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DOW + 34 on 200 net advances

NASDAQ COMP – 25 on 600 net declines

SHORT TERM TREND Bullish

INTERMEDIATE TERM Bullish

STOCKS: A rise in oil helped oil stocks and that pushed the Dow to another record high. The rest of the market wasn’t as strong. A weak high tech sector pulled down the NASDAQ.

We are encouraged by some of the comments we’re hearing from the financial talking heads. Many are saying the that market is getting ahead of itself. That’s not the kind of sentiment one tends to hear at significant tops.

GOLD: Gold jumped $17. There seems to be less worry about rate increases and more about global discord. A dropping dollar was also cited.

CHART The Trading Index (TRIN) was above 1.50 at the close (arrow). When it’s this high, the next couple of days tend to be higher. If you’re unfamiliar with TRIN, check the brochure in your introductory material.  

BOTTOM LINE:  (Trading)

Our intermediate term system is on a buy.

System 7 We are in cash. Stay there for now.

System 8 We are in cash. Stay there for now.

NEWS AND FUNDAMENTALS: Jobless claims were 244,000, in line with expectations. Oil inventories rose 600,000 barrels. Last week they rose 9.5 million. On Friday we get new home sales and consumer sentiment.

INTERESTING STUFF: Although the world is full of suffering, it is also full of the overcoming of it. ——— Helen Keller

TORONTO EXCHANGE: Toronto was down another 49.

BONDS: Bonds had a nice upward surge.

THE REST: The dollar down. Silver was up sharply. Crude oil had a nice bounce upon finding that OPEC members were largely keeping their promises to cut production.  

Bonds –Bullish as of Feb. 6.

U.S. dollar -Bullish as of Feb. 9.

Euro — Bullish as of December 2.

Gold —-Bullish as of Feb. 16.

Silver—- Bullish as of Jan. 31.

Crude oil —- Bearish as of Nov. 29.

Toronto Stock Exchange—- Bullish from January 22, 2016

We are on a long term buy signal for the markets of the U.S., Canada, Britain, Germany and France.   

Monetary conditions (+2 means the Fed is actively dropping rates; +1 means a bias toward easing. 0 means neutral, -1 means a bias toward tightening, -2 means actively raising rates). RSI (30 or below is oversold, 80 or above is overbought). McClellan Oscillator ( minus 100 is oversold. Plus 100 is overbought). Composite Gauge (5 or below is negative, 13 or above is positive). Composite Gauge five day m.a. (8.0 or below is overbought. 13.0 or above is oversold). CBOE Put Call Ratio ( .80 or below is a negative. 1.00 or above is a positive). Volatility Index, VIX (low teens bearish, high twenties bullish), VIX % single day change. + 5 or greater bullish. -5 or less, bearish. VIX % change 5 day m.a. +3.0 or above bullish, -3.0 or below, bearish. Advances minus declines three day m.a.( +500 is bearish. – 500 is bullish). Supply Demand 5 day m.a. (.45 or below is a positive. .80 or above is a negative). Trading Index (TRIN) 1.40 or above bullish. No level for bearish.

  No guarantees are made. Traders can and do lose money. The publisher may take positions in recommended securities.  

The dollar is possibly completing the right shoulder of a head and shoulders pattern. Overnight price completed a swing high suggesting a decent possibility the daily cycle has topped. Several scenarios for the dollar’s future price movement are discussed, as well as the implications for price performance of gold related investments:

….also: Stock Trading Alert: New Record Highs As Bull Run Continues – Can It Get Even Higher?

Geopolitical Futures’ forecast for 2017 says the following: “In hindsight, the coming year will be an inflection point in the long-term destabilization of Russia that we predict will reach a boiling point by 2040.” This may seem counterintuitive in light of the Russia hysteria following the US presidential election. Yet in the first six weeks of 2017, it is already possible to observe indicators that this forecast is on track.

These indicators fall roughly into four separate categories of instability: the distribution and prevalence of wage arrears, pressure on the Russian banking system, low-level social and economic unrest, and government purges. The map below summarizes these developments.

Click to enlarge.

Show Me the Money

The bottom part of the Russia map shows wage arrears as reported by region. “Wage arrears” is a fancy term for workers not being paid. In December 2016 (the last month for which Russia’s Federal State Statistics Service has data), total wage arrears amounted to 2.7 billion rubles (roughly $46.4 million in USD).

The regions with the largest wage arrears can be divided into two categories. The first is port regions. Primorsky region, whose capital Vladivostok is Russia’s largest port on the Pacific, has by far the worst incidence of wage arrears. It accounts for 21.2% of the country’s total. The area where it is the second most prevalent is Siberia (in places like Irkutsk and Novosibirsk).

The importance of these wage arrears is not their size in absolute figures. It is where Russian workers are not getting their paychecks. Russia’s economy is highly regionalized. More than a fifth of Russia’s wealth is generated in Moscow and its surrounding areas. The central government keeps the Russian Federation together by redistributing wealth to interior regions.

The first places to expect economic trouble are port and interior regions. The port regions will struggle because trade is the oxygen that port cities need to breathe, and Russia’s main export, oil, is facing prolonged low prices. The interior will struggle because the central government will have less money to allocate. This forces a lose-lose choice between austerity and cutting military spending

The wage arrears map is an indication that GPF’s model for Russia is accurate. If the model is accurate, the probability of the forecast coming to fruition greatly increases.

Russia’s Banking System

The decline in the price of oil has had a predictably negative effect on the Russian banking system. Incidents of Russian depositors applying for deposit insurance have increased markedly.

Some regions are suffering from banking crises. In Tatarstan, for example, the region’s leading bank suspended operations in December, depriving both individual depositors and businesses of access to funds. This led to workers not being paid and to bankruptcies. It also required intervention from the central government.

The above map identifies regions where over 100 banks have had their licenses revoked. By itself, this indicator does not present a clear picture. Russia’s banks could be under severe pressure. The fact that the main fund used by Russia’s Deposit Insurance Agency has decreased in value by 75% in two years gives this argument some weight. Russia could also be cleaning up its banking system and shutting down banks involved in illegal or irresponsible activity. In view of the other negative indicators about the current state of Russia’s economy, the former is a more likely explanation.

Protests in the Countryside

The logical consequence of economic difficulty is social unrest. The world is not always logical, but in this case, what logic would dictate appears to hold true. Small-scale protests have been observed throughout the Russian countryside. Small incidents have also occurred in major cities like Moscow and St. Petersburg. The map plots areas where protests have been observed.

It is important to note two things. First, none of these protests have indicated any sort of wider national organization. Second, they are relatively small (often in the low hundreds). They are important, but they should not be over-exaggerated. The Russian countryside is not singing the songs of angry men, nor is it close to doing so.

There are, though, concrete signs of dissatisfaction bubbling to the surface. These are tangible indicators of frustration with salary cuts, unpaid wages, and social services reduced by Moscow. These small events are the canary in the coal mine and spell trouble down the line for the Russian government.

Purges

The remaining two items on the map show political and security purges ordered by President Vladimir Putin. Russian media have described these moves as a “major political reshuffle.” That is a euphemism for what it really is.

The point of a purge is to get rid of potential challengers and install loyalists in their place. On Feb. 6–7, two governors from Perm and Buryatia regions were forced to resign. Vedomosti, a leading Russian-language business daily, reported that additional resignations and removals are expected in the regions identified in the map.

Unlike wage arrears, these purges are not confined to any one geographic area. Some are in Siberia to the east, some are in the regions toward the Caucasus, and others are in the immediate vicinity of Moscow. That Putin feels unsure enough of his own position to carry out these kinds of political changes reveals a great deal about the position in which he currently stands.

Presidential elections are coming for Russia. They will likely be held in 2018 (though there have been rumors they could happen in 2017). Like President Xi Jinping in China, who is using “anti-corruption” as a pretense to remove rivals ahead of his reappointment at this fall’s Communist Party Congress, Putin is securing his political position in the name of fighting corruption.

The purges are not limited to governors who have significant powers in the Russian Federation’s political system. Putin has also removed generals from the Interior Ministry as well as the Ministry of Civil Defense, Emergencies and Elimination of Consequences of National Disasters. These ministries are responsible for forces that are used to control domestic social order and quell protests. Ensuring the loyalty of such ministries is essential and must be done before serious problems emerge. A total of 16 generals have been removed, according to RIA Novosti, and two of those were also removed from military service.

Writing on the Wall?

This report is not meant to be alarmist. It is not GPF’s forecast that the Russian Federation is in danger of imminent collapse. None of these data points by themselves indicate that GPF’s forecast has been confirmed. They simply highlight Russia’s underlying weakness and explain why Putin, who just a few months ago was strutting on the world stage, has gone somewhat quiet. Important things need to be done at home. This is where Moscow’s focus is right now, and in choosing that focus, GPF and Russia have something in common.

George Friedman
Editor, This Week in Geopolitics

China has called all Bitcoin exchanges to a closed door meeting looking to shut down the flight of capital from China. China is looking to deal with the expected trade confrontation with Trump and looking to shut down the flow of capital that has been putting a downward pressure on their currency. We can see that the US dollar has risen for 35 months and this will be seen as a currency war by Trump for his advisers from Goldman Sachs are clueless assuming markets can simply be bullied or manipulated with power.

Our sources are also hinting China may tighten the quotas on importing gold even more since their actions last November (see FT). China is trying to curb the flight of capital which has contributed to the greenback’s rise for 35 months. However, with Europe tottering on the edge, the next country to withdraw from the EU may set off a collapse of the euro and that will only cause a surge higher yet in the dollar impacting China negatively with regard to trade disputes.

If the road to hell is paved with good intentions, American’s exorbitant privilege might be at risk with broad implications for the U.S. dollar and investors’ portfolios. Let me explain.

The U.S. was the anchor of the Bretton Woods agreement that collapsed when former President Nixon ended the dollar’s convertibility into gold in 1971. Yet even when off the remnants of the gold standard, the U.S. has continued to be the currency in which many countries hold their foreign reserves. Why is that, what are the benefits and what are the implications if this were under threat?

Let me say at the outset that the explanation I most frequently hear as to why the U.S. dollar is the world’s reserve currency – “it is because of tradition” – which is in my opinion not a convincing argument. Tradition only gets you so far – it ought to be policies and their implementation that guide investors. 

Wikipedia’s definition of exorbitant privilege includes: 

“The term exorbitant privilege refers to the alleged benefit the United States has due to its own currency (i.e., the US dollar) being the international reserve currency.[..]

Academically, the exorbitant privilege literature analyzes [..] the income puzzle [which] consists of the fact that despite a deeply negative net international investment position [NIIP], the U.S. income balance is positive, i.e. despite having much more liabilities than assets, earned income is higher than interest expenses.”

In the context of today’s discussion, I would like to focus on what I believe may be the most under-appreciated yet possibly most important aspect of the so-called exorbitant privilege: what makes the U.S. so unique is that it is de facto acting as the world’s bank. A bank takes on (short-term) deposits and lends long-term, capturing the interest rate differential. 

Applied to the U.S. as a country, investors borrow cheaply in the U.S., and seek higher returns by investing in the rest of the world. In the investment world, we also refer to this as carry, i.e. one might say the U.S. engages in an amazing carry trade. As long as this ‘carry trade’ works, it is quite a charm. That said, there are those who are concerned that the party cannot last forever. To quote from our own past writings, the former head of the European Central bank Wim Duisenberg said in 2003: ‘We hope and pray the global adjustment process will be slow and gradual.” — In fact, a reference to a “disorderly adjustment of global imbalances” was a risk cited by the ECB every month in its statement until about the time current head, Draghi, took over. This “adjustment process” is a thinly veiled reference to a potential dollar crash.’

So is there reason to believe the U.S. may no longer be serving as the world’s bank? At first blush, the answer would be no, as the U.S. has deep and mature financial markets. However, there are developments of concern:

• The first has already happened. Due to a regulatory change, our analysis suggests it is less attractive to issue debt in U.S. dollars for anyone other than the U.S. government. The regulatory change might look arcane at first, but in our Merk Insight “The End of Dollar Dominance?”, we argued that a quirk in money market fund rules that could be interpreted as an implicit subsidy for issuers of debt has gone away. It’s more than a quirk because funding cost for just about everyone other than the U.S. government has gone up, as evidenced by elevated intra-bank borrowing rates (LIBOR rates) independent of the rise in Federal Funds rate. If our analysis is correct, it means that the U.S. dollar is a less attractive currency to raise money in than it had been. These days, issuers might as well issue debt in euros, a trend exacerbated by the extraordinarily low interest rates in the Eurozone.

  Let me provide the link to U.S. Treasuries as reserve holdings: take an emerging market corporate issuer raising money in U.S. dollars because of what used to be a funding advantage: upon issuing debt (raising cash), they might sell dollars to buy the emerging market currency to fund their operations. In the meantime, their government buys U.S. dollars and subsequently U.S. Treasuries to sterilize the corporate issuer’s sale of the dollar. Due to regulatory changes in U.S. money market, it may now be no longer advantageous to issue debt in U.S. dollars, eliminating the downstream effects, including the holding of Treasuries as a reserve asset.

• A second change is under consideration: the House GOP tax proposal would eliminate the deductibility of net interest expense. If passed, it could have profound implications on how issuers around the globe get their funding, as we shall explain below.

If corporate America can no longer deduct net interest expense, we believe it will make the use of debt less attractive. It would discourage the use of leverage. Banks use a lot of leverage. And, as we are pointing out, one can look at the U.S. as a whole as if it were a bank. A system with less leverage may well be more stable; however, a system that uses less leverage may also have less growth. 

From the point of view of America’s exorbitant privilege, the key question in our view is how the world reacts. A plausible scenario to us is that American CFOs will move leverage to overseas entities where interest continues to be deductible. Similarly, to the extent that foreign issuers in the U.S. used U.S. legal entities to raise money, they would likely raise funds through foreign entities where interest expense would still be deductible. The question then becomes whether the money raised from these (newly minted) foreign entities would be in U.S. dollar or in foreign currency. If they raise money in foreign currency, the U.S. dollar would be cut out as the “middleman,” jeopardizing American exorbitant privilege.

If you take a U.S. firm, if they decide to use foreign subsidiaries to issue debt, they might want to also report more revenue overseas to make it worthwhile to deduct more. CFOs are highly paid, in part we believe, because of their ability to engineer where to recognize revenue and expenses. We would expect CFOs to rationally optimize shareholder value in the context of the regulatory and tax framework they are presented with. Once you take the step of recognizing more revenue abroad, it would only be prudent to match the liability, i.e. the interest expense, in the same currency. 

But won’t the U.S. be a more attractive place to invest if the entire GOP tax plan gets passed? What about if the U.S. changes to a territorial tax system? What about the border adjustment tax (or a variant thereof)? 

• If the U.S. were to move to a territorial tax system, i.e. no longer tax corporations on their global income, it may provide a further disincentive to issue U.S. debt. In the current tax system, corporations issue U.S. debt to fund domestic operations while avoiding the repatriation of foreign earnings.

• The concept of a border adjustment tax still needs to take shape before we can have a more definitive opinion about it. From what we see, it appears to foremost provide a one time shock to the system (possibly causing a one time inflationary impact as the cost of higher imports gets passed on to consumers); that said, corporate America might come up with a variety of tricks to mitigate the impact of such a tax (e.g. exporting fuel to their plant in Mexico, thus being able to deduct the cost of energy from imported goods).

• Not much discussed, but a potential U.S. dollar positive would be if indeed investments could be fully expensed the first years rather than a requirement to amortize expenses over many years, as in the current tax code. That is, if the U.S. incentivized investments over spending. We’ll discuss this in more detail once we have more clarity on the actual tax reform.

There’s still one more component: a U.S. government that needs to issue a lot of debt to fund its budget deficits. To the extent that foreign governments have less of a need to hold U.S. dollar reserves, funding costs for the U.S. government might rise. While some may believe higher borrowing costs might be a positive for the dollar, the opposite may be true if the Federal Reserve has to keep rates artificially low to prop up an economy that would otherwise deflate; or because government deficits would otherwise be unsustainable. The point being here that the U.S. dollar might become more vulnerable should fiscal and monetary policy not be sound… 

In summary, providing a disincentive for debt might make the world more stable, but lead to lower growth. It might encourage more issuance of debt in local currency, something that might also be healthy for global stability, but might leave the U.S. and the greenback behind. 

To expand on the discussion, please register for our upcoming Webinar entitled ‘Trump or Dump Gold?’ on Thursday, February 16, to continue the discussion. Also make sure you subscribe to our free Merk Insights, if you haven’t already done so, and follow me at twitter.com/AxelMerk. If you believe this analysis might be of value to your friends, please share it with them. 

Axel Merk 
Merk Investments, Manager of the Merk Funds