spending spree.

In the absence of Asian buyers, borrowing costs should go up. Specifically, longer dated Treasury bonds should fall in price, boosting long-term financing costs not just for the government, but also all private sector debt including mortgages. But that's exactly the opposite of what policymakers want: after all, policy makers want homes to be affordable, interest rates to be low. In our assessment, this challenge won't stop policymakers from trying to beat the system. In particular, the Federal Reserve (Fed) has, in recent months, instituted a number of programs to prepare for exactly this scenario. In a simplified form, the Fed may just go out and buy the debt the Treasury needs to issue. This may happen outright and is called ‘monetizing the debt'. But it looks like the Fed is pursuing a slightly more elegant variant of the same idea: as part of the recent bailout, the Fed was granted authority to pay interest on deposits with the Fed. In a world where interest rates approach zero, the Fed now has a tool to put a floor under the Federal Funds rate; the Fed hasn't stopped there. The Federal Reserve Bank of St. Louis publishes excess reserves in the banking system on a weekly basis (column 4 in table H3 of the Aggregate Reserves of Monetary Institutions). These are reserves beyond the minimum capital requirements; during normal times, these reserves hover at around $2 billion; since late September, excess reserves have increased dramatically from week to week; as of November 5, excesses reserves stood at $363 billion. This reflects cash provided by the Fed to the banking system: the Fed is literally throwing cash at banks. The published data show that banks are hoarding the cash. Financial institutions do not lend because they don't trust the health of consumers or that of many businesses. The Fed can provide all the money it wants, but the Fed cannot force lending.

If you think about this from the bank's point of view, what would you do with hundreds of billions if you don't want to lend to the private sector? How about buying government securities? Banks are in the business of borrowing short-term lending long-term: the cost of borrowing is very low, allowing banks to engage in a very profitable trade lending to the government. U.S. financial institutions are about to embark in the greatest carry trade of all times, all with money freely provided by the Fed.

This solves many of the problems: the government can spend as much money as it wants as the Treasury's bonds will be purchased by banks that in turn receive funding from the Fed. This cycle keeps the cost of borrowing low for the private sector; eventually, Goldilocks will come back to life and we will live happily ever after. And just in case there are some out there that believe that one can't square the circle, the Fed will introduce an official inflation target to signal to the market that monetary policy will be tightened in case inflation takes the upper hand. That threat alone will ensure the money markets will behave.

In our humble opinion, it won't work. We would like to point your attention to the Panic of 1908 – 100 years ago, there was a law that restricted New York City (NYC) from paying no more than 4.5% on debt it issued. Because investors considered it risky to extend a loan to NYC, there were simply no buyers for the debt. Only after J. Pierpont Morgan (the then 70 year old founder of what is now known as JPMorgan Chase) said he would provide a loan to the city did others come forward (including international investors). We see a direct parallel to what's happening now, although the tools are different: if you keep interest rates artificially low, buyers will abstain. It may be profitable for U.S. banks that receive free money from the Fed to buy the debt, but foreign buyers in particular may simply stay away. Given the enormous current account deficit, we see a severe drop in the dollar as the logical reaction to the policies in place.

A substantial drop in the dollar seems to be in the interest of policy makers. A lower dollar could boost exports. Conversely, for China it is a unique opportunity to lower the cost of imports to allow their currency to appreciate. If China does not act, we will build the same imbalances once again. However, it is questionable whether at the next crisis China will have the luxury to launch a massive stimulus. Further, if policymakers don't want housing prices to fall, inflation may be welcome as the cost of goods and services will float higher, reducing the cost of housing relative to everything else.

Fiscal spending is part of the problem, not the solution. At this stage, the dynamics over the coming years are shaping up. Investors may want to consider whether to take advantage of the panic buying of U.S. dollars to diversify their holdings. Typically, when a currency appreciates, the money is invested broadly in an economy; in recent months, most of the money flowing into the U.S. was invested in short-term Treasury Bills. We very much doubt that all this money will stay in the U.S. once the panic abates. Indeed, whereas just about everyone seems to be concerned about deflation, the risk of not only inflation, but hyperinflation increases with every step taken down this road.

Published on  Wed, Nov 19 2008, 14:30 GMT

Bretton Woods II – A Roadmap

Tue, Nov 11 2008, 14:39 GMT
by Axel Merk

Merk Hard Currency Fund

Following calls by European leaders for a “Bretton Woods II”, the Bush administration has invited the “G-20” countries to come to Washington with the lofty goal to reform the world financial system. Will the way we do business change November 15?

The first Bretton Woods conference, held in 1944, gave birth to the International Monetary Fund (IMF), the World Bank and – albeit with half a century delay – the World Trade Organization. The Bretton Woods conference is best known for firmly anchoring the U.S. dollar as the world's reserve currency. As we will elaborate on below, however, the dollar had to be devalued and taken off the gold standard in 1971 because of market dislocations that are not so different from what we are experiencing today.

As of yet, there is no published agenda for the G-20 meeting. German Chancellor Angela Merkel and French President Nicolas Sarkozy call for “genuine, all-encompassing reform of the international financial system.” This doesn't sound like we will know on November 15 how the world will be structured in the coming decades. In 1944, 44 governments met for 22 days. Today, numerous competing groups are trying to seize the opportunity to shape tomorrow's world. The November 15 meeting will start a process that may take some time. Don't forget that the U.S. has a lame duck administration and foreign leaders will want to negotiate with the new, not the old administration. It will be interesting to see how much of a running start the new administration can deliver.

The main goal of the conference should be to discuss ways of lowering the risks of a re-occurrence of a similar crisis. Discussions on how to deal with the current crisis should be dealt with separately as the past 18 months have shown that the heat of the moment leads to rushed decisions with side effects where the cure of the disease may be worse than the disease itself.

We do know that world leaders and the public alike are upset that the current financial crisis has spread to affect just about every business and person around the world – from the CEOs of what used to be investment banks; to Maine fishermen that have to dump Lobster at a loss making $2 a pound on the market because the processing facilities across the border in Canada have vanished as buyers as they relied on now defunct Icelandic banks for their lines of credit; to the retail industry in the U.S. because their suppliers cannot get lines of credit to ship containers from Asia despite an implosion of shipping rates by some 90%; to farmers that may be unable to buy the seeds for next year's crops; to starving children in Africa that may receive less aid. And why are we in this mess? From an Asian and European point of view, it comes down to a simple realization: because they loaned money to the U.S. The rest of the world wants to reign in what it perceives to be Wild West capitalism. There is also a lot of blame to be placed on foreign regulators, policy makers and financial institutions, but it is always more convenient to look for a scapegoat elsewhere, in this case in the U.S.

We believe discussions will center on making the financial system less risky and more transparent. One of the main weaknesses exposed has been that institutions take on low probability / high-risk positions. Akin to being afraid of a potential nuclear war, we tend to dismiss this risk because the odds of one happening are extremely low (see also minimizing the nuclear risk). In the corporate world, these risks are often ignored; one reason they are ignored is because most firms have limited liability: if the trade works, the payouts are huge. In the unlikely event of failure, you close the shop; let the creditors go home empty; then open a new shop. This model has been employed by hedge funds for years: after a bad year, you start a new hedge fund as you don't have to make up prior losses to get fat profit sharing fees. But now we have major corporations act as hedge funds and failure results in massive job losses and taxpayers are the ones footing the bill; the executives responsible, however, received their salaries and bonuses during the good years and are protected. Capitalism is built on risk taking; the concept of facilitating risk taking using limited liability has been very beneficial to economic prosperity. Changing this concept is unlikely to be on the table, especially since a model of unlimited risk has also shown severe flaws: many will remember Lloyds of London, where “Names” assumed unlimited liability for the insurance company. The “low probability / high-risk” event did occur – notably paying claims related to asbestos litigation -, threatening thousands of Names with personal bankruptcy.

In our view, the ‘Bretton Woods II' meeting's most visible result may be new regulation on the type and scale of risks institutions may engage in. In focus is the derivatives industry where contracts with no or low margins can be engaged in. Low margin requirements for commodity producers (also called commercials) to lock in prices not only make a lot of sense, but are vital to the industry. If a farmer had to deposit 50% of the value of the crop with a counter-party to lock in a price, the farmer would opt not to hedge, but produce less. There are, however, calls to require speculators to put up far higher collateral in the future, likely driving many away from the markets. As we have already seen, however, the markets need the speculators as well: the commercial player needs to have the speculator as a counter-party to take on the risk so that the commercial producer can hedge in the first place. What policy makers must focus on is that the failure of any risk taker does not cause a systemic risk. And the futures markets have worked quite well in that regard: on a regulated exchange, there are strict rules on providing sufficient collateral; this “mark to market” method is strictly enforced. Part of the recent volatility is due to brokers liquidating positions of hedge funds that cannot meet margin calls. But while such liquidations are painful, they preserve the system by forcing losses to be cut within hours or days.

In off-exchange derivatives, however, the rules are rather opaque. But there is a reason for the opaqueness as well: say, you are the beneficiary of a life insurance policy on your spouse. Your spouse is gravely ill. Will you require your life insurance carrier to deposit part of the insurance into a custody account? Will you require your life insurance to increase that deposit if the doctor says your spouse's life expectancy has just been slashed because he or she is not reacting to a medication? The reason why life insurance companies don't work that way is because they assume that not all of their customers die the same day. The financial services industry requires collateral on derivative contracts, but the collateral required during the boom years was rather small. As a result, the banking community was able to create a derivatives industry in the tens of trillions of dollars, mostly unregulated. In the case of credit default swaps (CDS), as the risk of default for formerly sound companies rose, counter parties required more collateral. Those who wrote insurance against the default of companies of, say, General Electric, now have to post large amounts of money, whereas the business model when such insurance was written assumed that the scenario was all but impossible. In the case of Lehman or AIG, it turns out that formerly “safe” companies were risky, after all. Returning to the example of the life insurance, we tend to only take out insurance on something we have a stake in. In the derivatives industry, however, only a fraction of buyers of CDS insure an underlying bond portfolio; the vast majority of positions are speculative positions that firm ABC fails; the speculator has no underlying exposure to ABC, merely betting on its demise. That's akin to you taking out life insurance on Joe the plumber, Joe Six-pack or any other Joe; Joe never has to know about the insurance, nor is Joe a beneficiary. To fix the problem, the Treasury and regulators in the European Union are urging the industry to agree on central clearing for CDS. By moving such contracts onto regulated exchanges, the counter-party risk is radically reduced. Collateral would need to be posted on a daily basis; importantly, a broker will close out a position if collateral is not posted. While this may create losses that wouldn't occur if the contract was held to maturity, it essentially eliminates the systemic risk and forces participants to be more prudent in the amount of leverage they use. A regulated exchange can also provide transparency, allowing regulators to see who bets on the demise of Joe's plumbing firm.

Regulation can also be counter-productive; capping the tax deductibility of executive pay in the early 90s led to the birth of options based compensation and subsequent scandals. If nothing else, there should be a drive to standardize executive compensation disclosures, so that they are not afterthoughts in financial statements, but become household financial variables that allow investors to evaluate when making investment decisions. Beyond agreeing on more disclosure, policy makers ought to be very careful on how to proceed. No matter what the regulations are, financial institutions may always find a way to abuse them during the peak of a bubble.

In our view, rating agencies will likely see major changes in how they will be regulated. Currently, the issuers of securities pay the agency, leading to a conflict of interest and tend to prefer paying for high rather than low ratings. For example, issuers opted not to pay for optional publication fees when ratings were undesirable. There are a number of models under consideration; ultimately, however, the buyers of securities have been too lazy by outsourcing their analysis. It was also the rating agencies that encouraged municipal bond insurers to broaden their revenue streams by insuring collateralized debt obligations (CDOs) to retain their high ratings; this sort of ‘consulting' can backfire as the CDO market has become the downfall for the bond insurers, although it is doubtful that incompetence can be regulated away.

A topic of controversy will be whether to relax fair value accounting standards. Those in favor argue that the downward spiral in financial asset prices could be halted if financial institutions were able to keep assets at cost if their intent is to hold them to maturity and if management believes the ultimate value realized may be a gain. However, it's precisely this attitude that has caused the credit markets to seize because institutions don't trust one another. Housing prices, the ultimate source of many of the problems in financial markets, continue to head lower; to allow companies to fudge their books is plain irresponsible. Unfortunately, the lobbies are strong and there is sympathy with the industry in the U.S., Europe and Japan.

The big fear of Bretton Woods II to the U.S. Treasury is that financial innovation will be stifled. While that's precisely what the public and many policy makers around the world want, the U.S. as a center of the world of finance has the most to lose. Already, many traders and hedge funds are closing their businesses, not just those who have lost a lot of money, but many others who simply do not want to trade when the rules change every day. The damage inflicted here will cost New York and London billions in tax revenue. The likely winner is Singapore that will try to lure some of that business to come to the small state.

The transition from U.S. accounting principles to international accounting principles may be accelerated as part of Bretton Woods II. This may sound insignificant, but has major implications: every new Chartered Financial Analyst (CFA) will no longer be studying U.S., but international rules. Under U.S. accounting rules, corporations can currently reduce the value of their liabilities if their own publicly traded debt is valued at cents on the dollar. That will contribute to a shift from a U.S. centric world to a global world. As healthy as this may be, it will reduce the importance of U.S. financial markets relative to others. There may be restrictions on the amount of leverage institutions may be allowed to use; or on short selling; or on how new financial products are developed. As is often the case with new regulation, the primary implication will be an increase in the barrier to entry. You won't be allowed to engage in short-selling, but those with special licenses will continue to be: note that market makers must be allowed to sell short to ensure an orderly market on the New York Stock Exchange. Or Exchange Traded Funds (ETFs) must allow Authorized Participants to engage in short selling to ensure that the ETF tracks an underlying index.

It is quite likely that the rest of the world will want to impose restrictions that negatively affect the way U.S. financial institutions operate. The question that has yet to be addressed is what will the U.S. demand in exchange for agreeing to reign in its industry. While the answer to this question is open, it can range from strategic to financial. A strategic demand could be concessions on military relationships. We believe there is a reasonable chance that the U.S. will ask the world to accept a substantially weaker U.S. dollar. That's because the U.S. needs to reflate its economy if it does not want housing prices to go any lower. In 2009, an unprecedented amount of debt needs to be raised, raising the odds that creditors will demand higher compensation, i.e. higher long-term interest rates. But if there is one thing the Federal Reserve (Fed) wants, it is to keep the cost of long-term interest rates low. The government may boost the involvement of Fannie and Freddie to offer subsidized mortgages, but sooner rather than later, the Fed may be forced to intervene in the bond markets to keep the cost of borrowing low. Fed Chairman Bernanke has repeatedly praised Franklin D Roosevelt's move to get the U.S. off the gold standard in the 1933 to allow the price level to rise to the pre 1929 level; his main criticism of the Great Depression and that of Japanese authorities in the 1990s has been that they have moved too slowly. As a result, while currently not the main topic of concern for Bretton Woods II, a currency adjustment may well be one of the consequences of the conference; in 1944, too, the realignment of currencies was a result, but not the motivation for the conference. In the end, to prevent a similar crisis from re-occurring, Asian countries in particular must allow their currencies to float higher to allow a normalization of global trade. It is unreasonable to expect the U.S. to start manufacturing consumer non-durables that will be exported to Asia; but a weaker dollar would boost exports and may be seen very favorably by U.S. policy makers.

To give a little more background as to why the dollar may indeed become a topic of the G-20 “Bretton Woods II” meeting, some historic perspective may be in order. In a 2003 analysis entitled “Global Warming”, we wrote: “The most recent experience to a serious dollar devaluation dates back to 1971 when the U.S. abandoned the gold standard on August 15. There are parallels to the events at the time. When the 1944 gold standard (Bretton Woods agreement) was put in place, the US dollar quickly became the world's preferred reserve currency, as it was not only the only currency convertible into gold (at $35 an ounce), but – unlike gold – it also paid interest. In the second half of the 1960s, LB Johnson increased government spending in a booming economy with full employment causing major imbalances. LBJ was more interested in re- election than in taming the economy. As a result, more dollars were printed and foreigners started to exchange their US dollars for gold. By 1970, only 55% of the US dollar was backed by gold; by 1971, that ratio had fallen to 22%. To support the dollar, the German Bundesbank (Buba) purchased US$4bn in April 1971. On May 4, 1971, the Buba purchased US$1bn in 1 day, and on May 5, 1971, the Buba purchased US$1bn in the first hour of trading, after which intervention was given up and currencies were allowed to float freely. A severe devaluation of the dollar ensued”. Similar imbalances have been re-created today, except that the U.S. dollar is no longer backed by gold and foreigners hold U.S. Treasuries; Asian countries in particular may have little choice, but to sell their holdings as they feel obliged to inject money into their domestic economies.

Asian and European policy makers may not be as excited about such a move because their exports have already fallen sharply in light of a weak U.S. consumer. But an adjustment in exchange rates may be inevitable. Europe in particular would not suffer as much as the European industry is favorably positioned to help build Asian infrastructure. If the euro continues to establish itself as a credible competitor to the U.S. dollar, it will benefit from steady inflows – the kind that in past decades has boosted U.S. economic growth. If Asian currencies are allowed to float higher, Asian countries will be able to more easily afford such projects. For Asia, while exports to the U.S. would drop, potentially causing serious disruptions to some sectors of the economy, the cost of imports, namely commodities, would drop. Countries producing at the higher end of the value chain will also be less affected as they will have more pricing power: China, in our view, benefits most from a revaluation. Think about it from a U.S. point of view as well: ever larger projects will need to be outsourced as all easy projects have already been outsourced. China is the one country that has the capacity, managerial know-how and infrastructure to absorb such projects. At the low end of the value chain, a country like Vietnam can only compete on price. When the world leaders meet, however, weaker Asian countries are unlikely to have a say in how the future of the world of finance will be shaped.

Published on  Tue, Nov 11 2008, 14:39 GMT

Outlook On Gold: Buying Opportunity and Hedge Against Uncertainty Ahead

Mon, Oct 27 2008, 10:23 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Perhaps the most interesting development during the intensification of the credit crisis is that the price of gold did not climb higher than it did. Upon the initiation of the crisis in August 2007, the price of gold surged reaching a high of $1002.95 on March 14, 2007. Since then the cost of the precious commodity has fluctuated with the most recent price action sending it to recent lows of 725.74. However, given the pervasive uncertainty in markets we think that this represents a strategic buying opportunity on the back of our bullish call for gold to spike towards $1100 in 2009 with the potential for a much larger move over the longer term.

• Download full Insights Market Outlook with charts

Published on  Mon, Oct 27 2008, 10:23 GMT

Credit and Money Supply Indicators: One Week After Capital Injections

Wed, Oct 22 2008, 09:07 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The injection of capital and elimination of caps on swap lines between foreign central banks and the Fed have engineered modest improvement in credit indictors over the past week.

• Download full report with charts

Published on  Wed, Oct 22 2008, 09:07 GMT

Reduced Gasoline Prices Provide Relief, But May Not Change Consumer Outlook

Fri, Oct 17 2008, 13:36 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Gasoline prices have seen a steep decline over the past three months. Since hitting a peak on July 20, the national average price for a gallon of gasoline has declined 52 cents, which should inject approximately $120 to $130 billion into the pocketbooks of consumers, with more expected on the way. Although, the decline in the cost of energy and other commodities will somewhat offset the overall fall in the rate of personal consumption, the US consumer is well on its way to pulling back the reins on spending in a manner that has not been seen since the early 1980's.

Real personal consumption looks to be on a pace to decline -3.0% in Q3'08 and will almost certainly see a second consecutive negative quarter during the final three months of the year. If consumption were to decline at a similar rate during the final quarter of the year it will be the first time since 1951 that changes of that magnitude have been observed in real personal consumption.

The combined impact of falling housing prices, the reduced value of equity portfolios and bleak job and income prospects are in the process of reshaping consumer expectations despite the positive impact from reduced gasoline prices on the bottom line of consumers. Recent data on retail sales provide tangible evidence that the consumer is in the process of a once in a generation retrenchment.

The primary question outstanding is not if consumers will cut back spending, but where and how. We anticipate that the majority of the reduction in consumption will occur in the ex food and energy category, with particular emphasis on imported goods. On a monthly basis, demand for imported goods declined from $194.94bln in July to $188.54bln in August. Inside the goods category that declined -3.3% in August, demand for computer accessories, household electronics and appliances all experienced declines.

Going forward we expect the consumer to begin increasing her rate of savings over the next year as individuals adjust to a diminished employment and income picture. Reduced demand for goods overall and imported goods in particular, will hit the retailers quite hard and curtail overall growth. The approximately $300bln output gap that the majority in Congress appear to be targeting with their new proposal will not provide direct rebate checks to consumers, but looks to be aimed at bailing out states and municipalities and focused on job creation vis-à-vis infrastructure projects. Thus, the largest decline in retail prices that have been recorded in the post war era looks to have little impact over the remainder of the year and well into 2009 on the behavior of the consumer.

• Download full Insights Market Outlook with charts

Published on  Fri, Oct 17 2008, 13:36 GMT

Recession Signals: Industrial Production Looks To Decline Again In September

Thu, Oct 9 2008, 16:18 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

While, the service sector does account for well over 80% of overall economic activity, industrial production often provides a very timely indicator implying the end of the business cycle and the onset of a recession. The pro-cyclical nature of the report provides a well-timed and sensitive indicator of the current rate of growth in overall output. We expect that the September industrial production report based on our forecast of a -1.4% print will confirm other grim data that the market has observed in the manufacturing sector and looks to provide a strong signal that the business cycle has reached its end and the American economy has entered a recession.

As always, the devil is in the details. On first glance, industrial activity picked up in the early summer due to the increase in production caused by the settlement of the strike at American Axel, a key supplier of parts to the domestic automotive industry. However, during the second quarter of 2008 total industrial production on a year over year basis, contracted at a rate of -3.2%. Moreover, with domestic light auto and truck sales in an advanced state of collapse, this implies that auto assembly going forward will see another round of retrenchment.

Looking at the September employment report total hours and overtime hours worked in the manufacturing declined for the third straight month with noticeable declines in the primary metals and fabricated metals sectors. Hours worked in natural resources and mining declined 1.0% on a monthly basis.

Perhaps more troubling is the decline in the September ISM report that saw the overall manufacturing index decline to 43.5 and production collapse to 40.8 even in light of a sharp fall in the prices paid category and still relatively decent demand from the external sector that saw growth during the month. The combined evolution of the data does strongly suggest that the economy has moved into territory consistent with overall contraction.

Thus, we do not anticipate that on a national basis that the manufacturing sector will see any growth during the final two quarters of the year. Our provisional forecast is that industrial production will contract at a rate of -0.7% in Q3’08 and -1.0% in Q4. The risk to that forecast is to the downside due to an expected decline in demand from the external sector going forward and the likely impact caused by a stronger dollar in the coming months.

• Download full Insights Market Outlook with charts

Published on  Thu, Oct 9 2008, 16:18 GMT

Recapitalizations – Rate Cuts – Yen becomes Hard Currency

Wed, Oct 8 2008, 16:23 GMT
by Axel Merk

Merk Hard Currency Fund

Europe was all but written off on Tuesday when Gordon Brown, the UK prime minister announced late in the day that £50 billion (about $85 billion) may be injected into several of the biggest banks. The details known so far are that eligible banks can issue preference shares to the government; the Bank of England makes another £200 billion of liquidity available in the short-term markets; and a further £250 billion of government guarantees are issued to help banks in their funding needs. We have been arguing that recapitalizing banks is the most effective way to support financial institutions (see our analysis of the $700 billion bailout package). Just as important, however, is that a European government was able to act. The British approach may serve as a model for the rest of Europe and possibly the US as well. Already, the Italian government has indicated that they will follow suit. The reason bank re-capitalizations are so much more effective is because fresh capital may be used with leverage; with fresh capital, financial institutions are free to employ a market based solution to their bad assets. In the UK model, other than the dilution of issuing shares, there is no penalty associated with the government support. While this may draw the ire of the public, it may encourage private investors to follow suit; the reason private investors have been reluctant to provide capital to financial institutions is because, at least in the US, equity holders have been wiped out whenever the government has provided support.

We saw a coordinated rate cut around the world Tuesday morning. Central banks around the world had waited with a coordinated cut until they saw a chance that such a cut would have an impact. For that, the program announced earlier this week by the Federal Reserve (Fed) to buy commercial paper was a necessary pre-condition; the Fed may now also pay interest on deposits. These programs may help to unlock the frozen money markets; the coordinated rate cut is intended as jumpstarting these markets that have been in cardiac arrest. If the money markets are frozen it does not matter what rates the Fed is charging. The design of the commercial paper program will help but may not be sufficient as the Fed will buy directly from corporations rather than act in the secondary market; the challenge with that approach is that rather than acting as a clearing agent, the market may outsource the commercial paper market to the Fed. This is still a relief to banks that can now protect their lines of credit, but will still make money market funds reluctant to buy commercial paper as it may not be possible to sell any securities acquired; however, it does remove the “rollover risk”, the risk that firms can refinance any maturing paper.

During the credit expansion, European Central Bank (ECB) Trichet had been arguing that ECB policy was not tight despite widespread criticism; his argument was that credit was easily available and the level of interest rates didn't matter as much. Using the same argument, the ECB now has leeway to cut rates without giving up its mandate on price stability. Because inter-bank lending rates are very high, the ECB's lowering of rates is merely an attempt at adjusting the market's rates to the level the ECB desires. The media spins the coordinated rate cut more as providing cover to the ECB; we believe that while the coordinated rate cut is certainly appreciated, the ECB is not wandering away from its mandate of price stability.

Indeed, by trying to stabilize the financial system in earnest now, we are moving to a new phase in adjustment of the global imbalances. In the current phase, should the governments succeed to stabilize financial institutions, we will allow an economic contraction to take place in an orderly, rather than chaotic manner. This is a deflationary force that central banks, in particular the Federal Reserve, may fight vigorously; this may cause problems down the road; gold is already signaling that this may eventually be inflationary; the dollar may follow suit versus other currencies.

A beneficiary of the current phase is the Japanese yen. The Japanese banking system appears now more stable than the banking system of any other country. The Bank of Japan (BOJ), while supportive of the coordinated rate cut, did not participate. Not only are the ultra-low interest rates in Japan now less extra-ordinary because of the rate cuts elsewhere; more importantly, the BOJ has shown restraint and prudence in recent months. This may well be a reflection that boosting exports by weakening the yen may prove ineffective in a weakening global economy rather than the BOJ suddenly adopting a stoic attitude. However, we are sufficiently encouraged to elevate the Japanese yen to the family of hard currencies. We have argued for some time that the Japanese economy could absorb a stronger yen – with pain, but without crumbling.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com. Please also register for our free webinar on October 15, 2008, to get an update on our views on the economy and the markets.

Published on  Wed, Oct 8 2008, 16:23 GMT

The World in Crisis: Where are the Safe Havens?

Tue, Oct 7 2008, 16:24 GMT
by Axel Merk

Merk Hard Currency Fund

We have been warning for some time that “there is no such thing as a safe asset anymore, you have to take a diversified approach to something as mundane as cash.” Unfortunately, the current crisis shows that we may be right. Physical gold is attractive to many investors because of its lack of counter party risk. The only counter party risk with gold held in your personal vault is that someone may break in and steal it. However, even staunch gold bugs rarely hold all their net worth in gold, but diversify if for no other reason that it is impractical to have essentially all your net worth in gold. And while gold is currently fulfilling its role as sound money, it often trades in tandem with other commodities; this can result in stomach-twisting volatility. As a result, many hold gold as insurance, but few truly live on their personal gold standard.

In late 2006, we forecast the ensuing surge in volatility to unwind the unprecedented credit expansion that had taken place in the previous years (please click here for past Merk Insights). When the crisis first started, we argued that the markets dealt with a valuation, not a liquidity crisis: financial institutions were unwilling to sell off assets on their books out of fear of jeopardizing their capital ratios. By now, the valuation crisis has morphed into a liquidity crisis where financial institutions don’t trust one another; inter-bank lending is grinding to a halt. The business model of most commercial banks consists of borrowing short-term funds to provide long-term loans; if short term funding is not available, central banks step in as the lender of last resort. Consumers, investment banks, large corporations, municipalities and states alike have realized that they do not have a central bank as a lender of last resort; when short-term funding dries up, they may have to file for bankruptcy protection even if they are otherwise financially sound. Quite simply, unless one can afford the risk of not obtaining refinancing, we believe long-term projects ought to be financed with long-term loans.

Accessing the lender of last resort for overnight funding requirements is generally frowned upon. Banks that may need to access the Federal Reserve (Fed) “discount window” or one of its new short-term facilities tend to reign in their lending activities to hoard cash; this is motivated by a desire to rebuild the balance sheet so that at some point reliance on the Fed may no longer be necessary. Similarly, if they were to access the interbank lending market at what is currently a very high rate, they would eventually have to pass on the elevated cost of borrowing to their customers. This makes credit availability “tight”; in a credit driven society, this is bad for economic growth. Hoarding cash to rebuild your balance sheet quickly becomes a habit - just as the Japanese or those who are still around to have experienced the Great Depression. A depression is not merely a severe recession; it is a state of mind.

Because of these concerns, policy makers want to jump start credit markets, especially short-term money markets, at just about any cost. The Fed just announced an increase of its Term Auction Facility (TAF) to over $900 billion; the TAF effectively allows financial institutions to park a broad range of collateral in return for cash with the Fed. The bailout plan approved in Congress tries to be a tool in Treasury Secretary Hank Paulson’s “toolbox”; a coordinated interest rate cut throughout the world may be applied with the same objective. One should not underestimate the will of the Fed to throw money at the problem; at the same time, the Fed has underestimated the markets’ resilience to make that money stick.

So far, efforts by policy makers have been ineffective. It appears that, at least for now, central banks may be losing control of the situation as massive liquidity injections are simply not enough to stabilize the credit markets. Much of it is because, in our assessment, the Federal Reserve has been losing valuable time by employing inefficient policy tools. Amongst them is that the cutting of interest rate had been mostly ineffective while we had a valuation, not a liquidity problem; now as we have a liquidity problem, the Fed has less ammunition. Similarly, the $700 billion bailout approved in Congress may be ineffective if it is not used to improve the capitalization of financial institutions, but merely replaces bad assets with good assets; this move may be helpful, but is not enough. Again, valuable ammunition is wasted should, to name potential challenges ahead, the credit continue to be seized up; should the automotive and airline sectors deteriorate further; should the anger in public increase and the mood in Congress to reach constructive solutions worsen; or should the consumer slide further into recession.

The implications of all of this heavily depend on how governments interfere in the markets. Without interference, only the strongest institutions may survive. That’s why the large U.S. financial institutions, in particular JP Morgan, Bank of America, Citigroup and Wells Fargo have experienced substantial inflows in recent weeks, at the cost of small banks. To stem the flow out of small institutions, Congress has increased FDIC insurance. In Europe the same trend can be observed with HSBC, Europe’s largest bank, experiencing large inflows – despite HSBC’s exposure to the U.S. subprime market through its 2003 acquisition of U.S. based Household International -, but many smaller or weaker institutions experiencing outflows. European governments are scrambling to issue guarantees for depositors to stem the tide; one may take note that many of these guarantees only affect personal, not business accounts. There is the danger that governments may not be strong enough to bail out their financial institutions. Iceland, in particular, has seen not only a flight on its institutions, but also on the currency; as the crisis deepens, there is the real fear that Iceland may become insolvent. For the time being, Iceland is negotiating a loan from Russia and is attempting to peg its currency; as of this writing, it is not sure whether this will work as trading liquidity dried up as a result as the unofficial exchange rate is about half of what the peg would suggest.

As most know by now, not all cash is the same. The U.S. government has taken steps to shore up confidence by, for example, temporarily increasing the insurance on FDIC insured deposits; or providing assurances on money market funds. Still, we have seen brokers transfer units of money market funds rather than cash for intra-broker transfers; this is a legitimate practice, but shows the strains in the money markets. One safe alternative is the purchase of U.S. Treasury Bills; the challenge is that the yield on a 4-week T-Bills is just above zero, possibly negative after commissions. Given the volatility in the current markets, it is possible to lose money if one needs to sell the T-Bills before they mature should they drop in value. Recently, we were unable to buy a 3-month T-Bill because the yield would have been negative. Imagine the strain on money market funds that don’t want to touch any commercial paper, but have to keep a stable net asset value, after expenses. Many Treasury-only money market funds may engage in overnight repurchase agreements; this may allow such money market funds to get sufficient return to keep a stable net asset value after expenses, but it is not what investors in these funds necessarily expect. To some, but certainly not all, it may be reassuring to some that the government provides a backstop to money market funds. Some opt to take the cash and put it under their mattress, literally. In California, everyone is encouraged to keep an emergency pack in case of an earthquake; why not also hold some cash and gold coins just in case the financial system seizes up? Financial institutions are hoarding cash, why shouldn’t you? Please note that this is not investment advice, but food for thought.

How will this play out? In recent days, there has been a flight to cash, U.S. dollar cash. The violent deleveraging has accelerated and the only currencies that have benefited from this are the Japanese yen and the U.S. dollar. The U.S. dollar has returned, at least for the moment, to its safe haven status. This has become a fairly common phenomenon in recent crisis, but did not necessarily last; U.S. investors repatriate foreign investors in times of crisis; as a second wave, they then decide how to deploy them. The challenge with holding U.S. dollar cash is that it is also not without risk because one can never underestimate just how determined the Federal Reserve is to get the credit markets going. Fed Chairman Bernanke has been critical of how the Japanese handled their banking crisis in the 1990s because they Bank of Japan was not forceful enough in pre-empting the crisis. This is part of the reason the Fed and the Treasury were pushing for the $700 billion bailout before the crisis was felt on Main Street. Japan, unlike the U.S., however, does not have significant foreign creditors; the U.S. is crucially dependent on foreigners to support the currency. Fannie Mae and Freddie Mac were quasi-nationalized after foreigners no longer bought these agency papers, causing a 94.5% drop in foreign investments in the U.S. in the 2nd quarter. Foreign investments have since returned, but foreigners have every right to be nervous on how the Treasury and the Fed steer through the waters. In the latest developments, the Fed has indicated that it will buy commercial paper directly; the initial positive reaction is that this very targeted action does indeed help the commercial paper market; the negative reaction is to the dollar that is reacting negatively.

In the meantime, fears about the European financial sector have increased. Hypo Real Estate, a large German real estate company and DAX listed company, would have collapsed had it not been for a government-orchestrated bailout. A €30 billion rescue package hastily put together collapsed over the weekend when an audit revealed that the short term funding requirements were substantially higher. By Sunday night, a new rescue package was put together. In Europe, not all cash is the same, either. The short-term money markets are seized up, only government securities issued by select Northern European governments are in demand; in Switzerland, for the second week in a row, T-Bills (other countries also issue T-Bills in their domestic currencies) were issued with 0 yield, resulting in a negative yield for any participant that had to pay commissions. In our view, though, the European Central Bank (ECB) has been prudent in not lowering interest rate to date; as of October 6, 2008, short-term rates have remained at 4.25%. This gives the ECB far more ammunition than the Fed to help the crisis. ECB President Trichet has re-iterated many times that they are exclusively focused on price stability and will not lower rates merely because of an economic slowdown. However, because interbank lending rates have soared, the ECB now has substantial leeway. Just as Trichet said in 2004 that monetary policy was not tight because credit was easily available, he can now lower rates without causing inflation because – even with lower rates – access to money is likely to remain relatively tight.

A major driver in all markets, including the currency markets, has been the at times violent unwinding of leveraged positions held by hedge funds. Multi-billion dollar hedge funds need to liquidate positions, partially to meet redemption requests (according to media reports, some of the largest funds had negative returns in excess of 50% in the first three quarters of 2008), partially to reduce counter-party risks. AIG, the bailed out U.S. insurance giant, for example, was the guarantor to many financial instruments, including some London based commodity exchange traded funds (ETFs); in the weeks before AIG’s collapse, in our analysis, hedge funds unwound ‘long inflation’/’short financial’ trades, causing seemingly erratic actions in the market. On Monday, October 6, 2008, the yen surged 4% versus the U.S. dollar while the Australian dollar fell by over 6.5%; such extreme action is a clear indication of an unwinding of the popular ‘carry trade’ where hedge funds had borrowed money cheaply in yen to buy higher yielding currencies, such as the Australian dollar. Volatility is the enemy of the carry trade as leverage of 30:1 or even 100:1 is the norm rather the exception for such trades. A day later, Australia’s central bank has lowered interest rates from 7% to 6%, which further reduces the attractiveness of the carry trade. Another suggestion that hedge fund liquidation is contributing to the volatility is the intra-day rise of the shares of Volkswagen, the German carmaker, of 55% on October 7, 2008; the carmaker did not reinvent the wheel, but a short-squeeze must have caused the massive rally. For the global deleveraging to succeed, we must see this type of action because hedge funds are one type of leveraged player that must be brought to its knees.

In our analysis, we have not seen the end of the crisis; we expect continued volatility in the days, weeks and months to come. While we have been critical of U.S. institutions for not acting fast enough, there is progress. The remaining large financial institutions may be too large to fail; institutions from Bank of America to Citigroup; from Goldman Sachs to General Electric have been swallowing tough medicine to strengthen their respective balance sheets in a market when capital is expensive. In Europe, financial institutions still have a lot of work ahead of them; however, it does look like European governments are waking up to the seriousness of the situation. Without passing judgment whether bailouts should have taken place, European governments have shown both will and ability to act. What makes us more positive about Europe than many is that, ultimately, European economies are less fragile because of – with some regional exceptions - much healthier consumers and less elevated home prices. European governments may also be more willing to nationalize banks or force capital injections to protect the system than U.S. regulators are. Ultimately, it is capital that is missing more than anything; and then there’s the value of homes that triggered all of these – in the U.S., home prices continue to be too expensive, posing further risks to the U.S. economy and the dollar. Finally in Asia, while Japan is ironically shining, the region has yet to see the full impact of weaker sales to the U.S. and potential shocks to their real estate markets.

We don’t have a crystal ball either. But being active in parts of the money markets both domestically and abroad, we are concerned at what we see. There is a significant risk that the U.S. dollar resumes its downward trend. As a result, investors may want to consider diversifying to take this risk into account.

Published on  Tue, Oct 7 2008, 16:24 GMT

US Employment Picture: September Non−Farm Payrolls Preview

Fri, Oct 3 2008, 08:54 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The upcoming release of the September non-farm payrolls report by the Bureau of Labor Statistics will not provide much comfort to the market or the public. Our forecast implies that payrolls will decline -105K and that the rate of unemployment will increase to 6.2% for the month. The strike at Boeing and the displacement of workers in the Southeast due to the twin hurricanes that hit the area during the sampling period should send the headline estimate of job losses above the recent trend. The risk for the report is to the downside and we do expect that the rate of job destruction will increase in the coming months.

Thus far 650K jobs have been lost during the year. The troubles in the housing sector and the now yearlong crisis in the credit market have begun to spillover into the broader economy. We anticipate that autoworkers and individuals in the technology sector, especially those in the work in computers may see an increase in unemployment in September and in the coming months.

We base this forecast on the growing evidence that that weakness in the manufacturing and goods producing sector has spilled over into the once potent service sector. We anticipate that close to half of all losses will occur in the manufacturing sector with the service sector seeing a fourth straight month of declines, in addition the weakness in the goods producing sector. Outside of the positive contributions from the government and the healthcare sector, the labor picture is in the process of moving in a decisively negative direction.

The deterioration in the unemployment picture is equally bleak. The sharp jump in the rate of unemployment in August was characterized by an increase in the duration of unemployment of 27 weeks or longer. Over the past year the number of unemployed individuals has increased by 2.2 million, while the unemployment rate jumped 1.4% over that same period, 1.3% over the past six months and 0.4% in August alone. During the post war period, each time the rate of unemployment has increased by 1.0% during a twelve-month period the economy proved each time to be in recession. Based on the most recent data we have updated our forecast on the rate of unemployment to 6.9% by mid 2009.

Looking forward, the September jobs report will not capture the recent intensification of the credit market and the complete seizing up of the short-term market for money. Firms that rely on the credit markets to roll over short-term debt and meet bi-monthly payrolls may find it increasingly difficult to do so. If the current financial crisis turns into an economic event, the market should ready itself to observe a far sharper dislocation in the workforce than is currently assumed. Thus, if the credit markets remain frozen well into October, there is a definitive risk that culling of the labor force will pick up beyond our provisional expectation of losses through the end of the year in the job sector of up to 150k per month.

Published on  Fri, Oct 3 2008, 08:54 GMT

Budgetary Consequences Of The Financial Crisis

Fri, Sep 26 2008, 13:56 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The consequences of the troubled asset relief program (TARP) will be felt for a number of years. The death of the investment-banking model, the transformation of the domestic system of finance and the coming wave of regulation of what is left of Wall Street will have far-reaching consequences. This, however, will take much time to absorb and assess. What is of immediate concern, is how the proposed $700 billion TARP will impact the budget outlook for fiscal year 2009.

Looking at the -$486 billion deficit throughout the first 11 months of the 2008 fiscal year the primary catalysts for the sharp increase in federal spending have been the fiscal stimulus and decline in tax revenues caused by the economic downturn. We expect that the final month of the fiscal year will see a net surplus for the month near $46 billion. Thus, the fiscal year, which will come to a close at the end of September, should see a deficit of -$440 billion in contrast with the -$162 billion deficit recorded in fiscal year 2007.

Once one begins to take a look at the staggering problem at hand, the deficit that was previously projected by the Congressional Budget Office of -$438 billion could easily double. Our first cut estimate now expects that the deficit could reach as high as -$585 billion in fiscal year 2009.

We make that estimate based on the following assumptions.

• * Tax revenues will continue to underperform on the back of a much rougher economic landscape than the CBO currently has penciled into their model
  
• * We expect an additional fiscal stimulus of a minimum of $50 billion dollars, with risk to the upside
  
• * Increased outlays to cover coming bank failures of a minimum of $30 billion in FY 2009.
  
• * An extension of the Alternative Minimum Tax fix
  
• * This does not account for any additional spending that may be put on the books in the first few months of the new administration in 2009
  
• * It is unclear how much of the estimated $700 billion TARP will be allocated to FY 2009 spending. We expect that it will be valued as such that it does not significantly increase the overall budget.
  
• * This assumes that the bailout of Fannie and Freddie are not put on the books in FY 2009
  
• * According to the CBO no decisions have been made regarding how the funds pledged will be allocated
  
• * CBO Director Peter Orszag believes that the bailout of Fannie Mae and Freddie Mac “should be directly incorporated into the federal budget.”
  
• * Our initial estimate of $300 billion as the price tag for the bailout of Fannie and Freddie was based on an assumption of a 5% loss in the overall value of the GSE's. This may be on the light side and the cost could be considerably larger.
  
• * Such a move would be quite contentious and could raise direct questions regarding the credit quality of the US.
  
• * Depending on how the U.S. Treasury proceeds and how the outlays are valued and classified the FY 2008 debt could easily reach $885 billion with considerable risk to the upside once one adds in any spending during the early portion of the new administration.

The short-term consequences of the bailout are quite clear. The fiscal years 2009 and 2010 will see record deficits on a nominal and possible real basis. The debt to GDP ratio will increase from roughly 3.0% of GDP in 2008 to a possible 6.0% in 2009. The steps that are about to be taken will crowd out other spending priorities and may lead to a reassessment of current entitlement obligations, foreign operations, national healthcare system and levels of taxation.

Long term however, the consequences are unclear. The major issue that is rightly being discussed is; will the increase in federal outlays be inflationary? On first look, the increase in spending and rising public debt is not necessarily inflationary. The Fed can take steps via the federal funds rate to maintain price stability.

Unlike, in many developing countries the Congress, outside of printing coins, does not have access to the printing presses. As long as the Federal Reserve does not make the decision to monetize the debt, the inflation problem from the increase in outlays could plausibly be addressed. However, this will require the Fed to remain focused on price stability and to continue to make the case that stable prices are a precondition of maximum sustainable employment. This may require the Fed to impose higher rates on short-term borrowing than our political and financial classes are currently comfortable. Yet, that is a very tall order for even an independent central bank to fill.

While, there is theoretically no direct impact on the rate of inflation due to the increase in spending, there is the chance that the introduction of political logic into an otherwise economic process could alter the equation. One does not need to be able to recall Lyndon Johnson literally pressuring Arthur Burns into funding his foreign adventures and ambitious domestic spending initiatives, to imagine that the constellation of political forces inside Washington could begin to bend the will of the Fed.

Should the current financial crisis lead to significant deterioration in the economy or taxpayer losses exceed current estimates due to the sheer cost of the financial bailout, pressure could be brought to bear on the Fed in such a way that it may be difficult for the central bank to focus on price stability. The central bank might at some point in the not so distant future decide to tolerate a far higher rate of inflation than is consistent with a non-inflationary target rate. The temptation to keep the federal funds rate low and partially monetize the debt may prove irresistible to the central bankers that may run the Fed in the aftermath of the Bernanke tenure.

Past episodes of inflation have often begun under such conditions. Past deterioration in public finances have often led to unwise monetary policy. Today, the probability of the printing presses being cranked up to fund current obligations of the Federal Government remains low. However, for individuals and institutions engaging in long term investment decisions the risk of higher inflation over the long term due to the sharp increase in federal outlays and public levels of debt should receive serious consideration. It cannot be automatically dismissed out of hand.

Published on  Fri, Sep 26 2008, 13:56 GMT

Urgent Appeal: Recapitalize Financial Institutions Rather than Bail Out Debt

Thu, Sep 25 2008, 16:02 GMT
by Axel Merk

Merk Hard Currency Fund

In the coming days, Congress may authorize $700 billion to buy bad debt from financial institutions. Even if all challenges of the plan were to be overcome, the plan does not address one of the fundamental reasons why credit markets don't function properly: the under-capitalization of financial institutions. Under-capitalized financial institutions may seek to repair their balance sheet rather than engage in lending activities. If securities are purchased at market value, all the Treasury Department's plan achieves is to provide liquidity to the markets. This is a worthy goal to allow the rolling of debt, but does not guarantee that banks will start to lend again, nor does it provide a floor under the housing market. The plan is fraught with risks that include lower economic activity and a lowered standard of living for all Americans should creditors demand higher interest rates for the sharply growing appetite for debt of the country.

Instead, a capital infusion on the equity side of financial institutions would strike at the core of the problem. Financial institutions employ leverage; any dollar added in equity may be worth ten dollars in lending power or more. Stronger financial institutions would be able to find a market based solution for their bad debt and, simultaneously, start lending again. $700 billion would be more than adequate to recapitalize financial institutions; however, $700 billion spent on buying bad assets may or may not be enough to find a cure for the system.

By providing capital, the government must avoid a critical mistake the Treasury has made in recent months. In recent months, whenever the Treasury intervened – be that in the case of Bear Stearns, Fannie & Freddie (the “GSEs”) or AIG, common stock holders were pretty much wiped out. This serves the political purpose of punishing equity holders, but has the disastrous side effect of signaling to the market that anyone providing equity to financial institutions is likely to be severely punished. After all, the Treasury successfully lobbied the GSEs to raise capital this summer, only to wipe out existing common and preferred stock holders a few weeks later. Other side effects of ad-hoc interventions included that commercial banks now have money market funds competing with FDIC insured deposits because of the emergency guarantees under consideration for money market funds. Aiding on the debt side may also be a lose-lose proposition for the dollar: if U.S. subsidiaries of foreign financial institutions receive inferior terms, a capital flight out of the U.S. may ensue; however, if they do receive the same terms, foreign financial institutions have a major incentive to move bad assets to their U.S. subsidiaries. Also importantly, providing capital infusions make the bailout plan less dependent on international cooperation than a bailout of bad debt would require; given that central banks and governments around the world have rather differing views on how to proceed in the current crisis, international cooperation cannot be counted on.

Understandably, the government does not want to reward shareholders whose firms have made bad decisions. At the same time, it is crucial for financial institutions to raise more capital, but capital is scarce. An auction model may be the most suitable compromise: firms that seek capital receive bids on the terms others are willing to inject capital. The government then offers to inject capital (possibly a multiple) using corresponding terms. The private sector bids are likely to be substantially higher if they know that the total capital raised by the firm will be sufficient to bring the firm on a sound footing. The punishment for existing shareholders comes through the dilution created by the market forces of the offering. Whether the government wants to achieve restrictions on executive pay is a political question, but a question the government should then ask as a shareholder, not as a legislator.

This proposal is not without risks, notably we could create a dozen Fannie and Freddie style entities if the government were to seize control of financial institutions. The government should receive restricted stock whose powers and influence are clearly defined; there should also be guidelines established to sell government shares over time by selling them to the public (at which point restricted stocks could be converted to common stock). The Treasury Department would be required to design and publish rules as to when the government would participate in an auction; note that to date, neither the Treasury, nor the Federal Reserve have provided guidelines on when they would interfere in the markets. While this may provide tactical advantages, the lack of a clearly communicated long-term plan may increase inflationary pressures as policy makers throw money at every new crisis that erupts. Any firm that desires to participate in the program should be required to have its books sufficiently transparent to allow for private investors to make bids and make a case as to why a failure of their firm would cause systemic risk. We understand that this solution is also far from perfect as it also raises many questions.

Our preferred scenario would be to allow free market forces play out. We should not throw 200 years of bankruptcy law history out of the window and replace it with a patchwork of new rules and regulation. The unintended consequences of ad-hoc regulations risk destroying New York as the financial capital of the world. The reason the U.S. enjoys this status is because it has traditionally had the fairest rules for all market participants, including allowing for the possibility of failure. Singapore, Dubai and other cities are eager to fill in any void created should policy makers create more harm than good.

However, if indeed a bailout is going to be taken and imminent, we urge policy makers to strongly consider injecting money on the equity side rather than buying bad fixed income securities. It is a political nightmare to manage such the ‘bailout portfolio’; and who would be willing to do so? A Warren Buffett wisely declines saying he may have too many conflicts of interests; that comment comes from a man who likely has less involvement in the bad debt under discussion than most in the industry. However, PIMCO is already pitching its services, even pro bono. Of course PIMCO would offer its services for free, as they could lift the prices of all their own debt securities by buying up comparable securities in the market, in the process possibly earning billions.

Of course, the above discussion does not address the second fundamental problem: the fact that home prices remain too high. In our humble opinion, the bailout as currently under consideration in Congress does little to address this. A capital infusion, however, at least provides banks with greater flexibility of finding a market-based solution, reducing, although not eliminating, pressure on policy makers to agree on how to address this.

We manage the Merk Hard and Asian Currency Funds, mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.

Published on  Thu, Sep 25 2008, 16:02 GMT

Potential Economic Fallout From Credit Crisis

Fri, Sep 19 2008, 13:18 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The events of the past seven days have altered the shape of the market and will impact the economy going forward. The current financial crisis reflects the failure of firms to deleverage in an acceptable period of time. The inability or unwillingness to accept the terms of re-capitalization offered troubled institutions has set in motion the financial train wreck of which we all bear witness. While growth over the past year has exceeded the very low expectations set by the market, the risk to economic output over the remainder of the year is to the downside.

First, the reduction of available credit to consumers and firms will impact overall economic activity. This should be initially observed inside the housing sector. The development community which, until recently took heart in the flattening in the negative slope of housing starts and falling interest rates, will take it on the chin once again as tight credit and lending standards impede the building of homes and the purchase of an already elevated existing stock on the market.

Second there are still pervasive problems in the banking industry. For example, WaMu (not a holding of the Merk Mutual funds) is currently trading just above $2.0 per share down from it recent high of $38.32 in September of 2007 and remains under duress. At the end of Q2'08 WaMu had just north of $150 billion in interest bearing deposits, held $181.5 billion or 58% of its total assets in home lending and wrote off $2.17 billion in non-performing loans, mostly attributed to mortgage defaults, in the second quarter. Currently, the FDIC has $52.413bln in its insurance fund balance and can tap a line of $30bln line of credit at the U.S. Treasury should additional banks fail.

Second, the sharp decline in the value of equities should provide a negative wealth effect on consumers. Personal consumption which we already expect to post a negative print in Q3'08 looks to now possibly contract at a rate of -1.0% during the quarter with additional downside risk in the final quarter of the year.

The decline in the cost of oil and gasoline will provide some savings to consumers and could possibly offset the negative impact on consumer psychology. However, as the recent data suggests even a decline of -4.2% in the cost of gasoline during the month of August did not lead to increase in retail sales during a time when back to school sales traditionally draw consumes into the malls. Given the storm clouds gathering over the consumer we think that recent events should cast a greater shadow over any increase in appetite for consumption.

External demand, which has provided a major source of support for overall economic activity during the now thirteen month financial crisis should see real declines on the back of the global credit tightening that the market is in the process of absorbing. While we are still only days into the recent evolution of the financial crisis, we are observing some unwinding of positions in Emerging Markets and risk aversion plays as capital flows into gold and Swiss Francs, two traditional safe havens in times of crises.

Should credit conditions not return to something approximating normal over the next few days our economic outlook will be adjusted accordingly. At this time, the damage wrought by the latest seizing up in the credit markets has not become an economic event. However, we have inched closer to the outcome and we continue to believe that risk is to the downside for the U.S. economic outlook.

Published on  Fri, Sep 19 2008, 13:18 GMT

Federal Open Market Committee Meeting: September 16

Mon, Sep 15 2008, 08:34 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Nearly ten years ago the Federal Open Market Committee convened a special meeting to address the problems in U.S. financial markets regarding the failure at Long Term Capital Management. It is not without irony that one decade later the Fed and the U.S. Treasury are addressing an infinitely more complex problem with respect to Fannie Mae and Freddie Mac, while at the same time contemplating the potential failure of major investment and commercial banks.

Unlike the special meeting that occurred over a decade ago, there is little doubt that the Fed will remain on hold ahead of the September 16 FOMC meeting. Due to the issues with inflation that still are at the forefront of Fed considerations, there will be no rate cut to assuage a market still reeling due to the ongoing problems in the financial system.

We expect that the statement will forthrightly acknowledge the actions taken by the U.S. Treasury and employ language regarding positive market reaction in light of the unprecedented move by the Federal Government. The FOMC will probably seek to place light on the narrowing in swap spreads and the decline in long-term mortgage rates that have occurred in the aftermath of Mr. Paulson's statement on Sunday September 7.

Without a doubt the actions taken by the U.S. Treasury will provide a major subject for discussion either in the formal meeting or any prospective special meeting that the statement may announce. The systemic risk posed by the issues at Fannie and Freddie are such that we went back and examined the transcript from the October 15, 1998 meeting surrounding the problems at Long Term Capital Management to ascertain the possible shape of the upcoming statement and the ensuing minutes to the meeting that will be released on October 7.

In that meeting committee members had a three primary concerns that provide an eerie parallel to the current crisis. First the committee was primarily concerned about a potential spillover of instability into the non-financial community. Like today, fear and uncertainty in the markets prevailed.

Second, the committee was concerned with major problems at other banks that were not acknowledged. William McDonough, who was the head of the NY Fed at that time openly, wondered if there were "skeletons still rattling around in the closets that have not been revealed."

Third, the committee was concerned with the issue of moral hazard caused by the bailout.

We think that this provides a good frame or reference in which to evaluate the upcoming FOMC statement. One year into the domestic financial crisis, the market has only observed partial spillover into the greater non-financial community that has largely been responsible for keeping the economy afloat during the crisis. And it is quite clear that many of the financial players singed by the heat from the meltdown in the housing industry have yet to come clean and mark to market their losses.

Given that the financial industry continues to access "temporary credit facilities" at the Fed we would not be surprised to see in a few years when the transcripts for this meeting are released if the committee is found to be considering opening access to such facilities to the non-financial community.

Our Senior Economic Advisor William Poole has made a very persuasive case that the Fed has inadequately defined the post Fannie and Freddie financial world. Concerns over moral hazard still prevail. After saving Bear Stearns we wonder if the Fed might be tempted to say yes, should a large auto company, a large insurance company or a major metropolitan area suddenly need emergency financing. We believe that these are but a few of the ideas behind the interesting discussion taking place in markets regarding the credit quality of the United States.

Thus, we anticipate that the committee will utilize language reinforce its intent to provide adequate liquidity should conditions in the market change in the aftermath of the action taken by the U.S. Treasury.

The committee should note the deceleration in economic activity in the context of weak labor markets and the ongoing stress in financial markets. The statement should retain language regarding the efficacy of past monetary policy with respect to fostering market liquidity and moderate economic growth.

We expect that the committee will note the recent decline in the prices of energy and some commodities, while reaffirming their expectation that inflation will moderate later this year, although that outlook will remain highly uncertain.

The assessment of risks should remain balanced between risk and growth. Even with the basic Taylor Rule implying that monetary policy remains accommodative by at least 150 basis points, the Fed will continue to hold rates steady as it modestly attempts to reduce the money supply after a long period of accommodation.

Published on  Mon, Sep 15 2008, 08:34 GMT

The Case For and Against the Dollar

Wed, Aug 13 2008, 15:22 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

We have been cautioning for some time that volatility in the currency markets may increase further, even from the elevated levels of the past year. Nonetheless, violent market action is nerve rattling, even to seasoned investors. An uptick in volatility tends to be associated with an unwinding of leveraged positions. This is also the case this time, but the types of trades being unwound look very different from those just a few months ago when the “carry trade” was the talk of the day. To shed some light on recent activity, we will focus on some key forces we believe act on the dollar and the currency markets.

Ultimately, the U.S. dollar’s value is determined by supply and demand. And just as with anything else that can be traded, the traders of the moment determine the price. Many may opt to trade on short notice, but typically most holders of the dollar or any security do not trade on a daily basis. In our view, in making medium to long-term term forecasts, it helps to look at possible cash flows scenarios to gauge who may be buying and who may be selling in the future.

To be less abstract, referencing the U.S. budget deficit in discussing risks to the U.S. dollar is appropriate, but there is little correlation to short- or medium term currency moves. The budget deficit is a balance sheet item; of greater relevance to short-term currency moves would be the trade deficit or its broader measure, the current account deficit: foreigners must buy over US$ 2 billion in U.S. dollar denominated assets every single day to finance excess domestic spending and a lack of exports to compensate for imports. Even so, as the U.S. economy slows down, the trade deficit may narrow because of a drop in domestic economic activity; if that’s the case, it may not be a good omen for future investments in the U.S. by foreigners.

The concept of differentiating between balance sheet and cash flow items sounds simple enough, but even experienced policy makers seem to get overwhelmed with the rapid succession of bad news coming out of the financial markets. In early July, solvency concerns of Fannie and Freddie, the government sponsored mortgage entities (GSEs), made it to the headlines after our senior economic advisor and former St. Louis Federal Bank president William Poole stated what was publicly known. The public discussion then focused on a government bailout; unfortunately, a phasing out of the GSEs has not been center of the discussion. One concern was whether guaranteeing the debt of the GSEs would increase the U.S. government’s debt by over $5 trillion and, as a result, cause a meltdown in the U.S. dollar. Without a doubt, such an escalation of government debt overnight would be more than a balance sheet event. However, this argument wrongly assumes that the debt of the GSEs was not government guaranteed beforehand. While there was no explicit guarantee, the public had always assumed these entities were too big to fail and would be bailed out. If one assumes that there was a 95% probability that the government would guarantee the debt, then making the guarantee explicit would “only” add 5% US$ 5 trillion to the public debt or about $250 billion. On the scheme of about $10 trillion in government debt, an increase by $250 billion is not a positive, but unlikely to cause a meltdown. We do not suggest that the giant debt loads of the GSEs are desirable, but we believe the market is smart enough to realize that this debt did not come out of nowhere in recent months.

Accounting schemes, be they by the government or private institutions, are unlikely to be hidden from the markets forever. Conversely, when mortgage insurer MBIA recently announced it would reduce the value of its own debt because the market trades it at a discount, such a smokescreen is unlikely to convince investors that MBIA is suddenly healthier. MBIA then trumped its arrogance by not taking any further reserves, again telling the markets more about its own desperation than its financial strength.

The far healthier approach would be to phase out the GSEs. Fannie Mae is a relic from the Great Depression, a socialist Ponzi scheme that makes housing not more affordable, but more expensive to potential new home buyers. If private enterprise were allowed to take their place, the mortgages would truly be in private hands and not on the government’s balance sheet; indeed, a few years ago, there was a period when Fannie and Freddie had a very low market share of new mortgage acquisitions as a result of limitations imposed by Congress at the urging of the Federal Reserve. Such a transition cannot happen overnight without disruptions, but, in our assessment, are urgently necessary for the long-term health of the U.S. dollar. The problems we have with Fannie and Freddie now are because of inaction of Congress for too long to clip their wings.

Given a sharp drop in euro holdings in the U.S. Treasury’s Exchange Stabilization Fund, it seems that the U.S. Treasury may have intervened in the currency markets, possibly out of fear that a more significant run on the dollar could have resulted while Congress was pondering about its GSE bailout. While taking out insurance against such a scenario may be understandable, we would argue that the recent surge in volatility may well be the side effect of such intervention. Without having proof, we would not be surprised if other countries, notably Asian governments, also interfered in the markets, although with very different motivations.

Asian countries have been suffering from a slowdown in the U.S. However, because of surging commodity prices and inflation, they have been reluctant to keep their currencies weak to spur exports. With commodity prices off from their highs, Asian governments may be blinded into thinking that inflation is less of a problem; that would allow them to weaken their currencies yet again. Taking advantage of historically low trading volume during August seems to be a tempting opportunity.

The positive of the surge in volatility is that it teaches hedge funds a lesson – too many of them pile into the same trades. In recent months, we believe these funds may have shorted financials to buy commodities and sell the dollar. The global deleveraging must continue; for that to happen, hedge funds must have their access to credit be tightened as well. We hear that brokers close out positions of speculators if margin calls are not met promptly; such a development causes more severe pain in the short-term, but may be necessary.

In the meantime, a lot of technical damage has been done to precious metals prices and hard currencies versus the U.S. dollar. Just as everyone was piling into the same trade, now it seems the speculators all either wanted to exit or received margin calls and had to exit their trades. Pundits were eager to call a major shift in the market, declare the end of inflation, the rebirth of goldilocks.

It is on this perceived drop in inflationary pressures that has contributed to the dollar’s recent rally. As European growth may be coming to a halt under a strong euro and high commodity prices, the idea is that the European central bank will focus more on growth, thus possibly lowering rates; that the Fed may be able to raise rates; and that Asia may be able to keep their currencies weak. Indeed, these are good arguments for a dollar rally.

We are concerned that pundits and policymakers alike may be pining their arguments more on hope than reality. The potential for interest rate hikes in the U.S. with drops in Europe may be the most compelling one to support the dollar, but will it happen anytime soon? In Europe, we expect the European Central Bank to take their time before they are convinced that the commodity boom is indeed over. The reason to be skeptical is that, of all things, the Fed may see falling commodity prices as a warning sign of a downward spiral in economic activity. Given the large number of homeowners that owe more on their homes than they are worth, the Federal Reserve may actually want inflation: a recent survey shows that one third of those who bought a home in the past five years now owe more on their home than it is worth. The Fed would never say it wants inflation, but what is needed is a relative adjustment of the cost of home ownership versus other goods and services. This can happen through a decrease in the value of homes – something most undesirable due to the negative implications on consumer spending -, or through an increase in the cost of other goods and services relative to housing. It’s the latter that the Fed may be banking on. In our assessment, the Federal Reserve will try to push growth until inflation can no longer be ignored. For the Fed, this threshold is likely to be the TIPS spread over Treasuries; that’s the premium paid for inflation-protected securities (TIPS) over bonds. Note that these TIPS reflect core inflation as measured by the government.

By then, real wages may not have picked up and if the Fed indeed decides to tighten monetary policy then to try to bring inflation under control, it may cause a rather severe recession. To wait until inflation is apparent even in the TIPS market may be waiting for too long as it may be extremely painful to get inflation back under control. However, the Fed may think it does not have another choice as the consumer and financial sectors are too fragile to tighten monetary policy.

Will inflation bring the dollar lower? It is possible that we will enter an inflationary growth period, but that may not be enough to cause a sustainable rally. In our assessment, the risk of a lower dollar is alive and well. We don’t have a crystal ball, either, but investors agreeing that this risk is real may want to consider diversifying to take that risk into account.

We manage the Merk Hard and Asian Currency Funds, mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. We manage these funds because we believe the forces weighing on the dollar reflect long-term issues. We do not typically engage in tactical trading or hedging in these funds; as a result, when there is a bounce in the dollar, investors in the funds may lose value; conversely, we do not have the cost of hedging if the dollar were to decline.

Published on  Wed, Aug 13 2008, 15:22 GMT

US Budget Deficit to Grow Much Worse

Fri, Aug 1 2008, 13:10 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The mid-session review of the federal budget released during the past week saw the White House revise its outlook for the deficit towards nominal highs. The administration is forecasting that the deficit will come in at $389 billion in 2008 and the 2009 deficit should arrive at $482 billion.

The provisional estimate is a snapshot of current spending plans that does not take into account the emerging economic reality. This year seven banks have failed, which may be a grim preview of the forthcoming problems among regional and second-tier banks. The economic slowdown has generated tax receipts through the first nine months of fiscal 2008 equal to 17.9% of GDP, which is less than the 40-year average. The second half of 2008 is shaping up to be especially painful for the economy and equally deleterious for the federal budget. This time frame, which will bridge the final quarter of fiscal 2008 and first quarter of fiscal 2009, implies that the current assumptions underlying the administrations estimates are more than just a bit rosy.

A hard-nosed, cold-eyed look at the emerging economic and political reality at this time suggests a policy alignment inside Washington that will shape the budget in a very different manner. During fiscal 2009 we anticipate expenditures on the part of the Federal government to expand in the areas of health care, infrastructure, education with little but lip service given to the looming tragedy in the Social Security, Medicare and Medicaid programs. Any claim made that tax increases on the wealthy or the on-renewal of the Bush tax cuts will cover the coming increase in expenditures should be taken with more than a grain of salt.

The $482 billion dollar estimate for fiscal 2009 does not reflect what we expect to be the defining features of the Federal Budget throughout the remainder of the year and well into the new administration. First, pressure for a second stimulus has begun to build as the county moves closer to the election. We expect that when the Congress convenes in the fall that the political calculus in Washington will overtake budgetary sanity and that the House and Senate will pass with veto proof majorities a second fiscal stimulus package. We will take the current conventional wisdom on the Capitol Hill as true and attach an additional $60 billion dollar price tag to 2009 budget.

Second, the FDIC has accepted into receivership 7 banks so far this year after only taking over three in 2007. At the end of Q3'07 the FDIC had $53 billion on account to respond to a crisis among member banks. The seizure of Indy Mac, with $32 billion in assets will put a major dent in that rainy day fund at the FDIC. Based on our very conservative estimate the FDIC may require up to additional $10 billion in funding which will add to the deficit in 2009. The failure of another major bank or a wave of bank failures on a regional basis will require a special supplemental to be passed, to inject funds to cover insured deposits by the FDIC.

Third, one major domestic auto producer has done a very good job at telegraphing to the market that it will come under severe financial pressure through the middle of the next fiscal year. Perhaps, the new President will choose to take a Thatcher-like hard line on rescuing a very important player in the manufacturing economy in the electoral rich upper Midwest, but we doubt it. The exact number and manner in which a potential rescue of one of the three remaining auto producers would be accomplished is unknowable at this time. It is safe to say that should the federal government contemplate the bailout of a major industrial player it will require a quite a bit more than the $1.5 billion dollars in loan guarantees that the Carter Administration and the Congress provided Chrysler in 1979. While admittedly a “wildcard” when it comes to forecasting expenditures on the part of Washington, this possible development should not be discounted. Should one or more of the major auto producers reach a crisis point, it would be quite interesting to see if a newly inaugurated President who in all probability may owe his electoral majority to the states of Michigan and Ohio would adopt a lassie-faire approach to the problem.

Finally, each of the presidential candidates has fiscal and taxation priorities that will add to the already expanding deficit. According to the Wall Street Journal the Obama administration would add $800 billion over the ensuing decade to the budget and a McCain Presidency would add up to $600 billion. So, to avoid unnecessary partisanship we will split the difference and assume that a newly minted American President will add $70 billion to the deficit in the first year after taking office.

Thus, once one starts to make a provisional estimate of what the true deficit may look like in 2009, in all probability it will arrive in the mid $550 billion range with a possible upside to $630 billion depending on how the financial crisis on Wall Street plays out and just how far it spills over to Main Street. Just to be complete, our forecast does not consider off balance sheet activities, ongoing foreign operations that remain off the official books any prospective response to the problems in Social Security that could get under way as early as 2012.

The trend in Federal expenditures under current assumptions, much less the contingencies that we have outlined within the context of continued stress in financial markets will constrain the ability of private economic actors to borrow. For years, economists have warned about the problem of unsustainable deficits to mostly deaf ears. Under conditions of a functioning global market for capital, the US could get away with its profligate ways. But, with money tight on a domestic basis and global creditors increasingly concerned about the financial health of Washington, the conditions are ripe for a fiscal crisis. Should this occur US consumers would observe a sharp rise in the cost of borrowing a concomitant fall in the value of the greenback and a genuine political breakdown. One hopes that this is discussed in more than a tangential manner during the upcoming election.

Published on  Fri, Aug 1 2008, 13:10 GMT

Tale of Two Economic Releases

Fri, Jul 25 2008, 14:06 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The upcoming week will be defined by two closely linked US macroeconomic data that will frame the debate about which direction the economy is poised to take during the latter half of 2008. Yet, these two data are likely to paint two very different portraits regarding the condition of the economy. On Thursday the market will observe the preliminary estimate of economic growth during the second quarter of the year, followed by the publication of the July non-farm payrolls the next morning.

According to Bloomberg, the current market consensus anticipates a 1.8% rate of growth, fractionally below our forecast of a 2.1%. Given the bear market rally that we have observed over the past week, there is little doubt that the 08:30 AM EDT release on Thursday morning will provide a fairly solid case for equity bulls who are claiming that a bottom is in the process of forming in the market. Demand from the external sector could approach 2.0% and personal consumption should hold steady at a 1.0% rate of growth. The contribution of government spending should remain quite solid, but our forecast implies that the combination of the decline in residential fixed investment and a reduction in inventories should combine to reduce overall growth by 1.1%. Due a strong rise in demand for net exports and the stimulus inspired rate of personal spending, the data does tend to suggest that the risk to the report is to the upside. We would not be surprised to observe an initial print as high as 2.6%, with subsequent revisions back to the downside during subsequent estimates towards our 2.1% forecast.

However, once the dust settles and the market begins to look at the source of growth and is able to evaluate its sustainability a different picture may emerge. What permitted personal consumption, which accounts for nearly 70% of overall growth, to obtain a rather anemic rate of growth, was not a resilient consumer, but the well-timed fiscal rebates. To be blunt, it was not a consumer hungry for a return to the malls, but government spending, which was behind a second straight quarter of weak growth in personal consumption. As the June retail sales data illustrated, the impact of the stimulus checks has begun to wane and there is very little going forward to support spending.

That very potent fact will be on vivid display the following morning when the July non-farm payrolls report is published. Unlike the previous days headline data, the data from the labor sector will not be construed as positive, but will be focused on the potential drag on future consumption. The current consensus forecast expects a net -70K jobs will be lost, which is little better than our forecast of -93K for the month. We think that the combination of downward revisions to recent payroll estimates and losses in goods producing, manufacturing and the service sector should push the headline towards the -100k mark for the first time since the downturn in the economic cycle began.

Our forecast for the US economic growth path for some time has been that output would resemble a “W.” We expect that Q2'08 represents the middle apex in what is shaping up to be a classic double dip economic downturn. Our growth forecast implies that the market should observe growth in the third quarter to check in at 1.1% and the final three months of the year to observe a 0% rate of growth, with an outsized risk of a negative print. Moreover, we do expect that the rate of unemployment will advance to 6.0% by the end of

the year and further job losses to add to the -438,000 jobs lost thus far in 2008. Thus, what on Thursday may be the source of much celebration among equity bulls, by Friday morning may not seem so compelling. In fact, by mid-day on Friday the recent bear market rally may fade into a classic bull trap. To our colleagues that are making the case that the economy is in recovery and now is the time to jump into the market and purchase equities we have one question; what will support consumption six months out once the stimulus power of the rebate checks evaporates?

Published on  Fri, Jul 25 2008, 14:06 GMT

Dissolve Fannie And Freddie

Mon, Jul 21 2008, 09:24 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

The Chinese symbol for crisis also can be expressed as an opportunity. The current collapse of confidence in the domestic system of finance and financial leadership provides such a potential moment. The three part proposal to rescue Fannie Mae and Freddie Mac has bestowed upon our political and economic leaders the responsibility of ensuring that no one company again becomes too big too fail. The crisis requires more than the avoidance of moral hazards. Rather, the solution to the current financial crises and its legislative response requires that no firm or enterprise ever again be permitted to obtain an implicit guarantee of Federal largesse. Fannie Mae and Freddie Mac need to be taken under federal protection, its assets used to cover the risk of the taxpayer bailout and its charter legislatively dissolved.

The initial steps taken by the US Treasury and the Federal Reserve are necessary but not sufficient to engage in the type of systemic reform concomitant with the failure of Fannie and Freddie. Preserving the government sponsored mortgage giants in their current form is exactly the wrong step to take at this crucial juncture. In particular, the blank check that the US Treasury has requested is more than a bit troubling. Even in the aftermath of 9-11, the Bush administration was not given an open-ended account to pursue Al-Qaeda.

Just as important are the implications for the US balance sheet, the US dollar and the interest rate environment should Washington absorb the liabilities of the failed government sponsored enterprises. If the rescue of the government-sponsored enterprises are not handled properly the US taxpayer will find themselves on the hook for trillions of dollars of liabilities, not to mention the outsized risks to the US dollar and higher interest rates that would occur if the rescue of the Fannie and Freddie were to be botched. What is next the monetization of the coming insolvencies at Ford and GM, not to mention the future collapse of Medicare, Medicaid, and Social Security?

We are not surprised that in a real crisis that the socialist paradise that Washington sometimes resembles is advocating a wholesale takeover of Fannie and Freddie. In fact, the discourse emerging from the apologists for Fannie and Freddie has been that the GSE's remain stout and that they represent the last best hope for containing the damage from the implosion in the domestic housing sector. The current approach favoring the use of taxpayer money to preserve the status quo is the very essence of why we stand mired deep in the financial crisis that we do.

It is fair to say that conventional wisdom among the majority in Congress is that both Fannie and Freddie are useful tools for the state to pursue social goals. The market inefficiencies and risk to taxpayer funds from politically based enterprises are legitimate since they to provide the Federal Government to provide low-income individuals with the means to purchase a home. In fact, I expect that in the coming weeks that the usual suspects that have protected Fannie and Freddie over the years will call to make them non-for-profit organizations with public guarantees to protect the financial and political privileges that have accrued to the GSE's and their political clients over the years.

Defenders of the GSE's will state that they have been “private” since the early 1970's and that the backing of the Federal Government has always been “implicit.” We beg to differ. An implicit guarantee is tantamount to being “a little bit pregnant.” Either you are our your not. There is no such thing as an implicit guarantee and the explicit use of taxpayer money that will be used to bailout the GSE's is a function of that “implicit” guarantee.

Given the current level of risk to both the domestic and global system of finance the Treasury needs to act in a much more provocative fashion than it currently is signaling. The Treasury should take the following steps.

First, the US Treasury Secretary through the administration should request authorization from the Congress to put Fannie and Freddie under direct Federal supervision. To specifically protect taxpayer interests, the operation of the twin giants should be directly and forever removed from the political process.

Second, the senior management at both Fannie and Freddie should be removed from their positions forthrightly and the Congress should commission and investigation into exactly how both GSE's arranged to avoid the type of transparency that would have avoided such a calamity. Washington may think that it will be able to buy itself out of this one, but once the public gets a whiff of what the costs of the bailout are going to be some very important political actors on the Hill may not be too excited about their future electoral prospects.

Third, the Congress, the Treasury and the Fed should move with all deliberate speed to set up a 21 st century version of the resolution trust corporation. A move to create a new RTC would get out ahead of the curve of the wave of banks that will fail later this year and in 2009. The Federal Reserve currently has a list of 90 banks on watch for failure and it is imperative that the Federal Government begins to get ready for the probability of a wave of failed banks. Most importantly, the Treasury and the Federal Reserve should make it clear that any regulatory reform in the pursuit of the notion that any firm that is too big to fail, also applies to Fannie and Freddie. The genuine systemic threat posed by the failure of the GSE's requires that what remains of them in the aftermath of the crisis be privatized. The public should never again tolerate a firm that operates as a privileged enterprise, free from market discipline and able to shield itself from accountability through the deft manipulation of the political process. The role that Fannie and Freddie carved out for itself in the mortgage market was not one of innovation, service or demand, but rather was obtained vis-à-vis its implicit government guarantee. The failure of Fannie and Freddie is not one of the market, but one caused by a government that remains far too large.

Published on  Mon, Jul 21 2008, 09:24 GMT

An Economy In Trouble

Fri, Jul 11 2008, 13:41 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Over the past few weeks many notable analysts have made the case that the economy is in the process of recovery. The market has celebrated the wonder of the “resilient consumer.” Given the still fragile state of the economy we think that this is a bit overblown. A cold-eyed, hard-nosed analysis of the true condition of all things financial provides us with a very different assessment of the economy. But, with a major week of fundamental data and the onset of earnings season for financials upon us we thought it pertinent to put a few ideas to rest.

First, the credit crisis has yet to run its course. A genuine credit crisis is comprised of two components: a liquidity crisis and insolvency crises. With already $400.00 billion in global write offs within the financial sector alone one might be tempted to declare the credit crises over.

Yet, the problems on the balance sheets of financials will continue. Write-downs and the process of de-leveraging have yet to be finalized. We believe that there are $75-$100 billion in write downs left in the US alone before we reach a conclusion to the liquidity portion of the crises. This will continue to depress whatever appetite for risk taking in equity and credit markets remains. The Fed did not extend its primary dealer credit facility well into 2009 by accident.

Moreover, we have only begun to embark on the insolvency portion of the economic tragedy unfolding before our eyes. Too many market players are operating on the unspoken assumption that the fall of Bear Stearns and the near miss at Lehman have signaled that the end of the troubles are at hand.

Unfortunately, this is not the case. The crisis that has primarily engulfed Wall Street is beginning to spillover onto Main Street. Ford and GM will both be candidates for mergers, bankruptcies or bailouts in 2009. It is quite clear to anyone that care to look that Fannie Mae and Freddie Mac will have to be bailed out by the Federal Government. Pending legislation in Congress regarding the end of private fee for service, if it is enacted, will put at least one major player in the healthcare sector and one minor actor at serious risk of insolvency early next year. And do not forget the 200-250 small and regional banks that the Fed has warned us will eventually fail. Even such stalwarts as the gaming sector, which has been traditionally impervious to systemic economic slowdowns is going to see a spree of consolidations and perhaps a few insolvencies on the back of too much debt and a sharp reduction in demand from consumers who have seen their discretionary income evaporate.

Second, the consumer is no longer resilient but in fairly significant trouble. A well -timed and quickly implemented fiscal stimulus program is masking the true condition of the consumer. Pre-fiscal stimulus, the trend in real personal consumption was absolutely flat. Once the positive aspects of the stimulus withers away the prevailing trend in real consumption will reassert itself and we shall be back to where we were in the first quarter of the year.

The market has observed six consecutive months of contraction in non-farm payrolls. Growth in the once vibrant service sector has collapsed to near zero growth over the past three months. The major factors keeping the labor sector from collapsing appears to be the very questionable birth-death model at the Bureau of Labor Statistics and the aforementioned healthcare and hospitality sectors. Over the next few months the modeling at the BLS will catch up with reality and the healthcare/leisure sector will experience outsized contraction based on current economic conditions and trends. The decline in real income will put additional pressure on an already stressed consumer and set the stage for the final capitulation.

Finally, we will see a series of revisions to recent economic data, including GDP that may change current perceptions of the economy. We expect that the downward revisions will confirm that we are in a mild recession. More importantly, we anticipate that when we get to the final quarter of 2008 will see another downturn in economic activity.

Since 2007 my forecast for the economy has been “W” (no pun intended) shaped recession. We saw the first trough in late February and early March of 2008. We are currently at the middle apex of the “W” and expect to see growth begin to decline during the early portion of Q4’08. The final trough in our double dip scenario should occur in the second quarter of next year.

The sub trend 2.1% rate of growth that we expect to see in Q2’08 is a function of Washington priming the pump and the a vibrant external sector. Once the stimulus from the Federal government begins to fade and the impact of the searing increase in the cost of energy and commodities can be assessed on a domestic and global basis, the last vestige of support for the economy, net exports will fade to away and the US economy will see its first major recession since the early 1980’s.

Published on  Fri, Jul 11 2008, 13:41 GMT

Coming Wave of Regulation and the Risk to the Dollar

Wed, Jul 2 2008, 15:29 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Over the past several months it has become clear that there is a cauldron of regulation brewing in Washington. The bursting of the subprime bubble and dislocation in the financial sector has brought with it, in its aftermath, the risk of overregulation. Members of the political class are brimming with confidence that the political, economic and social considerations have aligned to finally tame the market. Serious consideration is being given to policies that would curb the ability of investors to hedge against future instability in markets, engage in financial innovation and even determine the pay of senior managers, much less corporate executives. What is beginning to take shape is not a necessary bout of reform, but a wave of regulation that will stem that necessary flow of investment into the US and put the dollar at greater risk.

At this late stage in the game, one does not get the impression that our political elite has given proper consideration to the costs and benefits of returning to 1970's style regulation. On one hand the cry out of Washington is that the grabbing hand of the government must return to the marketplace to protect society and ensure the proper functioning of markets. Yet, those same political actors who bemoan the power of the market are the same ones considering the implementation of regulations that would create incentives for the necessary flow of capital to fund their earmarks and out of control spending.

The simple truth is that due to the deficit in the US current account, the country must import $1.9 billion per day to cover the shortfall in savings and investment that it needs. Unlike some of the economically ill-informed in our political class, we are not under the impression that foreigners invest in the US to provide leverage over our way of life or our foreign policy. What drives the flow of funds from abroad is the return on investment from parking capital in an efficient, deep and liquid market. An increase in regulation that would limit speculative activity to give the public the impression that Washington is doing something to curb the excess of the market, would in the end create inefficiencies in domestic markets, increase the cost of doing business, drive up interest rates and send the value of the dollar plummeting.

For example, the Congress is seriously considering curbing speculation in the oil markets. While this would provide a transitory measure of satisfaction to a certain political constituencies, but is it economically prudent? After all for markets to function properly it is essential that market participants are able to derive future prices. Put another way, current expectations of supply and demand over the next several months or years, out to be embedded in futures prices. This provides market players with a signal of future costs and guides investment, exploration and development in the industry. Perhaps, the members of Congress think that they can do a better job of allocating resources and setting prices. But it is doubtful.

Those that support a significant increase in regulatory activity on the part of Washington, suggest that it is the government and the government only that can enact the necessary steps that can save us from ourselves. They believe that without government intervention in the marketplace that financial institutions will not adopt sufficient risk practices to avoid another sub-prime type debacle. These would be reformers believe that speculative activity in the oil market will continue to drive up the price of gasoline, as if, China and India do not exist or that supply and demand do not matter in election years. Moreover, many make a straightforward argument that if public funds are used to bailout financial concerns such as Bear Stearns, that the federal government should dictate the how and what type of risks firms should take.

Such a step up in regulatory activity would be unwise on two accounts. First, the thinly disguised series of efforts currently underway have more to do with addressing what many in Washington view as a structural imbalance in the power between the market and the state. A move at this time to tilt the equation of power back towards the state would risk undoing many of the absolutely positive innovations in the market that have been accomplished over the past three decades.

A set of policies that would give the power to unelected bureaucrats in Washington the ability to set the parameters of risk taking inside the business community and create a series of incentives for potential foreign investors to send their capital elsewhere would be precisely the wrong direction to take. Just as the emerging world is adopting open economic policies that will provide the margin of comfort to get the US through what will be a very difficult transition, it would be unwise to adopt a set of policies that drives capital elsewhere. After years of lecturing other nations on the necessity and virtue open markets and flexible exchange rates, the irony will not be lost on an emerging world that is striving to construct exactly the type of futures markets that the Congress is considering regulating. After all, imagine what current levels of gross economic output and the interest rates would be if it were not for free trade, the flow of foreign funds into the country or the ability of firms to hedge against future uncertainty.

Second, the structural adjustment in the value of the dollar has yet to run its course. It is in both the interests of the US and the global economy that this process occurs in an orderly fashion. Any regulatory regime that has more to do with domestic political considerations of power and are not in the interests of maintaining an open and efficient market should be forthrightly opposed. While there is little that can be done to prevent the long term redressing of global imbalances, it is imperative that in this election year that a discussion take place that ensures a carefully considered and thought through regulatory regime. If this is not the case, the risk to the dollar is enormous and we would expect a downward spiral in the greenback should Congress wield too heavy of a hammer on the banking community and financial markets.

Published on  Wed, Jul 2 2008, 15:29 GMT

Tequila Sunrise: Fuel Subsidies In Mexico Stimulate Black Market Activity In The US

Fri, Jun 27 2008, 15:25 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Along the frontier between Southern California and Baja California it has always been a tradition for consumers to engage in a bit of arbitrage due to the temporary differences in prices for basic goods. Normally, this has been confined to non-durables and foodstuffs. But, beyond Mexican “cerveza” and other spirits, the changing price of oil has jump-started black market activity north of the border.

While an open secret in California, this activity became national news due to a recent Wall Street Journal article titled “Fill'er Up: Gas Is Cheap In Tijuana, So Californians Buy Big Fuel Tanks.” South of the border, where the Mexican government subsidizes the cost of fuel, the price environment for consumers is quite different. Gasoline costs $2.50 per gallon and the cost of diesel is less at $2.19. What is occurring is more than a temporary way for industrious residents of the border to profit from price differentials. It is a prime example of how government subsidies distort the efficient allocation of goods and services and can lead to a change in consumer behavior.

To the point, due to the near $5.0 per gallon price of gasoline throughout much of California, consumers have incentive to cross the border and purchase gasoline. While, on an individual such activity is no problem and due to the open border an eminently rational endeavor. Yet, if the pricing differentials persist long enough, behavior on the both sides of the border will change.

And that is exactly what has occurred. Residents in San Diego County, California are now doing much more than filling up their tanks. According to the aforementioned article, they are crossing the border with extra-large fuel tanks and returning home with profits in mind. Based on basic price differential, if an individual crosses the border and fills up a 100-gallon tank and returns home, he is in line for a tidy profit. At the subsidized price in Mexico filling up the tank would cost $250.00 dollar as opposed to $475.00 in the US based on an estimate of $4.75 per gallon. If that individual comes home and sells that tank of gas to his neighbors at $4.50 per gallon, he is in line to make a $200.00 profit for just a few hours work. Not bad.

Besides the utter irony of Americans crossing the border to Mexico to find economic opportunity, the real human behavior along the border is instructive regarding the basic economics of pricing. The behavior of US consumers and entrepreneurs is causing supply problems in Baja, California. Supplies of diesel are short and the lack of refinery capacity in Baja has, if you can believe this, Mexico importing refined gasoline from the US!

This state of affairs cannot last for two reasons. First, what economists refer to as “the law of one price,” ensures that in an efficient market all identical goods must have one price. Roughly translated, this means that after a short period of time efficiencies in the market dictate that opportunities to profit will come to a close.

Along the national frontier, the idea of efficient markets does not always hold. Yet, the distortion caused by the fuel subsidies for Mexican consumers cannot last. The logic of efficient markets will cause a change in the structural policies behind the change in individual behavior. Like many other emerging markets, Mexico will soon recognize the folly of its ways and understand that they are not only subsidizing the price of gasoline for their own citizens, but that of rich Americans. Moreover, the longer the price distortions continue to persist, the greater the cost for not only the government of Mexico, but for the citizens of the republic south of the border. In effect, the shortage of diesel and refined gasoline will continue to grow and the state will recognize that paying to import gasoline from the US and the subsidizing the consumption of it by US residents is a losing proposition.

Once that occurs, the current black market of cheap subsidized gasoline in the border region of Southern California will come to an end. But in the meantime, head down to the Ensenada, enjoy the warm summer nights and cold beer. And on the way back, fill up for the week. You will save a few bucks, and remember a time when the inefficient policies of a government actually worked to your favor.

Published on  Fri, Jun 27 2008, 15:25 GMT

US Current Account − Still A Drag On The Dollar

Fri, Jun 20 2008, 14:45 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

Lost amidst recent data on inflation, the rise in oil prices, a deepening crisis in the housing market and the uncanny ability of Goldman-Sachs to outperform market expectations was the deterioration of the current account balance in Q1'08. The U.S. current-account deficit increased to $176.4 billion in the first quarter of 2008 vs. the $167.2 billion recorded in the fourth quarter of 2007. The primary catalyst for the increase was a decline in earnings from foreign investments and the sharp increase in the cost of imported oil. Should such an unsustainable and large deficit continue to persist, the value of the dollar over time could see another sharp adjustment due to the combination of global macroeconomic imbalance and the unwise economic domestic economic policies pursued in the US over the past few years.

In contrast to many market players, economists often pay close attention to the current account balance. The current account is one of the two primary components of the balance of payments, the other being the capital account. Precisely defined, it is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). This broadest measure of trade implies that the US needs to attract roughly $1.9 billion of capital a day from foreign sources to bridge the gap in the current account. That gap, roughly translated, equaled 5.0% of gross domestic product in the first quarter of the year, which is an increase from the 4.8% posted in the final three months of 2008.

Many argue that due to the increasing depth of global capital markets, the damage that one would normally associate with large current account deficits does not necessarily have to follow. Others argue that if the current account deficit is driven by the private sector is not that problematic and that it can even be a virtue for an economy due to the large inflows of capital investment.

So, why should we care about something seemingly as arcane as the current account deficit? First, the type of deficits now facing the US are unsustainable and are linked to large global imbalances that may require non-market actors to set prices in order to facilitate what policymakers, who are often unelected and not-accountable to shareholders, refer to as an orderly adjustment. Such a move away from free market principals will only serve to cause further distortion in the price of the dollar and cannot be guaranteed to succeed.

Under normal circumstances action to reduce a current account deficit typically involves increasing exports or decreasing imports. In developing economies, such a goal may be achieved through import restrictions, quotas, duties or subsidizing exports.

However, the US economy and the US current account deficit cannot by any definition be assigned the label “normal. In a developed open economy, like that of the US, such action runs counter the free and flexible markets that are behind the increase in economic output that we have observed over the last quarter of a century. Thus, under current conditions internationally coordinated action would require placing a floor under the dollar and stimulating demand for US goods and services in Asia and the Middle East. Both lofty goals, that would be at best, very difficult policy objectives to achieve.

Because the prospect of coordinated international action is quite unlikely due to the varied interests that have to be satisfied to obtain such collective action, the policy initiative that has been pursued over the past several years has been purely a domestic endeavor. That policy has been to pursue a weak dollar to make imports more expensive and indirectly increase the balance of payments. Complementing a weak dollar policy to address a current account deficit has been a tolerance of higher domestic inflation vis-à-vis accommodative monetary policy and an increase in spending to favor domestic firms.

Second, social and political fads come and go. Yet, very little changes with respect to the logic of macroeconomics. The current account deficit as currently composed is not sustainable. The fact that it is increasing during a time of relative economic weakness should be some cause for concern. There is no guarantee that a coordinated intervention among central banks to prop up the dollar will succeed over the medium to long term. Just as important, the out of control spending on special interests and entitlement programs in Washington provide an outsized risk to the stability of the domestic economy and the long term viability of the dollar as a the global reserve currency.

In domestic terms, the attempt to derive a correction in the current account through the depreciation of the domestic currency may drive down the price of domestic goods and boosts exports relative to imports, but it also has opened the door to inflation. Instead of attempting to put into place a regulatory framework that provides incentives for pro-growth and savings policies to address the current account deficit or attempt to bring the out of control spending in Washington under control, the US has ushered in a set of policies that will stimulate a period of extended weakness for the dollar.

The weak dollar policy of the Bush administration and the accommodative monetary policy of the Bernanke led US Federal Reserve have been the primary factors that have driven down the value of the dollar. Short term there is a strong possibility that in the context of a Fed on hold in June, followed by a probable ECB rate hike on July 3, the market could observe a sharp reduction in rate expectations for the Fed and with it support for the dollar. We would not be surprised to the see the EUR/USD re-test 1.60 in the coming weeks. Medium term, a non-sustainable current account deficit is but one the primary factors that is behind our call of the EUR/USD to 1.70 and our long-term bearish outlook on the greenback.

Published on  Fri, Jun 20 2008, 14:45 GMT

Insights Market Outlook

Fri, Jun 6 2008, 08:46 GMT
by Joseph Brusuelas

Merk Hard Currency Fund

With the economy caught somewhere in the purple haze between recession and anemic growth, many market prognosticators have been making the case that the worst is behind us.

With respect to the credit crisis, I do think that with the exception of a few nerve-rattling write-offs still to come, that is true. Credit spreads have begun to narrow, volatility measures seem to have settled down in recent weeks and the very unorthodox liquidity measures taken by the Fed appear to have calmed the nerves of market actors and appears to be in the process of pushing the market back towards something approximating normalcy.

However, we do not think that the overall economic picture is as sanguine as many have implied over the past few weeks. We can sit and debate weather the economy actually dipped into recession (we do) or has bounced along at a sub-trend rate until the cows come home. What is much more important at this time is to recognize that the strong headwinds facing the US consumer have actually picked up steam over the past several weeks. Once the stimulus from the fiscal package fades near the end of Q3 there is the very real danger that the economy will, run out of steam and the consumer will finally capitulate after an impressive quarter of a century long run. We do urge our clients to recall that the reaction function of consumers to an increase in energy and food prices will occur with a lag and we do not expect to see an observable decline in the data to this objective fact until later this year. Unless an increase in the real incomes of consumers somehow materializes between now and the end of the year, there will be little to stimulate personal expenditures once the impact of the fiscal stimulus wanes.

We expect that premature declarations of the victory against the current deleterious economic conditions that provide a clear and present danger to overall growth will face a realty check in the coming weeks. Most noticeably, the upcoming May non-farm payrolls report where we see the economy shedding -65k jobs and the unemployment rate rising to 5.1% should provide a not so gentle reminder of the real trouble ahead. If it were true that the economy has experienced little more than a mid-cycle correction then we should not be observing the steady climb in the continuing claims series, that now stands in excess of 3.1mln. The combination of that rise in unemployment and inflation simultaneously has begun to unnerve players in the fixed income market will drive yield and interest rates higher to ward off the inflation coming down the pike. What is lurking deep in that purple haze that the economy seems to be stuck, is not recovery but something better described as stagflation.

Week Ahead In US Financial Markets

Monday 10:00 AM ISM Manufacturing (May)
The manufacturing sector still looks to be struggling under the combined pressure of weak aggregate demand in on the domestic side of the equation and the surging costs of basic inputs which look to provide an outsized risk going forward to global economic stability. Our forecast implies that the headline-manufacturing index would arrive in territory signaling economic contraction for the fourth consecutive month and the fifth time in the past six surveys. Our forecast of 48.1 carries significant downside risk specifically in both the prices paid and new orders categories that look to bearing the brunt of the current down cycle in the domestic economy. At this juncture the only positive in the entire series over the past few months has been the external sector and that looks to be cooling after several robust months due to the same pricing concerns that have become paramount in the United States.

Monday TBD Total Vehicle Sales (May)
For quite some time the major problem in the US auto industry was soft demand for the lackluster product put to market by Detroit. However, as the jump in the cost of gasoline and food have eaten away at the real incomes of US consumers, the domestic auto industry is faced with a growing problem that will require far more than gimmicky ad campaigns and the return of invoice pricing. We do not see significant consumer demand for new autos until the domestic price situation begins to stabilize. Many in the auto industry and the broader retail sector had placed significant hope on the potential firepower of the rebate checks that consumers have begun to receive as a means to a temporary bounce in consumer demand. The rise of $4.00 gasoline and $5.00 diesel are in the process of taking whatever wind is left in the sails of the domestic consumer. We are forecasting a monthly sales tally of 10.9mln in domestic auto purchases and a total of 14.5 in overall sales for the May sampling period.

Tuesday 10:00 Factory Orders (April)
A weak month of non-defense aircraft orders and third straight decline in new orders for vehicles and parts should facilitate a -0.1% decline in the April factory orders report. The risk for the month, however, is to the upside with robust external demand driving new orders for electrical equipment by 27.8% in April. The combination of a weak dollar and strong external demand is keeping the economy afloat and offsetting lackluster domestic demand during what is a very painful period of adjustment for the US economy.

Wednesday 8:15 ADP Employment (May)
Although, the ADP model over the past few months is clearly caught on the downside of the current adjustment in the labor market, it still is the best overall survey of the payroll landscape and does retain the power to move the market upon its release. Our forecast of a -40K print is based on the continuing outsized retrenchment in manufacturing, construction and goods producing jobs that is well underway in the economy. We anticipate that the ADP survey will continue to undershoot the first cut payroll number released by the BLS, but will make statistical adjustments along the way that will put it very close the longer term real data and position it for calling a turn in the labor market once the economy works of the inventory in the housing sector, works through the credit crisis and adequately deals with the inflation problem in the pipeline.

Wednesday 8:30 Non Farm Productivity (Q1'08)
The major narrative inside the non-farm productivity report for the first quarter of 2008 is the fact that unit labor costs have come to a full stop. With the rise in headline costs begging provide a deleterious impact on core costs, the last line of defense in the Fed's assumption that costs will remain contained is that unit labor costs will remain fairly muted concomitant with a decelerating economy and sagging labor prospects. We expect that productivity will increase 2.5% and unit labor costs will advance a modest 1.9% for the final estimate of Q1'08.

Wednesday 10:00 ISM Non-Manufacturing (May)
For all those market players who have taken positions regarding the efficacy of the Federal Government's fiscal stimulus program, we will get an advance preview in the guise of the demand for services for the month of May. In our estimation the real bite that the jump in gasoline and food prices is begging to take a toll on consumer discretionary spending. After a lackluster increase in retail sales for the month of April and several months of declining demand for US autos, we think that the very difficult month of May that consumers have faced will trigger a move below the critical threshold of 50 signaling contraction in the service sector for the fourth time in the past five months. We anticipate that the headline will fall to 49.0 vs. the 50.9 recorded in April.

Thursday 8:30 Initial Jobless Claims (Week Ending 31 May)
We expect that jobless claims will moderate slightly to 370K after the 372 posting for the week ending 24 May. With the headline and the four-week moving average looking to converge, the weekly labor series does look to be stabilizing in the 370-400K range. With the settlement of the American Axel strike, we do expect the headline to trend towards the bottom of the range. Our real concern is in the continuing claims series that has now moved to 3.1mln and looks to be poised to rise higher as the economy continues to tread water.

Friday 8:30 Non-Farm Payroll Report (May)
During the May sampling period the labor market moved sideways with leading indicators signaling no real improvement without significant deterioration in the data occurring either. We expect that the majority of the losses for the month of May will be directly attributed to the ongoing culling of the workforce in the manufacturing sector. Our forecast implies that the cuts in the goods producing sector look to be flattening out and the increase in non-residential construction appears to be providing an outlet for those workers displaced by the sharp decline in the housing sector. However, we do expect that damage in the household survey will continue to reflect the move above 3.0mln in the continuing claims series during the sampling period and the rate of unemployment should move to 5.1% for the month.

Published on  Fri, Jun 6 2008, 08:46 GMT