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US trade deficit, probably going to run 700B this year, and is said to carry on into 2006. US Federal deficit, down some from higher tax revenues, looking at 350B to 450B. However, I would like to point out that, if the US consumer pulls back in 2006, there WILL be a significant drop in the US trade deficit.... Also, assuming that China and Japan continue their growth some time past the onset of a US recession/depression, then that will also significantly affect the US trade deficit, probably knocking off 100B at least due to growing orders for the high end and technical high end US products, which have seen a lot of growth in foreign orders. I would not be surprised to see the US trade deficit decline by as much as 30 percent next year... due to the continuation of increased foreign orders and a decline in the US consumer both working to reduce the US trade deficit.... This means that the usual arguments that the USD will weaken due to ongoing trade problems (deficits) are probably going to be wrong on that score. Yes there will continue to be a US trade deficit, but if the TREND changes significantly from ever increasing ones to any kind of significant decline, then the USD bears will find much less ammunition for their arguments. Therefore, institutional and private investors seeking yield will be looking to continue the purchases of US yield instruments such as Treasuries. Such buying has been the explanation for the strength of the USD, in spite of very significant reductions in foreign central bank purchases of UST's (treasuries) and even out right sales of UST's. Do not underestimate the massive scale that private entities can reach in the purchase of UST's. They have trillions every year that has to be placed in fixed income safe yield investments. This is GOING to continue to be a very strong sector of support for both US treasuries, and consequently for the USD in the coming year, probably 2006 and 2007 as well. (barring a US currency crisis) Now the US federal deficit is seeing some reduction by increased tax revenues, however, I do not expect that to continue well past June 2006 roughly, because I am 100 pct sure now that the US housing bubble has peaked. 30 yr mortgage rates are now over 6 percent, and we are going to see bye bye to the US housing bubble in convincing terms after Jan 2006. Additionally, a year ago I predicted that the US housing bubble would peak at the point that the 10 Year UST increased by 1%. In Dec 2004, it was hovering around 4.25 %. That means that we would be looking for 5.25 % based on that prediction. Even though US T's have stayed low for most of 2004, the Ten year is now at 4.48 and is in a rising trend so we are looking at 5.25% to come soon, particularly where the US inflation rate is probably running well over 4%, and is probably really in the range of over 6% , and the Fed doesn't like that one bit. SO, they are going to raise US short term rates by at least another one half percent (50 Basis points) in the next two Fed meetings. I think they would really like a 1 percent jump but frankly there is just too much risk in that, particularly now that the Fed has used the baby step transparency strategy, knowing the incredible systemic risk posed by derivatives and the fact that interest rate derivatives account for the vast majority of the derivatives universe, something like 60 to 80 percent..... did you know that? The problem the Fed has created is that by using baby step (25 BP) increases and transparency (foretelling their intentions and perspectives), they have effectively taken away the monetary tightening effects of raising interest rates. This renders the Fed essentially unable to act decisively...They trade transparency and baby steps for less systemic risk, but lose the ability to really influence long term rates in a meaningful way, hence their conundrum. There would not be a conundrum if they were using increases that would really sock the markets, something like 50 or 100 BP a pop. That would do it, that would enable them to cool bubble markets... But evidently that is not going to happen soon. Now those short term increases in rates this last year had zero effect on the mortgage rates, a total of 325 BP (3.25%) increase did NOTHING to US mortgage rates for over a year after the Fed started raising rates a year and a half ago. However, ARM's were affected some. But Fixed rates were very low for over a year after the commencement of the Fed hikes. Now, however we are seeing those long term fixed rates rising, and those are the real measures of where the mortgage market is pricing money. Working against the rising short term Fed rates, were the MASSIVE amounts of private sector money ( insurance companies, private investors, and all the galaxy of fixed income seekers) who were moving hundreds of billions into all quality sovereign debt issues, predominately the US because it is such a huge market every year with lots of 'product'. Given the fact that most stock markets have languished, until recently, the US still languishing, there is just a zillion dollars of money that is made and saved every year that has to find a home with at least SOME yield. This is the explanation for the so called conundrum of US interest rates. THAT ELEMENT will definitely be there in 2006, barring a currency crisis. Of course a currency crisis could change everything, and it is a real risk now that is essentially a permanent feature of the new financial economy, what with things like 250 trillion $ in derivatives out there that are essentially created as bets on everything from currencies to commodities to you name it. It is a new VIRTUAL casino that will eventually have a bad day, just like any gambling enterprise. Derivatives are seen to be speculative, and they are because they are created using absolutely NO RESTRICTIONS on leverage, as is the case for stocks, or even the usual commodities futures markets.... derivatives are contracts between very large financial and industrial enterprises, between two large organizations, called counter parties, and they are massive leveraged bets, on the order of 50 to 200 X. That is something the FED is well aware of, but they don't try to regulate it because I believe that it probably would be impossible, and destabilizing. However, that does not mean derivatives are good by any stretch of the imagination. Even if you were to look at only the conservative derivatives contracts ( mere hedges against currency moves that affect a companies bottom line when they have to transact in foreign currencies) there are very real problems with what is called counterparty risk. To put that in a nutshell, counterparties are the opposite parties of the derivative contract. The risk is that one party cannot fulfill its part of the bargain, sending the holder who thought he was covered running for cover (probably to the FED ultimately).... Now the latest meeting with the FED about derivatives with the major institutions dealing in them resulted one improvement in the practice, namely increased cash collateral by hedge funds. That is most definitely a major improvement. I'm glad to hear it. BUT there is one serious issue, and that is the ridiculous levels of leverage, so even if you have millions in collateral, what is that compared to 100 million in an open derivatives position, or even 500 mil, or billions? Hey, I have researched the derivatives issue for quite a while now, and I'm gonna tell you that it really is the leveraged bet that it is .... 50 or 200 times leverage, and just like a person in the futures business, leverage can kill fast. There is no difference structurally as far as leverage is concerned, except that its just one hell a lot higher than any private entity could pull off.... that's not good.... There are organizations that say that the practice of risk offloading using what are called tranches (segments of risk sliced and diced by year, maturity date, high and low collateral priority and so on) creates quite a bit of safety. But all that does is DISPERSE risk not really mitigate it like you would expect. The net risk is the net risk..... Obviously, the more counterparties there are, the more the risk that CAN be taken. Dispersing risk is not just a mitigation, but it actually permits a higher level of leverage than normally would be achieved, and in my view really just masks risk... but does not really mitigate it. Derivatives are really a new market growing from about 20 trillion in 1990 to 250 now... and frankly is a financial Frankenstein that is not possible to regulate....I guess we will all just see where they take us. With the size of this new UNTESTED market, that is not possible to test because of its size....what kind of outcome to you expect in the next years??? I don't like the idea of a financial Frankenstein wandering around, hoping that his formerly criminal brain will be nice....Remember Frankenstein got pissed off at Dr. Frankenstein because of something, and as I recall threw him into a sulfur pool??? Was that how it went? Anyway, a bad end of some kind....for Dr F. So back to the original discussion, the two major trends that economists and gold bugs are using to say the USD is going to have another 25% decline soon could be quite wrong. Again barring a currency crisis. Of course if inflation were to really take hold not only in the US, but it is showing signs in Europe as well, and definitely in much of Asia, then gold will react accordingly and do well. So in that case we could see continued USD strength and gold strength together., as we are currently seeing now. That concurrent rising trend could continue for quite some time in such a situation. IE the USD rises for the reasons given above and gold rises due to inflation pressures.... But, I have some reasons that also argue that while there are inflation forces now, mid to late 2006 we will see them subside.... well stay tuned.
The Prudent Squirrel newsletter is Chris Laird’s weekly macroeconomic gold newsletter. A month or so ago, I predicted the short term gold bear market is over based on the weak USD and the continuing concern in the Mid East. That has proven to be true – holding up gold in spite of weakness in the base metals…. Stop by and have a look. CONTACT
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