Fall in U.S. Real Interest Rates to Send Gold Over $1800

By: Bob_Kirtley

One of main determinants of gold prices in the medium to long term is US real interest rates. US real rates are the rate of interest that can be earned on US Government bonds, minus the expected rate of inflation. One can monitor US real rates by watching the yields on Treasury Inflation Protected Securities (TIPS) and we watch them closely since they exhibit a negative relationship with gold.

Currently when we analyse where US real rates are in relation to gold prices, we come to the conclusion that gold prices are low in relation to US real rates. However most importantly we think US real rates will likely head significantly lower, sending gold to $1800+ within a matter of months.

The basic fundamentals behind this inverse relationship are that when US monetary policy is looser, real rates fall and therefore investors buy gold for a number of reasons. We have covered this relationship in previously commentaries, but for new readers will we run through the dynamics at play here.

Firstly, lower real rates could imply higher inflationary expectations in the future therefore gold is bought as a hedge against this possible inflation.

Secondly, lower real returns in Treasuries drives investors into risk assets in search of a higher return. This also sends gold higher but it also sends most commodities, risk currencies and equities higher too.

Thirdly, lower real returns on Treasuries reduce demand of US dollars, causing the dollar to fall and therefore the gold price to rise in US dollars. Finally, looser monetary policy implies that the economic situation is not as rosy as many would like to believe, so if the Federal Reserve acts by loosening monetary policy and driving down real interest rates then that sends a message that the economy is in a bad place therefore investors buy gold as a safe haven asset. There are probably many more reasons for this relationship, but we have just tried to cover the main ones.

Many gold investors tend to focus on the relationship between the US dollar and gold, citing that a lower dollar leads to higher gold prices in US dollars. Whilst this is an important dynamic of gold prices, the relationship gold has with US real interest rates is perhaps more important and more reliable for trading and investment purposes. For the first few years of this gold bull market, it was sufficient simply to acknowledge the USD down, therefore gold up dynamic, but in recent years things have changed. Over the past couple of years gold has rallied when the greenback has been making gains, as well as when it was weakening, therefore investors must now take note of the inverse relationship between US real interest rates and gold, which has been observed more consistently.

Whilst this inverse relationship is not perfect, it does have a distinct theoretical advantage over simply watching the USD versus gold relationship as sometimes both US dollars and gold can be in demand as safe haven assets. For example if there were to be a crisis, such as the recent sovereign debt issues in Europe, money would flow into gold in search of a safe haven, but also into dollars to escape the European issues. This creates what we dubbed “The Eurozone Crisis Premium” in the gold price. Investors would sell European bonds driving their yields higher, and buy US bonds driving their yields lower. Gold would be rising and the US dollar would be rising, negating their usually negative correlation. However US rates would be falling as investors bought treasuries as a safe haven and therefore the inverse relationship between gold and real US treasury rates is more likely to hold. That being said, we do of course closely monitor the currency markets as well as the interest rate markets, since both have major impacts on the price of gold.

The theoretical aspects of this relationship may all be well and good, but what really matters to investors and traders such as us is how these theories can be applied in the real world, and how effective they are in producing profitable signals to trade from. So here is a practical example of how we applied and profited from this relationship in the real world. In late August 2010 we noticed that US real rates were falling far more rapidly than gold prices were rising. We also held the view that the Federal Reserve was going to embark on another round of quantitative easing within the next three months; therefore we did not see US real rates rising, given that the Federal Reserve would likely begin buying bonds heavily. From this we inferred that gold prices we set to stage a major rally to a new all time high, so signalled to our subscribers to buy a great deal of out of the money GLD call options to benefit from this rise (more details can be viewed in our full trading records, which is published on our website). We banked profits in percentage terms, ten times higher that the gains made by gold or the HUI gold mining index during that period, and when the market began to price in QE2 and US real rates fell further we bought again and enjoyed a similar return.

We are now of the opinion that US real interest rates are low in relation to the current gold price and are heading lower, therefore we see the gold price going still higher to $1800 within the next six months. Of course this works both ways, so if US real rates begin rising there could be a serious correction/further consolidation in gold. We are monitoring this situation closely and adjusting our position (and that recommended to our subscribers) accordingly. However we are struggling to see what could either seriously dampen inflation expectations or cause a substantial rise in US interest rates, hence why we are very bullish on gold at present.

If the economic situation improves, inflation expectations will rise. If the economic situation deteriorates then central banks will likely combat this with further easing of monetary policy, which will be explosively bullish for gold prices. Further loosening of US monetary policy could come in the form of QE3 or perhaps a cap on longer term rates, which could be achieved by the Federal Reserve stating a target two year interest rate. We think that being long gold is the best way to play this move and that options offer the best trade from a risk-reward perspective. Our options trading service has outperformed gold, the HUI and also the doubled leveraged gold ETNs.

Hopefully this article will have drawn the reader’s attention to this relationship gold has with US real rates and we suggest that it form a pillar of your fundamental analysis with respect to gold. This is not to say other relationships such as the USD and gold are not to be noted, they should be, but in conjunction with US real rates. By pulling all these relationships together one can get a better picture of where the yellow metal is headed and when it is going to move, which ultimately leads to more profitable trading.

As mentioned before, we are of the opinion that gold prices are heading to $1800, so if you would like to take full advantage of this then please visit our website www.skoptionstrading.com to sign up to SK OptionTrader, our premium options trading service that costs just $199. We have closed 81 trades with 78 winners, for an average gain of 40.41% per trade including the three losing trades. We run a model portfolio for subscribers to follow if they wish, with suggested capital allocations to each trade and this model portfolio has an annualised return on investment of 117%.

We think that options are the best way to benefit from this coming major rally in gold prices. We trade options based on GLD, so one can execute the same trades with a simple US brokerage account that has stock options trading. All of our trades have limited downside and given the potential explosive upside in gold over the coming months, we think the risk-reward in some options trades at present are too good to pass up. 

On 1st July we recommended such an opportunity which is now showing a 210% profit in two weeks, and we think it could triple again from here. So, to find out what this trade is and others like it sign up now as we are about to place a number of trades that we think will prove to be extremely profitable over the coming months.

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What To Look For In A Stock Market Bearish Turn

By: Chris_Ciovacco

Does the current market look more like 2004 or 2007? The answer is important because stocks did well from August 2004 to October 2007, but they performed very poorly between October 2007 and March 2009. The fundamental picture remains quite uncertain with:

• Debt problems in Europe and the U.S.
• Inflation in Asia
• Central bankers with limited ammo

Based on a detailed study we just completed looking at market profiles dating back to 1981, there are similarities between the current market’s technical profile to both 2004 and 2007. The study can help us understand what to look for in 2011-2012 and if the implications lean toward bullish or bearish outcomes.

Why did our study begin in 1981? Fair question; the answer lies in the availability of detailed technical data. The study used historical values for the CCM Bull Market Sustainability Index (BMSI) and the CCM 80-20 Correction Index. You can use the links in the previous sentence to see the long list of technical parameters incorporated into these proprietary market models. This data is not easy to find going back into the 1970s.

The study looked at an extensive array of technical data based on daily, monthly, and weekly charts. The varied time frames help us zero in on periods in history where the balance of greed and fear in the markets was most similar to what we have today. After running historical data through the process shown in the flow chart below, four periods remained beginning in 1984, 2004, 2005, and 2007. 

The video below compares these periods to the present day and highlights both bullish and bearish signals that may emerge in the coming weeks. These signals can help us better access the market’s risk-reward profile within the context of today’s fragile fundamental backdrop. The charts covered in the video are also shown below the video player for further study

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U.S. Economic Policy Failures, Federal Debt Bomb End Game

By: John_Mauldin

Long-time readers are familiar with the wisdom of Lacy Hunt. He is a regular feature of Outside the Box. He writes a quarterly piece for Hoisington Asset Management in Austin, and this is one of his better ones. Read it twice.

"While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern ..."

As I write, Europe is starting to unravel. This is going to be much worse than 2008, at least as far as Europe is concerned, and odds are high that it will be very bad for the US. And the markets are still acting as if the problems in Europe can be resolved. The recent bank stress tests were a joke, as they assumed no Greek or Irish defaults. This simply can't be. There is a banking crisis of massive proportions in our future.

As Lacy notes, we are testing the economic theories of three (I think von Mises should be added) dead white guys. The dominant theories are being shown to be wrong. The sooner we acknowledge that the better. But don't hold your breath waiting for the major economic schools to come to grips with their failure.

This is a real problem, and there is just no way to avoid it. I wish I had more positive things to say.

Your trying to figure this out analyst,

John Mauldin, Editor Outside the Box

Three Competing Theories

By Lacy Hunt, Hoisington Asset Management

The three competing theories for economic contractions are: 1) the Keynesian, 2) the Friedmanite, and 3) the Fisherian. The Keynesian view is that normal economic contractions are caused by an insufficiency of aggregate demand (or total spending). This problem is to be solved by deficit spending. The Friedmanite view, one shared by our current Federal Reserve Chairman, is that protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock. Both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.

The Fisherian theory is that an excessive buildup of debt relative to GDP is the key factor in causing major contractions, as opposed to the typical business cycle slumps (Chart 1). Only a time consuming and difficult process of deleveraging corrects this economic circumstance. Symptoms of the excessive indebtedness are: weakness in aggregate demand; slow money growth; falling velocity; sustained underperformance of the labor markets; low levels of confidence; and possibly even a decline in the birth rate and household formation. In other words, the normal business cycle models of the Keynesian and Friedmanite theories are overwhelmed in such extreme, overindebted situations.

Economists are aware of Fisher's views, but until the onset of the present economic circumstances they have been largely ignored, even though Friedman called Irving Fisher "America's greatest economist." Part of that oversight results from the fact that Fisher's position was not spelled out in one complete work. The bulk of his ideas are reflected in an article and book written in 1933, but he made important revisions in a series of letters later written to FDR, which currently reside in the Presidential Library at Hyde Park. In 1933, Fisher held out some hope that fiscal policy might be helpful in dealing with excessive debt, but within several years he had completely rejected the Keynesian view. By 1940, Fisher had firmly stated to FDR in several letters that government spending of borrowed funds was counterproductive to stimulating economic growth. Significantly, by 2011, Fisher's seven decade-old ideas have been supported by thorough, comprehensive and robust econometric and empirical analysis. It is now evident that the actions of monetary and fiscal authorities since 2008 have made economic conditions worse, just as Fisher suggested. In other words, we are painfully re-learning a lesson that a truly great economist gave us a road map to avoid.

High Dollar Policy Failures

If governmental financial transactions, advocated by following Keynesian and Friedmanite policies, were the keys to prosperity, the U.S. should be in an unparalleled boom. For instance, on the monetary side, since 2007 excess reserves of depository institutions have increased from $1.8 billion to more than $1.5 trillion, an amazing gain of more than 83,000%. The fiscal response is equally unparalleled. Combining 2009, 2010, and 2011 the U.S. budget deficit will total 28.3% of GDP, the highest three year total since World War II, and up from 6.3% of GDP in the three years ending 2008 (Chart 2). Importantly, the massive advance in the deficit was primarily due to a surge in outlays that was more than double the fall in revenues. In the current three years, spending was an astounding $2.2 trillion more than in the three years ending 2008. The fiscal and monetary actions combined have had no meaningful impact on improving the standard of living of the average American family (Chart 3).

Why Has Fiscal Policy Failed?

Four considerations, all drawn from contemporary economic analysis, explain the underlying cause of the fiscal policy failures and clearly show that continuing to repeat such programs will generate even more unsatisfactory results.

First, the government expenditure multiplier is zero, and quite possibly slightly negative. Depending on the initial conditions, deficit spending can increase economic activity, but only for a mere three to five quarters. Within twelve quarters these early gains are fully reversed. Thus, if the economy starts with $15 trillion in GDP and deficit spending is increased, then it will end with $15 trillion of GDP within three years. Reflecting the deficit spending, the government sector takes over a larger share of economic activity, reducing the private sector share while saddling the same-sized economy with a higher level of indebtedness. However, the resources to cover the interest expense associated with the rise in debt must be generated from a diminished private sector.

The problem is not the size or the timing of the actions, but the inherent flaws in the approach. Indeed, rigorous, independently produced statistical studies by Robert Barro of Harvard University in the United States and Roberto Perotti of Universita Bocconi in Italy were uncannily accurate in suggesting the path of failure that these programs would take. From 1955 to 2006, Dr. Barro estimates the expenditure multiplier at -0.1 (p. 206 Macroeconomics: A Modern Approach, Southwestern 2009). Perotti, a MIT Ph.D., found a low but positive multiplier in the U.S., U.K., Japan, Germany, Australia and Canada. Worsening the problem, most of those who took college economic courses assume that propositions learned decades ago are still valid. Unfortunately, new tests and the availability of more and longer streams of macroeconomic statistics have rendered many of the well-schooled propositions of the past five decades invalid.Second, temporary tax cuts enlarge budget deficits but they do not change behavior, providing no meaningful boost to economic activity. 

Transitory tax cuts have been enacted under Presidents Ford, Carter, Bush (41), Bush (43), and Obama. No meaningful difference in the outcome was observable, regardless of whether transitory tax cuts were in the form of rebate checks, earned income tax credits, or short-term changes in tax rates like the one year reduction in FICA taxes or the two year extension of the 2001/2003 tax cuts, both of which are currently in effect. Long run studies of consumer spending habits (the consumption function in academic circles), as well as detailed examinations of these separate episodes indicate that such efforts are a waste of borrowed funds. This is because while consumers will respond strongly to permanent or sustained increases in income, the response to transitory gains is insignificant. The cut in FICA taxes appears to have been a futile effort since there was no acceleration in economic growth, and the unfunded liabilities in the Social Security system are now even greater. Cutting payroll taxes for a year, as former Treasury Secretary Larry Summers advocates, would be no more successful, while further adding to the unfunded Social Security liability.

Third, when private sector tax rates are changed permanently behavior is altered, and according to the best evidence available, the response of the private sector is quite large. For permanent tax changes, the tax multiplier is between minus 2 and minus 3. If higher taxes are used to redress the deficit because of the seemingly rational need to have"shared sacrifice," growth will be impaired even further. Thus, attempting to reduce the budget deficit by hiking marginal tax rates will be counterproductive since economic activity will deteriorate and revenues will be lost.

Fourth, existing programs suggest that more of the federal budget will go for basic income maintenance and interest expense; therefore the government expenditure multiplier may become more negative. Positive multiplier expenditures such as military hardware, space exploration and infrastructure programs will all become a smaller part of future budgets. Even the multiplier of such meritorious programs may be much less than anticipated since the expended funds for such programs have to come from somewhere, and it is never possible to identify precisely what private sector program will be sacrificed so that more funds would be available for federal spending. Clearly, some programs like the first-time home buyers program and cash for clunkers had highly negative side effects. Both programs only further exacerbated the problems in the auto and housing markets.

Permanent Fiscal Solutions Versus Quick Fixes

While the fiscal steps have been debilitating, new programs could improve business considerably over time. A federal tax code with rates of 15%, 20%, and 25% for both the household and corporate sectors, but without deductions, would serve several worthwhile purposes. Such measures would be revenue neutral, but at the same time they would lower the marginal tax rates permanently which, over time, would provide a considerable boost for economic growth. Moreover, the private sector would save $400-$500 billion of tax preparation expenses that could then be channeled to other uses. Admittedly, the path to such changes would entail a long and difficult political debate.

In the 2011 IMF working paper, "An Analysis of U.S. Fiscal and Generational Imbalances," authored by Nicoletta Batini, Giovanni Callegari, and Julia Guerreiro, the options to correct the problem are identified thoroughly. These authors enumerate the ways to close the gaps under different scenarios in what they call "Menu of Pain." Rather than lacking the knowledge to improve the economic situation, there may not be the political will to deal with the problems because of their enormity and the huge numbers of Americans who would be required to share in the sacrifices. If this assessment is correct, the U.S. government will not act until a major emergency arises.

The Debt Bomb

The two major U.S. government debt to GDP statistics commonly referred to in budget discussions are shown in Chart 4. The first is the ratio of U.S. debt held by the public to GDP, which excludes federal debt held in various government entities such as Social Security and the Federal Reserve banks. The second is the ratio of gross U.S. debt to GDP. Historically, the debt held by the public ratio was the more useful, but now the gross debt ratio is more relevant. By 2015, according to the CBO, debt held by the public will jump to more than 75% of GDP, while gross debt will exceed 104% of GDP. The CBO figures may be too optimistic. The IMF estimates that gross debt will amount to 110% of GDP by 2015, and others have even higher numbers. The gross debt ratio, however, does not capture the magnitude of the approaching problem.

According to a recent report in USA Today, the unfunded liabilities in the Social Security and Medicare programs now total $59.1 trillion. This amounts to almost four times current GDP. Modern accrual accounting requires corporations to record expenses at the time the liability is incurred, even when payment will be made later. But this is not the case for the federal government. By modern private sector accounting standards, gross federal debt is already 500% of GDP.

Federal Debt - the End Game

Economic research on U.S. Treasury credit worthiness is of significant interest to Hoisington Management because it is possible that if nothing is politically accomplished in reducing our long-term debt liabilities, a large risk premium could be established in Treasury securities. It is not possible to predict whether this will occur in five years, twenty years, or longer. However, John H. Cochrane of the University of Chicago, and currently President of the American Finance Association, spells out the end game if the deficits and debt are not contained. Dr. Cochrane observes that real, or inflation adjusted Federal government debt, plus the liabilities of the Federal Reserve (which are just another form of federal debt) must be equal to the present value of future government surpluses (Table 1). In plain language, you owe a certain amount of money so your income in the future should equal that figure on a present value basis. Federal Reserve liabilities are also known as high powered money (the sum of deposits at the Federal Reserve banks plus currency in circulation). This proposition is critical because it means that when the Fed buys government securities it has merely substituted one type of federal debt for another. In quantitative easing (QE), the Fed purchases Treasury securities with an average maturity of about four years and replaces it with federal obligations with zero maturity. Federal Reserve deposits and currency are due on demand, and as economists say, they are zero maturity money. Thus, QE shortens the maturity of the federal debt but, as Dr. Cochrane points out, the operation has merely substituted one type for another. The sum of the two different types of liabilities must equal the present value of future governmental surpluses since both the Treasury and Fed are components of the federal government.

Calculating the present value of the stream of future surpluses requires federal outlays and expenditures and the discount rate at which the dollar value of that stream is expressed in today's real dollars. The formula where all future liabilities must equal future surpluses must always hold. At the point that investors lose confidence in the dollar stream of future surpluses, the interest rate, or discount rate on that stream, will soar in order to keep the present value equation in balance. The surge in the discount rate is likely to result in a severe crisis like those that occurred in the past and that currently exist in Europe. In such a crisis the U.S. will be forced to make extremely difficult decisions in a very short period of time, possibly without much input from the political will of American citizens. Dr. Cochrane does not believe this point is at hand, and observes that Japan has avoided this day of reckoning for two decades. The U.S. may also be able to avoid this, but not if the deficits and debt problem are not corrected. Our interpretation of Dr. Cochrane's analysis is that, although the U.S. has time, not to urgently redress these imbalances is irresponsible and begs for an eventual crisis.

Monetary Policy's Numerous Misadventures

Fed policy has aggravated, rather than ameliorated our basic problems because it has encouraged an unwise and debilitating buildup of debt, while also pursuing short term policies that have increased inflation, weakened economic growth, and decreased the standard of living. No objective evidence exists that QE has improved economic conditions. Even before the Japanese earthquake and weather related problems arose this spring, real economic growth was worse than prior to QE2. Some measures of nominal activity improved, but these gains were more than eroded by the higher commodity inflation. Clearly, the median standard of living has deteriorated.

When the Fed diverts attention with QE, it is possible to lose sight of the important deficit spending, tax and regulatory barriers that are restraining the economy's ability to grow. Raising expectations that Fed actions can make things better is a disservice since these hopes are bound to be dashed. There is ample evidence that such a treadmill serves to make consumers even more cynical and depressed. To quote Dr. Cochrane, "Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power when it is basically helpless. If Bernanke had admitted to Congress, 'There's nothing the Fed can do. You'd better clean this mess up fast,' he might have a much more salutary effect." Instead, Bernanke wrote newspaper editorials, gave speeches, and appeared on national television taking credit for improved economic conditions. In all instances these claims about the Fed's power were greatly exaggerated.

Summary and Outlook

In the broadest sense, monetary and fiscal policies have failed because government financial transactions are not the key to prosperity. Instead, the economic well-being of a country is determined by the creativity, inventiveness and hard work of its households and individuals.

A meaningful risk exists that the economy could turn down prior to the general election in 2012, even though this would be highly unusual for presidential election years. The econometric studies that indicate the government expenditure multiplier is zero are evidenced by the prevailing, dismal business conditions. In essence, the massive federal budget deficits have not produced economic gain, but have left the country with a massively inflated level of debt and the prospect of higher interest expense for decades to come. This will be the case even if interest rates remain extremely low for the foreseeable future. The flow of state and local tax revenues will be unreliable in an environment of weak labor markets that will produce little opportunity for full time employment. Thus, state and local governments will continue to constrain the pace of economic expansion. Unemployment will remain unacceptably high and further increases should not be ruled out. The weak labor markets could in turn force home prices lower, another problematic development in current circumstances. Inflationary forces should turn tranquil, thereby contributing to an elongated period of low bond yields. The Fed may resort to another round of quantitative easing, or some other untested gimmick with a new name. Such undertakings will be no more successful than previous efforts that increased over-indebtedness or raised transitory inflation, which in turn weakened the economy by directly, or indirectly, intensifying financial pressures on households of modest and moderate means.

While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern, therefore we remain fully committed to the long end of the Treasury bond market.

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How Greece Could Trigger Another “2008″ Event

by Graham Summers

Editor’s Note: The following is an excerpt from my latest issue of Private Wealth Advisory. In it, I present the most comprehensive overview of the European debt crisis out there, but I also identified one Spanish Bank that is poised on the brink of collapse. To find out which bank it is, how to profit from its collapse and learn about my six other Crisis trades that will pay out double digit returns when the system breaks down again… Click Here Now

The first wave of the next crisis is going to come from Europe where it is clear that the ECB has reached the End Game of monetary intervention. To whit: Greece was bailed out only 13 months ago, it has since requested an extension on those loans and is now receiving a SECOND bailout.

Greece, as a country, really has very little to do with Europe’s economy (it’s about $330 billion out of the EU’s $16 trillion GDP). However, Greece was the first nation to be bailed out. And so it has set the trend for what’s to come in Europe. And what’s to come is the following: default, political shakedowns, and civil unrest.

Ultimately, the BIG players in the EU Crisis are Spain and Italy with GDPs of $1.46 trillion and $2.1 trillion respectively. There literally is NO WAY the ECB can bail these countries out. Which is why in Europe the End Game looms and Greece’s bailouts will ultimately be irrelevant.

What I mean by this is that the ECB has played its hand with the small players (Greece) and is now facing problems it cannot possibly solve. There is only one outcome to this scenario and it is default and restructuring which will involve European banks taking a “haircut” AKA losing billions of Euros worth of money on toxic debt.

However, there is a MUCH bigger problem here and that problem is the same one that created the 2008 disaster: DERIVATIVES.

US commercial banks have over $200 trillion in derivatives outstanding on their balance sheets. However, worldwide, the derivatives market is over $600 TRILLION in size. And the financial system in Europe is as saturated, if not MORE saturated with toxic debt than the US financial system.

According to the Bureau of International Settlements, the total exposure worldwide to PIGS (Portugal, Ireland, Greece, and Spain) debt is over $2.5 TRILLION. Most of this is in the form of derivatives. And 70% of it is from foreign entities (banks and firms located outside of the country).

Let’s take Greece for instance. Courtesy of derivatives, France has $92 billion in exposure to Greece debt. Germany is on the hook for $69 billion. Great Britain has $20 billion. And the US has $43 billion.

These levels, while dangerous, are not catastrophic. As I’ve stated before, Greece is NOT the big problem for the EU. However, worldwide exposure to Greek debt is in the ballpark of $277 billion. So a default there would result in significant market dislocations.

Now consider the exposure to a BIG Problem such as Spanish debt. In this situation, Great Britain is on the hook for $51 billion. The US is on the hook for $187 billion. France is on the hook for $224 billion. And Germany is on the hook for a whopping $244 billion.

As I said before, Greece is ultimately a small player in this mess. Worldwide exposure to Greek debt is $277 billion. Worldwide exposure to Spain, on the other hand, is north of $1 TRILLION.

Now this is where things get REALLY tricky. Because of the intertwined nature of the derivatives market, a Greek default could result in systemic risk for the simple fact that if one of the banks that goes down with Greece has extensive exposure to Spain as well, then things could get ugly very, VERY fast.

Indeed, given that the European banking system is just as, if not MORE saturated than the US’s when it comes to toxic debt, even a small player like Greece could end up triggering another round of systemic risk.

This all ties in with what I’ve been saying for months now… that 2008 was in fact the warm up and that the REAL Crisis is fast approaching. And when it hits, the Fed will be POWERLESS to stop it. Because this time it will be entire countries, NOT just Wall Street banks that collapse. So what’s coming will be the equivalent of 2008 all over again, along with food shortages, civil unrest, outbreaks in crime, bank holidays, and the like. 

It will, in short, be like what’s going on in the Middle East today (though NATO won’t be bombing us).

Which is why if you haven’t already taken steps to prepare yourself and your portfolio for the coming disaster, you need to do so NOW.

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THE ITALIAN BREAKING POINT: 7% YIELDS

by Cullen Roche

Recent research from Goldman Sachs says the breaking point for Italian yields is 7% or just 1.3% higher than current levels. As the EMU fails to create a sustainable solution the markets are wielding an enormous amount of power over the entire global economy. Another substantial economic shock is closer than most likely believe. FT Alphaville provides a nice summary of the situation in Italy:

“3. At what level would Italian yields become unsustainable?
Yields at somewhere around 7% are likely to become problematic, but this depends critically on our assumptions.

If the current rise in bond spreads is sustained and subsequent debt is issued at higher yields, the Italian government’s debt servicing cost will increase. While it would take a number of years for costs to rise (as debt is rolled-over), current yield increases would add to investor concerns that levels of public debt in Italy may not be sustainable. Theoretically, there is a threshold level for bond yields at which such worries over debt sustainability become self-fulfilling …

4. What is the likely impact of rising yields on financial conditions and GDP growth in Italy?

Higher interest rates and a falling stock market have tightened financial conditions by around 40bp in the past two weeks, adding downside risk to the Italian growth outlook.

We gauge the tightness of financial conditions in Italy by tracking four variables (the Italian 3-month interbank interest rate, the 10-year government bond yield, the trade-weighted currency and an aggregate stock market index) and assigning each a weight based on its relative importance in explaining future year-on-year GDP growth.

On this metric, financial conditions in Italy have tightened sharply in recent months—by around 130bp from their average in Q1 to their current level in mid-July. A substantial part (around 40bp) of this move has occurred in the past two weeks, as Italian short-term interbank rates have risen, long-term bond yields have hit post-Euro-zone highs, and the Italian stock market has fallen by some 7%. The Euro has depreciated—providing an offset to the tightening in conditions—but given Italy’s high degree of intra-Euro-zone trade, the weight of the currency in our measure is relatively low. In comparison, given the limited outflow of capital from the Euro-zone as a whole, yields have eased for less risky Euro-zone assets and our Euro-FCI is down about 30bp since the end of June.

On past correlations, if higher spreads are sustained and the stock market fails to recover, the negative impact of this sharp tightening in financial conditions on Italian GDP growth could be significant. There is a risk that annual GDP growth could fall from +1.0%yoy in Q1 into negative territory …”

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The Coming Correction in Gold & Silver

by J.W. Jones

“It’s going to be a season with lots of accidents, and I’ll risk saying that we’ll be lucky if something
really serious doesn’t happen.”
~ Ayrton Senna – Brazilian Race Car Driver ~

“Often you need to take some risk, but it must be a realistic risk, you can’t take a crazy risk.” ~ Sergei Bubka – World Pole Vault Record Holder ~

Currently risk assets are in a constant crossfire stemming from multiple forms of headline risk. The price action as of late has been choppy as the news flow is directly impacting the tape. I have been reluctant to accept any significant risk recently and I would point out that cash has certainly outperformed the S&P 500 over the past 6 – 7 trading sessions.

The news flow and economic event risk is reminiscent of 2008 when traders were sitting on edge waiting for the next piece of information detailing which investment bank would fail next. Economic reports were dismal, earnings disappointed, and structural unemployment reports spewed from the media. The fear was palpable and the current backdrop within the financial market construct feels eerily the same way.

This is not to say that I expect lower prices in the S&P 500, it is simply an acknowledgment of what transpired in the past. I remember initially trading small through various parts of the crisis but after getting chopped around I determined that sitting on the sidelines was a much less stressful strategy.

At this time I do not have a directional bias regarding the S&P 500, but what is evident to me is that this market is coiled up and the resolution of price discovery will be harsh regardless of which direction price ultimately moves. I expect the eventual resolution of price will be followed by strong volume and momentum and Mr. Market will tip his hand, if only for a moment. The outcome will be an extremely strong move in the underlying price action of the S&P 500. As always, the most important question is which way will Mr. Market ultimately favor?

The daily chart of the SPX illustrates the key price levels which will serve as clues about the short term price action in the index:

Instead of focusing on my agnostic position as it relates to the short term price action in the S&P 500 index, I determined that I would ruffle a few feathers and reiterate why I am expecting a looming correction in gold and silver. Before the hate mail begins piling up I would point out that in the longer term I remain a precious metals bull. However, astute traders recognize the inability of an underlying to rise in perpetuity.

Gold futures have risen from $1,478.30 / ounce on July 1st to $1,607.90 / ounce at the close of business on July 18th. The move higher in gold represents a net positive 8.76% gain in the price of gold in the past 17 days. In addition, gold futures have tested recent highs and broken out to the upside. Silver has also been on a tear higher. Silver futures have rallied from $33.47/ounce on July 1st to as high as $40.88/ounce on July 19th. The change in price represents a net 22.14% gain in less than 3 weeks.

As I stated above, in the longer term I continue to believe that higher prices are likely for both precious metals as a result of the continued devaluation of the U.S. Dollar by the Federal Reserve. The Federal Reserve is not alone in the blame as multiple Presidents, Congress, and agency heads have been complicit in creating the economic problems facing the United States as a country. The charlatans like to point the finger at one another, but in the end they are all to blame.

In addition to the wasteful spending practices and failed stimulus packages coming out of Washington, we recently heard from Federal Reserve Chairman Ben Bernanke during his recent press conference. In an unbelievable two day media blitz, the Fed chief went back and forth regarding the steps the Federal Reserve would take if the U.S. economy began to stall.

Ultimately Mr. Bernanke has threatened to initiate Quantitative Easing III and if such a program takes place the price of gold and silver will only go higher in the longer term. However, at this time I am viewing the price action in both metals as overbought or certainly nearing an overbought condition.

Another catalyst for a possible pullback or even a potential selloff in gold can be found on the 4-hour chart of $GLD. The existence of a bearish Fibonacci butterfly on the chart shown below lends credence to further downside.

I would make sure to point out that if the pattern fails the move higher will be swift and harsh. The pattern would still be intact if prices were to get to $160/share on $GLD. Fibonacci butterfly patterns show up all the time in price action. Just like any other type of analysis, they are not fool proof nor do they always work out. However, the presence of such a pattern must be noted. If the pattern fails gold will be off to the races, but if the pattern plays out a selloff is right around the corner.

I am anticipating that a possible back test of the recent breakout level seen on the $GLD daily chart below is becoming increasingly more likely.

If price tests the breakout level and support holds we could see a move to the $160/share price level play out. However, if the price of GLD falls below the key breakout level the daily chart will have carved out a failed breakout and lower prices will be imminent. For short term gold traders caution should be warranted.

Switching gears to silver, a back test of the breakout level is likely. Similar to gold, how price handles the breakout level will be telling. If silver prices push through support it is likely that the white metal will sell off sharply and price would carve out a failed breakout which could add momentum and volume to the selloff. Currently as I write this silver is testing the breakout level. The next few trading sessions will be critical in determining the price action of the white metal in the short run. The daily chart of $SLV is shown below:

The price action the remainder of this week and next week will be very telling as to the future prices of precious metals. We could see backtests that hold on gold and silver and higher prices in the near term or we could see breakdowns which carve out failed breakouts and fast moves lower.

Longer term I still like precious metals, but both gold and silver are due for a short term pullback. The question precious metals investors and traders should be considering is whether we experience a short term pullback or whether prices selloff sharply?

With regard to risk assets in general at present, I would reiterate that headline and market risk are exceedingly high! Proceed with caution!

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