Perverse Outcomes

By: Rodney C. Cook | Tue, Jul 1, 2003
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I read the pundits and none are consistently right. Particularly those who are emphatic about their specific insights. And the more passionate, it seems, the less right. You can watch the market throw the first stone at these false prophets. But most do not fall. Many prosper well, making the same erroneous forecasts time after time. The only thing that changes is their client base as it churns with new disciples. And fresh money. It is time to pay more attention to those who are sufficiently wise to explicitly state that they know little of the future. And act accordingly.

The lines of probability are becoming less distinct. They are obscured by increasing variability. And tortured by fundamental distortions. Distortions caused by intervention by various monetary authorities throughout the globe. Each with its own hegemonic ambitions. As such, inter-market relationships based upon the logic of the past do not always prevail. Certainly not in a timely fashion. It is at times like this where it is very easy to outsmart yourself.

Distortions

Playing the distortions, however, is tempting. Like finding an angle in a casino. I used to count cards at the blackjack tables. Basic scientific forecasting with a nice solid return. Hard work. But as I soon found out, I could make much more money by finding an insider's game. Where the dealer, usually with a pit boss in cahoots, would feed money to an associate playing at the table. The dealer would simply bust, and pay out to his associate on the other side of the table. Of course, this would be done at odd hours so that the masses did not participate. And the payout would be balanced by cheating the masses during heavier activity. By acting naive you could occasionally join these lone "gamblers" and go along for the ride. Taking money at several times the rate that good technical analysis dictated. And with much less effort.

But this is a rather simple metaphor for the financial markets, and serves only to make a point. One classic distortion has been played by the bond ghouls for decades. The Fed, by its very nature, feeds money over table. It is their job to loose money. To it's shareholders sitting at the table. By telegraphing its intent to its members first they get to the good seats in a timely fashion. They are judged by the structure of the institution to be wise and benevolent in their use of these monies. While most will disagree, it is financially astute to sit in their company.

More recently the Fed has clearly telegraphed that reduced rates are policy for the foreseeable future. But to a much wider audience. And that they will work their way up the yield curve to provide liquidity as necessary to fight deflation. So well trained speculators have been taking profits from selling at the short end and are re-deploying at the long end. This should continue to create quite a bubble in bonds. And should help maintain the housing bubble, as long as unemployment does not surge.

The insiders have profited nicely by positioning for this run. If you can count on our monetary magicians, the creation of liquidity shall continue. But at some point, when least expected, this trend will reverse. And higher interest rates will prevail. And someone will be left holding the bag as the hot money flows to the next bubble. So if you are sitting at this table, watch the insiders. If they get up and walk away from the table as the crowds are gathering, it may be prudent to take leave from this game.

The big unanswered question is what will be the catalyst for this reversal and what will be the next bubble. Sales of US bonds from foreign central banking reserves are the standard answer. China is often mentioned. So what will be purchased with these monies? Debts will be paid. Speculators will seek commodities. And central banks will ultimately buy gold. But internationally the number of players is much larger and this makes the game much more complex than simply front running the Fed. At some point these front runners will be slaughtered. Unless the dollar conquers the world.

Going Global

The Feds reflation efforts have a nice side benefit. They exact tribute from the rest of the world. Any nation with whom we have a trade deficit or any institution that has significant holdings of US imperial dollar debt is taking a nice razor cut. And the barber has a really scary blade that can easily be directed toward the throat.

So reflationary polices provide for incremental default on America's debt. In this regard the dollar has been an excellent weapon in the battle against the Euro (See Refault, 5/10/03). The constitutionally prescribed dollar, backed by gold and silver, is no longer the currency of the realm. So America's debt is held in this Federal Reserve note with no guaranteed backing. And there is no recourse for the creditor nation, except to devalue more aggressively. Or link to the dollar.

A New Front

But what's this? China is going to de-link and float the Yuan? A wee bit anyway. A modest range of 2.5% will be allowed. At least that's the expectation announced by our esteemed Secretary of the Treasury. How nice of him. I'm sure that the Chinese are pleased that the door will be opened for them to now pay tribute as well. Wonder what they got in return for this accommodation?

What do you want to bet that the dollar drops to the top of the range fairly quickly? Everybody expects so, and Yuan denominated bank accounts are becoming quite the rage. It will be interesting if the insiders will fleece those with this expectation. Is there a derivatives construct in place that has been designed to profit from this event? Several I'm sure. Count on some interesting distortions as the range for fluctuation is expanded and, eventually, the link is severed. And policies are telegraphed from several different authorities. And profits shift to the insiders. For a while.

The free market balance between the Yuan and the dollar mustn't be re-established in knife-edge fashion. There are several central planning authorities with varying agendas that must be accommodated. And they don't really like each other very much. So not only are there distortions in place, they are not necessarily stable.

The devaluation of the Yuan has been extensively posited as a pre-cursor to some nasty financial discontinuities. As such, China and America appear to be cooperating to manage this sea change. But with China liberalizing the gold trade there is a philosophical divide. A serious divide that is indicative of future financial hostilities. It is doubtful that China will surrender to the imperial dollar.

The pundits will be making many predictions about the resulting outcomes. Many will come to pass. Many will be mitigated. And the pundits will be mostly wrong on the timing.

Sure Can Smell the Rain

So expect perverse outcomes. Especially on the timing of events that appear obvious. And employ capital preservation strategies. A financial storm is coming on a biblical scale. And while it is not quite in sight, I sure can smell the rain. Ultimately gold is the only shelter from this storm.


 

Author: Rodney C. Cook

Currently Rod is the founder and manager of Bull Trout Capital, a boutique investment company, and author of the FishWrapper, a private investment newsletter. Bull Trout Capital was founded to maximize returns based upon long cycle dynamics and Austrian economic principles. Dr. Cook uses internet based methodologies to identify sectors, strategies and shares that will most likely outperform at the current point in the cycle whilst maximizing upside exposure to potential economic dislocations. The FishWrapper features Dr. Cook's personal investments, methods and strategies where he has demonstrated extraordinary returns. Before Bull Trout he founded Sightward and authored patents (now owned by InfoUSA) to forecast human behavior on the internet; co-founded Ark Interface (now owned by xSides) to develop and patent innovative computer user interfaces; founded Optimas (now owned by Media Cybernetics) for medical and scientific image processing systems; and founded BioSonics Imaging division and developed their Optical Pattern Recognition System. Dr. Cook began his career as a Biometrician for the International Pacific Salmon Commission applying his doctoral dissertation in applied pattern recognition from the University of Washington College of Ocean and Fisheries Science.

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