Thursday, November 12, 2009

Zero Interest Rates Can't Last Forever

Hi All!

I apologize for being so quiet this week. I am exremely busy recently so please forgive me!

Alrighty, let's get to these wacky markets.

I wanted to share some thoughts with all of you around the US dollar and the current "easy money" interest rate policy of the Fed.

Before I get into this, let me start by saying the market makes no sense right now when it comes to fundamentals(Surprise! Not!). A strong dollar is usually associated with a strong economy in most countries.

Our stock market is doing the exact opposite right now as the banks continue to buy the S&P using US taxpayer dollars.

The trend that's been working recently is short the dollar/long equities trade. Whenever the dollar strengthens(like today) the trade reverses and the market tends to fall apart.

This of course makes no sense. However, Should this really be a surprise when it comes to the crazy price action in our market lately?

The way I see it, the market is basically caught between a rock and a hard place as the economy continues to suffer. The only way for the banks to make money right now is in a zero interest rate environment.

This allows for them to borrow from the Fed at practically zero and then buy things like longer term treasuries that yield 3-4%. This is a sweet spread for the pigmen.

Ironically, the pigs on Wall St have no desire too see a recovery in the short term because the profitability of the trades like the one I explained above are beautiful in their eyes. This low rate environment basically enables the banks to make sweet profits with very little risk compared to lending out money to J6P.

The current scenario described above is also having an effect on how the stock market trades:

Stocks today tend to rise as the economy continues to suffer because Wall St understands that the Fed cannot take away the punch bowl and raise interest rates as Rome burns.

As a result, traders and investors buy equities and gold based on the idea that the dollar will fall. This is the "reflation trade" that you hear about on CNBC all day.

This trade has been extremely successful recently as gold and equities have soared. Gold now sits near an all time high of over $1100(this must make the Fed nervous). The Dow has flattened out a tad recently but still sits over 10K.

However, when the dollar reverses and rises, equities begin to sell off as the world begins to fear deflation. We saw this type of price action today as the dollar stabilized. This stabilization often occurs as a result of countries buying our dollars in an attempt to stabilize the buck in order to keep their own exports attractive.

A weaker market as a result of a stronger currency is the exact opposite of what should happen. A strong national currency usually is representative of a country that has a strong economy. This should be a boost for stocks during normal times.

As we all know, these are not normal times.

So what do you do when the market is zigging when it should be zagging after a 50+% bounce? Stay away IMO. I am tempted to short at these levels. In fact, I bought a few short contracts two days ago for **its and giggles.

For the most part as you all know, I continue to sit in cash and go long metals as the dollar continues to depreciate as a result of endless bailouts.

The risk of buying stocks with PE ratio's of over 100 is simply too risky for my taste.

So where are we headed?

IMO, I don't see why the dollar will strengthen anytime soon. As long as the fraud on Wall St continues and real price discovery continues to be ignored, the dollar is going to continue to get crushed.

The economy will not recover in such a scenario because the prices have not been allowed to "revert to the mean".

This forces buyers to sit on the sidelines thinking that prices are still too high which then kills the economy. Rising unemployment only exacerbates this problem. We now sit at a staggering 17.5% U-6 unemployment rate.

Don't forget: The real economy is dead folks. The government stimulus is the only thing keeping things afloat. Remember, the Feds would never spend like this and risk inflation/hyperinflation if they believed the economy could sustain itself.

As a result, the Fed's continued massive spending binge will dig us even deeper into trillion dollar debts. The US dollar will continue and take a beat down as a result..

Eventually this game will end because there will be no one left to borrow money from in order to keep the game going. Also keep in mind that the quantitative easing by the Fed is about to come to an end.

The Fed's treasury purchases are just about done, and the MBS QE purchases should be completed by March in my estimate. When this buying binge ends in the spring the market is in for a VERY rude awakening.

I predict interest rates are going to soar as the world's appetite for treasuries disappears once they realize the Fed is no longer a buyer!

Take a look at Japan if you want a preview of what happens to rates when a central bank stops QE'ing:

The Bottom Line:

As you can see above, once Japan's QE spending binge ended, rates began to rise. Are they still ridiculously low? Yes. However, Japan's famed deflation was not nearly as serious as it is usually depicted.

I expect a violent rise in interest rates next year when our QE ends. I also predict that the short dollar/long equities trade will fall apart once the dollar gets below the 72 area.

When the dollar falls to a certian level, it will be hard for the pump monkeys to continue and smoke the bull crack pipe when oil goes back up to $150 as a result of our collapsing currency.

The Fed is on a bridge to nowhere. They can't raise rates because the economy is too fragile, and the dollar will continue to fall the longer rates stay at zero. This will of course will create tremendous inflationary pressures on the economy.

Heading into early next spring I believe higher interest rates are inevitable as the various QE programs come to an end.

If the Fed ignorantly decides to extend these programs in an attempt to continue and bailout America, you better go out and a skateboard because it will be the only way you will be able to afford to commute to work.

Disclosure: Short a couple contracts via SPY for fun. Long Gold.