The Amphora Report's 2010 Topics in Review (3 of 4)

[Introduction below, and then continuing from Part 2.]

In 14 editions of the Amphora Report this year we have covered nearly 30 topics, many of which overlap in some way. What binds them all into a coherent set is our view that the economic policies being implemented in nearly all major countries are not just unsustainable but in some cases outright reckless. These countries include the US, the issuer of the world’s reserve currency. By implication, the dollar is likely to lose its pre-eminent reserve currency status in the coming years. The result is bound to be a period of global economic and financial market turmoil and, for most if not all traditional financial assets, underperformance in real, purchasing-power adjusted terms. What follows below is a list of all topics, including both a brief summary and an update of our thinking for 2011.


It remains our view that the US is headed for some sort of debt crisis during the coming 1-2 years. But if we are alone in this view, why aren’t Treasury bond yields higher if the deficit is about to explode on the upside? The answer to this apparent conundrum is surprisingly straightforward: supply and demand. Yes, Treasury supply is going up, but so is demand. We look at who buys Treasury securities and why, and we find that a substantial portion of the market is held by non-discretionary buyers, including of course central banks and, with QE2 underway, the Fed itself. Moreover, the Fed can frighten speculators into refraining from shorting Treasuries with credible threats to purchase more as yields rise.

The recent spike in Treasury yields may be an indication that investors are beginning to price in some combination of higher US deficits and inflation in future. Nevertheless, yields still remain extremely low in a historical comparison, in part because so many Treasury investors are essentially non-discretionary and will buy comparable amounts at any price absent fundamental changes in their mandates. We doubt that this is the beginning of an adjustment in US Treasury yields higher to more normal levels, as we think the Fed will soon grow concerned that a higher level of yields will quickly derail the weak economic recovery. Of course, were the economy fundamentally healthy, the Fed would feel otherwise, but the recent decisions to launch QE2 and also extend tax breaks and unemployment benefits demonstrate that the US economy remains in a perilous situation that will only become more so as Treasury yields rise.


While common sense informs us that you can’t get something for nothing, policymakers frequently speak and act as if there is not only a free lunch, but that they possess a magic wand that can reduce and/or eliminate economic and financial risk. It is reassuring to think so but contemporary developments suggest otherwise.

Among other developments, the various euro-area sovereign debt crises demonstrate that policymakers do not have a magic wand to make financial risks disappear and that attempts to do so, such as in Ireland for example, can have severe, unintended consequences. We are likely to see more attempts at using accounting tricks or other “smoke and mirrors” to disguise the true nature and scale of the debt problem in 2011. But investors will eventually see through such deception and the results will be sudden and, for those who disagree with our thinking in this regard, unexpected.


Bernanke’s recent speech at the Kansas City Fed’s annual Jackson Hole Symposium indicates that, as the US economy weakens again, the Fed is likely to consider increasingly radical means to provide additional monetary stimulus. A recent editorial by Bernanke’s friend and former colleague, Alan Blinder, indicates what Mr Bernanke may be planning for the future. The Fed’s chronic inability to address the negative, unintended consequences of past and possible future actions suggests that US monetary policy is becoming increasingly pathological.

The Jackson Hole Symposium and other such Fed policy forums used to be the primary way in which the Fed communicated its strategic thinking on monetary policy to a wider audience. No longer. Fighting an increasingly poor public image, the Fed now goes straight to the public. Recently, Chairman Bernanke published an op-ed in the Washington Post and has also been interviewed on the popular news program, 60 Minutes. In both cases, he has been attempting to explain the Fed’s recent decision to purchase some $600bn of Treasuries in the coming months which, perhaps just incidentally, roughly corresponds to the amount of new Treasury issuance expected during the period. Bernanke denies that this is equivalent to “printing money”–although that is really a matter of semantics–and also claims that this policy will reduce borrowing costs, stimulate investment, prop up the stock market and increase both economic activity and employment. He may be right for a time, but at what cost? A sharply weaker dollar? Sharply higher price inflation? Another asset bubble which ends in other bust, resulting perhaps in another bailout for Wall Street at taxpayer expense? With reckless disregard for the growing costs of ever-expanding monetary stimulus, we see ample evidence today that the Fed has become pathological.


While the several sovereign debt crises in the euro-area have taken markets largely by surprise–thus leading them to be labeled as unforecastable, “Black Swan” events–we see a potentially much greater risk ahead, that Germany, at some point, will reconsider its commitment to the bail-out framework agreed with other EU states in May. If so, the crises to date are likely to escalate and spread into additional euro-area countries, causing a general, global credit crisis perhaps as large as that catalyzed by the Lehman Brothers bankruptcy in Q4 2008.

As financial markets bid up the financing costs of one weak euro-area sovereign after another, we see growing frustration in Germany. The bailout arrangements hastily arranged earlier this year are subject to renegotiation. Indeed, many commentators in Germany think that the existing arrangements are not only not in Germany’s interest but are blatantly unconstitutional. While we believe that European Monetary Union (EMU) is going to continue in some form, as we enter 2011 we believe it is increasingly likely that much existing euro-area sovereign debt is going to be restructured in some way and that member countries will continue to follow tight fiscal policies. In time, this should be positive for the euro.


With all financial assets ultimately containing some risk of bankruptcy or default, however remote, and with currencies in general no longer providing reliable stores of value in a world of weak financial systems and deteriorating government finances, diversification benefits across global financial assets are at historic lows. Maintaining portfolio diversification in these conditions requires investors to increase their holdings of alternative assets, in particular commodities, which by nature cannot default.

The reasoning above may seem obvious to some, but to many, commodities are, by their very nature, “speculative” investments. We accept that they are subject to occasionally highly volatile price swings from time to time. But these swings are not driven by changing perceptions of credit risk. When all manner of financial assets, not only equities but also supposedly investment-grade corporate bonds and even sovereign bonds are at growing risk of default or currency devaluation, then investors need to look elsewhere for an alternative. Looking forward to 2011, as long as governments and central banks continue to resist the natural credit risk deleveraging process, a sensibly diversified basket of liquid commodities should continue to outperform a traditional portfolio of financial assets.


For years, the US has been pressuring China to allow its currency to appreciate. But Japan’s unilateral intervention in the foreign exchange market in September represents the opening of a new front in an escalating global currency war. Indeed, this event may be the trigger which sets off a series of similar actions elsewhere. Past episodes of global currency devaluation, such as in the 1970s and 1930s, have always led to increases in global commodity prices, even amidst relatively weak economic growth.

Many financial commentators now refer to a currency “war” being underway between the US and China, but that it just one front in a wider and broadening conflict. Japan, South Korea, Brazil, India, Russia and Vietnam, among several other countries, have taken specific actions this year to either weaken their currencies or control capital flows in some way. But as the US dollar is the global reserve currency, should the US continue to create liquidity to stimulate growth, much of this liquidity will leak out into the global economy, most probably contributing to a further rise in global commodities prices in 2011.


Absent widespread asset price deflation and debt restructuring that would be resisted at all costs by the US Fed and Treasury, the US economy can only return to sustainable growth when incomes catch up to existing asset prices. This requires substantial wage inflation. Amidst structurally high unemployment, the only way to generate wage inflation is via a weaker dollar, implying higher commodity prices. But how far would the dollar need to fall to push wages up by enough to bring incomes into line with current asset prices?

While still an immensely wealthy country by any reasonable measure, the US economy has become increasingly unproductive in recent years. Yet a massive debt has been run up which now needs to be serviced. Absent substantial real income growth–which has in fact been stagnant for decades–the US has no choice but to devalue the dollar to the point where US unit labor costs catch up the elevated level of asset prices. But that implies a much, much weaker dollar. Even if accompanied by business and jobs-friendly tax and regulatory policies, a 25-40% devaluation from the current trade-weighted level is probably required. It may be too early to expect such a large move in 2011, but you never know.


In recent months, global commodity prices ranging from precious metals to grains to cotton have risen dramatically, notwithstanding signs of moderating economic activity. Is this due to constrained supply or simply a weaker dollar? We find these explanations inadequate because commodity prices are rising in all currencies and relative to both stocks and bonds. This is highly unusual and suggests that investor preferences have shifted in favor of commodities for some reason. But why? We believe we know the solution to this mystery.

Since we wrote this topic, most of the trends described have remained in place, with the notable exception of late that crude oil prices have been rising along with others. This may indicate a pickup in global industrial demand, although other indicators, such as the Baltic Dry Shipping Index, suggest that activity is more or less stable. Regardless, it is important to note that commodity price strength is broad-based and is not merely the result of a weak dollar, as the dollar has been strong recently yet commodity prices continue to rise in nearly all currencies. As discussed in various other topics this year, as long as the Fed continues to add dollar liquidity to the economy, some of it is going to flow into commodities as a sensible hedge against currency devaluation and debt default. 2011 may not be as strong a year for commodities as 2010 however, as global industrial demand may begin to cool.

To be continued…


John Butler,
for The Daily Reckoning

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]