U-6 Year Over Year Delta of the Delta: Acceleration Slowing?



Context: this is the rate of change of the Year Over Year change in U-6 (unadjusted). The absolute number may go down from one monthe to the next but still represent an increase from the previous year...this approach avoids the seasonality issues but can be more than a little confusing when you start looking at the underlying time series. We may be seeing some flattening in the acceleration, which would be slightly encouraging in that the breathtaking rate of increase might at least subside. However, in the last recession the YoY U-6 continued to increase for another two years after that point (albeit, much more slowly). Here we are starting from a higher base rate for U-6 in absolute terms, ramping up much faster and will likely take longer to begin the reduction when that happy day finally arrives.


In the "it is different this time" department, I wondered how the end of year changes looked for the U-6 (unadj.) time series - how was the end of year holiday hiring? This graph looks at the change in U-6 (Dec 'XX - Sept 'XX) from 1999 to 2008. Grim.

China and the World Drives the Commodities Boom

The Baltic Dry Index (BDI), a shipping index considered as one of the most reliable global economic indicator, has been surging up for 17 consecutive days as of Feb. 11, 09. It's not often that something just keeps going up for 17 days. The strong rally of BDI has caught a lot of attentions. However, dry bulk shipping stocks like DRYS, EXM, EGLE, GNK, TBSI and NM plummeted instead of moving with BDI. What's going on? Let me digress a bit on the big pictures before talking about specifics of shipping fundamentals.

Most people remain skeptical about the outlook of the BDI, despite of 17 days rally. Trader Mark asked "What's Really Going On". Most believe the BDI rally will be short lived. So when BDI finally dropped for two days, Bespoke Group declared "BDI rally is DEAD"!

The skeptics are wrong because they only read the news headlines but failed to study the real reasons of the BDI plummet in 2008 and strong surge back recently. They do not know the fundamental forces behind the global commodities boom and China's emergence as a major economy. The skeptics failed to predict a rebound in BDI so soon and so powerful. I correctly called the bottom and called for an imminent and powerful rebound of the BDI as well. So I am comfortable to call the skeptics wrong and predict continued surge of BDI.

Skeptics are wrong because they know what's going on in the USA, but paid little attention to the rest of the world. Chinese knew even less about the world 30 years ago. There was no TV, no telephone and you were NOT allowed to listen to foreign radio stations. Today, China has more internet surfers and cell phone users than the USA has population. Chinese teenagers are bigger fans of America's Hip Hop than American teenagers. One rich Chinese farmer bragged to live in an exact replication of the White House, down to small details. The Chinese are eager to learn everything in America and Europe, and try to imitate everything.

The internet brought easy access to information and profoundly changed China and the world. INFORMATION, not idealism, is the fundamental driving force behind the global commodities boom. China is not alone. Changes are also happening in India, Brazil, Russia, and even in the African continent. An isolated African village could remain in a primitive lifestyle indefinitely. But once they have a TV or a computer or just an outside visitor, they will learn about the outside world. They will want a better life and they will be eager to learn to acquire knowledge and work skills. They will produce something to exchange for useful products from the rest of the world. The chain reaction will leads to more developments and more demands of the world's raw materials. As I discussed before, it all started with one Chinese's visit to Texas and a cowboy hat, and now it becomes a global trend no one can stop.

INFORMATION drives the global commodities boom. The current global financial crisis, severe as it is, will NOT last as long as the Great Depression. Easy access of information allows capitals (smart money) to quickly discover and relocate to new investment opportunities.

Many Americans believe the collapse of the US economy is the end of the global economy. But we are not the whole world. The rest of the world can live on without America. The danger America faces is that the rest of the global economy can continue to boom without us, as capitals flow away from American soil to find opportunities overseas. The Obama administration's new stimulus package WILL boost demand for sure, for a while. But will it bring home capitals to generate jobs, or rather drive capitals and jobs to overseas?

President Obama: I challenged you to bring home Jim Rogers, America's best known billionaire refugee. If he comes home with his money, we have hope. If he stays in Singapore, I might as well leave, too. Please abolish FASB#157, "Mark to Market" rule immediately! There is simply no fair market value in an unhealthy, distressed and distorted market. There have been heated debate of M-to-M rule on the Bank of America (BAC) message board on Yahoo (YHOO) Finance. Abolishing "Mark to Market" is the only way to save banks.

The outlook of global shipping is bullish as China's 4 trillion yuan stimulus program is already taking effect. China's bank loans in January more than double the record set a year earlier. Steel price surged 41% from the low, indicating a booming demand again. More demand on steel means more demand on iron ore and more demand on shipping.

In recent years China's economic growth rely on growth of export to the US and Europe. But China's export remains a small percentage of its GDP. China can sustain its growth without exporting goods to the USA in exchange of US dollars. The 1.3 billion population can and will generate huge domestic consumption demand. China is pushing people to consume more.

China sells goods to the USA and then uses the dollars to buying US treasury bonds. China is basically lending money to America so we can continue to buy Chinese products. This is unsustainable and will not be sustained. Instead China should lend the money to African countries so that Africa can purchase Chinese goods and export their natural resources to China for a payback. I have been reading XinhuaNet (ChinaView) daily. This is exactly what is being discussed in China and what China is doing in Africa. Unlike the debt-laden and tapped-out US market, the African market is completely un-tapped. Africa can afford to borrow more money from China, put more money in their infrastructure building and consume more goods and services. Eventually a developed Africa can afford to pay back the debts.

The information age is narrowing the gap between people and between nations. The world doesn't even have enough commodities to satisfy the development of one China. So does the world have enough to satisfy an Africa and a South America in addition to China? The developing world is developing rapidly and looking up to a much better life standard. Does the world have enough ships to ship raw materials from Africa to China, and goods from China to Africa?

I am bearish on US dollar and US treasury bonds. I am bullish on commodities, on global shipping, and on precious metals, especially palladium. Please read my last article on palladium's fundamentals. I am heavily invested in Stillwater Mining (SWC) and North American Palladium (PAL), the only two primary palladium producers in the world. People do need to be cautious about precious metal ETFs: GLD and SLV. James Sinclair publicly questioned where GLD gets all the gold bullion. He should ask where did SLV get all the silver bars with low serial numbers (like 1,2,3). Buy physical metals, not ETFs!

Trader Mark quoted from a Lloyd's List article, which expressed skepticism that the freight rate surge could be short lived. These concerns raised must be carefully addressed:
1. Recent freight rate surge resulted from China restocking the import iron ore inventory. It will slow down as there is no evidence of increased steel demand.

Well, surely there is already strong evidences China's economy and demand on raw materials is recovering rapidly. Pay more attention to news from China!
2. Despite of a remarkable raise in percentage, the BDI at current 2000, is still far below the all time high last August at 12000.

Come on! No one expect the BDI to return to high level overnight. Nothing goes straight up or down. BDI did not fall from 12000 to 666 overnight. No one expects it to return to 12000 tomorrow. The surge from 666 to 2000 in just a few weeks is a more remarkable recovery than any one can expect. In geometric scale, the recovery is at 38% already. From 666 to 2000 is a triple. Another triple will bring it to 6000, just a leap short of 12000.
3. Huge back log of new ship orders. New ships entering service in 2009 and 2010 could expand the global dry bulk fleet by 40%, causing capacity oversupply. Refer to this article on details.

That's a good argument. But we should not take data out of context. New ships are entering service but old ships are being scrapped at the same time. During recent years of shipping boom, scrapping was almost none, as ship owners extended the services of old ships to profit from high shipping rate. Now the shipping rate has fallen, there is a sudden rush to send all the old ships to scrap yards, to bring in cash liquidity and enhance the balance sheets. In just two month, 4 million DWT tons worth of ships were sent to demolition, more than the last few years combined. Scrapping old ships is surely faster than building new ships!

Numbers from the UNCTAD review need to be taken in context. As of end of 2007, there were 10053 new ships and 495M DMT tons on the order books, including 222M DWT tons of dry bulk carriers. That was 72 times higher than it was in 2002. 72 times!!!

Global dry bulk fleet is about 600M DWT tons in size, so assuming a new ship takes 2 years to build, 222M worth of new ships will be build in two years, not counting scrapping, the increase of global fleet will be 222M/600M = 37%. That's how some analysts figured the 40% increase.

But the number is wrong! Average ship lifespan is about 20 years. So normal scrapping due to aging would remove 10% of the fleet in 2 years. The speed up scrapping of over-aged ships could remove up to 20% of the fleet in 2 years. Subtracting 20% scrapping, the increase of the global fleet is only 17% in two years even if all new orders are built.

But don't expect 222M worth of new ships in the next two years. Due to low shipping rate and lack of financing, more than 1/3 of ship orders have already been canceled. More are being canceled or delayed. Read Hellenic Shipping News, ship yards around the world are in very bad shapes. Many could go bankrupt without help.

Question: If shipyards had normal business in 2002. Now their order book is 72 times bigger than the 2002 level. That looks like an incredible booming business by any standard. Why are shipyards in bad shapes now? Even if 30%, 50% or even 90% of orders were canceled, the remaining orders would still be many times bigger than the 2002 level, not to mention the profit from cancellation fees. There are not a lot of ship builders in the world. The list easily fits on one sheet of paper. Global ship building capacity could not have increased too much from 2002 level, surely not 72 times! There is not enough space, materials, building capacity or financial backing to build 10053 ships at the same time, and deliver them within two years.

Some one must get the numbers terribly wrong. In any case, you can be rest assured that if ship builders are on the brink of bankruptcy, then we will NOT see any rush of new ships joining the global fleet in the next two years. More likely the global fleet will shrink instead.

Thus I encourage people to take advantage of recent shipping stock plummet. Buy shipping stocks like EXM, EGLE, DRYS, NM, DSX, GNK, TBSI, OCNF, SB and PRGN. I have not looked at all of them in details. But based on my study, my personal favorites are EXM, EGLE, DRYS and NM. Please do your own due diligence research.

Disclosures: The author is heavily invested in palladium producers SWC and PAL. I also hold big positions in shipping stocks EXM, EGLE, DRYS. I do not own other stocks mentioned.

Price Level Targeting: An Example

In my previous post, I tried to make a case for using price level targets as a way to overcome the problem of money hoarding (which, under present circumstances, should be understood to include T-bill hoarding, and perhaps Treasury security hoarding in general). In this post I’m going to give an example of what a set of price targets might be and how it would work. You might even consider this a recommendation – although I wouldn’t recommend myself as the best person to recommend a specific set of price level targets.

In general, there are four characteristics that a good set of price level targets should have:
  1. It should be realistic. We might love to see a 3 percent inflation rate for 2009, but that’s not going to happen, no matter what the Fed does. To be credible, the targets must allow for a couple of years of low inflation, simply because we know that the Fed has little influence over the inflation rate in the short run. In general, the targets should be reasonably conservative relative to what might be possible, because, if the early targets are not hit, the Fed will have more difficulty hitting the later targets. We don’t want to set the Fed an impossible task in the case where things go badly at first.

  2. It should target prices high enough to make people nervous, even if they don’t think the Fed can hit those targets. This is where my poker game analogy (as discussed in the previous post) comes in. You may think that the player with the four hearts up is probably bluffing, but if she throws enough blue chips into the pot, and if you’re a conservative player, you’re going to fold your three aces anyway. These days almost everyone is a conservative player. So if the Fed sets the price level target high enough, just the risk that it might hit that target should be enough to motivate investors to hold nonmonetary assets. The choice today is between risky assets with a high expected return (stocks, high-yield bonds, etc.) and safe assets with a low expected return (cash, Treasuries, etc.). Set a price level target high enough, and the choice – even if you don’t have much confidence in the Fed’s ability to hit its targets – will be between two risky assets, one with a high expected return and the other with a low expected return.

  3. It should transition to a “normal” rate of inflation in the long run. A normal rate of inflation used to be 2 percent, but recent experience shows that 2 percent is dangerously close to zero. I think 3 percent is the lowest reasonable target for a long-run inflation rate, and that’s what I will assume in my example, because it’s close to what most people would think of as normal. If it were up to me, I would choose a long-run inflation target of 4 or 5 percent. (I’m using the phrase “inflation target” loosely. I mean the inflation rate implied by long-horizon price-level targets.) It’s an open question how long exactly the long run is. In my example, I’m choosing a set of targets that implies a 3 percent inflation rate starting in year 14 (2022, since 2009 is year 1). Note that the 3 percent implication is conditional on earlier targets being met. If the Fed falls short of the price target for the end of 2021, the inflation rate will have to remain higher than 3 percent for a while thereafter in order to catch up.

  4. It should target prices low enough that they don’t imply ridiculously high inflation rates. After a while it should be technically feasible for the Fed to engineer an inflation rate as high as, say, 20 percent, and if that were expected to happen, it would certainly discourage people from holding monetary assets. But at some point the cure becomes worse than the disease. If we’re targeting a long-run implied inflation rate of 3 percent, the transition from 20 percent to 3 percent would likely be very unpleasant. And at some point also, it becomes too unfair to ask today’s long-horizon creditors and fixed income recipients to bear such a large part of the burden for fixing the economy. The targets in my example imply a maximum annual inflation rate of 10 percent (conditional on earlier targets being met), a maximum (conditional) 5-year average inflation rate of 8.4 percent, and a maximum (conditional) 10-year average inflation rate of 6.7 percent. I would say that those are high (as point 2 requires) but not ridiculously high. (Others may have a different opinion.)
The targets in my example are for the core CPI (Consumer Price Index excluding food and energy), and there is a target for each December over the next 20 years. The targets may be understood relative to the actual reported core CPI (216.1) for December 2008. The table below shows the targets and their implications:

ABCDEFG
priceimpliedimpliedimpliedimpliedimplied
targetannualaverageinflationinflationaverage
coreinflationinflationtargettargetinflation
CPI)targettargetoverovertarget
frompriorpriorfrom
year zero5 years10 yearsyear 5
assuming
2008216.1zero
2009219.31.5%1.5%inflation
2010223.72.0%1.7%
from
2011230.43.0%2.2%year 0
2012239.74.0%2.6%to year 5
2013254.06.0%3.3%3.3%
2014274.48.0%4.1%4.6%27.0%
2015301.810.0%4.9%6.2%18.2%
2016329.09.0%5.4%7.4%15.0%
2017355.38.0%5.7%8.2%13.2%
2018380.17.0%5.8%8.4%5.8%12.0%
2019403.06.0%5.8%8.0%6.3%
10.9%
2020423.15.0%5.8%7.0%6.6%10.1%
2021
440.04.0%5.6%6.0%6.7%9.3%
2022453.23.0%
5.4%5.0%6.6%8.6%
2023466.83.0%5.3%4.2%6.3%8.0%
2024480.83.0%5.1%3.6%5.8%7.5%
2025495.33.0%5.0%3.2%5.1%7.2%
2026510.13.0%4.9%
3.0%4.5%6.8%
2027525.43.0%4.8%3.0%4.0%6.6%
2028541.23.0%4.7%3.0%3.6%6.3%

These targets imply a 5.8 percent average annual (compound) inflation rate over the next 10 years. (See the entry for December 2018 in column D.) Suppose the Fed were also to target the 10-year Treasury yield at zero (a target the Fed could certainly achieve by intervening directly in the longer term Treasury market, although meeting that target could conceivably require the Fed to buy up almost all of the national debt). The result, if the Fed were to hit its price level targets, would be a real (inflation adjusted) 10-year Treasury return of -5.8 percent.

Markets would not have full confidence in the Fed’s ability to hit its price targets, but the threat of a -5.8 percent real return, even with only limited credibility, should be enough to make people nervous. And the more nervous people get about holding monetary assets (in which term I mean to include Treasury notes), the more they will invest in real assets (or just spend money), and the easier it will be for the Fed to hit its target. It might not be necessary to set the target real return as low as -5.8 percent (i.e. to target the 10-year Treasury yield at zero), but the price level targets would give the Fed room to maneuver.

To get an idea of how the “catch up” process would work with these targets, consider the case where the average inflation rate over the first 5 years is zero. In December 2013, the Fed will miss the target by a factor of 0.85 (the actual core CPI of 216.1 divided by the target of 254.0). The Fed will then have to make to make up that 15 percent “deficit” over the subsequent years by pushing the inflation rate above the original “planned for” inflation rates. Column G shows the average annual inflation rates that would be necessary to make up the deficit in a given number of years. To make it up in one year (obviously unrealistic) would require an inflation rate of 27 percent. To make it up in five years (fairly realistic) would require an inflation rate of 12 percent.

To get an idea of the overall pattern of inflation rates implied by this set of targets, we can divide the next 20 years into 5-year intervals and look at what the average inflation rate would be in each of those intervals if all targets are hit:
  • Dec-2008 to Dec2013   3.3%
  • Dec-2003 to Dec2018   8.4%
  • Dec-2018 to Dec2023   4.2%
  • Dec-2023 to Dec2028   3.0%
So the major “push” comes in the second five-year period. The inflation rate over the first 5 years has to be relatively low just because the inflation rate is currently low, and it’s difficult or impossible to increase the inflation rate very quickly. Over the following 5 years, the inflation rate rises to its peak of 10 percent in 2015 and then gradually comes down thereafter.

The hope is that the transition from high to normal inflation (after 2015) will not be too difficult, because it will be fully anticipated. Individual businesses will expect a slowdown in the overall inflation rate and will therefore slow down their own price and wage growth, allowing the anticipated monetary policy to support a normal level of output and employment. That’s the theory, anyhow.




DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

A Con Game Too Successful for Its Own Good

As long as you’re willing to assume that the world will end some day and that the end will be known in advance, it’s a simple matter to prove by induction that money is worthless.

Consider the last minute of the world. If you were living in that last minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it, so what good would it be to you? In the world’s last minute nobody will accept money as payment and therefore it will have no value to anyone: it will be worthless.

Now consider some minute in time where it is known that money will be worthless a minute later. If you were living in that minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it before it becomes worthless, so what good would it be to you? A minute before money is to become worthless, it will already be worthless.

Therefore, according to the principle of mathematical induction, money is always worthless. It will be worthless at the world’s last minute; it will therefore be worthless a minute before that; it will therefore be worthless a minute before that; and so on. Go back as many minutes as you need to go back, and you can get to any point in time and show that money is worthless at that point in time.

Thus, fundamentally, money is worthless right now. But even people like me, who are well aware of this proof, are willing to accept money as payment despite its fundamental worthlessness. Money is valuable to us because we expect it to be valuable to someone else. And since we are reasonably confident in the monetary authorities’ ability to recruit new generations of victims in this endless Ponzi scheme, we willingly allow ourselves to become victims. All of which is very convenient because it allows us to use money as a medium of exchange, a unit of account, and sometimes even a store of value. And it allows authorities to manage the supply of money so as to minimize the frequency and severity of economic downturns.

It’s a nice con game, one where we may rightly cheer the operators, given that the success of their game normally results in benefits for everyone involved. Sometimes, usually in small countries where monetary authorities have limited credibility, we see the con game fail, and generally we lament that failure.

But the other danger is that the game can be too successful. If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation. And since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things. Accordingly, the operators of the game always suffer from a very rational fear of success. And today, it would appear, their fear is coming true.

But this is crazy. There must be a way to stop rational people from hoarding endless amounts of an asset they know is fundamentally worthless. There must be a way to blow the whistle on this con game.

The solution, it seems to me, is to have the operators come clean – not come clean entirely, not admit that money is completely worthless, but declare in no uncertain terms their intention to cheat us out of quite a lot if we persist in having so much confidence in their scheme. Of course even that approach may not work – it’s possible that our collective gullibility has no limits – but it certainly seems worth a try.

What I’m suggesting is something that has already been suggested – in rather less shocking terms, perhaps – by various other economists (as for example in these posts by Greg Mankiw and Nick Rowe): the Fed should announce a price level target for some point in the future. And it should make that target high enough to scare people (and institutions) out of hoarding money.

It’s still a game of chance. Nobody can be sure that the Fed will be able to hit its price level target, or even get anywhere near it. As I said, in terms of the Ponzi scheme, there may be no limit to our collective gullibility. But let’s shift metaphors here: when you’re playing five card stud and you see that one of the other players has four hearts showing, even if you know the odds are against that player’s having a full flush, you’ve got to have a fair amount of guts to make a big bet on your three aces. And guts are in short supply these days. Nobody will know whether the Fed is bluffing; even the Fed itself won’t know whether it’s bluffing; but if the price level target is high enough, if the player with the four hearts throws enough blue chips into the pot, a lot of today’s ultra-risk-averse investors are going to fold.

And if enough of them fold – OK, here I have to shift the metaphor a little bit again, or maybe you have to think about hundreds of poker games being played at once, with some kind of arrangement where the house is allowed to pass cards from one game to another when the players in the first game fold – if enough investors fold, the game is over. If enough investors give up thinking that their three aces, a.k.a.money (or zero-yield T-bills), are a safe asset, if enough investors start instead buying assets that are productive or useful, then the slack in the economy will diminish and eventually give the Fed a chance to push up prices by creating excess demand. And then the Fed can hit its price target and win the pot.



DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Why are the Fed and the Treasury Working Against Each Other?

It seems like every other day the last couple of weeks I read about how long Treasuries are tanking because markets are “worried about supply.” Then I read about how the Fed is saying they plan to buy long Treasuries, and they’re trying like heck to convince the markets that it’s really gonna happen, but the markets don’t quite believe it.

Maybe there’s a good reason that the markets don’t quite believe it: it doesn’t make any sense. The Treasury is going to issue a crapload of new long bonds, and the Fed is going to buy them back on the open market? Why? If the Treasury just issued short-term bills, the Fed would buy them anyway. At least it would buy enough to keep the federal funds rate near zero, and after that it doesn’t matter. And when the recession, or the potentially deflationary episode, or whatever it is, ends and the Fed wants to stop rolling over the bills, the Treasury can replace them with long bonds if it so chooses.

Now, you might say, “Ah, but when the recession, or the potentially deflationary episode, or whatever it is, ends, long term interest rates will go up, and the Treasury will have to pay more to borrow than it does now, so why not issue them now while the rates are cheap?” That reasoning seems to make sense, until you realize that the Fed, when this episode ends, is going to want to liquidate its long-term bond portfolio, and if rates have risen, it will have to do so at a loss. Since the Fed’s profits go directly into the Treasury, the loss passes right through, and, in terms of present value, it’s (almost) exactly as if the Treasury had issued new debt at a higher yield. Or the Fed could decide to hold the bonds to maturity, in which case it will be just as if the Treasury had never issued them. (In that case, if the Fed wants to reduce the money supply, it could stop rolling over its T-bills, in which case the Treasury will have to issue new ones at higher rates, just as it would have if it had not issued the long bonds in the first place.)

There are only two differences I can see between, on the one hand, having the Treasury issue long bonds and the Fed buy long bonds, and, on the other hand, having the Treasury never issue the bonds in the first place. And neither difference is really a difference. The first difference is that the Fed might buy seasoned bonds in addition to (or instead of) on-the-run issues. The Treasury, by definition, can only issue on-the-run bonds. But this, as I said, is not really a difference: the Treasury can just as well decide to retire its old bonds as to refrain from issuing new ones. Although most Treasury issues are not callable, the Treasury can retire them at market prices, and it will be just as if the Fed had bought them. And in any case, how much difference is there really between on-the-run and seasoned issues? The maturities are slightly different – no big deal in the grand scheme of things – and on-the-run issues are more liquid – a little bit more liquid, but it’s not like seasoned Treasuries sit on your books unintentionally for months because you can’t catch a bid. It’s a technical difference – one that will affect the details that Treasury traders care about, but not the sort of thing that should make headlines.

The other difference is between current policy and future policy. If future policymakers will be somehow influenced by the distribution of securities between the Treasury and the Fed, then that distribution will of course make a difference. But why should they be influenced by it? I can understand that the Fed and the Treasury may perceive themselves as having different interests, but in this case it doesn’t matter, because each one can undo what the other one does. If the Fed sells off its long bonds 5 years from now, the Treasury can stop issuing long bonds. If the Fed holds onto its long bonds, the Treasury can issue more of them. And if the Fed never buys the long bonds in the first place, then the Treasury can do whatever it wants with its finance policy 5 years from now. Again, there are the technical questions about maturity and liquidity, but I don’t see how these are going to make a difference that macro policy makers or investors (as opposed to traders) should care about. And since the timing of these events is unknown, I’m not even sure anyone would be able to make a reasonable guess as to how these technical matters will play out, so perhaps noone at all should care about them.

So what’s going on here? I really don’t get it. Are the Treasury and the Fed really going to insist on working against each other? Is one of them bluffing? (And if so, which one?) Have the markets misinterpreted their signals? Have the markets, in fact, correctly interpreted their signals as being meaningless?


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Recent Developments in Precious Metals and Shipping

Gold rush 2009 is on! Gold is the front runner in precious metals so far. Gold is now only 10% away from its early 2008 high; silver is 39% off; platinum is still 57% off the high; palladium is still 67% off the 2008 high. Gold is the front runner and palladium is the laggard.

Don't buy the front runner, buy the laggard! Chasing the front runner and big crowds is the fastest way of losing money. Just look at recent bloodshed in DryShips (DRYS), a front runner in shipping stocks. I switched from DRYS to EXM and cautioned about DRYS in mid January, 09. So I was lucky to have avoided the massacre in DRYS. There are inherit problems in DRYS that are now exposed, but big crowd sentiments added to the severity of plummet.

Gold is currently the front runner of precious metal because most people intuitively know what is gold. But few people have heard about palladium. Recent stories from Russia and South Africa indicate that palladium and platinum has the most bullish fundamentals among precious metals, while gold has the weakest fundamentals.

First, palladium. Norilsk Nickel, producer of 45% of the world's palladium, just released the Q4 and full year 2008 production. The palladium production dropped to 2.702M ounces, much lower than the 3.05M ounces in 2007, even though the nickel production is in line with 2007. Norilsk expects another drop of 7% in palladium production in 2009 to bring it down to about 2.5M ounces. The reason cited is lower grade of PGM content in the ores. I explained before that Norilsk has two types of minerals: the one high in nickel and low in palladium content, and the one low in nickel and high in palladium. Due to current low nickel price, they must opt to mine the high nickel ores, hence produce less palladium.

Base on my calculation of their mineral ores grades, if they produce the highest nickel grade while maintaining the nickel production level, the 2009 palladium production could drop to only 2.0M ounces, from 3.05M ounces in 2007. More likely, Norilsk will be forced to cut nickel production to meet weaker global demand. In that case, palladium production could fall significantly below 2.0M ounces.

Adding to the bullish case is news from South Africa of a looming mining worker strike to protest against the job cuts. I think the mining companies there, hurt by low PGM prices, would LOVE to see the strike proceed so as to drive up the metal prices.

The bullish case of palladium can not be better. Look at the supply/demand picture starting with data from Impala Platinum (IMPUY.PK); we will be talking about global demand of roughly 8.215M ounces. On the supply side, South Africa can provide roughly 2.2M ounces if current production cuts are implemented. Russian will provide 2.0M ounces, North America will provide about 0.33M from Stillwater Mining (SWC), other sources count for about 0.3M, and there will be little recycling as low palladium price discourages recycling.

Summing it up; we are looking at about 4.83M in palladium supply, versus 8.215M in industrial demand, not counting any investment demand on the physical metal. The deficit will be 3.385M ounces, or 41% of industrial demand. No other metal has such a large margin of deficit!

Remember, a less than 4% deficit in rhodium was all it took to drive the metal from $300 to $10000 per ounces!!! What would a 41% deficit in palladium do, to the price? What would investors do, when they jump on the palladium shortage wagon and help drive up the price?

Remember, the Russian Government is trying to help Norilsk Nickel with its financial difficulties due to current low metal prices. There have been talks that the government will purchase some of the precious metals from Norilsk Nickel and re-stock the government's depleted strategic stockpile. The Russians can easily drive palladium price up to $2000, $3000 or even $5000 per ounce, if they so choose. I don't see why not! The Polar Bears are not Santa Clause! They want to make money just like every one does.

In 2000/2001, upon one false rumor that Russian government was terminating the annual palladium stockpile sale, the panic buying drove palladium price up from $300 to $1100 per ounce. There was only one investment fund noticed the palladium rally, and profited from it. At the time gold was at the low and there was no interest in precious metals as safe haven assets.

Today, it is a material fact that Russian government stockpile sale ended, and Norilsk's palladium production is down, and Russian government may be buying the metals to help Norilsk as well as replenish its strategic stockpile. And today there is plenty of interest in all precious metals as safe haven assets as the financial crisis unfolds. Rest assured there will be a lot more investment interest in palladium than last time.

It's not too late to buy physical palladium. And time to buy stocks of the world's only primary palladium producers, Stillwater Mining Company (SWC) and North American Palladium (PAL).

I am openly calling these two companies to consider how they can help the average investors to acquire the physical metal easily, and hence be able to participate in and gain from the coming palladium boom. I believe that the precious natural PGM resources are NOT the private properties of mining companies, but belong to the people. These two companies, blessed with the privilege to produce the natural resources, have the social responsibility that they must maximize the value of the metals they produce so as to pay back the community.

Likewise, the Governments of the USA and Canada have the responsibility to ensure any minerals produced from their soil must maximize the values and must not be sold below cost. If the metals are priced below cost, then the governments should purchase and stockpile these precious strategic metals. The Chinese government is already stockpiling strategic metals to protect its domestic mining industry and take advantage of recent low commodity prices. The US and Canadian governments must do the same for their respective national interests.

Now let's talk about gold. Current price of gold is about $900 per ounce. I believe gold is fairly priced as most gold mining companies are making comfortable profits. I believe there is now no good reason for average Joe to buy gold at this price. Joe makes $40K per year, or $28K after tax. He makes $112 per work day after tax. So to buy a one ounce gold coin, he needs to work at least 8 full work days to earn enough money for it.

Joe might as well take 8 days off to go prospecting for gold. Some gold prospecting web sites claim you can collect up to two ounces of gold a day. Sounds like a better deal than earning a salary to buy gold. Maybe California the golden state should have zero unemployment? Lost your job? Go prospecting for gold and you get yourself a job making tax-free real money.

The economic incentive to prospect for gold rather than to buy gold puts a reasonable natural cap on gold price, in terms of purchase power. But silver, platinum and palladium are different as you can NOT prospect for these other precious metals. So these other precious metals should have bigger room for gain. My only advice is stay away from ETFs like GLD and SLV. Instead buy physical metals and precious metal mining shares. I am suspicious of these two ETFs after I browsed through their physical metal bars serial number lists. I will not elaborate here. Spend your time scrutinizing the lists to see if you can find some red flags.

What about shipping and the recent bloodshed in DRYS? The Baltic Dry Index has been going up strongly for TEN consecutive trade days in a row, reaching 1099. The low was 666 on Dec. 4, 08. How often do you see something going up 10 days in a row? That says the shipping is recovering strongly. The plummet of shipping rate last year was largely due to credit crunch freezing up trading activities, NOT due to supply and demand. As the credit now eases up, there will be pent-up demand to clean up the goods previously piled up on harbors.

The short term outlook of dry bulk shipping is bullish, the long term prospect is even better, as governments around the world, particularly China, are ramping up gigantic economic stimulation programs. Governments can print money out of thin air. They print paper money not to hoard their own money, but to spend the money.

When governments spend money, every dollar spent is a demand on physical goods and services, just like average Joe's grocery spending. So it is really a moot point talking about consumers spending less and saving 3% of their incomes, when the governments are racking up deficit spending in the tune of multiple trillion dollars.

China is one big driving force behind growing global demand on commodities, as well as growing demand on global shipping, and will continue to be, for many years to come. It's not just a matter of economic development; it is a matter of China's very survival. That's because China is rich in cheap labor forces, but poor in critical natural resources.

As Jim Rogers correctly pointed out, China's very survival hangs in one thing: WATER. China's biggest engineering projects are all water related. The most famous one is the Three Gorges Dam, the world's largest hydro-electric dam. At its peak of construction, this one project alone consumes 1/4 of the world's cement and steel production.

But Three Gorges Dam is nothing comparing with another mammoth project that's already well underway in China, but little talked about in the western world, China's South to North Water Diversion Project, which is at least TEN TIMES as big as the Three Gorges project. It's been talked about for half a century but was only recently rushed through the approval by the People's Parliament in a hurry without much debate: There is simply not much to debate about: Beijing, with its 14 million populations, is depleted of water resources and desperately needs the water to quench the thirsty! It's a non-negotiable, survival issue!

The South-to-North Water Transfer Project was supposed to take at least half a century to finish due to its gigantic scale, but will be rushed probably in a decade, due to the urgency of the water crisis in Northern China. Just think about how much concrete, steel, construction machineries and materials this one project will demands from the world! The infrastructure projects in China will ensure a global commodity and shipping boom for many years to come.

What do I think about DRYS's recent plummet? The panic was caused by DRYS's disclosure that two banks notified it that it was in breach of the loan covenants, as the fair market value of its ships has fallen below a certain percentage of the debts, and that DRYS was trying to raise $500M cash by selling shares in the open market, hence dilute the share value.

I do NOT think the loan covenant thing is too much a deal. How do you define a ship's fair value? I think any physical property's fair value is its replacement cost. But the convention is use recent market transactions of similar properties to determine the "fair market value". I think such terminology is ironic! The market is never a fair place to begin with so the word "fair" and "market" don't come together. Why would it be a "fair price" when a ship owner is coerced to sell its ship far below inherit value, under financial stress? Such unfair price is then used as "fair price" to undercut the assets of every one else and force many more defaults and stress sells, further escalating the crisis. This unfair "mark to market" rule results in distorted values of physical assets. It is one of the culprits of current crisis in real estates and other sectors. It must be abolished and replaced by a "mark to cost" rule.

In light of the continuous surging BDI index, the value of ships goes up with BDI. Banks know this and they don't want to bring an unnecessary crisis on themselves. They will work with shippers to find acceptable solutions to the loan covenants. It's in their best interest to do so.

My biggest worry about DRYS is the ongoing sell of shares to raise $500M. This will greatly dilute the value of DRYS shares. How much dilution? No one knows. So even though DRYS has become much cheaper, I would advice wait a little bit till the dust settles, just to see how much the share dilution factor is. Mean while I believe other shipping stocks like EXM, EGLE, GNK, DSX, TBSI and NM are better buys than DRYS, until we know more about DRYS's share dilutions. For the same reason, avoid OCNF for now.

Full Disclosure: The author is heavily invested in SWC, EXM and EGLE. I also own shares of PAL, OMG, TBSI, DRYS and USO. I do not own other stocks mentioned but positions may change at any time.