How to Protect Your Portfolio from the Fed

March 25, 2009 at 1:41 pm
Contributed by: Chris

For this week’s Energy and Capital, I analyze the effects of the Fed’s “quantitative easing” and see life returning to the oil and commodities sector as a hedge against reflation.

How to Protect Your Portfolio from the Fed

It’s 2008 All Over Again

By Chris Nelder
Wednesday, March 25th, 2009

For energy investors, the market is starting to look like 2008 all over again.

The Fed is printing money like it’s going out of style (and it is). The dollar is falling. Oil and other commodities, particularly metals, are rising steadily.

On March 18 the Fed announced a potential $1.15 trillion expansion of its balance sheet to buy up Treasuries and toxic assets. And on Sunday night, Treasury Secretary Tim Geithner threw a Hail Mary pass, begging the private capital community to step up and buy $1 trillion of bad mortgages using mostly FDIC financing.

The debasement of the dollar has reached truly frightening proportions. The government’s commitment to solving the financial crisis is now pushing $12 trillion by my calculation—nearly as much as the US GDP.

Put another way, that’s enough to pay off every mortgage in the country. Had the money been spent that way, it would surely have cured the fundamental ills of our economic backbone, and put us on a solid path to recovery.

Unfortunately, it wasn’t. Nearly all of it is designed to cure the banks’ problems and restore confidence in the credit markets, not to help consumers with mortgages and credit card debt and a shrinking job market. Worse, the Fed and FDIC have refused to even disclose who the recipients of the bailout money are. What we do know is that they are overwhelmingly the large banks (and their counterparties in credit default swaps, like AIG), that is, the very characters whose egregious excesses got us into this mess, whose CEOs know Hank Paulson personally. Regional and local banks who had the good sense and restraint to not participate in the subprime Ponzi scheme to begin with are still waiting for a response to their TARP funds applications.

Normally, such a frenzy of money printing would cause the dollar to fall, but these haven’t been normal times. The global recession has hurt the rest of the world’s currencies even more, and the dollar has appreciated steadily in its status as the “tallest midget.”

But with this latest drop from Helicopter Ben, and the desperate Treasury proposal, our currency may have finally jumped the shark. It certainly feels that way to me. On Monday the dollar posted its largest one-day drop since 1971, falling to 83.35 on the Dollar Index, where it is measured against a basket of world currencies.

The End of ‘Rome’ on the Potomac

Bloomberg quoted Alan Ruskin, head of international currency strategy in North America at RBS Greenwich Capital Markets Inc., as saying “This is a historic moment — the start of debasement of the world’s reserve currency. It feels to many participants that in the grand sweep of history we are witnessing the end of ‘Rome’ on the Potomac.”

The depreciation of the dollar is desirable, from the Fed’s perspective, because inflation reduces the burden of our debt, and makes US exports more competitive on the world market. Reinflation is now the name of the game, as a deliberate tactic to arrest the contraction of the US economy. Indeed, Fed chairman Ben Bernanke has indicated that he would like to see the US inflation rate in the 3-4% per year range.

Conversely, dollar depreciation is a major concern for holders of US debt, particularly China, which holds the most: about $1.3 trillion of it, mostly in short-term Treasury bills. Rapid inflation of the dollar would quickly destroy the value of their holdings.

Consequently, China has indicated that it is losing its appetite for T-bills, which is one factor motivating the Fed to begin buying back US debt (to support its market). At the same time, China is rapidly investing its dollars in hard assets, particularly miners and oil producers, and making further moves to reduce its exposure to the dollar.

This week, Chinese central bank Governor Zhou Xiaochuan even urged the International Monetary Fund to create a new “super-sovereign reserve currency” based on a large basket of currencies, which would replace the dollar as the world’s reserve currency. China is also working to conduct more of its foreign trade in its native yuan, or in other non-dollar denominated currencies.

Whether the notion of a new global reserve currency has legs or not, we should recognize these shots across our bow as clear indications that dollar inflation is the new big fear, and that it could zip past Bernanke’s targets, possibly even sending the US into a deadly hyperinflationary spiral.

We should not concern ourselves just yet with the dollar’s demise, reports of which are premature to be sure. What we should be aware of is the anti-dollar sentiment.

And that means that the anti-inflationary trade that put the wind in the sails of commodities last year is coming back. With extraordinarily large sums of capital sidelined by the deepening recession, funds holding cash are anxious to put it someplace—any place—where it will at least retain its value while inflation trashes the dollar.

Inflationary Safe Havens

So it should come as no surprise that the dollar’s fall this month was attended by a surge in commodity prices, despite a lack of clear indication that global demand is on the uptick. Oil has climbed steadily from the low $40s to over $53. Silver, gold, copper and lead prices have gained 20-30% in the last two months. Wheat, corn, soybeans, and barley have all gained steadily since their last bottom at the beginning of March. Fertilizer stocks and agricultural ETFs have been back in play as well, posting 15-25% gains for the month.

Does that mean that the bottom is in? Should investors start piling back into the sector, lest they miss out on the easiest gains and best valuations they might ever see in their lifetimes?

My gut says no.

Monday’s 7%, nearly 500-point rally in the Dow was indeed impressive and historic, and capped off the largest 10-day rally since 1938. But we should not forget that such sharp moves are precisely what bear market rallies are made of. Since 1928, the Dow has had 28 days with 7+% gains, including Monday’s, and 24 of those days occurred between 1929 and 1933. The market didn’t put in the true bottom until 1932.

Still, while the threat of reflation gone wild is hanging out there, and continuing to increase under “QE3” (the third round of “quantitative easing,” which is simply genuine Wall Street gibberish for printing money out of thin air), it’s prudent to put some money to work in commodities now. The steady gains in crude and minerals signal that the smart money is coming off the sidelines and getting some exposure to the sector again.

So how do you play it?

For those with a taste for adventure, there are the ETFs/ETNs that short the financial sector, like the double-leveraged ProShares UltraShort Financials (NYSE: SKF) and the triple-leveraged Direxion Financial Bear 3X (NYSE: FAZ). For those who remember Captain Contrarian, he has been on the sidelines for more than a year and is more bullish on gold than ever, and just went into SKF in size. These are riskier plays with sharp daily movements, however, and are not appropriate for most investors.

For broad, basic exposure to the commodities sector, I like the PowerShares DB Commodity Index Tracking Fund (AMEX: DBC). And in ag, I still like the PowerShares DB Agriculture Fund (NYSE: DBA), and the fertilizer plays The Mosaic Company (NYSE: MOS) and Potash Corp. (NYSE:POT). For many other suggestions, see the Related Articles below.

Another simple way to play oil directly is the ETF United States Oil Fund (NYSE: USO), among others. They all track the futures curve in different ways and are imperfect instruments that don’t echo the daily performance of oil prices very well, but over the medium term they work well enough.

(My thanks to the following people for contributing inspiration, data and ideas to this article, though I assume all responsibility for how their contributions are presented here: Tradefast, Aaron Task, Upside Trader, Dave Cohen, Steve Christ, Captain Contrarian.)

Until next time,

chris nelder

Chris

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1 Comment

  1. We have reached a structural limitation in the UK and US sovereign debt markets as the vicious delta of exploding supply and falling inward capital flows (from decreased global trade) take their toll and force monetization. Monetization is of course advertised as a policy lever to get rates lower. Actually, I believe the structure of flows indicates that monetization has come to stop-gap the shortfall in inward flows.

    Unless the world re-boots soon, and gets trade going and trade flows, we will move on to the next phase of the crisis, and it will be all about national balance sheets.

    I suspect that the food and grain area are flashpoints where a the first signs of hyperinflation could express themselves. Hyperinflation is both a structural but also a behavioral phenomenon. It could be triggered tomorrow, actually, if the entire world decided to stop buying our debt and the FED had to monetize every new treasury issued.

    Not saying that will happen. Of course. (cough!)

    Best,

    G

    Comment by Gregor — March 25, 2009 @ 7:05 pm

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