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Why the Dollar Could Strengthen - A Lot - From Here

50-100% appreciation possible in the next few years
Tuesday, September 16, 2014, 10:50 PM

Executive Summary

  • The critical role of interest rates and carry trades
  • How capital flows across borders
  • The growth in supply of dollars is slowing
  • The rationale for the dollar strengthening from here by 50-100%

If you have not yet read Is Part 1: The Dollar May Remain Strong For Longer Than We Think available free to all readers, please click here to read it first.

In Part 1, we reviewed the key concepts that drive supply/demand (and thus the price/relative value) of the U.S. dollar. In Part 2, we’ll cover the dynamics that could push the value of the USD vis-à-vis other currencies much higher in the years ahead.

Interest Rates, Bonds and Carry Trades

To understand the price of any currency—measured in other currencies, gold, oil, etc.—we look at a currency as a special kind of commodity, one that greases transactional trade of goods and services and also serves as a store of value. Like any commodity, its price relative to other commodities is determined by supply and demand.

If demand is strong and supply is tight, the value will increase. This is the same for dollars, gold, oil, grain, bat guano, etc. The reverse is equally true: if demand slackens and supply balloons, the value will decline.

To understand the supply and demand for currencies, we need to understand the role of interest rates, sovereign bonds and carry trades.

The connection between interest rates and demand is self-explanatory: if interest rates paid at home are near-zero, and another nation’s bonds are paying a higher yield, it makes sense to sell (or borrow) one’s own currency and buy a bond denominated in another currency.

This is the foundation of currency carry trades.  PP.com’s own Davefairtex recently offered an excellent explanation of how carry trades work on the Gold & Silver Group forum:

I believe that QE causes inflation in other countries by dropping rates to 0% which encourages carry trades, whereby traders borrow USD for extremely low rates here in the US, and then send it overseas to find a yield.  Cheap money in the US causes money to flow elsewhere, where rates are higher.

Carry Trade For Dummies:

Step 1) Borrow $1 billion US at LIBOR-1M rate; cost 0.16%.

Step 2) Trade $1 billion US for 1.075 billion AUD.

Step 3) Buy 1.075 billion 2-year AUD govt bonds; yield 2.52%

Step 4) Collect $23 million USD/year for doing no work at all.

Carry trades work in both directions for the dollar... » Read more

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Russian Energy Sanctions Will Bite Europe

And possibly the world
Tuesday, September 16, 2014, 2:44 AM

For several months now, we've been running with the hypothesis that Russia would wait until fall arrived and then begin to crimp off EU gas, possibly even just cutting it off.

Well, even though fall is still officially a few days away, Russia has begun to retaliate, subtly, by diminishing the flows of gas to several European countries. » Read more

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Off the Cuff: The Many Reasons To Fear A Market Correction

Just too many signs of instability
Thursday, September 11, 2014, 6:02 PM

In this week's Off the Cuff podcast, Chris and Charles Hugh Smith discuss:

  • The Irrational Altitude of Asset Prices
    • Too high, for all the wrong reasons
  • Dollar Strength
    • The dollar's rise is impacting all assets, some not rationally
  • The Cost of Our Failing Policies
    • We're diminishing the prosperity of future generations
  • Signs A Market Correction Is Beginning
    • Which asset classes to watch closely
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How to Hedge Against A Market Correction

Reducing the vulnerability of your portfolio
Wednesday, September 10, 2014, 12:04 AM

Executive Summary

  • What you need to know about hedging with
    • Stops
    • Inverse and leveraged ETFs
    • Shorts
    • Options
    • Futures
  • Deciding which hedging instruments are appropriate for your portfolio

If you have not yet read Part 1: Defying Gravity available free to all readers, please click here to read it first.

OK - hedging sounds prudent. But how do you do it?

Our focus here in Part 2 of this report is to cover the most common vehicles used in hedging strategies. Each one merits its own dedicated report (a series we'll likely create in the future) to truly understand how and when to best deploy, so this report will focus on providing you with a good introduction to each, with guidance on how to further explore the ones that strike you as appropriate for your needs and personal risk tolerance.

Stops

An easy way to limit your downside on large positions in your portfolio is to set stops.

(Stops can be used on positions of any size, but you'll typically want to employ them on your largest ones first, where your exposure is greater.)

stop order (also referred to as a "stop-loss" order) is used to trigger the sale or purchase of a stock once its price reaches a predetermined value, known as the stop price.

As an example, let's say you bought a stock for $50. You may decide you want to limit your maximum loss on the stock to 10%, so you enter a stop order for $45. Then, if the price of the stock subsequently drops below $45, your stop activates an order to sell the stock at market.

If instead of falling, the stock you buy climbs higher, your stop is not triggered and you continue owning the security.

As the name "stop-loss" implies, stops are intended to help you... » Read more

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Why The Dollar Is Gaining Strength

Warning us of another impending financial crisis?
Monday, September 8, 2014, 8:30 PM

Recently, the US dollar has gained at lot of territory compared to the yen, pound, euro, ruble, and pretty much every other currency you can think of. The dollar is now at a 14-month high and has been on a real tear.

The reasons why are not that hard to understand, and it's important that we do. » Read more

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Off the Cuff: Demand Has Disappeared

The fundamental failing of the global economy
Thursday, September 4, 2014, 10:24 PM

In this week's Off the Cuff podcast, Chris and Brian Pretti discuss:

  • Demand Is Drying Up
    • There's just no market pull to create economic growth
  • Phantom Profits
    • Todays corporate earnings are accounting mirages
  • The End Of The Debt Supercycle
    • We've grown the economy through debt, and it can't handle more
  • Blame The Central Banks!
    • They're responsible for today's zombie economy
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The Bad & The Ugly

Lack of final demand is the key constraint for this cycle
Wednesday, September 3, 2014, 1:02 AM

Executive Summary

  • Lack of demand is the key drag on economic growth. And there's no end in sight.
  • Private sector credit expansion just isn't happening fast enough
  • Why the central banks' "wealth effect" policies have been a total bust
  • Capital flows are simply chasing yield, precious little economic productivity is being created

If you have not yet read Part 1: Where To From Here available free to all readers, please click here to read it first.

The Bad 

Who wrote this tired sea song set on this peaceful shore?  I think you’ve heard this one before…

~ Steely Dan

As mentioned, at least for the small business community, availability of credit has not been a key fundamental issue in the current cycle. In fact, their number one issue of concern for years has been lack of final demand.

Personally, I believe the experience of the small business community is simply a microcosm of the larger domestic and global macro. Subdued final demand IS the key macro. Is this why we see a growing gap between small business perceptions of credit availability and actual capital spending? Probably. The credit is there, but actual final demand that would support credit expansion is not. Hence the current cycle divergence in what has been a very tight data series correlation between credit and cap spending historically.

Of course this is a segue into a broader dark cloud of the current cycle that is private sector credit expansion, or more correctly, lack thereof relative to historical experience.  When we listen to pundits speak of the economy potentially reaching “escape velocity”, they are of course referencing prior economic cycle growth results, aided and abetted by prior credit expansion that is now lacking. This is perhaps most dramatically seen in the rhythm of banking system credit, in the change in actual loans and leases outstanding.

As is clear in the chart below, never in any expansion cycle of the last four decades at least has banking system credit not grown in double-digit territory until... » Read more

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Off the Cuff: Warming Up The Helicopters

Yes, they're now talking about giving cash to citizens
Tuesday, September 2, 2014, 9:58 AM

In this week's Off the Cuff podcast, Chris and Mish discuss:

  • Winter Is Coming
    • Russia's trump card
  • Europe Back In Recession
    • The EU's structural weaknesses are re-emerging
  • Bond Market Madness
    • Risk is terribly underpriced right now
  • Helicopter Drop Trial Balloon
    • Yes, they're now talking about giving cash to citizens
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Something Very Wicked This Way Comes

Namely: certain & severe crisis when the bond bubble bursts
Wednesday, August 27, 2014, 8:17 PM

Executive Summary

  • How sovereign debt is becoming larger and more mis-priced each year
  • Why corporate borrowing is accelerating, but only being used for non-productive means
  • Junk bonds have never been priced so low (ever), indicating a complete denial of risk
  • Today's record bond prices are supported by near-historic low (i.e. extremely tenuous) levels of volume
  • Why, mathematically, nearly no-one will be able to exit unscathed when this overinflated market rolls over

If you have not yet read Is Part 1: I Blame The Central Banks available free to all readers, please click here to read it first.

Italy: Insanity On Display

Let’s look at one of the sovereign entities that has piled on the debt to staggering levels. In this case: Italy.

This can serve as a template for understanding the rest of the insanity that exists in the global sovereign bond market.

The rules for lending to a nation should be roughly the same as lending to an individual. You’ve got some measure of the country's credit-worthiness that needs to be taken into account, plus an assessment of its income.

After all, the future principal and interest payments have to come from future income. If there’s too much debt compared to income, then there’s an increasing risk that the debt servicing payments not only will not be made, but cannot be made.

Italy’s sovereign debt has been expanding enormously as the government borrows and spends. Its national debt finally cleared more than $2 trillion euros early in 2014:

Italy's public debt hits record 2.1072 trillion euros

Apr 14, 2014

(ANSAmed) - ROME, APRIL 14 - Italy's massive public debt hit a record 2.1072 trillion euros in February, the central bank reported Monday. The amount was up 17.5 billion euros since January, the Bank of Italy said.

The European Commission has criticized Italy's 2014 budget for not doing enough to bring down debt, around 132% of gross domestic product (GDP).

As a result it has put Italy under "specific monitoring" over its "excessive macroeconomic imbalances", which include high debt and poor competitiveness, as part of an in-depth review.

(Source)

Italy raked up significant debt at a far faster rate than its underlying economy was growing, leading to a steadily rising debt-to-GDP ratio as seen in this next chart... » Read more

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The Trouble With Natural Gas

The current 'bonanza' isn't nearly as good as promoted
Monday, August 25, 2014, 8:56 PM

One of the areas where there's an overblown amount of overtly politicized and outrageously propagandized information is shale natural gas (NG).

The US, for obvious geopolitical reasons, would love to supply Europe with NG and cut out Russia. But as we'll soon see, the basic facts just don't back up that desire just yet. » Read more