Dollar, Yuan, CDs and Silver

While the first several months of 2011 were dominated by non-market related events—the Middle-East uprising and the Japan catastrophes—April provided a month of nearly pure macroeconomic news. Despite the lack of sensational and heartbreaking headlines, these macroeconomic events will undoubtedly have implications on your money whether held in CDs or some of today’s favorite trades like gold and silver. Some of the more noteworthy news items include:

• The European Central Bank raised rates to 1.25% to tame inflation and despite struggling peripheral member countries. 
• Similarly, China increased banks’ reserve requirements to a record 20.5% less than two weeks after they raised interest rates; both desperate attempts to lock up cash and cool inflation. 
• Meanwhile, the US maintained QE2 and signaled prolonged loose monetary policy. 

The divergence in policies, which was confirmed in a late-April speech by Bernanke, means that the interest rate spreads between US Treasuries and other governments’ bonds are likely to continue to widen before they start to narrow—the forces driving the USD lower and gold/silver higher are going to get stronger before they get weaker. According to Bloomberg, “yields on Treasuries due in one to three years are 1 percentage point below that of government debt with similar maturities in the rest of the world on average, Bank of America Merrill Lynch indexes show. A year ago, there was no difference” (see here)

Bernanke’s speech combined with the technical breakdown in the USD solidified our convictions. We already had a substantial short USD position indirectly through international equities, which make up 50% of our total equities holdings, and international local currency bonds, as well as commodities like gold and silver, which historically have had a high negative correlation to the USD. However, in April we maxed out our non-USD holdings by initiating direct shorts against the USD—we moved excess cash in our clients’ portfolios to (1) a long position in the Chinese Yuan, which has been a “no brainer” trade that has gone nowhere for a long time, and (2) a basket of non-USD currencies.

Some may say we are late (and we are … by over three decades) and that everyone is already so bearish on the USD that now is the time to be a contrarian (which may prove true), but given Bernanke’s actions and the opposing actions of the world’s central bankers we are comfortable that over the medium-term the dollar will continue its slide.

Chinese Yuan - The Chinese have been very disciplined (or stubborn) in allowing the Yuan to appreciate relative to the USD. However, over the last several months it has become clear that China has an inflation problem and a wage inflation problem as well as possibly even a housing bubble. They have used rates and reserve requirement increases to try to alleviate their issues with relatively little success; now Governor Hu Xiaolian suggested on the central bank's website that The People's Bank of China plans to increase the Yuan's flexibility to cut the cost of imports and counter inflation. Yuan forwards traded at the biggest premium to the spot rate in more than five months, confirming speculation the central bank will allow faster currency gains (see here). Furthermore, the Yuan is making new multi-year highs—the Yuan strengthened beyond 6.5 per dollar for the first time since 1993 (see here)

The end result, we feel, is that the opportunity for a significant one-time jump in the Yuan is not only probable but could finally happen relatively soon.

Silver - On a different note, I spent much of Easter weekend looking at old Silver charts (get a life)—one of the more impressive ones is shown at right (March ’80).

Most of our clients hold silver, as well as gold, which have been great investments/trades recently. However now the concern becomes: when does it end?

Silver has a long history of making losers out of winners—rapid appreciation followed by extremely violent reversals means that most silver holdings fall back to cost or lower before the trader even knows what hit him. In the commodities market, and in particular silver, sentiment can shift very quickly with supply/demand dynamics changing over a matter of days or weeks rather than months or years.

With that said, we feel that silver likely still has some upside left given anticipated USD weakness. However, we are not initiating new positions until there is a significant pullback. It should be noted that given how volatile most commodities are, we follow a much quicker Risk Management process (see March 2011 Commentary) for commodities. This in theory should get us out of silver faster than most other investors. (Since the time of this writing margin requirements for silver have been raised twice by the CME which has had a deleterious effect on silver prices – see here)

To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.

Bottom Line: On a daily/weekly basis the USD may correct upwards; however in the medium-term the USD will slide well beyond its 35+ year inflation-adjusted lows until the disparity across interest rates is eliminated and there is clarity on the US deficits and economic recovery. This means that already struggling savings and CDs accounts, will be doubly penalized—first by near-zero interest rates and second, and more importantly, by a weak and declining dollar combined with inflation. Cash held “safely” in USD-denominated savings and CD accounts are, and will continue to lose value. Which begs the question how do you define safe?