carry trade currency

Shorting the US dollar

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I continue my winning strategy of shorting the U.S. dollar.  Since about the summer of 2009, I devised a strategy whereby I use the available margin in my combined US/Canadian trading accounts to borrow US dollars to buy CDN oil & gas and mining companies.  This trade has been a consistent winner.  Then in the Spring of 2010, I started to sell option puts on ABX, GG, NGD, PWE, PGH, ERF–Canadian companies which trade in the US stock exchanges and options markets.  This trade has been consistently profitable as well.  Indeed, I’ve only had two assignments on the US side, and within a week in each case, I was able to trade out of the assignment (with a small profit) and to sell another put on the same position.  As of today, puts in the Canadian market have been a net losing venture (on paper) and I still  own assignments in PBN, PBG, and DAY.  But it is just a matter of time before these companies recover.  Selling the puts has given me downside protection which I don’t have in my junior oil exposure or in my long positions that have gone south (e.g., TOL, PMT).

Questrade has made it easier for me to implement my strategy as a DIY investor, because their platform, unlike TD Waterhouse, gives the DIY investor direct access to OTC (over the counter) markets in the US.  With Waterhouse, I had to call the trade in, and while they gave me the discount brokerage commission rate, I could not change a bid in mid-stream without also calling them.  So, for example, I was able to use today my available margin to buy CDN equities in US dollars directly–and the OTC markets give me access to the companies too small to be listed on the New York stock exchanges.  Today, I bought LSG/LSGGF (Lake Shore Gold) at US $2.25, which has a NAV and book value now exceeding its share price.  They are having current production issues.  Raymond Brown downgraded it yesterday, but still considers it to have a one year target price of $3.40.

Macro Trends Supporting this Trade

Let’s just face it.  The US dollar is a failed currency.  It’s buying power must wane because in three short years, Ben Bernanke has created 3x the adjusted money base.  It is now only a matter of time before the dollar dies.  I doubt that anything can be done to save it now, even if Congress were to balance the budget.  But balancing the budget won’t be enough.  They would have to go and arrest Ben Bernanke and replace this tired out Keynesian with an Austrian, because nothing will stop him from creating more money out of nothing.  Sure, keep the debt ceiling where it is and Bernanke will simply monetize the old debt as it turns over.  Almost a half trillion dollars of debt will come due by the end of August, and Bernanke has been buying 70% US debt in the last few months.  Where is the US going to find buyers for this debt now?  Furthermore, nothing will stop Bernanke from buying the debt owed to the Social Security Trust Fund so that Obama can continue his spending spree.

The Canadian Loonie is climbing against US dollar.  It reached $1.06 today.  And this is not because it is a good currency; it is a terrible currency with the Bank of Canada holding interest rates below what is reasonable.  This has caused a housing bubble in Canada.  But the Canadian debt to GDP (30% acc. to the link) is much lower than in the US, which stands 350% according to the following chart (supplied by Lacy Hunt, Hoisington Asset Management):

Now we are hearing rumours that there is a debt deal between Boehner and Obama which will really disappoint a lot of hard-working Americans with savings:  3 trillion in spending cuts over 10 years for a 2.5 trillion ceiling raise.  When hyperinflation takes over and the dollar sinks to nothing, hopefully then, there will be some responsible adults who can take over the government of the United States.  Now it’s being run by children and criminals.

Ultimately, to do well in investing you have to own what the people who have money want. The creditors have told the world explicitly that they don’t want US dollars any more (and that’s why Bernanke is buying 70% of US debt)–though they continue to prop up the dollar,  biding their time so that they may exit this trade with the least damage to themselves; what they really want are hard assets: oil, gold, silver, rare earths, food and all other commodities. That’s why I am long physical gold and silver (Sprott Physical Gold and Silver Trusts) and Canadian oil & gas and gold mining.  This is how the Chinese are investing, you know the people with the largest currency reserves in the world that I am aware of.  What are they buying?  The Chinese are sinking another 2.1 billion into Canadian oil.

Meanwhile the American consumer is using his credit card to buy staples.  When that’s no longer possible, many people will be facing starvation.  Don’t look to the government for help because all they will be able to do is hand out debit cards (the new food stamps) filled with worthless dollars or welfare cheques likewise denominated in worthless dollars.

Ron Paul should have asked Bernanke if the US dollar was money.  If Bernanke had said it isn’t, he would finally show some understanding about economics.

Is it time to buy US? I. Studying the fundamentals

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Blogging has been a great help to DIY investors.  They can formulate their own strategies in writing, see what works, and share their knowledge with others.  Bloggers often have skin in the game; it might not be very much skin, as many are not rich people, but they are real investors and not like young journalists who don’t really have much hands on experience with trading or owning anything more elaborate than index or mutual funds in their RRSP accounts.

One of the clear reasons for thinking that many financial journalists are not particularly knowledgable about investing is that they are always engaging the advice of “experts” who are wrong most of the time.  Blogger Devon Shire is hypercritical of Robert Prechter, whose predictions are often dead wrong.  Another famous talking head is Dennis Gartman, whose own fund, HAG.TO, has remained essentially static since the fund began in 2009 while the stock indexes have greatly improved.  So why is this guy on TV?  He’s doing worse than an ING Direct savings account, where at least your money gets 1.5% interest.  The original investors of his HAG’s IPO at $10.00 are still 35 cents below water.  In the meantime, the Dow Jones and the TSX are both up about 60%.  How can a fund lose money in these conditions?  Why does Dennis Gartman get on TV and why do so many financial advisers read his famous Gartman Letter?  I think it may be because the journalists and the advisors are themselves incompetent.  At least all the many sheep following Warren Buffet around can say he is the best investor of all time.  A proven track record is actually a sign of competence.  But what proves that Gartman or Prechter know what they are talking about?

Bloggers, who have skin in the game and gain experience as they go, thus contrast with financial journalists.  Consider the Financial Post’s John Shmuel has a column with the title, “Lofty loonie spells buy opportunity”; but just a few weeks ago, he’s done columns on why Canadian stocks will outperform.  So why would he change his mind?–Or does he even see the contradiction? Well, as a journalist, he’s not actually trying to present a coherent strategy but information as it comes to him.  So I find that journalists can be great sources of information but terrible sources for eking out an investment strategy.  Why does Shmuel think that the lofty loonie spells a buying opportunity for US equities?  It seems for no better reason than that loonie is at a three year high.

Well, I did a few blogs about how and why I short the US dollar by using leverage in my US margin account to buy Canadian gold mining or oil and gas companies (e.g., abx, gg, erf, pwe, pgh).  The dividends from the oil and gas companies cover the interest charges and some.  Later, I added the selling of put options on the same equities, and reduced my overall cost of carry, because the leverage is now pushed off to some time in the future and I don’t actually have to pay interest on it today.  Has this strategy worked?  Extremely well.  Now that the loonie is at a three year high, will I now go long on the greenback or US equities as Shmuel’s article advises?  I don’t think so.  Consider the following chart (source Yahoo! Finance, straight line is mine):

What we see is that the loonie hit a low of $1.61 in 2002 and has basically improved in a nine year trend against a dollar.  Once the extremes of 2008-2009 are removed, a secular trend emerges which would suggest that the greenback will continue to move down against the loonie unless the fundamentals that caused this trend are changed.  If we looked at gold or oil against the dollar, we will see the same trend.  What we are seeing in the chart is US dollar inflation.  Not that the loonie is much better, but what happens in periods of inflation is that the cost of commodities rise.  Since the Canadian dollar depends so much on commodities, then whither commodities so the loonie.  If the price of commodities is increased by the inflation of the US dollar, can we expect this trend to reverse?  I think so if any of the following events were to happen:

(1) If Bernanke gives up QE.

(2) If Stephen Harper announces a deficit budget in the order of 150 billion or more (its is currently projected at 45.4 billion).

(3) If the US Congress makes serious cuts or attempts to balance the US federal budget.

(4) If the Chinese and other foreign investors decide to abandon Canada.

Let’s discuss each of these issues:

(1) If Bernanke gives up QE. I fully expect him to announce QE 3 in the next few months.  If he doesn’t continue to implement QE then the US government will have to make serious cuts of a trillion or so dollars from its current spending.

(2) If Stephen Harper announced a deficit budget in the order of 150 billion or more.  The Canadian population is about 1/10th that of the USA.  Therefore, the Canadian deficit would have to reach 150 billion in order to match the magnitude of the US deficits of 1.5 trillion.  I don’t see this happening under Harper’s watch.  In fact the trend is that the deficit is dropping in Canada.

(3) If the US Congress makes serious cuts or attempts to balance the US federal budget. This won’t happen until a cost cutting president gets elected.  It may actually never happen.  But the new Republican House is arguing over small cuts which won’t make any difference in a 1.5 trillion or so deficit.  Cut a few hundred billion out of that, and you are still over $1 trillion.

(4) If the Chinese and other foreign investors decide to abandon Canada. Right now, China, Korea, Thailand, Japan are all pouring money into Canadian resources.  Heck, foreigners are even buying our sovereign debt.  I see this trend continuing, as Canada has what these economies need, commodities.

The economy in the US is bad.  I’ve lost money in the US in a bad real estate deal started in 2008.  You won’t see me fall into that trap again unless the secular trends change.  My feeling is that my reasons for shorting the US dollar haven’t changed because the loonie has improved to $1.03 US.  This is a sign of secular trend not a buying opportunity for US stocks.

And if you ask me why I expatriated from the US?  I’ll tell you now that it’s so that at least one of my dad’s four children will still be able to take care of him in his old age.

Update:  Why pick on the Financial Post and John Shmuel?  David Berman has a similar article at the Globe & Mail: “Bruised greenback an opportunity for Canadian investors.”  Like Shmuel, he makes it clear that the US dollar is at a low but doesn’t seem to deal with any of the secular trends that put it there and then irrationally states:

It seems likely that the worst of the freefalling is over, given that the factors that drove the dollar down – including massive deficits and stimulative monetary policies – will probably move in reverse as the economy improves.

But he provides no actual proof that the US economy is improving.  That’s just baseless optimism as far as I can see.  Personally, I doubt that the damage of the QE that Bernanke’s already done has run its course.  Some inflationistas believe that when the economy actually improves, that’s when we will see the full effect of monetary inflation, because then velocity and credit will also expand.

Thoughts on Inflation

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Andrew wrote at the City of God about inflation as welfare for the rich:

(I’m using “inflation” in the Austrian sense here: increase in the money supply, rather than increase in CPI price levels)

I just heard this recently, and it made sense to me:

1. The entire Keynesian scheme of monetary/fiscal spending to stimulate the economy only works because it takes time for people to catch on to the reality that newly printed paper is not real wealth. That is, people don’t immediately realize that they are spending fiat-money, and thus act based on thinking they have more money than they really do.
2. This temporarily causes greater investment, which has the potential to create real wealth and real economic growth.
3. However, as time goes on, sellers realize that buyers have more money, and thus prices rise accordingly, bringing the economy back to status quo ante, except with possibly increased debt (if enough real economic growth did not occur before the sellers caught on).
4. In the case of monetary policy specifically, newly printed money inevitably goes to the rich first: to banks, and from there to massive corporate investments.
5. As time goes on, more of the poor get the new cash, but it also simultaneously becomes less valuable, since prices are rising.

Thus, monetary policy seems to be, inevitably, welfare for the rich.

(Note that none of this would be an argument against government welfare, based on tax-hikes (not spending fiat money), for the poor.)

I responded with some thoughts as an investor:

(1) CPI has not been affected by the inflation of fiat money because there has been no velocity (MV=PQ). Instead of lending money, banks have bought safe US treasury notes to pad their reserves. They have used TARP money to do this. Essentially the US government lends TARP to banks which lend it back to the US government. Also the Federal Reserve bank has bought CDOs from the bank, and the banks have used that money to buy US treasury notes as well.

(2) What we’ve seen since the 2008 credit collapse can therefore be better described as reflation–reflating shrunken credit with fiat money. There are still some mortgages that are collapsing so it may be sometime before we see the most serious detrimental effects of current US fiscal policy (1-2 years?).

(3) Investors are probably more aware of the potential dangers than the public. Therefore we have been making moves in anticipation of a US dollar collapse. This is known as the US dollar carry trade.

(4) Gold is an indicator of inflation, but it also experiences the anticipatory effects of panic about the dollar, as well as periods of profit taking. Its price may therefore at times suggest an overcompensation.

(5) The best hedge against inflation is debt. But you have to buy something with the funds you borrow in order to cover the interest: real estate, dividend bearing stocks, or income investments in foreign currencies or countries (a.k.a., carry trade). The risk is that the investment you make with the debt will not maintain its value, but I consider the current risk of loss of holding currency to be an absolute certainty. So better to own anything except money. For this reason, my current non-registered investment portfolio is 150% in stocks.

(6) Inflation caused by government deficits is not really generational theft as suggested so often by conservatives (or those criticizing current deficits). It is theft of current creditors, bank account holders, fixed income earners and workers, whose current paycheques are garnished through the hidden cost of inflation. It is true that CPI lags inflation, but then pay raises lag CPI. I consider inflation to be especially a heist of the retirement accounts of the older generation–financial advisers often recommend subtracting your age from 100 and that remaining number is what you should have in volatile assets like stocks. The remaining is to stay in fixed income. So if you follow this advice and you are over 70 years old, then 70% of your portfolio is subject to government theft by inflation. Many of these retirees just abandoned stocks altogether during the collapse and now they have cash which is being killed by inflation. It is not a pretty picture. But inflation is not a theft of the younger generation because when the enter the workforce they will earn the currency at its current value.

(7) Inflation in the US will be necessary: (i) to be able to pay the interest and principle on the current debt, inflation is the only way–it is a form of bankruptcy; (ii) to create an effective decrease in the recent minimum wage hike which has put millions of teens and other low wage earners out of work. (iii) to use bracket creep in order to increase everyone’s taxes; (iv) to make effective reductions of entitlement obligations which can’t be paid for.

(8) I am not “rich”, but as an investor, I’ve been able to ride this wave, and I’ve done very well thanks to being able to make the right kinds of move in anticipation of current US inflationary policy, but I may have to bite the bullet on an investment I made with my brother in Austin just before the collapse and that hurts.

(9) While not “rich”, we were able to get a huge amount of bank credit just when I needed it in Oct 2008. That has been great boost to my investments. So indeed, the banks were giving credit to some people, contrary to the widely held belief that no one could get loans.

(10) It is much better right now to be in Canada than the US.

(11) Inflation doesn’t rob the poor but the middle class and wealthy who have holdings which are not hedged against inflation.

(12) Ferengis will make money during periods of inflation.

I’ve since learned that CPI (Consumer Price Index) is manipulated and underestimates inflation by about 7% per annum.

Shorting the US dollar

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A Canadian friend told me that he was thinking about taking a long position in GE.  It was at an all time low and evidently oversold at the time (under $7).  I warned him that stocks held in US currency were risky for Canadians because they would have to buy US currency at a high price but that, with the Obama government overspending and all, the US dollar was going to lose its value quickly.

GE hit its low in early March, and let’s say that my friend bought at $6.66, its closing price on March 6.  On that day, he would have paid about CDN $1.27 for every US $1.  So 100 shares would have cost him $6679.99 (which is inclusive of the $19.99 commission), or CDN $8483.59.  GE today is selling at $16.52 today.  If you add the three quarterly dividends (ex dividend date 17 Sept, 17 June, 17 March), he would be looking at a total of $16.82 per share or a phenomenal 152% rate of return.  But what is that today in Canadian funds?  $16820 = $17755 (1.056)  That is today in Canada, his investment has 109% rate of return, which is still wonderful, but as a result of the diminished power of the US dollar, much less than 152%.  But in the likely event that the US dollar continues to plummet, his return on investment will continue suffer in Canadian value.

I’ve taken short positions against the dollar by borrowing US funds to buy Canadian oil and gold companies (erf, abx: NY) .  Also, I will convert every penny of US funds that come in into Canadian until the currencies reach par.

Yesterday I learned that many investors are beginning to use the US dollar as the new “carry trade currency”.  I didn’t know what that meant so I looked it up.  It is a reference to borrowing currency that has a low interest rate, changing into a foreign currency and making investments in that currency (such as GICs or buying stocks).  Well, I guess my investment strategy is a trend rather than idiosyncratic.  I was basing this strategy on the fundamental conviction that US dollar, despite the current deflationary tendency, would suffer because of the Obama budget deficit.

Links:

Dollar is the ‘New Peso’

Is the Dollar Set to Become the new yen?