Commentaries

The Elusive Abyss

Financial markets are currently in a panic, bonds spiked last week (this continues at the moment), cash deposit levels up sharply according to BNY Mellon, US debt downgraded by Standard and Poor’s from AAA to AA+ and equities crashing.  The Chinese rating agency Dagong Global Credit Rating Co. have now lowered their rating on the US debt from A+ to A after lowering their previous US rating from AA to A+ in November 2010.  All agencies are warning us that they are on “negative” in their forward view of their respective US ratings.

Here we are again back at the edge of the abyss …yet again.  This is not the first time we have not enjoyed this view of this elusive abyss and nor will it be the last unfortunately.  This debt crisis is far from over and this Gold Bull is far from over.

Over 10 years ago Gordon Brown was rumoured to state that the reason he sold half (at the time) of the UK gold hoard was; “We stared into the abyss and were concerned that a sharply rising gold price would alert the world to the crisis that the world was facing.  That is why we sold our gold”.  The bottom of the gold price in 1999 – 2001 is now known as the “Brown Bottom” in gold circles.

This now famous quote is the reason that you read the ‘staring into the abyss’ statement so much over recent times.  It will remain popular for some time to come; it will surface every time we come back to the edge.  The quote referred to here is actually very old.  Friedrich Nietzche stated “Battle not with monsters lest ye become a monster; and if you gaze into the abyss the abyss gazes into you”.  It tells us that we can become what we fight if we are not extremely careful.  This is a translation so allow me some slack here.  These days we just talk about not liking what we see in the abyss and miss the relevance which is far more profound.

What do I mean by that statement?

Monetary authorities are there to do what they are doing and part of that purpose is to provide stability.  They stare into this abyss at times like this wondering how to unwind this debt bubble with a soft landing – in other words with relative stability.  This is impossible at this time so they “kick the can down the road”.  Please forgive this other much touted quote but it fits perfectly.

Unfortunately the authorities are working with irrelevant financial modelling based on; fixed exchange rates, different global dynamics and far lower levels of debt.  They are also ill advised by those with vested interests.  Unfortunately this leads them to add more debt to the mountain in the hope that this financial mess does not blow up on their watch (cynical view). Alternately they hope that growth will return or that the BRICS (Brazil, Russia, India, China and recently South Africa) will grow large enough and fast enough to absorb a major western slow down.  At least this is the logic I am reading into their actions; perhaps I am wrong on this point.

They stare into the abyss and the fall is so unpalatable that they take drastic measures by pumping more and more money (debt) onto the pile.  They are also maintaining official rates way below real price inflation; thereby pushing the debt bubble way past the point of no return.  This awful fact has now reached a wider audience’s attention thanks to the debt ceiling debacle and recent events in Europe.  Sooner or later the Piper has to be paid guys – the debt mountain will implode if you keep adding stimulus.  Their ability to add more QE is diminishing.  The irony is that they are not only leading us into “that which they are trying to fight” they are also making the abyss bigger and bigger every time they back us away from this elusive yet unavoidable consequence.  The can kicking is all about containment, their dilemma is when do you let go?
Where are we now?

Now back to the current situation and the big question for investors at the moment which is… “are we there yet”?  Do we fall into the abyss right now or back away yet again?  You have to look at history to see the clear trend here because it is stark.  We have faced this situation many times in the past and the authorities step in again every time.  Many commentators believe this will keep happening until it is no longer viable, i.e. not their choice.  I am in this camp.

The actual leap or fall into that abyss will eventually happen when the debt maturity profiles in the bond markets converge and coincide with a total loss of confidence.  To put it another way, we go over the edge when we finally face a much larger version of what you now see with Greece (see the extent of the situation in the Greek 2, 5 and 10 year bond rates below).  Alternatively “it” happens when a rogue wave event of sufficient magnitude hits the markets and the panic cannot be contained.

We are seeing a significant yet partial loss of confidence now as a wider group of investors wake up.  This is not a total loss of confidence.  Fears of the debt contagion spread to Italy in recent weeks, the US has been downgraded as expected by the market but this is largely factored in now.  The gold community have long wondered how long the AAA Rating could possibly last so this is no surprise to us.  A few weeks back I was looking at Greece and telling subscribers that it could not be allowed to fail at this point because of the counter party risk throughout Europe.  Total collapse is possible if this develops too far right now so this fire will have be extinguished as well.  With gold up $48 an ounce as I speak you have to wonder when the next major intervention will be announced.

There is a lot to the can kicking (and why) which I cannot cover in the limited scope of this article so I will just point out the following facts and let your mind do the rest.  German and French banks are not rolling over most of their Portuguese, Irish, Spanish, Italian or Greek Bonds, or second tier corporate debt from these countries.  When maturity falls due they redeem (take the cash) and this is why we have seen 10 Year Greek bonds rise to 14.875%.  One month ago the same Greek bonds were at 16.2% and this implies that there is little interest; an extremely high price is being paid for new funds to rollover old debt.

Shorter term debt is even worse, 5 Year Bonds at a whopping 22.666% and 2 Year are at 32.594%.  A default is factored in.  Portugal is at 12.1%, 13.6% and 12.75% for 10 Year, 5 Year and 2 Year Bonds which is shocking but not yet at certain default levels.  Italy is not great however it is nowhere near as bad at 5.93%, 5.23% and 4.5% for 10 Year, 5 Year and 2 Year Bonds.

The banks are going home, they renew local debt (own country) and will avoid the rest but they still need more time to reduce this risk.  This debt crisis is also a banking crisis and there is also unacceptable debt default risk exposure in the insurance industry.  The same applies to Bond Funds and the giant Sovereign funds.

Just as I told you Greece would not fail, I again lean towards the view that this current crisis of confidence will get stamped out again to some degree.  Spain and Italy have been involved in rescue bond purchases of Greece and Ireland which I find quite bazaar, yet such is the cooperation to contain this crisis at this stage.  Now their Bond yields have been increasing, so their own repayment burden becomes even less sustainable.  This has come to the attention of the market at great concern to the ECB which has now stepped in and offered to buy Italian and Spanish bonds to contain the risk.  Yields have already come off a little as a result.

The whole notion of “sustainable growth” will come into disrepute by the time this crisis is over.  Debt will become a dirty word too as the world realizes you can’t print wealth and that they cannot turbo-boost growth with huge gobs of debt and call it a success.
The world will not end when we go into the abyss however politicians will not fix the mess until we fall over the edge either. Then they will be forced to do something realistic on their own watch.  So where are we now?  Let’s take a look at some interesting charts before I sign off.

Here is the 5 year / weekly 10 year US Bond Rate chart.  I lifted it from the recent GoldOz Newsletter and you can see the last two times the yield was smashed as hard as this we soon went into reverse. This creates a massive capital wave that has to find a home, so where does it go?

You will notice the RSI is heavily oversold on the Bond chart (upper) however there is a little room for more downside compared to last August 2010 – but we are very close.  As a bond trader you just don’t want to sit here at the moment you want to take your profits now.  Bonds are looking very expensive so perhaps the flight to safety has been overdone right now.

The probability is now that the bonds form a reversal formation soon and reverse.  In the chart above I highlighted last August for an important reason.  One place the capital wave finds itself going is equities.

I have included the weekly chart of the XGD below and what do we see from August 2010?  This anniversary is obvious; here we can break out from the latest green ellipse into a new upside rally with the leading gold stocks ahead of the charge.  The exact date for the last blast off point to the upside is later this week. Further correlation of this phenomenon can be seen back in December 2008 when Bonds were at the last major low; this is when the XGD took off as well.

Will it happen again this time?  There is no guarantee, just as there is no guarantee the XGD will not fall back to the 7000 level or below.  These stocks are extremely cheap relative to gold and getting cheaper, stretching that invisible elastic band of value off the charts.  Gold stocks are undated options on the future gold price.  They present excellent value as leveraged investments into the gold market and if you pick the larger unhedged profitable producers with a growth profile the risk is lower.  This investment class is extremely attractive now.  Anyway here is the XGD chart and the correlation to the bond prices.

The US currently has a moderately growing economy, well below the longer term average.  Pimco have been saying however that this long term average growth rate is gone and they are obviously right.  The old growth rates were boosted by the long term debt binge as we (collectively) built the debt bubble.  As the bubble stops’ expanding it begins to contract and this is called deleveraging.  This slows growth and Pimco now calls this the “new normal”.  Therefore it is a mistake to assume that flattening growth is the old “stall speed”.  No it isn’t the old “stall speed” it is the new normal.  Low growth rates will become very acceptable once investors adjust to this new normal.

What will reverse the markets right now?  Hard to say but I await the latest edition of the greatest show on Earth, the finance markets.  We still have our special discount offer on Gold Membership if anybody has interest.  Now the AUD: USD ratio is back in the support range it is certainly a better time for US dollar holders to invest in our gold stocks.
Good trading / investing.
Neil Charnock
goldoz.com.au
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Neil Charnock is not a registered investment advisor. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services. The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.