Many bloggers and commentators have been pumping out their visions for 2012. I would do the same, had I not done it in October:

Gold is up against a wall of incorrect perceptions: namely, that haven assets are limited to dollars, and to US treasury bonds. In the mainstream lexicon, gold is used to hedge tail risk and to make jewellery, and until that perception is shattered (specifically by an event that reveals Treasuries and dollars for the risky and debased assets that they really are) then I don’t think the funds will begin to significantly increase gold allocations (when they do, they will claim they are “hedging tail risk”).

There are two very strong pieces of evidence here for dollar and treasury weakness: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when (not if) these perceptions will be shattered.

What would a treasury crash look like? Most likely, it would be dictated by supply — the greater the supply of treasuries coming onto the market, the more there are for buyers to buy, the lower prices will be forced before new buyers come onto the market. Specifically, a treasury crash would most likely begin with a big seller dumping significant quantities of treasuries bonds onto the open market. I would expect such an event to be triggered bylower yields— most significant would be the 30-year, because it still has a high enough yield to retain purchasing power (i.e. a positive real rate). Operation Twist, of course, was designed to flatten the yield curve, which will probably push the 30-year closer to a negative real return.

A large sovereign treasury dumper (i.e. China with its $1+ trillion of treasury holdings) throwing a significant portion of these onto the open market would very quickly outpace the dogmatic institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike actually corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the (hugely dogmatic) market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”
  3. Both of the above.

If such an event was big enough to cause yields to spike 1% (very conservative estimate) it would jar the status quo enough to trigger a significant gold spike, as funds and banks move to cash positions (sensing both the post-crash buying opportunities, and margin hikes) and seek to “hedge tail risk”.

Now the pace and scope of China’s coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

The pace of events might also be significantly accelerated in the light of a Greek default.

Now 365 days is a strangely arbitrary period over which to make long term economic predictions. The business cycle is not tied to years, nor even decades. It wends and shifts in the winds of history, fluttering and flurrying. I have no idea if this scenario (or something similar) will play out in 2012, or 2013.

But I do know this: unless there is a real recovery in America — in employment and industrial output, as well as GDP — as well as a shift away from reliance on foreign oil and goods, and a successful deleveraging of the entire economy — especially government debt and shadow banking — it will play out sooner or later.

I took great pleasure last month to present a very similar scenario predicted by none other than Paul Krugman in 2003:

During the 1990s I spent much of my time focusing on economic crises around the world — in particular, on currency crises like those that struck Southeast Asia in 1997 and Argentina in 2001. The timing of such crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

I’m not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls “an early warning system to identify the likelihood of countries entering into financial crises.” Developing nations are looking pretty safe these days. But applying the same model to some advanced countries “would set Damocles’ alarm bells ringing.” Lehman’s press release adds, “Most conspicuous of these threats is the United States.”

Is America safe, despite its scary numbers?

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

Readers are, of course, encouraged to share their views on 2012 (and the future in general) in the comment section.

Meanwhile, here’s some prescience from Jefferson:

Happy New Year.

20 thoughts on “2012

  1. Happy new year Aziz.
    By the way, what do you think is the possibility of America provoking a proxy war with China but not directly engaging at it? It wouldn’t affect the American budget that much if America isn’t one of the belligerents and its government would gain from the weapons contract…… I just hope that if this scenario comes true, it doesn’t spread into a WW3.

    • America’s allies in Asia are deserting her. Look at Japan, ditching the dollar for trade with China.

      Does anyone — other than Israel — have the will to fight a proxy war for the United States?

      And Israel cannot and will not extend herself beyond the middle east. So that proxy war between America and China might be between Israel and Iran. How can that realistically hurt China?

      Cutting off her oil supply?

      That will hurt America more than China. First if global oil prices spike the American consumer will feel it at the pump, meaning they will have less disposable income, jeopardising the recovery. Secondly, the cost of oil will be passed on to America somewhat, because China is America’s productive base.

      America has put herself into an absurd position. She cannot hurt her enemy without hurting herself.

      China has played this ingeniously. It is almost Shakespearean.

  2. You don’t mention deliberate manipulations of the market which can wreak havoc with the market psychology. As a means of financial repression (i.e. you should only buy these wealth eating bonds) it’s in the interest of the status quo to tarnish gold’s reputation of a safe haven. This has been acknowledged/discussed even in non-crackpot circles (I think Gillian Tett from FT).

  3. I would like to ask for opinion regarding Center/East Europe countries (e.g. my Czech Republic)… what do you think these countries can expect from fact that they are parts of EU, but not members of Euro Currency “zone”?

    How do you think these countries are going to / can be affected by all the mess around? If Euro will crash, what will Czech Koruna do? It looks like CZK is kinda linked to EUR… our economy is very much relying on Germany (we exporty mainly there) etc.

    The whole situation is of course confusing to only realize, not to mention understand, from my “newbie” point of view (I am not trader).

    Thanks in advance, for some replies. Cheers.

    And Good luck in 2012, Aziz.

    • My unsolicited opinion: if you have savings in CZK I’d buy an option on USDCZK to protect them (with the expiration in Sep or Dec 2012). Though I don’t think EUR will “die” in 2012 – though everything must (from a scientific and historical point of view) come to an end (including the human species – a topic on which I like to poke fun at the “optimists” :P) – the only problem is timing.

      • Andrei’s suggestion is good, although it requires functioning FOREX markets, something that is not entirely guaranteed in the case of a Euro breakdown. (Many black swans).

        I personally believe the best hedges against the potential for a Euro collapse are a good supply of food and water and energy. Gold is also looking cheap right now.

        • My recommendation was based partly on Kyle Bass’ idea that the USD would be the last to die (being the reserve currency). One cannot hedge some obscure Eastern European currency with gold (this obscure currency can disappear without the global economy feeling anything) – while the gold left (as a hedge) will have pretty much the same value. And instead of converting your money to USD (which is not a good idea as your bank will eat the spread at each conversion back and forth – also USD is not the currency of the country you live in) I thought the better idea was insurance through an option. And of course, as John mentioned, some allocation in gold is recommended (as a hedge to your CZK that is actually USD-insured).

  4. I am going to continue to recycle (I don’t like spending on anything new!) save, and buy more arable farm land and sheep.

    And short the AUD and buy USD, as I agree with Andrei’s comment.

    • I prefer the idea of doing this through an option – so as to avoid spending my whole waking life in front of an FX terminal.

      There are plenty of solutions for 2012, and hopefully some of them will enter the heads of our dimwitted G20 leaders. One interesting idea I’ve come across is the idea of revaluing gold to something like ~20,000 USD which would not only erase most of the debts for various countries but would give them some leeway for future spending/investment.

      • No need to watch a FX terminal. The trend will be pro US dollar.

        Options are an insurance contract and that costs money.

        • It’s also possible they will print even before the elections. Any perceived boost in the economy may be enough for the lumpenvoters to shun the abstract idea of the dollar destruction on which various candidates hope to ride into the White House (or the idea that this might happen might be enough to untie Bernanke’s hands).

    • The leaders of any country are not magicians; they are limited by the choices of the previous leaders, and by what is practically possible when taking into account all the current constraints (economy, politics, people’s mindset, culture, existing social & political structures etc.). Currently the best & brightest are leaving US due to heavy anti-entrepreneurship regulation & meddling.

      • Related to this, it is said that one of USA’s greatest advantages is demographics: it’s one of the few developed world countries with expected positive population growth. Also about this, it’s a mystery to me why Japan must lose 30 million people over the next few decades. I can understand the median age getting higher, and the population aging – and this can be mitigated by increasing the retirement age while better healthcare will make healthier in old age (enough to be able to work), but why a population decrease? Can’t the Japanese do something about that worrying trend (i.e. encourage couples to have more kids etc.)?

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