The Dollar Value of Perceptions

A very interesting development is occurring in the market, and although signs of it first appeared some time ago, they revealed themselves with even sharper clarity this last Friday.  This is a development that we have alluded to several times in this space and that we have come to feel even more strongly about it with as it has come into maturity.

Last Friday, we witnessed the power and the speed with which the U.S. dollar can rise when economic conditions turn favorable.  In this case, a jobs report released by Washington revealed two important trends: a slow down in the number of jobless claims filed (we’re still losing jobs, but at a slower rate) and an improvement in the headline unemployment number.  Pictorially, it looks like this:

A mere 11,000 souls filed for first-time jobless claims, and the trend appears to have flattened.  The report also showed the unemployment rate declining to 10% (not on the chart).  Most were expecting no improvement from the previous month’s level of 10.2% – a 26-year high.

For those of us who read statistics for a living, there’s no reason to suspect the next few months won’t bring both positive job numbers and an increase in consumer confidence.

What’s important to note here is that neither of these numbers was expected. Furthermore, regardless of any future revisions or adjustments that are made to the figures, the impression they formed created and continues to create a great deal of anxiety among investors as regards the short and intermediate term price trends in commodities.  We will, however, return to that in just a moment.

For dollar bulls, both the news and the subsequent reaction were extraordinarily heartening.  Here is a picture of the U.S. Dollar action over the last six months:

It’s crystal clear that last week’s spike in the dollar constitutes the beginning of a break in the dollar’s slide, the start of a renewed confidence in a restored American economy, and the opening shots in the coming battle to renew the dollar’s role as the currency of choice for global investors and speculators.

What’s it mean for gold?

Sorry to say, but it appears that gold is going to take it on the chin here (along with commodities in general).  Not tomorrow or the day after, but over the course of the next six to eight weeks, as the dollar firms, we expect to be watching a very swift retreat on the part of the gold buggerers.  It will be a process, mind you, so the turn is going to be tricky, coming in fits and starts. This will convince everyone to stay dollar-short and gold-long, even though that is a sure recipe for financial suicide.

Equally certain is the fact that there will be money to be made in some very sharp jags in the currency/gold sphere in the coming months.  We personally prefer to stay wide of those sort of trades, but for those with the cohones and the pocketbook to back it, now is the time.

Practical advice to Residual Income Report subscribers: sell your gold holdings into strength in the coming weeks.  You may even get out at new highs.  Just don’t let those new highs convince you that any up-move in the precious metals is sustainable.  It patently ain’t.

And now, to take on the entire financial establishment…

It’s become clear to us over the last few months that the core of all current market uncertainty is the fate of the dollar.  Will it continue to slide?  Will it reverse?  Will the reverse last? Will it be fleeting?  All of these questions are obvious enough to have been asked by many.  Just how far-reaching the uncertainty regarding the dollar has reached, however, there is a question that has not been adequately addressed.

We at the R.I.R. can see it now coming into razor focus: a rejuvenated dollar (upon whose doorstep we now stand) will return us to a point analogous to the investment environment of the early 1990’s.  That is, to a point when bull markets existed in both American stocks and bonds.

Most will call me mad for such a prediction, but no matter.  There are a number of reasons to believe my prognostications correct.

First, inflation is not the threat most believe it to be, and deflation is unlikely in comparison.  The best bet is that that we will experience mild controlled real inflation as the world climbs out of recession – accompanied by very slowly rising rates at the short end and steady to very slowly falling rates at the long end.  The whole thing should lead to an eventual flattening of the yield curve by late 2010 – early 2011, by which time the environment will need to be reassessed.

Here’s a picture of the thirty-year treasury yield for the last year:

Rates at the long end have been range bound for six months and should continue to rattle about the 4.00% level for some time before moving lower.

Dollar Demand Driven Bull

A bull market will come into being in both debt and equity markets precisely because renewed confidence in the dollar will lead global investors to seek dollar denominated assets in which to invest. It won’t be enough to hold U.S. dollars.  Everyone from sovereign wealth funds to pension, insurance and mutual funds from around the world will be on a tear to buy American assets when dollar uncertainty evaporates. It’s just that simple.

To repeat: this will all come about because the dollar, deeply oversold at the moment, will correct and reverse its trend because the perception is growing globally that the American Economic Engine is healthy, and that its currency is no longer in danger.

For that reason, friends, it behooves us to take advantage of a credit market that’s currently offering a great opportunity.

Closed End Fund With A Fat Distribution

We were first tipped off to the Pimco Income Opportunity Fund (NYSE:PKO) when we saw its fund manager, Dan Ivascyn, buy up over $1.5 million of the fund’s shares in a 30 day span in the early fall.  After closer examination it became clear that Ivascyn, under the guiding hand of bond guru Bill Gross, was up to something good.

PKO pays just under 10% annually in monthly distributions and holds American corporate and sovereign debt issues with an average credit quality of BB.  Here’s trading in PKO for the last year:

We would be happy buyers of PKO stock between $20.50 and $22.00 and would look to add to the position on a break above resistance at $22.

Because a perfect investing season is dawning.

The Residual Income Report recommends immediate purchase of the Pimco Income Opportunity Fund (NYSE:PKO) with a stop loss at $20.50.

Matt McAbby
Analyst, Residual Income Report