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Change in demand IS something to fear. The reason to fear lower demand, or any economic weakness, is because we cannot afford to address the situation in a traditional manner.

It’s The Fed, Unfortunately

January 6th, 2013 by Kurt L. Smith
  • Looking back over the past year the defining point for the markets was Federal Reserve Chairman Ben Bernanke’s missive in September.  Asset prices peaked with Ben’s pronouncement.  Animal spirits are now dissipating.  The reversal eventually sent Municipal Bond prices to their high November 30th, along with my proclamation that Municipal Bonds were in bubble territory, heading for a big fall.

    Market prices of various assets do not peak at the same time but September 14th, 2012, may provide a turning point for many assets.  Fresh off Ben’s announcement of Quantitative Easing Infinity (whatever it takes, forever – if I may paraphrase), Stocks, Oil and other Commodities peaked in price.  Some prices, such as the Dow, Gold and Silver, continued higher into early October, but since then all have moved lower.

    Bond prices had peaked earlier, back in July, yet Ben’s announcement remains key.  Treasury bonds were at their weakest point since their high around September 14th while Corporate Bonds and Municipal Bonds went on to hit hit their highs in October and November respectively.

    High asset prices is certainly the theme for 2012.  I believe the Fed’s September announcement will prove to be a long-term turning point for all asset prices.  For this reason, Cash and short-term bonds remain the store of value we need to own in order to weather the coming asset price decline.

    We are merely weeks away from these asset price highs so what is the big deal?  One would expect a correction at some point, right?  How do we know this isn’t just a breather before a deal gets done on the fiscal cliff or something else happens?

    Commodity prices set their recovery high in May 2011, over eighteen months ago, primarily on the strength of oil prices.  Gold and Silver peaked over a year ago, and while commodity prices peaked on Ben’s September announcement, no commodity price came close to their 2011 highs.

    Similarly, the US Dollar Index, which usually moves inversely to asset prices, bottomed in 2011 with the Commodity price top.  Since then the Dollar rose smartly into a June high before hitting an interim low when asset prices peaked in September.  Taken together, and with eighteen months already behind us, we can say the US Dollar Index is trending higher while Commodity prices are trending lower.

    This is not good news for this economy.  If inflation were to be blamed for high asset prices then we would be seeing high asset prices across the board.  Commodity prices would be trending higher; they are not.  The US Dollar would be trending lower; it is not.  Inflation is not relevant and therefore our hope of reflating the economy so we can more easily pay off our ballooning debt is one false hope.

    What is happening is demand is falling apart.  Peak Commodity prices provided the impetus for more production and greater supply, but supply for what?  Where is the demand?  Change in demand IS something to fear.  The reason to fear lower demand, or any economic weakness, is because we cannot afford to address the situation in a traditional manner.  Let me explain.

    In more normal times, a run up in prices would stimulate more production.  Higher Oil prices beget more exploration and eventually production.  At some point prices no longer move higher, but instead would move lower to clear the market of the excess supply.  This cannot be allowed to happen today because the higher prices are supported by massive amounts of debt.  If oil prices somehow fell then debt based on oil prices would become impaired.  The collateral backing this Oil debt would be lacking.  Oil climbed to $147 a barrel in 2008, before collapsing to $32.40 a few months later.  Subsequently Oil rebounded to $114.83 in May 2011 but it has been lower ever since.  Oil as collateral is lacking and loans based on this collateral would be impaired.

    This is exactly the situation not only in Oil but in other Commodity-based debt, especially residential real estate.  Residential mortgage debt is grossly impaired.  Yet markets for residential mortgages exist.  Mortgages that seemingly few wanted in the aftermath of the financial crisis has since found a seeming plethora of buyers.  Some have played the bounce and have paper gains to show for it.  But a gain isn’t a gain until you take it.  Impaired loans are impaired by degree.  If the realization hits that residential real estate, like Commodities, is in a downward trend then watch out.  Like 2007, we know the music can stop abruptly and when it does prices fall quickly and dramatically.

    This is why it is so important to keep up the illusion of recovery.  Prices cannot be allowed to slump or move lower because of the impact on the value of the underlying collateral and hence the value of debt.  With Commodities already trending lower, who will buy the impaired Commodities’ debt?  But this is but a precursor to the gigantic question of who will buy impaired residential real estate debt once the recovery bounce is perceived as over?

    Ben Bernanke’s Fed wants none of it.  This is why Ben’s Fed is overly willing to purchase Treasury bonds ad nauseum.  By purchasing Treasuries the Fed hopes you will buy something else, even more junkier.

    But Ben plays only on the margins anyway.  Despite seemingly endless Treasuries financing seemingly bottomless deficits, the supply of Treasuries is dwarfed by all the debt that is impaired and will be impaired as asset prices slide.

    One would think that with so much riding on keeping asset prices high and moving higher that the Fed (and all of their believers, I mean bankers) would do more to keep prices from ever falling.  Unfortunately their actions and inactions are not working.  Unfortunately inflation is nowhere to be found.  Unfortunately the Fed is unwilling to buy assets other than Treasuries.  Unfortunately the market, since the Fed’s September announcement, realizes the gig is up.

    Watch prices like a hawk.  Since one can sell Stocks, Bonds and Commodities seemingly at any time their prices reflect our collective mood.  Lower prices need not signify impending doom but due to the amount of debt that stands to become impaired with lower asset prices, lower prices should not happen.  Much is at stake here.  So I am watching, and rather than merely hoping lower prices do not occur, we are investing primarily in Cash and short-term Bonds as a way of preserving value.

    So far Commodities lead the way and some may argue it is premature to say Stocks and Bonds have turned.  Perhaps, but remember prices on Commodities (and residential real estate) should never have collapsed to begin with if the illusion of the Fed’s strength was indeed reality.

    Remington Municipal Utility District, TX
    S&P: AA- (Enhanced) A- (Underlying)
    Unlimited Tax General Obligation
    DUE 9/1 DATED 2/1/13 MATURITY: 9/1/2032
    SALE AMOUNT: $9,280,000

    YEAR MATURITY COUPON YTM*
    1 2013 2.00% 0.60%
    2 2014 2.00% 0.75%
    3 2015 2.00% 0.90%
    4 2016 2.00% 1.00%
    5 2017 2.00% 1.20%
    6 2018 3.00% 1.28%
    7 2019 3.00% 1.46%
    8 2020 3.00% 1.71%
    9 2021** 3.50% 2.05%
    10 2022** 3.50% 2.25%
    11 2023** 3.75% 2.35%
    12 2024** 3.75% 2.45%
    13 2025** 3.75% 2.55%
    14 2026** 4.00% 2.65%
    15 2027** 4.00% 2.75%
    16 2028** 4.00% 2.80%
    17 2029** 4.00% 2.85%
    18 2030** 4.00% 2.90%
    19 2031** 4.00% 2.95%
    20 2032** 4.00% 3.00%

    *Yield to Worst (Call or Maturity) **Par Call: 9/1/2020
    Source: Bloomberg
    This is an example of a new issue priced the week of 12/31/12
    Prices, yields and availability subject to change

     

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