The Treasury Auction Shell Game
By: Peter Schiff, CEO & Chief Global Strategist

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Very few people have either the time or patience to sift through the data released by the Treasury Department in the wake of its bond auctions. But the numbers do provide direct evidence of the country’s current financial condition that in many ways mirror a financial shell game that typifies our entire economy.

Despite continued deterioration of America’s fiscal health, the Treasury is still attracting adequate numbers of buyers of its debt, even with the ultra low coupon rates. Market watchers take these successful auctions as proof that our current monetary and fiscal stimulus efforts are prudent. But who’s doing the buying, and what do they do with the bonds after they have been purchased?

Most people are aware that foreign central banks figure very prominently into the mix. They buy for political reasons and to suppress the value of their currencies relative to the dollar. And while we think their rationale is silly, we do not dispute that they will continue to buy as long as they believe the policy serves their own national interests. When that will change is harder to determine. But another very large chunk of Treasuries go to “primary dealers,” the very large financial institutions that are designated middle men for Treasury bonds. In a late February auction, these dealers took down 46% of the entire $29 billion issue of seven year bonds. While this is hardly remarkable, it is shocking what happened next.

According to analysis that appeared in Zero Hedge, nearly 53% of those bonds were then sold to the Federal Reserve on March 8, under the rubric of the Fed’s quantitative easing plan. While it’s certainly hard to determine the profits that were made on this two week trade, it’s virtually impossible to imagine that the private banks lost money. What’s more, knowing that the Fed was sure to make a bid, the profits were made essentially risk free.  It’s good to be on the government’s short list.   

Given that the Treasury is essentially selling its debt to the Fed, in a process that we would call debt monetization, some may wonder why it doesn’t just cut out the middle man and sell directly. But the Treasury is prevented by law from doing this, so the private banks provide a vital fig leaf that disguises the underlying activity and makes it appear as if there is legitimate private demand for Treasury debt. But this is just an illusion, and a clumsy one to boot. 

One wonders how the market could be soothed by these results when they are so clearly manipulated. But the more important question is when the foreign governments reverse their currency policies, and when the investment banks are no longer guaranteed a quick short term profit, will there be anyone left willing to show up at Treasury auctions?  

According to the Office of Management and Budget, the U.S. government is expected to run a $1.6 trillion deficit in fiscal year 2011 (which expires in September). The Federal Reserve’s current quantitative easing program is taking down a large share of that red ink. But “QE2” expires in July, and in fiscal year 2012, the Federal government is projected to run a $1.1 trillion deficit (that of course could grow if the economy weakens). An additional $1.1 trillion in Treasury notes and bonds will mature over that 12 month period.  So in total, the Treasury will need to issue a total of at least $2.2 trillion in notes and bonds in FY 2012. This translates into quarterly borrowing needs of approximately $550 billion, more than double the average of the last two quarters. To put this into perspective, the entire U.S. personal savings rate is about $650 billion annually. Even if every dime of this amount were ploughed into Treasuries, we would still need to borrow or print another $1.6 trillion.

At the height of the financial crisis in Q4 2008, the Treasury issued a record $560 billion of notes and bonds. Fortunately for them, that spike corresponded neatly with huge inflows of funds into Treasuries as investors sought safety from collapsing equity and corporate debt markets. Will the Treasury catch that break once again? There may be another financial panic, but will investor reaction be the same this time around? Bill Gross, the founder and chief investment officer of PIMCO, the world’s largest private purchaser of bonds, recently announced that he is reducing his Treasury holdings to zero. It is not clear what would convince Gross to get back into the market with both feet, but one might expect at minimum it would take much higher interest rates.

If private investors stay on the sideline, how does anyone expect the Treasury to sell its inventory without the support of a quantitative easing program from the Fed? Do they expect the Chinese to reverse course on their current policy and start heavily buying U.S. debt once again, irrespective of the damage to their own economy? That seems extremely unlikely given the drift in Chinese currency policy. More likely the Fed will remain the only buyer, meaning QE3, 4, and 5, are all but certainties. There should be no remaining doubts…the U.S. Government intends to monetize its own debt. Of course, as bad as things will be if QE ends, it will be that much worse the longer it continues.  

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After clicking the ad above, you will leave the Euro Pacific Capital website and be directed to the website of Euro Pacific Precious Metals, LLC. Neither Euro Pacific Capital nor any of its affiliates are responsible for the content of such website. Peter Schiff is CEO of Euro Pacific Capital, Inc. and CEO of Euro Pacific

Precious Metals, LLC. Precious metals are volatile, speculative, and high-risk investments. Physical ownership will not yield income. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. The value of the investment will fall and rise. Investing in precious metals may not be suitable for all investors.

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2012 Outlook: Developed vs. Emerging Economies
By: Jim Nelson, Portfolio Manager

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Many of the leading lights in the white shoe investment crowd have made news by arguing that developed markets, like the United States and Western Europe, will outperform emerging markets in 2011. But economic growth in emerging markets has been, and still remains, much higher than growth in the developed world. Virtually no one else expects that to change anytime in the foreseeable future. As such, the skepticism about emerging markets may seem hard to fathom. Before we dispute their arguments, a bit of background is in order. 

For most of the last decade emerging market investment returns outpaced those of the developed markets. This changed dramatically in the months before and after the financial crisis in the summer and fall of 2008. During that time, when all asset prices tumbled, emerging markets led the way down. But in the recovery of 2009 and early 2010, emerging markets led the charge. From March 2009 to March 2010, the EEM (iShares MSCI Emerging Markets Index Fund) returned 99.29% versus only 47.57% for the S&P 500. Past performance is no guarantee of future results.

Source: Google Finance, March 2009-2010.

More recently as the markets cooled down, and returns became much more modest, the edge went back to the United States. From March 2010 to March 2011, the EEM returned 10.58% versus 16.89% for the S&P 500.

Source: Google Finance, March 2010-2011.

So where do we go for the remainder of 2011? Those who currently overweight the developed markets warn of the alarming increases in consumer prices in the emerging economies. It is widely assumed that in order to stem inflation foreign central banks will raise interest rates, thus hurting valuations of equities in these markets. At the same time, these strategists believe that the slower growth in the developed markets will continue without significant inflation, thereby keeping interest rates low. We believe that this view places too much emphasis on interest rates as a determinant of equity performance, discounts the impact of currency valuation, and wholly confuses how inflation has been injected into the global economy in the first place. It also presupposes that the developed market recovery will continue, when in fact we believe there is a real risk for slower growth in 2011 - particularly in Europe, the UK and US. 

In the developing economies where food prices are the main issue, it's our belief that rate hikes alone will be somewhat ineffectual in fighting inflation. This is because commodity price increases impact developed and emerging economies in a very different way.

In emerging economies, where food is sometimes delivered by the shovelful from the back of a truck, prices are more directly tied to commodity movements. In addition, poorer consumers in these markets pay a much higher percentage of their disposable incomes for food and have limited ability to alter spending patterns to compensate for the rising prices of certain commodities. As a result, commodity price increases in emerging economies tend to create immediate problems. Higher currency valuation is the best way to immediately raise purchasing power by blunting the impact of rising commodity prices. 

However, it is also important to not allow a currency to appreciate so fast that export industries with narrow margins are forced to lay off workers and slow economic growth. In other words, growth needs to keep pace with increases in currency valuations. For this reason, and all else being equal (including the assumption the Fed continues to convince investors that inflation is not a problem in the US), we believe we will see a gradual appreciation of emerging market currencies versus the US dollar throughout 2011.

When foreign currencies appreciate, it is inevitable that rising import prices will push up inflation in the developed markets. And in fact, the latest US CPI number shows the first signs of increasing inflationary pressures for consumers. 

The Bureau of Labor Statistics reported in February that CPI increased 1.6% year-over-year in Jan 2011 and that energy and food accounted for over 2/3 of the increase. Meats, poultry, fish and eggs had increased 6.2%, which is significant because these items make up a larger portion of American food spending than most emerging economies. The USDA just increased its forecast for US food inflation from 2% to 4% for 2011, on February 25. In contrast to the developing world, the United States can not look to rising currency valuations as a remedy.

Critics of our view argue that rising prices in the developed economies will be borne by producers who will be unable to raise prices to consumers. But from our perspective, this hardly matters. Either way, developed markets lose. Under one scenario, US producers keep prices low yet face high input costs. This reduces margins and warrants a reduction in the market's price earnings multiple which is a negative for stocks. On March 18, Reuters reported that sports apparel-maker Nike Inc.'s margins are being squeezed by higher costs for oil, cotton and transportation, forcing price increases in the face of slack demand and driving down its share price. However, under the other scenario, rising consumer inflation could force the Fed to raise rates (or at least try), which also is negative for stocks. When Wall Street begins to factor these negatives into its estimates, the market will likely drop accordingly.

Thus, while there may be some short term advantages to the current "safety" trend of piling into the developed markets for fear of Asian inflation, we believe this trend will reverse over the medium to long term. Investors who are now overweight developed markets may have to deal with very difficult timing decisions, and high transactional costs, as they hope to stay afloat in the months ahead. We prefer a simpler strategy of buying and holding what we see as the more promising growth scenario. 

Jim Nelson is Portfolio Manager with Euro Pacific Capital.  Opinions expressed are those of the writer.

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Fed’s Ability to Raise Rates is an Illusion
By: Jim Nelson, Portfolio Manager and Mike Pento, Senior Economist

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One of the primary sources of comfort for those who believe that inflation will not take hold in the United States is that Fed officials have consistently and strenuously asserted that they stand ready to tighten policy as soon as price data starts to bubble upward. However, a close analysis of the Fed’s own financial condition, and the vulnerability of its balance sheet, clearly shows how little freedom they will have in snuffing out inflation. In short, establishing a positive real interest rate will not be an option they will likely ever consider.

As of February 16, 2011, the Fed held $2.3 trillion in assets on its balance sheet. The chart below shows how this figure has skyrocketed since July 2008 when that figure stood at just $473 billion. About half of those assets (or $1.15 trillion) is held in U.S. Treasury bonds. The other half is held in mortgage backed securities, primarily packaged home loans from government guaranteed Fannie Mae and Freddie Mac.

Source: Bloomberg, 2011: Federal Reserve System Open Market Account Holdings, July 2008 through February 2011. 

While holdings of foreign central banks are murkier than the data published by the Federal Reserve, it appears that as of February 2010, the Fed passed China to become the world’s #1 holder of US Treasuries (Bloomberg, 2011). Based on the explicit commitments in the Fed’s second quantitative easing program, the Fed needs to buy an additional $450 billion in treasuries by the end of the summer. At that point its balance will grow to a grand total of $2.8 trillion.

Both Treasury Bonds and Mortgage backed securities carry interest rate risk, which means that the value of existing bonds will tend to fall as current interest rates rise. As a result, any rise in interest rates will immediately impact the value of this enormous portfolio. The Fed has to be very careful that dips in value of these holdings don’t rattle investor confidence. 

For this reason, we believe it will be difficult for the Fed to raise rates meaningfully in the event of inflationary pressures. Based on our estimates, the Fed’s assets have an average duration of 5 years. While not a 1 to 1 relationship, generally a portfolio of bonds with such duration will decline in value by 5% for every 1% parallel increase in the yield curve. In other words, the Fed’s projected $2.8 trillion in bond assets would decline by $140 billion for every 1% in rate increase.

There is nearly universal agreement that if inflationary pressures were to show, the Fed could begin to raise rates. While the current Federal Funds Target Rate is at 0.25%, historically its range has been above 5%. What would happen to the Fed’s balance sheet if rates were to rise once again to that level? Although there is not a direct, linear relationship, according to our estimates, this could result in an unrealized loss of at least $500 billion!

Also if rates were to rise to 5%, it’s likely that the banks currently earning 0.25% on their excess reserves at the Fed would put those funds to work, thereby increasing the money supply and velocity of money. This will further add to inflationary pressure and force the Fed to take further tightening actions or sell assets to soak up the liquidity. You don’t need to be a genius to see the vicious cycle here.

At the very least, the Fed would be required to make the expensive choice of paying more than 0.25% to keep those reserves in balance. But it may only be able to raise those payments to a point that equals the upper bound of the yield that it receives from its bond portfolio. Anything above that would translate into an operating loss as the Fed earns less on its assets than it pays on its liabilities.

Although we think it likely that the Fed will begin to raise rates, at the very least to throw a bone to its critics, we believe that its tightening capabilities will be inadequate to combat inflation. For this reason, negative real interest rates are a phenomenon that will persist in the US for a very long time, in our opinion. This obviously is a negative for the dollar, and a positive for gold, commodities and currencies with positive real interest rates. 

Jim Nelson is Portfolio Manager and Michael Pento is Senior Economist with Euro Pacific Capital. Opinions expressed are those of the writers.

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Saudi Arabia: More Secure Than It Appears
By: John Browne, Senior Market Strategist

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As revolution spreads throughout North Africa and the Middle East, many fear that the forces that toppled regimes in Tunisia, Egypt, and possibly Libya, will spread to the Gulf oil states, particularly Saudi Arabia. Many may assume that Saudi Arabia is particularly vulnerable because of its large and restless youth population, and the distrust it has earned among many Arabs as a result of its heavy reliance on U.S. foreign aid and its strong support of American foreign policy. In fact, rebellion has arrived on Saudi Arabia’s doorstep in the tiny Gulf state of Bahrain, which so alarmed the Saudis that they dispatched their own troops to quell the disturbances there.

The specter of regime change in Saudi Arabia, which could result in radicalized Islamists taking control of the world's second largest oil producer, is a justifiably harrowing prospect. However, Saudi Arabia's political dynamics are very different from the Middle Eastern states that are in revolt. Understanding these forces should assure us that Saudi Arabia is not likely to be the next domino to fall.  

The power base of Saudi Arabia's rulers is distinct from that of the falling dictatorships in North Africa. The House of Saud has had legitimacy on the Arabian Peninsula since the mid-1700s, when the family led a series of uprisings against the Ottoman Empire to establish an independent state. In the ensuing years, many leaders of the family gave their lives for that cause, and they ultimately succeeded in establishing the kingdom we know today. By contrast, most Arab dictators came to power by unseating the previous domestic government, and have relied on repression as their sole claim to power.

Saudi Arabia is immersed in ultra-modern hardware; however, in many ways it is entrenched in a medieval mentality. A country of fundamental contradictions, it is often incomprehensible to the uninitiated. Allow me to provide a rough sketch.

The political strength of the House of Saud is supported by five main pillars:

#1: The safety of large numbers. With its royal family numbering well over 10,000, each employing several loyal retainers, there are few important areas of Saudi life that escape the notice of royal eyes. In effect, the family constitutes a private FBI, with members active in all key areas of life, including government, banks, police, and, of course, the military. By contrast, dictators in other Arab countries tend to have relatively small families or inner circles, which can be easily isolated or liquidated in a revolution.

#2: The careful exercise of power. The House of Saud has a near century-long track record of strict but benign rule, with careful deference shown to religion. The country's founder, King Abdulaziz ibn Saud al Saud, was an extremely shrewd and charismatic warlord, equal in leadership qualities to the best of Medieval Europe and Asia. He embraced an extremely conservative brand of Islam, but adopted such alien modern technologies as the telephone and radio.

It is important to note this ruling style largely mirrors the endemic conservatism of the country itself. The third son of Abdulaziz, King Faisal, may have been assassinated for the perception of his being too liberal (he allowed television into the country for the first time). His brothers have continued a strict but benign rule, carefully respectful of religion.

#3: The strength of tribal loyalty. Saudi Arabia largely remains a tribal society removed from outside influence. Shrewd use of socially accepted polygamy enabled King Abdulaziz to father more than 200 children with some 80 wives, forming strategic blood relationships with most of the important Saudi tribes.

#4: The power of money. Both the royal family as individuals and the government as a whole are enormously wealthy. This allows for the granting of considerable local patronage and gives the kingdom substantial influence and power abroad. An illustration of this could be seen in the immediate wake of 9/11: the private aircraft of some senior Saudis were the only airplanes allowed in US airspace, save for US government and military planes.

#5: The treaty with the US. The Saudi's have been very scrupulous in upholding the terms of their post-war 'oil for security' treaty with the US. Saudi Arabia has always acted as a force for moderation within OPEC and has secured OPEC's agreement to the principle that oil should be paid for exclusively in US dollars. The result is that Saudi Arabia enjoys extremely close defense relationships with both the US and UK.

In summary, it is clear to the informed that while the House of Saud faces severe security threats and political challenges, primarily from growing numbers of discontented youth, there are marked sources of strength in the kingdom that were not present in Egypt or Tunisia. The ruling family contains scores of shrewd and charismatic leaders, related by blood to most of the area's important tribes and to the political, military, and merchant elites. Their rule is strict and deeply religious, but encourages a benign free enterprise. This has provided great material wealth to its subjects. Finally, they sit at the head of an absolute monarchy that has the US and UK as deeply committed allies. These Western powers are acutely aware that should they fail to protect the House of Saud, the Chinese would replace them gladly. As a result, there is little reason to fear regime change in Saudi Arabia within the foreseeable future.

The price of petroleum may very well drift continuously higher based on irresponsible monetary policy in Washington, Brussels, and Beijing, but anyone who makes near-term investment decisions based on pending revolution in Riyadh could face a costly disappointment.

John Browne is Senior Market Strategist with Euro Pacific Capital. Opinions expressed are those of the writer.

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Norway? Yes Way!
By: Andrew Schiff, Director of Communications & Marketing

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Many of our long term readers are aware of our preference for non-Eurozone Europe as a destination for investment capital. It’s not that we have a problem with the crepes of France, the espresso of Italy, or the bratwurst of Germany, it’s just that the conflicting and unstable structure of the European Union as a political organization, and the euro as a currency, give us a slight case of economic indigestion. We prefer our European investment exposure to be pure. And we believe some of the best flavors can be found in Norway. Who doesn’t love a nice smoked salmon?  

Norway, like its next door neighbor Sweden, is not a member of the Eurozone (the collection of 17 countries that use the euro as currency). It has its own currency, the Norwegian Kroner. Unlike Sweden, Norway is not even a member of the 27-nation European Union. We like that kind of independence. As a result of this distance from chronic debt in some heavily indebted European states (Greece, Portugal, Ireland, etc.), we feel there is less chance that the Norwegian economy and its currency get dragged down by external problems. In fact over the past two years, an era characterized by a continually unfolding debt crisis, the Norwegian Kroner has appreciated against the euro by 11.5% (Bloomberg, 2011).

But what we really love about Norway is its abundant natural resources and well-disciplined economy. Timber, petroleum, and of course seafood can all be found in this sparsely populated country. And although the country practices a brand of state socialism that we don’t support, it practices what is known as the “Scandinavian model,” which combines welfare state services with light regulation of industry and active promotion of private resource development and entrepreneurship. It also helps that the Norwegians themselves are highly educated, hard working, and fiscally responsible and that 99% of the country’s energy comes from hydroelectric power. 

From a fundamental standpoint, Norway ranks higher than most other nations as well. The country had a 3.6% unemployment rate in Feb 2011 versus 9.9% for the Eurozone and 8.9% for the US. Its trade surplus at Dec 2010 was $6.1 billion versus a deficit of $712 billion in the Eurozone and $40 billion in the US. The country’s finances are in good order, with the government running a 9.5% surplus as a percentage of GDP versus an estimated 10% deficit for the Eurozone and an 8.6% deficit for the US, which is projected to grow even deeper. Norway maintains a higher GDP per capita than the US as well, at $52,238 versus $47,123 in the US.

Additionally, the Norwegian Kroner looks far from being overvalued versus the dollar. The traditional theory that currencies with higher nominal rates decline over time because of market efficiency regarding real rates cannot adjust for the fact that certain central bankers are expanding the monetary base at record speeds. Real rates are in fact not equal across the globe – and Norway has some of the highest. With Norway 2-yr government yields at 2.6% and the latest CPI number coming in at 1.2%, the country has  a positive real interest rate of 1.4%. Contrast this with the US 2-yr yield of 0.55% and latest CPI number of 1.6%, which put real rates in the US at negative 1.05%.

Country fundamentals and outlook for the currency have us consistently positive on Norwegian investments. Given the recent run up in energy and food prices around the world, Norway is particularly well-positioned to benefit from current trends. Our portfolio managers have recently returned from a trip to Norway where they met with many companies active in the energy, resource, banking, and infrastructure sectors. Two of their favorite picks are described below. 

Andrew Schiff is Director of Communications & Marketing with Euro Pacific Capital.  Opinions expressed are those of the writer.

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Investment Opportunities

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Company #1:

This company is the world’s second largest salmon farmer. It supplies seafood products destined for canneries, restaurants, and household consumers in more than 65 markets worldwide. The company maintains operations in coastal European countries, fishing the North Sea.

Though the dividend has fluctuated, the company has paid one every year for the last decade. The stock price currently is off from its all time high made a few months ago. Yield is 6.1%. *

Source: BigCharts.com. March 2010-2011.

The company risks are:

• Prices of fish could fall due to over supply
• Environmental scares could dry up demand
• Low harvest could hurt revenue
• Consumer taste for fish could change

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Company #2:  

This company is involved in every step  of oil and natural gas production and is active throughout Europe, Africa and South America. It has almost 5,000 miles of pipelines, piping gas and petroleum from the North Sea to continental Europe. The company also has a liquid natural gas (LNG) terminal that can load ships with LNG for destination around the globe.

The company recently stated that it wishes to grow its annual dividend to match growth in earnings.  In addition to cash dividends, the company said it plans to buy back shares from time to time.

The stock made its all time high in 2008 and is still below it.  Yield is approximately 4.1%. *

Source: BigCharts.com. March 2010-2011.

The oil producer risks are:

• Oil prices could fall if the Middle East/North Africa (MENA) problems resolve quickly
• If the MENA problems accelerate, the company might not have access to its MENA oil & gas, reducing revenue
• A recession in Europe could reduce revenue

The fluctuation of foreign currency exchange rates will impact your investment returns. 

* Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. 

INTERNATIONAL INVESTING MAY NOT BE SUITABLE FOR ALL INVESTORS.

CLICK HERE TO RECEIVE MORE INFORMATION ABOUT THIS COMPANY, AND TO SEE IF IT IS SUITABLE FOR YOUR INVESTMENT OBJECTIVES AND RISK TOLERANCE, OR CALL 1-800-727-7922 TO SPEAK TO AN INVESTMENT CONSULTANT.

Investing in foreign securities involves additional risks specific to international investing, such as currency fluctuation and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. Euro Pacific has not independently verified the information supplied by the company, and cannot make any representations as to its accuracy. This material is for private use of the subscriber; it may not be reprinted without permission. The opinions provided in these articles are not intended as individual investment advice.

Why don't we provide the company name?

Under FINRA Rule 2310, broker-dealers are required to make sure that every investment recommendation is suitable for each client's unique investment objectives and risk tolerance. The company overviews provided here are meant to give an indication of the type of recommendations a Euro Pacific Investment Consultant may make, depending upon your unique investment goals, risk tolerance, and profile. If you have questions about the companies described in this report, or think they may be suitable for your portfolio, please call (800) 727-7922 and a Euro Pacific Investment Consultant will assist you, with no obligation to purchase from us.

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