US Isolationism?

Frankly, I don't understand what's happening in the markets at the present time. Perhaps there is information to which I do not have access. Perhaps my model of what "should" be happening is faulty.

The key issue which is causing me to stop and re-examine the validity of my model, is yields. The following Charts (courtesy stockcharts.com and decisionpoint.com) reflect this issue:

Why, are yields not rising when:

• The US Government is so short of Capital that it is raiding pension funds to pay day-to-day expenses whilst it discusses raising its borrowing limit to over $8 trillion?
• The equities and commodity markets are giving buy signals - indicating that either the economy should grow from here (more robust economic activity places a strain on capital availability and rates should rise), or that inflation is expected to re-emerge (indicating that unless rates rise they will turn negative)?
• The US Dollar Index is reaching for long term technical support at around 80?

• The US Government continues to run its affairs such that expenditure exceeds income - giving rise to a need to either print money (inflationary) or borrow money? (Interest rates "should" reflect a credit risk premium, and the US Government surely represents an increasing credit risk at present).

Yes, I could understand it if the market thought we were heading for deflation. Then interest rates could (and should) remain soft. But by the same token, there is no way that commodities should be rising to new heights or the US equities markets should be giving buy signals.

Alternatively, given the latter two occurrences, interest rates should be also rising. But the only technical indicator that is showing interest rates are currently in a rising trend is that the rising trendline on the P&F chart is still intact. The PMO is turning down, when it "should" be breaking up. Why?

Why are yields not rising from here? It doesn't make sense, and there are only five conclusions that can be drawn:

• The "model" is flawed and needs to be reassessed.
• Something structural is changing which has not yet manifested
• The market is manifesting some form of schizophrenia, where some investors are bullish and others are bearish - but they are playing on different fields
• The buy signals in the equities markets and commodities markets are "false", and we are heading for a period of deflation
• The phenomenon of apparently weak yields is temporary.

There is a sixth possibility, but it seems a bit off-the-wall at present:

The US Dollar Index support level at around 80 does not hold, leading to a US Dollar collapse, and the commencement of a period of isolation of the US economy from the rest of the world.

At present, this idea seems a bit "flaky" to me, but let's explore it a bit.

If the US Government is going to insist on printing its way out of its problems, it will flood the market with cash. A surplus of cash will lead to two things:

1. A low price of capital inside the USA (and therefore low yields)
2. Rising inflation in US Dollar denominated items

In the meantime, such irresponsible behaviour will cause holders of dollars to want to get out of their holdings - so they will dump them, thereby causing a dollar collapse.

This line of thinking starts to sound less flaky when we look at the world economy from the perspective of someone who does not live in the USA.

First, let's look at the world through the eyes of the Chinese. Their Renminbi is linked to the US Dollar and so, to all intents and purposes, their economy is a Dollar denominated economy - but without the benefit of being able to print more dollars.

Here is what has been happening to the Shanghai Market over the past five years (courtesy yahoo.com)

It is not looking particularly happy.

And here are two charts of the Euro gold price

The following charts are courtesy of

http://www.gold.org/value/stats/statistics/monthlysince1971.html

Yes, it looks like those countries to whom gold is important - such as India - have been actively accumulating gold as a "currency"

And even the Japanese appear to be getting onto the band wagon

But what I find intriguing is that the gold charts of the "conservative" economic areas - such as Europe and Japan - are rising at relatively modest rates. It hardly looks like a panic situation from their perspective.

Some months ago, I started to be intuitively drawn to the biological concept of "bifurcation" - where an organism that is growing, splits into two separate entities.

It sounded flaky at the time, and I have to admit it still sounds a bit flaky. But the evidence seems to be mounting that the USA is going off in a direction that may lead to economic isolationism, whilst the rest of the world carries on going about its business.

Of course, those countries - like China - which have historically fed off the USA as a primary economic "driver" will likely suffer in the short term.

But guess what? Japan has quietly been building its own bank of R&D. It is now a world leader (through Japanese Rail) in Magnetically levitate trains, and (through Toyota and Honda) in the "next generation" of hybrid motor cars. Toyota has also committed via its own R&D to perfect a fuel cell driven vehicle. Yes, Japan's own capital markets are a bit dysfunctional, but its Industrial base is solid, and the country has been slowly reorientating to "next generation" technologies.

It is now generally accepted that Natural Gas will play a big role in the world economy going forward; and Australia has 100 years of "proven" reserves, and it anticipates a further 70 years of resources at current levels of consumption. It is also the worlds third largest producer of gold.

Look at its stock market performance (All Ordinaries) relative to the Dow Jones over the past five years

Conclusion

There are only three logical alternative reasons why yields in the USA are not behaving according to the model's expectations:

1. The buy signals in the equity markets and Dollar denominated commodity markets are "false" (increasingly unlikely)
2. Yields are only temporarily weak, and should soon start to rise (more likely, but as yet no conviction)
3. The USA dollar is heading for a collapse, and the US economy is headed for a period of isolationism.

At face value, 3 above may seem flaky, particularly given the USA's predisposition to play a world leading role on the "globalization" front; and particularly in light of its political and military activities on the world stage. Nevertheless, that's what the markets seem to be telling us at present.

In terms of a conventional biological model, the immune system of a sick organism will kick in to fight the cause of the sickness with the objective of eradicating it, so that the overall organism may heal itself. Either that, or the organism dies.

$8 trillion dollars? Maybe the USA can live with that internally, but from a foreigner's perspective, maybe we'll pass on that one.

Brian Bloom

November 20^th, 2004