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The Stronger US $ Will Mean a Lower Yen and Rupee Resulting in Lower Treasuries and Gold Price!

July 15, 2013

The impact of the lower yen and rupee versus the US dollar on Treasuries and bonds.  As a result of “the stronger dollar” the treasuries showed very nice gains measured in yen as a result of which the Japanese offloaded a record $30bn of foreign bonds, mainly treasuries, in June. Since September 2012 treasuries expressed in Yen achieved a gain of 31.7% until May 2013!! According to Fed figures foreign-held debt shows that China was the largest holder of US treasuries, at $1.25 trillion (as of March 2013) with Japan coming in as second, at $1.105 trillion.


10-Year Treasuries expressed in Yen chart



I believe that it is crucial to understand the disruptive forces of big currency movements and especially when it involves the US dollar, the reserve currency. Since November 2012 the Yen declined 22% versus the US dollar following monetary easing whilst since May 2013 the Indian Rupee fell approximately 9% against the US dollar due to the tapering issue. Expectations that the Federal Reserve will start tapering its bond-purchasing program strengthened the dollar and sent emerging markets' currencies plunging. Adding to the downward pressure on the rupee, foreign investors have withdrawn $4.7 billion from Indian bond funds, and the key issue now is whether Indian equities will experience the same ordeal. Indian equities have been one of the largest beneficiaries of the Fed's quantitative easing program among AXJ markets [Asian markets except Japan] making them vulnerable to tapering expectations. At home a weaker Indian currency will add to inflationary pressures, widen the fiscal deficit and slow capital inflows. In other words all kinds of different unpleasant consequences result from currency “devaluations” especially if export-boosting effects don’t compensate for the negatives any longer because there is hardly any growth of importance in the main countries (Eurozone, US, China). Growth for China is being downgraded continuously with growth rates forecast now between 3%-7.5%. Although this growth is still significant for a $7.5trn economy is represents quite a significant reduction from the 8%-12% range.

The point I am trying to make in this paragraph is that when the yen keeps on weakening further, or the dollar keeps on strengthening, it will automatically trigger more dumping of US treasuries forcing US interest rates automatically higher! And especially because Japan is the second largest foreign holder of treasuries this relationship is so important. It is much more important than the Rupee/US dollar relationship. India had reported treasury holdings of only $58bn in February 2013 and is thus not of significant importance with respect to putting upward pressure on US interest rates. The more negative effect here is that the lower rupee triggers foreign investors to sell Indian bonds forcing higher Indian rates.


The impact of a lower rupee on the gold price

Next to the currency effect on the treasuries the level of the rupee versus the US dollar is very price sensitive to the gold price measured in rupees. When the rupee gold price is high (weak rupee) Indians tend to sell gold whilst when the gold price measured in rupees is weak Indians tend to buy gold.  As we know demand from India is good for some 20%-25% of yearly gold demand and therefor the exchange rate has quite some influence on the gold price worldwide (in 1Q13 India and China accounted for 62% of gold jewelry demand). As I mentioned in earlier blogs a similar correlation exists for the Yen/Dollar gold relationship see chart here below.


Gold/Yen chart



Of all currencies only gold “cannot” be manipulated (printed/multiplied) and therefore is the best benchmark of wealth

In the end I believe you can also look at the gold price as the standard for currency valuation or devaluation, currencies (the benchmark of your wealth) will show their weakness or strength vis a vis the gold price. The reason I am saying that is because gold as we know “can’t be manipulated” in the sense that you can “print” gold at will contrary to all currencies, including and especially the reserve currency the US dollar. The four major currencies are the US dollar, the Euro, the Yen and gold and the only currency that is not being diluted is: gold! As we know paper can be printed ad infinitum contrary to gold that needs to be mined at certain cash cost which gives it its inherent value. Paper money only has value or credit because of the credibility of the economy and its monetary authorities. If you take this away paper money is not worth the paper it is written on. And this happens when you undermine the economic principles by issuing so much money for an extended period of time without having any substantial real results on the GDP output of the economy (the ultimate guarantor of the currency). And the “no traction”, counterproductive results from QE measures are especially accentuated in a situation when the Debt/GDP ratio has passed the tipping point, that is when the debt levels in relation to GDP start to negatively influence economic growth. This is in general the case when Debt/GDP ratio exceeds the 90% level. What a government pays for its debt servicing can’t be applied to stimulate growth through expenditures or lower taxes.

At interest rates of 1.6%-2.6% we can barely finance the current debt levels let alone what the impact will be when the average rate of interest on U.S. government debt rose to just 6%, the federal government would be paying out about a $1trn a year just in interest on the national debt. If U.S. bond yields rise by an average of 3 percentage points, it will cause investors to lose a trillion dollars. Imagine what this will do to the “real value” of the US dollar.

Anyway my point is look at the gold price if you want to get a feel for what your currency is really worth! Gold is the benchmark of your wealth and not the other currencies because they are heavily inflated and will show their real value when the chickens are coming home to roost! Can could use short term downward movements to pile up on gold for the long term.

Lower currencies don’t do the trick any longer when everybody is lowering its currency and there is no significant economic growth anywhere

With quantitative easing comes devaluation of the currencies (except for the US dollar!!), one of the main instruments for exporting economic weakness and unemployment towards its peer countries. Though we have to wonder how a country can increase its exports by lowering its currency if everybody brings down their currencies and the major economies have trouble growing over 2%! This is clearly illustrated by China's deteriorating trade performance for June, which showed drops in both exports and imports, according to customs data published Wednesday July 10. China's exports last month fell 3.1% from a year earlier, swinging from May's meager 1% gain. It marked the first year-on-year drop for exports since January 2012. Imports also dropped a 0.7% after slipping 0.3% in May whilst forecasts were looking for an 8% annual increase for June. The Shanghai index clearly illustrates the stock market expectations for growth and profitability for Chinese companies and thus the expected economic growth. Chinese stocks just experienced their largest decline since 2009. 

Food price inflation in China was 4.9% in June, compared with 3.2% in May, with rising pork prices partly to blame. While the headline inflation number was above analysts' expectations, it remains below the government's target figure of 3.5%. Analysts say the latest figure reduces the prospect of interest rate cuts in 2013. Cutting interest rates risks inflating a property bubble, while tightening may put additional pressure on the economy in the middle of the current global economic uncertainty. Again we see that the maneuvering room of the Chinese authorities to influence the economy, as is the case for the US monetary authorities, is getting smaller and smaller!

On July 15, despite earlier downplays by Chinese officials, it was announced that “China's economy grew 7.5%” (down from 7.7% in 1Q13) in the second quarter (the slowest rate in 23 years for the country!!) with industrial production for June rising 8.9% (9.1% forecast) from year-ago levels, though slowing from May's 9.2% growth. June retail sales rose 13.3% on an annual basis, beating May's 12.9% gain. Urban fixed-asset investment -- watched as an indicator of construction spending in ghost towns -- grew an average 20.1% in the January-June period, just short of Reuters' 20.2% projection and down from 20.4% in January-May. Anyway since there is no way of really verifying the numbers I believe that Chinese growth is rolling over. In my point of view the in and export figures tell a tale. China’s shadow banking system seems to be in a peril state, which is another indication of increasing adverse circumstances in China going forward. Moreover China pumped roughly $1.6 trillion in new credit (that’s 21% of GDP!) into its economy in the last two quarters whilst its GDP growth keeps on slowing with previous years.

We see a similar developed development as in the West, ever more Yuan are needed in order to get just 1 Yuan of economic growth. This is what a credit bubble bursting looks like. The second largest economy on earth is starting to have significant financial problems at the same time that our markets are peaking.

On July 12 UPS said its second-quarter earnings would be hurt as customers use cheaper options. The package delivery and logistics company also says it's seeing a slowdown in the U.S. industrial economy. And the banks appeared to be very wary of future earnings especially because the impact of higher interest rates on the remortgage earnings whilst next to that most of the loan-loss reserves have been released in the last quarters. 


Shanghai Index/CRB Index chart



The commodities are telling us a similar story. The above chart shows the correlation between the Shanghai index and the commodity prices expressed in the CRB index. As we know China accounts for some 40% of all commodities hence the correlation.

CRB Index chart


See below how important the copper price is for the CRB index and thus for the determination if we have deflation or not. When the copper price falls through the $3 level we could interpret that as another indication of a deceleration of (Chinese) economic activity. Copper is often referred to as “Dr. Copper” because of its unique ability to forecast economic trends because it is used in so many important sectors of the economy such as housing and cars.

Copper chart


Is the global economic downturn going to accelerate as we roll into the second half of this year? 

There is turmoil in the Turkey, Syria, Egypt, Brazil, and we are seeing things happen in the bond markets that we have not seen happen in more than 30 years (bond cycles in general last between 22-37 years), and much of Europe has already plunged into a full-blown economic depression with countries being downgraded continuously (Italy, France) forcing higher interest rates. The world is becoming increasingly unstable, we are living in the final phase of the greatest debt bubble in the history and the global financial system is even more vulnerable than it was back in 2008, though nobody wants to accept that till it is too late.  The reason for the higher vulnerability is that debts levels have passed the tipping point and that all the tools in the toolbox have been applied, and are being exhausted, without success.

Velocity of Money chart of the St Louis Fed


Amongst the main reasons to be deeply concerned about the global economy as we head into the second half of 2013 are: the all-time low for the velocity of money; much higher future interest rates, 3% and 4% (4% means a break out of the 32 year downward trend) are crucial levels; the higher taxes in the form of higher gasoline prices; the increasing unrest around the world following the corruption, lack of accountability and increasing discrepancy between the haves and have-nots within countries and between countries; the increasing unemployment rates, especially in the Eurozone; the misperception that things in Europe are improving (Portugal near a political crisis, the downgrade of Italy from BBB+ to BBB and France’s downgrade from AA+ to AA); the increasing inability to meet the enormous future entitlement obligations, especially pensions and Medicare payments; the flagrant abuse of civil rights by governments using terrorism as the justification for implementing a police state; Central banks selling off substantial amounts of U.S. Treasury bonds right now whilst U.S. mortgage bonds just suffered their largest quarterly decline in nearly 20 years. The number of mortgage applications in the United States falling at their fastest rate in more than 3 years as confirmed by JP Morgan’s results. Real disposable US income falling at the fastest rate in more than 4 years, which has been falling since 2001; The percentage of US companies issuing negative earnings guidance for this quarter is at a level that we have never seen before whilst the stock market is at all time highs.

Especially the $441trn in credit derivatives (BIS) could derail the monetary system

Last but not least according to the BIS there are $441trn (or 37 times the size of the $11.9trn US treasury market) of interest rate derivatives (used by institutional investors such as banks to combat the changes in market interest rates) sitting out there and interest rates have risen rapidly over the past few weeks, which could cause the entire global financial system to crash. Normally these bets do not cause a major problem when rates move very slowly and the system stays balanced.  But when rates break out (3% and 4% levels for the 10-y treasuries) they are likely to skyrocket, and the sophisticated financial models used by derivatives traders do not account for this kind of movement which could cause major disruptions and bring down the whole financial system. Does the factor 100 times for paper versus physical gold sound familiar?

The chart posted below shows how steeply the yield on 10 year U.S. Treasuries recently moved over a very short period following Bernanke’s tapering remarks.

10-Year Treasury Yield chart of the St Louis Fed


Right now, the yield on 10-year U.S. Treasuries is about 30% above its 50-day moving average.  That is the most that it has been above its 50-day moving average in 50 years! The same applies for the 5-year treasuries confirming the severity of the movement. What should be emphasized is the ferocity of the rate of change in a worldwide debt laden situation that could cause problems hardly anybody believes is realistic. 2008 will look pale in comparison.

There are eerie similarities between the situation today and that of 1987

Marc Faber noted recently, "markets will punish the interventionists one day," and while we are already seeing 'accidents' occurring in JGBs, Gold, EM debt, and now US Treasuries; US equities remain immune. US equities are the “last frontier” people can invest in because the outlook for bonds and emerging markets seems to have turned the corner. We know interest rates will rise. With respect to emerging countries many countries in the emerging countries have now reached income levels historically associated with growth slowdowns. Growth over the past decades was fuelled by very rapid improvements in productivity catching up towards the income levels of developed countries. Relative to their income levels, many countries have now eliminated this productivity-gap, and are unlikely to sustain the same pace of productivity growth in the future. Except for China, in many of these countries, the much-needed infrastructure has not kept up with economic growth and is hampering growth.

However, given the current uncertainty of macro-economic data, high-leverage, fear of rising interest rates, and instability of currency markets, all of the same conditions that led to the 1987 crash seem now to be present in financial markets. Conditions may be right for another 'market accident' to happen.  The last half of 2013 is shaping up to be very, very interesting.

Comparison 10-Year Treasury Yields 1987 and 2013



Comparison S&P 500 1987 and 2013



Gold and silver and the mining companies are setting themselves up for a generational rise in prices

Some people are arguing that the paper gold Ponzi scheme be on the verge of crumbling, I don’t know when but crumble it will driven by events.  There are reports that there is now a 100-day delay for gold owners to take physical delivery of their gold, for which they have already paid, from some warehouses owned by the London Metal Exchange. In other words there is a greater-than-three-month delay to refine the gold (or silver) being purchased and then ship it to their warehouse. In other words, the “bullion” which traders believe they are purchasing today is in fact merely ore, which hasn’t even been mined yet. It confirms the view that only a very small percentage of all the contracts traded on the CME is real time backed by the physical and that more paper (futures) gold contract buyers want physical delivery. Next to that it sanctions the conviction that if you have paper gold you don’t have anything! Who guarantees delivery when the gold price rises very steeply and who incurs the losses?

According to a study by Citi no gold company will generate free cash flow at current gold prices of $1,300/oz. After updating their precious metals' company cost curve, Citi's ominous warning that, a combination of rising unit costs (15% yoy), sustained high capital budgets and a falling gold price have resulted in a fast contraction in margins - so much that no gold company under their coverage will generate free cash flow at spot gold. See Citi chart below.

All in costs per ounce of gold mined comparison. Citi

Gold companies are trying to adjust to the lower gold prices by cutting capex, exploration and corporate costs. But it is also noticed that most of the global gold miners cost are burning cash at spot levels. Further cuts will be needed in the coming 12 months to make ends meet if the gold price stays at these or lower price levels. Anyway gold supply will be tight and by itself force higher prices going forward. Next to that funding for exploration and development companies will become even more challenging. In general these companies need 7 years of financing before they get to the final phase of production when they start producing positive cash flow depending on the gold price at that moment!

As I described in my former blog article strong corrections in the gold and gold mining market are not unusual and therefore voices that the gold bull market is over is greatly exaggerated. Is the excess money suddenly not there anymore. And as I mentioned here before all currencies continue to be diluted, sacrificed in order to achieve the so much needed but unattainable growth. Gold can’t be printed giving it its value and its qualification as the ultimate currency!

Conclusion: closely watch currency and interest rates!

Currencies can have a profound impact on interest rates and other asset classes when the treasury and gold price get a currency boost in local currencies (Yen, Rupee) because of the “stronger US dollar” which triggers disposals and thus higher interest rates and lower gold prices. Watch the crucial 3% and 4% 10-year interest levels for break outs and some serious tumult in the markets.

At present 10-y interest rates don’t really want to come down from the 2.6% level, next to that the Vix doesn’t show the same gravity as before showing us investors’ disbelieve of improving (stock) market conditions.

As described above:

·         When the average rate of interest on U.S. government debt rose to just 6%, the federal government would be paying out about a $1trn a year just in interest on the national debt.

·         If U.S. bond yields rise by an average of 3%, it will cause investors to lose a trillion dollars.

·         According to the BIS there are $441trn of interest rate derivatives, which could bring the financial system down when interest rates move quickly and uncontrollably.

Last but not least don’t disregard the similarities between the interest rates and the stock market performance in 1987 (see charts above shown).

S&P500 versus 10-y Treasury Note chart


July 15, 2013 © Gijsbert Groenewegen

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