It was a dull week for the stock market - the S&P 500 tacked on all of 4 points (0.47%) - but this may well be remembered in the future as the pivotal week in the great financial crisis of 2007-?. This was the week when the world finally recognized the damage wrought not by the financial crisis, but by the US government response to it. We will never know what the consequences would have been if we had simply allowed the market to work and the government had allowed failed companies to actually fail, but we are beginning to learn the consequences for what the government has actually done - and this week brought the picture into a little sharper focus. It isn’t pretty.

When the Federal Reserve announced in March that they would spend $1.75 trillion buying up Treasury, Agency and mortgage backed securities, the bond market initially reacted positively to the perceived increase in demand. The rally lasted all of one day. Why? The Fed’s commitment amounts to a drop in the bucket when compared to the size of the current market (very roughly around $20 trillion) and the ability of the Fed to influence that market diminishes as the amount outstanding continues to rise to fund our massive government deficits. With supply rising rapidly, just maintaining the current price would require a similar rise in demand and this week it became evident that the Fed’s $1.75 trillion is woefully inadequate to the task. As the minutes of the latest FOMC meeting made clear, some on that august committee are starting to realize that fact.

Long term bonds peaked in price at the end of last year and have fallen persistently since. In fact, although it hasn’t been widely reported, long term Treasury bonds are in a bear market that has seen investors lose over 20% of their principal just since the peak in December. Shorter maturities haven’t fallen as far and the reasons for that are also becoming clear. The largest holders of our debt are changing the composition of their holdings. The Japanese are now running trade deficits and seem unlikely to expand their holdings as they attempt to prop up their domestic economy. They may soon become net sellers of Treasuries. The Chinese have dumped Agency securities over the last year and are now mostly buying short term Treasuries and may be selling their longer maturities. Middle Eastern buyers are also trying to prop up their local economies and are buying less. And what they are buying is concentrated in short term maturities.

The Fed conducted a coupon pass last week, which is just an auction process in which they buy Treasuries, and bought $7.4 billion in maturities ranging from 2013 to 2016. Unfortunately, there were $45.7 billion in bonds offered in the auction. In other words the supply of bonds available for sale swamped the artificial demand created by the Fed coupon pass. When supply exceeds demand the price falls:

7-10 Year IShares Treasury Bond

A similar phenomenon can be seen in the market for the US Dollar. While the Chinese may not be dumping dollars en masse as many fear, there doesn’t seem to be a lack of sellers.

The Chinese are slowly diversifying their reserves out of dollars, but they are only one participant in the market for US Dollars. While everyone seems to fear that the Chinese will just dump the dollar, that fear ignores two realities. First of all, dumping their dollar holdings is not in the best interest of the Chinese. They would only hurt themselves by devaluing the dollar and further limiting our ability to purchase what they produce. Second, the US dollar market is so large even the Chinese cannot control it. It is easy to forget, but during the time China was accumulating most of those dollars, the value was falling pretty steadily.

The value of the dollar is subject to the same market forces as any other commodity and when supply exceeds demand the value is bound to fall. I don’t think it is trivial that the amount the Fed committed to buying Treasuries, Agencies and mortgages is essentially the same as the expected Federal deficit this year. The Fed has signaled to the world that they will monetize (print new money to buy) the new debt being issued to fund the spending fantasies of our profligate politicians. Without knowing how long this experiment in creative financing will last, holding dollars would seem to be a high risk endeavour. The response by investors last week was to buy the only money that governments can’t debase - gold:

Oil also continued to rise last week:

The commodity index ETFs are not rising as rapidly as oil or gold, but they are rising:

Non dollar denominated bonds are also rising as the dollar falls:

I increased our holdings of International bonds (BWX) and commodities (GSG) last week. This trend is a little extended at this point so I’ll likely wait to add more, but the trend seems well established now and I see very little the Fed can do about it. They can expand their purchases of Treasuries but it seems unlikely they can buy so many that it will offset the increase in supply from new issuance and the selling of existing holders. Furthermore, if they expand the purchases that will require more dollar issuance which will be perceived as inflationary and further expand the pool of Treasury and dollar sellers.

The Fed’s policies have implications for the US economy as well as the value of our bonds and currency. Inflation - and that is what this is even if it hasn’t shown up in the CPI yet - will cause economic activity. If the value of the dollar continues to fall, the hoarding of cash that the Keynesians so lament will come to an end and the resulting activity will show up in the economic statistics that, when aggregated, compose GDP. This growth will largely be an illusion - the price rises take time to show up in the government calculation of CPI - but it will be growth of a kind. And that can translate into higher stock prices - until the Fed has to address the inflation.

The US stock market has stalled at the 200 day moving average as I predicted:

Foreign markets are in better shape technically:

IShares Latin America

IShares EAFE

IShares Asia ex-Japan

While I suspect there is further upside to the US stock market over the next couple of months, the falling dollar favors the foreign markets. If there is further correction in stocks, I will likely use that opportunity to add to foreign stocks at the expense of the domestic market.

The economic statistics released last week were sparse and relatively unimportant. Housing starts fell to a record low but that was entirely due to a fall in multifamily starts. Single family home starts were up. Jobless claims fell slightly, but the trend in falling claims seems to be moderating. The best release of the week was the LEI which rose for the first time in seven months. The economy is in a bottoming process and as I said last week, we are in a transition period from the data getting less bad to actually getting better. There is no way to know how long that process will take, but I still believe it will happen quicker than the consensus currently expects. The monetary policy being applied by the Fed, as we saw this week, is powerful stuff and has real world consequences. While I think the long term implications are quite negative, the short term outlook is likely to improve.

I am in the process of writing a longer piece on the long term outlook and hopefully that will go out next week.

To sum up:

• Long term Treasuries are in a bear market and selling accelerated last week.
• The US dollar has resumed its downtrend
• Gold and commodities are reacting positively to the falling dollar
• Foreign markets are relatively more attractive than the US
• Economy in transition, but data is likely to improve in the short term