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Wednesday, August 3, 2011

Operation Twisted: Gold, the Swissie, Financial Repression and Annaly

The markets rebounded today and prevented the earning of the dubious distinction of longest down day streak set back in 1978 at 9. All three major indices finished up less than 1% but up none the less. Today Gold hit new highs today closing at $1666.30 after reaching as high as $1,675.90. Gold’s rise today was spurred by the economic situation and Switzerland’s decision to lower interest rates to try and weaken their currency.

There are few safe haven assets today besides the metals but the “Swissie” is one of them. The problem is that the amount of money flowing out of the Euro zone as well as other money from around the world seeking safe haven related to a growing distrust of FIAT currencies has been driving the “Swissie” to records. Yes, the Swiss Franc is a FIAT currency but the Swiss are known for their stewardship of the currency as well as being a monetary haven. Dear reader, if you think of Switzerland who still has a AAA credit rating along with a positive outlook but a GDP of about 550 Billion Swiss Francs and then think of the oceans of cash looking for a port in a storm and one can see why the “Swissie”  has appreciated.

The problem for the Swiss is that their currency has gotten so strong that it has caused a feedback loop of money seeking safe haven which continues to reinforce that strength. Ironically, just about a week ago I saw an article that described a proposal to have two Swiss Francs one of them backed by gold. Could you imagine how strong that currency would be versus how weak the regular “Swissie” would become.

Switzerland has a population of about 8 Million which is not large enough to have internal markets to support their industries, to do that a country needs around 30+ Million inhabitants. The Swiss economy is heavily export dependent and the strong currency is impacting their ability to compete for business. Remember that the manufacture of fine watches and great chocolates is only part of their economy and they have a very large and strong industrial sector as well.

As an aside before I went in to finance I ran a small manufacturing company that used to import machinery from a Swiss company. The machines that we imported were of very high precision and quality but the pricing was shall we say less than competitive with machines of the same size but lesser quality coming from Asia. The high price structure was due to the strength of the “Swissie” even at that time and the high cost of skilled labor there versus the same labor elsewhere in the world. The Swiss company ultimately went out of business and we acquired the rights and assets so we could continue to manufacture the machinery but here in the US. Even with the weaker dollar the labor costs of American machinists ate heavily in to our margins and while we were more competitive than our Swiss counterparts we were less competitive than manufacturers from the far East.

As a result of all the capital rushing in to the Swiss banking system and driving the value up action had to be taken. The Swiss have long been known as a business savvy and practical people so it did not surprise me to learn that that counter measure they took did not have to do with intervening in the markets like Japan regularly does.  The Swiss central bank instead decided to lower interest rates which made the “Swissie” slightly less appealing as a safe haven as some of the hot money may pull out seeking better yields elsewhere. This seems like a good strategy to me as not to undercut your currency but stem the flow with longer lasting results than direct intervention. The  problem for the Swiss is that their interest rate  is now basically at zero so they can’t pull that rabbit out of their hat again. This action by the Swiss National Bank is part of the reason for the strength in Gold and Silver today as another perceived safe haven takes it on the chin.

In addition to the Swiss actions today the rumor mill was fired up as there were rumblings of QE3 being discussed by various FED officials. The QE3 boogey did not cause but certainly aided the bounce off the lows today. As the markets were tanking out I decide to tune in CNBC again today to get a pulse of the mood. The prevailing mood was again a mixture of fear and despair as the stocks descended in to their lows and everyone from the hosts to the guests were bearish and expect further large declines.  I am not sure about you dear reader but after 8 days of declines it felt to me more like an exhaustion day and interestingly the volume increased as we came off the lows today. The consensus was that no one believes that this was a bottom of any kind, where as I get the feeling that the decline was manufactured since the markets got everything the wanted: no debt default, no tax raises, and no credit downgrade. The other fear over the past couple days was Italy’s debt status as they are considered “to big to bail” so fears of a contagion gripped the markets even though nothing really transpired there.

It would be my contention that what we have witnessed is the markets throwing a temper tantrum to cajole “B52 Ben” to fire up the QE3 bombers and give the order from HQ in Jackson Hole later this month. Now dear reader I have made my position pretty clear in the past that QE is a giant waste and serves no purpose other than to foster bubbles and bail out fat cats, but who is it that comprises the market? The QE programs have been a failure on so many levels but they did goose the markets didn’t they? I have also said that the next QE may not take the same form and most certainly will not be called QE. A new old euphemism has been circulating in place of QE called “Operation Twist” which is a rehash of the same ploy used 40 years ago in 1961. Essentially it is QE targeting certain duration of the yield curve to flatten it out. The net effect of Operation Twist, QE or Financial Repression is the same, to suppress interest rates and allow inflation to increase thereby reducing the size of deficits over time.

In this kind of environment safe havens like Gold and Silver (anti-debt assets) work well since you are dealing with negative real interest rates, cheap FIAT money and lots of debt. As I have stated in other missives companies that can grow their earnings and have a record of increasing dividends are also good candidates for this environment as I believe that for many investments dividends will be a major component of total return.

One stock that I have featured in the past is Anally Capital (NYSE : NLY) a stock that is commonly referred to  as an MReit or Mortgage Reit. Given that the FED has stated they intend to keep rates suppressed for an extended period a stock that pays a 14% yield is attractive and trades close to book value. Annaly is not the only MReit but in my opinion their management is top notch and has proven itself capable of navigating today’s tricky waters. I wrote an article recommending Annaly a while ago but I feel that the same rationale applies today, and you can read the article by clicking here. Others of interest in the Mreit space are Hatteras Financial (NYSE : HTS), Chimera (NYSE :CIM) (which Anally owns a big chunk of) and American Capital Agency Corp (NASDAQ : AGNC) . Each of the Mreits pays a high dividend but you should do your own due diligence as there are differences in how they get to those dividend numbers by the kinds of securities they deal in.

If you do buy in to the MReits you need to be aware that they can be somewhat volatile at times for a variety of reasons.  I have owned Annlay for well over a year and in that time the stock has trended higher over time and paid dividends but also there have been several price drops.  The most common reason for the drops in price that happened while I have owned the stock have come as a result of secondary offerings. The perception is that the secondary offerings are diluting the current share holders but that has not been the case. Instead of dilution  the capital raised by the offering is used to acquire more securities after all this is the method by which Annaly maintains market share and grows their own fees since they want to continue to make increasing sums of money just like you enjoy a salary increase.  A real risk to the Mreit is one of rising rates, since they do use leverage to achieve the high dividends they pay out, but in the current environment where the FED has telegraphed that its intention is to keep rates low the MReit should perform very well. The key will be not to overstay your welcome with an MReit. If one feels that rates are to rise then a new home should be found for your capital, until then you can enjoy the income.

The MReits have pulled back and are working their way back to equilibrium from a precipitous but extremely short lived crash. You see dear reader the Debt Ceiling debate, possible default,  potential US credit downgrade  and algorithmic machine trading all conspired one day last week to takedown the MReits. At the height of the Debt Ceiling Kabuki theater ,with the media publicizing every move of the legislative sausage making process the notion that Congress would not come to an agreement and actually default ran wild through the credit markets. MReits are interest rate and credit market sensitive instruments so the idea of a default caused a “no bid” scenario in the repo market and the next reaction was for the algorithms to kick in and sell off the MReits plunging some of them in excess of 15% in seconds. Fortunately, sanity returned to the market as the media flipped back to a story that no default would take place and the Mreits recovered much of their losses and today are almost back to the level they were at prior to the selloff. The other threat to Annaly or the other MReits would have been a credit down grade as that would have affected interest rates, but Fitch and Moodys both affirmed the US’s AAA status so that is not a problem at the moment.

I tell you this story because I want to highlight the potential scenarios you could face if you decide to invest in an MReit like Annaly. Armed with knowledge you will not panic when these situations play out and you can make clear decisions ahead of time and evaluate what is going on in the heat of battle.

1 comment:

Lynx said...

Thanks Roger! Any idea on how income from a US REIT is taxed if I'm in Canada? (it's me..Lynx) ;)

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