Big Liquidity Has Led To Over Speculation
Author: Monty Guild
Dear Friends,
The following is not meant to scare you, but rather to educate and make you more able to decipher the future for yourself.
Issue#1
As we all remember from our basic and intermediate undergraduate economics classes, money supply is a function of several variables. As I have explained in past letters, many countries can simultaneously create money supply for their various currencies. The amount of such creation determines the amount of money in various forms of circulation.
Issue #2
Is the issue of how often the money circulates. Rather than go into academic descriptions of the velocity of money, the multiplier effect, accelerator effect and other theories, lets keep it simple.
The amount of money available for investment and speculation is a function of the amount of money in circulation and the amount of turnover of that money.
The advent of derivatives that I and others like Jim Sinclair have been pointing out to you for years is a problem. The reason it is a problem is that it has greatly increased the amount of liquidity available for speculation by investors and speculators.
A BASIC ECONOMIC FACT IS THAT IN A FREE COMPETITION ENVIRONMENT, LOWER COSTS LEAD TO LOWER PRICES.
The cost of investment and speculation is the rate of interest that one must pay for money to speculate with. As money supply and money velocity have increased, interest rates have fallen. As a side note, in our opinion this is due to overzealous economic administrators in the developing world and derivatives in the developed world.
Lower interest rates lead to increased competition, lower risk premiums and lower profits on speculation.
Lower interest rates encourage competition and thus decrease the return on the speculator’s or investor’s capital. This lower return comes in the form of lower return on investment.
WHEN MORE COMPETITION ARRIVES, PROFIT MARGINS DECLINE AS MORE AND MORE PEOPLE ARE TRYING TO DO THE SAME THING.
Finally returns get ridiculously low and the market seizes up, no one is willing to invest for such a low return. When the seized up market reopens it is at a much different price which re-establishes a premium for risk and which has cleaned out the less sophisticated, less intelligent and less lucky participants.
This is what has happened in the bond market and is happening in the market for other financial instruments.
THE BIG QUESTION
The big question is "Will the seizing up of the subprime market be enough to slow and damage the US economy?" In a vacuum the US economy would certainly go into a recession, so the next question is "Will strong economic growth worldwide moderate the negative effect on the US economy?" But when the CMO market and the commercial paper market also seized up that was potentially devastating. Companies couldn't get capital for their day to day operations and there was and is a danger of freezing up the whole financial system with potentially devastating effects.
NOW THE FED HAS ADDED LIQUIDITY TO THE SYSTEM THROUGH EASED ACCESS TO THE DISCOUNT WINDOW
We must wait and see what this means. If liquidity returns quickly, a devastating crisis will be averted. However, every lender that I know feels he has been taken advantage of for the last few years. All of them want to increase the spreads they get for the risk they take, which they widely and correctly believe has been too low.
AVAILABLILTY OF CAPITAL IS DIMINISHING - SO THE PRICE OF CAPITAL (THE INTEREST RATE) WILL RISE
By this I do not mean interest rates on the safest investments like government bonds of major stable countries. I mean interest rates on everything else: real estate, commodity purchases, stocks and so on. higher interest rates mean lower PE rations and lower valuations for many assets.
HOW TO INVEST - FOREIGN CURRENCY BONDS AND GOLD ARE THE MOST OBVIOUS BENEFICIARIES
To us an obvious opportunity is in government bonds of foreign currencies, not US dollars. For those who think in US dollars and are very risk averse, they may want to hold US government bonds.
We will hold primarily bonds of four countries other than the US. They are UK government bonds, Canadian government bonds, Australian government bonds and Swiss government bonds. Of course gold is also an excellent vehicle by which to profit from the decline in the US dollar.
The US government will be forced by this crisis to lower their fed funds rate by at least 3/4% in the next few months from 5 1/4%. This will decrease the interest return on US bonds and make them less attractive.
We will watch and wait for other opportunities.
Sudden dislocations like the current one always present huge investment opportunities for the intelligent and intrepid.
In coming communications I will go into why we like the 4 currencies that we do. Some are buys because the partial unwinding of the carry trade has made them too cheap; others are buys because they do not have many speculators currently holding them. Thus carry trade speculators won't disgorge them.
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