Malice in Wonderland – Steering a Safe Course through the Distortion – Dec 14, 2012

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

Malice in Wonderland – Steering a Safe Course through the Distortion

This week, the Fed/FOMC determined that support of the mortgage market was still necessary. Some form of Operation Twist was needed to continue in the Treasury market, even if by another name – a rose is still a rose. As expected, roughly $85 billion (with a b) per month will be used to manipulate rates lower – creating a sense of calm, but distorting reality at the same time.

We often note that by intervening in a market, you can 1) distort asset values, sometimes to the point of creating a bubble, and 2) destroy price discovery. In a normal market, the process of price discovery is ongoing as buyers and sellers go back and forth, “haggling” and ultimately agreeing on the value of an asset. This discovery process is destroyed when market manipulation exists at the level we are witnessing today. Thus, we see pricing and yields distorted at present, yet regarded as accurate by many market practitioners who still consider the yield curve as a source of legitimate information.

12-12-12The truth of the matter is that this week, as in previous FOMC soirees, we’ve seen the market grow more and more comfortable with this pseudo-reality. The only concern of the market is that the Fed deliver more money than ever before, forgetting to look ahead to the consequences of present market distortion (Fed generated) and the unwinding of current commitments. We know that, on Bernanke’s watch, rate suppression will continue unabated.

Still, the Fed balance sheet is not expanding – it sits near $3 trillion (50:1 leverage), and is holding steady. We expect to see growth in the balance sheet later in the year as events necessitate extraordinary measures from the Fed. Not all of those measures will be balance-sheet-neutral (as were Operation Twist and its successor program, which amounted to swaps of one piece of paper for another, and were thus neutral). The next expansion will stoke concerns about inflation and rapidly rising rates because any “exit” from such a monumental commitment would necessitate capital losses for existing bond holders and entail higher rates.

Inflation remains a critically underestimated element even at the present time, with tail risk concerns focused on the deflationary end of the continuum. If the Fed were not buying 90% of the paper issued from the Treasury, there would at present still be sufficient buyers to maintain low rates (arguably not as low as we have now), but the market would be prone to quicker turns, operating as a true market and not a contrived and controlled one. Which comes first: overwhelming market forces or the Fed running out of money that is still trusted?

Tying loose monetary policies to an employment number (Ben B’s easy money policies will be in place until the new target of 6.5% unemployment is reached) may neglect changes in the labor force that are not likely to be undone anytime soon. For instance, when a company achieves productivity gains through hardware and software improvements, some lost jobs simply don’t come back. The consensus suggests that we will return to an environment like that of the past 20-30 years, with a rapidly expanding labor force that grows faster than the population. That is not necessarily the case. There is the productivity issue in play, but, additionally, we view a return to a robust economic cycle to be nearly impossible at present, considering the current state of the credit markets.

Precious metals are at a unique technical juncture. The gap between the 40- and 65-week moving averages continues to shrink, suggesting that the consolidation of the last 16 months is nearing an end. In the past, such action has preceded a major move higher. While such a move may be months away, January fits a number of our time studies as a probable turning point.

Meanwhile, short-term traders are in and out of metals just as they are in and out of stocks – with every Fed gesticulation or partisan fiscal cliff comment. The short term is relevant in the short run, but ultimately does not matter (don’t let it drive you crazy, or cause a shift away from primary trends). ETF purchases of metals have remained steady (which is an indication of consistent investor traffic into the space) and central bank announcements of purchases by the ton continue unabated.

The critical driver of metals prices in 2013 will likely be the challenge of smaller supplies alongside this steady demand. Supplies from scrap appear to have peaked, and, as the second largest and only semi-elastic source of ounces, suggests next year will be good for supply demand fundamentals. Easy money will act as an accelerant, but not the primary mover. Recall the lows nearly six months ago at $1532 and silver at $26. Progress has indeed been made from those levels. Our interim target is $1800, and then to new highs (with silver outperforming) in 2013. We will explore this fully in our year-end client letter and performance report.

Best regards,

David McAlvany
President and CEO


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