Is the American Government the Place to Park Your Money During Dangerous Times?


A Weak Week?

Stock markets around the world got the jitters, stumbled and then face planted. And that was just the first two days. Will the mud stick, or will the market get up and go-go-go from here on?

Why not ask Bill Bonner?

“We’ve had our bounce. Now, we’ll take the long slide down to the ultimate, final, this-is-where-it-stops end.”

Personally, I don’t think sliding is quite the right word. Indexes don’t slide around, they get pushed and shoved all over the place.

The strange thing about indices is that they only include the better performing companies. Most indicies have requirements for size or other factors before a company is included. If a company’s share price falls enough, it is often deemed too small to be included in the index any longer. Thus, the underperformers aren’t included in the index over time. The markets call this survivorship bias.

I call it fraud.

That’s because the “buy and hold” strategy the mainstream advocates is based on index returns over time. Buying and holding a diversified portfolio won’t necessarily get you the index returns, not that they are favourable in the first case.

If you diversify to the extent that the mainstream suggests, chances are that you will pick a lemon. It would only take one such lemon to make the whole portfolio sour. Meanwhile the index could happily continue on its way up, having dropped the lemon from its basket of companies.

Practice makes Perfect

We now know that world governments are perfectly comfortable with their “whatever it takes” attitude. Nobody else is. The humorous aspect to this is watching fund managers trying to work out where to park your/their money. Every country has a government willing to greet funds with open arms and an interest payment. More and more of those governments are in trouble though.

There has been much hype over ratings downgrades and increasing insurance costs on government bonds. What people are discovering is that there isn’t anyone to bailout a government. Well, at least not with real money. Central banks have an infinite supply of funny money waiting to be created from thin air, but we will get to that in a moment.

Did you really think that the risks inherent in the economy simply vanish when the government takes them on? Nope, they’re still there. In fact, you the taxpayer has taken them on.

Strangely enough, the government of choice when it comes to parking your money during dangerous times is the American one. Whenever markets tank, the American dollar and its government’s bonds seem to surge. Daily Reckoning readers know we consider this to be absurd. The American government is probably worse off than many countries in the long run.

So why does the “flight to dollars” commence each time world equity markets take a step backwards in their weird dance routine? Well, it’s all got to do with liquidity.

“The secondary market for U.S. Treasury securities is the most liquid secondary market in the world. The spread between bid and offer prices is usually considerably narrower than other securities, making most Treasury issues easy to purchase and sell. [Emphasis added]”

When you don’t know what to do, you try to keep your options open. Treasuries earn small amounts of interest, but are easily convertible to money, even in the large quantities that some funds deal in. This gives even the biggest investor the flexibility to move fast. The thing is that these government bonds probably aren’t worth holding on to for very long.

This leads to an incredible opportunity for investors. It’s “a no brainer” to sell short Treasuries says Nassim Taleb on Bloomberg. “Every single human being should have that trade.” Nassim’s ability to forecast the crisis made him and his book “The Black Swan” a household name.

The list of people who agree with him is enormous and includes some big players. But that makes me nervous. If everyone agrees, why has nothing dramatic happened? The answer we venture is that investors don’t want to get caught out investing outside of the US, just in case the flight to the dollar occurs again.

However, consider that Bernanke and his fellow counterfeiters have put in some good practice at manipulating markets. They can engineer quite a rally through their policy tools. So how does this play out?

Simply put, the Fed can support bond and other asset prices all day long, but only at the expense of the value of the US dollar. It can print money to buy US government bonds and other assets, but more money means that money is worth less – that’s inflation.

The illustrious forecaster of the financial crisis, Peter Schiff, is often misunderstood. I recall a video where he refused to give his prediction for how far stock markets would fall. After much coaxing from the TV host, an answer was finally given, much to the confusion of those watching.

The answer was that the Dow (the index commonly quoted) will be worth “1 ounce of gold”. This implies a significant fall in the Dow, or rise in the price of gold. What Schiff means is exactly my point above. The Dow could go anywhere if the value of the dollar changes as well. If the Dow rises by 50%, but the value of the dollar falls by 90%, you still have a whopping loss.

So, why one ounce of gold?

As gold is considered the only real money that has withstood the test of time, it is a better asset to measure the Dow against than any paper currency. Any change in the value of the dollar should occur in the value of gold, thus offsetting the instability of the dollar.

Of course, the value of gold isn’t just influenced by inflation, but it remains the asset which has outlasted many other paper currencies. An ounce of gold could buy you a snazzy outfit in Roman times and can still do the same in Rome today. Its value remains. Meanwhile, the Zimbabwe dollar and the Reichsmark don’t buy much at all.

Schiff may not only be right in his prediction for the Dow, but he has made it in a way that only savvy investors can understand.

The Ouzo Effect

Another possible kick in the shins for those shorting US government bonds, or the US dollar itself, would be a full blown sovereign debt crisis striking in Europe before the US, creating rally in the “safe” USA.

Nouriel Roubini, another predictor of world economic problems, has been vocal about the possibility of problems in Europe. In fact, he sees the potential for a serious shakeup of European economies: “Down the line, not this year or two years from now, we could have a breakup of the [European] monetary union.”

If the UK weren’t in as much, or more trouble this would bring delight to their faces. “Sound as a pound” is a favourite saying of one of my friends. Unfortunately, the PIIGS acronym may have to get a lot longer very soon.

“The problems currently faced by peripheral Europe could be a dress rehearsal for what the US and UK may face further down the road” said Jim Reid, a strategist at Deutsche Bank.

We would like to invite readers to submit their suggestion for a new acronym to include the US, UK and any other debt ravaged nations. Sadly, this will mean we won’t get to use a bacon analogy going forward.

But your former Daily Reckoning Week in Review editor, Dr Alex Cowie, has pointed out something better than bacon. It’s called the “Ouzo effect”.

“This is where we see contagion [from Greece] pass across to the other European countries with bad balance sheets like Portugal, Italy and Spain, the so-called ‘PIGS’. If this situation plays out slowly, and investors get little reassurance from the ‘PIGS’, then high risk assets such as mining equities may offer even better buying opportunities in coming weeks.”

For the record, Ouzo is a brilliant Greek alcoholic beverage. I would recommend it over mining stocks any day.

The Business of Banking

The Australian government has announced the withdrawal of the wholesale funding guarantee it has provided for some time now. In other words, the banks are going to be on their own… More or less… To some extent…

Let me ask you a simple question. If you were a butcher, baker or candlestick maker and the government decided how many fillet mignon, cupcakes or candles you could sell, how would you feel? What if the government then decided at what price you could sell those items?

Any person operating under those constraints deserves your utmost sympathy, right? It sounds like something out of Stalin’s Russia and Mao’s China.

There is, in fact, a huge industry in Australia operating under those very constraints. The price it sells its goods/services at and the amount it can sell are largely set by the government. In fact, the industry operates much the same way around the world, under the same or similar crippling circumstances.

Strangely enough, that very same industry has been accused of rampant greedy capitalism and profiteering. Even more surprising is that the regulation applied to the industry isn’t even decided on by the government. A private institution, unaccountable to government makes the rules.

What is the industry I’m on about?

You are probably thinking to yourself, “This plonker thinks I didn’t read the sub-heading he wrote himself just a few lines ago.”

That’s right, I’m on about the banks. And not about any new regulations either. I’m talking about business as usual.

Banks sell money in the form of loans. Their price is the interest paid. The regulator known as the central bank sets both the supply of money and the interest rate. Banks can theoretically diverge from this, but competition effectively keeps them pinned down to whatever the central bank deems as appropriate.

In my opinion, there is no industry in the world more regulated than banking. Everyone else I can think of can control the price they sell at and how much they can offer to sell.

Of all the people!

After almost bringing the world economy to its knees and relying on government support to survive, the banks, credit ratings agencies and economists are back to telling the politicians they are stupid. Poor old Barnaby Joyce. Apparently he was being irresponsible by warning of too much debt. Hahaha. It’s so ironic in so many ways.

The Labor party considers itself to represent the Aussie battler. Yet the Australian points out that “Swan [is] to resist [a] low-income wage breakout.” This comes after the same newspaper reported in 2008 that “Wayne Swan will make it a “top priority” in his first budget to protect low- and middle-income earners, after a study revealed the lowest-paid fared well under his predecessor, Peter Costello.” Maybe being a top priority of the government isn’t so great.

Meanwhile, the guy who was supposed to warn us of instability in financial markets before his promotion to Treasury Secretary, Tim Geithner, has made himself look ridiculous. Again. He said the U.S. government “will never” lose its triple A credit rating. It is well known that one does not grow up to face reality without leaving “Never Never Land”.

China’s military has other ideas for the US government’s borrowing plans, after being poked in the eye by the sale of US arms to Taiwan.

“Just like two people rowing a boat, if the United States first throws the strokes into chaos, then so must we…. attack by oblique means and stealthy feints… For example, we could sanction them using economic means, such as dumping some U.S. government bonds.”

The Chinese government holds about US$ 790 billion of those bonds and a further US$1.95 trillion in US dollar reserves…

Nickolai Hubble
The Daily Reckoning Week in Review

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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Nick Marshall
Nick Marshall
6 years 7 months ago
“The regulator known as the central bank sets both the supply of money and the interest rate.” Not true. The market sets the rate because the RBA always follows the Australian 3 month Treasury bill rate. Follow this link from Elliott Wave International to see a chart: This begs the question – Why have a central bank? Presumably to give the illusion that the government is in control, even though the RBA is supposed to be independent. Why anyone imagines that a small group of people should have a special insight that allows them to divine the correct interest… Read more »
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