Money Coming Out of Treasuries And Into Gold

To understand how the macroeconomic picture is changing, we can take a look at how various asset classes are changing relative to one another. With that in mind, see the chart below, which shows the ETFs for four asset classes -- Treasuries, gold, commodities, and the S&P 500 -- to see where money is moving.

The chart illustrates the following:

• 20+ year Treasury bonds were rising, but now appear to be consolidating and possibly turning bearish
• S&P is rangebound between 850 and 950
• Gold is rallying
• Commodities are still in a bear trend

Interpretation

The rise in gold coupled with weakening Treasury bonds, commodities, and S&P suggests the market is still rooting out false forms of wealth -- and that the market is shifting to gold as its preferred method of safety. Inflationists will posit that the rise in gold results from greater inflation concerns, and this may play a part into it as well; money supply indicators and money velocity indicators are both pointing to inflation.

Trade Setups

Two potential trade opportunities come to mind:

1. Betting on a continued exodus from Treasuries into gold, in that the market will continue to favor gold over Treasuries as a safe haven
2. Long commodities relative to S&P; commodities seem grossly underpriced relative to the S&P, doubly so for those expecting a deflation spiral.

Disclosure: Long gold.

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An Inside Look at the Beef Between Mike Shedlock and Peter Schiff

The Austrian economics blogosphere was rocked to its very core yesterday, when Mike Shedlock, one of the most popular economics bloggers on the web, dropped a serious smackdown on Peter Schiff in a post entitled, "Peter Schiff Was Wrong." In this post we'll analyze the beef between two of the most prolific economists of our time.

Meet the Contestants: Peter Schiff vs. Mike Shedlock

Peter Schiff: Adheres to the Austrian school of economics. President of his own brokerage firm, Euro Pacific Capital. Here's his web site.

Mike Shedlock: Austrian economist. Investment advisor. Prolific blogger -- check it.

Like any great rivalry -- Ali vs. Frazier, Google vs. Microsoft, Batman vs. Joker, etc. -- Schiff vs. Shedlock is not without history; see their previous debate.

Now that we've met the contestants and know the history of this longstanding rivalry, let's take a look at what it's really about.

Schiff vs. Shedlock = Dead Dollar vs. Rangebound Dollar

It's crucial to note that Schiff and Shedlock agree on quite a bit. Such as:

• Gold will rally
• US stocks will decline
• Japanese yen will appreciate

Their primary point of contention is their debate on what will happen to the US dollar. Schiff thinks the dollar is doomed and will lose more than half its value over time; how long is unclear, though Schiff has been anti-dollar for some time (since at least 2002), and is sticking to that as the long-term trend. Shedlock, on the other hand, thinks the dollar will be rangebound and is not expecting to see the dramatic decline Schiff is expecting.

Schiff is referred as an inflationist, while Shedlock is a deflationist. It is crucial to note the terms inflation and deflation refer to money supply, not prices. Thus, a key difference in the analysis of Schiff and Shedlock is that most inflationists will use MZM as a money supply indicator, while Shedlock and other deflationists are more inclined to use something else. As a result, the issue of how best to calculate money supply also plays into the heated rivalry between Schiff and Shedlock.

Secondary Conflicts Over Treasuries and Commodities

Their conflicting views on the US dollar lead to conflicting views on other asset classes -- namely government bonds (i.e. Treasury bonds) and commodities. Commodities are traditionally anti-dollar investments; if you think the US dollar will fall, buying commodities is a way to hedge against this. This was proven to commodities investors who enjoyed the rally from 2002 to mid-2008, which coincided with ongoing dollar devaluation. Likewise, bonds are typically favored when investors "go cold" and look for safety -- but are dreaded by those who view currency devaluation as a great concern.

Sizing Up Schiff

Peter Schiff is an icon of sorts amongst bears, as he has been the most successful in breaking the "bear barrier" and expressing bear ideology to millions via regular appearances on national television. Personally, I agree with Schiff's long-term fundamental analysis, which is bullish for commodities, metals, and Asia, while bearish on the US economy. I think dollar devaluation is baked in, that there is a bubble in Treasuries, and that once this bubble pops, a run on the dollar will ensue (the Argentina and Iceland scenario).

With that said, as Schiff himself admits, it is unclear when the bubble will pop. Bubbles can go on for a few years, and during that time, clinging to your investment thesis can hurt -- and Schiff's overall thesis did not fare well in 2008, as his archnemesis Shedlock is fond of reminding us. For that reason, I think it would be advantageous to couple Schiff's fundamental analysis with momentum following technical analysis. This is essentially my trading strategy, and 2008 was a healthy and profitable year for me -- as it was for anyone who coupled Schiff's views with technical analysis.

Sizing Up Shedlock

There is no denying Shedlock is an excellent economist, and he deserves much credit for being one of the few people who called for a strong rally in the dollar, US Treasury bonds, and a decline in commodities. While most perma-bears and Austrian economists saw the collapse of XLF (financials) and XHB (homebuilders) coming, a more common view was that the bubble would go to commodities, where it would stay and grow. Thus the calls of oil going to $200 (which is something I must confess to having said, but not traded). And we did proceed on this path -- oil got above $140 -- but then came sharply back down, and the bubble was passed to Treasuries.

Ultimately, Shedlock thinks the Treasury market is safe, and is not one of those concerned about a potential collapse in Treasury prices. Shedlock maintains this concern when wealth contraction occurs around the world, thus leaving less investment dollars available for foreigners to buy US Treasury bonds, and also while gold and silver become increasingly popular alternatively stores of wealth, something which Shedlock correctly forecasted. And he maintains the stability of the Treasury bond market when supply is set to increase significantly given Obama's aggressive stimulus mandates and philosophy of "deficit's don't matter."

The Key Factor: To What Extent Is Monetary Policy Fiat?

So who's the winner? Schiff or Shedlock?

Well, as noted previously, I consider both to be outstanding economists, and thus they have already won in the eyes of this judge. In terms of whose investment thesis will prove to be more victorious, however, much of it will boil down to one key question: is monetary policy fiat? Meaning can the Federal Reserve inflate if it wants, and deflate if it wants?

Deflationists will argue that because the Federal Reserve cannot force banks to lend, it cannot affect the portion of the money supply that is created by commercial banks when they lend money into existence, and that credit destruction (declining availability of credit and falling asset prices) will result in a declining money supply. Inflationists will argue deficit spending, interest rate cuts, induction of sell offs by foreign central banks, and coordinated activity with other central banks can always result in inflation, provided there is no restriction on money supply, like a commodity standard that guarantees the value of each note of circulation with respect to a commodity.

In my opinion, the Federal Reserve can inflate if it wants, and that monetary policy in an economy with a central bank a fiat currency is a fiat matter -- if inflation is decided, than that is what shall happen. As Bernanke and friends still view inflation as the solution and view deflation as intolerable, I'm inclined to think inflation/currency devaluation is the greater concern, and that Schiff's long-term thesis is still correct.

Alternatives to Schiff and Shedlock

There are those who may find Schiff and Shedlock to both be unsatisfying in ways, and thus may find the rivalry to be less than compelling. For those folks, I'd recommend Eric Janszen and Stefan Karlsson.

For another take on Schiff vs. Shedlock, see this commentary from David Waring.

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If Inflation is Institutionalized, We Need to Learn Short-Term Trading

Inflation is and has been the monetary policy of choice since the gold standard was fully abolished in 1971. See the long-term money supply chart below.

Consequences of Institutionalized Inflation

The key question for investors and traders: what are the consequences of inflation being institutionalized as monetary policy?

1. It leads to a "pass the bubble" economy. When the Federal Reserve inflates to counter deflation, the excess money supply will be directed into an asset class besides the ones being deflated, thus leading to a new bubble. The bubble in US Treasury bonds is the current example of this.

2. It leads to more of a fiscal-based economy, not a production-based economy. The creation of money and the financial markets, rather than market demands, guide investment and production.

3. As the fiscal economy -- the financial institutions that profit from the creation of bubbles -- becomes the dominant part of an economy, the largest incentives are in speculation and enabling speculation.

4. It's a trader's not an investor's, paradise. A "pass the bubble" economy is, in many ways, a short-term trader's dream come true. When an economy becomes more driven by monetary policy than by market demand, speculation becomes more profitable than production.

5. Consistent with the notion that institutionalized inflation favors traders, analytical tools like technical analysis and short-term money management practices become an increasingly important tool in forecasting price movement.

6. Because legislation and brokerage firms can steer the Federal Reserve's inflation into certain asset classes, sector trading -- trading based on the correlation between sectors -- may become more lucrative. The proliferation of ETFs facilitates this.

Other Key Considerations

It's worth noting that bubbles can last for quite a while. In fact, there are those who argue there is a bubble in Treasury bonds, and that it will last a while -- thus creating a prolonged deflation in the economy. As always we can look for momentum in price charts and potential outlier, "black swan" events to understand when the bubble is being deflated and how monetary policy will try to reflate.

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The Aggregator Bank Intervention Trade

In its simplest form, the financial mess could simply be explained as a bunch of bad loans being made -- loans to home buyers who couldn't really repay the loans, banks taking on too much debt due to the securitization of loans, and government issuing more debt than its tax base can handle.

The government response has been to try to bailout the bad debts through the usage of taxpayer funds and obligations. To this end, the Obama administration is now considering the creation of an "aggregator bank" -- one that will buy up bad loans, under the rationale that this will relieve the banks and cause them to lend.

As market speculators, there are a few things we should consider:

1. Whoever holds the bad loans is holding an asset that needs to fall in value. If the US government creates an aggregator bank specifically to acquire bad loans, the US government will bear the loss. As the US government borrows money, it would mean Treasury holders would bear the loss. Should appetite for Treasuries dry up, the dollar will be devalued, and US dollar holders will bear the loss.

2. As such, bailouts are a way of transferring market losses from financial institutions to taxpayers. An opportunity to trade this would be in going long XLF, an ETF that tracks the financial sector, while going short TLT, an ETF on 20+ year Treasury bonds.

The XLF chart is pictured below; currently, the market is at 9.66, almost 100 points above its 52 week low at 8.67. Government actions may hold up XLF and lead to a rally back up to resistance near 13.20, another key price point to watch.

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An Introduction to China-US Decoupling and the Potential Trade of the Century

Some argue that this financial crisis will lead to China "decoupling" from the US economy; meaning it will need to find other buyers of its exports, and will not be able to continue buying US Treasury bonds, which have the affect of propping up the US dollar's value. Instead, the decouplers argue, China will need to invest in increasing its own consumption capabilities. This will have the effect of decreased buying in the Treasury bond market while the supply of Treasuries expands as US government deficit increases -- thus making short selling long-term Treasuries one a very lucrative opportunity, if this is in fact the case.

Can this happen? If so, when?

Skeptics of decoupling argue that the decline of US demand will weaken the Chinese economy along with the US economy, and that the current structure of US consumption driving the global economy will maintain. Decouplers note that the Chinese economy will weaken, but this will force the Chinese government to invest in more infrastructure programs instead of buying Treasury bonds -- at a time when the US is planning to take on more debt and thus increase the supply of Treasury bonds. The result of this will be currency decoupling in that China will become an increasingly powerful buyer relative to the US. And from a geopolitical perspective, China is more economically aligned with Pakistan, Iran, Russia, and Hamas rather than the US/Israel/Britain economy. Thus far, we have seen China direct its buying towards domestic stimulus packages.

With that said, though, Treasury buying could go on for a while; Naked Capitalism notes that China is still buying Treasury bonds. For those who think decoupling is bound to happen, the opportunity to short Treasuries may be the best trade out there when the bubble starts deflating, whenever that may be. TBT is the double inverse ETF for the long-term Treasury bond market.

Three Little Pins and Their Quest for a Treasury Bond Bubble

As we've discussed previously, there is a bubble in the US Treasury bond market. And as we discussed in Ka-Poom Theory, bubbles always find black swan events -- "pins" to pop them and cause a market panic. As John Mills, a historian of market panics, said, "Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works."

What will be the pin that pops the Treasury bubble, causing a panic that reveals its true value? While it would be futile to try to predict an outlier event, understanding areas where it may be more likely can help us identify potential triggers for what will cause a market panic, so that we can more easily recognize it when it occurs.

There are three pins I think are most likely:

1. Mass monetization announcement. We are seeing appetite for Treasury bonds decline. If the Fed either significantly begins to monetize the debt (i.e. print money to pay it off) or announces it will do so, this could trigger an exit from Treasuries.

2. Military threat. 9/11 was a black swan event that punctured the dot com bubble significantly. As there is still a significant amount of conflict and political tension in the world, a military event triggering a mass exodus out of Treasuries seems possible -- particularly when one considers that some of the largest holders of Treasury bonds are foreign central banks with economic interests that run contrary to those of the United States.

3. "Legislation". The Federal Reserve can modify its charter, Congress can assign more authority to it, and central banks can come into new agreements amongst themselves. For instance, a regional currency which national currencies would be re-valued against is becoming a more commonly voiced idea in many parts of the world. If there is a monetary agreement of sorts, it will likely have the impact of devaluing the US dollar, as a way of compensating foreign US Treasury bond holders.

As a dollar trader, I'll be keeping an eye on potential pins for the Treasury bubble, as well as price charts that can show when momentum has turned. Though when the bubble will pop, as well as how bit it will get before doing so, remain unclear.

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Ka-Poom Theory: Understanding and Predicting Black Swan Events

In this post, we'll take a look at the Ka-Poom Theory, a framework for investing in "bubble" economies -- economies driven by the creation of asset bubbles.

Ka-Poom Theory: What It Is

Ka-Poom Theory is a theory that postulates how the asset bubble cycle works -- meaning how bubbles are created, destroyed, and reborn. It was developed by Eric Janszen, former venture capitalist who now writes commentary at iTulip.com.

Ka-Poom Theory offers the following framework for understanding bubble cycles:

1. The Bubble is created. Ka-Poom Theory posits that the creation of the bubble is a result of interest rates being kept too low by the central bank. This is the same conclusion reached by the Austrian Business Cycle Theory.

2. Also like Austrian Business Cycle Theory, Ka-Poom Theory expects the bubble to begin deflating at some point. In addition, though, Ka-Poom Theory expects a "black swan event" -- an unpredictable, external, outlier event that has a monumental impact and, in the context of Ka-Poom Theory, a deflationary effect. It does not, however, cause a deflationary spiral. Thus, Ka-Poom Theory refers to this state as disinflation.

3. The central bank will respond to disinflation with inflationary policies that will take approximately 12 months to impact the markets. The period of disinflation will be erratic.

4. The black swan event is the "ka" of the Ka-Poom Theory. The "Poom" is the subsequent re-inflation of the money supply. Deficit spending and inflationary policies initiated by the Fed dictate to what sector the re-inflation of the central bank will go.

Ka-Poom Theory posits this is what has been happening in the US economy since the dot com bubble, and thus is the current framework for understanding thus US economy.

Assumptions of Ka-Poom Theory

The most critical assumption the Ka-Poom Theory makes is that the central bank has the power to inflate the market at will, invariably. In other words, Ka-Poom Theory is based on the premise that if the Federal Reserve wants to inflate and create higher prices, it can -- by printing money, buying up assets, working through the credit market, or inducing foreigners to sell Treasury bonds and dollar holdings. It also assumes that the results of the central bank's actions are not instantaneous; the gap between their policy enactment and the corresponding re-inflation of asset prices is a period referred to as disinflation.

Because of this assumption, Ka-Poom Theory is essentially a framework for understanding how a planned economy works.

Implications of Ka-Poom Theory for Traders and Investors

To the extent that Ka-Poom Theory is valid, a few deductions can be made for traders and investors:

1. The period of disinflation -- what Ka-Poom Theory argues we are in now, which is characterized as the period between the Federal Reserve's policy enactment and the corresponding effects -- is deemed to be erratic. Janszen prefers to stay out of the market during these times.

2. In a debt-based bubble, the long-term bond market will likely be where the arbitrage opportunity is, in the sense that bond prices will fall as the market begins to re-inflate.

3. In order to understand what sectors will be set to inflate -- where the next bubble will be found -- Ka-Poom Theory looks at government spending to lead the way.

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