Before I get going describing my thought experiments, I feel I should admit to a couple of failures. In earlier posts, I had made the claims that GDX would not fall below $26.31 and that gold would not trade below ~$1250. I was wrong on both counts, so please take my musings below with a nice pinch of salt.
THOUGHT EXPERIMENTS. I wanted to step back and think about the news and bigger trends on which to base potential new positions or think through existing ones. What follows is my attempt to understand how the forces of money printing and bonds interplay and affect various other asset classes.
(1) For the first experiment, let’s start with the assumption that the Fed will actually start curtailing its bond purchases and eventually cease altogether. If the Fed stops buying bonds – I include in this category treasury notes of various duration and mortgage backed securities – then there will be a greater supply of these in the open market that will need to bought by investors. A supply increase implies a price decrease, which implies a coupon rate increase. The US government will need to keep issuing treasury notes to finance its deficit, unless it miraculously figures out a way to cut it, which is about as likely as me growing another two feet. The Fed has controlled the rates on treasuries by creating money out of thin air (electronically) and buying treasuries, setting up the signal that there was an overabundance of demand, which drove up bond prices and lowered their rates.
If the Fed stopped buying bonds, I would expect all of this to reverse, resulting in less demand for the notes/bonds, lower prices, higher rates. Higher rates, in turn, will put the brakes on home price increases, decrease number of mortgage applications and slow demand and returns in the housing market. Over the last two months, we have seen treasury rates rise in response to the bond buying tapering discussions issued by the Fed. So far most, including Goldman Sachs, believe that the Fed will start cutting back its bond purchases in September, which perhaps explains why rates are rising in anticipation of the beginning of the Fed’s wind-down. Take a look at the 10-year treasury note’s chart below:
What are the follow-on effects of higher rates? Generally, rates creep up when inflation is on the rise and the rise in rates counteracts or tempers inflation. Stock markets rise with outright inflation. Inflation and precious metals prices also tend to correlate positively, but since PM prices have been declining hard, the message being broadcast by the market is that inflation is not really present (leaving aside the calls for extended manipulation in the PM space). Deflation tends to be the nemesis of higher PM prices. Rates, then, may be going higher not as a result of inflation, but because of the de-repression that the Fed has induced through the tapering discussions; rates may be starting to represent the risks contained in the notes themselves, on the basis of the steep increase in government debt (and the debt to GDP ratio), reflecting the risk of default in treasury notes (we are nowhere near defaulting on an interest payment on outstanding treasury notes, but that number is also no longer 0).
What should we invest in if the Fed is preparing to exit the bond purchase program of the last four years? PMs are not the place to be long if the market’s projection of deflation is true. Bonds are also not the place to be long as rising yields will kill prices. A deflationary environment (which is what the Fed has been trying to fight – see Japan the last 30 years) with rising treasury rates means that defensive stocks will do well – an example sector would be healthcare (people get sick no matter what the economy is like).
Each of these sectors have their own risks, but the risks are quite company specific instead of cyclical for healthcare stocks. Aggregate consumer spending is expected to decrease in such an environment and the stock market, overall, would be expected to decline, making stock picking (in the healthcare sector, for example) a delicate and difficult task. The best investing strategy in such an economy would either be to stand aside or to be short the aggregate market, with carefully chosen long positions in certain companies in specific, counter-cyclical sectors.
(2) For the second thought experiment, let’s assume that the taper talk by the Fed is BS and that when the economy is assessed accurately as barely limping along, the Fed will do the opposite of tapering and crank the QE printing press higher than it currently is. What would induce the Fed to do so? Spiking treasury interest rates, at a level high enough to make interest payments painful, possibly threatening default; plunging market; economy grinding down almost to a stand-still; dollar screaming higher against all other major floating currencies; and probably a number of other things I am not thinking of. Those would be the broad indicators to watch.
What do we invest in if we see turmoil ahead and then another QE printing spree? In the near-term, a number of specific short positions seem worthwhile to establish. When the Double Down QE (DoubleD QE) is announced, going long all the usual suspects might work initially, until the market realizes that DoubleD QE is actually a bad sign. Before DoubleD QE, bonds will have gotten crushed, along with the market and the economy. Currency directions will flip the day of a DoubleD QE announcement, the market will likely scream higher and rates will collapse, as the Fed hurries to sop up all the paper that it can get its hands on. Things will seemingly be returning to “normal,” but the places that were hot before the plunge and DoubleD QE will lose their bubbliness as investors go in search of the next bubble to blow. My guess is that it will be in the precious metals sector, healthcare and food.
(3) CONCLUSIONS. At the moment we have a market that is surging higher, bond rates going higher and precious metals continuing their collapse. Here’s what I think these components may be telling us: market surging higher – more QE anticipated; bonds plunging – QE done; PMs going down – QE done (although this did not hold true for QE4). The last shoe to drop for a QE done consensus appears to be the market taking a plunge (which will probably be the cue for DoubleD QE). Once we have everything making a strong move down, the conditions will be set up for a no-QE to DoubleD QE transition. From a trading perspective, so long as stringent risk management is applied, going short and then flipping long is possible, but needs to be timed correctly. Alternatively, you can choose one or both sides, QE ending vs DoubleD QE, position accordingly over a longer horizon and let winning positions prosper.
This was an Excerpt From The July 5 Weekend Report @ www.protectedreturns.com, also posted at http://protectedreturns.blogspot.com/.
