Rising Interest Rates, Rising Geopolitical Concerns - Double Jeopardy?
Could rising global interest rates and rising geopolitical concerns that could translate into an escalation in the so called War on Terror be the double jeopardy that will take down the markets in 2006-2007? While these two issues are totally separate and many might take issue as to global geopolitical concerns both have potential negative impact on the markets. We currently view these two items as the ones that could be the trigger a recession and a serious stock market collapse going forward.
One of the arguments we consistently hear from the bulls and read in GaveKal Research's book "Brave New World" is that the huge debts don't matter; that the bears have been arguing they are a problem for years and nothing has happened. The bear's argument has been that the growing debts and huge global imbalances caused by the US Trade Deficit are an albatross that will eventually blow up and cause a global financial collapse. The bulls counter argument is that it doesn't matter that the US trade deficit is huge because much of the benefit has been going to US corporations that benefit from the platform economy where the design and distribution and high end profits are in the US while the manufacturing and volatile job market is in the foreign countries (China, India etc.). As well the foreign countries have a vested interest in recycling their US dollars back to the US in order to prevent their own currencies from rising and are not going to do anything to upset the balance as it would be to their own detriment.
Indeed in varying respects both sides are right but there is a danger and that danger is rising interest rates not only in the US but globally. Rising interest rates are what could change the equation and indeed tip the equation. If one recalls it was sharply rising interest rates that preceded all of the major (and minor) recessions over the past 30 years including the 1974-1975 recession, 1981-1983, 1990-1992 and to a lesser degree the minor recession of 2001-2002. What prevented the 2001-2002 minor recession following 9/11 from turning into something worse was the Fed's two pronged attack of cutting interest rates rapidly and sharply and massive injections of liquidity into the banking system.
But now interest rates are rising not only in the US but globally as well and we soon may be reaching the point where it begins to bite. From lows of 1.25% the Fed has hiked rates now some 14 times to 4.50%. All indications point to at least two more rate hikes to 5%. But Ben Bernanke also wants to become known as an inflation fighting Fed Chairman and in that respect the risk is that he raises interest rates even further than expected. The push may not come so much from economic forces in the US but from economic forces elsewhere.
Japan has been growing much more rapidly over the past few years. Following the moribund Japanese economy of the 1990's and even early in this decade the Japanese economy barely grew despite huge infusions of liquidity, interest rate cuts that had been pushed to zero and huge budget deficits by the Japanese government. This occurred even as they enjoyed a huge trade surplus and growing current account surplus.
No longer. The Japanese economy grew at a 4.2% rate in the latest year including 5.5% in the fourth quarter even as the US economy grew only an anaemic 1.1% in the same period. Sure Japanese inflation remains near zero and is expected to remain that way but the pressure of a growing economy is putting pressure on the Japanese to raise rates from their near zero level. At this stage the rise in rates seems almost negligible as 3 month Euro Yen has jumped only .04% in the past year and 10 year bonds are only up .10 basis points.
The current rate rise doesn't seem like much but the rapid economic growth (primarily domestic growth) coupled with growing signs of inflation is putting the pressure on rates. As well the recent decline in the Japanese Yen against the US Dollar is showing signs of turning around after a significant correction and that could mean the Japanese Yen is about to resume its upward trend against the US Dollar.
All of this has the ability to have a perverse impact elsewhere. It is has been a long time since we have mentioned the Japanese Yen carry trade. So what is the Japanese Yen carry trade? Quite simply it is the borrowing of Japanese Yen (or could be in any other low interest rate currency such as Swiss Francs) converting the proceeds to US$ or any other currency where interest rates are higher and purchasing higher yielding securities such as US Treasuries (or more speculative securities) to gain the pick up. This trade works as long as interest rates remain stable and the Japanese Yen remains relatively stable against other currencies particularly the US Dollar.
Rising interest rates and a rising Japanese Yen are anathema to the Yen carry trade. Compounding the problem is that with years of the carry trade working (with odd exceptions) it has meant that the major players, investment dealers, banks, insurance companies, hedge funds and mutual funds are involved in the trade and in particular the investment dealers, banks and hedge funds utilize leverage as well. The Yen carry trade has been used for more than investment in US Treasuries as global stock, bond and real estate markets have been huge beneficiaries of the massive injection of liquidity that is the result of the Yen carry trade.
There is now some growing skittishness in global currency markets. A couple of weeks ago the Icelandic Krone dropped about 8% in a couple of days. It was triggered by a downgrading of Icelandic debt. Now one wonders who cares about Iceland other than Icelanders. But we all recall the devaluation of at the time the little known Thailand Baht that helped trigger the debacle of the Asian flu in 1997 and again the Russian Rouble devaluation and Russian debt collapse that triggered the debacle in 1998 that ended with the collapse of the hedge fund Long Term Capital Management (LTCM). It is these kinds of obscure devaluations that have a way of triggering a global problem.
Not is only is the Central Bank of Japan making noise that they will hike rates to cool the economy and any inflationary pressures but rates are also under upward pressure in Europe as well. The Iceland devaluation also triggered devaluations in other high yielding currencies in New Zealand, Hungary and Brazil. It didn't turn into a debacle this time just yet but the risk has now turned firmly to the downside. With huge investments in risky areas of Latin America and elsewhere and assisting in the spawning of housing bubbles in the US and elsewhere the risk is slowly turning against the carry trade and the bubbles. Already US house sales have fallen in two out of the last three months and the inventory of unsold homes is growing even as we have record building starts.
There is literally hundreds of billions of dollars tied up in carry trades globally. Daily turnover in global foreign exchange, interest rates and derivatives markets totals some $2.4 trillion per day. Trying to unwind the trade can not be accomplished in any short period. The collapse in 1998 which was also accompanied by a sudden rising Japanese Yen was the trigger that as we noted caused the problems and collapse of LTCM and over the next few years several other large hedge funds also collapsed.
While the response from the Fed was a massive cut in interest rates and massive liquidity injections leading first up to the Y2K changeover in 2000 and again following the 9/11 attacks the ability to do this again is limited and will not have the same impact as it did in the past as globally the consumer and others are just too tapped out and the speculative excesses of the earlier periods have never been cleansed. Rising interest rates are the Achilles heal of the both the US and global economy and the pressure is growing in Japan, Europe and of course in the US where the hikes are not as yet finished.
The other danger is geopolitical. While the rhetoric between the US and Iran over Iran's nuclear ambitions (that has become even stranger given the new agreement with India that allows India to expand its nuclear arsenal) has been consistently on the front pages we believe as do others that the real reason behind the noise is the new Iranian oil bourse that will open on March 20, 2006. The Iranian oil bourse will trade in Euros based on Iranian crude and is a direct rivalry to West Texas Intermediate, Norway Brent and the UAE Dubai market makers. The latter three are all calculated in US Dollars.
Of course there are numerous questions as to the success of the new bourse but there are many that will welcome the ability to trade in other currencies besides the US$ as it will allow them to shift out of the overvalued US Dollar. It is also unknown just how successful this bourse might be and how much business it might attract and as well how much US Dollars will flow to Euros as a result. Results may not be known for months. But the US is concerned about the role of the US currency as the world's reserve currency and the potential impact on it. Any significant shift could mean a rapid decline in the value of the US$ and a subsequent negative impact to hike interest rates and its impact on the huge US trade deficit.
Recall that Saddam Hussein initiated oil for Euros programme in 2000 although it was not until 2003 that Iraq was invaded. Despite Saddam asking for payment in Euros Iraq still had to deal with the New York and London exchanges dealing in US$. So we doubt that any invasion or more likely bombing will occur in March but several months down the road if a negative impact is appearing then the US's hand might be called. Meanwhile the dance between the EU and Iran and negotiations between Iran and Russia on Iran's nuclear program will continue.
Oddly the start of the Iranian oil bourse coincides with the end of reporting of M3 money supply. After all if there is a drainage on the US$ without the M3 figures it will be difficult to calculate the extent of the drainage. But we admit that is pure speculation on our part and may have little to do with the reason they are ceasing to publish the M3 figures. But it is an odd coincidence.
Couple the potential for an Iranian crisis with the non-recognition of Hamas in Palestine, the threat of outright civil war in Iraq plus rhetoric against Syria over the assassination of the former Lebanese Prime Minister and it is assured that geopolitical concerns will remain at the top of the agenda over the coming year. The real danger is if talk turns to something worse. While the markets reacted positively to invasion of Iraq (and that was predictable) the markets would react very negatively to any extension of the war even if all they do is bomb Iran from the air (the most likely outcome).
The major beneficiaries of all this will be oil and gold/silver and to a lesser extent all commodities. While we believe that ultimately oil and gold/silver are going a lot higher over the next few years evidence suggests that they are currently going through a corrective period which may still have some time to run. Rising interest rates, a falling US$ and any bombing of Iran is positive for gold/silver and the Iran situation could send oil prices through the roof.
Our weekly chart of the XAU shows that we have since the lows of 2000 been moving up in distinct waves. A sharp up wave is usually followed by a period of consolidation/correction. The cycles between the lows of each of these cycles have been 13 months, 16 months and 26 months respectively. This is close to what Merriman (MMA Cycles) has suggested as an 18.5 month cycle for gold with an orb of 15-22 months. Since the last lows in May 2005 it took roughly 9 months to reach the highs seen here in February. That suggests that we could have anywhere from 7 to 13 months of correction to go through until we reach the next cycle low. Indeed the last Bull Run was the strongest and longest of the runs since the 2000 lows.
This time frame could carry us to anywhere from August/September 2006 for a low or as long as next March 2007. We are leaning towards the shorter cycle as the last one was particularly long. We believe it will be later this year at the earliest that any action might be started against Iran. Key points to keep in mind for the XAU are the Fibonacci retracements of the most recent move that could target anywhere from 126 down to 107 as possible zones for the correction.
We are also showing a chart of oil and the TSX Energy Index. Note the recent negative divergences where oil prices (and Natural Gas prices even more so) failed to make new highs even as the stock index made new highs. We often see these negative divergences at tops. Merriman also points out cycles in oil with a 46-month cycle (orb 11 months) subdivided into 2 to 3 18 month cycles (orb 15-21 months). The last 4 year cycle bottomed in November 2001 and since then we have seen corrective lows in April 2003 (17 months) and December 2004 (20 months) so our orb of 15-21 months puts us making a low anywhere from March 2006 to September 2006. This would also be a four-year cycle low.
The current ongoing negative divergences suggest that this correction still has a number of months to go. We suspect that oil will probably play itself out as an ABCDE type of correction. Downside could be limited due to the ongoing geopolitical concerns. Major support is seen down near $48-$50. We view this as the maximum downside. Interim support can be seen at around $55 and that area may contain any drop as well. Meanwhile the TSX Energy Index could correct down to major support zones seen near 240.
The major markets are also at crossroads. Here we have 4 year (2002), 18 year (1987) and 72-year (1932) cycles (Merriman) all converging suggesting that the next move could be sharply down. Interest rates as measured by the long US Treasury Bond also experience 6 year cycle lows and they are also due in this time frame. We are repeating a chart we showed a number of weeks ago as it shows these cycles very clearly. With the double jeopardy of rising global interest rates and geopolitical concerns 2006 could still prove to be a watershed year that investors will remember for some time.