Monday, February 22, 2010

Hello Inflation, Good-bye Dollar

An explosion in the supply of U.S. Treasury bonds:
It would be bad enough if Washington only had to borrow enough to equal each year's budget deficits. That would mean $1.6 trillion-worth of treasuries hitting the auction block this year alone, many times more than in prior record years.

But Washington also has to borrow enough to replace Treasuries that are maturing — and that means an even greater avalanche of Treasuries need to find buyers each year.

Already, total issuance of government debt already hit a stunning $922 billion in 2008. It then surged even higher to $2.1 trillion in 2009, and it's on track to top $2.5 trillion this year. The size of just ONE WEEK's debt auction has ballooned to almost $120 billion — more than the total supply hitting the market in a FULL year not long ago.

The laws of supply and demand dictate that when you get a massive increase in the supply of anything, its value plunges — and Treasury bonds are no exception.

-Martin D. Weiss, Ph.D., Money and Markets

Demand soft at US 30-yr inflation-linked bond sale
NEW YORK, Feb 22 (Reuters) - The U.S. government's $8 billion auction of 30-year inflation-protected bonds produced mixed results on Monday, which may cast a cloud over the rest of this week's record $126 billion worth of debt offerings.

Long-term Treasurys fall after 30-year TIPS auction
NEW YORK (MarketWatch) -- Prices for longer-dated Treasurys declined Monday as the government's first sale in nine years of inflation-indexed bonds with 30-year maturities drew what was deemed lackluster demand from investors.

The $8 billion auction was the first portion of $126 billion in U.S. debt sales scheduled for this week.

Nothing shocking here. Today's TIPS auction sets the tone for the balance of this weeks bond auctions. The Treasury has some heavy lifting to do this week. Tuesday they will attempt to unload $44 BILLION of 2 year notes, $42 billion in five-year securities on Wednesday and $32 billion of seven-year notes on Thursday. Can you say "Debt Bomb"?

Interest on U.S. government debt, a brewing time bomb [MUST READ]
By Michael Pollaro, True/Slant
It’s not talked about much, at least by mainstream analysts, but make no mistake, it’s a time bomb, locked and loaded, and it’s set to blow the U.S. government’s budget sky high.

That time bomb? The interest cost on the government’s debt.

And what you ask will light the fuse? The end of the 30 year bull market in U.S. government debt, the end of record low interest rates.

In my opinion, unless politicians decide to renege on the government’s obligations, it’s not a matter of if, it’s a matter of when. And in the end neither the U.S. government nor the Federal Reserve can do anything about it.

First, some preliminaries. At its most basic, the interest cost on the government’s debt is determined by three factors:

- The outstanding debt of the government

- The interest rate paid on that debt

- The maturity distribution of that debt

At the risk of stating the obvious, higher levels of debt mean a higher interest cost. Lower levels of debt mean a lower interest cost.

Similarly, higher rates of interest on that debt mean a higher interest cost. Lower rates of interest mean a lower interest cost.

And finally, shorter dated maturity distributions, leading to generally larger and more immediate refinancing needs, means more exposure to interest rates, and therefore, a higher interest cost when rates are rising and a lower interest cost near when rates are falling. Longer dated maturity distributions, leading to generally smaller and less immediate refinancing needs, means less exposure to interest rates, and therefore, a lower interest cost when rates are rising and a higher interest cost when rates are falling.

With those preliminaries out of the way, let’s go straight to the numbers.

State and Federal Borrowing Is Crowding Out Everyone Else
As if the credit markets aren't already under enough pressure, the mass intrusion of state and federal debt will only make matters worse.

At a time when credit availability is at a premium, the federal government has launched its biggest series of Treasury auctions yet while more states are issuing debt in order to support their spending needs.

Consumers and businesses looking to borrow and investors trying to find a way to navigate a marketplace heading toward higher interest rates will find the conditions daunting, experts say.

"Clearly the government is not the 800-pound gorilla-it's the 8,000-pound gorilla in the credit markets nowadays," says Mike Larson, analyst at Weiss Research in Jupiter, Fla. "These numbers are just so mind-boggling. Really what's going on is you have intractable debt and deficit problems in the country that neither side wants to tackle in a meaningful way, so the market is doing it for them."

The phenomenon in which public entities push private borrowers out of the market is often referred to as "crowding out." The result usually is higher borrowing rates and more difficult choices for investors who have to make sure they're not putting their money in assets that are sensitive to interest rate moves.

While that problem specifically has not hit the market full bore yet, the signs for intense credit pressure are there.

"You are crowding out a lot of other borrowing from the private sector and are at the very least pushing up interest rates," says Michael Pento, chief economist at Delta Global Advisors. "We have this huge system of artificially low interest rates and that is in the process of reversing."

Early signs of crowding-out pressure in the credit markets have come from the latest Treasury auctions.

While 2009 saw demand for Treasurys fairly strong, the early signs in 2010 aren't as good.

After a powerful opening in Asia last nite, Gold and Silver began to drift lower as markets opened in London, and then got their usual disrespect by the paper hangers as trading opened on the CRIMEX. With the Dollar waffling about all night and into the morning, it was once again obvious that US Government regulators are not in anyway interested in enforcing commodity law on the CRIMEX futures exchange. Gold was brought down thru the day with one purpose in mind: prevent Gold from closing above $1100 on Tuesday's options expiration.

But we expected as much, didn't we?

Gold support at 1113 held, but Silver support at 16.23 gave way. The US Silver Futures market has got to be the "Crime Of The Century".

The bear market rally in the US Dollar appears now to have about run it's course. There are few weak handed shorts left to squeeze, and the market lacks any fundamental reason to seriously "buy" the Dollar. The path of least resistance here appears to be down. Adam Hamilton makes a strong case for just such a rollover in the Dollar in a recent essay:

US Dollar Bear Market Rallies [MUST READ]
By: Zeal_LLC
With consensus for the US dollar very bullish today, I’m going to offer a contrarian perspective. Rather than being the start of a new cyclical bull, technically this dollar surge merely looks like a garden-variety bear-market rally within its secular bear. And provocatively, given bear-to-date precedent this particular rally looks mature. Odds are today’s dollar rally is either already over or soon will be.

The key question today is whether or not the dollar’s current bear rally will stretch beyond the normal into the exceptional. I really doubt it technically and fundamentally (which I’ll touch on later). Exceptional bear rallies have only happened once every few years, and our latest one ended less than a year ago. You also need extraordinary demand circumstances to drive such rallies. And despite the media frenzy these days, the sovereign-debt problems (such as Greece now) are nothing new. They aren’t panic-grade.

Within the context of the dollar’s broader secular bear, the USDX’s recent surge merely looks like a garden-variety bear-market rally. Both its magnitude and duration are right in line with the normal bear rallies we’ve seen in past years. It is truly nothing special. is important to understand just how normal and unremarkable the dollar’s recent advance has been in technical terms. It was a textbook-perfect bear-market rally, right in line with the majority of bear rallies we’ve seen in this long secular bear to date. With this rally looking mind-numbingly typical, today’s bulls have a heavy burden of proof in trying to argue it is anything beyond a normal bear-market rally. And if it is indeed a normal bear rally, it is probably mature and ready to roll over.

As always after a sharp USDX rally, bullish analysts love to make fundamental arguments to rationalize their popular stance. In the last couple weeks for example, I’ve seen a surprising number of analysts on CNBC claiming that the euro currency is in jeopardy due to sovereign-debt issues. This death-of-the-euro talk is woefully exaggerated though. One of many countries growing its government too large and getting into trouble is no more of a threat to the European Union than California defaulting on its “sovereign debt” would be to the United States. Though the euro is a strange composite currency, it isn’t going to implode.

The real issue with the US dollar today is not the euro, but its own fundamentals. The US dollar’s own unique supply-and-demand profile is what is going to drive its international price in the coming years. And there is no doubt at all that the dollar’s fundamentals remain terribly bearish. The goofy US government is creating vast new fiat-dollar supplies at the same time global demand is waning.

The bottom line is despite all the dollar enthusiasm and bullishness these days, so far all we’ve seen is a typical garden-variety bear-market rally. Throughout the dollar’s long secular bear, similar rallies have periodically erupted to erase oversold conditions and rebalance away excessively pessimistic sentiment. These are merely technical events, they don’t herald new bulls. Until global dollar demand growth starts to exceed supply growth, the US dollar’s strong secular bear will continue grinding lower on balance.

The Fed finds itself in one Hell of a pickle this week. On the one hand they have pledged to prevent deflation from overtaking the US Economy. On the other hand their mandate is price stability and low inflation. You can't prevent deflation with a rising Dollar, a falling Dollar signals inflation. The Treasury is caught in the middle, they need to sell some debt. A falling Dollar and inflation forces Treasury prices lower and yields higher. A rising Dollar spurs deflation, and a sagging economy, and in theory keeps a bid under Treasuries...keeping yields low. What a freaking mess! You can't have it both ways... that is unless the central bank buys all the debt.

And the the banks, feeling lucky to be on the inside, are terrified by what will result should interest rates begin to rise uncontrollably. The Interest Rate Swap catastrophe sits just over the horizon. And with $66 TRILLION [that's right TRILLION] in Interest Rate Swaps sitting on just it's books, JP Morgan faces certain destruction. Which of course means that the Man Of Change will be eating those words he spoke just last week declaring that " a second Great Depression is no longer a possibility ".

For more on just how catastrophic a rise in interest rates could be, I urge you to read the following two essays that were written early last summer. The Interest Rate Swaps bomb threatened to detonate last summer, but the fuse was wet. This Spring could well find that bomb with a very short fuse. Jim Willie and Rob Kirby explain this threat to the bond markets, and the economy, most eloquently.

Bond Volatility & Interest Rate Swaps
by Jim Willie, CB. Editor, Hat Trick Letter June 11, 2009

Theater of the Absurd:
A View From the Inside
BY ROB KIRBY may 18, 2009

And take note, Gold rose from $35 an ounce to $850 an ounce while interest rates rose from 3% to 14 1/2% in the last half of the 1970s. Imagine a 2400% increase in the price of Gold today if interest rates again rose from 3% to 14 1/2%! Gold would be over $28,000 an ounce! I'd hate to be short 30 MILLION ounces of Gold in that environment, even worse, holding $66 TRILLION of Interest Rate Swaps. I hope those crooks at JP Morgan invested those bonus billions wisely.

Fed's Yellen: U.S. economy still needs ultra-low rates
SAN DIEGO (Reuters) - The U.S. economy still needs extraordinarily low interest rates, as inflation is "undesirably low" and growth will likely be sluggish for several years, a top Federal Reserve official said Monday.

The Fed has kept its target interest rate for bank-to-bank overnight lending at near zero since December 2008 to combat the worst financial crisis and economic downturn since the Great Depression. It has also injected more than $1 trillion into the economy.

"Accommodative policy is appropriate, in my view, because the economy is operating well below its potential and inflation is undesirably low," Yellen said. "I believe this is not the time to be removing monetary stimulus."

Hello inflation, good-bye US Dollar. It only makes sense...the Fed will defend the bond markets at ALL costs.

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