Friday, April 8, 2011

Stagflation Update: Focus on the U. S. and Brazil

On February 28 of this year, I wrote a post for The Daily Capitalist titled "Getting Real". Its focus was the bullish case for the Brazilian real. Since that time, the real has appreciated about 1% a week. The closed-end fund that tracks the value of the real vs. the U. S. dollar, stock symbol BZF, was $26.88 then and may open around $28.40 today. The real is near its 2008 high against the USD.

Yet the case for the real may still be quite strong, at least against the USD. Interest rates in the U. S. are collapsing on the short end. They are a negligible 0.03% and 0.11% annualized for 3- and 6-month T-bills respectively as I write this at 8 AM Eastern Daylight Time. Meanwhile, the monthly price inflation rate in the U. S. as measured by MIT's Billion Prices Project is running around 0.48% monthly. Compounded over one year, this is well over 6% yearly. So the U. S. is running hugely negative interest rates. Brazil, on the other hand, has a flattish yield curve and interest rates in the low double digits while price inflation is running around 6%. Thus their interest rate structure is strongly positive. Brazil received a credit upgrade from Fitch this week to BBB. Brazil is also not a net importer of oil and is expected to be a net exporter later this decade, so the current oil price trends should be real-friendly on the margin.

On the budgetary side, the pro-life and pro-choice wings of the Republicrat/Demopublican party (AKA the Establishment) take turns posturing that they are fiscally responsible, except when they seize complete control of the government, at which point they always find some emergency requiring massive deficits and credit expansion. Part of the emergency spending always involves the military. The view from foreign shores is of a floundering country that purports to be the world's leader. Yet it can't even pass a budget, more than halfway through a fiscal year. None of this is dollar-friendly.

In contrast, the new leader of Brazil, Dilma Rousseff, recently addressed her country's budget deficit by doing such measures as canceling a major order for fighter jets that Brazil had been looking into for quite some time. Good for Dilma. Brazil has no natural enemies. They should spend on education, not the military, so they can move up the economic food chain.

So, strictly on interest rate differentials, it's hard to see a reason for the real to drop against the USD. If the real stays unchanged vs. the USD, ownership of BZF should yield at least a 10% return in USD terms over one year. That's a powerful lure in favor of the real.

In the broader sense, the ultra-low velocity of money that current U. S. T-bill rates imply does not bode well for the short-term future of the U. S. economy, in my opinion. These rates also suggest that a lot of capital would (to be anthropomorphic) rather receive essentially no interest payment than take the risk of today's stock and bond prices. Whether commodities, which are on a roll again, are included in that calculation is unclear.

With the average of Brent crude and West Texas Intermediate around $118/barrel this morning, oil importing countries are facing significant headwinds. Thus, the message of the markets I see for the U. S. involves a sea of troubles. So much funny money has been electronically printed in the past few years that it's hard to say what oil price is the tipping point for the American economy, but given how little wage increases have occurred, I'm nervous right about now.

Fed policy may be back to that of the 1940s, controlling short rates to an extreme level below that of price increases, but geopolitically, it looks more like the stagflationary 1970s to me, with the U. S. dollar having nowhere to go but down. Thus economic constraints can suddenly appear, leading the economy to slow and financial markets to turn on a dime.

Caution is especially prudent at times such as this. As is, in my opinion, continued exposure to precious metals vehicles and oil stocks.

Copyright (C) Long Lake LLC 2011

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