Please, click here to read this article in pdf format: may-16-2011

A week later, the sell off in commodities has continued, due to the global deleveraging that is taking place. It has been so serious that the media everywhere is almost calling the commodity rally dead. All sorts of explanations, most of superstitious nature, are given. We have even  read an analyst suggest that in general, all rallies last about 115 to 130 months…therefore, the rally in gold is finished!

Last week we noted that: “…In this context, it may no longer be wise to trade long risk (i.e. commodities, stocks), but on a hedged basis (i.e. short Euro), to address the many deleveraging bouts that we will experience…” Below, we show the long gold/short euro trade, expressed in US dollars, via two ETFs (DGP: 2x long gold and EUO: 2x short Euro), which yielded a 1.83% return for the week (= [3.35% + 0.31%] / 2) , way better (more profitable and less volatile) than to be long gold in US dollars.

Should this performance of commodities, in currencies other than the US dollar, signal that the rally is not dead? Does it indeed have legs? Whenever we ask this ourselves, we answer with another question: “What makes you think interest rates will rise?”

On this point, we like Peter Schiff’s view (watch: http://youtu.be/4bZglexQk4o ). Peter says that the Fed will not raise rates because it will make it very expensive for the US Treasury to service its debt. He also thinks that QE2 was not to “support” growth, but to finance the US Treasury. Although this makes sense to us, we fear that it may not necessarily hold true.

We think the Fed could find ways to raise the policy rate, without impacting the US Treasury debt servicing capability. At least in the short term, and we at least, live in the short term. This perspective is consistent with what the European Central Bank has done, under the so called “separation principle”. The ECB has raised rates and at the same time, it has considerably deteriorated the quality of its assets, extending liquidity lines to weak financial institutions and indirectly, to peripheral governments. This has of course weighted on the Euro, but it has so far worked. Can it work forever? No, it cannot. But it serves as an example.

On this line, we learned from a note by the Bank of America, that proposed margining rules under the derivatives reform provisions of the Dodd-Frank act may be passed requiring financial institutions in the US to raise collateral on their derivatives positions in the form of US Treasuries (refer: “Dodd-Frank Collateral Rules Implements QE3”, Credit Derivatives Strategist, May 11th, 2011) . If passed, Bank of America estimates this could coerce the purchase of sums comparable to those of QE2, effectively establishing another wave of government debt monetization. The important thing here is that this could take place in 2012 simultaneously with an increase in interest rates, without impairing the US Treasury. The overall effect would be a formidable crowding out of the private sector from the debt market. Gold bugs be warned!

Martin Sibileau