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ON THE USDOLLAR SQUEEZE THESIS

Three unexpected events will take place to alleviate liquidity pressure in the coming crises. JW thinks outside the box:

• currency carry trade will return with force, in opposition to the USDollar

• reverse mortgages will enable households to spend more of their home equity

• consumers will walk away from bad debts en masse, and hold onto good assets

Much commotion has been stirred by the illuminating and controversial April 15th article by George Paulos and Sol Palha. In “A Day Late and a Dollar Short” the authors raise the issue of a USDollar short squeeze rally, which could lose control. They describe how so many investments, and even cash debts, act as USDollar short positions. Debt levels are truly out of control, as they point out. They comprehensively list several factors, which could trigger a debt crisis. Outcomes are less certain, which they explore for stocks, precious metals, industrial commodities, housing, Treasury bonds, bank deposits, and TIPS. Most important is the trigger. They claim an event or events could set off a chain reaction, which sucks liquidity out of the system, only to cause a series of debt defaults and sharp decline in available money to spend and service debt. Collective action puts the aggregate of investments and debts at risk, due to their one-sided unanimous nature. In the aftermath, the deterioration in the general economy would ensure a severe decline in the USDollar. The risk lies in the preliminary stages leading to climax, where interest rates might climb in lost control. The USDollar might surprise to the upside in a sudden sustained rise from a short squeeze, which causes havoc.

Paulos debunks the widely held notion that the Federal Reserve can indeed contain the developing crisis situation, as it did successfully with the S&L resolution and LTCM bailout. Most credit creation is outside their purview (from mortgages, credit cards, and vendors). Palha is highly critical of mortgage procedures, wherein anyone with a pulse, anyone who draws breath, can qualify for a mortgage, sometimes with no income. He implies the weak link in the economy is the housing market. They each urge the public to shed debt, and to build a supply of gold and silver (Paulos coins, Palha bullion). However, they offer a rational analysis, a rational response by investors and cash debtors, when our entire nation has diverted its path to extremely irrational behavior. Greed, hedonism, entitlement, irresponsibility, innovation, desperation, and insanity will escalate. New abuses can be anticipated, such as reverse mortgages, even as consumers can be expected to walk away from bad debt.

Their thesis has prompted a few responses. In mid-April, an email crossed my desk from Paulos, commenting on my initial Monday essay on the deflationary implications of Fed reflation. The US$ squeeze issue is one of the most unnerving and supercharged in my two years of seriously analyzing the economy and gold bull market in progress. Resolving the market versus fundamental conundrum could become a life & death goldbug proposition. Figure it out, as the US Economy crashes, or face possible annihilation. To some investors, they may expect and prepare for a gold explosion, but encounter the strange risk of going broke before it happens. This essay is an attempt to keep the debate rolling, as Rick Ackerman has done.

DEBT EXPLOSION & USDOLLAR ACTION

The expansion of debt within the financial sector is utterly staggering. Is debt the great secret to the 1990’s, which were labeled “the decade of prosperity?” It sure seems so, which screams that a bubble explains the entire US Economy. Since the summer of 1996, when the Financial Czar Greenspan took the helm behind the curtains, sector debt has expanded 140%. Since the stock bust at the end of 2000, sector debt has grown 34%. Debt is the fuel of our financial machinery.

Can the USDollar rise and rise more, despite horrible fundamentals? The March trade gap was just announced to be an atrocious $46.0 billion, over 9% higher than the previous record deficit. Trade gap news could possibly have stopped the US$ rally in its tracks on fundamentals, after the JYen gap fill ended the rally on technicals. The JYen 87-89 gap is in the process of being filled. Gap filling is tantamount to backfilling earth under pillars supporting a back porch deck construction. The ground must be firm enough to support the structure, in addition to the added weight (higher exchange rate later) of more people at a barbeque. The JYen gap fill might be the door shutting on the US$ counter-trend rally, after higher interest rates disrupted the order. Following Iraqi bombing, terrorism effects on oil production, India govt change, and the arrival of cicadas, the USDollar has pulled back today while the USTNote has relaxed back to 4.7% yield. Resistance for each has held.

THE PREVIEW OF A SQUEEZE

Recent market activity has been tumultuous. Since February, and especially since April, commodity currencies have suffered. To a higher degree, commodity investors in stocks have been hurt. The USDollar enjoyed a technical bounce off its double bottom DXY=85 low in the last four months. The exaggerated April jobs report was followed by a May jobs report with even more assumed imputed job growth. Release of the two reports powered the USDollar toward some key technical barriers, thereby calling the Fed’s bluff on a stronger economy. Trendline boundary, critical moving average, and past turns have provided serious resistance for the US$. The gold chart offers a mirror image in technical support. The Japanese yen currency is in the process of filling its dreaded 87-89 gap. The Chinese have added fuel to the fire in two ways. First, public announcements, timed curiously after top USGovt cabinet leader visits, assure that the Asian powerhouse will engineer a slowdown, come hell or high water. Second, the reality of a slower than torrid growth pace in China has shown itself in sharply reduced machine tool orders for Japanese firms. The Nikkei fell last week in response, has fallen more since. The JYen has fallen to fill the cited gap. An over-reaction has taken place in the financial markets. Equity pricing might now factor in a Chinese recession, instead of a slower economy.

We have been given a preview, a frightening glimpse, of what happens to the financial sector when the USDollar rises even a little. We are free to call this a US$ squeeze. In my opinion this should be perceived purely as a reaction to rising interest rates, delivered as an assault on the carry trades, with collateral damage to stocks positioned in opposition to the US$. Recent turmoil was much more of a bond squeeze, which had a US$ squeeze echo. Housing, mortgage finance, and banking were harmed from the bond squeeze, while the ripple affected numerous commodities such as gold, silver, and major currencies from the US$ squeeze. We can call investments speculative for various commodities, but by their nature, most qualify as dollar shorts. Energy stands out as unique among them as far less prone to price decline risk, since supply shortages and delivery obstacles abound, even as Chindia demand is relentless.

An aside… Precious metals operate in a world with governmental motives to keep prices capped on the high end. The CFTC does not enforce limits to futures contract shorts, convenient for chronic price caps. It is not unusual for short open interest in gold or silver to be at a level equivalent to two years of world production. The central risk for them is more related to delivery default amidst extreme shortage, from controlled price, from depleted supply and just plain running out, in a corrupted market, rather than an explosive price risk to attract new supply. Again, goldbugs think rationally in an irrational world. Govt policies and controls have resulted in some systemic deflationary tendencies, since closed businesses and inactivity eliminate income and commerce (e.g. Washington state closure of aluminum smelter). Widespread shortages might result with or without price spikes, as companies exit businesses, which no longer remain profitable. One can no longer assume that shortages instigate rising prices.

The market reaction glimpse is confounded by the announcements out of China. US Economic (statistical) spurts came at the same time as Chinese (stated) desire to curtail its strength. Beijing will be diligent to slow economic growth and restrict credit. It seems that both commodity markets and stock markets are pricing in a Chinese recession, not reduced growth from 9-10% down to 6-8%. One cannot separate a USDollar rally from a Chinese slowdown. The yuan currency peg to the US$ ensures that at the Bilateral Bar & Grill, if the American right arm moves, the Chinese beer mug is spilled.

DERIVATIVE PYRAMID

The biggest risk for a USDollar short squeeze comes from the massive derivative pyramid, wherein the US Treasury securities are the biggest participating instruments. They are shorted in the numerous carry trades. Their long-dated bonds are capped by Fed monetization routinely. Bond-based carry trade represents the outsized risk, bar none, since nothing comes close in size and scope among all carry trades. P&P did not address this risk factor sufficiently. The bond-US$ dynamic is very evident nowadays. The bond-dollar-gold triangle is presently broken. With apparent renewed strength in the economy, with open statements of Fed plans to raise rates, with gathering evidence of price inflation across the board, bond yields have risen. The USDollar has been bolstered, and by domino, has hurt gold since the US$-gold dynamic is also evident and strong. Ironically, news of price inflation has hurt gold indirectly. Recent activity in financial markets clearly exposes the sheer power and awesome magnitude of bond futures and their associated carry trades in the process of unwinding. Bond vigilantes throw fuel on the fire.

Gold remains somewhat confused. My April 12-th essay “Failure of the Fed Reflation Initiative” argued in broad fashion how accommodative policy has amplified eventual price deflationary forces. Debts and abused credit will lead to default and hindered spending. Gold investors are an order of magnitude smarter than stock investors. They correctly detect the cross currents, which makes gold more vulnerable to swoons. Whiffs of price inflation could not hold the gold price. In January, my expectation was for a USDollar bounce, but one where gold would be supported by rising price inflation data. It did not happen, a vivid testimony to the power of the leveraged carry trades at work in the futures pits. The deflationary reality of monetary inflation via debt abuse and foreign production expansion, combined with monstrous impact from bond speculation being unwound, has exposed gold as less an inflation hedge, and more a US$ bear position.

SHIFT TO USDOLLAR CARRY TRADE

In my opinion, the P&P thesis does not adequately raise the possibility of an easy path for speculators to shift their leveraged gears from the bond-US$ pairing, and direct capital leverage elsewhere. Market liquidity will result. Incredibly detrimental fundamentals, which are not being fixed, indicative of pure hemorrhage, can be easily seen in the US Economy, whose currency is the USDollar. The March trade gap grew by a huge 9.1%, as announced last week. The federal deficit in reality is closer to $1 trillion on an operational basis, excluding the unlawful seizure of Social Security funds and including numerous off-budget items like the two wars. The USGovt also engages in pro-forma accounting. Election year politics dictate a slow Fed reaction, sure to keep rate differentials wide versus other nations, and a steep yield curve, which is good for gold. A falling US$ currency (world reserve) ensures the US Economy will have more price inflation than almost every other economy. The bond carry trade, both plain bonds and major yield spreads, will have to come to a halt and be unwound until long rates stabilize. The resumption of a USDollar decline is a good bet. In my opinion, the big gears of the bond speculation machinery will shift before long onto the trading lanes running directly opposite the US$. We have a long list of candidates, most of which are already in the carry trade game. There are euros, swissys, eurodollars, jyen, Canadian, and gold itself, the ultimate currency. Each has plenty of liquidity and easy availability across the globe, from Singapore to Tokyo to Frankfurt to London to New York and Chicago. Many market watchers might believe the entire carry trade apparatus will be shutting down. No way, José.

The only nation whose bond market will exhibit a steep yield curve will be the United States. A declining currency will keep our yield curve sloped upward. Evidence of rising prices will keep the slope sharp, since the Fed will be slow to act and short-term rates will not rise quickly. Other nations will see a flatter yield curve, as their rising currencies make imports cheaper, and dampen energy price hikes. Since most foreign economies have become reliant upon US import demand, they will see distress from slower export sales, as we see price inflation. Foreigners will experience a bigger deflationary cocktail, while the US will endure the opposite, an inflationary punch already underway. The speculative crowd knows this, and will keep the pressure on the USDollar, by capitalizing on other available anti-US$ carry trades. It will be too tempting, too available, and too successful. The US$ will resume its decline in a matter of weeks, perhaps sooner.

The October G-7 “green light” was highly unusual. Finance ministers the whole world over agreed that the USDollar needed to come down in order to rectify both huge trade imbalances, and dependence on indebted American consumers. If the US$ resumes its downward course from here, the intensity and unanimity of any lopsided carry trade activity is less certain. However, if the US$ rises beyond current levels to any significant degree, the next leg down for the buck is sure to have a more one-sided nature to it. Many believe the US$ has come down enough. Well, it has surely fallen in value versus other currencies since this process began in the spring 2002. But hardly any resolution to extreme imbalances (twin deficits & debts) has resulted. Until US consumers cut back in a big way on spending (especially imports), until a large slice of both households and large corporations seek bankruptcy restructure, until significant portion of the US mfg base returns to our nation, the Great USDollar Decline is nowhere near ended. It will not end until we get a crisis climax, which is a lock given the current situation marked by worsening imbalances in almost every important category under the sun.

Some like the Aden Sisters believe rising price inflation hurting gold is temporary. Until the powerful formula based bond-US$ carry trade unwinds to a much greater extent, until inflation shows up in wage growth, I believe gold will not act like it has in the past. Gold will keep its antagonist position versus the USDollar, but continue to be hurt by rising rates. Unwinding of the bond-US$ carry trade is the centerpiece to the US$ squeeze thesis. In time, it will be overshadowed by the combined carry trades running in opposition to the US$. A principal difference must be highlighted. In the 1994 era, the US$ began a truly magnificent multi-year rise. The US$ fundamentals are now so dreadful, deeply based in lethal hemorrhage, that carry trade (not bond speculation) opportunities abound. The period of adjustment might last for much more than nine months, as was the case in 1994. The bond unwind might easily take 18 to 24 months, as we work around the November election.

MORE CREDIT, REVERSE MORTGAGES, ABANDONED DEBT

A rising interest rate environment cannot presume to limit vendor inducements. Just look at GM, Ford, Chrysler, Best Buy, Circuit City, Kohl. They participate with easy money, apart from the banks. Look at new home construction, with their independent credit sources. Cars, housing, and electronics accommodate customers from money sources, which can easily originate from the bond market or corporate operations. They can subsidize discounts to interest rates in order to facilitate sales. Late in the game, these businesses will shutter and close down before limiting credit. They will abuse credit to the point of rapid bankruptcy. A case in point is Roomful Express, the furniture vendor. They offered zero deals for quite a while, and recently have closed many stores. The route to the graveyard is quick in the USA when easy credit fails. The step of restricted credit is often bypassed.

The fear of mortgages being called in is unrealistic, since Fanny owns such a big chunk of them, and the Federal Reserve will own most of those portfolios in due time. Plenty of mortgage agencies and banks sell packaged mortgage portfolios to other mortgage service outfits. The percentage of callable mortgages is unknown, as P&P do well to raise the issue. Within the standard bond carry trade, a big piece is owned by GSE agency hedge activity, principally Fanny Mae. GSE mortgage convexity is likely to be a much more destructive force than LTCM was back in 1998. As rates rise, refinance activity has dried up. Recent REFI data shows a 15% drop in the last month. Fanny & Freddie react by selling into their hedge book, aggravating the situation, simply to raise cash. More likely, banks will offload their mortgage risk into the black hole of Fanny’s retained holdings. The current bond scare might accelerate decisions by some banks to dump more portfolios to Fanny Mae. The USGovt will not rush to foreclose mortgages, even if underwater. Instead, mortgages held privately will rush to the GSE agencies.

Reverse mortgages have been introduced, but so far only as a retirement annuity device. Expect them to come into vogue, as households realize they are asset rich but cash poor. Income needs for necessary spending, for discretionary entertainment spending, and for debt service will gradually become acute. Reverse mortgages will greatly aid liquidity in the coming crunch caused by the rising rate squeeze. Never under-estimate the willingness of American consumers to eat their arms and burn their furniture, so they can live for today. Cashout refinances offer clear indications that the next stage will include reverse mortgages, acting like annuities. Higher rates will heighten the urge for homeowners to tap into home equity more aggressively. Banks will be at risk since they will act as virtual buyers for a depreciated housing asset. Adjustable reverse mortgages might reduce the annuity BALANCES down every three years instead of the interest rate (like with ARMs). In this environment, govt agencies and the Fed itself will provide astronomical liquidity rather than allow a new recession.

Within the USA in the last decade, a national trend away from personal responsibility has grown with alarm. Lawsuits, corruption, and debt abuse are symptoms. Households will not sell good assets to pay for bad debts. They will cling to good assets, and walk away from bad debts, while creditors extend terms. We have begun to see the phenomenon with jobless owners walking away from upside down car loans. Debts will rapidly be abandoned by the technically insolvent who find it increasingly difficult to continue to function as walking dead. P&P assume responsible behavior among irresponsible consumers. As sales diminish, creditors will avoid foreclosure and liquidation as bad loans mount. Being overwhelmed, they will extend terms on loans to absurdity. Furniture renters are already doing just that. Absurd debt levels might quickly lead to chaos of accompanied rotten loan portfolios and the bankruptcy of these creditors. Bailout of bank intermediaries (credit card issuers, subprime lenders) will be debated.

VICIOUS CIRCLE OF USDOLLAR DECLINE

I believe P&P under-estimate the magnitude of general liquidity in financial markets, when the Federal Reserve is a principal guide in policy making. We all know about the benefits in the stock market from the cover of short positions. A burst of liquidity comes. An actively traded stock can induce a large short position, whose cover can soften and catch a death spiral decline in a given stock. The FOREX and associated futures pits have incredibly large liquidity. Given the US Economy is the largest in the world, our financial markets are the largest in the world, and the USDollar is the world reserve currency, we can expect tremendous liquidity in short covering. That is not so much the issue. The critical issue is whether demand to cover is so great, and desire to hold the US$ is so poor, that a short cover episode gets out of control.

We are sure to see nice liquidity from USDollar short covering in numerous steps. In my June article "Vicious Circle and USDollar" last summer, the dynamics for a sequence of declines were developed. Each step down guarantees the next step down, since imbalances do not enjoy remedy. Well, add in another dynamic. Each step down guarantees the next short covering by the carry trade participants. Unless and until all confidence is lost, successive steps in the vicious circle might actually be less robust. Only when a trend becomes the widely-held consensus, like last October, will the next round be more vicious and powerful. This demonstrates to me that the great US$ crash will last a very long time. What P&P describe seems to be the climax, not the intermediate steps. We are nowhere near the climax. We have perhaps 3 or 4 more of these preview events on the path to $700 gold, even higher. Coordinated central bank chronic intervention makes certain that the US$ bear market and the gold bull market will last for several years. Competing currencies is talked about frequently. Japan and China are the active discounters of their currencies in round #1. Next, expect the competition to use heavier weapons such as carry trade vehicles, to lift the euro, swissy, jyen, and Canadian against the USDollar. Officials act like their actions can prevent the natural course of the US$ decline and economic breakdown. All they ultimately influence is the calendar, when the crisis occurs, and the magnitude, dictated by the extent of interference with natural equilibrium.

WHEN BOND DAMAGE HELPS GOLD

When big declines come in a broad selloff in any market, typically the highest quality assets also suffer. After a period of time following the declines, margin calls are made and investors respond. The best assets, like gold, also take hits to raise cash and meet the margin calls. The dwarf size of the precious metals sector must be considered. A big storm to the giant bond market will hurt the teeny precious metals sector. Only when the economy begins to deteriorate, only when the stock market bleeds from poor profitability prospects, only then will gold be able to siphon enormous amounts of money from the bond fallout. Sinclair seems to overlook this key factor, which he calls the “fifth element.” Bonds and stocks are still in heavy competition. We are told that corporate profits can more than offset rising rates. Later, when confidence wanes in govt central banks to control the damage, money will flock into gold. While the confidence slowly erodes, during this long process, when fear sets in, govt cartel activity will find it easy to deliver more gold bombs. The public must shed its belief that the financial world remains in control. P&P astutely claim that current confidence in the Fed is far greater than warranted. Much time is needed to eat away at this prevalent confidence, from the illiterates and mainstream alike. The first niche to abandon hope will be the ruling elite. They know the limitations of the Fed all too well.

USDOLLAR SACRIFICED TO SAVE BONDS

Countermeasures are few at the disposal of authorities, as they demonstrate. P&P overlook a truly enormous device though. The Fed in all likelihood will monetize many types of debt, but do so secretly. Better to add to the US$ money supply behind closed doors than to allow long rates and mortgage rates to rise uncontrollably. Rumors are so hot now that ears are burning. The Fed might be preparing to monetize the Fanny Mae hedge book. They are well aware of mortgage convexity, and its unchecked potential for rising rates to cause massive sales of overloaded GSE hedge books. Expect the Fed to bail out some private hedge funds (maybe Meriwether’s new hedge fund). The Fed is also sure to monetize some portion of the federal deficit after the US Economy falters from rising rates, its bane. This is a natural response to troublesome bond liquidity. Unfortunately, such budget bailout activity is done in a public fashion. It broadcasts an open season to short the USDollar. The carry trade crowd knows all too well how to read these marquee banners in flashing lights. Gold will respond very well in the next phase of lost control. Upcoming Fed-speak statements will be the source of amusement, if not derision. Fed credibility will be lost completely.

In a manner of speaking, the USDollar crash will be administered in a collectivized fashion in order to dilute the rate rise. Despite broad laughter, very large helicopter money drops, like with tax rebates, might be both commonplace and more socially fair, if not more economically practical. At least people would be able to pay bills. Do we want a cost push or a demand push? My vote is for a demand push. Put money in people’s hands and let the price structures adapt. The alternative is to allow for disruption from liquidity seizure. Americans love cash gifts, and American politicians love to give them. For certain, the next rounds of rate rises and US$ bounces will be frightening and disruptive. Never under-estimate the ability of American institutions to provide credit, and in the future for banks to advertise reverse mortgages. We respond to crises with evermore credit. Before long, the Fed itself will ensure credit supply. If the Japanese and Chinese deny supply, the Fed will surely step into the void and monetize both federal and commercial credit. The US$ will subsidize bond market supports. The ultimate victim will be the USDollar, a sacrificial lamb, which is headed into crisis mode.

NEWS TIDBITS

Financial markets were dominated by the Iraqi bomb event, India’s election of Gandhi, and terrorist concerns over oil supplies. The Nikkei was down 3.2% overnight, followed by the French CAC and German DAX each down about 2%. The Bombay Sensex fell 11% over fears that leftist Sonia Gandhi will build an alliance with the communist party. The New York Empire index came in below expectations, with a high number of firms able to pass on higher costs. Bonds are benefiting from bond-stock allocation model adjustments, even as the USDollar faltered against the European currencies. The Wall Street Journal reports Nortel under investigation for cash bonuses to executives before a selloff after an earnings warning. SEC is to charge at nine people over failure to report $1 billion in Lucent profits, failure to comply with an inquiry, and securities fraud. They have agreed to settle with no admission of wrongdoing, and to pay a $25 million fine. Oracle reduced its hostile takeover offer to $7.7 billion for rival Peoplesoft. Fanny Mae announced a 3-month exposure duration. Chinese crude oil demand rose 33% yr-yr for the first four months of the year. This is triple witching week.

Iraqi Governing Council president Salim was killed in a Baghdad car bomb. Terrorist leader Zarqari has claimed credit. It seems majority group Shiites do not expect to gain parliamentary control, while Sunni & Baath seculars expect retaliation, so democracy looks null & void. The US army found Sarin nerve agent in an artillery shell in Iraq. President Bush has fallen to 42% on approval ratings, with “poor job” votes given by 55% on the economy, 55% on Iraq War, and 47% on terrorism. Kerry leads by over 10% on issues such as the economy, deficits, unemployment, health care, and the environment. Four small bombs exploded in Turkey before English PM Tony Blair was due to arrive. A CNBC poll of 2517 people revealed 56% wanting no reappointment for Greenspan as Fed Chairman.

Smarty Jones won the Preakness horse race at Pimlico by a big 11-1/2 lengths. The LA Lakers eliminated the San Antonio Spurs by winning the last four games. Sammy Sosa hit his 549-th home run, and passed Mike Schmidt for the #9 rank. The movie “Troy” gained $45.6M to take the top box office position. Production had been delayed coincidentally by Brad Pitt’s achilles tendon injury. Controversy builds on whether Summer Olympics facilities will be prepared, following a bombing of a police station in Athens. Cosmetic surgery in 2003 had 6.2 million cases, with nose jobs ranked #1. Same sex marriages are now legal in Massachusetts.

TODAY’S MARKET

Today the Dow Jones Industrials wrapped up at 9906 (-107), S&P at 1084 (-11.7), Nasdaq at 1877 (-28). TENS yield 4.70% (+9 bpt). Currencies closed with Euro at 120.00 (+1.29), JYen at 87.48 (-0.14), Can$ at 71.40 (-0.48), so the JYen filled its big October gap. Metals finished with gold at 379.5 (unch), silver at 566.8 (-4.6), copper at 114.45 (-3.10). Energy ended with crude oil at 41.55 (+0.12), natural gas at 642.4 (+2.9), unleaded gasoline at 141.7 (+6.9). Prices are at major futures contracts.

Jim Willie CB

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