There’s been a strange consequence in the drop in the price of oil that not many people are talking about – increased oil production. Oil production is continuing to rise even as the price falls which on the surface doesn’t make any sense, so it’s a good thing we brought our superman rated x-ray goggles!

It’s bad enough that US shale companies’ margins have been destroyed by the fall in the price of oil but when you throw in the fact that these are the most heavily indebted companies in the US you start to see the big picture. They need good cash flow to sustain their operations and keep their credit rating high enough to obtain loans in the future to pay off existing debt. So they make up a loss in revenues from the drop in oil price through increased production. They can do this because although the cost of drilling a new well is high the cost of extracting oil from existing wells is still well below the WTI price of $45. Maybe the overall cost per barrel is above the current price but that doesn’t matter because these companies are trying to outlast their competitors.

Source: Zerohedge

Unfortunately, their competitors are not just limited to other shale companies but entire countries. And these countries aren’t in much better shape than the shale oil companies. They too depend on oil revenues to sustain their way of life. So they too will produce more as the price declines.

Source: Zerohedge

What this leads to is a downward spiral in the price of oil. As the price falls, countries and companies desperate for cash are forced to produce more and more in order to stay alive. So oil hasn’t bottomed out yet and it won’t until we see a massive reduction in supply due to bankruptcies in the capital intensive portion of the energy sector.

I am and remain heavily short US energy companies. I’ve been increasing my short position in XLE since the start of the year and will continue to do so. I haven’t been this bearish on a sector since Russian equities in October… and we all know how that turned out.

2014 was a big year. It was the year where we saw long term trends slowly start to reverse. The US dollar strengthened. Oil crashed. Volatility rose. The Fed tightened…And Gold bottomed out.

Ever since gold peaked in 2012 gold miners have been getting the short end of a very long stick. US equities soared while gold miners fell into oblivion reaching lows not seen since the 2008 financial crisis. If you bought back then at record lows you would have made a killing. I think the same opportunity has now presented itself.

The global economy is very fragile and is hurtling towards another crisis as oil plummets and volatility and uncertainty rise. Gold like bonds will see appreciation as people seek safe assets. And only one of those is the true safe haven. I’ll let you guess which one.

As I’m writing this article, gold has rebounded to $1239 while oil is sitting at $45. So even if you don’t believe another global crisis is around the corner, just look at the numbers. Gold miners cost of business has fallen meanwhile the thing they sell, gold, has increased in value. I stated this fact a while back while oil was around $70 in October but it needs to be said again. Gold miners will be THE equities to hold for the coming few years.

The Fed talks and the US market rallies. Yesterday marked the third time in as many months when the Fed was able to completely turn the market around. It doesn’t seem to matter what they say, as long as they say something.

The Fed’s newest piece of propaganda and subterfuge is one giant hand to pat the market on the back while it fashions a long jagged knife made of unicorn bone carved by the Hatari Honzo himself and tipped with the alien blood from alien. Yes the Fed is going to stab the market in the back but hey don’t worry about the price of oil. It’s temporary they say. Don’t worry about sub 2% inflation, it’s temporary too. Don’t worry about the US economy, it’s doing fine. We can be patient. We’ll stab the market very gently.

Yeah… but you are still stabbing the market with a alien blood tipped unicorn blade! It can’t handle that and I’m not alone in my thoughts. Just hours after the Fed released the minutes, Chicago Fed President spoke up and said “raising rates at the wrong time would be a catastrophe”. And that’s precisely what the Fed seems prepared to do. They want to get the first rate hike out of the way as soon as possible. That way, with a firm foothold and a calm market they can try and slowly normalize policy. But I have my doubts. Keep your eyes spotted for any flying pigs.

Will the S&P end 2015 at 2015? Or perhaps 2243? Will the Fed raise interest rates? Well why not? If not now when? Is Greece going to leave the EU? What does that mean for QE in Europe? And of course, OMG what the fuck’s going to happen to oil!? In the coming forecast, I am going to predict the answers to all of these important questions and more.

Happy New Year everyone! 2014 is in the rear view, the US growth story is taking off like Cinderella at midnight! Can I get a high five for that 5%GDP growth?! Now that’s what I’m talking about. The Fed has been on point with their tightening like it’s no one’s business. They stopped QE right at the exact point the US hit its stride. Their track record is so bad that this seems almost too good to be true…

Because it is. The Fed has failed to take something into account. It’s just a small thing known as the rest of the fucking global economy. I don’t know what they are smoking at the Fed but please don’t give it to me.

Now I am all for the Fed raising interest rates. I get it. Raise interest rates and cause a temporary surge of capital into the US as emerging markets shrivel up like a sponge in the desert. The global economy collapses but the US doesn’t crash first so you escape the blame. It’s beautiful and brilliant. The US will be the last man standing and when the US does have a crisis we can blame it on Greece, China, Japan, Germany whoever, because they will crash first. Of course, that’s the screenwriter inside me creating a villain out of a group of unelected bureaucrats who decide the fate of the “free” world.

Before I go on with my predictions let me make this clear, If the Fed raises interest rates, the dollar will strengthen too much and that alone will be sufficient to collapse the global economy.

If the Fed tightens, the dollar will strengthen. Emerging markets will do very poorly as capital flows from their countries into the US. Emerging markets will shrivel up like a sponge under the desert sun and the US will enjoy a temporary flood of capital. This will help suppress the yields on long term US treasuries. Thus as the Fed raises short term interest rates, long term interest rates will continue to fall. The effect of this will be ceiling on interest rate hikes by the Federal reserve. I don’t expect the Fed to raise its rate above 1% before something goes horribly wrong in the global economy however, if my doom and gloom is just that, then I expect long term treasuries to put a cap on rate hikes at about 2%. Just looking back at the Fed 2004-2006 rate hike cycle, the yield on the 30 year treasury didn’t rise and I expect that to happen again. The only difference now is the 30 year is at 2.65% instead of 4.5% back in 2004.

My main fear for a long position in long term US treasuries at this point is for the Fed to do QE4. But even if the Fed does embark on QE4, at that point in time, fears of inflation could be so far removed that investors will merely front run the Fed and buy more bonds.

If the Fed decides to loosen, and prints more money resulting in QE4, the dollar will weaken and equity prices will rise. That much is obvious at this point. A falling dollar might force some people out of the treasuries and into other currencies. However, we must consider why the Fed would do QE4 in the first place. The most likely event that will force the Fed’s hand is falling stock prices. We are likely to see a correction of greater than 10% in the US stock market in the first half of the year. The question on most people’s minds is if in response the Fed will launch QE4. The Fed would be in a horrible position if it wanted to raise rates given such a strong correction in the market. Perhaps the best thing for it to do is try and talk up asset prices as much as possible while simultaneously raising rates. But this just shows how the tightrope the Fed has been walking for the past 6 years is rapidly shrinking.

Now I don’t want to fall to the same logic as the Fed, so let’s take a look at the rest of the world and see if we can’t predict the answers to some of their questions. Although this article is getting a bit long in the tooth and I will skip the explanations and give you my predictions… for now!

First up Europe. Europe will continue to struggle. Could 2015 be the year where the periphery finally collapses under the weight of its debt and bureaucracy?

Greece will most likely exit the EU this year. This could pave the way for QE in Europe. If there is QE in Europe, it will not be substantial or have a meaningful effect. I still don’t find this a likely option as Germany repeatedly has come out against QE, but with inflation falling to 2009 levels it may just finally happen.

On to oil. As the price falls, it forces producers to pump as much as they can to make a return. Even for expensive shale oil projects, once the well is dug in the ground, the cost of extraction is $20 per barrel. So the price can still drop as these companies and countries produce to prevent even larger losses. Where does oil bottom out? Low 40’s is my best bullshit guess.

The fall in commodity prices has been overshadowed by oil’s plunge. Of course we know the source of the fall in commodity prices is due to the slowdown in growth from China. China’s slow down will continue to hurt its major trading partners such as the BRICS and Australia and New Zealand. Bond yields in both Australia and New Zealand will continue to fall. A rate cut from the RBA is likely and thus buying short term Australian bonds could be quite profitable.

Russia. I almost left you out of this. I’ve made my views clear several times on Russia’s situation in Ukraine. I don’t think 2015 is the year Putin backs down. He’s been significantly hindered by sanctions and cheap oil and the Russian economy will be in full blown recession next year. There could be a significant buying opportunity by the end of the year given the recent rate hikes and currency depreciation, but I feel a turn around isn’t likely due to an imminent global depression on the horizon, which will almost certainly come before the US crowns a new king.

One last thing, headed into 2015, I remain bearish on US equities. Only a major correction and promise of more QE from the Fed will change my mind at this point. Cheap energy doesn’t help the US as much as it hurts it. The economy isn’t nimble enough to handle such a transfer of wealth from energy producers to energy consumers. Is 2015 finally the year where the Fed who has played a major part in the markets finally discovers how little control over the markets it really has? With the recent drop in oil price, the strengthening of the dollar and the flight to safety the answer seems to be yes.

Desperation. It’s an important subject that I don’t think is discussed nearly enough on political and economic blogs/websites and that’s what I try and do here. I could talk about how screwed Japan is over and over again or how corrupt virtually every government is but I don’t. I leave that to the professionals. I like to talk about less obvious and more obscure topics because hey I’m a contrarian. The herd moves right and I go left.

Back to Desperation. People do dumb things when they are desperate. Really dumb things. 1920’s Germany’s hyperinflation debacle eventually led to the election of the Nazi party and Hitler.

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Japan is in a similar situation with their current leader, Shinzo Abe. I know I said I wouldn’t talk about Japan but they make a great contemporary example of how people do dumb things when they are desperate. Shinzo Abe was elected because he promised his people the moon but now reality is setting in and he didn’t get the moon. He couldn’t even get them a small little comet and even the European Space Agency could do that! Perhaps they should run for office.

Shinzo Abe’s three arrows have become a bit of a laughing stock. One of his arrows won’t even fire anymore so he’s forced to spam fire his QE arrow. He’s failed to deliver on his promises and so will every other leader who makes big promises in these very dark times. He’s recently called for a snap election, because clearly it’s parliament’s fault and not his failed policies for the mess they are in. I’m picking on Abe because he’s an easy target. I could just have easily made a case for the current president of the United States of America, Barack Obama.

The point is that it has become exceedingly obvious that politicians no longer have to be good at their job to get elected. They can skate by on big promises, grand statements, and “not doing stupid shit”. Of course these are terrible qualities to have in any human being let alone an elected official, and yet we continue to elect these people and as things get worse we will continue to elect the next moron to come up with some “grand scheme” to save us all from certain destruction but the inconvenient truth is NO ONE can save the current system. As the policies of the next politician fail people will become more desperate which in turn will force them to elect the next idiot who promises them the moon thus creating a downward spiral until the system collapses.

A few days ago it was announced that Japan had indeed fallen back into a recession. This of course came just two weeks after Abe decided to crank QE up to 11 million. The writing has been on the wall for a WHILE now. But apparently economists don’t ever look at the wall.

http://www.bloomberg.com/news/2014-11-16/japan-s-economy-unexpectedly-contracts-as-abe-weighs-tax-delay.html

How is this unexpected? They increased the sales tax by 60%! Japan’s government debt to GDP is over 200%. Government debt to revenues is over 800%. Their adult diaper industry is larger than their baby diaper industry. With an aging and xenophobic population, enormous debt levels, and a poorly run central government this should not be a surprise. It should actually be the most obvious thing in history. The only thing more obvious would be if you traveled back in time to the day before the 1929 crash and called the market top, but even then you may have entered an alternate universe where the 1929 crash actually happens in 1930.  The point is, Japan’s situation is dire and above all, obvious. So obvious that I mostly gloss over Japan because there’s not much to say at this point, except keep your eyes peeled on the USDJPY which hit 118 today.

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QE in America is a lot simpler than it is in Europe. In the US, the centralized authority, the Federal Government has a much cleaner connection with its Central Bank as well as stronger authority over its domain than the EU has over its member states. Each EU member has its own debt which is not equivalent to another member’s debt.

Unlike the Federal Reserve which could step in and buy US treasuries, the ECB can’t go and buy EU bonds. It has to go and buy bonds from individual members. So a question arises in which members’ bonds should the ECB buy and how much per member should it buy?

To make matters worse, the Germans who stand in the way of QE in the EU have put their foot down. They don’t want it. They don’t want it so much that they are going to balance the budget for the first time in 45 YEARS! Yup, it’s been over four decades since these guys have balanced a budget and somehow they are considered the most fiscally conservative EU member… I know right.

The point is. Germany is serious. They want the other members to somehow magically get their shit together, which let’s face it, won’t happen without serious structural changes and of course that won’t happen without a serious collapse.

In short, QE ain’t coming to the EU any time soon. Look for things to get even worse in Europe. And if you don’t believe me, perhaps a quote The Ben Bernanke will change your mind. When asked if the ECB was going to do Quantitative Easing Ben responded:

“The barriers to doing it are not really economic. The legal and political barriers being thrown up are going to make it very difficult to do that.”

Remember a few months ago when I told you to get the Hell out of US equities?  It was only three months ago I shouted from  an unknown blog that there was absolutely no reason to have any investments in US equities or how about just two weeks ago where I sounded the rising volatility alarm?

Well US stocks are down a few percent and the VIX is at levels not seen in over 2 years! And this is just a taste of what’s to come.

These past few years the world has enjoyed unprecedented tranquility across all financial markets. Bonds and stocks steadily climbed in the period of Pax Central Banker but now that seems to be over as the Fed is tapering and the invisible hand that holds up the market goes with it.

When a system is supported artificially for too long, the natural supports of the system weaken. Theey can weaken to the point that when the artificial support is removed the natural support won’t be able to handle the increased strain in its weakened state. This is of course the world we live in. And now that the artificial support is being removed people are starting to get nervous and we can see that in the dramatic rise in volatility across a variety of asset classes.

One of those being commodities, and to be more specific let’s take a look at oil. The price of which has fallen from over $115 a barrel to under $85 in a short few months. The initial decline was partly due to a stronger dollar, which was also reflected in the falling price of gold. However, we have seen both the strengthening dollar and the falling price of gold reverse. The EUR/USD got as low as 1.25 and is now back to above 1.27. USD/JPY was above 110 and is now back to 106. The dollar has retreated and as for gold, which hit 1180 has since risen back to 1240 an ounce. The dollar has weakened, yet the price of oil continues to decline, unlike the price of gold which is rising.

Interestingly, while this trend has been going on, gold miners have sold off like hot cakes, which to me doesn’t make sense when the thing they sell increases in value and the cost of producing it goes down. Many of which are selling at fraction of their price to book value.

I expect the price of gold to stay around the 1200 level as volatility remains high and the price of oil to remain low as global demand slows.

Now could this all be temporary? Could the price of oil stabilize back over 90?

I don’t think so. The Saudi’s seem pretty set on selling oil at lower prices to hurt its competition in Russia, Iran and here in the US. Shale oil producers have been hit the hardest as their break even point on shale oil is about $80 which is where WTI is floating around today. Which is interesting, because these companies have a shit ton of debt, and no cash flow. So one has to wonder how long these companies can hold out with oil prices so low.

A counter argument is that global growth is slowing and oil demand is going down with it. So even if the US loses some shale production, it won’t make up for the global loss in demand. Which is what I think will be the case at least in the short term. What happens after the largest financial crash in the history of the known universe remains to be seen.

And if you don’t believe that growth is slowing just look at US treasuries. The 30 year just hit 2.85%. With that in mind, I don’t have high hopes for growth any time soon and will look at which gold miners I can pick up on the cheap.

“I can put my record against any leader around the world in terms of digging
ourselves out of a terrible, almost unprecedented financial crisis”
~ President Barack Obama

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God Bless that ignorance! He must sleep like a baby at night. He’s not even half way through the magic act and he’s acting like he just finished the prestige. I mean the printing presses aren’t even cold yet and he’s prancing around like he’s pulled a debt free college educated millennial from his hat.

All this celebration for what? $4 Trillion dollars printed. Over $8 Trillion added to the public debt. And what do we have to show? Minimal  growth? Labor Force participation at multi decade lows? Where’s the fracking escape velocity we were promised?!

Look I didn’t believe we’d ever get this mysterious escape velocity. Though to be fair I don’t believe in the Easter Bunny, Santa Claus or the Keynesian Economics either.

The point is, our economy and financial system is no better than it was six years ago. When Bill Gross’ took an escape pod over to Janus Capital, he showed that in regards to stability we are worse off. PIMCO was forced to dump a large portion of bonds onto the open market. Unfortunately for them, they found the market to be less liquid than they would have liked.

I mentioned this in a previous post but it’s worth mentioning again, the corporate debt markets are a lot less liquid than they used to be. And when you get a big sell off into an illiquid market you can get big swings in volatility.

This means that volatility although low for now, is not likely to remain low for long. Once again, I’d like to reiterate how big a fan I am of long term out of the money VIX calls. If you see the VIX holding steady in the 12 and lower range, you should look to pick up the longest term available contracts and just hold. With rough seas of volatility ahead, it is a very safe play right now.

Remember the last time the Fed stopped printing money the VIX spiked to over 40, and the bond markets were more liquid then. If that happens now, who knows what will happen. So enjoy the low volatility while it lasts.

The dollar is getting stronger. This should be expected.

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This is what happens when you stop beating your currency like a runaway slave. To be fair the dollar is the Fed’s slave. After all we gave it to them for safe keeping back in 1913. There’s irony here somewhere.

Alright! Enough slavery references. I think I just lost the black vote forever. And that’s bad for the world economy because you elect people like Barack Obama to run your blog posts and it all goes down hill from there.

What is just as bad for the world economy is a strong dollar. Compared to other major economies the US economy is supposedly the cleanest of the dirty shirts. It’s still dirty but she gets the job done. You can still wear her to interviews without being thrown out.  One of the things that has made her passable is a cheap currency. That cheap currency is now rising as the Fed prepares to shut off its printing presses for good (for now?).

Let me tell a little story.

The dollar goes up, commodity prices fall, capital leaves emerging markets,  emerging markets contract, emerging markets buy less US products, the US slows, stocks fall, asset bubbles bursts, and the world enters the 2nd “great” depression.

Of course that scenario doesn’t have to happen but the Fed needs to act quickly and it needs to do more QE, a lot more.

Now I don’t know if the Fed will do more QE until the after the next crisis starts, and it doesn’t matter. Everything is screaming slower growth. Slower growth means yields will continue to fall. Combine that with a strengthening dollar, long term US treasuries look very good.

I’m not holding to maturity. This is also bubble waiting to burst but in my mind it will be the last one to do so and thus will see capital flows into US treasuries as the rest of the bubbles around the world burst. So when the next crisis strikes and treasuries appreciate, then I will sell. Until then I will collect a measly dividend and wait for the inevitable.

If you want to hold US equities and pray the Fed steps in when the shit hits the fan be my guess. Personally, the only US companies I hold are ones that thirty years from now could have a giant robot army and the only thing saving me from pure annihilation is the title of “shareholder”. I’m looking at you GOOG!