July 12, 2013

I have stood faithfully by the long dollar, short yen trade for some time. Though I suffered a major loss by over-committing prior to the break in the first few weeks of June, I was able to reestablish a smaller position at a good price, and I have stuck with this through the uptrend.

The trend is reinforcing. If the Japanese get their goal of inflation, interest rates will rise. This will make the government debt prohibitively expensive. Though the government is bound to try all sorts of tricks to keep the interest rate down, the only thing that will surely work is purchasing more government bonds with newly printed yen. This reinforces the downward move of the yen, accelerating inflation, and increasing the upward pressure on interest rates. It is like trying to force a growing helium ballon under water. Eventually, it will out. And the Japanese government will be left broke.

The government must know this. They are deceiving themselves if they think they can grow out of this problem by inflating the economy and increasing tax revenues. With insanely low tax rates and a massive debt, the interest payments are bound to grow faster than tax revenues. Which assures the eventual government crisis.

Kuroda, the head of the Bank of Japan has committed to no “step-wise” monetary measures. If the BOJ sticks with its word, the collapse will happen sooner rather than later. In which case, M3 would collapse (as defaults become common in a rapidly rising interest rate environment), which would lead to a deflationary debt spiral, shooting the yen upwards. I would be badly burned in such a scenario. In the opposite case, if the BOJ does not stick with its word, they will take the measures I have mentioned above, printing more yen to buy government bonds to keep the government from defaulting. I am biased toward the latter scenario. I think that if interest rates begin to rise too soon, officials will believe that “Abenomics”, the current government stimulus program, has not had time to work yet, so they will be convinced to push forward with a second round of yen printing. But I cannot lever up as much as I would like on this trade, as a sharp rise in interest rates could de-rail it at any moment.

The most worrisome thing about betting on the dollar with yen, is the fact that I am betting on the dollar at all. The dollar is the least bad option of all the world currencies, because it is the only one that has made a commitment to stop easing – i.e. M1 will not grow significantly once the Fed pulls back its policy. The effects on M3 – whether banks are really lending more – remain to be seen. I may transfer the yen short to a different currency once the Federal Reserve begins to pull back QE.

The Federal Reserve has stated that easing will continue for some time. The market views this as a backtrack of the Fed’s wording. In reality, Ben Bernanke never committed to pulling back QE3 in the first place. He has only reiterated the same statement in different ways that the market interpreted differently each time. The main message is: The Federal Reserve will pull back QE3 when the economy is ready. As to what that means, perhaps only the Fed knows. My best guess is that it will happen in the last few months of the year.

But it is certain that it will happen within the next year. And the effects of this have already manifested in the market, as participants try to move ahead of the central bank. Bonds have begun their descent. They have been too high for too long, and have fallen quickly. With knowledge of rising interest rates, everyone is trying to get in to position. REITS have also fallen. All income investments look less attractive when you know you can get a higher risk free interest rate in the near future.

Gold has begun to fall. I believe this is more in anticipation of the eventual rise in the dollar than in reaction to the actual rise in the dollar. That is, gold has gotten ahead of itself. The fall has already started to correct, after the Federal Reserve clarified that it will not stop easing any time soon.

This will have negative effects on oil and gas. So my dry gas plays are not as sure of a bet anymore. More demand will have to come online to push up prices in the face of this supply. Perhaps the Oil and Gas E&P’s were prescient in their view by not upping production earlier in the year. I stand corrected.

Rising interest rates generally have negative connotations for stock prices. However, the Federal Reserve is able to pull back QE because of real strength in the underlying economy. This biases me to think that stocks can continue to rise in the face of these interest rates. Since stocks have already risen so much (on the back of global speculation) there is not a lot of room to rise. Stocks are now at record highs. I do not imagine we will be much higher by the time the year ends.

I am in a precarious situation. Having already placed my bets in the oil and gas sector, I am stuck. I have a margin of safety on many of them – Penn West Virginia is trading significantly below Book Value, for example – but the prices of these may decline in the face of declining commodity prices. C&J Energy does look like a fairly sure play – the fracturing market will eventually recover – however the timing is uncertain, because of the uncertainty in the commodity market.

This leaves few options. Perhaps buying gold in Japanese Yen, as Dennis Gartman suggested. However, I do not have experience in the futures market, and I am not ready to experiment in it at this time. China is likely oversold at this point, so a small speculation may be warranted.

I will also continue to keep an eye out for small cyclical companies with margins of safety, with a mind to purchase on the next downturn in the market. All cyclicals should continue to rise for the next few years, provided the unemployment rate can continue the downward trend.