Dissent at the Fed

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The release of January’s FOMC minutes had a fairly substantial impact on precious metals this week as on Wednesday alone we witnessed more than a 2 percent sell off in the price of gold. Some analysts attributed this sell off to investors closing out gold positions as a number of them had been financed with borrowed money. The deleveraging witnessed in gold futures positions could very much be attributed to the downward movement in the price, but there is a bigger picture here in terms of what we are seeing in the markets and that is the expectations of higher interest rates.

The dissent at US Fed revealed by January’s minutes highlights the uncertainty from committee members regarding the costs and benefits of their bond purchasing program known as Quantitative Easing. There is beginning to be a revelation from committee members that by supressing long term interest rates high risk borrowers are able to finance credit at what might be discounted prices. This a direct off-shoot of the actions of the Fed extending the duration of their balance sheet by holding longer term bonds opposed to paper with a shorter period to maturity. As increasing number of committee members now fear, they very well could be setting up another asset bubble in junk bonds and high risk mortgages as these borrowers have been given the potential to overburden themselves with debt. In fact, when borrowers are able to finance debt at a lower than “usual” interest rates, it means that the price of that debt is perhaps overvalued, hence the bubble.

On Wednesday, all markets took this as the Fed could be ending QE a lot sooner than we expected. Not only did commodities take a hit, but as well equities sold off as risk appetite left the market place, which is accompanied by resurgence in the greenback. If it is the US central banks approach to begin scaling back their asset purchases, the Fed would likely take a loss on the long term bonds it holds as they attempt to trade them back into the market. It’s no secret that this is the Fed’s endgame as they look to reduce the same balance sheet representing the US currency that has more than tripled since the onset of the Sub-Prime Crises. However, the doubt amongst investors is still how the Fed plans on doing this, and perhaps at what price will the market absorb this barrage of US government debt?

This alone provides rational for the potential of long term interest rates starting to rise. Simply for the fact that not only will investors require a much higher interest rate as the economy now carries a credible risk of inflation over the longer term, yet also such a sudden bond supply increase discounts prices and in turn create upward pressure on interest rates. Therefore, savings that were sitting in gold could be sold off as these funds could flow back into the market and potentially earn a more attractive yield over time. This has to do with the potential of real interest rates rising and money leaving real assets.

The question we have to ask though surrounds what happens to the hopes of this US economic recovery when the above situation unfolds. Furthermore, when the US Federal Reserve begins to tighten monetary conditions and in turn reduce their bond holdings, with very high probability the market reaction in terms of interest rates will not be quite as theoretical as I have played out. It could be accompanied by some turbulence.

To digress, I find it humorous whenever someone tells me with great certainty that gold will hit 2500 US/oz. or some other ambiguous figure in a certain period of time. I loosely believe in the efficiency of markets, and as always the price of gold is reflected in its current price. If it should be 2500 US/oz., then it would be that price today. Nonetheless, gold closing the week at 1581.19 US/oz., down 2.3 percent hasn’t spooked me from holding it as it still has value as a hedge against that economic uncertainty that will prevail.

Are Currency Wars Really our Concern?

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The G20, a group composed of finance department officials and central bankers from twenty developed and emerging market economies from around the world are meeting this weekend in Moscow. One of the main topics of discussion will be the notion of currency wars and the links to fiscal and monetary policy. This whole premise of currency wars though has sparked a fear amongst investors that there will be a period of extreme volatility in exchange rates. Quickly though, the word “war” is far too extreme. It perhaps overhypes the implications of these policies. None the less, measures to spur domestic growth do have direct implications on a country’s exchange rate, and thus are much more far-reaching.

It was earlier this week, when a subgroup of the G20 (known to as the G7) issued a statement that created much confusion and unnecessary conflict around currency devaluation. To summarize, they proclaimed that central banks are permitted to utilize domestic policy measures to stimulate economic growth at home. In essence, they are saying that it is simply okay for policy makers to be willfully blind and not consider the unintended consequences of domestic policy on their exchange rate with nations with whom they trade.

It’s my opinion that the G7’s statement is truly naïve and lacks depth. There is no question that central bankers enacted these policies to spur domestic economic growth. The off shoot, however, is that these policies often devalue their price level and in turn their currency which encourages export led growth. The reason being that when, for example, the US dollar depreciates against the Chinese Yuan, US goods can become cheaper in China as fewer Yuan are required for the purchase. So really, it depends in which context a policy is considered domestic in a global economy.

Japan, for somewhat good reason, has been scapegoated as the villain when it comes to the excessive policy of central banks, but unfortunately for them it is because onlookers have a very myopic view. Furthermore, it is a faux pas for a Prime Minister to intervene in the actions of his central bank and thus has directed a lot of negative attention. That being noted, Japan’s currency has appreciated significantly since the financial crises because the country attracted capital as a result of the lose policy from the US Fed as investors seek a safe haven. They are only attempting to restore balance in their export led economy which has been competing with a strengthening Yen and loss in productivity from an aging population.

None of the above is to act as a defense for the Bank of Japan or the policy actions of other central banks around the world. It is simply fact. Many central bankers are following the actions of US Federal Reserve and the Bank of England such that their currency is not viewed as a safe harbor to attract capital and cut them off from export markets. This is why we have seen countries like Egypt and Brazil be considered as losers because they are or perhaps were strong emerging economies that attracted capital; therefore, their respective currencies appreciated against the US dollar.

These policies, prompted by central banks are primarily intended to encourage investors to put their money back into the economy and invest in equities and businesses. It is to prompt the reinvestment of cash that has been sitting idle for the last four years. What’s unfortunate is that there has to be a cost for all this beyond the notion of currency wars. The US Federal Reserve simply cannot triple their balance sheet to finance the US Treasury’s (aka Federal Government’s) operations without a cost. Same with the Bank of Japan who will tolerate higher levels of inflation by increasing bond purchases financed by expanding their money supply to encourage economic growth. Many are predicting inflation, it could be a credit crunch, it could be an erosion of confidence in the markets, but there’s no such thing as a free lunch.

Could the US oil boom be the trigger for Canada’s Housing Bubble?

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Record petroleum exports out of the US in December contributed to the geopolitical superpower narrowing their trade deficit by more than 10 billion USD. This allowed them to record their trade deficit at what is now a three year low. As the US trimmed back their imports in the month, the decrease in their deficit was also attributed to exports surging by 2.13 percent. It’s time for Canada to determine whether it wants to continue to play a prominent role in the State’s energy production. Right now, however, it does not look like we are very proactive in expanding our energy exports anywhere in the world.

Canada’s December trade numbers were abysmal. It’s no surprise that in a month when US oil imports are at the lowest level since 1997 that our exports amount to a drag on our gross domestic product. Data from the last decade shows the opportunity Canada has had in exporting our oil to the US. In 2002, Canadian crude accounted for less than 16 percent of the all US crude imports. Estimates are that that number is as high as 28 percent in 2012, and that was during a period when the US faced a decline in oil imports. The ease and opportunity for the US to import oil from a sound Western government such as Canada has crowded out their imports from less politically stable countries.

For a western democracy, however, direct concerns of stability are more centered on our economy vis-à-vis the housing and financial markets. It is no surprise that the Canadian housing market has gathered international intention, especially following the British governments attempt to interrogate Governor-elect Mark Carney for his record at the Bank of Canada. But what we are witnessing in Canada is no different to what other nations such as the US, UK, and Spain have witnessed in the past. Each of the aforementioned countries followed the pattern of household debt levels increasing in tandem with house prices, and as a result eventually saw a price correction. As is apparent with the Canadian market, house prices are yet to correct.

It’s my opinion though, that instead of waiting for prices to correct, there lays an alternative option to bring our household imbalances into check; exploit our natural resources, which will present opportunities inclusive of job creation and thus economic prosperity. Without missing an opportunity to take a shot at President Obama, the Keystone XL pipeline should have been approved in his first term in office. If he was less worried about the Electoral College votes from the state of Nebraska and more concerned over US job creation, greater volumes of Tar Sands crude would already be heading to the Gulf of Mexico. For that matter, when the opportunity arises to sell crude or natural gas to Asia, we’d rather flip flop around the actual issues and glorify so called environmentalists.

Beyond Canada’s housing market’s relation to that of the US, UK, and Spain, we’re not that different from other small western nations that have witnessed both real estate prices increase and been hindered by an appreciating exchange rate. Countries like Switzerland, Sweden, New Zealand, and Singapore have all fought a stronger currency while attempting to grow their economies, and in turn their housing markets attracted capital. The real assets of these nations are what investors perceive to have value when there is global uncertainty in equity markets. That is why when people suggest we are amidst a recovery, that people start to question whether home prices are overvalued.

In very simple terms, Canadians on average are overleveraged. We are holding too much debt. Why then, when there are present opportunities to relieve household imbalances are we balking at the opportunity to prosper as a nation?