Australian Dollar Consolidating Now

Through the end of 2012, I am one of those expecting a shift in economic power from Western economies (namely the US) to Eastern economies (China, Japan, etc). In particular, Australia, as a producer and exporter of precious metals -- which stand to rise when fiat currencies are troubled -- and commodities as well, may find its currency in greater demand.

So is it time to buy the Australian dollar? Let's take a look at the price chart to get an idea if now is the time.

After being in a strong bear market since August 2008, the Australian dollar is now rallying. It is currently forming an ascending triangle/rising wedge pattern, as the chart above illustrates. The hourly and weekly chart also show consolidation, suggesting the market may be ready for a breakout.

For US stock market traders, FXA is an ETF that tracks the Australian dollar.

Disclosure: Long Australian Dollar.

Banks Are Lending And Money is Abundant Again

Monitoring the money supply can be a useful tool in understanding "the big picture" of what is going on in the economy. Towards the end of the summer/early fall of 2008, we saw money supply indicators, like MZM, contract. This was the result of deleveraging; in our debt-based economy, in which all money originates out of debt, paying off debts reduces the money supply -- while the issuance of debts increases money supply. Thus, the combination of deleveraging (paying off debts) with a decrease in bank loans resulted in the money supply contracting, the dollar strengthening, and asset prices falling -- all characteristics of deflation.

These trends seem to be reversing. The chart below tracks MZM; note the recent spike upwards.

Likewise, the TED spread -- an indication of fear and risk in the market, and whether or not banks are lending -- has been declining. A lower TED spread means less fear and more lending. The increase in money supply makes sense with a lower TED spread. Both run contrary to reports from much of the media that banks are still unwilling to lend.

The chart below illustrates the TED spread; note it has declined significantly from its peak in October, when the psychology of fear was at its peak.

In terms of financial markets, we've seen the dollar weaken of late, while gold has been rising. This is consistent with the behavior of MZM and the TED spread.

Disclosure: Long gold.

Taking A Look at the Reversal in the Japanese Yen

The Japanese Yen has been strengthening against the world's other currencies for the past few months. For the time being, however, this trend seems to have reversed. The charts below tell the story.

CHFJPY - Note the recent strong uptrend.

EURJPY - Ascending triangle formation in the works.

USDJPY - Moving averages turning upwards, and price trading above moving averages.

Personally I've been in and out of short USDJPY since 101.30; I just closed my most recent USDJPY short position, as I think a short-term reversal of sorts may emerge. Still, though, I think the long-term trend of yen strength will continue. Accordingly, I'll look to re-enter on a break below 88.00, or possibly 85.00.

Yen traders may also find the recent comments of Akio Mikuni, president of credit ratings agency Mikuni & Co., to be of interest. Mikuni said:

Japan’s economic model has been dependent on external demand since the Meiji Period that began in 1868. The model where the U.S. relies on overseas borrowing to fuel its property market is over. A strong yen will spur Japanese domestic spending and reduce import prices, thereby increasing purchasing power.

Mikuni said the USDJPY could fall to 50 or 60 from its current price of just aboe 90 unless Japan takes "drastic measures" to help bail out the US economy.

Disclosure: No position.

Analyzing The Housing Sector and Opportunities to Short XHB

Let's take a look at the housing market, and potential trading opportunities it presents.

Fundamental outlook: Fundamentally, the housing market is still very much in a bear market. According to Austrian business cycle theory, the housing market represents a good short opportunity, as the housing bubble fueled by credit expansion is now being deflated as credit has become more scarce. Economist Mike Shedlock recently had a great post analyzing the housing market, in which he called for a bottom to be 3-5 years away, as we recently discussed.

The excess number of houses already created in the US as a result of the housing bubble, coupled with increasing job losses and tightening credit, makes shorting homebuilders an interesting proposition. US stock market traders can look to short XHB, an ETF tracking homebuilders, to capitalize on this opportunity.

Technical outlook: Technically, there has been some talk of a market reversal getting ready to happen, like we recently discussed. At the time of this writing I'd still prefer to see additional confirmation that a reversal is indeed forming -- preferably gold sustaining a break above 850 -- but if indeed we see a reversal of the trends we've seen for the past few months and the US stock market does rally, it could translate into an opportunity for traders to get short XHB at a higher price.

Below is a chart of XHB that offers some insight into key price levels traders looking to get short may want to watch.

Click to see enlarged image.

Disclosure: No position in XHB or any housing investment.

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Is a Reversal Shaping Up in the Markets?

There's been an increasing amount of talk lately that the US stock market market is gearing up for a rally, and that we're set to see a reversal of the market trends that have dominated the last few months of trading. Let's take a look at key signs of a reversal and corresponding trading opportunities.

1. Gold is rallying and is currently at an eight week high. GLD, an ETF that tracks gold, also appears to be rallying, as it is making higher highs and is testing key resistance at 81.72. A break above this level could provide momentum traders with the confirmation they are looking for.

2. Likewise in the forex market, we see EURUSD reaching breaking past key resistance at 1.3250, and USDJPY breaking below 92.00. A break below 91.00 may be a great opportunity for USDJPY traders looking to trade the longer-term trend to 85.00. For stock market traders, the FXY ETF may be of interest in capitalizing on this.

The Bigger Picture

If the rally is sustained, I would view it as a resumption of longer-term trends in the dollar and gold (weak dollar, rising gold), but a counter-trend correction in the US stock market (whose longer term trends is bearish in my opinion). In terms of gauging the overall health of the US economy, I would look to measure any gains in the US stock market in comparison to losses against the US dollar; if the stock market is rising but the dollar is falling, it may suggest an increase in nominal, but not in real value.

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A Beginner's Guide to Understanding Currency Valuation

The market value of asset is largely a reflection of supply and demand for that asset. And thus, if we are looking to assess the value of a currency, we should try to gauge the supply of and demand for that particular currency.

Understanding Supply

To understand money supply, it is crucial to note that in under current monetary policy, money is created out of debt. This happens in two ways:

1. Money is created when governments need to borrow, and central banks then print money and buy treasury bonds
2. The money supply is then expanded again when banks loan money; banks are allowed to loan out 10X the money they have in deposits, and thus expand the money supply when they loan.

Because money comes out of debt, we can extrapolate two further points:

1. If there is no more debt -- meaning if lenders are not willing to lend and borrowers are not willing to take on more debt -- the money supply will have difficulty expanding.
2. Paying off debts results in decreasing the money supply. Ironically, if all debts were repaid, there would be no money.

There are a number of ways to calculate the money supply; see our previous post on this subject. The Mises Institute also offers a free tool to let you compare various money supply indicators.

Understanding Demand

The following can help you gauge demand for a currency:

• Trade flows
• Capital flows
• Reserve currency status -- do other central banks hold the currency in question as part of their reserves? Are they changing their reserves?
• Commodity prices -- If commodity prices are rising, the currency is likely weakening

Gauging how supply and demand is changing can help you develop a longer-term outlook on how currency prices will fare.

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Comparing the Crisis in the Icelandic Krona to the Crisis in the US Dollar

We recently compared the crisis with the Argentinian peso in 2001/2002 with the current situation surrounding the US dollar, and postulated that the US would follow down the Argentinian path.

The current situation in Iceland also fits the bill of a currency crisis (also referred to as an inflationary depression). To illustrate this point, let's compare the factors leading up to the crisis in the Icelandic krona with the conditions of the US macroeconomy:

1. Like the US, Iceland de-regulated much of its banking sector in the '90s.
2. Like the US, Iceland then proceeded to target low interest rates. This resulted in a large amount of borrowing and spending, which resulted in a credit-based boom.
3. In both countries, de-regulation allowed for greater securitization -- meaning the loans that enabled this credit-based boom were re-packaged and sold to debt buyers all over the world. This resulted in a scenario where much of Iceland's wealth was owned by foreigners.
3. Like the US, Iceland also experienced the contraction forecasted by the Austrian business cycle theory, which we recently discussed.
4. In both countries, this resulted in a deflationary spiral: significant declines in equities markets, bank failures, and contracting GDP.

To learn more about the factors leading up to the Icelandic currency crisis, I recommend this article from CNN.

Now in Iceland, like in Argentina, the true breaking point came when its central bank became insolvent. The result was a complete lack of confidence in Iceland's ability to repay; essentially, Iceland had defaulted. The result has been a run on the Icelandic krona, which has lost half its value in just a few months time.

Government Response

Or should I say, there has been a partial run on the Icelandic krona -- for the government has put currency controls in place, after raising interest rates. Citizens of Iceland will find it difficult to legally exchange their krona for a foreign currency unless they are travelling.

Proposed solutions include integrating Iceland into the Eurozone, which would help stabilize Iceland, continue international trade, and help ensure that lenders are repaid, argue its proponents.

Social Response

Icelanders have united in protest against the government, in much the same way Argentinians did after their currency crisis. Thus far in the United States, criticism and dissatisfaction with the government handling of this crisis have risen significantly, though street protests remain at relatively low levels.

Market Response

The collapse of the Icelandic krona is the biggest event, as it devalues all assets denominated in the krona, as was the case in Argentina. A key difference between the US dollar and all other currencies, though, is that the US dollar is the world reserve currency. It will be interesting to see if Iceland enters the Eurozone as a solution to this crisis; if so, it paves the way for the creation of a world currency to be proposed as the solution to a crisis in the US dollar.

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Using Austrian Business Cycle Theory to Invest in the Current Depression

I know I've talked about Austrian business cycle quite a bit in my blog posts, but I wanted to make a post that provides a clearer introduction to it and its logic. So here goes.

Austrian economics and Austrian business cycle theory have regained a bit of popularity of late, given the recent turmoil in the financial markets. Understanding Austrian business cycle theory can help us understand where things are headed, so that we can invest accordingly.

What it is: Austrian business cycle theory basically posits that bubbles and busts result primarily from an overexpansion of credit. Credit is too cheap and too easy. Entrepreneurs are trained in finding market opportunities and inefficiencies in the market; and thus, the Austrian business cycle posits, entrepreneurs as a whole can only be collectively mislead for a sustained period if credit is excessively expanded. This will cause entrepreneurs to excessively invest in capital-intensive projects, like building houses.

The result: The result of this excessive expansion is that the market will eventually try to deflate and purge the misguided investments out of the market. This will result in deflation.

What government policy should be: According to Austrian business cycle theory, deflation is good, and government policy should be to embrace it -- not avoid it. Deflation will encourage "hoarding of cash," which is perhaps more accurately referred to as savings. These savings will then form the basis for the economy to heal itself and become strong again.

What happens if government intervenes: If government intervenes to prevent deflation, one of two things will happen: deflation will be prolonged and deepened, as we see in Japan; alternatively, if government goes into greater debt while its tax base diminishes, it runs the risk of being unable to find borrowers, at which point faith in the currency is lost and a run on the currency begins -- meaning everyone looks to sell the currency, causing its value to fall and prices to rise, as we saw in Argentina in 2001 and 2002.

Which brings us to where we are today.

So the key question: how much deflation? To answer that question, consider the chart below:

Note the uptrend that begins in 1995; this is the beginning of the tech bubble, which was brought about by excessive credit expansion under Greenspan's Fed. The market tried to deflate -- this was the "dot com apocalypse" from 2001-2003 -- but the Fed lowered rates again, preventing a full deflation, and instead pushing the bubble into the housing market. A full deflation would then push S&P back to the 1995 level of around 400. Alternatively, a run on the US dollar may cause the nominal price of stocks to rise, but it will fall respective to other currencies. A way to gauge whether the stock market is truly rising in value or if it is just a nominal gain resulting from currency weakness is to compare percentage gains in stocks to gains in gold. If stocks are rising faster than gold, it could be a sign of real growth.

According to Austrian business cycle theory, if money supply was not excesively expanded but was kept at appropriate levels, there would be no real bubbles or busts. This may make the stock market less fun. Conversely, it would lead to greater focus on profitability rather than financial ratios, and a corresponding focus on dividends rather than valuations.

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Next Stop for the US Dollar: Argentina

Something I've touched on before but have not elaborated too much on is the similarities between Argentina in 2001 and 2002 and the US now. Here is a fantastic analysis of this subject. Below is a breakdown of the key events:

1. In 1997, Argentina experienced a recession. The government response was to ease credit -- i.e. lower interest rates -- and increase government spending, which for Argentina, would mean increasing deficit spending (i.e. borrowing and spending rather than taxing and spending). The US followed the same path in the semi-bursting of the 2002 and 2003 NASDAQ bubble.

2. The excessive easing of credit leads to inflation. For Argentina this occurred in 1998 and 1999; in the US, this peaked in the summer of 2008. During these episodes of inflation, both countries receive warnings from the IMF that their monetary policies are unstable.

3. Both countries than revert back into a recession. This time, however, they are both saddled with greater debt.

4. The recession, coupled with the increased debt burden, leads to a credit crunch, defaults on borrowed funds, and bank failures. For both countries, this results in a decrease in the money supply.

This is where the similiarities end, as we don't know how the US will get out of this situation. Will it continue to follow Argentina? Let's see:

1. During its debt ridden recession of 2000, Argentina responded by continuing deficit spending. Likewise, Barack Obama has already stated that deficit spending is not a concern, and that deficits to stimulate the economy is needed.

2. Eventually, Argentina was having trouble finding borrowers to lend it money. To make its debt more attractive, it increased its yield -- what it was willing to pay to borrow money. In the United States, we are seeing bond prices rally, and many are pointing out similiarities to other bubbles. If this is a bubble, and if it starts deflating, interest rates will need to rise to make the bonds appealing (see our previous article on this subject). Interestingly, Paul Volcker, the Federal Reserve Chairman who raised rates in the '70s to help curb inflation and tighten the money supply, has been brought on to head a new economic advisory board. Are they looking to Volcker for assistance in raising rates?

3. For Argentina, the rate hikes were not sufficient. Eventually, the diminishing tax base, bank failures, and higher interest rates made Argentina unable to make debt repayments. The result was a run on the currency. If the US cannot find buyers for its debt, the same scenario would play out here, which would result in currency devaluation.

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What Will Be the Hottest ETFs in 2009?

As we enter the final month of 2008, it's time to start thinking about what will be hot in 2009. To start that off, I want to revisit this post I made in late September of 2008 -- a little more than two months ago -- regarding preserving your wealth in our current economic downturn. Here's a reassessment of that view:

1. My macroeconomic view remains unchanged; I still view what we're in as an inflationary depression. I grossly underestimated, though, the size of the deflationary forces, which currently are reigning supreme. Accordingly, I think we'll see deflation continue through much of next year. However, I do expect inflation to resume, perhaps some time in the second half of 2009, and I expect it to come back fairly sharply when it does.

2. I previously recommended foreign bond ETFs, particularly Asian bond ETFs like FAX, and still think they are a good buy and hold, and will do well once inflationary trends resume. However, for as long as we are seeing dollar strengthening, it will not do well -- and thus it has not done well for the latter part of 2008, and I would expect the bear trend to continue into the first half of 2009. If you're a trend follower -- which I am for everything aside from precious metals -- then you'll want to wait until the trend resumes. If you're a buy and hold type of person, now might be a time to do some bargain shopping.

3. I also recommended VEU, an ETF of foreign stocks designed to diversify against systemic US risk. I think this was an error on my part; while VEU could do well, I'm not particularly confident in it. Previously, I underestimated the size of deflationary forces not only in the US, but also in the rest of the world. I should note, though, that those who are interested in comprehensive risk diversification may still find some value in VEU.

4. My worst call was FXE, an ETF tracking the Euro. While I knew the Eurozone had problems, I underestimated the size of those problems, and I thought the Euro could replace the US dollar as the world reserve currency. While I expect the US dollar to lose its world reserve status, I no longer think the Euro stands much of a chance to replace it. I think things will just become more free-floating. A by-product of this will be that forex will become a more important market. With that in mind, I'm not interested in FXE, though as a currency trader with experience in trading EURUSD, I will probably trade EURUSD once I see signs of an uptrend resuming.

5. All forms of gold I am still bullish on -- very bullish, even more so than before. In terms of ETFs, that means GLD and GDX, the latter of which tracks gold mining stocks. As I noted, I always favor trend-following trading as a safer form of money management, but for gold, I make an exception. It's too volatile to predict and I'm extremely bullish on it, and so I am a buyer and a holder. All of that could change if gold starts to trade on COMEX below 650 US dollars, though gold has been holding up quite well against the US dollar during our current episode of deflation, so I would be a bit surprised if a break below that level is sustained.

6. The same holds true for silver, the ETF for which is SLV. I'm very bullish and still a buyer at these prices. At this point, I expect to hold gold and silver until at least 2013.

7. I previously was very bullish on oil, the ETF equivalent being USO. I view oil and the US dollar as inversely correlated in our current times, and thus I am still bullish on USO -- though it's in the same boat as my other dollar-hedge ideas, in that it is a buy and hold, and thus will require some patience until we see inflationary trends resume in 2009 or 2010.

8. I am still bullish on commodities, and thus think DBC is a good buy and hold for stock market investors. Commodities do not, however, do well during dollar strengthening, though when inflation resumes, I expect commodities to lead the way and outperform most others, save currencies and metals.

Some ETFs for the Deflationists in All of Us

I previously commented on what I think will do well in deflation, and as I expect deflation to continue into at least the first half of 2009, I still like inverse ETFs that let you short sectors and indices. SKF and SDS I am particularly fond of, and given Mike Shedlock's recent comments and what we've seen thus far, I'd add SRS to that list.

The Japanese Yen: Transcending the Inflation vs. Deflation Paradigm

Since we entered the sharp deflationary trends in September, all I've traded on a short-term basis is the yen (I've been accumulating gold and silver during this time as well, but for the long-term). This has worked out very well for me, and the Japanese Yen is a currency I expect to continue to do well, and thus look for trend-following opportunities to trade Yen strength -- particularly against the US dollar.

Money Management in 2009 and Beyond

One of the most dominant trends we've seen since September of 2008 -- which, for me, marks the beginning of the psychological shift in the marketplace, to where bearishness became the dominant mindset -- is greater volatility. Greater volatility makes money management and short-term trading even more appealing. I expect these trends to continue and be with us for quite some time.

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How the Mumbai Militants Will Affect Financial Markets

As has been widely reported by the international media, there were recently attacks by militants in Mumbai. Here are some thoughts on how this will affect financial markets:

1. Gold. The proliferation of militant networks around the world has coincided with the emergence of a bull market in gold. The more unexpected attacks by organizations that are not nation-states we see, the more we can see a rise in gold -- and likely silver as well.

2. Defense ETFs. US President-elect Barack Obama has already declared Pakistan a threat and has suggested he may order troops into Pakistan. Moreover, in light of these recent attacks, India has already requested Pakistan take action. In the event of US entry into Pakistan, this would be a bullish sign for US defense ETFs, like ITA and PPA. It is crucial to note, however, that we are in a bear market in US equities; personally, I don't see this bear market ending soon, and thus would be reluctant to go buy ETFs and stocks that are dependent on the US macroeconomy.

3. India ETFs. ETFs that track the Indian economy on US exchanges -- namely EPI and PIN -- may see additional downward movements. These markets were already in a bear trend prior to the attacks, similar to how US markets were already in a bear trend prior to 9/11. This would be an additional bearish argument for India ETFs.

Disclosure: Long gold and silver. No positions in Defense or India ETFs.

Five Rules of Survival for Private US Companies in the Global Downturn

By now the idea that this economic breakdown is not going to be solved in a week or two, and that it represents a restructuring of the global economy, is starting to become more apparent. With that in mind, here's guideline for private companies in the United States looking to safely grow over the next four years:

1. The big picture is the US dollar. As I've stated many times before, the US dollar, its value, and its role as the world reserve currency are at the heart of the current economic crisis. In my opinion, the end result of all these bailouts and collapse of the US financial markets will be currency devaluation, and thus I recommend businesses prepare accordingly.

2. While the US dollar is strong, shop till you drop. The US dollar has been strengthening for much of 2008; while this scenario continues, American private businesses should be looking to acquire. As the currency gets devalued over the next four years, prices will rise and purchasing power will decline. This makes now a great time to go shopping and buy assets that will be needed over the long-term.

3. Consider getting fixed rate credit. Right now, interest rates in the US are very low; they are approaching zero. This, coupled with the expectation of significant currency devaluation going forward, makes borrowing to buy now and pay back later (when the currency is worth less) a compelling strategy. This must be done carefully; only companies that can reasonably manage debt should consider this option. Also, as we have discussed previously, the Federal Reserve may need to raise interest rates to make the debt it continues to issue more attractive.

4. Don't forget to raise prices. Ask anyone who lived through the currency crises in South America: the biggest mistake companies make is failing to raise prices quick enough. Keep an eye on dollar prices and the rate of fluctuation in its value, and move your prices accordingly. Alternatively, if possible, consider pricing in other currencies -- particularly gold or silver. Last but not least, bear in mind that Asian currencies may appreciate while the US dollar declines, particularly if they stop purchasing US Treasuries but direct that wealth instead to domestic production, which China recently took a step towards doing via its stimulus package. As a result, opportunities for American businesses to export to Asia may be a sector to look into.

5. Everyone's a central banker now. Central banks maintain a reserve that is diversified across a number of currencies and precious metals. In a globally volatile economy, businesses must do the same to effectively hedge risk and preserve wealth. Precious metals and foreign currencies are more important than ever.

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EURUSD: The Comeback Kid of the Forex Market?

Last week EURUSD was testing the bottom of a descending trendline, and while I don't trade dollar strength because I don't trade against what I perceive to be the long-term trend, I expected it to fall.

Looks like I was wrong. EURUSD did shoot out of the descending triangle quickly -- but it did to the upside. So is EURUSD ready to start an uptrend again? Let's see what the charts tell us:

1. The four hour chart shows the moving averages bullishly aligned, Moreover, the three consecutive bullish candles, each with higher lows, and coming following a downtrend, suggests a three white soldiers pattern, which would be a bullish sign.





2. Meanwhile, on the daily chart, we also see the three white soldiers pattern, as well as the moving averages having turned bullish.





3. Lastly, on the weekly chart, we see that the market has been trading in a range for the past few weeks, consolidating its previous sharp moves. Now, though, we see a bullish breakout, as well as a change in direction on the 5 EMA.

Key Levels

If you're looking to go long EURUSD, I'd look for resistance at around 1.3250, with support at 1.2950. A break above the 50 EMA, which is currently at around 1.3250, may suggest a larger reversal of trend is forming.

Fundamental Factors Confirm

We're seeing dollar weakness show up in other markets as well; USDJPY broke south of its descending triangle, and gold has broken above resistance at both $748 and $800. US stock market traders will want to be particularly wary of bull markets at this time; is it really a bull market if it were priced in another currency, like gold?

Long-term I am very bearish on the US dollar, so now seems like there may be an opportunity for dollar bears in the EURUSD market.

Disclosure: No position in EURUSD. Short USDJPY.

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S&P 500 Heading to 500?

In David's wrapup yesterday, he posted this monthly chart of the S&P 500, going back to 1982.

As the chart illustrates, the S&P is approaching a trendline that has been in the making since 1982.

The market may bounce off this trendline, or trade in a range for some time. But consistent with the fundamentally bearish view I have over the long-term, I think this trendline is going to break, and I don't think it will take too long -- within six months, if I had to guess (but of course, traders will let the technicals tell them when to enter).

The viewpoint from the perspective of Austrian economics is that the stock market bubbles created under Greenspan's Federal Reserve are now being deflated. The big run up from 1995 to 2001, as visualized in the chart above, was largely the result of the Fed's lax monetary policy in the early 90s; now, as debts are being eradicated, the stock market is naturally correcting itself and removing the malinvestments and excessively high prices that resulted from such an artificially lax monetary policy. Note the significant downturn in the chart above in 2002 and 2003; this was the market trying to deflate itself, though the Fed intervened again by forcing rates too low and thus resulting in an expansion of the money supply and a reinflation of assets. Now, the Fed is once again trying to to cut rates and re-inflate the market -- but it seems as though no one is buying the debt (at least for now).

A full correction of the Greenspan bubbles would result in the S&P going to at least 500, probably further, in my opinion.

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The US Dollar's Five Vital Signs

As many economists and analysts have noted, the stability of the US dollar is a key issue in our current times of economic turbulence. To keep an eye on the stability of the dollar, its value, and how this will affect other markets, there are a few key factors to watch:

1. CDS Prices. Credit default swaps (CDS) can be thought of as default insurance; the buyer makes regular payments, and the seller makes a payoff if the credit instrument in question goes into default. When CDS prices rise, that is an indication that the market is pricing in an increase in the likelihood of default risk. The CDS price for 10 year US Treasury bonds has increased by 2500% over the past year. If the market believes the US government will not be able to pay off its debt, or will have difficulty doing so, it introduces concerns about the stability of the dollar, as it increases the likelihood of the Federal Reserve creating more money to pay off US government obligations.

2. US Government Debt and Deficit Spending. The more deficit spending -- meaning spending that is greater than the revenue the government takes in via taxation -- the more treasury bonds the US government will need to issue to raise capital to finance deficit spending. More deficit spending leads to a greater need for debt, which leads to more Treasury bonds being issued; this could lead to an expansion of the money supply and higher CDS prices, particularly if the Fed continues to seek a low interest rate. Currently US government debt is rising rapidly.

3. Fed Funds Rates. To counter the effect of rising CDS prices, the Federal Reserve may seek a higher Fed Funds target rate to make US debt more appealing, and to counter concerns about a weakening dollar. At this point, however, we still see the Federal Reserve moving in the opposite direction -- towards zero percent interest rates.

4. Money Supply Indicators. Monitoring money supply can also give an indication as to how inflationary forces -- attempts at expanding the money supply, which can potentially weaken the US dollar -- vs deflationary forces (money supply contractions resulting from credit destruction) can give us an idea of stability issues related to the US dollar. At this time, one money supply indicator that recently turned downward is MZM. Declines in the money supply often correlate to a strengthening of the currency, though demand for money is also a key issue.

5. TED Spread. The TED Spread measures the difference between the rate on three month US Treasury bonds and the the rate at which banks will lend to each other. A higher TED Spread indicates banks are trying to pull credit out of the market. High TED spreads also result in the market countering the inflationary actions of the Federal Reserve. TED spreads have been volatile this year; they are currently declining, which suggests banks are starting to lend again, which is a factor that can lead to money supply expansion and corresponding potential currency instability.

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Four Investment Opportunities in a Deflationary Market

Though I remain firmly in the inflationist camp in terms of how this economic crisis will unfold -- meaning I expect rising consumer prices, rather than falling asset prices, to be the primary source of the economic crisis, as I recently noted -- there is no denying we are seeing all the signs of deflation at the moment: MZM is contracting, equities markets are collapsing, the dollar is strengthening, and demand for US government treasuries is very high.

So what's an optimal portfolio for this bout of deflation look like?

1. Inverse ETFs. For those who love exchange traded funds (ETFs), now is an opportunity for inverse ETFs to shine. Broad indices are set to fall, and hence inverse ETFs -- meaning ETFs that go up when the underlying assets in the ETF go short -- are great for deflation. Ones that have done exceptionally well this year:

MZZ -- Twice the inverse of the S&P MidCap 400 Index. Up 105.75% this year.
SMN -- Twice the inverse of the daily performance of the Dow Jones U.S. Basic Materials index. Up 124.13% this year.
SKF -- Twice the inverse of the Dow Jones Financial Index. This is one of my favorites from a fundamental analysis perspective, and is up 52.44%.
SDS -- Twice the inverse of the S&P 500 Index. Up 85.68% this year.
DXD -- Twice the inverse of the Dow Jones Industrial Average. Up 70.37% for the year.I like all those ETFs, although I personally would feel most comfortable with SKF, as that makes the most economic sense to me.

2. US Dollar. I'm always reluctant to say dollar strength, in light of the terrible fundamentals on the US dollar and my inflationary outlook, though while MZM (money to zero maturity, a money supply indicator) is contracting -- which it currently is -- I think we'll see the dollar strengthen. UUP, the ETF for dollar bulls, is up 10.55% for the year.

3. US Treasuries. I'm still wary of the entire US bond market, and thus would not recommend US treasuries. With that said, it has become apparent traders/investors as a whole are favoring short-term treasuries as a safe-haven. To the extent the market continues to behave this way, treasuries will do well in deflation. I'd urge investors to consider arguments for why the bond market is due for a collapse. As a person who views inflation as a larger concern than deflation, the well-being of the bond market is of particular concern to me, as it could lead to a run on the US dollar.

4. Japanese Yen. My personal favorite, as it is the only thing I've found that can satisfy both inflationists and deflationists. The yen has been rallying along with the US dollar, and has even been rallying faster than the US dollar. FXY, the ETF monitoring the Japanese Yen, is up 14.69% for the year. I expect Yen bullishness to continue, and favor a portfolio diversified across Asian currencies.

What do you think? What's in your ultimate deflation portfolio? Discuss with us at InformedTrades.

Disclosure: I am long Japanese Yen.

Milton Friedman, John Keynes, and Other Foes of Sound Money

Given that debates on how to fix the financial crisis have become the conversation du jour, now seems like an appropriate time to re-visit various monetary theories to see what works. So here goes:

Keynesian. John Maynard Keynes is the father of contemporary macroeconomics. I would consider this to be a rather negative claim, given that Keynesian policies are at the heart of our current crisis. According to Keynes, deficit spending is not a problem, and the government should use it when necessary to stimulate the economy. Traditional Keynesian economists are not concerned with price inflation, because they argue that prices will not rise above aggregate demand (i.e. prices will not rise above what people are willing to pay for them). Stagflation is precisely the term for the scenario in which prices begin to rise beyond aggregate demand; witness Zimbabwe, and to a lesser extent, the United States in the late '70s and in 2007.

Regrettably, we still see Keynesian solutions being offered to Keynesian problems. US President-elect Barack Obama has stated that deficit spending should not be feared, and needs to be embraced in the short-term to boost the economy.

Friedmanites. Milton Friedman is not too different from Keynes; the only real difference the most significant difference is that Friedman advocates legislative bodies like Congress regulate the money supply via an agreed upon formula, rather than an independent central bank unbound by formulas. The assumption implicit in this school of economics, though, is that a proper formula can be devised, and that a political body can manage it appropriately without the threat of overwhelming corruption.

Supply-siders. Led by Arthur Laffer and Charles Kadlec, supply-siders argue for watching commodity prices, and then tinkering with the money supply to keep commodity prices stable. In a way, this is similar to the policies championed by Paul Volcker, Federal Reserve chairman during the late '70s. Gold prices were rising dramatically, and Volcker raised interest rates to effectively contract the money supply, strengthen the US dollar, and bring gold prices back down.

Austrians. The Austrian school of economics calls for commodity-backed money. This means that government's job is simply to ensure that each currency certificate can be redeemed for a specific commodity -- typically a precious metal like gold or silver -- and that it is government's role to define the terms of convertibility. The money supply is thus determined by the availability of a commodity. Should the market need to expand the money supply, demand for commodity production will grow. Thus the money supply is regulated by market forces.

What Type of Monetary Policy Can We Expect -- And How to Trade It

I am a strong proponent of the Austrian school of economics, and believe it will result in the most sound monetary system, upon which free market capitalism can best survive and flourish. Though the Fed is pushing interest rates to zero, should the US dollar give back the gains it made in 2008 and should the US government have difficulty finding buyers of its debt at such low rates in a globally weak economy, the result may be the need to raise interest rates sharply, thus bringing about a return to supply-side ideas and Volcker's policies in the '70s (we talked about this previously in our article on bond prices). This would be a bearish argument for gold -- just as we saw gold fall in price after Volcker's Fed raised rates.

Ultimately, though, I think Keynesianism is still the dominant ideology. The ideal result of this would be prolonged deflation, as seen in Japan, though as I've stated before, my larger concern is that this will result in sharp currency devaluation, as seen in Argentina.

Trade accordingly!

Inflation, Deflation, and the Depression

The key to my fundamental analysis of the markets is money supply: is money supply going up (inflation) or down (deflation)? As I've blogged about previously, I'm very much in the inflation camp.

While I am still an inflationist, it is clear we are in a deflationary environment, which I was not expecting; I was simply expecting the ongoing expansion of money supply to find is way into an asset class (stocks, commodities, housing, etc) and push prices up in that asset class, as is normally the case. Instead, the market's attempts at deflation -- at purging the overinvestments and malinvestments that have been created through excessive expansion of the money supply, thus returning money supply to the level that the market demands, have proven to be dominant. This results in falling prices, a rising currency, and deflation. The Federal Reserve has tried to inflate the markets with all its might, as recent money supply calculations suggest, but banks have been refusing to lend that money, and thus the deflationary forces have been winning.

Analyzing Where We're Headed

So how much longer will deflation lasts? Depends on what happens:

1. If the Fed resists the temptation to increase the money supply, it will likely be very sharp but relatively short. The dollar bubble is a 37 year bubble, which started once the dollar fully abandoned the gold standard in 1971. Here in my opinion is an excellent article on the implications of that.

2. If the Fed continues to intervene but deflationary forces prove to be stronger, it will likely be steady deflation for a long time. This is similar to what happened in Japan when the Bank of Japan tried to resist deflation. However, Mike Shedlock chimes in with some key differences if America goes deflationary.

3. If the Fed is able to successfully inflate, it will need to find a market to put a bubble into. Given that the US has terrible economic fundamentals -- GDP is faltering, high private and government debt -- it is hard to foresee a bubble in US markets. Perhaps international markets, like commodities, precious metals, foreign stocks, foreign currencies, etc -- will get an influx of US dollars, thus creating bubbles in those markets. This will result in significant dollar devaluation, as those newly created dollars will just be sold and put into non-US markets. This will push the price of US imports up, and thus will result in lots of price inflation for consumers. It could create an opportunity for US export-based businesses.

4. If the Fed inflates but the market realizes the Fed is just printing with no signs of self-constraint, we'll see hyperinflation. In other words, the Fed will have tried to purge the toxic debt by creating junk money, which devalues everything. Just as banks don't want the toxic debt and are not trading with each other because of it, no one will want "the toxic dollar." In other words, there will be a massive run on the dollar in this scenario, which will send dollar-denominated prices through the roof. This is the Argentina scenario.

My Opinions

I think there's going to be a combination of #3 and #4. It is critical to note, though, that foreign markets are experiencing a similar problem, and they are taking the central banking solution of trying to inflate the solution away. We are seeing bubble-type activities in certain markets, such as the Japanese Yen, evidenced particularly by big moves in EURJPY. Dennis Gartman has stated he views EURJPY as a great indicator of the global economy, which I found to be a compelling insight. EURJPY volatility has been huge of late.

In the US, deflationary forces are winning, as evidenced by the rallying dollar, falling commodity prices, and MZM as a money supply indicator, which economist Stefan Karlsson commented on. Meanwhile, reports of shortages and price suppresion in precious metals markets, and attempts on the part of government to force banks to lend to each other, which Mike Shedlock has commented on, are, on the other hand, inflationary arguments.

I do not expect deflation to be reigning for much longer. Government's desire to inflate markets, which is essentially a way of taxing those who hold the currency of the respective economy and transferring wealth to the recipients of the newly created money, is why I'm generally very biased towards viewing inflation as the primary concern. Bernanke has admitted deflation is not really possible, which suggests he will do whatever it takes to inflate the market. Bernanke has also acknowledged inflation is a tax, so he seems to favor this viewpoint with the knowledge that he is taxing the public. Meanwhile, members of Congress have reported that they were threatened with martial law if they did not pass the Paulson Plan, which was eventually passed. Furthermore, we do not see government spending being cut. So, the diminishing tax base is coming as government spending is increasing, which will either require further inflation of the money supply or the sale of additional US debt. As debt is now largely held by foreign countries with tenuous geo-political relationships with the United States -- namely China and Iran -- there is the possibility of economic warfare; foreign debtholders can refuse to continue buying debt, which would also fuel inflation, as the debt would be paid for through further expansion of the money supply.

The always insightful Agora Financial has stated that they expect oil to go to $50 and then $200 within 36 months. I like that assessment quite a bit.

Thoughts on Trading This Environment

My primary concern is wealth preservation. With that in mind, I'm primarily looking to protect against dollar devaluation. As a result, here's what I'm doing:

1. I'm viewing deflation as a great opportunity to accumulate precious metals. Gold and silver are great hedges against inflation, and even in deflationary environments, they fall less than other asset classes, and thus still offer opportunities for those who own gold and silver to gain purchasing power (i.e. gold and silver may be falling in price, but everything else is falling faster). I don't trade precious metals, but I "invest" in them -- meaning I accumulate them and don't plan on selling until at least a few years out.

2. I'm particularly concerned with dollar devaluation, and thus look for markets in which excess US dollars would find their way into. For a while, EURUSD was great for this. Now the Eurozone clearly has their own problems, though I think Asian currencies are going to pick up some dollars, and thus I've been trading the Yen, and am in a Yen trade now.

In deflationary environments, I'll be trading less, and will largely be out of the market, instead looking for opportunities to accumulate precious metals and cash. If you're into trading deflation, markets where the money supply is being pulled from may prove to be great short opportunities. As money supply contractions have a natural tendency to come from bubble markets, financial instruments and the US housing sector are natural opportunities. For those who believe the US recession of 2002/2003 was not complete -- meaning the NASDAQ bubble was not fully deflated -- US tech stocks may have some room to go down.

As an inflationist, I'll be in foreign currencies and precious metals. I'll buy and hold metals, and will enter currencies when they look bearish for the US dollar, my home currency. I also previously noted some ETFs on the US stock markets that I thought would be worth considering in an inflationary environment.

The Four Corners of Safely Managing Money in a Volatile Economy

It seems like all around the world, we're having some economic problems.

2008 is a year where we saw price inflation on a global basis. We're also seeing a global housing crisis. A global food shortage. And an increase in oil prices around the world.

What is going on here?

While there are many ideas as to what is causing all these problems, one thing is for certain: shortages and price shocks on a global basis require a different approach to wealth management. As one crisis can easily lead to another -- for instance, a rise in global oil prices will increase transportation costs, which in turn will increase prices for everyday goods and services -- there is a serious danger of a "domino effect" of sorts that creates greater economic chaos than most of us have seen in quite some time -- possibly in our life times.

With that in mind, there are four guiding principles individuals should bear in mind when looking to preserve their wealth in a turbulent global economy:

1. Liquidity is Key. Liquidity -- the ease with which you can get in and out of your investments -- is of greater value than ever before. As underlying economic ecosystems are vulnerable, investors should pay extra attention to ensure that they can get in and out of investments as easily as possible. As an example, houses tend to be a bit illiquid; it takes time to buy one, and to sell one. In a deepening housing crisis where the market is overwhelmed with sellers relative to buyers, sellers may be in a particularly dangerous situation; it's a buyers market, and as prices continue to fall, the relatively illiquidity of housing as an investment becomes more apparent and detrimental to one's overall investment portfolio.

2. Short Term Strategies. Related to the idea of liquidity is the notion of short-term investing. For the past few decades, many people, particularly Americans, have grown accustomed to thinking of long-term investing as a safer bet -- i.e. retirement funds, buy and hold strategies with solid companies, etc. In times of economic turbulence, longer term outlooks become harder to forecast. Instead, individuals should look to manage their wealth on a more short-term basis, where one can obtain a more reliable data set upon which to make investment decisions.

3. Technical Analysis. A natural extension of short-term investing is technical analysis -- the decision to base investing decisions based more so on price patterns rather than fundamentals. For instance, a longer term strategy may be to buy stocks of company XYZ, because company XYZ makes a great product and has an experienced and intelligent management staff. Such a strategy may have yielded great results in a more stable economic environment, but in today's more volatile markets, it becomes more important to look at buying and selling activity, and make decisions based on what assets appear to be overbought, oversold, or ready to make a big price increase. Technical analysis may seem like a foreign concept to many, but it is increasingly becoming the primary way professional speculators -- like hedge funds -- participate in the market. The good news is that with the advent of the Internet, an abundance of information, and online trading, learning and successfully applying technical analysis is easier than ever.

4. Diversify on a Macroeconomic Basis. As we noted earlier in this article, one potential cause of concern is for there to be a "domino effect" of crises -- this is why liquidity, short-term strategies, and technical analysis are important. Likewise, so too is the importance of diversifying on an international basis. In other words, as the economy becomes increasingly internationalized, true diversification will mean diversifying across economic ecosystems. One example is currency trading; this allows traders to diversify against currency crises. Another example is investing in commodities -- oil, agricultural products, precious metals, etc -- as these products have a global demand, as opposed to being dependent upon a single ecosystem, as individual stocks and mutual funds generally are. In sum, by embracing these four principles, individuals can find ways to preserve and even enhance their wealth during times of global economic turbulence.

EURUSD Trade Placed on September 5

I wanted to post the charts that led to me to place my EURUSD trade on September 5.



Below is a weekly chart I used to help identify a strong support level. The area highlighted is a 38.2 Fibonacci level.

I look to the daily chart to confirm that support level, and to wait for the moving averages to align downward as confirmation that the market is trending downward.







I enter on a break of support at 4321. One thing I forgot to include in the chart is the RSI indicator, which I used to check if there was RSI divergence on the break of support. There was no divergence, so I entered.



I'll exit portions of the position once the market begins to retrace and the moving averages begin to reverse.

A Simple Explanation of the Fannie and Freddie Bailout

The bailout of Fannie Mae and Freddie Mac has been all the talk of late in the economics and finance communities, and rightly so. The bailout will have massive economic consequences.

What I feel this means for traders:

1. The US government simply cannot afford the bailout that it has agreed to make. This will mean that the US government via the Federal Reserve will likely have to print more money, which will result in dollar devaluation.

2. While markets did react positively to this news in the short-term, the underlying economics have not changed. There is still too much bad debt going around. As such, I would expect paper assets -- i.e. financial instruments -- to continue falling.

3. With financial assets falling and the US dollar falling, smart money will increasingly go to hard assets and commodities.

As such, I would expect more of the same. Meaning:

1. Dollar devaluation, which will result in price inflation

2. A bullish market for commodities

3. A bearish market for US stocks

These are long-term outlooks -- think years. Recently, we've seen the dollar strengthen a good bit, and we've seen gold prices and oil prices fall; I would view these as momentary corrections in what I feel can only be described as a massive economic downturn. Short-term traders should of course base decisions based on price action and other technical factors, though I personally prefer to know whether I am trading with or against the long-term trend. Below are links to commentary I found to be accurate and insightful regarding the Fannie Mae and Freddie Mac bailout. Given the magnitude of this issue, I recommend traders gather a wide variety of opinions so as to be capable of making their own informed decision.

The Smart Money Tracker: The end of the bear?

Death of Fannie, Freddie Only the Beginning

Gov Bailout of Fannie and Freddie Would Destroy the Dollar

Fannie & Freddie Discussed on InformedTrades