A Late Weekly Update Puru

After dark pessimism last autumn, the pendulum has now swung towards optimism and extreme greed.

Over the past few months, we've seen a big rally in risky assets (emerging markets, commodities, junk bonds and major currencies) and on the flip side, we've seen sell-offs in US Treasuries, US Dollar and Japanese Yen. A swift economic recovery is now 'baked in the cake' and most investors seem to be convinced that the worst is over. Put simply, the whole world is (once again) 'long' inflation and 'short' the US Dollar. And as per our expectation, policymakers are fanning the flames of enthusiasm and taking credit for solving the crisis.

In our view however, the market is wrong to worry about immediate hyperinflation and the 'green shoots' hype is pure nonsense. In the real world, unemployment is still rising (America lost another 627,000 jobs last week), millions of people are losing their homes, nominal wages are in decline and private-sector debt in the West is contracting. All these negative forces are ensuring that the policymakers' wishes of further inflation aren't coming true as the private-sector debt bubble isn't expanding. Remember, central banks can take the horse to the water but they can't force it to drink!

In light of the above facts, we are concerned that this year may turn out to be a repeat of last year. It is likely that when investors realise that the economy is in fact getting worse and hyperinflation is a myth, there could be another round of panic selling in the following months. In such an event, emerging markets and commodities may be hit especially hard and we could see sharp rallies in long dated US Treasuries, US Dollar and Japanese Yen. It is worth noting that despite all the bullish noise, the US Dollar isn't falling apart and the Japanese Yen is also showing signs of firming. And over the past few trading days, long dated US Treasuries have carved out a bottom. Furthermore, over the past couple of days, credit spreads have started to widen again and this may be a sign of distress in the credit markets. In any case, we maintain our view that isn't the time to be taking any risk and investors may want to liquidate most of their 'long' positions. It looks as though most of the 'risky assets' made an intermediate-term top earlier in the month and the best outcome here would be a sideways grind. However, another massive sell-off can't be ruled out. So, our recommendation is to get out of harm's way.

Over in the commodities arena, crude oil and copper are in the process of forming a top and they are likely to decline over the following weeks. So, investors may want to liquidate their trading positions. Natural gas is in the process of forming an important low and we still have exposure to this commodity. After a base formation period, we anticipate a big rally in the price of natural gas. In the precious metals department, both gold and silver are caught in a sideways grind and we expect the consolidation to continue for a few more weeks. During this correction phase, we expect silver to underperform gold but once a new upleg commences, both silver and gold are likely to rally.

In the world of currencies, the US Dollar and Japanese Yen are trying to bottom out and all other currencies are vulnerable. Additional distress in the credit markets may be the catalyst which ushers in the next contraction and such an outcome would benefit the US Dollar and Japanese Yen. So, our suggestion is to keep your cash in these pieces of IOUs.

Finally, in the fixed income market, government bonds are in the process of bottoming out. As per our expectation, yields have dropped off over the past few days. At the time of writing, the yield on the 10-year US Treasury Note is 3.55% and the yield on the 30-year Treasury Bond is 4.33%. Considering the pathetic economic environment and negative consumer price inflation in America, real yields are currently attractive and we expect them to decline further over the following months. Remember, at the end of last year, fear drove yields to multi-decade lows and another deflation scare later in the year could do the same again. At this juncture, we are very 'long' US government bonds.