Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Interest: So Small a Thing, Yet So Important: Interest rate volatility haunts only the most committed of nerds. It is truly a more obscure market than most. Bonds are not as actively traded as stocks, prices are not re-marked to market on a second-by-second basis, and the bond market thus exists with an opacity that leaves the general public in the dark regarding current market status or longer-term trend. In recent days, however, activity in the interest rate market should have everyone’s attention, the least nerdy included.

We want to look at three questions that have come into greater focus, one of which is of personal importance to every home-owner in the country. First, is there another leg down in housing immediately ahead of us? Second, is the bond market today heralding a bond bust tomorrow? And lastly can BAB be turned into BABE, and will that help California in the least? (We can explain, just stick with us.)

Housing: If the recovery in housing has been slow to launch, even with near-record-low mortgage rates and continued unemployment pressuring households and adding to foreclosure inventories, what happens when rates begin to rise and the payment cost of housing moves further out of reach? Clearly, it will put downward pressure on the sticker prices of those lovely and readily available homes.

Mortgage rates hit a low of 4.17% a month ago (the lowest since 1971for a thirty-year fixed). They are now 4.87% (I want to meet the lucky soul that locked in at that bottom rate). While still ridiculously low, the impact of a 17% rise in the cost of capital is not insignificant. It can impact the marginal home buyer’s ability to squeeze into the dream house. And trust me, we need every buyer possible to soak up the current stock of homes.

Bottom line: Rates are moving higher and home prices lower. Inventories are plentiful and likely to remain so until prices reflect, not bargain pricing, but bankrupt pricing. This will in turn have a negative wealth effect as it strips equity out of family balance sheets. So, with the Bernanke presses gearing up for rapid dollar deployment, the two critical wounds in our economy (unemployment, and housing) continue to fester. The first round of QE, focused on housing, has failed. We believe the second, focused on treasuries, will share the same fate.

Secondly, by the looks of the ten-year Treasury and the long bond, there is more than a little indigestion following the Thanksgiving holiday. Bernanke and Obama are watching the bond markets reject the idea that all it takes to cure these economic ills is a little more liquidity (amply provided from the Fed spigot). Similar to mortgage rates, Treasuries have very quickly reversed course, with prices plunging and yields moving higher. Higher rates are of course an inconvenience when you want to roll over old debt, and, even more, vexing for those that already own treasuries. These are real-time capital losses.

Finally, as you observe the chart below of the 20 Year general obligation municipal bond market composite, you will see that rates have moved up over 26% in a matter of weeks. Look down and to the right, and you’ll see the market responding to the pending expiry of the Build America Bond (BAB) program. According to Bloomberg, this government “subsidy pays 35% of the interest on qualified state and local government bonds” – in essence, propping up more than a few states that have problems with debt.

Mr. Obama has not yet sought our advice, but should he request it we might offer a new acronym for the state life support program set to end in a matter of weeks. We suggest he call the next one BABE, the Build America Bonds Eternally, because this state-level crisis has only just begun. The number of states that are going to need something attractive to distract from the realities of insolvency are growing, and, in offering this suggestion, we’re just trying to think like the feds do.

2. The Dollar Index Debunked: Clients often inquire about foreign currencies and their viability as an investment alternative to the dollar. Today, I wanted to illustrate that investing in other currencies simply because they are not the dollar could lead to a costly lesson in financial relativity.

Let’s use the dollar index (chart shown below, DXY: US) as a base reference for this illustration. One would assume that, given the Fed’s record of obscene monetary activities, the dollar would be falling at light speed. Instead, we see here that the dollar has in fact formed a series of “higher lows” from March of 2008 – just prior to when the crisis began.

You might ask how this is possible. Well, when you look at the countries that make up the index, it all becomes clear. In percentage composition, the euro makes up 57.6%; the Japanese yen, 13.6%; the British pound, 11.9%; the Canadian dollar, 9.1%; the Swedish krona, 4.2%; and the Swiss Franc, 3.6% of the index.

All of these countries are connected in some way to the ongoing credit crisis here at home, and all have, to varying degrees, printed money to stave off a financial meltdown. Showing you a chart of these currencies may prove to be superfluous, as, for the most part, they reflect the same sideways pattern seen in the dollar, but in inverse order. Instead, let’s look at some charts of these currencies priced in gold over the same time period (since the beginning of ’06) as the dollar chart.

The euro (gold is up 135% in EUR terms):

Japanese yen (gold is up 89.4% in JPY terms):

The British pound (gold is up 187.82% in GBP terms):

The Canadian dollar (gold is up 122% in CAD terms):

And the Swiss franc (gold is up 99.88% in CHF terms):

So, if you were to measure the value of the U.S. dollar using the dollar index – or any currency comprising the index – you might be lulled into a state of complacency. Taken on their own or compared to each other, they fail to tell the story. In reality, your purchasing power against tangible assets – the “real currencies” – is diminishing. As the charts above show, that also goes for many of the foreign currencies you might want to invest in. Got Gold?

Have a great weekend.

David McAlvany
President and CEO

David Burgess
VP Investment Management