Debt-O, debt-uh-oh
Interest come and we need another loan
Debt-O, debt-uh-oh
Interest come and we need another loan

Work our lives just to lose our homes
Interest come and we need another loan
Stack default swaps till they come undone
Interest come and we need another loan

Come on Economists, tell us some more BS
Interest come and we need another loan
Come on Economists, tell us some more BS
Interest come and we need another loan

6%, 7% – it’s a credit crunch
Interest come and we need another loan
6%, 7% – it’s a credit crunch
Interest come and we need another loan

Debt-O, debt-uh-oh
Interest come and we need another loan
Debt-O, debt-uh-oh
When interest comes we’ll need another loan

It was the best of times (with the IMF predicting 3.9% Global growth) and the worst of times (with Roubini saying we’re all doomed) at Davos this week as the men who rule the world gathered to divide the spoils over card games while vying with each other for podium and TV time so they could talk their various books from the safety of the Swiss mountains.  Davos, a tiny village perched on a mountain with just two main streets, lacks the protests of other Global gatherings.  During the annual meeting, the town is taken hostage by thousands of police.  “Anyone who looks like a protester can be thrown off the train,” says Marco Leutholz, head of the local Socialist party (and that train often overlooks steep cliffs!).  Sir Howard Davies (director of the LSE) writes:

The mood is certainly better than last year, when the world was ending, but it is worse than at the beginning of last week. Alessandro Profumo of Unicredit acutely observed that Davos is likely to accentuate whatever mood you arrived in, rather as alcohol does, I guess. So those who arrived nervous about the economic prospects are leaving even more jittery. If you arrived feeling pessimistic, you will leave somewhere between suicidal and homicidal.

The market background has not helped. Anxiety about Greece has grown over the past three days. In the circumstances, it was strange to see both the Greek prime minister and his finance minister here. Maybe the subtext was to show that there can be no crisis if they are munching muesli in the mountains, but though some may have been reassured, more people asked who was at home minding the taverna.

Hey I like that guy – let’s sign him up as a regular writer!  Let’s NOT sign up Bill Gates, as Captain Obvious posted on his blog: “One of the big topics of conversation here in Davos is the economy.”  They say retirement makes your brain get all squishy and I guess that’s true, but maybe Bill was just all talked out after finishing his much more inspiring 2010 Foundation Report.  Sir Martin Sorrell takes his blogging very seriously and gives us an excellent rundown of events (must be something about knighthood):

Focus on the first day, amongst other things, is on the high levels of unemployment and consequent risk of more protectionism. As unemployment is already at a very high level – an average of 10 per cent in most western economies and youth unemployment at least double that rate – social stability and long-term social damage are major issues.

Bankers continue to be bashed. There’s a growing feeling, epitomised by last Thursday’s measures announced by the White House, that the banks are just conducting business as usual and are not resetting their approach. It seems that the industry will have to do much more than has been done already.  The man or woman in the street can’t understand why his or her money (through taxation and government intervention) was used to bail the banks out and now, only a year later, we are business as usual. Politicians who are there to be re-elected can’t afford to ignore such populist passions.

By the way, if you wish you could “kill all the bankers,” there’s now an App for that.  As the conference wound down, Sorrell noted that there were few signs of the Obama Administration in Davos, nor Russia, Japan or the UK as the general impression was that our leaders, unlike the Greeks, were at home trying to keep their fingers in their economic dykes.  Sorrell’s closing comments:

The media star, so far, seems to be ‘Dr Doom’, Nouriel Roubini, with his pronouncements on economic performance. His consulting practice must be going gangbusters. The biggest concern seems to be the direction of the US. Last Thursday’s announcements and policy changes seemed to be un-coordinated and tactical. And who was in control – Volcker, Geithner or Summers? Everyone is looking for coherence in this evening’s State of the Union speech – which is a long way away from Davos! We’re in the wrong place!  The unexpected story, so far? Why did the head of security for Davos allegedly commit suicide?

Why indeed?  At least a little murder didn’t stop the mayhem at the Google party, where wet-suited, snorkel-clad waiters served sushi and colored pure oxygen tanks for those in need of a blast while media moguls, politicos, all the young global leaders and even some royalty hit the dance floor.  According to Jasmine Whitbread, “the biz card ritual is like nothing I’ve ever seen outside Japan.  I swear some measure success of their participation by how many inches of cards they collect and give out.”

Clearly the man of the moment this year at the World Economic Forum was Nick Sarkozy of France, who blew people away with his opening day speech but you wouldn’t know it from reading Uncle Rupert’s Journal, where his keynote address (22 mins in on this video) didn’t even make the top of the fold in their entire Davos section with all his “Socialist rhetoric” that I guess didn’t seem worth repeating to American readers (don’t say censored, that’s China’s trademark!).  Sarkozy told the attendees at Davos that “globalization skidded out of control” and that the risks are simply too great if “we do not change the regulation of our banking system.”

Through excessive deregulation, we have let dumping and unfair competition set in. We have let globalisation be based on external growth, with everybody trying to grow by taking the businesses, the jobs, the market shares of others, instead of by working harder, investing more, increasing productivity and capacity for innovation…  It gave rise to a world in which everything was given to financial capital and almost nothing to labour, in which the entrepreneur gave way to the speculator, in which those who lived on unearned income left the workers far behind, in which the use of leverage, to an unreasonably disproportionate extent, created a form of capitalism in which taking risks with other people’s money was the norm, allowing quick and easy profits but all too often without creating either prosperity or jobs.

One of the most striking characteristics of this type of economy is that, within it, the present was all that mattered and the future counted for nothing. The steady depreciation of the future could be inferred from the exorbitant demand for high yields in the present. Those yields, inflated by leverage and speculation, were the discount rate applied to future revenues: the higher they rose, the lower the value of the future fell.

The same depreciation of the future could be seen in accounting practices which valued assets at the prices set by a marketplace fluctuating constantly to keep up with the ups and downs in share values. When the markets were on a high, balance sheets were reassessed, and the very same artificially boosted figures would feed a new high. When confidence fell, the balance sheets would suffer as a result and bring share prices down. During the financial crisis we saw, up close, the damage done by that kind of accounting, when the collapse of the markets led to a collapse in the banks’ capital reserves and further tightened the credit crunch.

Our entire system of representation had been falsified: the economic value of a company does not change from one second to another, nor every minute, nor every hour… To gain a clear idea of just how absurd that kind of accounting can be, we need only think of the fact that, in a market value system, a company in trouble can report a profit simply because its diminished credit rating has reduced the market value of its debts!

Each of us must hold the conviction that the world of tomorrow cannot be the same as the world of yesterday. There are indecent behaviours that will no longer be tolerated by public opinion in any country in the world.  There are excessive profits that will no longer be accepted because they are without common measure to the capacity to create wealth and jobs.

There are remuneration packages that will no longer be tolerated because they bear no relationship to merit. That those who create jobs and wealth may earn a lot of money is not shocking. But that those who contribute to destroying jobs and wealth also earn a lot of money is morally indefensible. In the future, there will be a much greater demand for income to better reflect social utility and merit. There will a much greater demand for justice. There will be a much greater demand for protection.  And no-one can escape this.

The full text of Sarkozy’s speech is HERE.  He is essentially building on the study by Stiglitz and Sen that we discussed last September, which gave poor Jim Cramer such conniptions as he called it: “So stupid, wrong and anti-empirical that it’s just downright silly that it doesn’t even dignify the use of video-tape or digital or whatever they do now.”  And now it’s the Keynote at Davos with the Dow back at 10,000, just 276 points higher than where Cramer said “sentiment is so negative right now, it’s all out of synch with reality.”

Oddly enough, Jimbo’s quote from Thursday’s show, with the Dow just 276 points higher than it was on Sept 16th, is: “This is not a dip to be bought; the sellers are too powerful and too willing to embrace any pretext like Greece, which in any other moment would have barely been a sideshow.”  So, I will attempt to summarize:  It’s BUYBUYBUY at 9,791 and SELLSELLSELL at 10,067 – talk about a tight trading range!  I’m not sure which reality Cramer will be embracing next week but Stiglitz was right in September and Sarkozy is right now – we cannot afford to go back to business as usual and if the markets want to have a little temper tantrum over a few speeches, that’s fine with us but we’re happy for a chance to do a little bottom fishing as we revisit these levels, not on any fundmental changes, but on changes in sentiment that we’ve been expecting for some time.

The aforementioned Greece took vows of austerity in Davos and we’ll see if that’s enough to stop the Euro from sliding this weekend (we hit $1.3861 to the Euro on Friday’s close, now down 8.5% since Thanksgiving.  The dollar is only up 7% over the same period and, amazingly, oil is down just 6.5% while gold is down 10% so we’ll be watching that $72.50 line in oil very closely next week.  Copper is only down 3.5% at $3.05 and holding that $3 line will be critical with no health until they get back over $3.20.

So now that I’ve caught up on my Davos reading I have to conclude that I’m still not sure which way we’ll go.  That means we’ll continue to build a mix of bullish and bearish trades into next week but, as we discussed in the Weekly Wrap-Up, we’ll also be looking at putting on a new set of disaster hedges, watching our 10,058 line closely, as we contniue to do some bullish bottom-fishing (see updated Buy List) so we can once again raise our hands and yell “wheeee” on the dips.

Are U.S. Treasuries a buy at current levels? It sounds like a nutty question… and yet there is an actual case to be made.

Should you be buying U.S. Treasuries? It sounds like a nutty question at first glance. Uncle Sam, after all, is looking more and more like a lousy credit risk with each passing day.

And yet someone is buying Treasuries – and buying in size.

The iShares Barclays 7-10 Year Treasury ETF (IEF:NYSE) tells the tale. The trend for the 10-year note has been up, not down, for the year 2010 thus far. The red circles show dramatic spikes in volume. Given that IEF is now headed upwards, we can surmise these spikes show highly motivated buyers.

In addition to aggressive ETF buying, there has been a large “mystery direct bidder” (or perhaps more than one) taking huge amounts of Treasuries directly from the source in recent weeks. As the Financial Times reported on Jan. 14, “Somebody, or a group of people, have bid directly with the Treasury and took more than 17% of the issue on offer. This is very rare… most investors still go through the primary dealer banks…”

What the FT news amounts to is that someone with very, very deep pockets – on the order of a large foreign central bank, or perhaps a savvy global hedge fund with billions under management – is attempting to build a very big bond position in secret.

Now let’s take a look at long bonds – specifically the iShares T-Bond 20+year ETF (TLT:NYSE).

Long bonds have been in a bull market for many years. Based on the monthly trend, one could argue the bull is still intact.

The huge spike you see at the end of 2008 came during the peak of the global financial crisis, when investors the world over panicked into Treasuries as a holding of last resort. Long bonds have come down since then, but they are arguably still on trend.

All Hat and No Cattle

The logic for selling U.S. Treasuries is fairly straightforward. America is drowning in a sea of debt, both public and private. One has to wonder how there can be appetite for much more.

Recent figures put the total public debt at $12.245 trillion – within spitting distance of the $12.394 trillion statutory limit. (They are going to have to do something about that rather quickly.)

In further effort to soothe public anxiety (and placate public anger), President Obama is expected to unveil a “three-year spending freeze” this week. And yet, as with many other political initiatives, this sounds good on paper but utterly flops in the real world. The “freeze” only applies to 17% of spending, and will do precious little to shrink the $1.4 trillion deficit.

Washington’s habit of being “all hat and no cattle” when it comes to reduced spending is another reason to be bearish on USTs. The great leviathan (i.e. government) has been expanding at record pace. Debt and deficits stretch out as far as the eye can see.

But again, the question remains. Given this bearish backdrop, why is anyone buying Treasuries (let alone buying in size)? The answer goes back to an area of great debate – future expectations for inflation, deflation and economic growth.

Malaise and Deflation Ahead?

The chart above shows the interest rate yield on 30-year Treasuries (i.e. long bonds). Rates move inversely to the price of bonds. That is to say: When bond prices fall, interest rates go up. When bond prices rise, interest rates go down.

By the end of 2008 – a spectacular year for long bonds – the long-term interest rate had plummeted to an incredibly low 2.6% (as you can see on the chart). As the 2009 stimulus took hold and the global economy recovered, the long-term interest rate crept back up, to its present level around 4.6%.

Those who see Treasuries as a buy believe long-term interest rates are going to fall once again. (Short-term rates can’t fall any more because they are basically at zero.) And why are interest rates going to fall once again? Because we have not yet escaped the grip of deflation, the bond bulls say, and recovery has largely been an illusion.

The Case for Deflation

If we head into a period of deflation, equities and inflation-linked investments will no longer look attractive. Consumers, focused on saving and paying down debt, will shift more of their available cash into the safety of bonds. Stagnant wages, chronic unemployment and excess capacity in a wide swathe of industries will guarantee slack prices and low morale. Government efforts to get the economy going will be like trying to start an old lawnmower… other than pulling and sweating and cursing, not a whole lot will happen at all.

The deflationists further argue that America is repeating the Japan experience. The entire world has been surprised at Japan’s seemingly endless domestic appetite for JGBs (Japanese Government Bonds) that yield next to nothing. This is the deflationary experience, the bond bulls say. In the United States, tepid economic growth will fuel a similar domestic appetite for bonds.

In further irony, the very weight of the public debt itself is expected to hamper economic growth.

Carmen Reinhart and Kenneth Rogoff are two highly respected economists who have done extensive research on financial crises and the long-run effects of excess debt. In a recent study based on data from 44 countries over 200 years or so, Reinhart and Rogoff report that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”

At $12.2 trillion and climbing, U.S. public debt is right around 90% of GDP. As it climbs further, America moves further into the well-established dead zone where growth stalls out.

Questioning Inflation

So are the bond bulls crazy? It’s hard to say. If we get serious inflation, bonds will certainly get slaughtered. (Of course, if they expected that to happen, they wouldn’t be bond bulls.)

To quickly recap, the case for serious inflation is more or less based on four inputs:

• Trillions in excess reserves created by the Bernanke Fed
• Loss of faith in Uncle Sam (a mass credit downgrade of the U.S. government)
• Supply and demand issues vis-à-vis large issuances of new debt (no one left to buy)
• Prospects for renewed economic growth (idle bank reserves flooding the system)

Deflationist bond bulls have answers to each one of the above points. They believe the multitrillion-dollar rescue effort, impressive as it may appear, actually pales in comparison to the size of the problem – like throwing a mattress into a volcano.

They further believe that talk of sovereign credit downgrades are overdone (still no viable U.S. substitute); that buyers of new U.S. debt will materialize (just as they have in Japan); and that due to economic slowdown, idle bank reserves will not be deployed any time soon.

Heed the Charts

Your humble editor’s advice? Heed the charts.

In the long run, serious inflation seems assured. If monetary history is any sort of guide, Western world governments will ultimately print themselves into oblivion. Barring that, compelling new growth-oriented opportunities will arise at some point, tempting timid savers away from their low-yield bond holdings.

And yet, the long run is very long. Waiting for inflation could well be like waiting for Godot (or waiting for the JGB bond bubble to burst).

From an investing perspective, your editor would not touch Treasuries with a 10-foot pole. He is happy to toss them into Charlie Munger’s “too hard” bucket and let someone else make that call. From a more nimble-footed trading perspective, the deflationist bond bulls do not have to be right forever… they only have to be right for a little while. And in the here and now, with the stock market looking jittery and a “flight to safety” mentality returning to the fore, the charts appear to be on the bond bulls’ side.

If you have thoughts, questions or insights to share – as related to USTs or the greater inflation/deflation debate in general – by all means send them here: justice@taipaindaily.com

Click The Chart Below To View The Video

The Mess That Greenspan Made

Even with the month of January now almost over, it’s still not too late to look at how another group of commodity ETFs and ETNs did in the year that just concluded – metals.

Earlier this month, the performance of Energy ETFs and ETNs in 2009 was examined and it was quickly learned that, while it was a good year for both investors in these commodities and the underlying commodities themselves, the returns on the former fell far short of the gains for the latter.

In one of the more extreme examples of this phenomenon, while the price of crude oil rose some 78 percent last year, the popular United States Oil Fund (NYSEArca:USO) finished with a gain of just 19 percent, no doubt leaving a large number of folks with money invested in this sector wondering what all the fuss over rising oil prices was all about.

The results were even worse for natural gas where investors suffered huge losses even though natural gas futures ended the year about where they began.

As it turns out, the wicked contango that crimped investment returns in energy commodities last year was all but absent for the entire metals group and investors who were able to set aside worries about a “gold bubble” and ignore reports about Chinese pig farmers storing large quantities of copper wire out back (and borrowing money against those rolls of wire to purchase even more) saw great returns.

After a tumultuous few years for every metal except for gold – the metal whose price rose steadily through the entire previous decade, much to the consternation of the editors at Money Magazine – prices for both precious metals and base metals ended 2009 far higher than where they began as shown below.
And, last year, the good news for investors in the 25 related ETFs/ETNs (by my count) for which full-year data was available is that they saw about the same gains as in the metals themselves, in some cases even more.

Before getting to the metal ETF/ETN returns, it’s worth looking closely at the last four years of data in the table above to see what, if anything, can be gleaned from it.

The first observation that can be made is that gold was the only metal to post gains in all four years – even in 2008 when nearly everything else plunged. Also, some of those impressive gains for base metals last year all of a sudden don’t look quite so good when you look at the large red numbers to their left.

For example, the 150 percent gain for lead in 2009 after a loss of 62 percent the year before doesn’t even get you back to even for those two years. As it turns out, lead’s gains in prior years help to put it in the top spot over the four year period shown, but not by much.

Lead’s total four-year gain of 229 percent is just slightly above that of gold at 211 percent, a fact that is not intuitively obvious when looking at the chart above as most people fail to realize just how severe losses of 40, 50, or 60 percent really are. Rounding out the top five metals over the last four years, zinc was up 196 percent, silver gained 189 percent, and copper rose 163 percent with platinum, palladium, aluminum and nickel all more than doubling.

As for investors, unless you have a futures trading account you can’t possibly have a four year history for any of these metals except for gold and silver since all but the first three funds in the table below were launched in 2007 or later, but, with the obvious exception of the inverse funds, you could have seen big gains with any of these last year.
There are just a few points to be made about the data above, the most important of which is that all of these offerings tracked the underlying commodity fairly well, most to within just a percentage point or two and even the leveraged and inverse funds were pretty close.

Of course, the “granddaddy of them all” – the world’s second largest ETF of any kind in the SPDR Gold Shares ETF (NYSEArca:GLD) – just continues to get larger and larger, now valued at around $40 billion. Since the inventory of gold bars there has been fairly steady for months, the value of the ETF just goes up and down with the gold price which, lately, has been going down.

At about $5 billion, the iShares Silver Trust (NYSEArca:SLV) is the second largest commodity fund available to retail investors. Institutional investors have access to much larger broad commodity funds such as the $11 billion PIMCO Commodity Real Return Strategy Institutional (PCRIX) which also provides a variety of share classes for retail investors.

As might be expected, trading volume has been highest in the large gold and silver ETFs, but, beyond those two, the PowerShares DB Gold Double Long ETN (DGP) seems to have attracted a good deal of interest. For all the bad news about leveraged funds last year, this one did quite well, up 46.2 percent, just below the expected 48 percent 2x gain for the metal.

The PowerShares DB Base Metals Double Long ETN (BDD) was the performance leader by a wide margin in 2009, up a whopping 228 percent, with copper and lead ETNs posting triple-digit gains.

Amid all the contango-related problems that have persisted for over a year now with broad commodity funds, energy ETFs, and agricultural funds, it’s nice to see that in at least this one sector, investors get what they think they’re going to get.

While the results for base metals were quite good last year, it remains to be seen whether this table will be full of ‘+’ signs or ‘-’ signs when it is updated here a year from now. My guess is that there will be at least a few more minus signs.

Full Disclosure – Long GLD only at time of writing.

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