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Sunday, December 07, 2008

Conversations with a trader

I have been having a conversation (or disagreement if you like) with a forex trader which will provide an insight into 2 people’s thinking on a few issues...people get pretty heated when it comes to understanding the global economy, but hang in there. This trader kicked off the dialogue with a press release. I'll disguise his identity because it serves no purpose to disclose it, and it was a private conservation.

Over the last couple of years a couple of the major warnings we have been clearly stating have taken hold this year;

1. Credit to implode: started, but we should have a long way yet to go as subprime and highly leveraged instruments are the first two steps in a 50 year overuse of credit.

2. Short Financials: spot on

3. Looking for a massive devaluation of all assets and major pullbacks in most major indices and markets: underway

4. Looking for either Ford or GM to not exist within the next 2-5years: cracks becoming more evident now, lets see what the government pulls out of its….hat.

5. Dollar strength as a safe haven and place where unwinding assets highly leveraged would have to go: underway

There are a number of other opportunities that have arisen but these as you are likely now aware of, are a few of the bigger ones.

The question then beckon’s….where do we go and what do we do for 2009???

The biggest answer is going to be CASH! Cash takes a number of forms in deflationary periods, such as increasing savings and paying down debt…….but another cash play that the average person cannot usually take advantage of is the trading of financial instruments such as currencies and indexes, bonds and commodities.

Well this differed from my view of the outlook so I was intrigued....I responded....

Why does there need to be an asset price collapse? Can't currency just be debased by creating more credit or printing money? Do you think the government is going to do nothing? For that reason I just bought a house in NZ. They produce food. I guess South Africa would be good too given the precious metal exposure, but the crime, and also a lot of these precious metal producers will go broke when the currency rises again, as happened last time. So for silver/gold stocks Aust is better, or USA/Canada.

Hi Andrew, it is all just a matter of opinion and analysis, but the devaluation of assets should encompass all assets in even the countries you mention according to our analysis. NZ has already experienced a 30% drop across many areas, hope you were able to buy after the dip. Australia I feel will eventually experience even heavier falls than NZ as they have a larger economy reliant on commodities as you mention and larger debt. NZ is often a safe haven currency and at some point shall find a reasonable bottom as
debt will only run so far in NZ versus countries such as Australia. As far as Gold/silver we have already seen 38%-45% drops already which may mean we are close to a bottom, but I wouldn't be looking to those assets as lifesavers during the next couple of years particularly....CASH will be King!

Yep, I appreciate the need for asset deflation, but there is also an opportunity for ‘cost of living’ inflation as well. Afterall in an emergency governments can also print money or subsidise debt creation. I think NZ is just as reliant on commodities as Australia, just Australia has more diversity, and obviously more towards minerals. NZ has greater welfare statism, less savings, but a new PM should change that. NZ debt is pretty bad as well, but Aust has compulsory savings scheme of around 9-10%, compared to just 2-4% in NZ. I wouldn’t call NZ or Aust safe haven currencies, as they are both extremely volatile, which is why they are traded relatively more compared to their economic significance. They are great countries though because they have a natural hedge. Commodity prices collapse, so does the currency, which is why you buy assets in such countries - - when they are cheap that is. When asset prices bottom as you are alluding too, we will see more ‘cost of living’ inflation. The governments will not allow a total wasting of assets, so there will be some stimulus. And I agree with gold, we should see some upturn soon, though the best equity prices I think were available in the recent dumping.

Just quickly to clarify, I don't see a turn up soon in Gold....I see a lower bottom followed by a number of years in a range trade that may eventually pop higher. As for governments and their ability to fix problems, I do not agree. I believe governments help make problems bigger and serve to eventually hurt those they seek to protect, therefore I don't agree with much of what you have said regarding debt creation. We are already at an historic high in terms of debt worldwide and that credit bubble is the cause of the problems....creating more debt will not fix the problem. Savings levels in Australia and the rest of the western world is horrendous regardless of the enforced superannuation which really is useless in terms of savings.

I don't understand your reasoning of hedging either? Why would I buy property in those countries if I believe the asset values have a lot further to fall and that the currencies also have a lot further to fall? On the currencies, a major reason volumes had been high in OZ and kiwi dollars was the carry trade and false belief that the commodity boom would last forever based on the China and India phenomenon....a joke in itself that don't have time to cover here. As for inflation, I do not see any chance of it over the next 5 years at least.

Wondering why you are negative on gold? Because of current asset deflation? Holding up quite well really given the collapse of other asset markets. I didn't mean to suggest government was a solution, merely that governments think short term and have a desire to hold up asset prices (keep people solvent) if it serves their short term interests. In that sense I see them increasing spending, in cases like Aust & NZ, and even the USA can print money or underwrite credit creation (since they are the base currency) without much concern. And yes I agree, they can only defer the problem, to the extent that problems can be deferred....that's why I see more inflationary outlook than you, and thus higher gold.

Yep, I agree with some of your points on debt, but in the short term option I think there are more possibilities than simply unwinding private debt through liquidation or foreclosure, though there will be some of that. I think the government will take over where the private sector left town. This will of course debase currencies through inflation & higher interest rates. This keeps asset prices artificially high and tax revenues healthy to fund more unemployment. There is a tendency to treat inflation as simply a demand phenomenon, but it actually has dual elements - assets and cost of living, and they are not just a demand phenomena, but a monetary one, as I see it.

I wasn't suggesting that Australian savings will fully salvage the Aust economy, just its a positive over NZ which has none, but NZ is more positive in that food is a greater necessity (my assertion) than over-supplied iron ore given the capacity increases. More farms are becoming housing, lifestyle jaunts, or unsustainable in the case of Japan, EU and aspects of USA.

By 'natural hedge' I mean that commodities are denominated in USD terms so commodity prices have collapsed, but so have the currencies of commodity produces. If I can shift money from yen or USD to those currencies (as I have done), then I can position myself for the day (say in 4-5 years) when that surplus mineral producing capacity is absorbed. By hedging I mean that as commodity price falls in USD terms, the price in AUD or NZD term improves, or stays steady. Look at gold in $AUD terms, its never been higher. That will eventually be reflected in gold stocks there. The other metals are less impressive because of poorer outlook, say nickel, the collapse in AUD nickel is not as bad given the collapse in currency. That is why Aust always fares better in these times, same as NZ.

You argued that the AUD and NZD will fall further...hmmm..I don't see that because of the hedge impact I am talking about. I've not looked a great deal at them lately because I've been travelling, but I'd see them as close to a bottom. [I would say NZD will fall to USD50c]. That’s fine because the house I bought was on vendor finance and from a low $NZ point, and I have Yen assets to sell as well.

Well I kinda agree with your points on carry trade, other than the fact that I see the carry trade opening up again some time in the future when Japanese have more confidence. The currency is low, it offers superior yields to yen, the $A denominated revenues from mineral exports will be high, so Japanese investors who sold can now rebuild these positions. The carry trade is dynamic. Confidence was undermined, as it should have been, once the market sees a bottom, they will do it again. Clearly you see further falls, so that thinking might perturb you. I dare say Japanese investment banks will wonder about Aust+NZ monetary policy for a while, maybe wait to see the swap rate widen again.

Wondering why you dont see any change in inflation?

Interesting to see where you are going with your line of reasoning, but I tend to think we are in a completely different situation than the recent past. I see the majority of the world coming together in an almost zero rate monetary policy in reaction to these stresses, and therefore much of the carry trade thinking will have to change especially amongst the majors for a sustained period I would think. I don't believe interest rates will increase for a number of years.

As far as hedging with commodities, I think that is flawed as commodities and all demand and currencies come off although I agree that the USD should grow in relative strength as time moves forward....the problem is that demand once reduced significantly will mean reliance goes back to domestic demand and therefore negates the idea of hedging based on USD values of commodities.

Gold is down to around 770 at the moment from over 1000 and should target around 580-650 before more of a bottom is hit....and may then experience a few years in a range before it can see nice moves. But as you say if the Aussie gets down to below its previous lows of 45 to the US then Gold will start to gain in relative terms....but at what opportunity cost to other investments?

I don't think it makes much difference whether it’s a zero rate (as it was in Japan) or 3%, if nobody is lending then rates don’t much matter. I paid cash for my house despite having 80% equity. Safest loan they could have, they are just not interested despite the rhetoric of interest rate cuts, and the promise of a first home grant of $21K also makes policy look like stimulus, but if you can't get finance then it makes little difference for anyone except those buying $80-100K rural houses.

The carry trade will always be there, traded in & out of, because it is inherent in the risk premium that countries like Australia and NZ will always require. I was not suggested trading commodities; I was suggesting Australia receives more money in AUD terms because of lower AUD than it would if higher against the USD.

Yep, most commodities will stay weak. I differ on precious metals of course. My argument is that Japan could retain a zero policy rate because it was stimulating the economy with that zero rate by keeping its currency low, exports boosted at a time when it was adjusting to lost competitiveness, ie. shipping manufacturing capacity to China. If no one is growing, then governments are inclined to create stimulus rather than rely on exports. Aust & NZ get it from a lower currency, creditor nations get it by govt spending, debtor nations like USA get it from printing money, as long as they can sustain those policies, and policies only need it to be a short term solution for them to embrace it.

The idea of 'hedging' is used metaphorically. You can't deny if there is no demand for industrial commodities, which we both seem to agree, then the commodity price is low but also commodity currencies. Funds places in those countries make good sense at those levels, though these positions you have several years to place. Also, any export earnings from those countries have a higher local dollar value than they would under a strong economy. The perfect example is gold because it has not change much in price despite the collapse of the metal price complex. It is now in AUD terms far stronger than it was when the AUD was strong ($A1250/oz last time I looked to $A950/oz) before.

As for low inflation...I believe we are headed for deflation especially in the US and Europe. As for OZ and NZ...well, let’s see how the markets react over the next 3 months to get a better gauge. Should be a very telling period as the markets need to make up their minds before committing on a direction and nothing like a nice bounce to find out if the bounce will be a false one or the start of a further rally.

[Didn’t get an answer to my question]. Ok, I think you want to wind up this conversation. I engage in these conversations because you do learn. I learn even by talking to people who know little because they will help me express what I want to say, bring a new perspective, and most of all I am challenging myself by thinking about the words I say. I agree with you on inflation, but its important to differentiate between 2 types of inflation:

1. Asset inflation - currently falling

2. Cost of living inflation - non traded things, mostly expenses like rent, food, but there is some overlap.

That period of supposedly low inflation was actually a period of high (asset) inflation. most people dont even understand inflation. The media doesn't, many economists dont.

Here is a good article from the SMH - just arrived this instance.
http://business.smh.com.au/business/markets/the-bond-bubble-20081208-6td7.html?page=fullpage#contentSwap2
Some inflationary worries - printing money or credit creation it’s all inflationary to me because it’s all money creation with no corresponding productive capacity, not that the economy needs any at this point. But it will hold asset prices higher until prices are eroded by inflation, which as I say will be there intent. They are not going to let asset prices collapse too much, they will debase money to restore a monetary equilibrium.


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Andrew Sheldon www.sheldonthinks.com
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