Two Sides Of The Coin

twosidescoin

While commodities are writhing in pain and US equities are sitting at all-time highs, two charts stand out dramatically as testaments to what is unfolding before our eyes…

Ever since the announcements of QE3 and QE4, commodities bulls have wondered what has gone wrong. The proclamations of infinite purchases by the Fed were supposed the be the defining moments on the way to inflationary nirvana…but alas, the last few quarters have been a nightmare for everything tangible.

What has happened? First off, the sentiment and positioning had reached bullish extremes in September/October of last year, but that is not the sole reason for the decline. In hindsight, the purpose of QE3 and QE4 has nothing to do with jobs, and it is not being used for inflationary purposes (unlike our neighbors across the Pacific). So then, why are we printing $85 billion/month of taxpayer money and buying toxic assets? The answer is simple – it is a safety net, a parachute, an airbag for the large banks in advance of the next crisis.

With trillions of derivatives on their balance sheets, on top of an economy with crumbling fundamentals that has never really recovered after the 2009 lows supporting those derivatives, the Fed has had no choice but to buy mortgage-backed securities and keep interest rates at zero to support the banks. It’s the equivalent of bailing your kid out of jail after he/she went on an all-night binge and ended up stealing Mike Tyson’s tiger (gratuitous The Hangover reference).

Looking at these two charts below, even a rocket scientist can figure out what the gimmick is:

U.S. Financial Data - Page 2

Velocity of Money

They are both parabolic, just in opposite directions. The Fed is pumping the banks’ reserves full of silicone implants, and the banks are sitting there stroking “their precious” like Gollum from the Lord of the Rings. This money is not being used for loans and it is not being used to purchase tangible assets, which is what inflationists believed would happen. Banks are also not letting the homes they have foreclosed on back into the marketplace, artificially restricting supply, and demand has driven up prices again. The byproduct of this is that the mortgage lending industry and the banks have started to loosen their lending standards again to accommodate those that are in the flipping/rental business, and now we are returning to the same speculations that got us into trouble in the first place.

I don’t know if the plan all along was to bypass inflation by letting QE go straight into the black hole of bank reserves and never come out…and I don’t know if there is an agreement for those reserves to not be used in the near-term. Regardless, it has sure fooled a majority of market participants, especially in the commodities space, and we are adding to our national debt at a rapid rate solely to put money where it will never be seen again. Unless there is a catalyst, an unknown bank reserves target, or an outside entity that forces this current arrangement to change, it will be a rough road ahead for inflationary assets because of the deflation that is happening in the real economy.

Maybe this is what has been priced in by the market already, and in the midst of multiyear lows in price and sentiment a new cycle can begin. As Refined Investors we only respond to what price is telling us, because our personal opinion is the most dangerous (and costly) thing in our trading. Price has to be moving in the same direction as our thesis, or we have to determine that one side of the battle has completely abandoned their position and then there is a mean-reversion opportunity. Risk management is vital when the markets get to extremes, but the biggest gains are also made when markets are emotional and price is distorted. Using the TEMPOS system, Refined Investors are prepared for when these entries present themselves, and looking at risk before imagining profits.

Good trading all.

Steve Chapman, TRI

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