The Devil Usually Wins

“If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money and the other is to miss opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive. I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: «No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble». On the other shoulder is the devil in a red robe with his pitchfork. He whispers: «Do it, you’ll get rich». In the end, the devil usually wins. Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.”

– Howard Marks

QE3 Pt. 2: Liquidity Trap and Quantitative Easing

QE3 Could Fail Due To A Liquidity Trap

 The Fed’s announcement on Thursday caused a rally for stocks and a fall for bonds. However, data from the bond market didn’t make much sense; the long end of the curve was rising and the short end falling. I was confused the long end because traders were selling bonds quickly, whereas the Fed had promised to buy Mortgage Backed Securities (MBS) – so the long end should have been stable or falling.

Adding to the confusion, I read the Fed’s statement on its website and it wasn’t clear if it was going to buy bonds in the open market or if these purchases were going to be made just to add liquidity in the banking system. If it’s the latter, then I wouldn’t make much of this event as the US has been in a liquidity trap for a long time. New money from a round of QE would just become trapped again.

I’m not sure about how this printed money would impact the country’s GDP, but right now it’s a safe assumption that most of it will be going towards stocks. The rapid sale of bonds on the long end of the curve shows that investors are planning to use that money for stocks and commodities as they expect inflation. So, the Fed’s money will be going to institutional banks and would be reinvested. The point of all of this is that this money would not have a high velocity – an argument I made in my previous article.

Stocks and commodities will continue to rise, but that is not what the US needs. A liquidity trap is broken people’s fears subside, and they do so when uncertainty ends. The new money will flow from the Fed to the banks, who will invest it in stocks and metals, and it would end there. Money won’t flow into the broader economy, where its velocity could help GDP growth.

QE3 might not even provide a strong rally for the stock market. $40 billion a month could be absorbed by the enormous market capitalization of stocks.

In the end, the Fed’s success or failure will depend on whether fear and uncertainty is removed or not.

Examining the liquidity trap

Consumers are the real force behind economic growth. If they save money out of fear monetary policy won’t be able to stimulate the economy.

Keynes believed the government spending was the best way to break the liquidity trap. There were two other options available as well, which are mentioned below:

  1. The government could lower interest rates. However, in a recession people may be so unwilling to borrow or spend that it would become impossible to lower interest rates after a certain point, i.e. when they reach 0.
  2. The government could increase the money supply (print money). Theoretically, it would work as this money would go around the economy, allowing people to invest and consume more. However, when a recession creates uncertainty they tend to hoard the cash instead, and it doesn’t travel around the broader economy, i.e. a liquidity trap.

The US has been stuck in a liquidity trap ever since quantitative easing began. The chart below illustrates this fact:

money stock m2 savings portion

The savings portion of M2 travelled along with M2 itself till 2007, and travelled much higher after 2008. This roughly corresponds with QE1 in November of 2008. While it cannot be said with certainty that quantitative easing was the reason why Americans started to save more, it’s safe to say that QE programmes didn’t do anything to address the public’s fears.

The following chart examines spendable cash in the economy since 2007, a key driver for growth.

money stock m2 saving component

Spendable cash is the key factor behind GDP growth. Note that it fell from $3.96 trillion in Nov 2008 to $3.59 trillion today. The Fed has spent $3 trillion since they started the quantitative easing rounds, and most of it has gone into savings. Had this money been circulating in the economy, it would have had a multiplier effect on GDP growth.

Unemployment is another way to measure this phenomenon. A reduction in spendable money supply is correlated with an increase in unemployment. The chart below shows the unemployment rate from 2008:

us unemployment rate

The unemployment rate started to climb when spendable money supply decreased.

All of this leads us to GDP growth:

us gdp inflation adjusted

When we look at the inflation adjusted GDP, we find out that there hasn’t been any growth at all since the recession. The conclusion is that QE rounds have not addressed the fear in the public and investors, which is hindering growth.

Even though we’ve long forgotten Keynes, some of his words still have some wisdom. On the liquidity trap, Keynes said:

If investment exceeds saving, there will be inflation. If saving exceeds investment, there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving.

Conclusion

Americans would get out of this problem once they boost their own confidence. Monetary and fiscal policies have not worked to end the fears so far. I could even argue that these measures are leaving the people worse than they were before; now, the people also have to deal with credit downgrades. When bonds start to reflect these downgrades, the country would have to carry even more costs than before.

Predictions for the stock market

I believe the market rally isn’t reflective of what’s going on, so it shouldn’t last that long. While the duration is analysed in another article, I support my argument by examining the current market situation. The country is experiencing a high amount of unemployment, there is a liquidity trap, the fiscal cliff exists, the eurozone is even worse off, China is experiencing a hard landing and debt is rising at an alarming rate.

In the end, QE3 is producing a short rally in stocks and commodities.

Update (20 Nov 12): The rally was short-lived, as the S&P 500 soon experienced a massive sell-off and reached a new low near 1340. QE3 is in the background now as the fiscal cliff looms.

More on Quantitative Easing:

  • QE3 Part 1: Velocity of Money and Quantitative Easing

For further debate on the Fed’s policies, I recommend Ron Paul’s book:

QE3 Pt. 1: Velocity of Money and Quantitative Easing

QE3 Could Fail Due To Money Circulation

I believe the Fed’s move towards Quantitative Easing would not be as fruitful as hoped, as QE3 does not solve problems in money circulation.

What is quantitative easing?

QE is an unconventional monetary tool used by central banks to stimulate the economy when there are no other options available. In a normal recession, the Fed would lower short-term interest rates to promote lending and consumption. However, during the current Great Recession the Fed has gone as low as possible, and can’t cut interest rates any more.

So the Fed prints money and starts to buy assets – Mortgage-backed Securities (MBS) for QE3 – to pump money into the economy and cut long-term interest rates. Theoretically, people are encouraged to spend more when this happens. Theoretically.

The QE3 announcement

On the 13th of September, the Fed announced that it would keep short-term interests rate low till 2015 and would buy $40 billion of Mortgage-Backed Securities (MBS). The market’s been responding positively since the announcement, but I’m a bit sceptical about QE3, even though I’m long on US equities and commodities.

Velocity of money and quantitative easing

QE’s purpose is to decrease the rate on yield-bearing assets. As the Fed buys these assets, the yields decrease, and investors are able to borrow at better rates. The Federal Reserve is relying on the theory that businesses would respond favourably to lower rates and stimulate the economy by increasing investment and consumption. All of this would be true if money keeps on circulating in the economy. If the public is not interested in consumption, and businesses not willing to invest, lower yields would not interest them as much as expected. This could lead to a liquidity trap.

The following chart examines money circulation (velocity of money) over the decades:

money circulation

From a historical perspective, velocity of money has taken a beating since the 2008 recession. To look at the post-recession conditions closely, let’s use a chart with a smaller time frame.

The chart explains it all. Even though the public can borrow at very low rates, they are less likely to, considering they are less likely to move the money back into the economy over time. The decrease in money circulation over the past year or more suggests that a new round of quantitative easing won’t be quite successful.

Government deficit and debt levels

Current US government debt levels are unsustainable. A government deficit arises when tax revenue is less than its expenditures. The following chart looks at government deficit from 2000:

Debt markets finance government deficits, so it is safe to say that the US is going to experience more debt in the future. As debt increase, the United States would have to spend more to fulfil its debt obligations. If this problem isn’t fixed, the government might have to raise taxes and the expenditure could become a problem for the economy.

The chart below looks at total US government debt:

US debt is increasing exponentially – and if something is not done – Americans would have to deal with massive debt levels.

Go with the flow

Even with all the negative talk, I would suggest going along with the market for now. The current rally should continue at least till the end of the election cycle, however, it could be a volatile journey. QE3 is promoting risky assets, so trading those would be better. Here are my positions for the next few weeks:

  • Commodities: Long
  • Gold and Silver: Long
  • Oil: Long (but keep politics and supplies in mind)
  • Forex: Short on USD, Neutral on USD/JPY
  • US Equities: Long on Indices, Long on Financials

More on Quantitative Easing:

  • QE3 Part 2: Liquidity Trap and Quantitative Easing
For further debate on the Fed’s policies, I recommend Ron Paul’s book:

No Current in Copper

This article explains long-term analysis for copper, other commodities and currencies. In the short-term I am bullish for copper, commodities and the AUD pairs I mention below.

Copper Indicates a Grim Economy

It’s becoming clear by the day that the global economy is experiencing a downturn once again, and this is going to produce some interesting effects on commodities and the US Dollar, among other things. My short-term and long-term predictions for USD are posted elsewhere, so I’m going to focus on a particular commodity today – copper.

Copper is the best judge of global economic recovery, especially emerging markets as they tend to have a strong demand for it. China is the greatest consumer of this industrial metal. So when traders start to pooh-pooh about copper, you know something is going down. I’m going to use copper to offer short-term and long-term views on commodities and economies, starting with a long-term view first.

Copper industry is bearish

Looking at a weekly view, Copper’s below its MAs and the main miners are not staying above the 10 week prices. The current has gone from copper; it has lost directional power and could sink in the long-term. However, I see a short-term rise:

copper technical analysis

MACD is in the negative but it is rising, while Stochastic is in a full swing upwards. There is no concrete evidence though, but I am wagering this for another reason.

The broader picture

In the short-term, I see the US Dollar declining and the commodities either struggling on their current levels or slightly rising. Bringing Australia as an example here, the country is still experiencing demand for its commodity exports and should continue to do in the short-term. That’s why we can see a sort of lifelessness in copper here.

But stretch this to a long-term view, then we have a lot of things cooking up. Firstly, copper’s going down, precisely because the emerging markets (China in particular) have dried up and can’t continue to replicate their noughties growth. This fate could be roughly translated to other commodities, so we should see an end to the long commodities boom in the future. It’s not all gloom and doom though – declining commodities is good for the poor third-world man as he should be able to afford the basic necessities once again (kind of). Bad news for South American countries and Australia though.

And while we’re talking about Australia, I’d like to prove that my commodities prediction has some backing. The Australian resources minister has said that the long boom is over, and with China slowing down, we could finally see an end to this (and see the Australian Dollar decline). Julia Gillard responded that this doesn’t apply to the short-term, but could be true over a longer period.

This is also backed by signs that USD is likely to become pricey in the long-term. While we’re linking things together here, I see leprechaun’s getting heart attacks, because gold’s bullish run is going to be over too, but hey – that’s explained in another article as well.

So what’s the point?

I’m going to summarize everything I just said. Copper tells us that while commodities are stable in the short-term, they’re about to decline along with the metal in the future. And this is being caused by a declining economy, which has now reached the emerging markets.

Long-term summary

  • Commodities: Bearish
  • Currencies: USD bullish, AUD  bearish
  • Gold & Silver: Neutral
  • Stocks: Bearish on mining companies (BHP Billiton, Xtrata, ENRC and Rio Tinto in particular)
  • Emerging markets: slowdown (China and India in particular)

For advice on how to trade commodities, I recommend the following book:

A Dollar Saved is a Dollar Lost

Short Term Implications for USD

I believe the US Dollar is going to decline the near future, supported by both fundamental analysis and technical analysis. While this article is mostly about the latter, I’d like to touch base with the fundamentals first.

Quantitative easing

If you have read the news lately, you’d know a new round of quantitative easing may be coming in the US. This means a decline for USD because QE promotes inflation and growth of the economy by increasing the money supply (printing of money). This results in the currency to fall. The fed has done this in the past and it has caused the US dollar to fall against other currencies.

Update: QE3 has hit the States and the US Dollar is currently sliding against major pairs.

us dollar debt money

Macro technical analysis

Greg Schnell has done a wonderful macro analysis of the USD, which I’m going to explain here with the help of a 10 year dollar chart.

usdtech1

Let’s go along with the chart bit by bit:

  1. The blue line hits the price’s head as it hits a peak.
  2. The rallies have similar slopes – the current one is quite comparable to the one experienced in 2005.
  3. The red-dotted reversal arrow predicts the future, although it is not guaranteed.

Although this chart is long-term, I’m using it to predict the new few months or perhaps a year. My real long-term means years (the way it’s supposed to be!).

Now, I do expect a decline of USD but it can prove tricky. The following chart explains why:

Usd support resistance

As seen above, there is a lot of support and resistance going on on the two horizontal lines. RSI is being supported for nearly 5 quarters, while Full STOs are still above 80. On the other hand, MACD just gave a sell signal along with Full STOs. In short, we see a tug-of-war happening here.

usdtech2

Above, the current upward slope is less slanting than the two before, so we could assume that there isn’t much force with this one. If it breaks, we could be witnessing a strong reversal.

From here we could either be witnessing a bounce, or more likely, a decline – especially because our fundamentals agree with that. So what we could see soon is USD falling and Gold rising, among other things. In my long-term perspective, I predict the opposite, keeping in mind my long-term is long, long-term for the average trader.

For further advice on tackling the USD, I recommend David Jones book:

Entrepreneur | Analyst